Reporting and Interpreting Owners’ Equity Chapter 11 Chapter 11: Reporting and Interpreting Owners’ Equity

Understanding The Business Simple to become an owner Easy to transfer ownership Provides limited liability Advantages of a corporation Because a corporation is a separate legal entity, it can . . . The corporate form of organization has several advantages. The major advantage is the ease of raising large amounts of money because both large and small investors can participate in corporate ownership. It is simple to become an owner of corporate shares of stock and it is just as simple to sell the shares. Organized exchanges, such as the New York Stock Exchange, maintain markets in which shares in thousands of companies are bought and sold each business day. Another advantage is limited liability. Stockholders’ losses are limited to the amount invested in the corporation. Corporate creditors cannot make claims on the personal assets of shareholders to satisfy corporate debt. Corporations are entities created by law that exist separately from their owners and that have rights and privileges. As separate entities, corporations can: Own assets. Incur liabilities. Sue and be sued. Enter into contracts. Stockholders are not agents of the corporation and cannot enter into contracts on the corporation’s behalf. Own assets. Sue and be sued. Incur liabilities. Enter into contracts.

Ownership of a Corporation Elected by shareholders Appointed by directors Ultimate control of a corporation rests with the stockholders. At their annual meeting, stockholders elect the Board of Directors and vote on important management issues facing the company. 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.

Common Stock Transactions Two primary sources of stockholders’ equity Retained earnings Contributed capital Common stock, par value Capital in excess of par value Corporations have two primary sources of equity. The first is contributed capital. The two accounts in contributed capital, common stock, par value, and capital in excess of par value, represent amounts that shareholders have invested by buying shares of stock from the company. The second source of equity is retained earnings. The retained earnings account reports the cumulative amount of net income the corporation has earned since its organization less the cumulative amount of dividends declared since organization. This is the portion of the net income that has been reinvested in the business rather than distributed to the owners in dividends.

Initial Sale of Stock Initial public offering (IPO) Seasoned new issue The first time a corporation sells stock to the public. Subsequent sales of new stock to the public. At the initial public offering, shares of stock are sold to the public for the first time, usually through major securities brokerage firms with retail offices in cities across the country. At a later date, the company may wish to raise additional capital with another sale of stock to the public. This is referred to as a seasoned new issue. Kroger Kroger issues new stock.

Stock Issued for Employee Compensation Kroger If Kroger does not have new stock to issue when the stock options are exercised, then . . Employee compensation package includes salary and stock options. Stock options allow employees to purchase stock from the corporation at a predetermined, fixed price. Many corporations have employee compensation packages that include both salary and stock options. Most stock option plans allow employees to buy shares of stock from the corporation at a predetermined, fixed price. If the market price of the company’s stock rises, holders of stock options can exercise those options and then sell the stock at a profit. Stock option compensation plans can motivate employees to increase financial performance which can increase the stock price. All investors in the company benefit when the stock price increases. If the company granting the options to its employees does not have unissued shares of stock to sell to employees when the stock options are exercised, the company can buy the shares in the open market. Employee

Kroger buys its own stock in the secondary market. (Treasury stock) Repurchase of Stock Kroger Kroger buys its own stock in Stockholders the secondary market. (Treasury stock) Kroger buys its own shares from current stockholders in a secondary market to make them available for employee stock option plans. The repurchased shares are called treasury stock. In addition to repurchasing shares for employee stock option plans, companies buy their own stock to support the market price, to increase shares needed to use in the acquisition of another company, to limit the shares available for a hostile takeover, and to return cash to shareholders who wish to sell their shares. Treasury stock has no voting or dividend rights. Treasury stock is not an asset. It is a contra equity account and is subtracted from the stockholders’ equity section on the balance sheet. Treasury stock is usually recorded at the cost to purchase it, and the total cost of all shares of treasury stock held by the company is the amount reported as a reduction in stockholders’ equity. Repurchased stock is called treasury stock. A corporation records treasury stock at cost. Treasury stock has no voting or dividend rights. Treasury stock is not an asset. It is a contra equity account.

Dividends on Common Stock Declared by board of directors. Not legally required. Requires sufficient Retained Earnings and Cash. Creates liability at declaration. Declaration date Board of directors declares the dividend. Record a liability. Cash dividends are declared by the board of directors. There is no legal obligation to declare a cash dividend, but once declared, there is a legal obligation to pay the dividend. Most corporations that pay cash dividends pay them quarterly. To pay a cash dividend, a corporation must have two things:  Sufficient retained earnings to absorb the dividend without going negative and Enough cash to pay the dividend. There are three important dates to remember when discussing dividends:  The date of declaration.  The date of record.  The date of payment. The date of declaration is the date the directors declare the dividend. At this time a liability is created and must be recorded. The entry at the date of declaration includes a debit to retained earnings and a credit to dividends payable.

Dividend Dates Date of Record Date of Payment Stockholders holding shares on this date will receive the dividend. (No entry) Date of Payment Record the dividend payment to stockholders. The date of record is important because it is the date when the corporation determines the owners of record who will receive the dividend. No entry is required in the accounting records on this date. The date of payment is the date the corporation pays the dividend to the stockholders who owned the stock on the record date. The entry on the date of payment includes a debit to dividends payable and credit to cash for the total amount of cash paid to the owners of record.

Stock Dividends Small Large Distribution of additional shares of stock to owners. No change in total stockholders’ equity. All stockholders retain same percentage ownership. No change in par values. A stock dividend is a distribution of additional shares of stock to stockholders. All stockholders retain the same percentage ownership. The stockholders have more shares of stock representing the same ownership as they had before the stock dividend. There is no change in total stockholders’ equity and par value per share does not change. Why do corporation issue stock dividends which are merely more pieces of paper evidencing the same percentage ownership? Corporations may issue stock dividends to: Reduce the market price per share of stock to make the shares more affordable for investors to purchase. Signal that the management expects strong financial performance in the future. A stock dividend can be classified as small or large. A small stock dividend is a distribution of stock that is less than 20-25 percent of the outstanding shares. Small stock dividends are recorded at the market value of the stock. A large stock dividend is a distribution of stock that is greater than 20-25 percent of the outstanding shares. Large stock dividends are recorded at the par value of the stock. Stock dividend < 20-25% Record at current market value of stock. Small Stock dividend > 20-25% Record at par value of stock. Large

Stock Splits Stock splits change the par value per share, but the total par value is unchanged. Assume that a corporation had 3,000 shares of $2 par value common stock outstanding before a 2–for–1 stock split. Increase Decrease No Change 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 per share of the stock changes. Each shareholder has the same percentage ownership of the company after the split as before the split. So we sometimes say that a stock split creates more, but smaller, pieces of the same pie. Let’s look at an example. Assume that a corporation had 3,000 shares of $2 par value common stock outstanding before a 2–for–1 stock split. After the two-for-one 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 100 percent stock dividend and a two-for-one stock split result in similar impacts to the price per share in the stock market. The stock split usually requires more administrative tasks to call in and reissue stock certificates.

Preferred Stock Preference over common stock Usually has no voting rights Usually has a fixed dividend rate 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 and is often callable by the corporation at a stated value.

Dividends on Preferred Stock Current Dividend Preference: The current preferred dividends must be paid before paying any dividends to common stock. Cumulative Dividend Preference: Any unpaid dividends from previous years (dividends in arrears) must be paid before common dividends are paid. Preferred stock has a current dividend preference when compared to common stock. Current preferred dividends must be paid to preferred stockholders before any dividends are paid to common stockholders. 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. If the preferred stock is noncumulative, any dividends not declared in previous years are lost permanently.

A sole proprietorship is owned by a one person. Chapter Supplement ─ Accounting for Owners’ Equity for Sole Proprietorships and Partnerships A sole proprietorship is owned by a one person. In addition to corporations, there are two other forms of business organizations: sole proprietorships and partnerships. A sole proprietorship is owned by one person. There are two equity accounts for a sole proprietorship: capital and drawings. Capital is the equivalent of common stock and retained earnings combined for a corporation. Drawings are the equivalent of dividends for a corporation. Let’s look at an example. Two equity accounts Capital Drawings

Partnerships Advantages Primary disadvantage Unlimited liability A partnership is owned by two or more individuals. Partnerships require clear agreements about authority, risks, and the sharing of profits and losses. Separate capital and drawings accounts are maintained for each partner. Partnership income is divided among the partners according to the partnership agreement. Advantages Primary disadvantage A partnership is owned by two or more individuals. Partnerships require clear agreements about authority, risks, and the sharing of profits and losses. Separate capital and drawings accounts are maintained for each partner. Partnership income is divided among the partners according to the partnership agreement. Partnerships have some advantages and disadvantages when compared to corporations. The primary advantages are ease of formation, complete control by the partners, and the avoidance of income taxes on the partnership income. Each partner pays taxes on his or her share of partnership income. The primary disadvantage of a partnership is unlimited liability. Creditors can make claims against partners’ personal assets to satisfy partnership debts. Let’s look at an example. Complete control by partners Ease of formation Unlimited liability No income taxes on business

Accounting and Reporting for Three Types of Businesses Here’s a convenient summary of the accounting and reporting issues for the three forms of business that we have discussed in this chapter.

End of Chapter 11 End of chapter 11.