Equity Basics – Understanding is the first step
Retained earnings, member capital, capital contributions, additional paid-in capital–all of these items have one thing in common, they relate to the overall equity of a company. The basic formula for a balance sheet is Assets = Liability + Equity. However, many times small business owners don’t fully understand the equity portion of the balance sheet.
The structure of your company will determine the terminology used in your equity accounts. If you are a corporation, you main equity account will be retained earnings. If you are a partnership, your main equity account will be member capital. Within the equity section of your balance sheet there are three main areas:
- Capital contribution (partnership) or common stock (corporation).
- Additional contributions (partnership) or additional paid-in capital (corporation).
- Distributions (partnership) or dividends (corporation).
There are other items that can occur in equity. However, for simplicity, those are outside the scope of this article.
Capital Contribution or Common Stock
The initial contribution made to set up a company is usually considered a capital contribution (partnership) or sale of common stock (corporation). It is important to note that setting up the initial contribution does not have to be in the form of actual cash. Many times, especially with a new business, the contribution is from fixed assets (say, the bulldozer you brought in to start the company) or even expenses that were paid with a personal credit card. Regardless of the form of payment, the set-up of a capital account is where you begin to track the funds used to get it up and running.
Now, most corporations set a par value of their stock. The par value is a nominal amount. Par value is what the initial owners decide at the inception of the company. When an individual purchases stock, they purchase the stock at the par value, then any amounts above the par value are recorded as additional paid-in capital.
A unique item in the accounting world is when you have more capital contributed to a company after the initial set up. This is more prevalent within a partnership. When the partner(s) decide to add capital to the company, they will post the entry to additional contributions.
Distributions or Dividends
Again depending on the structure of the company, you will take equity out of the company by either distributions (partnerships) or dividends (corporations). These accounts represent a reduction to the overall equity of the company.
Retained Earnings or Member Equity
The retained earnings (corporation) or members equity (partnership) are the accounts where the yearly net income is closed out. So if you have a positive net income in 2018, the total amount of the next income is ‘closed’ to the respective retained earnings or member equity account.
Importance of Proper Accounting
After understanding the basic structure of the equity section, the next aspect is to understand the importance of proper accounting within the equity accounts. The only transactions that should go through your equity accounts are:
- Issuance of dividends or distributions.
- Capital contributions of stock sales and purchases.
- Closing out of prior year net income.
At the initial start up phase of the company, you will have some sort of capital contribution, whether that is in the form of cash, non-cash, or stock issuance. The amount of the initial set-up should be its own account and, barring a sale of ownership, this account should never be touched after the initial set-up. When you have subsequent contributions, such as capital calls, these amounts should be booked into a new contribution account. This is to provide a way to track the set-up and subsequent contributions. Sure, these accounts could be combined into one account. But if you have to unwind in the future, the time it would take to do that could be substantial.
Next is the concept of distributions. For all companies, a separate distribution account should be set up within the general ledger. This account should track all distributions for the year. At the end of the year, the distribution account should be closed out to the retained earnings/members equity account because it makes it easier to get the equity to balance. Reconciling Equity
We have covered the basics of equity and the importance of proper accounting. Now, we are going to focus on how this all comes together when you reconcile your retained earnings/members equity. As we discussed earlier, outside of capital contributions and distributions, the only other entry to equity should be the closing out net income/loss to the retained earnings/members equity. When auditors and accountants reconcile the retained earnings account, they will take last years retained earnings account plus or minus the prior years net income or loss. This produces the beginning balance of retained earnings for the current year. This number is then compared to the retained earnings number on your general ledger. Usually, if there are differences then there are one of two likely culprits: an incorrect journal entry posted to retained earnings or a P&L entry post dated after the auditor had finished reviewing the prior year information. Either way, this reconciliation helps identify any items that were posted incorrectly or back dated. When you are reconciling your balance sheet for the fiscal year end, you should always tie out the retaining earnings account first. One Last Thought
At the beginning of this article I explained how the basic formula for the balance sheet is Assets = Liabilities + Equity. Another way to look at this formula is to consider Assets – Liabilities = Equity. Why is this way of looking at a company’s balance sheet important? If you use this formula when looking at your equity, you can get a better understanding of what truly makes up your equity. Usually current assets are reduced by current liabilities (see blog on current ratio), and any long term debt is eliminated by fixed assets. What is left is truly what your net assets are in the company. After you run the formula, are the current assets significantly more than current liabilities, can you make a distribution and not affect your net assets too much, are you only left with fixed assets that you can’t sell unless you sell the company? These are the thought provoking questions you should be asking when you look at the equity in your company.
At Hovland Forensic & Financial we help you better understand the equity of your company and how to best utilize your resources to get to your long term goals.
Steven D Hovland, CPA, Cr.FA
Steve Hovland, a certified public and forensic accountant, Hovland brings to his duties more than 20 years of experience in audit and accounting services as well as forensic investigations. For additional information call (888) 878-0047 or schedule a meeting at https://hovlandforensic.com/scheduling