Chapter 11 Accounting For Equity In this chapter we will learn about various aspects of a corporation. On the income statement, we will learn how to report discontinued operations, extraordinary items, and changes in accounting principles. On the balance sheet, we will learn about accounting issues related to common stock, preferred stock, retained earnings, restrictions, and appropriations.

Different Ways to Finance a Company BORROWING FROM A BANK (CH 9): NOTES PAYABLE – MORE EXPENSIVE AND RESTRICTIVE THAN BONDS. REQUIRES INTEREST & PRINCIPAL REPAYMENT. ISSUING BONDS (CH 10): EASIER TO DEAL WITH THAN BANK LOANS, REQUIRES INTEREST & PRINCIPAL REPAYMENT. SELLING STOCK (CH 11): GIVES UP OWNERSHIP SHARES, BUT DOES NOT REQUIRE INTEREST OR PRINCIPAL REPAYMENTS.

Characteristics of Corporations Advantages Separate legal entity Limited liability of stockholders Easy to transfer ownership Continuous life Lack of mutual agency for stockholders Ease of capital accumulation Disadvantages More Governmental regulation than proprietorship and partnerships Corporate taxation Corporations are entities created by law that exist separately from their owners and that have rights and privileges. Corporations may be privately or publicly owned. Publicly owned corporations have additional reporting responsibilities beyond those of a privately held corporation. The corporate form of organization has several advantages. It is a separate legal entity that can enter into contracts and sue and be sued. Stockholders’ losses are limited to the amount invested in the corporation. Ownership rights are transferable. The corporation continues in existence even when ownership changes. Stockholders are not agents of the corporation and can not enter into contracts on the corporation’s behalf. Capital needs can be met by selling more ownership in the corporation. Two disadvantages include extra governmental regulations imposed on corporations and corporate taxation of earnings. Corporations pay taxes on their earnings and then if they distribute a dividend to stockholders, the stockholders pay taxes on the dividends received. This is sometimes referred to as double taxation. 11-3

Organizing and Managing a Corporation Stockholders usually meet once a year. Ultimate control. Selected by a vote of the stockholders. Overall responsibility for managing the company. Ultimate control of a corporation rests with the stockholders who elect the Board of Directors. In turn, the members of the board of directors hire the executive officers of the corporation. Finally, officers of the corporation empower others to hire needed employees. Employees, officers, and members of the board of directors may also be owners of the corporation. In addition to voting on important issues at annual meetings, stockholders have the right to buy and sells shares of stock, to receive dividends when declared by the board of directors, and in the event of liquidation, they share equally in any remaining assets after creditors are paid. At their annual meeting, stockholders elect the Board of Directors and vote on important management issues facing the company. The Board of Directors has the ultimate responsibility for managing the company. The executive management team manages the day-to-day decisions for the corporation. 11-4

Basics of Capital Stock Total amount of stock that a corporation’s charter authorizes it to sell. Corporations must disclose information related to their stock, such as par value and number of shares authorized and issued. The corporate charter determines the number of shares of stock the corporation is authorized to sell. We can also find the number of shares actually issued by the company. In our example, the company had issued a total of ninety two million, five hundred fifty-six thousand, two hundred ninety-five shares by the end of 2009. Notice that this common stock has a par value of one cent. Low par values are normal in business. Let’s look at the meaning of par value. Total amount of stock that has been issued or sold to stockholders. 11-5

Classes of Stock C1 Par Value – assigned value that establishes minimum legal capital. No-Par Value – no assigned value. Stated Value – no-par value stock that is assigned a stated value. Par value is an arbitrary amount assigned to each share of stock in the corporate charter. Par value is typically a nominal amount, and is not related in any manner to market value which is the selling price of a share of stock. In addition to par value stock, some states permit no-par, stated value common stock, or no par value common stock. Let’s see how these 3 classes of stock work. 11-6

Issuing Par Value Stock On September 1, Matrix, Inc. issued 100,000 shares of $2 par value stock for $25 per share. Let’s record this transaction. Record: The cash received. The number of shares issued × the par value per share in the Common Stock account. The remainder is assigned to Paid-In Capital in Excess of Par Value, Common Stock. When par value stock is sold for cash, the Common Stock account is credited for the par value of the stock sold. Remember that par value and market value are not related. The difference between the par value of the stock and the market value of the stock is credited to Paid-In Capital in Excess of Par. If you added together the amount of par value in the Common Stock account and the amount in the Paid-In Capital in Excess of Par, Common Stock, you would have the market value of the sale of the stock. 11-7

Issuing Par Value Stock On September 1, Matrix, Inc. issued 100,000 shares of $2 par value stock for $25 per share. Let’s record this transaction. Part I Let’s record the entry for Matrix Incorporated for the issue of one hundred thousand shares of two dollar par value stock for twenty five dollars in cash. Part II Matrix would debit Cash for the market value of the stock sold: one hundred thousand shares times twenty-five dollars per share. Matrix would credit Common Stock for the par value of the share sold: one hundred thousand shares times two dollars per share. And, they would credit Paid-In Capital in Excess of Par Value, Common Stock, for the excess of market over par: one hundred thousand shares times twenty-three dollars per share. 11-8

Issuing Par Value Stock This is the way Matrix would report the common stock on its balance sheet. The two hundred thousand dollars is the par value of the stock sold and the two million, three hundred thousand dollars is the excess over par value Matrix received for the stock. These two amounts added together total two million, five hundred thousand dollars, the amount of cash received for the sale of the stock. 11-9

QS 11-2

Looking at Facebook’s IPO in May 2012 http://www.youtube.com/watch?v=zEXhNVDN-OI Facebook Made “Strategic Mistake” with IPO, says Mark Cuban https://www.youtube.com/watch?v=jArZ_qppJAo

Twitter’s IPO https://www.youtube.com/watch?v=vKAqvtHDmkc

Facebook’s Stock Price History

Issuing Stock for Noncash Assets P1 Par Value Stock On September 1, Matrix, Inc. issued 100,000 shares of $2 par value stock for land valued at $2,500,000. Let’s record this transaction. Record: The asset received at its market value. The number of shares issued × the par value per share in the Common Stock account. The remainder is assigned to Paid-In Capital in Excess of Par, Common Stock. A similar situation occurs when par value stock is exchanged for noncash assets. The Common Stock account is credited for the par value of the stock sold. The difference between the par value of the stock and the market value of the assets received is credited to Contributed Capital in Excess of Par. If you added together the amount of par value in the Common Stock account and the amount in the Paid-In Capital in Excess of Par, Common Stock, you would have the market value of the assets received. 11-14

Issuing Stock for Noncash Assets P1 Par Value Stock On September 1, Matrix, Inc. issued 100,000 shares of $2 par value stock for land valued at $2,500,000. Let’s record this transaction. Part I Let’s record the entry for Matrix Incorporated for the issue of one hundred thousand shares of two dollar par value stock for land valued at two million, five hundred thousand dollars. Part II Matrix would debit Land for its market value. Matrix would credit Common Stock for the par value of the share sold: one hundred thousand shares times two dollars a share. And, they would credit Paid-In Capital in Excess of Par Value, Common Stock, for the excess of land’s market value in excess of the par value. 11-15

Issuing Stock for Services https://www.youtube.com/watch?v=MtazR6Iu2yE

Corporate Investments Common Stock Voting Rights Dividends, back of line RISK Preferred Stock No voting rights Dividends, front of line Non-cumulative Cumulative Bonds Payable – Lender/Borrower

Usually has a stated dividend rate Normally has no voting rights Preferred Stock C 3 A separate class of stock, typically having priority over common shares in . . . Dividend distributions Distribution of assets in case of liquidation Usually has a stated dividend rate Normally has no voting rights Preferred stock is a separate class of stock that typically has priority over common stock in dividend distributions and distribution of assets in a liquidation. Preferred stock usually has a stated dividend that is expressed as a percentage of its par value. It normally does not have voting rights. 11-18

Reasons for Issuing Preferred Stock To raise capital without sacrificing control To boost the return earned by common stockholders through financial leverage To appeal to investors who may believe the common stock is too risky or that the expected return on common stock is too low Corporations may issue preferred stock to be able to raise needed capital without sacrificing control since preferred stock has no voting rights. Issuing preferred stock is a way to boost return to common stockholders. It is also a way to increase ownership in the company if the common stock is perceived as too risky or has a lower than expected return. 11-19

What is a Dividend? http://www.youtube.com/watch?v=fkO-NxhMn50

Cash Dividends To pay a cash dividend the corporation must have: A sufficient balance in retained earnings and The cash necessary to pay the dividend. To pay a cash dividend, a corporation must have two things:  Sufficient retained earnings to absorb the dividend without creating a deficit and  Enough cash to pay the dividend. 11-21

Cumulative or Noncumulative Dividend P4 Vs. Noncumulative Cumulative Dividends in arrears must be paid before dividends may be paid on common stock. Undeclared dividends from current and prior years do not have to be paid in future years. Cumulative preferred stockholders have the right to be paid both the current and all prior periods’ unpaid dividends before any dividends are paid to common stockholders. When the preferred stock is cumulative and the directors do not declare a dividend to preferred stockholders, the unpaid dividend is called a dividend in arrears and must be disclosed in the financial statements. Noncumulative preferred stock has no rights to prior periods’ dividends if they were not declared in those prior periods. Let’s look at an example. Most preferred stock is cumulative. 11-22

Cumulative or Noncumulative Dividend P4 Example: Consider the following Stockholders’ Equity Section of the Balance Sheet This company has both common stock and preferred stock. The directors did not declare a dividend in 2009. In 2010, the directors declare and pay cash dividends of forty-two thousand dollars. Let’s see how this dividend is distributed if the preferred stock is cumulative and if it is noncumulative. The Board of Directors did not declare or pay dividends in 2011. In 2015, the Board of Directors declare and pay cash dividends of $42,000. 11-23

Cumulative or Noncumulative Dividend P4 Cumulative or Noncumulative Dividend If the preferred stock is noncumulative, these stockholders have no rights to the missed dividends of the year 2009. However, they get first distribution of the dividends declared in 2010. The dividend for the preferred stock in 2009 is calculated as follows: one hundred dollar par value times nine percent times one thousand shares. Since forty two thousand dollars in dividends were declared, preferred would first get their nine thousand dollars, and the remaining thirty three thousand dollars would be divided evenly among the common stockholders. If the preferred stock is cumulative, these stockholders have rights to the missed dividends of 2009 in addition to the dividend in 2010. The preferred stockholders first get a distribution of nine thousand dollars for the missed dividends of 2009. Then they get another nine thousand dollars for the dividend in 2010. Since forty two thousand dollars in dividends were declared, preferred would first get their eighteen thousand dollars and the remaining twenty four thousand dollars would be divided evenly among the common stockholders. An additional preference for preferred stock is participation in dividends if they are declared above certain limits. This participation feature does not apply until common stockholders receive dividends equal to the preferred stock’s dividend percent. This is not a common preference seen in practice. 11-24

Three important dates Cash Dividends Record liability for dividend. Stockholders receive a return on their investment in two ways: one is through increases in the market value of the stock and one is through cash dividends. There are three important dates to remember when discussing dividends:  The date of declaration is the date the directors declare the dividend. At this time, a liability is created and must be recorded.  The date of record is important because you must own the stock on this date to receive the dividend. No entry is required in the accounting records.  The date of payment is the date the corporation pays the dividend to the stockholders who owned the stock on the record date. Let’s look at an example. Date of Declaration Date of Record Date of Payment Record liability for dividend. No entry required. Record payment of cash to stockholders. 11-25

Entries for Cash Dividends P2 On January 19, a $1 per share cash dividend is declared on Dana, Inc.’s 10,000 common shares outstanding. The dividend will be paid on March 19 to stockholders of record on February 19. Dividends Dana Incorporated declared a one dollar per share dividend on January 19th on its ten thousand common shares outstanding. The entry on January 19th includes a debit to Retained Earnings and a credit to Common Dividend Payable of ten thousand dollars. Date of Declaration Record liability for dividend. 11-26

Entries for Cash Dividends P2 On January 19, a $1 per share cash dividend is declared on Dana, Inc.’s 10,000 common shares outstanding. The dividend will be paid on March 19 to stockholders of record on February 19. On February 19th, the record date, we need to know who owns the stock, but an accounting entry is not needed. No entry required on February 19. Date of Record No entry required. 11-27

Entries for Cash Dividends On January 19, a $1 per share cash dividend is declared on Dana, Inc.’s 10,000 common shares outstanding. The dividend will be paid on March 19 to stockholders of record on February 19. On March 19th, the payment date, Dana Incorporated would debit Common Dividend Payable and credit Cash for the ten thousand dollar dividend. Date of Payment Record payment of cash to stockholders. 11-28

QS 11-7

Stock Dividends Why a stock dividend? P3 The corporation distributes additional shares of its own stock to its stockholders without receiving any payment in return. Why a stock dividend? Can be used to keep the market price on the stock affordable. Can provide evidence of management’s confidence that the company is doing well. HotAir, Inc. Common Stock 100 shares $1 par Sometimes corporations will distribute additional shares of stock as a dividend. Reasons for doing this include keeping the market price affordable by increasing the number of shares outstanding and providing evidence of management’s confidence in the company. 11-30

Stock Dividends Small Stock Dividend: £25% & Market Value P3 Small Stock Dividend: £25% & Market Value Distribution is £ 25% of the previously outstanding shares. Capitalize retained earnings for the market value of the shares to be distributed. Large Stock Dividend: >25% & Par Value Distribution is > 25% of the previously outstanding shares. Capitalize retained earnings for the minimum amount required by state law, usually par or stated value of the shares. A stock dividend can be classified as small or large. A small stock dividend is a distribution of stock that is less than or equal to twenty five percent of the outstanding shares. A large stock dividend is a distribution of stock that is greater than twenty five percent of the outstanding shares. Let’s look at the entries to record a small and large stock dividend. 11-31

Recording a Small Stock Dividend P3 Here is the stockholders’ equity section of Quest’s balance sheet prior to the declaration of a small stock dividend. Here is the equity section for Quest Incorporated prior to a small stock dividend. 11-32

Recording a Small Stock Dividend P3 On December 31, 2015, Quest declared a 2% stock dividend, when the stock was selling for $10 per share. The stock will be distributed to stockholders on January 20, 2016. Let’s make the December 31 entry. Quest declares a two percent stock dividend. The stock was selling for ten dollars a share. On the declaration date, Quest would debit Retained Earnings for the number of shares declared times the market value of the stock. In this example, that amount is twenty thousand dollars. The account Common Stock Dividend Distributable is credited for the par value of the shares declared. In this example, that amount is two thousand dollars. The excess is credited to Contributed Capital in Excess of Par Value. In this example, that amount is eighteen thousand dollars. 100,000 × 2% = 2,000 × $10 = $20,000 2,000 × $1 par = $2,000 11-33

Before the stock dividend. After the stock dividend. P3 Comparing Quest’s equity section before and after the stock dividend shows that the Common Stock dividend Distributable account is reported with the common stock and the Contributed Capital in Excess of Par Value is reported as additional paid in capital. Retained Earnings also decreased based on the previous entry. After the stock dividend. 11-34

Recording a Large Stock Dividend P3 Router, Inc. shows the following stockholders’ equity section just prior to issuing a large stock dividend. Here is the equity section for Router Incorporated prior to a large stock dividend. 11-35

Recording a Large Stock Dividend P3 On December 31, 2015, Router declared a 40% stock dividend, when the stock was selling for $8 per share. State law requires that large stock dividends be capitalized at par value per share. Router declares a forty percent stock dividend. On the declaration date, Router would debit Retained Earnings for the number of shares declared times the par value of the stock. In this example, that amount is twenty thousand dollars. The account Common Stock Dividend Distributable is credited for the par value of the shares declared. In this example, that amount is twenty thousand dollars. 50,000 × 40% = 20,000 shares × $1 par value = $20,000 11-36

Stock Splits P3 A distribution of additional shares of stock to stockholders according to their percent ownership. $10 par value Old Shares Common Stock 100 shares A stock split is the distribution of additional shares of stock to stockholders according to their percent ownership. When a stock split occurs, the corporation calls in the outstanding shares and issues new shares of stock. In the process of a stock split, the par value of the stock changes. Let’s look at an example. New Shares $5 par value Common Stock 200 shares 11-37

Stock Splits P3 After the 2-for-1 split the stockholders’ equity section of the balance sheet looks like this . No accounting entry is made. After the split, the number of shares doubled and the par value was cut in half. Notice that an accounting entry is not required, and that Retained Earnings is not reduced. In many respects a one hundred percent stock dividend and a two-for-one stock split result in similar impacts in the stock market. The stock split usually requires more administrative tasks to call in and reissue stock certificates. However, sometimes corporations do not reissue certificates in a stock split, saving some of the administrative costs. 11-38

Purchasing Treasury Stock On May 8, Whitt, Inc. purchased 2,000 of its own shares of stock in the open market for $8,000. Let’s change our focus to treasury stock. When a corporation re-purchases shares of its own stock, it is called treasury stock. Corporations acquire shares of their own stock for several reasons. These reasons include to use the shares to acquire another corporation, to purchase shares to avoid a hostile takeover of the company, to reissue them to employees as compensation, and to maintain a strong market for their stock or to show management confidence in the current price. Let’s see how this would be recorded: On May 8th, Whitt Incorporated purchased two thousand of its own shares in the market for eight thousand dollars. The entry on May 8th includes a debit to Treasury Stock and a credit to Cash for eight thousand dollars, which is the amount of the purchase. The Treasury Stock would be reported on the balance sheet in the equity section as a reduction from total equity. Treasury stock is shown as a reduction in total stockholders’ equity on the balance sheet. 11-39

Selling Treasury Stock at Cost P5 On June 30, Whitt sold 100 shares of its treasury stock for $4 per share. On June 30th, Whitt sold one hundred shares of the treasury stock for four dollars per share. This entry would include a debit to Cash and a credit to Treasury Stock for four hundred dollars. This was a nice clean entry because we sold the treasury stock for its original cost of four dollars per share. Let’s see what happens when the selling price of the treasury stock is different than the cost. $8,000 ÷ 2,000 shares = $4 cost per treasury share 11-40

Selling Treasury Stock Above Cost P5 Selling Treasury Stock Above Cost On July 19, Whitt, Inc. sold an additional 500 shares of its treasury stock for $8 per share. On July 19th, Whitt sold five hundred shares of the treasury stock for eight dollars per share. Remember that the original cost of the treasury stock was four dollars per share. This entry would include a debit to Cash for four thousand dollars. The credit Treasury Stock is for two thousand dollars. This is the original cost of four dollars per share times the five hundred shares sold. The difference between the selling price and the cost of the treasury stock is credited to Contributed Capital. In this example, that amount is two thousand dollars. Now, let’s see what happens if we sell treasury stock for less than its original cost. 11-41

Selling Treasury Stock Below Cost P5 Selling Treasury Stock Below Cost On August 27, Whitt sold an additional 400 shares of its treasury stock for $1.50 per share. On August 27th, Whitt sold four hundred shares of the treasury stock for one dollar and fifty cents per share. Remember that the original cost of the treasury stock was four dollars per share. This entry would include a debit to Cash for six hundred dollars. The credit to Treasury Stock is for one thousand, six hundred dollars. This is the original cost of four dollars per share times the four hundred shares sold. The difference between the selling price and the cost of the treasury stock is debited to Paid-In Capital, Treasury Stock. In this example, that amount is one thousand dollars. 11-42

QS 11-11

Options are given to key employees to motivate them to: Stock Options P5 Options are given to key employees to motivate them to: focus on company performance, take a long-run perspective, and remain with the company. Stock options give the owner the right to purchase common stock at a fixed price over a specified period of time. As the stock’s price rises above the fixed option price, the value of the option increases. Corporations give stock options to motivate employees to focus on the company’s stock performance, to take a long-run perspective, and to remain with the company. 11-44

Statement of Retained Earnings C 4 Total cumulative amount of reported net income less any net losses and dividends declared since the company started operating. The Statement of Retained Earnings is a summary of the activity that occurred in Retained Earnings during the period. It begins with the balance at the beginning of the period. If a company has net income, it is added to the beginning retained earnings balance. If a company has a net loss, then that would be subtracted. Any dividends declared are subtracted to arrive at the ending Retained Earnings balance. 11-45

Restricted Retained Earnings Legal Contractual Most states restrict the amount of treasury stock purchases to the amount of retained earnings. Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings. Retained earnings can have legal or contractual restrictions. In most states, the corporate charters will not allow companies to purchase treasury stock in excess of the balance in retained earnings. Some loan agreements place restrictions on how much dividends can be based on the balance in retained earnings. Restrictions on retained earnings are generally disclosed in the notes to the financial statements. 11-46

Appropriated Retained Earnings C 4 A corporation’s directors can voluntarily limit dividends because of a special need for cash such as the purchase of new facilities. Directors can voluntarily limit the use of retained earnings. This is called an appropriation. When there is an appropriation of retained earnings, it is separately reported in the financial statements and disclosed to inform users of special activities that require funds. 11-47

Prior Period Adjustments C 4 Correction of material errors in past years’ financial statements. If an amount is incorrectly expensed, add amount to Retained Earnings. Prior period adjustments are corrections of errors that occurred in prior periods’ financial statements. Prior period adjustments are reported net of tax effects on the statement of retained earnings. 11-48

Statement of Stockholders’ Equity Many companies issue a Statement of Stockholders’ Equity rather than a simple Statement of Retained Earnings. The Statement of Stockholders’ Equity is more inclusive and discloses changes in all equity accounts, not just Retained Earnings. This is a more inclusive statement than the statement of retained earnings. 11-49

Earnings Per Share A 1 Earnings per share is one of the most widely cited items of accounting information. Basic earnings per share = Net income - Preferred dividends Weighted-average common shares outstanding Earnings per share is one of the most widely used ratios. It is calculated as net income minus preferred dividends divided by weighted average common shares outstanding. 11-50

Price Earnings Price- Earnings = Market value per share This ratio reveals information about the stock market’s expectations for a company’s future growth in earnings, dividends, and opportunities. Price- Earnings = Market value per share Earnings per share The Price Earnings Ratio reveals information about the stock market’s expectation for a company’s future growth in earnings, dividends, and opportunities. It is calculated as market value per share divided by earnings per share. If earnings go up, will the market price of my stock follow? 11-51

Annual cash dividends per share Dividend Yield A 3 Tells us the annual amount of cash dividends distributed to common stockholders relative to the stock’s market price. Dividend Yield = Annual cash dividends per share Market value per share The Dividend Yield ratio provides the annual amount of cash dividends distributed to common stockholders relative to the stock’s market price. It is calculated as the annual cash dividend per share divided by the market value per share. 11-52

Book Value per Share—Common Records amount of stockholders’ equity applicable to common shares on a per share basis. Book value per common share = Stockholders’ equity applicable to common shares Number of common shares outstanding The Book Value per Common Share ratio records the amount of stockholders’ equity applicable to common shares on a per share basis. It is calculated as stockholders’ equity applicable to common shares divided by the number of common shares outstanding. 11-53

Book Value per Share—Preferred Records amount of stockholders’ equity applicable to preferred shares on a per share basis. Book value per preferred share = Stockholders’ equity applicable to preferred shares Number of preferred shares outstanding The Book Value per Preferred Share ratio records the amount of stockholders’ equity applicable to preferred shares on a per share basis. It is calculated as stockholders’ equity applicable to preferred shares divided by the number of preferred shares outstanding. 11-54