In the accounting and business worlds, money is of the utmost importance – not from a philosophical standpoint, but for a business to operate, money is crucial. When it comes to the business side of things, money not only flows into it as they sell their goods and services, but it’s also used as a tool to pay for things that the company needs to operate, such as employees, machinery, and other assets. In a business, owner’s equity is basically how much of that business’ assets the owner(s) actually own, as opposed to being owned by creditors.
Today, we’ll explain a bit about this important concept, and along the way, we’ll be getting a bit into the world of accounting and financial statements. To brush up on, or introduce yourself to, these handy accounting tools, check out this course on financial statements made easy, as well as this article on the layout of the balance sheet.
What is Owner’s Equity?
The term owner’s equity refers specifically to either a sole proprietorship, in which one person is the owner, and a partnership, where two or more people own the business. If a business is traded publicly, it’s referred to as stockholder’s equity because the business is publicly owned by the stockholders. Also known as the book value of a company, owner’s equity is officially defined as the “residual interest in the assets of the enterprise after deducting all its liabilities,” which can be better explained in the accounting equation. If you’re curious about accounting as a profession, this intro course on financial accounting will let you know if you’re cut out for this kind of work.
The Accounting Equation
One of the most basic and ubiquitous of all the equations found in accounting is the accounting equation, which is so integral to this industry, that it even bears its name. This equation is assets = liabilities + owner’s equity. Basically, it states that the value of all the assets of a company, or anything that is capable of being owned that not only has value, but produces value, comes from two sources: liabilities, which are creditors that you owe money to, and owner’s equity, the money put in by the proprietors. To think of it another way, you can rearrange the equation to read owner’s equity = assets – liabilities, which illustrates that once you take out the chunk of assets that are paid for by others, you’re left with the assets that the owner’s can lay claim to.
While owner’s equity is money that helps a business run, its most natural environment is in the accounting world. Owner’s equity is not only crucial for the people running a business, but those outside of the business, such as the government, or potential creditors, might be interested in looking at these figures, as well, and the balance sheet is where they’ll find them.
The balance sheet is a snapshot of a business’ operations on one day, and it consists of the three components of the accounting equation. It lists all of the assets on one side, then adds up the liabilities and owner’s equity on the other, and if everything is correct, then the two numbers should be equal. If you think you’d like to become an accountant, but are worried about your arithmetic skills, this course on the fundamentals of math should get you all caught up.
Owner’s Equity Accounts
There are some accounts that are affiliated with owner’s equity, some of which are associated with corporations, others with unincorporated firms.
- Retained Earnings Tracking the profits and losses of an incorporated business, the retained earnings account is the greatest contributor to the increase of owner’s equity. It is calculated on the income statement at the end of the year to figure out if there was a profit realized or not.
- Capital Used for smaller, unincorporated firms, the capital account reflects any and all cash and assets that the owner(s) have contributed to the business at any time, and results in an increase in owner’s equity.
- Drawings Also unique to unincorporated businesses, the drawing accounts are the flip side of the capital account, and reflect any withdrawals that any of the business owners may take out over time, thus reducing owner’s equity.
Without owner’s equity, there would be no businesses in the world, and accountants would have a tough time keeping track of everything. Even though it has a technical name, hopefully we were able to show you that it’s really quite basic and simple to understand. If all this talk of business and money has inspired you, this introductory course on entrepreneurship might help you realize your dream.