Expanded accounting equation

Expanded accounting equation
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Expanded accounting equation is expressed as six accounting elements like assets, liabilities, capital, revenues, expenses and drawing/dividends[1].

The expanded accounting equation formula

Basic accounting equation:

Assets = Liabilities + Owners’ Equity.

By extending the Owners’ Equity into Contributed Capital and Retained Earnings, the formula looks as follows:

Assets = Liabilities + Contributed Capital + Retained Earnings.

Finally, after extending the concept of Retained Earnings into Net Income and Drawing/ Dividends we receive:

Assets = Liabilities + Contributed Capital + Net Income – Drawing/Dividends.

Net income could be expressed as the revenue generated by the entity after deducting all the expenses. Therefore, the expand accounting equation becomes: Assets = Liabilities + Contributed Capital + Revenues – Expenses – Drawing/Dividends[2][3] Using the abbreviations:

A = L + C + R – E – D

The elements of expanded accounting equation

Each transaction is analyzed taking into account the accounting equation. The economic effects of the transaction are determined on the elements of the accounting equation[4][5]:

  • Assets – anything, that the business owns; items that are owned by a business and will provide future benefits
  • Liabilities – anything that the business owes; represent something owed to another business entity
  • Contributed Capital – the claim of the owners in the assets of the business
  • Revenues – the income generated from sale of goods or services, represent the total amount of products or services billed to customers
  • Expenses – the costs and charges incurred in an effort to generate revenue; the cost of doing business
  • Drawing – the withdrawal of cash or other assets by the owner from the business, for his own personal use; we talk about drawing in the sole proprietorship and partnership
  • Dividends – the return from investments in corporation for their stockholders; we talk about dividends in the case of corporation

The rules of debit and credit in expanded accounting equation

The most important rules in the process of analyzing transactions, which dictate the action to take, based on the effect of the transaction on the elements of the accounting equation are the rules of debit and credit. Debit means the left side of the account, credit means the right side of the account. The rules of debit and credit are directly related to the expanded accounting equation. In algebra we can change the expanded accounting equation expressed as A = L + C + R – E – D into A + E + D = L + C + R. It means, that the debit and credit rule for assets, expenses and drawing/dividends is the opposite of the debit and credit rule for liabilities, capital and revenues. It's necessary to understand the double entry accounting system to know how a business transaction are recognized on individual elements on expanded accounting equation[6].

Footnotes

  1. Agtarap-San Juan D. (2007), Fundamentals of accounting
  2. Rich J., Jones J., Mowen M., Hansen D. (2010), Cornerstones of Financial Accounting
  3. Camilleri E., Camilleri R. (2017), Accounting for Financial Instruments, A guide to Valuation and Risk Management
  4. Heintz J., Parry R. (2011), College Accounting
  5. Agtarap-San Juan D. (2007), Fundamentals of accounting
  6. Agtarap-San Juan D. (2007), Fundamentals of accounting

References

Author: Sławomir Maciejowski