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Expanding the Accounting Equation

Posted by Amrik Randhawa on February 4, 2016 at 6:00 AM

One of the basic building blocks of understanding accounting is the accounting equation. Did you know that in addition to the basic accounting equation (more on that in a bit), there are also expanded versions of the equation tailored to sole proprietorships and corporations? Let’s refresh on the basic equation and then dive into the components of the expanded versions...

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Back to Basics

Before we get into the expanded accounting equations for sole props and corporations, let’s take a look at the basic accounting equation. For a sole prop, the equation looks like this:

Assets = Liabilities + Owner’s Equity

Assets are the resources owned/controlled by your company that can bring your business financial gain. (Think: cash, real estate, equipment, etc.) On the other side of the equation you have liabilities, the financial obligations of your company, including things like like loans, credit card debt, and bill payments. Finally, owner’s equity is the owner’s stake in the business.

To make this equation applicable to a corporation, all we need to do is replace owner’s equity with shareholders’ equity (or stockholders’ equity), the stake of the shareholders in the company:

Assets = Liabilities + Shareholders’ Equity

You’ve heard of “balancing the books," right? Well, both sides of the accounting equation need to be equal, or balanced. When it's not, you know something’s gone wrong in your bookkeeping.

Expanded Equation for Sole Props

So what gets added to the accounting equation when we’re dealing with a sole proprietorship? Owner’s equity gets expanded to include the different accounts that contribute to it. Those accounts include Owner’s Capital, Revenues, Expensesand Owner’s Draws. That gives us an expanded accounting equation that looks like this:

Assets = Liabilities + Owner’s Capital + Revenues - Expenses - Owner’s Draws

You’ll notice that both Expenses and Owner’s Draws are subtracted from the right-hand side of the equation; that’s because entries in both of these accounts take away from owner’s equity.

Expanded Equation for Corporations

As you might have guessed, what defines the expanded accounting equation for corporations is an expansion of the accounts making up shareholders’ equity. This usually includes the accounts for Paid-in Capital, Revenues, Expenses, Dividends and Treasury Stock. Here’s the full expanded equation for corporations:

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

Paid-in Capital (or Contributed Capital), which adds to the shareholders’ equity side of the equation, is any capital that has been contributed to the corporation by its investors through purchasing stock in the company. Taking away from shareholders’ equity is Treasury Stock, which represents the part of the shares (often bought back from shareholders) held by a company in its treasury.

What Does the Expanded Equation Tell Us?

The expanded accounting equation does offer an insight into your company’s financial standing that the basic equation does not. For both sole props and corporations, the expanded equation allows you to assess net income and the impact owner’s or shareholders’ equity has on it. You can also see the effect that transactions performed by the company’s owners/shareholders (like an owner’s draw or the issuing of dividends) has on net income.

Bottom line: when it comes to balancing your company’s books, turn to the expanded accounting equation for a more nuanced look at your business’s financial standing.

Topics: Accounting Basics