Module 9: Stockholders’ Equity
1.Accounting for preferred and common
2.Treasury stock
3.Stock compensation plans
4.Retained earnings
-cash dividends
-stock dividends (and stock splits)
-property dividends (and other carve outs)
5.Other comprehensive income
6.Statement of stockholders’ equity
7.Convertible securities
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1. Preferred Stock

Advantages
–
–
–
–

Preference over common in liquidation
Stated dividend
Variety of features regarding dividends
Preference over common in dividend payout
Disadvantages
– Subordinate to debt in liquidation
– Stated dividend can be skipped
– No voting rights (versus common)

Debt or equity?
– components of both
– usually (but not always) classified with equity
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1. Common Stock

Advantages
– Voting rights:
 election of board of directors
 vote on significant activities of management
– Rights to residual profits (after preferred)

Disadvantages
– Last in liquidation
– No guaranteed return
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1. Accounting for Common Stock
(CS) and Preferred Stock (PS)

Par value - initially established to create a
“minimum legal capital”.
– Ex: Minimum legal capital in some states is
$1,000 for new corporations, so issue:



1,000 shares at $1par, or
100 shares at $10 par, or other combination. . .
Par value is not market value.
 Credit CS or PS for par value.
 Excess over par credited to “Paid in Capital in
Excess of Par or Stated Value” or abbreviated:
“Additional Paid-in Capital” (APIC).
 Some newer stock issues (for common stock) are
“no par” stock.
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1. Par versus No Par
Note: many companies have newer stock
issues that are no par, but most
companies still have older stock issues
which contain a par value and APIC.
The Stockholders’ Equity section of the
balance sheet of Sample Company
illustrates many of the components of
SE discussed in this chapter.
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Sample Co. Stockholders’ Equity
Common stock, $1 par value, 500,000 shares
authorized, 80,000 shares issued, and
75,000 shares outstanding
$ 80,000
Preferred stock, $100 par value, 1,000 shares
authorized, 100 shares issued and
outstanding
10,000
Paid in capital on common
$ 20,000
Paid in capital on preferred
3,000
Paid in capital on treasury stock
4,000
27,000
Retained earnings:
Unappropriated
$18,000
Appropriated
4,000
22,000
Less: Treasury stock, 5,000 shares (at cost)
(6,000)
Less: Other comprehensive income
(2,000)
Total Stockholders’ Equity
$131,000
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2. Treasury Stock

Created when a company buys back shares of
its own common stock.
 Reasons for buyback:
– reissue to employees for compensation.
– hold in treasury (or retire) to increase market
price and earnings per share.
– reduce total dividend payouts while
maintaining per share payouts.
– thwart takeover attempts by reducing
proportion of shares available for purchase.
– give cash back to existing shareholders.
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2. Treasury Stock - continued
The debit balance account called “Treasury
Stock” is reported in stockholders’ equity as a
contra (reduces SE). Note: not an asset.
 The stock remains issued, but is no longer
outstanding.

– does not have voting rights
– cannot receive cash dividends

May be reissued (to the market or to employees)
or retired.
 No gains or losses are ever recognized from
these equity transactions.
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3. Employee Stock Compensation Plans

Historically, companies granted stock options to
employees as a means of compensating
employees, without having to recognize any
compensation expense.
 Recently, the FASB required compensation
expense to be recognized on the income
statement, based on estimated fair value of the
option.
 Many companies have been shifting to restricted
stock plans to compensate and motivate
employees.
 The restricted stock plans require a recognition of
compensation expense, but based on the value
of the stock at the date of grant (rather than fair
value at date of full vesting).
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3. Employee Stock Options-History

Since 1970, APB Opinion 25 allowed the issue of
employee stock options. When the options were
granted at the market price at grant date, no
compensation expense was necessary.
 SFAS No. 123 was issued in 1995, and introduced
the fair value method for calculating the
compensation expense relating to employee stock
options.
 SFAS No. 123 recommended that expense be
recognized in the income statement, but did not
require this recognition.
 SFAS No. 123R was issued in 2004, to require the
recognition of expense in the income statement,
for public companies whose fiscal year begins
after June 15, 2005.
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3. Equity Compensation and Expense Recognition


Should compensation expense from stock options
and restricted stock plans be recognized in the
income statement?
Proponents say yes:
– It is a cost to the company of employing the workers.
– If the company had issued stock, then paid the
employees in cash, the amount would have been
recognized as comp. expense.

Opponents say no:
– The employee is essentially working as an “owner” of
the company, and contributing “sweat equity”; owners
do not receive salary distributions.
– Options and restricted stock are given as work
incentives, rather than straight compensation.
Remember: the value can go down as well as up
(unlike traditional compensation).
– These equity grants do not meet the definition of an
expense. See page 2-12.
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4. Retained Earnings
We will be expanding the basic retained earnings
formula in this chapter. Now, the Retained Earnings
Column of the Statement of Stockholders’ Equity will
include the following:
RE, beginning
xx
Add: net income
xx
Less dividends:
Cash dividends-common
xx
Cash dividends - preferred
xx
Stock dividends
xx
Property dividends
xx
Less: Adjustment for TS transactions xx
Appropriation of RE
xx
RE, ending
xx
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4. RE - Cash Dividends
 Note
that stated dividends to preferred
shareholders must be paid before any dividends
can be paid to common shareholders (including
dividends in arrears if cumulative).
 Preferred dividends may be cumulative, which
means that, if no dividend is declared in the current
year, they must be “caught up” (based on stated
dividend rate) for the preferred shareholders in a
future year before common shareholders get any
dividends.
 However, cumulative preferred dividends in arrears
are not recognized as a liability until a dividend is
finally declared by the board of directors. A
company might go for a number of years without
declaring a dividend, and there is no liability until a
dividend is actually declared.
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4. RE - Property Dividends
Property dividends are distribution of non-cash
property by a company to its shareholders.
The most common type of property dividend is
a “spin-off” where the shares of stock of a
subsidiary are distributed to the shareholders of
the parent company. This is also called a form
of “carve out”, as the company carves out a
segment and divests it.
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4. Other Carve Outs
Other forms of carve outs (though not
considered dividends) are sell-offs and splitoffs.
In a sell-off, the company sells its equity
interest in the investment/subsidiary to an
outside party.
In a split-off, the company sells its equity
interest in the subsidiary back to the subsidiary.
Thus the subsidiary is buying back its own
shares (for treasury or retirement) and the
parent is no longer an owner.
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4. RE - Stock Dividends
Stock dividends are distribution of additional
shares of a company’s own stock to its
shareholders. Note that the distribution of
additional shares does not result in any
value being given to the shareholders.
Example: 4 shareholders, each having 10
shares of common stock. Each owner has
25% of total (10/40). If I give each
shareholder 1 additional share of stock,
each shareholder still owns 25% of the
same company (11/44). Nothing has
changed, except the number of the pieces
of paper.
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4. RE - Stock Dividends
Large stock dividends (> 25% of the
outstanding common shares) are recorded at
par value.
The transfer is out of retained earnings and into
common stock (no cash is involved). Note that
the total effect on stockholders’ equity is zero.
However, retained earnings decreases and
common stock increases by the par value of the
stock dividend.
Small stock dividends (< 25% of the outstanding
common shares) are recorded at market value.
Since small stock dividends are rare, we will not
discuss here.
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Stock Splits
Stock splits are commonly declared by a
company to reduce its market price per
share. This makes the stock more
accessible to small investors.
 The process for stock splits is that the “old”
stock is voided, and new shares are
granted with a “new” description.
 The total par value of the new shares is
equal to the total par value of the old
shares, but the number of shares (and par
value per share changes.

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Example of Stock Split
IZM Company has 100,000 shares of $2
par value stock authorized, 10,000 shares
issued and outstanding.
The SE section of the balance sheet
shows:
– Common stock
$20,000
– Retained earnings 80,000
The market price of the outstanding shares
is $50 per share before the split is
distributed.
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Example of Stock Split
If IZM declared a 2 for 1 stock split, the
old shares would be voided and new
shares would be issued with the following
description:
 Common stock, $1 par value, 200,000
shares authorized, 20,000 shares issued
and outstanding.
 The total SE is still $100,000:

– Common stock
– Retained earnings
$20,000
80,000
The market price per outstanding share
would now be $25 per share.
 Note: No journal entry is necessary.

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4. Stock Dividends vs Stock Splits
Going back to the original IZM information.
Assume instead that IZM declared a 100%
stock dividend.
First, total par value for new shares (10,000
shares x 100% = 10,000 new shares x $2
per share = $20,000)
Transfer $20,000 from Retained Earnings to
the Common Stock account.
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4. Stock Dividends vs Stock Splits
Now note the new description for the stock
dividend:
 Common stock, $2 par value, 100,000 shares
authorized, 20,000 shares issued and
outstanding
 The total value in SE is still $100,000, but:
– Common Stock
$40,000 (up $20,000)
– Retained Earnings
60,000 (down $20,000)
 Note that the total market price per share would
change to $25 per share.
 Thus, a 2 for 1 stock split and a 100% stock
dividend have the same effect on:
– total stockholders’ equity and
– market price per share
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4. Stock Dividends vs Stock Splits
However, a stock dividend requires a
journal entry, which changes the
components of SE (RE and CS).
 A stock split changes the description of the
shares, including the par value per share.
 Many companies use a stock split to
change the market price per share, but
about half of the companies use the large
stock dividend to achieve the same result.
This action is called a “stock split effected
in the form of a dividend.”

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4. Stock Dividends vs Stock Splits
To summarize the effects on IZM Company:
100% Stock
2 for 1
After:
Dividend
Stock Split
Total sh. outstanding 20,000 sh.
20,000 sh.
Par value per share
$2
$1
Market price per share
$25
$25
Total stockholders’ eq: $100,000
$100,000
General ledger results:
CS account
$ 40,000
$ 20,000
RE account
$ 60,000
$ 80,000
Reminder: CS was $20,000 and RE was $80,000
before the split or dividend ( see slide 35). Since the
stock dividend required journal entries (see slide 36),
the amounts for CS and RE changed. Since the
stock split does not require a journal entry, the
amounts for CS and RE do not change.
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4. RE - Appropriations
Companies may choose to “restrict” a
portion of their RE for dividend payout.
 Reasons for this restriction may include
activities such as plans for corporate
expansion or plans for the retirement of
debt.
 The restriction does not create a cash
balance for these plans. It simply
indicates intentions.
 The restriction, or appropriation may be
indicated through disclosure, or through a
reclassification of retained earnings.

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5. Other Comprehensive Income
Comprehensive Income is a term that was
defined in the Statements of Financial
Accounting Concepts (SFAC 6).
 It consists of all non-owner changes in
equity. This includes net income as we
have been defining revenues and
expenses throughout the semester, and it
also includes “Other Comprehensive
Income.”

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5. Other Comprehensive Income
“Other Comprehensive Income” (OCI)
includes certain direct equity adjustments
that are not part of the current income
statement, but which may have eventual
effect on income.
 The amount is recorded in OCI, until the
effect is transferred to the income
statement.

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5. Other Comprehensive Income




One of the items in Other Comprehensive
Income is the Cumulative Translation
Adjustment.
This adjustment occurs when a company owns
a foreign subsidiary, and must translate the
foreign subsidiary to U. S. dollars before
consolidating.
The adjustment would only be realized as part
of the income statement if the foreign
subsidiary was sold or liquidated for U.S.
dollars.
The adjustment can be an increase or
decrease, depending on the cumulative
direction of change in the exchange rate.
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5. Other Comprehensive Income




Other items in Other Comprehensive Income
include:
Unrealized Gain/Loss on Available-for-Sale
Investments. These long term investments
are allowed to revalue each period up or down
to market. The revaluation causes a gain or
loss to be recognized (it is unrealized since the
investment has not been sold).
However, since the investment is long-term,
the gain or loss is NOT recognized in the
income statement. Instead, it is recognized
cumulatively in OCI, until the investment is
finally sold.
Similar treatment is given to certain kinds of
derivatives (a special form of investments).
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5. Other Comprehensive Income



One other item that will be discussed comes from
a recent standard (SFAS 158), and is part of the
new requirement by FASB to fully recognize all
pension assets and liabilities in the balance
sheet.
However, FASB allows companies to defer
recognition of a portion of the pension
components, and spread the effects over future
periods. These components (costs, losses, and
gains) are deferred to OCI, until they are
recognized in future income. (More in Module 10.)
In the past, some companies recognized an OCI
adjustment for “Minimum Liability”, but this
requirement is no longer in effect (ignore
comment in your text).
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6. Statement of Stockholders’ Equity
In this chapter, we have discussed the
Statement of Retained Earnings as the link
between the balance sheet and the income
statement.
 However, earlier chapters introduced the
Statement of Stockholders’ Equity, which
has become the default statement for large
companies in recent years.
 The Statement of Stockholders’ Equity
details the change in retained earnings,
including all the changes discussed in this
chapter, and it also shows the change
during the year in all of the stockholders’
equity accounts.

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Example of Statement of SE (in thousands)
CS
$200
PS APIC RE OCI
$ 50 $400 $400
250
(40)
$200
(200)
Balance 1/1/10
Net income
Cash dividends
Stock dividends
Purchase of TS
Reissue of TS
Revalue AFS Invest.
Balance, 12/31/10
$400
$ 50
TS
( 1)
$(40)
10
$400 $409
$12
$12 $(30)
CS = common stock;
PS = preferred stock;
APIC= additional paid-in capital;
RE = retained earnings
OCI = other comprehensive income; and
TS = treasury stock.
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7. Convertible Securities

Certain types of stocks and bonds may affect
stockholders’ equity.
 Preferred stock may be issued with a convertible
privilege, which allows investors to convert to
common stock at a predetermined ratio. This
conversion is usually recorded at book value of
the preferred stock, and no cash is required in the
exchange.
 Convertible bonds allow the investor to convert
the bonds to common stock at a predetermined
ratio. The conversion is similar to that for
preferred stock, but in this case, liabilities go down
and equity goes up.
 These convertible securities will have an effect on
earnings per share calculations, particularly
diluted earnings per share (see Module 5).
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