Question

The total owners’ equity is usually under a number of subcaptions on the corporation’s balance sheet.

Required:

a. List the major subdivisions of the stockholders’ equity section of a corporate balance sheet and describe briefly the nature of the amounts that will appear in each section.

b. Explain fully the reasons for subdividing the amount of stockholders’ equity, including legal, accounting, and other considerations.

c. Describe three kinds of transactions that will result in paid-in or permanent capital in excess of legal or stated capital.

d. Various accounting authorities have recommended that the terms paid-in surplus and earned surplus not be used in published financial statements. Explain briefly the reason for this suggestion and indicate acceptable substitutes for the terms.

Answer 1

(a) Major subdivisions

We have three sections in stockholder’s equity:

(i) Paid in Capital: It includes common stock, preferred stock, and any Paid in Capital accounts including Paid in Capital for treasury stock.

(ii) Retained Earnings: It comes from the Statement of Retained Earnings financial statement.

(iii) Treasury Stock: It reports the cost we paid for Treasury Stock and this reduces total equity

Common stock is a form of corporate equity ownership. It is a type of security. It shows the number of shares owned by the shareholder and their voting rights.

Preferred stock is type of corporate shares that are separate from common stock and have specific rights that aren't available to common shareholders.

There are many differences between preferred and common stock. The main difference between preferred and common stock is that preferred stock gives no voting rights to shareholders while common stock gives the voting rights. Common stockholders are last in line when it comes to liquidate the company assets, which means they will be paid out after creditors, bond holders, and preferred stockholders.

Treasury stock is stock repurchased by the issuer and intended for retirement or resale to the public. It represents the difference between the number of shares issued and the number of shares outstanding.

Retained earnings are the amount of net income left over for the business after it has paid out dividends to its shareholders. Often this profit is paid out to shareholders, but it can also be re-invested back into the company for growth of the company. The amount which is not paid to shareholders be known as retained earnings. Retained earnings are an equity account and appear as a credit balance. Negative retained earnings, on the other hand, appear as a debit balance.

(b) Reasons of subdividing

A main reason for subdividing the amount of shareholder’s equity is for creditors. State laws have protected creditors by establishing the concept of legal capital, which is the amount of net assets that cannot be distributed to stockholders. Legal capital must be reported separately from the total amount invested. The par or stated value of the outstanding shares generally constitutes a corporation’s legal capital.

(c) Kinds of transactions

There are certain kinds of transactions that will result in paid-in or permanent capital in excess of legal stated capital. One transaction includes selling at above par value, which is classified as additional paid-in-capital. A second transaction occurs after quasi-reorganizations. Losses or adjustments arising from contingencies existing at the date of reorganizations should be charged to additional paid-in-capital and not to current or future earnings or to retained earnings. A conversion can also result in paid in capital in excess of legal capital. This can occur when a stockholder converts preferred stock to common stock. The amount of capital in excess of par is recorded in the additional paid-in capital account in the balance sheet and has a credit balance in books.

For example, If a Company sell 100,000 shares of its common stock for $2 per share, and the par value of each share is $0.01, then the amount of the capital in excess of par is $199,000 (100,000 shares x $1.99/share) is known as additional paid-in-capital. It is also known as the premium on common stock.

(d) Terms paid in surplus and earned surplus

Paid in Surplus: It is a balance sheet term, it represents the amount that investors have paid in shares above the par value of the shares. It only refers to shares bought directly from the company, not traded on the market. Paid-in surplus equals the stock's total proceeds minus its total par value. A company reports paid-in surplus and par value on its balance sheet.

Earned surplus: It is the sum of a company's profits, after dividend payments, since the company's inception. It is important to understand that earned surplus does not represent extra cash or cash left over after the payment of dividends. Rather, earned surplus reflects what a company did with its profits; they are the amount of profit the company has reinvested in the business, since its inception. These reinvestments are either asset purchases or liability reductions.

Paid-in surplus is the incremental amount paid by an investor for a company's shares that exceeds the par value of the shares. If there is no par value, then the entire amount paid is classified as paid-in surplus. The paid-in surplus is also known as additional paid-in capital.

Earned surplus is the sum of a company's profits, after dividend payments, since the company's inception. It can also be called retained earnings, retained capital, or accumulated earnings.