The Accounting Equation – Equity Means Ownership
When you first start a business, you (along with any co-owners) put some of your own assets into the company. Those original contributions form the first entries in your equity account and get your business on its way. Adding resources into the company is one way to beef up your equity account, whether it comes from you and other involved owners or from silent investors.
Any asset you put into the business increases your equity stake. The most common contributed asset is money, but all other personal assets being used exclusively by the company count as well. Contributed assets can be anything from a laptop computer to a backyard shed to a pickup truck that now bears your company logo. For major assets like that pickup truck, it’s important to retitle the asset in the company name to avoid any problems down the line, such as the IRS questioning ownership.
The other way to grow the equity is by keeping some of the profits inside the business. Many small-business owners like to take out profits as soon as they’re earned; after all, they’ve had to pay tax on the money, and want to enjoy the benefits. If you’re planning to expand your company, though, leaving some of those profits inside is a great first step. It can also make your company more attractive to prospective lenders, as banks are often more likely to make a loan when they see there is substantial equity at stake.
Though equity is about ownership no matter what type of company you have, the accounts you use depend entirely on your business structure (as you’ll see in detail in Chapter 15). Sole proprietorships and partnerships will have a separate owner’s equity (or capital) account for each owner, along with a corresponding withdrawal account for each. The owner’s equity account is a permanent account, and contributions are made directly into this account. The withdrawal accounts are temporary and are folded into the owner’s equity account at the end of the accounting period, along with that period’s net profit or loss.
Corporations don’t have equity accounts geared toward individual owners. Instead, they have accounts for each type of stock they issue to represent the contributed capital. Unlike sole proprietorships and partnerships, no other accounts are folded into these. Earnings at the end of the period are held in an account called retained earnings. Owner withdrawals are a much more formal affair, and here exist only in the form of dividends; the dividends account is temporary and is rolled into retained earnings at the end of the period.