Chapter 12
Using Accounting Information
352
Shareholders’ Equity
Owners of a corporation are referred to as shareholders. This is because a corporation can sell a
fraction of its ownership to the general public in the form of shares. Corporations use the term
“shareholders’ equity” instead of “owner’s equity” to present the equity section of the balance sheet.
The shareholders’ equity category includes two sub categories, which are share capital, and retained
earnings.
Share Capital
Share capital
is a subsection on the balance sheet that includes accounts for a company’s equity
raised through different types of shares. Corporate shares can be divided into two major types,
“common shares” and “preferred shares.”
Common shares
are sold to investors, known as shareholders, in exchange for an investment (e.g.
cash) in the company. Shares that have been sold are called outstanding shares. Common shares
also represent a portion of ownership of the company.This means that common shareholders have
the right to vote for the directors and executives of the corporation. Basically, the shareholders
vote on who is in charge of running the company. The common shares section for the Proctor &
Gamble Company is highlighted in Figure 12.1.
Preferred shares
may also be sold to shareholders in exchange for an investment in the company.
However, preferred shareholders do not have any voting rights so they cannot decide on who is
in charge of running the company. Instead, preferred shares offer a higher claim on the assets of
the business. This means that in the event of bankruptcy, preferred shareholders are paid before
common shareholders. Accordingly, the preferred shares always appear before the common shares
in the shareholders’ equity section of a corporation’s balance sheet. The preferred shares section
for the Proctor & Gamble Company is highlighted in Figure 12.1. P&G’s outstanding preferred
shares are “convertible,” meaning that the preferred shareholders have an option to convert their
preferred shares into common shares. Unlike common shares, preferred shares may have different
features attached to them. Convertibility is only one example of preferred share’s features.
The common shares and preferred shares accounts separately track the total investments received by
the corporation through the sale of those share types.This is in contrast to sole proprietorships, in
which additional investments made by the owner are recorded directly in the owner’s capital account.
Sole proprietorships’ net income (loss) and cash withdrawal by the owner are also transferred to the
owner’s capital account. Corporations, on the other hand, have a separate account for recording
their net income (loss) and dividends, called “retained earnings,” which will be discussed next.
Retained Earnings
A corporation’s net income (or loss) for each period is transferred neither to the owner’s capital
account nor common/preferred shares account, but to the retained earnings account. When the
corporation pays dividends to shareholders, the dividends are also deducted from the retained
earnings account. In other words, the
retained earnings
account represents the cumulative net
