Third Year Finance and Accounting Major

Lecture Three: Equity

1. What is considered Equity in Accounting?

Equity, typically referred to as shareholders' equity (or owners' equity for

privately held companies), represents the amount of money that would be
returned to a company's shareholders if all of the assets were liquidated and all
of the company's debt was paid off in the case of liquidation. In the case of
acquisition, it is the value of company sales minus any liabilities owed by the
company not transferred with the sale

2. Equity on the Balance Sheet

A balance sheet shows the book value of the company’s assets and liabilities.
Then it shows equity—what you get when subtracting liabilities from assets.
The following formula shows how equity is calculated:

Assets – Liabilities = Equity

or, put another way:

Assets = Liabilities + Equity

Because your total assets should equal your total liabilities plus equity, a
balance sheet is sometimes laid out in two columns, with assets on the right
and liabilities and equity on the left.

3. The way owner Equity works

Owner equity is affected by various transactions, including:

Investments: When owners invest additional funds into the business, it

increases equity.

Profits: Net income from business operations increases equity, contributing to

retained earnings.
Losses: Conversely, losses decrease equity. If a company experiences a net loss,
it reduces the amount of retained earnings.

Dividends: When a company distributes profits to shareholders in the form of

dividends, it reduces retained earnings and, consequently, equity.

4. Types of Equity Accounts

There are several types of equity accounts that combine to make up

total shareholders’ equity. These accounts include common stock, preferred
stock, contributed surplus, additional paid-in capital, retained earnings, other
comprehensive earnings, and treasury stock.

Equity is the amount funded by the owners or shareholders of a company for the
initial start-up and continuous operation of a business. Total equity also
represents the residual value left in assets after all liabilities have been paid off,
and is recorded on the company’s balance sheet. To calculate total equity, simply
deduct total liabilities from total assets.
Third Year Finance and Accounting Major

Types of Equity Accounts

The seven main equity accounts are:

#1 Common Stock

Common stock represents the owners’ or shareholder’s investment in the business

as a capital contribution. This account represents the shares that entitle the
shareowners to vote and their residual claim on the company’s assets. The value
of common stock is equal to the par value of the shares times the number of
shares outstanding. For example, 1 million shares with $1 of par value would result
in $1 million of common share capital on the balance sheet.

#2 Preferred Stock

Preferred stock is quite similar to common stock. The preferred stock is a type
of share that often has no voting rights, but is guaranteed a cumulative dividend.
If the dividend is not paid in one year, then it will accumulate until paid off.

#3 Contributed Surplus

Contributed Surplus represents any amount paid over the par value paid by
investors for stocks purchases that have a par value. This account also holds
different types of gains and losses resulting in the sale of shares or other complex
financial instruments.

Example: The company issues 100,000 $1 par value shares for $10 per share.
$100,000 (100,000 shares x $1/share) goes to common stock, and the excess
$900,000 (100,000 shares x ($10-$1)) goes to Contributed Surplus.

#4 Additional Paid-In Capital

Additional Paid-In Capital is another term for contributed surplus, the same as
described above.

#5 Retained Earnings

Retained Earnings is the portion of net income that is not paid out as dividends
to shareholders. It is instead retained for reinvesting in the business or to pay
off future obligations.
#6 Other Comprehensive Income

Other comprehensive income is excluded from net income on the income

statement because it consists of income that has not been realized yet. For
example, unrealized gains or losses on securities that have not yet been sold are
reflected in other comprehensive income. Once the securities are sold, then the
realized gain/loss is moved into net income on the income statement.

#7 Treasury Stock (Contra-Equity Account)

Treasury stock is a contra-equity account. It represents the amount of common

stock that the company has purchased back from investors. This is reflected in
the books as a deduction from total equity.