Equity in Accounting Terms
In accounting parlance, equity represents ownership rights that a shareholder has in a corporation after purchasing shares of equity, or stocks. Equity also may represent initial investments that two or more business partners make to establish a private company. Accounting for equity in a corporation is important because it indicates how owners' funds are used to generate operating revenues.
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Definition
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Equity, according to the standard accounting equation, equals total assets minus total liabilities. A firm's assets are its economic resources, and its liabilities represent debt that it must reimburse. Examples of assets include cash, inventories and accounts receivable (short-term assets), or land, equipment and machines (long-term, or fixed, assets). A corporation's equity represents owners' cash investments and may include common stocks and preferred shares.
Types
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U.S. generally accepted accounting principles (GAAP) and international financial reporting standards (IFRS) allow a company to have three types of stocks—common, preferred and treasury—in its equity account. Common, or regular, stocks are standard shares that a company issues. Equity holders, or common stockholders, receive periodic dividend payments, and they make profits when share prices rise on securities exchanges. Preferred shareholders enjoy the same benefits as common shareholders, but they receive dividends before common dividends are paid. Treasury stocks represent shares that a firm buys back from shareholders.
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Equity Statement
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A corporation's equity statement indicates transactions related to the firm's owners during a period of time. This accounting summary typically indicates a beginning balance for the equity account, and it adds owners' investments during the period such as new common and preferred share purchases or other capital addition transactions. It then subtracts dividends paid to common and preferred shareholders, treasury stocks that the firm bought back and other capital withdrawal transactions.
Significance
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Equity is an important tool that a company uses to finance its operating activities. A firm that cannot raise cash on securities exchanges or seek financing from private transactions may be unable to operate and engage in long-term projects with customers, suppliers or lenders. A company's top leadership also evaluates sources of funds that the firm uses to gauge proper levels of borrowed funds (loans) versus equity funds.
Accounting for Equity
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U.S. GAAP and IFRS require a firm to record equity transactions at fair, or current, value. To illustrate, a biomedical company issues shares worth $1.5 million on the New York Stock Exchange. A corporate accounting clerk debits the cash account (asset) for $1.5 million, and she credits the common stock account (equity) for the same amount. At the end of the year, the firm pays dividends worth $25,000 to preferred and common shareholders. The accounting clerk credits the cash account for $25,000, and she debits the dividends payable (liability) account for the same amount.
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References
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