Accounting for Shareholders Wealth - Essay Example

Accounting for Shareholders’ Wealth of Introduction Financial accounting is a specialized section of accounting, which records and analyzes financial transactions of a company. Financial accountings follow certain principles and conventions for recording, summarizing and presenting financial data in the form of financial statements. The financial statements, such as, balance sheet, profit and loss account and cash flow statement, are useful to shareholders and other stakeholders of the company for understanding the firm’s performance and financial standing. The financial statements are highly beneficial for internal and external members of an organization. Every organization presents its financial statements on a routine schedule; for instance, at the end of every financial year. These statements are analyzed by bankers, lenders and shareholders to understand company’s ability to earn return or pay interest. The following sections of the paper discuss various components of the balance sheet related to shareholders’ and organizational wealth (R. Libby, P. A. Libby & Short, 2001). Defining, calculating and reporting shareholders’ equity Definition Shareholders’ equity is one of the three important components of the balance sheet of an organization. The other two components are assets and liabilities. Shareholders’ capital is defined as fund that is created from investment by the owner(s), investors and from profit retained for the business. Shareholders’ equity is otherwise known as equity capital, shareholders’ capital and shareholders’ fund. In a privately owned business, the shareholders’ equity comprises capital brought in by the company’s owner or the co-owners. In sole proprietorship firm, the shareholders’ capital is investment made by the owner and sometimes, his relatives; while in a partnership firm, the capital is brought in collectively by the partners. In a publicly owned firm, the fund or shareholders’ capital is gathered from investment made by owners as well as that raised from general public by issuing shares or stock (Cronqvist & Fahlenbrach, 2009). Calculation The total asset of a company is represented by sum of total liabilities and the shareholders’ equity. Hence, shareholders’ capital is the residual value after paying off all liabilities of the firm from its total asset. In accounting equation, the shareholders’ capital is obtained when total liabilities are deducted from total assets. Shareholders’ fund = Total assets – total liabilities In this regard, it is important to mention that total assets include both current as well as fixed asset, while the total liabilities includes current payables and long-term loans and debts. Reporting In the balance sheet, shareholders’ equity is reported in the liability side as a part of capital. Stockholders’ equity is represented in two parts, namely paid-in capital and retained earnings, in the financial statement. The paid-in capital is the net investment of stockholders, while retained earnings is profit retained by the company after paying dividend and appropriating for reserves and surpluses. In case of reporting, one important consideration is drawings. If the owner(s) takes out any amount from the total capital, then it will be considered as drawings and will be deducted from the owners’ capital in balance sheet (R. Libby, P. A. Libby & Short, 2001). Comprehensive income and its influence on the equity According to the Financial Accounting Standards Board, the comprehensive income is defined as net change in asset or equity of a corporation for a given period due to transactions and other events related to non-owner sources. As it is comprehensive in nature, all changes in the equity value for a given period are considered. However, it excludes those changes resulting from income distribution to investors and investment made by them. In simpler words, comprehensive earnings represent a firm’s total earning as a whole in its financial reporting. From shareholders’ point of view, measuring comprehensive income for financial analysis is important as it excludes the impact of changes on ownership interest. Comprehensive income is the aggregate of a firm’s net income as well as other incomes, which are included in the income statement in absence of realized value. These incomes/losses are inclusive of gains or losses from sale of securities and from translation of foreign currencies. Comprehensive income represents the total change in shareholder equity for a given period without including transactions with the owners. It considers all gains and losses that have an impact on shareholders’ equity, but are not included in the net income. The reporting of comprehensive statement is done either as a part of income statement or as a separate statement showing changes in shareholders’ equity. The total equity of the firm is represented after adding retained earnings and accumulated other comprehensive income to the paid-up capital (Hirst & Hopkins, 1998). Impact of new issue and buy back of shares on shareholders’ equity An organization issues shares for the first time through IPO (Initial Public Offerings) and then raises fund from the secondary market. A firm often raises additional shares through fresh issues, right shares as well as treasury stock. Treasury stock is defined as a portion of the total stock that a company can either not issue to shareholders or repurchase the issued shares from its shareholders. Treasury shares are also known as buyback shares and are utilized by the firm when extra fund for operations is required. Right shares are issued to existing shareholders so that dual benefits can be enjoyed by the firm in the form of zero transaction cost and additional fund. These shares are issued at a discounted price to shareholders who have an option to refuse the company’s offers. Apart from right shares, company often issues fresh stocks to raise capital. However, both this methods result in share dilution. The composite shareholders’ equity grows, but reduces the proportion of ownership of an existing investor. Issue of additional shares bring along reduced earnings from the share, unless all the additional shares are raised through right issue. The diluted EPS (earning per share) is lesser than Basic EPS (Core, Guay & Kothari, 2002). Treasury stock is the difference between the outstanding and issued stock, which a company at times reacquire on observing that market price of the share is low. Absorption of own shares in an open market by a company results in sudden rise in price of shares as well as reduction in dilution of shares. Buyback shares reduce assets of the company and thus, improve return on asset as well as return on equity. It also helps in enhancing the price earnings ratio, which indicates that the earning per share of existing shareholders has increased. Nevertheless, shareholders’ equity increases with less treasury stock (Skinner, 2008). Definition and accounting for retained earnings Retained earnings can be defined as the portion of net earnings that is retained by a corporation for reinvesting in core operations or for payment of debts. Retained earnings and dividends are two major components of a company’s net profit. The retained earnings is a source of long-term investment and is generally utilized for fund acquisitions, investment in research and development, building new facilities, purchase of inventory, payment of long-term debts and establishing cash and other reserves. When a company has profitable business over a long period of time and retains certain part of its profit for reinvesting purpose, it is possible to have a higher accumulated retained earnings balance than that of paid-in capital. Retained earnings are useful when an organization needs fund to explore new growth opportunities. As retained earnings are undistributed profit of a firm, it is cumulative in nature. They are represented as sum of past as well present value of earnings in the balance sheet (Skinner, 2008). Retained earnings = Beginning retained earnings + Net income – Dividends paid Similar to equity and debt capital, the retained earnings also bear cost. The cost of retained earnings is generally a little less than that of equity. The cost of retained earnings is calculated by the firm to satisfy shareholders that the fund raised is effectively utilized and is not kept idle. The statement of retained earnings is prepared as per the Generally Accepted Accounting Principles. It calculates the balance of retained earnings at the end of a given financial period and is shown in the balance sheet under the shareholders’ equity (R. Libby, P. A. Libby & Short, 2001). Corporate dividend: definition, distribution and accounting in financial statement A company can utilize its net profit in two ways. It can retain net profit as retained surplus and invest in core businesses and the other way is to distribute the profit as dividend to its shareholders as per their proportion of ownership. Dividend can be classified as cash dividend and stock dividend. Apart from annual dividend, companies often declare interim dividend as well (Skinner, 2008). Cash dividend is the most common form of payment and is paid through electronic fund transfer. Cash dividends are subject to taxation in some countries such as, the United States and Canada. However, the tax rate is usually less than that charged on general income. Stock dividend is the payment of dividend in the form of additional stocks to the existing shareholders. Then again, it is not compulsory for a shareholder to accept the option of stock dividend. The importance of stock dividend is that it is not taxable and while cash dividends are fixed, the shareholder can earn more from stock dividend by selling the shares at favorable time. When cash dividend is paid, two entries are done. On the day of dividend declaration, the retained earning account is debited and dividend payable account is credited. The dividend payable account is a current liability account and is debited on the day of dividend payment as the cash account (asset) is credited. In case of stock dividend, cash account of the company is not affected. In this regard, only shareholders’ equity account is affected as the retained earnings balance is reduced by the value of stock dividend. In addition, it is important to note that the paid dividend is showed in the balance sheet and not in income statement (Short, Zhang & Keasey, 2002). Conclusion In this paper, effort has been made to explain the shareholders’ capital and its basic contributing components in a concise manner, while highlighting on the impact of these components on shareholders’ equity and methods of accounting these factors in financial statements. The paper discusses importance of shareholder’s fund and methods of increasing shareholders’ fund. In the paper, issues such as, stock dilution and role of share repurchase, have been explained elaborately. Components of shareholders capital such as, retained earnings and dividends, along with their implication, have also been elucidated systematically. References Core, J. E., Guay, W. R. & Kothari, S. P. (2002). The economic dilution of employee stock options: Diluted EPS for valuation and financial reporting. The Accounting Review, 77(3), 627-652. Cronqvist, H. & Fahlenbrach, R. (2009). Large shareholders and corporate policies. Review of Financial Studies, 22(10), 3941-3976. Hirst, D. E. & Hopkins, P. E. (1998). Comprehensive income reporting and analysts valuation judgments. Journal of Accounting Research, 47-75. Libby, R., Libby, P. A. & Short, D. G. (2001). Financial accounting. New York: McGraw-Hill/Irwin. Short, H., Zhang, H. & Keasey, K. (2002). The link between dividend policy and institutional ownership. Journal of Corporate Finance, 8(2), 105-122. Skinner, D. J. (2008). The evolving relation between earnings, dividends, and stock repurchases. Journal of Financial Economics, 87(3), 582-609. Read More