Equity is the difference between assets and liabilities as shown on a balance sheet. In other words, equity represents the portion of assets that are fully owned by the owners (stockholders, partners, or proprietor) of a business.
When I prepare financial statements, I always review the general ledger (GL) account numbers that the client has coded on the check register. Whenever I see a balance sheet GL account number, I automatically double-check it. The reason I do this is that the balance sheet is the least understood part of the financial statements for most clients. This is especially true regarding the equity section. In a way, this is rather strange, since the equity section represents the owner’s share of the business. I would want to keep a very close eye on my investment and, to do that effectively, I would need to know the nature of each equity account and how to interpret the changes in those accounts as they occur.
If I am a sole proprietor, it’s not as crucial because everything in the equity section is mine. That’s not to diminish the importance of knowing what the accounts mean, as there are other good reasons to track the increases and decreases that occur within them. However, if I am a partner in a partnership or a stockholder in a corporation, it is my responsibility to protect my investment interest from mistakes and/or deliberate misstatements. This can be a challenge and accounting knowledge is required.
It is in this light that I thought a review of the equity accounts for a sole proprietor, partnership, and corporation could prove useful. In order to do this, you need to understand how debits and credits work. If you need a reminder, you can click on this link: http://www.reallifeaccounting.com/accounting_model.asp and print out a copy of the “Accounting Model” for a guide.
Sole Proprietor
The equity section title in a sole proprietorship is most commonly called “Owner’s Equity”. The accounts within this section are usually laid out in this fashion:
Owner’s Equity
Current Year Capital Contributions
Owner’s Draw
Net Profit or Loss
Look at the accounting model chart and find the equity section. An increase to the equity section requires a “credit” entry, while a decrease requires a “debit” entry. Following this “accounting logic”,
it makes sense that a contribution of personal money to the business requires a debit entry to Cash and a credit entry to Current Year Capital Contributions. On the other hand, if cash is removed from the business for personal reasons, a debit entry to Owner’s Draw and a credit entry to Cash would be required.
Furthermore, if the business showed a profit, that would indicate an increase in equity (credit), or if it showed a loss, that would indicate a decrease (debit) in equity.
Since the Owner’s Equity account (a credit balance account) is an “accumulation account”, all the other accounts are closed out at the end of the year into the Owner’s Equity account. This makes perfect sense when you follow the journal entries required to close out the accounts. For Instance:
Net Profit or Loss is automatically closed into Owner’s Equity at the end of the year by your computer. If a journal entry were written, it would look like this:
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Net Profit | 50,000 | |
| Owner’s Equity | 50,000 |
Or
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Owner’s Equity | 5,000 | |
| Net Loss | 5,000 |
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Owner’s Equity | 20,000 | |
| Owner’s Draw | 20,000 |
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Captial Contribution | 2,000 | |
| Owner’s Equity | 2,000 |
As you can see the function of the sole proprietor equity accounts is not complicated or difficult to understand.
Partnership
Depending on how many partners there are, partnership equity accounts usually are organized as follows under the title, “Partner’s Equity”:
Partner A, Capital Account
Partner B, Capital Account
Partner C. Capital Account
Net Profit or Loss
All the increases or decreases occur within the partner’s capital accounts. In other words, the partner capital accounts are the equity accounts. If a partner makes a capital contribution, then his/her capital account is increased (credit). If the partner takes a distribution, then the capital account is decreased (debit). If the business has a profit or a loss at the end of the year, then that profit
or loss is distributed among the partners at whatever ownership interest or other arrangement is appropriate.
General partners who work in the business are paid a management fee called a “guaranteed payment”. This fee is a legitimate business expense and therefore acts to lower the net profit of the business. This fee is similar to a salary paid to a working stockholder in a corporation, except, according
to U.S. tax law, a fee paid to a working partner cannot be run through payroll. It is treated as a draw, subject to self-employment taxes. Both the general partner’s guaranteed payment and share of the profits are taxable and subject to self-employment taxes.
Sometimes a business may not have enough cash to make a distribution to the partners even though the business realized a profit. Partners may have a rude awakening to discover that they still have to pay taxes on those profits regardless of whether they received any money.
Another scenario to be aware of if you are a non-working general partner or a limited partner is this one: You and your partner contributed an equal amount of cash for working capital. The reason for investing your money is because you expect to share in the profits. Your partner is a working partner and is entitled to receive a management fee for services rendered. You need to keep an eye on the books because there may never be a profit to share in if your partner simply continues to increase his/her management fee. It can be a sticky situation because the working partner may feel he/she is never making enough money to justify all the work he/she has to do. It is best to define what the management fee is going to be in the partnership agreement beforehand.
Corporation (Primarily closely held corporations)
Closely held (private) corporation equity accounts are a little more complicated than a sole proprietorship or partnership. These are the typical accounts found in the corporation equity section under the title, “Stockholder’s Equity”:
Retained Earnings
Paid-in-Capital
Dividends Paid
Common and/or Preferred Stock
Net Profit or Loss
Retained Earnings is similar to the Owner’s Equity account in that the Net Profit or Loss is closed into that account at the end of each accounting year. Paid-in-Capital is the account used to record capital contributions made by stockholders. Keep in mind, as in the examples above, that increases to an equity account are credits. For example:
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Cash | 5,000 | |
| Paid-in-Capital | 5,000 |
If dividends were paid the journal entry would look like this:
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Dividends Paid | 10,000 | |
| Cash | 10,000 |
When common stock is sold or issued to raise money or acquire property:
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Cash | 100,000 | |
| Common Stock | 100,000 |
When Net Profit is closed out for the year:
| DESCRIPTION | DEBIT | CREDIT |
|---|---|---|
| Net Profit | 20,000 | |
| Retained Earnings | 20,000 |
These accounts are also found on public corporations, however they may have additional equity accounts that are necessary to explain more complex activities.
You can see that the equity accounts in all three business entities function in a similar manner. From year to year, there should be continuity. This means there should be a logical explanation for any increases or decreases in theequity accounts. As an investor or owner, you have a right to know the reasons for any changes. If there has been a mistake, willful or otherwise, it is most likely going to show up in the equity section. Stay vigilant and protect your investment.
53 Comments
Partnership taxation is the concept of taxing a partnership business entity. Many jurisdictions regulate partnerships and the taxation thereof differently.
Kid: Can you give us an example of how a state might differ from federal taxation, i.e., a pass-through entity?
John
Equity accounts: represent the residual equity of a business (after deducting from Assets all the liabilities) including Retained Earnings and Appropriations.
Larry: Retained Earnings is part of the equity of a business. Please explain why you would deduct part of your equity to get to your equity.
John
nice post, thanks for sharing!
Very Good Post.
Appreciate for your contribution.
CHEERS
Equity is really your money, but not only your money. According to Robert Kijosaki it is everything that puts money in your pocket
nice post
thanks to you
I am very interested in being an accountant so I thought it would be a good idea to blog with one. I have a question about 401K and IRAs. What is the main difference between the two?
LaReina: Thanks for your question, however this blog is designed to answer questions related to small business accounting issues. All you need to do is Google in 401K vs. IRA and you will get numerous detailed explanations as to the advantages or disadvantages of each one.
John
Great info. I always follow your posts. Thanks again for all the great insight and knowledge.
Thanks for your post.
I am devoting myself to be an accountant.
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I am quite interested in getting an accountant so I concept it would be a excellent concept to blog with one. I have a question about 401K and IRAs. What’s the primary difference in between the two?
Suggest you Google to easily find the answer to your pension questions. This site is primarily to field questions related to small business accounting issues.
I am looking forward to be an accountant so I thought it would be a good idea to blog with one. I would post some of my question I encountered in my accounting study and seek for help from you experts.
tax accountant melbo: Sorry, that’s one thing I don’t do anymore is student’s homework. Often, academic accounting questions are not easily answered and takes time to research. I simply don’t have the time. I sympathize, but isn’t that what your accounting prof is for? I set the site up to help answer accounting questions related to small business and try to keep the questions within that boundary of my experience. You might try visiting http://www.accountingcoach.com.
It’s great to discover this blog for helping us to solve problems in small business. Thanks so much in advance!
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Hi John–thanks for this article… it’s helping me as a partner in a new partnership.
May I ask how you would record a partner’s initial contribution of time? For example, one partner is contributing equipment–the current market value of the equipment will be Debited to an appropriate Capital Asset account, and the balancing entry would be to a Credit Partner’s Contribution account. If another partner is contributing an equivalent value of working time as his initial contribution, the Partner’s Contribution Credit side would be the same, but what would the Debit side be? The Expense accounts that correspond to what the partner did? (web site setup, etc.)
I’m concerned that, as per your article regarding “Contributed Labor”, no money has changed hands, so maybe the Partner can’t contribute this way? http://blog.reallifeaccounting.com/2005/10/03/how-to-record-contributed-labor-on-the-company-books/
Thanks!
Ken
Ken: The issue with “contributed labor” is whether a business can take a deduction or not. Contributed services for a partnership interest is a different situation. This can be a very tricky issue depending on how the partners want to handle it. If it is an arrangement whereby the partner who is contributing service receives an immediate equal interest then it is fairly straightforward. However, the partner contributing services will have to report the amount as taxable income. The bookkeeping works the same as though a partner was actually being paid for services rendered, except, instead of crediting (decreasing) cash the partner’s capital account is credited (increased). The debit goes to “guaranteed payments” for that partner, which is an expense to the partnership. Of course, that deduction effects the bottom line which all the partners enjoy. All this activity is reported on the partner’s K-1 form.
Where it becomes sticky is when you decide that the contributing services partner should not get a full partnership interest right away, but perhaps a right to future profits. I highly recommend that you consult with your tax person to determine how to go about setting this up.
John
Hi John–great information, thank you very much!
In my case, the partner is receiving an immediate equal interest.
That makes sense that the partner contributing the services would have to report it as taxable income, seeing as the partnership gets a deduction. Somebody else suggested crediting the partner’s capital account and debiting/increasing “Goodwill”, that way it would not go against the other partners’ capital. But I’m not sure this would work. For example, when the partner took future cash from the partnership, you would need to credit/decrease Goodwill and debit/decrease the partner’s capital account, but then you’re left with no txn to make against the cash or bank account.
Thanks again for your help!
Ken
Ken: I would avoid the suggestion to debit “goodwill”. That makes no sense to me.
John
You are right, Equity is the difference between assets and liabilities as shown on a balance sheet. In other words, equity represents the portion of assets that are fully owned by the owners (stockholders, partners, or proprietor) of a business. That’s not to diminish the importance of knowing what the accounts mean, as there are other good reasons to track the increases and decreases that occur within them.
This is the informative blog. I think,Equity accounts represent the owners’ interest in the assets of a business. The owners’ interest is the part of assets that is left after all liabilities are paid. Therefore equity is sometimes called Net Assets.The stockholders’ equity accounts are balance sheet accounts and a part of the accounting equation Assets = Liabilities + Stockholders’ Equity. In this light you can view the stockholders’ equity accounts (along with the liability accounts) as sources of the amounts reported in the asset accounts.
Great post. The way you explain things is just very clear and understandable. I think yours is the only blog i’ve come across so far that has elaborated this well on equity.
sir please tell me that what is the proper head of Refereshment to customers ” in accounting for companies
Neelam: I’m not sure what you are asking me. Perhaps you could explain what ” proper head of Refreshment to customers” means. Is this an expense item? Are you asking whether to record the entry as a debit or credit if you are increasing the expense?
John
ok.. so.. I’m doing an assignment in school and it tells me that the owner invested 20,000 into the company with a cheque and has to be allocated to the following acounts bla bla…. How do I add the 20,000 into the owners contributions? when I go to distribute the money from the owners contributions, it puts owners contributions into the negatives!!!
Kristine: First, review the “accounting model” http://www.reallifeaccounting.com/accounting_model.asp. Then think out what you are doing in terms of increases and decreases. For example, the owner increased cash (debit) and increased his equity (credit) by 20,000. I Assume cash was increased because there was a cheque. Next, we have to assume that the money was contributed for specific purposes such as to pay for things. Therefore, you are either increasing an expense (debit), increasing an asset (debit) or decreasing a liability (debit) and decreasing cash (credit). What doesn’t make sense is your statement: “…distribute the money from the owners contributions, it puts owners contributions into the negatives”. When you say “into the negatives” do you mean a decrease in owner’s equity? If you are decreasing owner’s equity (debit) what is the credit? It helps to first figure out what is going on physically in terms of increases and decreases and then using the accounting model translate that into an accounting transaction (journal entry). When all else fails, consult your accounting teacher, that is what he/she is for.
John
This is great advice that is easily understood by any reader I’m sure. Keep up the good work.
Excellent examples that well thoughtout and easily followed. I’ll recommend this page to others.
I just started a franchise business(i’m the franchisee) and is a lil confused on how I should record the start-up capital, due to:
1. My company is a joint-venture(corporation) between me(10% share) and a representative of the franchisor (90% share).
2. The agreed start-up investment is $450K, of which $405K is in the form of loan(no interest) from the franchisor and I contribute cash $45K.
3. All the startup equipment, furniture, and purchases we got from the franchisor and they bill my company by invoices, amounting to RM 405K.
My question is, do I record the franchisor ‘s investment (which is in the form of a $405K loan) as a credit in the Paid-In Capital account, along with my cash investment of 40K?
The for the startup expenses, I post them as credit to the Franchisor Account Payable. But, which account I debit ?
Patty: First thing to do is to read my article about starting a new business(http://www.reallifeaccounting.com/pubs/Article_Theme_Starting_or_Buying_a_New_Business.pdf). However, new tax rules regarding the deduction for Organization Cost and Start-up Costs have changed since I wrote the article. So check with your tax person. Having said that, from what you are saying you may not have much of what is technically defined as “Start-Up Costs”. It sounds like you are buying from your franchisor mostly all the equipment and furniture you will need to run the business. The murky part in your description is the status of your franchisor. Is he an owner or a lender? Will he own stock just like you? The IRS doesn’t recognized a no interest loan. So if he is not a lender he must be an owner. If that is the case, the stock must be issued under the general ledger account of common stock assuming you are a C corp and not an S corp. Paid-in-Capital is money paid in over the original amount of stock purchased so is not the account to use. How is the money to be paid back to the franchisor? Is the franchisor to share in profits? Or, is he to get monthly payments? If your arrangement really is that the franchisor is a lender, then the $405K should be booked as a Long-Term Notes Payable. Perhaps if this is the true intent, a low interest rate could be set up. Your $45K should be booked as common stock as a credit. If the $405K is really a loan, then record it to Notes Payable as a credit and the $450K booked to the appropriate fixed asset accounts as a debit. A credit to Accounts Payable doesn’t fit this initial set-up. If there actually are some Organization and Start-up Costs then you will want to allocate the appropriate amounts to those accounts as debits.
Thank you for your quick response. Heres providing more information:
We can consider the franchisor as an owner of my business. He holds 90% and me 10%. He will share in profits, taking 90%.
Since he’s a a co-owner holding 90% share, can I book the $405K as a credit under common stock?
Patty: Yes, you should book your franchisor’s purchase of common stock as a credit to Common Stock. Be sure to issue the stock shares to each stockholder. You said it was a loan but it really isn’t.
Thanks for the comprehensive post and the added resources in the comment responses. Shows you pay attention and truly want to help your readers.
I am starting new corporation I will own 90% of stock another individual will own 10%. How will the opening entry be for the stock. I will be CEO and the other party will not do anything but own the stock. I will pay myself a reasonable salary.
What will the opening entries be for the issuance of the stock to each of us. $ 1 par or no par.
Edward: Let’s say you issue 1000 shares at $1 or $1,000. You will have 900 shares and the other person 100. It is common stock. The journal entry is to debit Cash $1,000 and credit Common Stock (an equity account) for $1,000.
Hello: I have a 2 person LLC (50/50) and we file as a partnership on a 1065. We pay ourselves each $7K per month and also split the profit 50/50 at the end of the year. We both work full time in the business and have no other income are attempting to pay ourselves for our services. This would increase our business expense and reduce our business’s taxable income, which gets taxed at 4.8% in Illinois.
Can we claim the 7K per month on line 10 of 1065 and the remaining profit as the actual profit of the business? Or should we report it all as profit of the business?
Thanks.
John: I should have mentioned no property or cash will be given for the stock. Also, how would an entry be made if additional stock is given to an additional shareholder who the original shareholder agree on as owning a percentage of the corportation for his expertize.
Ron: When you pay yourselves for services rendered in a partnership, it is called a “guaranteed payment”. So, yes line 10 is place to put it. It is a deductible expense and impacts the bottom line. Both guaranteed payments and net profit or loss are broken out separately on your year end K-1 forms. Both are subject to self-employment taxes.
Edward: I would suggest that you use some dollar amount. Even $100 will work so you can record it on the books. Since it is a new corporation and you are not really capitalizing the corporation, why don’t you have the “expert” pay a few bucks for his/her stock. For example, if it is 10% then have the person pay $10. You should keep in mind that if you don’t capitalize the corporation, your liability protection may be limited as the courts could “pierce the corporate veil” by saying it was simply a shell with no real substance.
John, Thanks for the reply. Do we need to have the guaranteed payment specified in our operating agreement in order to use it on a 1065? Or is it ok if we verbally agree on a payment?
Furthermore, is it ok if the guaranteed payment is variable from month to month to account for fluctuations in cash flow?
Thanks again!
Ron: It’s always good to specify in writing what your agreement is regarding compensation, so no confusion later. I have never heard it was a requirement in order to be a legitimate deduction, but we are veering into the tax advice area which I would rather avoid. You can pay yourselves on any time table that works for you.
John: appreciate your advice on posting journals for this scenario:
I received an advance payment in Feb for club entry dues of $50 for March and already deposited cash in the bank. I want to account for the $50 as club revenue in March and $10 as a related expense fee which is also due in March.
How do I post these in Feb to reflect both the future $50 revenue and the future payment of $10 due in March? I presume that I should debit cash and credit unearned revenue of $50 in Feb, but how can i account for the $10 expense as a payable?
Steve: Thanks for using the blog for your question. You’re onto it. Debit Cash and credit Deferred Revenue in Feb. In March, debit Deferred Revenue and credit Club Entry Dues (or whatever you call it). It sounds like you are saying you would like to record the $10 expense in February so debit the expense account and credit Accounts Payable. In March, when you actually pay the expense, debit Accounts Payable and credit Cash.
John
John: is there any other way to defer the $10 expense posting until March? I prefer to keep that on the B/S in Feb and recognize the $10 expense with the $50 revenue recognition in March. It something like a prepaid expense on the asset side but different since it’s not paid yet so not sure what can be debited.
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