What is an Equity Account? – Definition
Equity is defined as the owner’s interest in the company assets. In other words, upon liquidation after all the liabilities are paid off, the shareholders own the remaining assets. This is why equity is often referred to as net assets or assets minus liabilities.
Equity can be created by either owner contributions or by the company retaining its profits. When an owner contributes more money into the business to fund its operations, equity in the company increases. Likewise, if the company produces net income for the year and doesn’t distribute that money to its owner, equity increases.
Equity accounts, like liabilities accounts, have credit balances. This means that entries created on the left side (debit entries) of an equity T-account decrease the equity account balance while journal entries created on the right side (credit entries) increase the account balance.
Types of Equity Accounts – Explanation
There are several types of equity accounts illustrated in the expanded accounting equation that all affect the overall equity balance differently. Here are the main types of equity accounts.
Capital – Capital consists of initial investments made by owners. Stock purchases or partnership buy-ins are considered capital because both are comprised of cash contributions made by the owners to the company. Capital accounts have a credit balance and increase the overall equity account.
Withdrawals – Owner withdrawals are the opposite of contributions. This is where the company distributes cash to its owners. Withdrawals have a debit balance and always reduce the equity account.
Revenues – Revenues are the monies received by a company or due to a company for providing goods and services. The most common examples of revenues are sales, commissions earned, and interest earned. Revenue has a credit balance and increases equity when it is earned.
Expenses – Expenses are essentially the costs incurred to produce revenue. Costs like payroll, utilities, and rent are necessary for business to operate. Expenses are contra equity accounts with debit balances and reduce equity.
Unlike assets and liabilities, equity accounts vary depending on the type of entity. For example, partnerships and corporations use different equity accounts because they have different legal requirements to fulfill. Here are some examples of both sets of equity accounts.
Partnership Equity Accounts
Owner’s or Member’s Capital – The owner’s capital account is used by partnerships and sole proprietors that consists of contributed capital, invested capital, and profits left in the business. This account has a credit balance and increases equity.
Owner’s Distributions – Owner’s distributions or owner’s draw accounts show the amount of money the owner’s have taken out of the business. Distributions signify a reduction of company assets and company equity.
Corporate Equity Accounts
Common Stock – Common stock is an equity account that records the amount of money investors initially contributed to the corporation for their ownership in the company. This is usually recorded at the par value of the stock.
Paid-In Capital – Paid-in capital, also called paid-in capital in excess of par, is the excess dollar amount above par value that shareholders contribute to the company. For instance, if an investor paid $10 for a $5 par value stock, $5 would be recorded as common stock and $5 would be recorded as paid-in capital.
Treasury Stock – Sometimes corporations want to downsize or eliminate investors by purchasing company from shareholders. These shares that are purchased by the company are called treasury stock. This stock has a debit balance and reduces the equity of the company.
Dividends – Dividends are distributions of company profits to shareholders. Dividends are the corporate equivalent of partnership distributions. Both reduce the equity of the company.
Retained Earnings – Companies that make profits rarely distribute all of their profits to shareholders in the form of dividends. Most companies keep a significant share of their profits to reinvest and help run the company operations. These profits that are kept within the company are called retained earnings.
There is a basic overview of equity accounts and how their interact with the overall equity of the company.