Introduction to Owners Equity
Owners Equity is that part of your business finance which is provided by the owners. The Owner is the person who owns and controls a business for example a shareholder in a private company. It is important to note that the business is a separate entity from the Owner.
Equity includes two main components capital which is invested as cash or cash equivalents by the owners as a capital introduction and retained earnings which represent mainly profits of the business which have not been distributed to the owners.
Equity is a major component of the basic accounting equation:
Double entry bookkeeping and accounting is based on the Basic Accounting Equation which states that the total assets of a business must equal the total liabilities plus the shareholders equity.
One side represents the assets of the business (buildings, inventory, vehicles etc), and the other side represents how those assets were funded (capital, retained earnings, loans, supplier credit etc.). Notice that owners equity includes amounts invested by the owners (capital) and retained earnings of the business.
Owners equity is part of the balance sheet and is shown under the heading Capital & Retained Earnings.
It is important to understand that Retained Earnings are part of Shareholders Equity, they represent accumulated profits (and losses) of the business which have not yet been distributed to the owners, but which belong to the owner not the business.
Equity will change depending on whether the business makes a profit or loss even though no additional capital (cash) is injected by the owners.
For example, in year 1 if the Owners inject 1,000 the balance sheet will be as follows:
In Year 2 the business makes has net income of 500 and retains this within the business, the balance sheet will now be as follows:
The equity has increased by the 500 increase in retained earnings which is equal to the net income of the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.