Chapter 15 Stockholders' Equity

Reasons for issuance of No-par stock -

First, issuance of no-par stock avoids the contingent liability that might occur if the corporation issued par value stock at a discount. Second, some confusion exists over the relationship (or rather the absence of a relationship) between the par value and fair value.

State Corporate Law (1) -

Corporation must submit articles of incorporation to the state in which incorporation is desired.

Features of Preferred Stock -

Cumulative Participating Convertible Callable Redeemable A corporation may attach whatever preferences or restrictions, as long as it does not violate its state incorporation law

Illustration: Koebele Corporation has outstanding 1,000 shares of $100 par value common stock and retained earnings of $50,000. If Koebele declares a 10 percent stock dividend, it issues 100 additional shares to current stockholders. If the fair value of the stock at the time of the stock dividend is $130 per share, the entry is:

Date of declaration Retained Earnings 13,000 Common Stock Dividend Distributable 10,000 Paid-in Capital in Excess of Par-Common 3,000 Date of distribution Common Stock Dividend Distributable 10,000 Common Stock 10,000

Illustration: Horaney Mines Inc. issued a "dividend" to its common stockholders of $1,200,000. The cash dividend announcement noted stockholders should consider $900,000 as income and the remainder a return of capital. Horaney Mines records the dividend as follows.

Date of declaration Retained Earnings 900,000 Paid-in Capital in Excess of Par-Common 300,000 Dividends Payable 1,200,000 Date of payment Dividends Payable 1,200,000 Cash 1,200,000

Retiring Treasury Stock -

Decision results in cancellation of the treasury stock and a reduction in the number of shares of issued stock

Liquidating Dividends -

- Any dividend not based on earnings reduces corporate paid-in capital. - The portion of these dividends in excess of accumulated income represents a return of part of the stockholder's investment.

Cash Dividends -

- Board of directors vote on the declaration of cash dividends. - A declared cash dividend is a liability. - Companies do not declare or pay cash dividends on treasury stock. Three dates: Date of declaration Date of record Date of payment

Stock Dividends

- Issuance by a company of its own stock to stockholders on a pro rata basis, without receiving any consideration. - Used when management wishes to "capitalize" part of earnings. - If stock dividend is less than 20-25 percent of the common shares outstanding, company transfers fair market value from retained earnings (small stock dividend).

Stock Split

- To reduce the market value of shares. - No entry recorded for a stock split. - Decrease par value and increase number of shares.

Issuance of Stock Accounting problems:

1. Accounting for par value stock. 2. Accounting for no-par stock. 3. Accounting for stock issued in combination with other securities (lump-sum sales). 4. Accounting for stock issued in noncash transactions. 5. Accounting for costs of issuing stock

Illustration: The following series of transactions illustrates the procedure for recording the issuance of 10,000 shares of $10 par value common stock for a patent for Arganda Company, in various circumstances.

1. Arganda cannot readily determine the fair value of the patent, but it knows the fair value of the stock is $140,000. Patents 140,000 Common Stock 100,000 Paid-in Capital in Excess of Par - Common 40,000 2. Arganda cannot readily determine the fair value of the stock, but it determines the fair value of the patent is $150,000. Patents 150,000 Common stock 100,000 Paid-in Capital in Excess of Par - Common 50,000 3. Arganda cannot readily determine the fair value of the stock nor the fair value of the patent. An independent consultant values the patent at $125,000 based on discounted expected cash flows. Patents 125,000 Common stock 100,000 Paid-in Capital in Excess of Par - Common 25,000

The statement of stockholders' equity is frequently presented in the following basic format:

1. Balance at the beginning of the period. 2. Additions. 3. Deductions. 4. Balance at the end of the period

The following three categories normally appear as part of stockholders' equity:

1. Capital stock. 2. Additional paid-in capital. 3. Retained earnings.

Types of Dividends:

1. Cash dividends. 2. Property dividends. 3. Liquidating dividends. 4. Stock dividends All dividends, except for stock dividends, reduce the total stockholders' equity in the corporation

Two Primary Sources of Equity -

1. Contributed Capital 2. Retained Earnings

Two acceptable methods for Purchase of Treasury Stock:

1. Cost method (more widely used). 2. Par (Stated) value method. Treasury stock reduces stockholders' equity.

Features often associated with preferred stock:

1. Preference as to dividends. 2. Preference as to assets in the event of liquidation. 3. Convertible into common stock. 4. Callable at the option of the corporation. 5. Nonvoting

Two methods of allocating proceeds of Lump-sum Sales:

1. Proportional method. 2. Incremental method.

Three primary forms of business organization:

1. Proprietorship 2. Partnership 3. Corporation

Corporations purchase their outstanding stock for several reasons: (Reacquistion of Shares - Buyback)

1. Provide tax-efficient distributions of excess cash to stockholders. Increase earnings per share and return on equity. 2. Provide stock for employee stock compensation contracts or to meet potential merger needs. 3. Thwart takeover attempts or to reduce the number of stockholders. 4. Make a market in the stock.

Very few companies pay dividends in amounts equal to their legally available retained earnings. The major reasons are :

1. To maintain agreements (bond covenants) with specific creditors, to retain all or a portion of the earnings, in the form of assets, to build up additional protection against possible loss. 2. To meet state corporation requirements, that earnings equivalent to the cost of treasury shares purchased be restricted against dividend declarations. 3. To retain assets that would otherwise be paid out as dividends, to finance growth or expansion. This is sometimes called internal financing, reinvesting earnings, or "plowing" the profits back into the business. 4. To smooth out dividend payments from year to year by accumulating earnings in good years and using such accumulated earnings as a basis for dividends in bad years. 5. To build up a cushion or buffer against possible losses or errors in the calculation of profits

In the absence of restrictive provisions, each share carries the following rights:

1. To share proportionately in profits and losses. 2. To share proportionately in management (the right to vote for directors). 3. To share proportionately in assets upon liquidation. 4. To share proportionately in any new issues of stock of the same class—called the preemptive right.

Costs of Issuing Stock-

Direct costs incurred to sell stock, such as - underwriting costs, - accounting and legal fees, - printing costs, and - taxes, should be reported as a reduction of the amounts paid in (Paid-in Capital in Excess of Par).

Property Dividends -

Dividends payable in assets other than cash. Restate at fair value the property it will distribute, recognizing any gain or loss.

Large Stock Dividend -

20-25 percent of the number of shares previously outstanding. - Same effect on market price as a stock split. - Par value transferred from retained earnings to capital stock.

From a legal standpoint, a stock split differs from a stock dividend -

A stock split increases the number of shares outstanding and decreases the par or stated value per share. A stock dividend, although it increases the number of shares outstanding, does not decrease the par value; thus, it increases the total par value of outstanding shares

State Corporate Law (4) -

Accounting for stockholder's equity follows the provisions of each states business incorporation act.

State Corporate Law (3) -

Advantage to incorporate in a state whose laws favor the corporate form of business organization. ~Delaware

Illustration: Uretz Corporation's common stockholders' equity is $1,000,000 and it has 100,000 shares of common stock outstanding (Book value per share)

Amount each share would receive if the company were liquidated on the basis of amounts reported on the balance sheet.

Analysis -

Analysts use stockholders' equity ratios to evaluate a company's profitability and long-term solvency Three ratios: 1. Rate of return on common stock equity. 2. Payout ratio. 3. Book value per share.

Illustration: Hopkins, Inc. transferred to stockholders some of its equity investments costing $1,250,000 by declaring a property dividend on December 28, 2013, to be distributed on January 30, 2014, to stockholders of record on January 15, 2014. At the date of declaration, the securities have a market value of $2,000,000. Hopkins makes the following entries.

At date of declaration (December 28, 2013) Equity Investments 750,000 Unrealized Holding Gain or Loss—Income 750,000 Retained Earnings 2,000,000 Property Dividends Payable 2,000,000 At date of distribution (January 30, 2014) Property Dividends Payable 2,000,000 Equity Investments 2,000,000

Illustration: David Freight Corp. on June 10 declared a cash dividend of 50 cents a share on 1.8 million shares payable July 16 to all stockholders of record June 24

At date of declaration (June 10) Retained Earnings 900,000 Dividends Payable 900,000 At date of record (June 24) No entry At date of payment (July 16) Dividends Payable 900,000 Cash 900,000

Illustration: Bishop Co. issues 10,000 shares of $10 par value preferred stock for $12 cash per share. Bishop records the issuance as follows:

Cash 120,000 Preferred stock 100,000 Paid-in Capital in Excess of Par - Preferred 20,000

Illustration: Some states require that no-par stock have a stated value. If a company issued 1,000 of the shares with a $5 stated value at $15 per share for cash, it makes the following entry.

Cash 15,000 Common Stock 5,000 Paid-in Capital in Excess of Stated Value 10,000

Sale of Treasury Stock above Cost. Cripe acquired 10,000 treasury share at $11 per share. It now sells 1,000 shares at $15 per share on March 10. Cripe records the entry as follows.

Cash 15,000 Treasury Stock 11,000 Paid-in Capital from Treasury Stock 4,000

Illustration: Blue Diamond Corporation issued 300 shares of $10 par value common stock for $4,500. Prepare the journal entry to record the issuance of the shares.

Cash 4,500 Common Stock (300 x $10) 3,000 Paid-in Capital in Excess of Par Value 1,500

Illustration: Muroor Electronics Corporation is organized with authorized common stock of 10,000 shares without par value. If Muroor Electronics issues 500 shares for cash at $10 per share, it makes the following entry.

Cash 5,000 Common Stock 5,000

Sale of Treasury Stock below Cost. Cripe sells an additional 1,000 treasury shares on March 21 at $8 per share, it records the sale as follows

Cash 8,000 Paid-in Capital from Treasury Stock 3,000 Treasury Stock 11,000

Participating Preferred Stock -

Holders of participating preferred stock share ratably with the common stockholders in any profit distributions beyond the prescribed rate.

Proportional Method -

If the fair value or other sound basis for determining relative value is available for each class of security, the company allocates the lump sum received among the classes of securities on a proportional basis.

Incremental Method -

In instances where a company cannot determine the fair value of all classes of securities, it may use the incremental method. It uses the fair value of the securities as a basis for those classes that it knows, and allocates the remainder of the lump sum to the class for which it does not know the fair value

Illustration: Midgley Co. has cash dividends of $100,000 and net income of $500,000, and no preferred stock outstanding (Payout Ratio)

In the fourth quarter of 2011, 36 percent of the earnings of the S&P 500 was distributed via dividends.

Special characteristics of the corporate form:

Influence of state corporate law. Use of capital stock or share system. Development of a variety of ownership interests.

Illustration: Beveridge Corporation issued 300 shares of $10 par value common stock and 100 shares of $50 par value preferred stock for a lump sum of $13,500. The common stock has a market value of $20 per share, and the value of preferred stock is unknown.

Journal Entries: Cash 13,500 Preferred Stock (100 x $50) 5,000 Paid-in Capital in Excess of Par - Preferred 2,500 Common Stock (300 x $10) 3,000 Paid-in Capital in Excess of Par - Common 3,000

Illustration: Beveridge Corporation issued 300 shares of $10 par value common stock and 100 shares of $50 par value preferred stock for a lump sum of $13,500. Common stock has a market value of $20 per share, and preferred stock has a market value of $90 per share.

Journal Entries: Cash 13,500 Preferred Stock (100 x $50) 5,000 Paid-in Capital in Excess of Par - Preferred 3,100 Common Stock (300 x $10) 3,000 Paid-in Capital in Excess of Par - Common 2,400

Lump-sum sales -

Occasionally, a corporation issues two or more classes of securities for a single payment or lump sum (e.g., in the acquisition of another company).

Illustration: Marshall's Inc. had net income of $360,000, declared and paid preferred dividends of $54,000, and average common stockholders' equity of $2,550,000. (ROE)

Ratio shows how many dollars of net income the company earned for each dollar invested by the owners.

A company should disclose a liquidating dividend—

—that is, a dividend not based on retained earnings—to the stockholders so that they will not misunderstand its source

Restrictions on Retained Earnings -

Restrictions are best disclosed by note Restrictions may be based on the retention of a certain retained earnings balance, the ability to maintain certain working capital requirements, additional borrowing, and other considerations.

Issuance of Stock:

Shares authorized - Shares sold - Shares issued

State Corporate Law (2) -

State issues a corporation charter.

Treasury stock -

Technically, treasury stock is a corporation's own stock, reacquired after having been issued and fully paid. Treasury stock is not an asset. When a corporation buys back some of its own outstanding stock, it has not acquired an asset; it reduces net assets. Treasury stock is essentially the same as unissued capital stock.

Stock Issued in Noncash Transactions -

The general rule is: Companies should record stock issued for services or property other than cash at either the fair value of the stock issued or the fair value of the noncash consideration received, whichever is more clearly determinable.

Watered stock -

The overvaluation of the stockholders' equity resulting from inflated asset values

Companies usually issue preferred stock with a par value, expressing the dividend preference as a percentage of the par value.

Thus, holders of 8 percent preferred stock with a $100 par value are entitled to an annual dividend of $8 per share. This stock is commonly referred to as 8 percent preferred stock.

On January 20, 2012, Pacific acquires 10,000 shares of its stock at $11 per share. Pacific records the reacquisition as follows: (shows SH equity after purchase of stock)

Treasury Stock 110,000 Cash 110,000

Sale of Treasury Stock below Cost -

When a corporation sells treasury stock below its cost, it usually debits the excess of the cost over selling price to Paid-in Capital from Treasury Stock.

Sale of Treasury Stock above Cost -

When the selling price of shares of treasury stock exceeds its cost, a company credits the difference to Paid-in Capital from Treasury Stock

Sale of Treasury Stock -

Whether Above Cost or Below Cost, Both increase total assets and stockholders' equity.

The stated value is

a minimum value below which a company cannot issue stock.

Secret reserves -

a result of the issuance of stock for property or services, a corporation undervalues the recorded assets. An understated corporate structure (secret reserve) may also result from other methods: excessive depreciation or amortization charges, expensing capital expenditures, excessive write-downs of inventories or receivables, or any other understatement of assets or overstatement of liabilities

Convertible Preferred Stock -

allows stockholders, at their option, to exchange preferred shares for common stock at a predetermined ratio.

The share system -

easily allows one individual to transfer an interest in a company to another investor.

In the case of no-par preferred stock, a corporation expresses a dividend preference as a specific dollar amount per share,

for example, $7 per share. This stock is commonly referred to as $7 preferred stock.

Redeemable Preferred Stock -

has a mandatory redemption period or a redemption feature that the issuer cannot control.

Par Value Stock -

has no relationship to its fair value. At present, the par value associated with most capital stock issuances is very low. Low par values help companies avoid a contingent liability

Return on equity (ROE)

helps investors judge the worthiness of a stock when the overall market is not doing well

The Paid in Capital in Excess of Par account (Additional Paid-In-Capital) -

indicates any excess over par value paid in by stockholders in return for the shares issued to them.

Preferred stock -

is a special class of shares that possesses certain preferences or features not possessed by the common stock.

Preferred stock -

is a special class of stock is created by contract, when stockholders' sacrifice certain rights in return for other rights or privileges, usually dividend preference

Earned capital -

is the capital that develops from profitable operations. It consists of all undistributed income that remains invested in the company

Common stock -

is the residual corporate interest that bears the ultimate risks of loss and receives the benefits of success. It is guaranteed neither dividends nor assets upon dissolution.

Contributed (paid-in) capital -

is the total amount paid in on capital stock—the amount provided by stockholders to the corporation for use in the business. Contributed capital includes items such as the par value of all outstanding stock and premiums less discounts on issuance.

Rate of Return on Common Stock Equity

measures profitability from the common stockholders' viewpoint. This ratio shows how many dollars of net income the company earned for each dollar invested by the owners. Return on equity equals net income less preferred dividends, divided by average common stockholders' equity.

Book Value per Share -

of stock is the amount each share would receive if the company were liquidated on the basis of amounts reported on the balance sheet.

Callable Preferred Stock -

permits the corporation at its option to call or redeem the outstanding preferred shares at specified future dates and at stipulated prices. Many preferred issues are callable. The callable feature permits the corporation to use the capital obtained through the issuance of such stock until the need has passed or it is no longer advantageous

The preemptive right -

protects an existing stockholder from involuntary dilution of ownership interest. Without this right, stockholders might find their interest reduced by the issuance of additional stock without their knowledge, and at prices unfavorable to them.

The par or stated value method (Purchase of Treasury Stock) -

records all transactions in treasury shares at their par value and reports the treasury stock as a deduction from capital stock only

With No-par Stock, The exact amount received -

represents the credit to common or preferred stock

Stockholders' (owners') equity -

represents the cumulative net contributions by stockholders plus retained earnings

Retained earnings -

represents the earned capital of the company.

Cumulative preferred stock -

requires that if a corporation fails to pay a dividend in any year, it must make it up in a later year before paying any dividends to common stock holders. If the directors fail to declare a dividend at the normal date for dividend action, the dividend is said to have been "passed." Any passed dividend on cumulative preferred stock constitutes a dividend in arrears. Because no liability exists until the board of directors declares a dividend, a corporation does not record a dividend in arrears as a liability but discloses it in a note to the financial statements. A corporation seldom issues noncumulative preferred stock because a passed dividend is lost forever to the preferred stockholder. As a result, this stock issue would be less marketable

The cost method (Purchase of Treasury Stock) -

results in debiting the Treasury Stock account for the reacquisition cost and in reporting this account as a deduction from the total paid-in capital and retained earnings on the balance sheet

Owner's equity in a corporation is defined as-

stockholders' equity, shareholders' equity, or corporate capital

A major disadvantage of no-par stock is

that some states levy a high tax on these issues. In addition, in some states the total issue price for no-par stock may be considered legal capital, which could reduce the flexibility in paying dividends.

Stockholders' equity is

the difference between the assets and the liabilities of the company. (Assets - Liabilities = Stockholders' Equity)

No-par stock -

the issuance of capital stock without par value

Outstanding stock is -

the number of shares of issued stock that stockholders own

Payout Ratio -

the ratio of cash dividends to net income. If preferred stock is outstanding, this ratio equals cash dividends paid to stockholders, divided by net income available to common stockholders