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

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

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.

Authorized, Issued, and Outstanding Stock

• Authorized shares - the total number of shares that may legally be issued under the corporation’s articles of incorporation– Not all authorized shares are always issued.

• Issued shares - the aggregate number of shares sold to the public

Authorized, Issued, and Outstanding Stock

• Outstanding shares - shares in the hands of shareholders– Equal to issued shares less treasury stock

• Treasury stock - a corporation’s issued stock that has subsequently been repurchased by the company and not retired– Treasury stock has been issued, but it is no

longer outstanding.

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

Accounting for Stock IssuanceAlex 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.

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.

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.

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

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

Cash Dividends• The amount of cash distributed depends on

several factors such as market expectations, current and predicted earnings, and the corporation’s 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.

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.

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

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.

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 party’s rights and responsibilities.

• Bonds and preferred stock are also similar in the sense that they provide investors with a specific return.

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.

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.

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.

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.

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.

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?

Accounting for Stock SplitsBefore 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.

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.

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.

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

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.

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

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.

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.

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.

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.

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.

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 1,000,000Less: Treasury stock 50,000Total shares outstanding 950,000

=====================

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?

Disposition of Treasury StockRepurchase of the 10,000 shares of treasury stock:Treasury stock (10,000 x $10) 100,000 Cash100,000

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 shareCash 45,000Additional 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.

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.

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.

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.

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.