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Chapter 12: Stockholders’ Equity

Chapter 12: Stockholders’ Equity. Key Points. The three forms of financing and their relative importance to major U.S. Corporations. Distinctions between debt and equity. Economic consequences associated with the methods used to account for stockholders’ equity.

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Chapter 12: Stockholders’ Equity

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  1. Chapter 12:Stockholders’ Equity

  2. Key Points • The three forms of financing and their relative importance to major U.S. Corporations. • Distinctions between debt and equity. • Economic consequences associated with the methods used to account for stockholders’ equity. • Rights associated with preferred and common stock and the methods used to account for stock issuances. • Distinctions among the market value, book value, and par (stated) value of a share of common stock. • Treasury stock. • Cash dividends and dividend strategies followed by corporations. • Stock dividends and stock splits. • To review the relative importance of equity to liabilities, let’s look at page 504

  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. 2. Preferred Stock • 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

  5. 3. Common Stock • 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

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

  7. 4. Journal Entries 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.

  8. 4. Journal Entries -continued 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.

  9. Sample Co. Stockholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 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 $129,000

  10. 4. Journal Entries-Sample Co. 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

  11. 5. Treasury Stock • 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.

  12. 5. Treasury Stock - continued • 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.

  13. 5. Treasury Stock(TS) - Journal Entries 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 not used for TS transactions. To record purchase of TS from market: TS xx “cost” Cash xx (cost equals the cash paid)

  14. 5. Treasury Stock(TS) - Journal Entries 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.

  15. 5. TS Example from Sample Co. 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. Here is the illustration agqain

  16. Sample Co. Stockholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 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 $129,000

  17. 6. Employee Stock Options • 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 .

  18. 6. Employee Stock Options • 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.

  19. 6. Stock Options and SFAS No. 123 • 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.

  20. 6. Stock Options and SFAS No. 123 • 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.

  21. 6. Stock Options and SFAS No. 123 • However, if companies did not 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. • These disclosures 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.

  22. 6. Stock Options and Recent Changes • 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. • The FASB has approved a revised standard that became effective in 2005 that requires the recognition of expense through journal entries, using the fair value method.

  23. 6. Stock Options and Expense Recognition • Should compensation expense be recognized in the financial statements? What are the arguments? • 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).

  24. 7. Retained Earnings 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

  25. 7. RE - Cash Dividends Remember the dividend dates Date of declaration Date of record Date of payment 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

  26. 7. RE - Cash Dividends • 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.

  27. Stock Splits • 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.

  28. 7. RE - Prior Period Adjustments • A prior period adjustment is an adjustment to current retained earnings for an error in a prior year’s income statement. • The error was closed to prior RE, so the error is corrected at the beginning of the year (net of tax). The error can go in either direction, depending on the nature of the error (ex: omitted expense versus omitted revenue).

  29. 8. Other Comprehensive Income • Comprehensive Income is a term that was defined in the Statements of Financial Accounting Concepts (SFAC 6). • It consists of all non-owner changes in equity. This includes net income as we have been defining revenues and expenses throughout the semester (and again in Chapter 13), and it also includes “Other Comprehensive Income.”

  30. 8. Other Comprehensive Income • “Other Comprehensive Income” includes certain direct equity adjustments that are not part of the current income statement, but which may have eventual effect on income. • We already discussed one of these direct equity adjustments when reviewing Available-for-sale Investments. We found that any unrealized gains/losses from revaluation to market are shown in SE (as “other comprehensive income”) rather than on the income statement. • There are several others including foreign currency adjustments that are beyond the scope of this class

  31. 9. Statement of Stockholders’ Equity • In this chapter, we have discussed the Statement of Retained Earnings as the link between the balance sheet and the income statement. • However, earlier chapters introduced the Statement of Stockholders’ Equity • The Statement of Stockholders’ Equity details the change in retained earnings, including all the changes discussed in this chapter, and it also shows the change during the year in all of the other stockholders’ equity accounts. • Now let’s put all of this together

  32. Review Problem - 2004 The company issued 1,000 shares of $1 par value stock for $70 per share. Cash (+A) 70,000 Common Stock (+SE) 1,000 Additional Paid-In Capital (+SE) 69,000 Issued common stock.

  33. Review Problem - 2004 The company issued 500 shares of no par value, $5, cumulative preferred stock for $50 per share. Cash (+A) 25,000 Preferred Stock (+SE) 25,000 Issued preferred stock.

  34. Review Problem - 2004 Net income during the year = $2,000 Dividends = $0 No entry

  35. Pike Place Corporation Balance Sheet December 31, 2004 Stockholders’ Equity Preferred stock (500 sh., no par value) $25,000 Common stock (1,000 sh. @ $1 par value) 1,000 Additional paid-in capital (C/S) 69,000 Retained earnings 2,000 Total stockholders’ equity $97,000 Review Problem - 2004 Note: Dividends in arrears on cumulative preferred stock = $2,500 (500 sh. x $5/sh.)

  36. Review Problem - 2005 The company purchased 200 treasury (common) shares for $60 per share. Treasury Stock (-SE) 12,000 Cash (-A) 12,000 Acquired treasury stock.

  37. Review Problem - 2005 Net income for the year = $20,000. Dividends = $6,600: $5,000 for preferred shareholders [$2,500 dividends in arrears and $2,500 (500 sh. x $5/sh.)], and $1,600 for the common stockholders (800 outstanding sh. x $2/sh.). The dividends were declared and paid. Preferred Dividends (-SE) 5,000 Common Dividends (-SE) 1,600 Dividends Payable (+L) 6,600 Declared dividends. Dividends Payable (-L) 6,600 Cash (-A) 6,600 Paid dividends.

  38. Pike Place Corporation Balance Sheet December 31, 2002 Stockholders’ Equity Preferred stock (500 sh, no par value) $25,000 Common stock (1,000 sh. @ $1 par value) 1,000 Additional paid-in capital (C/S) 69,000 Retained earnings 15,400 Less: Treasury stock (200 sh. x $60/sh.) (12,000) Total stockholders’ equity $98,400 * $2,000 + $20,000 - $6,600 * Review Problem - 2005

  39. Review Problem - 2006 The company reissued 100 treasury shares for $65 each. Cash (+A) 6,500 Treasury Stock (+SE) 6,000 Additional Paid-In Capital, T/S (+SE) 500 Reissued treasury stock.

  40. Review Problem - 2006 The company reissued 50 treasury shares for $50 each. Cash (+A) 2,500 Additional Paid-In Capital, T/S (-SE) 500 Treasury Stock (+SE) 3,000 Reissued treasury stock. Different from book

  41. Review Problem - 2006 The company declared a 10 percent stock dividend. There were 950 common shares outstanding at the time of the dividend, each with a fair value of $5. Stock Dividend (-SE) 475 Common Stock (+SE) 95 Additional Paid-In Capital (+SE) 380 Declared stock dividend.

  42. Review Problem - 2006 Net income for the year = $35,000 Dividends = $4,590: $2,500 to preferred shareholders and $2,090 to common shareholders (1,045 sh. outstanding x $2/sh.). The dividends were declared but unpaid at year-end. Preferred Dividends (-SE) 2,500 Common Dividends (-SE) 2,090 Dividends Payable(+L) 4,590 Declared dividends.

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