Understanding the Statement of Stockholders' Equity

Statement of Owners' Equity (Statement of Retained Earnings)

The equity statement explains the changes in retained earnings.

Retained earnings appear on the balance sheet and most commonly are influenced by income and dividends.  The Statement of Retained Earnings therefore uses information from the Income Statement and provides information to the Balance Sheet.

The following equation describes the equity statement for a sole proprietorship:

Beginning Equity
+ Investments
- Withdrawals
+ Income
----------------
= Ending Equity

For a corporation, substitute "Dividends Paid" for "Withdrawals".  The stockholders' equity in a corporation is  calculated as follows:

Common Stock (recorded at par value)
+ Premium on Common Stock (issue price minus par value)
+ Preferred Stock (recorded at par value)
+ Premium on Preferred Stock (issue price minus par value)
+ Retained Earnings
------------------------------------------------------------
= Stockholders' Equity


Note that the premium on the issuance of stock is based on the price at which the corporation actually sold the stock on the market.  Afterwards, market trading does not affect this part of the equity calculation.  Stockholders' equity does not change when the stock price changes!

How the Financial Statements Tell a Story: Stocks and Flows

Articulation is the way in which the statements fit together, their relationship to each other.

 

The articulation of the income statement and balance sheet is through the statement of shareholders' equity and is described by the stocks and flows relation.

 

Beginning equity
+ Comprehensive income
- Net payout to shareholders
= Ending equity

 

Balance sheets give the stock of owners' equity at a point in time. The statement of shareholders' equity explains the changes in owners' equity (the flows) between two balance sheet dates, and the income statement, corrected for other comprehensive income in the equity statement, explains the change in owners' equity that comes from adding value in operations.

 

By recognising the articulation of the financial statements, the reader of the statements understands the overall story that they tell. That story is in terms of stocks and flows. (Stocks here refere to stocks of value at a point in time). The statements track changes in stocks of cash and owners' equity (net assets).

 

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Consolidated Balance Sheet of Company A (in millions)

 

February 1, 2008
Cash and cash equivalent 7764
Total shareholders' equity 3735

 

February 2, 2008
Cash and cash equivalent 9546
Total shareholders' equity 4328

 

Consolidated Statement of Income (in millions)

 

Net Revenue 61133
Total Operating expenses 8231
Operating income 3440
Investment and other income, net 387
Income tax provision 880
Net income 2947

 

 

Consolidated Statement of Cash Flows (in millions)

 

Cash flows from operating activities 3949
Cash flows from investing activities (1763)
Cash flows from investing activities (4120)
Effects of exchange changes on cash and cash equivalents 152
Net (decrease) increase in cash and cash equivalents: (1782)
Cash and cash equivalents at beginning of year 9546
Cash and cash equivalents at end of year 7764

 

Consolidated Statements of Shareholders' Equity (in millions)

 

Balances at (February 2, 2007) 4328
Net income 2947
Impact of adoption of SFAS 155 6
Cahnge in net unrealised gain on investments, net of taxes 56
Foreign currency translation adjustments 17
Change in net unrealised loss on derivative instruments, net of taxes (38)
________________________________________________
Total comprehensive income 2988 (Total of all the above)
Impact of adoption of FIN 48 (62)
Stock issuances under employee plans 153
Repurchases (4004)
Stock-based compensation expense under SFAS 123(R) 329
Tax benefit from employee stock plans 3
Balance at (February 1, 2008) 3735

 

 

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A Summary of Accounting Relations

The Balance Sheet (in millions)

 

Assets
- Liabilities
=Shareholders' equity

 

Beginning of 2008 fiscal year:
9546 in cash
4328 in equity

 

Ending of 2008 fiscal year:
7764 in cash
3735 in equity

 

Cash decreased by 1782 
Equity decreased by 593

 

 

The Income Statement (in millions)

 

Net revenue 61133
- Cost of goods sold
= Gross margin
- Operating expenses 57693
= Operating income before interest and taxes (ebit)
- Interest expense & other incomes 387
= Income before taxes
- Income taxes 880
= Income after tax and before ordinary items
+ Extraordinary items
= Net income 2947
- Preferred dividends
= Net income available to common 2947

 

or

 

Net revenue 61133
Operating expenses 57693
Other Income & Expenses 387
Pretax Income
Taxes 880
Net Income 2947

 

 

Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement) (in millions)

 

Cash flow from operations 3949
+ Cash flow from investing -1763
+ Cash flow from financing -4120
+ Effect of exchange rate 152
= Change in cash 1782

 

Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement) (in millions)

 

Beginning equity 4328
+ Comprehensive income 2988
- Net payout 3581
= Ending equity 3735

 

Net Income 2947
+ Other comprehensive income 41
= Comprehensive income 2988

 

Dividend
+ Share repurchases 4004
= Total payout
- Share issues 153
- Others 270
= Net payout 3581

 

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Comments:

 

The cash flow statement reveals that the $1782 million decrease came from a cash inflow of $3949 million in operations, less cash spent in investing of $1763 million, net cash paid out to claimants of $4120 million, and an increase in the US dollar equivalent of cash held abroad of $152 million.

 

But the main focus of the financial statements is on the change in the owners' equity during the year.

 

The Company A owners' equity decreased from $4328 million to $3735 million over the year by earning $2988 million in its business actiivities and paying out a net $3851 million ($4004 million - $153 million) to its owners (plus those other items in the equity statement $270 million).

 

The income statement indicates that the net income portion of the increase in equity from business actiivities ($2947 miillion) came from revenue from selling products and financing revenue of $61133 million, less expenses incurred in generating the revenue of $57693 million, plus investment and other income of $387 million, less taxes of $880 million.

 

So Company A began its fiscal 2009 year with the stocks in place in the 2008 balance sheet to accumulate more cash and wealth for shareholders. Fundamental analysis involves forecasting that accumulation.

 

For analysis of the fundamentals, the ability to see how the accounting relations is important in developing forecasting tools.

• Understand how the statements fit together.
• Understand how financial reporting tracks the evolution of shareholders' equity, updating stocks of equity value in the balance sheet with value added in earnings from business activities.
• And understand the accounting equations that govern each statement.

How Parts of the Financial Statements Fit Together

A Summary of Accounting Relations

The Balance Sheet

Assets
- Liabilities
=Shareholders' equity


The Income Statement

Net revenue
- Cost of goods sold
= Gross margin
- Operating expenses
= Operating income before interest and taxes (ebit)
- Interest expense
= Income before taxes
-  Income taxes
= Income after tax and before ordinary items
+ Extraordinary items
= Net income
- Preferred dividends
= Net income available to common


Cash Flow Statement (and the Articulation of the Balance Sheet and Cash Flow Statement)

Cash flow from operations
+ Cash flow from investing
+ Cash flow from financing
= Change in cash


Statement of Shareholders' Equity (and the Articulation of the Balance Sheet and Income Statement)

Beginning equity
+ Comprehensive income
- Net payout
= Ending equity

Net Income
+ Other comprehensive income
= Comprehensive income

Dividend
+ Share repurchases
= Total payout
- Share issues
= Net payout

The Statement of Shareholders' Equity

The statement of shareholders' equity starts with beginning-of-the period equity and ends with end-of-the period equity, thus explaining how the equity changed over the period. 

For purposes of analysis, the change in equity is best explained as follows:

Ending equity = Beginning equity + Comprehensive income - Net payout to shareholders

----

Beginning equity
+Comprehensive income
- Net payout
___________________
=Ending equity
___________________


This is referred to as the STOCKS AND FLOWS EQUATION for equity because it explains how stocks of equity (at the beginning and end of the period) changed with flows of equity during the period. 

Owners' equity increases from value added in business activities (comprehensive income) and decreases if there is a net payout to owners. 

Net payout is amounts paid to shareholders less amounts received from share issues.  As cash can be paid out in dividends or share repurchases, net payout is stock repurchases plus dividends minus proceeds from share issues. 

----

Dividends
+ Share repurchases
_______________
= Total Payout
-Share issues
_______________
= Net Payout
_______________

Comprehensive income includes net income reported in the income statement pl,us some additional income reported in the equity statement.  The practice of reporting income in the equity statement is known as DIRTY SURPLUS ACCOUNTING, for it does not give a clean income number in the income statement.  The total of dirty surplus income items is called OTHER COMPREHENSIVE INCOME and the total of net income (in the income statement) and other comprehensive income (in the equity statement) is COMPREHENSIVE INCOME:

Comprehensive income = Net Income + Other comprehensive income

----

Net Income
+ Other comprehensive income
________________________
Comprehensive income
________________________

A few firms report other comnprehensive income below net income in the income statement and some report it in a separate "Other Comprehensive Income Statement."