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Module 9: Stockholders’ Equity

1. Accounting for preferred and common 2. Treasury stock 3. Stock compensation plans 4. Retained earnings -cash dividends -stock dividends (and stock splits) -property dividends (and other carve outs) 5. Other comprehensive income 6.Statement of stockholders’ equity

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Module 9: Stockholders’ Equity

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  1. 1. Accounting for preferred and common 2. Treasury stock 3. Stock compensation plans 4. Retained earnings -cash dividends -stock dividends (and stock splits) -property dividends (and other carve outs) 5. Other comprehensive income 6.Statement of stockholders’ equity 7.Convertible securities 8.Comprehensive example Module 9: Stockholders’ Equity

  2. 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 1. Preferred Stock

  3. 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 1. Common Stock

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

  5. 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. 1. Journal Entries

  6. 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 illustrates many of the components of SE discussed in this chapter. 1. Journal Entries -continued

  7. 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 (2,000) Total Stockholders’ Equity $131,000 Sample Co. Stockholders’ Equity

  8. 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 (100x $102) 10,200 PS (100x $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 Journal Entries-Sample Co.

  9. 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. 2. Treasury Stock

  10. 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. 2. Treasury Stock - continued

  11. 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) 2. Treasury Stock(TS) - Journal Entries

  12. 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. 2. Treasury Stock(TS) - Journal Entries

  13. Tech 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, Tech Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2005, Tech Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2005, Tech Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2005 regarding the treasury stock. 2. TS - Example Problem

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

  15. 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). 2. TS Example -Journal Entries Cash 48,000 APIC-TS (1) 2,000 RE (2) 6,000 TS 56,000

  16. Historically, companies granted stock options to employees as a means of compensating employees, without having to recognize any compensation expense. Recently, the FASB required compensation expense to be recognized on the income statement, based on estimated fair value of the option. Many companies have been shifting to restricted stock plans to compensate and motivate employees. The restricted stock plans require a recognition of compensation expense, but based on the value of the stock at the date of grant (rather than fair value at date of full vesting). 3. Employee Stock Compensation Plans

  17. Since 1970, APB Opinion 25 allowed the issue of employee stock options. When the options were granted at the market price at grant date, no compensation expense was necessary. SFAS No. 123 was issued in 1995, and introduced the fair value method for calculating the compensation expense relating to employee stock options. SFAS No. 123 recommended that expense be recognized in the income statement, but did not require this recognition. SFAS No. 123R was issued in 2004, to require the recognition of expense in the income statement, for public companies whose fiscal year begins after June 15, 2005. 3. Employee Stock Options-History

  18. 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. 3. Stock Options-Illustration 1

  19. Illustration (SFAS 123R, 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. 3. Stock Options - Illustration 1

  20. 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). The journal entries in Illustration 1 are required with SFAS No. 123R. 3. Stock Options - Illustration 1

  21. 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. 3. Stock Options - Illustration 1(SFAS 123R: required journal entries)

  22. Given the following information: Que Company adopted a stock compensation plan that issued 10,000 shares of restricted stock to employees at January 2, 2005. The par value of the common stock was $10, and the stock was trading at $15 per share at the issue date. The vesting period was 2 years; after that time the stock would be unrestricted. The journal entry at the time of issue (1/2/05) would be (10,000 sh. x $15 = $150,000): Deferred comp. expense 150,000 CS (Restricted) 100,000 APIC - CS 50,000 (Note: Deferred Comp. is part of Other Comprehensive Income, until it is transferred to Income Statement over the 2 year vesting period.) 3.Restricted Stock-Illustration 2

  23. For 2005: Compensation expense 75,000 Deferred comp. expense 75,000 For 2006: Compensation expense 75,000 Deferred comp. expense 75,000 Jan. 2, 2007 (If separate account is used for restricted stock - transfer par value): CS (Restricted) 100,000 CS 100,000 (Otherwise, no journal entry required; the restriction is released and the shares are no longer restricted.) 3. Restricted Stock- Illustration 2

  24. Should compensation expense from stock options and restricted stock plans be recognized in the income statement? 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. Options and restricted stock are given as work incentives, rather than straight compensation. Remember: the value can go down as well as up (unlike traditional compensation). These equity grants do not meet the definition of an expense. See page 2-13. 3. Equity Compensation and Expense Recognition

  25. We will be expanding the basic retained earnings formula in this chapter. Now, the Retained Earnings Column of the Statement of Stockholders’ Equity will include the following: RE, beginning 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 4. Retained Earnings

  26. 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 4. RE - Cash Dividends

  27. 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. 4. RE - Cash Dividends

  28. 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. This is also called a form of “carve out”, as the company carves out a segment and divests it. As property dividends are declared: Property Dividends (RE) xx Property Div. Payable xx As property dividends are distributed: Property Div. Payable xx Investment xx 4. RE - Property Dividends

  29. Other forms of carve outs (though not considered dividends) are sell-offs and split-offs. In a sell-off, the company sells its equity interest in the investment/subsidiary to an outside party. In a split-off, the company sells its equity interest in the subsidiary back to the subsidiary. Thus the subsidiary is buying back its own shares (for treasury or retirement) and the parent is no longer an owner. 4. Other Carve Outs

  30. 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. 4. RE - Stock Dividends

  31. 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. 4. RE - Stock Dividends

  32. 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. 4. RE - Stock Dividends

  33. 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 is voided, and new shares are granted with a “new” description. 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

  34. 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

  35. If IZM declared a 2 for 1 stock split, the old shares would be voided 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

  36. 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 4. Stock Dividends vs Stock Splits

  37. 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 4. Stock Dividends vs Stock Splits

  38. 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 effected in the form of a dividend.” 4. Stock Dividends vs Stock Splits

  39. 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 35). Since the stock dividend required journal entries (see slide 36), 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. 4. Stock Dividends vs Stock Splits

  40. 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. 4. RE - Appropriations

  41. 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 it also includes “Other Comprehensive Income.” 5. Other Comprehensive Income

  42. “Other Comprehensive Income” (OCI) includes certain direct equity adjustments that are not part of the current income statement, but which may have eventual effect on income. One of these adjustments was discussed in this module: deferred compensation expense. The amount is recorded in OCI, until the effect is transferred to the income statement. 5. Other Comprehensive Income

  43. Another item in Other Comprehensive Income is theCumulative Translation Adjustment. This adjustment occurs when a company owns a foreign subsidiary, and must translate the foreign subsidiary to U. S. dollars before consolidating. The adjustment would only be realized as part of the income statement if the foreign subsidiary was sold or liquidated for U.S. dollars. The adjustment can be an increase or decrease, depending on the cumulative direction of change in the exchange rate. 5. Other Comprehensive Income

  44. Other items in Other Comprehensive Income include: Unrealized Gain/Loss on Available-for-Sale Investments. These long term investments are allowed to revalue each period up or down to market. The revaluation causes a gain or loss to be recognized (it is unrealized since the investment has not been sold). However, since the investment is long-term, the gain or loss is NOT recognized in the income statement. Instead, it is recognized cumulatively in OCI, until the investment is finally sold. Similar treatment is given to certain kinds of derivatives (a special form of investments). 5. Other Comprehensive Income

  45. One other item that will be discussed comes from a recent standard (SFAS 158), and is part of the new requirement by FASB to fully recognize all pension assets and liabilities in the balance sheet. However, FASB allows companies to defer recognition of a portion of the pension components, and spread the effects over future periods. These components (costs, losses, and gains) are deferred to OCI, until they are recognized in future income. (More in Module 10.) In the past, some companies recognized an OCI adjustment for “Minimum Liability”, but this requirement is no longer in effect (ignore comment in your text). 5. Other Comprehensive Income

  46. 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, which has become the default statement for large companies in recent years. 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 stockholders’ equity accounts. 6. Statement of Stockholders’ Equity

  47. Certain types of stocks and bonds may affect stockholders’ equity. Preferred stock may be issued with a convertible privilege, which allows investors to convert to common stock at a predetermined ratio. This conversion is usually recorded at book value of the preferred stock, and no cash is required in the exchange. Convertible bonds allow the investor to convert the bonds to common stock at a predetermined ratio. The conversion is similar to that for preferred stock, but in this case, liabilities go down and equity goes up. These convertible securities will have an effect on earnings per share calculations, particularly diluted earnings per share (see Module 5). 7. Convertible Securities

  48. Given the following SE balances for Company G at 1/1/08: Common stock, $10 par, 50,000 shares authorized, 20,000 shares issued and outstanding $200,000 APIC on common stock 400,000 Retained earnings 400,000 During 2008, Company G had the following activity: 1. Net income for the year was $250,000. 2. Cash dividends of $2 per share were declared and paid on February 1. 3. On June 1, Company G repurchased 2,000 shares of its own stock at $20 per share (using the cost method). 4. On December 1, Company G reissued 500 shares of treasury stock at $18 per share. 5. On December 15, Company G declared a 100% stock dividend, to be distributed to all of its shareholders (including treasury), on Jan. 15, 2009. 6. At Dec. 31, Company G recorded an AJE to revalue its available for sale investments from $20,000 to $32,000. 8. Comprehensive Class Problem - Stockholders’ Equity

  49. Required: A.Prepare journal entries for items 2 through 6 (item 1 would require detail information for revenues and expenses to prepare - just know that the credit is to retained earnings for $250,000). B.Prepare the Statement of Stockholders’ Equity for Company G for 2008. C.Prepare the stockholders’ equity section of the balance sheet for Company G for 2008, including the appropriate description for the common stock. Comprehensive Class Problem - Stockholders’ Equity (continued)

  50. A.Journal entries 1.No entry required. 2. Calc: 20,000 x $2 = 40,000 3. Calc: 2,000 shares x $20 = $40,000 Comprehensive Class Problem - Solution

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