©2009 The McGraw-Hill Companies, Inc.

Stockholders’ Equity = Assets - Liabilities
Primary Sections of Stockholders’ Equity
Paid-in capital Retained Earnings
Amount stockholders have invested in the corporation
Amount of earnings the corporation has retained
Treasury Stock
Corporation’s own stock that it has reacquired
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©2009 The McGraw-Hill Companies, Inc.

 Articles of incorporation (or corporate charter ) describe
(a) the nature of the firm’s business activities
(b) the shares to be issued
(c) the initial board of directors

Corporation’s stockholders control the corporation.
By voting their shares, they determine the makeup of the board of directors —which in turn appoints the management to run the corporation.
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The progression leading to a public offering might include some or all of these steps:




Investment by the founders of the business.
Investment by friends and family of the founders.
Outside investment by “angel” investors (wealthy individuals in the business community willing to provide investment funds) and venture capital firms (provide additional financing for a percentage ownership in the corporation).
Initial public offering (IPO), the first time a corporation issues stock to the public.
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Corporations may be either public or private.
Public Private



Stock trades on a stock exchange such as NYSE,
AMEX, NASDAQ; or by overthe-counter (OTC) trading.
Corporations regulated by the
Securities and Exchange
Commission (SEC)
Examples General Motors,
Microsoft, Wal-Mart



Corporation does not allow investment by the general public and normally has fewer stockholders.
Corporations not regulated by the Securities and
Exchange Commission
(SEC) and thus, do not need to file financial statements with it.
Examples Koch
Industries (oil and gas),
Mars (candy), Cargill
(agricultural commodities)
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



Right to Vote —Stockholders have the right to vote on matters that come before the stockholders, including the election of corporate directors.
Right to Receive Dividends —Stockholders have the right to share in profits when the corporation declares dividends . The percentage of shares a stockholder owns determines his or her share of the dividends distributed.
Right to Share in Distribution of Assets —Stockholders share in the distribution of assets if the corporation is liquidated. The percentage of shares a stockholder owns determines his or her share of the assets, which are distributed after creditors and preferred stockholders are paid.
Preemptive Right —The preemptive right allows a stockholder to maintain his or her percentage share of ownership when new shares are issued. Each stockholder is offered the opportunity to buy a percentage of any new shares issued equal to the percentage of shares he or she owns at the time. However, most corporations have dropped this right due to difficulties it causes corporations when they issue new shares.
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10-8
Advantages Disadvantages
(1) Limited liability
A stockholder can lose no more than the amount invested.
(1) Additional taxes
Corporate earnings are taxed twice
- at the corporate level and individual stockholder level.
(2) Ability to raise capital
Attracting outside investment is easier for a corporation.
(2) More paperwork
Federal and state governments impose additional reporting requirements.
(3) Lack of mutual agency
Stockholders cannot legally bind the corporation to a contract.

If a corporation has only one kind of stock, it usually is labeled as common stock.
Type of Stock
Authorized
Issued
Outstanding
Definition
Shares available to sell
(issued and unissued)
Shares actually sold
(includes treasury stock)
Shares held by investors
(excludes treasury stock)
Authorized – Unissued = Issued
Issued – Treasury Stock = Outstanding
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The legal capital per share of stock that’s assigned when the corporation is first established
Has no significant meaning today
Has no relationship to the market value of the common stock
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NO PAR VALUE common stock that has not been assigned a par value
STATED VALUE
Treated in the same manner as par value shares

When a corporation receives cash from issuing common stock, it debits cash. If it issues no-par value stock, the corporation credits the equity account entitled common stock.
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Cash (1,000 shares x $30)
Common Stock
(Issue no-par value common stock)
30,000
30,000
The entry changes slightly if the corporation issues par value stock rather than no-par value stock. In that case, we credit common stock and additional paid-in capital.
30,000 Cash (1,000 shares x $30)
Common Stock (1,000 shares x $0.01)
Additional Paid-in Capital (difference)
(Issue common stock above par)
10
29,990



“Preferred” over common stock
A mixture of attributes somewhere between common stock
(equity) and a bond (liability)
Factor
Voting rights
Risk to the investor
Expected return to the investor
Risk of contract violations
Preference for payments
Tax deductibility of payments
Common
Stock
Yes
Highest
Highest
Lowest
Lowest
No
Preferred
Stock
Usually No
Middle
Middle
Middle
Middle
Usually No
Bonds
No
Lowest
Lowest
Highest
Highest
Yes
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The entries to record the issuance of preferred stock are similar to those for the issue of common stock.
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Cash (1,000 shares x $40)
Preferred Stock (1,000 shares x $30)
Additional Paid-in Capital
(Issue preferred stock above par)
40,000
30,000
10,000

Flexibility allowed in its contractual provisions.
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Convertible Redeemable Cumulative
Shares can be exchanged for common stock
Shares can be returned to the corporation at a fixed price
Shares receive priority for future dividends, if dividends are not paid in a given year

A corporation’s own stock that it has reacquired
Why Corporations Repurchase Their Stock
 To boost under-priced stock.
When corporation management feels the market price of its stock is too low, it may attempt to support the price by decreasing the supply of stock in the marketplace.



To distribute surplus cash without paying dividends . While dividends usually are a good thing, investors do pay personal income tax on them.
Another way for a firm to distribute surplus cash to shareholders without giving them taxable dividend income is to use the excess cash to repurchase its own stock.
To boost earnings per share . Stock repurchases reduce the number of shares outstanding, thereby increasing earnings per share. However, with less cash in the corporation, it’s more difficult for companies to maintain the same level of earnings following a share repurchase.
To offset issuance of shares under stock-based compensation plans.
Perhaps the primary motivation for stock repurchases is to offset the increase in the number of shares created by employee stock award and stock option compensation programs.
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Reissue price
Treasury stock is reported as a contra-equity, or negative equity account, since treasury stock reduces total stockholders’ equity.
When a corporation repurchases its own stock, it increases, or debits treasury stock. When it sells treasury stock, it decreases, or credits treasury stock.
3,000 Treasury Stock (100 shares x $30)
Cash
(Repurchase treasury stock)
3,000
Cash (100 shares x $35)
Treasury Stock (100 shares x $30)
Additional Paid-in Capital (difference)
(Reissue treasury stock above cost)
3,500
Cost
3,000
500
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What if the stock price goes down and we reissue the treasury stock for less than we paid to buy back the shares?
Reissue price
Cash (100 x $25)
Additional Paid-in Capital (100 x $5)
Treasury Stock (100 x $30)
(Sell treasury stock below cost)
2,500
500
3,000
Cost
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©2009 The McGraw-Hill Companies, Inc.

RETAINED EARNINGS




Represents the earnings retained in the corporation
– earnings not paid out as dividends to stockholders.
Equals all net income, less all dividends, since the corporation began.
Has a normal credit balance consistent with other stockholders’ equity accounts.
If losses exceed income since the corporation began, retained earnings will have a debit balance and is called an accumulated deficit .
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Distributions by a corporation to its stockholders
Not paid on treasury shares repurchased by the corporation
Investors pay careful attention to cash dividends.
DECLARATION DATE
Date on which dividend is declared
RECORD DATE
Date on which the registered owners of stock are determined
PAYMENT DATE
Date on which the cash dividend is paid
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Lets consider the following dividend example
Declares a $0.25 per share dividend on its 2,000 outstanding shares
March 15 (Dividend declared)
Retained Earnings (2,000 shares x $0.25)
Dividends Payable
(Declaration of cash dividends)
500
500
March 31 (No entry for Record date)
April 15 (Dividend paid)
Dividends Payable (2,000 shares x $0.25)
Cash
(Payment of cash dividends)
500
500
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Sometimes, corporations distribute to shareholders additional shares of the companies’ own stock rather than cash. These are known as stock dividends or stock splits depending on the size of the stock distribution.
You will get You own 100 shares and assume a
10% stock dividend
20% stock dividend
100% stock dividend
10 additional shares
20 additional shares
100 additional shares
Large stock dividend or stock split (2-for-1)
Small stock dividend

Since the corporation’s shares double following a 100% stock dividend, we make an entry to reflect the increase in the par value of the common shares.
Retained Earnings (1,000 shares x $0.01)
Common Stock
(100% stock dividend, large stock dividend)
10
10
Small stock dividends are recorded by debiting retained earnings for the market value, rather than the par value, per share.
Retained Earnings (1,000 x 10% x $30)
Common Stock (1,000 x 10% x $0.01)
Additional Paid-In Capital (difference)
(10% stock dividend, small stock dividend)
3,000
1
2,999
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



A stock distribution of 25% or higher, although it’s technically a “large” stock dividend, is more often referred to as a stock split.
A 100% stock dividend is effectively the same as a 2for-1 stock split, although the accounting for a 100% stock dividend and a 2-for-1 stock split differs.
Make no journal entry to record a stock split.
After a 2-for-1 stock split, the common stock account balance (total par) represents twice as many shares and the par value per share is reduced by one-half.
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©2009 The McGraw-Hill Companies, Inc.
APPAREL STORE

($ in thousands)
Stockholders’ equity:
American Eagle Outfitters, Inc.
Balance Sheet
(Stockholders’ Equity Section)
February 3, 2007
Preferred stock, $0.01 par value
Common stock, $0.01 par value
Additional paid-in capital
Total paid-in capital
Retained earnings
Less: Treasury stock, 25,699 shares
Total stockholders’ equity
$ 2,461
-
453,418
455,879
1,324,059
(362,626)
$ 1,417,312
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10-27
Balance, January 1
Issued common stock
Issued preferred stock
Repurchase of treasury stock
Sale of treasury stock
Cash dividends
100% stock dividend
Net income
Balance, December 31
Summarizes the changes in the balance in each stockholders’ equity account over a period of time .
Preferred
Stock
-0-
30,000
Canadian Falcon
Statement of Stockholders’ Equity
For the year ended December 31, 2010
Common
Stock
Additional
Paid-in
Capital
Retained
Earnings
-0-
10
-0-
29,990
10,000
-0-
Treasury
Stock
-0-
(3,000)
Total
Stockholders’
Equity
-0-
30,000
40,000
(3,000)
$30,000
10
$20
500
$40,490
(500)
(10)
30,000
$29,490
3,000
$0
3,500
(500)
-0-
30,000
$100,000

Equity Analysis
Return on
Equity
Return on the Market
Value of Equity
Price-Earnings
Ratio
Earnings Per
Share
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Measures the ability of company management to generate earnings from the resources that owners provide.
Return on equity
=
Net income
Average stockholders’ equity
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To supplement the return on equity ratio, analysts often relate earnings to the market value of equity calculated as the ending stock price times the number of shares outstanding.
Return on the market value of equity
=
Net income
Market value of equity
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


Measures the net income earned per share of common stock
Useful in evaluating the earnings performance of a company over time.
Not useful in comparing earnings performance across companies
Net income
Earnings per share =
Average shares outstanding during the period
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

A high PE ratio indicates investors expect future earnings to be higher.
A low PE ratio indicates investors lack of confidence in future earnings growth.
Price-Earnings
Ratio
=
GROWTH STOCKS priced high in relation to current earnings
Stock price
Earnings per share
VALUE STOCKS priced low in relation to current earnings
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©2009 The McGraw-Hill Companies, Inc.

The percentage of stock held by the investor provides a guideline in determining the degree of influence
Investor’s equity ownership and influence
0%
Insignificant influence
20%
Significant influence
50%
Fair value method
Equity method
Controlling influence
Consolidation method
Consolidated Financial
Statements
100%
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Purchase of Investments
Let’s assume we purchase 1,000 shares of Canadian
Falcon common stock at $30 per share. The entry to record this transaction is:
Investment in Canadian Falcon
Cash (1,000 shares x $30)
(Purchase common stock)
30,000
30,000
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Receipt of Dividends
If Canadian Falcon pays cash dividends of $0.50 per share, the entry to record receipt of cash dividends on our 1,000 share investment is:
Cash (1,000 shares x $0.50)
Dividend Revenue
(Receive cash dividends)
500
500
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Sale of Investments Above Cost
Gains and losses on the sale of equity investments are recorded in the income statement as part of net income.
If the investment sells for more than its cost
Cash (100 x $36) 3,600
Gain on Sale of Investments (difference)
Investment in Canadian Falcon (100 x $30)
(Sale of investments above cost)
GAIN
600
3,000
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Sale of Investments Below Cost
Gains and losses on the sale of equity investments are recorded in the income statement as part of net income.
If the investment sells for less than its cost
Cash (100 shares x $28)
Loss on Sale of Investments (difference)
Investment in Canadian Falcon (100 x $30)
(Sale of investments below cost)
2,800
200
LOSS
3,000
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At the end of each period, we adjust equity investments to their new fair value.
After selling 200 shares, we still hold 800 shares in Canadian Falcon at a cost of $30 per share. If the fair value at the end of the year is
$32 per share, we would increase our investment account by $2 per share with the following entry:
Investment in Canadian Falcon
(800 shares x $2)
Unrealized Holding Gain —Other
Comprehensive Income
(Increase investments to fair value)
1,600
1,600
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If, one year later, the fair value dropped from $32 to $27 per share, we would decrease our investment account by $5 per share with the following entry:
Unrealized Holding Loss —Other
Comprehensive Income
4,000
4,000 Investment in Canadian Falcon
(800 shares x $5)
(Decrease investments to fair value) means the investment has not been sold
• Comprehensive income is an expansion of net income.
• The statement of comprehensive income reports all changes in stockholders’ equity other than those caused by transactions with shareholders.
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©2009 The McGraw-Hill Companies, Inc.