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Lesson 1: Introduction to Financial Statements
The Statement of Changes in Stockholders’ (Owners’) Equity
The statement of changes in owners’ equity, as the name implies, reports any changes that have occurred in the components of equity. Often, it is called the statement of owners’ equity, or statement of stockholders’ equity if the company is a corporation. Three elements of FASB’s conceptual framework are found in this financial statement:
- Investments by owners: Transfers, usually cash, from owners to the company. A & N Lawn Care’s owners have invested $1,000, which we have called contributed capital. Owner investments increase equity.
- Net income: Amounts generated through transactions with nonowners. In our discussion of the income statement, we saw that A & N Lawn Care had transactions with customers to earn revenue, and with suppliers to purchase various items, resulting in net income of $1,270. Net income is an addition to equity each period. If there were a net loss, it would decrease equity.
- Distributions to owners: Transfers, usually cash, from the company to its owners. Suppose Andy and Nick were so pleased with their first month’s work that they decided to each take a distribution of $100 from the company, instead of waiting until the end of the summer to split all of the profits. Distributions to owners for the month would be $200. Distributions decrease equity.
The accumulation of net income over the years, minus any distributions to owners, is called retained earnings. A statement of owners' equity shows changes in retained earnings by adding net income and subtracting distributions.
Figure 1.4 is A & N Lawn Care’s statement of changes in owners’ equity for the month of June.
Please watch Video 1.3 to learn more about the statement of changes in owners' equity.
This is A and N Lawn Care's Statement of Changes in Owners' Equity for the month of June. The two main components of owners' equity are contributed capital and retained earnings.
We've already defined contributed capital. Since it is a new company, A and N Lawn Care began with a zero balance in contributed capital, and 1,000, here's your zero balance, 1,000 was added at the beginning of the month. By the end of June, the balance was still 1,000.
Retained earnings is the accumulation of net income or loss since the company began operations. Remember that another term for net income is earnings. The business may keep its earnings within the company and use the cash generated to make additional purchases or investments to grow the company. In other words, the earnings are retained within the company.
Net income or loss of each period is added to or subtracted from retained earnings. So added if it is positive net income and subtracted if it's a net loss, and it accumulates over time. When distributions are made to owners, retained earnings are decreased by the amount of the distribution.
Now as a new company, A and N Lawn Care's retained earnings started also with a zero balance. Net income for the month of June increased retained earnings by 1,270, the amount of net income, and distributions were $200, 100 for each of the owners. So this column shows changes in retained earnings from the beginning of the month to the end of the month. The end of the month ending balance in retained earnings is 1,070.
Finally, the owners' equity column shows, again, the beginning balance of zero, and then all of the changes from everything within owners' equity, contributed capital as well as retained earnings. So we've got the owner contributions of 1,000, the net income of 1,270, and the distributions of 200. The total, positive amounts added to equity minus the distribution to the owners, which is subtracted from equity, gives you a total of 2,070 for the month under owners' equity.
Another thing to notice about the Statement of Changes in Owners' Equity is that it again, is a statement that covers a particular period of time. The date is shown as for the month ending June 30, 20xx. Again, the statement covers from the beginning of June to the end of June.
At this point I'm going to erase what I have on the screen here because I wanted to highlight retained earnings. In this retained earnings column, you see the calculation for retained earnings. I talked through it a minute ago, but this is a really important calculation.
You've got to remember that retained earnings equals the beginning balance in retained earnings plus net income for the period, in this case one month, minus dividends that might have been paid out during the period. And that equals ending retained earnings. So you should probably call this ending retained earnings. That formula is really important because retained earnings is really an accumulation of all of the retained earnings in the company from the beginning when the company began operations. Every year net income will be added to retained earnings and any dividends will be subtracted.
Notice also that dividends are subtracted separately from the addition of net income. That's also an important point. Dividends are not part of net income. Dividends are not an expense, and you will never see them on the income statement. So net income increases retained earnings, but separately, dividends decrease retained earnings.
As noted, changes in retained earnings are shown in the statement of owners' equity. It is important to highlight the formula for retained earnings (Figure 1.5):
In a corporation, distributions to owners (shareholders) are called dividends. Always remember that distributions (dividends) are not reported in net income. In other words, distributions are not an expense and are not subtracted from revenues to arrive at net income. Rather, dividends are a direct reduction from retained earnings; they never pass through net income.