1 © 1999 by Robert F. Halsey Stockholders’ Equity In this section we will review: ¶ The nature of Stockholders’ Equity – The characteristics of the corporate form of organization – The types of stock a company can have (common and preferred) – The difference between issuing Equity vs. Debt · The accounting for elements of Stockholder’s Equity? – Issuance and repurchases of shares of stock – Dividends

2 © 1999 by Robert F. Halsey Corporate Form of Organization - limited liability of shareholders That means that shareholders of the corporation have limited liability - they can only lose what they have invested in the business. If the debts of the business are greater than its assets, creditors lose; they cannot sue shareholders for the deficit. Unlike other forms of business organization, like sole proprietorships and partnerships, a corporation is a legal entity that is separate and distinct from its owners.

3 © 1999 by Robert F. Halsey Double taxation The fact that a corporation is a separate legal entity also means that the IRS taxes it like any other taxpayer. It is taxed on the income it earned, regardless whether that income is paid out to shareholders as dividends So, after having earned a profit and paying tax on that profit, should a company decide to pay out a portion of that profit to its shareholders as a dividend, the IRS taxes the individual shareholders on the dividends they receive. This is the concept of double taxation.

4 © 1999 by Robert F. Halsey Nature of Stockholders Equity  Stockholder’s equity is a residual concept - it is what is left over to the shareholders after the claims of other parties (creditors, preferred shareholders) have been satisfied.  Stockholder’s equity also represents the resources that have been provided by the company’s owners in the form of capital contributions (purchases of stock) and earnings retained from operations.

5 © 1999 by Robert F. Halsey Equity versus Debt Assume that a company wants to raise $10,000. It can either sell, Ü Bonds Bonds, $1000 par value, 8% coupon payable annually rate sold at 100, mature in 10 years (interest paid per year = 10 * $1,000 * 8% = $800), or Ü Common Stock shares, $1 par value, market value = $100 per share (assume total dividends paid = 8% or $800). Let’s “issue” these securities -- What is the result?

6 © 1999 by Robert F. Halsey Equity Vs. Debt Issue (cont’d) Although the amount of the payment ($800 per year) to the sources of funds (debt holders or stockholders) is the same in both cases, there are important differences: Ü interest payments are a fixed contractual obligation that must be paid even if the business is not earning profits, and creditors can force the company into bankruptcy if interest payments are not paid when due. Ü Dividends, on the other hand, are not required to be paid and can be discontinued in a business downturn.

7 © 1999 by Robert F. Halsey l There is another important difference between the two forms of raising capital: shareholders have a vote in the election of the company’s board of directors and, through the board of directors, indirectly control the corporation. Debt holders do not have that right and exercise their share of corporate governance through bond agreements that limit the activities of the company. l In sum, shareholders bear more of the risk and receive more of the benefits of financial outcomes (downside and upside), but at the same time equity-holders can exercise control (votes) with limited liability.

8 © 1999 by Robert F. Halsey Accounting for the Issuance of Common Stock Ü Let’s look at an example to understand the accounting for the issuance of common stock: (Click here to view an example of the accounting for the issuance of common stock)

9 © 1999 by Robert F. Halsey This is an example of the stockholder’s equity section from Wal-Mart’s balance sheet: Wal-Mart has issued million shares of $.10 par common for total proceeds of $880 million ($445 + $435). Wal-Mart’s board of directors has authorized its management to issue up to 5.5 million shares, so not all of the authorized shares have been issued. No preferred stock has been sold.

10 © 1999 by Robert F. Halsey Treasury Stock l Stock repurchase programs have become quite common among companies. Many of these programs are highlighted in annual reports as a mechanism to increase shareholder value. l Why do companies repurchase their own stock? Ü To increase the number of shares available for the exercise of stock options by employees or for acquisitions Ü Increase earning per share (the denominator is reduced) Ü To signal the market that management believes the company’s stock is under-valued.

11 © 1999 by Robert F. Halsey Ü Let’s take a look at an example of the accounting for the repurchase of common stock: (Click here to view an example of the accounting for stock repurchases) Accounting for the repurchase of common stock

12 © 1999 by Robert F. Halsey Here is an example of the reporting of treasury stock from Colgate-Palmolive’s annual report. Colgate-Palmolive has repurchased treasury stock with a cumulative cost of $2.3 billion. Its stockholder’s equity has been reduced by this amount.

13 © 1999 by Robert F. Halsey 10 Preferred Stock What makes preferred stock preferred? Preferred shares have certain “preferences” with respect to common stock.  The shares have a preference as to dividends. This means that preferred shareholders receive all of the dividends to which they are entitled before common shareholders are paid.  The shares have a preference as to assets in liquidation. If the company becomes insolvent and the assets are liquidated, preferred shareholders will be paid before common shareholders.

14 © 1999 by Robert F. Halsey Preferred stock is a “contract” l It is important to understand that preferred shares are sold pursuant to a contract between the company and the purchasers of the shares. Any terms that are agreeable to both parties can be inserted into that contract. For example, Ü The shares may be callable at the option of the company to force conversion of the shares into common stock or the shareholders may be able to convert the preferred shares into common at their option. Ü The preferred share may have a cumulative dividends preference, meaning if the required dividends are not paid in any year, these “dividends in arrears” must be paid, plus current preferred dividends, before common shareholders are paid Ü The preferred share may have a redemption provision that required the company to repurchase a portion of the shares each year.

15 © 1999 by Robert F. Halsey l Preferred stock has features of both debt and equity: Ü Preferred shareholders receive a yield similar to the interest in debt (the yield is fixed, however, and preferred shareholders do not receive additional dividends if the company performs well). Ü Like debt, it is not completely residual (similar to interest paid to bondholders, its dividends are paid before common’s) Ü However, the payments to preferred are avoidable in the event of a business downturn and there is no maturity for repayment of principle (other than for redeemable preferred). Ü The preferred dividends, like common, are not tax deductible by the company as opposed to interest payments on debt. l Preferred stock is generally accounted for and reported as part of stockholder’s equity (redeemable preferred is reported between liabilities and stockholder’s equity to reflect its debt-like character - click here to see an example ). Preferred Stock Vs. Debt

16 © 1999 by Robert F. Halsey Here is an example of the reporting of preferred stock from DuPont’s annual report: DuPont has sold million shares of no par cumulative preferred stock for $100 per share. Each share pays $4.50 in dividends per year, or a 4.5% yield. Cumulative means that if the company does not pay dividends on the stock in a year, it must make up the amount due before common shareholders are paid a dividend.

17 © 1999 by Robert F. Halsey Dividends The two most common types of dividends are cash dividends, dividends paid in cash, and stock dividends, dividends paid by issuing additional shares of stock to the shareholder. Dividends are declared by the board of directors (who are elected by the shareholders). Note that the company does not have to pay dividends. No liability is, therefore, reflected in the company’s balance sheet for the payment of dividends until the board of directors declares that a dividends should be paid.

18 © 1999 by Robert F. Halsey From a legal standpoint, most states permit the payment of dividends as long as the company is solvent, that is, able to pay its debts. From an accounting standpoint dividends are paid out of the retained profits of the corporation. As a result, the basic accounting entry to records the payment of dividends debits retained earnings. For example, assume a company pays out $50,000 in cash to its shareholders as a dividend. The required journal entry is as follows: Retained earnings50,000 Cash50,000

19 © 1999 by Robert F. Halsey Stock Dividends l With a stock dividend -- no assets are distributed; rather a reclassification takes place within owners’ equity -- from retained earnings to contributed capital. l Proportional ownership interest does not change. More share are outstanding but each share is worth less.

20 © 1999 by Robert F. Halsey Accounting for Stock Dividends Let’s take a look at the accounting for stock dividends: (Click here to view an example of the accounting for stock dividends)

21 © 1999 by Robert F. Halsey Stock Splits l Companies frequently declare stock splits and distribute additional shares to shareholders in proportion to the number of shares previously held. For example, if a company declares a 2 for 1 stock split, each shareholder receives 1 additional share for each share held. The percentage of the company that they own, both before and after the stock split, is the same since each shareholder receives the same proportionate increase in the number of shares owned. l From an accounting standpoint, no journal entries are required since a transaction has not taken place. The number of shares outstanding is increased and the par value adjusted to reflect the additional shares issued.

22 © 1999 by Robert F. Halsey In recent years, stock splits are more commonly accomplished in the form of a stock dividend. For example, in 1996, Sun Microsystems declared a 2 for 1 stock split in the form of a 100% stock dividend. The notes to its annual report describe this transaction:

23 © 1999 by Robert F. Halsey This is how the stock dividend affected stockholder’s equity. Notice that the par value of the shares issues was transferred form retained earnings to common stock. Additional paid-in- capital was not effected since the par value was used.

24 © 1999 by Robert F. Halsey The End

25 © 1999 by Robert F. Halsey Here is an example of redeemable preferred stock from VF Corp’s annual report: