Statement of Changes in Equity

 

Chapter 3: Statement of Changes in Equity Learning Objectives: 1.  Understand the purpose of the Statement of Changes in Equity. 2.  Appreciate that the presentation of the t he Statement of Changes in Equity is dependent on the form of business organization; 3.  Identify the elements of the Statement St atement of Changes in Equity. 4.  Determine the nature of the different equity accounts used by corporations; and 5.  Prepare a Statement of Changes in Equity. What is a Statement of Changes in Equity? The financial statements form a set of interrelated reports. The Statement of Financial Position (SFP) was discussed in Chapter 1. In chapter 2, we studi studied ed the Statement of Comprehensive Income (SC(). The third part of the set, which we will discuss in this chapter, is the Statement of Changes in Equity (SCE). Recall that the SFP is a report on the company’s assets, liabilities, and equity. The equity component of the SFP shows the claim of the owners on the company’s assets. This is the reason why equity account are of particu particular lar interest to the readers of the financial statements. The SoCE is prepared to meet the requirements of the readers to understand the transactions that caused the movements in equity e quity account. The SoCE is a statement dated “for the year ended”. The re report port shows a reconciliation of the beginning and ending balances of the equity account. It summarizes the equity transactions with the owners of the business that occurred during the year. Balance, January 1, 20x1

P 100,000

Equity transactions With owners Balance, December 31, 20x1

P 150,000

Figure 1: Objective of Statement St atement of Changes in Equity Forms of Business Organization The business organization determines the presentation of the SoCE and equity portion portion of the SFP. In this light, we begin our study with a review of the forms of business organizations. There are three basic forms of business organization, namely: (1) sole proprietorship, (2) partnership, and (3) corporation. They differ in terms of number of owners, legal personality of the business, and ease of transferability transferability of ownership. Sole Proprietorship is Proprietorship is the simplest form of a business business organization. There is only one owner referred to as sole proprietor. Oftentimes, the owner owner is als also o the man manager. ager. The business has no legal personality separate from iits ts owner. In the eyes of the law, the business and the owner is one entity. For example, the business and the owner are taxed as one. Also, the claim of the creditors of the business extends to the personal assets of the owner. As a result, raising capital for the business is constrained to the owner’s resources and credit standing. In contrast to a sole proprietorship, a Partnership  is a business owned by two or more owners called partners. They pool their resources together such as money property and industry, to operate a business and divide the profit among themselves. Partners re generally involved in in the management of the b business. usiness. The agreement of the partners is stat stated ed in the contract of partnership specifically, the partner’s profit and loss sharing arrangements. arrangements.   A partnership has a legal personality personality separate from its owners’. It is taxed separately from the partners except for those formed for the practice of the profession of the partners (i.e. lawyers, lawyers, accountants, etc.) However, the claims of the partnership creditors may extend to the partners personal assets.

Corporation is the most complex form of business business organization. A corporations is owned by many o owners wners called stockholders or shareholders. Ownership is divided into into common stocks or share of stocks. One shareholder can own many stocks. Shareholders are not normally normally involved in the day to day day operations of the corporation. Rather, owners set up policies for the management of the corporation. In policy setting, each stock is normally entitled to one vote. A stockholder that owns 1,000 stocks has 1,000 votes. Therefore, the stockholder that owns 50% +1 of the total stock outstanding can control the corporation. Rules that govern the management of the corporation a are re written in the Articles of Incorporation and By-Laws.

 

  The Corporation Code governs all corporations in the Philippines. Corporations are registered with the Securities and Exchange Commission Commission (SEC). Some corporations are listed in the Philippin Philippine e Stock Exchange (PSE). (PSE). This means PSE provides a platform where investors can buy and sell stocks of listed corporations. One of the characteristics of a corporation is the separation of own ownership ership and management. Shareholders invest their funds and the corporation only only have claims to the corporation’s asset. asset. A corporati corporation on is a legal entity separate from its owners. Discussion Questions: Questions: before moving on to the next part. Answer the following following questions: 1.  2.  3.  4.  5.  6. 

What is the objective of the SoCE? Which form of business organization has its own legal personality? Allocation of net income is most critical in which form of business organization? Why? True or false. Business creditors can always lay claim on the personal assets of the the owners. True or false. A business owned by more than one owner is a partnership. Separation of ownership and management is a characteristic of which business organization?

Preparation of Statement of Changes in Equity. The form of business organization determines the equity accounts reported on the financial statement. statement. As we have reviewed above, the form of business organization differ in terms of number of owners and the transferability of ownership. These inherent characteristics of business organizations organizations led to the difference in the presentation of equity. We will discuss each business form separately. Sole Proprietorship The SFP and SoCE will present one capital account because there is only one owner. The owner’s capital account follows this naming convention: convention: , Capital. Capital. If the same of the sole proprietor proprietor is Juan Dela Cr Cruz, uz, then the name of the account is Juan Dela Cruz, Capital. The owner’s Capital account has a normal credit balance.  balance.  Accountants use the owner’s Drawings account to record withdrawals of the owner. The Drawings account follows the naming convention for for Capital: , Drawings. Entries to this account decrease equity. It is closed at the end of the year to the Capital account, it is a nominal account with a nominal balance.

Drawings Debit Beg. balance 0 Withdrawals xxx End balance xxx

Owners Capital Credit

xxx Final balance

Closing

Debit

Withdrawals

0

xxx xxx xxx

Credit Beg. Balance Contributions Net income

xxx

End balance

xxx

Figure 2. T-Account T-Account of Owner’s Capital  Capital 

The owner’s Capital account tracks the following transactions of the owner: (1) capital contributions; (2) withdrawals and (3) net income or net loss generated by the business. business. Why is net income closed to the capital account? Consider this (a) the net income generated from the operation of the business is owned by the owner and (b) the capital account represents the part of the business that belongs belongs to the owners. Therefore, the net income that belongs to the owner should be included in his capital account. The SoCE of a Sole Proprietorship Proprietorship is basically a summary summary of the owner’s capital account. The bottom-line bottom-line of the SoCE is reported as equity in the SFP (Figure 3)

 

ABC Company Statement of Changes in Equity For the period ended December 31, 20x1 Owner, Capital. January 1, 20x1 Add: Net income Owner’s contribution  contribution  Less: Drawings -------------------------------------------------------------------------------Owner, Capital, December 31, 20x1 =================================================

xxxxxx xxxx xxxx xxxx ---------------------xxxxxx =============

Accounts payable Notes payable -------------------------------------------------------------------------------Total liabilities

xxxxx xxxxx --------------------xxxxx

Owner’s capital -------------------------------------------------------------------------------Total liabilities and owner’s equity  equity  =================================================

xxxxx ---------------------xxxxxx ==============

Liabilities and Equity portion of the Statement of Financial Positions Figure 3: Statement of Changes in Equity Sole proprietorship Friendly Convenience Convenience Store: Sole Proprietorship Juana Dela Cruz is the owner of the Friend Friendly ly Convenience Store. The store was estab established lished on January 1, 20x0. Juana deposited P 10,000 to a bank account in the name of Friendly Convenience Convenience Store Friendly Convenience Store. She made three more deposits of P 2,500 each during the year from from her personal account. The store generated net income of P 35,670 in 20x0. Juana regularly withdraws P 1,000 per month from the store’s bank accoun accountt for her personal expenses. expenses.   1.  Determine the 20x0 year-end balance of the Juan dela Cruz, drawings account. 2.  Prepare a statement of changes in equity for the year ended December 31, 20x0. Answer 1.  The 20x0 year-end balance of the Juana dela Cruz, drawings account is P 12,000. This is computed as P 1,000 X 12 month. 2.  Statement of Changes in Equity Friendly Convenience Store Statement of Changes in Equity For the period ended December 31, 20x1 Juana dela Cruz, Capital, January 1, 20x0 P -ooAdd: Owner’s contributions (P 10,000 + P 7,500)  7,500)   17,500 Net Income 35,670 Less: Drawings (P 1,000x12) (P 12,000) ---------------------------------------------------------------- -----------------------------Juana dela Cruz, Capital, December 31, 20x0 P 41,170 ================== Partnership A partnership is owned by two or more more partners. Our objective is to account for the equity of each partner. Therefore, we need more than one capital account. As a matter of fact, the number of capital accounts that will be reported on the SoCE and the SFP is equal to the number number of partners. Similar to the capital account used in sole proprietorships, each partner’s capital account will track his contributions to the business, business, his share in the net income and his drawin drawings. gs. A  Drawings account is also maintained for each partner. The naming convention for both the capital and drawings accounts is the same as in sole proprietorship. Recall that net income is closed to the capital account. How do we determine that amount of net income that will be closed to each partner’s partner’s capital account? Accountants call this process “allocation of net income”. Net income iiss allocated based on the profit and loss loss sharing agreement stipulated in the partnership contract. Allocation of net income is unique only to partnership. The partnership SoCE and the connection to the SFP are in Figure 4.

 

ABC Company Statement of Changes in Equity For the period ended December 31, 20x1 Partner A Partner A Partner A Total Capital Capital Capital ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance, January 1, 20x1 xxxx xxxx xxxx xxxx Add: Net Income xxxx xxxx xxxx xxxx Partner’s contribution xxxx xxxx xxxx xxxx Less: Drawings xxxx xxxx xxxx xxxx ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance December 31, 20x1 xxxx xxxx xxxx xxxx ============================================================================================== Accounts payable

xxxx

Accrued expenses Notes payable Total liabilities

Xxxx xxxx xxxx

Partner A, Capital xxxx Partner B, Capital xxxx Partner C, Capital xxxx Total owner’s equity  equity  xxxx ----------------------------------------------------------------Total liabilities and owner’s equity  equity  xxxx ======================================== Liabilities and owner’s equity portion of the balance sheet   Figure 4: Statement of Changes in Equity – Equity – Partnership  Partnership Partnership The DEF Partnership was established in 20x0. The partners, Diana, Emina and Fanny have January 1, 20x1 outstanding capital balances of P 25,600, P 43,800 and P37,655, respectively. Diana contributed P 15,000 during 20x1. Emina and Fanny also contributed P 10,000 each in 20x1. The 20x1 year end balances of each partner’s Drawings account are as follows: Diana P 12,000, Emina P 15,000 and Fanny P 14,000. The partnership reported 20x1 net income of P 75,650. According to the partnership agreement, the partner’s partner’s profit sharing ration is 30%, 40% and 30% 3 0% for Diana, Emina and Fanny. Prepare the 20x1 SoCE of DEF Partnership.

Answer ABC Company Statement of Changes in Equity For the period ended December 31, 20x1 Diana Emina Fanny Total Capital Capital Capital ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance, January 1, 20x1 P 25,600 P 43,800 P 37,655 P 107,055 Add: Net Income 22,695 30,260 22,695 75,650 Partner’s contribution  contribution  15,000 10,000 10,000 35,000 Less: Drawings (12,000) (15,000) (14,000) (41,000) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance December 31, 20x1 P 51,295 P 69,060 P 56,350 P 176,705 ================================================================================================

 

Corporation A corporation is owned by many stockholders that could number to thousands. Moreover, the ease of transferring ownership in corporations results in fast turnover turnover of owners. If we maintain one capital account ffor or each stockholder, we will end up with thousands of capital capital accounts. The fast turnover of owners will mean accountants wi will ll be faced with the voluminous and unending unending job of opening, transferring and closing capital accounts accounts.. More so, we are faced with the problem of allocating the corporation’s net income to the t he thousands of fast moving shareholders. shareholders.   The solution to these these issues is simple. We will not maintain maintain a capital account for each shareholder. As a result, there is no need to allocate net income to the thousands of shareholders. shareholders. We introduce three new equity accounts, namely, capital stock, additional paid in capital and retained earnings. We remain focused on only three equity transactions – capital  – capital contributions, drawings and accumulation of net income. The stockholders’ equity of a corporation is divided into two parts, namely, paid in capital and retained earnings. of contributions or will be given the corporation corto poration in exchange for its common stocks. Paid-in capitaldiscussion  is the amount In our previous of sole proprietorshipgiven and partnership, we to referred this as capital contribution to the business. Paid-in capital is composed of capital stock and additional additional paid-in capital (Figure 5). The balance of Capital Stock reflects the par value of the issued common shares. Par value is the minimum price by which corporations can issue stocks to shareholders. However, corporations generally issue issue stocks in exchange for an amount greater than par. The excess of the issue price over the par is reported as Additional Paid-In Capital.  The second half of the stockholders’ equity is the Retained Earnings. This account reports the undistributed earnings of the corporation. The balance of retained earnings is computed as foll follows: ows: net income minus net losses and dividends from the date of incorporation up to the cut-off or date of SFP (Figure 5). Dividends are distributions distributions to stockholders, similar to owners’ drawings in sole proprietorship and and partnership. Dividends are deducted from retained earnings because dividends are taken from income generated generate d by the corporation. Recall from Chapter 1 that equity accounts have normal credit balances. All three equity accounts discussed in this section, namely, capital stock, additional paid-in capital and retained earnings all have normal credit balances (Figure 5).

The SoCE of corporations and the connection to the SFP is in Figure 6 6..

Capital Stock Debit

xxxx

Credit Par value of stock issued

Additional Paid-in Capital Debit xxxx

Credit (Issue price – price – Par)  Par) x Issued stocks

Total proceeds from issuance of stocks during the

Retained Earnings Debit Net loss Dividends

Credit xxx xxx

xxx

Net income

xxxx End balance Figure 5: T-accounts of Capital Stock, Additional Paid-in Capital and Retained Earnings.

 

ABC Company Statement of Changes in Equity For the period ended December 31, 20x1 Additional Retained Paid-in Total Earnings Capital ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance, January 1, 20x1 xxxx xxxx xxxx xxxx Add: Net Income xxxx xxxx Issuance of new stocks xxxx xxxx xxxx Capital Stock

Less: Dividends (xxxx) (xxxx) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance December 31, 20x1 xxxx xxxx xxxx xxxx ============================================================================================== Accounts payable

xxxx

Accrued expenses Notes payable Total liabilities

Xxxx xxxx xxxx

Capital stock xxxx Additional Paid-in Capital xxxx Retained Earnings xxxx Total stockholder’s stockholder’s equity  equity  xxxx --------------------------------------------------------------------------Total liabilities and stockholder’s stockholder’s equity  equity  xxxx ============================================== Liabilities and owner’s equity portion of the balance sheet   Figure 6: Statement of Changes C hanges in Equity - Corporation Corporation GHI Incorporated was established in 20x0. The corporation issued 10,000, P 10 par vale shares of stock at an issue price of P 20 per share. On July 15, 20x1, the corporation issued 1,000 new shares at an issue price of P 25 per share. The corporation reported net income of P 56,785 and P 65,870 in 20x0 and 20x1, respectively. Dividends of P2.15 per share were declared and distributed to shareholders on February 1, 20x1. There were no dividends distributed on the first year of operations of the corporation. Prepare the 20x1 Statement S tatement of Changes in Equity of the GHI Incorporated.

Answer ABC Company Statement of Changes in Equity For the period ended December 31, 20x1 Additional Retained Paid-in Total Earnings Capital ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance, January 1, 20x1 P 100,000 P 100,000 P 56,785 P 256,785 Add: Net Income 65,870 75,650 Issuance of new stocks 10,000 15,000 25,000 Capital Stock

Less: Dividends (21,500) (21,500) ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Balance December 31, 20x1 P 110,000 P 115,000 P 101,155 P 326,155 ================================================================================================

 

  Computations: 1.  Capital stock, January 1, 20x1 Number of stocks issued as of January 1, 20x1 Par value Capital stock, January 1, 20x1

P

10,000 P 10 100,000

2.  Additional paid-in capital, January 1, 20x1 Number of stocks issued as of January 1, 20x1 Issued price in excess of par value (P 20 20 –  –  P 10)

10,000 P 10

Additional paid-in capital, January 1, 20x1

P

100,000

3.  Capital stock, Issuance Number of stocks issued as of July 1, 20x1 Par value Capital stock issuance

P

1,000 P 10 10,000

P

1,000 P 15 15,000

P

1,000 P 2.10 21,000

4.  Additional Paid-in capital issuance Number of stocks issued as of July 1, 20x1 Issue price in excess of par value (P 25 – 25 –  P 10) Additional Paid-in capital issuance 5.  Dividends Number of stocks issued as of February 1, 20x1 Dividend per share Dividends for 20x1

Discussion Questions: before moving on to the the next part, answer the following questions: 7.  How many capital accounts are presented on the SoCE of a sole proprietorship? 8.  How many capital accounts are presented on the SoCE of a partnership? 9.  How many capital accounts are presented on the SoCE of a corporation? 10.  What is “drawing” account?  account?  11.  What is “Paid-in “Paid-in capital? 12.  What is “Additional paid-in paid -in capital? 13.  What is Retained Earnings?

Comprehensive Illustrative Illustrative Problem: Mira’s Store  Store  On February 1, 20x4, Mira Delamar opened a store that sells sells school supplies. Mira wanted to know the balance balance of her capital account. Mira started her business by depositing depositing P 30,000 to open the checking account. account. On October 15, 20x4, the business is in need of additional cash so Mira Mira deposited P 5,000 to the checking account from her personal account. account. Mira also withdrew P 15,000 from the business over the year. The business earned a net income of P 37,450 for 20x4. Required: prepare the Statement of Changes in Equity for the year ended December 31, 20x4.

Solution: Mira’s Store  Store  Statement of Changes in Equity For the period ended December 31, 20x1 Mira Delamar, Capital, January 1, 20x4 Add: contributions Net Income Less: withdrawals

P

-oo35,000 37, 450 (P 15,000)

 

---------------------------------------------------------------Mira Delamar, Capital, December 31, 20x4

-----------------------------P 57,450 ==================

End of Chapter Summary: 1.  The SoCE is prepared to help the readers understand the transactions that affected the balances of the equity accounts. 2.  Sole proprietorship is a simple form of business organization characterized by only one owner who is also often times the manager of the business. 3.  A partnership is owned by partners who pooled together their resources to achieve a mutual goal to operate a and share the profits among themselves. 4.  business A corporation is a business owned by many shareholders and ownership is expressed ex pressed n terms of shares of stocks. a.  Ownership is separated from management. b.  The limited liability of stockholders meant that creditors of corporation only have claims to the corporation assets and not the personal resource of o f the stockholder. c.  Ownership in corporations is easily transferrable by selling the shares of stocks. stoc ks. 5.  Only one equity account is is presented on the SFP and SoCE of sol sole e proprietorships. This account tracks the contributions from the owner, net income from the operation of the business and owner’s drawings.  drawings.  6.  The owner’s Drawings account is used to record withdrawals of the the owner. It is a nominal account that is clo closed sed to the Capital account at the end of the year. 7.  In a partnership, the number of capital account that will be presented on the SFP and the SoCE is equal to the number of partners. a.  Each capital account contains the contributions contributions of the specific owner, his share in the net income from from the operations of the business and his drawings. b.  The partnership net income is allocated to individual partners based on their the ir profit and loss sharing agreement. 8.  The stockholder’s equity of a corporation is divided into two parts, pai pai-in -in capital and retained earnings. ear nings. a.  Paid-in capital is the amount of contribution given or will be given to the corporation in exchange for the shares of stock. It is composed composed of cap capital ital stock and additional paid-in capital. i.  The capital stock account reports the number of issued stocks at its par value or stated valued. ii.  The excess of the issue price over par is reported as additional paid-in capital. b.  The retained earnings account reports the t he undistributed earnings of the corporations corporations –  – all  all the net income less net losses and dividends from the date of incorporation up to the cut-off or balance sheet date.