Three basic transactions account for most of the changes that occur in shareholders’ equity:
- Sale of stock to investors
- Recognition of periodic net income or loss
- Declaration of cash dividends to shareholders
Each of these transactions is examined in this section. Other less frequent types of transactions are discussed in a subsequent section.
Sale of Stock to Investors
Suppose that Du Pont’s management decides to issue an additional 10 million shares of stock to investors, and the market price is $70 per share of stock. In this case, Du Pont would receive a total of $700 million ($70 * 10 million shares) from investors. In this example, note that we are ignoring any transactions costs, such as fees and commissions incurred by the issuing firm. The transaction would increase cash and invested capital by $700 million. The invested capital would consist of $3 million in par value (10 million shares * $0.30 par value per share), and $697 million in capital invested in excess of par value ($700 million total invested minus $3 million recorded as par value).
Managers would immediately put these funds to work to earn returns for the shareholders, such as by investing in additional plant and equipment. In other words, the transaction to issue shares of stock is immediately followed by many other transactions in which the money is used for some corporate purpose.
In some instances, noncash items can be received when stock is issued to investors. Examples include noncash assets, such as property or intangible assets, and services, such as work from a company’s attorneys.
Recognition of Periodic Net Income or Loss
Business firms must periodically determine the amount of net income (or loss) from their activities. Net income (loss) represents an increase (or decrease) in a firm’s share-holder equity, or net assets, due to its revenues, expenses, gains, and losses during the period. For example, Du Pont earned $2,405 million of net income during 1997 and paid $1,401 million as dividends. In addition, other items reduced Du Pont’s retained earnings by $1,546.
Declaration and Payment of Cash Dividends
Du Pont paid dividends of $1,401 million to its shareholders in 1997. On the date of declaration, the dividend became a liability because Du Pont obligated itself to make the dividend payment. On that date, retained earnings were decreased and liabilities were increased by $1,401 million.
Additional Transactions Affecting Stockholders’ Equity
In addition to the three basic transactions discussed in the last section, a variety of other, less frequent occurrences may affect the reported amount and composition of shareholders’ equity. This section examines several of these additional types of transactions and events.