Equity = Net Worth

The Balance Sheets of proprietorships with their considerably simpler net worth structures are adequate to illustrate the principles of the equity section of the Balance Sheet. Some of the more complex aspects for corporate equity will be covered in this section. Normally, the more obscure elements of the equity section of the balance sheet do not figure prominently in the typical credit analysis. Often, the total net worth or the tangible net worth is all the data that a credit will evaluate.  However, without an understanding of the various forms of equity an analysis of the equity section of the balance sheet can be so confusing that creditors may overlook information pointing to serious problems.

Corporate equity can be broken down into the following four major categories:

• Common Stock at par value,
• Additional paid in capital,
• Retained earnings, 
• Preferred stock

Preferred stock:  Owners of preferred stock usually have no voting rights, but are paid a specific or fixed dividend.   Preferred stockholders are also guaranteed that they will receive that dividend before common stockholders receive any dividend. These, and often other conditions, are stated in the terms of each issue of preferred stock. Often, preferred issue lacks corporate voting power.  As a result, preferred stockholders have no direct control over the day-to-day management of the business.

Common stock is the term applied to corporate shares which have no preferences as to dividend payments.  The holder of common stock have voting rights.  The purchasers of common stock generally purchase the stock for the potential for stock value appreciation and for future dividends.

To illustrate: Corporation X has issued both preferred and common stock. Its preferred stock has a par value of $100 per share and a fixed annual dividend of 5 percent. Its common stock has a declared value of $5 and no fixed annual dividend. These issues might appear on the corporation's balance sheet as follows:

Capital Stock
Preferred Stock, 5%, par value $100, authorized and issued 10,000 shares	$1,000,000
Common Stock, $5 par value, authorized and issued 40,000 shares	$200,000

In short, Capital Stock is the original amount paid by investors to a corporation for its stock when first issued.  It is important to note that the value of the Capital Stock bears no relationship to the value of the assets of the corporation.

Capital Surplus

The par value of stock does not have any relation to its market values, but stock is not sold below its par value since the purchasers would become liable to the corporation's creditors for an amount equal to the discount if its assets were insufficient to pay its costs. Often, they are sold at prices higher than these values. For example, Corporation X's preferred stock sold for $125 per share and its common stock for $100 per share. The surplus resulting from these sales-$25 from each share of preferred stock and $95 from each share of common stock-are listed under the Capital Surplus heading:

Capital Surplus
Preferred Stock	$250,000
Common Stock	$3,800,000

 

Also listed in this category are any surpluses arising from donations by stockholders or outsiders. Corporation X has received a tract of land as a gift from a town that hopes to induce the company to build a plant there. This acquisition might be entered as follows:

Plant site donated by Centerville $ 50,000

Earned Surplus or Retained Earnings

After dividends have been paid, a portion of the corporation's earnings will be retained against future needs. These may result from the sale of fixed assets or investments the company has made, as well as profits from operations. Regardless of their source they are included under the heading Retained earnings [or Earned Surplus]: Earned Surplus $750,000

When a corporation purchases stock it has itself issued, this reacquired stock is known as Treasury stock. Treasury stock may be acquired for a variety of reasons. It may be the company is trying to buy out a certain stockholder, or that it wants to reduce the total number of share outstanding, or that it is attempting to generate additional demand for the stock. In any event, Treasury Stock is issued stock that has been reacquired and is therefore available for resale, distribution or retirement.

More important than the reason for the acquisition, however, is the way that the corporation enters its treasury stock on its balance sheet. If the stock is entered as an asset, be on your guard. The purchase of treasury stock does not result in the creation of an asset. Instead it reduces the corporation's net worth. It should, therefore, be deducted from capital stock and surplus, and the firm that does not do so is not properly accounting for the stock repurchase.

For example, if Corporation X reacquired 500 shares of its common stock at $100 per share, this treasury stock should appear in the net worth section of the balance sheets as follows:

Capital Stock
Preferred Stock, 5%, par value $100, authorized and issued 10,000 shares	$1,000,000
Common Stock, no par value, declared value $5, authorized and issued 40,000 shares	$200,000
Capital Surplus
Preferred Stock	$250,000
Common Stock	$3,800,000
Plant site donated by Centerville	$50,000
Earned Surplus	$750,000
Total	$6,050,000
Less 500 shares of treasury stock at cost	$50,000
Total Net Worth	$6,000,000

The Statement of Earned Surplus
Most changes in earned surplus are reported in the net worth section of the balance sheet, but there are some which call for a separate statement altogether. Firms most often issue a statement of earned surplus to:
1. Report any considerable non-operating or non-recurring gain or loss, so as to distinguish It from normal operating income or loss, or
2. Correct significant errors that have appeared in financial statements for prior reporting periods.

A traditional statement of surplus normally consists of these items of information:

• Surplus at the beginning of the period, 
• Net income for the period, 
• Extraordinary and extraneous profits and losses, and/or corrections of operating profits and losses of prior periods, 
• Dividends paid or declared, 
• Surplus at the end of the period.

Example 1

One year, Corporation A had a total income of $120,000, all resulting from normal operations. The next year, income from operations dropped to $80,000; but, because a tract of land owned by the company is sold at a profit of $200,000, total income increased to $280,000. To make it clear that this increase in profits is due to non-operating income, and not to a sudden expansion of business, company management reports it in a statement of earned surplus, as follows:

Example 2

In its financial report, Corporation C made two significant errors: (1) inventory value was overstated by $5,000, and (2) machinery depreciation was insufficient by $10,000. The resulting $15,000 error is corrected in following year's statement of earned surplus:

Example 3

In its financial report, Corporation C made two significant errors: (1) inventory value was overstated by $5,000, and (2) machinery depreciation was insufficient by $10,000. The resulting $15,000 error is corrected in following year's statement of earned surplus:

Edited by Michael C. Dennis.