Session 22
Equity
Background on
Stockholders’ Equity
• Corporations are business entities
authorized in accordance with state
laws
• Stockholders have the right to:
–
–
–
–
Vote
Share in corporate profits
Share in any assets left at liquidation
Acquire more shares of subsequent issues
of stock
• Stockholders vote to elect the board
of directors
Background on
Stockholders’ Equity
• A corporate proxy is a written
authority granted by shareholders to
have another party cast their votes
at the annual meeting
• A preemptive right is the right to
acquire a proportional amount of any
new issue of capital stock
• Stockholders have limited liability
– Creditors have claims only on the assets
owned by the corporation
– Stockholders’ personal assets are not at
risk
Authorized, Issued,
and Outstanding Stock
• The articles of incorporation detail
the number of shares and types of
capital stock
• Shares can be:
– Authorized—the total number of shares
that can be issued
– Issued—the number of shares exchanged
with stockholders
– Outstanding—the number of shares still
held by the stockholders
• Treasury shares are shares of the
corporation’s own stock which have
been repurchased
Common Stock
• Common stock represents the basic ownership
interest in a corporation. The stockholders bear
the major risks and can reap the major rewards.
• Common stock frequently carries a "par value" set
out in the Corporate Charter or Certificate of
Incorporation. This amount is set by the Board of
Directors and is typically quite small. It is
irrelevant in a value sense - it does not measure
value. It is set at a low value primarily for
legal reasons.
• The issuing price of a share over and above the
par value of the share is referred to as
additional paid in capital or capital in excess of
par value.
• Legal capital or contributed capital equals the
par value plus additional paid in capital.
Stock values
• Par value:
– A measure of protection of creditors
establishing the minimum legal capital
liability
• Book value
– Historical accumulated accounting value
of the stock (includes Additional paidin earnings and retained earnings, and
reserves...)
• Market value (FINANCE)
– POSITIVE ACCOUNTING
– Values the firm under completely
different parameters
Accounting for Stock
Issuance
• Many companies separate their
contributed stock recognition into
two categories:
– Par value
– Additional paid-in capital—the amount
above par value
• If UPS issues an additional 1
million shares of its $.01 par value
stock at $63, the journal entry is:
Cash
63,000,000
Common stock at par
Additional paid-in capital
10,000
62,990,000
Cash Dividends
• Dividends are proportional
distributions of income to
shareholders
• To pay cash dividends a corporation
must have:
– Cash
– Retained earnings
• Dividends must be declared by the
board of directors—they are not
automatic
Cash Dividends
• There are three important dates
associated with dividends:
– Date of declaration—the date when
dividends are announced by the
board
– Date of record—stockholders owning
stock on this date receive the
dividend
– Date of payment—the date the
company makes payment
Cash Dividends
• A company declares a $20,000 cash
dividend on September 26 to be paid
on November 15 to the October 25
stockholders of record. The journal
entries are:
Sept. 26
Retained earnings
20,000
Dividends payable
20,000
To record the dividend declaration
Nov. 15
Dividends payable
20,000
Cash
20,000
To record payment of dividends
Preferred Stock
• Preferred stock offers owners different
rights and preferential treatment
– Dividend preference—preference over dividend
claims of common stockholders
– Liquidation preference—preference to assets in
the event of a liquidation
– Preferred stock does not normally have voting
rights
• Par value is significant for preferred
stock in cases in which the dividend is
stated as a % of par and/or when the
amount due at liquidation is tied to par.
• Preferred stock is accounted for in the
same way as common stock.
Preference in Liquidation
• Preferred stock usually has a
liquidation value
– The liquidation value must be paid to
preferred stockholders before
distributions to common stockholders
when a company is liquidated
– The liquidation value is often the same
as par value
• The company must pay off all debts
first
• There is less risk associated with
preferred stock than common stock
Other Features of
Preferred Stock
• Participating preferred stock
receives a fixed dividend but can
receive dividends above this amount
if the company has a good year
• Callable preferred stock gives the
company the right to redeem the
stock at a certain call price
• Convertible preferred stock gives
the owner the option to exchange the
preferred shares for common shares
Stock Warrants
• Long-term call options on the issuing
firm’s stock. Call options give their
holders the right to buy shares of the
firm at a specified price for a given
period of time. These options are
frequently included as part of a unit
offering, which includes two or more
securities offered as a package (e.g.
attached to bonds or preferred stock as an
"equity kicker" or "sweetener”) and issued
to the general public. If the warrants are
detachable a separate value is assigned
and recorded by the corporation.
Employee Stock Options
• Stock options are rights to purchase
a specific number of shares of a
corporation's capital stock at a
specific price for a specific time
period
• Stock options vest when an employee
remains with the company for a
specific time period
• Once vested, an employee may
exercise options anytime before they
expire (usually about 5 years)
• Stock options are used as a form of
employee compensation (expense)
Employee Stock Options
• Definitions
– Grant date is the date that a company
gives a stock option to an employee.
– Exercise date is the date that an
employee exchanges the option and cash
for shares of common stock.
– Exercise price or strike price is the
price specified in the stock option
contract for purchasing the common
stock.
– Vesting period is the period that must
expire before the employee is entitled
to exercise an option to acquire the
firm’s stock
Employee Stock Options
• Suppose in 2002 UPS grants options
to purchase 30,000 shares of its
$.01 par value common stock at $60.
The estimated value of each option
is $7. The options can be exercised
over a 3-year period starting 5
years from the date of grant. The
2002 journal entry is:
Compensation expense, stock options
Additional paid-in capital
*30,000 x $7 = $210,000
210,000*
210,000
Employee Stock Options
• Now suppose executives exercise
all options 5 years after the
date of grant. The journal
entry in 2007 would be:
Cash
1,800,000*
Common stock
300**
Additional paid-in capital
210,000
*30,000 x $60 = $1,800,000
**30,000 x $.01 = $300
Restricted Stock
• Granting restricted stock is like
paying employees with common stock
instead of cash
– Employees cannot sell the stock until it
vests
– The stock is generally sold back to the
company at the prevailing market price
• The company records compensation
expense and an increase to paid-in
capital
• Employees holding restricted stock
receive dividends if declared
Stock Splits
• A two-for-one stock split involves issuing
an additional share for each share
currently owned
• The number of shares outstanding double
and the par value decreases by 50%
• Total stockholders’ equity remains
unchanged
• The market price should drop 50%
• Companies split their stock in order to
make their shares more affordable to small
investors
Stock Dividends
• Dividends paid in the corporation’s own
shares of common stock
• Require the transfer of an amount from
retained earnings to paid-in capital
• Result in issuance of additional shares of
stock to each shareholder in proportion to
their current holdings.
• Such "dividends" are issued to:
– relieve pressure for cash dividends in the
future or
– signal an increase in total cash dividends, if
the cash dividend per share is kept constant.
• Share prices often do not fall
commensurately after issuance of a stock
dividend.
Stock Dividends
• The entries below illustrate a 100,000
shares stock dividend at par vs. a 2,000
shares stock dividend at market price for
a company with 100,000 shares of $10 par
value common stock with a market value of
$150
Stock Dividend (100%)
Retained earnings (100,000 x $10)
Common stock
Small Stock Dividend (2%)
Retained earnings (2,000 x $150)
Common stock (2,000 x $10)
Additional paid-in capital
1,000,000
1,000,000
300,000
20,000
280,000
Repurchase of Shares
• Companies repurchase shares because they:
– Want to retire the stock
– Think the stock is undervalued by the market
(“investment”)
– Want to change to proportion of debt and equity
in the company
– Need shares to distribute in a stock option
plan
– Want to return cash to shareholders without
creating expectations for permanent increases
in dividends
– Defensive measure in takeover bids.
• Repurchased shares also increases EPS
• Upon repurchase, the treasury stock is
generally recorded at cost.
• Purchased with the intent to resell.
Retirement of Shares
• Suppose Allstar company purchases
and retires 5,000 of its outstanding
$10 par value shares at $150 for a
total of $750,000 cash. Allstar
originally issued the shares at $50
per share. The following journal
entry reverses the original paid-in
capital and charges the additional
amount to retained earnings:
Common stock (5,000 x $10)
Additional paid-in capital (5,000 x $40)
Retained earnings
Cash (5,000 x $150)
50,000
200,000
500,000
750,000
Treasury Stock
• Now suppose Allstar in the previous
example decides to temporarily hold
the repurchased shares rather than
retiring them. The journal entry for
the repurchase of the shares is:
Treasury stock (5,000 x $150)
Cash
750,000
750,000
• Treasury stock is a contra
stockholder equity account—not an
asset
Treasury Stock
• The entries below show reissuance of
Allstar’s treasury shares at an
amount above or below the
acquisition cost ($150):
Reissue at $180
Cash (5,000 x $180)
Treasury stock (original cost)
Additional paid-in capital
900,000
750,000
150,000
Reissue at $120
Cash (5,000 x $120)
Additional paid-in capital
Treasury stock (original cost)
600,000
150,000
750,000
Other Issuances of
Common Stock
• Common stock is not always issued
for cash
• Common stock can also be issued in:
– Noncash exchanges for assets or services
– Conversions of convertible bonds or
preferred stock
• Common Stock can also increase
through pure accounting changes:
– Change some of the Retained
Earnings/Reserves into Common Stock
Retained Earnings
Restrictions
• State laws or contractual obligations
often restrict retained earnings (and
assets) for the protection of creditors
• Example: Dividends cannot be paid out to
the point that retained earnings is less
than the cost of treasury stock
• Companies can disclose restrictions by:
– Footnotes
– A line item on the balance sheet called
restricted or appropriated retained earnings
ARTIGO 35º
Código das Sociedades Comerciais
(Perda de metade do capital)
1. Os membros da administração que, pelas contas de
exercício, verifiquem estar perdida metade do capital
social devem propor aos sócios que a sociedade seja
dissolvida ou o capital seja reduzido, a não ser que os
sócios se comprometam a efectuar e efectuem, nos 60 dias
seguintes à deliberação que da proposta resultar,
entradas que mantenham pelo menos em dois terços a
cobertura do capital.
If the Equity value drops below 50% of the Common Stock
value, then one (or more) of the following three actions
should be taken within 60 days:
• Dissolve (liquidate) the corporation,
• Reduce the common stock,
• Increase the Equity.
The Equity/Common Stock should be brought to at least 2/3.
Convertible Bonds
• Bonds are sometimes issued with a
feature that allows holders to
convert the bond into common stock.
Convertible bonds provide the
comfort of a guaranteed return (from
the bond) but allow the holder to
become a common stockholder if that
option becomes attractive. This
conversion feature causes the bond
to carry a lower interest rate.