Shareholder equity refers to the residual value of a company’s assets after deducting its liabilities. It represents the owners’ (or shareholders’) investment in the company and their claim on the net assets.
Shareholders’ equity can be classified into contributed capital and retained earnings.
- Contributed capital is the amount of money the owners have invested in the company, such as common and preferred stock.
- Retained earnings refer to the company’s profits that have been reinvested in the business instead of being distributed to the owners as dividends.
To calculate your total equity, you must add up the value of your company’s sources of capital and retained earnings. You can use the following formula:
Total Equity = Contributed Capital + Retained Earnings
Alternatively, you can use the accounting equation to calculate your equity as the difference between assets and liabilities. You can use the following formula:
Total equity = Total Assets — Total Liabilities
Comparing the equity calculated with the accounting formula and the one based on the contributed capital and retained earnings is a benchmark of the quality of your bookkeeping.
It’s the basis of the double-entry system. If both results don’t match the last cent, it’s evidence of a mistake.
That said, it’s important to note that both numbers coinciding don’t necessarily imply that everything is as it should be.
Suppose a company has the following equity:
The total equity of the company is:
Total Equity = $60,000 + $5,000 + $15,000
Total Equity = $80,000
Using the accounting equation and the values of the assets and liabilities from the previous examples, the total equity of the company is:
Total equity = $210,000 − $130,000
Total Equity = $80,000
In this example, everything checks out.
The Accounting Equation and Business Structures
The accounting equation forms the foundation of financial statements and is closely related to a company’s business structure.
While the accounting equation itself isn’t exclusive to any specific business structure, including LLCs (Limited Liability Companies), the role of an LLC in this equation is distinct due to its unique characteristics.
We can further elaborate on the role of an LLC in the accounting equation as follows:
Limited Liability Protection
The ‘Limited Liability’ aspect of an LLC is crucial. It means that the personal assets of the LLC members are separate from the business’s assets.
This separation protects members’ personal assets from business liabilities.
Members of an LLC contribute equity, usually in the form of initial investments. This equity becomes a part of the equity component of the accounting equation.
The members’ ownership interests are reflected in the equity section, emphasizing their claim on the LLC’s assets.
Applications of the Accounting Equation
The accounting equation is a theoretical concept but also a practical tool you can use for various purposes. Some of the applications of the accounting equation are:
- Calculating the three primary financial statements, i.e., the balance sheet, income statement, and statement of changes in equity.
- Providing the foundation of the double-entry bookkeeping system.
- Calculating a company’s worth in terms of its book value.
- Calculating income and retained earnings.
Additionally, you can visualize the accounting equation and its components using advanced visualization tools like Tableau.
Accounting software can help you see the double-entry system in action by showing how each accounting equation component changes after each financial transaction.
You’ll also see how both sides of the equation rise and fall simultaneously, always remaining equal.
Limits of the Accounting Equation
The accounting equation is a valuable and powerful tool that can help understand and analyze a company’s financial situation. However, it has some limitations you should consider when using it:
- It doesn’t reflect the effects of inflation, impairment, depreciation, and amortization on the value of the assets and liabilities.
- It doesn’t capture the qualitative aspects of a company, such as its reputation, customer loyalty, brand recognition, etc., which may significantly impact its value and performance.
- It doesn’t account for the risks and uncertainties that a company may face, such as market fluctuations, competition, regulation, etc.
- It doesn’t consider the time value of money, which is the concept that money available today is worth more than money available in the future due to its potential earning capacity.
The Expanded Accounting Equation
We can expand the accounting equation to include more details and categories of the elements of the equation, such as revenues, expenses, gains, losses, dividends, and contributions.
We can thus write the resulting expanded accounting equation in different ways, such as:
Assets = Liabilities + Contributed capital + Retained earnings
Assets = Liabilities + Contributed Capital (CC) + Beginning Retained Earnings (BRE) + Revenues + Gains – Expenses – Losses – Dividends
The expanded accounting equation shows how the different components of the income statement and the statement of changes in equity affect the balance sheet and how the financial activities of a company are interconnected.
The Accounting Equation Forms the Basis of Accounting
The accounting equation is a fundamental principle of accounting. It expresses the relationship between a company’s assets, liabilities, and equity and is the foundation for preparing and analyzing financial statements.
The accounting equation also provides a framework for recording and tracking a company’s business transactions using the double-entry accounting system, making it an essential tool for business owners.
Moreover, it can be used for various purposes in accounting and business, such as calculating a company’s net income and retained earnings and estimating a company’s worth.
At the end of the day, it helps a stakeholder or potential investor understand the effects of different financial events on a company’s financial position and performance.