In the previous article, we mentioned shareholders’ equity (investments from the owners of the company) as well as liabilities (amounts borrowed from lenders) in the context of the accounting equation. In this article, we are going to discuss shareholders’ equity in detail.
Shareholders’ Equity in Detail
Shareholders’ equity refers to the investment into the business by shareholders. This investment enables the business to acquire assets, which are the economic resources owned by the business. Here is a more concrete example. Say you invested $10,000 cash into a startup company. The company now owns $10,000 in cash (an asset). Without this investment from you, the business will not be able to own that asset.
Shareholders equity can be further broken up into two main components: paid-in capital and retained earnings.
Paid-in capital is the amount of capital investment in a corporation by its owners (like the $10,000 mentioned above). Retained earnings refer to accumulated profits made by the company that is reinvested into the business (rather than distributed back to the owners as drawings/ dividends).
Shareholders’ Equity Calculation
Here is how the retained earnings account works:
- The business earns revenue and incurs expenses. The difference is net income (or loss).
- The net income is added to the retained earnings account – the account that shows the earnings accumulated by the firm throughout the years
- The business distributes part of its earnings to shareholders. From another point of view, the shareholders withdraw part of the earnings
- The total shareholders’ equity is the sum of paid-in capital and retained earnings.
In the next article, we will look at liabilities – another component of the accounting equation.
Horngren, C., Sundem, G., Elliott, J., & Philbrick, D. (2014). Accounting: The Language of Business. In Introduction to Financial Accounting (Eleventh ed., p. 9).