Chapter 3

Large stock

A large stock dividend involves the distribution of additional shares that is more than 20-25% of the currently outstanding shares. Par value is used to record large stock dividends. Retained Earnings is debited and common stock is credited for the par value. Large stock dividends have a greater market price reaction than small stock dividends.

Dividend yield ratio

A measure of profitability. Measures the dividend return on the current price of stock. Must be considered in conjunction with stability and growth of the price of common stock.

Small stock

A small stock dividend involves the distribution of additional shares that is less than 20-25% of the currently outstanding shares. Market value is used to record small stock dividends. Retained Earnings is debited for the market value of the shares, common stock is credited for the par value, and the difference is credited to Capital in Excess of Par Value.

Stock dividends

A stock dividend is a distribution of additional shares of a corporation's own capital stock on a pro-rata basis (to maintain the same percentage of shares previously held) to its stockholders at no cost. Usually consist of common stock issued to holders of common stock. Common for rapidly growing companies that want to retain their assets to finance growth.

Benefits of stock ownership

A voice in management: Owners are granted the right to vote at stockholders' meetings on major issues concerning the management of the corporation including the election of the board of directors. In lieu of attending a meeting, a vote by proxy (absentee ballot) gives the stockholders' voting rights to a designated party. Dividends: Owners may receive dividends (distributions of corporate profits). Residual claim: Owners may receive distributions from the corporation upon liquidation.

Common stock v preferred stock

All corporations must issue common stock, but preferred stock is not issued by every corporation.

Authorized shares

Authorized number of shares is the maximum number of shares that can be issued by a corporation as specified in its charter. This should be a larger number than a corporation plans to issue initially to provide for future flexibility.

Initial sale of stock journal entry

Cash xx Common Stock xx

Additional amount journal entry

Cash xx Common Stock xx Capital in excess of par value xx

Preferred stock

Combines some of the features of bonds and common stock. Typically lacks the control feature of common stock in that it usually does not have voting rights. Often used to raise corporate capital without diluting common stockholders' control. Generally, preferred stock is less risky than common stock because of its preference to receive dividends and asset distributions (upon liquidation) before common stockholders. Most preferred stock has a fixed dividend rate such as a specified percent of par or a specified amount per share.

Common stock

Common stock is the residual equity (the "leftovers") of a corporation. It ranks after preferred stock for dividends and liquidation distributions. Common stockholders are the "risk takers" and, therefore, they are voting owners of a corporation.

Common stock transactions

Common stockholders receive dividends after the preferred stockholders receive their dividends. Dividend rates are determined by the board of directors, usually based on the company's profitability for common stockholders.

Three important dates for dividends

Date of declaration Date of record Date of payment

Balance sheet effects - stock dividends

Does not create a liability when it is declared. Does not reduce assets when it is distributed. Total stockholders' equity does not change. A portion of retained earnings is changed into contributed capital. This is called capitalizing earnings. When retained earnings are reclassified to contributed capital, it reduces the amount available for future dividends.

Earnings per share ratio

EPS is a measure of profitability. Facilitates comparing companies of different sizes.

Balance sheet effects - treasury stock

If a company has treasury stock on its balance sheet date, the amount of treasury stock is subtracted in the stockholders' equity section. Note disclosure is required. A restriction is placed on retained earnings to the extent of the treasury stock cost to preclude dividend declarations of that amount.

Initial sale of stock

In the case of no-par common stock that has no stated value, the total proceeds received at the issue are debited to Cash and credited to No-Par Common Stock. The capital in excess of par value account is not used under these circumstances. There are two types of initial stock offerings to the public. An initial public offering (IPO) involves the very first sale of a company's stock to the public (when a company first goes public). A seasoned new issue is a subsequent sale of new stock (not previously issued) to the public after an IPO.

Dividends

Investors buy stock to receive a return on their investment in the form of stock price appreciation and/or dividends. Dividends are created when the board of directors of a corporation declares them. There is no legal obligation of a corporation to pay dividends until they are declared. Types of dividends: Cash dividends. (Without a qualifier, the term dividend means a "cash" dividend.) Property dividends (noncash assets). Stock dividends (the company's own capital stock).

Issued shares

Issued number of shares is the total cumulative number of authorized shares that have been issued to date by the corporation. Unissued number of shares is the number of authorized shares that have not yet been issued to date.

No par value

No-par value stock does not have an amount per share specified in the charter. Some states require no-par stock. Legal capital is established by law. In the case of no-par value stock, legal capital is either the amount for which stock is originally sold or a stated value.

Outstanding shares

Outstanding number of shares is the number of shares currently owned by stockholders ("out" there).

Par value

Par value is a nominal (arbitrary) value established in the corporate charter. It has no relationship to the market value of the stock. The initial issue of stock may be at par value or at a premium (above par value). In most instances, the initial issue of stock may not be at a discount (below par value). The concept of par value was established as a protection for creditors by specifying a permanent amount of capital (legal capital) to be maintained by the corporation (not available for withdrawal by the owners). Though the definition of legal capital varies among states, it is usually considered to be the par value of stock outstanding.

Stock splits

Stock splits are not dividends, but stock splits and stock dividends have similar effects on the stockholder. Each stockholder will own additional shares of stock. The effects on the issuing company are quite different. A stock split does not require a journal entry by the corporation. Instead, the old shares are returned to the corporation and new shares are issued. The stock split is accomplished by reducing the par value per share and increasing the number of shares issued. Retained Earnings is unaffected. Note disclosure is required for stock splits.

Two requirements to be met for cash dividends to be declared and paid

Sufficient retained earnings are needed. State laws often limit cash dividends to the amount of retained earnings (less any amount of treasury stock). Sufficient cash is needed. Retained earnings does not equal cash. Cash is needed for continuing operations and for operational asset acquisitions. There must be adequate cash after these commitments are met in order to pay dividends.

Corporation

The corporation is the only form of business recognized as a separate legal entity. Creation and governance of corporations are highly regulated by law. Corporations are created under state (not federal) laws. Each state has different laws for incorporation. A corporation submits an application for a charter to the state where it chooses to incorporate. The application specifies the name of the corporation, purpose of the corporation (type of business), kinds and amounts of capital stock authorized, and the minimum legal capital to be invested by owners at the date of incorporation. Upon approval of the application, the state issues a charter (articles of incorporation). The corporate charter may need to be amended in the future (with the approval of the stockholders). The stockholders elect the board of directors, which is the governing body of the corporation.

Date of record

The date on which the corporation prepares a list of current stockholders based on stockholder ownership records. This list indicates to whom dividend checks will be sent. No journal entry is required on this date.

Date of payment

The date that dividend checks are disbursed. The liability account is debited (reduced), and the Cash account is credited (reduced). This is the date on which the dividend liability is liquidated.

Date of declaration

The date that the board of directors officially approves the dividend. For a cash dividend, a liability is credited at that time (Dividends Payable). The debit may be made to a Dividends Declared account or directly to the Retained Earnings account. Dividends Declared is a contra equity account that is closed to Retained Earnings.

Treasury stock

Treasury stock is the number of shares that have been issued to investors and then reacquired by the corporation. If there is no treasury stock, the number of issued shares will equal the number of outstanding shares.

Cost method records treasury at its cost

Treasury stock xx Cash xx

Resale of Treasury Stock

When treasury stock shares are resold, Cash is debited and treasury stock is credited (reduced by the cost of the proportional number of shares resold). If treasury stock is acquired and resold for the same amount, that is the extent of the journal entry. If the acquisition and resale amounts differ, additional elements appear in the journal entry. Treasury stock is resold for more than its cost (an economic gain): Capital in Excess of Par is credited for the difference. Results in an overall increase in stockholders' equity. Treasury stock is resold for less than its cost (an economic loss): Capital in Excess of Par is debited for the difference. If that account balance is not adequate to absorb this difference, Retained Earnings is reduced to the extent needed. Results in an overall decrease in stockholders' equity

Dividend yield ratio equation

dividends per share/market price per share

Earnings per share ratio equation

income / average number of common shares outstanding

Treasury stock

is previously issued stock that is reacquired by the issuing corporation. Held by the corporation. Has no ownership rights. It is not outstanding stock so it has no right to vote or to receive dividends. It is not an asset to the corporation. Treasury stock is a contra equity account (it reduces total stockholders' equity).

Outstanding shares equation

issued shares - treasury stock shares

Sale of stock in secondary markets

After the issue of stock by a corporation, shares may be exchanged (traded) in secondary markets such as the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the NASDAQ market. These subsequent sales only affect the books of the investors involved. No transactions are recorded on the corporation's books. However, corporate management is very alert to stock trading prices in the secondary market.

Dividends on preferred stock

Investors in preferred stock give up some rights (voting) compared to common stock. Preferred Stock enjoys a preference in dividends. Dividends must be allocated between preferred shareholders and common shareholders. Two dividend preferences are: Current Dividend Preference Preferred stock always has a right to be paid dividends before any dividends can be paid on common stock. Once this current preference is met, dividends may be paid to common stock. Cumulative Dividend Preference Some preferred stock carries the additional feature of accumulating any current dividend amounts not declared in a previous year. Dividends In Arrears are these "unsatisfied" accumulations. Stock with this feature is called Cumulative Preferred Stock. Impact of Dividends in Arrears Dividends in arrears are not liabilities. Dividends must be declared to become a liability. Any preferred stock arrearage must be disclosed in the notes to the financial statements. When preferred stock is cumulative, the arrearages and the current preference must be allocated to preferred stock before any dividends are available to common stock. If preferred stock is noncumulative, no dividend arrearage can exist. Restrictions on Retained Earnings Restrictions on retained earnings require full-disclosure on the financial statements or in the notes. Items that can place restrictions on retained earnings include debt covenants and treasury stock transactions. These restrictions place a limit on the ability of a company to pay dividends to its owners. Analysts are particularly interested in retained earnings restrictions because of the impact on a company's dividend policy.