The owner’s equity of a business is the residual amount left after deducting all liabilities from book value of company assets. It isn’t a measure of the value of a company, but rather a way to track both paid-in capital and retained earnings. Paid-in capital or contributed capital are contributions of the business owners while retained earnings are the accumulated net income and losses throughout the life of the business.
To understand the concept of owner’s equity, we refer to the accounting equation below:
Assets = Liabilities + Owner’s Equity
Since owner’s equity is what’s left to the owners, we derive the accounting equation as follows:
Owner’s Equity = Assets – Liabilities
What Is the Statement of Owner’s Equity?
The statement of owner’s equity is a financial statement that shows the changes in owner’s equity items during the period. It reconciles the beginning owner’s equity to ending owner’s equity, which both must agree to the owner’s equity amount shown on the beginning and ending balance sheet. This financial statement isn’t common in small business accounting software.
Below is an example of a statement of owner’s equity for a sole proprietorship:
KC Consulting Statement of Owner’s Equity For the Year Ended December 31, 2022 | ||
|---|---|---|
Kelly Clarkson, Capital, Jan. 1, 2022 | $ 25,000 | |
Additional Investment | $ 5,000 | |
Withdrawals | (1,000) | |
Net Income During 2022 | 11,300 | |
Increase in Owner’s Equity | 15,300 | |
Kelly Clarkson, Capital, Dec. 31, 2022 | $ 40,300 | |
- Beginning capital: This is the year-end balance of the capital accounts from the previous statement of owner’s equity, which should also equal the balance on the previous balance sheet.
- Additional investment: If the owner infuses cash or contributes new property to the business, it’s considered an additional investment that increases both owner’s equity.
- Withdrawals: Technically called “drawings” for sole proprietorships, withdrawals pertain to money withdrawn from a business by its owners. These are also the owner’s personal expenses paid using company resources.
- Net income: Net income from the current period increases owner’s equity while net losses from the current period decrease owner’s equity.
- Ending capital: This is the year-end balance of capital after considering the effect of investments, net income, and withdrawal. This must agree to the equity section of the balance sheet.
What Is the Difference Between Shareholder’s Equity vs Owner’s Equity?
Shareholder’s equity is another name for owner’s equity for companies that are organized as corporations since their owners are often referred to as shareholders. Owner’s equity is an umbrella term for the residual interest of business owners. It’s what’s left if the business pays all its liabilities. Owner’s equity represents the investment of the owners plus retained earnings.
Owner’s Equity Accounts on the Balance Sheet
Equity accounts can be classified into two groups: contributed capital and earned capital. Contributed capital is the investment of owners, whereas earned capital is net earnings of the company that haven’t been distributed to the owners. Earned capital is commonly referred to as retained earnings.
Examples of contributed capital are common stock, preferred stock, and additional paid-in capital for corporations. For sole proprietorships, owner investments are generally referred to as capital contributed.
MegaWorld Corporation Statement of Stockholders’ Equity For the Fiscal Year Ended June 30, 2022 | |||||
|---|---|---|---|---|---|
Common Stock, $10 par | Preferred Stock, $20 par | Additional Paid-in Capital | Retained Earnings | Total | |
Beginning Balances | $ 100,000 | $ 300,000 | $ 400,000 | $ 1,200,000 | $ 2,000,000 |
Net Income | 250,000 | 250,000 | |||
Issuance 1,000 Common Stock at $48 Each | 10,000 | 38,000 | 48,000 | ||
Issuance 1,000 Common Stock at $48 Each | (150,000) | (150,000) | |||
Ending Balances | $ 110,000 | $ 300,000 | $ 438,000 | $ 1,300,000 | $ 2,148,000 |
Common Stock
The common stock account represents the par value of common stocks. A common stock is a form of equity ownership where the shareholders shoulder all risks and rewards of a business. However, if the business goes bankrupt, it’s the common stockholders who will suffer the loss.
Preferred Stock
The preferred stock account represents the par value of preferred stocks. Preferred stocks aren’t common for small businesses but are popular forms of equity ownership in large and multinational corporations. Preferred stock is a special class of stock where shareholders are guaranteed a particular dividend rate and are paid prior to common shareholders in the case of bankruptcy. However, preferred shareholders aren’t allowed to vote on company matters.
Additional Paid-in Capital
Common and preferred stocks have par values. However, corporations always issue stocks above par. The excess amount goes to additional paid-in capital or APIC. In the sample stockholders’ equity statement above, MegaWorld Corporation issued 1,000 common stock for $48 with a par value of $10. MegaWorld Corporation received $48,000 from an investor, but its par value is only $10,000. The excess goes to APIC. The journal entry to record the issuance of common stock and APIC would be:
DEBIT | CREDIT | |
|---|---|---|
Cash (1,000 Shares x $48 per Share) Common Stock (1,000 Shares x $10 Par) APIC - Common Stocks | 48,000 | 10,000 38,000 |
Retained Earnings
The retained earnings (RE) account absorbs all income and losses of the business since its inception and is decreased by any owner distributions or dividends. Therefore, retained earnings can be thought of as the undistributed earnings of the company.
Sole proprietorships have no retained earnings account. Instead, all net income and losses are directly added to the capital balance of the owner. The same treatment applies to partnerships. However, the amount credited to the partner’s capital account is only equivalent to their profit sharing ratio.
Bottom Line
The owner’s equity of a business represents the book value of assets less all liabilities. Because the book value of assets can vary greatly from the asset’s fair market value, you should never assume that owner’s equity is a measure of the value of a company. It’s merely a set of accounts that tracks the total capital contributed by owners plus any undistributed income of the company.
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Now, let's break down the key concepts mentioned in the article:
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Owner's Equity: Owner's equity is the residual interest in a business's assets after deducting all liabilities. It represents the owners' claim on the company's assets and is calculated using the accounting equation: Assets = Liabilities + Owner's Equity. In other words, it's the portion of the company's value owned by its owners.
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Paid-in Capital: Paid-in capital, also known as contributed capital, refers to the contributions made by the business owners or shareholders to the company, typically in the form of cash or property. It represents the initial investments made to establish or expand the business.
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Retained Earnings: Retained earnings are the cumulative net income (profits) and losses that a company has earned and retained over its lifetime. These earnings are reinvested in the business and can be used for future growth or distributed to shareholders as dividends.
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Statement of Owner's Equity: The statement of owner's equity is a financial statement that outlines the changes in owner's equity during a specific period. It reconciles the beginning and ending owner's equity balances, taking into account additional investments, withdrawals (or drawings), and net income (or net losses) during that period.
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Shareholder's Equity vs. Owner's Equity: Shareholder's equity is essentially the same as owner's equity but is specifically used in the context of corporations, where business owners are referred to as shareholders. Both terms represent the ownership interest in the company, including contributed capital and retained earnings.
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Equity Accounts on the Balance Sheet: Equity accounts can be divided into two main categories:
- Contributed Capital: This includes the capital contributed by owners or shareholders. For corporations, it can consist of common stock, preferred stock, and additional paid-in capital (APIC).
- Earned Capital: Earned capital represents the company's accumulated net earnings that haven't been distributed to owners or shareholders. It is commonly referred to as retained earnings.
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Common Stock and Preferred Stock: Common stock and preferred stock are types of equity ownership in a corporation. Common stockholders bear the risks and rewards of the business and have voting rights. Preferred stockholders receive a fixed dividend rate and are paid before common stockholders in the event of bankruptcy but do not typically have voting rights.
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Additional Paid-in Capital (APIC): APIC is the portion of the capital that exceeds the par value of stock issued by a corporation. It represents the additional funds received from issuing stock above its par value.
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Retained Earnings: Retained earnings account for all income and losses in the business since its inception. It is reduced by owner distributions or dividends and represents the undistributed earnings of the company.
In summary, owner's equity is a fundamental concept in accounting, representing the residual interest of business owners in their company's assets. It is composed of contributed capital and earned capital, with the statement of owner's equity providing a summary of changes over a specific period. Shareholder's equity is the same concept but is used specifically for corporations, while equity accounts on the balance sheet categorize the different components of owner's equity.
