“…and therefore the equity is very important for the balance sheet.”
article researched by Subhadra Kartik, written by Wayne Brown
Note to readers: In this category Finance-4-Execs, we aim to provide executives with a working knowledge and learning on Management Finance. A finance major undergraduate has researched each article in this series. Be aware however that Skills 4 Executives Limited, and we as authors of this document, are not qualified, financial professionals. Therefore nothing stated herein should be taken as financial advice. You will note in the articles that we leverage heavily from other subject experts and their articles. Under each section, you will find the reference sources for additional deeper dives into the topics.
Business organizations come in different forms and types of ownership…
Let’s dive straight into this topic by exploring the definitions of business ownership. The basic forms of Business ownership are Sole Proprietorship, Partnership and Corporation.
- The sole proprietorship is easy to establish and common for individuals and small businesses.
- The Partnership is a business owned by two or more partners, who divide the profits or losses.
- A Corporation is a separate legal entity from its owners. The owners (shareholders) have limited access to the company’s operation but enjoy the share of profits. The shareholders elect the Board of Directors, who control the activities of the business.
- In a corporation, the owners can lose no more than the amount they have invested in that corporation. The corporations’ owners are stockholders or shareholders because they hold stock shares, which serves as evidence of their ownership. When an investor/ shareholder invests in a corporation, he is issued a certificate of ownership interest. This certificate is known as a stock certificate, capital stock, or stock. Most of the Corporations today have the certificate of shares or stock electronic form.
The ratio of investors to stock owned;
This differs for every corporation, and it may keep changing depending on who is selling or buying stock.
The stockholders elect a board of directors as their representatives in the corporation’s affairs. The Board of Directors appoints the Office of the Corporation, comprising the President, Vice President, CFO, COO, Treasurer, and others. (terminology may vary by country)
Article sources: (refer to the following sites to explore the discussion further)
- Types and Forms of Business article from Accounting Verse
- Stockholders’ Equity article from Accounting Coach, Harold Averkamp
A Company needs capital to buy assets...
They can raise capital by borrowing through banks or equity. However equity capital is generated not by borrowing but by selling shares of company stock. The benefit of raising equity capital is that the company is not required to repay shareholder investment.
Instead, the cost of equity capital refers to the amount of return on investment shareholders expect based on company performance. These returns come from the payment of dividends and stock valuation. Each shareholder is a part-owner of the company, so businesses must ensure the company remains profitable to maintain an elevated stock valuation while continuing to pay any expected dividends. Equity is also termed capital and received from investors in exchange for ownership in the business.
Since liabilities and stockholders’ equity fund assets, they have to be equal to their sum. From this rule, we can derive a simple mathematical formula for the stockholders’ equity:
The Stockholders’ Equity = Total Assets – Liabilities
A profit or a loss that a company makes in an accounting period is recorded as retained earnings in stockholders’ equity. For a Corporation, income is distributed to shareholders in the form of dividends. Dividends reduce retained earnings, and therefore reduce owner’s equity. Income increases owner’s equity, while losses decrease owner’s equity.
Components of Shareholder’s Equity…
Common Stock –
When a corporation has issued only one type or class of stock, it will be common stock . The common stockholders elect the Board of directors. They also vote on merging with another company, and get huge returns on their investment if the corporation becomes successful.
Preferred Stock –
When it comes to dividends and liquidation, the preferred stock owners have preferential treatment over common stock owners. Preferred stockholders receive their dividends before the common stockholders receive theirs. When the corporation does not declare a dividend to preferred stock, there cannot be a dividend on the common stock. In return, the preferred stockholders usually give up the right to share in the corporation’s earnings above their dividends.
Paid in Capital –
Capital stock is a term that encompasses both common stock and preferred stock. “Paid-in” capital (or “contributed” capital) is the equity received when it issued its shares. The Par Amount is credited to Common Stock. The actual amount received for the shares minus the Par Value is credited to Paid-in Capital.
Retained earnings –
The term “retained earnings” refers to the cumulative net income (from the date of incorporation to the current balance sheet). From this is deducted the cumulative amount of dividends declared. An established corporation that has been profitable for many years will often have a very large credit balance. The balance sits in its Retained Earnings account, frequently exceeding the investors’ paid-in capital. On the other hand, if a corporation has experienced significant net losses since its formation, it could negatively retain earnings. These sit as a debit balance instead of the normal credit balance in its Retained Earnings account). When this is the case, the account is described as “Deficit” or “Accumulated Deficit” on the corporation’s balance sheet.
Accumulated other comprehensive Income –
Accumulated other comprehensive income refers to income which is not reported as net income on a corporation’s income statement. These items involve things such as foreign currency transactions, hedges, and pension liabilities.
Treasury stock –
When a corporation reacquires some of its stock and does not retire those shares, the shares are treasury stock. Treasury stock reflects the difference between the number of shares issued and the number of shares outstanding. When corporations hold treasury stock, a debit balance exists in the general ledger account Treasury Stock (contra stockholders’ equity account).
Article sources: (refer to the following sites to explore the discussion further)
- Accounting 101: Owner’s Equity – article from The Daily CPA, by Jeremias Ramos
- What Is Stockholders’ Equity? – article from Bezinga, by Allyson Brooks
- Common Stock, Accounting for Stockholders’ Equity – article from Accounting Coach, Harold Averkamp
- Preferred Stock – article from Accounting Coach, Harold Averkamp
Importance of Equity…
Equity plays an important role in organizations, because it can finance expansion. A Business can fund development by selling stock shares to investors; this is “equity financing.” By selling stock to investors, companies gain access to a large amount of cash without debt.
Equity shareholders provide funds enabling the company to acquire assets, hiring personnel, or paying for marketing. There are no or limited concerns about ever paying it back. Therefore, equity contributions only enhance cash flow.
On the balance sheet, assets minus liabilities equal stockholders’ equity.
Stockholders’ equity is referred to as net worth…
Stockholders’ equity records how much you and other co-owners or investors have contributed to the corporation by purchasing shares. These include any initial contributions and any additional paid-in capital. Stockholders’ equity also reflects the profits your corporation has retained or distributed to shareholders. The profits retained or losses accrued are called retained earnings, whilst the shareholder distributions are called dividends.
The primary shareholder objective for a corporation is to maximize the value of the corporation. Corporations exist to provide goods and services to generate revenue and net income. So net income gets passed to the shareholders via dividends and distributions. Additionally, it’s passed through the sale of a shareholder’s stock back to the company or another individual or entity.
Expanding the corporation’s geographical reach, business lines, or products serves to increase revenues. When enacting measures cut costs without impacting quality or service, they increase profitability. Both revenue growth and profitability help to maximize the corporation’s value.
Article sources: (refer to the following sites to explore the discussion further)
- The Importance of Equity to an Organization – article from Chron by Gregory Hamel
- The Importance of Stockholders’ Equity – article from azcentral by Tiffany C. Wright
Statement of Shareholders Equity…
The statement of shareholders’ equity is a financial document a company issues as part of its balance sheet.
It highlights the changes in value to stockholders’ or shareholders’ equity or ownership interest in a company. This value commences from the beginning of a given accounting period to the end of that period.
Stockholder’s equity on a financial statement is an important indicator of a corporation’s financing sources. It indicates to the investor whether the corporation borrows funds to operate or relies on its own cash. The statement also helps the top management understand dividend payments that the corporation periodically sends out to investors.
Article source: (refer to the following sites to explore the discussion further)
- The Importance of a Stockholder’s Equity on a Financial Statement – article from Biz Fluent, by Marquis Codjia
- The Stockholder’s Equity Section of the Balance Sheet – article from ER services
Stockholder’s Equity on Balance Sheet…
A corporation may report stockholder’s equity on the balance sheet in accordance with GAAP, while stockholder’s equity on a balance sheet relates to investments from two types of shareholders—common and preferred shareholders. Common shareholders are investors who buy common or regular shares of equity. Common shareholders receive periodic dividend payments and make profits when share prices increase. Preferred shareholders are investors who buy preferred shares. These shareholders enjoy similar privileges as common shareholders but receive dividends before common shareholders.
Stockholder’s Equity on Retained Earnings Statement…
A company may report stockholder’s equity on the Statement of Retained Earnings in compliance with GAAP. Stockholder’s equity on a Statement of Retained Earnings relates to the stockholder’s equity balance at the beginning of a period. As are dividends paid during a period, net income, and stockholder’s equity balance at the end of a period. For instance, a company’s Statement of Retained Earnings may show;
- a stockholder’s equity beginning balance of $1 million,
- and dividends paid of $300,000,
- net income of $1 million,
- and a stockholder’s equity ending balance of $1.7 million.
Example:
The following are 3 case studies for testing your knowledge from this article…
Case Study 1: Corporations and Stockholders’ Equity Case Studies Report
- IvyPanda. (2019, December 12). Corporations and Stockholders’ Equity Case Studies.
Shareholders provide capital to ensure smooth running of an organization.
Therefore, they have certain rights, obligations, and powers in the running of an organization. Similarly, the Board of Directors and employees have their duties in the organization. They are guided by a professional code of ethics and conduct. Ethics denotes a set of laws that regulate a certain profession. The paper discusses ethical concerns in two cases which involve shareholders, Accountant, and Board of Directors. It points out the ethical issues and suggests prudent ways of handling the issues.
A shareholder provides equity financing to a company.
Is it ethically correct for a shareholder to give the company money either as a way of debt or equity? Therefore, a shareholder can lend money to the company at an interest. The shareholder can borrow funds or use savings to fund the loan.
There is no statutory condition to this transaction, aside from needing to register the borrowings with the Registrar of Companies, but the only ethical issue would be the interest rate. A shareholder should lend money to the company at a market rate, but not at his preferred interest rate.
However, there are certain conditions that he must meet to obtain tax relief on the interest rate. Firstly, he must own over 5% of the company’s shares or have acted in management’s capacity for a long time. Secondly, the company must be a private company.
A stakeholder can ethically be a customer;
of a business through normal purchases of the company’s commodities.
In this case, he intended to buy commodities to reverse the anticipated poor performance at year-end.
This action is unethical since it amounts to manipulation of company earnings.
Purchase of merchandise worth $250,000 would lead to robust sales in the month of December. It would increase income and provide enough cash to meet the expenses. Amounting to unethical manipulation of the company’s earnings and financial statements. Therefore, a stockholder cannot ethically become a customer to improve sales and net income.
The amount of the purchase is of utmost importance. It helps gauge whether the sales are normal or have a material impact on the financial statements. The CEO was concerned since ethical behavior is a strong tenet in business relations. Thus, an individual or a business should not make unfair gains in business. Besides, professionals must adhere to the professional code of conduct and ethics in any line of business. Further, the CEO was aware that manipulating the financial statements would mislead the users and other stakeholders. Therefore, the CEO had genuine ethical concerns.
Case Study 2: Statement of Changes in Owner’s Equity
- from Sophia by Sophia Tutorial
Case study of a company called Legacy Realty that owns and leases their rental properties. An example of preparing a statement of changes in owner’s equity, which details the owner activity for a period. Some information from the adjusted trial balance and the income statement to create this statement.
Case Study 3: Preparing a Statement of Changes in Equity – A Business Case:
- Statement of Changes in Equity: Purpose & Examples – article from Study.com Chapter 1, Lesson 6.
It is the month of February, and your accounting department is hard at work finalizing the financial statements. The Board is demanding a draft of the financial statements to assess the company’s health and performance. Your manager has decided to divide the task among the accounting team members. You have to prepare a draft Statement of Changes in Equity for the most recent year. The following preliminary information provides the previous year’s financial statements and the current year’s activity:
Opening balances of all equity accounts:
Preliminary financial data:
- Revenue was $555,200, and expenses were $490,700 for the year.
- A payment of $10,000 cash dividend was declared and paid in the current year.
- A retrospective change in accounting policy (i.e., changed depreciation method) resulted in an understatement of last year’s income by $5,500.
- The Other Comprehensive Income for the year is $6,000.
Required:
- Prepare and present in good form a Statement of Changes in Equity for the year.
Solution:
Additional reference sources…
Videos:
- Shareholders’ Equity on a Balance Sheet- Jun 2018
- Statement of changes in equity–April 2020 – What is the statement of changes in equity. How can I use the statement of changes in equity to better understand the balance sheet? The fiscal year-end consolidated balance sheet of Walmart of 2019.
- Statement of Stockholders’ Equity-Nov 2018 – Statement of Stockholders equity from a Trial balance
- Preparing the Statement of Changes in Equity-Aug 2019 – This Module shows accounting terminology and how to prepare the income statement, statement of changes in shareholders’ equity, and the balance sheet.
Books:
- Private Equity: Minority Investments and Buyouts, a Guide to working with Private Equity – Author: Lewis Invest, Published:Nov 2019
- The Private Equity Playbook: Management’s Guide to Working with Private Equity – Author: Adam Coffey, Published: Feb 2019
- Statements of Income, Cash Flow, & Balance Sheets – PART 2: Stocks & Shareholder Equity – Author: Buster MBA, Published: Kindle Edition-Jan 2014
- Creating Shareholder Value: A Guide For Managers And Investors – Author: Alfred Rappaport, Published: Kindle Edition-Oct 1999
Conclusion:
This series is gradually building your financial literacy and understanding. Follow along week on week and establish a sound understanding in the basics of Management Finance.
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