I understand Equity to be "Net Worth", as calculated by Assets - Liabilities. I also understand the "Expanded Fundamental Accounting Equation" to be

Assets + Expenses = Liabilities + Equity + Income

How is Equity interpreted in the Expanded Equation? It seems like it can no longer be considered Net Worth.

Let me explain.

Say I have two checking accounts and two purchases:

2016/10/26 Opening Balance
    Assets:Checking:Chase                   $2000.00
    Assets:Checking:Wells Fargo              $500.00
    Equity:Opening                         $-2500.00

2016/11/04 Gas station
    Expenses:Auto:Fuel                        $20.00
    Assets:Checking:Chase                    $-20.00

2016/11/05 Dinky Donuts
    Expenses:Recreation:Dining                 $5.00
    Assets:Checking:Wells Fargo               $-5.00

This yields the following balance report:

            $2475.00  Assets:Checking
            $1980.00    Chase
             $495.00    Wells Fargo
           $-2500.00  Equity:Opening
              $25.00  Expenses
              $20.00    Auto:Fuel
               $5.00    Recreation:Dining

Everything within me screams that, because I have no Liabilities, my Net Worth must be $2475. However, my Equity is this plus my $25 in Expenses. My Net Worth is no longer simply Assets - Liabilities. Sure, the $-2500 in Equity balances the equation

Equity = (Assets + Expenses) - Liabilities

But how can I interpret Equity in a more meaningful way than "It balances the equation"?

  • 3
    Can you show where you got that equation? I don't think it's correct because it mixes point-in-time measures (assets, liabilities, equity) and period measures (expenses, income). I have seen other "expanded" balancing equations that make more sense. – D Stanley Mar 28 '19 at 13:03
  • I pieced it together from a number of sources (always a reliable practice!). It comes mainly from: gnucash.org/viewdoc.phtml?rev=3&lang=C&doc=guide and seems to confer with en.wikipedia.org/wiki/…, mainly that A and Ex are debits (LHS) and Eq, L, and I are credits (RHS). – Lorem Ipsum Mar 28 '19 at 13:14

The equation you are using is a bit misleading and incomplete. It is combining point-in-time measures (Assets, Liabilities, Equity) with period measures (revenue, expenses) A better equation would be:

Ending_Assets + Expenses = Ending_Liabilities + Beginning_Equity + Income

Since income - expenses (net profit) are absorbed into equity at the end of the period (into retained earnings). But, for a corporation this leaves out other things that affect equity like issuance of new stock, buybacks, paid in capital, etc. So from a personal finance standpoint the equation is probably good enough, but for more complex entities that are some pieces missing. Another, more complete expanded equation I have seen is:

Assets = Liabilities + Paid-in Capital + Total Revenues – Total Expenses – Dividends – Treasury Stock

Which just breaks "equity" into the components that make it up, and still might be incomplete for more complex entities. But even then, you must include all dividends, revenues and expenses (not just the last period).

But how can I interpret Equity in a more meaningful way than "It balances the equation"?

It's still the same interpretation - what you own (assets) minus what you owe (liabilities). Revenue and expenses affect equity since they impact either assets or liabilities, but not both. Things like borrowing money or paying down debt do not affect equity since they affect both assets and liabilities equally. These expanded equations just show the different measures that affect equity.

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