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Shareholder Equity Explained

Updated on March 15, 2017

Shareholder Equity Explained

Shareholder Equity

Shareholder equity is a section of a company balance sheet that can be misleading in some ways. This is because GAAP rules allow companies a good amount of latitude in how they chose to determine shareholder equity. The decisions made and actions taken by a company can have an impact on shareholder equity, and make the company look as if it is in financial health than it actually is. How a company chooses to value inventory depreciate assets, and handle the outstanding stock are a few things that will have an impact on shareholder equity and retained earnings. In this paper I will discuss the elements of shareholder equity and retained earnings, and how they are reported. I will also show how things such as share buy backs, dividends, and comprehensive income effect shareholder equity and retained earnings.

Shareholder equity is defined as what is left once a company satisfies all of its liabilities. The basic calculation for shareholder equity is assets minus liabilities equal liabilities. Shareholder equity is made up of four major components. These are paid in capital, retained earnings, comprehensive income, and treasury stock. “The four classifications within shareholders’ equity are paid-in capital, retained earnings, accumulated other comprehensive income, and treasury stock” (Spiceland, Sepe, & Nelson, 2011). Paid in capital are the amounts invested by shareholders into the business. Retained earnings are the amounts earned by the company. Comprehensive income is the changes in shareholder equity not reported in the traditional income statement. Treasury stock refers to shares sold that have been repurchased from shareholders.

Shareholder equity is reported on the balance sheet of a company’s financial statements. It is listed as a section under the company liabilities. There is a typical format used by most companies when reporting shareholder equity. This starts with the details of common stock, capital in excess of par, retained earnings, comprehensive income, and treasury stock, the total of these amounts will equal total shareholder equity. If there are any changes to a company’s equity accounts these changes are reported in a statement of shareholder equity. This statement will have more details of the amounts and transactions that caused the balances to change.


Comprehensive Income

Because comprehensive income is not from traditional business transactions, in 1997 FASB issued SFAS No. 130 for reporting comprehensive income. The main requirement of this is related to the reporting format of the income. The ruling also requires calculation and display of adjustments, display of any accumulated balances, and interim period reporting. There is some flexibility a company has in the format it chooses when reporting comprehensive income under SFAS 130. However, regardless of the reporting format it must start with net income so the components of comprehensive income can be added to reach total comprehensive income. “No Longer Buried in Equity SFAS No. 130, Reporting Comprehensive Income, requires a company to report comprehensive income and its components in a full set of financial statements and is effective for fiscal years beginning after December 15, 1997” (Brauchle, & Reither, 1997). Without the separate reporting of OCI gains and losses on the income statement would not give a clear or accurate picture of the company.

“Someone looking only at the income statement may otherwise think that the entity's wealth increased by $2 million during the period. However, an analysis of the changes in OCI for the period and related disclosures would reveal that while income increased by $2 million, OCI for the period decreased by the same amount, leaving total comprehensive income (and hence the wealth of the entity) unchanged” (Casabona, & Coville,2014).

Comprehensive, and accumulated comprehensive income are components of shareholder equity that require more detail because they are not from traditional business transactions. This section of shareholder shows for the most part the investing activities of the company. The gains and losses reported in this section are from things such as investments, benefit plans, derivatives, and foreign currency transactions.

Retained Earnings

Once all the assets and liabilities of a company have been accounted for we are left with net income or loss for the company. This is also referred to as retained earnings. If a company has a credit balance in their retained earnings account this represents amounts earned by the company but not distributed to shareholders. There are several ways a company can choose to distribute retained earnings. They can declare a dividend, or a stock split.

When a company chooses to distribute retained earnings by way of a dividend this will naturally decrease the balance in retained earnings. If a cash dividend is declared then an entry is made to reduce retained earnings and cash and record the liability. A company can also declare a non cash dividend also called a property dividend. This will also reduce the retained earnings account but not the cash balance. An example of a property dividend could be distributing to shareholders shares of stock the company was holding as an investment. When shareholders receive a cash dividend they are receiving a certain amount of new shares for each share they already own. However doing so increases the amount of shares outstanding and will reduce the share price. A dividend is recorded as a debit to retained earnings and a credit to paid in capital. “However, stock dividends allow firms to transfer retained earnings to paid-in capital, increasing the amount of paid-in capital, and specifically, changing the equity composition of capital structure” (Adaoglu, & Lasfer, 2011). A company can also choose to distribute retained earnings with a stock split. A company can declare a 2 for 1 stock split. In this case each shareholder would receive 2 shares of stock for each one owned. If a shareholder held 100 shares priced at $100 a share, after a 2 for 1 split they would now have 200 shares valued at $50 a share. In both cases the value of the shares is still $1,000.00. This kind of distribution increases the share count and reduces the share price, but does not affect retained earnings like a cash dividend. “The effect of the stock dividend on the stockholders equity is much greater. It increases the number of shares outstanding and increases the total legal capital without decreasing the total equity. This means there must be a transfer from either paid in capital in excess of the legal requirements or from retained earnings. In most circumstances the transfer comes from retained earnings” (Lowe, 1961). When company have a stock spilt the paid in capital account is increase and the offset is stock and not retained earnings.

Share Repurchases and Issued

When a company decides to repurchase stock, it does not seem to be a distribution of earnings but in fact they it is. The reason being that when a company repurchases shares it increases the earnings per share which benefits shareholders because their stake in the company is now worth more. Any gains from the increase in the share price are tax at a lower capital gains rate as opposed to dividends which are taxed at a higher income tax rate. This can be look at as a return on investment, or a way the company is redistributing the earning of the company. “To the extent this strategy is effective, a share buyback can be viewed as a way to “distribute” company profits without paying dividends” (Spiceland, Sepe, & Nelson, 2011). Many companies prefer share buyback to dividends because unlike a dividend there is no obligation to repurchase any stock. If the company does repurchase stock it does not have to do so on a regular basis. If a company is repurchasing shares and stops it is not viewed as a negative event such as lowering to ending a dividend. However a company may have many different reasons for a share buyback. Many of which will have nothing to do with wanting to give shareholders a return on investment.

One major reason companies repurchase shares is to manage the capital structure of the company. “As companies buy back stock, the equity base contracts and debt/equity ratios increase. Repurchases, thus, are a tool for managing capital structure” (Konan, Ikenberry, & Inmoo, 2004). One way this can be done is if a company knows that employees are going to exercise compensation based stock options by employees. When employee exercise options it dilutes the share so buying those shares back is one way to maintain the current share structure. Oher reasons for share repurchases can be to distribute in a merger or prevent a hostile takeover.

Once company stock is repurchased it can be accounted for in a couple different ways. One way is to formally retire the shares, or classify the shares as treasury stock. Treasury shares have no voting rights and receive no dividends. When a company uses cash to purchase shares and retires them, the size of the company is reduced. The company has less cash, and the amount of shares outstanding are also reduced. Retiring shares are recorded as a debit to Stock, paid in capital, and retained earnings, and a credit to cash. When shares are repurchased as treasury stock, it is intended to be resold at a later date. This is recorded as a debit to treasury stock and a credit to cash. This is considered a temporary or incomplete transaction. When the treasury shares are sold, it is when the transaction is considered complete.

Companies will issues and sell new shares in the open market to raise equity. A company can sell common or preferred shares for cash or non-cash considerations. If a company has to issue shares on the open market it is usually to raise cash for different reasons. A company could issue new shares to give as employee options or to use to acquire another company. The new shares in the market lowers the earnings per share. The company does receive cash in the transaction. When companies do issue stock it is usually common stock. Companies can have more than one class of common stock, usually Common stock can have for example class A, B, and C shares. Common and preferred stock has certain rights associated with it. These rights are the right to share in the profits and loss of the company, voting rights, and liquidation rights. Preferred stock holders will have even more rights. The major difference between preferred and common shareholders is preferred holders will be paid before holders of common shares. This is if a dividend is declared, or if the company liquidates. Preferred shares can also have a convertible option, where they can be converted into common shares.

When shares are issued for cash. The cash account is debited and the corresponding stock account either common preferred or both is credited for the par value, and paid in capital in excess of par is credited. When stock is issued for non-cash considerations, the transaction is listed at fair value of the asset best known. Some things that can be used to determine fair value is the market price of the shares, the cash amount that would have been paid for the asset, or an independent appraisal. When a company issues new shares, it dilutes the existing shareholders so they have less ownership in the company.

Conclusion

In conclusion shareholder equity is the profits or losses that is left after a company satisfies all of its liabilities. The basic calculation is assets minus liabilities equal shareholder equity. The shareholder equity section of the financials can be found on the company’s balance sheet, listed under liabilities Shareholder equity involves many different variables. Shareholder equity is comprised of paid in capital, retained earnings, comprehensive income, and treasury stock. There are many different things a company can do that will affect shareholder equity, and retained earnings. Some of these things include, issuing or repurchasing the company shares on the open market, they can choose to declare a dividend to or have a stock split to redistribute the earnings back to shareholders. Knowing the things that have an impact on shareholder equity such as depreciation, inventory valuation, as well as the company share structure will give a clearer picture of the financial health of the company.

References

Adaoglu, C., & Lasfer, M. (2011). Why Do Companies Pay Stock Dividends? The Case of Bonus Distributions in an Inflationary Environment. Journal Of Business Finance & Accounting, 38(5/6), 601-627. doi:10.1111/j.1468-5957.2011.02233.x

Brauchle, G. J., & Reither, C. L. (1997). SFAS No. 130: Reporting comprehensive income. CPA Journal, 67(10), 42.

Casabona, P. A., & Coville, T. (2014). Statement of Comprehensive Income: New Reporting and Disclosure Requirements. Review Of Business, 35(1), 23-34.

Lowe, H. D. (1961). The Classification Of Corporate Stock Equities. Accounting Review, 36(3), 425.

Konan, C., Ikenberry, D., & Inmoo, L. (2004). Economic Sources of Gain in Stock Repurchases. Journal Of Financial & Quantitative Analysis, 39(3), 461-479.

Brauchle, G. J., & Reither, C. L. (1997). SFAS No. 130: Reporting comprehensive income. CPA Journal, 67(10), 42.

Spiceland, J. D., Sepe, J. F. & Nelson, M.W. (2011). Intermediate accounting (6th ed.). New York, NY: McGraw-Hill Irwin. ISBN: 9780077500375.

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