The basic accounting equation is a simple formula where assets are equal to liabilities plus shareholder equity, but the equation can be made more granular to provide greater insight into equity transactions. The type of business impacts the format of the expanded accounting equation, but the concept is still the same – a detailed accounting of owners’ equity transactions.
The expanded accounting equation is a useful tool 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, serves as the foundation for double-entry bookkeeping. The expanded equation uses the income statement to provide additional detail of the company’s transactions.
Remember that under double-entry accounting, debits are recorded on the left side and, credits are recorded on the right side.
Expanded Accounting Equation
The expanded accounting equation builds on the standard accounting equation using double-entry accounting by adding granularity to 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. This helps 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 corporation or another legal entity with multiple owners, the basic accounting equation becomes total assets are equal to liabilities, plus paid-in capital, 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 financial position of the company. 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.
Owners 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 gives an indication of 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 accounting equation is still relevant. On the asset side of the equation, items such as cash, accounts receivable and inventory are listed. Obligations would include items such as accounts payable and notes payable. Owners 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 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 have a direct impact on the viability of business over the long term.
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.