FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition

1. Chapter 12 – Shareholders’ Equity: Capital Contributions, Earnings, and Distributions FINANCIAL ACCOUNTING AN INTRODUCTION TO CONCEPTS, METHODS, AND USES 10th Edition Clyde P. Stickney and Roman L. Weil

2. Learning Objectives 1. Understand the different priority claims of common and preferred shareholders and the disclosure of those claims in the shareholders’ section of the balance sheet. 2. Understand the underlying concepts and apply the accounting procedures for the issuance of capital stock. 3. Understand why the format for reporting income matters and that different kinds of income require different formats.

3. Learning Objectives (cont.) 4. Understand the distinction between earnings and comprehensive income. 5. Understand the underlying concepts and apply the accounting procedures for cash, property, and stock dividends. 6. Understand the underlying concepts and apply the accounting procedures for the acquisition and reissue of treasury stock. 7. Develop the skills to interpret disclosures about changes in shareholders’ equity account.

4. Chapter Outline 1. Capital Contributions. 2. Issuing Capital Stock. 3. Reporting Operating Transactions. 4. Corporate Distributions. 5. Earnings and Book Value per Share. 6. Disclosure of Changes in Shareholders’ Equity. Chapter Summary 7. Appendix 12.1

5. Capital Contributions 1. Capital Contributions: Corporations issue common or preferred stock to obtain funds to finance operating and investing activities. 2. Operating Transactions: Firms use assets provided by creditors and owners to generate earnings. 3. Distributions: Firms distribute assets to shareholders either as a dividend or as repurchase of common or preferred stock.

6. Review of Important Concepts 1. Shareholders’ equity is a residual interest, representing the shareholders’ claims on the assets of a firm in excess of the claims of creditors. 2. All firms issue common stock. Firms may also issue preferred stock which has a senior but limited claim on assets. 3. Common and preferred stock usually have a par or a stated value. 4. Firms accumulate information about revenues and expenses to support the income statement. Revenues and expenses are closed to retained earnings at the end of the accounting period. 5. Firms may distribute assets to shareholders as a dividend which reduces retained earnings and assets. 6. Retained earnings is the accumulation of earnings reduced by dividends.

7. Capital Contributions • The Corporate form: 1. Limits the liability of owner, 2. Allows for raising funds by issuing shares, 3. Makes transfer of ownership easy in secondary markets. • Financing a corporation: a. Preferred stock. b. Common stock.

8. 1.a. Preferred Shareholders’ Equity • Preferred shareholders generally have a claim on assets that is superior or senior to any claim by common shareholders. • Their claims are often limited so that preferred shareholders look more like creditors than owners. • Some preferred is convertible into common shares. • Firms do not have to issue preferred stock and many firms have not.

9. 1.b. Common Shareholders’ Equity • All corporations have common stock; they need not have preferred stock. • Common shareholders are the residual interest owners; that is, they own everything that is left after all other obligations have been fulfilled. • Balance sheet disclosure includes: 1. Capital contributions 2. Earnings and dividends 3. Accumulated other comprehensive income 4. Treasury share transactions

10. 2. Issuing Capital Stock a. Issue for Cash. b. Issue for non-cash Assets. c. Issue under Option Arrangements. d. Employee Stock Option Plans. e. Stock Rights. f. Stock Warrants. g. Convertible Bonds or Preferred Stock.

11. 2.a. Capital Contributions -- Issue for Cash • A firm needing financing may issue new shares of stock. In return for the shares, the firm gets cash. • This is not disadvantageous to previous owners of shares because even though ownership goes up, the total assets go up also. • for historical and legal reasons, the increase in equity is separated into an increase in common stock at par and the remainder, an increase in additional paid-in capital. Cash 100,000 Common stock ($10 par) 10,000 Additional P.I.C. 90,000

12. 2.b. Capital Contributions -- Issue for Non-Cash Assets • A firm may find it desirable to trade stock for an asset other than cash. • In this case, the question is what is the value of the transactions? • We look first to a reliable market based value of the asset and record that stock and the asset at this price. • If the value of the asset is hard to measure, we may take the market value of the stock instead.

13. 2.c. Capital Contributions -- Issue Under Options Arrangements • Firms sometimes give stock at reduced prices or free in exchange for goods or services or as compensation. • Top management is often compensated in stock or stock options so that they will have strong incentives to make decisions which will increase the price of shares.

14. 2.d. Employee Stock Option Plans • A stock option is a contract that allows the holder to buy a stated number of shares of stock for a fixed price, called the exercise price. If the market price is above the exercise price, then the option have value. Otherwise, the holder will just ignore the option and it has no value. • On the grant date, the firm transfers options to an employee, for a reduced price or free. • The employee typically cannot sell the stock immediately but must wait until the vesting date. • When the employee does buy shares of stock using the option (to get the lower price), this is called exercising the option.

15. 2.d. Employee Stock Option Plans (cont.) • How do you value an option? If the price of the stock fall, it is valueless. If the price goes up, then the amount of increase is the value. • One cannot know the ultimate value until the exercise date. • Two GAAP methods: • Market Value Method. • APB Opinion 25 Method. • Firms have argued (under APB 25) that if the exercise price is above the current stock price, then the option has no value and requires no recording.

16. 2.e Stock Rights. • Like stock options, stock rights give the holder the right to acquire shares at a specified price. • Stock Options are generally granted to employees and cannot be transfer until vested. • Stock Rights are generally granted to current shareholders who can trade them in secondary public markets. • GAAP ignore any value inherent in the stock right on the date of the grant and make no entry when granted. Of course, the exercise of a stock right is recorded like the sale of shares.

17. 2. f. Stock Warrants. • Firms issue stock warrants to the investing public for cash. • When sold, the warrants are recorded in a manner similar to a liability. • When warrant holders exercise their rights, the firm records the transaction like the sale of stock except that the warrant account created when granted is reduced.

18. 2.g. Convertible Bonds or Preferred Stock • A convertible security may be exchanged at the holders option for another security. • For example, a convertible bond may be exchangeable for a share of common stock. • This feature allows the holder to choose the option that has the greater benefit and is a desirable feature. • Convertible securities are recorded as regular securities until they are converted.

19. 3. Reporting Operating Transactions a. Reporting operating transactions. b. Comprehensive income . c. Adjustments to retained earnings. d. Corporate distributions. • Dividends in cash. • Dividends in stock. • Stock splits. e. Treasury shares. f. Earnings per share.

20. 3. Reporting Operating Transactions (cont.) • The term Earnings has no precise definition. It is used to refer to profits in a general sense but not a technical sense. It is often used as a broader view of profit which might include changes in economic wealth not captured by net income. • Net Income is a measure of earnings using accrual accounting methods as defined by GAAP. • Earnings and net income are gages of the operating activities of the firm. • We assume that investors desire earnings information so that they can forecast future cash flows as input to their investment decision.

21. 3. Reporting Operating Transactions (cont.) a. Reporting operating transactions 1. Recurring/nonrecurring and central/peripheral 2. Measurement of earnings effect 3. Classification in the income statement 4. Unrealized gains and losses from changes in market values… 5. An international perspective b. Comprehensive income

22. 3.a. Recurring/Nonrecurring and Central/Peripheral • Recurring/nonrecurring refers whether earnings can be expected to repeat in the future. • Central/peripheral refers to how closely earnings are related to the core activities of the firm. The firm may be more efficient in core activities than in peripheral activities. Sometimes the term core competencies is used.

23. Fig 12.2 Nature of Income Items Recurring Nonrecurring Creation and sale of Firm’s regular products Income from sales of product or lines of business that the firm intends to discontinue. Primary operating activity Peripheral to primary operating activity Periodic sales of equipment previously used in manufacturing Losses from earthquakes or hurricanes.

24. 3.b. Measurement of Earnings Effect • Revenues and expenses result from recurring primary activities of the firm. • Gains and losses result from either peripheral or nonrecurring activities. • Revenue and gains result in increases in shareholders’ equity. • Expenses and losses result in decreases in shareholders’ equity. • Revenues and expenses are gross concepts in that nothing is subtracted. • Gains and losses are net concepts in that a cost basis is subtracted from an inflow in defining the gain or loss.

25. 3.c. Classification • Earnings from continuing operations are revenues, gains, expenses and losses from activities of the firm that can be expected to continue in the near future. • Earnings, gains and losses from discontinued operations are separate reports of activities that will be discontinued in the near future. • Extraordinary gains and losses are gains and losses from events which are both 1. Unusual in nature, and 2. Infrequent in occurrence. • Adjustments for changes in Accounting Principles are disclosures of the effects of a change in the use of accounting rules.

26. 3.d. Unrealized Gains and Losses from Changes in Market Values • The FASB has increasingly required firms to report certain assets and liabilities at their current market values: 1. Inventories at lower of cost or market 2. Plant assets and intangibles at current market value when asset impairment has occurred 3. Financial instruments including derivatives at market value 4. Marketable equity securities at market value

27. 3.d. Unrealized Gains and Losses from Changes in Market Values (Cont.) • When an asset (or liability) account is changed to market value, double entry accounting systems require an offset. • The offset is generally to an unrealized gain or loss. • Unrealized means that the gain or loss was not the result of an economic transaction, but rather a market adjustment. Marketable securities nnn Unrealized gain (or loss) nnn • What is the nature of the unrealized gain or loss account?

28. 3.d. Unrealized Gains and Losses from Changes in Market Values (Cont.) • The unrealized gain or loss account is part of earnings because it changes the wealth of the firm. • It may or may not be part of net income depending of the accounting rules. • Unrealized gains or losses may be closed at the end of the accounting period and appear on the income statement. • Or they may bypass the income statement and appear on the balance sheet.

29. 4. Corporate Distributions • A dividend is the distribution of assets to the owners. • The amount of any dividend may be limited by statue or by contract. • Three forms of dividends: a. Cash dividends. b. Stock dividends. c. Stock splits. • Stock may be repurchased as treasury stock.

30. 4. Corporate Distributions (cont.) 1. Legal limits on dividends -- statutory some states limit the payment of dividends: they are not allowed if retained earnings were to be forced to below zero. 2. Legal limits on dividends -- contractual contracts with debtors or others may further restrict the payment of dividends. 3. Dividends and corporate financial policy 4. Accounting for dividends a. cash dividends c. stock dividends b. property dividends d. stock splits

31. 4.a. Dividends in cash a. Cash dividends -- dividends paid in cash • When dividends are declared, they give rise to a liability and a reduction in retained earnings Retained earnings 150,000 Dividends payable 150,000 • When the cash is sent out, the liability is fulfilled Dividends payable 150,000 Cash 150,000

32. 4.a. Dividends in non-cash. b. Property dividends -- dividends paid in assets other than cash. • The accounting is similar to cash dividends except when the dividend is paid, the credit is to the asset rather than to cash. Dividends payable 150,000 Asset 150,000

33. 4.b. Dividends in Stock. c. Stock dividends • Technically this is a dividend paid in new shares of stock and not general dividends. • However the term is often used to refer to all kinds of dividends including cash dividends in the sense of “dividends on stock” rather than “dividends paid in stock.” • Retained earnings are reduced (debited) and common stock and a.p.i.c. are increased (credited). • The effect of this is to move equity from retained earnings to common stock and a.p.i.c.

34. 4.c. Stock Splits. d. Stock splits or split-ups • Theoretically this is just a large stock dividend. • It has long been debated whether there is any difference between a stock dividend and a stock split other than the size. • GAAP does consider the two different and requires a different accounting treatment for stock splits. • Specifically, no journal entry is required for a stock split. • Many believe that a stock split will result in an increase in the market price of the shares. Empirical evidence seems to support this, but a causal relationship has not been established.

35. 4. Stock Repurchases. • Treasury shares are common shares that have been repurchased by the firm. • Treasury shares are not assets or investments. • Instead, they are a reversal of the issuance of common shares. • Recall that when stock was issued, the firm received cash and issued stock: Cash 100,000 Common stock ($10 par) 10,000 Additional P.I.C. 90,000

36. 4. Treasury Shares (Cont.) • The purchase of treasury shares is the reverse of the issuance; the firm gives up cash and gets back the shares: Treasury shares (cost) 110,000 Cash 110,000 • Treasury shares are recorded at cost and kept in a separate account so that the firm can more easily resell them, if they desire. • Treasury shares are a contra account to the shareholders’ equity section. • Treasury shares do not receive cash dividends or vote. They may split or receive dividends in stock.

37. 4. Treasury Shares (Cont.) • If treasury shares are later resold, there is no gain or loss on the sale. • Rather any difference increases or decreases the additional paid in capital account. Cash 14,000 Treasury shares (cost) 11,000 Additional p.i.c. from sale of treasury shares 3,000

38. 5. Earnings Per Share • Publicly traded firms must show earnings-per-share data in the body of the income statement. • Earnings per common share is net earnings divided by the average number of outstanding common shares. • Firms that report more than one of the four categories of earnings must disclose earnings per common share for each category. • Securities (such as preferred shares) that are convertible into common shares complicate the meaning of this number. This is an advanced accounting topic.

39. 6. Disclosure of Changes in Shareholders’ Equity • Annual reports must explain the changes in all shareholders’ equity accounts. • For retained earnings, this means that a reconciliation must be presented. This reconciliation may be in the income statement, the balance sheet or as a separate statement. • Also, this means that other comprehensive income accounts must also be reconciled.

40. An International Perspective – Capital Contributions • Accounting for shareholders’ equity is similar the world over. • Foreign financial statements often use the term reserve in the equity section to show a restriction on equity. • U.S. GAAP discourages the use the the word reserve because it may seem to some that there is a cash or asset fund available -- there is not.

41. An International Perspective -- Earnings • Almost all industrial countries require income statements. • The format and classification of earnings items on those income statements vary. • Revenue and expense recognition rules may vary in detail but most countries require a form of accrual accounting rather than cash basis. • The nature of what can by-pass the income statements may vary. • A few countries require inflation adjustments to items on the income statement.

42. Chapter Summary • This chapter has presented issues in accounting for earnings and its effect on shareholders equity. • Careful distinctions were made between results of operations and other changes in the firms’ wealth. • These distinctions are presented as separate parts of the income statement. • The shareholders’ equity section is likewise divided into different sections reflections distinctions among sources of capital.

43. Appendix 12.1-- Effects on Cash Flows of Shareholders’ Equity Transactions • Capital contributions (including cash received from the issuance of stock options or warrants and treasury stock transactions) are a source of cash in the financing section. • The conversion of convertible securities into common stock is a financing activity but is not reported unless it does not involves cash. • Dividends are use of cash in the financing section.