CHAPTER 10

Owners’ Equity

Owners’ equity, funds given to the firm by its owners plus cumulated earnings retained by the firm, is the final category in the Balance Sheet equation:

Assets = Liabilities + Owners’ Equity

Like many prior chapters, the owners’ equity chapter has lots of terminology. However, once you understand the terminology, the accounting choices explained in this chapter will hopefully feel straightforward.

Contributed Capital

The nature of a firm’s ownership and control is set out in its corporate charter (or articles of incorporation), which in the United States is governed by state law. Corporations can incorporate in any state whether they have business operations in the state or not. Most U.S. public firms (over half of all public firms and 64 percent of the Standard and Poor’s [S&P] 500 firms¹) are incorporated in the State of Delaware that has a court system (the Delaware Chancery) largely dedicated to corporate matters and is viewed by many as corporate-friendly (in the sense of antitakeover, antilawsuits, and so on).

The first set of accounts in owners’ equity is called contributed capital. As previously noted, contributed capital is the cumulative amount all the individual owners have given to the firm. However, the firm’s accountants usually break down this amount to provide more detail related to different ownership terms.

The accountants state what type, or class, of shares the owners have. A firm may have different types of ownership units but a corporation must have at least one residual voting class of common shares (stock) representing the owners’ investment in the firm and subordinate to all others. It can also have what are called preferred (or preference) shares and there can be additional classes within each of these categories.

The amount the owners give a firm for a particular class of share (i.e., the price the owners pay per share) can be broken into two categories: “par value” (a notional value attached to the shares) and “additional paid-in capital in excess of par value” (the difference between the total amount the owners paid and the par value).² Shares can also be issued as non-par value, which means there is just the one category. Although there are some technical legal issues concerning par value shares, the distinction between par value and contributed capital (par value plus additional paid-in capital in excess of par) generally has no impact on the vast number of public firms and the users of their financial statements. For this reason, many users (your author included) often sum the par value and additional amount for each class of shares and simply have one line called contributed capital for each class of shares in their spreadsheet.

Also, remember the amounts recorded are what the owners give the firm for shares (that is why the item is called “contributed capital”). When the shares are subsequently traded between members of the public, the prices paid on the market have no effect on the firm or its financial statements because the capital is being exchanged between shareholders and not between a shareholder and the firm.

There are three nonfinancial amounts associated with shares:

    •   Authorized, the legal maximum number issuable according to the corporate charter.

    •   Issued, the number of shares the firm has given to owners.

    •   Outstanding, the number of issued shares less any repurchased.

One major distinction between types of shares is whether or not their owners have voting power in the firm. Generally, the voting shares are common shares. At least one class (category) of shares must be voting shares, but there can be multiple classes having one vote per share or having different numbers of votes per share. For example, there could be three (or more) classes of common shares: Class A, nonvoting; Class B, one share one vote; and Class C, with multiple votes per share.³

Preferred shares have, as their name suggests, a preference over the common shares.⁴ What kinds of preference do preferred shares have? First, the preferred shares are entitled to receive a dividend before any can be paid to the common shares.⁵ Second, the dividend on the preferred shares is often at a set amount (e.g., $1.00 per share) and can be either cumulative or noncumulative—these shares are called “cumulative preferred shares” and “noncumulative preferred shares.” The cumulative feature is extremely important to the value of preferred shares. The cumulative feature means that if the preferred shares do not receive a dividend in a particular year, the amount accumulates to the next. For example, if a cumulative preferred share with a $1.00 stated dividend is not paid a dividend for 6 years, then in the seventh year, the preferred shareholders would have to receive $7.00 before any dividends can be paid to the common shareholders ($6.00 from accumulated dividends of prior years plus $1.00 for the current year). If the preferred shares are noncumulative, in the seventh year preferred shareholders would only have to receive $1.00 per share before a dividend can be paid to the common shareholders. Third, the preferred shares can have a convertible feature allowing the holder to turn them in for a set number of common shares. Fourth, the preferred shares may have a call feature, allowing the firm to buy them back at a set price. Finally, they can be voting or nonvoting.

Typical ownership share classifications

Retained Earnings

As noted back in Chapter 3, retained earnings are the cumulative profit or loss a firm has made from its inception to the date of the Balance Sheet less any funds given to the owners, which are called dividends. Retained earnings can be written as:

Opening R/E + Profit − Loss − Dividends = Ending R/E

Profit and loss, as previously noted, are the closing (resetting to zero) of the temporary revenue and expense accounts. Thus, the only new variable here is dividends, which are the distribution of accumulated profits to the owners.

Firms with excess cash (funds they do not need to maintain or grow their business, acquire new businesses or pay down their debt) can return these funds to the owners by paying dividends.

There are three important dates related to dividends:

    •   Declaration—the date the board of directors declares that the firm will pay dividends (the declaration makes the firm legally bound to pay the dividends it declared).

    •   Record—the date determining which owners get the dividend (the holder on the record date gets the dividend).⁶

    •   Payment—the date the dividend will be paid (to the shareholders of record).

The timing of these events must occur in this order (declaration, record, and payment). However, the events can be on the same date, or two dates, or three dates.

It is important to note that dividends can only be paid up to the amount of retained earnings (dividends cannot be paid when retained earnings are negative or in an amount that would cause retained earnings to become negative). If the firm has no retained earnings (or has a deficit with accumulated losses exceeding accumulated profits), it cannot legally pay a dividend, and if it does, the directors become personally liable to the firm’s creditors for the difference. However, it is possible for a firm to pay a dividend when it has positive retained earnings but subsequently lose money, causing retained earnings to become a deficit. It should also be noted that dividend payments are “sticky.” Once a firm starts paying a dividend, it is usually very reluctant to stop paying the dividend or even decrease it because doing so normally causes a sharp decline in stock price.

Treasury Stock

Dividends are not the only method a firm has to provide funds to its owners. An alternative method is for the firm to repurchase its own shares. Share repurchases usually have lower tax rates for shareholders. So why don’t firms use share repurchases instead of dividends? Primarily because the International Revenue Service (IRS) will treat repurchases as dividends if a firm does regular repurchases (e.g., every quarter). Share repurchases are often done: (1) as part of a merger involving a stock swap, (2) to fend off a hostile takeover, (3) to redeem stock options in share-based compensation plans, or (4) to increase or stabilize earnings per share (the latter two are discussed in more detail in Accounting for Fun and Profit: Understanding Advanced Topics in Accounting).

There are three main ways firms repurchase their shares. One is open market purchases, simply buying shares in the market like anyone else. A second is called a fixed price tender. Here the firm publicly announces details of the number of shares it hopes to buy and the set (fixed) price it will pay. The firm is then obligated to buy at least the minimum number to which it committed, but it can buy more. Finally, firms can also repurchase their shares using what is called a “Dutch auction tender.” Here the firm sets the number of shares but not the price per share, or the firm sets the price per share but not the number of shares it will purchase.⁷

Regardless of how a firm repurchases its shares, there is NEVER a gain or loss on the repurchase of a firm’s own shares. This differs from a firm’s accounting of marketable securities, where the firm reports a gain or loss on its investment. When buying back its own shares, the firm records a decrease in cash and a decrease in either contributed capital (if the firm retires the shares) or an increase in account called “treasury stock”—in either case, owners’ equity is reduced. (Treasury stock is a contra or negative equity account that reduces owners’ equity. If treasury stock increases, it means that the firm has decided not to retire the shares and can reissue them in the future.)

If at some future point, the firm decides to issue additional shares, and it has both unissued shares (authorized shares that have never been issued) and treasury stock (once issued shares that were repurchased), it can issue either. Basically, cash increases and either contributed capital increases or treasury stock decreases. There are some additional details on how this is done, but it generally does not impact the outside user of financial statements.

Stock Dividends and Stock Splits

Firms sometimes provide owners (shareholders) with additional shares instead of cash dividends. This is known as a “stock dividend” and has two impacts. First, the number of shares issued and outstanding is increased. Second, contributed capital increases and retained earnings decreases by the number of shares times the market price (if there is no market price, some estimate is used). Remember, owners’ equity is comprised of contributed capital and retained earnings. A stock dividend is simply a reallocation of the components of owners’ equity.

Although a stock dividend has no impact on total owners’ equity, it does have an impact on dividends. Remember, as noted above, firms are only allowed to pay dividends up to the amount in retained earnings. By paying a stock dividend, the firm increases its contributed capital and reduces its retained earnings, thereby reducing its future dividend-paying ability.

Firms can also decide to split their stocks. This changes the number of shares authorized, issued, and outstanding, but it has no impact on any dollar amounts in the accounts. So, why would a firm do a stock split? The reason is to change the market price of the shares. For example, consider the price of one Class A share of Berkshire Hathaway. On April 7, 2016, the shares traded at $211,000 per share. Someone with $50,000 to invest could not buy a share. Additionally, someone with one share who wanted $30,000 to buy a car could not sell part of a share in order to get the money he or she needed. In the past, Warren Buffet, the legendary investor behind Berkshire Hathaway, did not want lots of small investors and was happy having shares that not everyone could afford (he also has never paid a dividend). Then, in 1996, he changed his mind and decided to bring his shares to the masses by creating a second class of shares. Why did Warren Buffet change strategies and decide to welcome small investors? His stated reason was to stop brokerage houses from trying to attract business by buying his shares and offering fractional ownership to their clients. Now, a Class B share of Berkshire Hathaway is worth 1/1,500th of a Class A share. The Class A shares can be converted into 1,500 Class B shares. The Class B shares cannot be converted to Class A shares. Only the Class A shares have the right to vote (one vote per share). The Class B shares traded on April 7, 2016, at $140.51. Note the Class A shares have a vote, so the Class B shares should be worth less, which while not always true, was true on April 7, 2016 (1,500 Class B shares were trading for $210,765 ($140.51 each) vs. the $211,000 for a Class A share).

Most public firms try to keep their shares under $100 per share. For example, Apple Inc. initially issued its shares for $22 a share back on December 12, 1980. The firm then split its shares two for one on three separate occasions (June 15, 1987; June 21, 2000; and February 28, 2005) and most recently, split the shares seven for one (on June 9, 2014). When Apple announced the most recent split on April 23, 2014, its shares were trading at $524.75. The seven-for-one split would value each share at $74.96. At the time, the average share in the S&P 500 was $77.91.⁸

This means that one original Apple share purchased for $22 in 1980 would have morphed into 57 shares today. Apple shares traded at a value of $116.47 on November 21, 2014, which means an initial $22 investment would have increased to $6,638.79 (57 shares times $116.47 each).⁹ This is a total increase of 30,000% (or an average annual return of 26.9%). Someone who invested $3,322 in Apple in 1980 (purchased 151 shares for $22 each) would now have 8,607 shares worth just over $1 million (8,607 × $116.47).

Firms can also do reverse splits. This is done when a firm’s share price is falling. Many stock exchanges (NYSE, NASDQ, and so on) have rules preventing the trading of shares if they fall below a certain price (e.g., $1.00 per share). A reverse split will normally increase a share’s market price, but often at less than the presplit value (e.g., a share trading at $1.50 has a one-for-three reverse split and the price moves to $4.00 not $4.50). This is because a reverse split is seen as a negative signal: It tells the market that management is worried that the shares will fall below the exchange minimum.

The Bottom Line

Owners’ equity represents the funds given to the firm by the owners, the cumulative profits and losses earned by the firm, less amounts returned by the firm to the owners.

This ends our, Chapters 5 through Chapter 10, walk down the Balance Sheet. The next chapter presents a discussion of cash flows.

_________________

¹As of September 2014. See http://technically/delaware/2014/09/23/why-delaware-incorporation/.

²The par value of shares is not analogous to the par value of bonds. Par value of shares is, as noted, a fictional amount which bears no relationship to what the owners will receive in the future.

³There is even an idea to have “tenured” shares where the shares have more votes based on the years they have been owned (one vote if owned less than a year, two votes if owned for 2 years, and so on). See D.K. Berman. March 18, 2015. “Seeking a Cure for Corporate Activism,” The Wall Street Journal, B1.

⁴Note that in the United States, the words “shares” and “stock” are used interchangeably. In the UK, the word “stock” normally means inventory.

⁵Remember, a firm does not have to pay a dividend. The dividends only become a required payment if the board of directors declares them. Of course, the shareholders have the power to vote in board members and thus, indirectly, generate the dividends (e.g., by voting in people they believe will tend to have the firm pay dividends).

⁶Another discussed date is the “ex-dividend date.” This is usually two business days before the record date. The seller of a stock on the ex-dividend date (rather than the buyer) will receive the dividend.

⁷Most, but not all, countries allow firms to repurchase their own shares. Additional details on why and how a firm repurchases its own shares are beyond the scope of this book but available in most finance textbooks.

⁸See http://blogs.wsj.com/moneybeat/2014/04/23/apples-7-for-1-stock-split-is-very-unusual/ (viewed November 23, 2015).

⁹Alternatively, adjusting for the splits, each of the 57 shares cost only $0.39 ($22 / 57).