Accounting: The Language of Business (Part 79)

The great problem with corporate capitalism is that publicly owned companies have short time horizons. Unlike a privately owned business, the top executives of a publicly owned corporation generally come to their positions late in life. Consequently, they have a few years in which to make their fortune.

Paul Craig Roberts

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

by

Charles Lamson 

Reporting Stockholders' Equity

As with other sections of the balance sheet, alternative terms and formats may be used in reporting stockholders' equity. In addition, the significant changes in the sources of stockholders' equity---paid-in capital and retained earnings---may be reported in separate statements or notes that support the balance sheet presentation.

Stockholders Equity and the Balance Sheet

Two alternatives for reporting stockholders' equity in the balance sheet are shown in Exhibit 5. In the first example, each class of stock is listed first, followed by related paid-in capital accounts. In the second example, the stock accounts are listed first. The other paid-in capital accounts are listed as a single item described as Additional paid-in capital. These combined accounts could also be described as Capital in excess of par for stated value of shares or a similar title. 

EXHIBIT 5 Stockholders' Equity Section of a Balance Sheet

Significant changes in stockholders' equity during a period may be presented either in a statement of stockholders' equity or in notes to the financial statements. In addition, relevant rights and privileges of the various classes of stock outstanding must be disclosed. Examples of types of information that must be disclosed include dividend and liquidation preferences, rights to participate in earnings, conversion rates, and redemption rights. Such information may be disclosed on the face of the balance sheet or in the accompanying notes.

Reporting Retained Earnings

A corporation may report changes in retained earnings by preparing a separate retained earnings statement, a combined income and retained earnings statement, or a statement of stockholders equity.

When a separate retained earnings statement is prepared, the beginning balance of retained earnings is reported. The net income is then added (or net loss is subtracted) and any dividends are subtracted to arrive at the ending retained earnings for the period. An example of such a statement for Adang Corporation is shown in Exhibit 6.

EXHIBIT 6 Retained Earnings Statement

An alternative format for presenting the retained earnings statement is to combine it with the income statement. An advantage of the combined format is that it emphasizes net income as the connecting link between the income statement and the retained earnings portion of stockholders' equity. Since the combined form is not often used, it is not illustrated.

Restrictions

The retained earnings available for use as dividends may be limited by action of a corporation's board of directors. These amounts, called restrictions or appropriations, remain part of the retained earnings. However, they must be disclosed, usually in the notes to the financial statements.

Restrictions may be classified as either legal, contractual, or discretionary. The board of directors may be legally required to restrict retained earnings because of state laws. For example, some state laws require that retained earnings be restricted by the amount of treasury stock purchased, so that legal capital will not be used for dividends. The board may also be required to restrict retained earnings because of contractual requirements. For example, the terms of a bank loan may require restrictions, so that money for preparing the loan will not be used for dividends. Finally, the board may restrict retained earnings voluntarily. For example, the board may limit dividend distributions so that more money is available for expanding the business.

Prior Period Adjustments

Material errors in a prior period's net income may arise from mathematical mistakes and from mistakes in applying accounting principles. The effect of material material errors that are not discovered within the same fiscal period in which they occurred should not be included in determining net income for the current period. Instead, corrections of such errors, called prior period adjustments, are reported in the retained earnings statement. These adjustments are reported as an adjustment to the retained earnings balance at the beginning of the period in which the error is discovered and corrected.

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 495-498*

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