Understanding Stockholders' Equity and Rights

1. Chapter 11 Stockholders’ Equity

2. Learning Objectives After studying this chapter, you should be able to: • Describe the rights of shareholders. • Differentiate among authorized, issued, and outstanding shares. • Contrast bonds, preferred stock, and common stock. • Identify the economic characteristics of and accounting for stock splits.

3. Learning Objectives After studying this chapter, you should be able to: • Account for both large-percentage and small-percentage stock dividends. • Explain and report stock repurchases and other treasury stock transactions. • Record conversions of debt for equity or of preferred stock into common stock. • Use the rate of return on common equity and book value per share.

4. 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

5. 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

6. Background onStockholders’ Equity • Preemptive rights - the rights to acquire a pro rata amount of any new issues of capital stock • When companies issue new stocks, many new owners may be added. In this case, the old owners’ percentage of ownership decreases. • The preemptive right allows current owners to purchase shares directly from the corporation, in a pro rata amount, to keep their percentage of ownership the same.

7. 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.

8. 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

9. 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.

10. 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

11. Accounting for Stock Issuance Alex 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.

12. 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.

13. 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.

14. 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

15. 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

16. 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.

17. 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.

18. 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

19. Cumulative Dividends Hobson Company has 10,000 shares of $4 cumulative preferred stock outstanding (preferred shareholders are entitled to $40,000 in dividends each year). The company paid the following amounts of dividends. Year 1 -0- Year 2 25,000 Year 3 125,000 How are the dividends distributed to preferred and common shareholders?

20. Cumulative Dividends Total Preferred Common Year Dividends Dividends Dividends 1 $ -0- $ -0- $ -0- 2 25,000 25,000† -0- 3 125,000 95,000* 30,000 †Since no dividends were paid in year 1, preferred shareholders receive all dividends declared until they have received what they are entitled to for all years before the common shareholders receive any dividends. *Remaining in arrears from year 1 $15,000 Arrears for year 2 40,000 Current for year 3 40,000 $95,000 ==============

21. 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.

22. Other Features of Preferred Stock • Participating - a characteristic of preferred stock that provides increasing dividends when common dividends increase • If preferred stock is nonparticipating, the preferred stockholders receive dividends first, but that is all they will receive; they get nothing more than the amount stated. • The participation feature allows preferred stockholders to get more dividends if enough is declared and specified conditions are met.

23. Other Features of Preferred Stock • Callable - a characteristic of bonds or preferred stock that gives the issuer the right to redeem the security at a fixed price • The stock is bought back at a call price, or redemption price, which is usually set high enough to compensate stockholders for the fact that the stock can be automatically bought back at any time at the issuer’s choice.

24. Other Features of Preferred Stock • Convertible - a characteristic of bonds or preferred stock that gives the holder the right to exchange the security for common stock at a specified price • Because the ability to convert the stock can be very valuable if common stock prices rise, the dividend rate is usually somewhat lower.

25. 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.

26. 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.

27. 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.

28. 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.

29. Stock Options • Stock options - special rights usually granted to executives to purchase a corporation’s capital stock in the future at a specified price • Measurement of the value of the options is difficult because executive stock options are not sold to the general public, so no market value is readily available for use as a guide. • Currently, options are given a zero value as long as the option price is the same as the market price at the date of the grant.

30. Stock Options • Since no value is assigned to the options at the date of grant, no journal entry is required. • However, the number and types of options outstanding and an assessment of their value must be included in the notes to the financial statement.

31. Stock Options A company has outstanding options to purchase 100,000 shares of $5 par common stock at a price of $10 per share. The options can be exercised over the next 10 years. The date of grant: No entry required The options are exercised in the 7th year following the grant: Cash 1,000,000 Common stock 500,000 Additional paid-in capital 500,000

32. Stock Options • Significant debate about stock options has arisen recently. • Some argue that when a company grants an option, it gives something of value in exchange for services rendered, so options should be recorded as an expense when granted. • Others argue that recording options as an expense and as income to the executives would undermine the markets and entrepreneurship. • The FASB simply requires measurement using one of several techniques and disclosure of the values to stockholders.

33. 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.

34. 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.

35. 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?

36. Accounting for Stock Splits Before 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.

37. 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.

38. 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.

39. 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

40. Large-Percentage Stock Dividends • Large-percentage stock dividends are accounted for at the par or stated value of the stock. • An entry is made to transfer the par or stated value of the new shares from Retained Income to the Common Stock account. Retained income (# shares x par value) xxx Common stock xxx

41. Large-Percentage Stock Dividends • The market value of the stock is now split between the old shares and the new shares. • This effectively reduces the market price per share, but the total market value remains unchanged. • The proportional ownership of shares does not change because the stock is distributed proportionally based on ownership. • The dividend per share is decreased proportionally, however.

42. 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.

43. 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

44. 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.

45. Relation of Dividends and Splits • Companies use large-percentage stock dividends to accomplish the same thing as a stock split. • The market price is reduced, and the total amount of dividends distributed to the stockholders is increased. • Stock dividends are often used to save clerical costs. • It is cheaper to issue new stock certificates at the original par value than it is to reissue all new stock certificates with new par values.

46. Fractional Shares • Corporations issue shares in whole units, but sometimes stockholders are entitled to fractional units of shares. • If fractional units must be distributed, the company would issue the whole number of shares in stock, and the fractional units will be issued as a cash dividend.

47. The Investor’s Accounting for Dividends and Splits • The accounting by the investor is basically opposite that of the corporation. • Stock split or large-percentage stock dividend - no entry; memo giving details of the stock split or stock dividend • Cash dividend - entry recording the receipt of cash and the recognition of dividend income • Small-percentage stock dividend - no entry; memo disclosing the increase in the number of shares owned and the related decrease in the market value per share of the stock

48. 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.

49. 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.

50. 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.