Expanded Accounting Equation Explanation and Examples

X receives the cash from the new shareholders and also grants them equity in the company. To make the Accounting Equation topic even easier to understand, we created a collection of premium materials called AccountingCoach PRO. Our PRO users get lifetime access to our accounting equation visual tutorial, cheat sheet, flashcards, quick test, and more. 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.

When a company first starts the analysis process, it will make a list of all the accounts used in day-to-day transactions. For example, a company may have accounts such as cash, accounts receivable, supplies, accounts payable, unearned revenues, common stock, dividends, revenues, and expenses. Each company will make a list that works for its business type, and the transactions it expects to engage in. The accounts may receive numbers using the system presented in Table 3.2.

Some common examples of assets are cash, accounts receivable, inventory, supplies, prepaid expenses, notes receivable, equipment, buildings, machinery, and land. 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. The expanded accounting equation breaks down shareholder’s equity (otherwise known as owners’ equity) into more depth than the fundamental accounting equation.

Balance Sheet and Income Statement

As each month passes, the company will adjust its records to reflect the cost of one month of insurance usage. 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.

The expanded accounting equation breaks down the equity portion of the accounting equation into more detail. This expansion of the equity section allows a company to see the impact to equity from changes to revenues and expenses, and to owner investments and payouts. It is important to have more detail in this equity category to understand the effect on financial statements from period to period. This may be difficult to understand where these changes have occurred without revenue recognized individually in this expanded equation.

Therefore, always consult with accounting and tax professionals for assistance with your specific circumstances. Cash includes paper currency as well as coins, checks, bank accounts, and money orders. Anything that can be quickly liquidated into cash is considered cash. Cash activities are a large part of any business, and the flow of cash in and out of the company is reported on the statement of cash flows. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

In our examples below, we show how a given transaction affects the accounting equation. We also show how the same transaction affects specific accounts by providing the journal entry that is used to record the transaction in the company’s general ledger. The accounts are presented in the chart of accounts in the order in which they appear on the financial statements, beginning with the balance sheet accounts and then the income statement accounts. Additional numbers starting with six and continuing might be used in large merchandising and manufacturing companies. The information in the chart of accounts is the foundation of a well-organized accounting system. A business can now use this equation to analyze transactions in more detail.

The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations. The income statement reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement. If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement. The expanded accounting equation is a form of the basic accounting equation that includes the distinct components of owner’s equity, such as dividends, shareholder capital, revenue, and expenses. The expanded equation is used to compare a company’s assets with greater granularity than provided by the basic equation. Contributed capital and dividends show the effect of transactions with the stockholders.

How to use the Expanded Accounting Equation

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 small business accounting 101 difficult, you may refer back to the explanation in the previous lesson. To learn more about the income statement, see Income Statement Outline. The 500 year-old accounting system where every transaction is recorded into at least two accounts. Parts 2 – 6 illustrate transactions involving a sole proprietorship.Parts 7 – 10 illustrate almost identical transactions as they would take place in a corporation.Click here to skip to Part 7.

What is the expanded accounting equation?

Revenues and expenses are often reported on the balance sheet as “net income.” Service companies do not have goods for sale and would thus not have inventory. what is a business contingency plan Before we explore how to analyze transactions, we first need to understand what governs the way transactions are recorded. To learn more about the balance sheet, see our Balance Sheet Outline. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . Take your learning and productivity to the next level with our Premium Templates.

1. Parts 2 – 6 illustrate transactions involving a sole proprietorship.Parts 7 – 10 illustrate almost identical transactions as they would take place in a corporation.Click here to skip to Part 7.
2. It allows analysts and accountants to see the components of shareholder’s equity and how it impacts the company.
3. Owner’s or stockholders’ equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.
4. One of the main financial statements (along with the balance sheet, the statement of cash flows, and the statement of stockholders’ equity).
5. Notice that all of the equations’ assets and liabilities remain the same—only the ownership accounts are changed.
6. Unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided by the company.

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. Recall that the basic components of even the simplest accounting system are accounts and a general ledger. Accounts shows all the changes made to assets, liabilities, and equity—the three main categories in the accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger.

What Is the Expanded Accounting Equation?

Liabilities are obligations to pay an amount owed to a lender (creditor) based on a past transaction. It is important to understand that when we talk about liabilities, we are not just talking about loans. Money collected for gift cards, subscriptions, or as advance deposits from customers could also be liabilities.

For another example, consider the balance sheet for Apple, Inc., as published in the company’s quarterly report on July 28, 2021. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.