This paper examines the fundamental components of stockholders' equity on corporate balance sheets. It defines stockholders' equity as the residual capital claim after liabilities are subtracted from assets, then systematically explores six primary equity accounts: common stock, additional paid-in capital, preferred stock, retained earnings, and treasury stock. The paper also addresses specialized equity transactions including accumulated other comprehensive income, stock splits, and stock dividends, illustrating concepts with examples from major corporations. By clarifying how each equity account functions and how transactions are recorded, this paper provides a practical reference for understanding the capital structure of publicly traded companies.
Stockholders' equity is an item of the balance sheet that represents the capital that has been raised by the investors in the business in exchange for stock, referred to as paid-in capital, retained earnings, and donated capital. It represents the stake of the investors in the company and is calculated by deducting the company's total liabilities from their total assets. Accounting experts commonly refer to stockholders' equity as the book value of the company since it captures the funds that were originally invested by the investors and the additional investments that they made thereafter (Lowe, 1961). It also captures earnings that the company retained over time. For older companies, most of which started as small outfits have grown and retained earnings represent the largest portion of stockholders' equity.
There are several types of stockholders' equity accounts. The first is common stock, which is the portion of the stock that is paid in by the investors. This is usually attributable to the par stock value. If the par stock value is minimal, then the balance on this account is often small. Where the stock does not have par value, for example in a startup, this account is not used in the balance sheet.
The second account is the additional paid-in capital on common stock. This represents the price that the investors paid for common stock in the company at a price above the fair market value of the stock. This account is only used if the state laws require the company to report a par value of the stock against the paid-in value in excess of the common stock. This is a requirement to assess capital gains in the part of the company selling stock. Google reports class A and B common stock and additional paid-in capital of $15 billion in the year ended 2009 and this has grown to $25 billion at the end of the year ended 2013 (Google Inc., 2013).
Preferred stock are the third account. This contains the amount that investors pay for preferred stock in a company. Preferred stock refers to a class of ownership where the stockholders have a higher claim on the company's assets and earnings than stockholders of common stock. Dividends are always paid out to holders of preferred stock while common stockholders may or may not be paid dividends based on the financial performance of the company (Soo & Soo, 1994). Preferred stockholders also do not have voting rights as common stockholders do. Google does not have any preferred stock accounts in their balance sheet meaning they have not issued preferred stock (Google Inc., 2013).
The fourth account for stockholders' equity is additional paid-in capital on the preferred stock. This is similar to the account for additional paid-in capital on common stock except this account is for preferred stock. It captures the prices that is paid by the company's investors for preferred stock at a price exceeding the fair market value of the stock (Nurnberg, Stickney, & Weil, 1975).
The fifth account for stockholders' equity is retained earnings. This refers to the cumulative income that the company has earned less the dividends paid out. Often companies reporting profits issue dividends at a certain percentage of the profit and retain the remainder to finance future activities. These retained earnings are the amount that the company uses to grow its capital base. This is illustrated in Google's balance sheet. Since the company has been profitable for several years, their retained earnings have increased from $20 billion to $61 billion over the last five years. Their stockholders' equity has also grown from $36 billion to $87 billion over the same period (Google Inc., 2013). However, a large value of retained earnings does not necessarily mean the company has a large cash balance since these retained earnings may be a portion of capital expenditure for the company in that year.
The last stockholders' equity account is the treasury stock account. This account is used when a company reacquires some of its stock from shareholders when it has a large amount of money that is lying idle. Companies often do this when the market price of the company's stock is low. Therefore, the company buys back its shares to reduce the number of shares available to trade thus increase their value. When a company reacquires its stock, the earnings per share for this company increases, increasing the demand for these shares. This in turn increases the stock price. Treasury stock is a contra account to stockholder's equity account since it is a debit balance in the ledger (Ray, 1962).
Treasury stock can be recorded using the cost method or the par value method. Using the cost method, the stock that the company acquires is debited to the treasury stock account and the amount is credited from the company's cash (Sprouse, 1959). When the company sells its treasury stock, the amount of stock sold is credited to the treasury stock account and the cash debited to the company's cash account.
Some companies invest their cash and retained earnings in foreign currency, hedge funds, pension funds, and other investment vehicles. The gains or losses from these investments are recorded separately under accumulated other comprehensive income. This account captures changes in stockholder equity other than by transactions by the investors. These changes often appear in the company's income statement and need to be recorded in the balance sheet as well. This is important to capture these gains or losses separately since though they affect the stockholders' equity by increasing or decreasing the paid-in capital (Maines & McDaniel, 2000). Google reported accumulated other comprehensive income of 125 million in the financial year ended 2013.
"Structural changes to shares and accounting impact"
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