Lesson 24 - Beginner accounting course

24. Equity in Accounting: Understanding Owner’s Equity and Shareholder’s Equity

Equity represents the ownership interest in a business after all liabilities have been deducted from assets. It reflects the residual value that belongs to the owners or shareholders. In accounting, equity plays a vital role in assessing the financial health of a company, determining ownership structure, and evaluating profitability over time.

Definition of Equity

Equity is calculated using the accounting equation:

It represents the net worth of a business and shows how much of the company's assets belong to the owners or shareholders after all debts have been settled.

Types of Equity

Equity can be classified into two main categories based on the business structure:

1. Owner’s Equity – Relevant to sole proprietorships and partnerships.

2. Shareholder’s Equity – Applicable to corporations with stockholders.

Understanding Owner’s Equity

Owner’s equity is found in sole proprietorships and partnerships. It consists of:

• Capital Contributions – The money or assets an owner invests in the business.

• Withdrawals (Drawings) – Money taken by the owner for personal use.

• Retained Earnings – Profits reinvested in the business instead of being distributed.

Example of Owner’s Equity Calculation

A sole proprietor starts a business with a $50,000 investment. At the end of the year:

• Business earns a profit of $20,000.

• The owner withdraws $5,000 for personal use.

The owner's equity would be:

Understanding Shareholder’s Equity

Shareholder’s equity is relevant to corporations and consists of:

• Common Stock – Represents ownership and voting rights in the company.

• Preferred Stock – Offers fixed dividends but limited voting rights.

• Additional Paid-in Capital – Extra money shareholders pay above the stock’s par value.

• Retained Earnings – Profits that are reinvested instead of being paid out as dividends.

• Treasury Stock – Company shares that have been repurchased.

Example of Shareholder’s Equity Calculation

A corporation’s balance sheet reports:

• Total assets: $500,000

• Total liabilities: $300,000

Using the equity formula:

Why is Equity Important?

1. Measures Business Health – A company with growing equity is financially strong.

2. Determines Ownership Rights – Defines how much stake an owner or shareholder has.

3. Affects Investment Decisions – Investors analyze shareholder equity before investing.

4. Impacts Financial Statements – Changes in equity influence the balance sheet and retained earnings.

Final Thoughts

Equity is a critical component of financial accounting. Whether in a sole proprietorship or a corporation, understanding how equity is recorded, measured, and managed helps business owners and investors assess the financial stability and profitability of an enterprise.