Different Entities Mean Different Equity – Accounting for Sole Proprietorships
A sole proprietorship has a single owner, making his equity the easiest of all to calculate. For this entity, the basic accounting equation says it all: the assets minus the liabilities equals the owner’s equity (a rearrangement of the classic assets equal liabilities plus equity version). Since you are the only owner, you do not have to split up the equity any further, as you would for other business structures.
Sole proprietorships have one permanent equity account, called either owner’s equity or owner’s capital. You can have any number of temporary accounts to handle your withdrawals, as long as you have at least one.
Technically, revenues, costs, and expenses fall under the equity umbrella, because they all eventually are folded into the equity account; practically, though, they aren’t included as equity accounts. Withdrawals also are closed into the permanent account at the end of the period, but they still keep a place in the capital section during the period.
FACT
Some entrepreneurs like to split out their withdrawals to make their personal finances easier. For example, they may have one withdrawal account for general cash, one for estimated tax payments, and one for health insurance premiums. This can help when it’s time to do your personal tax return, as deductible items are already added up in a single spot.
On your balance sheet, only the single permanent owner’s equity account appears, after closing entries. If you want (or need) to demonstrate how the capital has changed, you can prepare the optional statement of changes to owner’s equity. This simple statement contains just a few lines: the opening account balance, a list of changes to it (which can include income, losses, contributions, and withdrawals), and the resulting ending account balance.
Entries That Increase Equity
Any time you post a credit to your permanent equity account, you increase your stake in the business. There are essentially two ways to do that: by earning profits, or by making capital contributions.
Profits are posted to your capital account during the closing entries. Contributions are posted as you make them, whether they take the form of cash or other assets. Any time you put any asset of your own into the business, it counts as a capital contribution. For the journal entry, you debit the applicable asset account and credit your capital account.
Entries That Decrease Equity
The two big equity depleters, marked by debits to the permanent account, are withdrawals and losses. Losses are posted to your equity account during closing entries, if costs and expenses have exceeded revenues for the period.
Withdrawals, initially recorded in dedicated contra equity accounts, all eventually hit the capital account as debits. However, you must record a withdrawal every time you take something out of the business. Most of the time this will be cash, but it’s also very common for product-based business owners to raid their inventory. That, too, counts as a withdrawal and must be recorded in the same manner; in this case, your debit would still be the withdrawals account, but the credit would be to inventory.