Lesson 3: Statement of Changes in Equity

Recall that SFP is a report on the company’s asset, liabilities and equity. The equity component of SFP
shows the claim of the owners on the company’s assets. This is the reason why equity accounts are of
particular interest to the readers of the financial statements. The SoCE is prepared to meet the
requirement of the readers to understand the transactions that caused the movements in equity
accounts.

The SoCE is a statement dated “for the year ended”. The report shows a reconciliation of the beginning
and ending balances of the equity accounts. It summarizes the equity transaction with the owners of the
business that occurred during the year

Balance, January 1, 20X1 ₱100,000

Balance, December 31, 20X1 ₱150,000

Forms of Business Organization

The business organization determines the presentation of the SoCE and equity portion of the SFP. In this
light, we begin our study with a review of the forms of business organizations.
There are three basic forms of business organizations, namely: (1) sole proprietorship (2) partnership,
and (3) corporation. They differ in terms of number of owners, legal personality of the business, and
ease of transferability of ownership.
Sole proprietorship is the simplest form of a business organization. There is only one owner referred to
as sole proprietor. Oftentimes, the owner is also the manager. The business has no legal personality
separate from its owner. In the eyes of the law, the business and the owner is one entity. For example,
the business and the owner are taxed as one. Also, the claim of the creditors of the business extends to
the personal assets of the owner. As a result, raising capital for the business is constrained to the
owner's resources and credit standing.
In contrast to a sole proprietorship, a partnership is a business owned by two or more owners called
partners. They pool their resources together such as money, property, and industry, to operate a
business and divide the profit among themselves. Partners are generally involved in the management of
the business. The agreement of the partners is stated in the contract of partnership specifically, the
partners profit and loss sharing arrangements. A partnership has a legal personality separate from its
owners. It is taxed separately from the partners except for those formed for the practice of the
profession of the partners (i.e. lawyers, accountants, etc.). However, the claims of the partnership
creditors may ex tend to the partners' personal assets.

Corporation is the most complex form of business organization. A corporation is owned by many owners
called stockholders or shareholders. Ownership is divided into common stocks or shares of stocks. One
shareholder can own many stocks. Shareholders are not normally involved in the day to day operations
of the corporation. Rather, owners set up policies for the management of the corporation. In policy
setting, each stock is normally entitled to one vote. A stockholder that owns 1,000 stocks has 1,000
votes. Therefore, the stockholder that owns 50% +1 of the total stock outstanding can control the
corporation. Rules that govern the management of the corporation are written in the Articles of
Incorporation and By-Laws.
The Corporation Code governs all corporations in the Philippines. Corporations are registered with the
Securities and Exchange Commission (SEC). Some corporations are listed in the Philippine Stock
Exchange (PSE). This means PSE provides a platform where investors can buy and sell stocks of listed
corporations.
One of the characteristics of a corporation is the separation of ownership and management.
Shareholders invest their funds and the corporation is managed by professional managers. Stockholders
have limited liability. Creditors of corporation only have claims to the corporation's assets. A corporation
is a legal entity separate from its owners.

Preparation of Statement of Changes in Equity

As we have reviewed above, the form of business organization differ in terms of number of owners and
the transferability of ownership. These inherent characteristics of business organizations led to the
difference in the presentation of equity.
Sole Proprietorship
The SFP and SoCE will present one capital account because there is only one owner. The owner's capital
account follows this naming convention: <Owner's name>, Capital. If the name of the sole proprietor is
Juan Dela Cruz, then the name of the account is Juan Dela Cruz, Capital. The owner's Capital account has
a normal credit balance.
Accountants use the owner's Drawings account to record withdrawals of the owner. The Drawings
account follows the naming convention for Capital: <Owner's name>,Drawings. Entries to this account
decrease equity. It is closed at the end of the year to the Capital account. It is a nominal account with a
normal debit balance.
The owner's Capital account tracks the following transactions of the owner: (1) capital contributions; (2)
withdrawals; and (3) net income or net loss generated by the business. Why is net income closed to the
capital account? Consider this: (a) the net income generated from the operations of the business is
owned by the owner, and (b) the capital account represents the part of the business that belongs to the
owners. Therefore, the net income that belongs to the owner should be included in his capital account.
The SoCE of a sole proprietorship is basically a summary of the owner's capital account
The bottom-line of the SoCE is reported as equity in the SFP
 Friendly Convenience Store: Sole Proprietorship

Juana Dela Cruz is the owner of Friendly Convenience store. The store was established on January 1,
2019. Juana deposited P10,000 to a bank in the name of Friendly Convenience Store. She made three
more deposits of P2,500 each during the year from her personal account. The store generated net
income of P35,670 in 2019. Juana regularly withdraws P1,000 per month from the store's bank account
for her personal expenses.

Requirement:

1. Determine the 2019 year-end balance of the Juana Dela Cruz, Drawings account.

2. Prepare a Statement of Changes in Equity for the year ended December 31,2019.

Answer

1. The 2019 year-end balance of the Juana Dela Cruz, Drawings account is P12,000.

This is computed as P1,000 per month x 12 months

2. Statement of Changes in Equity

Partnership
Our objective is to account for the equity of each partner. Therefore, we need more than one capital
account. As a matter of fact, the number of capital accounts that will be reported on the SoCE and the
SFP is equal to the number of partners. Similar to the capital account used in sole proprietorships, each
partner's capital account will track his contributions to the business, his share in the net income and his
drawings. A Drawings account is also maintained for each partner. The naming convention for both the
capital and drawings accounts is the same as in sole proprietorship.
Recall that net income is closed to the capital account. How do we determine the amount of net income
that will be closed to each partner's capital account? Accountants call this process "allocation of net
income." Net income is allocated based on the profit and loss sharing agreement stipulated in the
partnership contract. Allocation of net income is unique only to partnership.

Corporation
The ease of transferring ownership in corporations results in fast turnover of owners. If we maintain one
capital account for each stockholder, we will end up thousands of capital accounts. The fast turnover of
owners will mean accountants will end up faced with the voluminous and unending job of opening,
transferring and closing capital accounts. More so, we are faced with the problem of allocating the
corporation's net income to the thousands of fast moving shareholders.
The solution to these issues is simple. We will not maintain a capital account for each shareholder. As a
result, there is no need to allocate net income to the thousands of shareholders. We introduce three
new equity accounts, namely, capital stock, additional paid in capital and retained earnings. We remain
focused on only three equity transactions - capital contributions, drawings and accumulation of net
income.
The stockholders' equity of a corporation is divided into two parts, namely, paid in capital and retained
earnings. Paid-in capital is the amount of contributions given or will be given to the corporation in
exchange for its common stocks. In our previous discussion
of sole proprietorship and partnership, we referred to this as capital contribution to the business. Paid-
in capital is composed of capital stock and additional paid-in capital. The balance of Capital Stock
reflects the par value of the issued common shares. Par value is the minimum price by which
corporations can issue stocks to shareholders However, corporations generally issue stocks in exchange
for an amount greater than par. The excess of the issue price over the par is reported as Additional
Paid-In Capital.
The second half of the stockholders' equity is the Retained Earnings. This account reports the
undistributed earnings of the corporation. The balance of retained earnings is computed as follows: net
income minus net losses and dividends from the date of incorporation up to the cut off or date of SFP.
Dividends are distributions to stockholders, similar to owner’s drawings in sole proprietorship and
partnership. Dividends are deducted from retained earnings because dividends are taken from income
by the corporation.

Recall from Chapter 1 that equity accounts have normal credit balances. All three equity accounts
discussed in this section, namely, capital stock, additional paid in capital and retained earnings all have
normal credit balances.