shareholders' equity chapter 10. corporations a corporation is an entity which is owned by its...

Shareholders' EquityShareholders' Equity

Chapter 10

CorporationsCorporations

• A corporation is an entity which is owned by its shareholders and which raises equity capital by selling shares of stock to investors.

• Each share of stock represents a fractional interest in the issuing company.

• Large business firms prefer to organize as corporations.

• A primary advantage of the corporate form of business organization is the ability to raise large amounts of cash by selling stock to many different individuals and institutions on the major security exchanges.

• Stockholders expect to receive dividends or to earn capital gains on their investment.

• Dividends are distributions of corporate assets, usually cash, to shareholders.

• Capital gains (or losses) occur when the shares of stock increase (or decrease) in price while investors own the shares.

• Each state has laws governing the formation of corporations.

• The state issues to a new corporation a charter which lists various items, among them the businesses’ purpose and the number and types of shares of stock the corporation is allowed to sell.

• The most basic type of ownership is common stock.

• Common shareholders are residual owners of a corporation.

• If a business liquidates, then the order of distribution of assets (if any) is creditors, preferred shareholders, common shareholders.

Shareholders' Equity Shareholders' Equity

• Shareholders' equity, or net assets consists of invested capital and retained earnings.

• Invested capital (usually consisting of par value and paid-in capital) is the amount received by the corporation upon the sale of its stock to investors.

• Retained earnings is the amount of prior earnings that the firm has not paid to shareholders in the form of dividends.

Shares of Stock Shares of Stock

• Shares of stock are classified as authorized, issued, or outstanding.

• Authorized shares are the shares that the firm is permitted to issue according to its corporate charter.

• Issued and outstanding shares are those presently held by investors.

• All issued shares may not necessarily be outstanding.

• The term "issued" means that the shares of stock have at one time been sold into the marketplace but does not necessarily mean that the shares are currently still in the marketplace.

• At times, a business may buy back its own shares from investors in the marketplace.

• For legal purposes, the shares of most firms have a par or stated value.

• Par value is usually a very small amount, such as $.25, and bears no relation whatsoever to the dollar amount for which the shares are selling in the marketplace (called the fair market value).

Transactions Affecting Shareholders' EquityTransactions Affecting Shareholders' Equity

• Three basic transactions account for most of the changes in shareholders' equity.

Transactions Affecting Shareholders' EquityTransactions Affecting Shareholders' Equity

• Sale of stock to investors• Recognition of net income or loss• Declaration of cash dividends to

shareholders

Sale of Stock to Investors Sale of Stock to Investors

• If a corporation sells 100,000 shares of its $1.00 par value common stock for $5.00 per share, then cash and shareholders' equity both increase by $500,000.

• There is a further subdivision within shareholders' equity.

• Par value increases by $100,000 while the remaining $400,000 increases capital in excess of par value.

Sale of Stock to InvestorsSale of Stock to Investors

• The corporation may issue stock for noncash assets, too, such as land or equipment.

Recognition of Periodic Net Income or LossRecognition of Periodic Net Income or Loss

• Net income (loss) represents an increase (decrease) in a firm's shareholders' equity due to its revenues, expenses, gains, and losses during the accounting period.

• Firms prepare statements of retained earnings which are reconciliations of the beginning and ending balance in the retained earnings account.

• The ending balance reflects the net income earned by the firm less net loss incurred and dividends paid over the entire life of the firm.

Declaration and Payment of Cash DividendsDeclaration and Payment of Cash Dividends

• There are three dates which are important in the declaration and distribution of cash dividends.

• On the date of declaration, the dividend becomes a liability.

• Retained Earnings is decreased and Dividends Payable is increased by the amount of the dividend.

• Shareholders who own the stock on the date of record are eligible to receive the dividend.

• Shareholders who purchase the stock after the date of record but before the date of payment buy the stock "ex dividend," which means "without the dividend."

• On the date of payment, both the liability and cash are reduced by the amount of the dividend.

Date of Declaration of DividendsDate of Declaration of Dividends

Date of Payment of Dividends Date of Payment of Dividends

Additional TransactionsAdditional Transactions

• A variety of less frequent occurrences may affect the amount and composition of shareholders’ equity.

Stock DividendsStock Dividends

• Stock dividends are dividends issued to shareholders in the form of shares of stock, not cash.

• A corporation has outstanding 10 million shares of common stock and decides to issue a 2% stock dividend when the market price of the stock is $45 per share.

• The firm will issue 200,000 new shares (10 million shares X 2%), and the total value of the dividend is $9 million (200,000 X $45).

• Retained Earnings will decrease and Invested Capital will increase by $9 million.

• Invested Capital will be further subdivided into par value and capital in excess of par value.

• Only the shareholders' equity section of the accounting equation is affected.

• A dollar amount is transferred from Retained Earnings into Invested Capital.

• Since it is the same dollar amount, nothing happens to the total of shareholders' equity because of the stock dividend.

Stock Dividends Stock Dividends

• A stock dividend gives nothing of present value to the investor when he receives the shares of stock.

• However, the investor now has more shares of stock which can appreciate in price in the future.

Stock SplitsStock Splits

• Stock splits also increase the number of outstanding shares but, unlike dividends, they do not entail a reduction in retained earnings or an increase in paid-in capital.

• The description of the firm's stock is changed to reflect the new par value and the number of shares authorized, issued, and outstanding.

• If a firm had 500,000 shares of $2.00 par value common stock outstanding when the market price was $100 per share, then the following will happen when the firm declares a 2-for-1 stock split.

• The number of shares will double to 1,000,000, the par value will decrease by half to $1.00, and the market price will decrease by half to $50 per share.

• The description of the firm's stock is changed to reflect the new par value and the number of shares authorized, issued, and outstanding.

• The total of invested capital, $1,000,000, will be exactly the same before and after the split.

• Companies often split their stock when the market price becomes so high that small investors cannot afford to buy the stock.

• Companies usually do not like that only large, institutional investors hold their shares.

Treasury StockTreasury Stock

• If a company buys back its own shares of stock, the repurchased shares of stock are called treasury stock.

• They have issued but not outstanding status.

• Companies buy back stock for various reasons.– To support the stock price.– To have available shares for

employee stock option plans.– To take off the market shares which

could be purchased by a hostile buyer.

• Wall Street analysts usually view treasury stock purchases very favorably and as a sign of strength for the repurchasing company.

• The acquisition of treasury reduces cash and shareholders' equity, and treasury stock is a contra-equity account (subtracted from shareholders' equity).

• Consider the following example of the acquisition of treasury stock.

• A corporation has repurchased $6,722,000 of its shares.

• Cash and shareholders' equity have both decreased by $6,722,000.

Purchase of Treasury StockPurchase of Treasury Stock

• If the corporation later sells the same stock for $10 million.

• Cash will increase by $10 million; Treasury Stock will increase by the original $6,722,000; and Paid-in Capital will increase by the difference of $3,278,000.

Sale of Treasury Stock Sale of Treasury Stock

Employee Stock OptionsEmployee Stock Options

• Stock options are rights to purchase a firm's stock at a specific price over some designated future period.

• Stock options are usually granted as part of the compensation paid to key executives and other employees.

• There are several benefits of stock options for employees and firms.

• They usually highly motivate option holders to improve the performance of the firm.

• Option holders avoid the downside risk of loss if the stock price declines.

• Current accounting rules allow firms to choose between two ways to report the cost of employee stock options.

• Under the intrinsic value method, companies do not recognize any compensation expense associated with the options.

• In the year in which options are granted, no compensation expense is recorded.

• When they are exercised, the company increases Cash and Invested Capital for the appropriate dollar amount.

• Under the fair value method, compensation expense is measured at the grant date based on the estimated fair market value of the award.

Exercise of Employee Stock OptionExercise of Employee Stock Option

Preferred StockPreferred Stock

• Preferred stock has a priority claim over common stock with respect to dividends and in the event of a liquidation of a company's assets.

• Preferred stock may be cumulative and/or convertible.

• Cumulative means that any dividend not paid to preferred shareholders will not be forever lost — it will be paid in a year in which the firm has money to pay that dividend.

• Convertible indicates that preferred shares may be exchanged for common shares at the preferred shareholders' option.

Convertible DebtConvertible Debt

• Convertible bonds allow the bondholder to exchange bonds for a specified number of shares of stock.

• Investors usually view this convertibility feature very favorably.

• Convertible bonds are an example of hybrid securities which are neither clearly debt nor clearly equity.

• The proper accounting for hybrid securities is a matter of sharp debate.

Conversion to Common StockConversion to Common Stock

Shareholders’ Equity RatiosShareholders’ Equity Ratios

• Shareholders’ equity is used extensively in ratio analysis of financial statements.

Shareholders’ Equity RatiosShareholders’ Equity Ratios

• Four widely employed measures are used.

Earnings Per Share Earnings Per Share

• Earnings per share indicates the portion of company income applicable to a single share of common stock.

• It is such a highly regarded ratio that it is the only ratio required to be reported on the front of a financial statement (the income statement).

Earnings Per ShareEarnings Per Share

• It is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding.

• Consider the following example to compute the weighted average number of shares.

• A company had outstanding 100,000 shares of stock on January 1.

• On July 1 it issued another 20,000 shares of stock, and on October 1 it bought back 30,000 shares.

• The weighted average number of shares is computed as follows:

Jan. 1 100,000 x 6/12 = 50,000

July 1 120,000 x 3/12 = 30,000

Oct. 1 90,000 x 3/12 = 22,500

102,500

• If net income for the above company is $550,000, then earnings per share is $5.37 (rounded).

• If preferred stock is present in the capital structure, then its dividend must be subtracted from net income before dividing by the weighted average number of common shares.

• Using the same example, if the annual preferred dividend is $30,000, then earnings per share is $5.07 (rounded).

Financial Leverage RatioFinancial Leverage Ratio

• The financial leverage, or debt-to-total-assets ratio is computed by dividing total assets into total liabilities.

• This ratio is widely used by analysts in assessing the risks of debt and equity securities.

• High financial leverage is associated with lower bond quality ratings and, therefore, higher borrowing costs.

• The share prices of highly leveraged firms tend to be more volatile than the share prices of firms with lower financial leverage.

• Just as is true with other ratios, care must be taken when comparing firms in different industries.

Market-to-Book-Value RatioMarket-to-Book-Value Ratio

• The market-to-book-value ratio is computed by dividing book value per share into market price per share.

Market-to-Book-Value RatioMarket-to-Book-Value Ratio

• Market price measures the economic value of the stock while book value reflects the methods used to identify and measure assets and liabilities.

Price-to-Earnings RatioPrice-to-Earnings Ratio

• The price-to-earnings ratio is computed by dividing earnings per share into the market price per share.

• This ratio is often used to assess growth, risk and earnings quality.

• Earnings quality refers to the sustainability of currently reported earnings in future periods.

• Firms using conservative methods of income measurement are more likely to be viewed as having higher earnings quality than firms using more liberal income measurement methods.

Shareholders' EquityShareholders' Equity

End of Chapter 10

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