Lesson Objectives:- Defining equity in the context of financial accounting
- Performance of equity in relation to performance
- Equity recorded on financial statements
- Real world examples of changes in equity
Let's look at the third concept that is recorded on the balance sheet; equity. Also referred to as owners' equity, this value represents the total assets of a business that is available to distribute to shareholders. The equity is left over after the liabilities are deducted.
A common misconception is that the value of equity reflects the value of the business. The potential sale or acquisition price of the business is not correlated to the equity figure as it takes into account many other factors such as intellectual property and perceived value.
Think of equity as what belongs to the business owners, after all financial obligations are satisfied. The accounting equation that we will talk about in the next lesson, explains that when you subtract the liabilities from the assets, you are left with the residual interest known as equity. Equity is the least tangible of the main three concepts and often the hardest to conceptualize.
Equity on the balance sheet is recorded in two categories: retained earnings and common shares. There are more types of accounts such as preferred stock that are detailed in more advanced accounting courses, but for the purpose of this lesson we will just look at the two components circled below on the balance sheet.
Common stock is the amount of money received from the sale of shares. This amount is essentially the ownership amount of the stockholders.
Retained earnings refers to the residual amount of profit left over after paying dividends and liabilities.
Take a look at the sample statement of retained earnings above. This figure is further broken down into based on the changes from the previous year.
When equity is constantly going up year over year, this can mean that the business is facing one of two scenarios.
The common shares values are increasing or the company is issuing out more shares, thus diluting the population.
The company is earning higher profits, in which case the retained earnings are going up.
Corporation A has 10 million in assets, 5 in liabilities and 5 in equity. Using the Accounting equation, Assets = Liabilities + Owners' Equity, this would equate to 5 million in Equity. If we assume there are 10 shareholders in the company then each person will have $500,000 invested in the company.
Corporation B has 850,000 in total assets and the same amount of $850,000 in liabilities. The shareholders will be left with $0 in equity.
Corporation D purchases a piece of commercial property for $500,000 but needs financing for $200,000 of the purchase. The remaining $300,000 in cash the business puts down is the equity, the amount of ownership they have in the asset. If the value of the property goes up to $600,000 and the property is sold, then you have to subtract the loan liability from the total sale price which will leave the corporation with $400,000 in equity.
As you can see in these examples, Equity is the amount after the liabilities have been subtracted from the assets. Essentially equity is the residual interest that belongs to the owners or stockholders.