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Introduction to Finance/Corporations/Stockholders' Equity

Corporations

Contents

Stockholders' Equity

Overview of Stockholders' Equity

Stockholders' equity is the equity section of the balance sheet for a corporation.
Equity is the owner's right to the resources of a business, and the equity of an organization is essentially its net worth. The equity is calculated as the difference between the assets and the liabilities. Stockholders' equity is the owners' equity in a corporation.

The Accounting Equation for Every Business

The accounting equation for corporations is basically the same for sole proprietors and partnerships. However, the equity for corporations, called stockholders' equity, includes contributed capital and retained earnings.
For corporations, the equity section of the balance sheet is referred to as the stockholders' equity section. This section is divided into two main sources of equity: contributed capital and retained earnings. These concepts are specific only to corporations. The main thing to note is that while the asset and liability sections remain the same, because ownership is different for corporations than it is for sole proprietors and partnerships, it is necessary to represent the equity section differently.

Stockholders' Equity Components

Components that are specific to the stockholders' equity section of the balance sheet include paid-in capital, retained earnings, and dividends. These components are necessary to describe the net worth of an organization.

Capital contributed to the corporation by its stockholders is called paid-in capital. It is the amount of capital that has been contributed or paid in by investors during stock issuances. This amount includes the par value of the shares themselves as well as any additional amount in excess of par value. The par value of the stock is the nominal value in dollars that are assigned to each share of stock on the stock certificate. Paid-in capital is specifically the funds raised from stock purchases, not from funds earned through ongoing operations. The amount of paid-in capital is separated by each class of stock.

Retained earnings include net income that is retained in a corporation, accumulated net income that has not been distributed to its owners. These earnings are available to reinvest in the organization's core business or can be used to pay down its debt or pay off creditors. The net income from each period increases retained earnings, while net losses and the distribution of earnings to stockholders decrease retained earnings. These increases and decreases are moved to the retained earnings account at the end of the period through closing entries. As a reminder, the retained earnings account is an equity account; therefore, it carries a normal credit (right side) balance. In closing entries, a credit represents an increase (net income), and a debit represents a decrease (net loss or dividends).

Moving Net Income to Retained Earnings Journal Entry

Date Description Debit Credit
Dec 31 Revenue accounts (to close) $5,000  
  Expense accounts (to close)   $2,000
  Retained Earnings (the difference)   $3,000
  To record the closing entries for the period and move net income to retained earnings    

In most cases, retained earnings will have a net credit balance because of income generated by the company. If there is a net debit balance in the retained earnings account, there is a deficit. This can happen if a company has experienced net losses on a continuous basis. When a deficit exists, the retained earnings of the corporation are deducted from the contributed capital to arrive at the total stockholders' equity. The balance in retained earnings does not represent cash.

A dividend is a distribution of the corporation's earnings in the form of cash, stock, or property to the stockholders as voted on by the board of directors. As stated above, dividends decrease the retained earnings account. Because the retained earnings account carries a net credit balance, the balance for dividends is typically a debit. Dividends are considered a contra-equity account because they decrease equity. Therefore, though it is a right side account, it is treated much like a left side account in posting transactions.

A board of directors may sometimes place restrictions related to dividends. A restriction is a limitation on the use of retained earnings as payment of dividends, used by a corporation's board of directors. Any restriction must be disclosed in the financial statements. Some types of restrictions are:

  • Legal—based on state laws that require a restriction of retained earnings
  • Contractual—based on a clause of a contract entered into by the corporation
  • Discretionary—based on voluntary restriction by the board of the corporation to restrict the retained earnings
<Nature of Corporations>Accounting for Stock Transactions