Financial Statement Series: Balance Sheet, Part 5, Equity Section

Rylan Kaliel
Apr 18
6 min read

Updated: Jun 20

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Dear readers we are coming to the end of the balance sheet series. In this section we will discuss the mostly ignored equity section.

Why is the Equity Section Important?

You may ask yourself why the equity section is important and well I will tell you why. In lament terms equity shows you how much value you have contributed and created in the business. It shows you if you paid all your debt (current plus long-term) what you would be left with.

If your equity is positive that means after you pay off all your debt you would have something in the business for you to take away. However, if it is negative, it tells you that even after using all disposing of all of your assets what you would be left with is more debt. That is why this section should be reviewed on a regular basis to ensure that you are monitoring the health of your business and not digging yourself into a hole.

The equity section keeps track of all of your contributions and withdrawals from the business.

At the inception of the business, the equity section will reflect the initial money you have invested into the business.

Let’s say you want to start a pizza shop, and you bring in $20,000 of your own money into the business (your initial investment) then the equity at that point would be $20,000.

Retained Earnings

Let’s first look at the common area of the equity section in general and later we can discuss how these sections can differ with different business structures such as sole ownership, partnership or corporations.

The one line that will be shared through all the different structures is the retained earning line. This account shows how much income a company has made over time.

Let’s go back to our pizza shop example. Let’s say in the first year of business the net income of the shop (revenue - expenses) for a company was $5,000. Then the retained earnings for that year at the end of the fiscal year would be $5,000. Let’s say the next year the shop makes $15,000 then at the end of that fiscal year the retained earnings would be $20,000.

The remaining areas of the equity section will be discussed under the different business structures.

Equity for Sole-Proprietorships

There are 3 main accounts under the equity section of a sole proprietorship.

Owner’s capital

This account shows the owners investment into the business. Again, let’s use the pizza shop as an example here. The owner’s capital account in the first year would have a balance of $20,000. Let’s say in the following year you decided to invest another $40,000 into the business then at the end of that year your owner’s capital account would have a balance of $60,000.

Owner’s drawings

This account shows the owners withdrawals from the business. Let’s say that in the third year of owning the business you decide to take $10,000 of your money out of the pizza shop and go for a nice vacation then the account’s balance at the end of that period would be $10,000.

It is important to note that the owner’s drawing account is a contra account. What this means is that it is a temporary account used to show your withdrawals for a year but at the end of the year it gets netted out against the owner’s capital account. Typically, contra accounts are used as tools to adjust balances but are not shown on the financial statements. This would then mean that at the end of the third year the balance of the owner’s capital account would be decreased by $10,000 and would be standing at $50,000.

Retained earnings

As discussed before, this account shows the performance of the business over time and changes by the net income or losses incurred by the business.

Partnerships

Partnerships are similar to sole-proprietorships. There are 3 types of accounts however their treatment differs in one keyway from the sole proprietorship which is that all equity accounts need to be separated between the partners.

Partner capital account

This account shows the initial and subsequent investments of each partner to the business. It is important to note that there will be a separate account for each partner.

Partner drawings account

The drawings account shows all the partner withdrawals made within one fiscal year and is a contra account as discussed in the sole-proprietorship section that gets netted against the individual partners account at the end of the fiscal year.

Retained earnings

As discussed before this account illustrates the gain and losses of the business. However, unlike the sole-proprietorship this account is a contra account. At the end of each fiscal year the gain and losses get allocated to each partner based on the ownership contract and investment in the company.

Corporations

It is important to mention off the bat that corporation’s equity section is extremely complicated and next to impossible to explain in a short blog such as this. We will focus on learning the basics of this section in this blog. In later blogs we will take a deeper dive into each section.

There are 6 main accounts in the corporation’s equity section.

Common stock or common shares

This account represents the most common and basic ownership of a corporation. You can think of this account as an owner’s capital account, where all owners invest in the company through buying shares. The common shareholders generally have a right to vote on company matters, however like an election your vote counts more if other shareholders agree with you. Typically, the value of the common shares will increase as the value of the business also increases, however, this is not reflected on the Balance Sheet. Please note that in this account the par value (the minimum price where the company can legally sell the share for) of the stock is recorded, however, in today’s environment, par shares are extremely rare.

Preferred shares

Preferred stocks are like common stocks except that they get priority when dividends are paid and in case of the failure of the business, they get generally priority for payment over those who hold common shares. Preferred shares commonly have a fixed dividend entitlement and do not normally increase in value as the business’s value goes up. Please note that preferred shares are also recorded at par value.

Additional paid-in capital

This account is used to record the amount of money invested by investors through the purchase of shares. Please note that this account holds the excess of the prices paid per share over the par value of that share. This account can also reflect amounts contributed by the shareholders where no shares are received in exchange. Where there is no par value for shares and all cash invested resulted in shares being issued no amounts would typically be included in this account.

Let’s see this in an example, using the pizza shop example from above. Let’s say you got a lot of attention and decided to grow the business exponentially. You incorporated the business and decided that the par value would be $5 each. When you sell the shares you end up selling them for $8 each instead. Then the $5 would go in the share account and the remaining $3 per share would go to the additional paid-in capital account.

Retained earnings

This account is like the ones we have looked at before and shows the accumulated profits of the company minus the dividends paid to the shareholders.

Accumulated other comprehensive income

This account shows the profits and losses that arise from activities that are not a normal part of the business. For example, if you sell a piece of equipment from the pizza shop, then you would record the profit or loss in this account. This account only arises in specific accounting frameworks, such as IFRS and may not apply to all businesses.

Summary

I hope that you have found this blog informative. As always please note that the information shared here are a brief overview of a very complex area of accounting. If you have any questions about the accounting around these concepts or how to structure a business to best serve your purpose, please feel free to contact KLV accounting for a free consultation. We at KLV accounting offer free consultations on many different topics and are always happy to help.

In the next blog we will discuss the Balance Sheet as a whole and look at some examples of it.

KLV Accounting, a Calgary-based accounting firm, is here to help. Contact us today to enhance your financial strategy, minimize your taxes, and drive business success! For a free consultation, call us at 403-679-3772 or email us at info@klvaccounting.ca.