Lesson 9: Equity
In this lesson, we will define equity in the context of financial accounting,
explain how the performance of equity relates to overall performance, and show
where equity is recorded on financial statements. We will finish by covering
some 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.
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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.
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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.
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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.
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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.