• Define owners’ equity

 

The basic accounting equation is [latex]\text{Assets}=\text{Liabilities}+\text{Owner’s Equity}[/latex].

Owner’s equity can be further broken down into four components:

• Capital contributed. This represents the dollar value of resources put into the company by the owner. Often, this is cash, but it could also be assets like machinery or accounts receivable. In any case, these are personal assets that are used to fund the business.
• Withdrawals. This is the dollar value of resources (usually cash) taken out of the company by the owner for personal use.
• Revenues. This is the income a business takes in. We’ll further define and discuss revenues on this page.
• Expenses. This is what the business spends. We’ll further define and discuss expenses on this page.

Think of a business as a machine that generates cash. Raw materials, like products and workers’ labor, go into the machine, and the machine works its magic adding value to the inputs. After that, out the other side come profits. Economically speaking, profits are additions to the wealth of the owner. Profits are also called income (or net income) in accounting.

There are two elements of profits: revenue and expenses.

Revenue

Revenue is income that results from a business engaging in the activities that it is set up to do. For example, a computer technician earns revenue for repairing a computer for a customer (performing the service for which the company exists). If the same computer technician sells a van that is no longer needed for the business, the proceeds are not considered revenue. However, if a used car dealer sells a van on the lot, the proceeds from that sale are considered to be sales revenue for the dealership. If the car dealership sells an old office computer, the proceeds from that sale aren’t really revenue for the dealership.

Products vs. Service

Sales revenue is an account name normally used when a retailer sells an item. Fees earned is an account name commonly used to record income generated from providing a service. In a service business, customers buy expertise, advice, action, or an experience but do not purchase a physical product. Consultants, dry cleaners, airlines, attorneys, and repair shops are service-oriented businesses. The fees earned account falls into the revenue category.

Expenses

Expenses are bills and other costs a business must pay in order for it to operate and earn revenue. As the adage goes, “It takes money to make money.” Think back to the wealth generative machine. In order to generate profits from the machine, the owner has to put something in. In our basic example, the inputs were raw materials and labor. The machine took those two things and combined them in a new and better way that made them more valuable to customers, but it cost some money to create the value. Another way to describe expenses is “costs of doing business.”

The word “expense” literally means “used up.” When you go to the gym, you “expend” energy. Expenses are resources that get used up as the company generates revenue. This is an important accounting concept to remember: expenses are costs that are directly related to generating revenue.

Imagine a business that creates cable wraps for your computer that tidy up the space under and behind your desk. In this business, the labor is people spending time doing what their customers don’t (or can’t) do—creating the wraps from plastic. The business owner buys plastic and pays people to convert that plastic into something of value to customers. If you buy it for more than the combined cost of the component bits, the company makes a profit, stays in business, and makes more wraps. If you don’t want or need the wrap, or if you can find it cheaper somewhere else, the company spends more than it earns, which we call a loss.

Some common business costs (expenses) include:

• Cost of paying hourly employees (salaries and wages).
• Cost for the use of property that belongs to someone else (rent).
• Costs such as electricity, water, phone, gas, cable TV, etc. (utilities).
• Cost of small items used to run a business (supplies).
• Cost of protection from liability, damage, injury, theft, etc. (insurance).
• Cost of promoting the business (advertising).
• Costs related to the upkeep of machinery and buildings (repairs and maintenance).

Capital Contributed and Withdrawals

The final two components of owner’s equity are capital contributed and withdrawals.

• Capital Contributed. This is money put into the company by the owner or investors.
• Withdrawals. This is money the owner takes out of the company (i.e., the owner paying themself or other investors).

Owner’s Equity

The basic accounting equation is:

[latex]\text{A}=\text{L}+\text{OE}[/latex]

 

Mathematically, an owner’s equity can be expressed like this:

[latex]\text{Owner’s Equity}=\text{Capital Contributed}-\text{Withdrawals}+\text{Revenues}-\text{Expenses}[/latex]

Or, in general terms, the owner’s equity is equal to what the owner puts in, minus what the owner takes out, plus what the business has generated in additional wealth for the owner, minus the costs associated with generating that wealth.

So, the expanded accounting equation is:

[latex]\text{A}=\text{L}+\left(\text{CC}-\text{WD}+\text{Rev}-\text{Exp}\right)[/latex]