In double entry accounting, how does income become equity?

Question

Using GNUCash, help, putting it all together, I'm accounting for a lottery income transaction.

I was able to get the example shown with 2 transactions.

1. Dr. Savings        750,000
    Cr. Income:Lottery          750,000

2. Dr. Income:Lottery 750,000
    Cr. Equity:Lottery          750,000

Result:
Account Balances

1. Savings 750,000
     2. Income        0
     3. Equity  750,000

Questions:

As a general accounting practice, by what process does Income become Equity?
Are the above two transactions the way to properly, according to accounting rules, record this event?

SL2 · Accepted Answer

GnuCash uses the extended accounting equation, which is

Assets - Liabilities = Equity + Income - Expenses

Confusingly, the entire right hand side (Equity + Income - Expenses) is also known as Equity if you use the standard accounting equation (as THEAO has pointed out).  The equity you're trying to increase is the entire right hand side, and in GnuCash this is usually done by increasing your income.  GnuCash will keep track of your overall equity on its own.

Equity accounts in GnuCash aren't meant to have your overall equity as a balance.  To quote Derek Atkins from the gnucash-users mailing list:

You are confusing "Equity Accounts" from "Instantaneous Equity"..  The
  I.E. includes Income and Expense values, which are not rolled up into your
  Equity Accounts.  To compute your Instantaneous Equity you need to run a
  Balance Sheet.
  
  Your Equity accounts will always show your equity at a single point in
  time.  Generally it's the Opening Balances, but you can roll up your
  Income and Expense accounts into an Equity account by "closing the books".

Closing the Books

(...) “closing the books,”--an accounting process that resets the
  balances of the income and expense accounts. In this process, income
  account balances are transferred into an income equity account, while
  expense account balances are transferred into an expense equity
  account. (...)
  
  Closing Date (...)
  
  Income Total: Specify the account into which the total balance of all
  income accounts will be transferred. (...)
  
  Expense Total: Specify the account into which the total balance of all
  expense accounts will be transferred. (...)
  
  How It Works (...) GnuCash just uses [ordinary] transactions to close
  the books (...)
  
  Necessity (...) Note that closing the books in GnuCash is unnecessary.
  You do not need to zero out your income and expense accounts at the
  end of each financial period. GnuCash’s built-in reports automatically
  handle concepts like retained earnings between two different financial
  periods.
  
  In fact, closing the books reduces the usefulness of the standard
  reports (...)

THEAO · Answer

Towards your question #1 The basics of double-entry accounting run off of the equation that (Assets) - (Liabilities) = (Owner's Equity).

In terms of double entry bookkeeping, you always need 1 "event"'s set of transactions to balance the left (A - L) and right (OE) sides of the equation. Here are some examples to show what I mean:

Ex 1: Company starts with $100 in cash from last period. This would show up on the balance sheets as A: $100 Cash L: $0 =  OE: $100.

Company buys $50 worth of ice cream. This would record as A: -$50 Cash --> A: +$50 Inventory

Company sells all the ice cream for $75. This would record as A: +$75 Cash --> A: -$50 Inventory --> OE: $25 (Profit).

If this was the only activity for the period, then at the end of the... month? The accounts would show:

Assets:

Cash

Starting: $100 
  -$50 Inventory Purchased
  +$75 Revenue on Sales Cash
  Ending: $125

Inventory:

Starting: $0 (Assuming we had none to start)
  +$50 Inventory Purchased
  -$50 Inventory Sold
  $0 Ending Inventory

Liabilities: nothing

===

Owner's Equity:

Starting $100
  +$25 Profit on Sales
  Ending: $125

Hopefully this helps you to see how you're really recording each event in two (or more) places, hence the 'double entry' aspect of the name.

Ex 2: This gets at your specific question, which is something like 'How do I record a revenue transaction that doesn't really have any associated inventory or costs?'

Remember that your "A - L == OE" equation has to balance, so you either need to simultaneously (a) increase and decrease Assets... like buying ice cream/inventory, (b) increase Assets and increase Liabilities, (usually by 'buying' inventory and setting up a short-term liability) or (c) increase Assets and increase Owner's Equity.

Based on what you've got in your example, I would expect the lottery winnings/inheritance stuff to show up under "Assets" in some kind of setup like "Assets... Cash: +$250,000 Lottery Winnings" --> "Owner's Equity... +$250,000". If you wanted it to be in an account "savings" after that, I would personally record that as "Assets... Cash: -$250,000 Transfer to Savings" --> "Assets... Savings: +$250,000".

Hopefully that shows you exactly how revenue... or income passes through from accounts under "Assets" into overall "Equity".

Now, on your second question: no, you've totally screwed it up. But at the same time, it seems like this is an attempt at tracking your personal net worth in accounting software, so technically there's no "right" or "wrong" way. I'm not personally familiar with GnuCash, so I can't give you a walk-through on that... maybe someone else can.

What I can do is tell you the accounts that I would probably set up in GnuCash or Quickbooks or Peachtree or whatever accounting system you were to use. I'm also assuming that this is a personal accounts setup, but I'll be glad to edit it to reflect your real situation if you comment.

That being said, I would have the structure be something like:

Assets:

Cash on hand
Checking  
Savings
MMA or CDs (Short-term investments)
401K/IRA/Whatever (Longer-term investments)
Real Property Assets (House, Car, Computer, Bike)

Liabilities:

Credit Cards
Car Loan(s), maybe other installment loans on furniture or whatever
Student Loans
Mortgage (if you've got one)

===

"Owner's" Equity: (you're welcome to get as specific on this as you like, but that's just extra work...)

Overall Growth in Net Worth 
Margin on House?
Margin on Car?
...?

From there you use double entry book-keeping with a vengeance. For the 'right' way to do your two transactions, you would have some kind of 'revenue' hit one of your "Assets" accounts (maybe +$250,000 to Savings?) and record a corresponding increase to your Net Worth (maybe +$250,000 to Overall Net Worth?). Then you would do the same thing for your Inheritance: (+$500,000 to Savings?... +$500,000 to Overall Net Worth?).

We can talk about how you would account for taxes and other expenses some other time... that's definitely a topic for "Lesson 2". :)

shoyu · Answer

Income doesn't "become" Equity as such;
Income ( = Revenue) is Equity:

That is to say, the Income and Expense Accounts are sub-accounts to the Equity Balance Sheet account(s).

As for Gnucash-specifics, SL2's answer points in the right direction.

In double entry accounting, how does income become equity?

3 Answers

Closing the Books

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