In accounting, there are many different equations that are used, but one is so prevalent and important to the profession, that it actually has the name of the profession in its title: the accounting equation, AKA the balance sheet equation. This equation illustrates the relationship between a firm’s liabilities (its obligations) and its owner’s capital/equity (resources owned by the business owner), and how they relate to the company’s assets. Sometimes there’s a demand from those both inside and outside the business to show more detail in this equation, and a need arises to break down the equity part of the equation into its component parts, and that’s where the expanded accounting equation arises.
The expanded accounting equation brings more detail to the owner’s equity part of the accounting equation, and rather than simply focusing on the balance sheet, like the regular version of the equation does, the expanded version brings the income statement into the picture, allowing for a more detailed look at the owner’s transactions. Today, we will be discussing this expanded accounting equation in its different forms, and how it’s used in the accounting field. If you’re somewhat familiar with accounting, but would like to brush up on the financial statements involved in the expanded accounting equation, this course on financial statements made easy and this article on the balance sheet will familiarize you with the statements we will be discussing today.
Formula for the Expanded Accounting Equation
Let’s begin our discussion of this formula by first showing you the unexpanded version of the equation: Assets = Liabilities + Owner’s Capital/Equity. Like we said before, this is also referred to as the balance sheet equation because it explains how one side of the balance sheet (assets) equals the sum of the components of the other side (liabilities and owner’s equity). One of the main tenets of accounting is that a transaction in one place must have an equal effect in another. Basically, this formula shows that what the firm owns (assets) were purchased by both what it owes (liabilities) as well as the owner’s investment (capital/equity). The expanded accounting equation looks to delve more deeply into the equity part of this equation, but both the assets and liabilities parts stay the same. Because there are three different types of entities that may use this equation, each with different ownership layouts, sometimes it needs to be tailored specifically to that business type. The types of businesses and their respective expanded accounting equations are as follows:
Because a corporation is publicly owned, its equity is a bit more complicated, and includes stocks and dividends. Here, assets are owned by the stockholders, but liabilities have priority over assets when applying the stockholders’ rights of ownership. Assets = Liabilities + (Common Stock – Dividends + Paid in Capital – Treasury Stock + Revenues – Expenses) Paid in capital represents the shares of stock, based on its par value. Dividends are the profits that are distributed out to the owners (stockholders). Treasury stock is shares bought back by the company that are meant for resale in the market. To learn more about the world of corporations, check out this course on corporate finance
A partnership, as its name suggests, is a business that’s owned by two people, and the accounting equation that’s expanded to accommodate this type of business takes into account funds that the owners not only put into the firm, but also the funds taken out by them. Assets = Liabilities + (Members’ Capital – Distributions + Revenues – Expenses).
- Sole Proprietorship
This type of a business is owned by a single person, and the expanded accounting equation for this type of business opens up the owner’s equity to include withdrawals and expenses that are the responsibility of the single owner. Assets = Liabilities + (Owner’s Capital + Revenues – Withdrawals – Expenses). Sometimes in businesses that operate on a smaller scale, the owner does their own accounting or bookkeeping in the beginning, not only to save money, but also to become intimately familiar with the firm’s finances. This course on the basics of bookkeeping provides an in-depth look at this money-saving job.
The reasoning behind expanding the expanded accounting equation are twofold:
- It illustrates how the overall equity of a firm is affected by net income, being increased by revenues and decreased by expenses. In terms of financial statements, the expanded accounting equation highlights the connection between the balance sheet and income statement, and bookkeepers and accountants are able to more specifically report where the equity comes from, what may be causing it to ebb and flow, and they are better able to understand profit trends.
- It also shows the effects of owners’ transactions, such as withdrawals, interest, dividends, and sales or purchases of ownership interest. While the regular accounting equation ensures the balancing of accounts, the expanded version is able to illustrate how much of that balance was affected by interest payments to shareholders.
In reference to owner’s withdrawals, or draws, this is when the owner of a company, most likely a limited liability company, or LLC, withdraws funds from the firm, usually to pay workers’ salaries. If this occurs in a corporation, the draws taken out for salary take the form of dividends paid out by investors. If keeping track of all of these transactions sounds confusing, this course on QuickBooks Pro 2014 will show you how the pros keep their meticulous records.
Not only will people within the firm wish to see the expanded accounting equation carried out, but potential creditors may also be curious about it, as well. When utilized, this equation can be used internally to analyze and plan a budget. Those considering lending money to a firm may be interested in seeing not only where money is being allocated, but also how well funds are being managed over time.
Examples of The Expanded Accounting Equation
Next, we will illustrate a situation in which the expanded accounting equation would be used. Below, are some transactions made by the owner of a sole proprietorship, along with the figures associated with these transactions. We will then apply these figures to the expanded accounting equation to make sure everything is in balance.
Example: $25,000 was invested into ABC Ltd. by its owner. The owner made $12,500 in revenue, which he then spent on inventory for the company. He then draws out the other $12,500 in order to pay his workers’ salaries.
We know the type of business is a sole proprietorship, so we can expand out the accounting equation as such: assets = liabilities + (owner’s capital + revenues – withdrawals – expenses). We can calculate the accounting equation as follows: 12,500 (salaries paid) + 25,000 (owner’s capital) + 12,500 (revenue) – 12,500 (salary expense) – 12,500 (draws) = $25,000 in assets
The expanded accounting equation is simply a more detailed look at a firm’s owner’s equity within the context of assets and liabilities. Like the more simplified version of the equation, there needs to be a balance between the two sides of the equation, and even though the expanded version is taking into account several other of a business’ owners’ transactions, it doesn’t change the fact that the left side should always equal the right side. If you’d like to learn more about this and many other accounting equations, this article on the 11 most used accounting ratios, along with this course on the basics of financial accounting, will both introduce you to this organized world.