The retained earnings are thus a measure of the assets that have been accumulated through business operations. 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 revenue is recorded under the retained earnings/shareholders’ equity because the $1000 was generated though the operations of your company. 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). Your cash balance (an asset) would increase by $1000, and so would your revenue. Consider the following example.Īs a telecommunications consultant, you sell a service for $1000. Looking at the accounting equation, you might wonder how revenues, expenses and dividends fit in the balance. Where do revenues, expenses and dividends fit in the equation? 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. 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. 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).

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. To this end, they employ a system called double-entry bookkeeping to record every business transaction in view of both sides of the equation. Having the books in balance does not exclude an error from being present.) Double-entry bookkeepingĪs stated, accountants must keep the equation in balance. (Note, however, that the flip side of this circumstance does not hold true. 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. The balance sheet itself is in fact a reflection of this equation. Known as the fundamental accounting equation , it states:Īssets = Liabilities + Shareholders’ Equityīy definition, this equation must remain in balance on a company’s financial statements. A mathematical equation underlies the entire accounting process.

Double entry bookkeeping