We’ve reached the final “clean-up” section of analyzing a balance sheet. The Equity section is perhaps the least understood and the most mis-used. The major categories in most small businesses are:
Opening Equity – initial cash/assets given by the owner(s) to begin the business
Common or Preferred Stock – the par value of the stock sold to the investors
Contributions – additional funds/assets contributed during the business life
Draws (sole-proprietor or LLC) or distributions (corporation) – funds withdrawn from the business
Retained Earnings – cumulative prior years’ gains or losses over the life of the business
Net income – current year’s gain or loss
Ideally, each of these categories is broken out by owner so the net equity of each owner is displayed.
Most incorrect values in Equity come from mis-use (whether intentional or not). Here are some things to look for in each category:
Opening Equity – This is for the initial contribution to start up. Additional contributions don’t go in here. This account should never be negative. There’s a frequently-occurring error when using an accounting software to sync with your bank account. If there is a balance in the bank account when syncing up for the first time, it will put that balance into opening equity. Many of our clients saw that when they set up new accounts to account for PPP funds. Any cash already in the bank should be accounted for in the correct account. For the PPP funds, the offsetting account should have been PPP loan, not opening equity.
Contributions – Make sure that all contributions are recorded correctly. Each owner should have a separate contributions account to track their individual balance. Also, review your operating agreement or articles of incorporation to ensure that contributions are following the document. Many times, if cash is needed, all owners must provide the cash.
Common or Preferred Stock – Is the amount correct? This will only apply to corporations, and there should be very few or no transactions here, especially with a small closely held corporation.
Draws or Distributions – Money taken out of the company is recorded here. This is for cash withdrawn as well as any personal expenses paid for by the business. The balance in this account should always be negative. Remember to check your operating agreement or articles of incorporation to ensure each member is making draws as stipulated.
Retained Earnings – Most accounting software calculates this automatically. This balance is the cumulative sum of all gains and losses over the prior years. If there are multiple owners, retained earnings accounts can be manually created for each owner, and the system-generated retained earnings can be reclassified to individual accounts. (Your accountant can help you with this.)
Net income – This is your income or loss for the current year. This may be more or less than what goes on your tax return for the year, but your tax accountant should be able to help you understand the differences. Remember, if you’re not recording your income and expenses properly, this amount will not be accurate. For example, if you’re paying your personal expenses out of the business but not recording them as draws, this figure will be inaccurate.
Now that your books are cleaned up – or you know where the issues are - you can better view the health of your business. We’ll talk in future blog posts about some of the things to look at to assess where you are now and how to plan for the future. Have questions? Need help? Reach out to us today.
