Expanded accounting equation

Expanded accounting equation is an extended form of the basic accounting equation that we learnt in our previous chapter. Remember the example from previous chapter where we left some transactions related to income statement accounts. Let’s now see the relationship of income statement accounts with the accounting equation.

Income statement has two components namely income and expenses. As a business, whatever the business earns becomes part of owner’s equity. So, the net income or loss i.e. income less expenses becomes a part of owner’s equity. In addition to the capital invested by the owner and net income or loss, there is owner’s drawings as well which is also a part of equity. In expanded accounting equation, we breakdown the equity and show all its elements in the equation. However, it must be noted that the overall relationship between assets, liabilities and equity is the same i.e. Assets = Equity + Liabilities.

Let’s see the expanded accounting equation of sole proprietorship:

Assets = [Owner’s Capital + Income – Expenses – Owner’s Drawings] + Liabilities

As the equity component of corporations is slightly different from that of sole proprietorship, so its expanded accounting equation is also different. Following is the expanded accounting equation of corporations:

Assets = [Paid-up Capital + Income – Expenses – Dividends – Treasury shares*] + Liabilities

* Treasury shares (or treasury stock) are the corporation’s own shares which are bought back by the corporation from the shareholders, thus reducing the number of shares outstanding in the market. Treasury shares can be sold to other shareholders or retired or can be kept as treasury shares in the books of the corporation.

Remember the example from previous chapter, we left some of the transactions. Let’s complete that example and see the impact of remaining transactions on the expanded accounting equation.

Example

Mr. Arteta started a business related to IT services by incorporating a new company on 1 July 20xx with an initial capital of $15,000. During the first month of the business, following transactions took place:

  • On 3 July, the Company paid $5,000 security deposit to the landlord for the office which was acquired on rent. Monthly rent of $2,500 was agreed which will be paid at the end of each month.
  • On 5 July, the Company purchased some office equipment such as laptop, printers etc. by paying $4,000. Useful life of this equipment is estimated to be 3 years.
  • On 15 July, the Company purchased some supplies worth $6,000 required for completing a project. Half of this amount was paid in cash whereas half was agreed to be paid after 30 days.
  • On 20 July, the Company obtained an interest free loan of $15,000 from a related party to manage its working capital.
  • On 27 July, the Company successfully completed its first project worth $16,000. It was agreed that 25% of the amount will be paid by the customer at the time of completion of project whereas the remainder amount will be paid after 60 days.
  • On 31 July, the Company paid monthly rent of $2,500 and paid salaries to its employees amounting to $4,500.

In previous chapter, we have considered the transactions which were not bold and italic. Now let’s consider the remaining transactions which are in bold and italic text and check their impact on the expanded accounting equation. We’ll record the journal entry of each transaction and then check its impact on the expanded accounting equation.

Date Accounts Debit Credit
15 July Material cost 6,000  
  Cash   3,000
  Accounts payable   3,000
  (Recording the purchase of supplies which are used in the project)    

Date Accounts Debit Credit
27 July Cash 4,000  
  Accounts receivable 12,000  
  Sales revenue   16,000
  (Recording the revenue earned from a project)    

Date Accounts Debit Credit
31 July Office rent expense 2,500  
  Cash   2,500
  (Recording monthly rent expense)    
31 July Staff cost 4,500  
  Cash   4,500
  (Recording monthly staff cost)    
31 July Depreciation expense 111  
  Accumulated depreciation   111
  (Recording monthly depreciation of fixed assets; $4,000/36 months)    

From the above example, it is established that if the accounting is done properly as per double-entry accounting system, the accounting equation will always be in balance.