subject: Understanding Owners' Equity [print this page] In order to understand the purpose of the accounting system one must first understand how the individual components interact. The basic elements are assets, liabilities, and owners' equity. These three parts to the whole monetary distribution of a company can be broken down in many ways and calculated infinitely more accurately, but that is not the main focus of this article. In this article I hope to shed light onto the fact that the entire purpose of the accounting system derives itself from owners' equity and why this system has developed over time to safeguard equity and accurately explain to the owners' what the financial situation of their company is. We begin with the basic accounting equation of A = L + OE, or Assets = Liabilities + Owners' Equity. We see that assets, or the representation of what a company owns, must equal the liabilities, or representation of what a company owes, plus the Owners' Equity, or the amount that the owners in a corporation can lay claim to. So in more layman's terms, the amount of stuff owned by a company is equal to what the owners bought as well as what has been borrowed. Why is this important? Well because in order for the initial investment in a company an owner expects to receive a return on his or her investment. Over time a company becomes successful and starts generating profits, at which point the profits are distributed based on ownership percentages. This ultimately drives accounting and is built into the most basic of accounting principles.
Owners' Equity can be thought of in a myriad of ways, but first and foremost it breaks down into Revenues minus Expenses, or R - E, although the amount of money earned through producing a good or providing a service doesn't automatically go straight to the owners. First the cost of producing the goods, or providing the services must be calculated and then subtracted from the amount of money made. So we have our earnings minus our costs which in accounting we call revenue and expenses respectively. When the amount of revenue exceeds the expenses then an accounting profit has been made. This profit is the increase in owners' equity, or the reward bestowed to a person for taking the risk of investing in a company and can either be paid as a monetary payment called a dividend, or reinvested in the company to provide growth opportunities and expand. If the profit is not paid out in dividend form then the Owners' Equity increases and can be cashed in on at a later time through a number of ways. On the flip side, when expenses exceed revenues then Owners' Equity decreases although the real world repercussions of decreasing owners equity are beyond the scope of this paper, the basics involve a decrease in stock price, shaky investor confidence, less ability to take out loans, and in general the shrinking of the initial amount of Owners' Equity invested to the point of bankruptcy or selling out low to cut losses.
Another way to look at Owners' Equity involves manipulating the accounting equation itself. In this way the amount of Owners' Equity can quickly be calculated. Knowing the Assets and the Liabilities we rearrange the equation from A = L + OE to a more easy to work with A - L = OE. Basically the amount of stuff owned minus the amount of stuff borrowed equals how much the owners get. If the amount owned, or the assets, is higher than the amount borrowed, or liabilities, then if the owners chose to cash out they would receive money. If the amount borrowed is higher than the amount owned then a company must declare bankruptcy and the owners' have lost all their money. Using basic numbers lets say we have 10,000 dollars of assets, 5,000 dollars of liabilities (bank loans) then what would the owners claim be if they were to cash out. Well A - L = OE so 10,000 - 5,000 would equal 5,000. The Owners' Equity would be 5,000 dollars. This is a good way to get a quick check of the value of ownership in a company, for a myriad of applications including investments, the loan/ lending system, and the recognition of the overall health of a company.
Another reason why Owners' Equity factors into the accounting system involves the mistrust inherent in the monetary relationships between human beings. If all the owners of a company trusted each other (and of course the government trusted all of them) there would be no reason for accounting, but since people tend to gravitate towards misrepresenting money every once in awhile accounting has become a necessary system to accurately represent and safeguard the monetary information of a company. Accounting accurately represents the flow of money through a corporation and allows for everyone in a company, and external users as well, to understand how the money is allocated, where it goes, when it goes their, and how it affects the overall health of the company. Without accurate tracking and recording of money, the entire system of ownership and profits would crumble and capitalism would become a rampant greedy mess, as has been demonstrated by Enron and the pending Goldman Sachs fiasco.
Overall I will conclude with the idea that Owners' Equity represents the value of the Owners' total investment plus their profits (or losses) after all debts have been repaid. It also gives reason for the accounting principles themselves in order to safeguard the ownership proportions and accurately represent the monetary position of a company at any given point or over periods of time so that information can be gathered about the company for many different uses.
