Businesses rely on equity investments for capital. Issuing common stock in exchange for a capital contribution has the advantage that unlike a loan, the business doesn't have to pay back an equity investment. However, the investor who buys the stock has an ownership interest in the company, and the company has to make proper accounting entries in order to reflect the new capital contribution.
The typical case: cash for stock
The most common reason that a company issues stock is to raise cash. In that case, the way you'll typically account for the cash received in the stock offering is to add the amount of the proceeds to the cash line item on the asset side of the balance sheet.
To offset this addition to assets, you'll then increase shareholders' equity by the same amount. If you issue shares with a par value, then you'll often split the increase into two categories. The equity attributed to the common stock's par value will increase by the number of shares issued multiplied by the par value per share. Any remaining proceeds will increase the line item for additional paid-in capital in excess of par value.
For most publicly traded companies, stock offerings are made for cash. But small businesses often have more flexible arrangements to raise capital.
For instance, some businesses will issue stock in exchange for tangible assets or real property. In that case, the way you account for the in-kind capital contribution is similar to how you handle cash, except that you'll increase the line item for the appropriate type of property on the asset side of the balance sheet rather than cash. How you handle shareholders' equity remains the same.
Another situation that sometimes arises is that someone who loaned money to the business will agree to accept stock in repayment of the loan. In that case, no adjustment to the asset side of the balance sheet is necessary. Instead, the amount of debt that the company carries on the liability side of the balance sheet will go down, and the shareholders' equity line item will rise in the same way as in the other cases.
Accounting for stock transactions can be complicated, but it's also necessary to keep a firm grip on your company's finances. Knowing the impact of issuing stock to raise cash or other capital is vital to make sure you make the best financial decisions for your business.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.