Equity accounts represent the financial ownership in a company and are visible in the balance sheet immediately after the liability accounts. There are different kinds of equity accounts that are aggregated to form shareholder’s equity.
Almost all equity accounts have credit balances. This means that an entry on the debit side (left side of the T-account) of an equity account means a decrease in that account balance while an entry on the credit side means an increase in the account balance.
What is Equity?
Equity, which can also be called net assets, is the amount that is left after paying the business’s total liabilities. In other words, total equity is calculated by subtracting the total liabilities from the business’s total assets (this is just rearranging the basic accounting equation).
Equity is the amount contributed by shareholders to start a business and to keep the operation of the business alive. Equity can also be built by retaining the residual profits, for instance, if a company generates a net income and does not payout to the shareholders, equity increases.
Types of Equity Account
There are six types of equity account attributed to corporations which are discussed in more detail below. Sole proprietors and partnerships have different equity accounts because of different legal requirements.
Sole Proprietorship and Partnerships
A sole proprietorship is a business owned by a single owner and a partnership is owned by two or more individuals. The following are the most common equity accounts that are associated with these two business entities.
- Owner’s capital. The owner’s capital which is known as members’ capital for partnerships is the equity account consists of capital that has been contributed or invested by a single owner or two or more members.
The essence of this account is much the same as retained earnings for corporations. The ending owner’s capital is equal to beginning balance reduced by any withdrawals, increased by any new investment, and increased or decreased by net profit or loss for the period accordingly.
- Owner’s distribution. This is a contra equity account that records all the income distributions made to the owners. In other words, this account tells us the amount of money that has been taken out of the business.
This reduction in money is not an expense rather this account is intended to note all the distribution that has been made to the owner for a year.
Common Stock (Capital contributed by shareholders or issued capital)
This is an equity account where the amount contributed initially by shareholders is recorded. The right to vote and the residual claim on the company’s assets depends upon the share entitled in this equity account.
The value of this equity account is usually recorded at par value of share times the number of shares outstanding. The number of shares outstanding must also be disclosed in the balance sheet and it is equal to issued shares subtracted by treasury shares.
For example, 10 million shares with $1 of par value would result in $10 million of common share capital on the balance sheet.
This account has the par value of the preferred stock. These shares have precedence over the common shares – precedence that pertains to receipt of dividends and receipt of assets in case the company declared bankrupt.
The preferred stocks have the characteristics of both debt security and common stock. Preferred stockholders do not have the voting rights, but they are usually guaranteed by cumulative dividend, which means the dividend can be accrued until paid off.
For example, preferred stock with a fixed $10 dividend per year. The company has not paid the dividends for the past three years. For the current year, the preferred stockholder will be entitled to receive a total of $40.
Additional Paid-In Capital
This equity account is also known as contributed surplus is the excess amount that investors have paid in addition to the par value of the stocks (equity or preferred), it is seen as the gain which a company has earned when it issues the stocks initially.
Additional paid-in capital can be reduced when a company repurchases its shares. This account can also increase or decrease in value when the gain and loss occur due to the sale of shares.
For example, a company issues 100,000 $5 par value shares for $10 per share. A total of $500,000 will be recorded in a common stock account and the excess amount of $500,000 (100,000 shares x ($10-$5)) will go in the additional paid-capital account.
Retained earnings are the part of the company’s net earnings which is retained after paying dividends to shareholders. The motive of retaining such earning is to use those proceeds to pay off debt, launch a new product or business, or acquire other beneficial companies.
For example, a company has retained earnings of $100,000. For the current year, the company has earned a profit of $10,000 (net profit) and decided to pay $2000 in dividends. So the ending retained earnings for the year will be equal to $108,000 ($100,000 + ($10,000 – $2000)).
Other Comprehensive Income
This account includes all the changes in equity of a business for a year except those resulting from investments by the shareholders or distributions to them. In other words, other comprehensive income excludes the profit that has not been realized yet.
A classic example of this equity account is the portfolio of bonds that the company has invested in. Profit & loss due marked to the market value of this portfolio can be determined in other comprehensive income. Once the bonds have matured or sold the realized gain/loss is moved into net income.
This is one of the equity accounts that have a debit balance. A contra account that represents the amount a company has paid to repurchase its common stock. These stocks are kept as treasury stocks instead of canceling them, a company can sell (reissue) them.
Some of the motives behind to repurchase its shares is when management think that shares are undervalued or when employees of the company want to exercise stock options. The acquisition of treasury stocks reduces the number of shares outstanding.