In the expanded accounting equation, the "capital" portion is broken down into several components.
We know that capital is affected by contributions, withdrawals, income, and expenses.
Contributions and income increase capital. Withdrawals and expenses decrease it.
The accounting equation for a sole proprietorship can be rewritten as:
Assets = Liabilities + Capital - Withdrawals + Income - Expenses
Owners' contributions are recorded directly into Capital. Hence, additional contributions are already included in "Capital". Nonetheless, if you want to show all of the components, then you can rewrite the equation as:
Assets = Liabilities + (Capital, beginning + Additional Contributions - Withdrawals + Income - Expenses)
Assume the following transactions:
- Mr. Alex invested $20,000 to start a printing business
- The company obtained a loan from a bank, $30,000
- The company purchased printers and paid a total of $1,000
- Rendered services and received cash, $500
- Rendered services on account, $750
- Purchased office supplies on account, $200
- Had its equipment repaired for $400, to be paid after 15 days
- Mr. Alex, the owner, withdrew $5,000 cash for personal use
- Paid one-third of the loan obtained in transaction #2
- Received customer payment from services in transaction #5.
The effects to the expanded accounting equation of the transactions are as follows:
Notice that the equation stays in balance. If you take the total of the right side of the equation (i.e. liabilities, capital, income, expense, and withdrawals) you will get $36,450, which is equal to the total assets in the left side.
Study the examples above and try to determine what specific items were affected under each element and why they increased or decreased. Do it one transaction at a time. If you find it difficult, refer to the explanations in the previous lesson. You will appreciate it better if you do this yourself.
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.
There is a two-fold effect in every transaction. This results in the movement of at least two accounts in the accounting equation. The amount of change in the left side is always equal to the amount of change in the right side, thus, keeping the accounting equation in balance.
The accounting equation is very important. It will guide you in understanding related accounting principles and help you solve many accounting problems.