The concepts of owner's equity and retained earnings are used to represent the ownership of a business and can relate to different forms of businesses. Owner's equity is a category of accounts representing the business owner's share of the company, and retained earnings applies to corporations.
How Owner's Equity Works
Owner's equity belongs entirely to the business owner in a simple business like a sole proprietorship because this form of business has just a single owner, It belongs to owners of partnerships and LLCs as agreed to by the owners. For example, a partnership of two people might split the ownership 50/50 or in other percentages as stated in the partnership agreement.
Three categories on a balance sheet represent the business's financial position from an accounting standpoint: assets, liabilities, and owner's equity. Under each category are different accounts, like "cash" for assets, "supplies" for assets, and liabilities for things like taxes, a mortgage, or other debts. The individual owners' equity of each other is shown in a capital account under the category of owner's equity.
All business types (sole proprietorships, partnerships, and corporations) use owner's equity, but only sole proprietorships name the balance sheet account "owner's equity." Partners use the term "partners' equity" and corporations use "retained earnings."
The Basic Accounting Equation
The basic accounting equation is Assets = Liabilities + Owner's Equity.
In other words, the value of a business's assets is equal to what the business owes to others (liabilities) plus what the owners own (owner's equity.
Expressed in another way: Owner's Equity = Assets – Liabilities.
Owner's equity can increase or decrease in four ways.
- It increases when an owner invests in the business. It is called a capital contribution because the owner is putting capital (money or property) into the business equation.
- It can increase when the company has a profit, when income is greater than expenses. The profits go into the company for use to pay down debt and to increase owner's equity.
- It can decrease if the owner takes money out of the business, by taking a draw, for example.
- It can also decrease if the expenses are greater than income (the business has a loss).
Let's say that a business opens its doors with $1,000 in assets, including cash, supplies, and some equipment. The business owner put in $200 of her own money, and she borrowed the other $800 from her local bank. So the initial accounting equation would look like this:
Assets $1,000 = Liabilities $800 + Owner's Equity $200
It could also look like this:
Owner's equity $200 = Assets $1,000 – Liabilities $800
Now let's say that at the end of the first year, the business shows a profit of $500. This increases the owner's equity and the cash available to the business by that amount. The profit is calculated on the business's income statement, which lists revenue or income and expenses.
Now the equation is:
Owner's Equity $700 = Assets $1,500 – Liabilities $800.
But what if the owner took out $300 from the business as a draw during the year? The draw reduces the owner's capital account and owner's equity, so now the equation is:
Owner's Equity $400 = Assets $1,200 – Liabilities $800.
Remember that owner's equity is a category. The account for a sole proprietor is a capital account showing the net amount of equity from owner investments. This account also reflects the net income or net loss at the end of a period.
How Retained Earnings Work
Retained earnings are corporate income or profit that is not paid out as dividends. That is, it's money that's retained or kept in the company's accounts.
An easy way to understand retained earnings is that it's the same concept as owner's equity except it applies to a corporation rather than a sole proprietorship or other business types. Net earnings are cumulative income or loss since the business started that hasn't been distributed to the shareholders in the form of dividends.
Corporate net earnings = cumulative net income – cumulative losses – dividends declared.
The statement of retained earnings shows whether the company had more net income than the dividends it declared.
The earnings of a corpoartion are kept or retained and are not paid out directly to the owners, while the earnings are immediately available to the business owner in a sole proprietorship unless the owner elects to keep the money in the business.
Partnerships, LLCs, and S Corporation Owners
Partner ownership works in a similar way to ownership of a sole proprietorship. The partners each contribute specific amounts to the business in the beginning or when they join. Each partner receives a share of the business profits or takes a business loss in proportion to that partner's share as determined in their partnership agreement. Partners can take money out of the partnership from their distributive share account.
Owners of limited liability companies (LLCs) also have capital accounts and owner's equity. The owners take money out of the business as a draw from their capital accounts.
Owner's Equity vs. Retained Earnings and Business Taxes
All business types except corporations pay taxes on the net income from the business, as calculated on their business tax return. The owners don't pay taxes on the amounts they take out of their owner's equity accounts.
Here's an example: Jake's sole proprietorship business had net income of $25,000 for the year, and he took out $12,000 as draw. He must pay tax on the $25,000, not the $12,000.
A corporation pays tax on annual net income (profits minus deductions, credits, etc.), not retained earnings. The owners of a corporation (shareholders) pay tax on dividends they receive, not on the retained earnings of the corporation.