Question

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

Answer 1

Stockholder’s Equity is divided into two main parts:

1. Paid-in-capital (contributed capital)
2. Retained Earnings

Common Stock is the basic form of capital stock. The common stockholders own a corporation.Preferred Stock is stock that gives its owners certain advantages, such as the priority to receive dividends before the common stockholders and the priority to receive assets before the common stockholders if corporation liquidates.Par Value is an arbitrary amount, assigned by a company to a share of its stock.

Paid-up Capital

One of the two main sources of stockholders' equity is paid-in capital. Paid-in capital is the money brought into the business by selling stock in the company. These funds are often the initial source of stockholders' equity. Over time, firms might sell additional stock to raise money for various reasons. For example, a company might need funds to expand into a new market. When more stock is sold, the firm's stockholders' equity increases.

Retained Earnings

Retained earnings are the other main source of stockholders' equity. Retained earnings are made up of the accumulated yearly profits earned by the firm, minus any dividend payments. For example, if a firm records a net profit of $100 million at the end of 2012, then the stockholders' equity on the balance sheet increases by the same amount. These profits are a reflection of how successful a company has operated over time.

Other Sources

In addition to paid-in capital and retained earnings, there are other sources of stockholders' equity. For example, a business might own a subsidiary with foreign currency earnings. Sometimes, when the currency is converted to U.S. dollars there is a gain. This gain increases stockholders' equity. Another source of stockholders' equity is unrealized gains of securities the firm is holding to sell. The common feature of these types of sources is that they do not reflect the firm's core operations.

The Differences Between Additional Paid-in Capital and Retained Earnings

Shareholders' equity can increase when a firm issues more common stock because that affects both the common stock and the additional paid-in capital accounts. Assume, for example, that XYZ firm issues 1,000 shares of $10 par value common stock for $30 a share. Common stock is increased based on the par value of each share, or $10,000, and additional paid-in capital is increased by the remaining $20 per share ($20,000).

When a company generates net income, those profits increase the retained earnings in the shareholders' equity section of the balance sheet. At the end of each month, the net income in the income statement is adjusted to zero, and the total is posted to retained earnings. The retained earnings balance is the sum of all net income since inception less all cash dividends paid since the firm started.

Reason for Dividing stockholders equity into Retaining Earnings:

Retained earnings refer to the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business, or to pay debt. It is recorded under shareholders' equity on the balance sheet. The formula calculates retained earnings by adding net income to, or subtracting any net losses from, beginning retained earnings, and subtracting any dividends paid to shareholders.

1. BREAKING DOWN 'Retained Earnings'

The formula for retained earnings is as follows:

Retained Earnings (RE) = Beginning RE + Net Income - Dividends, also known as the "retention ratio" or "retained surplus."

In most cases, companies retain earnings in order to invest them into areas where the company can create growth opportunities, such as buying new machinery or spending the money on more research and development. Should a net loss be greater than beginning retained earnings, the retained earnings can become negative, creating a deficit. The retained earnings general ledger account is adjusted every time a journal entry is made to a revenue or expense account.

2. Retained Earnings

Retained earnings are reported at the end of an accounting period as the accumulated amount of a company's prior earnings, net of dividends. They can show a positive earnings accumulation or can turn negative and have a deficit if a current period's net loss exceeds the period's beginning retained earnings. Even though changes in retained earnings during each accounting period are not explicitly reported, they can be inferred by comparing the amounts of beginning and ending retained earnings of the period. An increase or decrease in accumulated retained earnings during an accounting period is the direct result of the amounts of net income or loss and dividend payouts for that period.

3. Net Income

Net income or loss adds to retained earnings by way of recording certain closing entries in accounting. The accounts to record net income, revenues and expenses are periodic and temporary accounts used repeatedly during each accounting period. Their balances must be closed at period end, allowing the accounts to be reused in the next period. Revenues and expenses are closed to an account called income summary, which displays the amount of net income or loss. They are subsequently closed to retained earnings, with net income increasing earnings, and loss decreasing them. Thus, the effect of net income on retained earnings derives from the integral effects of revenues and expenses on retained earnings.

4. Dividends

Dividends can be in cash or stock, and both forms of dividends reduce retained earnings. Cash dividends are paid out from a company's earnings or net income, and the more dividends distributed, the less earnings retained. The dividend account is also a temporary account because dividend payments are a periodic recurrence, and are closed to retained earnings at period end, effectively reducing retained earnings. Companies may issue additional shares of its stock as dividends, increasing the amounts of both common-stock and additional-paid-in-capital accounts in the balance sheet. To keep the balance sheet balanced, the account of retained earnings is decreased by the same amounts.