What is the Expanded Accounting Equation

The basic accounting equation is a simple formula where assets are equal to liabilities plus shareholder equity, but this basic equation can be made more granular to provide greater insight into equity transactions. The type of business impacts the expanded accounting equation format, but the concept is still the same – a detailed accounting of owners’ equity transactions.

The expanded accounting equation is a useful tool or terminology because of the additional detail on the owner investments section of the accounting equation. Unlike the basic accounting equation (also known as the balance sheet equation), which only focuses on the balance sheet, it serves as the foundation for double-entry bookkeeping. The expanded equation uses the income statement to provide greater detail of business transactions and operations of the business.

Remember that under double-entry accounting, debits are recorded on the left side and, credits are recorded on the right side of the equation.

Expanded Accounting Equation

The expanded accounting equation builds on the standard accounting equation using double-entry accounting by adding granularity to the owners’ equity portion of the formula. The chart of accounts is a numbering system that lists all of a company’s accounts in the order in which they appear on the financial statements, beginning with the balance sheet accounts and then the income statement accounts. For a sole proprietorship, the accounting equation becomes assets are equal to liabilities, plus the owner’s capital, plus revenues, minus expenses minus owner draws. These components help to illustrate cash flows of the business attributable to normal operations and contributions or the owner’s withdrawals. In other words, we can see how the income and expense accounts flow through the equation and eventually end up being reported at the end of the accounting cycle in the equity account of the balance sheet.

If the business is a type of entity structure such as a corporation or another legal entity with multiple owners, the basic accounting equation becomes total assets are equal to liability total, plus paid-in capital or capital contributions cc, plus revenues, minus expenses, minus dividends minus treasury stock. For corporations, this equation sheds light on important capital structure and common stock data points. Without insight into equity, business owners would be unable to effectively manage the finances of a business.

How Is This Equation Used?

Regardless of the form of business, the expanded accounting equation provides insight into two important aspects of operations – revenue and owner transactions. The formula is useful as it shows the relationship between your income statement and balance sheet. Net revenue or loss can impact owners’ equity, and it’s important to understand what percentage change in equity is attributable to net income and the company’s financial position. If a business has had a bad year or quarter, the expanded accounting equation breaks down the impact of negative performance on equity. Conversely, if retained earnings balance is high, that change is also illustrated.

Owner’s contributions and withdrawals are also important to understand because they impact the cash position of a business, and they help illustrate the capital structure of a business during a set accounting period. For example, if there are significant treasury stock transactions, it can give an indication of what management is trying to accomplish regarding stock price. It also indicates what management’s views about the future are.

Example Of The Formula

In a sole proprietorship, the balance sheet may be simple, but the expanded version of the accounting equation is still relevant. On the asset side of the equation, common examples of assets such as cash, machinery, accounts receivable, and inventory is listed. Obligations would include items such as accounts payable and notes payable. The owner’s capital would include all owner contributions to a business. Revenues would include items such as retail sales and similar gross income line items. Expenses could be items such as the cost of goods sold, administrative expenses, and payroll.

Owner draws could be quarterly distributions that an owner would take from their business. Corporations would be similar except for the stockholder’s equity portion of the equation. For example, treasury stock are shares in a corporation that have been purchased back from investors. Paid in capital is a reflection of the sale of stock to investors in a corporation. All of these transactions directly impact the viability of business over the long term, so the effect of transactions has a direct impact on the business.

Relevance For Accountants

From a practical standpoint, the accounting equation helps accountants produce complete and accurate financial statements because it keeps all accounts in balance. If accountants want to ensure the balance sheet accounts are accurate, they can use the accounting equation and perform a high-level analysis. This is very helpful when preparing financial statements outside of an accounting software system. If financials are being prepared in Excel, mistakes can be made, and the basic accounting equation may become out of balance.

The expanded accounting equation can help accountants perform a more granular check on the accuracy of the financial reports. In situations where owners’ equity transactions are under review, using the expanded equation can help catch errors in financial statements and help add credibility to Excel schedules that illustrate financial activity. Tools such as this equation are essential for internal control and the accuracy of financial reporting.

The expanded accounting equation has the power to provide useful insights into the owners’ equity transactions that a business engages in. This granularity can give business owners and leaders alike an understanding of capital structure for strategic planning. If equity transactions are impactful, then the expanded accounting equation is particularly relevant to analysts.