Basic concept question on "Basic Accounting Equation"

[John Edwards]

On Thu, Feb 25, 2010 at 11:55 AM, Duncan Thomson <clymbon at gmail.com> wrote:

> The "GnuCash Tutorial and Concepts Guide" provides the following as the
> "Accounting Equation"
>
> *   Assets - Liabilities = Equity + (Income - Expenses)*
>
> But that seems wrong.  It is equivalent to
>
> *   Equity = Assets - Liabilities - Income + Expenses*
>
> That would imply that as my income goes up my equity goes down, and as my
> expenses go up my equity also goes up.  I wish that were true!
>
> Am I missing something?
>

Sort of. Income and Expenses are temporary accounts, that *eventually *form
part of equity. However, they are not put into equity until you close the
books at the end of the year. Therefore, the amount in your Equity accounts
does not change until then.

In your second equation, taking in income causes no effect on your Equity,
as your assets (either Accounts Receivable or Cash) will increase up by the
same amount. An Expense will cause equivalent movement in either Assets (by
going down) or Liabilities (by going up).

Suppose you started a business:

Your first transaction is an investment of $10,000. The entry is:
DR Cash  10,000
  CR   Equity (Owner's Capital) 10,000

At that point the Equity is 10,000. And your second equation would be 10000
= 10000 - 0 - 0 + 0.

You then take in $100 for performing a service
DR Cash   100
   CR  Service Income 100

At that point, your Equity remains 10,000. The second equation is now 10000
= 10100 - 0 - 100 + 0.

At the end of the year, when the books are closed, you would then transfer
the amounts in Service Income (along with the other Income and Expense
accounts) into Income Summary, and the amount in Income Summary to Retained
Earnings - an Equity account.

John

-- 
John Edwards
"You can insure against the weather, but you can't insure against
incompetence, can you?" - Phil Tufnell