Old Loans and "Retained Earnings"

[David Overton]

On Sun, Oct 14, 2001 at 10:05:47PM -0400, Roland Roberts wrote:
> >>>>> "David" == David Overton <doverton@bigpond.net.au> writes:
> 
>     David> On Thu, Oct 11, 2001 at 12:09:52AM -0400, Roland Roberts wrote:
> 
>     >> I'm converting from Quicken to GnuCash 1.4.  I have some old loans
>     >> where, in Quicken, they simply had an "initial balance" shown.
>     >> Quicken sets this up as going to a "Retained Earnings" asset account.
>     [...]
> 
>     David> The retained earnings account should have type "Equity"
>     David> rather than "Asset".
> 
> You're correct and my lack of knowledge about accounting is showing.
> GnuCash did, in fact, create an equity account, not an asset account.
> 
> But, as I commented in a follow-up to my message, I still don't really
> understand this.  The old loans are correctly shown as debits in the
> equity account, but the balance shown on the main accounts list is
> positive.  Uhm, are "equity" accounts the opposite of "asset"
> accounts?

(Disclaimer: IANAA)

Kind of.  If I understand all this stuff, there are basically three
types of accounts in a double-entry accounting system: Assets,
Liabilities and Equity.  Most people find Assets and Liabilities easy
enough to understand, but find Equity accounts quite puzzling.  I will
try to explain them to the best of my understanding.

The invariant which relates these three types of accounts is:

	Assets = Liabilities + Equity

For a business, the account types can be thought of as having the
following meaning:

Assets:
	What the business owns.

Equity:
	What the business owes its owner(s).

Liabilities:
	What the business owes other people.

By convention, assets are shown as positive when they are in debit, and
liabilities and equity are shown as positive when they are in credit.
(To get GnuCash to follow these conventions, you need to set
"Reverse-balance account types" to "Credit Accounts" in the GnuCash
Preferences.  If you don't have this setting, that is the reason your
equity account balance has the wrong sign.)

Some examples of transactions may make this clearer.  Each transaction
involves two (or more) accounts and the total amount of debits for the
transaction must equal the total amount of credits.

1.  Bob starts up a business called Bob's Business.  He sets up a new
set of books (i.e. chart of accounts) for that business.  Bob has $10000
to invest in the business so he starts by making two accounts: a "cash"
account of type asset and an "owner's equity" account of type "equity".
He then debits "cash" $10000 and credits "owner's equity" $10000.   This
records that Bob's Business now has $10000 in cash and owes Bob (its
owner) $10000.

Aside:  if Bob was keeping his own personal set of books separate from
his business (which he should do), he would record the above transaction
in those books as well.  Assuming he had two asset accounts called
"Bob's Cash" and "Bob's Investment in Business" he would credit "Bob's
Cash" and debit "Bob's Investment in Business".  Note an important
concept here:  a set of books is kept for a particular entity.  Bob and
his business are two separate entities so have two separate sets of
books.

2.  John decides to start recording all his finances in GnuCash.  At the
point he starts he has $2000 in ABC Bank and a loan for $500 from XYZ
bank.  John creates three accounts: "ABC Bank Acount", "XYZ Loan" and
"Opening Balances" of types asset, liability and equity, respectively.
To record the opening balance of the ABC bank account he debits "ABC
Bank Account" $2000.  However, there must be a second account involved
in this transaction for it to balance.  The account to use is the equity
account "Opening Balances" which is credited $2000.

John also needs to record the opening balance of his loan.  To do this he
credits "XYZ Loan" $500.  Again he needs to balance this so he debits
$500 from "Opening Balances".

The Balances are now:
	ABC Bank		$2000 (DR)
	XYZ Loan		$ 500 (CR)
	Opening Balances	$1500 (CR)

So what does this mean?  John has $2000 in ABC Bank, but owes XYZ Bank
$500.  This means that that his net worth is $1500, which is reflected
in the value of the equity account "Opening Balances".  As you can see,
the equation "Assets = Liabiities + Equity" holds here.

3.  So what about "Income" and "Expense" accounts?  Well they are
basically just types of equity accounts, but are kept separate to make
it easier to see stuff such as Profit and Loss.  Unlike income and
other equity accounts, expenses are shown as positive when they are in debit
rather than credit.  With this in mind, if you keep income and expenses
separate from other equity, the invariant becomes:

	Assets = Liabilities + Other Equity + Income - Expenses

It is useful at the end of an accounting period to "close off the books"
to separate income and expense in one period from the next.  Going back
to the example of Bob's Business.  Assume at the end of the first year
the business accounts look like this:

	Cash:		$50000 (DR)
	Owner's Equity: $10000 (CR)
	Income:		$80000 (CR)
	Expenses:	$40000 (DR)

A quick check shows us that our invariant holds.  We can also see that
Bob's business has made a profit (Income - Expenses) of $40000.

To close off the books for the year, the balances of Income and Expenses
should be transferred to an equity account.  To keep things simple we
will transfer them to the Owner's Equity Account, although in practice,
accounts with names such as "Retained Earnings" are used.  So the
transaction is:

			Debit		Credit
	Income		$80000
	Expenses			$40000
	Owner's Equity			$40000

resulting in balances of:
	Cash:		$50000 (DR)
	Owner's Equity: $50000 (CR)
	Income:		$    0 (CR)
	Expenses:	$    0 (DR)

The accounts are now ready to start recording income and expenses for
the next year.

However, Bob probably would like to use some of that $40000 profit for
his own personal use, since the reason he set up the business in the
first place was to make himself some money.  He decides to withdraw
$30000 from the business (and reinvest the other $10000 as "retained
earnings").  The transaction is:

			Debit		Credit
	Owner's Equity	$30000
	Cash				$30000

The balances are now:
	Cash:		$20000 (DR)
	Owner's Equity: $20000 (CR)
	Income:		$    0 (CR)
	Expenses:	$    0 (DR)

Well, this turned out to be a rather long post (and has gone a lot
further than merely answering your question -- sorry about that).  I
hope this has gone some way to clarifying the role of equity accounts.
But as I said earlier, I am not an accountant so if there are any
accountants on the list who would care to correct me where I've probably
got stuff wrong, that would be much appreciated.



David