Stockholders’ equity is the total of the claims against a corporation that are held through ownership rights. Stockholders’ claims differ from liabilities in several ways. First, there is generally no preestablished due date on which the owners’ claims have to be satisfied. Second, owners face a much more difficult situation than creditors if they are dissatisfied with the prospects of collecting their claims. Creditors have several well-established methods of compelling payments of their claims that are not available to owners and precede stockholders in the event of liquidation. Third, stockholders have five basic rights that creditors do not:
- Voting: stockholders have the right to vote for candidates for the board of directors, for changes in the corporate charter, and for various other aspects of corporate government.
- Dividends: stockholders have the right to share in assets distributed as dividends.
- Liquidation: stockholders have the right to share in any remaining assets distributed upon liquidation of the corporation.
- Preemption: stockholders have the right to acquire new shares issued by the corporation in order to maintain the same degree of control.
- Information: stockholders have the right to obtain information about the activities of the corporation and its managers; this right is guaranteed specifically by statute in each state.
Any of these five rights, as well as the right to sell or otherwise dispose of the shares, can be modified or waived by the stockholders under the corporation’s bylaws.
Accounting Objectives of Stockholders’ Equity:
Earning power assessments are not greatly aided by disclosures of the structure of stockholders’ equity. For example, evaluation of the use of leverage through debt financing is not aided by distinguishing among the categories of stockholders’ equity. However, if the firm uses preferred stock to develop leverage for the common stockholders, distinguishing between each class of equity may be useful. Disclosures about different classes of stock may impact assessments by various groups of stockholders in terms of the likelihood of receiving future cash distributions.
The balance of retained earnings describes the amount of claims that may be satisfied through dividends. Actual dividend policy is affected, however, by a number of other factors such as available cash and plans for growth. Accounting for stockholders’ equity can be complex and intricate. One origin of the complexity is the substantial effect on GAAP of tradition that is often based on narrowly constructed (and possibly obsolete) legal requirements. Another major origin of the complexity lies in the wide variety of equity instruments and the many types of transactions that affect stockholders’ claims.
Accounting for stockholders’ equity is directed toward identifying the sources of the claims and the amounts arising from each source. The amounts are measured by the net value received from the events that created them. For example, equity created by the issuance of stock is measured by the amount of proceeds received less the costs of issuing the stock.
The sources of equity are classified broadly by the type of event that caused the claims to come into existence. While a more detailed classification could be used, the basic types can be grouped into four general categories:
- Capital Stock
- Capital in Excess of Par (or stated) value
- Additional Paid In Capital
- Retained Earnings
More detailed headings are used when it is informative to distinguish claims held by different classes of stockholders. Categories 2 and 3 shown above are often combined in practice into one item known as additional paid-in capital. Categories 1, 2, and 3 are often grouped together as paid-in or contributed capital
In very limited and well-defined circumstances, a category of negative stockholders’ equity, known as an unrealized loss, is used to disclose the effects of declines in value not yet confirmed by transactions.