Introduction to Financial Accounting, 7th Edition PowerPoint Presentations

1
Chapter 11

Stockholders Equity
2
Learning Objectives

• After studying this chapter, you should be able
  to
• Describe the rights of shareholders.
• Differentiate among authorized, issued, and
  outstanding shares.
• Contrast bonds, preferred stock, and common
  stock.
• Identify the economic characteristics of and
  accounting for stock splits.

3
Learning Objectives

• After studying this chapter, you should be able
  to
• Account for both large-percentage and
  small-percentage stock dividends.
• Explain and report stock repurchases and other
  treasury stock transactions.
• Record conversions of debt for equity or of
  preferred stock into common stock.
• Use the rate of return on common equity and book
  value per share.

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Background onStockholders Equity

• The rights of shareholders usually include the
  right to
• Vote in affairs of the corporation
• Share in corporate profits
• Share in any assets left upon
  liquidation
• Acquire shares of subsequent issues of stock

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Background onStockholders Equity

• Corporations hold annual meetings of shareholders
  where votes are taken on important matters.
• Naturally not all shareholders can attend every
  meeting.
• Corporate proxy - a written authority granted
  by individual shareholders to others to cast
  the shareholders votes

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Background onStockholders Equity

• Preemptive rights - the rights to acquire a pro
  rata amount of any new issues of capital stock
• When companies issue new stocks, many new owners
  may be added. In this case, the old owners
  percentage of ownership decreases.
• The preemptive right allows current owners to
  purchase shares directly from the corporation, in
  a pro rata amount, to keep their percentage of
  ownership the same.

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Background onStockholders Equity

• One of the most important rights of shareholders
  is limited liability.
• Creditors of the corporation have claims on the
  assets owned by the corporation, not on the
  assets of the owners of the corporation.

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Authorized, Issued, and Outstanding Stock

• Authorized shares - the total number of shares
  that may legally be issued under the
  corporations articles of incorporation
• Not all authorized shares are always issued.
• Issued shares - the aggregate number
  of shares sold to the
  public

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Authorized, Issued, and Outstanding Stock

• Outstanding shares - shares in the hands of
  shareholders
• Equal to issued shares less treasury stock
• Treasury stock - a corporations issued stock
  that has subsequently been repurchased by the
  company and not retired
• Treasury stock has been issued, but it is no
  longer outstanding.

10
Accounting for Stock Issuance

• To account for an issuance of stock, the receipt
  of cash is recorded and an account is created to
  represent the ownership interest.
• Most companies separate this ownership interest
  into two categories
• Par value
• Additional paid-in capital

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Accounting for Stock Issuance

• Alex Corporation issues 100,000 shares of 2 par
  value stock for 5 per share. The journal entry
  to record the issuance is as follows
• Cash 500,000
• Common stock 200,000
• Additional paid-in capital 300,000
• Common stock is always credited for the par value
  of the shares issued.
• Any amount in excess of the par value is credited
  to the Additional Paid-in Capital account.

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Accounting for Stock Issuance

• Par value was originally conceived as a measure
  of protection for stockholders.
• Par value established the minimum legal liability
  of a stockholder.
• Creditors were assured that the corporation would
  have at least a minimum amount of ownership
  capital because the shareholders were required to
  invest at least the amount of the par value per
  share.

13
Cash Dividends

• Dividends are a means of proportionally
  distributing income to shareholders of a
  corporation.
• Dividends are usually paid in cash.
• Distributions of other assets are
  not very common, but distributions
  of stock are more
  common.
• Dividends must be approved by the board of
  directors.

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Cash Dividends

• Three important dates regarding dividends
• Declaration date - the date the board of
  directors declares a dividend
• Date of record - a future date that determines
  which stockholders will receive the dividend
• Only persons actually owning stock on this date
  will receive the dividend.
• Payment date - the date the dividends are paid to
  the shareholders of record

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Cash Dividends

• Journal entries to record dividends
• Declaration date
• Retained income 20,000
• Dividends payable 20,000
• Date of record
• No entry required
• Payment date
• Dividends payable 20,000
• Cash 20,000

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Cash Dividends

• The amount of cash distributed depends on several
  factors such as market expectations, current and
  predicted earnings, and the corporations cash
  position and financial plans for the future.
• The biggest factor is the amount of cash that the
  company has available for distributions.
• Another factor is the amount of retained income.
• Companies generally cannot pay more dividends
  than they have retained income.

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Preferred Stock

• Corporations can issue two types of stock.
• Common stock - the most basic and common type of
  stock
• Owners have all the basic rights previously
  discussed.
• Preferred stock - stock that offers owners
  different rights and preferential treatment
• Owners do not usually have voting rights, but
  they have priority in events such as liquidations
  and dividends.

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Cumulative Dividends

• The amount of preferred stock dividends is
  usually specified and does not change over time.
• Just because a corporation decides not to pay
  dividends in a given year does not mean that the
  company can avoid the obligation.
• Cumulative preferred stock - a characteristic of
  preferred stock that requires that undeclared
  dividends accumulate and must be paid in the
  future to preferred shareholders before common
  shareholders

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Cumulative Dividends

• Hobson Company has 10,000 shares of 4
  cumulative preferred stock outstanding (preferred
  shareholders are entitled to 40,000 in dividends
  each year). The company paid the following
  amounts of dividends.
• Year 1 -0-
• Year 2 25,000
• Year 3 125,000
• How are the dividends distributed to preferred
  and common shareholders?

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Cumulative Dividends

• Total Preferred Common
• Year Dividends Dividends Dividends
• 1 -0- -0- -0-
• 2 25,000 25,000 -0-
• 3 125,000 95,000 30,000
• Since no dividends were paid in year 1,
  preferred shareholders receive all dividends
  declared until they have received what they are
  entitled to for all years before the common
  shareholders receive any dividends.
• Remaining in arrears from year 1 15,000
• Arrears for year 2 40,000
• Current for year 3 40,000
• 95,000

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Preference in Liquidation

• Liquidating value - a measure of the preference
  to receive assets in the event of corporate
  liquidation
• The company must pay the liquidating value to all
  preferred stockholders before it can distribute
  any assets to common stockholders.
• Also, any preferred dividends in arrears must be
  paid before common stockholders receive any
  assets.
• If there is not enough cash, the common
  shareholders simply wind up getting nothing.

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Other Features of Preferred Stock

• Participating - a characteristic of preferred
  stock that provides increasing dividends when
  common dividends increase
• If preferred stock is nonparticipating, the
  preferred stockholders receive dividends first,
  but that is all they will receive they get
  nothing more than the amount stated.
• The participation feature allows preferred
  stockholders to get more dividends if enough is
  declared and specified conditions are met.

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Other Features of Preferred Stock

• Callable - a characteristic of bonds or preferred
  stock that gives the issuer the right to redeem
  the security at a fixed price
• The stock is bought back at a call price, or
  redemption price, which is usually set high
  enough to compensate stockholders for the fact
  that the stock can be automatically bought back
  at any time at the
  issuers choice.

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Other Features of Preferred Stock

• Convertible - a characteristic of bonds or
  preferred stock that gives the holder the right
  to exchange the security for common stock at a
  specified price
• Because the ability to convert the stock can be
  very valuable if common stock prices rise, the
  dividend rate is usually somewhat lower.

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Comparing Bonds andPreferred Stock

• Bonds and preferred stock are similar in the
  sense that they are both contracts between an
  investor and an issuer that spells out each
  partys rights and responsibilities.
• Bonds and preferred stock are also similar in the
  sense that they provide investors with a specific
  return.

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Comparing Bonds andPreferred Stock

• The size and nature of the return to the
  investors differs greatly.
• Bonds pay interest which appears on the income
  statement of the company as an expense.
• Interest is tax deductible to the issuing company
  and taxable to the recipient.
• Preferred stocks pay dividends which represent
  distributions of profits and reduce the Retained
  Income account directly.
• Dividends are not considered expenses and are not
  tax deductible by the issuing company but are
  still taxable to the recipient.

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Comparing Bonds andPreferred Stock

• Bonds and preferred stocks differ in the sense
  that bonds have specific maturity dates, at which
  time they must be repaid, but preferred stock
  generally has unlimited life.
• Preferred stock is somewhat riskier than bonds
  because it never matures (the investor does not
  get the original investment back) and dividends
  are not required to be paid.

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Additional Stock Issuance

• Stocks can be issued after the original formation
  of the company for several reasons.
• The firm may wish to raise additional equity
  capital.
• Shares are made available to employees in the
  form of stock options to encourage employees to
  work harder in order to raise the market price of
  the stock.
• Shares are sometimes issued to existing
  shareholders in order to signal something about
  the company, to change the market price, or to
  alter the dividend payments.

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Stock Options

• Stock options - special rights usually granted to
  executives to purchase a corporations capital
  stock in the future at a specified price
• Measurement of the value of the options is
  difficult because executive stock options are not
  sold to the general public, so no market value is
  readily available for use as a guide.
• Currently, options are given a zero value as long
  as the option price is the same as the market
  price at the date of the grant.

30
Stock Options

• Since no value is assigned to the options at the
  date of grant, no journal entry is required.
• However, the number and types of options
  outstanding and an assessment of their value must
  be included in the notes to the financial
  statement.

31
Stock Options

• A company has outstanding options to purchase
  100,000 shares of 5 par common stock at a price
  of 10 per share. The options can be exercised
  over the next 10 years.
• The date of grant
• No entry required
• The options are exercised in the 7th year
  following the grant
• Cash 1,000,000
• Common stock 500,000
• Additional paid-in capital 500,000

32
Stock Options

• Significant debate about stock options has arisen
  recently.
• Some argue that when a company grants an option,
  it gives something of value in exchange for
  services rendered, so options should be recorded
  as an expense when granted.
• Others argue that recording options as an expense
  and as income to the executives would undermine
  the markets and entrepreneurship.
• The FASB simply requires measurement using one of
  several techniques and disclosure of the values
  to stockholders.

33
Stock Splits and Stock Dividends

• Several events exist that allow the company to
  issue additional shares to existing shareholders
  without receiving any cash.
• Stock splits and stock dividends are two examples.

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Accounting for Stock Splits

• Stock split - issuance of additional shares to
  existing stockholders for no payments by the
  stockholders
• When a stock split occurs, the total amount of
  paid-in capital does not change.
• The number of shares outstanding increases.
• The par value and market value of the stock are
  both decreased in proportion to the increase in
  the number of shares.
• Stock splits are often done to reduce the market
  value of a stock to make it more attractive to
  investors.

35
Accounting for Stock Splits

• Walters Corporation has 100,000 shares of 2 par
  common stock outstanding when the corporation
  issues a 2-for-1 stock split. What is the effect
  on common stock?

36
Accounting for Stock Splits

• Before the 2-for-1 stock split
• Shares outstanding 100,000
• Par value per share 2
• Total common stock 200,000
• After the 2-for-1 stock split
• Shares outstanding 200,000
• Par value per share 1
• Total common stock 200,000
• The market value should also decrease by
  one-half.

37
Accounting for Stock Splits

• Generally, no entry is necessary for recording a
  stock split because amounts in the paid-in
  capital accounts have not changed.
• Usually a note in the general journal will
  suffice.
• Sometimes a company will keep the par value the
  same after the stock split.
• The company is merely rearranging owners equity
  from Additional Paid-in Capital to Common Stock
  or from Retained Income to Common Stock.

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Accounting for Stock Dividends

• Stock dividends - distributions to stockholders
  of a small of additional shares for each share
  owned, without any payment to the company by the
  stockholders
• The number of shares issued is less than in a
  stock split, and the par value does not
  change.

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Accounting for Stock Dividends

• With stock dividends, new shares are issued and
  the Common Stock account is increased to
  recognize this increase.
• The dollar amount of the increase to Common Stock
  depends on the size of the dividend.
• Large-percentage stock dividend - 20 or more of
  the outstanding shares of common stock
• Small-percentage stock dividend - less than 20
  of the outstanding shares of common stock

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Large-Percentage Stock Dividends

• Large-percentage stock dividends are accounted
  for at the par or stated value of the stock.
• An entry is made to transfer the par or stated
  value of the new shares from Retained Income to
  the Common Stock account.
• Retained income ( shares x par value) xxx
• Common stock xxx

41
Large-Percentage Stock Dividends

• The market value of the stock is now split
  between the old shares and the new shares.
• This effectively reduces the market price per
  share, but the total market value remains
  unchanged.
• The proportional ownership of shares does not
  change because the stock is distributed
  proportionally based on ownership.
• The dividend per share is decreased
  proportionally, however.

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Small-Percentage Stock Dividends

• Small-percentage stock dividends are accounted
  for at market value, not at par or stated value.
• An entry is made to transfer the market value of
  the new shares from Retained Income to Common
  Stock and Additional Paid-in Capital.
• This is often justified because a
  small-percentage stock dividend is often
  accompanied by an increase in the total cash
  dividends distributed.

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Small-Percentage Stock Dividends

• The proportional ownership of shares does not
  change because the stock is distributed
  proportionally based on ownership.
• The journal entry to record a small-percentage
  stock dividend is
• Retained income ( shares x market value)
  xxx
• Common stock ( shares x par value) xxx
• Additional paid-in capital xxx

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Why Use Stock Splitsand Dividends?

• Stock splits and dividends effectively decrease
  the market price of the stock.
• This attracts more investors because it is easier
  to get investors to pay the lower stock prices.
• Companies often wish to retain cash for
  expansion.
• Stock dividends allow the company to retain cash
  and still give the stockholders a dividend that
  will entitle them to more cash dividends in the
  future.

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Relation of Dividends and Splits

• Companies use large-percentage stock dividends to
  accomplish the same thing as a stock split.
• The market price is reduced, and the total amount
  of dividends distributed to the stockholders is
  increased.
• Stock dividends are often used to save clerical
  costs.
• It is cheaper to issue new stock certificates at
  the original par value than it is to reissue all
  new stock certificates with new par values.

46
Fractional Shares

• Corporations issue shares in whole units, but
  sometimes stockholders are entitled to fractional
  units of shares.
• If fractional units must be distributed, the
  company would issue the whole number of
  shares in stock, and the
  fractional units will
  be issued as a cash
  dividend.

47
The Investors Accounting for Dividends and Splits

• The accounting by the investor is basically
  opposite that of the corporation.
• Stock split or large-percentage stock dividend -
  no entry memo giving details of the stock split
  or stock dividend
• Cash dividend - entry recording the receipt of
  cash and the recognition of dividend income
• Small-percentage stock dividend - no entry memo
  disclosing the increase in the number of shares
  owned and the related decrease in the market
  value per share of the stock

48
Repurchase of Shares

• Companies repurchase their own shares for two
  main purposes.
• To permanently reduce shareholder claims (retire
  the stock)
• To temporarily hold shares for later use, usually
  to be granted as part of employee bonus or stock
  purchase plans
• These temporarily held shares are called treasury
  stock.

49
Repurchase of Shares

• By repurchasing its own shares, a company can
  effectively increase the market value per share
  of the remaining shareholders.
• Firms also buy back shares to change the
  proportion of debt and equity.
• Buying back shares increases the relative
  importance of debt.

50
Repurchase of Shares

• Buybacks also allow the company to return cash to
  the shareholders without creating expectations of
  future dividends.
• Another benefit of stock buybacks is that
  investors pay taxes only on the gain on the sale
  of the stock instead of the entire dividend.
• Also, the tax rate on a long-term gain is less
  than on a dividend.

51
Retirement of Shares

• When shares are retired, the shares are no longer
  outstanding
• Total stockholders equity is reduced because the
  amount of stock retired is charged against Common
  Stock, Additional Paid-in Capital, and Retained
  Income.
• Common stock ( shares x par value) xxx
• Additional paid-in capital ( shares x
  (original
• issue price - par value)) xxx
• Retained income ( shares x (repurchase
• price - original issue price)) xxx
• Cash ( shares x repurchase price) xxx

52
Treasury Stock

• Treasury stock that is held temporarily is not an
  asset to the company.
• It is a contra account to Owners Equity, much
  like Accumulated Depreciation is a contra account
  to Plant Assets
• It is a deduction from total stockholders equity
  on the balance sheet.
• Cash dividends are not paid on treasury stock
  because treasury stock is not considered to be
  outstanding shares of stock.

53
Treasury Stock

• When treasury stock is repurchased, it is
  recorded in a separate account called Treasury
  Stock.
• Common Stock, Additional Paid-in Capital, and
  Retained Income are untouched by treasury stock
  purchases.
• Calculation of outstanding shares
• Shares issued 1,000,000
• Less Treasury stock 50,000
• Total shares outstanding 950,000

54
Disposition of Treasury Stock

• Assume that 10,000 shares of treasury stock are
  purchased for 10 per share 5,000 of the shares
  are then resold for 12 per share. A year later,
  the remaining 5,000 shares are sold for 9 per
  share. How are these transactions recorded?

55
Disposition of Treasury Stock

• Repurchase of the 10,000 shares of treasury
  stock
• Treasury stock (10,000 x 10) 100,000
• Cash 100,000
• Sale of 5,000 shares at 12 per share
• Cash 60,000
• Treasury stock (5,000 x 10) 50,000
• Additional paid-in capital (5,000 x 2)
  10,000
• Sale of 5,000 shares at 9 per share
• Cash 45,000
• Additional paid-in capital (5,000 x 1)
  5,000
• Treasury stock (5,000 x 10) 50,000
• If the balance in Additional Paid-in Capital
  is insufficient, Retained Income is debited.

56
Disposition of Treasury Stock

• Any differences between the acquisition costs and
  the resale proceeds of treasury stock must never
  be reported as losses, expenses, revenues, or
  gains in the income statement.
• Treasury stock is not an asset of the company,
  nor is it intended to be treated like inventory
  to be resold a company cannot make
  profits or losses by
  buying
  or selling its own stock.

57
Effects of Repurchases on Earnings per Share

• As stated before, when shares are repurchased by
  a corporation, the number of shares outstanding
  is decreased.
• This decrease in the number of shares tends to
  increase earnings per share.

58
Other Issuances of Common Stock

• Sometimes common stock may be issued for assets
  other than cash.
• Common stock may be issued for assets such as
  land, buildings, or equipment.
• Bonds or other securities may also be converted
  into common stock.

59
Noncash Exchanges

• Noncash exchanges raise the question of the
  proper dollar value of the transaction to be
  recorded in both the buyers and the sellers
  books.
• The value to be recorded is the fair value of
  either the securities or the exchanged assets,
  whichever is easier to determine objectively.
• This amount is to be used by both the buyer and
  the seller.

60
Conversion of Securities

• For the issuer, when convertible preferred stock
  is converted into common stock, the transaction
  merely converts one form of stock into another.
• The accounts are adjusted as if the common stock
  had been originally issued.
• The convertible preferred stock and any
  additional paid-in capital is taken off the
  books, and the common stock and additional
  paid-in capital is put on as if it had been
  issued originally instead of the convertible
  preferred stock.

61
Conversion of Securities

• The investor may make a journal entry to show
  that the investment in convertible preferred
  stock is now an investment in common stock.
• The investor may also change any subsidiary
  records that document the composition of the
  Investments general ledger account.

62
Tracking Stock

• Tracking stock is sometimes issued based on a
  part of a large company.
• Tracking stock is similar to common stock
• The company can produce financial statements for
  the subunit of the company.
• The company can pay dividends on the tracking
  stock.
• The company can issue stock options on the
  tracking stock.
• The stock trades on stock markets just like
  common stock.

63
Tracking Stock

• The big disadvantage of tracking stock is that
  the shares do not represent voting rights in a
  separate company.
• The board of directors has all discretion in
  making decisions that affect the subunit.
• These decisions might harm the subunit in favor
  of the entire company, and the holders of the
  tracking stock have no opportunity to affect
  those decisions.

64
Retained Income Restrictions

• Dividends typically cannot be declared if those
  dividends would decrease retained income to a
  negative number.
• Some states require that dividends cannot be
  declared if the dividends reduce stockholders
  equity to below total paid-in capital.

65
Retained Income Restrictions

• Restictions of retained income are usually
  disclosed in the notes to the financial
  statements.
• Some restrictions appear on the face of the
  balance sheet.
• Restricted retained income (appropriated retained
  income) - any part of retained income that may
  not be reduced by dividend declarations

66
Other Components of Stockholders Equity

• Two other elements that deserve mention
• Foreign currency translation adjustment - amounts
  that arise when a company has subsidiary
  companies in other countries
• The amounts arise when a foreign currency is
  translated into U.S. dollars.
• Employee stock ownership plan (ESOP) - a plan
  that rewards employees with shares of stock
• A separate entity is set up to hold shares of
  stock on behalf of the employees.

67
Financial Ratios Related to Stockholders Equity

• Rate of return on common equity (ROE) - measures
  how effectively the company uses resources
  provided by the shareholders
• Focuses on the companys profitability based on
  the book value of the common equity

Rate of return on common equity
68
Financial Ratios Related to Stockholders Equity

• Book value per share of common stock -
  stockholders equity attributable to common stock
  divided by the number of shares outstanding
• Comparing book values to market values often
  reveals the causes behind the differences in
  values.

Total stockholders equity - Book value of
preferred stock
Book value per share of common stock

Number of common shares outstanding
69
Introduction to Financial Accounting8th
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