Why is appropriate titling important on a balance sheet?
Going back to Accounting 101, the equity section of a balance sheet represents all investments made to a company from all sources. Not to be confused with the actual term “Equity,” the equity section of the balance sheet depends on the legal form of a business. Below, we will look at various legal forms and the appropriate titling with the equity section for each as well as cover fundamental software use in the proper recording of these types of transactions.
A sole proprietor is owned by one person and rarely presents a balance sheet—brief at best. The only account in the equity section of a sole proprietorship is “Capital.” Whether they are funds/assets contributed by the owner, a distribution from the entity, or net earnings closed out at end of the calendar year, everything rolls into a “Capital” account. Bottom line: The equity for a sole proprietor is called, “Owner’s Capital” or “Proprietor’s Capital.”
Fairly self-explanatory, a partnership must include two partners but can include more. Similar to a sole proprietor, it 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. There are no articles of organization or incorporation to the file with the Secretary of State, so it’s a fairly user-friendly business. The equity section is similar to a sole proprietor. It uses a capital account to track the running investment each partner has in the partnership. Many accountants will set up separate distribution accounts for each partner, but those distributions are closed to each partner’s capital account at the end of the year. Bottom line: The equity inside a partnership is called “Partners’ Capital.”
Limited Liability Company (LLC):
An LLC is typically required to file Articles of Organization with the Secretary of State, considering it a formally registered business. An LLC is organized in much the same way as a corporation as opposed to a partnership. The equity section of an LLC’s balance sheet has been called both “Members’ Equity” and “Members’ Capital.” So, which one is correct? If you refer to the guidelines of the AICPA and FASB, it indicates an LLC’s equity should be referred to as “Members’ Equity.” However, many public LLCs have referred to their equity section as “Members’ Capital” and it has been approved by the SEC. Bottom line: Either choice is acceptable but be ready to defend it.
Corporation (C or S):
The typical stockholder’s equity section of most balance sheets contains three items: common stock: represents the ownership of the company in terms of shares owned at the stated par value of the stock. When presenting a balance sheet, the following three items must be presented as well: par value of the common stock number of authorized shares of the corporation number issued and outstanding shares as of the balance sheet date additional paid-in capital: represents the amount of money shareholders have invested in the corporation over-and-above the par value of the common stock. retained earnings: the cumulative earnings that have been retained in the company currently and in the past. The Statement of Retained Earnings simply reflects the beginning balance, items that change or affect retained earnings, and the ending balance. preferred stock (sometimes) treasury stock (sometimes)
The number of accounting software packages in the market is huge and is continuing to grow. Because these programs are needing to 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. Let’s say you have a three-person partnership. You are going to close a capital account for each partner. When you close your income statement, your annual profit or loss typically will be closed to the retained earnings account. Instead of closing the income statement, you have one more entry to make. Assume these partners have equal ownership and annual profit is $90,000. To zero out retained earnings account, make the following journal after the income statement close (see below). 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 presentation of your financial statement is crucial. While your “working” financial documents and schedules may have some initial errors you would not want your published financials to have, you need to be aware that poor presentation of published financial statements creates doubt. If the account names are not correct, what else could be wrong with the statements? Bottom line: Nomenclature matters.