ACCT 301B - CHAP. 15 - STOCKHOLDERS' EQUITY

Why doesn't a corporation record a Gain on Sale of Treasury Stock?

1. Gains on sales occur when selling assets; treasury stock is NOT an asset. 2. A gain or loss should not be recognized from stock transactions with its own stockholders.

sale of treasury stock

1. If the selling price of treasury stock equals its cost: debit cash and credit Treasury Stock. 2. If selling price of shares of treasury stock is ABOVE its cost: Debit Cash Credit Treasury Stock Credit Paid-In Capital from Treasury Stock (the difference between the two) 3. If selling price of shares of treasury stock is BELOW its cost: Debit Cash Debit Paid-In Capital from Treasury Stock (the difference between the two) Credit Treasury Stock

What are the special characteristics of the corporate form that affect accounting?

1. Influence of state corporate law. 2. Use of the capital stock or share system. 3. Development of a variety of ownership interests.

What is the procedure companies must follow when issuing stock?

1. The state must authorize the stock, generally in a certificate of incorporation or charter. 2. The corporation offers shares for sale, entering into contracts to sell stock. 3. After receiving amounts for the stock, the corporation issues shares.

What are the main reasons very few companies pay dividends in amounts equal to their legally available retained earnings?

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 (to protect against loss for creditors). 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.

Share buybacks now exceed dividends as a form of distribution to stockholders. What are the most common reasons that corporations purchase their outstanding stock?

1. To provide tax-efficient distributions of excess cash to shareholders (capital gain rates on sales of stock to the company by the stockholders can be advantageous). 2. To increase earnings per share and return on equity (often enhances certain performance ratios for the short-term, but add no real long-term value). 3. To provide stock for employee stock compensation contracts or to meet potential merger needs. 4. To thwart takeover attempts or to reduce the number of stockholders. (By reducing the number of shares held by the public, existing owners and managements bar "outsiders" from gaining control or significant influence. Companies may also use stock purchases to eliminate dissident stockholders). 5. To make a market in the stock (purchasing stock in the marketplace creates a demand; this may stabilize the stock price, or even increase it).

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 corporate assets upon liquidation. 4. To share proportionately in any new issues of stock of the same class (called preemptive right or stock right or warrant).

What are the 3 categories that 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 (dividends in kind) 3. liquidating dividends 4. stock dividends

What are the two general methods of handling treasury stock in the accounts?

1. cost method (most common) 2. par (stated) value method

What are the most common features attributed to preferred stock?

1. cumulative preferred stock 2. participating preferred stock 3. convertible preferred stock 4. callable preferred stock 5. redeemable preferred stock A corporation may attach whatever preferences or restrictions, in whatever combination it desires, to a preferred stock issue, or multiples classes of preferred stock, as long as it does not specifically violate its state incorporation law.

methods that result in secret reserves

1. if a corporation undervalues recorded assets as a result of issuing stock for property/services 2. excessive depreciation or amortization charges 3. expensing capital expenditures 4. excessive write-downs of inventories or receivables 5. any other understatement of assets or overstatement of liabilities

What are the 2 methods of allocation used to allocate lump-sum proceeds to several classes of securities?

1. proportional method 2. incremental method

What are the 3 primary forms of business organization?

1. proprietorship 2. partnership 3. corporation

cash dividends

A declared cash dividend is a liability, usually a current liability since payment is generally required very soon. Upon approval of the resolution, the board of directors declares a dividend, but must prepare a current list of stockholders before paying it. The timeline is usually: [Date of declaration] for dividends payable on [Date of payment] to all stockholders as of [Date of record] Date of declaration: Debit Retained Earnings (or Cash Dividends Declared) Credit Dividends Payable Date of Payment: Debit Dividends Payable Credit Cash

recording a large stock dividend (stock split-up effected in the form of a dividend)

Companies transfer from retained earnings to contributed capital (capital stock) the PAR VALUE of the stock issued. The amounts used in the journal entries are: number of shares outstanding multiplied by the percent stock dividend, then multiplied by the PAR VALUE per share at date of declaration: Debit Retained Earnings Credit Common Stock Dividend Distributable at date of distribution: Debit Common Stock Dividend Distributable Credit Common Stock

After eliminating the credit balance in Paid-In Capital from Treasury Stock, the corporation debits any additional excess of cost OVER selling price to Retained Earnings (i.e. when a corporation sells additional shares). What would the journal entry look like?

Debit Cash Debit Paid-In Capital from Treasury Stock Debit Retained Earnings Credit Treasury Stock

What does the SEC encourage, in regard to dividend policy?

For companies to disclose their dividend policy in their annual report, especially those that 1. have earnings but fail to pay dividends 2. do not expect to pay dividends in the foreseeable future 3. consistently pay dividends, and should indicate whether they intend to continue this practice in the future.

incremental method

If a company cannot determine the fair market value of all classes of securities: it uses the fair market 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 market value. If a company cannot determine the fair value for any of the classes of stock involved in the lump-sum exchange, it may need to use other approaches (i.e. rely on expert's appraisal, or best estimate if it knows there will be a determinable fair market value in the near future).

proportional method

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

What is a major disadvantage of no-par stock?

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

recording a small stock dividend

The amount of additional shares issued by the company is the amount of shares outstanding multiplied by the percent stock dividend (a number less than 20-25 percent) at date of declaration: Debit Retained Earnings (the FMV of the stock at the time of declaration multiplied by the amount of additional shares issued) Credit Capital (Common or Preferred) Stock Dividend Distributable (the amount of additional shares multiplied by par value of the stock) Credit Paid-in Capital in Excess of Par - Capital Stock at date of distribution: Debit Capital Stock Dividend Distributable (the amount of additional shares multiplied by par value of the stock) Credit Common Stock

costs of issuing stock

The company should report direct costs incurred to sell stock (i.e. underwriting costs, accounting and legal fees, printing costs and taxes) as a reduction of amounts paid in. Issue costs are a cost of financing and therefore, reduce the proceeds received from the sale of the stock. The company debits issue costs to Paid-In Capital in Excess of Par - Common Stock because they are unrelated to corporate operations. ALL other indirect costs related to the stock should be expensed (i.e. management salaries, recurring costs like registrar and transfer agents' fees).

A company may exchange unissued stock or treasury stock (issued shares that it has reacquired but not retired) for property or services. If it does this, it should use the fair value of the treasury stock, if known, to value the property or services (NOT the cost of the treasury shares). True or false?

True

A company often issues preferred stock (instead of debt) because of a high debt-to-equity ratio. True or false?

True

A preference as to dividends does NOT assure the payment of the dividends. It merely assures the corporation must pay the stated dividend rate or amount applicable to the preferred stock before paying any dividends on the common stock. True or false?

True

After reacquiring shares, a company may either retire them or hold them in the treasury for reissue. True or false?

True

Companies DO NOT declare or pay cash dividends on treasury stock. True or false?

True

Each share of stock has certain rights and privileges. Only by special contract can a company restrict these rights and privileges at the time it issues the shares. Owners must examine the articles of incorporation, stock certificates, and the provisions of the state law to ascertain such restrictions on or variations from the standard rights and privileges. True or false?

True

Each state has its own business incorporation act, and the accounting for stockholders' equity follows the provisions of these acts. True or false?

True

Nearly half of public corporations in the U.S. are incorporated in Delaware because the state has a favorable tax and regulatory environment. True or false?

True

Owners' equity in a corporation is defined as stockholders' equity, shareholders' equity, or corporate capital. True or false?

True

Preferred stock generally has no maturity date. Therefore, no legal obligation exists to pay the preferred stockholder. As a result, companies classify preferred stock at par value as the FIRST item in the stockholders' equity section of the balance sheet. True or false?

True

Stockholders' equity in a corporation generally consists of a large number of units or shares. Within a given class of stock, each share exactly equals every other share. True or false?

True

Stockholders' equity ratios are used to evaluate a company's profitability and long-term solvency. True or false?

True

The preemptive right protects an existing stockholder from involuntary dilution of ownership interest. But, many corporations have eliminated the preemptive right because it makes it inconvenient for corporations to issue large amounts of additional stock, as they frequently do in acquiring other companies. True or false?

True

When a corporation buys back some of its own outstanding stock, it has not acquired an asset; it reduces net assets. True or false?

True

All dividends, except for stock dividends, reduce the total stockholders' equity in a corporation. True or false?

True. Also, the basis journal entry for all dividends (except stock dividends) is: Debit Retained Earnings Credit Dividends Payable

Before declaring a dividend, management must consider availability of funds to pay the dividend. A company should not pay a dividend unless both the present and future financial position warrant the distribution. True or false?

True. The existence of current liabilities strongly implies that a company needs some cash to meet current debts as they mature. Day-to-day cash requirements for payrolls and other expenditures not included in current liabilities also require cash.

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

True. example: Holders of 8 percent preferred stock with a $100 par value are entitled to an annual dividend of $8 per share. In the case of no-par preferred stock, a corporation expresses a dividend preference as a specific dollar amount per share.

Whenever corporations issue additional shares for the purpose of reducing the unit market price, then the distribution more closely resembles a stock split than a stock dividend. This effect usually results only if the number of shares issued is more than 20-25 percent of the number of shares previously outstanding. True or false?

True. A stock dividend of more than 20-25 percent of the number of shares previously outstanding is called a "large stock dividend" but should instead be called "a split-up effected in the form of a dividend" or "stock split."

The par value of a stock has no relationship to its fair value. True or false?

True. At present, the par value associated with most capital stock issuances is very low. Low par values help companies avoid the contingent liability associated with stock sold below par.

The share system easily allows an individual to transfer an interest in a company to another investor. Individuals owning shares in a corporation may sell them to others at any time and at any price without obtaining the consent of the company or other stockholders. True or false?

True. Each share is personal property of the owner, who may dispose of it at will.

Stockholders' equity is not a claim to specific assets but a claim against a portion of total assets. True or false?

True. Its amount is not specified or fixed; it depends on the company's profitability.

Anyone who wishes to establish a corporation must submit articles of incorporation to the state in which incorporation is desired. After fulfilling requirements, the state issues a corporation charter, thereby recognizing the company as a legal entity subject to state law. True or false?

True. Regardless of the number of states in which a corporation has operating divisions, it is incorporated in only one state.

Restrictions on retained earnings or dividends are best disclosed by notes to the financial statements. True or false?

True. 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.

The owners' or stockholders' interest in a corporation is a residual interest. True or false?

True. Stockholders' (owners') equity represents the cumulative net contributions by stockholders plus retained earnings. As a residual interest, stockholders' equity has no existence apart from the assets and liabilities of the company - stockholders' equity equals net assets.

Together, common stock and preferred stock reflect the par value of a corporation's issued shares. True or false?

True. The company credits these accounts when it originally issues the shares. It makes no additional entries in these accounts unless it issues additional shares or retires them.

In corporate law, the board of directors has the power to set the value of noncash transactions, and sometimes abuses this power by overvaluing property/services received and therefore, overstating corporate capital. The overvaluation of the stockholders' equity resulting from inflated asset values creates watered stock. True or false?

True. The corporation should eliminate the "water" by writing down the overvalued assets.

If a company has undistributed earnings over several years and accumulates a sizable balance in retained earnings, the market value of its outstanding shares likely increases. True or false?

True. The higher the market price of a stock, however, the less readily some investors can purchase it.

If a company cannot readily determine either the fair value of the stock it issues or the property or services it receives, it should employ an appropriate valuation technique. True or false?

True. The valuation may be based on market transactions involving comparable assets or the use of discounted expected future cash flows. Companies should avoid using the book, par, or stated values as a basis of valuation for these transactions.

When a stock dividend is less than 20-25 percent of the common shares outstanding at the time of the dividend declaration, the company is required to transfer the FAIR VALUE of the stock/shares issued from retained earnings to paid-in capital accounts. True or false?

True. These stock dividends are often referred to as small (ordinary) stock dividends

A publicly held corporation may choose to "go private" by purchasing all of its outstanding stock. True or false?

True. This is often accomplished through a leveraged buyout (LBO), in which the company borrows money to finance the stock repurchases.

treasury stock (treasury shares)

a corporation's own stock, reacquired after having been issued and fully paid It is NOT an asset. When a company purchases treasury stock, a reduction occurs in both assets and stockholders equity. Treasury stock is essentially the same as unissued capital stock.

convertible preferred stock

allows stockholders, at their option, to exchange preferred shares for common stock at a predetermined ratio The convertible preferred stockholder not only enjoys a preferred claim on dividends but also has the option of converting into a common stockholder with unlimited participation in earnings.

no-par stock

capital stock without a par value True no-par stock should be carried in the accounts at issue price without any additional paid-in capital or discount reported. Issued because (1) company can avoid the contingent liability that may occur if it issued par value stock at a discount and (2) some confusion exists over the absence of a relationship between par value and fair value (questionable treatment of using par value as a basis for fair value never arises) - advantageous when issuing stock for property items like intangible or tangible fixed assets

cost method (for treasury stock)

debit the Treasury Stock account for the reacquisition cost of the shares, and credit the account for this same cost upon reissuance of the shares (the "Common Stock" and "Paid-In Capital in Excess of Par - Common Stock" accounts are NOT affected because the number of shares issued does not change) Deduct treasury stock from the TOTAL paid-in capital (common stock + additional paid-in capital) and retained earnings on the balance sheet. The original price received for the stock does not affect the entries to record the acquisition and reissuance of the treasury stock.

liquidating dividends

dividends not based on earnings, and therefore reduces the Paid-in Capital account implies that such dividends, in excess of accumulated income, are a return of the stockholders' investment rather than of profits commonly used by extractive industries because the companies perform for a period of time, then company is sold; then the company may pay dividends equal to the total of accumulated income and depletion How to know it is a liquidating divided: 1. The problem states dividend amount and "the remainder is a return of capital." 2. The retained earnings balance is less than dividends declared.

property dividends (dividends in kind)

dividends payable in assets of the corporation other than cash (i.e. merchandise, real estate, investments, or whatever form the board of directors designates) Because of the obvious difficulties of divisibility of units and delivery to stockholders, the usual property dividend is in the form of securities of other companies that the distributing corporation holds as an investment. When declaring a property dividend, the corporation should restate at FAIR MARKET VALUE the property it will distribute, recognizing any gain or loss as the difference between the property's fair value and carrying/book value at DATE OF DECLARATION. For a gain (FMV > book value): Debit Equity Investments Credit Unrealized Holding Gain or Loss - Income For a loss (FMV < book value): Debit Unrealized Holding Gain or Loss - Income Credit Equity Investments Record dividend on date of declaration: Debit Retained Earnings (or Property Dividends Declared) Credit Property Dividends Payable (equal to the fair value of the distributed property) Record dividend on date of distribution: Debit Property Dividends Payable Credit Equity Investments (the account containing the distributed asset, restated at FMV)

redeemable preferred stock

has a mandatory redemption period or a redemption feature that the issuer cannot control These are debt-like securities, and must be classified as liabilities and be measured and accounted for similar to liabilities.

participating preferred stock

holders of this type of stock share ratably with the common stockholders in any profit distributions beyond the prescribed rate example: 5 percent preferred stock, if fully participating, will receive not only its 5 percent return, but also dividends at the same rates as those paid to common stockholders if paying amounts in excess of 5 percent of par or stated value to common stockholders

payout ratio

if no preferred stock outstanding: (cash dividends paid to common stockholders) / (net income - preferred dividends)

What is a corporation's principle advantage?

its facility for attracting and accumulating large amounts of capital

stock split

management of a corporation reduces the market price of shares, by targeting a market price sufficiently low to be within range of the majority of potential investors NO ENTRY IS RECORDED FOR STOCK SPLITS, but a corporation enters a memorandum note to indicate the decreased par (stated) value of the shares and the increased number of shares.

return on common stock equity (ROE)

measures profitability from the common stockholders' viewpoint; shows how many dollars of net income the company earned for each dollar invested by the owners; helps investors judge the worthiness of a stock when the overall market is not doing well (net income - preferred dividends) / average common stockholders' equity (using prior year and current year, excluding the par value of preferred stock)

stated value

minimum value below which a company cannot issue a no-par stock No-par stock with a low stated value permits a new corporation to commence its operations with additional paid-in capital that may exceed its stated capital.

stock issued in noncash transactions

noncash = property or services 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. If a company can readily determine both, and the transaction results from an arm's-length exchange, there will probably be little difference in their fair values.

callable preferred stock (commonly used)

permits the corporation at its option to call or redeem the outstanding preferred shares at specified future dates and at stipulated prices The corporation usually sets the call or redemption price slightly above the original issuance price and commonly states it in terms related to the par value. 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 existence of a call price or prices tends to set a ceiling on the market price of the preferred shares unless they are convertible into common stock. When a corporation redeems preferred stock, it must pay dividends in arrears.

par (stated) value method (for treasury stock)

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

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 stockholders 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. A corporation records a dividend in arrears in a note to the financial statements (because no liability exists until the board of directors declares a dividend). 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.

retiring treasury shares

results in cancellation of the treasury stock and a reduction in the number of shares of issued stock Retired shares have the status of authorized and unissued shares. The accounting effects are similar to the sale of treasury stock except that corporations debit the paid-in capital accounts applicable to the retired shares (INSTEAD of cash).

What is the difference between shares authorized, shares sold, shares issued, and shares outstanding?

shares authorized - the SEC authorizes the company's ability to issue stock shares sold - company offers shares for sale; shares must be sold before issued; investors must pay stock price before they can be issued shares issued - shares that investors/stockholders currently hold shares outstanding - shares that investors/stockholders currently hold MINUS any treasury stock the company may have

preferred stock

special class of stock that stockholders may have to sacrifice certain rights in return for other special rights or privileges A common preference given to preferred stockholders is a prior claim on earnings. The corporation assures them a dividend, usually at a stated rate, before it distributes any amount to the common stockholders. In return, preferred stockholders may sacrifice their right to a voice in management or their right to share in profits beyond a stated rate.

book value per share

the amount each share would receive if the company were liquidated on the basis of amounts reported on the balance sheet (common stockholders' equity) / (outstanding shares)

earned capital

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

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 distributes NO assets; there is just a mere reclassification of stockholders' equity. If management wishes to "capitalize" part of the earnings (i.e. reclassify amounts from earned to contributed capital) and thus keep earnings in the business on a permanent basis, it may issue a stock dividend. Each stockholder maintains exactly the same proportionate interest in the corporation and the same total book value after the company issues the stock dividend.

trading on the equity

the practice of using borrowed money or issuing preferred stock in the hopes of obtaining a higher rate of return on the money used

common stock

the residual corporate interest that bears the ultimate risks of loss and receives the benefits of success Common stockholders are NOT guaranteed dividends or assets upon dissolution. But, they generally control the management of a corporation and tend to profit most if the company is successful. represents the basic ownership interest

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 includes items like the par value of all outstanding stock and premiums less discounts on issuance

Paid-In Capital in Excess of Par

this account indicates 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. The individual stockholder has no greater claim on the excess paid in than all other holders of the same class of shares.

stock issued with other securities (lump-sum sales)

when a corporation issues two or more classes of securities for a single payment or lump sum (i.e. in the acquisition of another company) The accounting problem is how to allocate the proceeds among the several classes of securities.