Equity

As an accounting and financial term, equity is defined by the Financial Accounting Standards Board in Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements. In its most basic conceptual form, equity represents the net assets of an organization; that is, the residual interest in the assets of the organization less its liabilities. The fundamental difference between a liability and equity lies in the nature of the claim against assets. Generally, liabilities have a definitive claim, whereas the equity claim is residual in nature.

Although conceptually the same across organizations, equity takes on different names based on the nature of the organization. In most business entities that are organized as taxable, for-profit entities with ownership based on shares of common stock, equity is broadly defined as stockholders' equity. There are several components to shareholders' equity, as discussed further. In the language of not-for-profit organizations, which do not have ownership interest as such represented by shares of stock, equity is known as net assets. These are categorized into several classes depending on the nature of any donor restrictions. Although the components of net assets of not-for-profit organizations are not discussed here, the basic concept of assets less liabilities remains the same.

Stockholders' equity consists of several distinct components, each with its own origin and its own purpose and nature. The stockholders' equity section of an organization's balance sheet must clearly disclose these components. In complex equity situations, such as where there are several classes of ownership interests, the rights and preferences of the different classes of ownership interest must also be disclosed.

The fundamental element of stockholders' equity for an organization is its capital stock. Most commonly, the ownership of an organization consists of common stock. Such stock may have a par or stated value, which historically has been related to the legal capital that a state requires to be available. Certain common stock in some jurisdictions may be no-par and, therefore, there is no distinction between a par value and amounts that may be paid in to the corporation in excess of par. Any amounts that are paid in excess of par constitute additional paid-in capital, which may be returned to stockholders in the form of a distribution. As indicated, there could be several classes of common stock in more complex corporations, and the rights and preferences of each may differ. However, one class of common stock owner has first claim to the assets and, therefore, the greatest ownership risk.

Preferred stock owners represent a class of ownership who have certain rights and preferences, with regards to claims on earnings or on assets, that are above those of common stockholders. These preferences may include first rights to earnings in the form of a stated dividend and preferential rights to assets in the event of a liquidation. Dividends may be cumulative and accumulate in arrears, or they may be noncumulative. The preferred shares may also have additional earnings participation features or may be convertible to common stock as specified in the preferred stock agreements.

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