Owner's equity is one of the three main components of a sole proprietorship's balance sheet and accounting equation. Owner's equity represents the owner's investment in the business minus the owner's draws or withdrawals from the business plus the net income(or minus the net loss) since the business began.
Mathematically, the amount of owner's equity is the amount of assets minus the amount of liabilities. Since the amounts must follow the cost principle (and others) the amount of owner's equity does not represent the current fair market value of the business.
Owner's equity is viewed as a residual claim on the business assets because liabilitieshave a higher claim. Owner's equity can also be viewed (along with liabilities) as a source of the business assets.
Equity is used in accounting in several ways. Often the word equity is used when referring to an ownership interest in a business. Examples include stockholders' equity or owner's equity.
Occasionally, equity is used to mean the combination of liabilities and owner's equity. For example, some restate the basic accounting equation Assets = Liabilities + Owner's Equity to become Assets = Equities.
Equity is also used to indicate an owner's interest in a personal asset. The owner of a $200,000 house that has an $80,000 mortgage loan is said to have $120,000 of equity in the house.
Outside of accounting, the word equity is also used to indicate fairness or justice.
It is possible for owner's equity to be a negative amount. The following illustrates how it might occur.
In 2008, a sole proprietorship was begun with the owner investing $100,000. During the years 2008 through 2011 the owner withdrew most of each year's net income. As a result, the total owner's equity at the end of 2011 was $110,000 (original investment of $100,000 plus $10,000 of net income not withdrawn). During 2012 the company's expenses exceed revenues by $125,000 and there were no draws or additional investments by the owner. The owner's equity at the end of 2012 would be a negative $15,000.
The negative amount of owner's equity also means that the company's balance sheet will report liability amounts greater than the amount of assets. The company could operate under those conditions if its assets are turning to cash before the liabilities need to be paid.
The accounting equation is Assets = Liabilities + Owner's Equity. This is the same format used in a sole proprietorship's balance sheet. (A corporation's balance sheet will use Stockholders' Equity instead of Owner's Equity.)
The accounting equation will always remain in balance if double-entry accounting is followed accurately. For example, if a company borrows $10,000 from its bank, Assetsincrease by $10,000 and Liabilities increase by $10,000. When a company buys inventory with cash, one Asset (Inventory) increases and one Asset (Cash) decreases. If the owner invests $5,000 of personal assets in the business, the company's Assets increase and Owner's Equity increases. If the owner withdraws $2,000 from the business for her personal use, the company's Assets decrease and Owner's Equity decreases.
Revenues causes Owner's Equity to increase, and expenses cause Owner's Equity to decrease. If the company earns $1,500 in service fees, the company's Assets (Cash or Accounts Receivable) will increase and Owner's Equity will increase. When the company incurs electricity charges, the company's Liabilities increase and Owner's Equity decreases. If the company pays for ads to appear in this week's newspaper, Assets decrease and Owner's Equity decreases.
Bookkeepers and accountants will be entering amounts into two or more accounts for every transaction. This occurs with business accounting software as well, but the software might be doing part of the entries behind the scenes.
What is the bookkeeping equation?
The bookkeeping equation for a sole proprietorship is assets = liabilities + owner's equity. The bookkeeping equation for a corporation is assets = liabilities + stockholders' equity. The bookkeeping equation is also referred to as the accounting equation.
In the bookkeeping equation:
· assets are the resources owned by the business
· liabilities are the amounts the business owes
· owner's equity is the amount the owner invested plus the net income of the business minus the amounts the owner withdrew for personal use (all since the business began)
Often it is said that the liabilities and owner's equity are the claims against the assets. It can also be said that the liabilities and the owner's equity are the sources of the assets.
The bookkeeping equation should always be in balance because of double-entry bookkeeping.
All expenses are debits because they reduce owner's equity. Revenues are credits because they increase owner's equity.
If you think of the accounting equation, Assets = Liabilities + Owner's Equity, assets are on the left side of the equal sign and assets will normally have their account balances on the left side or debit side. Owner's equity is on the right side of the equal sign and owner equity accounts will normally have their balances on the right side or credit side.
If a company pays $800 for the current month's rent, the company's assets and its owner's equity will decrease. To decrease an asset such as Cash, the company will credit the Cash account for $800. Since every entry must have debits equal to credits, the company will need to debit another account for $800. In this case it needs to debit the account Rent Expense. Eventually the debit balance in the Rent Expense account will be transferred/closed to another owner equity account. (The owner equity account might be a proprietor's capital account or a corporation's retained earnings account).
If the company earns and receives $300 for providing a service, the company's assets and owner's equity will increase. The asset Cash will be increased with a debit of $300. Therefore another account will need to be credited. In this case Service Revenues will be credited for $300. Service Revenues is a temporary account that will eventually be closed to an owner equity account. (Recall that owner equity accounts will normally have credit balances and therefore will be increased by credits.)
A company's payment of each month's rent is recorded with a credit to Cash and a debitto Rent Expense. The credit to Cash causes a reduction in the company's assets. The debit to Rent Expense causes owner's equity (or stockholders' equity) to decrease.
The reason the debit causes owner's equity to decrease is that expenses are temporary accounts that will be closed to the owner's capital account (or to a corporation's retained earnings account within stockholders' equity).