Introduction to Stockholders' Equity

If you were to reduce a corporation's entire balance sheet into its most skeletal form, you would
end up with the following accounting equation:

As you can see, stockholders' equity is one of the three main components of a corporation's
balance sheet. If you rearrange the equation, you will see that stockholders' equity is the
difference between the asset amounts and the liability amounts:

Stockholders' equity is to a corporation what owner's equity is to a sole proprietorship. Owners of

a corporation are called stockholders (or shareholders), because they own (or hold) shares of the
company's stock. Stock certificates are paper evidence of ownership in a corporation.
U. S. corporations are organized in, and are regulated by, one of the fifty states. Because laws
differ somewhat from state to state, accounting for corporations also differs somewhat from state
to state. (If you need to determine the specific rules for a corporation in a specific state, you
should seek the guidance of a professional who is knowledgeable with the laws of that state.) For
our purposes, we will focus on the structure and concepts that are fundamental to most U.S
corporations.
The concepts and vocabulary we will introduce in this topic (such as dividends, earnings per
share, and book value) are important not only to accountants, but to investors, business owners,
business students, and others.

What Is a Corporation?
Most of the world's largest companies do business as corporations. Companies such as WalMart, Exxon Mobil, General Motors, Ford Motor, and General Electriceach with sales in excess
of $100 billion annuallyare corporations. As opposed to a sole proprietorship or a partnership,
a corporation is a business that is recognized by law as a separate legal entity with its own
powers, responsibilities, and liabilities. Before the owners/managers of a business choose to
incorporate their business (become corporations), however, they should examine the advantages
and disadvantages of doing so.

Advantages
A corporation has several advantages over the sole proprietorship and the partnership form of
business. The four major advantages are: (1) limited liability, (2) ease in transferring ownership,
(3) continuity, and (4) ease in raising money.
1. Limited liability for the owners. Generally, the owners of a corporation can lose no more
than the amount they have invested in that corporation. On the other hand, with a sole

proprietorship or partnership, an owner could lose not only her or his investment, but
could also lose other personal assets as well. In other words, the corporate form of
business "shields" the owners from most creditors. This occurs because corporations are
considered to be legal entities, separate and distinct from their owners. (Due to their legal
entity status, a corporation can sue others, can be sued, and must pay income taxes on
its taxable income.)
2. Ease in which owners can sell their ownership interest. If the stock is publicly
traded, investors can sell their ownership interest in a corporation in a matter of minutes
simply by giving instructions to their stockbroker. If the stock is not publicly traded, the
stock certificate can be transferred to another owner by signing a transfer statement.
3. Continuity. When a stockholder sells shares of stock, the transaction is between the
seller and the buyer of the stock. Unless the corporation is the buyer or the seller, the
corporation is not involved in the transaction. This means that even if a corporation's
stock is the most actively traded stock of the day, the corporation itself will not skip a beat
in its day-to-day operations. When notified by a stockbroker of a transfer between
stockholders, the corporation merely changes in its records the name of the owner of the
shares.
4. Ease in raising money. Because of limited liability and the ease of buying/selling
shares, it is easy to understand why investors are more attracted to investing in
corporations rather than in sole proprietorships or partnerships. This investor attraction
allows corporations to raise the capital needed to manage and expand their operations.

Disadvantages
Some view the legal complexity of starting and running a corporation to be a disadvantage. To
incorporate, an application must be filed with and approved by one of the fifty states, and once
approved, the corporation must comply with that state's regulations. In contrast, a sole
proprietorship can be started in minutes, sometimes with nothing more than a tax identification
number from the state. Many of the legal requirements imposed on a corporation do not apply to
sole proprietorships.
Another disadvantage associated with corporations is the possibility of "double taxation" on the
dividends it pays. Some argue that a regular corporation's net income is first taxed on the
corporation's income tax return. Then, if the corporation distributes some of the net income to the
stockholders as a dividend, the dividend will be taxed again on the stockholders' personal income
tax returns. (To gain more insight into this and to minimize or to avoid this potential problem, you
should discuss various forms of business structures with tax and legal professionals.)

Governance
The owners of corporations are referred to as stockholders or shareholders, because they hold
the shares of stock, which serve as the evidence of their ownership. (The term stockholders and
shareholders are used interchangeably. However, we will use the term stockholders.)
Because it would be impossible for 30,000 stockholders to sit around a boardroom table and give
meaningful input to the direction of their company, the stockholders elect a board of directors as

their representatives in the corporation's affairs. The board of directors formulates the
corporation's policies and appoints officers of the corporation to carry out those policies. The
board of directors also declares the amount and timing of dividend distributions, if any, to the
stockholders.
The officers of a corporation are appointed by the corporation's board of directors to carry out
(or execute) the policies established by the board of directors. The officers include the president,
chief executive officer (CEO), chief operating officer (COO), chief financial officer (CFO), vice
presidents, treasurer, secretary, and controller.