The equity section of the balance sheet identifies the approximate dollar value of net worth accrued to the owners/investors. Equity type accounts can have both credit and debit balances. By far the most preferred is a credit value. Debit values do not mean that something is wrong, actually it can be a great sign of a good operation. The key is to understand how the equity section works, is structured and why both debits and credits exist in equity accounts.
Notice that in the other types of accounts there is a tendency towards a particular type of balance – debit or credit. A little review is in order:
- Asset type accounts – customarily end in debit balances (the preferred balance);
- Liability accounts – credit balances;
- Revenue accounts – definitely want credit balances;
- Cost of Sales – traditionally carry debit balances;
- Expenses/Overhead – without a doubt, almost always carry debit balances.
Equity accounts? In general, they should carry credit balances, but some of the accounts actually have debit balances and believe it or not, this is a really wonderful type of entry to have. This lesson explains this in more detail below.
Before going further, you may want to first review this part of the balance sheet and have a thorough understanding. Please review the following three articles from businessecon.org to help you gain a better understanding:
There are several more articles related to this section of the balance sheet, but these three really explain it well.
For the bookkeeper you need to understand some basic legal principles. If you read the articles you’ll begin to see that different terms are used related to the equity section. These terms have everything to do with the type of legal entity the business operates as within the respective state laws. The various legal formats determine which terms are used with the various accounts in the equity section. Overall, there are really four major groups of accounts used in the equity type accounts. They are as follows with a short description:
- Initial & Ongoing Investment – whether a stock company or a single owner, the business started with some form of investment and often the owner(s) have to contribute more money to keep the business going or expand the operation.
- Historical Earnings – the amount of money the business has earned over its entire life to date, i.e. the PROFIT!
- Current Earnings – the amount reported on the income statement for the most current period of time, typically the calendar year to date.
- Payments to Owners – depending on the nature of the legal formation, this is also called Dividends, Distributions, Disbursements or Draws. This is the return on the investment back to owners of the business.
All accounts in the equity section fall within one of these four groups of accounts.
Remember the net worth of a business is total assets minus total liabilities. The balance sheet carries both of these type of accounts and a third group is the equity type of accounts. Therefore, the equity is the net worth of the company. OK, seems relatively simple enough.
Now remember assets are always debit balances (Lesson 4). This means that liabilities are the opposite – credit balances (Lesson 5). Basic accounting tells us the formula for the balance sheet is Assets = Liabilities plus Equity. A debit group (assets/upper half of balance sheet) equals the combination of two credit groups or stated another way DEBITS via assets = CREDITS via liabilities plus CREDITS via Equity.
Therefore in general, equity accounts have credit balances.
JUST A MINUTE! It was stated up in the third paragraph above that some accounts in the equity section carry debit balances and this a good thing. How can this be?
Well, let’s explore this for just a few minutes.
Owner’s go into business by investing and they want a return on their investment. Right? They get that return in two ways. First is via earnings in the company that get paid out to the owners. This is the most common method. The second is of course selling the business just like you would sell any asset and hopefully you have a gain on your sale.
But for us, the key is paying the owners the profits earned. Notice up in my four major groups of accounts found in the equity section I mention the fourth group is ‘Payments to Owners’. The other three accounts customarily have credit balances which means that in the earnings section it is a carryover from the income statement. We want Sales that are basically credits to exceed cost of sales and expenses both of which are debit oriented. If sales is greater than total costs than the business generates a profit which is a credit balance. This is reported on the balance sheet in the equity section. The current year information is reported via Current Earnings. See Lesson 9 for a more comprehensive review of this accounting relationship.
The first three groups are credit driven. The payments are the exact opposite – debits. Payments to owners are a good thing. Therefore, debits in the equity section are also a good thing provided they are payments to owners!
By the way, the entry looks like this and is recorded in the Equity Journal or Disbursements Journal:
Payment to Owners $200
Cash Account $200
Remember, credits in the cash account decrease the balance of the bank account.
So there you go, debits in the equity section is a desired outcome, it just depends on which line item in the equity section debits are posted.
If a debit balance exists in historical earnings or in current earnings it means the company has lost money in prior periods or in the current period. This is not a good thing to have. Thus, debits can be a bad thing depending on which group of accounts in the equity section they are posted.
Now for one final lesson within this article. In general, the historical earnings, current earnings and payments to owners are combined to form RETAINED EARNINGS, i.e. the amount held back from earnings and reinvested in the business.
A typical equity section will look something like this:
Capital Paid In $1,000
– Beginning Balance $5,000
– Current Earnings 3,000
– Distributions (2,000)
– Retained Earnings Ending Balance $6,000
Total Equity $7,100
To sum this up, equity has a credit balance. Debits are a wonderful entry provided it refers to payments to owners. ACT ON KNOWLEDGE.