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Chapter 13 Stockholders’ Equity

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Chapter 13Stockholders’

Equity

Learning Objectives

1. Identify the characteristics of a corporation

2. Journalize the issuance of stock

3. Account for the purchase and sale of treasury stock

4. Account for cash dividends, stock dividends, and stock splits

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Learning Objectives

5. Explain how equity is reported for a corporation

6. Use earnings per share, rate of return on common stock, and the price/earnings ratio to evaluate business performance

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Learning Objective 1

Identify the characteristics of a corporation

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What Is a Corporation?

• A corporation is a business organized under state law that is a separate legal entity.

• Corporations dominate business activity in the United States.

• Most well-known companies are corporations.

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Characteristics of Corporations

• Unique characteristics of corporations:– Separate legal entity– Number of owners– No personal liability of the owner(s)– Lack of mutual agency– Indefinite life– Taxation– Capital accumulation

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Characteristics of Corporations

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Stockholders’ Equity Basics

• The maximum number of shares of stock a corporation may issue is called authorized stock.

• Issued stock has been issued by the corporation.

• Stock held by the stockholders is called outstanding stock.

• Stockholders are issued stock certificates. • Capital stock represents a stockholder’s

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Stockholders’ Equity Basics

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Stockholders’ Equity Basics

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Stockholders’ Rights

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• A stockholder has four basic rights:1. Vote: Each share of basic ownership in the

corporation carriers one vote. 2. Dividends: Stockholders receive a

proportionate part of any dividend declared and paid.

3. Liquidation: Stockholders receive their proportionate share of any assets remaining after liquidation.

4. Preemptive right: Stockholders have a right to maintain their proportional ownership.

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Capital Stock

• Corporations issue different classes of stock:– Common stock– Preferred stock

• Stock may carry a par value or may be no-par stock.

• Stated value stock is no-par stock that has been assigned an amount similar to par value.

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Stockholders’ Equity

• A corporation’s equity is called stockholders’ equity.

• The two basic sources of stockholders’ equity are: – Paid-in capital– Retained earnings

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Learning Objective 2

Journalize the issuance of stock

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How Is the Issuance of Stock Accounted For?

• Companies raise capital by issuing stock. • A company can sell its stock directly to

stockholders, or it can use the services of an underwriter.

• Stocks of public companies are bought and sold on a stock exchange, such as the New York Stock Exchange (NYSE) or NASDAQ Stock Market.

• The issue price is the amount a corporation receives from issuing stock.

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Issuing Common Stock at Par Value

• Smart Touch Learning’s common stock carries a par value of $1 per share, and the charter authorizes 20,000,000 shares of common stock. The stock issuance of 15,000 shares of stock at par value is recorded as:

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Issuing Common Stock at a Premium

• Smart Touch Learning issues an additional 3,000 shares for $5 per share. The $4 difference between the issue price ($5) and the par value ($1) is a premium, recorded in Paid-in Capital in Excess of Par.

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Issuing Common Stock at a Premium

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Issuing No-Par Common Stock

• Smart Touch Learning’s common stock is no-par. Assume the company issues 15,000 shares for $1 and 3,000 shares for $5.

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Issuing No-Par Common Stock

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Issuing Stated Value Common Stock

• Smart Touch Learning issues 3,000 shares of $1 stated value stock for $5 per share. Accounting for stated value stock is similar to accounting for par value stock.

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Issuing Common Stock for Assets Other Than Cash

• Smart Touch Learning receives furniture with a market value of $18,000 in exchange for 5,000 shares of its $1 par common stock. It is recorded at the market value of the stock issued or of the asset received, whichever is more determinable.

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Issuing Preferred Stock

• Smart Touch Learning issues 1,000 shares of its $50 par, 6% preferred stock on January 3, 2017, at $55 per share.

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Issuing Preferred Stock

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Learning Objective 3

Account for the purchase and sale of treasury stock

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How Is Treasury Stock Accounted For?

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• Treasury stock is a company’s stock that it has previously issued and later reacquired.

• Companies purchase treasury stock to:– Increase net assets by buying low and selling

high– Support the company’s stock price– Avoid a takeover– Reward valued employees with stock

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Treasury Stock Basics

• The basics of accounting for treasury stock:– The Treasury Stock account has a normal debit

balance. Treasury Stock is a contra equity account.

– Treasury stock is recorded at cost, without reference to par value.

– The Treasury Stock account is reported beneath Retained Earnings on the balance sheet as a reduction to equity.

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Purchase of Treasury Stock

• On March 31, Smart Touch Learning purchased 1,000 shares of previously issued common stock, paying $5 per share.

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Sale of Treasury Stock

• Smart Touch Learning sells 100 of the treasury shares on April 1 for $5 each.

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Sale Above Cost

• Smart Touch Learning resold 200 of its treasury shares for $6 per share on April 2. (Recall the cost was $5 per share.)

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Sale Below Cost

• On April 3, Smart Touch Learning resold 200 treasury shares for $4.30 each.

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Sale Below Cost

• What happens if Smart Touch Learning resells an additional 200 treasury shares for $4.50 each on April 4?

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Sale of Treasury Stock

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Learning Objective 4

Account for cash dividends, stock dividends, and stock splits

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How Are Dividends and Stock Splits Accounted For?

• A profitable corporation may make distributions to stockholders in the form of dividends.

• Dividends can be paid in the form of cash, stock, or other property.

• Legal capital refers to the portion of stockholders’ equity that cannot be used for dividends.

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Cash Dividends

• Three dividend dates are relevant:

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Declaration date •The board of directors announces the intention to pay the dividend, and a liability is created.

Date of record •This is the date the corporation records the stockholders that will receive dividend checks.

Payment date •This is the date the dividend is paid to the stockholders.

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Declaring and Paying Dividends – Common Stock

• On May 1, Smart Touch Learning declares a $0.05 per share cash dividend on 22,700 outstanding shares of common stock.

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Declaring and Paying Dividends – Common Stock

• On May 15, the date of record, no journal entry is recorded. On May 30, Smart Touch Learning pays the dividend to its shareholders.

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Declaring and Paying Dividends – Preferred Stock

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• A preferred stock dividend in arrears is a dividend that has not been paid for the year.

• Preferred stock can be:– Cumulative preferred stock– Noncumulative preferred stock

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Declaring and Paying Dividends – Preferred Stock

• Suppose Greg’s Games’ preferred stock is cumulative and in 2016 the business did not pay any cash dividends.

• Greg’s Games must first pay preferred dividends of $3,000 (1,000 shares × $50 per share × 6%) for 2016 and $3,000 for 2017.

• Assume on September 6, 2017, Greg’s Games declares a $50,000 total dividend.

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Declaring and Paying Dividends – Preferred Stock

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Stock Dividends

• A stock dividend is a distribution of a corporation’s own stock to its shareholders.

• Stock dividends have the following characteristics:– They affect only stockholders’ equity

accounts. – They have no effect on total stockholders’

equity. – They have no effect on assets or liabilities.

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Why Issue Stock Dividends?

• A company issues stock dividends in order to:– Continue dividends but conserve cash– Reduce the market price per share of its stock– Reward investors

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Recording Stock Dividends

• There are three dates for a stock dividend:– Declaration date– Record date– Distribution date

• A small stock dividend is less than 20% to 25% of issued and outstanding stock.

• A large stock dividend is greater than 20% to 25% of issued and outstanding stock.

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Recording Stock Dividends

• Greg’s Games distributes a 5% common stock dividend on 2,000,000 shares issued and outstanding when the market value is $50 per share. Greg’s Games will issue 100,000 (2,000,000 × 0.05) shares to its stockholders.

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Recording Stock Dividends

• On February 25, Greg’s Games distributes the common stock and records the following:

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Recording Stock Dividends

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Stock Splits

• A stock split is fundamentally different from a stock dividend.

• A stock split increases the number of issued and outstanding shares of stock.

• A stock split decreases the par value and the market value per share, whereas stock dividends do not affect par value per share.

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Cash Dividends, Stock Dividends, and Stock Splits Compared

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Learning Objective 5

Explain how equity is reported for a corporation

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How Is Equity Reported for a Corporation?

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• The statement of retained earnings reports how the company’s retained earnings balance changed from the beginning of the period to the end of the period.

• Companies can report a negative amount in retained earnings. This is called a deficit.

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Statement of Retained Earnings

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Appropriations of Retained Earnings

• Cash dividends and treasury stock purchases require a cash payment.

• Banks often require a company to maintain a minimum level of stockholders’ equity.

• Appropriations of retained earnings are retained earnings restrictions recorded by journal entries.

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Prior-Period Adjustments

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• Occasionally a company may make an accounting error as a result of mathematical mistakes or other errors not discovered until the following period.

• Corrections to Retained Earnings for errors of an earlier period are called prior-period adjustments.

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Prior-Period Adjustments

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Statement of Stockholders’ Equity

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Learning Objective 6

Use earnings per share, rate of return on common stock, and the price/earnings ratio to evaluate business performance

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How Do We Use Stockholders’ Equity Ratios to Evaluate Business Performance?

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• Investors are constantly comparing companies’ profits.

• Three important ratios used for comparison are:– Earnings per share (EPS)– Rate of return on common stock– Price/earnings ratio

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Earnings per Share

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• The final segment of a corporate income statement reports the company’s earnings per share (EPS).

• EPS is the most widely used of all business statistics.

• EPS reports the amount of net income (loss) for each share of the company’s outstanding common stock.

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earnings per share

• Green Mountain Coffee Roasters, Inc., Fiscal 2013 Annual Report reports the following amounts:

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• Green Mountain Coffee Roasters, Inc., earnings per share for 2013 is computed as follows:

Price/Earnings Ratio

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• The price/earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings per share.

• This ratio tells investors how much they should be willing to pay for $1 of a company’s earnings.

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Rate of Return on Common Stock

• Rate of return on common stockholders’ equity, often shortened to return on equity, shows the relationship between net income to common stockholders and their average common equity invested in the company.

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