1. 9B-1 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren CHAPTER 9 Measuring and Reporting Stockholders’ Equity PART B

2. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-2 A corporation may purchase its own stock and retire it by canceling the stock certificates Retired stock cannot be reissued RETIREMENT OF STOCK Stock

3. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-3 Retiring stock decreases the corporation’s outstanding stock and decreases the number of shares issued In retiring stock, the corporation removes the balances from all paid-in capital accounts related to the retired shares RETIREMENT OF STOCK

4. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-4 RETAINED EARNINGS AND DIVIDENDS The Retained Earnings account carries the balance of the business’s net income less its net losses and less any declared dividends accumulated over the corporation's lifetime notThe Retained Earnings account is not a reservoir of cash waiting for the board of directors to pay dividends to the stockholders

5. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-5 A retained earnings deficit arises when a corporation’s lifetime losses and dividends exceed its lifetime earnings The deficit is subtracted from the sum of the other equity accounts to determine total stockholders’ equity RETAINED EARNINGS AND DIVIDENDS

6. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-6 A dividend is a corporation’s return to its stockholders of some of the benefits of earnings, most commonly in the form of cash payments Three relevant dates for dividends are –Declaration date The board of directors announces the intention to pay the dividend The declaration creates a liability for the corporation RETAINED EARNINGS AND DIVIDENDS

7. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-7 –Date of record As part of the declaration, the corporation announces the record date, which determines who receives the dividends The corporation makes no journal entry on the date of record because no transaction occurs –Payment date Payment of the dividend usually follows the record date by two to four weeks RETAINED EARNINGS AND DIVIDENDS

8. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-8 Dividends on Preferred and Common Stock Declaration of a $50,000 cash dividend is recorded by debiting Retained Earnings and crediting Dividends Payable, as follows: June 19 Retained Earnings50,000 Dividends Payable 50,000 To declare a cash dividend June 19 Retained Earnings50,000 Dividends Payable 50,000 To declare a cash dividend

9. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-9 Dividends on Preferred and Common Stock Payment of the dividend is recorded by debiting Dividends Payable and crediting Cash: July 2 Dividends Payable50,000 Cash 50,000 To pay a cash dividend July 2 Dividends Payable50,000 Cash 50,000 To pay a cash dividend

10. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-10 Dividends on preferred stock are paid first –When a company has issued both preferred and common stock, the preferred stockholders receive their dividends first –The common stockholders receive dividends only if the total declared dividend is large enough to pay the preferred stockholders first RETAINED EARNINGS AND DIVIDENDS

11. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-11 Pine Industries, Inc., has both common stock and 90,000 shares of preferred stock outstanding. Preferred dividends are paid at the annual rate of $1.75 per share. Assume that in 2001, Pine Industries declares an annual dividend of $1,500,000. The allocation to preferred and common stockholders is as follows: Preferred dividend (90,000 x $1.75 per share) 157,500 Common dividend (remainder: $1,500,000 - $157,500) 1,342,500 Total dividend$1,500,000 Preferred dividend (90,000 x $1.75 per share) 157,500 Common dividend (remainder: $1,500,000 - $157,500) 1,342,500 Total dividend$1,500,000 RETAINED EARNINGS AND DIVIDENDS

12. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-12 Differences between preferred stock and common stock –To an investor, preferred stock is safer because it receives dividends first –The earnings potential from an investment in common stock is much greater than the earnings potential of an investment in preferred stock –There is no upper limit on the amount of common dividends RETAINED EARNINGS AND DIVIDENDS

13. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-13 The different ways to express the dividend rate on preferred stock are –Percentage rate “6% preferred” means that owners of the preferred stock receive an annual dividend of 6% of the stock’s par value –Dollar amount “$3 preferred” means that stockholders receive an annual dividend of $3 per share regardless of the preferred stock’s par value RETAINED EARNINGS AND DIVIDENDS

14. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-14 Dividends on cumulative and noncumulative preferred stock –The owners of cumulative preferred stock must receive all dividends in arrears plus the current year’s dividend before the corporation can pay dividends to the common stockholders RETAINED EARNINGS AND DIVIDENDS

15. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-15 –The law considers preferred stock cumulative unless it is specifically labeled as noncumulative –Dividends in arrears (passing the dividend) occurs when a corporation fails to pay a dividend to preferred stockholders If the preferred stock is noncumulative, the corporation is not obligated to pay dividends in arrears RETAINED EARNINGS AND DIVIDENDS

16. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-16 Having dividends in arrears on cumulative preferred stock is not a liability to the corporation A corporation must report cumulative preferred dividends in arrears in a note to the financial statements RETAINED EARNINGS AND DIVIDENDS arrears

17. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-17 Dividends on Cumulative and Noncumulative Preferred Stock Suppose Pine Industries passed the 2001 preferred dividend of $157,500. Before paying dividends to its common stockholders in 2002, the company must first pay preferred dividends of $157,500 for both 2001 and 2002, a total of $315,000. If the company declares a $500,000 dividend in 2002, the entry to record the declaration is as follows: Sep. 6 Retained Earnings 500,000 Dividends Payable, Preferred ($157,500 x 2) 315,000 Dividends Payable, Common ($500,000 - $315,000) 185,000 To declare a cash dividend Sep. 6 Retained Earnings 500,000 Dividends Payable, Preferred ($157,500 x 2) 315,000 Dividends Payable, Common ($500,000 - $315,000) 185,000 To declare a cash dividend

18. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-18 STOCK DIVIDENDS A stock dividend –Is a proportional distribution by a corporation of its own stock to its stockholders –Increases the stock account and decreases Retained Earnings –Is different from cash dividends because stock dividends do not transfer the corporation’s assets to the stockholders Common Stock

19. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-19 –Is distributed to stockholders in proportion to the number of shares they already own The reasons for stock dividends are –To continue dividends but conserve cash –To reduce the market price of its stock STOCK DIVIDENDS

20. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-20 Generally accepted accounting principles distinguish between a –Large stock dividend (25% or more of issued stock) Significantly increases the number of shares available in the market and usually decreases the stock price Transfers the par value of the dividend shares from Retained Earnings to Common Stock STOCK DIVIDENDS Common Stock

21. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-21 –Small stock dividend (less than 20-25% of issued stock) It is less likely to significantly affect the price of the company’s stock Retained Earnings is decreased for the market value of the dividend shares, Common Stock is credited for the stock’s par value, and Paid-in Capital in Excess of Par is credited for the remainder STOCK DIVIDENDS Common Stock

22. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-22 Assume that Louisiana Lumber Corporation has the following stockholders’ equity prior to a stock dividend: Common stock $10 par, 50,000 shares authorized, 20,000 shares issued$200,000 Paid-in capital in excess of par--common 70,000 Retained earnings 85,000 Total stockholders’ equity$355,000 Stockholders’ Equity STOCK DIVIDENDS

23. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-23 If the market value of the company’s common stock is $16 per share, the following entries illustrate the accounting if the dividend is large (a 50% dividend) or small (a 10% dividend): par Large Stock Dividend - 50% (Accounted for at par value) Retained Earnings100,000 Common Stock (20,000 shares x.50 x $10 par) 100,000 Retained Earnings100,000 Common Stock (20,000 shares x.50 x $10 par) 100,000 market Small Stock Dividend - 10% (Accounted for at market value) Retained Earnings (20,000 x.10 x $16 market) 32,000 Common Stock (20,000 x.10 x $10 par) 20,000 Paid-in Capital in Excess of Par 12,000 Retained Earnings (20,000 x.10 x $16 market) 32,000 Common Stock (20,000 x.10 x $10 par) 20,000 Paid-in Capital in Excess of Par 12,000 STOCK DIVIDENDS

24. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-24 STOCK SPLITS A stock split is an increase in the number of authorized, issued, and outstanding shares of stock, coupled with a proportionate reduction in the stock’s par value A stock split decreases the market price of stock--with the intention of making the stock more attractive to investors

25. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-25 If a company splits its stock 2-for-1, the number of outstanding shares is doubled and each share’s par value is halved STOCK SPLITS Common Stock $10 par $5 par

26. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-26 Assume that IBM wishes to decrease the market price from $100 to approximately $25. IBM splits the common stock 4-for-1. Assume that IBM had 140 million shares of $5 common stock issued and outstanding before the split: Common stock, $5 par, 187.5 million shares authorized, 140 million share issued Capital in excess of par Retained earnings Other Total stockholders’ equity $ 700 6,800 11,630 3,293 $22,423 Common stock, $1.25 par, 750 million shares authorized, 560 million share issued Capital in excess of par Retained earnings Other Total stockholders’ equity $ 700 6,800 11,630 3,293 $22,423 Before 4-for-1 Stock Split: IBM Stockholders’ Equity (Adapted): After 4-for-1 Stock Split: In millions

27. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-27 STOCK SPLITS After the 4-for-1 stock split, IBM would have 750 million shares authorized and 560 million shares (140 million shares x 4) of $1.25 par ($5/4) common stock. No formal journal entry is necessary, the split is recorded in a memorandum entry such as the following: Called in the outstanding $5 par common stock and distributed four shares of $1.25 par common stock for each old share previously outstanding Aug. 19

28. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-28 Similarities and differences between stock dividends and stock splits –Both increase the corporation’s number of shares of stock issued and outstanding A 100% stock dividend and a 2-for-1 stock split both double the number of outstanding shares and cut the stock’s market price per share in half –They differ in that a stock dividend shifts an amount from retained earnings to paid-in capital, leaving the par value per share unchanged STOCK SPLITS

29. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-29 Effects of Dividends and Stock Splits on Total Stockholders’ Equity Declaration of cash dividend Decrease Payment of previously declared cash dividend No effect Declaration of stock dividend No effect Distribution of stock dividend No effect Stock split No effect Event Effect on Total Stockholders’ Equity

30. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-30 DIFFERENT VALUES OF STOCK Market Value –A stock’s market value is the price for which a person could buy or sell a share of the stock –In almost all cases, stockholders are more concerned about the market value of a stock than about any of the other values

31. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-31 Redemption value –Preferred stock that requires the company to redeem (pay to retire) the stock at a set price is called redeemable preferred stock –The price the corporation agrees to pay for the stock, which is set when the stock is issued, is called the redemption value DIFFERENT VALUES OF STOCK

32. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-32 Book value –Book value is computed by dividing total stockholders’ equity by the number of shares of common outstanding –If the company has both preferred stock and common stock outstanding, the preferred stockholders have the first claim to owners’ equity –The preferred equity is its redemption value plus any cumulative preferred dividends in arrears DIFFERENT VALUES OF STOCK

33. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-33 Book value per share of common is computed as follows: Book value per share of common stock Total stockholders’ equity Preferred equity - = Number of shares of common stock outstanding DIFFERENT VALUES OF STOCK

34. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-34 Assume a company’s balance sheet reports the following amounts: Preferred stock, 6%, $100 par, 5,000 shares authorized, 400 shares issued, redemption value $130 per share$ 40,000 Paid-in capital in excess of par--preferred 4,000 Common stock, $10 par, 20,000 shares authorized, 5,500 shares issued 55,000 Paid-in capital in excess of par--common 72,000 Retained earnings 85,000 Treasury stock--common, 500 shares at cost (15,000) Total stockholders’ equity$241,000 Stockholders’ Equity

35. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-35 Suppose that four years’ (including the current year) cumulative preferred dividends are in arrears and that preferred stock has a redemption value of $130 per share. The book-value-per-share computations for this corporation are as follows: Redemption value (400 shares x 130)$ 52,000 Cumulative dividends ($40,000 x $0.06 x 4 years) 9,600 Preferred equity$ 61,600 Total stockholders’ equity $241,000 Less preferred equity (61,600) Common equity $179,400 Book value per share [$179,400/5000 shares outstanding (5,500 share issued - 500 treasury shares)]$ 35.88 Preferred equity Common equity

36. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-36 Book value and decision making –Companies negotiating the purchase of a corporation may wish to know the book value of its stock –Some investors compare the book value of a share of a company’s stock with the stock’s market value –A stock selling below its book value may be underpriced and, thus, a good buy DIFFERENT VALUES OF STOCK

37. 9B-37 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren Evaluating Operations: Rate of Return on Total Assets and Rate of Return on Common Stockholders’ Equity

38. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-38 The rate of return on total assets (return on assets) measures a company’s success in using its assets to earn income for –Creditors –Stockholders RETURN ON ASSETS Them Us

39. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-39 Rate of return on total assets Average total assets Net Income Interest Expense + 26,111 + 17,417 26,111 + 17,417 (382,593 + 445,879) /2 43,528 414,246 0.105 Return on assets is computed as follows, using data from the 1998 annual report of IHOP Corp. (dollar amounts in thousands): Rule of Thumb: Rates of return vary widely by industry. Compare the company’s rate of return with the industry average or that of competitors. = = = =

40. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-40 RETURN ON EQUITY Rate of return on common stockholders’ equity (return on equity) shows the relationship between net income and average common stockholders’ equity –The numerator is net income minus preferred dividends –The denominator is average common stockholders’ equity--total stockholders’ equity minus preferred equity

41. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-41 Rate of return on common stockholders’ equity Average common stockholders’ equity Net Income Preferred dividends - = 26,111 - 0 26,111 - 0 (156,184 + 187,868) /2 = 26,111 172,026 = 0.152 = IHOP Corp.’s rate of return on common stockholders’ equity for 1998 is computed as follows (dollar amounts in thousands): Rule of Thumb: The higher the rate of return, the more successful the company. Investors also compare a company’s return on stockholders’ equity with interest rates available in the market.

42. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-42 IHOP’s return on equity (15.2%) is higher than its return on assets (10.5%) –This difference results from the interest- expense component of return on assets Borrowing at a lower rate than the company’s return on investments is called using leverage RETURN ON EQUITY

43. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-43 REPORTING ON THE STATEMENT OF CASH FLOWS Stockholders’ equity transactions are financing activities: –Issuance of stock increases cash –Purchase of treasury stock decreases cash –Sale of treasury stock increases cash –Payment of dividends decreases cash –Stock dividends are not reported on the statement of cash flows because the company receives no cash

44. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-44 Proceeds from issuance of common stock $ 16.9 Proceeds from issuance of stock to employees 41.4 Sale of treasury stock 37.0 Purchase of treasury stock(24.0) Repurchase and retirement of common stock (1,034.0) Payment of dividends (351.5) Net cash used by financing activities $(1,314.2) Cash Flows from Financing Activities (In millions)

45. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-45 VARIATIONS IN REPORTING STOCKHOLDERS’ EQUITY Businesses often use terminology and formats in reporting stockholders’ equity that differ from the general examples in this chapter A more detailed format is used in the text The next slide presents a side-by-side comparison of our general teaching format and the format that you are more likely to encounter in real-world balance sheets

46. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-46 General Teaching Format Real-World Format

47. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-47 END OF CHAPTER 9