Owners'_Equity

Owners' equity One of the categories presented on the balance sheet is the stockholders’ equity, which “is the stockholders’ claim on the assets of the business” (Weygandt, Kieso, & Kimmel, 2005, p. 13). The section of the stockholders’ equity encompasses capital stock, additional paid-in capital, and retained earnings (Kieso, Weygandt, & Warfield, 2010, p. 744). It is essential from an economic as well as a legal point of view to distinguish between paid-in capital and earned capital because the sources of funding differ. Paid-in capital Stockholders choose to invest assets – most commonly cash - in the corporation providing funds to support business operations. Capital stock and additional paid-in capital represent capital contributed by stockholders in exchange for shares of common or preferred stock. Amounts paid in over par or stated value and paid-in capital from treasury stock is recorded as additional paid-in capital, whereas stated capital is the par value of the shares (Kimmel, Weygandt, & Kieso, 2005, p. 548). Earned capital Earned capital or retained earnings represent capital earned by a company as a result of business operations less paid-out dividends. “Earned capital consists of all undistributed income that remains invested in the company” (Kieso, Weygandt, & Warfield, 2010, p. 744). Companies often use a percentage of the net income as retained earnings to reinvest into the company to support development and growth. A net loss occurs when expenses exceed revenues; in this case the net loss is debited to retained earnings. If the net loss exceeds the beginning retained earnings, it may result in negative retained earnings and is recorded as a deficit. For investors it is more important to concentrate on the amount of earned capital because it represents profit generated through business operations, whereas paid-in capital is generated through the sales of stocks. Studying retained earnings also gives investors an informative overview how well the earnings are reinvested into the corporation and how management decides to distribute capital. Basic or diluted earnings “Earnings per share (EPS) is a measure often used in evaluating a firm’s stock price and assessing the firm’s future earnings and ability to pay dividends” (Epstein, Nach, & Bragg, 2009, p. 99). EPS are divided into two main forms: basic earnings per share and diluted earnings per share. The calculation of basic earnings per share is relatively simple and straight-forward: the corporation’s net income less any preferred stock dividends is divided by the total number of shares outstanding. This computation gives shareholders a general overview, but it lacks accuracy because it fails to take into account that outstanding convertible securities could be converted to common stock. Investors prefer the more complex but also more accurate calculations of diluted earnings per share. In addition to regular outstanding stocks, diluted EPS factor in the possibility that all outstanding convertible securities are converted to common stock, which results in a lower value than basic EPS. Such outstanding convertible securities include convertible preferred shares, convertible debts, stock options, and warrants (Berry, 2011, p. 44). Considering these factors lead to a more realistic view of a corporation’s earnings per share. If a company has to report a net loss, the dilutive shares become anti-dilutive, “because the inclusion of dilutive shares in the earnings per share equation would then reduce the amount of the loss per share” (Accounting Tools, 2012). Conclusion As a general rule, investors should study all financial statements and every category within the statements to arrive to an educated conclusion about a company’s financial health. When researching the statement of financial position, investors need to pay close attention to the sources of the shareholders’ equity. Paid-in or contributed capital is important if users want to know about the amount of equity invested by the owners. It is, however, essential to peruse the information provided about the earned capital because it is generated through the profitable operations of the company. Earnings per share indicate how a company performs and indicates to investors their share of the company’s total profits. Basic and diluted earnings per share are computed in a similar fashion but diluted EPS also takes into account common stock equivalents and all other securities that potentially could be converted into common stock. Therefore, diluted EPS presents a more accurate estimation of the total earnings per share and is the preferred method by investors.   References Accounting - Financial or Tax. (2012). Stockholders' Equity (Contributed Capital, Earned Capital, Comprehensive Income, Treasury Stock). Retrieved from http://accounting-financial-tax.com/2008/10/stockholders-equity-contributed-capital-earned-capital-comprehensive-income-treasury-stoc/ Accounting Tools. (2012). Diluted Earnings per Share Formula. Retrieved from http://www.accountingtools.com/diluted-earnings-per-share-for Berry, L. E. (2011). Financial Accounting Demystified. New York, NY: McGraw Hill. Epstein, B. J., Nach, R., & Bragg, S. M. (2009). Wiley GAAP 2010. Hoboken, NJ: John Wiley & Sons, Inc.. Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2010). Intermediate Accounting (13th ed.). Hoboken, NJ: John Wiley & Sons, Inc.. Kimmel, P. D., Weygandt, J. J., & Kieso, D. E. (2005). Principles of Accounting. Hoboken, NJ: John Wiley & Sons, Inc.. Weygandt, J. J., Kieso, D. E., & Kimmel, P. D. (2005). Financial Accounting (5th ed.). Hoboken, NJ: John Wiley & Sons, Inc..