Chapter 18 Shareholders’ Equity
PAID-IN CAPITAL
Fundamental Share Rights
One of the most important features of the corporate form of business is the issuance of capital
stock in exchange for capital contributions. Each share of capital stock typically carries the
following rights:
1. To share proportionately in profits and losses
2. To share proportionately in management by voting for the board of directors
3. To share proportionately in corporate assets upon liquidation
4. To share proportionately in any new issues of stock of the same class (preemptive
rights)
There can be a large variety of stock issues but in essence there are two kinds of capital stock:
common stock and preferred stock. Common stockholders have a residual interest in the
corporation and receive the benefits of profitable operations and incur the risks of unprofitable
operations. Preferred stockholders have certain preferential rights with respect to the receipt of
dividends. In exchange for this preference they sacrifice some if not all of the rights attributed to
common shareholders.
Preferred Stock
This class of stock is preferred because it gives the stockholders certain preferences over
common stockholders. There is some discussion as to the true status of preferred shareholders.
In many respects they are a special class of creditors but for financial accounting purposes we
consider them stockholders. The preferences attributed to preferred stock are:
1. Dividends are paid to preferred stockholders first
2. Priority above common stockholders in the event of liquidation
3. Convertible to common shares at the option of the stockholders
4. Callable at the option of the corporation
5. Preferred shareholders are not able to vote on corporate matters
Special Features
Cumulative Preferred Stock: If the corporation fails to declare dividends in year 1 and declares
and pays dividends in year 2, stockholders with cumulative preferred stock will received their
dividends for both year 1 and year 2 before the common stockholders receive any dividends.
Any unpaid dividends from prior years are called dividends in arrears.
Participating Preferred Stock: If preferred stock is participating, then after receiving the
prescribed dividend the stockholders participate in dividends with the common stockholders.
Convertible Preferred Stock: At a predetermined ratio preferred stockholders may within a
specified period convert their preferred shares for common shares. This gives the preferred
stockholders an opportunity to participate in the gain in value of the stock as a result of the
success of the company. The conversion is at the option of the stockholder.
Callable Preferred Stock: In certain circumstances a corporation might issue callable preferred
stock. This gives the corporations option of redeeming the preferred shares of stock at a specific
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Chapter 18 Shareholders’ Equity
future date at a specified price. If the shares are redeemed by the corporation, it must first bring
current any dividends in arrears.
Reporting Preferred Stock in the Financial Statements
The par value of preferred stock is listed first in the equity section of the balance sheet followed
by the par value of common stock. After the par value of all authorized, issued and outstanding
stock is listed then the additional paid-in capital accounts are listed. Again, the additional paidin capital-preferred stock is listed first followed by the additional paid-in capital-common stock
account. This following is the format that should be used when preferred stock has been issued
by a corporation:
Shareholders' Equity
Capital stock:
Preferred stock, $100 par value, 7% cumulative, 100,000
shares authorized, 30,000 chares issued and outstanding
Common stock, no par, stated value, $10 per share,
500,000 shares authorized, 400,000 shares issued and
398,000 shares outstanding
Common stock, dividend distributable, 20,000 shares
Total capital stock
Additional paid-in capital:
Additional paid-in capital, preferred stock
Additional paid-in capital, common stock
Total paid-in capital
Retained earnings:
Appropriated for plant expansion
Unappropriated
Total paid-in capital and retained earnings
Less: cost of treasury stock (2,000 shares, common)
accumulated other comprehensive loss
Total shareholder's equity
$3,000,000
4,000,000
200,000
7,200,000
$150,000
840,000
2,200,000
2,160,000
990,000
8,190,000
4,360,000
12,550,000
(190,000)
(360,000)
$12,000,000
Accounting for the Issuance of Shares
The balance sheet normally has three categories of stockholders’ equity.
1. Capital stock
a. Common stock-amounts include only the par or stated value of the common stock
issued
b. Preferred stock- amounts include only the par or stated value of the preferred
stock issued
2. Additional paid-in capital
a. Common stock- amounts include only the premium paid or discount taken on the
issuance of common stock
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Chapter 18 Shareholders’ Equity
b. Preferred stock- amounts include only the premium paid or discount taken on the
issuance of preferred stock
3. Retained earnings
a. Accumulation of net income less or net losses less dividends from the beginning
date of business
The Concept of Par Value
Typically the par value of stock is extremely low as opposed to the market value. Par value is
the state mandated legal capital which cannot be distributed to the stockholders. For each class
of stock (common and preferred) there will be a credit to the capital stock account and the
additional paid-in capital account when stock is initially sold to investors.
No-par stock would be carried in the books at the issue price with no additional paid-in capital or
discount account. This is very rare. In states that allow no-par stock there is normally a stated
value that is handled in the same manner as the par value.
Shares Issued for Cash
When stock is sold for cash the entry includes a debit to cash and a credit to one or more paid-in
capital equity accounts.
Example: Spencer Corporation sells 100 shares of common stock with a par value of $1 for
$500. The journal entry would be as follows:
Account
Debit
$500
Credit
Cash
Common stock
$100
Additional paid-in capital, common stock
400
To record the sell of 100 shares of $1 par value common stock for $5 per share.
Shares Issued on Credit
When an investor purchases stock on a subscription basis prior to incorporation of the business
entity, a partial payment is received and the stock is not issued until the final payment is made.
Example: Prior to incorporation, the organizers of Spencer Company arranged to sell stock on a
subscription basis to one of the organizers. The future shareholder agreed to purchase 200 shares
of the company’s $1 par value stock for $1,000. A $500 payment was made at the date of
subscription and the remaining balance was paid on the date the stock was issued. The journal
entries to record the issuance of a subscription and the receipt of the down payment are as
follows:
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Chapter 18 Shareholders’ Equity
Account
Debit
Credit
Subscriptions receivable
$1,000
Common stock subscribed
$200
Additional paid-in capital, common stock
800
To record the subscription of 200 shares of $1 par value common stock for
$5 per share.
Account
Debit
$500
Credit
Cash
Subscriptions receivable
$500
To record the receipt of $500 on the subscription of 200 shares of $1 par
value common stock for $5 per share.
Once the business entity is incorporated shares sold on contract result in the issuance of the
shares and the recording of a share purchase contract receivable. This is a promissory note from
the subscriber.
The journal entries to record the receipt of the remaining balance on the share purchase contract
receivable and the issuance of the shares of common stock are as follows:
Account
Debit
Credit
Cash
$500
Subscriptions receivable
$500
To record the receipt of $500, the remaining balance on the stock
subscription.
Account
Debit
Common stock subscribed
$200
Common stock
To record the issuance of 200 shares of subscribed stock.
Credit
$200
Example: One of the officers of Spencer Company entered into a share purchase contract to
purchase 200 shares of the company’s $1 par value stock for $1,000. A $500 payment was made
at the date of contract and the remaining balance was paid on the date the stock was issued. The
journal entries to record the issuance of a share purchase contract and the final issuance of the
stock are as follows:
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Chapter 18 Shareholders’ Equity
Account
Cash
Receivable from share purchase contract
Common stock
Additional paid in capital, common stock
Debit
$500
500
Credit
$200
800
To record the purchase of 200 shares of $1 par value common stock for $5
per share on a share purchase contract.
Stock Issued for Other Than Cash
Stock issued for services or property other than cash should be recorded at the fair market value
of the stock issued OR the fair market value of the non-cash consideration received, whichever is
more clearly determinable.
Example: Spencer Company enters into a transaction to purchase a patent in exchange for 100
shares of its $1 par value stock. There is no readily determinable market value for the stock or
the patent. The company hires an appraiser to determine the fair market value of the patent. The
appraiser determines that the patent is worth $6,000, therefore the journal entry to record this
non-cash transaction is as follows:
Account
Debit
$6,000
Credit
Patent
Common stock
$100
Additional paid in capital, common stock
5,900
To record the issuance of 100 shares of $1 par value common stock in
exchange for a patent valued at $6,000.
Stock Issued with Other Securities
There are two methods available to allocate the purchase price in a lump sum sale of more than
one class of stock; the proportional method and the incremental method. If the fair market value
of each class of stock is known then the allocation can be made using the proportional method.
The respective market values are used as a basis for allocation.
Example: Spencer Company purchased 100 shares $1 common stock and 100 shares of $1
preferred stock of Fido Chow for $9,000. At the time of the purchase the fair market value of the
common stock was $80 per share and the fair market value of the preferred stock was $50 per
share. Using the proportional method the allocation of the purchase price would be as follows:
Securities
Common stock
Preferred stock
Totals
Number Market Total Relative
of Shares Value Market Value
100
$80 $8,000
62%
100
50
5,000
38%
200
$13,000
100%
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Allocation of
Purchase
Price
$5,538
3,462
$9,000
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Chapter 18 Shareholders’ Equity
If in the above example we do know that the market value of the common stock is $80 but we
don’t know the market value of the preferred stock then the allocation would be completed as
follows:
Lump sum sale
Allocated to common stock
Balance allloacted to preferred stock
$9,000
8,000
$1,000
Share Issue Costs
Share issue costs are those costs that are incurred by the corporation in bringing the stock to
market. They include legal, accounting, promotional costs and the fees charged by the
investment bankers. All such costs reduce the amount of cash that the company received from
the stock issue. Rather than treating this as an expense it is debited to the paid-in capital, excess
of par account.
Example: Spencer Company issued 10,000 shares $5 par value common stock at a market price
of $30 per share. The stock issue costs to bring this stock issue to market were $5,000. The
journal entry to record the issuance of this stock is as follows:
ACCOUNT
Cash
Common stock
Paid-in capial, excess of par
To record the issuance of 10,000 shares of common stock
Analysis of cash received:
Number of shares issued
Market price per share
Gross selling price
Less: issue costs
Cash received
DEBIT
295,000
CREDIT
50,000
245,000
10,000
30
300,000
5,000
295,000
Reacquisition of Shares
Accounting for Retired Shares
Shares retired are effectively considered shares authorized and not issued. The journal entry to
retire shares of stock involves a credit to cash for the purchase price, and a debit to common
stock for the par (or stated) value and paid-in capital, excess of par. If there is a gain on the
transaction the remaining credit is to paid-in capital, share repurchase. If there is a loss on the
transaction the remaining debit is to paid-in capital, share repurchase to the extent that there is an
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Chapter 18 Shareholders’ Equity
existing credit balance in the account. If there is a loss, in excess of the balance in the paid-in
capital, share repurchase account, it is debited to retained earnings.
Example: Spencer Company retired 1,000 shares of $5 par value stock that was originally
issued at $30 per share. If the repurchase price is $27 per share the journal entry to record the
transaction would be as follows:
ACCOUNT
DEBIT
5,000
25,000
Common stock
Paid-in capital, excess of par
Paid-in capital, share repurchase
Cash
To record the repurchase of 1,000 shares of common stock at $27
CREDIT
3,000
27,000
Assuming that there is no balance in the paid-in capital, share repurchase account, if the stock
was repurchased at $32 per share the journal entry to record the transaction would be as follows:
ACCOUNT
DEBIT
5,000
25,000
2,000
Common stock
Paid-in capital, excess of par
Retained earnings
Cash
To record the repurchase of 1,000 shares of common stock at $32
CREDIT
32,000
Accounting for Treasury Stock
When a corporation repurchases its own stock and it is not retired, the stock is referred to as
treasury stock. Treasury stock is not an asset but rather a contra-equity account.
If stock has been repurchased, the balance sheet will reflect this debit balance account in the
equity section. The following is an example of the equity section of a balance sheet for Spencer
Company after it acquired 100 shares of treasury stock for $7,000.
Shareholders' equity
Paid-in Capital
Common stock, $1 par value, 5,000 shares authorized
and issued, 4,900 shares outstanding
Additional paid-in capital
Total paid-in capital
Retained earnings
Total paid-in capital and retained earnings
Less: treasury stock (at cost) 100 shares
Total shareholders' equity
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$5,000
20,000
25,000
180,000
205,000
(7,000)
$198,000
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Chapter 18 Shareholders’ Equity
There are two methods of recording the purchase of treasury stock. The cost method is the most
widely used in practice. In this approach the total reacquisition cost is debited to the treasury
stock account. As you can see from the example above the treasury stock account is reported as
a reduction in stockholders equity on the balance sheet. The application of the par value method
is discussed in appendix 15A of your textbook.
Example: Spencer Company acquired 100 shares of its own stock for $7,000. This transaction
would be recorded as follows:
Account
Debit
Treasury stock
$7,000
Cash
To record the purchase of 100 shares of treasury stock.
Credit
$7,000
Resale of Shares
If treasury stock is sold above the reacquisition cost then there will be an increase in additional
paid-in capital to reflect this increase in contributed capital. Note that the credit goes into a
separate additional paid-in capital account entitled “Additional paid-in capital-treasury stock.”
In the above example, Spencer Company purchase treasury stock for $7,000. Now if the
company resells the treasury stock for $10,000 the following journal entry would record the
transaction:
Account
Cash
Treasury stock
Additional paid-in capital, treasury stock
To record the sale of 100 shares of treasury stock.
Debit
$10,000
Credit
$7,000
3,000
There are situations in which the company may be required to resell the treasury stock at a loss.
If Spencer Company had to sell the above treasury stock for $5,000 the following journal entry
would record the transaction:
Account
Debit
Cash
$5,000
Additional paid-in capital, treasury stock
2,000
Treasury stock
To record the sale of 100 shares of treasury stock.
Credit
$7,000
Now this presents a problem. We can’t have a debit balance in an additional paid-in capital
account. If the account “Additional paid-in capital-treasury stock” reaches a zero balance, then
the excess loss (debit) must be recorded as a debit to retained earnings. In the above example we
only have one transaction so therefore there is no previous balance in the “Additional paid-in
capital-treasury stock” account. Therefore, the correct journal entry in this situation is as
follows:
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Chapter 18 Shareholders’ Equity
Account
Debit
Cash
$5,000
Retained earnings
2,000
Treasury stock
To record the sale of 100 shares of treasury stock.
Credit
$7,000
Retiring Treasury Stock
When treasury stock is retired it is removed from further circulation. For financial reporting
purposes it is authorized but not issued stock. To retire treasury stock the original common stock
and additional paid-in capital-common stock accounts are debited for the amounts involved in
the original issue. The treasury stock account is credited for the amount paid when the stock was
reacquired. If the company paid more for the treasury stock then it received in the original issue
the difference is debited to retained earnings. If the company paid less for the treasury stock then
it received in the original issue the difference is credited to additional paid-in capital-treasury
stock.
Example: Spencer Company decides to retire 1,000 shares of treasury stock that it purchased in
the open market for $100,000. The stock has a par value of $1 and was originally sold for
$80,000. The company paid more for the treasury stock then received in the original issue.
Therefore the journal entry would be as follows:
TREASURY STOCK > ORIGINAL ISSUE
ACCOUNT
DEBIT
Common stock
1,000
Additional paid-in capital, common stock
79,000
Retained earnings
20,000
Treasury stock
CREDIT
100,000
In the above example, assume that Spencer Company retires 1,000 shares of treasury stock that it
purchased in the open market for $60,000. The par value and original selling price are
unchanged. In this case the company paid less for the treasury stock then received in the original
issue. Therefore the journal entry would be as follows:
ORIGINAL ISSUE > TREASURY STOCK
ACCOUNT
DEBIT
Common stock
1,000
Additional paid-in capital, common stock
79,000
Treasury stock
Additional paid-in capital, treasury stock
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CREDIT
60,000
20,000
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