The last variable in the accounting formula is owner’s equity. To review, Assets = Liabilities + Owner’s Equity. Equity is the section of the balance sheet that represents the capital received from investors in exchange for ownership in the business. Owner’s equity represents the stake the individual owners have in the business in relation to its assets and liabilities. An alternative way to look at owners equity is the difference between the assets and the liabilities of the business.
Breaking Down Owner’s Equity
Owner’s equity, often referred to as book value, comes in different forms. For example, partnership share of owner’s equity is the partner’s basis while S-corp’s share of owner’s equity is considered stockholder’s equity. Although they have varying treatment, the underlining concept remains the same.
Paid In Capital/Contributions
For corporations, investors need to buy stock as a form of ownership. The money paid into the business in exchange for ownership is considered paid in capital. For example, if an investor pays $10,000 for an original issue of stock in a corporation then the paid in capital will be $10,000 (Debit cash for $10,000 and credit Paid in Capital for $10,000)
For partnerships, when partners put money into the business it is an increase in their partnership basis. In both of these transactions owner’s equity will increase.
Retained Earnings/Partners Share of Income & Loss
The current year profits or loss will have a direct impact on the owner’s equity. If a business has more income than expenses then the owner’s equity will increase. For corporations, prior year income will be shown as retained earnings and at the close of each year the current income or loss will be closed out into retained earnings. For example, if the business has Income of $10,000 and expenses of $5,000 then retained earnings will increase by $5,000.
For partnerships, partner’s basis will increase in proportion to their share of income and will reduce by their share of losses. For example, if a partner puts $10,000 into the business and their share of partnership income is $2,000 then their new basis will be $12,000
Notice how there is a different treatment between a corporation and a partnership but the net effect is the same. Income increases owner’s equity while losses decrease owner’s equity.
For a corporation, income is distributed to shareholders in the form of dividends. Dividends reduce retained earnings and therefore reduce owner’s equity.
For a partnership, money or property given to partners is considered a distribution. Distributions reduces the basis of the partners and therefore reduces owner’s equity. Once again, the treatment of disbursement of income or capital to partners is different but the overall impact on owner’s equity remains the same
Regardless of the entity, the underling principle is the same; owner’s equity is increased by cash coming in from owners and current year income while also reduced by current year losses and distributions.
Bob puts $20,000 into a new business. At the end of year 1 Bob has gross revenue of $30,000 and expenses of $15,000. Bob also takes distributions of $5,000. What is the Owner’s Equity at the end of year 1?
$20,000 (initial investment) + $30,000 (Gross Income) – $15,000 (expenses) – $5,000 (distributions) = $30,000