ARTICLE TABLE OF CONTENTS
As a business owner, your interest in your company is called owner’s equity, also commonly referred to as shareholder’s equity. It consists of the capital contributed to the business by the owners and any retained earnings.
Owner’s equity can be broken down using the fundamental accounting equation, which shows the relationship between owner’s equity, and the assets and liabilities of the business. The expanded accounting equation breaks it down into more depth and provides a clearer picture of the equity’s distribution.
What Is the Fundamental Accounting Equation?
Developing a strong grasp on the fundamental accounting equation is essential to understanding the benefits of the expanded accounting equation. The fundamental accounting equation is sometimes also referred to as the basic accounting equation.
Fundamental Accounting Equation
Assets = Liabilities + Shareholder’s Equity
Many financial experts and accounting specialists agree the foundation of all accounting is based on the fundamental accounting equation. This is particularly true of the double-entry accounting system. It is with the double-entry accounting concept that all transactions equally impact both sides of the accounting equation, with the equation staying balanced continuously.
Assets are the resources of the business. The value of the resources determines the value of a business’s assets. Different types of assets include machinery, prepaid expenses, cash, land, and accounts receivable.
Liabilities are business obligations to third parties, resulting from past transactions. Examples of obligation include bank loans, accounts payable or tax liabilities.
Shareholder’s equity represents the residual claims on a company’s assets once all liabilities have been deducted. Equity and liabilities fund the assets of the business.
A Close Look at the Expanded Accounting Equation
Assets = Liabilities + (Contributed Capital + Beginning Retained Earnings + Revenue – Expenses – Dividends)
In the expended accounting equation, equity is broken down into its components.
The original stockholders are the ones to provide the initial capital needed to start and maintain a company’s operations, which is reflected as contributed capital.
When profits are not distributed but carried over to the next accounting period, this is known as beginning retained earnings.
The costs of running a business are classified as expenses while a business’s revenue results from sales of products or services.
Distributions made back to the owners are reflected as dividends.
This equation can be rearranged to allow for further analysis:
Businesses can work with the expanded accounting equation to create a layout that best suits their operational goals. But no matter the layout, it has to be always be balanced.
Example Sole Proprietors Expanded Accounting Equation in Action
1) John contributed $10,000 in his business and put the money in a bank account.
2) He took a business bank loan for $30,000.
3) An office printer was purchased for $500.
4) He rendered services and received cash $600.
5) Rendered services on account $700.
6) John bought a business phone for $350 on account.
7) John needed to pay $500 for repairing his company car with a 15-day repayment period.
8) He withdrew $2,000 cash to use for personal expenses.
9) John paid one-third of the loan.
10) A customer payment was received for services related to transaction 5.
As you look over the balance sheet shown above, you can clearly see how the equation maintains balance at all times. When you look at the total of the right side of the equation, you see that the total is equal to the total amount of assets shown on the left side. It’s important to study the chart above to reflect on how each transaction has a two-fold effect.