The ownership claim on total assets is owner’s equity. It is equal to total assets minus total liabilities. The assets of a business are claimed by either creditors or owners. To find out what belongs to owners, we subtract the creditors’ claims (the liabilities) from assets. The remainder is the owner’s claim on the assets—the owner’s equity. Since the claims of creditors must be paid before ownership claims, owner’s equity is often referred to as residual equity.
According to SFAC 6 “the residual interest in the net assets of an entity that remains after deducting its liabilities” (Para. 49)
The ownership interest is defined in the Framework as equity. Equity is the residual interest in the assets of the entity after deducting all its liabilities. The term net assets is used as a shorter way of saying ‘total assets less total liabilities’. Because the ownership interest is the residual item, it will be the owners of the business who benefit from any increase in assets after liabilities have been met. Conversely it will be the owners who bear the loss of any decrease in assets after liabilities have been met.
The ownership interest applies to the entire net assets. It is sometimes described as the owners’ wealth, although economists would take a view that the owners’ wealth extends beyond the items recorded in a balance sheet. If there is only one owner, as in the sole trader’s business, then there is no problem as to how the ownership interest is shared. In a partnership, the partnership agreement will usually state the profit-sharing ratio, which may also be applied to the net assets shown in the statement of financial position (balance sheet). If nothing is said in the partnership agreement, the profit sharing must be based on equal shares for each partner.
Types of Owner’s Equity
In a company the arrangements for sharing the net assets depend on the type of ownership chosen. The owners may hold ordinary shares in the company, which entitle them to a share of any dividend declared and a share in net assets on closing down the business. The ownership interest is in direct proportion to the number of shares held. Some investors like to hold preference shares, which give them a preference (although not an automatic right) to receive a dividend before any ordinary share dividend is declared. The rights of preference shareholders are set out in the articles of association of the company. Some will have the right to share in a surplus of net assets on winding up, but others will only be entitled to the amount of capital originally contributed.
The ownership interest is called equity. Equity is the residual interest in the assets of the entity after deducting all its liabilities. Net assets means the difference between the total assets and the total liabilities of the business: it represents the amount of the ownership interest in the entity.
Owner’s Equity Recognition
There can be no separate recognition criteria for the ownership interest because it is the result of recognizing assets and recognizing liabilities. Having made those decisions on assets and liabilities the enterprise has used up its freedom of choice. The owner will become better off where the net assets are increasing. The owner will become worse off where the net assets are decreasing.
>> Related Course Principles of Accounting.
Mukharji, A., & Hanif, M. (2003). Financial Accounting (Vol. 1). New Delhi: Tata McGraw-Hill Publishing Co.
Narayanswami, R. (2008). Financial Accounting: A Managerial Perspective. (3rd, Ed.) New Delhi: Prentice Hall of India.
Ramchandran, N., & Kakani, R. K. (2007). Financial Accounting for Management. (2nd, Ed.) New Delhi: Tata McGraw Hill.