CH. 11

The stockholders' equity section of a corporation's balance sheet consists of two parts:

(1) paid-in (contributed) capital and (2) retained earnings (earned capital).

Retained earnings

Net income that a company retains in the business.

Authorized stock

The amount of stock that a corporation is authorized to sell as indicated in its charter.

Stated value

The amount per share assigned by the board of directors to no-par stock.

Paid-in capital

The amount stockholders paid in to the corporation in exchange for shares of ownership.

When a corporation has only one class of stock, it is __________

common stock.

Treasury Stock is a ______________ account.

contra stockholders' equity

a _________ is an entity separate and distinct from its owners

corporation

The purchase of treasury stock is generally accounted for by the __________

cost method.

A stock dividend results in a ________ in retained earnings and an increase in paid-in capital.

decrease

the cumulative effect of the declaration and payment of a cash dividend on a company's financial statements is to ___________

decrease both stockholders' equity and total assets.

In general, as long as the return on assets rate _______ the rate paid on debt, a company will increase the return on common stockholders' equity by the use of debt.

exceeds

T or F / Preferred stockholders do not have the right to share in the distribution of corporate income before common stockholders.

false

Under the cost method, companies ___________Treasury Stock by the price paid to reacquire the shares. Treasury Stock __________by the same amount when the company later sells the shares._

increase (debit), decreases

Corporations expense organization costs as __________

incurred.

Years ago, par value determined the _______ per share that a company must retain in the business for the protection of corporate creditors.

legal capital

Corporations engaged in interstate commerce must also obtain a _______ from each state in which they do business.

license

How does a corporation set the price for a new issue of stock? Among the factors to be considered are (5)

(1) the company's anticipated future earnings, (2) its expected dividend rate per share, (3) its current financial position, (4) the current state of the economy, and (5) the current state of the securities market. The calculation can be complex and is properly the subject of a finance course.

Three dates are important in connection with dividends:

(1) the declaration date, (2) the record date, and (3) the payment date.

In the stockholders' equity section of the balance sheet, companies report paid-in capital, retained earnings, accumulated other comprehensive income, and treasury stock. Within paid-in capital, two classifications are recognized:

1.Capital stock, which consists of preferred and common stock. Companies show preferred stock before common stock because of its preferential rights. They report information about the par value, shares authorized, shares issued, and shares outstanding for each class of stock. 2.Additional paid-in capital, which includes the excess of amounts paid in over par or stated value.

The accounting profession distinguishes between a small stock dividend (less than _________of the corporation's issued stock) and a large stock dividend (greater than __________).

20%-25% / 20%-25%

Corporation

A company organized as a separate legal entity, with most of the rights and privileges of a person.

Return on common stockholders' equity (ROE)

A measure of profitability from the stockholders' point of view; computed by dividing net income minus preferred dividends by average common stockholders' equity.

Payout ratio

A measure of the percentage of earnings a company distributes in the form of cash dividends to common stockholders.

Cash dividend

A pro rata (proportional to ownership) distribution of cash to stockholders.

Stock dividend

A pro rata (proportional to ownership) distribution of the corporation's own stock to stockholders.

•Charter indicates the number of shares of stock that a corporation is authorized to sell •Number of authorized shares is often reported in stockholders' equity section ______________

Authorized Stock

Which of these statements about stock dividends is true? a. Stock dividends reduce a company's cash balance. b. A stock dividend has no effect on total stockholders' equity. c. A stock dividend decreases total stockholders' equity. d. A stock dividend ordinarily will increase total stockholders' equity.

B

Par value stock

Capital stock that has been assigned a value per share in the corporate charter.

Retained earnings restrictions

Circumstances that make a portion of retained earnings currently unavailable for dividends.

Organization costs

Costs incurred in the formation of a corporation, including legal and state fees and promotional expenditures.

Entries for cash dividends are required on the: a. declaration date and the record date. b. record date and the payment date. c. declaration date, record date, and payment date. d. declaration date and the payment date.

D

Treasury stock may be repurchased a. to reissue the shares to officers and employees under bonus and stock compensation plans. b. to signal to the stock market that management believes the stock is underpriced. c. to have additional shares available for use in the acquisition of other companies. d. More than one of the above.

D

Which of these statements is false? a. Ownership of common stock gives the owner a voting right. b. The stockholders' equity section begins with paid-in capital. c. The authorization of capital stock does not result in a formal accounting entry. d. Legal capital is intended to protect stockholders.

D

Debt has one major disadvantage:

Debt reduces solvency.

T or F / All states require a par value per share for capital stock.

False

T or F / Similar to partners in a partnership, stockholders of a corporation have unlimited liability.

False

T or F / The journal entry to record the authorization of capital stock includes a credit to the appropriate capital stock account.

False

T or F / The separation of ownership and management is an advantage of the corporate form of business.

False

•Corporation can issue common stock •Directly to investors or •Indirectly through an investment banking firm _______________

Issuance of Stock

*The distinction between paid-in capital and retained earnings

Legally, corporations can make distributions of earnings (declare dividends) out of retained earnings in all states. However, in many states they cannot declare dividends out of paid-in capital. Management, stockholders, and others often look to retained earnings for the continued existence and growth of the corporation.

What factors must management consider in deciding how large a dividend to pay?

Management must consider the size of the company's retained earnings balance, the amount of available cash, the company's expected near-term cash needs, the company's growth opportunities, and what level of dividend the company will be able to sustain based upon its expected future earnings.

•has been assigned a value per share •Years ago, it determined legal capital per share that a company must retain in business for protection of corporate creditors

Par and No-Par Value Stocks

Dividends in arrears

Preferred dividends that were supposed to be declared but were not declared during a given period.

one type of corporate form, called an __________, allows for legal treatment as a corporation but tax treatment as a partnership—that is, no double taxation.

S corporation

Stock Dividend versus Stock Split Effects - Differences between the effects of stock dividends and stock splits - Total retained earnings

Stock Dividend = Decrease / Stock Split = No Change

Payment date

The date cash dividend payments are made to stockholders.

Declaration date

The date the board of directors formally authorizes the dividend and announces it to stockholders.

Record date

The date when the company determines ownership of outstanding shares for dividend purposes.

Stock split

The issuance of additional shares of stock to stockholders accompanied by a reduction in the par or stated value per share.

Discuss the major characteristics of a corporation.

The major characteristics of a corporation are separate legal existence, limited liability of stockholders, transferable ownership rights, ability to acquire capital, continuous life, corporation management, government regulations, and additional taxes.

Accumulated Other Comprehensive Income

This account includes the cumulative amount of all previous items reported as other comprehensive income.

2 primary sources of equity

Treasury stock, paid-in capitol

T or F / In addition, stockholders must pay taxes on cash dividends (pro rata distributions of net income). Thus, many argue that the government taxes corporate income twice (double taxation)—once at the corporate level and again at the individual level.

True

T or F / It is relatively easy for a corporation to obtain capital through the issuance of stock.

True

T or F / That is, once a share has been issued, a subsequent repurchase of that share as treasury stock does not affect its status as "issued."

True

Upon receipt of its charter from the state of incorporation, the corporation establishes __________-. These establish the internal rules and procedures for conducting the affairs of the corporation.

by-laws

The declaration of a _________ commits the corporation to a binding legal obligation.

cash dividend

*when a corporation has only one class of stock, it is ________

common stock.

*A stock split changes the par value per share but (does or does not)affect any balances in stockholders' equity.

does not

In closing entries, a company debits a net loss to the Retained Earnings account. It (does or does not) debit net losses to paid-in capital accounts.

does not

The authorization of capital stock (does or does not) result in a formal accounting entry. The reason is that the event has no immediate effect on either corporate assets or stockholders' equity.

does not

the issuance of common stock affects only __________

paid-in capital accounts.

Two common ways to classify corporations are by ______ and by ownership

purpose, ownership

a ________ results in a reduction in the par or stated value per share

stock split

Owners' equity is identified by various names: (3)

stockholders' equity, shareholders' equity, or corporate capital.

The charter indicates....

the amount of stock that a corporation is authorized to sell.

T or F / A corporation can issue common stock directly to investors.

true

T or F / A corporation can issue the stock indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors.

true

In an indirect issue, the investment banking firm may agree to _________ the entire stock issue.

underwrite

•Types of dividends

•Cash •Property •Stock •Scrip (promissory note)

6 Other Forms of Business Organization besides corporation

•Limited partnerships •Limited liability partnerships (L L P s) •Limited liability companies (L L C s) •S-Corporations •No double taxation •Cannot have more than 100 shareholders

•Reasons why corporations issue stock dividends

•Satisfy stockholders' dividend expectations without spending cash •Increase marketability of corporation's stock •Emphasize a portion of stockholders' equity has been permanently reinvested in business

•Corporations acquire treasury stock for various reasons (4)

•To reissue the shares to officers and employees under bonus and stock compensation plans •To enhance the stock's market value •To have additional shares available for use in the acquisition of other companies •To increase earnings per share

*Cash dividends are not paid on treasury shares. For a corporation to pay a cash dividend, it must have the following. (3)

1.Retained earnings. 2.Adequate cash. 3.Declared dividends.

Bond Financing Advantages

1.Stockholder control is not affected.-bonds do not affect owner control 2.Tax savings result.-interest on bonds is tax deductible 3.Return on common stockholders' equity may be higher.-bonds can increase return on equity

A corporation may acquire treasury stock for various reasons: (4)

1.To reissue the shares to officers and employees under bonus and stock compensation plans. 2.To increase trading of the company's stock in the securities market. Companies expect that buying their own stock will signal that management believes the stock is underpriced, which they hope will enhance its market price. 3.To have additional shares available for use in acquiring other companies. 4.To reduce the number of shares outstanding and thereby increase earnings per share. A less frequent reason for purchasing treasury shares is to eliminate hostile shareholders by buying them out.

What, then, are the purposes and benefits of a stock dividend? Corporations generally issue stock dividends for one of the following reasons: 3

1.To satisfy stockholders' dividend expectations without spending cash. 2.To increase the marketability of the stock by increasing the number of shares outstanding and thereby decreasing the market price per share. Decreasing the market price of the stock makes it easier for smaller investors to purchase the shares. 3.To emphasize that the company has permanently reinvested in the business a portion of stockholders' equity, which therefore is unavailable for cash dividends.

Stockholder Rights (4)

1.Vote in election of board of directors at annual meeting and vote on actions that require stockholder approval. 2.Share the corporate earnings through receipt of dividends 3.Keep the same percentage ownership when new shares of stock are issued (preemptive right) 4.Share in assets upon liquidation in proportion to their holdings. This is called a residual claim because owners are paid with assets that remain after all other claims have been paid.

Privately held corporation

A corporation that has only a few stockholders and whose stock is not available for sale to the general public.

Publicly held corporation

A corporation that may have thousands of stockholders and whose stock is traded on a national securities market.

Treasury stock

A corporation's own stock that has been reacquired by the corporation and is being held for future use.

Deficit

A debit balance in Retained Earnings.

Dividend

A distribution by a corporation to its stockholders on a pro rata (proportional to ownership) basis.

Charter

A document that describes a corporation's name and purpose, types of stock and number of shares authorized, names of individuals involved in the formation, and number of shares each individual has agreed to purchase.

Cumulative dividend

A feature of preferred stock entitling the stockholder to receive current and unpaid prior-year dividends before common stockholders receive any dividends.

Outstanding stock

Capital stock that has been issued and is being held by stockholders.

Preferred stock

Capital stock that has contractual preferences over common stock in certain areas.

No-par value stock

Capital stock that has not been assigned a value in the corporate charter.

Explain how to account for cash dividends, stock dividends, and stock splits.

Companies make entries for dividends at the declaration date and the payment date. At the declaration date, the entries for a cash dividend are debit Cash Dividends and credit Dividends Payable. Preferred stock has contractual provisions that give it priority over common stock in certain areas. Typically, preferred stockholders have a preference as to (1) dividends and (2) assets in the event of liquidation. However, they sometimes do not have voting rights. The effects of stock dividends and splits are as follows. Small stock dividends transfer an amount equal to the fair value of the shares issued from retained earnings to the paid-in capital accounts. Stock splits reduce the par value per share of the common stock while increasing the number of shares so that the balance in the Common Stock account remains the same.

Stock Dividend versus Stock Split Effects - Differences between the effects of stock dividends and stock splits - Shares outstanding

Stock Dividend = Increase / Stock Split = Increase

Stock Dividend versus Stock Split Effects - Differences between the effects of stock dividends and stock splits - Total paid-in capital

Stock Dividend = Increase / Stock Split = No Change

Stock Dividend versus Stock Split Effects - Differences between the effects of stock dividends and stock splits - Total par value (common stock)

Stock Dividend = Increase / Stock Split = No Change

Stock Dividend versus Stock Split Effects - Differences between the effects of stock dividends and stock splits - Par value per share

Stock Dividend = No Change / Stock Split = Decrease

Stock Dividend versus Stock Split Effects - Differences between the effects of stock dividends and stock splits - Total stockholders' equity

Stock Dividend = No Change / Stock Split = No Change

How do stock dividends affect stockholders' equity?

They change the composition of stockholders' equity because they result in a transfer of a portion of retained earnings to paid-in capital. However, total stockholders' equity remains the same. Stock dividends also have no effect on the par or stated value per share, but the number of shares outstanding increases.

Explain how to account for the issuance of common, preferred, and treasury stock.

When a company records issuance of common stock for cash, it credits the par value of the shares to Common Stock. It records in a separate paid-in capital account the portion of the proceeds that is above par value. When no-par common stock has a stated value, the entries are similar to those for par value stock. When no-par common stock does not have a stated value, the entire proceeds from the issue are credited to Common Stock. Companies generally use the cost method in accounting for treasury stock. Under this approach, a company debits Treasury Stock at the price paid to reacquire the shares.