Stockholders' Equity (Explanation Part 1)

Introduction to Stockholders’ Equity

If you were to reduce a corporation’s entire balance sheet into its most skeletal form, you would end up with the following accounting equation:

As you can see, stockholders’ equity is one of the three main components of a corporation’s balance sheet. If you rearrange the equation, you will see that stockholders’ equity is the difference between the asset amounts and the liability amounts:

Stockholders’ equity is to a corporation what owner’s equity is to a sole proprietorship. Owners of a corporation are called stockholders (or shareholders), because they own (or hold) shares of the company’s stock. Stock certificates are paper evidence of ownership in a corporation.

U. S. corporations are organized in, and are regulated by, one of the fifty states. Because laws differ somewhat from state to state, accounting for corporations also differs somewhat from state to state. (If you need to determine the specific rules for a corporation in a specific state, you should seek the guidance of a professional who is knowledgeable with the laws of that state.) For our purposes, we will focus on the structure and concepts that are fundamental to most U.S corporations.

The concepts and vocabulary we will introduce in this topic (such as dividends, earnings per share, and book value) are important not only to accountants, but to investors, lenders, business owners, business students, and others.

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What Is a Corporation?

Most of the world’s largest companies do business as corporations. Companies such as Wal-Mart, Amazon, Apple, Exxon Mobil, and CVS Health—each with sales in excess of $200 billion annually—are corporations. As opposed to a sole proprietorship or a partnership, a corporation is a business that is recognized by law as a separate legal entity with its own powers, responsibilities, and liabilities. Before the owners/managers of a business choose to incorporate their business (become corporations), however, they should examine the advantages and disadvantages of doing so.

Advantages

A corporation has several advantages over the sole proprietorship and the partnership form of business. The following are four of the advantages:

• Limited liability for the owners. Generally, the owners of a corporation can lose no more than the amount they have invested in that corporation. On the other hand, with a sole proprietorship or partnership, an owner could lose not only her or his investment, but could also lose other personal assets as well. In other words, the corporate form of business “shields” the owners from most of the corporation’s creditors. This occurs because corporations are considered to be legal entities, separate and distinct from their owners. (Due to their legal entity status, a corporation can sue others, can be sued, and must pay income taxes on its taxable income.)

• Ease in which owners can sell their ownership interest. If the stock is publicly traded, investors can sell their ownership interest in a corporation in a matter of minutes simply by giving instructions to their stockbroker or through a computer app. If the stock is not publicly traded, the stock certificate can be transferred to another owner by signing a transfer statement.

• Continuity. When a stockholder sells shares of stock, the transaction is between the seller and the buyer of the stock. Unless the corporation is the buyer or the seller, the corporation is not involved in the transaction. This means that even if a corporation’s stock is the most actively traded stock of the day, the corporation itself will not skip a beat in its day-to-day operations. When notified of a transfer between stockholders, the corporation merely changes in its records the name of the owner of the shares.

• Ease in raising money. Because of limited liability and the ease of buying/selling shares, it is easy to understand why investors are more attracted to investing in corporations rather than in sole proprietorships or partnerships. This investor attraction allows corporations to raise the capital needed to manage and expand their operations.

Disadvantages

Some view the legal complexity of starting and running a corporation to be a disadvantage. To incorporate, an application must be filed with and approved by one of the fifty states, and once approved, the corporation must comply with that state’s regulations. In contrast, a sole proprietorship can be started in minutes, sometimes with nothing more than opening a business checking account. Many of the legal requirements imposed on a corporation do not apply to sole proprietorships.

Another disadvantage associated with corporations is the possibility of “double taxation” on the dividends it pays. Some argue that a regular corporation’s net income is first taxed on the corporation’s income tax return. Then, if the corporation distributes some of the after tax net income to the stockholders as a dividend, the dividend will be taxed on the stockholders’ personal income tax returns. (To gain more insight into this and to minimize or to avoid this potential problem, you should discuss various forms of business structures with tax and legal professionals.)

Governance

The owners of corporations are referred to as stockholders or shareholders, because they hold the shares of stock, which serve as the evidence of their ownership. (The terms stockholders and shareholders are used interchangeably.)

Because it would be impossible for 30,000 stockholders to sit around a boardroom table and give meaningful input to the direction of their company, the stockholders elect a board of directors as their representatives in the corporation’s affairs. The board of directors formulates the corporation’s policies and appoints officers of the corporation to carry out those policies. The board of directors also declares the amount and timing of dividend distributions, if any, to the stockholders.

The officers of a corporation are appointed by the corporation’s board of directors to carry out (or execute) the policies established by the board of directors. The officers include the president, chief executive officer (CEO), chief operating officer (COO), chief financial officer (CFO), vice presidents, treasurer, secretary, and controller.