To help you better grasp the meaning of the Opening Balance Equity why it is created and what you should do with it, we are going to review some basic accounting concepts. Many do not know that the whole accounting is based on a simple and significant principle known as the accounting equation.
This equation uses basic mathematics, which are studied back when you just started school. It only requires one to be able to add and subtract figures. If you wanted to calculate how much the business is worth based on the accounting records, you would need to subtract the financial records of what the business owes to its partners, for utilities, employees and other parties from the total of records that reflect how much the company has in monetary form.
If you wanted to set up a business to trade, then you would need resources to operate. In the financial records, this can be reflected as resources supplied by the owner equals resources in the business. The resources supplied by the owner are typically referred to as capital or equity, while the resources that the business now actually has would be called assets. This means that the accounting equation can be represented as Capital = Assets.
Besides the owner, most businesses receive financing from other sources, which are known as liabilities. Now, our accounting equation would take the following form: Capital = Assets – Liabilities. There are several ways this equation can be rearranged and expanded, but we are not going to go into that. What matters to us right now is that when we are going to be entering a transaction or balance under Capital (Equity), we will need to balance it out with an entry under Assets. If we have an entry under Liabilities, for example, we would have an entry under Assets and so on. What matters is that the total on one side of the equal sign should always be of equal amount to the total on the other side.
Opening Balance Equity
Accounting and bookkeeping software are gaining more and more popularity among small and large businesses. However, along with it, business owners and bookkeepers see unfamiliar to them accounts. One of such accounts is Opening Balance Equity. The Opening Balance Equity account is not something you would see in traditional bookkeeping records whether they are done on paper, in Excel, or similar program.
You will see that this account is used only by accounting software, such as Xero and FreshBooks. It is simply the difference between the debit balance and credit balance in the General Ledger of the business that is starting to use such accounting programs. In fact, there are several cases when Opening Balance Equity is created:
- As mentioned before, when you first enter the bookkeeping software and connect your bank account to the software to import your transactions, the program will create this account which will have a balance equal to the balance on your bank account.
- You might also start using the software by manually entering data, so when you, let’s say, add an asset account to the list of all the other accounts, in many cases, the Opening Balance Equity will be automatically added to maintain the accounting equality.
- It can also be created when you add a new customer or vendor to your accounting records with, for instance, an outstanding balance, thereby adding an accounts receivable opening balance.
If the number in the Opening Balance Equity account does not equal the amount of the total Owner’s Equity of the business at the time it started using the accounting software, it should be corrected so the amounts are the same.
Once you are done with setting up your bookkeeping record in the program, the Opening Balance Equity should be closed to either Retained Earning or the Owner’s Equity account. Why? This is only a temporary account that the computer creates automatically to ensure that the accounting balance we talked about in the beginning is maintained when you are entering starting amounts under other accounts.
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You are a small business owner that had a coffee shop successfully operating for two years. To keep track of all your expenses, income, and other items, you used an Excel spreadsheet. Now, you want to attract investors to be able to open new coffee locations. To make your business look more presentable and make bookkeeping for your growing business less time-consuming, more accurate, and informative, you decide to use one of the accounting software available on the market.
It is really important to start off with correct bookkeeping balances in order for your business to benefit the most from transferring your books to the accounting software. Thanks to the Opening Balance Equity account, getting the Balance sheet account balances in your bookkeeping program right is much easier. Why only Balance sheet accounts? Because the Income statement accounts are closed to the Retained earnings, which is a Balance sheet account, and you start from scratch every accounting period.
After signing up, you start setting up your Chart of Accounts, importing transactions from your bank account, and entering balances for each account based on what you have recorded in your Excel spreadsheet. For example, you entered your inventory amount, imported your cash balance from your bank account, recorded all your fixed assets, and made sure to account for the rent, utility, and wages you still owe.
When you add your fixed assets, you would need to make another entry showing where the resources came from to acquire these assets. You could have either borrowed money, used your own money, or take the funds out of the Retained earnings account. As you can see in the illustration above, there are no equity accounts. That is because to make the initial entering of the balances easier, the accounting program automatically creates the Opening Balance Equity account which it uses in place of Equity accounts to balance out the bookkeeping records.
How to Fix It
Just like we said, this is a temporary account and just like any other temporary account, it should be closed. Thus, after you set up your list of all the accounts, add starting balances to all existing accounts, and check that the amount on that automatically created account called Opening Balance Equity is the same as the amount under Equity in your bookkeeping records, you need to close zero out this account.
How much should the Opening Balance Equity have on its account if you have the data provided in the example above? The answer is very simple, it should be the difference between the debit and credit entries or $60,000 less $45,000, which gives us $15,000 of equity.
To zero out the Opening Balance Equity account, you simply need to make an adjusting entry, transferring the balance to the Owner’s Capital account or Retained Earnings account. Which account you will close this account to will depend on the type of business you are, otherwise, the essence of the closing process does not change, only the account names.
Author: Charles Lutwidge