Basic concept question on "Basic Accounting Equation"

Duncan Thomson clymbon at gmail.com
Thu Feb 25 12:49:48 EST 2010


OK, thanks that helps.

This is all just simple addition and subtraction, so the math is trivial.
What's confusing is the definitions of terms.  I was interpreting "Equity"
as "Net Worth," and in fact the manual implies that definition:

"...your net worth is calculated by subtracting your liabilities from your
assets:

*Assets - Liabilities = Equity"*
But I think that's where I'm going wrong.  Because clearly net worth goes up
and down every time I take in income or incur an expense.  If I buy a
package of ramen noodles for $.45 and eat them up (yummy!) my net worth just
went down by 45 cents.  That's assuming I'm not counting my improved
nutritional state as an asset.

Right?

So.. I think you're telling me that "Equity" in this equation is just a
constant.  It represents my net worth at some point in time before I start
taking in income and paying out expenses.

Am I on track here?  (I come from a math background, I find it a little hard
to think like an accountant.)

Thanks,

Duncan

On Thu, Feb 25, 2010 at 12:27 PM, John Edwards <jedwards80 at gmail.com> wrote:

> 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
>


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