What is Equity?

THE PURPOSE

The purpose of any financial statement is to provide information about an entity’s transaction history that is USEFUL for internal and external users. 

You can read more about accounting and the purpose of Financial Statements here (refer to What is accounting blog)  

Financials must also be made using the Accrual Method of Accounting if prepared for external users. (refer to accrual blog)

WHAT IS THE EQUITY SECTION OF THE BALANCE SHEET?

The Equity section of the Balance Sheet is an ending balance of different accounts and items and represents the Owner’s or Shareholder’s Claim to Net Assets. 

In other words…

Equity is what is left over in a company after the liabilities are subtracted from the assets on any given day?This amount is what is left over for the owners of the company.

EQUITY SECTION KEY COMPONENTS

The Equity Section of the Balance Sheet (refer to balance sheet blog) is made up of several key components of an entity:

1. Partner Capital Accounts

2. Capital Stock Accounts AND Additional Paid in Capital (APIC)

3. Retained Earnings
   
   

All of these make up the STATEMENT OF CHANGES IN OWNERS EQUITY, as well as the ending balance in the Equity Section of the Balance Sheet. 

(There are other components, but most small to medium-sized companies do not use them).

1.  PARTNER CAPITAL ACCOUNTS

This account represents the basis each owner in a partnership has. 

When starting a company, or when a partner enters into a company, they each have a “basis” in the company, depending on how much they personally put into the company at inception. 

This “basis” is reduced and increased by company earnings, personal contributions and personal distributions (depending on the type of entity structure and amount owned by each partner) refer to our “What is Tax Basis” blog for more. 

1. CAPITAL STOCK ACCOUNTS – PREFERRED or COMMON STOCK and ADDITIONAL PAID IN CAPITAL (APIC).

If an entity issues Stock to shareholders instead of to general partners, the Equity section includes the balances in the outstanding Preferred and/or Common Stock. 

The company has to state the issued shares “Par Value”, which is the stated value at the time it was issued (for example $1 par value).

If the shareholder purchases the stock and the stock is trading for $15, which is the current fair market value. 

This means that the shareholder pays an extra $14/share to own stock in that company. This extra $14/share is added to an account “Additional Paid in Capital (APIC)”, which increases the total Equity Balance.  

1. STATEMENT OF RETAINED EARNINGS:

There is also a Retained Earnings part of the Equity Account, which is the Accumulated Profits (earnings) that are left over each year not paid out in the form of Dividends or Distributions, or Appropriated (reserved) for specific purposes. 

This account carries forward the prior year’s ending balance, is increased by Net Income, and is reduced each year by Dividends (Distributions) and Net Loss.

Super confusing, right?!

This is why always it is invaluable for business owners to use the quality service of a trusted accountant, you want to make sure your financials are done right, and that your tax return is an accurate representation of what really happened in your company.