Stockholders’ Equity
A business corporation’s owners are referred to as stockholders or shareholders because they hold stock certificates which provide evidence of their share of ownership in the corporation. Hence, the balance sheet of a business corporation will report the following:
Stockholders’ equity (along with corporation’s liabilities) can be viewed as:
- Sources of a corporation’s assets, and/or
- Claims against the corporation’s assets. (However, the liabilities (creditors’ claims) come ahead of the stockholders’ claims.)
The stockholders’ equity section of the balance sheet consist of the following components:
- Paid-in capital (or contributed capital)
- Retained earnings
- Accumulated other comprehensive income
- Treasury stock (however, this is a deduction/negative amount)
The changes which occurred during an accounting year are reported in the annual statement of stockholders’ equity, which is one of the five required external financial statements.
Paid-in Capital or Contributed Capital
Paid-in capital or contributed capital is the first component listed in the stockholders’ equity section of the balance sheet. It includes the amounts that the corporation received from investors when the corporation issued its shares of capital stock. (Capital stock is used to describe both common and preferred stock.) All corporations issue common stock, but a few will also issue preferred stock. If preferred stock is issued, the amounts received will be reported separately from the amounts received for its common stock. If any of the shares of stock have par values or stated values, those amounts are listed separately.
Common Stock
Common stock is the capital stock that is issued by all U.S. business corporations. (Relatively few corporations issue preferred stock in addition to the common stock.) The holders of common stock:
- Elect the corporation’s directors
- Vote on significant issues such as its acquisition by another corporation
- Receive dividends if declared by the board of directors
Depending on state laws, each share of common stock could have a par value, a stated value, or neither. If the shares have a par or stated value, that amount is reported separate from the amount in excess of the par or stated value. When approved by a corporation’s board of directors, the common stockholders will receive cash dividends based on the number of shares of common stock owned.
Preferred Stock
In addition to common stock, a few corporations also issue preferred stock. These shares have a preferential treatment as far as dividends and liquidation. This means that stockholders of the preferred shares of stock must receive their dividends before the corporation can pay a dividend on its common stock.
The dividend for the preferred stock is based on its stated dividend rate and the par value of the preferred stock. For example, each share of 6% preferred stock with a par value of $100 must be paid its $6 per year dividend before the common stockholders will receive any dividend. (Only participating preferred stock will receive more than the stated dividend.)
When the stock is cumulative preferred, any past omitted dividends plus the preferred stock’s current dividend must be paid before a dividend can be given to the common stockholders. Any past omitted dividend on the cumulative preferred stock is known as a dividend in arrears and it must be disclosed in the notes to the financial statements.
Par Value or Stated Value
The par value or stated value of shares of stock is a legal amount (based on state laws) that must be recorded and reported separately from the amounts received in excess of the par or stated value. The par value of a corporation’s preferred stock (if any is issued) will determine the dividends for the preferred stockholders. For example, a 6% $100 par value preferred stock will receive a $6 per year dividend. However, the shares of common stock often have no par value or a very small par value.
Retained Earnings
Generally, retained earnings are the cumulative amounts of the corporation’s earnings or net income since the corporation began minus the cumulative amounts of dividends that the corporation declared since the corporation began. The amount of retained earnings is reported separately in the stockholders’ equity section of the balance sheet and must be a positive amount (a credit balance) in order for the corporation to declare and pay dividends to its stockholders. For successful corporations the amount of retained earnings is often many times the amount of its paid-in capital.
Accumulated Other Comprehensive Income
Accumulated other comprehensive income is a separate line within the stockholders’ equity section of the balance sheet. While retained earnings reports the cumulative amounts of earnings or net income, accumulated other comprehensive income reports the cumulative amount of the other comprehensive income or loss.
(Other comprehensive income involves gains or losses on hedging transactions, foreign currency translation adjustments, and a few others.)
Treasury Stock
Treasury stock is usually the amount that a corporation has paid to repurchase some of its own shares of stock (and has not reissued or retired the shares). The corporation’s cost is debited to the general ledger account Treasury Stock. This debit balance will appear as a subtraction near the end of the stockholders’ equity section of the balance sheet.
Cash Dividend
A cash dividend is a distribution of cash by a corporation to its stockholders. The dividend amount will reduce the balance in the account Retained Earnings (as well as reduce the corporation’s cash). In order for a corporation’s board of directors to declare a cash dividend, the Retained Earnings must have a positive, credit balance.
Stock Dividend
A stock dividend is a distribution of additional shares of a corporation’s own shares of stock to its existing stockholders. For instance, if a corporation declares a 5% common stock dividend and the corporation has 100,000 shares of common stock outstanding, the corporation will be issuing and distributing 5,000 additional shares of common stock. After the stock dividend there will be 105,000 shares outstanding (instead of 100,000) but the total amount of the corporation’s assets, liabilities, and stockholders’ equity do not change. The journal entry to record the declaration of a stock dividend will usually debit Retained Earnings for the market value of the new shares and will credit the paid-in capital accounts for the same total amount.
Stock Split
A stock split reduces the market value per share of common stock by increasing the number of shares outstanding. If the market value of a share of common stock was $60 before a 2-for-1 stock split, the market value per share of common stock should be approximately $30 after the stock split. If the corporation had 300,000 shares of $10 par value common stock outstanding and it declares a 2-for-1 stock split, the corporation will have 600,000 shares of $5 par value common stock after the stock split. No journal entry is necessary since the total amounts of the stockholders’ equity are unchanged. A memo is entered to indicate the stock split and to note the new total number of common shares and the new par value per share.
Declaration Date
The declaration date is the date that the board of directors declares a dividend to the corporation’s stockholders. The declaration date is used to record a credit to the liability account Dividends Payable and a debit to the account Retained Earnings (or the temporary account Dividends).
