GAAP – Accounting for Equity

An Introduction to Equity

The Basic Accounting Equation says that

Assets – Liabilities = Equity

Equity (stockholders’ equity, owners’ equity, etc.) is the claim shareholders of a company have on assets once the liabilities have been satisfied.

Equity on the Balance Sheet

There are five critical entries on a balance sheet related to equity: retained earnings, common stock, preferred stock, treasury stock, and other comprehensive income. Unlike assets and liabilities, equity tends to be much easier to calculate.

Retained Earnings

retained earningsRetained earnings is one of the most useful numbers taken off the balance sheet. It shows how much money the firm keeps after all other payments and expenses have been accounted for. “Retained earnings” is basically net income minus any cash dividends the company pays out to shareholders. On the balance sheet, retained earnings is added to an account known as “accumulated retained earnings”. These earnings are “retained” by the company to invest in growth projects, pay off debt, etc.

If a company reports negative net income, the account balance of accumulated retained earnings does down, which reduces total equity.

Common Stock (Contributed Capital)

All public companies finance themselves in part by issuing common stock. Purchasing common stock represents an ownership in the company. Companies use the money raised from issuing stock to pay off debt, start new projects, and more. In return, investors expect the stock to go up in value (and possibly pay a dividend). Common stock also comes with voting rights, meaning investors are entitled to a vote on certain issues within the company. These votes range from electing new board members to creating stock splits.

The price of common stock changes all the time, but the balance sheet only uses the stock’s par value.  This is not the price quoted on an exchange, but a legal value used by the company at the shares’ inception. Par value is usually the amount a firm agrees not to sell stock below.

The value of common stock on the balance sheet is:

par value X number of shares outstanding

If a company has 100 outstanding shares with a par value of $1, the “common stock” line of the balance sheet is $100. If the firm issues 10 more shares, this increases to $110. Changes to common stock on the balance sheet happens when new shares are issued or the firm buys back shares from investors.

Preferred Stock

priorityPreferred stock is a less common form of equity. Preferred stock acts somewhat like debt because it has no voting rights and typically earns a fixed dividend. Unlike debt, owners of preferred stock get these dividends forever. Preferred stockholders also have a claim on a firm’s assets before common stock holders do. This means preferred stockholders always get paid dividends first. If the company goes bankrupt, preferred stockholders also get “first claim” on any remaining assets after all debts are paid.

Treasury Stock

Treasury stock comes from a firm repurchasing shares of its own stock from investors. Treasury stock eventually gets retired, so it does not stay on the balance sheet for very long. Even though it is designated as stock, treasury stock receives no dividends, and has no voting rights. Treasury stock reduces the total stockholders’ equity since it means there is less outside investment. On the balance sheet, it is a “contra-equity” balance, meaning it is subtracted to arrive at total equity. Unlike common stock, Treasury stock is recorded at the market value at which it was purchased, not par value.

Other Comprehensive Income

incomeOther Comprehensive Income (OCI) is all the income a company makes that is not on the Income Statement as part of “Net Income”. “Net Income” is a company’s revenue minus expenses, interest, and taxes. However, a firm may have other sources of income, like as buying stock in another company and earning a dividend. If this company sells that stock or earns a dividend, it does not normally appear on the income statement. That is because these earnings are not relevant to the main operations, just like individuals do not count investment gains as salary. Basically, any income a firm gets that is not counted as part of the Income Statement is counted as “Other Comprehensive Income”.

OCI, together with net income, represents comprehensive (or total) income. Increases in OCI will increase equity on the balance sheet, since the investors in a company also have a claim to these other sources of income.

Changes in Equity

The main number that will change from year-to-year is retained earnings, because that is tied to the income statement. Any factor that changes net income will also affect equity because of this.

Increases or decreases in costs, taxes, interest payments, and dividends paid will all have an impact on retained earnings. Otherwise, the only changes to equity will come from a company issuing more stock, repurchasing its shares as treasury stock, or if it earns income from Other Comprehensive Income.

Stock Dividends and Stock Splits

If a company pays out a cash dividend to its shareholders, the total dividends paid is subtracted from retained earnings on the balance sheet. This means paying out cash dividends will reduce total equity.

On the other hand, companies can also issue stock dividends (or stock splits). Stock dividends and stock splits do not affect equity, since this simply changes how many shares are outstanding without costing the company any cash.

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