Chapter 8 Liabilities and Stockholders’ Equity

Learning Objectives After studying this chapter, you should be able to…  Describe how businesses finance their operations.  Describe and illustrate current liabilities, notes payable, taxes, contingencies, and payroll.  Describe and illustrate the financing of operations through issuance of bonds.  Describe and illustrate the financing of operations through issuance of stock.  Describe and illustrate the accounting for cash and stock dividends.  Describe the effects of stock splits on the financial statements.  Describe financial statement reporting of liabilities and stockholders’ equity.  Analyze the impact of debt or equity financing on earnings per share.

Learning Objective 1 Describe how businesses finance their operations

Financing Operations Businesses must finance operations through one of two ways: –Debt Financing – includes all liabilities owed by a business –Equity Financing – investments from owners of the business. Stock is issued to represent ownership interest in a corporation.

Learning Objective 2 Describe and illustrate current liabilities, notes payable, taxes, contingencies, and payroll

Liabilities Debts owed to others Current liabilities – due within a short time, usually 1 year Long-term liabilities – due beyond 1 year Some liabilities are contingent on the outcome of future events

Notes Payable Longer and more formal than accounts payable Usually bear interest Issued to creditors when merchandise or other assets are purchased

Assume that a business issues a 90-day, 12% note for $1,000, dated August 1, 2008 to satisfy an open account payable

Income Taxes Includes federal income taxes and possibly state and local income taxes Most corporations are required to pay federal income taxes in four installments throughout the year

Taxable Income vs. Income Before Taxes Taxable Income – determined according to federal tax laws (IRS Code) Income Before Taxes – determined according to generally accepted accounting procedures (GAAP) Differences between the two may need to be allocated between various financial statement periods

Accounting for Temporary Differences

Contingent Liabilities

Payroll The amount paid to employees for services they provide during a period –Salary – payment for managerial, administrative, or similar services –Wages – payment for manual labor, both skilled and unskilled Payroll and related taxes significantly impact the net income of most businesses

Recording Payroll

Payroll Taxes Employer Taxes FICA Federal and State Unemployment Taxes Employee Taxes FICA Federal and State Income Taxes Payroll taxes become a liability when the related payroll is paid to employees. The liability is relieved when the taxes are paid to the appropriate agencies.

Learning Objective 3 Describe and illustrate the financing of operations through issuance of bonds

Bonds A form of interest-bearing note Bonds include interest that must be paid on a regular basis Bonds face value must be repaid at maturity. Bond indenture – contract between the company issuing the bonds and the bondholders A bond issue is normally divided into several individual bonds. The most common face value is $1,000 per bond.

Calculating the Bond Issue Price Based on the price buyers are willing to pay Depends on three factors: –The face amount of the bonds due at the maturity date. –The periodic interest to be paid on the bonds – stated in the bond indenture. Is called the contract or coupon rate. –The market (effective) rate of interest

Recording Bond Issuance Assume that a business issues $100,000 of 12%, 5-year bonds, with interest of $6,000 payable semiannually. Coupon and effective interest rates will be the same.

Additional Bond Entries

Bonds Not Issued at Face Value Discount on Bonds Payable –Market rate of interest > contract rate –Buyers are not willing to pay face value for the bonds Premium on Bonds Payable –Market rate of interest < contract rate –Buyers are willing to pay more than face value for the bonds

Learning Objective 4 Describe and illustrate the financing of operations through issuance of stock

Stock Major means of equity financing Shares –Authorized – total number allowed to issue –Issued – shares issued to shareholders –Outstanding – shares currently in the hands of stockholders

Shares of Stock Can be issued with or without a monetary amount: –Par: monetary value stated on stock certificate –No-par: some states might require a stated value Legal Capital –Minimum stockholder contribution required by some states

Stock Rights Right to vote in matters concerning the corporation Right to share in distributions of earnings Right to share in assets on liquidation

Common and Preferred Stock Each share has equal rights Each share has voting rights Has preference rights over common stock Dividend rights stated in monetary terms or % of par CommonStockPreferredStock

Issuance of Stock The price at which stock sells depends on a variety of factors: –The financial condition, earnings record, and dividend record of the corporation. –Investor expectations of the corporation’s potential earning power. –General business and economic conditions and prospects.

Stock Issuance Assume that a corporation issues 2,000 shares of $1 par value common stock for $55 per share.

Reacquired Stock Treasury Stock –Stock that a corporation has issued and then reacquires –Balance at year-end is reported as a reduction of stockholders’ equity

Learning Objective 5 Describe and illustrate the accounting for cash and stock dividends

Cash Dividends Cash distribution of earnings by a corporation to its shareholders Most common form of dividend Usually three conditions: –Sufficient retained earnings –Sufficient cash –Formal action by the board of directors

Dividend Announcement Dates

Cash Dividends Assume a company declares the following cash dividend on December 1 for payment on January 2:

Stock Dividends Distribution of stock to stockholders (usually common shares) No distribution of cash or other assets Requirements: –Sufficient retained earnings –Formal action by board of directors Amount transferred for small stock dividends (<25% of outstanding shares) is market value per share

Learning Objective 6 Describe the effects of stock splits on the financial statements

Stock Splits Reduces the par value per share Increase the number of shares outstanding Major objective is to reduce the stock’s market price per share in order to attract more investors

Stock Splits

Learning Objective 7 Describe financial statement reporting of liabilities and stockholders’ equity

Financial Reporting of Liabilities and Equity Liabilities –Current are due within 1 year –Long-term are due beyond 1 year Stockholders’ Equity –Part of the balance sheet –Details of the changes in stockholders’ equity are disclosed in a separate statement

Balance Sheet

Statement of Stockholders’ Equity

Learning Objective 8 Analyze the impact of debt or equity financing on earnings per share

Earnings Per Share Major profitability measure reported in the financial statements Followed closely by the financial press Net Income – Preferred Dividends Number of Common Shares

Effect of Alternative Financing Plans

End of Chapter 8