5.4 The Statement of Owner’s Equity

What Is Equity?

Recall that the accounting equation can help us see what is owned (assets), who is owed (liabilities), and finally who the owners are (equity). The statement of owner’s equity addresses the last segment of the accounting equation in detail by laying out the equity elements of the firm and highlighting changes in these elements throughout the period.

Equity represents the ownership of the firm. The stockholders’ equity section of the balance sheet for corporations contains two primary categories of accounts. The first is paid-in capital or contributed capital—consisting of amounts paid in by owners. The second category is earned capital, consisting of amounts earned by the corporation as part of business operations. On the balance sheet, retained earnings is a key component of the earned capital section, while the stock accounts such as common stock, preferred stock, and additional paid-in capital are the primary components of the contributed capital section.

Common stock represents ownership in the firm. Common stockholders normally have voting rights. Preferred stock has unique rights that are “preferred,” or more advantageous, to shareholders than common stock. Unlike common stockholders, preferred shareholders typically do not have voting rights and do not share in the common stock dividend distributions. Instead, the “preferred” classification entitles shareholders to a dividend that is fixed (assuming sufficient dividends are declared). Treasury stock is shares that were outstanding and have been repurchased by the firm but not retired. Thus they are still issued, but not outstanding. Additional paid-in capital is the difference between the issue price and par value of the common stock. For example, if a firm issued and sold stock at a market price of $20 that had a $5 par value, $5 for each share would be recorded into common stock and the excess $15 per share would be recorded into the additional paid-in capital account.

If we review the balance sheet for Clear Lake Sporting Goods, we see just two elements of equity: common stock and retained earnings. Common stock in the prior year was $75,000 and increased to $80,000 in the current year, indicating Clear Lake issued additional common stock (see Figure 5.13).

Figure 5.13 Stockholder Equity Section of Balance Sheet

Distributions to Owners

When firms earn a profit, they have two options as to what to do with their earnings. They can keep (retain) them and reinvest them back into the business, or they can pay them out to their shareholders in the form of dividends. Dividends are commonly in the form of cash, but dividends can be paid out in the form of stock or other assets as well.

To pay a cash dividend, the firm must have enough cash on hand and sufficient retained earnings. They cannot pay out a dividend beyond the retained earnings available. Some companies issue shares of stock as a dividend rather than cash or property. This often occurs when the company has insufficient cash but wants to keep its investors happy. When a company issues a stock dividend, it distributes additional shares of stock to existing shareholders.

A property dividend occurs when the firm pays out dividends in the form of something other than stock or cash, often one of their assets or something they hold in inventory. For example, Walt Disney Company may choose to distribute tickets to visit its theme parks. A property dividend may be declared when a company wants to reward its investors but doesn’t have the cash to distribute, or if it needs to hold on to its existing cash for other investments.

Remember, the retained earnings account reflects the cumulative earnings of a firm since they began business, less dividends paid out to shareholders. This includes all forms of dividends (cash, stock, and other assets). Note that dividends are distributed or paid only to shares of stock that are outstanding. Treasury shares are not outstanding, so no dividends are declared or distributed for these shares. Regardless of the type of dividend, the declaration always causes a decrease in the retained earnings account.

Elements of the Statement of Owner’s Equity

Now that we have covered the basic elements of equity and know what dividends are, we have the basic pieces we need to create the statement of owner’s equity. The statement is broken out into columns, one for each element of equity: common stock, preferred stock, additional paid-in capital, retained earnings, and treasury stock.

The first line of the statement provides the balance of each segment as of the first day of the period. Each following line provides information on any events during the period that changed the value of any of the accounts. Common examples of events found on the statement include net income or loss for the period, issuing common or preferred stock, purchasing or selling treasury stock, and declaring a dividend.

Clear Lake Sporting Goods has just common stock and retained earnings to report in their statement of owner’s equity. They had just two events to report in their statement that impacted their equity accounts; they reported net income and they issued dividends (see Figure 5.14).

Figure 5.14 Statement of Stockholder Equity for Clear Lake Sporting Goods