1. Chapter 11
Stockholders’ Equity

2. Learning Objectives
After studying this chapter, you should be able to:
Describe the rights of shareholders.
Differentiate among authorized, issued, and outstanding shares.
Contrast bonds, preferred stock, and common stock.
Identify the economic characteristics of and accounting for stock splits.

3. Learning Objectives
After studying this chapter, you should be able to:
Account for both large-percentage and small-percentage stock dividends.
Explain and report stock repurchases and other treasury stock transactions.
Record conversions of debt for equity or of preferred stock into common stock.
Use the rate of return on common equity and book value per share.

4. Background on Stockholders’ Equity
The rights of shareholders usually include the right to:
Vote in affairs of the corporation
Share in corporate profits
Share in any assets left upon liquidation
Acquire shares of subsequent issues of stock

5. Background on Stockholders’ Equity
Corporations hold annual meetings of shareholders where votes are taken on important matters.
Naturally not all shareholders can attend every meeting.
Corporate proxy - a written authority granted by individual shareholders to others to cast the shareholders’ votes

6. Background on Stockholders’ Equity
Preemptive rights - the rights to acquire a pro rata amount of any new issues of capital stock
When companies issue new stocks, many new owners may be added. In this case, the old owners’ percentage of ownership decreases.
The preemptive right allows current owners to purchase shares directly from the corporation, in a pro rata amount, to keep their percentage of ownership the same.

7. Background on Stockholders’ Equity
One of the most important rights of shareholders is limited liability.
Creditors of the corporation have claims on the assets owned by the corporation, not on the assets of the owners of the corporation.

8. Authorized, Issued, and Outstanding Stock
Authorized shares - the total number of shares that may legally be issued under the corporation’s articles of incorporation
Not all authorized shares are always issued.
Issued shares - the aggregate number of shares sold to the public

9. Authorized, Issued, and Outstanding Stock
Outstanding shares - shares in the hands of shareholders
Equal to issued shares less treasury stock
Treasury stock - a corporation’s issued stock that has subsequently been repurchased by the company and not retired
Treasury stock has been issued, but it is no longer outstanding.

10. Accounting for Stock Issuance
To account for an issuance of stock, the receipt of cash is recorded and an account is created to represent the ownership interest.
Most companies separate this ownership interest into two categories
Par value
Additional paid-in capital

11. Accounting for Stock Issuance
Alex Corporation issues 100,000 shares of $2 par value stock for $5 per share. The journal entry to record the issuance is as follows:
Cash ,000
Common stock ,000
Additional paid-in capital 300,000
Common stock is always credited for the par value of the shares issued.
Any amount in excess of the par value is credited to the Additional Paid-in Capital account.

12. Accounting for Stock Issuance
Par value was originally conceived as a measure of protection for stockholders.
Par value established the minimum legal liability of a stockholder.
Creditors were assured that the corporation would have at least a minimum amount of ownership capital because the shareholders were required to invest at least the amount of the par value per share.

13. Cash Dividends
Dividends are a means of proportionally distributing income to shareholders of a corporation.
Dividends are usually paid in cash.
Distributions of other assets are not very common, but distributions of stock are more common.
Dividends must be approved by the board of directors.

14. Cash Dividends Three important dates regarding dividends:
Declaration date - the date the board of directors declares a dividend
Date of record - a future date that determines which stockholders will receive the dividend
Only persons actually owning stock on this date will receive the dividend.
Payment date - the date the dividends are paid to the shareholders of record

15. Cash Dividends Journal entries to record dividends: Declaration date:
Retained income 20,000
Dividends payable 20,000
Date of record:
No entry required
Payment date:
Dividends payable 20,000
Cash ,000

16. Cash Dividends
The amount of cash distributed depends on several factors such as market expectations, current and predicted earnings, and the corporation’s cash position and financial plans for the future.
The biggest factor is the amount of cash that the company has available for distributions.
Another factor is the amount of retained income.
Companies generally cannot pay more dividends than they have retained income.

17. Preferred Stock Corporations can issue two types of stock.
Common stock - the most basic and common type of stock
Owners have all the basic rights previously discussed.
Preferred stock - stock that offers owners different rights and preferential treatment
Owners do not usually have voting rights, but they have priority in events such as liquidations and dividends.

18. Cumulative Dividends
The amount of preferred stock dividends is usually specified and does not change over time.
Just because a corporation decides not to pay dividends in a given year does not mean that the company can avoid the obligation.
Cumulative preferred stock - a characteristic of preferred stock that requires that undeclared dividends accumulate and must be paid in the future to preferred shareholders before common shareholders

19. Cumulative Dividends
Hobson Company has 10,000 shares of $4 cumulative preferred stock outstanding (preferred shareholders are entitled to $40,000 in dividends each year). The company paid the following amounts of dividends.
Year
Year ,000
Year ,000
How are the dividends distributed to preferred and common shareholders?

20. Cumulative Dividends Total Preferred Common
Year Dividends Dividends Dividends
1 $ $ $
, ,000†
, ,000* ,000
†Since no dividends were paid in year 1, preferred shareholders receive all dividends declared until they have received what they are entitled to for all years before the common shareholders receive any dividends.
*Remaining in arrears from year 1 $15,000
Arrears for year ,000
Current for year ,000
$95,000
==============

21. Preference in Liquidation
Liquidating value - a measure of the preference to receive assets in the event of corporate liquidation
The company must pay the liquidating value to all preferred stockholders before it can distribute any assets to common stockholders.
Also, any preferred dividends in arrears must be paid before common stockholders receive any assets.
If there is not enough cash, the common shareholders simply wind up getting nothing.

22. Other Features of Preferred Stock
Participating - a characteristic of preferred stock that provides increasing dividends when common dividends increase
If preferred stock is nonparticipating, the preferred stockholders receive dividends first, but that is all they will receive; they get nothing more than the amount stated.
The participation feature allows preferred stockholders to get more dividends if enough is declared and specified conditions are met.

23. Other Features of Preferred Stock
Callable - a characteristic of bonds or preferred stock that gives the issuer the right to redeem the security at a fixed price
The stock is bought back at a call price, or redemption price, which is usually set high enough to compensate stockholders for the fact that the stock can be automatically bought back at any time at the issuer’s choice.

24. Other Features of Preferred Stock
Convertible - a characteristic of bonds or preferred stock that gives the holder the right to exchange the security for common stock at a specified price
Because the ability to convert the stock can be very valuable if common stock prices rise, the dividend rate is usually somewhat lower.

25. Comparing Bonds and Preferred Stock
Bonds and preferred stock are similar in the sense that they are both contracts between an investor and an issuer that spells out each party’s rights and responsibilities.
Bonds and preferred stock are also similar in the sense that they provide investors with a specific return.

26. Comparing Bonds and Preferred Stock
The size and nature of the return to the investors differs greatly.
Bonds pay interest which appears on the income statement of the company as an expense.
Interest is tax deductible to the issuing company and taxable to the recipient.
Preferred stocks pay dividends which represent distributions of profits and reduce the Retained Income account directly.
Dividends are not considered expenses and are not tax deductible by the issuing company but are still taxable to the recipient.

27. Comparing Bonds and Preferred Stock
Bonds and preferred stocks differ in the sense that bonds have specific maturity dates, at which time they must be repaid, but preferred stock generally has unlimited life.
Preferred stock is somewhat riskier than bonds because it never matures (the investor does not get the original investment back) and dividends are not required to be paid.

28. Additional Stock Issuance
Stocks can be issued after the original formation of the company for several reasons.
The firm may wish to raise additional equity capital.
Shares are made available to employees in the form of stock options to encourage employees to work harder in order to raise the market price of the stock.
Shares are sometimes issued to existing shareholders in order to signal something about the company, to change the market price, or to alter the dividend payments.

29. Stock Options
Stock options - special rights usually granted to executives to purchase a corporation’s capital stock in the future at a specified price
Measurement of the value of the options is difficult because executive stock options are not sold to the general public, so no market value is readily available for use as a guide.
Currently, options are given a zero value as long as the option price is the same as the market price at the date of the grant.

30. Stock Options
Since no value is assigned to the options at the date of grant, no journal entry is required.
However, the number and types of options outstanding and an assessment of their value must be included in the notes to the financial statement.

31. Stock Options
A company has outstanding options to purchase 100,000 shares of $5 par common stock at a price of $10 per share. The options can be exercised over the next 10 years.
The date of grant:
No entry required
The options are exercised in the 7th year following the grant:
Cash 1,000,000
Common stock ,000
Additional paid-in capital ,000

32. Stock Options
Significant debate about stock options has arisen recently.
Some argue that when a company grants an option, it gives something of value in exchange for services rendered, so options should be recorded as an expense when granted.
Others argue that recording options as an expense and as income to the executives would undermine the markets and entrepreneurship.
The FASB simply requires measurement using one of several techniques and disclosure of the values to stockholders.

33. Stock Splits and Stock Dividends
Several events exist that allow the company to issue additional shares to existing shareholders without receiving any cash.
Stock splits and stock dividends are two examples.

34. Accounting for Stock Splits
Stock split - issuance of additional shares to existing stockholders for no payments by the stockholders
When a stock split occurs, the total amount of paid-in capital does not change.
The number of shares outstanding increases.
The par value and market value of the stock are both decreased in proportion to the increase in the number of shares.
Stock splits are often done to reduce the market value of a stock to make it more attractive to investors.

35. Accounting for Stock Splits
Walters Corporation has 100,000 shares of $2 par common stock outstanding when the corporation issues a 2-for-1 stock split. What is the effect on common stock?

36. Accounting for Stock Splits
Before the 2-for-1 stock split:
Shares outstanding ,000
Par value per share $ 2
Total common stock $200,000
====================
After the 2-for-1 stock split:
Shares outstanding ,000
Par value per share $ 1*
*The market value should also decrease by one-half.

37. Accounting for Stock Splits
Generally, no entry is necessary for recording a stock split because amounts in the paid-in capital accounts have not changed.
Usually a note in the general journal will suffice.
Sometimes a company will keep the par value the same after the stock split.
The company is merely rearranging owners’ equity from Additional Paid-in Capital to Common Stock or from Retained Income to Common Stock.

38. Accounting for Stock Dividends
Stock dividends - distributions to stockholders of a small of additional shares for each share owned, without any payment to the company by the stockholders
The number of shares issued is less than in a stock split, and the par value does not change.

39. Accounting for Stock Dividends
With stock dividends, new shares are issued and the Common Stock account is increased to recognize this increase.
The dollar amount of the increase to Common Stock depends on the size of the dividend.
Large-percentage stock dividend - 20% or more of the outstanding shares of common stock
Small-percentage stock dividend - less than 20% of the outstanding shares of common stock

40. Large-Percentage Stock Dividends
Large-percentage stock dividends are accounted for at the par or stated value of the stock.
An entry is made to transfer the par or stated value of the new shares from Retained Income to the Common Stock account.
Retained income (# shares x par value) xxx
Common stock xxx

41. Large-Percentage Stock Dividends
The market value of the stock is now split between the old shares and the new shares.
This effectively reduces the market price per share, but the total market value remains unchanged.
The proportional ownership of shares does not change because the stock is distributed proportionally based on ownership.
The dividend per share is decreased proportionally, however.

42. Small-Percentage Stock Dividends
Small-percentage stock dividends are accounted for at market value, not at par or stated value.
An entry is made to transfer the market value of the new shares from Retained Income to Common Stock and Additional Paid-in Capital.
This is often justified because a small-percentage stock dividend is often accompanied by an increase in the total cash dividends distributed.

43. Small-Percentage Stock Dividends
The proportional ownership of shares does not change because the stock is distributed proportionally based on ownership.
The journal entry to record a small-percentage stock dividend is:
Retained income (# shares x market value) xxx
Common stock (# shares x par value) xxx
Additional paid-in capital xxx

44. Why Use Stock Splits and Dividends?
Stock splits and dividends effectively decrease the market price of the stock.
This attracts more investors because it is easier to get investors to pay the lower stock prices.
Companies often wish to retain cash for expansion.
Stock dividends allow the company to retain cash and still give the stockholders a dividend that will entitle them to more cash dividends in the future.

45. Relation of Dividends and Splits
Companies use large-percentage stock dividends to accomplish the same thing as a stock split.
The market price is reduced, and the total amount of dividends distributed to the stockholders is increased.
Stock dividends are often used to save clerical costs.
It is cheaper to issue new stock certificates at the original par value than it is to reissue all new stock certificates with new par values.

46. Fractional Shares
Corporations issue shares in whole units, but sometimes stockholders are entitled to fractional units of shares.
If fractional units must be distributed, the company would issue the whole number of shares in stock, and the fractional units will be issued as a cash dividend.

47. The Investor’s Accounting for Dividends and Splits
The accounting by the investor is basically opposite that of the corporation.
Stock split or large-percentage stock dividend - no entry; memo giving details of the stock split or stock dividend
Cash dividend - entry recording the receipt of cash and the recognition of dividend income
Small-percentage stock dividend - no entry; memo disclosing the increase in the number of shares owned and the related decrease in the market value per share of the stock

48. Repurchase of Shares
Companies repurchase their own shares for two main purposes.
To permanently reduce shareholder claims (retire the stock)
To temporarily hold shares for later use, usually to be granted as part of employee bonus or stock purchase plans
These temporarily held shares are called treasury stock.

49. Repurchase of Shares
By repurchasing its own shares, a company can effectively increase the market value per share of the remaining shareholders.
Firms also buy back shares to change the proportion of debt and equity.
Buying back shares increases the relative importance of debt.

50. Repurchase of Shares
Buybacks also allow the company to return cash to the shareholders without creating expectations of future dividends.
Another benefit of stock buybacks is that investors pay taxes only on the gain on the sale of the stock instead of the entire dividend.
Also, the tax rate on a long-term gain is less than on a dividend.

51. Retirement of Shares
When shares are retired, the shares are no longer outstanding
Total stockholders’ equity is reduced because the amount of stock retired is charged against Common Stock, Additional Paid-in Capital, and Retained Income.
Common stock (# shares x par value) xxx
Additional paid-in capital (# shares x (original
issue price - par value)) xxx
Retained income (# shares x (repurchase
price - original issue price)) xxx
Cash (# shares x repurchase price) xxx

52. Treasury Stock
Treasury stock that is held temporarily is not an asset to the company.
It is a contra account to Owners’ Equity, much like Accumulated Depreciation is a contra account to Plant Assets
It is a deduction from total stockholders’ equity on the balance sheet.
Cash dividends are not paid on treasury stock because treasury stock is not considered to be outstanding shares of stock.

53. Treasury Stock
When treasury stock is repurchased, it is recorded in a separate account called Treasury Stock.
Common Stock, Additional Paid-in Capital, and Retained Income are untouched by treasury stock purchases.
Calculation of outstanding shares:
Shares issued 1,000,000
Less: Treasury stock ,000
Total shares outstanding ,000
=====================

54. Disposition of Treasury Stock
Assume that 10,000 shares of treasury stock are purchased for $10 per share; 5,000 of the shares are then resold for $12 per share. A year later, the remaining 5,000 shares are sold for $9 per share. How are these transactions recorded?

55. Disposition of Treasury Stock
Repurchase of the 10,000 shares of treasury stock:
Treasury stock (10,000 x $10) 100,000
Cash ,000
Sale of 5,000 shares at $12 per share:
Cash ,000
Treasury stock (5,000 x $10) ,000
Additional paid-in capital (5,000 x $2) 10,000
Sale of 5,000 shares at $9 per share
Cash ,000
Additional paid-in capital* (5,000 x $1) 5,000
*If the balance in Additional Paid-in Capital is insufficient, Retained Income is debited.

56. Disposition of Treasury Stock
Any differences between the acquisition costs and the resale proceeds of treasury stock must never be reported as losses, expenses, revenues, or gains in the income statement.
Treasury stock is not an asset of the company, nor is it intended to be treated like inventory to be resold; a company cannot make profits or losses by buying or selling its own stock.

57. Effects of Repurchases on Earnings per Share
As stated before, when shares are repurchased by a corporation, the number of shares outstanding is decreased.
This decrease in the number of shares tends to increase earnings per share.

58. Other Issuances of Common Stock
Sometimes common stock may be issued for assets other than cash.
Common stock may be issued for assets such as land, buildings, or equipment.
Bonds or other securities may also be converted into common stock.

59. Noncash Exchanges
Noncash exchanges raise the question of the proper dollar value of the transaction to be recorded in both the buyer’s and the seller’s books.
The value to be recorded is the “fair value” of either the securities or the exchanged assets, whichever is easier to determine objectively.
This amount is to be used by both the buyer and the seller.

60. Conversion of Securities
For the issuer, when convertible preferred stock is converted into common stock, the transaction merely converts one form of stock into another.
The accounts are adjusted as if the common stock had been originally issued.
The convertible preferred stock and any additional paid-in capital is taken off the books, and the common stock and additional paid-in capital is put on as if it had been issued originally instead of the convertible preferred stock.

61. Conversion of Securities
The investor may make a journal entry to show that the investment in convertible preferred stock is now an investment in common stock.
The investor may also change any subsidiary records that document the composition of the Investments general ledger account.

62. Tracking Stock
Tracking stock is sometimes issued based on a part of a large company.
Tracking stock is similar to common stock:
The company can produce financial statements for the subunit of the company.
The company can pay dividends on the tracking stock.
The company can issue stock options on the tracking stock.
The stock trades on stock markets just like common stock.

63. Tracking Stock
The big disadvantage of tracking stock is that the shares do not represent voting rights in a separate company.
The board of directors has all discretion in making decisions that affect the subunit.
These decisions might harm the subunit in favor of the entire company, and the holders of the tracking stock have no opportunity to affect those decisions.

64. Retained Income Restrictions
Dividends typically cannot be declared if those dividends would decrease retained income to a negative number.
Some states require that dividends cannot be declared if the dividends reduce stockholders’ equity to below total paid-in capital.

65. Retained Income Restrictions
Restictions of retained income are usually disclosed in the notes to the financial statements.
Some restrictions appear on the face of the balance sheet.
Restricted retained income (appropriated retained income) - any part of retained income that may not be reduced by dividend declarations

66. Other Components of Stockholders’ Equity
Two other elements that deserve mention:
Foreign currency translation adjustment - amounts that arise when a company has subsidiary companies in other countries
The amounts arise when a foreign currency is translated into U.S. dollars.
Employee stock ownership plan (ESOP) - a plan that rewards employees with shares of stock
A separate entity is set up to hold shares of stock on behalf of the employees.

67. Financial Ratios Related to Stockholders’ Equity
Rate of return on common equity (ROE) - measures how effectively the company uses resources provided by the shareholders
Focuses on the company’s profitability based on the book value of the common equity
Rate of return
on common
equity

68. Financial Ratios Related to Stockholders’ Equity
Book value per share of common stock - stockholders’ equity attributable to common stock divided by the number of shares outstanding
Comparing book values to market values often reveals the causes behind the differences in values.
Total stockholders’ equity - Book value of preferred stock
Book value per share of common stock =
Number of common shares outstanding

69. Introduction to Financial Accounting 8th Edition PowerPoint Presentation
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University of Mississippi
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