The basic accounting equation is, assets=liabilities + owner's equity. This equation lays the background of double entry bookkeeping. This means that one side of the accounting equation must balance with the other side. The residual interest after subtracting liabilities is the owner’s equity. Owner’s equity is the capital that shareholders contribute to have a share of ownership in the corporation in the form of shares. Stock certificates are issued as evidence of ownership in a publicly owned corporation.
Common stock, generally known as an ordinary share, is a type of security that represents ownership in a corporation. Holders of common stock influence and make major decisions of a firm through votes. Some of the decisions made include electing a company’s board of directors, determining stock splits, and establishing objectives and company policies. With common stock, the company is under no obligation to pay dividends. Common stock has no fixed dividend paid out, so the returns are uncertain.
Preferred stock is a category of ownership in a corporation that has a priority claim on earnings and assets over ordinary stock. It has a fixed dividend that must be paid out before paying common stock holders dividends. Preferred stock holders do not possess voting rights and therefore are not involved in decision making.
Retained earnings are the portion of net earnings that are retained by the corporation instead of distributed to its stockholders as dividends. Retained earnings are accumulated through the years, with losses offsetting earnings. Retained earnings are included in the owner’s equity section of the balance sheet and may be used by the firm for investments in later years.
Treasury stock refers to the difference between the number of shares issued and the number of shares outstanding. If a firm holds treasury stock, there exists a debit balance in the general ledger account treasury stock. If the firm sells treasury stock, debit cash and the cost of shares sold is credited to the stockholders' equity account treasury stock. This is one of the elements of owner’s equity in the balance sheet.