Needles Powers Crosson Financial and Managerial Accounting 10e Stockholders’ Equity 12 C H A P T E R © human/iStockphoto ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Concepts Underlying the Corporate Form of Business  A corporation is a separate entity chartered by the state and legally separate from its owners, or stockholders.  Contributed capital refers to stockholders’ investments in a corporation. –It is a major means of financing a corporation. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Advantages of Incorporation  Separate legal entity  Limited liability: Creditors can satisfy their claims only against the assets of the corporation, not against the personal property of the corporation’s owners.  Ease of capital generation  Ease of transfer of ownership  Lack of mutual agency: The corporation is not bound by any contracts that individual stockholders may enter into.  Continuous existence  Centralized authority and responsibility  Professional management ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Disadvantages of Incorporation  Government regulation: Corporations must file many reports with the state in which they are chartered, and publicly held corporations must also file reports with the SEC and with their stock exchanges.  Double taxation: A corporation’s earnings are subject to federal and state income taxes. If any of the corporations’ earnings are paid out as dividends, the earnings are taxed again as income to stockholders.  Limited liability: This may restrict the ability of a small corporation to borrow money.  Separation of ownership and control: Management may make decisions that are not good for the corporation. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Equity Financing (slide 1 of 2)  Equity financing is accomplished by issuing stock to investors in exchange for assets. –Once the stock has been issued to them, stockholders can transfer their ownership at will.  Large corporations often appoint independent registrars and transfer agents (usually banks and trust companies) to help perform the transfer duties. –Two important terms in equity financing are:  Par value—an arbitrary amount assigned to each share of stock. It must be recorded in the capital stock accounts.  Legal capital—the number of shares issued multiplied by the par value. It is the minimum amount that a corporation can report as contributed capital. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Equity Financing (slide 2 of 2) –To help with its initial public offering (IPO), a corporation often uses an underwriter—an intermediary between the corporation and the investing public.  The corporation records the amount of the net proceeds of the offering in its Capital Stock and Additional Paid-in Capital accounts. The net proceeds are what the public paid less the underwriter’s fees, legal expenses, and other direct costs of the offering.  The costs of forming a corporation are called start-up and organization costs. These costs include state incorporation fees, attorneys’ and accountants’ fees, the cost of printing stock certificates, and other expenditures necessary to form the corporation. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Advantages and Disadvantages of Equity Financing  Advantages –Decreased financial risk  Issuing common stock is less risky than financing with long-term debt. –Increased cash for operations –Better debt to equity ratio  Disadvantages –Increased tax liability  Whereas the interest on debt is tax-deductible, the dividends paid on stock are not. –Decreased stockholder control  When a corporation issues more stock, it dilutes its ownership. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Components of Stockholders’ Equity (slide 1 of 2)  The stockholders’ equity section of a corporate balance sheet usually has at least three components: – Contributed capital—the stockholders’ investments in the corporation – Retained earnings—the earnings of the corporation since its inception, less any losses, dividends, or transfers to contributed capital. These are reinvested in the business. – Treasury stock—shares of the corporation’s own stock that it has bought back on the open market ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Components of Stockholders’ Equity (slide 2 of 2)  The stockholders’ equity section gives a great deal of information about the corporation’s stock. – Under contributed capital, it lists the kinds of stock, their par values, and the number of shares authorized, issued, and outstanding.  Corporations may disclose more detail in a statement of stockholders’ equity, which summarizes changes in the components of the stockholders’ equity section of the balance sheet. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Types of Stock  A corporation can issue two types of stock: –Common stock—the basic form of stock  Shares of common stock carry voting rights and usually provide their owners with the means of controlling the corporation.  Common stock is also called residual equity because the claims of all creditors and usually those of preferred stockholders rank ahead of the claims of common stockholders. –Preferred stock—stock that gives its owners preference over common stockholders in terms of receiving dividends and in terms of claims to assets if the corporation is liquidated. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Types of Shares  Authorized shares are the maximum number of shares that a corporation’s charter allows it to issue.  Issued shares are those that a corporation sells or otherwise transfers to stockholders.  Outstanding shares are shares that a corporation has issued and that are still in circulation. A corporation may have more shares issued than are currently outstanding if it has bought back treasury shares. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Preference as to Dividends  Preferred stockholders ordinarily must receive a certain amount of dividends before common stockholders receive anything. –If the stock is noncumulative preferred stock and the board of directors fails to declare a dividend in any year, the company is under no obligation to make up the missed dividend in future years. –If the stock is cumulative preferred stock, the dividend amount per share accumulates from year to year if unpaid, and the company must pay the whole amount before it pays any dividends on common stock.  Dividends not paid in the year they are due are called dividends in arrears. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Convertible and Callable Preferred Stock (slide 1 of 2)  Owners of convertible preferred stock can exchange their shares of preferred stock for shares of common stock at a ratio stated in the preferred stock contract. –If the market value of the common stock increases, the conversion feature allows these stockholders to share in the increase by converting their stock to common stock.  Most preferred stock is callable preferred stock—that is, the issuing corporation can redeem it at a price stated in the preferred stock contract. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Convertible and Callable Preferred Stock (slide 2 of 2) –The call price, or redemption price, of callable preferred stock is usually higher than the stock’s par value. –If the preferred stock is convertible, the stockholder can either surrender the stock or convert it to common stock. –When preferred stock is called and surrendered, the stockholder is entitled to:  The par value of the stock  The call premium  Any dividends in arrears  The current period’s dividend prorated by the proportion of the year to the call date ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Issuance of Common Stock  A share of capital stock may be par or no-par. –The value of par stock is stated in the corporate charter and on each stock certificate.  A corporation cannot declare a dividend that would cause stockholders’ equity to fall below the legal capital. Thus, par value is a minimum cushion of capital that protects a corporation’s creditors. –No-par stock does not have a par value.  Most states require that all or part of the proceeds from a corporation’s issuance of no-par stock be designated as legal capital, which cannot be used unless the corporation is liquidated.  State laws often require corporations to place a stated value on each share of stock they issue. The stated value can be any value set by the board unless the state specifies a minimum amount, which is sometimes the case. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting for Treasury Stock  Treasury stock is stock that the issuing company has reacquired, usually by purchasing shares on the open market. –A company may want to buy back its own stock for any of the following reasons:  To distribute to employees through stock option plans.  To maintain a favorable market for its stock.  To increase its earnings per share or stock price per share.  To have additional shares of stock available for purchasing other companies.  To prevent a hostile takeover. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounting for Cash Dividends  A dividend is a distribution of the assets that a corporation’s earnings have generated. –Stockholders receive these assets, usually cash, in proportion to the number of shares they own. –Although a corporation may have sufficient cash to pay a dividend, its board of directors may not do so for several reasons:  The corporation may need the cash for expansion.  It may want to improve its overall financial position by liquidating debt.  It may be facing major uncertainties. –If a corporation declares a dividend that exceeds retained earnings, this is called a liquidating dividend. A corporation usually pays a liquidating dividend only when it is going out of business or reducing its operations. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Dividend Dates  Three important dates are associated with dividends: –Declaration date—the date on which the board of directors formally declares that the corporation is going to pay a dividend –Record date—the date on which ownership of stock is determined  Persons who own stock on the record date will receive the dividend.  Between the record date and the date of payment, the stock is said to be ex-dividend.  If the owner on the date of record sells the shares of stock before the date of payment, the right to the dividend remains with that person. –Payment date—the date on which the dividend is paid to the stockholders of record ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Stock Dividends  A stock dividend is a proportional distribution of shares among a corporation’s stockholders. –Unlike a cash dividend, a stock dividend involves no distribution of assets. –A board of directors may declare a stock dividend for the following reasons:  To give stockholders some evidence of the company’s success without affecting working capital.  To reduce the stock’s market price by increasing the number of shares outstanding (a goal more often met by a stock split).  To make a nontaxable distribution to stockholders.  To increase the company’s permanent capital by transferring an amount from retained earnings to contributed capital. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Stock Splits  A stock split occurs when a corporation increases the number of shares of stock issued and outstanding and reduces the par or stated value proportionally. –A company may plan a stock split for the following reasons:  To lower its stock’s market price per share and, thereby, increase the demand and volume of trading for its stock at this lower price.  To signal to the market its success in achieving its operating goals. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Book Value and Book Value per Share  The book value of stock represents a company’s total assets less its liabilities (in other words, its net assets).  The book value per share is the equity of the owner of one share of stock in the net assets of the company. –If a company has only common stock outstanding, book value per share is calculated as follows: Stockholders’ equity ÷ Common Shares Outstanding = Book Value per Share –If a company has both preferred and common stock, the preferred stock’s call value and any dividends in arrears are subtracted from stockholders’ equity to determine the equity pertaining to common stock. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Dividend Yield  Dividend yield is computed by dividing the dividends per share by the market price per share. –Investors use the dividend yield ratio to evaluate the amount of dividends they receive. –Companies that pay no dividends have a dividend yield of zero. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Return on Equity  Return on equity is the ratio of net income to average total stockholders’ equity. –It is the most important ratio associated with stockholders’ equity and is a common measure of management’s performance. –As a company sells more shares of stock, –Management can reduce stockholders’ equity, thereby increasing return on equity, by buying back the company’s shares on the open market. This has the following effect: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Price Earnings Ratio  The price/earnings (P/E) ratio is a measure of investors’ confidence in a company’s future. –It is calculated by dividing the market price per share by the earnings per share. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Stock Options as Compensation  Stock option plans give employees the right to purchase stock in the future at a fixed price. –Because the market value of a company’s stock is tied to a company’s performance, these plans are a means of both motivating and compensating employees. –As the market value of the stock goes up, the difference between the option price and the market price grows, which increases the amount of compensation. –Another key benefit is that compensation expense is tax-deductible. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.