Lecture: Stockholders' Equity
Lecture script · about 15–20 minutes spoken · Week 14
Opening
Picture three groups of owners. A few friends start a small software firm and sell shares to their families to get going. Neighbors who shop at a cooperative grocery each buy a share to become members. And our bicycle shop, now in Year 2, wants $45,000 to grow without borrowing it. In every case, owners put money in, and sooner or later the business hands some back. This lecture is about how a corporation records both directions.
Let me remind you where we are. In Week 1 you met the corporation, a legal entity separate from its owners, who have limited liability. In Week 2 you split stockholders' equity into contributed capital and retained earnings, and you learned that a dividend is never an expense. In Week 5 you prepared a statement of retained earnings and closed Dividends. In Week 12 you listed current liabilities, and in Week 13 you watched the shop borrow with bonds. This week is the other way to raise money: selling a piece of the business.
Here's the plan. We'll describe the corporate form, count shares three ways, and issue stock above par. We'll meet preferred stock, pay a cash dividend, and talk through splits. Then we'll buy back shares, build the equity statements, and compute earnings per share. Next week, in the statement of cash flows, every one of these moves shows up again.
1. The corporate form
Start with two friends who run a food truck as partners. If the truck can't pay its debts, the partners may owe them personally. And if one partner wants out, the business may have to end and start over. That's a lot riding on two people.
A corporation changes both of those things. The first change is limited liability, which you met in Week 1: an owner can't lose more than they put in. The second is transferable shares: shares an owner can sell or give to someone else without the business closing or changing. Put those two features together and you have the corporate form.
There's a tax side too, and I'll state it as plain fact, never as advice. A C corporation is taxed separately under the federal corporate income tax. An S corporation's income passes through to its shareholders for federal income tax. A cooperative grocery is a different ownership type again, and in this course we only name it.
Pause and try this. The shop's founders sell some of their shares to a new owner. Does the shop have to close and reopen as a new business?
Think about which feature of the corporate form answers this.
Here's the answer. No, it keeps going. Transferable shares let ownership change hands while the corporation stays the same business.
2. Authorized, issued, and outstanding
Here's a puzzle. Ask how many shares the shop has, and you'll get three honest replies, because accountants count shares three ways.
Authorized shares are the largest number of shares a corporation's charter allows it to issue. The shop's charter authorizes 100,000. Issued shares are the shares it has sold to owners so far. Outstanding shares are the issued shares still held by owners, which means issued shares minus any the corporation has bought back.
Each share also carries a par value, a legal amount per share printed in the charter. It sets how much goes to the Common Stock account, and it is not the share's market value. The shop's stock is $1-par. Go back to Dataset A, which is illustrative. On Day 1 of Month 1, the founders paid $30,000 for 30,000 shares. That's $1 a share, exactly par, so all $30,000 went to Common Stock.
Pause and try this. In Year 2 the shop's shares sell for $9 each. Does their par value change to $9?
Hold on to what par value is for.
Here's the answer. No, par stays $1. Par is a legal amount fixed in the charter, and the $9 is what a buyer pays, which is market value.
3. Issuing stock above par
Imagine joining friends whose business has been running for three years. They took the early risk, and the business is worth more now. You'd expect to pay more per share than they did on the first day. That gap between par and what you pay is exactly what this entry records.
When a corporation issues common stock above par, Common Stock gets par, and Additional Paid-in Capital gets the rest. That's the account that records what owners paid for shares above their par value.
Here's the shop's Year 2 issue, from Dataset K. On the first day of Year 2, it sells 5,000 shares at $9 a share, so it receives $45,000. Par is 5,000 shares at $1, which is $5,000 to Common Stock. The rest, $45,000 minus $5,000, is $40,000 to Additional Paid-in Capital. So the entry debits Cash for $45,000 and credits Common Stock for $5,000 and Additional Paid-in Capital for $40,000. Debits and credits both total $45,000. Issued shares are now 35,000, and all of them are outstanding.
Pause and try this. Why doesn't the shop credit the whole $45,000 to Common Stock?
Think about what Common Stock is supposed to equal.
Here's the answer. Because Common Stock holds only par. With 35,000 issued shares at $1 par, the account should read $35,000, and the $40,000 above par belongs in Additional Paid-in Capital.
4. Preferred stock
Think about a line that serves one group first. Everyone gets served, but some people go ahead. Preferred stock works like the front of that line. It's a class of shares with priority over common stock for dividends and in liquidation, usually without voting rights.
Priority means order. When the board pays a dividend, preferred owners get theirs before common owners get anything. If the corporation closes and sells everything, preferred owners are repaid first too. What preferred owners usually give up is a vote.
The shop issues no preferred stock. So its preferred dividends are $0, and that zero will matter in a few minutes, when we compute earnings per share.
Pause and try this. Does "preferred" mean preferred owners always end up with more money than common owners?
Separate the idea of order from the idea of size.
Here's the answer. No, it means they're paid first. Common owners keep whatever the business earns beyond the preferred dividend, and preferred owners usually can't vote.
5. A cash dividend and its three dates
A dividend doesn't happen in one moment. It happens on three days, and only two of them get an entry.
A cash dividend is a dividend paid in cash, declared as an amount per share on the shares outstanding. On the declaration date, the board declares it and the corporation records the liability. On the record date, nothing is recorded; that date only fixes who receives the dividend. On the payment date, the corporation pays and removes the liability. The liability is Dividends Payable, a current liability like the ones you listed in Week 12.
Here's the shop. Its board declares $0.20 a share on its 35,000 outstanding shares, which is $7,000. In Month 5 it declares and sets the record date. The declaration entry debits Dividends for $7,000 and credits Dividends Payable for $7,000. In Month 6 it pays: debit Dividends Payable, credit Cash, $7,000 each. At year end, Dividends closes to Retained Earnings, as it did in Week 5.
Pause and try this. On which of the three dates does the shop make no entry at all?
Ask which date moves no money and creates no debt.
Here's the answer. The record date. It only settles who gets paid, so it changes no account.
And remember Week 2: a dividend is a distribution to owners, never an expense, so it never touches the income statement.
6. Stock dividends and stock splits
Think about a cake cut into eight pieces instead of four. You have more pieces, but no more cake. Two equity events behave the same way.
A stock dividend hands owners additional shares instead of cash and moves an amount from retained earnings to paid-in capital. A stock split increases the number of shares and cuts par value per share in proportion. In a 2-for-1 split, every share becomes two, each with half the par value.
In this course we treat these in words, and the one point I want you to keep is this. Neither a stock dividend nor a stock split changes total stockholders' equity. No asset leaves the corporation, and no owner pays anything in. The same claim is sliced into more pieces.
Pause and try this. After a 2-for-1 split, does a corporation's total stockholders' equity double?
Picture the cake again.
Here's the answer. No, it stays the same. The shares double and par value halves, but nothing enters or leaves the business.
7. Treasury stock at cost
Picture a family business that once sold shares to a friend. The friend is moving away and wants cash, so the business buys the shares back. Now it's holding a piece of itself.
Treasury stock is a corporation's own shares that it has reacquired and not retired. Under the cost method it's recorded at cost and reported as a deduction from stockholders' equity. It reduces shares outstanding, but not shares issued, because those shares were issued once and haven't been cancelled.
At the end of Month 6, the shop buys back 1,000 of its own shares at $10 a share, for $10,000. The entry debits Treasury Stock for $10,000 and credits Cash for $10,000. Issued shares stay at 35,000. Outstanding shares fall to 34,000.
Pause and try this. The shop paid $10,000 cash and got its shares back. Should Treasury Stock be listed as an asset?
Ask whether a business can own a claim on itself.
Here's the answer. No, it's a deduction from equity. A corporation can't own a claim on itself, so the $10,000 shrinks the owners' remaining claim instead.
8. The equity statements
Now imagine a lender reading the shop's Year 2 balance sheet. The lender wants to know where the owners' claim came from: what the owners paid in, and what the business earned and kept.
Start with the statement of retained earnings. Retained earnings begin Year 2 at $13,000. Add net income of $69,000, subtract the $7,000 of dividends, and you end at $75,000.
Then the stockholders' equity section, the part of the balance sheet that lists the paid-in capital accounts and retained earnings, less treasury stock. Common Stock is $35,000. Additional Paid-in Capital is $40,000. Retained Earnings is $75,000. Subtract Treasury Stock of $10,000, and total stockholders' equity is $140,000.
Last, the statement of stockholders' equity, which shows how each equity account changed during the year. The year opens at $43,000: the founders' $30,000 of Common Stock plus $13,000 of retained earnings. Add the $45,000 stock issue and the $69,000 of net income. Subtract the $7,000 of dividends and the $10,000 buyback. The year closes at $140,000, the same total as the equity section, so the two tie.
Pause and try this. Which account does the shop's $69,000 of net income go into: Common Stock, Additional Paid-in Capital, or Retained Earnings?
Ask whether the owners paid that money in or the business earned it.
Here's the answer. Retained Earnings. Paid-in capital records only what owners paid for shares, and the $69,000 is what the business earned.
9. Basic earnings per share
Here's a carpool question. If a carpool carries six riders for half the year and five for the other half, how many riders did it carry on average? Somewhere in between. Earnings per share asks the same kind of question about shares.
Basic earnings per share is net income minus preferred dividends, divided by the weighted-average common shares outstanding, which counts each group of shares for the part of the year it was outstanding. The shop had 35,000 shares outstanding for the first half of Year 2 and 34,000 for the second half. Half of 35,000 is 17,500, and half of 34,000 is 17,000. Together that's 34,500. Net income is $69,000, and preferred dividends are $0. Divide $69,000 by 34,500, and basic earnings per share is $2.00.
Pause and try this. Why doesn't the shop divide by the 34,000 shares it had at year end?
Think about the 1,000 shares it bought back halfway through.
Here's the answer. Because those 1,000 shares were outstanding for half the year. The weighted average counts that half, which gives 34,500 shares and $2.00 a share.
Closing
Let me pull it together. The corporate form gives owners limited liability and transferable shares, and a C corporation is taxed separately while an S corporation's income passes through. Shares are authorized, issued, and outstanding, and par value is a legal amount, not a price. When the shop sold 5,000 shares at $9, Common Stock took $5,000 and Additional Paid-in Capital took $40,000. Preferred stock is paid first. The $7,000 dividend was recorded when declared and paid a month later, with nothing on the record date. Splits and stock dividends left equity unchanged. The $10,000 buyback reduced equity, not assets.
Here's the sentence to keep. In Year 2 the owners put in $45,000, the shop earned $69,000, paid its owners $7,000, and bought back $10,000 of its own shares. So equity grew from $43,000 to $140,000, and each average share earned $2.00.
Next in this module come the slide deck, the Readings and Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment. Next week, in The Statement of Cash Flows, Analysis, and the Course Synthesis, you'll follow the shop's cash across Year 2.
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