Equity or Owner Equity or Shareholder Equity refers to the amount of money that the owner/shareholders have invested into the business. It represents the amount of assets which belong to the owner/shareholders. It is a part of the accounting equation that represents the Assets, Liabilities, and Equities.
Owner Equity can be increased after the business makes a profit for a few years. The net profit from the income statement will be accumulated as the retained earnings. This balance will be classified as part of the equity in the balance sheet. So if the company keeps making a profit more and more, the equity will keep increasing.
Besides the retained earning, equity includes other components such as capital, treasury stock, additional paid-in capital, and other reserves.
Equity = Asset – Liability
Capital is a part of equity, it represents the amount of investment that the owner/shareholder invests in the company. It does not include other balances such as retain earnings, and other reserves. Capital is equal to or less than equity.
Capital will be increased by the capital injection made by the owner/shareholder when it is necessary. On the other hand, the capital will decrease when the owner withdraws the capital which is different from the dividend.
For example, base on Company A’s balance sheet, there are some components as the following:
- Capital: company’s owner has invested $ 80,000 since they start the business in 202X. One year later, they have invested an additional $ 20,000 to expand the business.
- Retain Earning: the company has made a total accumulated profit of $ 50,000 over its lifetime.
- Other reserves: the balance raise due to property evaluation.
- During the year, management decided to withdraw a dividend of $ 10,000
Please calculate Capital and Equity.
Capital equal to initial investment plus additional capital, less any capital withdrawal. Base on the company’s financial statement, the owners have invested $ 100,000 in total and there is no withdraw.
Capital = 80,000 + 20,000
Equity = 100,000 + 50,000 + 5,000 – 10,000 = 145,000
Key Different between Equity and Capital
Equity is one of the main components present on the balance sheet. It is the amount that equals assets less liability.
On the balance sheet, it represents the accounting equation in which assets are equal to liability plus equity. The company needs assets to operate the business to make a profit. The assets can arrive from liability or equity.
In the event of liquidation, equity is the amount that the owner or shareholders will receive after paying off the liability to the creditors. It is the residual amount that remains after deducting the liability from the company’s assets.
Capital is the amount of cash that the owner or shareholder contributes to the company. It is one of the components of the company’s equity. It represents the amount of cash that owner/shareholders invest into the company.
Impact of Profit
The profit is the result of the company’s performance over a period of time. It presents the amount of revenue that are left after settling the expenses during the period.
The profit will increase the retained earnings on the balance sheet. As the retained earning is the equity component, so the profit also increases the equity amount on the balance sheet.
However, the profit will not have any impact on the company’s capital. The capital only increases when the owner or shareholder injects new cash into the business. When the company is facing financial health difficulties, it will seek new capital. The owner is one of the people who can help by injecting new capital into the company. This capital injection will increase assets and the company’s capital.
Impact of Loss
Opposite to profit, the loss will reduce the retained earnings of the company. At the same time, it also reduces the amount of equity on the balance sheet.
Similar to profit, the net loss will not have an impact on the company’s capital. Capital will decrease only due to the withdrawal of the owner under any specific condition. When owner withdraws capital from the company, it will reduce the assets and the capital balance.
The reserve is a part of the company equity. The purpose of the reserve is to ensure that the company has enough funds to cover its liabilities. The accounting for reserves can be done on a quarterly or annual basis. The company’s auditor will review the financial statements and make sure that the funds are available to cover the liabilities. If the company does not have enough funds to cover its liabilities, the auditor will make a recommendation to the board of directors. The board of directors will then decide how to raise the necessary funds. Accounting for reserves is an important part of the company’s financial planning.
Reserve and capital is the part of the company’s equity. But the reserve is not under the capital. Both items are presented on the balance sheet. They present independently on the company’s balance sheet.
When a company revalues its assets, any increase in the asset’s value is recorded as a revaluation surplus on the balance sheet. This can happen if the market value of the asset rises or if the company’s own valuation methods show that the asset is now worth more than it was previously recorded. The revaluation surplus represents the difference between the previous carrying value of the asset and its new value. While a revaluation surplus does not directly affect a company’s cash flow or profits, it can have an indirect impact by increasing the equity on the balance sheet. For these reasons, revaluation surpluses are important to take into account when assessing a company’s financial health.
Similar to reserve, the revaluation surplus is part of the company’s equity but it is not under the company’s capital.