Aug 28, 20224 min read

Stockholders Equity

What is Stockholders Equity?

Stockholders Equity (also known as Shareholders Equity) is an account on a company’s balance sheet that consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities. By rearranging the original accounting equation, Assets = Liabilities + Stockholders Equity, it can also be expressed as Stockholders Equity = Assets – Liabilities.

Stockholders Equity provides highly useful information when analyzing financial statements. In events of liquidation, equity holders are last in line behind debt holders to receive any payments. This means that bondholders are paid before equity holders.

Therefore, debt holders are not very interested in the value of equity beyond the general amount of equity to determine overall solvency. Shareholders, however, are concerned with both liabilities and equity accounts because stockholders equity can only be paid after bondholders have been paid.

Components of Stockholders Equity

Stockholders Equity is influenced by several components:

Share Capital – amounts received by the reporting entity from transactions with its owners are referred to as share capital.
Retained Earnings – amounts earned through income, referred to as Retained Earnings and Accumulated Other Comprehensive Income (for IFRS only).
Net Income & Dividends – Net income increases retained earnings while dividend payments reduce retained earnings.

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1. Share Capital

Share Capital (contributed capital) refers to amounts received by the reporting company from transactions with shareholders. Companies can generally issue either common shares or preferred shares. Common shares represent residual ownership in a company and in the event of liquidation or dividend payments, common shares can only receive payments after preferred shareholders have been paid first.

If a company were to issue 10,000 common shares for $50 each, the contributed capital would be equal to $500,000. The journal entry would be:

DR Cash 500,000

CR Common Shares 500,000

In addition to shares being sold for cash as in the previous example, it is also common to see companies selling shares on a subscription basis. In these situations, the buyer usually makes a down payment on purchasing a certain number of shares and agrees to pay the remaining amount at a later date. For example, if XYZ Company sells 10,000 common shares for $10 each on a subscription basis that requires the buyer to pay $3 per share when the contract is signed and the remaining balance 2 months later, the journal entry would appear as follows:

DR Cash 30,000

DR Share Subscriptions Receivable 70,000

CR Common shares subscribed 100,000

The share subscriptions receivable functions similar to the accounts receivable (A/R) account. Once the receivable payment is paid in full, the common shares subscribed account is closed and the shares are issued to the purchaser.

DR Cash 70,000

CR Share Subscriptions Receivable 70,000

DR Common shares subscribed 100,000

CR Common Shares 100,000

More Share Terminology

A few more terms are important in accounting for share-related transactions. The number of shares authorized is the number of shares that the corporation is allowed to issue according to the company’s articles of incorporation. The number of shares issued refers to the number of shares issued by the corporation and can be owned by either external investors or by the corporation itself.

Finally, the number of shares outstanding refers to shares that are owned only by outside investors, while shares owned by the issuing corporation are called treasury shares.

The relationship can be visualized as follows:

Shares Authorized ≥ Shares Issued ≥ Shares outstanding

Where the difference between the shares issued and the shares outstanding is equal to the number of treasury shares.

2. Retained Earnings

Retained Earnings (RE) are business’ profits that are not distributed as dividends to stockholders (shareholders) but instead are allocated for investment back into the business. Retained Earnings can be used for funding working capital, fixed asset purchases, or debt servicing, among other things.

To calculate retained earnings, the beginning retained earnings balance is added to the net income or loss and then dividend payouts are subtracted. A summary report called a statement of retained earnings is also maintained, outlining the changes in retained earnings for a specific period.

The Retained Earnings formula is as follows:

Retained Earnings = Beginning Period Retained Earnings + Net Income/Loss – Cash Dividends – Stock Dividends

3. Dividend Payments

Dividend payments by companies to its stockholders (shareholders) are completely discretionary. Companies have no obligation whatsoever to pay out dividends until they have been formally declared by the board. There are four key dates in terms of dividend payments, two of which require specific accounting treatments in terms of journal entries. There are various kinds of dividends that companies may compensate its shareholders, of which cash and stock are the most prevalent.

Applications in Personal Investing

With various debt and equity instruments in mind, we can apply this knowledge to our own personal investment decisions. Although many investment decisions depend on the level of risk we want to undertake, we cannot neglect all the key components covered above. Bonds are contractual liabilities where annual payments are guaranteed unless the issuer defaults, while dividend payments from owning shares are discretionary and not fixed.

In terms of payment and liquidation order, bondholders are ahead of preferred shareholders, who in turn are ahead of common shareholders. Therefore, from an investor’s perspective, debt is the least risky investment, and for companies, it is the cheapest source of financing because interest payments are deductible for tax purposes and also because debt generally offers a lower return to investors.

However, debt is also the riskiest form of financing for companies because the corporation must uphold the contract with bondholders to make the regular interest payments regardless of economic times.

Applications in Financial Modeling

Calculating stockholders equity is an important step in financial modeling. This is usually one of the last steps in forecasting the balance sheet items. Below is an example screenshot of a financial model where you can see the shareholders equity line completed on the balance sheet.