Question of the Week

Which of the following steps is inaccurate with respect to calculating a figure for shareholder's equity?

(a) Total liabilities must be subtracted from total assets.
(b) All dividends, be it for preferred or common shares, must be deducted from net income before it is added to the retained earnings component of shareholder's equity.
(c) Depreciation must be added back to net income before it is added on the retained earnings portion of shareholder's equity.
(d) All the capital that equity holders have invested into the firm must be added to the earnings that have been retained by the company over time.

Answer:

The correct answer is c.

Depreciation is added back to net income only when calculating for cash flow. In the case of shareholder's equity, all figures are derived using accrual methods. Therefore, even though net income is at best only an estimate of the true economic profit of the firm, only dividends are deducted from it before it is added to retained earnings.

CFA Level 1 LOS: 7.1.A.j