Accounting Equation: In-Depth Explanation with Examples

This dual-impact mechanism ensures the balancing nature of the equation. Regardless of how is common stock an asset complex a transaction might be, the left side (Assets) will always equal the right one (Liabilities + Equity). As you dive further into business finance, there is an equation poised to become more than just numbers on a page for you. Professionals use it to understand the effectiveness of the accounting policies followed by the organization. A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold.

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 the components of shareholder’s equity and how it impacts the company. It breaks down net income and the transactions related to the owners (dividends, etc.). Since all of the necessary information should be included on the detailed balance sheet, its computation only requires a close investigation of current business financial records. You might ask what’s the problem with the original accounting equation?

Different Types of the Expanded Accounting Equation

The accounts may receive numbers using the system presented in Table 3.2. The key benefit of using the expanded accounting equation is the extra visibility it provides into how the various components of the equity section of the balance sheet change over time. This is useful for outside analysts, who base their stock recommendations on detailed analyses of this type. The equation is especially useful for reviews of changes in the equity accounts of a business.

Accounting Equation for a Sole Proprietorship: Transactions 1-2

At the end of each year the account’s debit balance is closed to J. In our examples below, we show how a given transaction affects the accounting equation for a corporation. We also show how the same transaction will be recorded in the company’s general ledger accounts. The remaining parts of this Explanation will illustrate similar transactions and their effect on the accounting equation when the company is a corporation instead of a sole proprietorship. The proceeds of the bank loan are not considered to be revenue since ASC did not earn the money by providing services, investing, etc. As a result, there is no income statement effect from this transaction.

Stockholder’s equity is reported on the balance sheet in the form of contributed capital (common stock) and retained earnings. The expanded accounting equation also demonstrates the relationship between the balance sheet and the income statement by seeing how revenues and expenses flow through into the equity of the company. This expanded equation takes into consideration the components of Equity.

The accounting equation helps prepare the balance sheet, record journal entries, and keep accounts correct. In exams, students must apply this concept in questions, problem-solving, and preparing financial statements. This equation represents your company’s reality in terms of its economic resources (assets), obligations (liabilities), and residual ownership claims (ownership equity).

• Revenues and expenses are often reported on the balance sheet as “net income.”
• This provides a more granular view of financial performance and changes in equity.
• Further, it also elaborates on the detailed aspects of any increase in cash flows on account of revenue earned or any decrease in cash flows on expenses incurred for running the operations.

The creditors provided $7,000 and the owner of the company provided $9,300. Viewed another way, the company has assets of $16,300 with the creditors having a claim of $7,000 and the owner having a residual claim of $9,300. It will become part of depreciation expense only after it is placed into service.

Accounting Equation for a Corporation: Transactions C3–C4

Understanding the expanded accounting equation can be instrumental for any business owner. It assists in translating complex financial transactions into simple, digestible insights that can inform strategic decision-making. An important thing to remember is that revenues increase equity while expenses and owner’s different types of bookkeeping accounts and their specifics withdrawals decrease it.

In this context, withdrawal means the owner’s removal of assets (cash or otherwise) from the business for personal use. The expanded accounting equation operates on simple invoices in 9 steps the principles of double-entry bookkeeping, where each financial transaction your business makes affects at least two accounts. Think of it as going through a buffet spread of your business operations, filled with assets, liabilities, revenues, expenses, and owner’s equity. Naturally, you may be drawn towards some aspects while being cautious about others. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement.

The Financial Accounting Standards Board had a policy that allowed companies to reduce their tax liability from share-based compensation deductions. This led companies to create what some call the “contentious debit,” to defer tax liability and increase tax expense in a current period. See the article “The contentious debit—seriously” on continuous debt for further discussion of this practice. Unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided by the company. Since the company has not yet provided the product or service, it cannot recognize the customer’s payment as revenue, according to the revenue recognition principle. The company owing the product or service creates the liability to the customer.

The term losses is also used to report the writedown of asset amounts to amounts less than cost. It is also used to refer to several periods of net losses caused by expenses exceeding revenues. A gain is measured by the proceeds from the sale minus the amount shown on the company’s books. Since the gain is outside of the main activity of a business, it is reported as a nonoperating or other revenue on the company’s income statement. Fees earned from providing services and the amounts of merchandise sold. Under the accrual basis of accounting, revenues are recorded at the time of delivering the service or the merchandise, even if cash is not received at the time of delivery.

Example of the Expanded Accounting Equation in Practice

• The expanded equation highlights where and how these draws decrease overall equity.
• This equation determines the relationship between the assets, liabilities, and equity.
• Gain better visibility into your profits and shareholder investments using this nifty tool.
• Knowing the accounting equation helps in school board exams, competitive tests, and future business careers.
• The expanded accounting equation allows us to identify the impact on the owner’s equity in detail.

Interest earned by a bank is considered to be part of operating revenues. The accounting term that means an entry will be made on the left side of an account. That will be followed by looking at similar transactions at a corporation. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For a bit of challenge, study the examples above and try to determine what specific items were affected under each element and why they increased or decreased. If you find it difficult, you may refer back to the explanation in the previous lesson.

By breaking down owner equity into revenue and expense components, bookkeepers can report more specific information about where that equity comes from, and what is causing it to ebb and flow. An analysis of a company’s income statement is a key goal behind use of the expanded accounting equation, as it provides a better understanding of profit trends. You will notice that stockholder’s equity increases with common stock issuance and revenues, and decreases from dividend payouts and expenses.

Corporation Transaction C4.

Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching. After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career. Below is a portion of Exxon Mobil Corporation’s (XOM) balance sheet as of September 30, 2018.

Eventually that debt must be repaid by performing the service, fulfilling the subscription, or providing an asset such as merchandise or cash. Some common examples of liabilities include accounts payable, notes payable, and unearned revenue. It shows the effect of every transaction taking place and how it affects the corporation’s liabilities. Further, it also elaborates on the detailed aspects of any increase in cash flows on account of revenue earned or any decrease in cash flows on expenses incurred for running the operations.

The company will issue shares of common stock to represent stockholder ownership. The accounting equation emphasizes a basic idea in business; that is, businesses need assets in order to operate. First, it can sell shares of its stock to the public to raise money to purchase the assets, or it can use profits earned by the business to finance its activities. Second, it can borrow the money from a lender such as a financial institution. You will learn about other assets as you progress through the book. Let’s now take a look at the right side of the accounting equation.

Well the expanding formula shows the relationship between the income statement and the balance sheet. In other words, it shows how the income and expense accounts flow through the equation and eventually end up being reported on the equity section of the balance sheet at the end of the accounting cycle. The balance sheet is a formal view of the accounting equation which is made by companies to monitor their progress. The statement of financial position is also monitored by shareholders to see the profitability of the organization. Moreover, the balance sheet is used to check the liquidity position of the company, by banks and sellers to see if the firm will be able to pay back the loans and the goods or services purchased on credit.