Equity Section of the Balance Sheet

published October, 2007

I got a question about the “equity section” of the balance sheet and what goes there.

The section is divided up into different accounts. Exactly what name things are called depends on the particular type of company, but there are several items that are common to all companies.

The Equity section is a way to calculate the “book value” of the company as a whole. An accounting convention is A=L+OE, which means Total Assets of a company (all the cash, receivables, fixed assets and property) is equal to the Liabilities plus Owners Equity. 

In theory, if you converted all the assets of the company to cash and paid off all the liabilities, the owners get to keep what ever is ‘left over.’ That is their Equity in the company. 

It is possible to have more liabilities than assets, so the owners actually owe more money than the company has in assets. If the owners are personally liable for what the company owes, they’d have to pay to go “out of business.” That’s generally a bad thing. Companies with negative Equity can stay in business if they have good Cash Flow that allows them to service their debt long enough to become profitable. Negative Equity and bad cash flow leads to bankruptcy.

Corporations have an account called “Stock” or “Capital Stock” (same thing). This represents money the corporation has on “permanent loan” from the stockholders. This amount is set at the beginning of a corporation, and is the initial deposit made to open the checking account, plus the value of any assets contributed. This number rarely changes over the life of the corporation. Service businesses typically have smaller amounts than capital intensive businesses like computer rental companies where you’d expect a certain amount of cash to purchase equipment. I often set this account up when I prepare the first year’s tax return, if it isn’t already set up. If you’re not a corporation, you probably don’t have this account.

There is a “Net Income” account that tracks the current year income. This number should exactly match the Net Income at the bottom of the Profit and Loss statement for the year to date. This account is typical to all businesses. This is only current year income; no prior year income should be included here.

The first year, there is no “Retained Earnings” account, because this account tracks the Net Income for every year previous to the current year. (Remember the current year is all in Net Income). In the second year the Net Income moves to the Retained Earnings account: you ‘zero’ the Net Income and start Net Income over again.

Both Net Income and Retained Earnings may be either positive or negative numbers. In a typical startup, these numbers are negative the first few years until income starts to accumulate. If these numbers are negative, there should be a good reason, or you should quit.

“Distribution/Draw/Dividends Paid Out” is an account that usually carries a ‘negative’ balance. The official name depends on the form of your business, but this account is where you keep track of money taken out of the business by the owner(s). This is different from payroll, if the owners have payroll (like in a corporation). Payroll is always an expense.

There can be some other wacky accounts in the Equity section, like Treasury Stock and Paid In Capital, but you probably won’t need these in a typical set of books.

If you have questions about your Equity Section, give us a call.