Back in my overview post, I gave some formulas to remember. The important one right now is the one that says Assets = Liabilities + Equity.
Equity in its simplest terms is the difference between the assets and the liabilities. To expand on it, this is to say that if a business sold all its assets, then paid off the money it owed (liabilities), the money left over would be the equity. Of course, it does get more complicated, but we’re only looking for a basic understanding here, so this definition works for our purpose.
Now, there can be a negative equity situation where the money you owe is more than your assets. As artists, we could fall into this very easily unfortunately. Let’s take an example.
Shane is a painter and he’s bought $800 worth of canvases on a credit card. He didn’t have the money to pay it off and has just been making monthly minimum payments so now his balance is at $875. Then he decides to quit painting because he just isn’t making money and would be better off going back to school to be a dentist. He now has some canvases painted on, but other are blank and wrapped. He gives away the painted canvases to a friend, but decides to sell the unused ones on eBay. Those go for rock bottom prices and after shipping costs he’s only managed to make $475. This means he personally still owes $400 ($875 – $475).
This illustrates why it’s so necessary to keep an eye on the accounts on the balance sheet (assets, liabilities, and equity) and not just on if you’re making a profit (income and expenses). I said in Part 2 about liabilities to keep the money you owe to people as low as possible. Hopefully, now that we’ve looked at the equity side of it, you understand how you become liable for making up the difference between what you owe and what you could sell your assets for if you absolutely had to.
The equity section is also how sole proprietors put money in and take money out of their business.
When you set up your art as a business and you’re initially setting up your chart of accounts, any assets and/or inventory you already have need to be “journaled” in. I’m assuming you already have assets, inventory, and supplies when you decide to start your art business because for so many of us it starts as a hobby first and grows from there – sometimes unexpectedly. So if you have an air compressor you paid $100 for when you were doing art as a hobby, then you’ll set up a fixed asset for your compressor of $100 and in the equity section you’ll have an account called something like “Owner investments – equipment” for $100. Of course, there’s still depreciation on the compressor depending how long you’ve had it, but really, that’s a detail best left for your accountant. Just get the basics set up and go from there.
If you need to put cash into your bank account to pay for a prepaid expense like booth fees, you’ll deposit the money and make a credit entry to an account like “Owner investments – cash.”
Now to get the money out. Let’s say you worked really hard at a show and sold $1000 of product (and as an additional piece of information, you had $350 in expenses for the show). You need $200 to pay some of your personal bills (or maybe you’ve been looking at a new pair of shoes and decide to reward yourself for reaching your show goal). So, how do you pull that $200 out of your business. Since it’s a personal item, you can’t just expense it. Instead, you write yourself a check for $200 (the credit side of your entry) and debit $200 to Owner Draws. When the end of the month comes and you’re reviewing your financials, you see that your income is $1000 and your expenses are $350, leaving a net profit of $650. If you’d expensed your $200 withdrawal, your expenses would be overstated at $550, making your net profit appear to be $450.
It seems like a lot of numbers and may be overwhelming. Just remember that this is important for two reasons. First, and the one that seems the most boring, is when you’re doing your tax return. You’re income and expenses aren’t correct and so your return won’t be correct. The second reason it matters is for your own peace of mind. Does it sound better to think that you made $650 profit or $450? Chances are that if you don’t realize you’re making money, you’re going to wonder why you’re staying in the art business. I personally feel this is exactly the reason why so many frustrated artists decide to stop or get depressed– they aren’t getting an true picture.
I know I feel a lot better when I reflect on my financial statements and see that I grossed $1000, netted $650, and was able to withdraw $200 for myself. It’s an empowering feeling. But if you’re expensing your draws, the financial statements are going to tell you that you grossed $1000 but only netted $450 which looks like your expenses are eating up more than 50% of the money you’re making.
Yes, overall the reality is that you have $450 in your bank account to spend on your business or withdraw for later personal use, but it’s the story that your financials tell. Only when the story is full and complete can you get an accurate picture of your art business.