Stockholders' Equity (1)

Equity versus Debt

Equity is Ownership in a company.

Debt represents all liabilities, bills and money owed by a company, including bank loans and mortgages.

The Accounting Equation is Assets = Liabilities + Owners' Equity

As we see by this equation, all assets are financed by total equity and debt.

Banks and other lenders expect the owners to take most of the risk in a business. Banks may be willing to lend a corporation some money, but only after stockholders have put in their share first.

Banks generally lend long-term money for long-term assets. This includes mortgage loans for land, buildings and equipment. The asset is pledged capital against the loan, so the bank can take the property back in the event the loan payments aren't made. This further limits the bank's risk of loss.

But, banks generally don't lend long-term money for short-term needs. Short term needs include daily operating expenses, inventory, payroll, insurance premiums and the like. Loaning long-term money for short-term needs is very risky for a bank. They have no collateral to repossess if the corporation defaults on the loan.

Short-term money comes from stockholders, who must take the greatest risk.But in exchange for taking the risk, stockholders are also entitled to benefit from the growth and earnings of the company for years to come. Some companies fail and the stockholders lose their entire investment. But other companies are extremely successful and the financial reward to stockholders can be huge.

Creating a corporation and issuing stock

The life of a corporation starts when the Organizers file an application with the Secretary of State, and pay a fee. The application contains the Articles of Incorporation and asks the State to authorize the company to issue stock.

Authorized, Issued, Outstanding and Treasury stock
Authorized - The Secretary of State authorizes a corporation to issue shares of stock. This determines the total number of shares that can be issued, and the par value per share.

Issued - Once a corporation sells a share of stock to a stockholder, that share is issued. A share can be issued only once by the corporation, but it can be traded any number of times among shareholders and investors. Trading is generally done on a public stock market, and transactions go through a stock broker.

An Initial Public Offering (IPO) is the sale and issue of new stock, usually by a new corporation. After the IPO all future trading will take place on a stock market, with shares being traded amoung investors. After the IPO, the corporation is essentially out of the picture, when it comes to stock market activities. The corporation receives money only in the IPO.

Outstanding - After being authorized and issued, the total number of shares held by stockholders is called outstanding. Dividends are paid on outstanding shares only.

Treasury stock - Sometimes a company buys its own stock back from stockholders. This stock is held in the treasury (along with all the gold and crown jewels :-). No dividends are paid on treasury stock. Treasury stock can be held indefinitely, resold at any time, or retired. Retired stock is permanently removed from future sale and dividends.

A treasury stock journal entry includes a debit to the treasury stock account. It appears as a negative amount in the stockholders' equity section of the balance sheet.

Buying treasury stock reduces the number of shares outstanding. This has several effects. Reducing the number of shares increases Earnings Per Share (EPS). In return the stock's market price generally goes up, or at least holds steady in declining economic times. Since fewer shares are outstanding it also reduces total dividends.

An example: XYZ, Inc plans an IPO. The Secretary of State authorizes them to sell 1,000,000 shares of $1 par common stock. Through a stock market the company offers 750,000 shares for sale to interested investors. They hold back 250,000 shares from issue, because these may be needed later for employee stock option plans. Later that year the corporation decides buy back 50,000 shares that were previously issued.

	authorized	issued	treasury	outstanding
Authorized	1,000,000	0	0	0
Sold in IPO	1,000,000	750,000	0	750,000
Bought Treasury	1,000,000	750,000	(50,000)	700,000