If the source of an asset was an investor purchasing new shares of common stock, the corporation would credit the stockholders’ equity account Common Stock and perhaps Paid-in Capital in Excess of Par–Common Stock, or Premium on Common Stock. If the source of an asset was an investor purchasing new shares of preferred stock, the corporation would credit the stockholders’ equity account Preferred Stock and perhaps Paid-in Capital in Excess of Par–Preferred Stock, or Premium on Preferred Stock.

If the source of an asset was the net income earned by the corporation, the stockholders’ equity account Retained Earnings would be credited. If a corporation reduces its assets by purchasing its stock from its stockholders, the contra-stockholders’ equity account Treasury Stock is debited.

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If the cumulative earnings minus the cumulative dividends declared result in a negative amount, there will be a negative amount of retained earnings. This negative amount of retained earnings will be reported as a separate line within stockholders’ equity.

If the amount of negative retained earnings is greater than the amount of paid-in capital, the total of the stockholders’ equity section will also be a negative amount.

To recap, negative amounts can occur and the negative amounts must be reported.

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The second entry occurs on the date of the payment to the stockholders. On that date the current liability account Dividends Payable is debited and the asset account Cash is credited.

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From an accounting standpoint, the par value of an issued share of common stock must be recorded in an account separate from the amount received over and above the amount of par value. For example, if a corporation issues 100 new shares of its common stock for a total of $2,000 and the stock’s par value is $1 per share, the accounting entry is a debit to Cash for $2,000 and a credit to Common Stock—Par $100, and a credit to Paid-in Capital in Excess of Par for $1,900. In total the Cash account increased by $2,000 and the paid-in capital reported under stockholders’ equity increased by a total of $2,000 ($100 +$1,900).

If a corporation is not required to have a par value or a stated value and the corporation issues 100 shares for $2,000, then the accounting entry will be a debit to Cash for $2,000 and a credit to Common Stock for $2,000.

In other words, when the issued stock has a par value, the proceeds from the issuance gets divided between two of the paid-in capital accounts within stockholders’ equity. If the issued stock does not have a par value, the proceeds from the issuance goes into just one paid-in capital account within stockholders’ equity.

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Other comprehensive income includes unrealized gains and losses on certain investments in securites, foreign currency items, and certain pension liability adjustments.

Net income is reported on the income statement and is included in the retained earnings section of stockholders’ equity.  Other comprehensive income items are not reported on the income statement, and are included in the accumulated other comprehensive income section of stockholders’ equity.

The accounting for comprehensive income is provided in the Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, available for reading at www.FASB.org/st.

Paid in capital, also referred to as contributed capital, is the amount that the corporation received from stockholders when the corporation issued its stock. Paid in capital is also referred to as permanent capital.

Retained earnings is the cumulative amount of after tax net income earned by the corporation since its inception minus the dividends that have been distributed to the stockholders since the corporation began.

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For example, if a corporation without preferred stock has stockholders’ equity on December 31, 2007 of $12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per share is $12.42.

Keep in mind that the book value per share will not be the same as the market value per share. One reason is that a corporation’s stockholders’ equity is simply the difference between the total amount of assets reported on the balance sheet and the total amount of liabilities reported. Long term assets are generally reported at original cost less accumulated depreciation and some valuable assets such as trade names might not be listed on the balance sheet.

Learn more about Financial Ratios by using AccountingCoach.com’s free Explanation of Financial Ratios, its free Drills for Financial Ratios, its free Crosswords for Financial Ratios, and its free Word Scramble Puzzle for Financial Ratios.

To illustrate, let’s assume that a corporation’s net income after tax was $100,000 for the year 2007. Let’s also assume that it did not have any preferred stock outstanding and that its stockholders’ equity was $950,000 at the beginning of 2007 and was $1,050,000 at the end of 2007. The increase was at a uniform rate throughout the year. The return on stockholders’ equity will be 10% ($100,000 divided by the average stockholders’ equity of $1,000,000).

If a corporation has preferred stock outstanding, the relevant name is return on common equity and will be calculated as follows: net income after tax minus the required dividends on its preferred stock, divided by the average amount of common stockholders’ equity during the period of the income.

As with most ratios, you should compare your corporation’s return on equity with the ratio for other corporations in your industry.

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For example, when a corporation issues shares of its common stock and receives more than the par value of the stock, two accounts are involved: 1) the account Common Stock is used to record the par value of the shares being issued, and 2) the amount that is greater than the par value is recorded in an account entitled Paid-in Capital in Excess of Par—Common Stock, or Premium on Common Stock.

Many years ago, the account Paid-in Capital in Excess of Par—Common Stock and the account Premium on Common Stock were referred to as capital surplus.

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When a corporation issues shares of its stock for cash, the corporation’s current asset Cash will increase with the debit part of the entry, and the account Contributed Capital will increase with the credit part of the entry. If the corporation then uses some of its cash to purchase equipment, its current asset Cash will decrease and its non-current asset Equipment will increase.

If a corporation receives equipment in exchange for newly issued shares of stock, the non-current asset Equipment will increase and Contributed Capital will increase.

The effects of double entry accounting are illustrated under the topic Accounting Equation.

For example, if a corporation has cumulative preferred stock with an annual dividend of $10,000 and it has omitted the dividends for the past three years, there is $30,000 of dividends in arrears. In order to pay any dividend to its common stockholders, the corporation will have to first pay its preferred stockholders $40,000. That is the amount of the past omitted dividends of $30,000 and the current year preferred dividend of $10,000.

Using the information above, but assuming that the corporation pays a total of only $5,000 in dividends in the current year, the preferred stockholders must receive the entire $5,000 and the dividends in arrears will be $35,000 at the end of the current year.

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Occasionally, equity is used to mean the combination of liabilities and owner’s equity. For example, some restate the basic accounting equation from Assets = Liabilities + Owner’s Equity to Assets = Equities.

Equity is also used to indicate an owner’s interest in a personal asset. The owner of a $200,000 house that has an $80,000 mortgage loan is said to have $120,000 of equity in the house.

Outside of accounting, the word equity is also used to indicate fairness or justice.

Learn more about the Balance Sheet. Learn more about the Accounting Equation.

A stakeholder is anyone that has an interest or is affected by a corporation. In other words, the stockholder isn’t the only party having a stake in the corporation. Other stakeholders in a corporation include the employees, the employees’ families, suppliers, customers, community, and others.

Some organizations do not have stockholders, but have stakeholders. For example, the state university doesn’t have stockholders, but it has many stakeholders: students, the students’ families, professors, administrators, employers, state taxpayers, the local community, the state community, society in general, custodians, suppliers, etc.

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However, capital market can also include less structured markets such as private placements for stocks, bonds, and other debt.

If the business is a corporation and the owner’s infusion of cash is an investment, the account Common Stock is credited. (If the common stock has a par value, Paid-in Capital in Excess of Par is also used.) If the owner lends cash to the corporation, the liability account Notes Payable to Stockholder is credited. When the asset is not cash, the amount recorded is the cash equivalent or fair market value of the asset or the fair market value of the common stock isssued, whichever is more clear.

You should consult with your accounting and tax professional about the pros and cons of investing versus lending.

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For example, a corporation might issue 9% $100 Preferred Stock. The stock agreement (indenture) states that the stock is callable by the corporation after three years at $109 per share plus any accrued interest. If in the fourth year, market interest rates decline to say 7%, the corporation can call-in the preferred stock by paying the call price of $109 plus any accrued interest.

The callable feature allows the corporation to get out of the preferred stock agreement requiring it to pay 9% interest. In turn, the stockholders will be deprived of receiving the 9% interest in a 7% market. The call price has the effect of limiting how high the market value of preferred stock will rise.

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Arrears is also used in the context of annuities. When an annuity’s equal payments occur at the end of each period, the annuity is said to be an annuity in arrears or an ordinary annuity.

Arrears is also used to simply mean past due, or behind in payments.

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The net result of the declaration and payment of the dividend is that the corporation’s assets and stockholders’ equity have decreased. Specifically, the balance sheet accounts Cash and Retained Earnings were decreased.

The income statement is not affected by the declaration and payment of cash dividends on common stock. (The cash dividends on preferred stock are deducted from net income to arrive at net income available for common stock.)

The cash dividends will be reported as a use of cash in the financing activities section of the statement of cash flows.

Interest on bonds and other debt is an expense of the corporation. The interest expense will reduce the corporation’s net income and its taxable income. When interest expense occurs and is paid, the corporation’s cash is reduced by the interest payment, but some cash will be saved by the reduction in income taxes. The corporation’s retained earnings will also be reduced by less than the amount of interest expense. For example, if a corporation has an incremental tax rate of 40%, interest expense of $100,000 will result in $40,000 less in income tax expense and income tax payments. This means that an interest payment of $100,000 will reduce the corporation’s cash and retained earnings by the net amount of $60,000 ($100,000 of interest minus $40,000 of tax savings).

Since interest is formally promised to the lenders, accountants must accrue interest expense and the related liability Interest Payable. If the payment for interest is not made, the corporation will face legal consequences.

Dividends on common stock are not legally required. Therefore, if the corporation does not declare a dividend there is no liability for the omitted dividends.

In the expanded accounting equation for a corporation, Stockholders’ Equity in the basic accounting equation (Assets = Liabilities + Stockholders’ Equity) is replaced by these components: Paid-in Capital + Revenues - Expenses - Dividends - Treasury Stock. The resulting expanded accounting equation for a corporation is: Assets = Liabilities + Paid-in Capital + Revenues - Expenses - Dividends - Treasury Stock.

The expanded accounting equation allows you to see separately (1) the impact on equity from net income (increased by revenues, decreased by expenses), and (2) the effect of transactions with owners (draws, dividends, sale or purchase of ownership interest).

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To illustrate the premium on common stock, let’s assume that a corporation issues one share of its common stock having a par value of $0.10 per share. If the corporation receives $20 in exchange for the share, $19.90 will be recorded as the premium on common stock.

Accounting textbooks often refer to the premium on common stock as paid-in capital in excess of par value–common stock or as contributed capital in excess of par value–common stock.

For example, if a corporation has 100,000 shares of $1.00 par value stock and it declares a 2-for-1 stock split, the corporation will have 200,000 shares with a par value of $0.50 per share. Before and after the stock split, the total par value is $100,000. Other account balances within stockholders’ equity also remain the same.

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Treasury stock is the result of a corporation repurchasing its own stock and holding those shares instead of retiring them.

In the general ledger there will be an account Treasury Stock with a debit balance. (At the time of the purchase of treasury stock, the corporation will debit the account Treasury Stock and will credit the account Cash.)

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Another use of the word arrears occurs with annuities. (An annuity is a series of equal amounts occurring at equal time intervals…such as $1,000 per month for 20 years.) If the recurring amount comes at the end of each period, the annuity is described as an annuity in arrears or as an ordinary annuity. A loan repayment schedule is usually an annuity in arrears. For example, you borrow $10,000 on September 30 and your first monthly payment will be due on October 31, the second payment will be due on November 30, and so on.

While the amount of retained earnings is reported in the stockholders’ equity section of the balance sheet (and in the accounting equation), the retained earnings are probably invested in assets that are also reported on the balance sheet. For example, let’s assume that you start a corporation to provide website consulting services. You invest $500 in the corporation, and immediately find a client who pays you $4,000 for your services. Your corporation’s Cash is now $4,500 which equals the Paid-in Capital of $500 plus the Retained Earnings of $4,000. On the next day, you spend $3,500 to acquire a computer and other equipment for your corporation plus $300 of supplies. Right after these items are purchased, your corporation will report $700 of Cash + $300 of Supplies + $3,500 of Equipment = Stockholders’ Equity of $4,500—of which $4,000 is Retained Earnings.

The Retained Earnings amount is clearly reported as part of Stockholders’ Equity, but the amount is usually invested in assets or used to reduce liabilities. Rarely will the retained earnings be entirely in cash. The retained earnings need to be invested in income producing assets or in the reduction of liabilities in order to earn a return for the stockholders, who have opted to reinvest their earnings in the corporation.

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One possible explanation for the small amount of cash in relation to the retained earnings is that the company invested in new plant assets in order to expand its operations. Rather than distributing the company’s cash to its stockholders, the company used the cash to pay for the factory and equipment in order to meet demand for its new product line.

Corporations might have a stated policy on dividends. For example, a corporation might pay dividends equal to approximately 40% of its earnings. Another corporation might have a plan to increase the amount of dividends each year by more than the rate of inflation. A new corporation might pay no dividends until its ratio of debt to equity is a specified percentage.

Gain more insight between the relationship between cash and net income with Cash Flow Statement.