Study: Define Common Equity Accounts
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Slides 1-2 (:59s):
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Welcome to introduction to accounting, preparing for a user’s perspective preparing.
Define common equity accounts.
How is equity defined by the FASB? Equity Links to an external site.or net assets, and make sure you focus on this idea of net assets. It is the residual, meaning the leftover interest in the assets of an entity that remains after deducting its liabilities.
“Equity or net assets is the residual interest in the assets of an entity that remains after deducting its liabilities.”
Statement of Financial Accounting Concepts No. 6 Elements of Financial Statements—a replacement of FASB Concepts Statement No. 3 (incorporating an amendment of FASB Concepts Statement No. 2) CON6-12.25
Copyrighted by, and reproduced with permission of, the Financial Accounting Foundation, 401 Merritt 7, Norwalk, CT 06856, USA.
This definition comes from the balance sheet equation: Assets = Liabilities + Equity.
All of these assets are funded either by debt
Links to an external site.or by equity. If we want to know what equity means we can solve for equity.
When we do that we would deduct liabilities from both sides, and result in the following equation: Assets - Liabilities = Equity.
Equity, or net assets, is the residual interest. As you can see here, assets minus liabilities, leaves over a residual. That residual belongs to the owners.
Let’s look at some common equity accounts and see what increases and decreases them.
Slide 3 (1m:55s):
Links to an external site. Here is the list of common equity accounts that we will be using in this course [see below].
We may add a couple more, but this is a good starting point.
If you were to look at a balance sheet Links to an external site. and you were to only see something like “Kevin Kimball, Capital”, immediately, you would know that this is a sole proprietorship, because there is only one capital account and it is named after the individual sole proprietor Links to an external site..
Now, if you were to see two or more capital accounts, with peoples’ names on them, you would know that that is a partnership.
If you were to see something like common stock, preferred stock and retained earnings, these would represent that this is a corporation Links to an external site..
Common stock Links to an external site. and preferred stock Links to an external site. are types of stock that are given to owners in exchange for resources.
Retained earnings Links to an external site. is the amount of income the company has earned and the owners have chosen to keep within the company rather than have them paid out in the form of withdrawals Links to an external site.or dividends Links to an external site.(dividends would be the appropriate term if we’re dealing with a corporation, withdrawals would be the word we use for partnerships and sole proprietorships).
These equity accounts keep a permanent running total of a company’s total equity. They appear on the balance sheet. They are known as permanent accounts because they keep a running total year after year, after year.
These equity accounts are only temporarily used during a given period to explain why these balance sheet equity accounts changed from one year to the next, or one accounting period to the next.
Capital Links to an external site.distributions, withdrawals and dividends, appear on the statement of owners’ equity or shareholders’ equity. Withdrawals and dividends are payments to the owners out of the company’s earnings. And [a] capital distribution is effectively giving them [the owners] back their original capital.
Revenues Links to an external site., gains, expenses and losses appear on the income statement. If you take all the revenues and gains and deduct all the expenses and losses, you will arrive at net income. Net income Links to an external site. serves to increase retained earnings.
Slide 4 (:41s):
Links to an external site. You should recall the T-account format []provided below].
It’s just another way of computing an ending balance. Liabilities and equity normally have their beginning balance on the right-hand side, and increase on the right, and decrease on the left. The ending balance would [normally] be on the right-hand side.
If we were to then look at this equity account and say, “How did we get this equity?” [we would realize that] equity usually comes in two forms, either it is contributed by owners, or its earned through net income and retained [by owners] in the company.
Slide 5 (1m:17s):
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If we were to take this equity account here and break it out into two pieces, we would get the contributed equity, which we will give a general term “Capital Stock” and earned equity, which we will call “Retained Earnings”.
If you want to increase either of these two accounts, you would record it [the increase] on the right-hand side. If you want to decrease it, you [would] record it [the decrease] on the left-hand side.
What increases the contributed equity capital stock account? If owners make capital contributions, that [capital stock] will increase.
What would cause it [capital stock] to decrease? If the company were to distribute capital back to the owners, that would decrease their capital stock account.
If they issued new stock, that would increase it. If they were to buy the stock back, that would decrease it.
Over to our earned equity, retained earnings. It increases when we have revenues and gains, it decreases when we have expenses and losses.
These together, if you take all of your revenues and gains less your expenses and losses, that would be your net income.
Hopefully your revenues and gains will be greater than your expenses and losses, resulting in a net increase in equity called net income.
If your expenses and losses are greater than your revenues and gains, then you will have a net loss resulting in a decrease in retained earnings.
If you were to have net income, the owners could choose to withdraw it (if it is a sole proprietorship or partnership), or have dividends paid out to them (if it’s a corporation).
Slide 6 (54s):
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Assets – Liabilities = Equity
When assets increase by more than liabilities, owners’ equity will increase.
For example, if we had $10 in assets come into the company but liabilities were to only increase by $7, then the owners would have claim on the additional $3 [of net assets].
When assets increase by the same amount as liabilities, owners’ equity will not change.
If we have that $10 [in assets] come in but we have liabilities increase by an equal amount [of $10], then the owners have no additional equity.
When assets increase by less than liabilities, owners’ equity will decrease.
If we have [a] $10 [increase in assets], but our liabilities increase by a larger amount, that excess liability effectively will reduce the owners’ equity [claims] in the company’s assets.
What transactions could explain these different examples?
Slide 7 (1m:12s):
Links to an external site. I’ve [now] set this up, you’ve just barely seen this.
Here’s your equity account broken out into the two types of equity, the contributed equity and the earned equity, and the opposite side is your assets minus liabilities.
If we purchase $10 of inventory on account Links to an external site. that means our assets increase by $10, and [since] we bought it on account, that means our liabilities increased by $10.
As you can see [above] the assets increase [of $10] is exactly equal to the liabilities increase [of $10] and therefore there is no change in equity.
If we were to then sell the inventory to customers for $13 we would have to give away the inventory so we are going to reduce it [inventory] by $10. When we give away inventory to customers that will be an expense we will call it cost of goods sold Links to an external site..
As you can see here [in the diagram above], assets reduced and equity reduced by the same amount, but [because] we sold [the inventory] for $13 on account we would have another asset called accounts receivable Links to an external site. increase and since that did not change our liabilities that [increase of $13] would have to belong to the owners. We’ll call that revenue.
Assets are now $13. Liabilities are now $10. No change in our contributed capital [occurred] and our retained earnings [account] is $3. As you can see, this balances out. $ 3 on this side ($13 [of assets] minus $10 [of liabilities]) equals the 3$ [of equity] on the other side.
Slide 8 (:19s):
Links to an external site. If [let’s assume] we issued $3 in stock in exchange for a company that had $13 in assets and $10 in liabilities. So we’re going to issue $3 in stock. In exchange we got $13 in assets and $10 in liabilities as you can see $13 [of assets] - $10 [of liabilities] = $3 [of net assets].
Slide 9 (:16s):
Links to an external site. If [let’s assume] we issued $3 in stock in exchange for cash, our cash would go up and it’s a stock issuance [for] $3. We stay in balance. As you will notice as we go through these, every transaction we record will keep this left-hand side [assets-liabilities] equal to this right-hand side [equity] when assets increase by the same amount as liabilities owners equity will not change.
Slide 10 (:31s):
Links to an external site. Purchase $10 of inventory on account. We already saw this. Our assets when up by $10 [and] liabilities when up by $10. No change in equity.
If we borrow $10 under a note agreement, our assets would go up by $10 and it’s a note [therefore] it’s a liability [resulting in an increase of $10]. No change in equity.
If we borrow $10 using a mortgage to purchase a home we would have an asset called home go up and a mortgage payable go up.
As you can see, equity never changed. So, there is zero on this side [assets-liabilities] and zero on the other side [equity].
Slides 11-12 (2m:37s):
Links to an external site. When assets increase by less than liabilities owners’ equity will decrease.
For example if you purchase $13 of inventory on account and then sell it for only $10. Hopefully, you see right off-the-bat that this is not a great business proposition. You are buying something at a high price and selling it for a low price, but let’s see what it does to the overall balance sheet equation and our net assets.
Purchase $13 of inventory on account. So, if you bought [$13 of] inventory, your assets would go up [by $13] and, it’s on account meaning you haven’t paid for it yet, so your liabilities would increase [by $13]. In this case, equity has not changed yet. It’s when you go and sell this [inventory] for less than its cost, that’s when the owners lose.
We’re going to sell it for $10. If you sell it for $10, first you have to get rid of the inventory so your asset will go down. When you give [$13 of] inventory away to customers that’s an expense that we call cost of goods sold. That reduces our income, which reduces retained earnings, then, in exchange for that $13 of inventory we are going to get $10. Since it just says “sell it for $10”, you can assume it was [sold] for cash.
Our assets go up by $10. Since the liabilities are not affected by that transaction it must have increased equity.
Since this was a transaction with the customer we will call that a revenue.
Let’s see where we’re at now. If we were to compute our [net] asset balance we [would] have $10 in assets, $13 in liabilities and we [would] have a net loss which [would] reduce retained earnings by $3.
Let’s look at another transaction. If [let’s assume] we borrowed $13 and then owners withdrew $3 in cash or we paid a dividend of $3.
So let’s borrow $13. We’re going to bring in $13 of cash. We borrowed it [so there is] no change in equity yet [but there is an increase of $13 in liabilities]. Then we use this cash, that we just brought in, to pay a dividend to the owners. Reduce assets by $3 and [because] it’s a dividend of $3 I’m going to put it down here (but it is a dividend of $3).
Let’s compute our balance. We have $23 [in asset increases] minus $3 [in asset decreases], that’s $20 [in assets], minus our liability balance of $26. So $20 [of assets] minus $26 [of liabilities], this is not a good sign, we do not have any net assets, in fact we [our owners’ equity] are negative.
Why are we [is our owners’ equity] negative, because we pulled $6 out of our retained earnings by creating losses and paying a dividend.
I hope you can see how that all works together we’re going to move on to preparing the financial statements but if you can get the logic of how this all works it will go a long way for your understanding [of] accounting.