6.1: Accounting Equation
The Accounting equation is the basis for all transactions in accounting. It must be in balance at all times. It involves the three types of accounts that appear on the balance sheet.
The accounting equation is Assets = Liabilities + Stockholders’ Equity . The corporation has assets, and it must pay for these assets. It can do so in two ways. The corporation can use its own money or it can borrow and use other people’s money, incurring liabilities, or debts.
Indirectly, revenue and expense accounts are part of this accounting equation since they impact the value of stockholders’ equity through closing entries, which move revenue and expense account balances into Retained Earnings.
Common Stock + Retained Earnings = Total Stockholders’ Equity
Retained earnings is a company’s accumulated profit since it began operations minus any dividends distributed over that time.
Stockholders’ equity (account category) is the amount of a business’s total assets that is owned by the stockholders. Two accounts that you know so far fall in this category: stockholders’ equity is the total of the balances in the Common Stock and Retained Earnings accounts.
Common Stock (account) is the ownership value in the business that comes from outside the company - investors put their own money into the business.
Retained Earnings (account) is the ownership value in the business that comes from inside the company - the business makes a profit that is shared by its stockholders.
Dividends (account) are distributions of profits from Retained Earnings to stockholders.
Any change in the Common Stock , Retained Earnings , or Dividends accounts affects total stockholders’ equity.
Stockholders’ Equity can increase in two ways:
- Stock is issued and Common Stock increases and/or
- Business makes a profit and Retained Earnings increases
Stockholders’ Equity can decrease in two ways:
- Dividends are distributed and Retained Earnings decreases and/or
- Business takes a loss and Retained Earnings decreases