The Differences in Creditors & Stockholders in Accounting
A small business can fund its operations using either debt capital from creditors or equity funding from stockholders. While stockholders own a stake in your company and do not require repayment, creditors have no ownership and must be repaid. In addition, you must account for these two types of financing differently on your financial statements. Understanding these differences can help you accurately report the capital contributed to your company and the correct profit.
A company lists the money it borrows from creditors in the liabilities section of its balance sheet. Examples of liabilities include bank loans, notes payable and bonds. A liability account’s balance represents the claim a creditor has against the company’s assets. As a business repays a debt, it reduces the account balance by the amount paid. For example, if you borrow $20,000 from a bank, you would list a bank loan for $20,000 as a liability. If you repay $5,000 of it, you would decrease the balance to $15,000.
Most creditors require periodic interest payments. Interest represents the cost of borrowed money and is calculated as a percentage of the outstanding balance. A company reports the interest that applies to a particular accounting period as an expense on its income statement. This expense reduces profit. For instance, if a creditor charges your small business 10 percent annual interest on a $10,000 loan, you would report $1,000 in interest expense on your annual income statement. The expense would reduce your profit by $1,000.
A business reports funds from stockholders under “contributed” or “paid-in” capital in the stockholders’ equity section of the balance sheet. Depending on the state of incorporation, it might report the amount in one account or might report a portion of the proceeds separately as “par value.” This par value is typically an insignificant amount used as an accounting formality. Unlike creditors, stockholders typically have a claim on the company’s assets that exceeds the reported amount of their initial contribution, because they also own a piece of the company’s past and future profits.
While a business must pay interest to creditors, it can decide whether or not to pay dividends to stockholders. Some small businesses never pay dividends. Unlike interest payments, dividends do not reduce a company’s profits but are instead a distribution of its retained earnings -- the profits it has accumulated since it started. A business reports dividends on the statement of stockholders’ equity. For example, if you declare a $10,000 dividend, you would reduce retained earnings by $10,000 and report the dividend on the statement of stockholders’ equity.