Chapter 15, Stockholder's Equity Key Terms

What is the balance sheet?

A balance sheet is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.

What are dividend in arrears mean?

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

What is a 'Lump-Sum Payment?

A lump-sum payment is a one-time payment for the value of an asset such as an annuity or another retirement vehicle. A lump-sum payment is usually taken in lieu of recurring payments distributed over a period of time. The value of a lump-sum payment is generally less than the sum of all payments that you would otherwise receive, since the party paying the lump-sum payment is being asked to provide more funds up front than it otherwise would have been required to.

What is the cost method?

A method of accounting for treasury stock, in which a company debits a treasury stock account for the cost of reacquiring stock to be held in the treasury and reports this account as a deduction from "total paid-in capital and retained earnings" on the balance sheet. If you receive any dividends from the investment, those dividends get treated as revenue.

What is the par (stated) value method?

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

What is a preferred stock?

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

What is a small (ordinary) stock dividends?

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

What are large stock dividends?

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

What are stock dividends?

A stock dividend is a dividend payment made in the form of additional shares rather than a cash payout, also known as a "scrip dividend." Companies may decide to distribute this type of dividend to shareholders of record if the company's availability of liquid cash is in short supply. These distributions are generally acknowledged in the form of fractions paid per existing share, such as if a company issued a stock dividend of 0.05 shares for each single share held by existing shareholders. A stock dividend, although it increases the number of shares outstanding, does not decrease the par value; thus, it increases the total par value of outstanding shares.

What is stated value?

A value below which a company cannot issue no-par stock, as required by law in some states. Stated-value stock thus becomes, in effect, stock with a par value. For example, if no-par stock has a stated value of $5 per share but sells for $11, all such amounts in excess of $5 are recorded as additional paid-in capital.

What is Paid-in capital in Excess of par?

Any excess over par value paid in by stockholders in return for the shares issued to them. Once paid in, the excess over par becomes a part of the corporation's additional paid-in capital. Also called additional paid-in capital. Paid-in capital also refers to a company balance sheet entry listed under stockholder's equity, often shown alongside the balance sheet entry for additional paid-in capital.

What is 'Additional Paid In Capital mean?

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

What is a no-par stock?

Capital stock that has not been assigned a par value. No-par stock avoids the contingent liability that might occur if the corporation issued par value stock at a discount and avoids the possibility of mistakenly using par value as a basis for fair value. The issuance of no-par stock avoids the contingent liability that might occur if the corporation issued par value stock at a discount. If shares have no-par value, the questionable treatment of using par value as a basis for fair value never arises.

What is a cumulative preferred stock?

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

What is liquidating dividends?

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

What are property dividends?

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

What is the proportional method?

If the fair value or other sound basis for determining relative value is available for each class of security, the company allocates the lump sum received among the classes of securities on a proportional basis. Proportional consolidation, in accounting for joint ventures, is a method of including items of income, expense, assets and liabilities in proportion to the firm's percentage of participation in the venture. The proportional consolidation method was initially favored by IFRS accounting standards, though it also allows use of the equity method. Under U.S. GAAP, a firm's interest in a joint venture is accounted for using the equity method. Recently, IFRS standards have begun to converge with those of GAAP on this matter.

What is the Incremental Method?

In instances where a company cannot determine the fair value of all securities, it may use the incremental method. It uses the fair 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 value.

What is a statement of stockholders' equity?

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

What is stockholders' (owners') equity?

Owner's (Stockholders') Equity. Owner's Equity—along with liabilities—can be thought of as a source of the company's assets. Owner's equity is sometimes referred to as the book value of the company, because owner's equity is equal to the reported asset amounts minus the reported liability amounts. Stockholder's equity is also known as Owner's equity, shareholders' equity and or corporate capital. It is the cumulative net contributions by stockholders plus retained earnings. It equals net assets.

What is a convertible preferred stock?

Preferred stock that allows stockholders, at their option, to exchange preferred shares for shares of 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.

What are redeemable preferred stocks?

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

What is Callable preferred stock?

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

What is a participating preferred stock?

Preferred stock whose holders share ratably with the common stockholders in any profit distributions beyond the prescribed rate. Its holders receive the prescribed return for preferred stock plus dividends generally at the same rates as those paid to common stockholders if the company pays dividends on common stock in excess of the prescribed preferred rate. For example, 5 percent preferred stock, if fully participating, will receive not only its 5 percent return, but also dividends at that same rates as those paid to common stockholders if paying amounts in excess of 5 percent of par or stated value to common stockholders.

What are cash dividends?

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

What is the return on common stockholders' equity ratio?

Profitability ratio that indicates how many dollars of net income the company earned for each dollar invested by the common stockholders. Also called return on equity (ROE). Computed as net income less preferred dividends divided by average common stockholders' equity. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income - Preferred stock Dividends / Average Common Stockholders' Equity. Also known as "return on net worth" (RONW).

What is the payout ratio?

Profitability ratio that measures the percentage of earnings a company distributes to common stockholders in the form of cash dividends. Computed as cash dividends paid to common stockholders divided by net income available to common stockholders (net income minus preferred dividends).The Payout Ratio is calculated as follows: Payout Ratio = Cash Dividends / Net Income Also known as dividend payout ratio.

What is secret reserves?

Secret Reserve. The amount by which shareholder equity in a company exceeds the amount claimed on its financial statements. Secret reserves arise when a company overstates its liabilities or understates its assets, usually because its accounting practices depart from GAAP. ... The understated corporation structure (secret reserve) may also result from other methods: 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. It is also called the hidden reserve

What are treasury stocks?

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

What is book value per share ratio?

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

What are common stock?

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

What is earned capital?

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

What is residual interest?

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

What are retained earnings?

The earned capital of the company, which develops from profitable operations. It consists of all undistributed income that remains invested in the company. The formula for retained earnings is as follows: Retained Earnings (RE) = Beginning RE + Net Income - Dividends, also known as the "retention ratio" or "retained surplus."

What is a stock split?

The issuance of additional shares of stock by dividing existing shares into multiple shares for each share owned; e.g., a 4-for-1 split gives a shareholder 4 shares for each 1 share owned. The motive is to reduce the market price of shares to be within range of the majority of potential investors. Companies record no entry for a stock split, but make a memorandum note to indicate the changed par value and the increased number of shares.. For example, with a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share is reduced by half: two shares now equal the original value of one share before the split.

What are lump-sum sales?

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

What is trading on the equity mean?

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

What is a preemptive right?

The right of shareholders (unless prohibited in articles of incorporation) to share proportionately in any new issues of stock of the same class. The preemptive right protects existing stockholders from involuntary dilution of ownership interest when a corporation issues additional stock. Stock warrants (an option to purchase stock) are commonly used to satisfy this right.. Without this right, stockholders might find their interest reduced by the issuance of additional stock without their knowledge and at prices unfavorable to them.

What is contributed (paid-in) capital?

The total amount paid in on capital stock—the amount provided by stockholders to the corporation for use in the business. Contributed capital includes the par value of all outstanding stock plus additional paid-in capital (any excess over par value paid in by stockholders). Paid-in capital also refers to a company balance sheet entry listed under stockholder's equity, often shown alongside the balance sheet entry for additional paid-in capital.

What is a leveraged buyout (LBO)?

Transaction in which a company borrows money to finance the repurchase of all of the company's outstanding stock, in order to eliminate public (outside) ownership. A leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.

What is a water stock?

Watered stock is an asset with an artificially-inflated value. The term is most commonly used to refer to a form of securities fraud common under older corporate laws that placed a heavy emphasis upon the par value of stock. The corporation should eliminate the "water" by simply writing down the overvalued assets.