The equity of a firm represents the total value of the company to its owners. Total equity is calculated using the accounting equation of assets minus liabilities equals equity. This calculation can be used to determine which transactions affect the equity of a company . If the equity number is negative, for example, there is no equity and the business is in the red. The four major types of transactions that affect equity in a business are owner withdrawals, advertising, new investments and business transactions that lead to the accumulation of profits or losses.
Business Transactions and the Accounting Equation
A company's financial position is based of its assets, liabilities and total equity. Assets are everything the company owns. Liabilities are everything the company owes to others. Equity is the net income of a company that has not been withdrawn by the owners. The accounting equation of a company is that its assets subtract its liabilities equals its total equity. The affect of a transaction on a company's equity can be found using this equation.
Shareholders' Equity and Owner Withdrawals
Transactions affecting stockholders equity include owner withdrawals, when the owner of a business takes out money of company assets for personal use. This is known as a draw. Withdrawing cash from a business will cause a reduction in the company's assets resulting in lower equity. This is different than using cash to buy inventory or equipment. In this case, the cash would be replaced by a company asset of equal value on the financial statements resulting in equity staying the same. Since funds are taken out of the business, its equity will lower.
The Role of Advertising
Money spent on advertising will cause an initial reduction in equity. Paying for advertising costs cash out of a company's assets. Unlike buying equipment, which gives an immediate new asset, advertising gives a future economic benefit. A future benefit cannot be measured according to accounting principles and cannot be listed as an asset by a company. As the advertising brings in new income to the company, its equity will then rise accordingly. At the beginning, an investment in advertising will lower a company's equity.
Investment of Capital
If new funds are added to a company by its owners, the company's equity will rise. This can be done by more investment by the current owners or by selling new shares of the business to other investors. This investment raises equity as it gives more cash, higher assets, to the company without taking an additional liability. This contrasts with raising money with a bank loan. The asset of cash from a loan is matched by the liability of the loan resulting in no impact on equity.
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