Owner's Equity vs. Retained Earnings
Small Business vs. Corporation
The concepts of owner's equity and retained earnings are often confused. These two terms are used to represent the ownership of a business, for different types of businesses. We'll start with owner's equity, which is a category of accounts representing the business owner's share of the company, and we'll move on later to retained earnings (which applies to corporations).
How Owner's Equity Works
In a simple business like a sole proprietorship, which has a single owner, owner's equity belongs to the sole business owner.
Let's look at this very simply. The way a business is represented from an accounting standpoint is that there are three categories on a balance sheet: assets, liabilities, and owner's equity. So, owner's equity is a category. Under each category are different accounts, like "cash" (an asset), "supplies" (an asset, taxes payable (a liability), and a mortgage (a liability).
The recognized accounting equation is
Assets equal Liabilities plus Owner's Equity.
In other words, on the left are the assets, the things owned by the business, and on the right are the owners (banks, credit unions, etc., and the business owners).
For our purpose, we'll turn around the equation to be
Owner's equity equals Assets minus Liabilities.
Owner's equity increases or decreased in four ways: (1)it increases when an owner invests in the business. (This is called a capital contribution.) (2) It increases or decreases when the company has a profit (increase) or a loss (decrease), and (3) It decreases when an owner takes money out of the business (as an "owner's draw").
(4) Owner's equity can also decrease if liabilities increase and assets don't increase by the same amount.
Here's a simple example:
A business opens its doors with $1000 in assets (cash, supplies, some equipment). The business owner put in her own money $200 and she borrows the other $800 from her local bank.
So, the initial accounting equation is:
Total Assets $1000 equals Total Liabilities $800 plus Total Owner's Equity $200
Owner's Equity $200 equals Total Assets $1000 less Liabilities $800.
Now, at the end of the first year, the business has a profit of $500, increasing 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 (income) and expenses.
Now the equation is
Owner's equity $700 equals Assets $1500 less Liabilities $800.
But, during the year, the owner took out $300 from the business as a draw. The draw reduces the owner's capital account and owner's equity, so now the equation is:
Owner's equity $400 equals Assets $1200 less Liabilities $800.
Owner's equity accounts
Owner's equity, remember, is a category. The accounts for a sole proprietor are:
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.
A separate draw account is also shown on the balance sheet, reflecting the amount taken out by the owner during the period of time in question.
What about Retained Earnings?
Retained earnings , as explained by Rosemary Peavler, is
that portion of net income or net profit...that is not paid out as dividends.
That is, it's the money that's retained (kept in the company's accounts).
The easy way to understand retained earnings is that it is simply the same concept as Owner's equity, only it applies to a corporation instead of a sole proprietorship. A corporation has shareholders, and each shareholder has a capital account.
Two other differences between owner's equity and retained earnings:
1. In a corporation, the earnings of the company are kept (retained) and are not paid out directly to the owners, while in a sole proprietorship, the earnings are immediately available to the business owner, unless the owner decides to keep the money in the business.
2. In a corporation, owners (shareholders) are paid dividends instead of being given direct payments.
What about a Partnership?
Partner ownership works in a similar way to ownership of a sole proprietorship.
1. The partners each contribute specific amounts to the business in the beginning or when they join.
2. Each partner receives a share of the business profits (or takes a business loss) in proportion to that partner's share, as determined in the partnership agreement.
3. Partners can take money out of the partnership from their distributive share account.
In conclusion, owner's equity accounts for sole proprietors, Limited Liability Company owners, and partners are similar to retained earnings accounts for corporation shareholders.