What is Equity in Accounting?
Business owners use the term equity in accounting. Essentially, it refers to the value of the owner’s interest in a company minus all the liabilities.
In other words, the book value of equity is the difference between the company’s assets and liabilities on the company’s balance sheet. In some cases, it is called shareholders equity, stockholders equity, ownership equity or owner’s equity.
This word also refers to personal finances. For instance, if the person owns personal assets such as a property worth 700,000 and the mortgage of 200,000, the owner has 500,000 personal equity in the property.
In non-profit settings, equity is referred to as net assets or net positions.
While this is the basic explanation of equity, there is much more to know about equity, as we explain below.
What are Examples of Equity Accounting?
There are two main types of equity value in accounting;
Equity is listed in book value. An accountant determines equity by preparing financial statements. The equation that defines equity is:
Equity = Assets – Liabilities.
The assets are a sum of the non-current and current assets. The main assets in this type of equity are intangible and tangible assets, such as accounts receivable, fixed assets, cash, property equipment and plant, goodwill, cash, inventory, intangible assets, and intellectual property.
The liability includes the sum of the non-current and current liability. It may consist of accounts payable, deferred revenue, lines of credit, short-term debt, long-term debt, capital leases and other aspects of the financial statements.
To calculate the total value of the equity, the following accounts are out into consideration:
- Contributed Surplus – Shares sold above their value
- Share Capital
- Retained Earnings
- Net Income
The accountants, investment bankers or financial analysts consider the company’s share capital and retained earnings. Retained earnings comprise the cumulative net income minus the cumulative dividends in the company’s financial statements.
Financially, market value is an expression of equity. Market value may be different from book value because accounting statements result from the past, yet analysts look forward to the future.
It is easier to calculate the value of a publicly traded company compared to a private company. Many companies hire accounting firms, boutique firms, private equity analysts and investment banks for thorough analysis. Surprisingly, when two professionals are hired to estimate the market value of a company, they can arrive at different results as market value analysis can be subjective.
There are three main methods used to estimate the value of equity.
- Comparable Company Analysis – Compare similar companies
- Precedent transactions – look at multiples and sums for similar companies sold in the past
- Discounted Cash Flow Approach – looking at the forward cash flow forecast
Of all these methods, the discounted cash flow approach is the most used by analysts. This method is valued as it forecasts future free cash flow for businesses while simultaneously discounting it back to the present rate using a discount rate. Therefore, it is detailed and considers all aspects of a company and is heavily relied upon by businesses for accuracy.
What is Equity Financing
Equity financing involves raising capital for businesses via investors. Therefore, the company owners give the company a percentage of shares in ownership in exchange for money for the company.
Equity financing offers risks and rewards for business owners and investors. While the investor risks not having his cash paid back, they benefit from profits as they own a percentage of the company. On the other hand, the investor may earn more as the company progresses, but they lose everything if it falls.
The business owner can realise the dream but will probably have to share ownership interest and significant decisions with the new shareholders, depending on the percentage of ownership they may give to the investors. In some cases, relationships between these different partners end up strained.
Where is Equity Recorded?
A company’s equity appears on its balance sheet, usually displayed at the bottom of the sheet. It is described by terms such as ‘owner’s equity and ‘stockholders equity’ depending on the ownership model.
In most cases, it is always positive equity, and if it is negative, it is not a good sign. Negative equity means that the liabilities in a business outweigh the assets, which points to poor financial performance. This indicates that a company is in bad shape and probably in debt. For this reason, most publicly traded and privately-owned companies keep a close eye on their equity.
Is Equity an Asset?
While many people may be confused, equity and asset are not the same things. The main difference is that equity can be anything invested by the owner. Assets are anything owned by the company that is bound to provide economic benefits to the company in the future.
A company purchases a stock asset intending to sell it for capital gains at a future time.
A Detailed Explanation of Assets
Assets are what enable the company to manufacture its products and to generate revenue for operating. Therefore, they help in running and growing businesses. Different items add up to form assets in the sheet and are cash and cash equivalents. They include machinery, plants, and property. They can also include intangible assets such as goodwill created during the acquisition of a new company. Therefore:
Assets = Liability + Equity
They are reported in the balance sheet as gross fixed assets and are netted with accumulated depreciation, resulting in net fixed assets.
Depreciation is an operating expense that is part of the operating expense. During each quarter, month or year, the assets are depreciated. The market value of an asset depends on the asset itself, whether it is reported in the balance sheet on the book or market value.
Equities and assets both form parts of the balance sheet. Therefore, in the balance sheet, assets are equal to liability plus equity in a company. While equity is a source of funds for the company needed to acquire assets, assets will steer the growth of a business and run it. Assets based on their liquidity can either be classified as current or fixed assets.
Conclusion – What is Equity
Hopefully, we have answered the question what is equity in accounting? Equity is part of the balance sheet and refers to the owner’s interest in the business after liabilities have been deducted.
For further reading, check out Investopedia.
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