The Equity Section of a Balance Sheet

Understanding What Your Business is Worth

The term equity, or net assets, is a section on your balance sheet that reflects the difference between your total business assets, which are all the resources your company owns, and its liabilities, which are all the claims against your company. How you record owners' interest in the equity section of the balance sheet depends on the organization of your business.

There are three different types of entities you can use to organize your business: a sole proprietorship, a flow-through entity like a partnership, and a corporation. 

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Sole Proprietor Equity

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As the name implies, a sole proprietorship has one and only one individual owner. And this owner can't collectively own the business with anyone else, like their spouse or another relative or a friend. All the equity in the business belongs solely to that single proprietor. As such, the sole proprietorship has two unique equity accounts: 

Owner Capital

The owner capital account includes the following:

  • Cash Contributions: This is any money you used to start the business. Many sole proprietorships also have an on-and-off need over the years for an influx of cash from the owner. It's a simple fact of doing business that sometimes you have to pay for business expenses before you collect the money from your customers.
  • Non-Cash Contributions: When you started your sole proprietorship, you may have already personally owned computer equipment and furniture that you converted to business use. If you decide to make these assets the property of the business, you increase your owner's capital by the amount of the fair market value of the assets, which is what an unrelated third party would pay in an open marketplace. For example, you have a desk that originally cost $500. Comparable used desks are selling online for $100. The fair market value for this asset is $100.
  • Net Income/Loss: Net income/loss is the difference between your revenues and your expenses. If your business revenues are more than your expenses, you have net income. If your business expenses are more than your revenue, you have a net loss. How much money your business brings in at the end of day affects your capital account. Net income increases it and net losses decrease it.
  • Retained Earnings: This shows the combined total of all net income or loss over the years your business is in operation. Say Business X has been operating for two years. Its net income was $15,000 in 2016 and $20,000 in 2017. The retained earnings on 12/31/2017 was $35,000 ($15,000 plus $20,000).

Owner Draw

The owner draw section of the balance sheet shows money and other assets that the owner takes from the business for personal use. Sole proprietors use this account frequently because this is how they get paid. Unlike salaried employees, sole proprietors don't receive paychecks with taxes withheld and reported on a W-2 at the end of the year. They just write themselves a check, adding to their draw account and reducing their overall capital and owners' equity.

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Corporation Equity

Owners of corporations are essentially stockholders. The equity section of the balance sheet for a corporation shows the claim these shareholders have to the net assets of the business. There are three common components to stockholders' equity: paid-in capital, treasury stock, and retained earnings. Paid-in capital and treasury stock involve transactions dealing with corporate stock issuances. Retained earnings shows income and dividend transactions.

Paid-in Capital

Paid-in capital represents money the shareholders in the corporation invest in the business (contributed capital). It consists of common stock, preferred stock (although if you've opted to incorporate your  business you'll probably only have common stock), and additional paid-in capital. Don't worry, you're not seeing double! Additional paid-in capital is a sub-set of paid-in capital.

  • Common stock shows your residual ownership in your corporation, which consists of any remaining net assets after preferred stockholders claims are paid. In order to be a real business, at least one share of common stock has to be issued. After all, somebody has to be in charge of the corporation! Common stockholders elect the board of directors, which oversees the business. The board of directors elects the corporate officers, (president, vice president, secretary, and treasurer), who handle the day-to-day operations of the business.
  • Most businesses don't go through all the hoopla of issuing anything but common stock. However, it's a good idea to at least know what preferred stock is. Like common stock, it shows ownership in the corporation. However, preferred stock shows traits of both debt and equity. What this means is if your business sells its assets and closes its doors, preferred shareholders get back the money they invested in the corporation, plus any dividends owed to them, which is income the corporation pays to the shareholders.
  • Additional paid-in capital is the excess of what you paid to buy stock in your business over the par value of the stock. Par value is what's printed on the face of the stock certificate, reflecting the cost of the stock. Wondering how par value is determined? Whoever was in charge of originally forming the corporation (probably you) decided on the amount of par value. Most of the time it's an insignificant amount, selected at random. For example, the par value for Business Y common stock is $10 per share. You buy buy 20 shares for $15 a share. The addition to Business Y's common stock account is $200 (20 shares at $10 par value). Additional paid-in capital is $100, which is calculated by multiplying those 20 shares by the excess you paid for the stock over their par value (20 shares times $5).

Retained Earnings

This account shows your net income/loss since you opened shop (see above), reduced by any dividends you paid yourself or other shareholders.

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S-Corporation Equity

The equity section of the balance sheet for an S-Corporation is the same as the equity section for a regular corporation. This is because the S-Corp designation is a taxation rather than accounting issue. All S-Corps have to start out as corporations (C-Corps). First, you file whatever paperwork (usually a corporate charter or articles of incorporation) that your secretary of state needs in order to recognize your corporation.

After you get notification from the secretary of state that your paperwork is a-ok, you can opt to be taxed as an S-Corp. You do this by filling out Form 2553 with the Internal Revenue Service. However, nothing about your selection changes the corporation's equity accounts. You'll still have retained earnings and additional paid-in capital.

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Partnership Equity

A partnership is a business in which at least two people hold any percentage of interest. For example, one partner can have a 99 percent interest, and the other can have a 1 percent. It doesn't matter, as long as the combination adds up to 100 percent. Neither does it matter how many partners are involved. 

Limited Liability Partnership

Many states allow for limited liability partnerships, which basically means if you are a limited partner, your liability for partnership debt is limited to your investment in the partnership. However, as a limited partner, you may not have any say in how the partnership is run.

Partner Capital

Partner capital accounts include some of the same items that are found on the balance sheet of sole proprietors, and they are defined in roughly the same way. These include cash contributions, non-cash contributions, and current net income and loss (see above.)

In the case of net income and loss, however, how much money your business brings in at the end of day affects your partner capital account proportionately, based on what's in the partnership agreement. For example, if the partnership agreement states you have a distributive share of 25 percent and the net income is $15,000, your distributive share is $3,750.

Partners' Draw

Partners' draw shows money and other assets the partner takes from the business for personal use. Like sole proprietors, this is how the partners get paid. The amount of draws a partner is allowed to take can be different than their partnership interest. So even though you have two equal partners, it doesn't mean they have to take the same draw amount. This is because of the differences in beginning and ending partners' capital accounts, as outlined above.