Relation of Balance Sheet and Income Statement
The amounts recorded in revenue and expense accounts are used in preparing the income statement for the period. Then these accounts are transferred to equity because they are temporary accounts showing increases and decreases in equity. The income of the period is added to the equity section of the balance sheet during month end. An account in the equity section shows the accumulated amount of such income for all periods to date. A common title for this account is Retained Earnings. Often the income earned for the current fiscal year is added to a separate account shown in the equity section called Current Earnings or Profit/Loss. At the end of the fiscal year, the current earnings account is added to the retained earnings account.
Equity increases by the income of the period, that is, the difference between revenues and expenses. The Retained Earnings account is debited for amounts paid to the owners as dividends or some other type of withdrawal. For example, a dividend of $500 would be recorded as follows:
|
Dr. Retained Earnings |
500 |
|
|
Cr. Cash |
500 |
Since the Retained Earnings account is credited for the amount of income, or earnings, and debited for amounts paid to the owners, the balance is the amount of earnings that have been retained in the entity. To some people, the word retained suggests that Retained Earnings stands for an amount of cash kept in the entity, which is not true. All the entity's cash is reported in its Cash account. Retained Earnings is a claim against cash and also against the other assets.