Accounting Equation

[Doug Laidlaw]

On Sat, 30 Jun 2007 03:54:54 pm lingwitt at bellsouth.net wrote:
> Hello,
>
> I don't have any credentials and my arithmetic is terrible,
> but it seems to me like the documentation's development
> of the accounting equation is completely wrong.
>
> This makes sense:
>
> 	Assets - Liabilities = Equity
>
> But then it says:
>
> 	"Furthermore, you can increase your equity through
> 	income, and decrease equity through expenses."
>
> So for income:
>
> 	EquityWithIncomeAndExpenses = Equity + Income - Expenses
>
> or
>
> 	EquityWithIncomeAndExpenses = Assets - Liabilities + Income - Expenses
>
> If we just refer to EquityWithIncomeAndExpenses as Equity, then:
>
> 	Equity  = Assets - Liabilities + Income - Expenses
>
> or
>
> 	Assets - Liabilities = Equity - (Income - Expenses)
>
> but the docs say:
>
> 	Assets - Liabilities = Equity + (Income - Expenses)
>
> That is, the docs say:
>
> 	(Assets - Income) - (Liabilities - Expenses) = Equity
>
> and I say this:
>
> 	(Assets + Income) - (Liabilities + Expenses) = Equity
>
> Clearly the latter is correct.
>
> Why not dispel with Income and Expenses anyway and just
> call them Assets and Liabilities?
>
> Please correct me (I'm serious).
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Assets and liabilities remain fairly constant, income and expenses are the 
things that increase or decrease those.

Your equation

Equity  = Assets - Liabilities + Income - Expenses

is accurate, but doesn't get the point.

If your assets are greater than your liabilities, you are solvent, otherwise 
you are insolvent. i.e. your equity is negative.

If your expenses are greater than your income, you may be solvent now, but 
eventually you won't be.  That is the essential difference.

To take an example with figures (and like all these examples, no attempt to 
keep them realistic):

Suppose that you have a bank account -an asset of $1 000.00 and a debt you 
owe - a liability - of $200.  Then your equity or capital is $800.

If you receive pay of $500 (Income) and pay a power bill (expense) of $150, 
you have $350 left over.  Whether it is in your bank account or your pocket, 
I will assume that it is in the bank.

So you now have an asset - the bank account - worth $1 350
Your liability is unchanged at $200.00
Your equity is the difference, now $1 150.00
If you now pay off the debt, your bank account reduces to $1 150,
but you have no liabilities.  Your equity is unchanged at $1 150.

In financial reports at the end of the year, it is put:

Assets			1000
Liabilities 		 200
                               -------
Equity						800

Income			500
Expenses			150
                               --------
Net profit						350
                                                    -----------
New equity					1 150

HTH,

Doug.
-- 
If you don't have a dream,
How are you going to have a dream come true?
   - Oscar Hammerstein II.