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- Withdrawals: Technically called “drawings” for sole proprietorships, withdrawals pertain to money withdrawn from a business by its owners.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. Learn more about owner’s draws.
- 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.
