by The equity method is a type of accounting used for intercorporate investments. It is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.
There are several types of equity accounts that combine to make up total shareholders’ equity. These accounts include common stock, preferred stock, contributed surplus, additional paid-in capital, retained earnings, other comprehensive earnings, and treasury stock.
Equity is the amount funded by the owners or shareholders of a company for the initial start-up and continuous operation of a business. Total equity also represents the residual value left in assets after all liabilities have been paid off, and is recorded on the company’s balance sheet.
Types of Equity Accounts
Preferred Stock
Preferred stock is quite similar to common stock. The preferred stock is a type of share that often has no voting rights, but is guaranteed a cumulative dividend. If the dividend is not paid in one year, then it will accumulate until paid off.
Common Stock
Common stock represents the owners’ or shareholder’s investment in the business as a capital contribution. This account represents the shares that entitle the shareowners to vote and their residual claim on the company’s assets. The value of common stock is equal to the par value of the shares times the number of shares outstanding.
Contributed Surplus
Contributed Surplus represents any amount paid over the par value paid by investors for stocks purchases that have a par value. This account also holds different types of gains and losses resulting in the sale of shares or other complex financial instruments.
Retained Earnings
Retained Earnings is the portion of net income that is not paid out as dividends to shareholders. It is instead retained for reinvesting in the business or to pay off future obligations.
Additional Paid-In Capital
Additional Paid-In Capital is another term for contributed surplus, the same as described above.
The following formula and calculation can be used to determine the equity of a firm, which is derived from the accounting equation:
Shareholders’ Equity = Total Assets – Total Liabilities
This information can be found on the balance sheet, where these four steps should be followed:
- Locate total liabilities, which should be listed separately on the balance sheet.
- Locate the company’s total assets on the balance sheet for the period.
- Note that total assets will equal the sum of liabilities and total equity.
- Subtract total liabilities from total assets to arrive at shareholder equity.
Components of Shareholder Equity
Retained earnings are part of shareholder equity and are the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use. Retained earnings grow larger over time as the company continues to reinvest a portion of its income.
At some point, the amount of accumulated retained earnings can exceed the amount of equity capital contributed by stockholders. Retained earnings are usually the largest component of stockholders’ equity for companies that have been operating for many years.
Treasury shares or stock represent stock that the company has bought back from existing shareholders. Companies may do a repurchase when management cannot deploy all the available equity capital in ways that might deliver the best returns. Shares bought back by companies become treasury shares, and their dollar value is noted in an account called treasury stock, a contra account to the accounts of investor capital and retained earnings. Companies can reissue treasury shares back to stockholders when companies need to raise money.
Common variations on equity:
- On a company’s balance sheet, the amount of the funds contributed by the owners or shareholders plus the retained earnings (or losses). One may also call this stockholders’ equity or shareholders’ equity.
- A stock or any other security representing an ownership interest in a company.
- In margin trading, the value of securities in a margin account minus what the account holder borrowed from the brokerage.
- When a business goes bankrupt and has to liquidate, equity is the amount of money remaining after the business repays its creditors. This is most often called “ownership equity,” also known as risk capital or “liable capital.”
- In real estate, the difference between the property’s current fair market value and the amount the owner still owes on the mortgage. It is the amount that the owner would receive after selling a property and paying any liens. Also referred to as “real property value.”
