What is Equity and why does it matter?

research and draft compiled by Subhadra Kartik

article written by Wayne Brown

Let’s set the stage about Equity…

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Business organizations come in different forms and types of ownership. The basic form of Business ownership are Sole Proprietorship, Partnership and Corporation.

  • The sole proprietorship form is usually owned by an individual, easy to set up and usually adopted by small businesses.
  • The Partnership is a business owned by two or more persons who are partners who divide the Profit/loss of the business.
  • A Corporation is a separate legal entity from its owners. The owners (shareholders) have limited access in 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 owners of the corporations are called stockholders or shareholders, because they hold the shares of stock, which serves as an 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 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 appoint the Office of the Corporation which comprises of the President, Vice President, CEO, CFO, COO, treasurer and others. (terminology may vary by country)

A corporation’s balance sheet reports its assets, liabilities, and stockholders’ equity. Stockholders’ equity is the difference (or residual) of assets minus liabilities. Stockholders’ equity represents a book value of the company and it can be used to value shares of the company.

Stockholders’ Equity

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A Company needs capital to buy assets. They can raise capital by borrowing through banks or through Equity. 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 the performance of the company.

These returns come from the payment of dividends and stock valuation. Each shareholder is a part owner of the company. Businesses must ensure the company remains profitable to maintain an elevated stock valuation while continuing to pay any expected dividends. Equity can be termed as the capital received from investors in exchange for ownership in the business.

Since assets are funded by liabilities and stockholders’ equity, 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 booked 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 – If a corporation has issued only one type, or class, of stock it will be common stock. It is the common stockholders who elect the board of directors, vote on whether to have a merger 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 owners of preferred stock have preferential treatment over the owners of common stock. Preferred stockholders receive their dividends before the common stockholders receive theirs. In other words, if the corporation does not declare and pay the dividends to preferred stock, there cannot be a dividend on the common stock. In return for these preferences, the preferred stockholders usually give up the right to share in the corporation’s earnings that are in excess of 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 that section of stockholders’ equity that reports the amount a corporation received when it issued its shares of stock. State laws often require that a corporation is to record and report separately the par amount of issued shares from the amount received that was greater than the par amount. The par amount is credited to Common Stock. The actual amount received for the stock minus the par value is credited to Paid-in Capital in Excess of Par Value.
  • Retained earnings The term retained earnings refers to a corporation’s cumulative net income (from the date of incorporation to the current balance sheet date) minus the cumulative amount of dividends declared. An established corporation that has been profitable for many years will often have a very large credit balance in its Retained Earnings account, frequently exceeding the paid-in capital from investors. If, on the other hand, a corporation has experienced significant net losses since it was formed, it could have negative retained earnings (reported 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 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 If a corporation reacquires some of its stock and does not retire those shares, the shares are called treasury stock. Treasury stock reflects the difference between the number of shares issued and the number of shares outstanding. When a corporation holds treasury stock, a debit balance exists in the general ledger account Treasury Stock (a contra stockholders’ equity account).

Importance of Equity

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Equity plays an important role to organizations as it can be used to finance expansion. A Business can fund the expansion by selling shares of stock to investors. This is known as “equity financing.” By selling stock to investors companies gain access to a large amount of cash without having to take on debt.

Equity shareholders provide funds that enable your company to perform actions such as acquiring assets, hiring personnel, or paying for marketing, with no or limited concerns about how to pay it back. Therefore, equity contributions only enhance cash flow.

On the balance sheet, assets less liabilities equal stockholders’ equity. Therefore, stockholders’ equity is also referred to as net worth. Stockholders’ equity records how much you and other co-owners or investors have contributed to the corporation through the purchase of 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, and 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. The net income gets passed to the shareholders via dividends and distributions or through the sale of a shareholder’s stock back to the company or to another individual or entity. Expanding the corporation’s geographical reach, business lines or products serves to increase revenues. Enacting measures that cut costs without impacting quality or service increases profitability. Both revenue growth and profitability serve to maximize the corporation’s value.

Statement of Shareholders Equity

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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, 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 as 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.

Stockholder’s Equity on Balance Sheet

A corporation may report stockholder’s equity on the balance sheet in accordance with GAAP. 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. Preferred 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 amounts on a statement of retained earnings relate to the stockholder’s equity balance at the beginning of a period, dividends paid during a period, net income, and the 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, dividends paid of $300,000, net income of $1 million and a stockholder’s equity ending balance of $1.7 million.

Example:

Statement of changes in Shareholders Equity
 Common Stock Paid-in-CapitalTreasury Stock Accumulated other comprehensive lossRetained earningsTotal
 SharesAmount SharesAmount   
Balance as of Januray 201235842339(111)(5977)(53)101956508
Comphrehensive income     8986994
Stock option and awards set of tax2 115 (9)  106
Dividends paid    3 (303)(300)
Treasury stock purchases   (27)(1260)  (1260)
Balance at February 201336042454(138)(7243)(45)108786048
Comphrehensive income     11889900
Stock option and awards set of tax4 144 (13)  131
Dividends paid    3 (305)(302)
Treasury stock purchases   (15)(799)  (799)
Balance at February 201436442598(153)(8052)(34)114625978
Comphrehensive income     14867881
Stock option and awards set of tax3 145 (19)  126
Dividends paid    4 (321)(317)
Treasury stock purchases   (13)(677)  (677)
Balance as of Januray 201536742743(166)(8744)(20)120085991
Shareholders Equity Statement
Common Stock4
Paid in capital2743
Treasury Stock(8744)
Accumulated other comprehensive loss(20)
Retained earnings12008
Total shareholders equity5991

Case Study-One: Corporations and Stockholders’ Equity Case Studies Report

  • IvyPanda. (2019, December 12). Corporations and Stockholders’ Equity Case Studies. Retrieved from https://ivypanda.com/essays/corporations-and-stockholders-equity-case-studies-report/

Shareholders provide capital to ensure smooth running of an organization. Therefore, they have certain right, obligations and powers in the running of an organization. Similarly, board of directors and employees have their duties in the organization. Their conducts are guided by profession code of ethics and conduct. Ethics denote a set of laws which regulate a certain profession. The paper discuses ethical concerns in two cases which involve shareholder, 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. It is ethically correct for a shareholder to provide money to the company either as 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 any statutory condition to this transaction except that charges to secure the borrowing must be registered with the registrar of companies. The only ethical issue would be on the interest rate. A shareholder should lend money to the company at market rate and not at his preferred rate of interest.

However, there are certain conditions that he must meet in order to obtain a tax relief on the interest rate. First, he must own over 5% of shares of the company or have acted in the capacity of a management for a long time. Secondly, the company must be a private company.

A stakeholder can ethically be a customer of a business. This should be done within normal purchases of the company’s commodities. In the case, his intention was to buy commodities so as to reverse the anticipated poor performance at year end. This action is unethical since it amounts to manipulation of earnings of the company.

A purchase of merchandise worth $250,000 would lead to robust sales in the month of December, an increase in income and provide enough cash to meet the expenses. This amounts to manipulating the earnings and financial statements of the company thus unethical. Therefore, stockholder cannot ethically become a customer in order to make purchases just to improve the sales and net income.

The amount of the purchase is of utmost importance since it helps in gauging whether the sales are normal or have a material impact on the financial statements of the company. 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-Two: Statement of Changes in Owner’s Equity – from Sophia by Sophia Tutorial

Case study of company called Legacy Realty that is in the business of owning and leasing their own 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 in order to create this statement.

Case Study-Three: Preparing a Statement of Changes in Equity – A Business Case:

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 in order to help them assess the company’s health and performance. Your manager has decided to divide the task among the members in the accounting team and has trusted you to prepare a draft Statement of Changes in Equity for the most recent year. You are provided with the following preliminary information for the previous year’s financial statements and the current year’s activity:

Opening balances of all equity accounts:

Item    $  
Share capital  500,000
Retained earnings23,500
Accumulated Other Comprehensive Income  6,500

Preliminary financial data:

  • Revenue was $555,200, and expenses were $490,700 for the year.
  • A Cash dividend of $10,000 was declared and paid in the current year.
  • A retrospective change in accounting policy (i.e., change in 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:

AccountShare capital  Retained earningsAccumulated Other Comprehensive IncomeTotal Equity
Beginning balance500,00023,5006,500530,000
Net income =555,200-490,700 64.500 64.500
Dividends         (10,000) (10,000)
Retrospective adjustment fore policy change  5,500                 5,500
Other Comprehensive Income  6,000     6,000
Ending balance              500,00092,50012,500605,000

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Category: Finance 4 Execs

This series is gradually building your understanding. If you follow through from the beginning, week on week we will build with you a sound understanding on the basics of Management Finance.

NEXT UP: CASH IS KING

Until then, stay safe and healthy. Bye for now. Wayne

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