The equity section of the balance sheet looks different depending on the legal structure of your business. The most common entity types are corporations, partnerships, and sole proprietors. In this article, we’ll take a look at what the equity section of the balance sheet looks like and what goes under equity on a balance sheet for sole proprietors.
The Basics of Equity on the Balance Sheet
What is an equity account? What is equity on a balance sheet? Is owner’s equity on the balance sheet? What makes up owner’s equity? If you’ve ever found yourself asking these questions while doing the accounting for your sole proprietorship and struggling to understand the equity portion of the balance sheet, we’re here to help.
As a reminder, the balance sheet has three major sections: assets, liabilities, and equity. The equation Assets = Liabilities + Equity is true for all entities. For a sole proprietorship balance sheet, equity is called Owner’s Equity. There are typically two accounts listed: the Owner’s Capital Account and Owner’s Draw Account.
Owner’s Capital Account. The statement of owner’s equity represents how much money the owner has put into the business. Also included are cumulative business income or loss amounts from prior years.
Owner’s Draw Account. This balance represents how much money the owner has taken out of the business. Since a sole proprietor does not get a paycheck, taking money out of the business via a draw is how they get their money.
A third account will show up in the equity section of a balance sheet if you run a report in your accounting system on any date during the year: Current Year Earnings.
Current Year Earnings. This balance is the same as the net income on the year-to-date income statement. It represents the profit in the business.
On a formal sole proprietorship balance sheet for external purposes, only one account will show and that’s the Owner’s Capital Account. The draw and the current year earnings will roll into that account.
Salary vs. Draw on a Sole Proprietorship Balance Sheet
Distinguishing between the idea of a salary and a draw. In corporations, owners receive salaries in the form of paychecks, where payroll taxes are taken out and W-2s are issued at year-end. The salary and taxes are deducted as expenses in the corporation’s income statement. In sole proprietor accounting, this is not at all how it works.
A sole proprietor has no salary. There is no payroll expense or payroll taxes on the income statement for the owner. The owner could have employees, and those payroll expenses would be shown on the income statement, but there is nothing for the owner.
The owner takes draws, which is not an expense. Draws are a reduction in equity. They do not affect profits. They do not change taxes owed. An owner can take a lot of money out of the business, and there is no impact on profits. There is definitely an impact on cash flow and equity on the balance sheet though!
A sole proprietor does pay payroll taxes in the form of self-employment taxes. They simply do it on their IRS Form 1040 as opposed to payroll tax forms that a corporation would use.
The equity section of a balance sheet can be the most difficult section to understand. Hopefully, our explanation about equity on the balance sheet and how it impacts sole proprietorship accounting will provide a bit more clarity so you can better understand how to read your business’s financial statements.
More about understanding equity: Understanding Equity on the Partnership Balance Sheet
