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.
The Common Accounting Equation is as follows:
Assets = Liabilities + Equity
Assets = a company's resources that have future benefit (e.g. cash, PP&E,)
Liabilities = a company's obligations that must be paid to a lender (e.g. taxes owed, bank loans,)
Equity = how much the company's owner(s) has/have invested in the firm (through investing or)
Retained earnings represent a company's remaining net income after all of its dividends have been paid out to its shareholders.
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.
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.
Now, we can look at the expanded version of the common accounting equation. Notice how shareholders' equity has been broken down:
Assets =+ [CC + BRE + R - E - D]
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.
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.
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 ofon 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.
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.
In this example, Company X engaged in the following transactions during the month of February 2022:
February 01: 10,000were 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
|Feb 01 - Feb 05||100,000 – 300 + 300||100,000|
|Feb 10||100,000 - 5,000 + 5,000||100,000|
|Feb 15||100,000 - 10,000 + 30,000||20,000||100,000|
|Feb 20||120,000 + 25,000||20,000||100,000||25,000|
|Feb 25||145,000 - 200||20,000||100,000||25,000||200|
|Feb 27||144,800 - 18,000 + 18,000||20,000||100,000||25,000||200|
|Feb 28||144,800 - 750||20,000||100,000||25,000||200 + 750|
|Feb 28||144,050 - 4,000||20,000||100,000||25,000||950||4,000|
|Feb 28||144,050 - 8,000||20,000||100,000||25,000||950 + 8,000||4,000|
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
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.
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.
Some companies use varying terminology to describe the sections of their balance sheet. For example, Contributed Capital is sometimes called Paid-In Capital.