EQUITY (fourth component of the Balance Sheet)

To date, we have discussed the Heading component of the balance sheet, the Asset component of the balance sheet, and the Liability component of the balance sheet. The fourth and final component of the balance sheet is known as Equity.

The equity section of the balance sheet represents all investments made into a company. Equity comes in the form of cash investments or other asset investments. Other asset investments might include personal items invested into a company by its owners such as office equipment, office furniture, automobile, and land. When such items are invested by their owners, it's imperative that each item be appraised and shown on the company's "books" at their current market value. It's important to note that personal assets invested into a business become the property of the business and should appear under the company's asset section of the Balance Sheet.

The appearance of the equity section will depend on the Legal Form of Your Business (sole- proprietor, partnership or a corporation). Moreover, the equity section of a corporation is quite different for the equity section of a sole proprietorship and a partnership. Lets look at the equity section for each form of business structure, starting with the equity section of the balance sheet for a sole proprietor.

The Equity Section for a Sole Proprietor
A sole proprietorship is a business owned by only one person. The equity section of a sole proprietorship is rather simple. It consists of only one account called CAPITAL. Capital can be referred to as an owner's direct investment into their company. These investments usually occur within the initial stages of the company's formation, however, a owner may contribute cash or other assets into the company at anytime. Recall under the assumption section of our example the following;

"Donald Sutherland is the sole-proprietor of The Toy Company. He invested his life savings of $10,000 (cash) into the business. The Company buys preassembled wooden toys from a supplier in Maine and sells them to end consumers (you and I). Donald registered the company as a sole proprietor on January 1, 200X and has been operating it since then".

Three important points stem from the assumption;

1.   The business is a sole proprietorship
2.   Donald invested $10,000 cash into the company on January 1, 200X
3.   No additional investments (cash or other assets) were made.

On January 1, 200X The Toy Company accounting records would show a capital account with a balance of $10,000. In essence, Donald gives The Toy Company $10,000 cash, in return, for a capital account valued at the same amount.

If you're an existing sole proprietor and print off your financial statements every month, you may notice a different capital account balance each month. Did you every wonder why? Well it's simple, the capital account will always change if one of the following events occur;

1.   When additional cash or other assets are invested into the company

2.   When the owner withdraws cash from the business

3.   When the company makes a profit or incurs a loss (income statement)

To illustrate this point, lets examine the changes that occurred in the Toy Company's Capital Account from January 1 to December 31, 200X. Recall, the capital account on January 1, 200X had a balance of $10,000. And on December 31, 200X, the capital account has a new balance of $12,514. Below shows the change in the capital account from January 1 to December 31, 200X

How did the capital account change from $10,000 to $12,514 during this period? Remember from above, the only way a capital account changes is if Donald invests additional assets (cash or other assets) into the company, withdraws money from the company, or if the company makes a profit or a loss.

We have to refer back to the assumptions section of our example to answer the following question that will show us how The Toy Company's capital account changed.

1. Did Donald invest additional cash or other assets into the company during the business year (January to December 200X)?  Nowhere in our assumptions does it tell us that Donald made additional investments. Therefore, we can assume that he didn't.

2. Did Donald withdraw any money from the business? The assumptions section tells us that Donald drew $500 cash each month, for a total of $6,000 over the year ($500 x 12 months = $6,000). Owners of sole proprietorships and partnerships withdraw cash from their company in order to pay personal expenses, for instance. Think of a withdrawal as a reduction of an owner's investment in the company. A withdrawal is not a wage expense or a salary expense since owners of unincorporated business, such as sole proprietorships and partnership, cannot enter into a legal binding contract with him or herself to hire and to pay him or herself a salary. Moreover, a wage is an expense that doesn't reduce the owners investment. A drawing is not an expense and does reduce the owner's investment account (IE capital account).

3. Did Donald's Company make a profit or incur a loss? Yes, every company either makes a profit or incurs a loss. Under the assumptions section of our example, we know that the company made a Net Income After Tax (profit) of $8,514. A Net Income After Tax is added to a sole proprietor's capital account because the owner automatically invests it back into the company. A Net Loss, on the other hand, reduces the capital account because the owner will have to "dip" into his/her investment to absorb the loss. In order for Donald to determine if the company made a profit or incurred a loss, he would have to develop an income statement of the year ending December 31, 200X.

Those are the only three questions Donald must answer in order to determine the new capital account balance on December 31, 200X. Here's how the new account balance would be calculated;

Notice, the beginning capital (Donald's initial investment into the company of $10,000 is added to Donald's other investments made into the company during the year ($0.00) and to the profit made by the company during the business year ($8,514). The sum of these three items represent the new total investment in the company. Donald's cash withdrawals represent a reduction of his overall investment and therefore are subtracted from his total investment or capital. The end result is known as the new or ending capital account balance ($12,514). Now lets look at the equity section of the balance sheet for a partnership.

Equity Section for a Partnership
A partnership type of business involves more than one owner. For instance, a partnership business could consist of two, three, four, or fifty owners.  The equity section of the balance for a partnership is the very same as that of a sole proprietor. A partnership also uses a capital account to keep track of each owner's investment. In other words, a sole proprietor has one capital account to track the sole owner's investment, while a partnership has a capital account for each owner. For instance, a partnership with five owners would have five capital accounts; one for each of the owners.

The Toy Company is a sole proprietorship, with Donald Sutherland being the only owner. Lets assume for a moment that on January 1, 200X Donald and his friend Bill Jones formed a partnership and each invested $10,000 into The Toy Company. Therefore, on January 1, 200X the equity section of the balance sheet would look like this.

As of January 1, 200X (their first day of operation), Donald and Bill each own $10,000 of the business. No other investments were made by either owner. Lets further assume, they develop a partnership agreement that simply states; "profits and losses will be shared equally. This means 50% of the profits or losses go to Donald and 50% of all profits or losses go to Bill. Over the year (January 1 to December 31), Donald withdrew $6,000 cash from the company and Bill withdrew $9,000 cash from the company. Lets also assume that the 200X net income after tax for the Toy Company (partnership) remains at $8,514. What amounts would appear in each capital account on December 31, 200X.

To calculate this, we need to answer the following questions;

1. Did either partner invest additional cash or other assets into the company after January 1, 200X?   Assume no additional investments were made by either party after January 1, 200X.

2. How much did each owner withdraw for the company during the business year? Donald withdrew $6,000 cash and Bill withdrew $9,000 cash from The Toy Company.

3. What was the Net Income after Tax as of December 31, 200X and how is it shared between the partners? The Net Income After Tax is assumed to be $8,514 and will be shared 50 - 50. That means, Donald's share of the profit is $4,257 ($8,514 x 50%) and Bill's share of the profit is also $4,257 ($8,514 x 50%).

Now the ending capital account balances for each partner can be calculated.

Therefore, the equity section on the company's December 31, 200X balance sheet would look like this;

As you can see, Donald's capital account is larger than his partners' by $3,000. Although, they both invested the same into the company ($10,000) and share the net income equally (50-50), Donald's investment account is larger. The reason for this difference lies in the amount of cash withdrew by each partner; Bill took $3,000 more cash drawings from the company than Donald. As a result, Bill has less invested into the company than his partner as of December 31, 200X.

This concludes the equity section of a partnership's balance sheet. Notice that the only account appearing under the equity section of a partnership and a sole proprietorship's is capital; one capital account for a sole proprietorship and one capital account for each owner of a partnership. Also notice, the capital account balances constantly change as a result of three factors;

1.   Additional investments (cash or other assets) made into the business;

2.   The withdraws of cash or other assets from the business; and

3.   The net income made by the company.

These are the only factors that affect the capital account of a sole proprietor ship and a partnership. Let's now look at how a corporation's equity section appears on the balance sheet.

The Equity Section for a Corporation:
As we have seen above, the equity section of a sole proprietorship and a partnership consist of only one account called capital. The equity section of a corporation, however does not use the capital account to illustrate the investments made into the company. Rather it uses "shares" accounts to show all the investments contributed by its owners. In addition, a corporation is required by law to distinguish between the company's investors (contributed capital by its owners) and the company's earnings over the years. Therefore, corporations use accounts called common shares, preferred shares (and/or other classes of shares), along with an account called retained earnings. The shares account show the investments made by owners (shareholders) into the company. The retained earnings account keeps track of all the company's earnings and all the dividends paid to the owners (shareholders) over the years of the corporation's life.

A graphical view of a typical corporation's equity section would be;

Notice the title of the equity section of a corporation is called Shareholders Equity. Don't be confused with the term shareholder. It simply means all the people who own a share or portion of the corporation. A corporation can have one shareholder or 100 million shareholders. To further explain a corporation's equity section of the balance sheet, lets assume the following;

1. Donald Sutherland, Bill Jones and three other people formed a corporation on January 1, 200X.

2. Each of the five people invested $4,000 in the corporation by buying 1,000 shares of its common stock. Therefore, the total investment by the shareholders was $20,000 ($4,000 * 5 investors).

3. The corporation earned $12,000 in its first year of operation (January 1 to December 31, 200X).

4. The Corporation's board of directors declared and paid dividends of $5,000 during 200X

On December 31, 200X (the corporation' year end) the Shareholders' Equity section would look like this.

Notice the common shares depict the investment made by the owners (5 shareholders x $4,000 invested by each = $20,000). The retained earnings, on the other hand, are comprised of two items;

1. The earnings (net income after taxes) of the corporation over the years.

2. The dividends paid to shareholders of the corporation. A dividend is similar to a withdrawal taken by owners of a sole proprietorship or a partnership. A corporation's board of directors declare when dividends will be given to its shareholders or owners. In this example, the board of directors declared $5,000 dollars of dividends during the 200X business year.

To calculate the retained earnings simply add the beginning retained earnings to the current year's net income (or net loss) and subtract any dividends. The following chart shows how the ending retained earnings were calculated for our corporation example.

The beginning retained earnings has an account balance of zero because this is the first year of the corporation's operations. Therefore, prior to January 1, 200X, the corporation would not have any earnings nor dividends.

The $12,000 represents the corporation's net income for the year (from January 1, 200X to December 31, 200X). The $5,000 represents the dividends that had been either declared or paid to the shareholders during 200X. In summary, beginning retained earnings account is added to the net income or net loss to arrive at the new contributed capital amount. Dividends are then subtracted to give us the ending retained earnings. The December 31, 200X ending retained earnings ($7,000) will become the beginning retained earnings for the 200Y business year.

In summary, the equity section of a corporation shows the same items as the equity section of a sole proprietorship or a partnership. The only difference, however, is the name applied to the accounts. Moreover, a unincorporated business only shows a capital account for each owner, while an incorporated business shows a shares account and a retained earnings account. Below summarizes the structure for each type of business.

You are advised to consult an accountant and/or a lawyer to determine which business structure is best for you. Sole proprietorship and partnerships can be set up without the assistance of a professional, however, we do suggest you utilize their services. The need for these professionals greatly increases when setting up a corporation. Now let's look at how to calculate total equity.

Total Equity
The total equity calculation will depend upon the legal structure of the business (a sole proprietorship, a partnership and a corporation). Total Equity for a sole proprietorship will simply be the amount specified in the owner's capital account. As presented below, Donald's capital account on December 31, 200X shows an account balance of $12, 514. Therefore, The Toy Company's total equity is $12,514 .

Remember, the capital account was calculated by adding the Net Income After Tax of $8,514 (from the income statement) to Donald's investment in the company of $10,000 and subtracting Donald's drawings over the business year of $6,000. ($10,000 + $8,514 - $6,000 = $12,514).

The total equity of a partnership is calculated by totalling all the ending balances in each owner's capital account. In our partnership example, the ending capital account balances for Donald Sutherland and Bill Jones are as follows;

Therefore, the total equity for the partnership would be $13,514. Be sure to understand that the ending capital account balances for each owner is calculated in the same fashion as for a sole proprietorship. (Initial investment + any other cash or other asset investment made during the year + portion of each partner's net income after taxes (or loss) - each partner's drawings during the year).

The total equity of a corporation is calculated by adding the value of all contributed capital (common shares, preferred shares, etc) to the ending balance in the retained earnings account. The contributed capital account(s) changes as more shares are sold, while the retained earnings account changes as earnings are made, loses are incurred, and when dividends are declared.

The final caption of the balance sheet is the total liabilities and equity.

Total Liabilities and Equity
The Total Liabilities (current liabilities + long-term liabilities) are added to the Total Equity to arrive at the company's Total Liabilities and Equity account balance. The Toy Company's total liabilities as of December 31, 200X amount to $42,866 and its total equity as of December 31, 200X amount to $12,514. Therefore the company's total liabilities and equity as of December 31, 200X amount to $55,380. See Below:

Notice the value of the company's Total Assets as of December 31, 200X is $55,380. As you can see, the Total Assets equal the same balance (value) as the company's Total Liabilities & Total Equity. This is how the balance sheet receive its name. Moreover, the total assets must ALWAYS equal (balance) the sum of the total liabilities and equity account. If these two amounts do not balance, then the balance sheet is incorrect (IE  it's out of balance).