|Owners’ equity represents the ownership interest in the business after liabilities are subtracted from assets.|
Owners’ equity is also called book value because it based on the book value of assets less the book value of liabilities, or the company book value. Other names for owners’ equity are net assets, net worth, and stockholders’ equity for publicly traded corporations.
The Accounting Equation (rearranged)
|Assets – Liabilities = Owners’ Equity (Book Value)|
The accounting equation shows that increases in assets increase owners’ equity. This can come from sales that increase cash or accounts receivable, or contributed capital from the owner or other investors in the form of cash or other assets.
The accounting equation also shows that increases in owners’ equity does not occur from purchasing or financing assets. For example, if a business owner purchases an asset with cash, the increased asset is offset by the decrease in cash, also an asset. Similarly, if the asset is financed, the increase in the asset account is offset by the increase in the liability account (e.g. note payable), with no effect on owners’ equity. In this way, the accounting equation always stays in balance.
This means that there are essentially only two ways to increase assets and owners’ equity: net profits and contributed capital.
Increasing Owners’ Equity
|There are two ways to increase the owners’ equity account:
Similarly, the owners’ equity account is reduced from capital distributions to owners (dividends for corporations) and net losses incurred on the income statement.
To understand this process, let’s look at the two ways Sunny increased his owner’s equity account.
Owner’s Equity Example
As an avid outdoorsman and golfer, Sunny recognized the need for quality sunglasses at a reasonable price. He researched the industry and saw profitable gross profit margins for retail sunglasses. He decided to start his business, Sunny Sunglasses Shop, on January 1, 2010. On this day, he withdrew $50,000 from his own personal account and invested it in the business.
Journal Entry to Record Initial Investment in Sunny Sunglasses Shop
|Date||Account and Explanation||Reference||Debits||Credits|
|Jan 1||Owner’s Equity||300||–||$50,000|
This affects the accounting equation as follows:
Sunny Sunglasses Shop Owner’s Equity
|Assets (Cash)||= Liabilities||+ Owner’s Equity|
|$50,000||= $0||+ $50,000|
The accounting balance sheet for Sunny Sunglasses Shop now shows:
|Owner’s Equity (Net Worth)|
At the end of 2010, Sunny made a profit of $15,283. Net income directly increased the value of the business.
The following formulas show how net income becomes part of owners’ equity:
|Net Income = Revenue – Expenses|
|Owners’ Equity = Net Income + Investment of Owners – Distribution to Owners|
From this formula we can see that the value of the business, or owners’ equity, is directly affected by net income as well as investments by owners, either privately or by stockholders.
The owners’ equity account is a permanent account listed on the balance sheet. The amount retained from profits, or net income, is accumulated in retained earnings. Net profits for the period measured (e.g. a month, quarter, or year) are rolled into permanent equity accounts by making closing entries in the accounting cycle:
|Owner’s Equity (Net Worth)|
|Total Owner’s Equity||$65,283|
Retained Earnings does not Equal Cash
Accumulated net profits, or retained earnings, is not the same as cash in the bank. This is because many sales are made on account. Additionally, cash that is earned from sales is often used to pay expenses, or to pay liabilities such as interest, loans, and taxes. It is thus essential that businesses distinguish retained earnings in the owners’ equity account from cash flow.
The statement of cash flows is used to measure the amount of actual cash generated from the business, and to reconcile net profits to actual cash from period to period. Businesses that are profitable can quickly run out of cash, and go out of business, if cash is not properly measured in relation to net profits earned.
Net profits from the business are also taxable, regardless of actual cash in the bank or cash flows from operations. This makes it even more important to monitor cash with the statement of cash flows in relation to retained earnings.
Owners’ Equity in Partnerships
Sunny, as a sole proprietor, has one owner’s equity account. If Sunny Sunglasses Shop were a partnership, then there would be an owner’s equity account for each partner or co-owner of the business. The partnership agreement then determines how profits and losses are split among the partners, and are allocated to each of the capital accounts as agreed (e.g. 50-50, 70-30, etc.). Profits and losses can be allocated differently (50-50 for profits, 80-20 for losses). In the absence of a partnership agreement, all partners share equally regardless of capital account balances and each partner’s activity in the business.
Stockholders Equity in Corporations
For a corporation, owners’ equity is called stockholders’ equity, or shareholders’ equity. Just as for privately held businesses owners’ equity can be increased with capital contributions and net income, in a public corporation stockholders’ equity is increased with contributed capital from the sale of stock.
Similarly, stockholders’ equity is also increased from net earnings that are accumulated in retained earnings account, also listed under the shareholders’ equity section of the balance sheet.