Chapter 15 Stockholders' Equity

small (ordinary) stock dividends

A stock dividend (a corporation's issuance of its own stock to its stockholders, on a pro rata basis) of less than 20-25 percent of the number of shares previously outstanding. The company transfers, from retained earnings to capital stock and additional paid-in capital, the fair value of the stock issued. Payment of the stock dividend does not affect any asset or liability, but is a reclassification of stockholders' equity.

earned capital

The capital that develops from a company's profitable operations. It consists of all undistributed income that remains invested in the company. Earned capital is differentiated from contributed (paid-in) capital that comes from stockholders' purchase of capital stock.

preemptive right

The right of shareholders (unless prohibited in articles of incorporation) to share proportionately in any new issues of stock of the same class. The preemptive right protects existing stockholders from involuntary dilution of ownership interest when a corporation issues additional stock. Stock warrants (an option to purchase stock) are commonly used to satisfy this right.

liquidating dividends

Dividends based on amounts other than retained earnings, implying that the dividends are a return of the stockholder's investment rather than of profits. Any dividend not based on earnings reduces corporate paid-in capital.

statement of stockholders' equity

One of the basic financial statements, which reports the changes in each stockholders' equity account and in total stockholders' equity during the year. It typically shows balances at the beginning of the period, additions and deductions, and balances at the end of the period. Companies disclose changes in the separate accounts either in separate statements or in the basic financial statements or notes thereto.

cash dividends

Pro rata distributions of cash to a company's stockholders as of a certain date (date of declaration), as approved by the company's board of directors. A company may declare dividends either as a certain percent of par or as an amount per share. A declared cash dividend is a current liability of the company between the date of declaration and the payment date. Companies do not declare or pay cash dividends on treasury stock.

return on common stock equity

Profitability ratio that indicates how many dollars of net income the company earned for each dollar invested by the common stockholders. Also called return on equity (ROE). Computed as net income less preferred dividends divided by average common stockholders' equity.

dividend in arrears

A dividend on cumulative preferred stock that a company's board of directors fails to declare at the normal date for dividend action. Such a dividend is said to have been "passed." The corporation must make up the passed dividend in a later year before it can pay any dividends to common stockholders.

preferred stock

A special class of stock that gives its holders certain special preference or features not possessed by common stock. Holders typically get preference as to dividends and to assets in the event of liquidation, and the preferred stock may be convertible into common stock or callable at the option of the corporation. The preferred stockholder may sacrifice certain rights in return for the other special rights and privileges; preferred stock may be nonvoting, noncumulative, and nonparticipating. The accounting for preferred stock is similar to that for common stock, with preferred stock classified in a separate category in stockholders' equity.

large stock dividend

A stock dividend (a corporation's issuance of its own stock to its stockholders, on a pro rata basis) of more than 20-25 percent of the number of shares previously outstanding. The company transfers, from retained earnings to capital stock, the par value of the stock issued. Such a distribution (often referred to as a split-up effected in the form of a stock dividend) typically reduces the market price of the stock, making it more marketable. The effects of large stock dividends thus make them more like stock splits than like an ordinary stock dividend.

stated value

A value below which a company cannot issue no-par stock, as required by law in some states. Stated-value stock thus becomes, in effect, stock with a par value.

no-par stock

Capital stock that has not been assigned a par value. No-par stock avoids the contingent liability that might occur if the corporation issued par value stock at a discount and avoids the possibility of mistakenly using par value as a basis for fair value.

cumulative preferred stock

Cumulative preferred stock constitutes a dividend in arrears. A corporation does not record a dividend in arrears as a liability (because no liability exists until the board of directors declares a dividend), but discloses it in a note to the financial statements.

property dividends

Dividends payable in assets of the corporation other than cash. Also called dividends in kind. Property dividends may be merchandise, real estate, or investments. The company restates at fair value the property it will distribute, recognizing any gain or loss on the difference between the property's fair value and carrying value, and records the dividend in either the retained earnings account or a property dividends account.

redeemable preferred stock

Preferred stock that has a mandatory redemption period or a redemption feature that the issuer cannot control, making the security more like debt than like an equity instrument. The FASB requires that these (and similar) debt-like securities be classified and accounted for as liabilities.

treasury stock

Shares of stock reacquired by the issuing company and either retired or held in the treasury for reissue at a later date. Treasury stock is essentially the same as unissued capital stock; it is not an asset. Companies use two methods of accounting for treasury stock: the cost method (which records the purchase in a treasury stock account and reports that amount as a deduction from "paid-in capital and retained earnings" on the balance sheet), or the par-value method (which records all transactions in treasury shares at their par value and reports the treasury stock as a deduction from capital stock only). Companies generally use the cost method to account for treasury stock.

residual interest

The difference between the assets and the liabilities of the company, which represents the owners' or stockholders' interest in the company. The concept of residual interest means that stockholders' equity has no existence apart from the assets and liabilities of the company—that stockholders' equity is not a claim to specific assets but a claim against the assets remaining after financial obligations have been met.

retained earnings

The earned capital of the company, which develops from profitable operations. It consists of all undistributed income that remains invested in the company.

contributed (paid-in) capital

The total amount paid in on capital stock—the amount provided by stockholders to the corporation for use in the business. Contributed capital includes the par value of all outstanding stock plus additional paid-in capital (any excess over par value paid in by stockholders).

leveraged buyout (LBO)

Transaction in which a company borrows money to finance the repurchase of all of the company's outstanding stock, in order to eliminate public (outside) ownership.

cost method

A method of accounting for treasury stock, in which a company debits a treasury stock account for the cost of reacquiring stock to be held in the treasury and reports this account as a deduction from "total paid-in capital and retained earnings" on the balance sheet.

par (stated) value method

A method of accounting for treasury stock, in which a company records all transactions in treasury shares at their par value and reports the treasury stock as a deduction from capital stock only.

Paid-in Capital in Excess of Par

Any excess over par value paid in by stockholders in return for the shares issued to them. Once paid in, the excess over par becomes a part of the corporation's additional paid-in capital. Also called additional paid-in capital.

Additional Paid-in Capital

Any excess over par value paid in by stockholders in return for the shares issued to them. Once paid in, the excess over par becomes a part of the corporation's additional paid-in capital. Also called paid-in capital in excess of par.

callable preferred stock

Preferred stock that permits the corporation, at its option, to call or redeem the outstanding preferred shares at specified future dates and stipulated prices. The callable feature enables the company to use the capital from the issuance of the preferred stock until the need has passed or it is no longer advantageous.

participating preferred stock

Preferred stock whose holders share ratably with the common stockholders in any profit distributions beyond the prescribed rate. Its holders receive the prescribed return for preferred stock plus dividends generally at the same rates as those paid to common stockholders if the company pays dividends on common stock in excess of the prescribed preferred rate.

payout ratio

Profitability ratio that measures the percentage of earnings a company distributes to common stockholders in the form of cash dividends. Computed as cash dividends paid to common stockholders divided by net income available to common stockholders (net income minus preferred dividends).

book value per share

The amount each share of stock would receive if a company were liquidated, based on the amounts reported on the balance sheet. Computed as common stockholders' equity divided by the number of outstanding shares of stock. If the valuations on the balance sheet do not approximate the fair value of the shares, the book value per share figure loses its relevance.

common stock

The basic ownership interest in a corporation, as evidenced by shares that represent proportional ownership. Holders of common stock bear the ultimate risks of loss (they are guaranteed neither dividends nor assets upon dissolution) and receive the benefits of success through distributions of dividends or sales at a gain. They also generally control the management of the corporation through voting rights. If a corporation has only one authorized issue of capital stock, that issue is by definition common stock.

stock dividends

The issuance by a corporation of its own stock to its stockholders on a pro rata basis, without receiving any consideration. The company transfers, from retained earnings to capital stock and additional paid-in capital, the fair value of the stock issued. Payment of the stock dividend does not affect any asset or liability, but is a reclassification of stockholders' equity. The term stock dividend usually refers to what are properly classified as small (ordinary) stock dividends. (In contrast, large stock dividends are more like stock splits because of their effect of the market price of the stock.)

stock split

The issuance of additional shares of stock by dividing existing shares into multiple shares for each share owned; e.g., a 4-for-1 split gives a shareholder 4 shares for each 1 share owned. The motive is to reduce the market price of shares to be within range of the majority of potential investors. Companies record no entry for a stock split, but make a memorandum note to indicate the changed par value and the increased number of shares.

lump-sum sales

The issuance of two or more classes of securities for a single payment (lump sum). Companies use one of two methods of allocating the proceeds among the multiple classes of securities: the proportional method (allocate among classes on a proportional basis) or the incremental method (allocate using fair value of securities for which fair value is known and allocate the remainder to the class for which market value is not known).

stockholders' (owners') equity

The ownership claim on a company's total assets, computed as the difference between a company's assets and its liabilities. Stockholders' equity represents the cumulative net contributions by stockholders plus retained earnings. Reported in the stockholders' (owners') equity section of the corporate balance sheet, stockholders' equity consists of capital stock, additional paid-in capital, and retained earnings.

trading on the equity

The practice of using borrowed money or issuing preferred stock in hope of obtaining a higher rate of return on the money used. If return on the assets is higher than the cost of financing these assets, the excess accrues as a profit to the common stockholders.