Illustrate the expanded accounting equation
As you have learned, the accounting equation of Assets = Liabilities + Equity is the foundation of the double-entry accounting system. However, the way it is presented does not really reflect the whole picture. In order to understand how this equation really works, we expand the equation to reflect all of its component parts. We refer to this as the “expanded” accounting equation:
Assets = Liabilities + (Common Stock – Dividends + Revenues – Expenses)
This expanded equation takes into consideration the components of Equity. Equity increases from revenues and owner investments (stock issuances) and decreases from expenses and dividends. These equity relationships are conveyed by expanding the accounting equation to include debits and credits in double-entry form.
The increases (credits) to common stock and revenues increase equity; whereas the increases (debits) to dividends and expenses decrease equity. Remember, the normal balance of each account (asset, liability, common stock, dividends, revenue, or expense) refers to the side where increases are recorded.