Module 9: Stockholders

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Module 9 Stockholders Equity

• 1. Accounting for preferred and common
• 2. Treasury stock
• 3. Stock compensation plans
• 4. Retained earnings
• -cash dividends
• -stock dividends (and stock splits)
• -property dividends (and other carve outs)
• 5. Other comprehensive income
• 6.Statement of stockholders equity
• 7.Convertible securities

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1. Preferred Stock

• Advantages
• Preference over common in liquidation
• Stated dividend
• Variety of features regarding dividends
• Preference over common in dividend payout
• Disadvantages
• Subordinate to debt in liquidation
• Stated dividend can be skipped
• No voting rights (versus common)
• Debt or equity?
• components of both
• usually (but not always) classified with equity

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1. Common Stock

• Advantages
• Voting rights
• election of board of directors
• vote on significant activities of management
• Rights to residual profits (after preferred)
• Disadvantages
• Last in liquidation
• No guaranteed return

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1. Accounting for Common Stock (CS) and
Preferred Stock (PS)

• Par value - initially established to create a
  minimum legal capital.
• Ex Minimum legal capital in some states is
  1,000 for new corporations, so issue
• 1,000 shares at 1par, or
• 100 shares at 10 par, or other combination. . .
• Par value is not market value.
• Credit CS or PS for par value.
• Excess over par credited to Paid in Capital in
  Excess of Par or Stated Value or abbreviated
  Additional Paid-in Capital (APIC).
• Some newer stock issues (for common stock) are
  no par stock.

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1. Par versus No Par

• Note many companies have newer stock issues
  that are no par, but most companies still have
  older stock issues which contain a par value and
  APIC.
• The Stockholders Equity section of the balance
  sheet of Sample Company illustrates many of the
  components of SE discussed in this chapter.

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Sample Co. Stockholders Equity

• Common stock, 1 par value, 500,000 shares
• authorized, 80,000 shares issued, and
• 75,000 shares outstanding 80,000
• Preferred stock, 100 par value, 1,000 shares
• authorized, 100 shares issued and
• outstanding 10,000
• Paid in capital on common 20,000
• Paid in capital on preferred 3,000
• Paid in capital on treasury stock 4,000
  27,000
• Retained earnings
• Unappropriated 18,000
• Appropriated 4,000 22,000
• Less Treasury stock, 5,000 shares (at cost)
  (6,000)
• Less Other comprehensive income (2,000)
• Total Stockholders Equity 131,000

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2. Treasury Stock

• Created when a company buys back shares of its
  own common stock.
• Reasons for buyback
• reissue to employees for compensation.
• hold in treasury (or retire) to increase market
  price and earnings per share.
• reduce total dividend payouts while maintaining
  per share payouts.
• thwart takeover attempts by reducing proportion
  of shares available for purchase.
• give cash back to existing shareholders.

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2. Treasury Stock - continued

• The debit balance account called Treasury Stock
  is reported in stockholders equity as a contra
  (reduces SE). Note not an asset.
• The stock remains issued, but is no longer
  outstanding.
• does not have voting rights
• cannot receive cash dividends
• May be reissued (to the market or to employees)
  or retired.
• No gains or losses are ever recognized from these
  equity transactions.

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3. Employee Stock Compensation Plans

• Historically, companies granted stock options to
  employees as a means of compensating employees,
  without having to recognize any compensation
  expense.
• Recently, the FASB required compensation expense
  to be recognized on the income statement, based
  on estimated fair value of the option.
• Many companies have been shifting to restricted
  stock plans to compensate and motivate employees.
• The restricted stock plans require a recognition
  of compensation expense, but based on the value
  of the stock at the date of grant (rather than
  fair value at date of full vesting).

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3. Employee Stock Options-History

• Since 1970, APB Opinion 25 allowed the issue of
  employee stock options. When the options were
  granted at the market price at grant date, no
  compensation expense was necessary.
• SFAS No. 123 was issued in 1995, and introduced
  the fair value method for calculating the
  compensation expense relating to employee stock
  options.
• SFAS No. 123 recommended that expense be
  recognized in the income statement, but did not
  require this recognition.
• SFAS No. 123R was issued in 2004, to require the
  recognition of expense in the income statement,
  for public companies whose fiscal year begins
  after June 15, 2005.

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3. Equity Compensation and Expense Recognition

• Should compensation expense from stock options
  and restricted stock plans be recognized in the
  income statement?
• Proponents say yes
• It is a cost to the company of employing the
  workers.
• If the company had issued stock, then paid the
  employees in cash, the amount would have been
  recognized as comp. expense.
• Opponents say no
• The employee is essentially working as an owner
  of the company, and contributing sweat equity
  owners do not receive salary distributions.
• Options and restricted stock are given as work
  incentives, rather than straight compensation.
  Remember the value can go down as well as up
  (unlike traditional compensation).
• These equity grants do not meet the definition of
  an expense. See page 2-12.

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4. Retained Earnings

• We will be expanding the basic retained
  earnings formula in this chapter. Now, the
  Retained Earnings Column of the Statement of
  Stockholders Equity will include the following
• RE, beginning xx
• Add net income xx
• Less dividends
• Cash dividends-common xx
• Cash dividends - preferred xx
• Stock dividends xx
• Property dividends xx
• Less Adjustment for TS transactions xx
• Appropriation of RE xx
• RE, ending xx

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4. RE - Cash Dividends

• Note that stated dividends to preferred
  shareholders must be paid before any dividends
  can be paid to common shareholders (including
  dividends in arrears if cumulative).
• Preferred dividends may be cumulative, which
  means that, if no dividend is declared in the
  current year, they must be caught up (based on
  stated dividend rate) for the preferred
  shareholders in a future year before common
  shareholders get any dividends.
• However, cumulative preferred dividends in
  arrears are not recognized as a liability until a
  dividend is finally declared by the board of
  directors. A company might go for a number of
  years without declaring a dividend, and there is
  no liability until a dividend is actually
  declared.

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4. RE - Property Dividends

• Property dividends are distribution of non-cash
  property by a company to its shareholders. The
  most common type of property dividend is a
  spin-off where the shares of stock of a
  subsidiary are distributed to the shareholders of
  the parent company. This is also called a form of
  carve out, as the company carves out a segment
  and divests it.

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4. Other Carve Outs

• Other forms of carve outs (though not considered
  dividends) are sell-offs and split-offs.
• In a sell-off, the company sells its equity
  interest in the investment/subsidiary to an
  outside party.
• In a split-off, the company sells its equity
  interest in the subsidiary back to the
  subsidiary. Thus the subsidiary is buying back
  its own shares (for treasury or retirement) and
  the parent is no longer an owner.

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4. RE - Stock Dividends

• Stock dividends are distribution of additional
  shares of a companys own stock to its
  shareholders. Note that the distribution of
  additional shares does not result in any value
  being given to the shareholders.
• Example 4 shareholders, each having 10 shares
  of common stock. Each owner has 25 of total
  (10/40). If I give each shareholder 1 additional
  share of stock, each shareholder still owns 25
  of the same company (11/44). Nothing has
  changed, except the number of the pieces of paper.

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4. RE - Stock Dividends

• Large stock dividends (gt 25 of the outstanding
  common shares) are recorded at par value.
• The transfer is out of retained earnings and into
  common stock (no cash is involved). Note that the
  total effect on stockholders equity is zero.
  However, retained earnings decreases and common
  stock increases by the par value of the stock
  dividend.
• Small stock dividends (lt 25 of the outstanding
  common shares) are recorded at market value.
  Since small stock dividends are rare, we will not
  discuss here.

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Stock Splits

• Stock splits are commonly declared by a company
  to reduce its market price per share. This makes
  the stock more accessible to small investors.
• The process for stock splits is that the old
  stock is voided, and new shares are granted with
  a new description.
• The total par value of the new shares is equal to
  the total par value of the old shares, but the
  number of shares (and par value per share changes.

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Example of Stock Split

• IZM Company has 100,000 shares of 2 par value
  stock authorized, 10,000 shares issued and
  outstanding.
• The SE section of the balance sheet shows
• Common stock 20,000
• Retained earnings 80,000
• The market price of the outstanding shares is 50
  per share before the split is distributed.

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Example of Stock Split

• If IZM declared a 2 for 1 stock split, the old
  shares would be voided and new shares would be
  issued with the following description
• Common stock, 1 par value, 200,000 shares
  authorized, 20,000 shares issued and outstanding.
  
• The total SE is still 100,000
• Common stock 20,000
• Retained earnings 80,000
• The market price per outstanding share would now
  be 25 per share.
• Note No journal entry is necessary.

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4. Stock Dividends vs Stock Splits

• Going back to the original IZM information.
  Assume instead that IZM declared a 100 stock
  dividend.
• First, total par value for new shares (10,000
  shares x 100 10,000 new shares x 2 per share
  20,000)
• Transfer 20,000 from Retained Earnings to the
  Common Stock account.

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4. Stock Dividends vs Stock Splits

• Now note the new description for the stock
  dividend
• Common stock, 2 par value, 100,000 shares
  authorized, 20,000 shares issued and outstanding
• The total value in SE is still 100,000, but
• Common Stock 40,000 (up 20,000)
• Retained Earnings 60,000 (down 20,000)
• Note that the total market price per share would
  change to 25 per share.
• Thus, a 2 for 1 stock split and a 100 stock
  dividend have the same effect on
• total stockholders equity and
• market price per share

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4. Stock Dividends vs Stock Splits

• However, a stock dividend requires a journal
  entry, which changes the components of SE (RE and
  CS).
• A stock split changes the description of the
  shares, including the par value per share.
• Many companies use a stock split to change the
  market price per share, but about half of the
  companies use the large stock dividend to achieve
  the same result. This action is called a stock
  split effected in the form of a dividend.

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4. Stock Dividends vs Stock Splits

• To summarize the effects on IZM Company
• 100 Stock 2 for 1
• After Dividend Stock Split
• Total sh. outstanding 20,000 sh. 20,000 sh.
• Par value per share 2 1
• Market price per share 25 25
• Total stockholders eq 100,000 100,000
• General ledger results
• CS account 40,000 20,000
• RE account 60,000 80,000
• Reminder CS was 20,000 and RE was 80,000
  before the split or dividend ( see slide 35).
  Since the stock dividend required journal entries
  (see slide 36), the amounts for CS and RE
  changed. Since the stock split does not require
  a journal entry, the amounts for CS and RE do not
  change.

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4. RE - Appropriations

• Companies may choose to restrict a portion of
  their RE for dividend payout.
• Reasons for this restriction may include
  activities such as plans for corporate expansion
  or plans for the retirement of debt.
• The restriction does not create a cash balance
  for these plans. It simply indicates intentions.
• The restriction, or appropriation may be
  indicated through disclosure, or through a
  reclassification of retained earnings.

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5. Other Comprehensive Income

• Comprehensive Income is a term that was defined
  in the Statements of Financial Accounting
  Concepts (SFAC 6).
• It consists of all non-owner changes in equity.
  This includes net income as we have been defining
  revenues and expenses throughout the semester,
  and it also includes Other Comprehensive
  Income.

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5. Other Comprehensive Income

• Other Comprehensive Income (OCI) includes
  certain direct equity adjustments that are not
  part of the current income statement, but which
  may have eventual effect on income.
• The amount is recorded in OCI, until the effect
  is transferred to the income statement.

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5. Other Comprehensive Income

• One of the items in Other Comprehensive Income is
  the Cumulative Translation Adjustment.
• This adjustment occurs when a company owns a
  foreign subsidiary, and must translate the
  foreign subsidiary to U. S. dollars before
  consolidating.
• The adjustment would only be realized as part of
  the income statement if the foreign subsidiary
  was sold or liquidated for U.S. dollars.
• The adjustment can be an increase or decrease,
  depending on the cumulative direction of change
  in the exchange rate.

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5. Other Comprehensive Income

• Other items in Other Comprehensive Income
  include
• Unrealized Gain/Loss on Available-for-Sale
  Investments. These long term investments are
  allowed to revalue each period up or down to
  market. The revaluation causes a gain or loss to
  be recognized (it is unrealized since the
  investment has not been sold).
• However, since the investment is long-term, the
  gain or loss is NOT recognized in the income
  statement. Instead, it is recognized
  cumulatively in OCI, until the investment is
  finally sold.
• Similar treatment is given to certain kinds of
  derivatives (a special form of investments).

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5. Other Comprehensive Income

• One other item that will be discussed comes from
  a recent standard (SFAS 158), and is part of the
  new requirement by FASB to fully recognize all
  pension assets and liabilities in the balance
  sheet.
• However, FASB allows companies to defer
  recognition of a portion of the pension
  components, and spread the effects over future
  periods. These components (costs, losses, and
  gains) are deferred to OCI, until they are
  recognized in future income. (More in Module 10.)
• In the past, some companies recognized an OCI
  adjustment for Minimum Liability, but this
  requirement is no longer in effect (ignore
  comment in your text).

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6. Statement of Stockholders Equity

• In this chapter, we have discussed the Statement
  of Retained Earnings as the link between the
  balance sheet and the income statement.
• However, earlier chapters introduced the
  Statement of Stockholders Equity, which has
  become the default statement for large companies
  in recent years.
• The Statement of Stockholders Equity details the
  change in retained earnings, including all the
  changes discussed in this chapter, and it also
  shows the change during the year in all of the
  stockholders equity accounts.

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Example of Statement of SE (in thousands)

• CS PS APIC RE OCI TS
• Balance 1/1/10 200 50 400 400
• Net income 250
• Cash dividends (40)
• Stock dividends 200 (200)
• Purchase of TS (40)
• Reissue of TS ( 1) 10
• Revalue AFS Invest. 12
• Balance, 12/31/10 400 50 400 409
  12 (30)
• CS common stock
• PS preferred stock
• APIC additional paid-in capital
• RE retained earnings
• OCI other comprehensive income and
• TS treasury stock.

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7. Convertible Securities

• Certain types of stocks and bonds may affect
  stockholders equity.
• Preferred stock may be issued with a convertible
  privilege, which allows investors to convert to
  common stock at a predetermined ratio. This
  conversion is usually recorded at book value of
  the preferred stock, and no cash is required in
  the exchange.
• Convertible bonds allow the investor to convert
  the bonds to common stock at a predetermined
  ratio. The conversion is similar to that for
  preferred stock, but in this case, liabilities go
  down and equity goes up.
• These convertible securities will have an effect
  on earnings per share calculations, particularly
  diluted earnings per share (see Module 5).