Using the Accounting Equation in Your Small Business Bookkeeping

This accounting equation to retained earnings is shown on the balance sheet under stockholder’s equity. It is used in Double-Entry Accounting to record transactions for either a sole proprietorship or for a company with stockholders. Although the accounting equation appears to be only a balance sheet equation, the financial statements are interrelated. Net income from the income statement is included in the Equity account called retained earnings on the balance sheet. In a sole proprietorship or partnership, owner’s equity equals the total net investment in the business plus the net income or loss generated during the business’s life.

From the accounting equation, we see that the amount of assets must equal the combined amount of liabilities plus owner’s (or stockholders’) equity. The balance is maintained because every business transaction affects at least two of a company’s accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease.

Expanded Accounting Equation for a Corporation

You want the total of your revenue account to increase to reflect this additional revenue. Revenue accounts increase with credit entries, so credit lawn-mowing revenue. You have received more cash from customers, so you want the total cash to increase. Cash is an asset, and assets increase with debit entries, so debit cash.

This reduces the cash account and reduces the retained earnings account. Based on the data in the previous section, here’s the journal entry to record the payment of the accrued December rent in January. Liabilities are amounts owed to other persons or entities as a result of a past event and involve a future settlement using cash, goods, or services.

Need help with accounting? Easy peasy.

The accounting equation is the first concept you need to master to build on this skill set. Per the image below, the accounting equation states that the value of a company’s assets is equal to the sum of the company’s liabilities and equity. The beautiful thing about accounting and the three-statement models it helps inform is that they create a closed system. What affects the income statement also affects the balance sheet, and any change on the balance sheet must be captured by the cash flow statement.

• The transactions in the accounts are then summarised to create summary values for each account.
• You will notice that the transactions from January 3, January 9, and January 12 are listed already in this T-account.
• As you will see, on the left-hand side of the equation a debit increases an account, and on the right-hand side of the equation, a credit increases an account.
• Some of the listed transactions have been ones we have seen throughout this chapter.
• This increases the fixed assets account and increases the accounts payable account.

As a result, there is no income statement effect from this transaction. The accounting equation reflects that one asset increases and another asset decreases. We present nine transactions to illustrate how a company’s accounting equation stays in balance. Owner’s draws and expenses (e.g., rent payments) decrease owner’s equity. How do I record dividends paid in an adjustment entry?

Shareholders’ Equity in the Accounting Equation

You have performed the services, your customers owe you the money, and you will receive the money in the future. Debit accounts receivable as asset accounts increase with debits. In the journal entry, Dividends has a debit balance of $100. This is posted to the Dividends T-account on the debit side. This is posted to the Cash T-account on the credit side.

• This should be impossible if you are using accounting software, but is entirely possible if you are recording accounting transactions manually.
• The accounting equation is the foundation of a bookkeeping system.
• Each time we record a transaction, we must record a change in at least two different accounts.