Public companies need extra cash for many purposes, including upgrading production facilities, expanding into new markets, or pursuing a major acquisition. One of the easiest ways to raise funding is through issuing common stock, which carries both positive and negative traits in comparison to taking out a traditional loan. For example, unlike a loan, cash generated from stock issues doesn't have to paid back. However, it confers ownership of a portion of the business to the buyer.
Accounting for common stock issues
The way a company accounts for common stock issuances can seem complicated, but at its most basic level the move simply involves crediting, or increasing cash while at the same time crediting, or increasing stockholders' equity. For this exercise, it's helpful to think of stockholders' equity as what's left when a company has paid all of its debts, sometimes referred to as book value.
In issuing its common stock, a company is effectively selling a piece of itself. The stock purchaser gives up cash, and in exchanges receives a small ownership stake in the business.
From the company's perspective, the transaction is recorded through traditional double-entry accounting that preserves the balance in the following equation:
assets = liabilities + stockholders' equity
The inflow of cash increases the cash line in the balance sheet. In other words, the company's assets rise. To balance that accounting entry out, stockholders' equity is credited by the same amount. This entry typically occurs in a line item called "paid-in capital."
In this way, the accounting equation above remains in balance. Of course, the formula works in reverse, as well. If a company chooses to repurchase some of its common stock, its assets will decrease by the amount of cash it spends even as stockholders' equity falls by the same amount. The only difference in this case is that the accounting entry for the debit is called "treasury stock," whereas a credit is accounted for as "paid-in capital" in a company's financial statements.
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