Each Tuesday, our new series, "Accounting Tips Tuesday," brought to you by Zoho Books, presents articles that fit into one of two categories.
First, we look at the theory behind basic, and not so basic, accounting concepts with practical applications, including the old "debits and credits" appropriate to the situation.
Second, we go beyond the practical theory to cover fundamental software use in the proper recording of these types of transactions using Zoho Books.
This week, we are stepping away from our mini-series, "Inventory Accounting 101," in order to discuss the proper identification and nomenclature associated with the equity section of your balance sheet.
Equity section article title
Today’s article starts off with an illustration of an actual situation I dealt with recently. The following excerpt is from the equity section of a client’s LLC balance sheet prepared by their in-house controller (Note: This company is taxed as a partnership):
Capital article - figure 1
Does anything strike you? One thing? Two things? More?
Well, the first thing that struck me was the presence of the Retained Earnings account in balance sheet of a limited liability company. Do LLCs have retained earnings? Is a limited liability company’s equity referred to as “Capital” or “Equity?”
Burning questions, huh?
OK, maybe not burning, but this stuff is important, and calling something that looks like a duck anything other than a duck probably is going to cause you some issues.
Over the years, I think I’ve seen most every type of financial statement, whether it be a sole proprietorship, partnership, limited liability company or corporation. And while most of the financials are created and vetted by well-meaning preparers, inevitably there will be one that makes my pet peeve list.
Have you seen the word “Capital” in the equity section of a corporation’s balance sheet? Or maybe “Retained Earnings” on a limited liability company’s balance sheet? Well, neither is correct – and nomenclature matters.
The dual subjects for this article are ensuring the equity section of your balance sheet is properly identified and with the proper nomenclature. Although this subject typically is straight-forward and without much contention, there is at least one exception (See the section on Limited Liability Companies below).
Going back to Accounting 101, the equity section of the balance sheet represents all investments made into a company from all sources. The term "Equity" should not be confused with the actual titling within the equity section of a balance sheet. Rather, the titling within the equity section of the balance sheet depends on the legal form of your business. Cutting to the chase, we’ll look at various legal forms and the appropriate titling with the equity section of each.
A sole proprietorship is owned by only one person, thus the word “sole.” While many, if not most, sole proprietorships rarely present a balance sheet, anyone preparing financial statements should know the proper presentation.
A sole proprietorship’s equity section is succinct at best. The only account in the equity section of a sole proprietorship is “Capital.” Whether they are funds or assets contributed by the owner, a distribution from the entity – or net earnings closed out at the end of the calendar year – everything rolls into the “Capital” account.
The bottom line: The equity for a proprietorship is called, “Owner’s Capital” or “Proprietor’s Capital.”
A partnership also is fairly self-explanatory relative to its makeup. It must include at least two partners, but can include 50, 75 or more. Regardless, like a sole proprietorship, it too is an unincorporated and, typically, unregistered business. There are very few requirements for establishing a partnership, other than obtaining an EIN and filing an annual income tax return (although you should strongly be recommending a partnership agreement and a buy/sell agreement). There are no articles of organization or incorporation to file with the Secretary of State (in most states), so all-in-all, it’s a fairly user-friendly business format.
The equity section of the balance sheet in a partnership financial statement is no different than that of a sole proprietor. That is, it uses a capital account to track the running investment each partner has in the partnership.
Now, many accountants will set up separate distribution accounts for each partner, just for annual tracking, but at the end of the year, those distributions are closed to each partner’s capital account, as are respective shares of profit (or loss).
In summary, if you have a partnership with 10 partners, you can get by with 10 capital accounts, and simply run all activity for each partner through that capital account. Or, for those who like a more detailed chart of accounts, you can create a distribution account for each partner.
Just don’t forget to close it to the capital account along with the profit interest no later than December 31.
The bottom line: The equity inside a partnership is called “Partners’ Capital.”
Limited Liability Company
So, what is the difference between a limited liability company and a partnership?
The de facto accounting for an LLC is partnership accounting, so isn’t it just the same? Not exactly. But if there is a business format with some level of incongruous titling, you’ll find it in an LLC.
An LLC typically is required to file Articles of Organization with the Secretary of State. As a result, it is considered a formally registered business. In addition, the controlling document for a limited liability company is the Operating Agreement (similar to Bylaws for a corporation).
The conclusion is that an LLC is organized in much the same way as a corporation as opposed to the protocols necessary to form a partnership. However, that is where the comparisons end.
Let’s get to the potential titling conflict I mentioned earlier. I’ve seen the equity section of a limited liability company’s balance sheet called Members’ Equity. I’ve also seen it titled, Members’ Capital.
Which is correct?
Cutting to the chase, the authoritative guidance I tend to follow – the AICPA and FASB (American Institute of Certified Public Accountants and Financial Accounting Standards Board) – indicates a limited liability company’s equity should be referred to as “Members’ Equity” (AICPA Technical Practice Aid, Practice Bulletin 14, Sec. 12,140.10).
So, if you’re referring to the equity section of an LLC as "Members’ Capital," you are flying in the face of AICPA guidance, and probably are on the wrong side of the argument, right? Maybe.
Playing the contrarian, I can show you a handful of limited liability companies that are public companies that refer to their equity section as “Members’ Capital.”
And since these are companies required to follow generally accepted accounting principles and file their financials with the Securities and Exchange Commission (also known as the “SEC”), you have to believe they are correct – right? That's a great question that apparently has no definitive answer.
I’m going with the AICPA guidance – Members’ Equity, not Members’ Capital, because of the documented authority I cited. Make your own call, but be prepared to justify it.
Corporations (C or S)
The venerable corporation is the entity type we typically cut our teeth on when we learned the principles of accounting. It’s the primary entity used even today in the college textbooks, so most of what I’m writing here will be redundant. But, in the spirit of being thorough, here goes:
The typical stockholder’s equity section of most balance sheets contains three items:
- Common stock
- Additional paid-in capital
- Retained earnings
Common stock represents the ownership of the company in terms of shares owned at the stated par value of the stock. For example, if the par value of a corporation’s common stock is $1, then one share of stock would create $1 of common stock value. When presenting a balance sheet prepared under the strict guidelines of generally accepted accounting principles, the following three items must be presented as well:
- The par value of the common stock
- The number of authorized shares of the corporation
- The number issued and outstanding shares as of the balance sheet date
Additional paid-in capital (or Paid-in Capital) represents the amount of money shareholders have invested in the corporation over-and-above the par value of the common stock. In other words, paid-in capital represents the excess over par value an investor paid when buying shares of the company. For example, if a share of stock sold for $50 and the par value of the underlying stock was $1, the difference, $49, represents the amount of paid-in capital you would book upon completion of the stock purchase.
Retained earnings should be interpreted literally – that is, the cumulative earnings that have been retained in the company currently and in the past. As an example, in year one, a corporation closes its books and its net income of $100,000 is closed out to the retained earnings account.
In each successive year, the net income (or loss) is closed to retained earnings, and the cumulative amount in retained earnings at any point in time represents those cumulative earnings. In a GAAP financial statement, a Statement of Retained Earnings is an integral part of the basic financial statement presentation. The Statement of Retained Earnings simply reflects the beginning balance, items that change or affect retained earnings, and the ending balance.
There are a couple additional accounts you might see in a corporation’s equity section:
- Preferred stock is another class of stock a corporation can issue with different rights, dividends and ownership attributes. In almost all cases, preferred shareholders do not have the voting rights enjoyed by common shareholders.
- Treasury stock is stock previously issued by the corporation that has been repurchased from shareholders and has not been retired by the corporation. Mathematically, treasury stock represents any difference between the numbers of shares issued and outstanding. Consequently, the dollar value of treasury shares repurchased by the corporation is reflected as a debit within the equity section (a contra-account to common stock).
As I’m sure every reader is aware, the number of accounting software packages in the market is massive, and seems to be growing annually. Because these programs must cater to the masses, the issue of closing profit and loss to the balance sheet is a problem. The program must allow for every type of entity, so most programs default to retained earnings as the repository account for the income statement close.
What to do, huh?
Really, it’s fairly simple. Let’s say you have a partnership with three partners. You’re going to create a capital account for each partner. When you close your income statement at the end of the year, your annual profit or loss typically will be closed to the retained earnings account.
Now, you’re stuck with the three partner capital accounts and retained earnings, and I just told you that presentation is wrong. Instead of closing the income statement and moving on to new business, you have one more entry to make. Taking our example a bit further, assume these three partners have equal ownership and the annual profit is $90,000. To zero out the retained earnings account and remove it from your published financial statements, make the following journal entry immediately after the income statement close:
Capital Equity figure 2
Now, your retained earnings account is $0 and the partner capital accounts have the proper allocation of net profit to their respective capital accounts.
The Bottom Line
The presentation of your financial statements is very important. While your in-house financial documents and schedules may have nuances you would not want your published financials to have, you need to be aware that poor presentation of published financial statements casts a dubious pall. If the account names are not correct, what else is wrong?
So, the bottom line here is: nomenclature matters.