Expanded Accounting Equation Definition
The expanded accounting equation takes the basic accounting equation and divides equity into its four principal elements, which are the owner’s capital, owner’s withdrawals, revenues, and expenses. The section of the basic equation which contains both the assets and liabilities remains unchanged in the expanded equation. Economic analysts can get a clearer idea of how to use profits for various things like dividends which are reinvested into the firm or kept as cash; by breaking down equity into smaller parts. The expanded accounting equation shows the various units of stockholder equity in greater detail. The main reason for the expansion of the equation is to differentiate an equity increase in relation to economic events.
- The expanded accounting equation is said to be the same as the basic accounting equation, but differing by its segregation of equity into smaller units.
- The equation divides equity into its four principal units, which are owner’s capital, owner’s withdrawals, revenues, and expenses.
- The expanded accounting equation shows the various units of stockholder equity in greater detail.
- Some terminologies may be modified due to the type of entity structure being examined. “Members’ Capital” and “Owners’ Capital” are commonly used for partnerships and sole proprietorship, respectively. Whereas, “distributions” and “withdrawals” are substituted names for “dividends”.
- The equation gives analysts a better understanding of individual units of a company’s shareholders’ equity.
The role of equity in the basic accounting equation is described by the expanded version of the accounting equation. The basic accounting equation is written as:
Assets = Liabilities + Owner’s Equity
While the expanded accounting equation is written as:
Assets = Liabilities + Contributed Capital + Beginning Retained Earnings + Revenue − Expenses − Dividends
Looking at the two equations above, it can be observed that the owner’s equity section in the basic equation has been split into contributed capital, beginning retained earnings, revenue, expenses and dividends.
The expanded accounting equation allows analysts to see individually:
- the effect net income (increased by revenues, decreased by expenses) has on equity.
- the effect of transactions with owners (draws, dividends, sale or purchase of ownership interest).
What Does the Expanded Accounting Equation Tell You?
Occasionally, analysts want a better understanding of what a firm’s shareholders’ equity is made up of. Stockholders’ equity apart from assets and liabilities which are part of the basic accounting equation is spread into various elements, such as, contributed capital, beginning retained earnings, revenue, expenses, and dividends.
The outcome of a firm’s transactions with stockholders’ is reflected by the contributed capital and dividends. The net income for a firm’s stockholders’ equity is shown by the difference between the revenue and the profit accrued, including incurred expenses and losses.
In summary, the expanded accounting equation is relevant when identifying how stockholders’ equity in a firm changes from time to time at a basic level.
Example of the Expanded Accounting Equation
Taking an example of a corporation X to see how its business transactions affect it’s expanded equation.
- X’s assets and common stock increases when it receives cash from its new shareholders and grants them equity after it was formed at the beginning of the year. It issued 1,000 $10 par value stocks.
- X purchases new equipment worth $2,000 which decreases its assets and increases its assets.
- X employs someone to operate its new equipment and start production. Two weeks later, the worker is given a check. This reduces assets.
- X ends up with large profits and issues a $10,000 dividend to its shareholders. This reduces assets.
It can be observed that the expanded equation always balances.