[GNC] Handling of Equity and Retained Earnings

[Adrien Monteleone]

> On Jan 21, 2020 w4d21, at 9:36 AM, Christian Lynbech <clynbech at gmail.com> wrote:
> 
> I thank you all for the discussion, it has been very interesting.
> 
> What I am trying to do is to establish a workflow with GnuCash that provides some decisions on the three somewhat intertwined questions:
> How to handle the transition from one year to the next
> What reports provide the information I need
> How my account tree should look to support the above
> 
> Just for context, I am starting from scratch and have only a very modest number of transactions in 2019, so it is quite easy for me to make some experiments.
> 
> I am tempted to go the route of not closing books, as that seems to be both recommended and the easiest to handle, but I still have some problems understanding how to make that work.
> 
> The requirement from the danish tax authorities on a small single person company is quite modest. One is required to do book keeping but there are not strict requirements on how that is done, basically the only thing is that the books should make it clear how the result of the business has been derived. For taxation, only the result should be reported and the books should only be sent in to the authorities if explicitly requested. The taxation year follows the calendar year.
> 
> In my current attempt, I have one equity sub-account for the money I put into (or take out) of the business and thus no equity accounts for neither retained earnings or opening balance as one would get from the account wizard.

If you don’t have an Opening Balances account it means your books started with zero assets and liabilities. If that is correct, all is well. If this was an existing business, I’d bank that wasn’t correct.

> 
> I am struggling a bit to find out how to get this to work in the rolling model.
> 
> It does seem as if the balance sheet contains all the information I need, however have I understood it correctly that one only specifies a single date (as opposed to an interval)? In other words, does the balance sheet always produce the accumulated result from the beginning of the book to the selected date? There is another report called Equity Statement that works on periods and while it has the end result, it lacks all of the individual account details that the balance sheet has.

Balance Sheets show you a snapshot of all of your accounts as of a certain date. (so by necessity, from the beginning of the books till that date) It shows you that all of your assets are balanced by the sum of all of your liabilities and your equity. (you can even print this in two columns if it helps to see this better, Assets will be in one column, Liabilities & Equity in the other)

As Christopher noted, you probably want the Income Statement (also labeled Profit & Loss, or P&L in the report menu - they are the same report) for the tax authorities, but you might also need Balance Sheets and other reports. Talk to a local CPA to find out exactly what you need and in what form. (that is, the items it needs to contain)

The Income Statement will show everything that came in “Revenue” or “Income” (depending on your preference, see below) and everything that went out “Expenses” that were part of the ‘operations of the business’.

This won’t reflect equity added or withdrawn, loans taken out, loans paid off, (but will show interest expense) or any changes in assets like acquiring property, plant or equipment for long term use or resale. (but you would have a line for depreciation expense if applicable)

Thus, the Income Statement shows how the business made money and where it spent money, with a net at the end. This would be profit. (The traditional equation is “Income = Revenue - Expenses” and most accounting texts will present this more traditional terminology. Some people prefer “Profit = Income - Expenses” but you can quickly see that unless the discrepancy is understood, reading the term ‘income’ without context might get confusing unless you know they mean ‘income’ to be ‘revenue’ rather than ‘profit’. To ease my own sanity, I re-labeled my top ‘Income’ account as ‘Revenue’ and then my P&L shows ’Total Revenue’, ‘Total Expenses’ and ‘Net Income’ just like a text book example. I’m not familiar with accounting texts in other languages so maybe this issue doesn’t crop up for others.)

I haven’t looked at the Equity Statement report yet, so not sure of its purpose.

> 
> Somewhat related to this, I am also still struggling to figure out to handle the equity. On the Balance Sheet, I see the equity sum and the result, but the two are not combined. Are there any alternative to closing the book or do some manual transaction to get equity rebalanced?

What are you referring to as ’sum’ and ‘result’ and why do you think Equity is ‘out of balance’?

> 
> Let me try to provide an example.
> 
> In year 1, I put 1000 into the company which is added to the equity sub-account “Founder Deposit”, the company buys a computer for 100 and does some work that pays 200. On the Balance Sheet for year 1, this is listed as equity of 1000 and result (income - expense) of 100. Lets say the company in year 2 also does work that pays 200, how do I handle that year 2 starts with equity of 1100, rather than equity of 1000 and a result of 100? I can move the result to equity by closing the book, but is there any report that takes this into account without actually doing the close?

Let’s walk through some simple (and likely aggregated) transactions:

#1 - investing 1000 into the business by the owner
--------------------------------------------------
Dr. Assets:Cash
Cr. Equity:Owner’s Capital(Founder’s Deposit)


Your Balance Sheet now looks like this:

Assets		1000
Liabilities	   0
Equity		1000




#2 - Buying a computer for 100 (cheap!)
---------------------------------------

hmm... Was this computer for the use of the business in operations? Or was this for re-sale?

The rules on long-term assets are different for each jurisdiction. Some leave it up to the business to determine the life of the item, or its purpose and whether or not to expense it right away or depreciate it over time.

We have three possibilities:


A. Acquisition of Equipment
----------------------------
Dr. Assets:Equipment
Cr. Assets:Cash

over time, you’ll make entries ‘using up’ or ‘expensing’ the equipment like so:

Dr. Expenses:Depreciation
Cr. Assets:Equipment


B. Acquisition of Resalable Inventory
-------------------------------------
Dr. Assets:Inventory
Cr. Assets:Cash

as you sell inventory you make the following entries:

Dr. Assets:Cash (full amount of sale)
Dr. Expenses:Cost of Goods Sold (COGS)
Cr. Assets:Inventory (same amount as COGS)
Cr. Income

(if you charged sales tax/VAT, that could be included here, just more splits)


After *either* ‘a’ or ‘b’ your Balance Sheet would look like:

Assets		1100
Liabilities	   0
Equity		1100



C. Direct Expense Purchase (you either can’t or opted not to depreciate)
--------------------------
Dr. Expenses:Equipment
Cr. Assets:Cash


In this case your Balance Sheet looks like:

Assets		900
Liabilities	  0
Equity		900

to get a grasp as to why the difference, let’s break out Equity:

Income(so far)	   0
Expenses	 100
		====
Equity		-100


If you were to ‘close the books’ at this point of the computer purchase you’d make the following entry:

Dr. Equity	 100
Cr. Expenses	 100


Which is why it shows as 900 in the above Balance Sheet

You reduced Assets:Cash by 100, so that’s why it is now 900.


#3 - Sales of 200
-----------------
Dr. Assets:Cash	 200
Cr. Income	 200


Your Balance Sheet now looks like:

Assets		1100
Liabilities	   0
Equity		1100

again, let’s show the ‘close the books’ transaction if you waited to do so after the income was entered:


Dr. Income	 200
Cr. Expenses	 100
Cr. Equity	 100

Looking above at the Balance Sheet as of the Purchase, your assets decreased to 900, but then increased to 1100 from the sale.
Your Equity was increased by 100 (from the original 1000) as net-income.

If you look carefully, you’ll notice with all 3 examples, your Balance Sheet looks like:

Assets		1100
Liabilities	   0
Equity		1100

The difference is in how you got there, and that is interesting to tax authorities. (the Income Statement will show that detail)

So take that Balance Sheet as of 12/31/2019

Now this year you make another 200.

While technically Equity started at 1100, you didn’t close the books. So it still shows 1000.

Assuming no expenses, you’ve now increased your Equity by 200 this year and 100 last year, for 300 total.

So the cumulative transaction is:

Dr. Income	400
Cr. Expenses	100
Cr. Equity	300

Since Equity was 1000, it is now 1300 your Balance Sheet at the end of year 2 looks like:

Assets		1300
Liabilities	   0
Equity		1300

When you don’t close the books, GnuCash does the Income-Expense to Equity calculation for the *entire* book, not just the previous year.

If you want to know what was ’net income’ for the just previous (or current) year, run an Income Statement.

Hope all that helps. Note, this is all Accounting 101 stuff. Find a good text book in print or online, read through it, do the exercises and practice with GnuCash. You’ll be speeding through it in no time.

Regards,
Adrien