Understanding Equity on the Sole Proprietor’s Balance Sheet
A balance sheet is a financial statement showing a company’s assets, liabilities, and equity at a specific point in time. It’s one of the foundational financial reports for your business. But did you know the equity section of the balance sheet looks different depending on a business’s legal structure? The most common entity types are corporations, partnerships, and sole proprietors. Recently, we discussed what equity looks like on a corporate balance sheet. This time, we’ll review what the equity section of the balance sheet looks like for sole proprietors.
The Equity Section
The equation Assets = Liabilities + Equity is true for all entities. For a sole proprietor, equity is called Owner’s Equity. There are typically two accounts listed: the Owner’s Capital Account and Owner’s Draw Account. We define both below.
Owner’s Capital Account. This balance 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 receive their money.
A third account will show up if you run a balance sheet report in your accounting system on any date during the year: Current Year Earnings. This balance is the same as the net income on the year-to-date income statement. It represents the profit of the business.
On a formal balance sheet for external purposes, only one account will show: the Owner’s Capital Account. This is because the draw and the current year’s earnings will roll into that account.
Salary vs. Draw
It’s important to distinguish between the concepts of a salary and a draw. In corporations, owners receive salaries in the form of paychecks, where payroll taxes are deducted, and W-2s are issued at year-end. In the corporation’s income statement, the salary and taxes are deducted as expenses.
For a sole proprietor, this is not at all how it works. A sole proprietor has no salary. Therefore, 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.
Instead, the owner takes draws, which are not an expense; they’re simply a reduction in equity. They do not affect profits or change taxes owed. An owner can take a great deal of money out of the business, and there is no impact on profits. There is undoubtedly an impact on cash flow, however!
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 can be the most challenging to understand on the balance sheet. Hopefully, the explanation above will provide more clarity so you can better understand how to read your business’s financial statements.