Ch. 1 Types of Business and Financial Statements
1.4 Financial Statements: Statement of Stockholders’ Equity
Learning Objectives
After finishing this section, students will be able to:
- Prepare a Statement of Stockholders’ Equity.
When thinking about the concept of equity, it is often helpful to think about an example many families are familiar with: purchasing a home. Suppose a family purchases a home worth $200,000. After making a down payment of $25,000, they secure a bank loan to pay the remaining $175,000. What is the value of the family’s equity in the home? If you answered $25,000, you are correct. At the time of the purchase, the family owns a home worth $200,000 (an asset), but they owe $175,000 (a liability), so the equity or net worth in the home is $25,000.
Statement of Stockholders’ Equity
The statement of stockholders’ equity, which is the second financial statement created by accountants, is a statement that shows how the equity (or value) of the organization has changed over time. Similar to the income statement, the statement of owner’s equity is for a specific period of time, typically one year. Equity is a term that is often confusing but is a concept with which you are probably already familiar. In short, equity is the value of an item that remains after considering what is owed for that item. So, the statement of owner’s equity is a financial statement that shows how the net worth, or value, of the business has changed for a given period of time.
Common Stock
A company’s primary class of stock issued is common stock, and each share represents a partial claim to ownership or a share of the company’s business. For many companies, this is the only class of stock they have authorized. Common stockholders have four basic rights.
- Common stockholders have the right to vote on corporate matters, including the selection of corporate directors and other issues requiring the approval of owners. Each share of stock owned by an investor generally grants the investor one vote.
- Common stockholders have the right to share in corporate net income proportionally through dividends.
- If the corporation should have to liquidate, common stockholders have the right to share in any distribution of assets after all creditors and any preferred stockholders have been paid.
- In some jurisdictions, common shareholders have a preemptive right, which allows shareholders the option to maintain their ownership percentage when new shares of stock are issued by the company.
Beginning Common Stock + Common Stock Issued = Ending Common Stock
Preferred Stock
A company’s charter may authorize more than one class of stock. Preferred stock has unique rights that are “preferred,” or more advantageous, to shareholders than common stock. The classification of preferred stock is often a controversial area in accounting as some researchers believe preferred stock has characteristics closer to that of a stock/bond hybrid security, with characteristics of debt rather than a true equity item. For example, unlike common stockholders, preferred shareholders typically do not have voting rights; in this way, they are similar to bondholders. In addition, preferred shares 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), similar to the fixed interest rate associated with bonds and other debt items. Preferred stock also mimics debt in that preferred shareholders have a priority of dividend payments over common stockholders. While there may be characteristics of both debt and equity, preferred stock is still reported as part of stockholders’ equity on the balance sheet.
Not every corporation authorizes and issues preferred stock, and there are some important characteristics that corporations should consider when deciding to issue preferred stock. The price of preferred stock typically has less volatility in the stock market. This makes it easier for companies to more reliably budget the amount of the expected capital contribution since the share price is not expected to fluctuate as freely as for common stock. For the investor, this means there is less chance of large gains or losses on the sale of preferred stock.
Dividends
Dividends are corporate earnings that companies pass along to their shareholders. To pay a cash dividend, the corporation must meet two criteria. First, there must be sufficient cash on hand to fulfill the dividend payment. Second, the company must have sufficient retained earnings; that is, it must have enough residual assets to cover the dividend such that the Retained Earnings account does not become a negative amount upon declaration.
Retained Earnings
Retained earnings is the primary component of a company’s earned capital. If you break the words down, retained means “to keep” and earnings means “money made”. So you kept to keep the money you made (net income) minus any dividends paid. A basic statement of retained earnings is referred to as an analysis of retained earnings because it shows the changes in the retained earnings account during the period.
Beginning Retained Earnings + Net Income (Net Loss) – Dividends = Ending Retained Earnings
Let’s create the statement of stockholders’ equity for Cheesy Chuck’s for the month of June. Since Cheesy Chuck’s is a brand-new business, there is no beginning balance of retained earnings. The items to account for are the increases in value/equity, which are investments by stockholders and net income.
The amount of common stock invested by the stockholders was $12,500. Next, we account for the increase in value as a result of net income, which was determined in the income statement to be $4,582. It is important to note that an organization will have either net income or net loss for the period, but not both. Next, we determine if there were any activities that decreased the value of the business. More specifically, we are accounting for the value of dividends to the shareholders $1,450.
The statement of owner’s equity demonstrates how the net worth (also called equity) of the business changed over the period of time (the month of June in this case). Since this is a brand-new store, the beginning value of the business is zero. During the month, the stockholders invested $12,500 and the business had profitable operations (net income) of $4,582. Also, during the month the stockholders were paid $1,450 of dividends, resulting in a net change (and ending balance) to stockholders’ equity of $15,632. Notice the amount of net income (or net loss) is brought from the income statement. In a similar manner, the ending equity balance is carried forward to the balance sheet.
| Cheesy Chuck’s Classic Corn | ||
| Statement of Stockholders’ Equity | ||
| For Month Ended Jun 30, 20X8 | ||
| Beginning Common Stock | $0 | |
|---|---|---|
| + Common Stock Issued | 12,500 | |
| Ending Common Stock |
$12,500 | |
| Beginning Retained Earnings | 0 | |
| + Net Income | 4,582 | |
| – Dividends | 1,450 | |
| Ending Retained Earnings | 3,132 | |
| Total Stockholders’ Equity | $15,632 | |
Net Income of $4,582 came from the previous section.
Common Stock of $12,500, Retained Earnings of $3,132, and Total Stockholders’ Equity of $15,632 will be used in the Balance Sheet in the next section.
Note: Colors are used to aid in learning and should not be used on real-life financial statements.
Statement of Owner’s Equity Formatting
Notice the following about the statement of owner’s equity for Cheesy Chuck’s:
- The format is similar to the format of the income statement (three lines for the heading, three columns).
- The statement follows a chronological order, starting with the first day of the month, accounting for the changes that occurred throughout the month, and ending with the final day of the month.
1.4a Example
Using the multi-step Income Statement created in 1.3 Example, create a Statement of Stockholder’s Equity for McCall Company for October 31, 20XX.
| Account | Amount |
|---|---|
| Accounts Payable | 20,000 |
| Accounts Receivable | 16,000 |
| Accumulated Depreciation (contra asset, needs to be subtracted from assets) | -500 |
| Cash | 99,600 |
| Cost of Goods Sold | 12,000 |
| Common Stock | 100,000 |
| Depreciation Expense | 500 |
| Dividends | 1,500 |
| Dividends Payable | 1,500 |
| Income Tax Expense (calculated at federal tax rate of 21%) | 11 |
| Income Tax Payable | 11 |
| Insurance Expense | 200 |
| Interest Expense | 250 |
| Interest Payable | 250 |
| Inventory | 23,000 |
| Notes Payable | 30,000 |
| Office Equipment | 8,000 |
| Prepaid Insurance | 2,200 |
| Prepaid Rent | 2,000 |
| Rent Expense | 2,000 |
| Salary Expense | 6,000 |
| Sales | 22,000 |
| Utility Expense | 1,000 |
1.4a Practice
Using the multi-step Income Statement from 1.3a Practice, create a Statement of Stockholders’ Equity using the following accounts for Rachel’s Clothing Company for November 20X6.
| Accounts Payable | 59,030 |
| Accounts Receivable | 112,520 |
| Accumulated Depreciation (contra asset, needs to be subtracted from assets) | -40,200 |
| Allowance for Doubtful Accounts (contra asset, needs to be subtracted from assets) | -8,750 |
| Bad Debt Expense | 14,810 |
| Beginning Retained Earnings | 38,852 |
| Cash | 20,320 |
| Common Stock | 53,500 |
| Cost of Goods Sold | 180,292 |
| Dividends | 12,000 |
| Income Tax Expense (calculated at federal tax rate of 21% and at state tax rate of 4%) | 16,572 |
| Income Tax Payable | 16,572 |
| Interest Expense | 30,000 |
| Interest Payable | 3,010 |
| Interest Receivable | 990 |
| Interest Revenue | 5,890 |
| Inventory | 164,010 |
| Land | 53,000 |
| Notes Payable | 123,470 |
| Notes Receivable | 16,320 |
| Office Equipment | 76,060 |
| Operating Expenses | 91,110 |
| Prepaid Rent | 13,510 |
| Rent Expense | 4,910 |
| Salaries expense | 122,090 |
| Salaries Payable | 12,890 |
| Sales Revenue | 503,610 |
| Unearned Revenue | 62,740 |
Check Figures:
- Retained Earnings, $76,568
- Solution (Excel file will download)
1.4a Homework
The following accounts for Elm Connections as of December 31, 20X9.
| Account | Amount |
|---|---|
| Accounts Payable | 502,690 |
| Accounts Receivable | 34,672 |
| Accumulated Depreciation (contra asset, needs to be subtracted from assets) | -500 |
| Advertising Expense | 37,517 |
| Buildings | 350,000 |
| Cash | 597,323 |
| Common Stock | 432,975 |
| Cost of Goods Sold | 175,630 |
| Depreciation Expense | 500 |
| Dividends | 5,000 |
| Income Tax Expense (calculated at federal tax rate of 21%) | 66,095 |
| Income Tax Payable | 66,095 |
| Inventory | 263,909 |
| Office Supplies Expense | 9,008 |
| Rent Expense | 15,485 |
| Revenue | 578,059 |
| Sales Salaries Expense | 25,180 |
Instructions:
- Using the multi-step Income Statement created in 1.3 Homework, prepare a Statement of Stockholders’ Equity for December 31, 20X9
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
