Brief Review of the Balance Sheet
The balance sheet sums up the financial health of an entity at a specific financial period by detailing its assets, liabilities, and equity. By comparing and contrasting the beginning owners’ equity with the ending owners’ equity, the user of the financial statement will know if the capital for that accounting period was expanded or abated.
According to the Financial and Accounting Standards Board, the items to be reported on the balance sheet, and in any other financial statements, must be measurable, relevant, and reliable. The balance sheet contains three elements: assets, liabilities, and stockholders’ equity.
The Stockholders’ Equity
It should be remembered that;
Assets = Liabilities + Stockholders’ Equity where;
Stockholders’ Equity = Assets – Liabilities
After the liabilities have been subtracted from the assets, the remaining interest in the assets of an entity is called the stockholders’ equity or the net assets. In the balance sheet, these are the assets claimed by the owners of the company.
In general, the stockholders’ equity section on the corporation’s balance sheet contains the paid-in capital, retained earnings, other accumulated comprehensive income (loss), and treasury stock.
Sometimes ascribed as contributed capital, the paid-in capital represents the amount of investment an owner has in a business. Paid-in capital can also be described as the amount paid by stockholders in exchange for shares of ownership.
There are three categories under paid-in capital: common stock, preferred stock, and additional paid-in capital.
- Common Stock
In situations wherein no other classes of stocks are authorized, common stock is referred as capital stock. Basically, it represents retained ownership.
Common stockholders are considered as the absolute owners of the corporation. As such, they have control on residual assets. In the event of bankruptcy, their obligations are circumscribed on the amount of their investment. They are not compelled to increase their investment in order for the business to compensate for its losses. Responsibilities of common stockholders include electing members of the board of directors, authorizing transactions such as mergers, and ratifying changes in the corporate charter.
Common stock can either be of par value or of no-par-value. Par value is the designated minimum amount on each share, as described in the corporate charter.
On the balance sheet, the numbers of shares of stocks authorized, issued, and outstanding are indicated. The authorized shares are the maximum allowable shares a corporation can issue. Issued shares are shares that have been sold or turned over to stockholders. It should be noted that this does not imply that the shares are outstanding in nature. Outstanding shares are shares that are currently in possession of the stockholders.
- Preferred Stock
What makes preferred stock distinct from common stock is its debt-like characteristics. Moreover, it pertains to dividends or the sharing of the corporation’s income to its owners. In situations like liquidation, preferred stockholders have bounded claim on assets.
Dividends under preferred stocks have cumulative, participating, convertible, or callable characteristics. In the event that no dividend is declared in one year, the dividend on preferred stock will be regarded as a debt, therefore the dividend is cumulative. This must be settled first before ensuing common dividends are distributed.
If there is a very large dividend in a year, the excess dividends will be distributed among the common and preferred stockholders in a specified ratio on top of the preferred and common stockholders’ usual dividends, ergo the dividend is participating.
From the name itself, a convertible dividend can be converted or transformed into a common stock. In this way, stockholders are given the option to increase their returns through a common stock or the advantage of lower risk with a preferred stock.
A callable dividend can be redeemed at the discretion of the corporation.
On the balance sheet, the preferred stock contains information on the par value and dividend rate; liquidating value or redemption value; and the shares issued, retained, and sanctioned by the corporate charter.
- Additional Paid-In Capital
Sometimes referred as capital in excess of par value, stated value, and capital surplus, an additional paid-in capital shows the excess amount obtained by the owner from selling preferred or common stock.
Retained earnings or earned capital is the amount of net earnings of a company throughout its operations that are not paid out as dividends. From an economic perspective, the difference between paid-in capital and retained earnings is that paid-in capital is the amount paid for the stocks or shares of the company while the retained earnings is the gained capital retained for future use.
In defining the owners’ equity section on the balance sheet, it should be noted to keep the disparities between paid-in capital and retained earnings.
Other Accumulated Comprehensive Income (Loss)
Based on the released Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income,” by the Financial Accounting Standards Board (FASB), accumulated other comprehensive income (loss) covers the accruing adjustments in foreign currency translation, gains or losses on particular derivative instruments, latent gains or losses on investments that are ready to be sold, and variations during the time in earlier service costs and net actuarial gains or losses relative to the post-retirement and pension plans.
A study guide from the California State University, Long Beach described treasury stock as “the corporation’s own stock that has been issued, fully paid for, repossessed by the corporation, and retained in its treasury for eventual use.
Corporations acquire treasury stock for various reasons. It can be used to curtail the number of outstanding shares in order to expand the earnings per share or use it to get rid of antagonistic shareholders by buying them out. Furthermore, treasury stock can be reissued to employees and executives as bonus or stock compensation.
Generally, there are two methods in accounting the treasury stock. It can be via cost method or par method. The cost method debits the treasury stock by the cost to repossess the shares while par method debits the treasury stock by the quantity of acquired shares multiplied by the par value. Between the two, the par method is ideal since it keeps the relationship of the stock accounts and paid-in capital in excess of par.