A mathematical equation underlies the entire accounting process. Known as the fundamental accounting equation, it states:
Assets = Liabilities + Shareholders’ Equity
By definition, this equation must remain in balance on a company’s financial statements. The balance sheet itself is in fact a reflection of this equation. Should a company’s financial statements show one side of the equation unequal to another, then the balance has been lost and an accounting error has been made. (Note, however, that the flip side of this circumstance does not hold true. Having the books in balance does not exclude an error from being present.)
As stated, accountants must keep the equation in balance. To this end, they employ a system called double-entry bookkeeping to record every business transaction in view of both sides of the equation. Thus each journal entry contains two parts; it notes either an equal impact (increase or decrease) to both sides of the equation, or it notes an equal and opposite impact to a single side. For example, if your company received a bank loan for $15,000, then your assets (one side of the equation) would increase by $15,000 but so would your liabilities (other side of the equation). On the other hand, if you purchased laboratory equipment for $5,000, then your cash assets (one side of the equation) would decrease by $5,000 but your equipment assets (same side) would equally increase, thus maintaining the balance. This recording of equal (or equal and opposite) impacts—called debits and credits —to more than one account for every event recognizes and reflects the fact that in all business transactions in order to gain one thing, another thing must be given up or exchanged.
Looking at the accounting equation, you might wonder how revenues, expenses and dividends fit in the balance. Consider the following example.
As a telecommunications consultant, you sell a service for $1000. Your cash balance (an asset) would increase by $1000, and so would your revenue. But where does the revenue appear in the equation to keep the balance? In the journal entry, an accountant would record an increase of $1000 in your assets (one side of the equation) and correspondingly record an equal increase in your retained earnings (a part of the shareholders’ equity, the other side of the equation). The revenue is recorded under the retained earnings/shareholders’ equity because the $1000 was generated though theoperations of your company. It helps to know, or keep in mind, that the income statement (which tracks revenue and expenses) is a temporary statement and at the end of the fiscal period, its journal entries are closed and its numbers transferred to the retained earnings account. The retained earnings are thus a measure of the assets that have been accumulated through business operations.
Similar to revenue, expenses comprise a part of the operating activity of your company, and so the payment of an expense would be recorded as an impact (a decrease) to your retained earnings as well as to your assets. In the same vein, the payment of dividends would also impact (decrease) your retained earnings as well as your assets because payments to the shareholders are considered a fundamental objective of running a company and so make up a further subset of normal business operations. Hence the recording of revenue, expenses and dividends fit within the fundamental accounting equation and help achieve its balance.
Markle, K. (2004, August). Introduction to Accounting. Presentation delivered at Schulich School of Business, York University, Toronto, Canada.
Pratt, Jamie. (2003). Financial Accounting in an Economic Context.New York: John Wiley & Sons. pp. 105. 107-8, 110, 112.