Stockholders’ Equity
In this section we will review:
 The nature of Stockholders’ Equity
– The characteristics of the corporate form of
organization
– The types of stock a company can have (common
and preferred)
– The difference between issuing Equity vs. Debt
 The accounting for elements of Stockholder’s
Equity?
– Issuance and repurchases of shares of stock
– Dividends
© 1999 by Robert F. Halsey
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Corporate Form of Organization limited liability of shareholders
Unlike other forms of business organization, like sole
proprietorships and partnerships, a corporation is a legal
entity that is separate and distinct from its owners.
That means that shareholders of the corporation have
limited liability - they can only lose what they have
invested in the business. If the debts of the business
are greater than its assets, creditors lose; they cannot
sue shareholders for the deficit.
© 1999 by Robert F. Halsey
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Double taxation
The fact that a corporation is a separate legal entity also
means that the IRS taxes it like any other taxpayer. It is
taxed on the income it earned, regardless whether that
income is paid out to shareholders as dividends
So, after having earned a profit and paying tax on that
profit, should a company decide to pay out a portion of
that profit to its shareholders as a dividend, the IRS
taxes the individual shareholders on the dividends they
receive.
This is the concept of double taxation.
© 1999 by Robert F. Halsey
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Nature of Stockholders Equity

Stockholder’s equity is a residual concept - it is what is
left over to the shareholders after the claims of other
parties (creditors, preferred shareholders) have been
satisfied.

Stockholder’s equity also represents the resources that
have been provided by the company’s owners in the
form of capital contributions (purchases of stock) and
earnings retained from operations.
© 1999 by Robert F. Halsey
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Equity versus Debt
• Assume that a company wants to raise
$10,000. It can either sell,
 Bonds -- 10 Bonds, $1000 par value, 8% coupon
payable annually rate sold at 100, mature in 10
years (interest paid per year = 10 * $1,000 * 8% =
$800), or
 Common Stock -- 100 shares, $1 par value, market
value = $100 per share (assume total dividends paid
= 8% or $800).
• Let’s “issue” these securities -- What is the
result?
© 1999 by Robert F. Halsey
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Equity Vs. Debt Issue (cont’d)
Although the amount of the payment ($800 per year)
to the sources of funds (debt holders or
stockholders) is the same in both cases, there are
important differences:
 interest payments are a fixed contractual obligation that
must be paid even if the business is not earning profits,
and creditors can force the company into bankruptcy if
interest payments are not paid when due.
 Dividends, on the other hand, are not required to be paid
and can be discontinued in a business downturn.
© 1999 by Robert F. Halsey
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 There is another important difference between the two
forms of raising capital: shareholders have a vote in the
election of the company’s board of directors and, through
the board of directors, indirectly control the corporation.
Debt holders do not have that right and exercise their
share of corporate governance through bond agreements
that limit the activities of the company.
 In sum, shareholders bear more of the risk and receive
more of the benefits of financial outcomes (downside and
upside), but at the same time equity-holders can exercise
control (votes) with limited liability.
© 1999 by Robert F. Halsey
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Accounting for the Issuance
of Common Stock
 Let’s look at an example to understand the accounting
for the issuance of common stock:
(Click here to view an example of the
accounting for the issuance of common stock)
© 1999 by Robert F. Halsey
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This is an example of the stockholder’s equity section from
Wal-Mart’s balance sheet:
Wal-Mart has issued 4.448 million shares of $.10 par common
for total proceeds of $880 million ($445 + $435). Wal-Mart’s
board of directors has authorized its management to issue up
to 5.5 million shares, so not all of the authorized shares have
been issued. No preferred stock has been sold.
© 1999 by Robert F. Halsey
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Treasury Stock

Stock repurchase programs have become quite
common among companies. Many of these programs
are highlighted in annual reports as a mechanism to
increase shareholder value.

Why do companies repurchase their own stock?
 To increase the number of shares available for the
exercise of stock options by employees or for
acquisitions
 Increase earning per share (the denominator is reduced)
 To signal the market that management believes the
company’s stock is under-valued.
© 1999 by Robert F. Halsey
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Accounting for the repurchase
of common stock

Let’s take a look at an example of the
accounting for the repurchase of common
stock:
(Click here to view an example of the
accounting for stock repurchases)
© 1999 by Robert F. Halsey
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Here is an example of the reporting of treasury stock from
Colgate-Palmolive’s annual report.
Colgate-Palmolive has repurchased treasury stock with a
cumulative cost of $2.3 billion. Its stockholder’s equity has
been reduced by this amount.
© 1999 by Robert F. Halsey
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Preferred Stock
What makes preferred stock preferred? Preferred shares
have certain “preferences” with respect to common
stock.
 The shares have a preference as to dividends. This
means that preferred shareholders receive all of the
dividends to which they are entitled before common
shareholders are paid.
 The shares have a preference as to assets in
liquidation. If the company becomes insolvent and the
assets are liquidated, preferred shareholders will be
paid before common shareholders.
10
© 1999 by Robert F. Halsey
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Preferred stock is a “contract”

It is important to understand that preferred shares are sold
pursuant to a contract between the company and the
purchasers of the shares. Any terms that are agreeable to
both parties can be inserted into that contract. For example,
 The shares may be callable at the option of the company to force
conversion of the shares into common stock or the shareholders
may be able to convert the preferred shares into common at their
option.
 The preferred share may have a cumulative dividends preference,
meaning if the required dividends are not paid in any year, these
“dividends in arrears” must be paid, plus current preferred dividends,
before common shareholders are paid
 The preferred share may have a redemption provision that required
the company to repurchase a portion of the shares each year.
© 1999 by Robert F. Halsey
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Preferred Stock Vs. Debt

Preferred stock has features of both debt and equity:
 Preferred shareholders receive a yield similar to the interest in debt
(the yield is fixed, however, and preferred shareholders do not
receive additional dividends if the company performs well).
 Like debt, it is not completely residual (similar to interest paid to
bondholders, its dividends are paid before common’s)
 However, the payments to preferred are avoidable in the event of a
business downturn and there is no maturity for repayment of
principle (other than for redeemable preferred).
 The preferred dividends, like common, are not tax deductible by
the company as opposed to interest payments on debt.

Preferred stock is generally accounted for and reported as part
of stockholder’s equity (redeemable preferred is reported
between liabilities and stockholder’s equity to reflect its debt-like
character - click here to see an example
).
© 1999 by Robert F. Halsey
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Here is an example of the reporting of preferred stock from
DuPont’s annual report:
DuPont has sold 1.673 million shares of no par cumulative
preferred stock for $100 per share. Each share pays $4.50 in
dividends per year, or a 4.5% yield. Cumulative means that if
the company does not pay dividends on the stock in a year, it
must make up the amount due before common shareholders
are paid a dividend.
© 1999 by Robert F. Halsey
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Dividends
Dividends are declared by the board of directors (who are
elected by the shareholders). Note that the company
does not have to pay dividends. No liability is, therefore,
reflected in the company’s balance sheet for the payment
of dividends until the board of directors declares that a
dividends should be paid.
The two most common types of dividends are
cash dividends, dividends paid in cash, and
stock dividends, dividends paid by issuing
additional shares of stock to the shareholder.
© 1999 by Robert F. Halsey
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From a legal standpoint, most states permit the payment
of dividends as long as the company is solvent, that is,
able to pay its debts. From an accounting standpoint
dividends are paid out of the retained profits of the
corporation.
As a result, the basic accounting entry to records the
payment of dividends debits retained earnings. For
example, assume a company pays out $50,000 in cash
to its shareholders as a dividend. The required journal
entry is as follows:
Retained earnings 50,000
Cash
© 1999 by Robert F. Halsey
50,000
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Stock Dividends

With a stock dividend -- no assets are distributed;
rather a reclassification takes place within owners’
equity -- from retained earnings to contributed capital.

Proportional ownership interest does not change.
More share are outstanding but each share is worth
less.
© 1999 by Robert F. Halsey
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Accounting for Stock Dividends
Let’s take a look at the accounting for stock dividends:
(Click here to view an example of the
accounting for stock dividends)
© 1999 by Robert F. Halsey
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Stock Splits


Companies frequently declare stock splits and distribute
additional shares to shareholders in proportion to the
number of shares previously held. For example, if a
company declares a 2 for 1 stock split, each shareholder
receives 1 additional share for each share held. The
percentage of the company that they own, both before and
after the stock split, is the same since each shareholder
receives the same proportionate increase in the number of
shares owned.
From an accounting standpoint, no journal entries are
required since a transaction has not taken place. The
number of shares outstanding is increased and the par
value adjusted to reflect the additional shares issued.
© 1999 by Robert F. Halsey
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In recent years, stock splits are more commonly
accomplished in the form of a stock dividend. For example,
in 1996, Sun Microsystems declared a 2 for 1 stock split in
the form of a 100% stock dividend. The notes to its annual
report describe this transaction:
© 1999 by Robert F. Halsey
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This is how the stock dividend affected stockholder’s equity.
Notice that the par value of the shares issues was transferred
form retained earnings to common stock. Additional paid-incapital was not effected since the par value was used.
© 1999 by Robert F. Halsey
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The End
© 1999 by Robert F. Halsey
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Here is an example of redeemable preferred stock from VF
Corp’s annual report:
© 1999 by Robert F. Halsey
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