in this video you'll find out what

equity means that accounting I'm going

to give you two definitions yest then

we're going to break it down to see what

it's made up and take all of the pieces

and fit them back together to get a

complete picture of what equity is and

how it fits into the expanded accounting

equation hey viewers I'm James and

welcome to accounting stuff the channel

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then check out my accounting basics

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out over the past couple of weeks we've

talked about assets and liabilities

which leads us nicely into today's topic

equity the third and final pillar of the

accounting equation which looks like

this assets are equal to liabilities

plus equity I've had plenty of requests

for this topic and I totally get why

equities the oddball in the accounting

equation and there are so many different

terms and jargon that come with it as

part of the parcel Wow so many and this

isn't even all of them but I've cherry

picked these ones to teach you today

because if you can understand these then

you'll have a solid grasp of what equity

means and to be honest you'll be far

ahead of most of the other people out

there who is still battling with this

topic oh and by the way if my voice

sounds funny today it's because I've

been struck down by the man flu we've

had a chilly week in Vancouver and has

finally got to me but anyways are you

ready the let's do this at the start of

this video I promised you two

definitions of equity in accounting and

here's the first equity is the residual

value of an entity's assets after

deducting all its liabilities that's it

hold on I'll explain how this works

first let's bring up the accounting

equation again you'll be seeing this

quite often in this video and it'll

become clear why later on assets are

equal to liabilities plus equity if we

rearrange this formula then we can see

that equity is made up of assets minus

liabilities now we accountants have

another word to describe assets minus

liabilities
net assets I said a moment ago that

equity is the residual value of an

entity's assets after deducting all its

liabilities residual value basically

means what's left over after you take

all of an entity's assets and deduct its

liabilities in other words what we've

got here equity represents the net

assets of a business simple hey yes it

looks simple but what does it actually

mean definition number two is gonna help

us shed some light on this it says that

equity represents the net funds invested

into a business by its owners I like

this description of a grotty because it

gives us some context let me explain

with the help of the accounting equation

on the broadest scale there are two ways

that funds can be invested into a

business to finance its operations and

you're currently looking at both of them

it could choose to borrow money from

third-party lenders like banks which in

essence are liabilities or it could

choose to use the net funds invested

into the business by its owners in other

words it could choose equity so now we

know that equity represents the net

assets of a business and at the same

time it represents the net funds

invested into the business by its owners

so what we're saying here is that the

owners of a business owned will have a

claim on all of its net assets and we

call this equity make sense now that

we've got an idea of what equity means

let's have a look and see what it's

actually made of full disclosure here

equity is made up of a lot of things and

some parts are a bit complicated but I

mentioned at the start that I've cherry

pates the parts that I think are most

important that will give you the most

value 3 in particular that together will

give you a solid understanding of what

equity is and I'll share them with you

in a moment but first I think will be

easier for you to picture all of this if

we work with an example imagine that

you've got an idea for a business you've

been following the plastic free bed

movement on the internet and you've come

across this video 90%

you realize that plastic makes up 90% of

all ocean debris so you come up with an

idea to decrease the number of plastic

bags by developing your own reusable

shopping bag to help save the planet but

there's a problem you have a choice to

make that all startup businesses end up

facing how to structure your business

you could choose to go it alone become a

sole proprietor and avoid incorporating

the business as a separate legal entity

you could go in 50/50 with a mate and

form a partnership or you could decide

to create your own corporation a

separate legal entity that's owned by

shareholders now there are pros and cons

to each of these but that's for another

day let me know down the comments if

you'd like to hear more about it I want

us to rewind for a second I said that

equity is essentially made up of three

things and the reason why I've laid all

this out here is because the words we

used to describe these three things

changes depending on the structure of

the entity and I think that's partly

what makes equity seem so complicated

there is so much different jargon that

we used to describe what is essentially

the same thing let me show you the first

thing that makes up equity is capital

contributions capital relates to the

funds raised to support a business and

contributions simply mean that these are

given to the business so capital

contributions is the money that the

owners invest into the business out of

their own pockets now the way that we

describe this changes depending on who

the owners are and that changes based on

the structure of the business if you're

a sole proprietor then there's only one

owner you so you'd call the money that

came out of your own pocket owner's

equity however if you were part of a

partnership then the owners of the

business would be the partners so you'd

call the capital contributions partner

contributions and if you created a

separate legal entity a corporation then

the owners of the business would be the

shareholders and you'd call the funds

invested shareholders equity so we have

three different terms that describe

basically the same thing

capsule contributions are one of the

ways that businesses tend to fund

themselves during the early start

days before they become profitable

imagine that you choose to become a sole

proprietor at least at first and you

invest $1,000 of your own money into

your reusable bag business

what's your business's financial

position let's bring up the accounting

equation again your business has assets

of $1000 in the form of cash and you the

owner have a claim of $1000 on those

assets which we call owner's equity the

accounting equation is in balance as it

should be because when we're looking at

a snapshot of a business's assets

liabilities and equity at a single point

in time we're looking at its balance

sheet now capital contributions aren't

the only thing making up equity when

your business generates revenues or

incurs expenses is to make a profit or a

loss which is just revenues less

expenses what happens to that profit and

who does it belong to you of course

you're the owner so you could choose to

reinvest these profits back into the

business or hold on to them to use in

the future

over time these profits and losses that

you're holding on to build up and we

call them retained earnings retained

earnings are defined as accumulated

profit held for future use and

thankfully this term stays the same

regardless of whether you're a sole

proprietor a partnership or a

corporation your business's equity is

made up of two things capital

contributions and retained earnings over

time your reusable bag business starts

to make some real money so much in fact

that you no longer need to dip into your

own pocket to fund it using capital

contributions you can cover all of the

expenses using the accumulated profits

that you've held on to and set aside

you've retained earnings within a year

your business is booming you've got much

more money coming in than what's going

out in other words you've got a net cash

inflow but back home all is not so rosy

you've invested so much of your own

savings into the business through

capital contributions they are running

out of money to live on for yourself you

need to withdraw some cash out of the

business to cover your own personal

expenses well how does that work

retained earnings are made up of a

couple of things remember I said that

they're your accumulated profits help a

future use so a big chunk of your

retained earnings is your accumulated

profits which are your revenues less

your expenses

which comes straight from your income

statement an income statement is a

financial report that you use to track

your revenues and expenses over a period

of time but retained earnings are also

made up of withdrawals the money that's

taken out of the business and

distributed to its owners we have

different terms to describe withdrawals

depending on the structure of your

business for sole proprietors we call

them drawings and for partnerships we

call them partner drawings and for

corporations we call them dividends

which a profits distributor to the

shareholders again we have three terms

all used to describe what is essentially

the same thing withdrawals as the sole

proprietor your reusable bag business

you can use drawings to withdraw your

accumulated profits for personal use

this impacts the accounting equation by

decreasing assets because the business's

cash has gone down and decreasing equity

because your claim on those net assets

has decreased hold on now I want to show

you something interesting we've broken

equity down into capital contributions

retained earnings and withdrawals but

let's see how this all fits together

using the accounting equation earlier I

said that when we look at a snapshot of

the accounting equation at a single

point in time we're looking at a balance

sheet the balance sheet is made up of

three things assets liabilities and

equity and we know that equity is made

up of capital contributions from the

businesses owners and retained earnings

which are its accumulated profits held

for future use retained earnings break

down further still into accumulated

profits less withdrawals and accumulated

profits are a business's revenues less

expenses which when looked at over a

period of time make up its income

statement so what we've got here is the

expanded accounting equation and I like

this because we can see how two of the

business's major financial statements

the income statement and the balance

sheet are linked together through equity

thanks for watching if you found this

video useful give it a like share it

comment subscribe if you haven't already

do you remember that guy from the video

I showed you earlier well that's

actually my brother will he created the

campaign for plastic free Feb so if

you'd like to learn more about that and

how to get involved then join the

Facebook group and follow their

Instagram I'll drop the links to these

down in the description below it's a

great cause and it would be awesome to

have you involved the next time and you

don't even have to wait till February

you can follow some of their

recommendations and start cutting back

on some of that plastic now as always

let me know down in the comments if

you've got any questions or message me

directly on instagram at accounting

staff see you next time