Corporations and Equity Accounts

By Maire Loughran from Intermediate Accounting For Dummies

The major advantage to incorporation is limited liability, which means that, unless debt is personally guaranteed, no individual retains responsibility for paying off debt. Other advantages are continuity, which means that, until the corporation is formally dissolved, it exists in perpetuity, and easy transferability of shares, which means you can sell your shares of stock in a corporation to anyone you want.

One major exception arises concerning the limited liability aspect of incorporation: the trust fund portion of the payroll taxes. Trust funds include the FICA and federal withholding amount withheld from employee paychecks. This amount doesn’t include the employer FICA match.

You may not have the same type of personal intrigue in a corporation as you have in a sole proprietorship, but this structure does have disadvantages. For example, it costs money to incorporate. You also must follow the proper corporate formalities of organizing and running a corporation to receive the benefits of being a corporation, including completing legal and taxation paperwork and filing in a timely fashion.

Corporations have distinct equity accounts consisting of retained earnings, paid-in capital, and stock. Following is a brief discussion of each:

Retained earnings: This account shows income and dividend transactions. For example, imagine that the business opens on April 1, 2013. On December 31, 2013, it has cleared $100,000 but has also paid $20,000 in dividends to shareholders. Retained earnings is $80,000 ($100,000 – $20,000).

Retained earnings accumulate year after year, ergo the “retained” in the account name. So if the business makes $40,000 in 2014 and pays no dividends, retained earnings on December 31, 2014, is $120,000 ($80,000 + $40,000).

You may have seen the accounting equation truncated down to net assets equaling equity. However, keep in mind that although retained earnings is a source of assets, it’s not an asset itself. It shows up in the equity section of the balance sheet because it’s an investment by the owners, which increases their interest in the actual assets of the business.
Paid-in capital: This element of equity reflects stock and additional paid-in capital. Corporations raise money by selling stock, a piece of the corporation, to interested investors.

Additional paid-in capital shows the amount of money the investors pay over the stock’s par value. Par value is the price printed on the face of the stock certificate. For example, if the par value of Green and Blue, Inc., is $20 per share and you buy 100 shares at $25 per share, additional paid-in capital is $500 [$5 ($25 – $20) @@ts 100 shares].

Another stock account is treasury stock. Treasury stock is its own stock that the company buys back from its investors. Treasury stock is a part of equity but isn’t a part of paid-in capital.