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Intermediate Accounting

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1 Intermediate Accounting
Chapter 15 Contributed Capital © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2 What Information Does Shareholders’ Equity Provide? (Slide 1 of 2)
Equity is the residual interest in the assets of a company that remains after deducting its liabilities. The balance sheet accounting for financing activities by common equity shareholders typically involves: Contributed capital accounts, such as common equity at par and additional paid-in capital Earned capital accounts, such as retained earnings and accumulated other comprehensive income Contributed Capital is the section of shareholders’ equity in which a corporation records the results of all its stock transactions in capital stock accounts and additional paid- in capital accounts.

3 What Information Does Shareholders’ Equity Provide? (Slide 2 of 2)
Retained Earnings is an account in shareholders’ equity where any net income that has been reinvested in the corporation and not paid out to shareholders as dividends is reported. Accumulated Other Comprehensive Income is an account in shareholders’ equity where a corporation reports any increase or decrease in shareholders’ equity as a result of other comprehensive income. A company’s equity changes: As it earns net income As it declares dividends As transactions between the company and its owners occur As other comprehensive income transactions occur

4 How Are Corporations Organized?
Shareholders (or stockholders) are owners of a corporation. The primary advantage of the corporate form is the ability to raise large amounts of capital by issuing shares of stock. Limited legal liability is a concept in which owners bear no personal liability for the corporation’s debts and risk; they risk only their capital investment. Corporations generally pay more taxes than other organization forms because of: Higher tax rates than other forms Owners are subject to double taxation

5 How Are Corporations Classified? (Slide 1 of 2)
Privately held corporations are any corporations not owned by the government. Open corporations (often called publicly traded corporations) are corporations whose stock can be purchased by any individual on a stock exchange. Closed corporations (often called privately held corporations) are corporations that do not allow the sale of stock to the general public. For example, the candy company Mars, Inc. Public corporations are corporations owned or operated by governmental units.

6 How Are Corporations Classified? (Slide 2 of 2)
Domestic corporations are companies doing business in the state in which it is incorporated. Starbucks, which is incorporated in the State of Washington, is a domestic company with respect to Washington. Walmart is a domestic corporation with regard to the State of Arkansas. Foreign corporations are companies that are operated in a state other than the one in which it is incorporated. Starbucks is a foreign corporation with regard to the State of North Carolina.

7 How Are Corporations Formed?
In the United States, a corporation is a legal entity of a particular state. An approved application for incorporation becomes a corporation’s articles of incorporation (or corporate charter). For a corporation to perform its functions, the state gives it various rights and powers. These include the right to: Enter into contracts Hold, buy, and sell property Sue and be sued Continue indefinitely

8 How is the Capital Structure of a Corporation Defined?
A stock certificate is a serially numbered document that indicates the number of shares owned and the par value (if any). Because stock certificates are easily transferred from one investor to another, state laws require that each corporation keep appropriate records of its shareholders. A transfer agent (such as a bank) handles the issuance of stock certificates. A registrar is a person who maintains the shareholder records.

9 Capital Stock and Shareholders’ Rights
(Slide 1 of 2) Capital stock refers to the shares of stock issued by the corporation and owned by its shareholders. Each shareholder has various rights. Right to a dividend when it is declared Right to elect directors and to establish corporate policies (voting right) Right (called a preemptive right) to maintain a proportionate interest in the ownership of the corporation by purchasing a proportionate (pro rata) share of additional capital stock if more stock is issued Right to share in the distribution of the assets of the corporation if it is liquidated

10 Capital Stock and Shareholders’ Rights
(Slide 2 of 2) Common stock is capital stock that carries all of the rights of ownership. Some corporations issue more than one class of common stock such as Class A and Class B common stock. In this case, usually one type of common stock has greater voting rights than the other to maintain control over the corporate activities. Preferred stock is not granted all of the common stock’s rights, but receives in exchange certain other privileges.

11 Basic Terminology Authorized capital stock is the number of shares of capital stock (both preferred and common) that a corporation may issue as stated in the corporate charter. Issued capital stock is the number of shares of capital stock that a corporation has issued to its shareholders as of a specific date. Outstanding capital stock is the number of shares of capital stock that a corporation issued to stockholders and that are being held by shareholders as of a specific date. Treasury stock is the number of shares of issued capital stock reacquired from shareholders, but not retired. Subscribed capital stock is the number of shares of capital stock that a corporation will issue upon completion of an installment purchase contract with an investor.

12 Legal Capital (Slide 1 of 2)
To protect the corporation’s creditors, state laws have established the concept of legal capital as the amount of stockholders’ equity that the corporation cannot distribute to shareholders. The definition of legal capital varies among states. Most states designate that the par value of all its issued stock is the legal capital.

13 Legal Capital (Slide 2 of 2)
The par value of a corporation’s capital stock (either common or preferred) is a designated dollar amount per share that is established in the articles of incorporation and is printed on each stock certificate. The par value of a stock has no relation to its market value. Stock rarely sells initially for less than its par value, because it is illegal to do so in most states. No-par capital stock is stock that does not carry a par value. When a corporation issues no-par stock, some states require that the corporation designate the entire proceeds received as legal capital. Stated value per share of no-par stock, when multiplied by the number of shares issued, generally determines the amount of the corporation’s legal capital.

14 Additional Paid-in Capital
State law requires the corporation to record the par or stated value. Additional paid-in capital is the excess value received (the difference between the exchange price and the par or stated value) in each type of stock transaction. While most companies use the term Additional Paid-in Capital, you may also see the terms: Capital in Excess of Par (or Stated) Value Paid-in Capital in Excess of Par (or Stated) Value Additional Capital

15 Stock Issuance Costs A corporation may incur miscellaneous costs that arise from issuing its capital stock. Legal fees Accounting fees Stock certificate fees Underwriter’s fees Promotional fees Postage When these costs are incurred at the initial issuance of stock at the time of incorporation, they are considered an organization expense.

16 Stock Subscriptions Investors sometimes agree to purchase capital stock from a corporation and pay at a later date. This creates a legally-binding subscription contract between the corporation and the future shareholders. This contract requires the investor to buy a certain number of shares at an agreed-upon price, with payment spread over a specified time period. The contract often requires a down payment and may require the investor to issue the company a promissory note. The contract will also set forth what will happen if the investor is not able to pay and defaults.

17 Nonmonetary Issuance of Stock
A nonmonetary exchange is any type of transaction in which a corporation issues capital stock for assets other than cash, or for services performed. The general rule is to record the exchange at the fair value of the stock issued or the asset received, whichever can be measured with greater representational faithfulness. Stock may be closely held and not actively traded. The fair value of the assets received may provide a more representationally faithful value of the transaction.

18 Stock Splits To reduce the market price of a corporation’s stock so that it falls within a desired “trading range” of most investors, a corporation may authorize a stock split. A stock split is proportionally decreases in market price and par value per share of stock and increases the number of shares issued. A stock split also results in a proportional increase in the number of shares authorized. A reverse split increases the par value per share and proportionally decreases the number of shares issued.

19 Stock Warrants Stock warrants represent the right to purchase additional shares of common stock at an established price, usually referred to as the exercise price. Exercise price (or strike price) is the price at which the holder of an option or warrant has the right to buy or sell the common stock. Detachable warrants are warrants that can be separated from the other security and traded independently.

20 How Do Companies Account for Noncompensatory Share Purchase Plans?
A noncompensatory share purchase plan enables employees to buy shares of stock, usually at a discount. Three criteria for share purchase plan to be noncompensatory: All employees who meet limited employment qualifications may participate in the plan on an equal basis. The discount from the market price does not exceed the per-share amount of stock issuance costs avoided by not issuing the stock to the public. The plan has no option features other than the following: Employees are allowed a short time (no longer than 31 days) from the date the purchase price is set to decide whether to enroll in the plan The purchase price is based solely on the market price of the stock on the purchase date, and employees are permitted to cancel their participation before the purchase date and obtain a refund of any amounts previously paid.

21 What Are Share-Based Compensation Plans?
A share-based compensation plan is a compensation arrangement in which employees receive share options, shares of stock, or cash payments based on the change in stock price instead of cash bonus. A compensatory share option plan is an arrangement intended to provide additional compensation by rewarding employees shares in the company or cash bonuses tied to changes in the company’s stock price. Restricted share awards and appreciation rights are arrangements intended to provide additional compensation by awarding employees shares in the company or cash bonuses tied to changes in the company’s stock price.

22 Overview of Compensatory Share Option Plans
In developing a compensatory share option plan, a company’s objective is to better align the company’s goals with those of management and its owners. The grant date is the date on which the company provides the share options to the employees. The intrinsic value method is a method whereby a corporation measures the total options-based compensation cost for each employee as follows: Total Options-Based Compensation Cost = Number of Share Options × Market Price of the Stock on Date of Grant Exercise Price of the Share Option

23 How Do We Account for Compensatory Share Option Plans? (Slide 1 of 2)
Option pricing models are used to estimate the fair value of the option. The option pricing model that a corporation uses must take into account the following variables as of the grant date: Exercise price Expected life of the option Current market price of the underlying common stock Expected volatility of the stock price Expected dividends on the stock Risk-free interest rate for the expected term of the option An option’s value is determined at the grant date as follows: Option Value (Fair Value) = Current Stock Price ‒ Present Value of Exercise Price

24 How Do We Account for Compensatory Share Option Plans? (Slide 2 of 2)
The cost recognized by a company for its share-based compensation plan is the total fair value of the share options that actually become vested. Vested occurs when an employee has fulfilled the service requirement and has ownership of the share options. If the corporation expects that a significant number of employees will forfeit their options, then it records the compensation expense each year based on an estimate of the number of options expected to vest. The estimated total compensation cost is determined at the grant date as follows: Estimated Total Compensation Cost = Fair Value per Option × Estimate of the Number of Share Options Expected to Vest

25 Performance-Based Option Plans
Performance-based share option plans (or variable-term share option plans) are plans in which one or more terms are not fixed at the grant date. These plans are set up so that the terms will vary depending on how well the selected employees perform during the service period.

26 Restricted Share Plan Because some employees who qualify to buy shares of stock in a compensatory plan have a cash-flow problem, corporations have developed share-based plans involving restricted shares. A restricted share plan is a plan in which employees are granted actual shares of stock. While the employee becomes an actual shareholder on the date of the grant, the company maintains physical possession of the shares, restricting the employee’s ability to sell the shares until the employee reaches certain goals. These restrictive shares are referred to as noninvested shares.

27 Share Appreciation Rights
Share appreciation rights (SARs) are rights granted to selected employees that enable them to receive cash, shares, or a combination of both equal to the excess of the market value over a stated price of the corporation’s stock on the date of exercise. A company accounts for a SARs plan using the fair value method. For SARs the fair value can only be determined on the date the rights are exercised. To record the compensation expense for the SARs plan, an estimate of the total compensation cost is made at the end of each year based on the fair value of the SARs at that time. Adjustments are made after each service period has expired.

28 What Characteristics are Associated with Preferred Stock?
Various preferred stock characteristics may be specified in preferred stock contract: Preference as to dividends Accumulation of dividends Participation in excess dividends Convertibility to common stock Attachment of stock warrants Callability by the corporation Mandatory redemption at a future maturity date Preference to assets upon liquidation of the corporation Lack of voting rights

29 Cumulative Preferred Stock
Noncumulative preferred stock is stock carrying the provision that the holder will never be paid a dividend in a particular year if dividends are not declared in that year. Cumulative preferred stock is stock carrying the provision that, if a corporation fails to declare a dividend on cumulative preferred stock at the stated rate on the usual dividend date, the amount become dividends in arrears. Dividends in arrears accumulate from period to period. Dividends in arrears are not liabilities. A corporation cannot pay common shareholders any dividends until it has paid the preferred dividends in arrears.

30 Participating Preferred Stock
Participating preferred stock is stock carrying the provision that preferred shareholders share with the common shareholders in any additional dividends. Participating preferred stock may be either fully or partially participating. Fully participating preferred shareholders are shareholders who share equally with the common shareholders in any extra dividends. Partially participating preferred shareholders are shareholders who share in extra dividends, but the participation is limited to a fixed rate or amount per share.

31 Convertible Preferred Stock
Convertible preferred stock is stock with a provision that allows shareholders, at their option and under specified conditions, to convert the shares of preferred stock into another security of the corporation. Accounting for the conversion of preferred to common stock is very straightforward because the book value method is used. The conversion of preferred to common stock changes the components of shareholders’ equity, but does not affect the corporation’s total shareholders’ equity.

32 Preferred Stock with Stock Warrants
A corporation may also attach warrants to preferred stock to enhance their attractiveness. These warrants represent rights that allow the holder to purchase additional shares of common stock at a specified price over some future period. Because these warrants are detachable from the preferred stock, they usually begin trading on the stock market at some market price. The investor in detachable preferred stock has dual rights: Right to dividends that will be paid on the preferred stock Right to the market value appreciation of the common stock that may be purchased as a result of the warrants

33 Callable Preferred Stock
Callable preferred stock is stock that may be retired (recalled) under specified conditions by a corporation at its discretion.

34 Redeemable Preferred Stock
In contrast to convertible preferred stock and callable preferred stock, some preferred stock is redeemable. Redeemable preferred stock is stock that may either be subject to mandatory redemption at a specified future maturity date for a specified price or redeemable at the option of the holder. Redeemable preferred stock has a key characteristic of a liability because of the obligation of a cash outflow in the future that the company has no ability to prevent. Preferred stock that is redeemable at the option of the holder is not reported as a liability. It is reported in shareholders’ equity.

35 Preference in Liquidation
If a corporation is liquidated, the preferred stock contract usually allows the preferred shareholders liquidation preference over the common shareholders (but secondary to creditors). The preference is typically expressed as a percentage of (or equal to) the par value. It also frequently requires the payment of dividends in arrears. A corporation discloses this information either parenthetically in its shareholders’ equity section or in the notes accompanying its financial statements.

36 What is Treasury Stock and How is it Accounted For? (Slide 1 of 3)
Treasury stock is a corporation’s own capital stock that (1) has been fully paid for by the shareholders, (2) has been legally issued, (3) reacquired by the corporation, and (4) is being held by the corporation for future issuance. A corporation may acquire treasury stock to: Use for share option, bonus, and employee purchase plans Use in the conversion of convertible preferred stock or bonds Use excess cash Use in acquiring other companies Signal to the capital market that the company managers believe the shares are underpriced

37 What is Treasury Stock and How is it Accounted For? (Slide 2 of 3)
Reduce the number of shares held by hostile shareholders and thereby reduce the likelihood of being acquired by another company Use for the issuance of a stock dividend Treasury stock is not an asset. To ensure that treasury stock is handled in the best interest of the shareholders, states have passed laws regulating corporate activities as follows: A corporation must acquire treasury stock for some legitimate corporate purpose. Treasury stock does not vote, has no preemptive rights, ordinarily cannot participate in dividends or liquidation. Treasury stock does not participate in stock splits.

38 What is Treasury Stock and How is it Accounted For? (Slide 3 of 3)
The acquisition of treasury stock does not formally reduce a corporation’s legal capital. Treasury stock transactions may reduce retained earnings but may never increase retained earnings. If the treasury shares are not retired, the corporation may reissue the treasury stock at a price above or below the acquisition price or the par value. A corporation may account for treasury stock transactions by either the cost method or the par (stated) value method. The cost method is used by the vast majority of companies that hold treasury stock.

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