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Owners’ Equity - Elements of Balance Sheet in Financial Accounting
This final element of the balance sheet represents the equity of the firm’s owners. As noted in "FASB Definitions of Assets, Liabilities, and Owners’ Equity" in the section Definitions of Assets, Liabilities, and Owners’ Equity, the FASB defines owners’ equity simply as the “residual interest in the assets of an entity that remains after deducting liabilities.” This definition makes it clear that the balance sheet’s valuation of owners’ equity is determined by its valuations of assets and liabilities. This view of owners’ equity as a residual amount is apparent when we rearrange the balance sheet equation in the following way:
OWNERS’ EQUITY = ASSETS - LIABILITIES
Sample Company’s balance sheet in Figure 2.1 in the section "Elements of the Balance Sheet" shows a firm that has been organized as a corporation, which is an entity that is owned by a group of shareholders. Although a corporation’s owners’ equity may be called shareholders’ equity, in Sample Company, it comprises both paid-in capital, which represents direct investments by the owners of the firm, and retained earnings, which represents the earnings of the firm that have been reinvested in the business. Sample Company’s balance sheet in Figure 2.1 in the section "Elements of the Balance Sheet" shows that owners have paid $600,000 for shares of stock of the company. Sample Company has received this invested capital (probably in cash from investors) in exchange for its shares of stock. In addition, the firm has been profitable in the past, and Sample Company has reinvested $258,000 of those profits in the business. This $258,000 represents Sample’s retained earnings.
If in the next year, Sample Company reports profits of $200,000 and pays dividends to shareholders of $75,000, then retained earnings will increase by $125,000 ($200,000 - $75,000). Bear in mind, however, that retained earnings do not represent cash available for the payment of dividends. Rather, retained earnings reflect the amount of resources that a firm has obtained as a result of operations. The firm has retained this increase for use in its operations, rather than returning it immediately to the investors as dividends. Those resources are presently invested as shown on the asset side of the balance sheet. For this reason, it is possible that a firm may have a large retained earnings balance, but have insufficient cash available for dividends.
Case study 2.3 illustrates the reporting of shareholders’ equity for two firms, one of which reports a negative (deficit) balance in retained earnings.
Case Study 2.3
The following schedule summarizes the components of shareholders’ equity reported in the end-of-1997 balance sheets of Bethlehem Steel and Lear Corporation:
Required
a. Which firm has obtained the larger amount of capital through sale of stock to investors?
b. Which firm has obtained the larger amount of capital through reinvestment of earnings?
c. Explain why Bethlehem reports a negative (deficit) balance in retained earnings at the end of 1997.
d. Suppose that Lear earns $150 and pays dividends of $90 during 1998. What would be the firm’s ending balance in retained earnings? (All dollars are in millions.)
Solution
a. Paid-in capital represents the amount that each firm has received through the sale of stock to investors. Bethlehem Steel has obtained $1,923 million, and Lear obtained $852 million from this source.
b. Lear has obtained $401 million of its investment in net assets through retention of earnings. Bethlehem Steel, on the other hand, has a negative balance in its retained earnings. For this reason, Bethlehem has not obtained any of its capital through reinvestment of earnings.
c. Retained earnings are increased when a firm is profitable and decreased when a firm pays dividends to shareholders or incurs losses. The negative (deficit) balance in Bethlehem’s retained earnings indicates that since the firm began operations, its total dividends and losses have exceeded its total income.
d. Lear would report a balance in retained earnings at the end of 1998 of $461 (in millions), computed as follows:
This discussion of owners’ equity completes our tour of Sample Company’s balance sheet, and, at this point, you are aware of the typical components of the balance sheets of most business firms. In future chapters, we will generally use the term shareholders’ equity, rather than the more generic term owners’ equity.
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