Shareholders' equity represents the interest of a company's shareholders in the net assets of the company. It equals the excess of a company's total assets over its total liabilities.
A company's total assets are either brought in by the shareholders or financed by the creditors. Creditors are entitled to the assets to the extent of the total funds they have contributed. The residual interest lies with the shareholders who enjoy all profits and bear all losses. This fundamental relationship is expressed in the form of accounting equation, which is as follows:
Assets = Liabilities + Shareholders' equity
A little algebraic manipulation gives us precisely the definition of shareholders equity:
Shareholders equity = Assets - Liabilities
In case of a sole proprietor, the residual interest is called 'capital' while in case of a partnership the residual interest is the sum of individual capital of all the partners.
In case of companies, shareholders equity has the following possible components:
- Common stock
- Preferred stock
- Additional paid-up capital-common stock
- Additional paid-up capital- preferred stock
- Retained earnings
- Foreign currency translation reserve
- Available-for-sale securities reserve
- Cash flow hedge reserve
- Revaluation reserve
- Treasury shares
- Non-controlling interest (also called minority interest)
Common stock represents interest of shareholders who are owners of the company, who have voting powers, who are the ultimate recipients of all profits and losses after interest and preferred dividends are paid, and who bear any loss or enjoy any gains in event of winding up.
Common stock = Number of shares issued × par value per share
Number of authorized share capital with reference to common stock is the number of shares the company is legally entitled to issue. Number of shares issued is the number of shares the company has actually issued since its formation.
Preferred stock represents the shareholders who have secondary interest in the residual assets because they do not normally have voting powers, who enjoy a fixed dividend before anything is paid to common shareholders and who have preference over common stock holders in case of winding up.
Preferred stock = Number of preferred shares issued × par value per share
Additional paid-up capital
Additional paid-up capital (also called share premium) represents the amount received from investors on all shares issued by a company is excess of the balance in common stock account.
Additional paid-up capital = Number of shares issued × (share price – par value)
Additional paid-up capital account accumulates all the share premium received since formation.
Contributed capital is the total consideration received from shareholders in return of the ownership right.
Contributed capital = common stock + additional paid-in capital
Contributed capital = shares issued × issue price
Retained earnings (or accumulated earnings) or accumulated losses is the amount of earnings accumulated from previous periods. Retained earnings increase by the amount of net income for a period and decrease on account of dividend payments and restatement, if any.
Retained earnings at the start of a period
+ Net income for the period
- Dividends paid
± Restatement on account of accounting policy changes or errors
= Retained earnings at the end of a period
Foreign currency translation reserve
Foreign currency translation reserve accounts for the net effect on shareholders equity when a company's financial statements are converted from its functional currency to its presentation currency.
Available for sale securities reserve
Available for sale securities reserve accounts for fair value changes in the available for sale securities. While the realized income and loss from available for sale securities is included in the net income, unrealized gains and losses i.e. fair value changes are reflected directly in shareholders equity.
Cash flow hedge reserve
Reserve for cash flow hedge represents effective changes in fair value of a hedging item. For example, if a company has hedged a bond with an option, changes in value of the option which successfully offsets changes in fair value of the bond is accounted for in reserve for cash flow hedge.
Revaluation surplus (or revaluation reserve) appears in IFRS financial statements and it accounts for changes in value of property, plant and equipment for which a company has adopted the revaluation model. Upward revaluation is credit to revaluation surplus and downward revaluation is debited to the account with any excess taken to the income statement.
Treasury shares are a company's common shares which the company has purchased back. Treasury shares account is a contra-equity account, i.e. its has a debit balance in contrast with the normal credit balance of equity accounts. It is subtracted from the sum of all other shareholders equity components.
Non-controlling interest (minority interest)
Non-controlling interest is a shareholders equity component that appears in case of consolidated financial statements. It represents the shareholders equity attributable to owners other than the parent company, i.e. those shareholders who do not have controlling stake in the company.
Non-controlling interest = total shareholders equity – shareholders equity attributable to parent
Written by Obaidullah Jan, ACA, CFA