Chapter 11: Stockholders' Equity

Where do you apply to create a corporation?

State government (NOT federal gov't)

How are stock dividends accounted for?

Stock dividends are accounted for by transferring an amount from retained earnings to contributed capital accounts

What is another way to think of retained earnings?

Think of retained earnings as the amount of equity that the company itself has generated for stockholders (through profitable operations) but not yet distributed to them

Is ROE used for comparing across companies?

This ratio can be appropriately compared across companies since it uses dollars contributed to and reinvested in the company

Is P/E Ratio used for comparing across INDUSTRIES?

This ratio will vary across industries so it is best to compare a company over time with itself or with competitors in the same industry

define income investment

buying stocks that consistently pay dividends

What are the advantages of equity financing?

- Equity does not have to be repaid - Dividends are optional (interest must be paid on debt)

What is the difference between equity and debt financing?

- Equity financing involves issuing new stock to investors - Debt financing involves borrowing money from lenders

define price/earnings ratio

- How many times more than the current year's earnings investors are willing to pay for a company's common stock - A higher number means investors anticipate an improvement in the company's future results - formula: current stock price (per share)/ Earnings per share (annual)

What are the advantages of debt financing?

- Interest on debt is tax deductible (dividends are not tax deductible) - Debt does not change stockholder control (a stock issue gives new stockholders the right to vote and share in the earnings, diluting existing stockholders' control)

How does preferred stock differ from common stock?

- Preferred stock allows different voting rights (it can carry anything from no voting rights to super-voting rights) - Dividends on preferred stock, if any, may be paid at a fixed rate - Preferred stock carries priority over common stock

Why would a corporation repurchase its own stock?

- Send a signal to investors that the company itself believes its own stock is worth acquiring - Obtain shares that can be reissued as payment for purchases of other companies - Obtain shares to reissue to employees as part of employee stock purchase plans - Reduce the number of outstanding shares to increase per-share measures of earnings and stock value

In a corporation, investors can easily participate in ownership. What factors is this ease of participation related to?

- Shares of stock can be purchased in small amounts - Ownership Interests are transferable - Stockholders are not liable for the corporation's debts

What things do companies look at when deciding whether to pay dividends?

- Sufficient Retained Earnings - Sufficient Cash (retained earnings are not cash and just because a company has a sufficient credit balance in RE does not mean it has enough cash to pay the dividends)

define return on equity (ROE) and give the formula

- The amount of income earned for each dollar of common stockholders' equity - A higher ratio means stockholders' are likely to enjoy greater returns - formula: (Net Income - Preferred Dividends)/ Average common Stockholders' Equity

Define earnings per share (EPS) and give the formula

- The amount of income generated for each share of common stock owned by stockholders - A higher ratio means greater profitability - formula: (net income - preferred dividends)/ average number of common shares outstanding

What are benefits to the owners of common stock?

- Voting rights - Dividends - Residual claim - Preemptive rights

define stock split

- an increase in the total number of authorized shares by a specified ratio; does not affect retained earnings - It usually involves revising the corporate charter to reduce the per-share par value of all authorized shares so that the total par value across all shares is unchanged - No journal entry is needed

In what ways can investors get a return on their investment when they acquire stock?

- dividends - increases in stock prices

Which financial statement is affected by transactions between a company and it's stockholders?

All transactions between a company and its stockholders affect the company's balance sheet accounts only

How is preferred stock treated when computing EPS?

Because preferred stock has priority over common stock, any dividends on preferred stock are subtracted from net income when computing EPS

How are stock dividends and stock splits similar and different?

Both stock dividends and stock splits increase the number of shares outstanding and decrease the per-share market price, However, stock dividends cause a reduction in retained earnings and a true stock spit does not

Is EPS used for comparing across companies

EPS is an effective and widely used measure for comparing a company with itself over time, it is not appropriate for comparing across companies

define year-end

Move dividends debit balance to retained earnings in order to close it at year end. This does not actually effect the total SE

How is treasury stock reported?

Treasury stock is not an asset. It as a permanent account reported as contra-equity (it is subtracted from total SE)

define accumulated deficit?

When a company accumulates more net losses than net income over its life, it is called an Accumulated Deficit rather than retained earnings

define stock dividend

a dividend that distributes the additional shares of a corporation's own stock -- These are distributed on a pro rata basis at no cost to the stockholder (pro rata means each stockholder receives additional shares equal to the percentage of shares held)

define financial leverage

a way to increase a return by relying heavily on debt rather than equity financing

What are the four main sections of the Stockholders' Equity section of the balance sheet?

contributed capital retained earnings treasury stock accumulated other comprehensive income (or loss)

What are the 4 important dates involved with a cash dividend?

declaration date, record date, payment date, year-end

Why do people use corporations as a business model, despite the fact they are expensive?

people use them as a business model because corporations can raise large amounts of money due to the fact that investors can easily participate in a corporate ownership.

define treasury stock

reports shares that were previously issued to and owned by stockholders but have been reacquired and are now held by the corporation

define contributed capital

reports the amount of capital the company received from investors contributions, in exchange for the company's common stock and preferred stock

define retained earnings

reports the cumulative amount of net income earned less the cumulative amount of dividends paid out since the company was first organized

define Accumulated Other Comprehensive Income (Loss)

reports unrealized gains and losses, which are temporary changes in the value of certain assets and liabilities the company holds

define outstanding shares

shares that are currently held by stockholders (not the corporation itself) (is computed as the difference between issued shares and treasury stock)

define preferred stock

stock that has specified rights over common stock

define payment date

the date on which a cash dividend is paid to the stockholders of record (decrease cash, decrease dividends payable)

define declaration date

the date on which the board of directors officially approves a dividend. (entry: increase dividends payable and increase dividends)

define record date

the date on which the corporation prepares the list of current stockholders as shown on its records; dividends can be paid only to the stockholders who own stock on that date, No journal entry required

define current dividend preference

the feature of preferred stock that grants priority on preferred dividends over common dividends (preferred dividends are paid first)

define authorized shares

the maximum number of shares of capital stock of a corporation that can be issued, as specified in the charter

define cumulative dividend preference

the preferred stock feature that requires current dividends not paid in full to accumulate for every year in which they are not paid. These cumulative unpaid amounts (called dividends in arrears) must be paid before any common dividends can be paid Side note: Because dividends are not an actual liability until the board of directors declares them, dividends in arrears are not reported on the balance sheet. Instead they are disclosed in the notes

define initial public offering (IPO)

the very first issuance of a company's stock to the public

define growth investment

when investors buy stock that pays little to no dividends because companies that reinvest the majority of their earnings tend to increase their future earnings potential, along with their stock price