The Expanded Accounting Equation Explained

Insurance, for example, is usually
purchased for more than one month at a time (six months typically). The company does not use all six months of the insurance at once,
it uses it one month at a time. As each month passes, the company will adjust
its records to reflect the cost of one month of insurance
usage. 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.

At the point they are used, they no longer have an economic
value to the organization, and their cost is now an expense to the
business. Cash (asset) will reduce by $10 due to Anushka using the cash belonging to the business to pay for her own personal expense. As this is not really an expense of the business, Anushka is effectively being paid amounts owed to her as the owner of the business (drawings). The assets of the business will increase by $12,000 as a result of acquiring the van (asset) but will also decrease by an equal amount due to the payment of cash (asset).

  1. This version of the accounting equation illustrates how different economic events lead to an increase or decrease in shareholders’ equity.
  2. 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.
  3. The inventory (asset) will decrease by $250 and a cost of sale (expense) will be recorded.
  4. Equity increases from revenues and owner investments (stock issuances) and decreases from expenses and dividends.
  5. 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.

Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. The increase on the asset side would be in the long-term asset column instead of the current asset column. We may even want to be even more specific and use an account labeled equipment under the heading long term asset. $10,000 of cash (asset) will be received from the bank but the business must also record an equal amount representing the fact that the loan (liability) will eventually need to be repaid. It will guide you in understanding related accounting principles and provides a foundation that will help you solve many accounting problems.

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. Essentially, anything a business owes and what makes some people more likely to volunteer than others has yet to pay within a period is considered a liability, such as salaries, utilities, and taxes. Cash includes paper currency as well as coins, cheques, bank accounts, PayPal accounts. Anything that can be quickly liquidated into cash is considered cash.

2: Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions

The company owing the product
or service creates the liability to the customer. Liabilities are obligations to pay an amount owed to a lender
(creditor) based on a past transaction. It is important to understand that when we talk
about liabilities, we are not just talking about loans. Money
collected for gift cards, subscriptions, or as advance deposits
from customers could also be liabilities. Essentially, anything a
company owes and has yet to pay within a period is considered a
liability, such as salaries, utilities, and taxes. Equipment examples include desks, chairs, and computers;
anything that has a long-term value to the company that is used in
the office.

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— X hires an employee to start producing products with its new equipment. The cash disbursement reduces assets and the payroll expense is recorded as a reduction of equity. This transaction decreases assets when the cash is distributed and increases assets when the new equipment is received. Here is the expanded accounting equation for a sole proprietorship.

This method relies on duality, meaning that every transaction must be expressed in debit and credit. This concept is closely related to the expanded and basic accounting equation. The double-entry accounting system is used to keep the expanded accounting equation in balance. This guide will help you understand the concept in theory and teach you how to apply it in practice. Net income reported on the income statement flows into the
statement of retained earnings. If a business has net income
(earnings) for the period, then this will increase its retained
earnings for the period.

Basic Accounting Equation vs. Expanded Accounting Equation

Machinery and buildings are often called PPE – Property Plant and Equipment. Unlike other long-term assets such as machinery, buildings, and equipment, land is not depreciated. The process to calculate the loss on land value could be very cumbersome, speculative, and unreliable; therefore, the treatment in accounting is for land to not be depreciated over time. A business can now use this equation to analyse 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.

An account is a contra account if its normal balance is opposite of the normal balance of the category to which it belongs. 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 expanded accounting equation breaks down shareholder’s equity (otherwise known as owners’ equity) into more depth than the fundamental accounting equation. It allows analysts and accountants to see the components of shareholder’s equity and how it impacts the company. It breaks down net income and the transactions related to the owners (dividends, etc.). A notes payable is similar to accounts payable in that the
company owes money and has not yet paid.

Cash includes paper currency as well as coins, checks, bank accounts, and money orders. Cash activities are a large part of any business, and the flow of cash in and out of the company is reported on the statement of cash flows. The expanded accounting equation goes hand in hand with the balance sheet; hence, it is why the fundamental accounting equation is also called the balance sheet equation.

For example, a business uses $400 worth of utilities in May but is not billed for the usage, or asked to pay for the usage, until June. Even though the business does not have to pay the bill until June, the business owed money for the usage that occurred in May. Therefore, the business must record the usage of electricity, as well as the liability to pay the utility bill, in May.

Cash activities are a large part of any business, and the flow of cash in and out of the business is reported on the statement of cash flows. For accounting purposes, any form of cryptocurrency is considered an asset in the same way as a Renaissance painting. 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. This equation plays a significant role in financial reporting by providing a framework for presenting a detailed and accurate picture of a company’s financial status in balance sheets and other financial statements. Cash includes paper currency as well as coins, checks, bank
accounts, and money orders.

As you can see from all of these examples, the expanded equation always balances just like the basic equation. — At the end of the year, X ends up with large profits and the management decides to issue dividends to its shareholders. When dividends are issued, cash is disbursed to shareholders reducing assets while the dividends reduce equity. Let’s take a look at a few example business transactions for a corporation to see how they affect its expanded equation. Let’s look at an example of the expanded version of the accounting equation.

Expanding the accounting equation

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). We could also look to XOM’s income statement to identify the amount of revenues and dividends the company earned and paid out. The
dividend could be paid with cash or be a distribution of more
company stock to current shareholders. Stockholder’s equity refers to the owner’s
(stockholders) investments in the business and earnings.

The company will issue shares of common stock to represent stockholder ownership. You will learn more about common stock in Corporation Accounting. Contributed capital and dividends show the effect of transactions with the stockholders. 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.

Profits retained in the business will increase capital and losses will decrease capital. The accounting equation will always balance because the dual aspect of accounting for income and expenses will result in equal increases or decreases to assets or liabilities. The expanded accounting equation can allow analysts to better look into the company’s break-down of shareholder’s equity. The revenues and expenses show the change in net income from period to period. Stockholder transactions can be seen through contributed capital and dividends.