The equity section of a balance sheet represents the amount of equity invested by the owners in the business. This equity can be split into earnings retained by the business, and capital stock introduced by the owners.
When a business operates through a company or corporation the equity is referred to as stockholders’ equity, shareholders’ equity, shareholders’ investment or capital and the capital introduced is referred to as capital stock or share capital, and represents ownership in the company or corporation.
This ownership also gives the shareholder a right to a share in the retained earnings of the business. The unit of ownership in the business is called a share of stock.
The amount of the company a shareholder owns will depend on how much of the capital stock (share capital) they own, and this in turn will depend on how many shares they own. A share is a term used to describe a unit of capital stock, and is identified by a share certificate or stock certificate which can be traded by the shareholder.
For example, if a company has issued 1,000 shares and a shareholder owns 100 shares then they own 100 / 1000 = 10% of the capital stock of the company entitling them to 10% of the retained earnings of the business.
Companies can issue different types of capital stock each of which carries different rights mainly relating to dividends, and voting. The two types of capital stock usually issued are common stock, and preferred stock.
The owners of the common stock (stockholders) own the equity in the business entitling them to a distribution of the profits. The owners control the business by appointing the board of directors who manage the business, and by voting on major issues of policy.
Common stock is a more risky investment as it has no rights to a preference for the return of capital or a dividend, and in the event of liquidation, has to wait until preferred shareholders, bond holders, other secured lenders and creditors have been paid.
The advantage of common stock is that it is entitled to a distribution of the profits of the business and generally provides a higher return on investment in the long term.
Types of Capital Stock
- Authorized shares: The maximum number of shares the company is allowed to issue.
- Issued shares: The shares actually issued to stockholders.
- Unissued shares: Authorized shares which have not yet been issued.
- Outstanding shares: Issued shares which are still held by stockholders.
- Treasury shares: Issued shares which have been bought back by the company.
When a company is started is must complete various legal formalities including stating what the maximum number of shares it intends to issue is. This maximum number of shares is referred to as the authorized shares or authorized capital stock. For example, a company might have 1,800,000 authorized shares.
Authorized shares have not been issued to shareholders, and simply define the maximum number of shares the company can issue (sell).
As the issued shares must not exceed the authorized shares, it is normal to have the number of authorized shares set higher then the immediate requirement for shares to be issued. A company can change its authorized share capital at a later stage, but this involves additional formalities and costs, so it is easier to start with a larger authorized share capital
The issued shares is the amount of authorized shares which the company has actually issued (sold) to shareholders in return for payment (usually cash).
So for example, a company might have 1,800,000 authorized share capital, but might have only issued 700,000 shares to shareholders, it therefore has 1,100,000 share remaining which is can issue at a later stage.
In order to raise funds from shareholders a company will issue shares at a price. For example, if the company wanted to raise 1.4 million in cash it might issue 700 shares at a price of 2.00 each. The total value of capital stock or share capital issued is then:
Capital stock = Number of shares issued x price per share Capital stock = 700,000 x 2.00 Capital stock = 1,400,000
The 700,000 shares are issued at a price of 2.00 each and the company receives 1,400,000 from the shareholders in cash. If the authorized number of shares is 1,800,000, it can still issue a further 1,100,000 shares at a later date to raise additional cash.
Accounting for Capital Stock
Having received the cash it might be expected that the double entry bookkeeping journal would simply be as follows:
* All amounts shown in ‘000
However, historically each share has a designated par value (sometimes referred to as face value, nominal value), which is a notional price per share below which the share cannot be issued. Accounting convention requires that the amount of capital stock relating to the price above par value must be shown separately as a premium on stock, usually referred to as paid in capital in excess of par value.
So, if in the above example, the shares had a par value of 0.50 each, the value above the par value is 2.00 – 0.50 = 1.50 premium per share, and the amount to be shown as the stock premium is:
Stock premium = Number of shares issued x premium per share Stock premium = 700,000 x 1.50 Stock premium = 1,050,000
The double entry bookkeeping entry for the issue of these shares would then be
|Premium on Common stock||1,050|
* All amounts shown in ‘000
Capital Stock in the Balance Sheet
In the financial statements, the issued capital stock is the amount included on the balance sheet as part of shareholders equity, whereas the authorized capital stock is disclosed by way of note.
|Common stock, par value 0.50; 1,800,000 shares authorized; 700,000 shares issued and outstanding||1,400|
* All amounts shown in ‘000
Further examples of equity journal entries can be seen in our stockholders equity journal entries reference.
Treasury Shares and Outstanding Shares
A company can purchase its shares back from shareholders. The shares purchased are referred to as Treasury shares or Treasury stock. The accounting journals relating to the purchase of treasury stock are shown in our treasury stock cost method journal entries reference. Any issued shares not repurchased are referred to as outstanding shares.
Share trading is the process of buying and selling shares in a company. It is important to note that this process goes on between shareholders and has no accounting or bookkeeping impact on the company unless the shares are issued or purchased (see treasury stock) by the company. So for example, if a company issues shares at a price of 2.00 each, and shareholder A buys a 1,000 shares, then the company will receive 1,000 x 2.00 = 2,000 in cash. Ignoring any premium the company will make the following entry
If the market value of the shares now rises to 5.00 per share and shareholder A sells to shareholder B, then shareholder B pays cash of 1,000 x 5.00 = 5,000 to shareholder A, and shareholder A has made a profit of 1,000 x (5.00 – 2.00) = 3,000, being the 5,000 they received less the 2,000 they paid for them. The company is not involved in this transaction and no bookkeeping entries are necessary.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.