Chapter 11 Important Concepts and Key Terms

Par Value

an insignificant value per share of capital stock specified in the charter (In any event, par value is a legal concept and is not related in any way to the market value of the company's stock.)

A cash dividend involves four important dates, only three of which require accounting entries. Four important dates for a cash dividend

1. Declaration Date 2. Date of Record 3. Date of Payment 4. Year-End

continuation of previous example

Continuing with this example, assume that 5,000 shares of treasury stock were reissued later at a price below its repurchase price. The difference between the repurchase price ($25 per share × 5,000 = $125,000) and the reissue price (say, $23 per share × 5,000 = $115,000) is recorded as a reduction in Additional Paid-in Capital. The accounting equation effects and journal entry for this case, reissuing at less than cost, are:

Return on Equity (ROE) explained

Like EPS, return on equity (ROE) reports a company's return to common stockholders. However, rather than relate net income to the average number of shares outstanding, the return on equity (ROE) ratio relates net income to the average dollars of common stockholder investment in the company.3 Because ROE uses dollars contributed to and reinvested in the company, this ratio can be appropriately compared across companies.

Declaration Date (example from book)

On the declaration date, the company's board of directors formally approves the dividend, thereby creating a legal liability for the corporation. The dividend declaration is accounted for by increasing Dividends Payable and increasing a temporary account called Dividends. Because dividends are a distribution of the company's prior earnings, this Dividends account is deducted from Retained Earnings when it is closed at year-end. Until then, the temporary account is accounted for as a decrease in Stockholders' Equity, as shown below. Although they reduce Retained Earnings, dividends are not an expense. Rather, they are a distribution of prior profits.

capitalizing retained earnings

Stock dividends are recorded by transferring an amount from Retained Earnings to Common Stock (and possibly other contributed capital accounts) - this transfer is called "capitalizing retained earnings" The amount transferred is either the stock's par value (for large dividends) or its market value (for small dividends).

Earnings Per Share (EPS)

The calculation of EPS can involve many details and intricacies, but in its basic form, it is computed by dividing net income by the average number of common shares outstanding. Because preferred stock has priority over common stock, any dividends on preferred stock are subtracted from net income when computing EPS.

Price/Earnings ratio explained Price to Earnings ratio explained P/E Ratio explained

The price/earnings ratio is the most basic way to determine the value investors place on a company's common stock. The P/E ratio, as most people call it, measures how many times more than current year's earnings investors are willing to pay for a company's stock.

Year-End

Year-End. All temporary accounts, including Dividends, are closed into Retained Earnings at each accounting year-end. This closing journal entry zeroes out the temporary account Dividends by transferring its (debit) balance to its permanent home in Retained Earnings. The closing entry has no effect on total stockholders' equity.

Stock Dividends

a dividend that distributes additional shares of a corporation's own stock These dividends, called stock dividends, are distributed to a corporation's stockholders on a pro rata basis at no cost to the stockholder. The phrase pro rata basis means that each stockholder receives additional shares equal to the percentage of shares held. A stockholder who owns 10 percent of the company's shares would receive 10 percent of any additional shares issued as a stock dividend.

If a company has issued stock previously, additional issuances of new stock by the company are called seasoned new issues.

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The very first issuance of a company's stock to the public is called an initial public offering, or IPO.

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Treasury stock

issued shares that have been reacquired by the company

Because dividends are not a liability until the board of directors declares them, dividends in arrears (i.e., dividends not declared on cumulative preferred stock) are not reported on the balance sheet. Instead, they are disclosed in the notes to the financial statements as National Beverage did in a previous year: "Unpaid dividends at April 27, 2013 were $141,000."

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During the time treasury stock is held by the corporation, the shares do not carry voting, cash dividend, or other stockholder rights.

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Large Stock Dividends

A stock dividend is large when the issue is more than 25 percent of the outstanding shares. A large stock dividend is recorded at the stock's par value. National Beverage declared a large stock dividend several years ago, resulting in the issuance of 7.6 million common shares with a par value of $0.01 per share. The total par value (7.6 million × $0.01 = $76,000) was accounted for as

effects of a stock repurchase on the accounting equation and the journal entry

Assume that during the next fiscal year, National Beverage repurchased 50,000 shares of its stock for $25 per share (50,000 shares × $25 = $1,250,000) and held these stock in treasury. Using the cost method, the effects of this repurchase on the accounting equation and the journal entry for it would be (We use the notation +xSE in the journal entry to remind you that Treasury Stock is not an asset.)

How stock dividends are accounted for

Stock dividends are recorded by transferring an amount from Retained Earnings to contributed capital accounts. The value used to record a stock dividend varies depending on the size of the stock dividend. A large stock dividend (more than 25 percent of the company's outstanding stock) is recorded at par value; thus, the decrease in Retained Earnings equals the increase in the Common Stock account. A small stock dividend (less than 25 percent of the company's outstanding stock) is recorded at market value. Regardless of size, a stock dividend affects only the balances within stockholders' equity; it does not change a company's total stockholders' equity.

Reissuance of Treasury Stock GAAP does not permit a corporation to report income or losses from investments in its own stock because transactions with the owners are not considered profit-making activities...

...Instead, this type of transaction affects only the balance sheet, just like other stock issuances. To illustrate, let's extend our previous example where National Beverage had repurchased its stock at a cost of $25 per share. If National Beverage reissues 5,000 shares of this treasury stock for $28 per share (5,000 × $28 = $140,000), the accounting equation effects and journal entry would be:

Advantages of Debt Financing

1. Interest on debt is tax deductible. Dividends on stock are not tax deductible. 2. Debt does not change stockholder control. In contrast, a stock issue gives new stockholders the right to vote and share in the earnings, diluting existing stockholders' control.

Benefits of owning Common Stock

1. voting rights 2. dividends 3. residual claim - If the company ceases operations, stockholders share in any assets remaining after creditors have been paid. 4. preemptive rights - To retain their ownership percentages, existing stockholders may be given the first chance to buy newly issued stock before it is offered to others.

Repurchase of Stock Reasons a company would repurchase its own stock

A corporation may want to repurchase its stock from existing stockholders to (1) send a signal to investors that the company itself believes its own stock is worth acquiring, (2) obtain shares that can be reissued as payment for purchases of other companies, (3) obtain shares to reissue to employees as part of employee stock purchase plans, and (4) reduce the number of outstanding shares to increase per-share measures of earnings and stock value.

Statement of Stockholders' Equity

Retained Earnings is only one of their stockholders' equity accounts. To show the causes of changes in all stockholders' equity accounts, public companies report a more comprehensive version of the statement of retained earnings called the statement of stockholders' equity. The statement of stockholders' equity has a column for each stockholders' equity account and shows the increases and decreases in each account balance during the period.

No-par Value

capital stock that has no par value specified in the corporate charter

Why EPS is important

1) In other words, current EPS influences expectations about future dividends, which investors factor into the current stock price. 2) Another reason EPS is so popular is that it allows you to easily compare results over time.

dividends in arrears

dividends on cumulative preferred stock that have not been declared in prior years

net income can be affected by differences in how two companies cost inventory, estimate bad debts, depreciate long-lived tangible assets, and estimate losses from contingent liabilities. So, while EPS is an effective and widely used measure for comparing a company with itself over time, it is not appropriate for comparing across companies.

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example of statement of stockholders' equity - part 1 (first half of screenshot)

from this screenshot (and the next half of it) we can quickly see the most significant stock transactions for National Beverage during its 2016 fiscal year: its net income and its dividend on preferred stock (both of which affected Retained Earnings), and the issuance of common stock and redemption of preferred stock (both of which affected Additional Paid-In Capital).

Outstanding Shares

shares that are currently held by stockholders (not the corporation itself)

Preferred stock

stock that has specified rights over common stock

Common Stock

the basic voting stock issued by a corporation to stockholders

Outstanding shares formula

Outstanding shares = Issued shares - treasury stock

Issued Shares

shares of stock that have been distributed by the corporation

3 reasons corporations are attractive

1) Shares of Stock can be purchased in small amounts 2) Ownership interests are transferable 3) Stockholders are not liable for the corporations' debts

Advantages of Equity Financing

1. Equity does not have to be repaid. Debt must be repaid or refinanced. 2. Dividends are optional. Interest must be paid on debt.

Differences between common stock and preferred stock

1. Preferred stock allows different voting rights. Preferred stock can carry anywhere from no voting rights to super-voting rights. This flexibility allows a corporation to separate stock ownership from voting control. No voting rights are useful if you want to raise financing from a key stockholder who already owns a lot of common stock and you don't want that stockholder to take control. Super-voting rights can let founding stockholders retain control and yet still issue shares to the public. Recently, Facebook and Snap have adopted stock structures that give super-voting rights to some stockholders and no voting rights to others. 2. Dividends on preferred stock, if any, may be paid at a fixed rate, specified as either a dollar amount or a percentage per share. For example, if dividends are declared on National Beverage's "2.5%, $1 par value" preferred stock, the dividend will equal 2.5 cents per share ($0.025 = 2.5% × $1.00). A fixed dividend can be attractive to certain investors, such as company founders or retirees, who seek stable investment income. 3. Preferred stock carries priority over common stock. Preferred stockholders have higher priority than common stockholders if a corporation distributes assets to its owners through dividends or at liquidation. That is, any dividends the corporation declares must be paid to preferred stockholders before they can be paid to common stockholders. Also, if the corporation goes out of business, its assets will be sold and used to pay creditors and then preferred stockholders. Common stockholders are paid last from whatever assets remain after paying preferred stockholders.

When deciding whether to declare a cash dividend, a company's board of directors considers the following two key financial requirements:

1. Sufficient retained earnings. The corporation must have accumulated a sufficient amount of Retained Earnings to cover the amount of the dividend. State laws often limit dividends to no more than the balance in Retained Earnings. A company may be further restricted by clauses in its loan agreements that require an even larger minimum balance in Retained Earnings. If the company were to violate such a loan covenant, a lender could require renegotiation of the loan and possibly demand its immediate repayment. Because restrictions on Retained Earnings can severely limit dividends, accounting rules require that companies disclose any restrictions in their financial statement notes. In a prior year, National Beverage reported in its financial statement notes that "$1,320,000 of retained earnings were restricted from distribution." 2. Sufficient cash. The corporation must have sufficient cash to pay the dividend. Cash can be used in many ways, so the mere fact that Retained Earnings has a large credit balance does not mean the company has sufficient cash to pay a dividend. Remember, retained earnings is not cash.

3 reasons why a company issues a stock dividend.

1. To lower the market price per share of stock. If you increase the number of shares without changing the company in any other way, the stock price per share will fall proportionately: 20 shares at $100 per share become 40 shares at $50 per share after a 100 percent stock dividend. National Beverage has declared stock dividends four times since becoming a public company, each time to make the company's stock more affordable to small investors. 2. To demonstrate commitment to stockholders while conserving cash during difficult times. This reason was given by the hotel company Marriott during the financial crisis of 2009 when it replaced its regular cash dividend with a stock dividend. Unlike a cash dividend, a stock dividend does not involve cash payments or any distribution of assets. But the stock dividend did allow Marriott to continue boasting that it had declared a dividend "in every year since going public in 1953." 3. To signal an expectation of significant future earnings. Companies can declare future cash dividends only when they maintain an adequate balance in Retained Earnings through profitable operations. Because stock dividends cause a reduction in Retained Earnings, companies will declare stock dividends only if they expect sufficient future earnings to replenish the balance in Retained Earnings after a stock dividend. Nike used this reasoning to explain its 100 percent stock dividend in a recent year; the company's CEO said it was a sign of "the ongoing confidence we have in our strategy to generate long-term profitable growth."

Small Stock Dividends

A stock dividend is small when less than 25 percent of the company's outstanding shares are issued. A small stock dividend is accounted for at the market value of the company's stock. Because market value exceeds par value, the company must record the excess as Additional Paid-In Capital. To illustrate, assume National Beverage issues a small stock dividend of 10,000 common shares when its stock is trading at $20 per share. The total market value of the dividend is $200,000 ($20 × 10,000), whereas the total par value is $100 ($0.01 × 10,000), so the excess of market value over par value is $199,900 ($200,000 − $100). The effects of this small dividend would be accounted for as

the balance sheet accounts National Beverage reported in the stockholders' equity section of its balance sheet at the end of its 2016 fiscal year. It includes four main elements:

Contributed Capital reports the amount of capital the company received from investors' contributions. That is, contributed capital represents paid-in capital. As Exhibit 11.2 suggests, contributed capital can include several components, relating to common stock and preferred stock, as we'll explain later in this section. Retained Earnings reports the cumulative amount of net income earned by the company less the cumulative amount of dividends since the corporation was first organized. Retained Earnings represents earned capital. Treasury Stock reports shares that were previously issued to and owned by stockholders but have been reacquired and are now held by the corporation. To fully understand treasury stock, it's helpful to follow stock transactions through from authorization to issuance and repurchase, as we do in the following section. 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. They can relate to pensions, foreign currencies, and financial investments, such as National Beverage's contracts to stabilize the cost of its aluminum cans. Accounting rules relating to Accumulated Other Comprehensive Income (Loss) are explained in advanced financial accounting courses.

Date of Payment

Date of Payment. The payment date is the date on which cash is disbursed to pay the dividend liability owed to each stockholder. The distribution of cash and reduction in liability are recorded on this date, as follows:

Date of Record

Date of Record. The shares of public companies are bought and sold all the time; it takes time to determine who should receive the dividend payment after the dividend has been declared. The record date is the cut-off date for determining the specific stockholders to be paid the dividend. No journal entry is recorded on this date.

Preferred Stock Redemption

In the same way a company can repurchase its common stock, it also can reacquire its previously issued preferred stock. The reacquisition of preferred stock typically is referred to as a redemption because, rather than being held in treasury, the preferred stock is formally retired as if it were never issued. To account for the redemption of preferred stock, a company reverses the original issuance. For example, in 2016, National Beverage redeemed 120,000 shares of its $1 par value preferred stock for $6 million. It accounted for this redemption by decreasing Cash (with a credit) for $6,000,000, decreasing Preferred Stock (with a debit) for the $120,000 par value, and decreasing Additional Paid-In Capital-Preferred (with a debit) for the $5,880,000 in excess of par.

Journal entry of stock issuance (example from book)

Most stock issuances are cash transactions. To illustrate the accounting for a stock issuance, assume that during the next fiscal year, National Beverage issues 100,000 shares of its $0.01 par value stock at the market price existing at the time of issuance of $20 per share. The accounting equation effects of this stock issuance and the journal entry to record them would be:

Cumulative Dividend Preference

Preferred stock feature that requires specified 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. A cumulative dividend preference states that if all or a part of the current dividend is not paid in full, the cumulative unpaid amount, known as dividends in arrears, must be paid before any future common dividends can be paid.

Retained Earnings

Retained Earnings represents the company's total earnings that have been retained in the business (rather than being distributed to stockholders). The balance in this account increases when the company reports net income and it decreases when the company reports a net loss (expenses greater than revenues) or declares cash or stock dividends to stockholders. Should a company ever accumulate more net losses than net income over its life, it will report a negative (debit) balance in the Retained Earnings account. This amount is (a) shown in parentheses in the stockholders' equity section of the balance sheet, (b) deducted when computing total stockholders' equity, and (c) typically called an Accumulated Deficit rather than Retained Earnings.

Preferred Stock Issuance Just like a common stock issuance, a preferred stock issuance increases a company's cash and its stockholders' equity.

Several years ago, National Beverage issued 400,000 shares of its $1 par value preferred stock for $19,704,000. As shown below, the Preferred Stock account increased by its par value for each share issued ($1 × 400,000 = $400,000) and the amount of cash received in excess of par value was recorded as Additional Paid-In Capital—Preferred:

Stock Split

an increase in the total number of authorized shares by a specified ratio; does not affect retained earnings

Declaration Date

the date on which the board of directors officially approves a dividend

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 stock holders who own stock on that date

Current Dividend Preference

the feature of preferred stock that grants priority on preferred dividends over common dividends A current dividend preference requires that preferred dividends be paid before paying any dividends to holders of common stock.

Authorized Shares

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