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Chapter 12: Stockholders’ Equity

Chapter 12: Stockholders’ Equity. 1. Debt versus equity 2. Preferred stock 3. Common stock 4. Accounting for preferred and common 5. Treasury stock 6. Stock options 7. Retained earnings - dividends - appropriations - prior period adjustments 8. Comprehensive income

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Chapter 12: Stockholders’ Equity

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  1. Chapter 12:Stockholders’ Equity

  2. 1. Debt versus equity 2. Preferred stock 3. Common stock 4. Accounting for preferred and common 5. Treasury stock 6. Stock options 7. Retained earnings - dividends - appropriations - prior period adjustments 8. Comprehensive income 9. Statement of stockholders’ equity Chapter 12: Stockholders’ Equity

  3. DebtEquity Formal legal contract No legal contract Fixed maturity date No fixed maturity date Fixed periodic payments Discretionary dividends Security in case of default Residual asset interest No voice in management Voting rights - common Interest expense deductible Dividends not deductible Double taxation 1. Debt versus Equity

  4. 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 2. Preferred Stock

  5. 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 3. Common Stock

  6. 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. 4. Accounting for Common Stock (CS) and Preferred Stock (PS)

  7. Issue PS at greater than par value: Cash xx mkt. value Preferred Stock xx total par APIC - PS xx excess(plug) Issue CS at greater than par value: Cash xx mkt. value Common Stock xx total par APIC - CS xx excess(plug) Note: most states do not allow companies to issue at less than par value. 4. Journal Entries

  8. Issue no par common stock: Cash xx mkt. value Common Stock xx mkt. value 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 (yellow handout) illustrates many of the components of SE discussed in this chapter. 4. Journal Entries -continued

  9. Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 Common stock dividends distributable 2,000 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 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income items (unrealized loss on AFS securities) (2,000) Total Stockholders’ Equity $131,000 Sample Co. Stockholders’ Equity

  10. Now, using Sample Company information, record the following additional issues of common and preferred stock: Issued 100 shares of PS at $102 per share: Cash (100 x $102) 10,200 PS (100 x $100 par) 10,000 APIC - PS (plug) 200 Issued 500 shares of CS at $5 per share: Cash (500 x $5) 2,500 CS (500 x $1 par) 500 APIC - CS (plug) 2,000 4. Journal Entries-Sample Co.

  11. 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. 5. Treasury Stock

  12. 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. 5. Treasury Stock - continued

  13. There are two techniques for recording TS transactions (Par Value method and Cost method). We will use only the Cost method. This technique establishes a “cost” for TS equal to the amount paid to acquire the TS. Par value is notused for TS transactions. To record purchase of TS from market: TS xx “cost” Cash xx market (cost equals the cash paid) 5. Treasury Stock(TS) - Journal Entries

  14. To reissue TS to market at greater than cost: Cash xx market APIC - TS xx over cost TS xx cost To reissue TS to market at less than cost: Cash xx market APIC - TS xx if available Retained Earnings xx if needed* TS xx cost *debit RE if no APIC-TS available to absorb the remaining debit difference. 5. Treasury Stock(TS) - Journal Entries

  15. Look again at the information for Sample Co. Note that Sample Company has 5,000 shares of TS at a total cost of $6,000, or a cost of $1.20 per share. The journal entry to record that purchase would have been: TS 6,000 Cash 6,000 Note that Sample Company also has APIC - TS of $2,000 in the balance sheet. This must be from previous TS transactions, where the TS was purchased, then reissued for more than original cost. All that remains of those transactions is the APIC -TS. 5. TS Example from Sample Co.

  16. Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 Common stock dividends distributable 2,000 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 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income items (unrealized loss on AFS securities) (2,000) Total Stockholders’ Equity $131,000 Sample Co. Stockholders’ Equity

  17. Tiger Corporation has 100,000 shares of $1 par value stock authorized, issued and outstanding at January 1, 2005. The stock had been issued at an average market price of $5 per share, and there have been no treasury stock transactions to this point. Assume that, in February of 2005, Tiger Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2005, Tiger Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2005, Tiger Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2005 regarding the treasury stock. 5. TS - Example Problem

  18. Feb: repurchase 10,000 sh. @ $7 = $70,000. July: reissue 2,000 sh @ $ 8 = $16,000 (cost = 2,000 @ $7 = 14,000) 5. TS Example -Journal Entries

  19. Dec: reissue 8,000 sh. @ $ 6 = $48,000 (cost = 8,000 sh.@ $7 = 56,000) Now we need to debit one or more accounts to compensate for the difference. (1) debit APIC -TS (but lower limit is to -0-). (2) debit RE if necessary for any remaining balance (this is only necessary when we are decreasing equity). 5. TS Example -Journal Entries

  20. Stock options represent the right of the holder to purchase common stock at a designated price, and during a designated time frame. Stock options are given to employees as a means of compensation. Historically, two kinds of employee stock options (compensation is defined at the date of grant): compensatory, because the exercise price is below the market price at the date of grant. noncompensatory, because the exercise price is equal to the market price at the date of grant . 6. Employee Stock Options

  21. APB Opinion 25 states that “compensation” is measured at the date of grant (market price - exercise price), and any difference is allocated to compensation expense over the life of the option. If there is no difference, there is no comp. expense. The APB Opinion 25 method is known as the intrinsic value method, because it measures the value of the stock options at the date of grant (the intrinsic value at inception). This method has been the default method for recording employee stock options, even after SFAS 123 (discussed later) was issued. 6. Employee Stock Options

  22. Given the following information: Em Company adopted a stock option plan that granted options to employees to purchase 30,000 shares of the company’s $10 par value common stock. The options were granted on January 2, 2005, and were exercisable 2 years after the date of grant if the employee was still employed at the company. The exercise price was set at $40 in the option contract. At the date of exercise January 2, 2007, the market price was $80 per share. 6. Stock Options- APBO 25

  23. Illustration 1 (intrinsic value method): Assume the market price at the date of grant was $45 per share. Therefore, the stock options are compensatory, and total compensation expense is measured as: $45 mkt - $40 exercise = $5 per share x 30,000 shares = $150,000. Since total compensation expense = $150,000, we will recognize it over the life of the option (150,000 / 2 = $75,000 per year). For 2005: Compensation expense 75,000 APIC - stock options 75,000 For 2006: Compensation expense 75,000 APIC - stock options 75,000 6. Stock Options - Illustration 1

  24. Note that, for the previous entries, the company is not paying the employees with cash, it is paying the employees with the promise of equity. Also, the employee is contributing time in exchange for future equity (thus the credit to APIC as the employee “pays in” time). Now, when the options are exercised at Jan. 2, 2007, at the exercise price of $40 per share: Cash ($40 x 30,000) 1,200,000 APIC - stock options 150,000 Common stock ($10 x 30,000) 300,000 APIC - common stock (plug) 1,050,000 Note that, even though the market price of the stock at 1/2/07 is $80 per share, the transaction is recorded at the market price at the date of grant ($45 per share). The company never recognizes the additional “value” that it has given to the employees. 6. Stock Options - Illustration 1

  25. Illustration 2 (intrinsic value method): Assume the market price at the date of grant was $40 per share. Therefore, the stock options are noncompensatory, and total compensation expense is measured as:$40 mkt - $40 exercise = -0- (Since total compensation expense = -0-, no expense is recognized on the options, not now, not ever.) For 2005 Compensation expense -0- APIC - stock options -0- For 2006: Compensation expense -0- APIC - stock options -0- 6. Stock Options - Illustration 2

  26. Now, when the options are exercised at Jan. 2, 2007, at the exercise price of $40 per share Cash ($40 x 30,000) 1,200,000 APIC - stock options -0- Common stock ($10 x 30,000) 300,000 APIC - common stock (plug) 900,000 Most stock options have been issued as “noncompensatory” at the date of grant, primarily to avoid the recognition of compensation expense. Note that, even though the market price of the stock at 1/2/07 is $80 per share, the transaction is recorded at the market price at the date of grant ($40 per share). The company never recognizes the additional “value” that it has given to the employees. 6. Stock Options - Illustration 2

  27. In 1993 (its second attempt), the FASB tried to rectify the lack of recognition of compensation expense in the financials for “noncompensatory” options. It proposed that companies “estimate” the present value of the future cash flows that was being promised to employees, then recognize that estimate as compensation expense over the life of the contract. There were many protests, particularly in the high tech industry, where employment and growth were tied heavily to stock options. 6. Stock Options and SFAS No. 123

  28. The FASB eventually modified the standard, so that SFAS 123 recommended recognition of expense in the financial statements for noncompensatory (as well as compensatory) stock option plans. However, it allowed companies to continue using the APB Opinion 25 method for recording expense in the financials. The SFAS 123 technique is known as the fair value method. Illustration 3 shows the recommended journal entries using SFAS 123. 6. Stock Options and SFAS No. 123

  29. Illustration 3 (fair value method): Assume the market price at the date of grant was $40 per share, and the stock options are, therefore, noncompensatory. However, compensation expense is estimated using the Black-Scholes option pricing model (other models are acceptable), and the present value of the estimated total compensation expense (based on the projected market price at exercise) is $200,000. 6. Stock Options - Illustration 3

  30. Basically, the pricing model assumes a number of factors which could affect the growth in the price of the stock, and also incorporates probabilities for the number of employees that would actually exercise the option. Since total compensation expense = $200,000, we will recognize it over the life of the option ($200,000 / 2 = $100,000 per year). 6. Stock Options - Illustration 3

  31. For 2005: Compensation expense 100,000 APIC - stock options 100,000 For 2006: Compensation expense 100,000 APIC - stock options 100,000 Jan. 2, 2007: Cash ($40 x 30,000) 1,200,000 APIC - stock options 200,000 Common stock ($10 x 30,000) 300,000 APIC - common stock (plug) 1,100,000 Note that, even though the market price of the stock at 1/2/07 is $80 per share, the transaction is recorded at the PV of the estimated future price at the date of exercise ($46.67 per share). The company never recognizes the additional “value” that it has given to the employees. 6. Stock Options - Illustration 3(SFAS 123: recommended journal entries)

  32. However, if companies chose not to recognize the expense in the income statement, SFAS 123 also required that companies disclose the “pro forma” effect on net income, as if the estimated compensation expense had been recognized. Since the issue of SFAS 123, most companies have chosen to disclose, rather than accrue, compensation expense. The disclosure helped the financial statement reader to ascertain several things: what income would have been if SFAS 123 had been fully implemented. how much equity the company is promising to the employees. 6. Stock Options and SFAS No. 123

  33. In 2003 and 2004, many companies began voluntarily recording option compensation as an expense on the income statement. There were several reasons, including the desire to be more transparent with shareholders. FASB has approved a standard that will tentatively become effective mid-2005, and will require the recognition of expense through journal entries, using the fair value method. 6. Stock Options and Recent Changes

  34. Should compensation expense be recognized in the financial statements? 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. If companies had to recognize expense, they would stop offering stock options. Options are given as work incentives, rather than straight compensation. Remember: the value can go down as well as up (unlike traditional compensation). 6. Stock Options and Expense Recognition

  35. We will be expanding the basic retained earnings formula in this chapter. Now the Statement of Retained Earnings will include the following: RE, beginning (unadjusted) xx Add/Subtract: Prior period adjustment xx RE, beginning (restated) xx Add: net income xx Less dividends: Cash dividends-common xx Cash dividends - preferredxx Stock dividends xx Property dividends xx Less: Adjustment for TS transactions xx Appropriation of RE xx RE, ending xx 7. Retained Earnings

  36. As cash dividends are declared: Dividends (RE) - common xx Dividends (RE)- preferred xx Dividends Payable xx As cash dividends are paid: Dividends Payable xx Cash xx 7. RE - Cash Dividends

  37. 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. 7. RE - Cash Dividends

  38. 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. As property dividends are declared: Property Dividends (RE) xx Property Div. Payable xx As property dividends are distributed: Property Div. Payable xx Investment xx 7. RE - Property Dividends

  39. Stock dividends are distribution of additional shares of a company’s 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. 7. RE - Stock Dividends

  40. Large stock dividends (> 25% of the outstanding common shares) are recorded at par value. As stock dividends are declared: Stock Dividends (RE) xx par Stock Div. Distributable xx par As stock dividends are distributed: Stock Div. Distributable xx par Common Stock xx par Note that Stock Dividends Distributable is nota liability, it is another equityaccount (see Sample Company) which indicates that there are additional shares of stock that will be issued but are not currently outstanding. 7. RE - Stock Dividends

  41. Analyze the effect of the transactions on the balance sheet: Stock Dividends (RE) xx - SE Stock Div. Distributable xx + SE As stock dividends are distributed: Stock Div. Distributable xx - SE Common Stock xx + SE 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 (< 25% of the outstanding common shares) are recorded at market value. Since small stock dividends are rare, we will not do journal entries here. 7. RE - Stock Dividends

  42. 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 certificates are turned in, and “new” stock certificates with a new description are issued to the same shareholders. 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. Stock Splits

  43. 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. Example of Stock Split

  44. If IZM declared a 2 for 1 stock split, the old shares would be turned in and newshares 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. Example of Stock Split

  45. Going back to the original IZM information. Assume instead that IZM declared a 100% stock dividend. First, prepare the JEs to record the declaration and distribution of the stock dividend for new shares (10,000 shares x 100% = 10,000 new shares x $2 per share = $20,000): Stock Dividends (RE) 20,000 Stock Div. Distributable 20,000 Stock Div. Distributable 20,000 Common Stock 20,000 7. Stock Dividends vs Stock Splits

  46. 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: Common Stock $40,000 Retained Earnings 60,000 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 7. Stock Dividends vs Stock Splits

  47. 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. Most companies use a stock split to change the market price per share, but some companies use the large stock dividend to achieve the same result. This action is called a “stock split in the form of a dividend.” 7. Stock Dividends vs Stock Splits

  48. To summarize the effects on IZM Company: 100% Stock 2 for 1 After: DividendStock 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 42). Since the stock dividend required journal entries (see slide 44), the amounts for CS and RE changed. Since the stock split does notrequire a journal entry, the amounts for CS and RE do not change. 7. Stock Dividends vs Stock Splits

  49. 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. 7. RE - Appropriations

  50. If reclassification is used, the following journal entry is necessary: RE xx RE-Appropriated xx This entry will create “two” retained earnings in the SE section of the balance sheet. (See page 527 of your text for a full example.) The debit side of the entry reduces “unappropriated” or “unrestricted” RE in the Statement of RE, and the credit side creates a new RE account. Note that the JE does not change total SE, or even change total RE. 7. RE - Appropriations

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