Coming now to the equity segment of the balance
sheet. Equity is the owners residual claim on a company's
assets after subtracting its liabilities. Sometimes
this is also called net assets, and here are the various
components of equity. You will notice that, with equity
there are no rules defining how equity is valued,
because equity is simply the difference between
assets and liabilities. We will study rules for
measuring different kinds of assets. We will study
rules for measuring different kinds of liabilities
and equity is simply the differential. However, with
equity we need to understand the different categories
and those categories, at least two major ones, are
shown over here. Contributed capital is the money
that has actually been contributed by the owners,
either at the start of the company, or during the life
of the company. So, this is money that is coming from
outside the company given by owners to the company,
and obviously owners then have an ownership claim
based on the money that they have contributed to
the company. This is called common stock or issued
capital, it may have a par value or a stated value.
A company needs to disclose the number of shares
which are authorized, issued, and outstanding. When
a company is created, it has to state how many shares are
authorized. Let's say that a company is started and
the number of shares authorized is a 100 million.
This means that the company has the authorization
to issue up to a 100 million shares. It does not
mean that 100 million shares will be issued
immediately. Let's say that out of this 100
million the company initially issues 40 million
shares. So, that is the amount of shares that have
been issued. Notice that issued shares will have
to be less than the number of shares authorized.
A year later, a company might buy back 10 million
shares. This buyback of shares is called a treasury
stock operation. This is referred to as treasury
shares. So, we buy back 10 million treasury shares, and what
we are then left with is 30 million shares outstanding,
so shares outstanding is 30 million. Earlier when we talked
about earnings per share calculation, we were actually
calculating earnings per outstanding shares.
So the outstanding shares are the shares that are
being traded, and that is the critical item out of
these three. Retained earnings refers to the earnings
that a company has generated which have not been
paid out as dividends. Earning that have not been paid out as dividends are retained within the company, and
we've seen several examples up till now. A company
might generate a 100 million in profits of which it might pay out
20 million as dividends and retain 80 million.
This 80 million would be called retained earnings. Next
year a company might retain another 80 million which
would create a 160 million worth of retained earnings.
The reason this is called equity, is that the 100
million really belongs to shareholders and rather
than takingit out, they are putting it back in the company.
So, they are plowing the money back or reinvesting
the money or retaining the money, hence it is considered
part of equity. Accumulated Other Comprehensive
Income. We have already talked about this. There are items, such
as available for sale securities where the gains,
the unrealized gains, on AFS are not passed through the
income statement. They directly increase equity,
and their increase is reflected in the component
of equity called other comprehensive income. There
are three other items that cause OCI to go up, and I
have asked you to memorize those three items in an early
reading. Non-controlling interest is the minority
interest. If you own a company, let's say you have 80%
ownership then there is this other party which has
20% ownership, that 20% ownership is shown as the non-controlling
interest or minority interest that is also equity,
and finally preferred shares or preference shares.
These are classified as equity or financial liabilities
depending on the characteristics. Now if we have
preferred shares, that are redeemable or that are
going to be redeemed, at a certain price by a certain
date, then the preferred shares have to be classified
as liabilities. On the other hand, perpetual preferred
shares are generally classified as equity. To understand
the major components of equity, let's look at this
simple example. At the start of year 1, owners contribute
100, so that is the issued capital. Among other
assets, the company purchases financial assets
categorized as AFS worth 100. So, during year 1 the net income is 20, which
is retained. The value of financial assets goes
up to 12. During Year 2, there is a treasury stock operation
worth 30. Net income is 40, which is retained. Financial
assets go up to 15. You need to show the relevant equity
components at the end of year 1 and end of year 2. Pause
the video before you look at the solution. Here is
what you should come up with; the issued capital at
the start and end of year 1 is 100,000. During year 1,
there was no treasury stock operation. The retained
earnings for year 1 are 20, because we said the entire
net income of 20 is retained. Accumulated other comprehensive
income, so started from 0, and AFS started at 10,
went up to 12, so the increase is 2, OCI therefore, is 2. Total equity of
the end of year 1 is 122. Then for end of year 2, issued capital stays
the same but in year 2 we have a treasury stock operation
worth 30, so this is -30. A treasury stock corporation
is always a negative. It's reducing the number of
shares outstanding. Accumulated retained earnings
goes up to 60, because we started year 2 at 20, and then
in year 2 we have earnings of 40 and this entire amount
is retained. So, the accumulated retained earnings
equals 60. Other comprehensive income for year 2
is 3, because we went from 12 to 15. So, the OCI for year
2 is 3. The accumulated OCI is 2 plus 3, which is 5. The total equity, at the end of year 2
is simply a sum of these items, and that is 135. The
statement of changes in equity presents information
about the increases or decreases in a company's
equity over a period. IFRS requires the following information
in the statement of changes in equity, so you can
read this. I think US GAAP is a little easier to understand.
US GAAP requirement is for companies to provide
an analysis of changes in each component of equity
as shown in the balance sheet, and to understand this
let's look at an excerpt from Apple's consolidated
changes in shareholders equity. You don't need
to understand every detail here, but you should
try to get the main point. This first row, represents
the start of the period. At the start of the period, the common stock is 7,177. This represent
the amount that has been contributed by owners.
The retained earnings equals 15,129. This is the
total amount of earnings that have been retained
up till this date. The accumulated OCI on this date is
-9 and you add up these items you get total shareholders
equity at the start, equal to 22,297. The bottom represents the
situation at the end of the period. The common stock is 8,210,
retained earnings 23,353, which is a much larger
number compared to the start of the period. OCI went up
to 77, this is actually accumulated OCI, and note that
the total shareholders equity went up from 22,000
to approximately 31,640. Now, where did this change
come from? What you can notice from the bottom line
is that a significant contribution came from retained
earnings, which is good, but let us evaluate this
a little more. When you look at common stock, the company
has issued new stock, the company has some stock-based
compensation and then there is common stock issued
under stock plans. New shares are issued, which is
why this column is going up. The most interesting
item here is that retained earnings are going up
a lot, because of this high net income and this shows
that the company is doing well. So, there is a major
element right here. With OCI, if you recall I asked
you to remember the four items that contribute to
OCI and you see them over here. The one that you need
to understand, is changes in unrealized loss on AFS
securities. So, notice that in this period there must have been substantial
gains on the AFS front, which is why the OCI is going
from negative territory to substantially positive territory.
Other OCI elements also had a contribution, but a negative
contribution. Now, there are a few other minor items here,
but I don't think you really need to get into the details.
The key points have been addressed.