Owner Equity and Changes in Owners EquityOwner’s equity represents the residual claims of the owners to the assets of the business and sometimes is referred to as net assets or net worth. The balance sheet shows the total amount of owner’s equity at a point in time and includes the amounts invested by the owners and the profits retained or reinvested in the business. The statement of owner’s equity shows any additional investments made during the year, the profit or loss, and the amounts withdrawn by or distributed to the owners.

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In this post I will bring you into a closer look of owner’s equity and its changes; what makes it change, why and how it changes. I will begin by discussing the basic characteristics and concepts of owner’s equity for three types of business entities: sole proprietorships, partnerships, and corporations. In the final portion of this post, we will discuss corporations in more detail. Along, I will overview owner’s equity on each type of the business entities. As usually, it is illustrated with case examples. Enjoy!

 

 
Sole Proprietorships

A sole proprietorship is a business with a single owner, often the person who manages the business. Legally, the business is not considered separate from the owner; the owner is personally responsible for business actions and can be personally liable for business debts. However, according to the business entity assumption, business activities are reported separately from the personal activities of the owner. Personal expenses of the owner paid by the business and the owner’s salary are treated as withdrawals and not as business expenses. The results of business activities are included on the owner’s personal income tax return, and the owner personally pays income taxes on business profits; the business entity is not taxed.

In the case of a sole proprietorship, the owner’s equity is referred to as capital, which includes the owner’s investments and profits retained by the business presented as a single amount on the balance sheet, as shown below:

Balance Sheet [Partial]
December 31, 2009

Owner’s Equity
Lie, Capital $400,000

 

An additional financial statement, the statement of owner’s equity, shows the cause of any changes in owner’s equity that occurred during the year. The next figure shows the statement of owner’s equity for 2010, the second year of business operations:

Statement of Owner’s Equity
For the Year Ended December 31, 2010

Capital, January 1, 2010          $400,000
Add: Owner Investments            20,000
Net Income for 2010                   80,000
Total                                        500,000
Less: Withdrawals                     (40,000)
Capital, December 31, 2010    $460,000

 

This statement shows that the owner invested $20,000 of additional capital in the business during the year, the increase in owner’s equity when the business earned a profit of $80,000, and that the owner withdrew $40,000 of the profits for personal use, but the remainder of the earnings were reinvested or retained by the business. The year-end capital balance of $460,000 includes the amounts invested by the owner as well as the profits which were retained or reinvested in the business.

 

 
Partnerships

A general partnership is a voluntary association of two or more owners which can be based on a simple verbal agreement but ideally should be based on a written contract. Partners may consist of individuals, other business entities, estates or trusts, or other parties. In fact, many business joint venture activities are structured as partnerships.

Similar to a sole proprietorship, a general partnership is not considered to be a legal entity “separate from its owners, although the business is considered a separate accounting entity. The partners are personally responsible for business actions and can be held personally liable for business debts. Personal expenses paid by the partnership and the partners’ salaries are treated as withdrawals and not as business expenses.

The partnership files an informational income tax return and reports each partner’s share of the income to the taxing authorities. However, the partnership entity IS NOT taxed on its income; each partner’s share of the income is reported and taxed on each partner’s separate income tax return.

 

If the business in the earlier example had been structured as a partnership with two owners, the 2010 financial statements would include the information. Recall that a partnership had two owners: Lie invested and owned a one-fourth interest and Lou invested and owned the other three-fourths of the partnership. Partnership income can be divided among the partners in any manner to which they agree, but in the absence of an agreement, each is considered an equal partner and is entitled to an equal share of the profits. However, in this example, we assumed that the partners agreed to divide the profits on the basis of the relative capital invested, with one-fourth (1/4) going to Lie and three-fourths (3/4) to Lou. The withdrawals might be the share of the partnership profit each partner is allowed to withdraw in lieu of a salary.

 

 
Partnerships and Related Business Forms

The discussion above was based on what might be called a general partnership, but there are many partnership-like variations for entities with multiple owners. Some are more like partnerships and others are more like corporations, with a range of variations in between. Each form has its unique advantages and disadvantages, often pertaining to which owners have the authority to manage the business and make decisions, the risk of personal liability of the owners, or differences in the way business income and distributions are taxed. The characteristics, advantages, and disadvantages of each of these business forms should be investigated and understood before one selects a particular form of business entity, based on expert accounting and legal advice.

Although a detailed discussion of various forms of entities is beyond the scope of this post, here I provide short outlines for the more common ones below:

  • General Partnership – In a general partnership, each partner has the right to conduct business on behalf of the partnership, is entitled to a share of the profits, and has a residual interest in the net assets, but can be held personally liable for actions against the partnership and for partnership debts.
  • Limited Partnership – There must be at least one general partner with decision-making authority and personal risk in a limited partnership entity. The limited partners are more like passive investors; they provide capital to the business and usually are guaranteed a return on their investments. They do not participate in the management of the business and are not personally liable for partnership debts.
  • Limited Liability Partnership (LLP) – A limited liability partnership is similar to a general partnership in terms of the rights to participate in management, a share of the profits, and a residual interest in net assets. However, the individual partners generally are protected from personal liability unless it is caused by a partner’s own personal negligence or malpractice.
  • Limited Liability Company (LLC) – A limited liability company is a bit more like a corporation as the owners are not liable for business debts but similar to a general partnership in the distribution and taxation of profits. The owners of an LLC are referred to as members.

 

 
Corporations

A corporation is both a separate legal entity and a separate accounting entity and is formed subject to the laws of the state in which it is incorporated. Ownership in a corporation is evidenced by shares of stock; the equity of an individual stockholder is based on the proportion of the total stock that is owned. If the corporation is publicly held, its shares of stock may be purchased and sold readily by investors, and the individual owners of the corporation may change frequently. A nonpublic or closely held corporation may establish limitations pertaining to the type of parties permitted to own stock or the conditions for selling stock to other parties. A corporation may have a single stockholder, a few owners or hundreds, and the owners may be individuals, partnerships, estates or trusts, corporations, or other parties.

Because a corporation is a legal entity that is separate from its owners, the stock-holders do not participate in its management or operations unless they also happen to be officers or employees.

Stockholders are not personally liable for business activities or business debts. A corporation files a tax return and also pays income taxes on the income earned by the corporation. In addition, the stockholders also may be individually subject to income taxation on earnings distributed as cash dividends, other distributions, and gains and losses from the sale of their stock investments.

 

In the case of a corporation, owners’ equity is referred to as stockholder’s equity. Owners receive shares of stock as evidence of their ownership and investment in the corporation, typically common stock, although there are other types. A public corporation may have hundreds of stockholders, and ownership can change daily as shares of stock are traded in the financial markets. As a result, a corporation reports the amounts originally invested (contributed) by the stockholders and the profits retained by the corporation rather than the equity of individual owners.

The next figure shows how stockholder’s equity is presented if the business is structured as a corporation:

Corporation Balance Sheet [Partial]
December 31, 2009

Stockholder’s Equity
Common Stock, 40,000 shares  $  80,000
Retained Earnings                      $ 320,000
Total Stockholder’s Equity         $400,000

 

Although the equity of an individual stockholder is not presented in the financial statements, this can be determined by calculating the book value of a share of stock. In this case by dividing total stockholders’ equity of $400,000 by 40,000 shares of stock, the book value is $10 for one share of stock. The equity of an individual stockholder who owns 10,000 shares, or one-fourth of the stock, is $100,000 (10,000 shares x $10 book value per share), which is equivalent to the amount of Lie’s capital balance in the previous partnership example.

The next figure shows the statement of stockholders’ equity that would be presented in the corporation’s 2010 financial statements. Stockholders invested an additional $20,000 by purchasing additional common stock. The corporation earned a profit of $80,000, of which $40,000 was distributed to its stockholders in the form of cash dividends and the remaining profit earned in 2010 was retained or reinvested.

At December 31, 2010 the corporation has $100,000 of common stock which represents the amounts stockholders invested, and retained earnings of $360,000 which represents the cumulative amount of profits earned to date that were retained by the corporation.

Statement of Stockholder’s Equity
For the Year Ended December 31, 2010

                                                        Common     Retained       Total
                                                        Stock           Earnings

Balances, January 1, 2010               $80,000        $320,000       $400,000
Add: Common Stock Issued             20,000                                  20,000
Net Income for 2010                                                80,000           80,000
Less: Dividends Declared                                      (40,000)         (40,000)
Balances, December 31, 2010        $100,000        $360,000      $460,000

 

Balance Sheet [Partial] December 31, 2010
Stockholders’ Equity

Common Stock                     $100,000
Retained Earnings                   360,000
Total Stockholder’s Equity   $460,000

 

Building on the basic stockholder’s equity concepts above, the final portion of this post will focus on additional concepts and terminology likely to be found in the financial statements of a corporation.

 

 
Common Stock

The corporate charter indicates the types and amount of stock a corporation is authorized to issue. Most corporations have common stock or capital stock. Common stockholders are the true owners of the business and are entitled to one vote for each share of stock owned. Stockholders do not participate directly in the management of the business unless they also happen to be directors, officers, or employees.

Stockholder participation is based on exercising voting rights to elect the board of directors and certain other matters. One may control a corporation by owning more than 50 percent of the stock, although control may be achieved with lesser ownership if other stockholders do not unite and vote as a unit or by other means.

 

Common stockholders have the right to receive a proportionate share of cash dividends if and when they are declared by the board of directors, but common stock does not carry a stated or guaranteed cash dividend. Common stockholders also have the first right to purchase a proportionate share of any additional stock issued, and to receive a proportionate share of corporate assets upon liquidation, but only after creditor claims and other claims have first been paid.

 

 
Preferred Stock

Corporations may also be authorized to issue other types of stock, such as preferred stock, which may appeal to a different set of investors than those who invest in common stock. Despite its name, “preferred stock” IS NOT necessarily a better or a preferred type of investment; rather, the term preferred is used for a category of stock which conveys specific or preferential rights that common stockholders do not receive.

Preferred stockholders do not have voting rights; however, there is a stated cash dividend that will be paid to preferred stockholders and must be paid before distributions to the common stockholders can be made. In most cases, preferred stock dividend rights are cumulative; if a corporation is unable to pay the required preferred stock dividend in a particular year, the amounts accumulate and must also be paid before any distributions to the common stockholders. If a corporation has past-due or dividends in arrears, it will disclose this information in the financial statement footnotes.

Preferred stockholders have other special rights; they will be paid a stated amount for their stock if the corporation retires or redeems it, and if the corporation liquidates and creditors have been paid, the preferred stockholders will be paid for their equity before any distributions can be made to the common stockholders.

 

“Par Value” or “Stated Value”

The corporate charter may specify a par value or stated value associated with a share of stock. “Par valueis a legal concept that generally specifies the minimum amount stockholders must invest in the corporation at the time the stock is first issued and a minimum amount of capital the corporation must maintain. In theory this provides some protection to corporate creditors whose claims can be paid only from corporate assets (and not from the personal assets of the owners as might happen in the case of a sole proprietorship or partnership).

  • For common stock, the par or stated value is usually a nominal amount and should not be viewed as an indication of the current market price or value of one share; in fact, the par value of some company’s common stock is one penny. The amount stockholders invest typically is greater than the par value of the common stock, and the excess is reported separately as contributed capital in excess of par value.
  • For preferred stock, the par value is the amount on which the stated dividend will be based. For example: a share of preferred stock with par value of $100 and a 10 percent dividend rate will be paid a $10 cash dividend each year.

 

 

Retained Earnings, Deficits, and Restrictions

Let’s use a simple example to illustrate what we mean by retained earnings or reinvested earnings and explain why even a profitable corporation may not distribute its profits to its stockholders.

Case Example

Assume a corporation’s net income for its first year of operations was $100,000, and it has $100,000 in cash in the bank at year-end. Rather than paying cash dividends to its stockholders now, the company can grow bigger and faster if it reinvests those earnings in a building it needs, and so it purchases a building with the $100,000 in cash. At year end it has $100,000 of retained earnings but no cash because its earnings were reinvested in the building it purchased.

Next year its net income is $200,000, but it still has no cash; it paid for all of its operating expenses but has not collected the $200,000 its customers still owe from this year’s sales even though it expects it will collect this amount early next year. At this point, the corporation has earned a total of $300,000 of net income and has $300,000 of retained earnings, but still it has not paid the stockholders any cash dividends. However, if the corporation reinvests its earnings and continues to perform well, the market price of its stock may increase over time and the stockholders will be better off in the long run than they would be if they received cash dividends now and purchased some other type of investment.

 

A company may have profits but no cash. It may have retained earnings but no cash. It may have profits and cash but can create greater value in the long run by reinvesting its earnings and cash instead of paying cash dividends.

Instead of retained earnings, a corporation may have a deficit. Most people associate this term with news broadcasts about the economy and the federal government. Deficit spending means that the government is spending more than it brings in from income tax revenues and other sources. A trade deficit means that the value of goods the United States imports exceeds the value of the goods it exports to other countries. In the case of a corporation, a deficit means that since the time of incorporation its cumulative losses have exceeded its cumulative profits and this is definitely not a good signal.

Retained earnings that are earmarked for particular purposes or are legally unavailable for distribution to the owners are disclosed in the financial statements or the footnotes. Some borrowing agreements may restrict the amount of earnings available for dividends until the loans are repaid, but a corporation may restrict its earnings voluntarily as a signal of its plans for future expansion or for other reasons.

 

 
Dividends

Dividends are a distribution of past or present earnings to the stockholders, but they are not expenses of the corporation and do not appear on the income statement. Dividends are similar to owner withdrawals in a sole proprietorship or a partnership; however, it is the board of directors, not the owners, which determines the amount and timing of dividend payments.

Preferred stockholders are entitled to a specified dividend stated on the stock certificate: a fixed dollar amount or a percentage of the par value.

 

Common stock ordinarily does not have a specified dividend rate. The amount of dividends declared is at the discretion of the board of directors even if the corporation has paid regular cash dividends in the past.

Rather than distributing cash, the corporation may declare a stock dividend, and each stockholder receives a proportionate amount of the stock distributed. When a company’s stock price continues to rise, it may declare a stock split to keep the price of a share in a more reasonable zone. For example, if the market price of one share of stock has risen to $200, the corporation may declare a two-for-one stock split. Each owner will have twice as many shares as before the split, but each share will be worth half as much because the market price would be expected to decline to $100 after the stock split.

 

 
Treasury Stock

Just like any other investor, a corporation can purchase shares of stock in other companies or even its own stock. Treasury stock represents a corporation’s own shares of stock which were issued to its stockholders but have been reacquired by the corporation. As was discussed in other sections of this post, investments in the stock of other companies may be found under several different balance sheet classifications, depending on the purpose and intended holding period. However, when a corporation purchases (reacquires) its own stock from existing stockholders, it is not considered an asset; instead, it is shown as a deduction from total stockholder’s equity as less stock owned by outside investors.

A corporation may purchase its own stock for many reasons. If the market price is falling, it can purchase the shares at a low price and perhaps sell (reissue) them later when the price goes up. It may purchase shares to avoid a hostile takeover of the company or to distribute to key executives later as additional compensation or to sell to employees as part of an employee stock ownership plan. Shares held in the treasury have no voting or dividend rights; treasury stock represents shares that were issued but are no longer outstanding for voting and dividend purposes.

Treasury stock is shown as a deduction from total stockholder’s equity in the balance sheet, along with disclosure of the number of treasury shares held and any restrictions placed on retained earnings. If the shares later are reissued at a price higher or lower than their price when purchased, those gains or losses are reflected as increases or decreases in stockholder’s equity, not in the income statement. A corporation cannot report profits or losses from dealing in its own stock.

 

 
Accumulated Other Comprehensive Income

You may [or may not] know that trading and available for sale securities are adjusted to market value on the year-end balance sheet. The unrealized holding gain or loss on trading securities is reported in the income statement; however, if the investments are classified as available for sale, the unrealized gain or loss is reported in stock-holders’ equity, not included in net income or in the year-end retained earnings.

Accounting guidelines firmly support the notion that all revenues and/or gains and expenses and/or losses be reported in the income statement, with proper classifications and disclosures. However, there are a handful of exceptions, including the unrealized holding gain or loss on available for sale securities and some others which are beyond the scope of this post. Since these gains and losses bypass the income statement, thus are not reflected in retained earnings at year-end, stockholders’ equity includes these unique types of gains and losses in a separate caption, referred to as accumulated other comprehensive income.

On the basis of the additional concepts discussed above, below figure provides a more detailed illustration of the stockholder’s equity portion of the balance sheet. Follow on…

 
Balance Sheet: Stockholder’s Equity
December 31, 2010

Contributed Capital

10% Preferred Stock, $100 par value,
1,000 shares authorized, 100 shares 
issued and outstanding                                        $10,000

Common Stock, $5 par value,
50,000 shares authorized, 5,000 shares 
issued, of which 100are held as 
treasury stock                                                        25,000

Contributed capital in excess of par
value on common stock                                         65,000

Total Contributed Capital                                                       $100,000
Retained Earnings                                                                     360,000
Accumulated Other Comprehensive Income                               30,000
Less:  Treasury Stock, 100 shares (at cost)                                (3,000)
Total Stockholders’ Equity                                                      $487,000

 

Note:

The amounts invested by the preferred and common stockholders are shown first under the heading of contributed capital and the income reinvested in the corporation is shown separately asretained earnings:

  • As you review the above, note that each type of stock is shown separately, along with some additional information. For example: the corporate charter authorized the corporation to issue 1,000 shares of preferred stock, but to date it has issued only 100 of the 1,000 shares authorized. It can issue additional preferred stock at a future date without having to amend its charter. The preferred stock has a par value of $100 and a 10 percent stated dividend rate; the annual dividend requirement is $10 per share, and preferred stock dividends must be paid before the common stock-holders receive any distributions.
  • The corporate charter authorized the issue of 50,000 shares of common stock, but only 5,000 of those shares have been issued to date; additional stock can be issued at a later date if the corporation needs to raise more capital to finance growth and expansion. The par value of the common stock, typically a nominal amount, is only $5 per share; the amount reported as common stock represents the par value of the 5,000 shares issued or $25,000. However, when the common stock was issued, the market price must have been much higher than $5 per share. The common stockholders contributed (invested) $65,000 more than the par value, for a total investment of $90,000; thus, the 5,000 shares of common stock were issued at an average market price of $18 a share.
  • Sometime after the common stock originally was issued, the corporation reacquired 100 shares of its own stock, which appears as a deduction from stockholders’ equity, not as an investment in the asset section of the balance sheet. The $3,000 amount reported as treasury stock is based on the cost at the time the stock was reacquired. Thus, the market price when the 100 shares were reacquired must have been at an average price of $30 per share.
  • Finally, corporation reports $30,000 as accumulated other comprehensive income. Perhaps this is the unrealized holding gain on available for sale securities that was discussed in an earlier section of this post; this signifies that the company has investments in available for sale securities for which the current market value is $30,000 greater than their cost.