# Basic Accounting Concepts - what am I missing?

Jim Smith jimsmth761 at gmail.com
Mon Jan 3 11:14:55 EST 2011

On Mon, Jan 3, 2011 at 7:57 AM, Tony <penury at gmail.com> wrote:

>
> On Mon, 3 Jan 2011 01:28:44 -0500, Jim Smith <jimsmth761 at gmail.com> wrote:
>
> > I have come to understand the Accounting Equation as a function rather
> than
> > a mathematical equation. It is a function because of the restriction that
> > double entry is always required. It doesn't work as a purely mathematical
> > equation. Thinking of it as an equation leads to nonsensical results.
>
> The accounting equation is both functional and mathematical.  It's probably
> best to understand assets/liabilities/equity as balance accounts (i.e. that
> hold amounts) and income/expense as flow accounts (i.e. that show the
> transition of balance accounts from time x to time y).
>
> The fundamental equation Assets - Liabilities = Equity holds at all times,
> but it is underspecified for the purposes to which you are putting it.
> Better would be to write it as Assets(t) - Liabilities(t) = Equity(t) where
> t is some specific point in time.
>
> If we take t=0 to be the beginning of some period and t=1 to be the end of
> that period, then the equation trivially gives us (abbreviated):
>
> A(0) - L(0) = E(0)
> and
> A(1) - L(1) = E(1)
>
> If we define Income(1) and Expense(1) to be the sum of all income and
> expense (flows) over the period from t=0 to t=1, then we can arrive at the
> equations you are attempting to understand.  We need one more basic fact
> (related to the "clean surplus" concept), E(1) = E(0) + NI(1), where NI(1)
> = net income over the period = Income(1) - Expense(1).
>
> With these definitions in place, we can see that both formulations that
> caused confusion were "correct", but merely underspecified:
>
> We can transform A - L + ( I - Ex) = Eq (note the + sign) into the more
> precise:
>
> A(0) - L(0) + ( I(1) - Ex(1) ) = Eq(1)
>
> Similarly, we can transform A - L - ( I - Ex) = Eq (note the - sign) into
> the more precise:
>
> A(1) - L(1) - ( I(1) - Ex(1)) = Eq(0)
>
> this last equation manipulates to A(1)-L(1) = Eq(0)+I(1)-Ex(1)
>
> So, in general, the expanded formulations of A-L=Eq that include income and
> expenses implicitly reference a beginning and end period, and you just have
> to careful about which amounts are measured at the beginning of the period
> and which are being measured at the end.
>
> Tony
>

Tony,
That is a brilliant explanation! Thank you. That clears up my confusion. You
brought together all the concepts that were missing and put them into a very
concise answer. Not only did you answer my original question, you explained
why people more knowledgeable than me gave answers that apparently (at the
time) didn't make sense. Now I understand where the confusion was coming
from.

Thanks to everyone else on the list. This was a very helpful discussion.
Jim