Owner’s Equity – This is one of the most important things in your accounting books that you must be aware of as a business owner.
In this guide, we’ll explore some of the most important aspects related to owner’s equity in order to make it easy for you to understand what it is and how to calculate it.
- The Definition Of Owner’s Equity
- An Example Of Calculating Owner’s Equity
- What Counts As Owner’s Equity?
- The Statement Of Owner’s Equity
The Definition Of Owner’s Equity
The term “owner equity” means the portion of business assets that the owner can rightfully claim.
To put it simply, anything that’s left after deducting liabilities from total assets is to be considered off as owner’s equity.
Typically, every company’s balance sheet follows a simple equation:
Assets – Liabilities = Capital (or Owner’s Equity)
Owner’s equity, as a term, is mostly applicable to businesses that run on a sole proprietorship model, and if the kind of business under consideration is an LLC, then the usage of the term “Stockholder’s equity” is more apt.
If the total value of a business’s liabilities exceed the total value of assets that a business owns, then the owner’s equity will be considered negative. This effectively means that the owner will have to invest more capital into the business in order to pay off its debts.
A negative balance on the account of owner’s equity will inadvertently increase the amount of taxes a business owner has to pay if he/she continues to withdraw money from the business with the account still being negative. This is because, the tax laws then consider these withdrawals as capital gains, which come under taxable income.
You can only draft a statement of owner’s equity after completing your income statement because the profits you earn for the year are carried forward in the balance sheet.
Additionally, some people think that the owner’s equity is an asset, and technically they are right.
However, when you look at a balance sheet, you will notice it doesn’t come under assets, and that’s because it’s an asset that belongs to the owner itself, not the business. For the business itself, the owner’s equity is a liability since the business and the individual are considered as separate entities in the accounting domain. This can become tricky since the nature of the owner’s equity is not as straightforward to understand as other accounting terms like accounts receivables or payables. But with time, you can easily understand how this comes under liability for the business itself despite it being advantageous to you as a business owner.
Calculating the owner’s equity can often become quite challenging if the number of transactions you run each month continues to grow. Therefore some businesses prefer hiring in-house accountants to do their accounts. However, if you are cash strapped and can’t afford to hire an internal team to do your accounts then I would suggest opting for the best online bookkeeping services.
An Example Of Calculating Owner’s Equity
The formula for calculating the owner’s equity is simple:
Assets – Liabilities = Owner’s Equity
Now let’s apply the equation to an example to understand further.
The following example is about Melissa Smith, who has decided to start an online business for selling authentic makeup. Here are the expenses and transactions that happened in the first year.
- Melissa invested $10,000 in her company to buy a laptop, delivery bike, inventory, and other necessary assets.
- At the end of the year, Melissa earned a net profit of $50,000.
- Melissa invested an additional amount of $2,300.
Here’s what the calculation will look like
The balance sheet shows that the owner’s equity is the difference between assets and liabilities and it adds up to $62,300.
This equity also includes the amount that Melissa invested in her new business before she started operations and the additional investment she made during the year.
The balance sheet can seem confusing to someone who doesn’t have an accounting background, so here is a simplified version of it for you.
The owner’s equity formula is Assets – Liabilities = Owner’s Equity
As per the balance sheet the values are:
$115,000 – $53,200 = $62,300
However, if Melissa decides to sell her business, then the selling price would be much different than the owner’s equity based on other factors. For e.g. ascertaining the value of intangible assets like brand equity is often impossible so they are not included in accounting statements of any kind, but their value is often added to the final transaction to buy off the business, hence the difference will always be there in the owner’s equity amount shown in the accounting statements and the amount paid to the owner of the business when selling it.
What Counts As Owner’s Equity?
The aforementioned balance sheet only shows a limited number of headings including that of assets, liabilities, and owner’s equity.
The things that count as owner’s equity can go far beyond that; Melissa’s case is just an example.
Let’s have a look at what else comes under the heading of owner’s equity.
- Any withdrawals that the business owner makes from the business.
- The money an owner invests in the business for any reason.
- Any profits earned by the company.
- Any amount of equity deducted after payables.
As a corporation, you are liable to add the following under the owner’s equity:
- Paid-in capital by the shareholders.
- Retained earnings
- Common Stock
- Treasury Stock
- Preferred Stock
- Income or Loss Involving Foreign Transactions
The Statement Of Owner’s Equity
It is a financial statement that is drafted to understand all the changes that occurred in the owner’s equity during the year.
The statement is drafted using the value of the following transactions:
- Opening and closing balances of the account for owner’s equity
- Changes in owner’s equity due to profits or withdrawals
- Additional capital investment made by the owner
So, how do you determine if the value of the owner’s equity is correct? It’s pretty simple, actually.
Once you have drafted the owner’s equity statement, you just cross-check the value with the owner’s equity value on your balance sheet. The values should match for the accounting period.
The statement of owner’s equity is fast becoming an important financial document to have for various purposes. Banks and other financial institutions will often work in your favor when processing loans or other credits if you have this statement with you as well when filing for the loans.
Also, making this statement on a regular basis will increase your chances of understanding the current financial viability of your business. If you are continuously investing money into your business to keep it afloat instead of the business sustaining itself through its own earnings, you will become aware of this precarious situation by making a statement of owner’s equity. This way you can ensure that you take necessary steps towards correcting the course of your business and taking necessary steps to bring it to profitability.