Exploring Owners’ Equity | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

In this lesson, we’ll discuss the last major component: owners’ equity.

What is Owners’ Equity?

Owners’ equity is the residual interest in assets that remains after subtracting an entity’s liabilities. It includes:

• Contributed capital
• Treasury stock
• Preferred stock
• Retained earnings
• Accumulated other comprehensive income
• Non-controlling interest

Let’s walk through setting up a new company with equity and no debt to learn about these items.

Contributed Capital

At incorporation, a company may decide to authorize 2,500 common shares and issue 2,000 of them to shareholders. If the par value is $1 per share, and the shares are issued at a premium of an additional dollar, the company receives $4,000 in cash. This amount forms the contributed capital under owners’ equity.

Treasury Stock

If the company buys back 200 common shares at $3 each, these shares become treasury stock. The number of outstanding shares drops to 1,800, and the contributed capital is reduced by $600 to $3,400.

Preferred Stock

Suppose the company issues 1,000 shares of preferred stock at $3 each. It receives $3,000 in cash, and $3,000 preferred stock is created under owners’ equity. Preferred stock has certain rights and privileges not conferred by common stock.

Retained Earnings

When the company makes a net income of $1,000 for the year, $400 is paid out to common shareholders as dividends, and the remaining $600 goes to equity as retained earnings.

Accumulated Other Comprehensive Income

For example, if the company buys shares of other companies and classifies them as available-for-sale, and the market value later triples, there’s a $1,200 unrealized gain. This amount is reported as other comprehensive income.

Non-Controlling Interest

Finally, minority interest is the minority shareholders’ pro-rata share of a subsidiary’s net assets, not wholly owned by the parent. For example, if the company acquires a controlling 60% stake in a subsidiary with $4,000 in net assets, $1,600 of minority interest is created.

Statement of Changes in Stockholders’ Equity

This statement summarizes all transactions that increase or decrease equity accounts for a period. Here’s a recap of the changes for our example company:

• $4,000 of common stock and $3,000 of preferred stock were issued.
• $600 was used to repurchase 200 shares of common stock.
• The company earned a net income of $1,000, which went into retained earnings.
• A $1,200 unrealized gain from available-for-sale securities was considered other comprehensive income.
• $400 cash dividends were paid out to common shareholders.
• A 60% stake in a subsidiary was acquired, creating $1,600 of minority interest.

Adding all these up, we get the ending balance of stockholders’ equity, which should correspond with what is shown in the balance sheet.

And with that, we have completed the 5 major components of the balance sheet. In our next lesson, we’ll wrap up this topic with a discussion on financial analysis using balance sheet data.