A company’s balance sheet has three primary components. These include assets, liabilities, and equity. Assets represent resources that companies own or control and may result in future inflows of economic benefits. On the other hand, liabilities are the obligations that a company accumulates due to its past deals. These obligations may result in outflows of economic benefits in the future.
Both assets and liabilities are crucial for the company. These represent the primary components that fund a company’s working capital. However, equity is also equally important. Equity represents the residual amount after deducting a company’s liabilities from its assets. In the balance sheet, it comes under the shareholders’ equity section. There are several accounts that may appear under it. However, it is critical to understand stockholders’ equity first.
What is Stockholders’ Equity?
Stockholders’ equity in the balance sheet represents a company’s equity accumulated over the years. In accounting, it represents the residual amount after deducting liabilities from assets. However, it is much more than just the difference between the two figures. Stockholders’ equity represents the amount that the company’s shareholders will receive if the company liquidates.
Stockholders’ equity refers to a company’s shareholders’ rights to its assets. However, they cannot receive these assets when the company is operational. When the company liquidates, it will pay its liabilities off first from the existing assets. Any residual amount will go to the company’s shareholders. It is the definition of equity in accounting. However, several factors may impact this amount.
Stockholders’ equity also represents a company’s book value. For stakeholders, this value is critical as it defines how much it the company is worth. The calculation for a company’s book value involves subtracting its liabilities from its assets. The same definition applies to the stockholders’ equity balance reported in the balance sheet.
However, the stockholders’ equity doesn’t only represent the difference between assets and liabilities. It contains several components, that when accumulated, will equal the company’s equity. These components include paid-in capital, additional paid-in capital, retained earnings, treasury stock, preferred stock, etc. Most companies will only have the first three components under the equity in the balance sheet.
What are the Stockholders’ Equity Accounts?
The stockholders’ equity accounts represent a company’s total equity. As mentioned, there are several accounts that companies will report under the shareholders’ equity section. Usually, these include paid-in capital, additional paid-in capital, retained earnings and treasury stock. Some companies may report their stock as share capital and share premium.
Overall, these accounts make up a company’s shareholders’ equity. For some companies, it may also include other reserves that relate to the equity component. However, the most common include the above four accounts. An explanation of each of the stockholders’ equity accounts is as below.
Share Capital
The share capital account represents the sum of the par values of a company’s issued shares. In other words, it consists of the finance raised through issuing its shares. The share capital account only includes the par value of shares. It does not include any additional amounts received for allocating shares above that value. For companies, share capital is the most crucial component of the stockholders’ equity.
Share capital represents the product of a company’s total number of outstanding shares and their par value. These outstanding shares come from the overall shares the company has issued over the years. In contrast, the par value arises from its incorporation. When a company forms, it also decides the par value of its shares at the time.
Share capital account may also get other names, for example, common stock or ordinary stock. As mentioned, it shows the par value of the outstanding number of shares for a company. However, it does not necessarily represent the total funds received through issuing shares to shareholders. This value may differ since a company may allocate shares above or below the par value.
Share Premium
Share premium is an account closely related to the share capital account. Usually, companies do not issue shares at par value. Instead, they offer these shares at a price higher than that. The premium on this process also represents equity raised through shareholders for companies. However, the share capital account only holds the par value of the shares issued by a company.
The share premium account holds any excess balance for shares issued above par value. Therefore, it acts as a premium account for when companies allocate stocks at a higher rate. There is no specific formula to calculate the balance on this account, unlike for share capital. However, it makes up a part of a company’s stockholders’ equity balances.
Overall, the share premium account holds the excess funds received for issuance above par value. Sometimes, companies may issue shares below par value, for example, with rights or bonus issues. The share premium account will also compensate for the reduction in the price. Therefore, this account acts as a container for shares issued above or below par value.
Retained Earnings
Profits are one of the primary objectives for companies. However, these profits relate to the income statement. Companies must transfer them to the balance sheet to present their operations accurately. The retained earnings account helps with that. Usually, the retained earnings account holds the balance for a company’s profits over the years after deducting dividends.
Retained earnings is a crucial account in the balance sheet. It shows a company’s reserves raised over the years through its profitable operations. It also represents the internal finance that companies build over the years. However, these earnings only come after deducting the dividends paid to shareholders. Retained earnings also contribute to a company’s reputation.
Some companies may report their retained earnings as accumulated profits. For others, it may also include accumulated losses. In essence, this account represents a picture of a company’s financial performance over time. By doing so, it provides a link between its balance sheet and income statement. Usually, it includes any profits held off for reinvesting in the company’s operations.
Treasury Stock
Some companies will also report a treasury stock balance in the stockholders’ equity. However, this case only applies to companies that buy back their shares from their shareholders. It involves a long process through which companies use excess funds to pay for their own shares. Furthermore, there are several reasons why companies will indulge in this process. It is a contra account that can also impact other equity balances.
A company’s treasury stock account acts as a temporary account. Usually, companies buy their shares back and later sell them in the market. Therefore, the treasury stock account only holds these amounts until the company decides to sell them to the public. In some cases, companies may also retire the stock held in the treasury stock account.
Companies don’t keep balances in the treasury stock for long periods of time. Usually, this balance stays on the balance sheet until the company decides how to tackle them. There are two methods that companies can use to recognize treasury stock. Based on the methods used, the balance on this account may differ. In essence, however, it will always represent the value of the shares reacquired through share buybacks.
Conclusion
Stockholders’ equity represents a company’s book value calculated by subtracting its liabilities from its assets. There are several components that make up this balance. These usually include share capital, share premium retained earnings and contra account treasury stock. Each of these contribute to a company’s stockholders’ equity in the balance sheet.
