Examining the Statement of Stockholders' Equity in Financial Statements
 
 

Examining the Statement of Stockholders' Equity in Financial Statements

The Statement of Stockholders' Equity Overview:

When examining the financial statements of the business the statement of stockholders equity is a key financial statement to evaluate because it provides the information regarding the changes in the businesses stockholders equity that include contributed capital as well as retained earnings. The statement of stockholders equity can help investors, managers, and accountants to get a clear picture and understand the structure of a business is ownership profile. In this article we will evaluate to stockholders equity of WH3 Corp., who produces widgets.

Learning Objectives

  • You should be able to understand how the statement of stockholders' equity is organized.
  • You should be to understand the business manager's responsibilities for the financial statements of a business.
  • You should be ablanalyze and interpret the statement of stockholders' equity for a business.
  • You should be able to understand treasury stock.
  • You should be able to understand par value as well as additional paid-in capital.
  • You should be able to understand accumulated income and other comprehensive income.

Real World Application:

Over 80 years ago oil prospectors also known as wildcatter's named Bill and Steve gathered up all of their savings and purchased a piece of land in Texas. Both Bill and Steve each invested $1000 because they suspected that the land they were purchasing contain oil underneath the ground. Bill and Steve both agreed to share the profits 50-50 and they became equal partners in this business venture. They began to drill for oil book and but could not find anything so they hired an old wildcatter name Jack who was a self-proclaimed expert at finding oil in the area. Bill and Steve had both spent their entire savings on purchasing the land and they had no money to pay Jack with for his help. So in order to have Jack's help both Bill and Steve offered 33% of the land in exchange for his knowledge and work. Therefore this reduced any profits duckbill and Steve would receive down to one third each.

Now that Jack was a full partner Bill and Steve had reduced any profits that they might receive. This meant that if they found $100,000 worth of oil in the ground that could have previously been split 50-50, $50,000 for Bill and $50,000 for Steve now they would have to split the profits $33,000 for Bill $33,000 for Steve and $33,000 for Jack. The way that a business divides up its ownership shares is very important. There are some businesses that offer more than one type of ownership share and some of these can be more valuable than others. Other businesses will sometimes offer their employees stock in the business at a discounted price therefore watering down or "diluting" the existing stockholders shares and their value. Often times many investors will ignore this information at their own expense. This is due to the fact that they may not even realize that the shares they own are not entitled to receive dividends until the higher value or higher priority shares have been paid dividends.

Statement of Stockholders' Equity:

The stockholders' equity is designed to show the financing that has been provided for the business from its owners. This can help potential investors understand the ownership structure for particular business. In this article we will review changes and structures of the statement of stockholders' equity for our simulated business WH3 Corp. additionally we will also discuss the retained earnings, dividends, and stock splits. When a business is initially launching most business owners will file their business as a corporation, which is recognized as a legal entity separate from its owners in matters of personal liability. Corporations are required to file paperwork with the state such as Texas, Nevada, or Delaware. Corporations split up their ownership into shares of corporate stock. For example if WH3 Corp., issues 10,000 shares of stock, each share will then represent 1/10,000th of the entire amount of ownership stock for the corporation.

If a corporation wants to be publicly traded where shares of the business can be bought and sold on various stock exchanges such as the NASDAQ and the New York Stock Exchange then they must file what is known as an IPO or initial public offering. In order to file an IPO the corporation must file a charter with their state of domicile then issue shares of stock by selling them to investors in exchange for other assets (this is usually cash). These filings will help determine the total a number of authorized stocks, which will serve as the maximum number of shares that a corporation is allowed to print. The issuance of stock can also occur as part of the IPO because the initial public offering is the first time that stock in the business is offered to the public. When a corporation wants to repurchase or buy back shares of stock from investors this particular type of stock is referred to as treasury stock. Many times accountants and investors will refer to a term known as shares outstanding when discussing the stock a corporation. The number of shares outstanding refers to the total number of shares of stock that are owned by investors at given point in time. This number can be derived from taking the number of shares that have been issued and subtracting the number of shares of treasure stock that the corporation has repurchased for the same period of time. The number of shares outstanding formula is listed below.

Number of Shares Outstanding Equation:

Shares Outstanding = Shares Issued – Treasury Shares

Two Classifications of Stockholders' Equity:

On the balance sheet in the equity sections there are two basic classifications that are used. The classifications are: capital and earned capital. The contributed capital is defined as the net amount of funding that a business receives from selling or repurchasing its stock. The earned capital is defined as the total amount of net income that has been kept or retained by the business and not paid out as dividends. Many accountants and investment analysts often refer to equity as the residual interest. This implies that the stockholders of a business have a legal claim on any assets that exceed the value of what is required for the business to meet its obligations to its creditors.

  • Contributed Capital

Contributed Capital

Preferred Stock- The value that is generated from the original sale of stock. Generally the preferred stock has less ownership rights than compared to common stock.

Common Stock- The par value that is generated from the original sale of common stock.

Treasury Stock- The money that a business spent to repurchase its common stock from investors.

Paid-In Capital- The money that a business receives from the historical or original sale of stock to shareholders in excess of the par value for the common stock of the business.

Earned Capital

Retained Earnings- The retained earnings are the accumulated amount of net income that has not been paid out by a business to its stockholders.

Accumulated Income or Loss- These are the accumulated or collected changes in the equity accounts of the business that are generally not listed in the income statement.

Stock Based Compensations and Awards:

Treasury Stock:

The treasury stock business is the stock that has been repurchased from investors. A business will sometimes buy back stock from investors for a few reasons one being to increase the earnings-per-share (EPS) of the business by lowering the overall number of outstanding shares. When a business does this it changes the ratio of outstanding shares to the profits of the business and in turn when the business reduces the number of shares outstanding the earnings per share (EPS) will increase. Another reason for a business buy back stock is to issue that stock to managers and executives as a form of stock-based compensation.

The accounting procedure for dealing with treasury stock is very important to understand. When treasury stock is repurchased from investors it has the effect of reducing stockholders equity that is recorded on the balance sheet therefore making it negative stockholders equity. One of the most important concepts to understand is at it is not recorded on the financial statements as an asset because it is technically impossible for a business to itself. Additionally if the business were to buy treasury stock at a low price and then ideally sell it again at a higher price the differential between the cost of the stock and its selling price is not recorded as a gain. Instead this differential is recorded as an increase in the additional paid-in capital. This relationship exists as well if the selling price is lower than the purchase price than it would not be recorded in the financial statement as a loss instead it would be recorded as a decrease to the additional paid-in capital.

Retained Earnings:

Retained earnings are defined as the net income that is earned by the business that has not been paid out to shareholders in the form of dividends. The equation were retained earnings is listed below.

Retained Earnings Equation:

Retained Earnings = Total of all Profits – The total of all Dividends

The retained earnings can be thought of as a pool of cash that future dividends of a business could be paid from. Generally without sufficient retained earnings on the balance sheet dividends cannot be paid out to shareholders because there will not be enough in retained earnings to cover the full amount of the dividend distributions. When a business has incurred losses rather than made a profit then it has negative retained earnings that are also referred to as the accumulated deficit. The changes in the value of shareholders equity and the resulting effects are listed below.

The Value of the Stockholders' Equity Increases When:

1.) The business makes a profit and therefore the change increases the reported retained earnings.

2.) The business sells new stock and therefore the change increases capital stock.

The Value of the Stockholders' Equity Decreases When:

1.) The business pays dividends to the shareholders therefore decreasing the retained earnings that are reported.

2.) The company has a loss and does not make a profit therefore lowering the retained earnings that are reported.

Stock Dividends and Splits:

Dividends- The dividends from stocks payments usually in the form of cash that are based off of a percentage value of the price of the stock, they can also technically be in the form of additional stock if the company has a dividend reinvestment program also known as a DRIP program. The dividend reinvestment program reinvests all of the dividends earned from a stock back into new shares of the same stock. This can be thought of like compound interest, and over time the number of shares you own will increase. The stock dividends can also be thought of as much smaller increases that are proportional to the number of shares outstanding. An example of this would be if WH3 Corp. had a 10% dividend on its stock then a stockholder who owns 100 shares of stock would be awarded the value 10 shares of new stock in the Corporation.

Stock Splits- much like the name implies stock splits refer to a split in the value of the stock by increasing the number of shares outstanding. An example of this would be what is commonly referred to as two-for-one split where for every one share of stock it is now divided in half where the value is half of the original value but there are now twice as many shares. This means that the stockholder still owns the same dollar amount of value in the company but now the stock price has been cut in half and the shareholder owns twice as many shares as before.

KEY POINTS REVIEW

  • The statement of stockholder' equity provides users with information regarding the change in a stockholders' equity of a corporation. This includes the contributed capital as well as the retained earnings which both help accountants, investors, and anybody using these financial statements to get a clear picture of the corporation's ownership structure.
  • The United States GAAP accounts for preferred stock as equity as opposed to the IFRS standard that reports preferred stock as debt with the dividends as an interest expense shown on the income statement.
  • The contributed capital states amounts that are contributed or paid for the shares of stock by the investors. These different amounts can be classified as additional-paid in capital, which are the amounts that have been paid in addition to the par value. The other classification is the Par Value, which is the legal value that has been assigned to the individual shares of stock for the corporation.
  • The other comprehensive income will generally include the gains or losses that are not directly tied to the operations of the business and are also not listed on the income statement.
  • There are two main types of stock:

1.) Common stock- Common stock is the most basic type of equity stock that can be purchased from an exchange such as the NASDAQ or the New York Stock Exchange.

2.) Preferred stock- Preferred stock shares are usually more expensive and receive dividend distributions before common stockholders and in many cases they receive preferential treatment.

 
 
Popular Courses
 
Learn More! Take an Online Course...