The basic idea of the accounting equation remains the same which states that a firm’s total assets will always be equal to the sum of total liabilities and shareholders’ equity. The expanded accounting equation breaks down the shareholders’ equity into further sub-items.
Shareholders’ equity = Owners’ capital + Retained earnings
Retained earnings will further be broken down into revenue, expenses, and dividends. Therefore, the expanded accounting equation will finally look like as follows:
| Retained Earnings | ||||||||||||
| Assets | = | Liabilities | + | Owner’s capital | + | Revenue | – | Expenses | – | Dividend | ||
We can further explain it with the help of an example.
Let us suppose that Company ABC starts a business with $25,000 cash. The accounting equation will look like as follows:
| Retained Earnings | ||||||||||||
| Assets | = | Liabilities | + | Owner’s capital | + | Revenue | – | Expenses | – | Dividend | ||
| Cash | Inventory | Accounts Receivable | Accounts payable | |||||||||
| 25,000 | 25,000 | |||||||||||
Suppose the firm purchases $8,000 merchandise inventory on account. It will increase the assets by $8,000 (because of merchandise inventory) and increase the accounts payable by the same amount. Now, the accounting equation will look like as follows:
| Retained Earnings | ||||||||||||
| Assets | = | Liabilities | + | Owner’s capital | + | Revenue | – | Expenses | – | Dividend | ||
| Cash | Inventory | Accounts Receivable | Accounts payable | |||||||||
| 25,000 | 25,000 | |||||||||||
| 8,000 | 8,000 | |||||||||||
Further, the business sold merchandise costing 5,000 for $7,000 on account. Now, the accounting equation will be a follows:
| Retained Earnings | ||||||||||||
| Assets | = | Liabilities | + | Owner’s capital | + | Revenue | – | Expenses | – | Dividend | ||
| Cash | Inventory | Accounts Receivable | Accounts payable | |||||||||
| 25,000 | 25,000 | |||||||||||
| 8,000 | 8,000 | |||||||||||
| (5,000) | 7,000 | 7,000 | (5,000) | |||||||||
The firm paid salaries amounting to $1,000 in cash. After this transaction, the expanded accounting equation will appear as follows:
| Retained Earnings | ||||||||||||
| Assets | = | Liabilities | + | Owner’s capital | + | Revenue | – | Expenses | – | Dividend | ||
| Cash | Inventory | Accounts Receivable | Accounts payable | |||||||||
| 25,000 | 25,000 | |||||||||||
| 8,000 | 8,000 | |||||||||||
| (5,000) | 7,000 | 7,000 | (5,000) | |||||||||
| (1,000) | (1,000) | |||||||||||
This way, the expanded accounting question shows the effect of a transaction on each of its elements in detail.
