Expanded Accounting Equation

Provides greater detail on the different sections of shareholders' equity.

Before diving into the expanded accounting equation, let's go over the common accounting equation. This can also be referred to as the basic common accounting equation. 

Expanded Accounting Equation

The Common Accounting Equation is as follows: 

Assets = Liabilities + Equity 

Where,

  • Assets = a company's resources that have future benefit (e.g. cash, PP&E, accounts receivable)

  • Liabilities = a company's obligations that must be paid to a lender (e.g. taxes owed, bank loans, accounts payable)

  • Equity = how much the company's owner(s) has/have invested in the firm (through investing or retained earnings)

Note

Retained earnings represent a company's remaining net income after all of its dividends have been paid out to its shareholders.  

Note

Equity can be referred to as Owner's Equity, Shareholders' Equity, or Stockholders' Equity. You will see Owner's Equity in reference to a sole proprietorship or a small business that is not a corporation. 

On the other hand, corporations use either Shareholders' or Stakeholders' Equity. The two are interchangeable, but for the sake of this article, we will use Shareholders' Equity.

Before further exploring the accounting equation, it is important to understand the importance of accounting, in general, for business operations. 

The process of accounting allows a firm to keep track of its income and expenditures. When making business decisions, a firm must be able to present management and investors with the necessary financial information. 

The basic version of the accounting equation simply illustrates the relationship between a firm's assets, liabilities, and equity. The numbers that represent these variables are found as values on a company's balance sheet. 

The accounting equation is useful because it provides a concise representation of a company's multi-item, complex balance sheet. In order for a company to keep accurate track of its financials, every transaction must be recorded in two of its accounts.

For example, if a company takes out a loan from a bank, the transaction will be recorded on two parts of the balance sheet. The loan will be recorded as an increase in assets, as well as an increase in its loan liability

The accounting equation is the basis of what is known as Double-Entry Accounting or Bookkeeping. The concept of double entry is fundamental to accounting and states that a firm's total debits on the left side must equal the total credits on the right side. 

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What is the expanded accounting equation?

The expanded accounting equation is a more detailed version of the common accounting equation. It provides greater detail on the different sections of shareholders' equity, allowing companies to see how their profits are used. 

Notes

Now, we can look at the expanded version of the common accounting equation. Notice how shareholders' equity has been broken down:

Assets = Liabilities + [CC + BRE + R - E - D]

Where,

  • CC = Contributed capital: the capital that the original shareholders provided

    • Also referred to as Paid-In Capital

  • BRE = Beginning Retained Earnings: earnings that have not been distributed to shareholders from the previous period 

  • R = Revenue: what's brought in by the sales and operations of the company

  • E = Expenses: costs of business operations

  • D = Dividends: earnings distributed to shareholders of the company

This version of the accounting equation illustrates how different economic events lead to an increase or decrease in shareholders' equity. 

The various economic events that alter shareholders' equity represent the profits and losses that appear in the shareholders' equity section of the balance sheet

The expanded accounting equation does not elaborate on the assets or liabilities sections of the basic accounting equation, as those components are not immediately affected by changes in income.   

Purpose of the expanded accounting equation

In general, the major benefit of utilizing the expanded version of the accounting equation is the additional clarity on the equity portion of the balance sheet over time. 

Purpose

Using the expanded version of the common accounting equation, economics analysts can more easily understand the breakdown of shareholders' equity. It can be especially useful to analyze how a firm uses its profits. 

The equation quantifies how a company utilizes its profits, whether reinvesting in the business, increasing its retained earnings, or paying dividends. 

With the expanded accounting equation, firms can analyze:

  • The effect of net income on equity

    • Equity is increased by revenues 

    • Equity is decreased by expenses

  • The effect of shareholder transactions

    • Analyzing contributed capital and dividends allows investors to understand how a company transacted with its owners. 

Calculator

The expanded accounting equation makes it easier to see how shareholders' equity in a company changes between periods. 

The basic accounting equation can be used when an analyst merely desires a simple calculation of a firm's value (in terms of its equity and liabilities). When more detail is required, it is best to use the expanded version. 

Additionally, those offering loans to a company will want to see where the firm's company is being allocated and how it is managing its funds over time. 

Example use of expanded accounting equation

Let's look at an example of the expanded version of the accounting equation. 

Example

In this example, Company X engaged in the following transactions during the month of February 2022:

  • February 01: 10,000 shares of common stock were issued at $10 per share

  • February 05: Purchased office supplies for cash $300

  • February 10: Purchased office equipment for cash, $5,000

  • February 15: Purchased business car for $30,000

           a. Paid $10,000 cash and issued a note for the balance

  • February 20: Billed clients $25,000 on account

  • February 25: Paid utility bills for the month of February, $200

  • February 27: Received $18,000 cash from clients billed on February 20

  • February 28: Paid office rent for the month of February, $750

  • February 28: Cash dividend paid $4,000

  • February 28: Paid salary for the month of February in cash $8,000

Expanded Accounting Equation
   Shareholder's Equity   
 AssetsLiabilitiesPaid-In CapitalRevenueExpensesDividends
Feb 01 - Feb 05100,000 – 300 + 300 100,000   
Feb 10100,000 - 5,000 + 5,000 100,000   
Feb 15100,000 - 10,000 + 30,00020,000100,000   
Feb 20120,000 + 25,00020,000100,00025,000  
Feb 25145,000 - 20020,000100,00025,000200 
Feb 27144,800 - 18,000 + 18,00020,000100,00025,000200 
Feb 28144,800 - 75020,000100,00025,000200 + 750 
Feb 28144,050 - 4,00020,000100,00025,0009504,000
Feb 28144,050 - 8,00020,000100,00025,000950 + 8,0004,000
 132,05020,000100,00025,0008,9504,000

Check using the expanded accounting equation:

Assets = Liabilities + [CC + BRE + R - E - D]

132,050 = 20,000 + 100,000 + 25,000 - 8,950 - 4,000

132,050 = 136,050

Key takeaways

The importance of accounting

  • Accounting is important for a company because the process allows it to keep track of its income and expenditures. When management and other companies ask about a firm's financials, it must be able to provide an accurate and organized report.

The common accounting equation

  • A company can assess the relationship between its assets, liabilities, and shareholders' equity using the common accounting equation. The values for these variables can be found on a company's balance sheet. 

The expanded accounting equation

  • The expanded version of the common accounting equation provides a more detailed breakdown of a company's shareholders' equity. The expanded version still includes a company's total assets and total liabilities but does not make any changes to them. 

Purpose of the expanded accounting equation

  • The expanded accounting equation is particularly useful when trying to analyze how a company manages and spends its profits. 

Double-entry bookkeeping

  • Both accounting equations follow double-entry bookkeeping, which states that a company's total debits on the left side must equal the total credits on the right side. 

Varying Terminology

  • Some companies use varying terminology to describe the sections of their balance sheet. For example, Contributed Capital is sometimes called Paid-In Capital.

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Researched and authored by Rachel Kim | LinkedIn

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