Expanded Accounting Equation

Breaks down shareholder’s equity into more depth

What is the Expanded Accounting Equation?

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 how shareholder’s equity is distributed and how that may impact the company. It shows the impact on equity concerning net income and the transactions related to the owners (dividends, etc.).

 

Expanded Accounting Equation

 

Fundamental Accounting Equation

The more simplified version of the accounting equation is called the “fundamental accounting equation” or the “balance sheet equation.” It is equal to:

 

Assets = Liabilities + Shareholder’s Equity

 

The fundamental accounting equation is debatably the foundation of all accounting, specifically the double-entry accounting system and the balance sheet. Double-entry accounting is the concept that every transaction will affect both sides of the accounting equation equally, and the equation will stay balanced at all times. Double-entry accounting is seen when doing journal entries of any kind.

  • Assets are resources a company has that hold value. Assets are found by combining all current assets with all non-current assets. Common examples of assets include cash, accounts receivable, machinery, land, and prepaid expenses.
  • Liabilities are obligations of a company to pay money owed to a lender as a result of a previous transaction. The liability total can be found by adding all current liabilities with all long-term debts and other obligations. Common examples of liabilities include accounts payable, taxes owed, and bank loans.
  • Shareholder’s equity is the company owners’ residual claims on assets after deducting all liabilities deducted. The expanded accounting equation will further break them down.

 

Understanding the Expanded Accounting Equation

The expanded accounting equation is broken down to be:

 

Assets = Liabilities + Share Capital + Retained Earnings

Assets = Liabilities + CC + BRE + R + E + D

 

Where:

  • CC = Contributed Capital
  • BRE = Beginning Retained Earnings
  • R = Revenue
  • E = (–) Expenses
  • D = (–) Dividends

 

N.B.: Expenses and dividends will be negative numbers if applicable.

 

  • Contributed capital comes from the capital provided by the original stockholders.
  • Beginning retained earnings is the carryover retained earnings that were not distributed to stockholders during the previous period.
  • Revenue comes from the sales and operations of the business.
  • Expenses are the costs associated with running the operation.
  • Dividends are the earnings that are distributed to stockholders of the company.

 

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. Although these numbers are basic, they are still useful for executives and analysts to get a general understanding of their business.

 

Expanded Accounting Equation - Shareholder's Equity

 

Rearranged Expanded Accounting Equation

The expanded accounting equation can be rearranged to suit better the needs of the individual using it. We can rearrange the equation to be:

 

Assets – Liabilities = Shareholder’s Equity

Assets – Liabilities = Share Capital + Retained Earnings

Assets – Liabilities = CC + BRE + R + E + D

 

Rearrangement in such a way can be useful when looking at bankruptcy. The equation layout can help shareholders to see more easily how they will be compensated.

Short and long-term debts, which fall under liabilities, will always be paid first. The remainder of the liquidated assets will be used to pay off parts of shareholder’s equity until no funds are remaining.

The expanded accounting equation can be rearranged in many ways to suit its use better. With that being said, no matter how the formula is laid out, it must always be balanced.

 

Examples

 

Journal Entry

As was previously stated, double-entry accounting is based around the expanded accounting equation. Double-entry accounting is a fundamental concept that backs most modern-day accounting and bookkeeping tasks.

It specifies that all financial transactions will include a corresponding and opposite entry in two or more accounts, balancing the journal entry and accounting equation. Transactions are recorded with one (or more) accounts being debited and one (or more) accounts being credited. Below are some examples of journal entries:

*Notice how in all cases, the equation stays balanced.

 

Explanation: New computers that cost $2,500 are purchased. $1,000 is paid upfront in cash and the rest is paid on account.

Dr. Computer (Asset) $2,500

Cr. Cash (Asset)          $1,000

Cr. A/P (Liability)         $1,500

 

2,500 – 1,000 = +1,500 + CC + BRE + R + E + D

 

Explanation: $1,000 is paid out of retained earnings to stockholders as dividends.

Dr. Retained Earnings $1,000

Cr. Dividends                $1,000

 

Assets = Liabilities + CC + 1,000 + R + E + (–)1,000

 

Explanation: A supplies expense of $600 is paid on account

Dr. Supplies Expense            $600

Cr. Accounts Payable            $600

 

Assets = 6,000 + CC + BRE + R + E + (–)600 + D

 

Balance Sheet

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. Any changes to the expanded accounting equation will result in the same change within the balance sheet.

 

Additional Resources

CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

  • Financial Accounting Theory
  • Projecting Balance Sheet Line Items
  • Journal Entries Guide
  • Projecting Income Statement Line Items

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