Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:
Assets (A) = Liabilities (L) + Owners' equity (E)
This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.
If the equation is rearranged:
Assets - Liabilities = Owners' equity
The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.
Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.
Owners' equity = Contributed capital + Retained earnings
Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.
Revenue - Expenses = Net income (loss)
Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.
Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.
Ending retained earnings = Beginning retained earnings + Net income - Dividends
The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:
Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends
- Dividends and expenses decrease owners' equity.
- Revenues increase owners' equity.
Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation: