What is the expanded form of the accounting equation when incorporating revenues and expenses?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Assets = Liabilities + Capital + (Revenues - Expenses)
The modern accounting is based on double-entry system, which implies equality of assets and equities (liabilities and capital), i.e. A = E
Where E = L + C
Now A = L + C
Where A = Assets
E = Equities
C = Capital
L = Liabilities
Thus, Assets = Liabilities + Capital
In this equation the Liabilities means claims on the firm by creditors and the Capital means claims of owners. The claims of owners keep on changing due to success (profit) or failure (loss) of the firm. This is reflected by the income statement, which provides the summary of income and expenses of business for a given accounting period. Keeping this in view, the above equation can be re-written as:
Assets = Liabilities + Capital + (Revenues – Expenses)