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)
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.
The Equity Section of the Balance Sheet (refer to balance sheet blog) is made up of several key components of an entity:
Partner Capital Accounts
Capital Stock Accounts AND Additional Paid in Capital (APIC)
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).
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.
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.
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.
This publication is designed to provide information on federal tax and accounting laws and/or regulations. It is presented with the understanding that the author is not rendering legal or accounting services.
This text is not intended to address every situation that arises or provide specific, strategic tax and/or accounting planning advice. This text should not be used solely to answer tax and/or accounting questions and you should consult additional sources of information, as needed, to determine the solution to tax and/or accounting questions.
This text has been prepared with due diligence. However, the possibility of mechanical or human error does exist and the author accepts no responsibility or liability regarding this material and its use. This text is not intended or written by the practitioner to be used and cannot be used by a taxpayer or tax return preparer, for the purpose of avoiding penalties that may be imposed.