Chapter 11
Equity
Financing
Albrecht, Stice, Stice, Swain
COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
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Debt vs. Equity
• Debt
• Equity
– Company is obligated
to repay the principal
amount, even during
bad times.
– Company is not
obligated to repay the
principal amount
(investors can lose all
of their investment).
– Lender does not share
in the success of the
company.
– Investor shares in the
success of the
company.
2
Proprietorships and
Partnerships
• Proprietorship
– A business owned by one person.
• Partnership
– An association of two or more individuals or
organizations to carry on economic activity.
• Characteristics
– Ease of formation.
– Limited life.
– Unlimited liability
3
Corporations
• Corporation
– A legal entity chartered by a state; ownership
is represented by transferable shares of
stock.
• Characteristics
– Limited liability.
– Easy transferability of ownership.
– Ability to raise large amounts of capital.
– Double taxation.
– Close government regulation.
4
Common Stock
• Rights of the common stockholder
– Voting rights.
– Preemptive right.
• The right to purchase additional shares whenever
stock is issued. Allows stockholders to maintain the
same proportion of ownership.
– Dividend rights.
– Corporate asset rights.
• Once all loans have been repaid and the claims of
preferred shareholders are met, all of the excess
assets belong to the common stockholders.
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Preferred Stock
• Rights of the preferred stockholder
– Usually no voting rights.
– Limited to a fixed cash dividend.
– In the event the corporation is liquidated,
preferred stockholders are entitled to have
their claims repaid fully before any cash is
paid to common stockholders.
– Many times includes a conversion option.
6
Issuance of Stock
• Par value
– A nominal value assigned to and printed on
the face of each share of a corporation’s
stock.
– Has no real significance today.
To record the issuance of 1,000 shares of $1 par stock for $10:
Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10,000
Common Stock . . . . . . . . . . . . . . . . . .
1,000
Paid-In Capital in Excess of Par,
Common Stock . . . . . . . . . . . . . . . . . .
9,000
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Issuing Stock for Property
• The asset should be recorded at the current
market value of the stock.
• If the market value of the asset cannot be
determined then the market value of the asset
should be used as the basis to record the
transaction.
To record the issuance of 1,000 shares of no par stock for land.
Assume the market value of the stock is $10 per share at the
date of the exchange:
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10,000
Common Stock . . . . . . . . . . . . . . . . . .
10,000
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Stock Repurchases
• Reasons why management repurchases
stock
– The stock is wanted for a profit-sharing,
bonus, or stock-option plan for employees.
– Management feels the stock is selling for an
unusually low price and is a good buy.
– Management wants to stimulate trading.
– To remove shares from the market in order to
avoid a hostile takeover.
– To increase reported earnings per share by
reducing the number of shares outstanding.
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Repurchasing Stock
• Treasury Stock
– Issued stock that has subsequently been
reacquired by the corporation.
– The stock is debited at its cost (market value)
on the date of the repurchase.
To record the repurchase of 1,000 shares of $1 par stock when
the market value of the stock is $20:
Treasury Stock, Common . . . . . . . . . . . . . . .
20,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . .
20,000
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Reissuance of Treasury Stock
• If the stock is reissued for more than the
company paid for it, the excess goes in
“Paid-In Capital, Treasury Stock.”
• If the stock is reissued for less than the
company paid for it, the loss is recognized
as a reduction in Paid-In Capital, Treasury
Stock (if a balance exists) or as a
reduction in retained earnings.
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Reissuance Examples
To record the reissuance of 500 shares of stock when the
market value of the stock is $25. The stock was originally
purchased for $20:
Cash . . . . . . . . . . . . . . .
12,500
Treasury Stock, Common . . . . . . . . . .
10,000
Paid-In Capital, Treasury Stock . . . . .
2,500
To record the reissuance of the other 500 shares of stock when
the market value of the stock is $10:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5,000
Paid-In Capital, Treasury Stock . . . . . . .
2,500
Retained Earnings . . . . . . . . . . . . . . . . . .
2,500
Treasury Stock, Common. . . . . . . . . .
10,000
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Balance Sheet Preparation
• Par values are listed separately from paidin capital.
• Common stock is listed separately from
preferred stock.
• Treasury stock is recognized as a contrastockholders’ equity account.
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Retained Earnings
• Retained earnings
– The portion of a corporation’s owners’ equity
that has been earned from profitable
operations and not distributed to stockholders
since incorporation.
– NOT cash!
– Increased by net income.
– Decreased by dividends, net losses, and
some treasury stock transactions.
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Dividends
• Dividends
– Distributions to the owners (stockholders) of a
corporation.
• Should a company pay dividends?
– Stable companies pay out a large portion of
earnings.
– Growing companies pay little or no dividends.
– If a company declares dividends, they are
expected to continue that level of dividends in
future periods.
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Accounting for Cash Dividends
• Recorded as a payable when declared.
• Dividend account is closed to retained
earnings at the end of the year.
To record the declaration of a $20,000 dividend:
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . .
20,000
Dividends Payable. . . . . . . . . . . . . . . .
20,000
To close Dividends to Retained Earnings at the end of the year:
Retained Earnings . . . . . . . . . . . . . . . . . . . . .
20,000
Dividends . . . . . . . . . . . . . . . . . . . . . . .
20,000
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Dividend Preferences
• Cumulative-dividend preference
– The right of preferred stockholders to receive
current dividends PLUS all dividends in
arrears before common stockholders receive
any dividends.
• Dividends in arrears
– Missed dividends for past years that preferred
stockholders have a right to receive if and
when dividends are declared.
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Dividend Preferences
• Calculate the amount of the preferred dividend
and the common dividend for each case.
Case
Preferred Dividend
Feature
Years
Total
Preferred
in
Dividend Dividend
Arrears
1 5%, Noncumulative
N/A
$ 1,500
2 5%, Noncumulative
N/A
3,000
3 5%, Cumulative
2
5,000
4 5%, Cumulative
2
11,000
Common
Dividend
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Dividend Preferences
• Calculate the amount of the preferred dividend
and the common dividend for each case.
Case
Preferred Dividend
Feature
Years
Total
Preferred
in
Dividend Dividend
Arrears
Common
Dividend
1 5%, Noncumulative
N/A
$ 1,500
$1,500
$
0
2 5%, Noncumulative
N/A
3,000
2,000
1,000
3 5%, Cumulative
2
5,000
5,000
0
4 5%, Cumulative
2
11,000
6,000
5,000
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Dividend Payout Ratio
• Dividend
– The percentage of earnings paid out in
dividends.
Cash Dividends
Net Income
– Most large U.S. companies pay out 40 to 60%
of their annual income as dividends.
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Other Equity Items
• Equity items that bypass the income
statement
– Foreign currency translation adjustment.
– Unrealized gains and losses on available-forsale securities.
– Unrealized gains and losses on hedging.
– Minimum pension liability.
• Designed to exclude uncontrollable gains
and losses from affecting net income.
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Comprehensive Income
• Accumulated other comprehensive income
– Equity category that summarizes the effect on
equity of certain market-related gains and
losses. (It is a cumulative account.)
• Comprehensive income
Net Income
+ Unrealized gain (loss) on investments
+ Unrealized gain (loss) on hedging
+/– Foreign currency translation adjustments
– Minimum pension liability
= Comprehensive income
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Statement of
Stockholders’ Equity
• Statement of Stockholders’ Equity
– A financial statement that reports all changes
in stockholders’ equity.
– Reconciles the beginning and ending
balances for all stockholders’ equity accounts
reported on the balance sheet.
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