Chapter 10

1. Chapter 10 Stockholders’ Equity

2. Stockholders’ Equity Stockholders’ Equity = Assets - Liabilities Primary Sections of Stockholders’ Equity Paid-in capital Retained Earnings Treasury Stock Amount stockholders have invested in the corporation Amount of earnings the corporation has retained Corporation’s own stock that it has reacquired

3. Part A Invested Capital

4. LO1 Corporations • Articles of incorporation (or corporate charter) describe (a) the nature of the firm’s business activities (b) the shares to be issued (c) the initial board of directors • Corporation’s stockholders control the corporation. By voting their shares, they determine the makeup of the board of directors—which in turn appoints the management to run the corporation.

5. Stages of Equity Financing The progression leading to a public offering might include some or all of these steps: • Investment by the founders of the business. • Investment by friends and family of the founders. • Outside investment by “angel” investors (wealthy individuals in the business community willing to provide investment funds) and venture capital firms (provide additional financing for a percentage ownership in the corporation). • Initial public offering (IPO), the first time a corporation issues stock to the public.

6. Stock trades on a stock exchange such as NYSE, AMEX, NASDAQ; or by over-the-counter (OTC) trading. Corporations regulated by the Securities and Exchange Commission (SEC) Examples - General Motors, Microsoft, Wal-Mart Public or Private Corporations may be either public or private. Private Public • Corporation does not allow investment by the general public and normally has fewer stockholders. • Corporations not regulated by the Securities and Exchange Commission (SEC) and thus, do not need to file financial statements with it. • Examples - Koch Industries (oil and gas), Mars (candy), Cargill (agricultural commodities)

7. Stockholder Rights • Right to Vote—Stockholders have the right to vote on matters that come before the stockholders, including the election of corporate directors. • Right to Receive Dividends—Stockholders have the right to share in profits when the corporation declares dividends. The percentage of shares a stockholder owns determines his or her share of the dividends distributed. • Right to Share in Distribution of Assets—Stockholders share in the distribution of assets if the corporation is liquidated. The percentage of shares a stockholder owns determines his or her share of the assets, which are distributed after creditors and preferred stockholders are paid. • Preemptive Right—The preemptive right allows a stockholder to maintain his or her percentage share of ownership when new shares are issued. Each stockholder is offered the opportunity to buy a percentage of any new shares issued equal to the percentage of shares he or she owns at the time. However, most corporations have dropped this right due to difficulties it causes corporations when they issue new shares.

8. Advantages and Disadvantages of a Corporation

9. Type of StockDefinition Authorized Shares available to sell (issued and unissued) Issued Shares actually sold (includes treasury stock) Outstanding Shares held by investors (excludes treasury stock) Authorized – Unissued = Issued Issued – Treasury Stock = Outstanding LO2 Common Stock If a corporation has only one kind of stock, it usually is labeled as common stock.

10. Par Value The legal capital per share of stock that’s assigned when the corporation is first established Has no relationship to the market value of the common stock Has no significant meaning today NO PAR VALUE common stock that has not been assigned a par value STATED VALUE Treated in the same manner as par value shares

11. Accounting for Common Stock Issues When a corporation receives cash from issuing common stock, it debits cash. If it issues no-par value stock, the corporation credits the equity account entitled common stock. The entry changes slightly if the corporation issues par value stock rather than no-par value stock. In that case, we credit common stock and additional paid-in capital.

12. LO3 Preferred Stock • “Preferred” over common stock • A mixture of attributes somewhere between common stock (equity) and a bond (liability)

13. Accounting for Preferred Stock Issues The entries to record the issuance of preferred stock are similar to those for the issue of common stock.

14. Features of Preferred Stock Flexibility allowed in its contractual provisions. Convertible Redeemable Cumulative Shares can be exchanged for common stock Shares can be returned to the corporation at a fixed price Shares receive priority for future dividends, if dividends are not paid in a given year

15. LO4 Treasury Stock A corporation’s own stock that it has reacquired Why Corporations Repurchase Their Stock • To boost under-priced stock. When corporation management feels the market price of its stock is too low, it may attempt to support the price by decreasing the supply of stock in the marketplace. • To distribute surplus cash without paying dividends. While dividends usually are a good thing, investors do pay personal income tax on them. Another way for a firm to distribute surplus cash to shareholders without giving them taxable dividend income is to use the excess cash to repurchase its own stock. • To boost earnings per share. Stock repurchases reduce the number of shares outstanding, thereby increasing earnings per share. However, with less cash in the corporation, it’s more difficult for companies to maintain the same level of earnings following a share repurchase. • To offset issuance of shares under stock-based compensation plans. Perhaps the primary motivation for stock repurchases is to offset the increase in the number of shares created by employee stock award and stock option compensation programs.

16. Accounting for Treasury Stock Treasury stock is reported as a contra-equity, or negative equity account, since treasury stock reduces total stockholders’ equity. When a corporation repurchases its own stock, it increases, or debits treasury stock. When it sells treasury stock, it decreases, or credits treasury stock. Reissue price Cost

17. Accounting for Treasury Stock What if the stock price goes down and we reissue the treasury stock for less than we paid to buy back the shares? Reissue price Cost

18. Part B Earned Capital

19. LO5 Retained Earnings and Dividends RETAINED EARNINGS • Represents the earnings retained in the corporation – earnings not paid out as dividends to stockholders. • Equals all net income, less all dividends, since the corporation began. • Has a normal credit balance consistent with other stockholders’ equity accounts. • If losses exceed income since the corporation began, retained earnings will have a debit balance and is called an accumulated deficit.

20. Dividends Distributions by a corporation to its stockholders Not paid on treasury shares repurchased by the corporation Investors pay careful attention to cash dividends. DECLARATION DATE Date on which dividend is declared RECORD DATE Date on which the registered owners of stock are determined PAYMENT DATE Date on which the cash dividend is paid

21. Dividends Lets consider the following dividend example Declares a $0.25 per share dividend on its 2,000 outstanding shares March 31 (No entry for Record date)

22. LO6 Stock Dividends and Stock Splits Sometimes, corporations distribute to shareholders additional shares of the companies’ own stock rather than cash. These are known as stock dividends or stock splits depending on the size of the stock distribution. Large stock dividend or stock split (2-for-1) Small stock dividend

23. Stock Dividends Since the corporation’s shares double following a 100% stock dividend, we make an entry to reflect the increase in the par value of the common shares. Small stock dividends are recorded by debiting retained earnings for the market value, rather than the par value, per share.

24. Stock Splits • A stock distribution of 25% or higher, although it’s technically a “large” stock dividend, is more often referred to as a stock split. • A 100% stock dividend is effectively the same as a 2-for-1 stock split, although the accounting for a 100% stock dividend and a 2-for-1 stock split differs. • Make no journal entry to record a stock split. • After a 2-for-1 stock split, the common stock account balance (total par) represents twice as many shares and the par value per share is reduced by one-half.

25. Part C Reporting and Analyzing Stockholders’ Equity APPAREL STORE

26. LO7 Stockholders’ Equity

27. Statement of Stockholders’ Equity Summarizes the changes in the balance in each stockholders’ equity account over a period of time.

28. LO8 Equity Analysis Equity Analysis Return on Equity Price-Earnings Ratio Return on the Market Value of Equity Earnings Per Share

29. Return on Equity Measures the ability of company management to generate earnings from the resources that owners provide.

30. Return on Market Value of Equity To supplement the return on equity ratio, analysts often relate earnings to the market value of equity calculated as the ending stock price times the number of shares outstanding.

31. Earnings Per Share • Measures the net income earned per share of common stock • Useful in evaluating the earnings performance of a company over time. • Not useful in comparing earnings performance across companies

32. Price-Earnings Ratio (PE Ratio) • A high PE ratio indicates investors expect future earnings to be higher. • A low PE ratio indicates investors lack of confidence in future earnings growth. GROWTH STOCKS priced high in relation to current earnings VALUE STOCKS priced low in relation to current earnings

33. Appendix Equity Investments

34. Investor’s equity ownership and influence 0% 20% 50% 100% Insignificant influence Significant influence Controlling influence Fair value method Equity method Consolidation method LO9 Investment in Equity Securities The percentage of stock held by the investor provides a guideline in determining the degree of influence Consolidated Financial Statements

35. Fair Value Method Purchase of Investments Let’s assume we purchase 1,000 shares of Canadian Falcon common stock at $30 per share. The entry to record this transaction is:

36. Fair Value Method Receipt of Dividends If Canadian Falcon pays cash dividends of $0.50 per share, the entry to record receipt of cash dividends on our 1,000 share investment is:

37. Fair Value Method Sale of Investments Above Cost Gains and losses on the sale of equity investments are recorded in the income statement as part of net income. GAIN If the investment sells for more than its cost

38. Fair Value Method Sale of Investments Below Cost Gains and losses on the sale of equity investments are recorded in the income statement as part of net income. LOSS If the investment sells for less than its cost

39. Adjustments to Fair Value At the end of each period, we adjust equity investments to their new fair value. After selling 200 shares, we still hold 800 shares in Canadian Falcon at a cost of $30 per share. If the fair value at the end of the year is $32 per share, we would increase our investment account by $2 per share with the following entry:

40. Adjustments to Fair Value If, one year later, the fair value dropped from $32 to $27 per share, we would decrease our investment account by $5 per share with the following entry: means the investment has not been sold • Comprehensive income is an expansion of net income. • The statement of comprehensive income reports all changes in stockholders’ equity other than those caused by transactions with shareholders.

41. End of chapter 10