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Understanding the Expanded Accounting Equation

written by: ciel s cantoria•edited by: Michele McDonough•updated: 5/19/2011

In understanding the expanded accounting equation, the matter of determining the type of business is important since accounting for a single proprietorship is different from a corporation. The capital composition is different; hence, the components presented are not the same.

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    What is the Expanded Accounting Equation for a Single Proprietorship?

    In a single proprietorship, the owner’s assets, liabilities and personal expenses should be separate and distinct from that of his or her business. Hence, the reader of the Balance Sheet report will have a ready reference about the composition of the Owner’s Capital account if the expanded accounting equation is used.

    Whereas the fundamental accounting equation for a single proprietorship is:

    Asset= Liabilities + Capital

    The expanded accounting equation for a single proprietorship would be:

    Assets= Liabilities + Owner’s Capital + Revenues – Expenses – Capital Drawing

    As an aid to understanding this expanded accounting equation, the components of the equation are explained as follows:

    Assets- This is the value of the business’s available resources. In a sole proprietorship, examples of accounts included under this component are cash, accounts receivables, inventory on hand, prepaid expenses, office equipment and machinery, and all other resources used as tools for carrying out the business operations.

    Liability- This is the value of the amount borrowed by the business proprietor from other sources; the proceeds or benefits of which, were used to sustain the business operations. Examples of accounts included under this component are accounts payable, notes payable, and accrued expenses payable.

    Capital- Initially, this represents the amount of money invested by the proprietor to put up his business. This account increases as the company realizes annual net profits or additional funds are infused as capital. Net losses and capital drawings will decrease this account.

    Revenues- The revenue presented in this expanded accounting equation will be at the gross amount of all sales realized during the year whether cash (COD) or on credit. In the general ledger, this is a temporary account and may have additional descriptions such as Sales Revenues, Service Revenues, or Interest Revenues. As a temporary account it will be transferred to the Profit and Loss Summary at year-end closing. As of year end, all revenue accounts will have zero balances.

    Expenses- This represents the total expenses incurred by the business related to business operations. All expenses incurred will be based on the accounting period in which the expense is related to and not on the date the expense was paid. This is also a temporary account and will likewise be transferred to the Profit and Loss Summary in order to zero out the balance as of year-end.

    Capital Drawing- Any personal expenses incurred by the owner using the business’s cash fund and in no way related to business operations will be classified under this account. This is also a temporary account which will be transferred to the Owner's Capital account at year end in order to zero out its balance.

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    What is the Expanded Accounting Equation for a Corporation?

    In understanding the expanded accounting equation for a corporation, you will have to keep in mind that the corporation has a separate identity. All assets will be recognized as owned by the stockholders of the corporations. On the other hand, all liabilities will have first priority over the assets before the stockholders’ rights of ownership are applied. Ownership rights will be evidenced by shares of stocks while the stock issued by the company will be limited up to the amount approved by the U.S. Securities and Exchange Commission as Authorized Capital Stocks.

    The accounting for assets and liabilities of the corporation is generally the same as that of a sole proprietorship except for other investment transactions the corporations may enter into or offer as investments. Examples of these are long-term or short–term bonds. Recognition of revenues and expenses will also be based on the accounting principles of matching income and expenses. Most of the differences in corporate accounting as against accounting for sole proprietorships are in the handling of the shareholders’ investments and the distribution of net revenues or profits.

    Whereas the fundamental accounting equation for a corporation is:

    Assets = Liabilities + Stockholders’ Equity

    The expanded accounting equation for a corporation would be:

    Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock

    Paid-in-Capital- This represents the shares of stock, whether common or preferred, as well as subscribed and paid-up by the stockholders. Valuation will be based on the par value of the stock.

    Dividends- Initially, the company will have to set a policy on how they will treat the net income generated annually. A company may decide to distribute the net profit yearly and pay it outright as dividends. However, other companies accumulate their annual net profits under a retained earnings account and will set a date as to when dividends will be declared and paid. Hence, the expanded accounting equation may use the retained earnings account instead of dividends.

    Treasury Stock- There will be instances that the company will buy back a stockholder’s share up for sale in the stock market. It is important that the treasury stock account is used to record shares of stocks owned by the company as a result of buy-backs. Management and external users will have a ready reference regarding this type of transaction since such stocks will not be included in dividend declarations or have voting rights.

    Summary

    The above accounts are essential in understanding the expanded accounting equation in relation to the Balance Sheet report of the business. Through this type of equation, the reader of the report will readily perceive the earning capacity of the company and the amount it has to spend in order to earn its annual revenues. The net effect between revenues and expenses which can either be net income or net loss will increase or decrease the capital of a sole proprietorship or the dividends/retained earnings of a corporation.

    There are other components to a corporation’s stockholder’s equity account used in accounting for transactions related to the stockholder's equity. However, since this article pertains only to what is basic in understanding the expanded accounting equation for a corporation, components that are complex in nature were not included.