Stockholders' equity
Corporations raise money by issuing shares. Equity accounting tracks contributed capital, retained earnings, dividends, and share buybacks.
The corporate form
A corporation is a legal entity separate from its owners, the stockholders, who have limited liability. Corporations can raise large amounts of capital by selling shares, and ownership can transfer easily, but they face more regulation and, for many, double taxation: corporate profits are taxed, and dividends are taxed again for shareholders.
Types of stock
Common stock gives owners voting rights and a residual claim on profits and assets. Preferred stock usually has no vote but receives dividends before common shareholders and has priority in liquidation. Some preferred stock is cumulative: missed dividends must be paid before common dividends.
Issuing stock
When stock is issued, cash is debited. Common Stock is credited for the par value (a nominal legal amount, often 0.01 dollars) and Additional Paid-in Capital for the excess. Issuing 1,000 shares of 1-dollar par stock for 20 dollars each records Common Stock 1,000 and Additional Paid-in Capital 19,000.
Dividends
Cash dividends are declared by the board of directors. On the declaration date, Retained Earnings is debited and Dividends Payable credited; on the payment date, Dividends Payable is debited and Cash credited. Shareholders of record on the record date receive the dividend.
Stock dividends and splits
A stock dividend distributes additional shares rather than cash, moving amounts from retained earnings to contributed capital without changing total equity. A stock split, such as 2-for-1, increases the number of shares and reduces par value proportionately, with no journal entry; it often aims to make shares more affordable.
Treasury stock
Treasury stock is a company's own shares that it has repurchased. It is recorded at cost as a contra-equity account, reducing total equity. Companies buy back shares to return cash to shareholders, raise earnings per share, or offset dilution from employee stock plans. Treasury shares do not vote or receive dividends.
Equity ratios
Return on equity (net income / average equity) measures returns to shareholders. Earnings per share (net income minus preferred dividends, divided by weighted average common shares) and the dividend payout ratio (dividends / net income) are widely used. The price-to-earnings ratio compares share price with EPS.
Worked example
A corporation has net income of 500,000 dollars, preferred dividends of 50,000, and an average of 150,000 common shares outstanding. EPS = (500,000 - 50,000) / 150,000 = 3.00 dollars. If its share price is 45 dollars, the P/E ratio is 15. If it pays 150,000 in common dividends, the payout ratio on common earnings is 150,000 / 450,000, about 33%.
Key takeaways
Corporations offer limited liability and easy share transfer but face regulation and double taxation. Common stock votes; preferred stock gets dividend and liquidation priority. Issued stock credits Common Stock at par and Additional Paid-in Capital for the excess. Cash dividends reduce retained earnings; stock dividends and splits do not change total equity. Treasury stock is a contra-equity account. ROE, EPS, payout ratio, and P/E measure equity performance.
Flashcard
Separate legal entity
Check your understanding
A company issues 2,000 shares of 1-dollar par common stock for 15 dollars per share. How much is credited to Additional Paid-in Capital?