Owners equity is the dessert of the accounting field. This is the one topic everybody likes to discuss, and that most individuals who own and operate a business really like to watch as it increases. What is the correct definition of owner’s equity, and why is it one of the most important pieces of the accounting reporting?
Owner’s equity is the owner’s rights to the assets of the business. If the business is a sole proprietorship, the owner’s equity is also known as the owner’s capital account. As this figure increases, the owner’s right to the assets of the business increase. More simply translated, the larger the equity, generally, the smaller the debt.
Owning a business free and clear of any long-term liabilities is the dream of the business owner. For when this condition exists, the owner is usually in the position of realizing gains, and of also realizing they have been successful in the operation of their business.
What can an owner do with the figures represented in the Owner’s equity area? The options are many. If a small business owner wants to expand the business, the greater the amount of equity, the more likely a lending institution will be to grant additional funds for the expansion. If an owner wants to sell the business, the owner’s equity is the basis for the asking price of the business. It is not the only contributing factor in determining the value of the business, but it is the baseline figure providing a definite foothold for establishing the value of the business.
How does this figure “grow” in value? What is the catalyst for the increase in owner’s equity? The retained earnings shown on the income statement are the greatest contributor to an increase in owner equity. The greater your profitability in your business, and the more of the income you retain, the greater your owner equity will become. This figure also increases as debt is paid down or completely off. This is a great example of the links between the income statement, statement of cash flows, and the balance sheet. When you follow the trail of information through each report, you can begin to understand the importance of this trio.
What happens when money is withdrawn from owner’s equity? If a business owner chooses to withdraw funds from the owner’s equity account, the value of the funds withdrawn will be taxed as capital gains. Right now, capital gains tax is at an all-time low. If you were going to make an exit from your business, or make a lump sum withdrawal, now is the perfect time to consider such a move.
The owner’s equity column is also the difference on the balance sheet between asset and liability accounts. The accounting equation used to represent this is:
Assets – Liabilities = Owner’s Equity
This is one of the oldest building blocks of the accounting industry. The one equation an accounting student will learn in the beginning of the education, and will still be using diligently, when they finish their accounting career.