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General Accounting Discussions: Deficit Owner's Equity - How do you explain this?

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    • CommentAuthorrgan79
    • CommentTimeFeb 1st 2010
     
    Is it possible that the Assets of a company is less than it's liabilities. If yes, then according to the basic accounting equation , equity turns out to be negative which seems absurd. How can the investment made by the owners of a firm be negative?
    • CommentAuthorArcSine
    • CommentTimeFeb 2nd 2010
     
    It's pretty easy if owner draws are being at least partially financed with debt. Overly simplistic illustration, but you'll get the drift...

    Start a brand new biz; owner puts up $100 cash as starting capital. Company borrows another $500.

    Thus, the initial balance sheet is Cash 600; Debt 500; Equity 100.

    Next, owner takes a $200 draw from the cash.

    Balance sheet now stands at Cash 400; Debt 500; Equity (100).

    Switching gears a bit, start with that same opening balance sheet, with 600 in the bank, of which 100 came from Owner and 500 came from lender. But now suppose that the biz incurs expenses of 200 (which it pays in cash), but earns zero revenue. You'd again end up with (after closing the net loss to Equity) a balance sheet of...

    Cash 400; Debt 500; Equity (100).

    In general, anytime debt is financing losses, or excess draws, or some combo of the two, you can easily have an upside-down balance sheet.
  3.  
    Its a very good discussion about owner's activity. Thanks for sharing your knowledge here!

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