Expanded accounting equation

Expanded accounting equation
See also
Underlying Profit Book profit Adjusted ebitda EBITDAR Distributable profit Unlevered free cash flow Du Pont analysis Income summary account Operating expense ratio

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

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 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:

• 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.

Examples of Expanded accounting equation

• Assets = Liabilities + Capital + Revenues − Expenses − Drawings/Dividends

For example, a company has $100,000 in assets, $50,000 in liabilities, $25,000 in capital, $20,000 in revenues, $15,000 in expenses, and $10,000 in drawings/dividends. The expanded accounting equation for this company would be: Assets = Liabilities + Capital + Revenues − Expenses − Drawings/Dividends

$100,000 = $50,000 + $25,000 + $20,000 − $15,000 − $10,000

• Assets = Liabilities + Capital + Revenues − Expenses − Drawings/Dividends

For example, a company has $500,000 in assets, $200,000 in liabilities, $100,000 in capital, $50,000 in revenues, $25,000 in expenses, and $5,000 in drawings/dividends. The expanded accounting equation for this company would be: Assets = Liabilities + Capital + Revenues − Expenses − Drawings/Dividends

$500,000 = $200,000 + $100,000 + $50,000 − $25,000 − $5,000

Advantages of Expanded accounting equation

The expanded accounting equation is a useful tool for analyzing and managing financial information. It consists of six accounting elements: assets, liabilities, capital, revenues, expenses and drawing/dividends. The following are the advantages of using the expanded accounting equation:

• Assets: The expanded accounting equation clearly identifies the value of assets held by the company, which helps to make better business decisions.
• Liabilities: This equation also clearly shows the liabilities of a company, which helps in understanding the financial obligations of the business.
• Capital: It helps to evaluate the net worth of the company, which is the total of its assets minus its liabilities.
• Revenues: This equation is helpful in tracking the income generated by the business activities, which helps in making sound financial decisions.
• Expenses: Expenses are also recorded in this equation, which helps to understand the cost of running the business.
• Drawings/Dividends: The equation also records the drawings and dividends, which helps to understand the distribution of profits to the owners.

Limitations of Expanded accounting equation

The expanded accounting equation is an expanded version of the traditional accounting equation which includes six accounting elements: assets, liabilities, capital, revenues, expenses and drawing/dividends. However, this equation has certain limitations that should be taken into consideration when using it. These limitations are:

• It does not account for important financial information such as cash flow, which is an important indicator of a company's financial health.
• It does not take into account the effects of inflation or other economic changes on the value of assets and liabilities.
• It does not account for the value of intangible assets such as goodwill or brand value.
• It does not account for the tax implications of certain transactions.
• It does not capture the true economic value of a company's operations.
• It does not take into account any non-monetary transactions that might have taken place.

Other approaches related to Expanded accounting equation

The expanded accounting equation is an important concept in accounting and financial reporting, as it provides a more detailed view of the accounting equation. Other approaches that build on this equation to provide additional insight into a company's financials include:

• The Statement of Cash Flows, which provides a detailed view of how cash moves in and out of a business. It tracks cash inflows and outflows from operating, investing, and financing activities.
• The Balance Sheet, which is a snapshot of a company's assets, liabilities, and equity at a given point in time. It provides an overview of the financial health of a business and helps to identify any potential under- or over-leveraged areas.
• The Income Statement, which is a summary of a company's revenues and expenses over a certain period of time. It helps to assess the performance of a business and provides useful information to investors and creditors.
• The Statement of Owner's Equity, which tracks the changes in a company's equity over a period of time. It helps to identify how much capital has been contributed by owners, how much has been withdrawn, and how much is retained in the business.

In summary, the expanded accounting equation is an important tool for understanding a company's financials, and other approaches such as the statement of cash flows, balance sheet, income statement, and statement of owner's equity can provide additional context and insight.

References

• Agtarap-San Juan D. (2007), Fundamentals of accounting, AuthorHouse
• Camilleri E., Camilleri R. (2017), Accounting for Financial Instruments, A guide to Valuation and Risk Management, Routledge Taylor & Francis Group
• Heintz J., Parry R. (2011), College Accounting, South-Western Cengage Learning
• Rich J., Jones J., Mowen M., Hansen D. (2010), Cornerstones of Financial Accounting, South-Western Cengage Learning

Author: Sławomir Maciejowski