Expanded Accounting Equation with Income & Expense Example

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 (Figure). The accounts may receive numbers using the system presented in Table 3.2. In Introduction to Financial Statements, we addressed the owner’s value in the firm as capital or owner’s equity. The primary reason for this distinction is that the typical company can have several to thousands of owners, and the financial statements for corporations require a greater amount of complexity. This expanded equation takes into consideration the components of Equity.

The normal balance is the expected balance each account type maintains, which is the side that increases. As assets and expenses increase on the debit side, their normal balance is a debit. Dividends paid to shareholders also have a normal balance that is a debit entry. Since liabilities, equity (such as common stock), and revenues increase with a credit, their “normal” balance is a credit. Table 3.1 shows the normal balances and increases for each account type. A set of financial statements includes the income statement, statement of owner’s equity, balance sheet, and statement of cash flows.

1. If the business will stay operational in the foreseeable future, the company can continue to recognize these long-term expenses over several time periods.
2. The company will
   issue shares of common stock to represent stockholder ownership.
3. We begin with the left side of the equation, the assets, and work toward the right side of the equation to liabilities and equity.
4. So in order to balance the equation, one asset must increase (Car) and other must decrease (Bank).

A customer may not pay for the service on the day it was provided. Even though the customer has not yet paid cash, there is a reasonable expectation that the customer will pay in the future. Since the company has provided the service, it would recognize the revenue as earned, even though cash has yet to be collected. Examples of supplies (office supplies) include pens, paper, and
pencils.

Machinery is usually specific to a manufacturing company
that has a factory producing goods. Unlike other long-term assets such as machinery,
buildings, and equipment, land is not depreciated. The process to
calculate the loss on land value could be very cumbersome,
speculative, and unreliable; therefore, the treatment in accounting
is for land to not be depreciated
over time. A business can now use this equation to analyze transactions in
more detail.

The expanded accounting equation breaks down shareholder’s equity (otherwise known as owners’ equity) into more depth than the fundamental accounting equation. It allows analysts and accountants to see the components of shareholder’s equity and how it impacts the company. It breaks down net income and the transactions related to the owners (dividends, etc.). The owner’s investments in the business typically come in the
form of common stock and are called contributed
capital.

Disadvantages of the Expanded Accounting Equation

The primary exceptions to this historical cost treatment, at this time, are financial instruments, such as stocks and bonds, which might be recorded at their fair market value. Some companies that operate on a global scale may be able to report their financial statements using IFRS. The SEC regulates the financial reporting of companies selling their shares in the United States, whether US GAAP or IFRS are used. The basics of accounting discussed in this chapter are the same under either set of guidelines.

Example 6: Pay back a loan

Insurance, for example, is usually purchased for more than one month at a time (six months typically). The business does not use all six months of the insurance at once, it uses it one month at a time. As each month passes, the business will adjust its records to reflect the cost of one month of insurance usage. A business can now use this equation to analyse transactions in more detail. But first, it may help to examine the many accounts that can fall under each of the main categories of Assets, Liabilities, and Equity, in terms of their relationship to the expanded accounting equation.

Capital essentially represents how much the owners have invested into the business along with any accumulated retained profits or losses. The capital would ultimately belong to you as the business owner. For example, Lynn Sanders owns a channel profitability small printing company, Printing Plus. The customer did not pay cash for the service at that time and was billed for the service, paying at a later date. When should Lynn recognize the revenue, on August 10 or at the later payment date?

Example 1: Purchasing a car with cash

The expanded accounting equation is derived from the common accounting equation and illustrates in greater detail the different components of stockholders’ equity in a company. The inventory (asset) of the business will increase by the $2,500 cost of the inventory and a trade payable (liability) will be recorded to represent the amount now owed to the supplier. This concept is important when valuing a transaction for which the dollar value cannot be as clearly determined, as when using the cost principle. Conservatism states that if there is uncertainty in a potential financial estimate, a company should err on the side of caution and report the most conservative amount. This would mean that any uncertain or estimated expenses/losses should be recorded, but uncertain or estimated revenues/gains should not. This gives stakeholders a more reliable view of the company’s financial position and does not overstate income.

Expanded Accounting Equation for a Sole Proprietorship

Thus, there is no need to show additional detail for the asset or liability sides of the accounting equation. The accounting equation, whether in its basic form or its expanded version, shows the relationship between the left side (assets) and the right side (liabilities plus capital). It also shows that resources held by the company are coupled with claims against them. The expanded accounting equation is a more detailed version of the common accounting equation.

Without a dollar amount, it would be impossible to record information in the financial records. It also would leave stakeholders unable to make financial decisions, because there is no comparability measurement between companies. This concept ignores any change in the purchasing power of the dollar due to inflation. For example, Lynn Sanders purchases two cars; one is used for personal use only, and the other https://intuit-payroll.org/ is used for business use only. According to the separate entity concept, Lynn may record the purchase of the car used by the company in the company’s accounting records, but not the car for personal use. In applying their conceptual framework to create standards, the IASB must consider that their standards are being used in 120 or more different countries, each with its own legal and judicial systems.

Here are a few of the principles, assumptions, and concepts that provide guidance in developing GAAP. Equipment examples include desks, chairs, and computers;
anything that has a long-term value to the company that is used in
the office. Equipment is considered a long-term asset, meaning you
can use it for more than one accounting period (a year for
example). Equipment will lose value over time, in a process called
depreciation. We begin with the left side of the equation, the assets,
and work toward the right side of the equation to liabilities and
equity. The owners’ investments in the business typically come in the form of issued shares and are called contributed capital.

Expanded Accounting Equation with Income & Expense Example

The concept of the T-account was briefly mentioned in Introduction to Financial Statements and will be used later in this chapter to analyze transactions. A T-account is called a “T-account” because it looks like a “T,” as you can see with the T-account shown here. The time period assumption states that a company can present useful information in shorter time periods, such as years, quarters, or months. The information is broken into time frames to make comparisons and evaluations easier. The information will be timely and current and will give a meaningful picture of how the company is operating. Once an asset is recorded on the books, the value of that asset must remain at its historical cost, even if its value in the market changes.

It is important to remember that auditing is not the same as accounting. The role of the Auditor is to examine and provide assurance that financial statements are reasonably stated under the rules of appropriate accounting principles. The auditor conducts the audit under a set of standards known as Generally Accepted Auditing Standards. The accounting department of a company and its auditors are employees of two different companies. The auditors of a company are required to be employed by a different company so that there is independence.