Basic concept question on "Basic Accounting Equation"

[John Edwards]

On Thu, Feb 25, 2010 at 12:49 PM, Duncan Thomson <clymbon at gmail.com> wrote:

> 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.)
>

Yes, "Equity" is a constant in that equation. There are five types of
accounts: Assets, Liabilities, Equity, Income and Expense. Assets, Liability
and Equity are all permanent, Income and Expense are temporary.

In your noodles example, you're correct. You would enter a "Food Expense"
for $0.45, and your assets (Cash) would drop by $0.45. In your prior
example, though, you'll see that the $0.45 gets added to and subtracted from
the same side of the equation. Your net worth would drop by $0.45 as a
result of that transaction. (If you were to calculate it, the $0.45 in Food
Expense would eventually get subtracted from your Equity account, and that
would balance with the $0.45 drop in your Cash.)

Theoretically, you could change the Equity account every time, if you don't
use Income and Expense accounts. It's not wrong, but you'd be unlikely to do
it as it doesn't produce useful results. Income & Expense hold amounts that
will become Equity eventually.

Equity can get much more complex when you are dealing with a corporation,
but for individuals the only time an Equity account (Net Equity, or whatever
you call it) would change would be when (if) you reset the Income and
Expense accounts back to 0. That resetting is what's called "closing the
books."

In GnuCash, you would normally set up and Equity account called "Opening
Balances", which is what balances out your amounts of assets and liabilities
as of when you started using the program. That amount is your net worth as
of the date that you started using the system. You may then also decide to
set up another Equity account to hold your net income (I - E) after you
close the books at the end of the year. If you don't do that, those amounts
would simply sit in their respective accounts, and your net worth at any
given time would be Opening Balances + Income - Expenses.

John

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