Expanded Accounting Equation Examples Concept Explanation

He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

When Should I Use the Basic Accounting Equation?

Additional numbers starting with six and continuing might be used in large merchandising and manufacturing companies. The information in the chart of accounts is the foundation of a well-organized accounting system. A business can now use this equation to analyze transactions in more detail. But first, it may help to examine the many accounts that can fall under each of the main categories of Assets, Liabilities, and Equity, in terms of their relationship to the expanded accounting equation.

Related In-Depth Explanations

The main problem with the expanded accounting equation is that it provides no information about the financial results of a business. In effect, it provides insights into a reporting entity’s balance sheet, but not its income statement. Similarly, it provides no information about the cash flows of the reporting entity. We could also use the expanded accounting equation to see the effect of reinvested earnings ($419,155), other comprehensive income ($18,370), and treasury stock ($225,674).

The balance is maintained because every business transaction affects at least two of a company’s accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as the double-entry accounting or bookkeeping system. These retained earnings are what the company holds onto at the end of a period to reinvest in the business, after any distributions to ownership occur.

The normal balance for the equity category is a credit balance whereas the normal balance for dividends is a debit balance resulting in dividends reducing total equity. The owner’s investments in the business typically come in the form of common stock and are called contributed capital. There is a hybrid owner’s investment labeled as preferred stock that is a combination of debt and equity (a concept covered in more advanced accounting courses). The company will issue shares of common stock to represent stockholder ownership.

What Is the Expanded Accounting Equation?

The expanded accounting equation breaks down the equity portion of the accounting equation into more detail. This expansion of the equity section allows a company to see the impact to equity from changes to revenues and expenses, and to owner investments and payouts. It is important to have more detail in this equity category to understand the effect on financial statements from period to period.

1. For a bit of challenge, study the examples above and try to determine what specific items were affected under each element and why they increased or decreased.
2. It is important to have more detail in this equity category to understand the effect on financial statements from period to period.
3. The owner’s investments in the business typically come in the form of common stock and are called contributed capital.
4. The dividend could be paid with cash or be a distribution of more company stock to current shareholders.
5. If a company keeps accurate records using the double-entry system, the accounting equation will always be “in balance,” meaning the left side of the equation will be equal to the right side.

Access and download collection of free Templates to help power your productivity and performance. Rearrangement in such a way can be useful when looking at bankruptcy. The equation layout can help shareholders to see more easily how they will be compensated.

The difference between the revenue and profit generated and expenses and losses incurred reflects the effect of net income (NI) on stockholders’ equity. Overall, then, the expanded accounting equation is useful in identifying at a basic level how stockholders’ equity in a firm changes from period to period. If a company keeps accurate records using the double-entry system, the accounting equation will always be “in balance,” meaning the left side of the equation will be equal to the right side.

The expanded accounting equation can be rearranged in many ways to suit its use better. With that being said, no matter how the formula is laid out, it must always be balanced. If you take the total of the right side of the equation (i.e. liabilities, capital contribution, income, expense, and withdrawals) you will get $36,450, which is equal to the total assets in the left side. This transaction decreases assets when the accounting services blog cash is distributed and increases assets when the new equipment is received. As was previously stated, double-entry accounting supports the expanded accounting equation. Double-entry accounting is a fundamental concept that backs most modern-day accounting and bookkeeping tasks.

Let’s now take a look at the right side of the accounting equation. Recall that the basic components of even the simplest accounting system are accounts and a general ledger. Accounts shows all the changes made to assets, liabilities, and equity—the three main categories in the accounting equation.

Advantages of the Expanded Accounting Equation

“Members’ capital” and “owners’ capital” are commonly used for partnerships and sole proprietorships, respectively, while “distributions” and “withdrawals” are substitute nomenclature for “dividends.” By decomposing equity into component parts, analysts can get a better idea of how profits are being used—as dividends, reinvested into the company, or retained as cash. The Financial Accounting Standards Board had a policy that allowed companies to reduce their tax liability from share-based compensation deductions. This led companies to create what some call the “contentious debit,” to defer tax liability and increase tax expense in a current period.

The accounting equation emphasizes a basic idea in business; that is, businesses need assets in order to work in progress inventory operate. First, it can sell shares of its stock to the public to raise money to purchase the assets, or it can use profits earned by the business to finance its activities. Second, it can borrow the money from a lender such as a financial institution. You will learn about other assets as you progress through the book.