Stockholders' equity, the claim investors have on the assets of a firm, can increase or decrease from changes in retained earnings. Each accounting period net income accumulates in the retained earnings account. Net income increases retained earnings, which can increase stockholders' equity. However, investors should understand that other accounts can offset retained earnings gains.
Retained earnings is a balance sheet account that records the cumulative amount of a firm's earnings that have been retained in the company rather than being paid out to shareholders. Retained earnings is increased by net income. For example, if a firm earned net income of $100 million, then the retained earnings account would increase by the same amount. Stockholders' equity may also increase when retained earnings grow, but other accounts can offset the net income gain.
Items Impacting Stockholders' Equity
Retained earnings is one of the several accounts that impact stockholders' equity. Paid-in capital, other comprehensive income, unrealized gains on available-for-sale securities and treasury stock can also change the amount of stockholders' equity. Therefore investors should be aware that stockholders' equity may not necessarily increase by the exact amount of the company's net income. For example, a $100 million increase in retained earnings could be partially offset by a firm buying $40 million worth of treasury stock.
One of the main sources of stockholders' equity is paid-in capital. A company's stockholders' equity could rise more than the gain in retained earnings if the firm's paid-in-capital account also increases. This could occur if the company sold additional shares during the same time period. Funds provided by investors to purchase stock is often the initial source of stockholders' equity. Over time firms sell additional stock to raise needed funds and the company's paid-in capital account increases.
Investors should be aware that stockholders' equity can decline even when net income is positive. The gain to stockholders' equity from an increase in the retained earnings account could be negated by changes to one or a combination of accounts. For example, repurchase of shares and foreign currency translation adjustments could total more than net income. Similarly, a firm's stockholders' equity might fall due to a combination of higher pension liability adjustments and unrealized losses on available-for-sale securities or derivatives.