Unit 04 - Stockholders' Equity - Ch 15

Shareholder Rights

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 the preemptive right. (protects an existing stockholder from involuntary dilution of ownership interest by issuance of new stocks etc.)

Residual Interest

Stockholders' equity has no existence apart from the assets net liabilities. It is the residual, meaning the leftover interest in the assets of an entity that remains after deducting its liabilities.

Steps to Issue Stock

(1) The state must authorize the stock, generally in a certificate of incorporation or charter. No GL entry. (2) The corporation offers shares for sale entering into contracts to sell stock. (3) After receiving amounts for the stock, the corporation issues shares.

IFRS Equity: Residual Interest

Equity is this and therefore its value is derived from the amount of the corporations' assets and liabilities. Only in unusual cases will a company's equity equal the total fair value of its shares. For example, BMW recently had total equity of €20,265 million and a market capitalization of €21,160 million.

Financial Statement Analysis: Payout Ratio

Formula = [ Cash Dividends ] / [ Net Income ]. //// If preferred stock is outstanding, this ratio equals cash dividends paid to common stockholders, divided by net income available to common stockholders.

Reasons for Stock Buybacks

To provide tax-efficient distributions of excess cash to shareholders. Capital gains tax on buybacks is about half of the rate for dividends. /// To increase earnings per share and return on equity. /// To provide stock for employee stock compensation contracts or to meet potential merger needs. /// To thwart takeover attempts or to reduce the number of stockholders. /// To make a market in the stock. Purchasing stock in the marketplace creates a demand. This may stabilize the stock price or increase it. ///// The conventional wisdom is that companies which buy back shares believe their shares are undervalued. Thus, analysts view the buyback announcement as an important piece of inside information about future company prospects. On the other hand, buybacks can actually hurt businesses and their shareholders over the long run.

Accounting for the Sale of Treasury Stock

*AT COST*: Simple DR Cash / CR Treasury Stock. //// *ABOVE COST*: Difference is CR 'Paid-in Capital from Treasury Stock'. //// *BELOW COST*: Difference is DR 'Paid-in Capital from Treasury Stock' until it is zeroed out then the balance is DR 'Retained Earnings'. //// *EITHER WAY*: They wipe out the 'Treasury Stock' equity account. // The total to the 'Treasury Stock' account is always the COST of the stocks. // It never touches 'Common Stock'. //// *GAIN/LOSS*: This is not a gain/loss because gain/loss are on sales of assets and treasury stock is not an asset. Also, gain/loss should not be recognized from stock transactions with its own stockholders.

Dividends: Types of

Companies generally base dividend distributions either on accumulated profits (that is, retained earnings) or on some other capital item such as additional paid-in capital. *CASH DIVIDENDS*: Follows the normal process. *PROPERTY DIVIDENDS*: Any asset other than cash. Gold bars, stocks of other companies. *LIQUIDATING DIVIDENDS*: Based on something other than retained earnings. Return of stockholder's investment rather than profits.

IFRS Equity: Contributed Capital vs Earned Capital

Companies often make a distinction between contributed capital (paid-in capital) and earned capital. Contributed capital (paid-in capital) is the total amount paid in on capital shares and includes items such as the par value of all outstanding shares and premiums less discounts on issuance. Earned capital is the capital that comes from profitable operations. This includes all undistributed income that remains invest in the company aka retained earnings.

Preferred Stock: Calculating the Dividend

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*. 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*. /// A preference as to dividends *does not assure the payment of dividends*. It merely assures that the *corporation must pay the stated dividend rate or amount applicable to the preferred stock before paying any dividends on the common stock*.

Dividends: Disclosure of Restrictions

Many corporations restrict retained earnings or dividends, without any formal JE's. These are disclosed in the Notes of the financials. Restrictions due to bond indentures and loan agreements generally require extended explanations.

Accounting for No-Par Stock: Why Have No-Par Stock

Many states permit no-par stocks. Two reasons they allow it. (1) This avoids the contingent liability that might occur if the corporation issued par value stock at a discount. (2) Avoids the confusion of why par value has no relationship to fair value and removes the question of if it can be valued at par value instead of at fair value. // 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.

Accounting for Stock Issued in Lump-Sum Sales

Two ways to rate them: proportional or incremental methods. //// *PROPORTIONAL* Method: If two classes of stock are issued together for one lump sum. Times the share count times the *FAIR* value (not par/stated value) for a total for each class of stock. Use those totals to allocate the lump sum proportionally to those classes. Ex: Common 1K + Preferred 1K = $30,000. Common 1K x $20 = $20K. Preferred 1K x $12 = $12K. $20K+$12K = $32K. Common % is ($20K/$32K) x $30K. Preferred % is ($12K/$32K) x $30K. //// *INCREMENTAL* Method: When the company cannot determine the *FAIR* value of all classes of securities. The lump sum is allocated to the stock with a known fair value at the full fair value. The balance is allocated to the unknown valued stock. Ex: Common 1K + Preferred 1K = $30K. Common 1K x $20 = $20K. $10K left over to Preferred. //// If a company cannot determine fair value for any of the classes of stock involved in a lump-sum exchange, it may need to use other approaches such as expert appraisal or best estimates with intent to adjust later upon establishment of a fair value.

Leveraged Buyout

When a company borrows money to finance the stock repurchases. // Some publicly held corporations have chosen to "go private," that is, to eliminate public (outside) ownership entirely by purchasing all of their outstanding stock.

Reacquisition of Shares aka Stock Buyback

When a company buys back their own shares. This is considered a form of distribution to stockholders sometimes exceeding dividends. This is usually replaced by debt financing.

Dividends: Stock Dividend

When a company issues more stocks as dividends on existing stocks. Used when management wants to 'capitalize' part of the retained earnings. No assets are distributed. The company transfers funds from 'retained earnings' to 'capital stock' and 'additional paid in capital' for the FAIR value of the stocks. Each stockholder now owns a higher quantity of shares but they are issued on a pro rata basis so the dispersal keeps each holder owning the same percentage of the company. //// A distribution of <20-25% is called a SMALL/ORDINARY STOCK DIVIDEND and uses FAIR value. //// A distribution of >20-25% is called a LARGE STOCK DIVIDEND and uses PAR value.

Dividends: Types of: Property Dividends

When declaring a property dividend, the corporation should restate at fair value the property it will distribute, recognizing any gain or loss as the difference between the property's fair value and carrying value at date of declaration. /// At date of declaration: DR Asset (difference between book value and fair value) / CR Unrealized Holding Gain or Loss - Income / DR Retained Earnings (amount of the full dividend) / CR Property Dividend Payable. /// At date of distribution: DR Property Dividend Payable / CR Asset.

Three Normal Categories of Stockholders Equity

*Capital Stock and Additional Paid-In Capital* combined are the total amount paid in on capital stock. The amount provided by stockholders to the corporation for use in the business. This includes items such as the par value of all outstanding stock and premiums less discounts on issuance. *Retained Earnings aka Earned Capital*: is the capital that develops from profitable operations. It is undistributed income that remains invested in the company.

Preferred Stock: Most Common Features

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. /// The features that distinguish preferred from common stock may be of a more restrictive and negative nature than preferences. For example, the preferred stock may be nonvoting, noncumulative, and nonparticipating.

Secret Reserves

An asset recorded at an undervalued amount or a liability overstated. Creates an understatement of owners' equity. //// Example: 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. An example of a liability overstatement is an excessive provision for estimated product warranties that ultimately results in an understatement of owners' equity.

Financial Statement Presentation: Statement of Stockholders' Equity

Basics: Balance at the beginning of the period. Additions. Deductions. Balance at the end of the period. /// Must show changes to each account. Sometimes done in columnar form.

Dividends: Financial Conditions

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. /// The SEC encourages companies to disclose their dividend policy in their annual report, especially those that (1) have earnings but fail to pay dividends, or (2) do not expect to pay dividends in the foreseeable future. ///// The SEC encourages companies that consistently pay dividends to indicate whether they intend to continue this practice in the future.

Dividends: Types of: Cash Dividends and Process

Board declares the dividend on 1/10 (date of declaration). Payable on 2/1 (date of payment) to all stockholders of record 1/20 (date of record). /// 1/10-1/20 company completes and register any transfers in process. 1/20-2/1 transfer agent to process the checks. /// A declared cash dividend is a liability. Because payment is required very soon, it is usually a current liability. /// Date of Declaration: DR Retained Earnings / CR Dividends Payable. // Date of Record: No JE. // Date of Payment: DR Dividends Payable / CR Cash. // Could also use 'Cash Dividends Declared' instead of retained earnings then close it to Retained Earnings at period end.

Dividends: General Info

Companies who pay dividends are more likely to keep doing so to show that their income is real and to maintain a good strong image in the market. // Very few companies pay dividends in amounts equal to their legally available retained earnings. Reasons: (1) Maintain agreements with some bond covenants to retain a portion of the earnings in assets to protect against loss. (2) Meet state corporation requirements that earnings equivalent to the cost of treasury shares purchased be restricted against dividend declarations. (3) Retain assets for financial growth and expansion. Aka internal financing, reinvesting earnings, or plowing the profits back into the business. (4) Smooth out dividends by accumulating good years earnings to compensate in bad years earnings. (5) To build a cushion or buffer against possible losses or errors in calculations. // Dividend payouts are taxable at 15%, lower than the income tax of the past.

Dividends: Types of: Liquidating Dividends

Dividends based on other than retained earnings are sometimes described as liquidating dividends. This term implies that such dividends are a return of the stockholder's investment rather than of profits. //// any dividend not based on earnings reduces corporate paid-in capital and to that extent, it is a liquidating dividend. Even if it is funded partially from earnings and partially from excess paid in capital. //// This must be disclosed so stockholders don't erroneously believe the corporation is operating at a profit. //// JE for split source: At Date of Declaration: DR Retained Earnings / DR Paid-in Capital in Excess of Par - Common Stock / CR Dividends Payable. //// Same process for companies using this type of dividend to close it's doors.

Financial Statement Analysis: Book Value Per Share

Formula = [ Common Stockholders' Equity ] / [ Outstanding Shares ].

Financial Statement Presentation: Comprehensive Stockholders' Equity Presentation

Header. // CAPITAL STOCK: Capital Stock, list each class of stock with a few basic details and the total funds issued and outstanding on them, do not list any amounts for authorized but not issued shares. Common stock dividends distributable. TOTAL CAPITAL STOCK. // ADDITIONAL PAID-IN CAPITAL: Excess of par preferred, excess over stated value common. TOTAL PAID IN CAPITAL. // RETAINED EARNINGS. // TOTAL PAID-IN CAPITAL AND RETAINED EARNINGS // LESS: cost of treasury stock, accumulated other comprehensive loss. TOTAL STOCKHOLDERS EQUITY.

IFRS: Ordinary Shares

Instead of 'Common Stock' and 'Paid-In Capital' accounts they call them the 'Share Capital' and 'Share Premium' accounts. // No par shares are booked at their selling price no mater wat it is. True no-par shares should be carried in the accounts at issue price without any share premium reported. // Some countries require that no-par shares have a stated value that they can't be sold for less than par. These end up with very low par values and are treated poorly with the large balance difference being available for dividends.

IFRS Differences

Major differences relate to terminology used, introduction of concepts such as revaluation surplus, and presentation of stockholders' equity information. // Many countries have different investor groups than the United States. Examples: private financing and ownership vs bank financing and ownership culture. // Retirement of treasury shares. GAAP allows the funds in excess to be transferred to retained earnings or paid in capital or both. IFRS may require changed to paid-in capital depending on the original transaction around share issuance. // Statement of Stockholders' / Shareholders' Equity is called Statement of Changes in Equity. // IFRS relies on the term 'reserve' as a dumping ground for other types of equity transactions such as other comprehensive income and unusual transactions related to convertible debt and share option contracts. GAAP relies on the account Accumulated Other Comprehensive Income (Loss). // Under IFRS, it is common to report "revaluation surplus" related to increases or decreases in items such as property, plant, and equipment; mineral resources; and intangible assets. The term surplus is generally not used in GAAP. In addition, unrealized gains on the above items are not reported in the financial statements under GAAP.

Accounting for No-Par Stock: Entry Upon Initial Sale

No-par stocks are sold like par stocks for whatever price they will bring. However, they are issued without a premium or a discount. The exact amount received represents the credit to common or preferred stock. DR Cash / CR Common Stock No-Par Value / for the exact amount of the sale. // True no-par stock should be carried in the accounts at issue price without any additional paid-in capital or discount reported.

IFRS: Preference Shares

Preference (preferred) convertible shares are equity (not liability like under GAAP). Dividends on preference shares are a distribution of income and not an expense.

Accounting for the Retiring of Treasury Stock

Retired treasury 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. /// Example: if a corporation originally sells the shares at par, it debits Common Stock for the par value per share. If it originally sells the shares at $3 above par value, it also debits Paid-in Capital in Excess of Par—Common Stock for $3 per share at retirement.

Enron's Stock Receivable

SEC settled this by saying that unissued stock and treasury stock and such should be reported as a contra equity approach because the risk of collection in this type of transaction is often very high. /// They issued stocks to a "special-purpose entities" in exchange for a note receivable. They then recorded the note as an asset and stockholders' equity which they call an accounting error.

Accounting for and Reporting Preferred Stock

Sale of stock is: DR Cash / CR Preferred Stock (par value) / CR Paid-in Capital in Excess of Par - Preferred Stock (any over par). // Pertinent outstanding stock data is disclosed in a note on the financial statements.

IFRS Equity: Statement Categories

Share capital. Share premium. Retained earnings. Accumulated other comprehensive income. Treasury shares. Non-controlling interest (minority interest).

Preferred Stock

Special stock contracts. The stockholder may sacrifice certain of the standard shareholder rights in return for other special rights or privileges.

IFRS: Presentation of Equity (Financials)

Statement of Financial Position aka Comprehensive Equity Presentation looks very much the same. Statement of Changes in Equity looks similar but there are subtle details on pg 877.

Dividends: Stock Dividend vs Stock Split

Stock Dividend: Share count goes up, par value stays the same, amount in common stock account goes up. Stock Split: Share count goes up. Par value splits, amount in common stock account does not change. //// A distribution of >20-25% is called a LARGE STOCK DIVIDEND. Such a distribution should not be called a stock dividend but instead "a split-up effected in the form of a dividend" or "stock split". The transfer amount from retained earnings to common stock is at PAR value.

Treasury Stock

Technically, treasury stock is a corporation's own stock, reacquired after having been issued and fully paid. // Issued shares that the company has reacquired but not retired. Reduces common stock outstanding. // Treasury stock is not an asset. The buyback reduces assets (cash) and stockholders' equity (common stock). // The possession of treasury stock does not give the corporation the right to vote, or any other shareholder rights. // It is essentially the same as unissued capital stock.

IFRS Similarities

The accounting for the issuance of shares and purchase of treasury stock. // The accounting for declaration and payment of dividends and the accounting for stock splits. // Both use the term 'retained earnings'.

Common Stock

The class of stock that represents the basic ownership interest. The residual corporate interest that bears the ultimate risk of loss and receives the benefits of success. Not guaranteed dividends or assets upon dissolution. Stockholders generally control the management of the corporation and tend to profit most if the company is successful. If there is only one type of stock for the whole company then it is common stock even if it is not called that.

Accounting for Costs of Issuing Stock

The direct costs to issue stock should be debited to 'Paid-in Capital in Excess of Par - Common Stock' as a reduction of the amounts paid in because it is a cost of financing and not related to operations. // Direct costs include underwriting costs, accounting and legal fees, printing costs, and taxes. // Other related costs are considered indirect and should be expensed because it is difficult to establish a relationship between these costs and the sale proceeds.

Accounting for 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. // If both are determinable then the basis should not matter. // If neither are determinable then use a comparable transfer. // Avoid using the book, par, or stated values. // If using treasury stock then use the fair value of the stock not the cost of the stock to value the purchased items/service. // In corporate law, the board of directors has the power to set the value of noncash transactions.

Outstanding Stock

The number of shares of issued stock that stockholders own.

Watered Stocks

The overvaluation of the stockholders' equity resulting from inflated asset values creates these. The corporation should eliminate the "water" by simply writing down the overvalued assets.

Accounting for Par Value Stock

The par value has no relationship to its fair value. Low par values are common because they help companies avoid the contingent liability associated with stock sold below par. *PREFERRED STOCK OR COMMON STOCK*: The company credits these accounts for the par value when it originally issues the shares. Then there are no additional entries unless additional share are issued or shares are retired. *PAID-IN CAPITAL IN EXCESS OF PAR aka ADDITIONAL PAID-IN CAPITAL*: This account indicates any excess over par value paid in by stockholders in return for shares. Once paid in, the excess over par becomes a part of the corporations additional paid-in capital.

Accounting for No-Par Stock: Stated Value Stock

The stated value is a minimum value below which a company cannot issue it. In effect, stock with a very low par value. Any amount received over the stated value is 'Paid-In Capital in Excess of Stated Value - Common Stock' and is open for dividends. // DR Cash $15K / CR Common Stock $5K / DR Paid-In Capital in Excess of Stated Value - Common Stock $10K.

Preferred Stock Features: Cumulative Preferred Stock

These stock require 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. A year with no declared dividend is said to have been "passed". Passed dividends become '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.

Preferred Stock Features: Convertible Preferred Stock

These stocks allow stockholders, at their option, to exchange preferred shares for common stock at a predetermined ratio. // When the option to convert is exercised it is done so at book value. There is no gain/loss. The amount in 'Preferred Stock' is transferred to 'Common Stock' and the same with the two 'Paid-in Capital in Excess of Par'.

Preferred Stock Features: Redeemable Preferred Stock

These stocks have a mandatory redemption period or a redemption feature that the issuer cannot control. This makes it more secure like a debit instrument (legal obligation to pay). FASB says these are liabilities not equity.

Preferred Stock Features: Callable Preferred Stock

These stocks permit the corporation at its option to call or redeem the outstanding preferred shares at specified future dates and at stipulated prices. This tends to set a ceiling on the market price of these shared unless they are convertible. When redeemed the company must pay any dividends in arrears.

Preferred Stock Features: Participating Preferred Stock

These stocks share ratably with the common stockholders in any profit distributions beyond the prescribed rate. That is, 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.

Dividends: Stock Splits

This multiplies the number of shares and effectively reduces the price per share to something more manageable. No JE but there needs to be a note on the financials. /// Example: a 4-for-1 stock split, 100 open stocks becomes 400, fair value goes from $400 per share to $100, par value goes from $100 per share to $25 per share, total 'common stock' and 'paid-in capital' and 'retained earnings' all stay the same amount. /// Studies show that split shares out perform those that don't split. /// If the shares are trading too low a company might do a revers split to combine them. This is a bad sign on the market. (((If a company's per share price falls below $1 for 30 consecutive days, it is a violation of stock exchange listing requirements.)))

Financial Statement Analysis: Return on Common Stock Equity aka Return on Equity (ROE)

This ratio shows how many dollars of net income the company earned for each dollar invested by the owners. //// Formula = [ ( Net Income ) - ( Preferred Dividends ) ] / [ ( Average Common Stockholders' Equity ) ]. //// Trading on the equity describes the practice of using borrowed money or issuing preferred stock in hopes of obtaining a higher rate of return on the money used.

Accounting for the Purchase of Treasury Stock

When treasury stock is acquired through a buyback it is valued at either the Cost Method or the Par/Stated Value Method. /// *COST METHOD*: 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. /// *PAR/STATED VALUE METHOD*: Records all transactions in treasury shares at their par value and reports the treasury stock as a deduction from capital stock only. /// The cost method has more widespread use.