Welcome, in this video, we're going to discuss the accounting of

interacting with your owners, or shareholders equity.

There's two accounts that you need to understand before we really get into

the debit and credit details to understand shareholders equity.

The first is contributed capital.

These are amounts given to the company by shareholders.

They represent investments shareholders placed directly into the firm.

It could be cash, that's what it usually is,

or it could be something else of value.

But the main point is, they've been contributed directly by the shareholders

and given to management for management to use.

Now the other account may seem a little more complicated at first, but

it's really not.

And that account's retained earnings.

So, what retained earnings is,

is the sum of all the value creation over the life of the firm,

less any amounts that have already been distributed back to the shareholders.

Another way to think about this is, it represents the lifetime

earnings of the firm that have been retained by the firm, thus,

that creative name that accountants have given it, retained earnings.

But, what does retained earnings really mean?

Well, as values created,

the firm can either chose to return it to the shareholders, or

it can be kept inside the firm, so that it can be used for future value creation.

If it's kept inside the firm, the way to think of this is,

it's really another investment by the shareholders.

Instead of taking those assets back themselves,

they let the managers keep them.

And, the managers use that to create future value.

So just like the directly contributed capital,

this is another way that the shareholders are invested in the firm, and

thus another part of the firm that's owned by the shareholders.

Now that we understand those two big accounts,

let's take a closer look at how we do the accounting to get them.

Let's start with contributed capital, and I'm going to use an example.

So, we've got investors they give $150,000 to a firm to get $150,000 shares of stock.

That is they pay a $1 per share.

We're going to do two scenarios with this.

In one, the stock's what is called no par value,

and in the other it's a par value of $0.10 per share.

Let's start with the no par value.

This is about a simple accounts going to get.

When we do the journal entry,

what we have to do is reflect what' s happen with the firm.

So as what you can see, we debit cash for $150,000,

that's to show that the firm now has $150,000 of cash, and

then like any journal entry, we need to say, well, where that come from?

It came from shareholders, so

we are going to call that contributed capital, and credit it.

That let's us know that,

this is value put directly into the firm by the shareholders.

Now when we move on to par value, it's really no more complicated than that,

we just need to add one more line.

Let's start with the part that's exactly the same, the cash.

We got the same 150,000 in cash, so we're going to debit that, and

show that on our balance sheet, as an increase in our cash.

So economically, this is really the same transaction.

Which means, what we need to show in our credits is, where did it come from from?

Well, it come from shareholders.

The only difference is that, because this stock has what's call the 10% par value,

we're going to say the first $0.10 on every share of stock is going to be called

contributed capital across the 150,000 shares.

That means, there's $15,000 of contributed capital.

Then the remaining 150,000, the 135,000 that's leftover,

we're going to cost something like additional paid-in-capital.

You might see a called something different like paid-in-capital

on access of par value or capital beyond par value.

Any of those terms are just letting you know that,

this also came from the shareholders.

And it's just something an access of this declared par value.

Notice that if you add it up, it's the same 150,000.

And if you see these accounts on a balance sheet somewhere,

you should just think of them all as being contributed capital.

Now, about now is were you're asking yourself well,

why do we even bother with this par value?

Why do we have this thing?

I get that question all the time.

The fact to the matter is, for the most part, it's just a historical leftover.

It has very little economic impact.

There's a few cases where it may matter, for

example, when you first register shares, there's a tax for those new shares.

If you have a par value, go use that par value to calculate the tax.

If you don't, they'll impute it in another way.

This is why you often see very low par values if you do see them.

There may be a few other places where it matters, but really for the most part,

it's kind of like an appendix in a person.

You probably have friends who've had their appendix out.

They're operating perfectly fine without it.

In fact, you may not even know that they had their appendix out as you look at them

doing everything everyday.

Par values pretty much the same.

The company is going to operate exactly the same,

whether it had par value stock or not.

Okay, now that we've covered the initial contribution of capital, we need to think

about the next step, which is, as the firm earns value, it's going to accumulate

that value and then eventually distribute it out to shareholders.

We're going to use an example here, too.

We're going to look at a firm that operates over two years,

creating value in both of those years, a little more value in the second year than

the first year, and at the end of the second year, they're going to go ahead and

distribute some of that value back.

So in year one, our firm creates $50,000 worth of value.

That get's accumulated over the year in that account that we call net income.

Now recall that what net income does is,

it captures all of the net value creation and destruction, and sums it up and

says, over the period, we've created a net of $50,000 of value.

At the end of the year we say, okay, that value's been created.

We're going to pull it out of the income statement, so that we can reset the income

statement for the next year, and reflect it on the balance sheet.

And reflect that in that account called retained earnings.

So, we moved the 50,000 over, as you can see on the slide

from the income statement, and we put it into retained earnings.

We didn't distribute any of that earnings back, so

at the end of the year we continue to retain all 50,000.

You'll also notice on this slide, I've added a cash T account.

We're going to assume that we start it with 250,000, and throughout this example,

I'm only going to show you the impact that our transactions for

shareholders have on the cash account.

Notice here in year one,

since we didn't pay a dividend, there is no impact on cash.

Now so we move on to year two, we create another 75,000 of value throughout

the year, that gets moved over to the retained earnings and added in.

So that in total, we've created 125,000 in value.

But at the end of the year,

we've also decided to distribute 10,000 of that value back to our shareholders.

So that amount's not going to be retained.

We're going to debit that out of our retained earnings,

to come up with our new total of 115,000.

That's the 125,000 of value created over the life of the firm,

less the 10,000 that we've now distributed and not retained.

Thus, our retained amount of 115,000.

Notice also, that this is the first time cash is impacted.

When we gave that value back to the shareholders,

we gave it to them in the form of cash, so we need to reflect the fact that,

we have less cash at the end of the period as well.

Now, I know some of you prefer journal entries, so here it is in journal entries.

In the first period, we close our net income out by debiting it, and

we move that over to retained earnings with a credit.

In the second period, we have a net income of 75,000,

we close that out by crediting it over to retained earnings.

We don't impact cash at all until we've decided to issue a dividend,

and at that point when we give a dividend to the shareholders,

we credit cash to show that it's been reduced.

And we debit retained earnings to show that those earnings are no longer

retained.

There is two things that I want you to remember when you're thinking of retained

earnings.

First of all, noticed that dividends never impact the income statements.

Dividends are transaction with our shareholders.

Unlike any transactions with our shareholders,

we're just moving value from one account to another.

In this case, we're moving it from the asset that the shareholders call

their investment in the company, into the asset that's their bank account, and

then they'll do with it whatever they want.

So we haven't created or

destroyed value, we've just moved value between assets that the shareholders own.

The second thing is that, retained earnings is an economic concept,

just like net income is an economic concept.

Net income captures the value created or destroyed during this particular period.

Retained earnings measures all of the value created over the life of the firm

that's been retained by the firm.

It's not a big pile of cash.

We all hear people say all the time, we're going to finance this transaction, or

finance this purchase through retained earnings.

Or, we're going to use our retained earnings to buy this.

But remember, when we created retain earnings, we weren't impacted cash at all.

It doesn't represent cash, it represent an economic concepts of total value

created and still retain by the firm.

I hope this is how to clarify this important accounts,

when we think about our interactions with our shareholders.

Basic Bookkeeping for Equity

Accounting for Decision Making

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