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Shareholder’s Equity – Simple Definition & Examples

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Ever come across the term “shareholder’s equity” in financial reports or news and wondered what it means? This article cuts through the jargon to explain this key financial concept in straightforward terms.

Shareholder’s Equity in Simple Words

Shareholder’s Equity is what’s left over after we deduct the liabilities from the assets.

Shareholder’s Equity (also known as Owner’s Equity or Stockholder’s Equity) represents the leftover amount after we deduct liability (what we owe) from the assets (what we own). It is the amount that truly belongs to the owner. It is the third and last type of account presented on the Balance Sheet.

For example, if someone has $100 in their wallet but owes their roommate $40, then only $60 truly belongs to them. Their equity would be $60, while their asset is $100 and their liability is $40.

The principle balance sheet formula serves as an illustration of this concept: Assets = Liabilities + Equity. When we rearrange the formula, it becomes Equity = AssetsLiabilities.

Equity is presented at the bottom of the Balance Sheet, which conveniently represents the concept of “leftover.”

Two Main Types of Equity Accounts

There are two main types of balance within the equity section:

1) Earned capital – retained earnings. This is a business’s true “profit” or the “Net Income” presented in the income statement. In other words, this is the earnings an owner will be able to retain after paying off the expenses.

2) Contributed capital – Investment/Common Stocks/Additional paid-in capital. This is the money the business owner or other parties invested in this business. For example, if you decided to start a business with the $2,500 savings in your bank account, how would you account for this “Investment”? See below.

Shareholder’s Equity Simple Examples

Pho my Life Noodle Shop (PML) has the following equity accounts on its balance sheet.

Small Business

  • Retained earnings $2,000 – This is the net income the PML noodle shop has earned in the past period (Ex: last year). The keyword here is net income, or profit, which is the leftover amount after the noodle shop deducted the expenses from its revenues. This is the earned capital.
  • Owner’s Investment $2,500 – This is the amount that the owners of the PML noodle shop have invested in the business. This is the contributed capital.

Public Company

Now, let’s present a more complicated scenario of the equity section: the type of equity publicly traded companies present on their balance sheet. Most accounting textbooks teach these accounts in the equity section as well.

  • Retained earnings $2,000 – Same as above. This is the net income from the previous period (Ex: last year), which is the earned capital.
  • Common Stock $500 – Assume the PML noodle shop has filed for IPO (or going public), and they issued 500 shares to the market at $1 per share. Note that $1 is the issuance price (or par value), not the market price, which is discussed below.
  • Additional Paid in Capital (APIC) $2,000 – The PML noodle shop initially thought they would only price their share at 1$ and issue 500 shares. But the market likes PML. Therefore, when their stocks start trading, their share price has risen to $5 per share. The difference between the issuance price ($1) and market price ($5), which is $4, becomes their “APIC.” Since PML traded 500 shares, the APIC balance is $4*500 = $2,000. 

Common Types of Equity

Here is a list of common types of liabilities – all explained in simple words.

  • Retained Earnings: This is the “net income”, or “profit” from a previous period (Ex: Last year). This is the earnings that the owner retained/earned after paying all the expenses. If the company is publicly traded and distributes dividends, then retained earnings are the “net income” minus the “dividend distributed.” Because what’s distributed is no longer retained by the owners.
  • Common Stock/Preferred Stock: This is the original value of stocks issued by the company (par value). The difference between common stock and preferred stock is the privilege. Preferred stockholders get paid their dividends before common stockholders. However, there isn’t a big difference in accounting except that they are shown separately on the balance sheet.
  • Additional Paid in Capital (APIC) This represents the difference between the par value (common stock/preferred) and the actual value those stocks were sold at. In other words, It is the money received for stock issuance more than the par value.
  • Accumulated other comprehensive income (AOCI): Similarly to “Retained earnings,” GAAP requires a company to disclose several types of earnings or losses separately. That includes foreign transaction adjustment, unrealized gains/losses on AFS securities, etc. These items are more common among big-sized public companies.

Quick Q&A

Q: What is the difference between shareholder’s equity and retained earnings?

A: Retained earnings are part of the shareholder’s equity. The other part of shareholder’s equity is the contributed capital (investment, common stock, APIC, etc.) 


Q: What is the difference between net income and retained earnings?

A: They are the same except when a company issues dividends, then retained earnings are net income minus dividends distributed. Because what’s distributed is no longer “retained” by the owners.


 

Q: How to increase shareholder equity?

A: A business owner can either 1) increase the net income of the company, which will increase the retained earnings account, or 2) invest more money in the business, attract investment from other parties, or file for an IPO.

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