We have noticed in working with clients that people often relate to accounting the same way they relate to their checkbook. In this framework, money going out is an expense and money coming in is income. Accounting should be this simple, right?
Problems with the Checkbook Framework of Accounting
However, within this checkbook framework of accounting, it becomes confusing to code transactions such as:
- The payment of a security deposit for an event venue
- The return of the security deposit
- A credit card charge at the time the charge is made
- A cash withdrawal to create a petty cash fund for a special event
- A transfer from PayPal to the checking account
These transactions don’t “feel” like income or expense. Yet, for lack of a different way to understand them, they are coded to an income or expense account and therefore affect the profit and loss report. Or in the case of the credit card charge they are not recorded at all — recording only happens when the card is paid which might be a month or two later than the original charge.
Introducing the Three Bucket Framework
While the basic accounting framework is not terribly complex, it has a lot more going on than just income and expenses. Think of the accounting framework as having three buckets: Assets, Liabilities and Net Assets. Income and expenses are part of the Net Assets bucket. Each bucket contains accounts for transactions affecting that bucket as listed below.
The Assets Bucket
The Assets bucket includes things you own, both tangible and intangible, such as
- Pledges receivable from donors (promises to make gifts in the future)
- Expenses you’ve paid in advance, such as insurance premiums
- Money owed to the organization, such as an employee advance
- Physical assets like a building, computer equipment or vehicles
The Liabilities Bucket
The Liabilities bucket includes amounts you owe such as
- Payments due to vendors for services provided (accounts payable)
- Credit card charges for supplies
- Payroll earned by employees but not yet paid
The Net Assets Bucket
The Net Assets bucket holds all the income and expenses of the organization. The Net Assets bucket is simply the difference between Assets and Liabilities. It is calculated as Assets minus Liabilities equals Net Assets. (The for-profit equivalent term for net assets is equity.) Net assets increase when the organization receives income and decrease when the organization incurs expense. The total of the Assets bucket always equals the total of the Liabilities bucket plus the total of the Net Assets bucket. Hence you have the basic accounting equation: Assets = Liabilities + Net Assets.
If you use a checkbook framework to understand accounting, you are only working out the Net Assets bucket. There are two other whole buckets you can use! The three bucket framework beats the checkbook framework any day of the week.
Examples Using the Three Bucket Framework
Take the first example above – paying a security deposit for an event venue. A security deposit is not an expense because you will get that money back after the event (assuming no damage!). To record the payment of the security deposit, think in terms of which buckets are affected, then which accounts within each bucket. In this example, the Assets bucket is impacted because a check will be written to the venue for the amount of the deposit, reducing cash and impacting the bank cash account in your accounting system. (Usually the bank cash account in your accounting software is named for the specific bank, such as Wells Fargo Checking.) The other account affected is another Asset account called Security Deposits. This transaction simply increases one asset account, Security Deposits, and decreases another asset account, Cash. The three buckets of Assets = Liabilities + Net Assets remain in balance.
How about the credit card charge for supplies? No cash is impacted at the time of the charge, but you have obligated the organization to pay money in the future. Which buckets are affected? The purchase increased credit card debt so the Liabilities bucket is affected, specifically the Credit Card Liability account. (Usually this account is named for the credit card, such as Amex.) What other account is affected? You incurred an expense for supplies. Therefore a Supplies Expense account would also be impacted, which is part of the Net Assets bucket. In this example the Liabilities bucket increased and the Net Assets bucket decreased by the amount of the charge. Hence the three buckets of Assets = Liabilities + Net Assets continue to remain in balance.
Remember to use all the buckets at your disposal when trying to make sense of accounting. There are only three of them and they always maintain the same relationship to each other:
Assets = Liabilities + Net Assets
We’ll continue to help you get more familiar with the accounts inside of each of these three buckets. For now we hope we’ve given you the big picture. By using the Three Bucket Framework, you will be able to make sense of the financial story behind any transaction!