Accounting: The Language of Business (Part 74)

A criminal is a person with predatory instincts without sufficient capital to form a corporation.

Howard Scott

Corporations: Organization, Capital Stock Transactions, and Dividends (Part B)

by

Charles Lamson

Stockholders' Equity

Owner's equity is essentially the owner's rights to the assets of the business. Its what is left over for the owner after you have subtracted all the liabilities from the assets. The term "owner's equity" is typically used for a sole proprietorship (bench.co).

The owner's equity in a corporation is commonly called stockholders' equity, shareholders equity, shareholders investment, or capital. In a corporation balance sheet, the stockholders' equity section reports the amount of each of the two main sources of stockholders' equity. The first source is capital contributed to the corporation by the stockholders and others, called paid-in capital or contributed capital. The second source is net income retained in the business, called retained earnings.

An example of a stockholder's equity section of a corporation balance sheet is shown below.

The paid-in capital contributed by the stockholders is recorded in separate accounts for each class of stock. If there is only one class of stock, the account is entitled Common Stock or Capital Stock.

Retained earnings are generated from operations. Net income increases retained earnings, while dividends decrease retained earnings. Thus, retained earnings represents a corporation's accumulated net income that has not been distributed to stockholders as dividends.

The balance of the retained earnings account at the end of the fiscal year is created by closing entries. First, the balance in the income summary account (the net income or net loss) is transferred to Retained Earnings. Second, the balance of the dividends account, which is similar to the drawing account for a proprietorship, is transferred to Retained Earnings.

Other terms that may be used to identify retained earnings in the financial statements include earnings retained for use in the business and earnings reinvested in the business. A debit balance in retained earnings is called a deficit. Such a balance results from accumulated net losses. In the Stockholders' Equity section, a deficit is deducted from paid-in capital in determining total stockholders' equity.

The balance of retained earnings should not be interpreted as representing surplus cash or cash left over for dividends. The reason for this is that earnings retained in the business and the related cash generated from these earnings are normally used by management to improve or expand operations. As cash is used to expand or improve operations, its balance decreases. However, the balance of the retained earnings account is unaffected. As a result, over time the balance of the retained earnings account normally becomes less and less related to the balance of the cash account. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 484-486*

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