What is Equity?
Every Business is owned by somebody!
Theoretically, the Equity section of the Balance Sheet represents the owners portion of the business after all the Liabilities have been paid off.
Technical Stuff: Calculation of Equity
The Accounting Equation states
ASSETS = LIABILITIES + OWNERS EQUITY.
which can also be written as,
ASSETS - LIABILITIES = EQUITY
The 2 Sources of Equity
There are TWO IMPORTANT SOURCES that form the balances you see in the Owners Equity account.
The First source of Equity is the contribution made by the owners directly into the company.
The Second source is the Cash the company Retains from its own operations.
The First Source of Equity - Capital Accounts
When a Business starts, the money originally invested in the company by the owners is represented in the Capital Accounts.
In smaller businesses, it is easier to track this cash inflow and each owner gets their own capital account.
Interesting Fact
Even if owners contribute assets other then cash, the value in the capital account can be increased. For Example, smaller business may have owners contribute to items to the business such as equipment, vehicles etc.
In larger corporations each share of stock represents a percent of ownership in the company so the owners could number in the thousands.
Common Stocks, par value, Preferred Stocks and Treasury Stocks get a bit technical and we will leave that discussion for the Advanced Accounting Section for now.
The Second Source of Equity- Retained Earnings
The SECOND SOURCE of Equity is the money that the company Retains in the Business from the profits it accumulates over the years.
Retained Earnings
If a company makes a profit - each year the company has to make one of two choices.
CHOICE #1. Either pay out their net profit to the owners (shareholders).
This is called Drawings in small and medium businesses (not incorporated) and Dividends in bigger Corporations.
CHOICE #2. Retain all or some of the profit and use it as reserves, for growth, reinvestment or somewhere else.
If the company decides to keep the Profits to itself, the amount of Profit the company keeps is called Retained Earnings.
The Retained Earnings in the Equity Section of the Balance Sheet is cumulative and consists of all the profits over the years that have not been distributed to it's owners.
Interesting Fact
Owners Equity is also referred to as net assets or net worth.
However, don't get misled by the term net worth which implies that the business is worth the amount recorded in the owners equity accounts (If only things were this easy!)
In the real world, the worth of a business is dependent on the Equity plus several factors such as market share, cash flow, net profit, brand name, quality of management and many others.
Conclusion
- Equity is the Owners interest in a Business.
- There are two important sources that contribute to Equity Accounts in the Balance Sheet.
- They are the Owners (Capital Accounts) and the Profits that are retained in the Business (Retained Earnings).
Final Thoughts
If you are new to accounting the next thing I would read about would be Liabilities.
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