When a company talks about stockholders' equity, it means the total amount of capital a company has received from investors in exchange for shares in the company. It represents all the assets in the company that investors own outright. Almost all profit-making companies have as their objective "to increase shareholder value," which basically means the company is in business to increase the shareholders' equity. This is a complicated exercise, however, since multiple transactions can decrease stockholders' equity, including favorable transactions such as paying out stock dividends.
A Reduction in Retained Earnings
Retained earnings refers to the money the company has made that it has not paid out as dividends. Rather, the company has elected to hold onto this money to finance its operations and repay debt. Retained earning, including net income for the current year, make up part of stockholders' equity. Retained earnings reports the firm's cumulative net income from inception to the most recent accounting period. If a corporation operates at a loss, stockholders' equity decreases because the current year's net income reduces retained earnings.
Changes to Revenues and Assets
Revenues increase stockholders' equity through retained earnings, and expenses decrease it. This helps illustrate the direct connection between a company's income statement and balance sheet. Since stockholders' equity is equal to the sum of assets plus liabilities, an increase in assets causes an increase in stockholders' equity, while a decrease in assets or increase in liabilities causes a decrease in stockholders' equity.
Paying Out Stock Dividends
When corporations pay dividends on stock, the payout activity decreases stockholders' equity. The dividend payments reduce retained earnings, which in turn reduces stockholders' equity. Firms also have a stockholders' equity account called treasury stock, which is a contra-account to stockholders' equity. The contra-account offsets the balance of stockholders' equity and reports stock re-purchases.
A company may buy back its stock for several reasons. It may choose to distribute it to employees using a stock option plan, distribute it as a stock dividend, or repurchase it to defend against a hostile takeover bid. When the company repurchases stock, an accountant debits or decreases cash. The result is a decrease in stockholders' equity.
Other Important Adjustments
Stockholders' equity may contain other items such other comprehensive income, or OCI. Items recorded in this account do not impact the income statement. They arrive at stockholders' equity through retained earnings, which means that an accountant records them directly to the OCI account in stockholder's equity. These entries include gain or loss on available-for-sale securities, or foreign currency translation adjustment. They can either increase or decrease stockholders' equity.