Shareholders Equity in Financial Accounting

Corporations are the dominant form of business organization in advanced industrial nations such as the United States. Although they only represent about 25 percent of business firms, they generate about 80 percent of business revenues. A corporation is an entity that is owned by its shareholders and raises equity capital by selling shares of stock to investors. Equity capital is an ownership interest in the corporation and each share of stock represents a fractional interest in the issuing firm. Its important to note that equity capital is not a liability to be repaid at a future date.

Most major corporations stock is traded (bought and sold) on major security exchanges, such as the New York and American Stock Exchanges. For business managers, a primary advantage of the corporate form of organization is the capability to raise large amounts of cash by selling shares of stock to many different individuals and institutions (such as mutual funds, insurance companies, and pension plans), rather than relying on the investments of a few owners and lenders.

Stockholders expect to earn returns on their investments in the form of dividends and capital gains. Dividends are distributions of assets, usually cash, that the corporation elects to make periodically to its stockholders. Capital gains (or losses) result from increases (or decreases) in the market price of stocks over the period during which an investor holds them. Neither the payment of dividends nor the appreciation in stock prices is guaranteed to the equity investor. Instead, the capability of a corporation to generate cash through profitable operations determines its capability to pay dividends and also influences the market price of its stock. A corporation comes into existence when its charter is approved by the state in which it chooses to locate and incorporate. State laws vary, so consequently many features of corporations depend on the state in which a firm incorporates. Among other things, the charter indicates the corporations business purpose and authorizes the firm to issue one or more types of ownership shares. The most basic type of ownership share is common stock. Common shareholders are the true residual owners of a corporation. After all other claims against a firms assets have been satisfied, the common shareholders own what remains. This view of shareholders equity is apparent when we write the basic balance sheet equation in the following way: Shareholders Equity= Assets - Liabilities

This expression shows that the value of shareholders equity reported on a firms balance sheet is determined by the valuation of its assets and liabilities. Recall that financial accounting reports use historical costs rather than current market prices in evaluating the firms assets and liabilities. For this reason, the reported value of shareholders equity does not attempt to measure the market value of the firms outstanding shares of stock. Shareholders equity comes primarily from two sources: invested (paid-in) capital and retained earnings. Invested capital is the amount received by the corporation after the sale of its stock to investors. Note that invested capital usually includes two components: par value and additional paid-in capital. For our purposes, we will concentrate on the sum of these parts, not on the individual components. Retained earnings are the amount of prior earnings that the firm has reinvested in the business, that is, the portion that has not been paid to shareholders as dividends. Figure 9.1 shows the shareholders equity section from the 1997 balance sheet of E. I.

Figure 9.1 - Shareholders Equity Components

Du Pont de Nemours and Company (Du Pont). Note that Du Ponts total shareholders equity at the end of 1997 was $11,270 (in millions of dollars). Of that amount, $8,574 was received from the sale of stock to investors, $4,389 represented past earnings that were reinvested in the firms operations, and $1,693 represented reductions in shareholders equity from various other sources. For most profitable firms, retained earnings represent the major part of shareholders equity. The description of DuPonts common stock in Figure 9.1 distinguishes between the number of common shares that are authorized and issued. Authorized shares are those that the firm is permitted to issue according to its corporate charter.

Some of the issued shares may have been repurchased and held as treasury stock, as is explained later in the chapter. Figure 9.1 also shows that Du Ponts common stock has been assigned a par value of $0.30 per share, and the total par value of the outstanding shares is reported separately on the balance sheet. Although for legal purposes the shares of most firms have a designated par or stated value, this value is usually a minor amount compared to the actual market price of the stock. For example, although Du Ponts common stock has a par value of just $0.30 per share, the stock has a market price per share of about $62 at the end of 1997. At the end of this chapter you will: 1. Understand why large business firms prefer to organize as corporations. 2. Comprehend the types of transactions and events that affect the components of shareholders equity. 3. Interpret shareholders equity ratios that are helpful in analyzing financial statements.

Shareholders Equity Contents

Transactions Affecting Shareholders Equity

Stock Dividends Stock Splits Treasury Stock Employee Stock Options Preferred Stock Convertible Debt

Earnings per Share

Basic EPS (Earnings per Share) Diluted EPS (Earnings per Share)

Analysis Based on Shareholders' Equity

The Financial Leverage Ratio Market-to-Book Value Ratio Price-to-Earnings Ratio