The Accounting Equation and Financial Statements

The Accounting Equation

The Accounting Equation is the basic formula for all business accounting. The equation states that assets are equal to the liabilities of the company plus the owner(s)/shareholder's equity. The detailed equation is as follows:

Assets = Liabilities + Contributed Capital + Retained Earnings

In the equation, both sides must equal. Therefore, any changes to assets must be reflected in either liabilities or equity (and vice versa).

The parts of the equation are assets, liabilities and equity. Assets are the resources owend by a business. They are items that will be converted to cash or will be used by the business in the future. This includes cash, land, supplies and Accounts Receivable. Liabilities are claims against the assets held by creditors (non-owners). This includes Accounts Payable. Owner's Equity are claims against the assets held by the owners. Owners equity includes Capital Stock, Revenues and Expenses. Revenues and expenses, along with dividends, comprise the retained earnings of the company. Equity is increased by investments by owners and by revenues. Equity is decreased by expenses and dividends.

Financial Statements

The reports that provide the information of the business' transactions are called financial statements. The principle statements are: Income Statement, Retained Earnings Statement, Balance Sheet, Statement of Cash Flows. The header always is three rows. The first row is the company name, second is the type of report, and the third is "for the month ended" (or the date on the balance sheet) of the report. The third row represents the time frame or date of the financial statement.

Income Statements are a summary of the revenues and expenses for a specific period of time. All of the revenues, minus the expenses (but not dividends) comprise the income statement. If the final amount is positive, then the company has a Net Income. If the final amount is negative, then the company has a Net Loss. The income statement is prepared using the matching concept. This concept is applied by matching the expenses with the revenue generated during a period of time. The Net Income divided by the company's net sales (the revenue from sale of goods and services) is the company's profit margin.

The Retained Earnings Statement is a summary of the changes in the earnings retained in the corporation for a specific period of time. It starts with the previous retained earnings. To this is added the net income (or subtracted the net loss) from the income statement. Finally, dividends are subtracted. The formula is:

Retained Earnings = Previous retained earnings + Net Income - Dividends

The Balance Sheet is a list of the assets, liabilities and owner's equity as of a specific date. The total of the assets must equal total of liabilities and equity. The retained earnings are brought in from the Retained Earnings Statement, and are listed under equity. There are two ways to show the Balance Sheet: Account Form and Report Form. Account form shows the assets to the left, with liabilities and equity to the right. Report form shows assets at the top, with liabilities and then equity under it.

The Statement of Cash Flows is a summary of the cash receipts and cash payments for a specific period of time. Net cash flow (final amount) becomes Cash on the Balance Sheet. There are three forms of cash flow that generate revenue for a business: Operating Activities, Investing Activities, and Financing Activities.

  • Operating Activities are the general operating activities of the company that generate cash flow.
  • Investing Activities generate cash flow from the acquisition and sale of relatively permanent assets, such as land.
  • Financing Activities generate cash flow from cash investments by stockholders, borrowings and cash dividends.

Financial statements are prepared in the order of income statement, retained earnings statement, balance sheet, and statement of cash flows. It is important that they be prepared in this order, as they are interrelated. This means that information from one report is then used on another.