Chapter 12
Shareholders' Equity – Capital
Contributions and Distributions
BUS780
Objectives of this Chapter
I. Basic characteristics of a corporation
 Characteristics of Common Stock.
 Characteristics of preferred stock.
II. Accounting for common stock and preferred
stock:
 Issuance of common and preferred stock.
 Stock rights, stock warrants, stock options.
 Convertible P.S, callable P.S, redeemable
P.S. and convertible bonds.
Stockholders' Equity
2
Objectives of this Chapter (contd.)
III. Accounting for repurchase of common
stock
VI. Transactions affecting retained
earnings : dividends and prior period
adjustment.
V. Accumulative other comprehensive
income.
Stockholders' Equity
3
I. Corporation



A form of business entity.
It is established as a legal entity
separated from its owners.
It has all rights as a person has (i.e.,
can sue or be sued, can own property,
sign contract) except for voting and
marriage.
Stockholders' Equity
4
Types of Corporations
A. Private corporations.
B. Public corporations.
Stockholders' Equity
5
A. Private Corporations

Types of Corporations
Private corporations: privately owned
including
a. nonstock companies: companies do not
issue stock and do not operate for profit
(i.e., universities, hospitals churches).
b. stock companies: companies issue
shares of stock to stockholders and
operate for profits.
Stockholders' Equity
6
Types of Corporations
A. Private Corporations (contd.)
Stock companies include:
(1)Publicly-traded corporations: stock is
available to public on a stock
exchange.
(2)Privately-held corporations: do not allow
sale of stock to the general public and
stock is held by a few stockholders.
Stockholders' Equity
7
B. Public Corporations

Types of Corporations
Public corporations: owned by
governmental units such as Federal
Deposit Insurance Corporation,
Pension Benefit Guaranty Corporation.
Stockholders' Equity
8
Procedures of Forming a
Corporation
1. Apply for a charter by submitting
articles of incorporation to the
appropriate state officials.
2. If the application is approved, the state
will issue a charter.
3. A stockholders' meeting would be held
at which the initial issuance of capital
stock is made to the incorporators.
Stockholders' Equity
9
Procedures of Forming a
Corporation (contd.)
4. A board of directors is elected, a set of
rules regulating the operation is
established, and the board appoints the
executive officers.
4. Ready for operations.
5. Issuance of stock to public to raise more
capital (IPO).

Note: Regardless of the number of states in which a corporation
operating, it is incorporated in one state.
Stockholders' Equity
10
Organization of a Corporation
a. Stockholders (owners).
b. Board of Directors (elected by stockholders)
Decide major operation principles.
Arrange major loans, authorize contract,
determine the salaries of executives.
Appoint officers.
c. Management: Appointed by the board of
directors.
Responsible for day-to-day operations and
the preparations of the financial
statements.
Stockholders' Equity
11
Advantages of a Corporation
1. Separated legal entity from its owners: it
can buy, sell and own properties.
2. Limited liability for stockholders.
3. Continuous existence.
4. Ease of transfer of ownership.
5. Ease of capital generation.
6. Centralized authority and responsibility-- to
the President, not to numerous owners.
7. Professional management.
Stockholders' Equity
12
Disadvantages of a Corporation
1. Government regulations.
2. Corporation taxes (double taxation).
3. Separation of ownership and
management: principal & agent
conflicts.
Stockholders' Equity
13
Stockholders' Equity Section of a
Corporation Balance Sheet State.
Microsfot Corporation
Balance Sheets (6/30)
in millions
1999
Stockholders' equity:
Convertible preferred stockshares authorized 12,000; shares
issued and outstanding 13 and 0
980
2000
0
Common stock and paid-in
capital -shares authorized 12,000;
shares issued and outstanding
5,109 and 5,283
13,844
Stockholders' Equity
23,195
14
Stockholders' Equity Section
(cont.)
Microsfot Corporation
Balance Sheets (6/30) (contd.)
in millions
1999
2000
Stockholders' equity(contd.) :
Retained earnings, including
other comprehensive income
of $1,787 and $1,527
13,614
18,713
Total stockholders' equity 28,438
41,368
Stockholders' Equity
15
Stockholders' Equity Statements
Microsfot Corporation
Stockholders' Equity Statements (year ended 6/30)
in millions
1999
2000
Convertible preferred stock
Balance, beginning of year
980
980
Conversion of pref.to com.
(980)
Balance, end of year
980
0
Stockholders' Equity
16
Stockholders' Equity Statements
(contd.)
Microsfot Corporation
Stockholders' Equity Statements (year ended 6/30)
in millions
1999
2000
Com. stock and paid-in capital
Balance, beginning of year
8,025
Common stock issued
2,338
Common stock repurchased
(64)
Structured repurch. price differ.
(328)
Proceeds from sale of put warrants 766
Stock option income tax benefits 3,107
Balance, end of year
13,844
Stockholders' Equity
13,844
3,554
(210)
472
5,535
23,195
17
Stockholders' Equity
Statements(contd.)
Microsfot Corporation
Stockholders' Equity Statements (year ended 6/30)
in millions
1999
2000
Retained earnings
Balance, beginning of years
Net income
Other comprehensive income:
Net unrealized invest. gains/losses
Translation adjustment
Comprehensive income
7,622
7,785
13,614
9,421
1,052
69
8,906
(283)
23
9,161
Stockholders' Equity
18
Stockholders' Equity
Statements(contd.)
Microsfot Corporation
Stockholders' Equity Statements (year ended 6/30)
in millions
1999
2000
Retained earnings (contd.)
Comprehensive income
Preferred stock dividends
Immaterial pooling of interests
Common stock repurchased
Balance, end of year
Total stockholders' equity
8,906
(28)
(2,631)
13,614
$28,438
Stockholders' Equity
9,161
(13)
97
(4,686)
18,173
$41,368
19
Terminologies Related to
Stockholders' Equity (contd.)
1. Common Stock: a class of stock with the
rights of:
(a)To share proportionately in profits
and losses;
(b)To share proportionately in
management;
(c) To share proportionately in
corporate assets in liquidation;
(d) To share proportionately in any new
issuance of stock of the same class
(the preemptive right).
Stockholders' Equity
20
Terminologies Related to
Stockholders' Equity (contd.)
2. Preferred Stock: a class of stock with
rights of
(a) Dividends (with a higher priority than that
of common stock);
(b) Sharing assets in liquidation (with a
higher priority than that of common stock).
Stockholders' Equity
21
Terminologies Related to
Stockholders' Equity (contd.)
3. Par
Value Stock: capital stock with a nominal
dollar amount printed on the stock
certificate. Some states designate the par value of
issued stock as the legal capital.
4. No-Par
Stock: capital stock without a Par
Value. Some states require the entire proceeds received
for issuing no-par stock be designated as legal capital.
Many states allow the board of directors to establish a
stated value, in general, is the legal capital.
Stockholders' Equity
22
Terminologies Related to
Stockholders' Equity (contd.)
5.Additional Paid-in Capital (or Paid-in Capital in Excess
of Par Value): The excess of the issuance price
over the par (or stated) value.
6. Contributed Capital: the portion of stockholders'
equity contributed by shareholders (i.e., par
value and the paid-in capital of common and
preferred stock).
7. Legal Capital: the amount of contributed capital
not available for dividends (usually equal to the
par or stated value of outstanding stock).
Stockholders' Equity
23
Terminologies Related to
Stockholders' Equity



This concept of par value and legal capital
has been eliminated entirely by Model
Business Corporation Act which is adopted
by many states.
Reasons: companies have assigned very low par
value to common stock to avoid the watered share
liabilities and dividend distribution restrictions.
However, companies have issued par value
stock prior to the changes in the state law
and continued to issue previous authorized
par value shares.
Stockholders' Equity
24
Terminologies Related to
Stockholders' Equity (contd.)
8. Outstanding Stock: issued stock held by
investors (not being repurchased back).
9. Treasury Stock: issued stock repurchased
by the corporation and held by the
corporation, not retired.
10. Authorized Capital: the number of shares
of stock that the corporation can issue as
stated in its corporate Charter.
Stockholders' Equity
25
Issuance for Cash
II. Accounting for the Issuance of
Stock

Stock issued for cash

Example 1: (Common Stock with Par) Issued 1,000
shares of $10 par common stock for $50 per
share.

Journal Entry
Cash
Common Stock
Paid-in Capital in Excess
of Par--Common Stock
50,000
Stockholders' Equity
10,000
40,000
26
Issuance for Cash
Example 2: (Preferred Stock with Par)


Issued 1,000 shares of $10 par
preferred stock for $30 per share.
Journal Entry
Cash
30,000
Preferred Stock
10,000
Paid-in Capital in Excess
of par -- Preferred Stock
20,000
Stockholders' Equity
27
Issuance for Cash
Example 3 (Common Stock with Stated Value
Set by the Board of Directors)


Issued 1,000 shares of no-par common
stock with a stated value $1 per share.
Shares are issued at $5 per share.
Journal Entry
Cash
5,000
Common Stock
Paid-in Capital in Excess
of Stated Value
Stockholders' Equity
1,000
4,000
28
Issuance for Cash
Example 4 (No-par Common Stock
without Stated Value)


Issued 1,000 shares of no-par and no
stated value common stock for $5 per
share.
Journal Entry
Cash
Common Stock
5,000
5,000
Stockholders' Equity
29
Stock Issued for Noncash Assets


Principle: Stock issued for service or
property should be recorded either at the fair
value of the stock or the fair value of the
property, whichever is more clearly
determinable (reliable).
In most cases, if stock is traded frequently,
the fair value of stock is used. Otherwise,
use the market value of the property.
Stockholders' Equity
30
Example- Stock Issued for Noncash
Assets


Issued 10,000 shares of $5 par C.S. for
building. The market value of the stock
is $15 per share and the stock is traded
frequently.
Journal Entry:
Building
C.S.
Additional paid-in
150,000
Stockholders' Equity
50,000
100,000
31
Stock Splits

Reasons
(1) To increase the marketability of
stock by decreasing the market
value and par value per share.
(2) To increase the numbers of shares
outstanding.
Stockholders' Equity
32
Example: 2 for 1 split
Before Split
After Split
Shares
Outstanding
Par
value
Market
Price
1,000
$50
$120
a
b
c
Stockholders' Equity
33
Accounting for Stock Splits


No entry. A memo is required.
a. 2,000
b.$25
c.$60(likely)
Proportionate Stock Split: the memo
indicates the increase in shares outstanding
and the reduction of par value.
Stockholders' Equity
34
Stock Rights Issued to Current
Shareholders



Accounting Treatment: no entry is
required.
A memo listing the number of additional
shares that maybe acquired through the
exercise of the stock rights is made.
If the right expires, another memo is
made.
Stockholders' Equity
35
Stock Warrants Issued to General
Public for Cash

Example: ABC issues 1,000 warrants for
$10,000 cash to the public to purchase 1,000
share of its common stock for $30 each:
J.E. Cash
10,000
Common Stock Warrants

10,000
Warrants holders exercise the rights to
purchase 900 shares of $5 par at $30 each:
Stockholders' Equity
36
Stock Warrants Issued to General
Public for Cash

J.E. Common STK Warrants 9,000
Cash
27,000
Common Stock -$5 par
4,500
Additional Paid-in Capital
31,500

The remaining 100 warrants expire:

J.E. Common STK Warrants
1,000
Additional Paid-in Capital
Stockholders' Equity
1,000
37
Convertible Bonds (contd.)
Possible reasons of issuing
convertible bonds:
1. As an indirect way to issue stock
when facing resistance from current
stockholders to issue additional
stock.;
2. To issue bonds at a higher price
(thus, lower effective interest rate);

Stockholders' Equity
38
Accounting Treatment for
Convertible Bonds

APB Opinion 14 requires that the
issuance of convertible debt is
recorded in the same manner as the
issuance of nonconvertible debts
without allocating a value (from the
proceeds received) to the conversion
feature. (Reason?)
Stockholders' Equity
39
Recording for the Conversion
Two acceptable methods:
A. Book Value Method: the stockholders’
equity is recorded at the book value of the
convertible bonds on the date of conversion.
 No gain or loss is recorded upon
conversion.
 If the par value of the common stock is
greater than the book value of the bonds,
the difference is recorded as a reduction
of retained earnings.
Stockholders' Equity
40
Recording for the Conversion
(contd.)
B. Market Value Method: The
stockholders’ equity is recorded at the
market value of the shares issued on
the date of conversion, and a gain or
loss is recorded (treated as an ordinary
income or loss).
Stockholders' Equity
41
Example

Shannon Company has outstanding
convertible bonds with a face value of
$10,000, interest has been paid on these
bonds, and the bonds have a book value
of $10,500.
Each $1,000 bond is convertible into 40
shares of common stock (par value $20
per share).
Stockholders' Equity
42
Example (contd.)

If all the bonds were converted into
common stock when the market value
of Shannon’s common stock is $26.5
per share, the following alternative
entries may be made:
Stockholders' Equity
43
Example (contd.)
A. Book Value Method: (BV of the bonds=
$10,500) (more commonly used by companies)
Bonds payable
10,000
Premium on Bonds Payable
500
Common Stock 1
8,000
Paid-in Capital from
Bond Conversion 2
2,500
1. $20 x 40 x 10
2. 10,500 - 8,000
Stockholders' Equity
44
Example (contd.)
B. Market Value Method : (MV of converted
Stock = 26.5 x (40x 10) = 10,600)
Bonds payable
10,000
Premium on B/P
500
Loss on Conversion
100
Common Stock
8,000
Paid-in Capital from
Bond Conversion
2,600 1
1. 10,600 - 8,000
Stockholders' Equity
45
Preferred Stock Characteristics


Preference as to dividends: holders
have a preference to dividends.
The annual dividends are expressed
as percentage of the par value. If nopar preferred stock is issued, the
dividend is expressed as a dollar
amount per share.
Stockholders' Equity
46
Convertible Preferred Stock


Convertible preferred stock allows
stockholders, at their option, to convert
the shares of preferred stock into another
security of the corporation under specified
conditions.
Both the preferred features and the
potential for common stock equity are
valuable to investors in convertible
preferred stock.
Stockholders' Equity
47
Convertible Preferred Stock



Therefore, conceptually, the proceeds
received upon issuance should be separated
into preferred and common stock equity.
However, APB Opinion No. 14 requires that
when convertible preferred stock is issued,
no value is assigned to the the conversion
feature.
Any difference between the par and market
values is recorded as the paid-in capital.
Stockholders' Equity
48
Accounting for the Conversion of
Preferred to Common Stock
Book value method is used.

Example: A corporation issued 500 shares
of $100 par convertible preferred stock at
$120 per share. Each preferred share was
converted into 4 shares of $20 par common
stock. The following entry will be recorded
for this conversion:
Stockholders' Equity
49
Example (contd.)
Preferred Stock
Additional Paid-in
Capital on P.S
50,000
10,000
Common Stock
Additional Paid-in capital
on Common Stock
Stockholders' Equity
40,000
20,000
50
Callable Preferred Stock



Callable Preferred Stock: preferred stock
may be retrieved (recalled) under specified
conditions by the corporation.
The call price is usually several points
(dollars) higher than the issuance price.
Also, the specified conditions and call price
are specified in the stock contract. Payments
of dividends in arrears before the execution
of call option is in general required in the
stock contract.
Stockholders' Equity
51
Callable Preferred Stock (contd.)


When callable preferred stock is issued, no
value is assigned to the call feature.
Upon recall, the difference between the call
price and the original issuance price is NOT
treated as a gain or loss, but treated as a
reduction of retained earnings (when call
price > issuance price) or as an increase of
additional paid-in (when call price < issuance
price).
Stockholders' Equity
52
Callable Preferred Stock (contd.)

This treatment is to avoid a company
from manipulating its earnings by
recognizing a gain (or a loss) in
transaction involving its own equity
securities.
Stockholders' Equity
53
Example

Koden Corporation has outstanding 1,000
shares of $100 par callable preferred stock
that was issued at $110 per share and no
dividends are in arrears. If the call price is
$112, the following entry is made to record
the recall of these shares:
Preferred Stock
Additional Paid-in on P.S.
Retained Earnings
Cash
100,000
10,000
2,000
Stockholders' Equity
112,000
54
Redeemable Preferred Stock


Redeemable at the option of the holders
for a specified price or mandatory at a
specified future maturity date for a
specified price.
Thus, redeemable preferred stock has
some of the characteristics of a liability.
Stockholders' Equity
55
Redeemable Preferred Stock (cont.)


SEC requires this stock to be reported as a
separate component of the balance sheet
(i .e., before the stockholders’ equity) and
requires the disclosure of the redemption
features, shares issued and redeemed.
FASB does not require a separate reporting
but requires a similar disclosure.
Stockholders' Equity
56
III. Treasury Stock



Treasury stock: issued stock that has
been purchased back (reacquired) by the
issuing corporation.
Treasury stock carries no voting or
preemptive rights, no right to dividends,
and no right at liquidation.
However, it does participate in stock split.
Stockholders' Equity
57
Reasons of Acquiring Treasury
Stock
1. To use for stock option plans, bonus and
employee purchase plans;
2. To use in the conversion of convertible
preferred stock or bonds;
3. To use excess cash and help maintain
the market price of its stock; to increase
EPS;
Stockholders' Equity
58
Reasons of Acquiring Treasury
Stock (contd.)
4. To use in the acquisition of other
companies;
5. To use for stock dividend;
6. To reduce the number of shares held by
outside shareholders and thereby reduce
the likelihood of being acquired by
another company.
Stockholders' Equity
59
Accounting Methods for Treasury
Stock
A. Cost method
B. Par value method (rarely used)
Stockholders' Equity
60
Cost Method

T.S. is recorded at cost paid for transactions:
1. Issuance of 6,000 shares of $10 par common
stock for $12 per share
Cash
72,000
C.S., $10 par
Additional Paid-in
Capital on C.S.
Stockholders' Equity
60,000
12,000
61
Cost Method (contd.)
2. Reacquisition of 1,000 shares of C.S. at $13
per share:
Treasury Stock
13,000
Cash
13,000
3. Reissuance of 600 shares of T.S. at $15 per
share
Cash
9,000
T.S.
7,800
Additional Paid-in
Capital from T.S.
1,200
Stockholders' Equity
62
Cost Method (contd.)
4. Reissuance of another 200 shares of T.S. at
$8 per share:
Cash
1,600
Additional Paid-in
Capital from T.S.
1,000
Treasury Stock
2,600
Stockholders' Equity
63
Cost Method (contd.)
5. Reissuance of another 100 shares of T.S. at
$6 per share
Cash
600
Additional Paid-in
Capital from T.S.
200
Retained Earnings
500
Treasury Stock
1,300
Stockholders' Equity
64
Cost Method (contd.)
6. Retirement of the last 100 shares of T.S.
Common Stock, $10 par
1,000
*Additional Paid-in on
Common Stock
200
Retained Earnings
100
Treasury Stock
1,300
* [12,000  (100/6,000)] = $200
Original additional Paid-in Capital on common
stock for 6,000 shares.
Stockholders' Equity
65
Retirement of Stock
 Repurchased stock can be retired
immediately. Example: 100 shares of stock
were repurchase at $14 per share and
retired immediately:
Common Stock, $10 par
1,000
Additional Paid-in on
Common Stock
200
Retained Earningsa
200
Cash
1,400
a. If there is a credit balance in the paid-in
capital-repurchase of stock account, this paid-in
capital account needs to be debited first before
debiting R/E.
Stockholders' Equity
66
Balance Sheet Presentation of
Treasury Stock

Before the last 100 shares of treasury
stock were retired, the stockholders'
equity section is prepared after
transactions 1-5 as follows:
(The Retained earnings has a credit
balance of $40,000 prior to record any
treasury stock transaction.)
Stockholders' Equity
67
Cost Method
Contributed Capital:
Common stock, $10 par (20,000 shares
authorized, 6,000 shares issued, of which
100 are being held as Treasury Stock)
Additional paid-in capital on C.S.
Total Contributed Capital
Retained Earnings (see Note)
Total Contributed Capital and
Retained Earnings
Less: Treasury Stock (100 shares at cost)
Total Stockholders' Equity
$ 60,000
12,000
72,000
39,500
111,500
(1,300)
$110,200
Note: Retained Earnings are restricted regarding
dividends in the amount of $1,300, the cost of
treasury stock.
Stockholders' Equity
68
Overview of Treasury Stock



Cost method is widely used due to its
simplicity but par value method is theoretically
preferable.
Treasury stock is not an asset; it is treated as
a reduction of stockholders' equity.
Treasury stock does not have voting rights, no
preemptive right; does not participate in
dividends; does not participate in assets at
liquidation, but participate in stock split.
Stockholders' Equity
69
Overview of Treasury Stock(contd.)



Treasury stock transactions do not result in
gains or losses.
Treasury stock transactions may reduce
retained earnings but may never increase
retained earnings.
Retained earnings may be restricted
regarding dividends in the amount of the
treasury stock on hand.
Stockholders' Equity
70
IV. Retained Earnings


Stockholders’ equity consists of
primarily stockholders’ investments
(i.e., contributed capital), retained
earnings and accumulated other
comprehensive income.
The primary factors that affect retained
earnings besides net income (or net
loss) include (1) dividends and(2) prior
period adjustments.
Stockholders' Equity
71
Dividends


While the net income increases the
retained earnings, the distribution of
dividends reduces the retained
earnings.
In order to declare dividends, a
company must meet both legal and
contractual requirements and have
assets available for distribution.
Stockholders' Equity
72
Dividends (contd.)


Most states require a positive
retained earnings before dividends
may be declared.
In this case, the amount of dividends
declared cannot exceed the balance
of the retained earnings.
Stockholders' Equity
73
Dividends:(contd.)


Contractual agreements (such as
long-term bond provisions) may
restrict a Corp. from declaring
dividends.
The board of directors is responsible
for the establishment of dividend
policy and the determination of the
amount, timing and types of
dividends to be declared.
Stockholders' Equity
74
Dividends:(contd.)



A few types of dividends may be
considered: (1) cash, and (2) stock.
Cash dividends decrease retained
earnings (R/E) and the stockholders’
equity.
Stock dividend decreases R/E but
increases contributed capital in the
same amount. So, there is no change
in the total stockholders’ equity
Stockholders' Equity
75
Cash Dividends


A cash dividend is the most common
type of dividend.
Four days are relevant to the cash
dividend: 1) the date of declaration,
2) the ex-dividend date, 3) the date
of record, and 4) the date of
payment.
Stockholders' Equity
76
Cash Dividends:(contd.)


Example: on Nov. 3, 20x5, the board of
directors declares preferred dividends
totaled $10,000 and common dividends
totaled $20,000.
These dividends are payable on 12/15/x5
to stockholders of record on 11/24/x5. In
addition, the ex-dividend date is 11/20/x5.
The journal entries for the declaration and
other related events are:
Stockholders' Equity
77
Cash Dividends:(contd.)
11/3/x5 the date of declaration
Retained Earnings
30,000
Dividends Payable: CS
20,000
Dividends Payable: PS
10,000
 Shares are traded with dividends
attached after this date.
 Companies are legally liable for
declared dividends on this date.

Stockholders' Equity
78
Cash Dividends:(contd.)
11/24/x5 The date of record
Memo: the company will pay dividends
on 12/15/x5 to preferred and common
stockholders of record as of today, the
date of record.
 Stockholders on the record will be paid
of dividend even if they sell those
shares prior to 12/15/x5, the payment
date.

Stockholders' Equity
79
Cash Dividends:(contd.)

12/15/x5 Dividend payment date
Div. Payable: Com. stk 20,000
Div. Payable: Prefer.stk 10,000
Cash
30,000
Stockholders' Equity
80
Preferred Stock Characteristics



Preferred stockholders have a
preference to dividends.
A preference to dividends does not
guarantee a dividend distribution.
Because a dividend declaration is at
the discretion of the board of directors.
Stockholders' Equity
81
Preferred Stock Characteristics
(contd.)

If a corporation fails to declare a
dividend, or declares a dividend which
is less than the stated rate of the
preferred stock, the "passed" dividend
of non-cumulative preferred stock will
never be paid.
Stockholders' Equity
82
Cumulative Preferred Stock



For cumulative preferred stock, the
amount of passed dividend becomes
"dividend in arrears”.
The “dividend in arrears” has the highest
priority to be paid in the following periods.
Common stockholders cannot be paid
any dividend until the preferred dividend
in arrears has been paid.
Stockholders' Equity
83
Cumulative Preferred Stock


Dividend in arrears accumulate from
period to period.
The “dividend in arrears” is not a liability
because no liability exists until the
dividend declaration.
Stockholders' Equity
84
Stock Dividends




A stock dividend is a proportional
distribution of additional shares of a
corporations own stock to its
shareholders.
When a stock dividend is distributed,
no corporate assets are distributed.
Each stockholder maintain the same
percentage of ownership as before.
Stock dividend is similar to a stock
split.
Stockholders' Equity
85
Stock Dividends (contd.)
Accounting treatment:
a. Small stock dividend (less than 25% of
previous outstanding shares):
the stock dividends are accounted for
by transferring from retained earnings
to contributed capital an amount
equals to the fair market value of the
additional shares issued.
Stockholders' Equity
86
Stock Dividends :(contd.)

Example 1: Small Stock Dividend
A Corporation with 20,000 shares
outstanding declares and issues a
10% stock dividend. On the date of
declaration, the stock is selling for
$23 per share with a par value of
$10 per share. The journal entry to
recorded the stock dividend is :
Stockholders' Equity
87
Stock Dividends :(contd.)

Date of Declaration (no change on par
value):
Retained Earnings
46,000
C.S. To be Distributed **
Additional Paid-in Capital
from Stock Dividend

Date of Issuance:
C.S. To be Distributed
C.S. $10 par
20,000
20,000
26,000
20,000
** reported as a component of contributed capital.
Stockholders' Equity
88
Stock Dividends :(contd.)

Example 2: Large Stock Dividend
Similar to example 1 except that the stock
dividend increases from 10 % to 40% of the
shares outstanding:
Date Declaration:** $10 x(40% x 20,000 shares)
Additional paid in Capital* 80,000**
C.S to be Distributed
80,000
*Reason of debiting paid-in capital rather than R/E
for large stock dividends: to prevent transferring
earned capital to contributed capital.
Stockholders' Equity
89
Stock Dividends :(contd.)
* (contd.) An alternative account is retained


earnings. If R/E is used, the accounting
standard does not prevent the capitalization
of a larger amount per share.
The impact of stock dividend and stock splits
on total firm value, the ownership % of
existing shareholders are the same.
A 100% stock dividend is equivalent to a twofor-one stock split (par value will be changed
proportionately) in substance.
Stockholders' Equity
90
Prior Period Adjustments
Items reported as prior period
adjustments of retained earnings
include:
a. changes in accounting method (when
a retrospective approach is used),
b. corrections of errors of prior periods.

Stockholders' Equity
91
Prior Period Adjustments (error
correction)
Example: In 20x5, Fox Company
discovered that it did not accrue
$10,000 of interest expense for 20x4.
The income tax effect is $3,000, the
correct entries are:
1. Retained Earnings
10,000
Interest Payable
10,000
2. Income Tax Refund Rece. 3,000
Retained Earnings
3,000

Stockholders' Equity
92
Prior Period Adjustments (contd.)

Presentation on the Retained Earnings
Statement:
R/E, as previous reported Jan 1, 20x5 $102,400
Less: Correction of overstatement in
20x4 N/I due to interest expense
understatement (Net of $3,000 I/T)
(7,000)
Adjusted Retained Earnings,
Jan 1, 20x5
$95,400
Stockholders' Equity
93
V. Other Component of
Stockholder's Equity
Accumulative Other Comprehensive
Incomea:
Other Comprehensive income
accumulated over the current (reported
on the combined income statement)
and prior periods.
a. Comprehensive income: changes in
equity other than from owner related
transactions (i.e., additional investment and
dividends distribution).
Stockholders' Equity
94
Other Component of Stockholder's
Equity (contd.)
 Comprehensive income includes:
a. Net income
b. Other Comprehensive Income (all net of
tax):
Unrealized gain (loss) from SAS
Foreign currency translation adjustments
Minimum Pension liability adjustment
Deferred gain (loss) from derivatives
Stockholders' Equity
95
Example of Stockholders’ Equity and Statement
of Changes in Stockholders’ Equity

KARDWELL CORPORATION
Stockholders’
Equity December 31, 20x5
Contributed capital:
Common stock , $5 par (30,000 shares
authorized, 11,400 shares issued, of which
100 shares are being held treasury stock)
Additional paid-in capital on common stock
Additional paid-in capital from treasury stock
Paid-in Capital - stock options
Total Contributed capital
Accumulative Other Comprehensive Income
Unrealized gain from valuation of SAS
Retained earnings (see note)
Total contributed capital, unrealized capital,
and retained earnings
Less: Treasury stock (at cost)
Total stockholders' equity
57,000
197,400
5,000
3,600
263,000
40,000
386,200
689,200
(3,000)
686,200
Note: R/E are restricted regarding dividends in the amount
of $3,000, the cost of the treasuryStockholders'
stock. Equity
96
Example of Stockholders’ Equity and Statement
of Changes in Stockholders’ Equity: (Contd.)

Statement of Changes in Stockholders’ Equity for
Year Ended December 31, 20x5
Common Stock
Explanation
Balances, 1/1/95
Issued for cash
Reissued treaury
stock
Issued for exercise
of stock options
Compensation
expense for stock
options
Compensation cost
for new stock
options
Shares
Issued
10,000
1,100
Par
Value
50,000
5,500
Additional
Paid-in Capital
Paid-In Accum.
Capital- Other
Common Treasury
Stock
Stock
170,000
22,000
2,300
Stock
Options
Compre.
Income
Retained
Earnings
2,000
10,000
322,000
2700
300
1,500
Stock
(Cost)
(7,500)
4,500
5,400
1,600
Unrealized gain from
valuation of SAS
Net income
Cash dividends
Balances, 12/31/95
Treasury
30,000
97,000
(32,800)
11,400
57,000
197,400
5,000
3,600
40,000
386,200
Stockholders' Equity
(3,000)
97
Stock Option Plans



Corporations have programs that enable
employees to acquire shares of stock, often
at a price less than the current market price
(at the time of exercising the right).
These programs involve the issuance of
options to the employees and are referred to
as stock option plans.
A compensatory stock option plan is to provide
additional compensation to selected
employees.
Stockholders' Equity
98
Compensatory Stock Option Plans

The additional compensation is the
difference between the amount of
proceeds the corporation will receive
from the issuance of the shares related
to the stock option plan and the amount
of the proceeds that it could receive if
the stock were issued on the open
market.
Stockholders' Equity
99
Compensatory Stock Option Plans – the
Intrinsic Value Method (Eliminated by SFAS
123 ( R ))


Based on APB 25, the compensation cost
related to a stock option plan is the
excess of the market price over the
option price on the measurement date (no
consideration of time value of options).
The measurement date is usually the
grant date.
Stockholders' Equity
100
Compensatory Stock Option Plans
(Contd.) – the intrinsic Value Method

The total compensation cost is
recognized as an expense over the
service period (the years in which
company receives the benefit of the
employee’s service).
Stockholders' Equity
101
Compensatory Stock Option Plans –
the Intrinsic Value Method Example



Assume that on 12/31/x2, a corporation
grants A. Paul the nontransferable right to
acquire 1,000 shares of $10 par common
stock for $27 per share.
The market price on the date (12/31/x2) is
$29 per share, and the service period is 4
years.
The stock option may not be exercised until
the service period expired and the rights
terminate at the end of 7 years or if Paul
leaves the corporation.
Stockholders' Equity
102
Compensatory Stock Option Plans –
Example: the Intrinsic Value Method (cont.)
J.E.
12/31/x3 Compensation expense 500 a
Paid-in capital-stock options

500
a. ($29-27) * 1,000 = $2,000; $2,000/4 = $500
The compensation expense is also recognized for
x4,x5 and x6 service years:
J.E. for 12/31/x4,x5 and x6:
Compensation Expense
500
Paid-in capital –stock options
500
Stockholders' Equity
103
Compensatory Stock Option Plans –
Example: the Intrinsic Value Method (cont.)
When the options are exercised on 3/6/x8, the
following J.E is recorded:
Cash ($27 * 1,000)
27,000
Paid-in capital-stock options
2,000
Common Stock ($10*1,000)
10,000
Additional Paid-in Capital
19,000

 Disclosure on the Balance Sheet (x3):
Contributed Capital:
paid-in Capital-stock options
500
Stockholders' Equity
104
Compensatory Stock Option Plans –
Example: the Intrinsic Value Method (cont.)
If 500 shares of vested stock options were
expired (due to market price fall below the
exercise price) on 1/1/x9, the following entry
will be recorded:
Paid-in capital-stock options
1,000
Paid-in capital from
expired options
1,000
 Note: when stock options expired, the
previously recognized compensation
expense is not adjusted.

Stockholders' Equity
105
The Fair Value Method (SFAS No. 123):
Effective for fiscal year beg. after 12/15/1995
 Under the intrinsic value method, when
setting the option price equals the market
price of the stock on the grant date, the
intrinsic value of the option would be zero.
 Thus, companies can avoid the
recognition of compensation expense by
setting the option price equals the market
price.
Stockholders' Equity
106
The Fair Value Method (SFAS 123)
 Based on available stock option pricing
models, the fair value of employee stock
options (ESO) can be estimated on the
grant date based on the following factors:
exercise price, expected term of the
option (the time value), current market
price of the stock, expected dividends,
expected risk-free rate of return and
expected volatility of the stock.
Stockholders' Equity
107
The Fair Value Method (SFAS 123) (contd.)


Using the fair value method, the
estimated fair value of ESO based on an
option pricing model would be allocated
over the service (vested) period. The
journal entries are similar to those of the
intrinsic value method as follows:
Compensation Expense xxx
Paid in capital – stock options
Stockholders' Equity
xxxx
108
The Fair Value Method (SFAS 123)


Using the fair value method, the estimated
compensation cost is not calculated as the
difference between the option price and
the market price on the grant date.
Rather, it is based on an option pricing
model. Thus, the option value may not be
zero even setting the option price equals
the market value on the grant date.
Stockholders' Equity
109
The Emergence of the Fair Value
Method in the Early 1990s


The public began to be more aware of
the executive compensation in the form
of stock options at the begining of
the1990s.
It is apparent that under the intrinsic
value method, the ESO compensation
expense is undervalued and therefore,
under-expensed.
Stockholders' Equity
110
The Emergence of the Fair Value
Method (cont.)

With the encouragement from both
the SEC and the Congress, the FASB
moved forward with its stock option
project and issued the Exposure
Draft requiring the fair value method
for the ESO accounting in 1993.
Stockholders' Equity
111
The Emergence of the Fair Value
Method (cont.)


The FASB encountered strong
opposition toward the fair value method
accounting from many sectors of the
society (i.e., the corp. executives, the
auditors, members of the Congress, the
SEC, etc.).
The objection reasons provided by the
critics:
Stockholders' Equity
112
The Emergence of the Fair Value
Method (cont.)




1. ESO with no intrinsic value should
have no fair value;
2. It is impossible to estimate the fair
value of ESO;
3. The fair value method would have
unacceptable economic consequences.
Note: The fair value method does not have any cash
flow impact.
Stockholders' Equity
113
The Emergence of the Fair Value
Method (cont.)

As a result of the strong opposition, the
FASB modified its position on the fair
value method to allow companies to
choose between the intrinsic value
method (APB 25) and the fair value
method to account for the ESO
compensation expense.
Stockholders' Equity
114
The Fair Value Method (SFAS 123)

Under SFAS No. 123, a company can
choose either the intrinsic value
method (i.e., method prescribed in
APB No. 25) or the fair value method
to account for the stock based
compensation cost.
Stockholders' Equity
115
The Fair Value Method (SFAS 123)

However, companies that choose the
intrinsic value method are required to
disclose the pro-forma net income and
EPS, as if the fair value method were
used.
Stockholders' Equity
116
The Fair Value Method : SFAS 123 ( R )
(issued 2004, effective for fiscal year beg.
after 6/15/2005


SFAS 123 (Revised 2004) requires
companies to use the fair value method
(NOT the intrinsic value method) to
account for ESO expense.
The estimated fair value of ESO will be
allocated over the vested period as
compensation expense.
Stockholders' Equity
117
The Emergence of the SFAS 123 ( R )


Prior to 2002, only two companies
volunteered expensed employee stock option
compensation at the fair value method.
The accounting scandals (i.e., fraudulent
reports) of the high-profile companies lead to
some degree of public consensus that the
greed of the executives is a contributing
factor to those misleading reports.
Stockholders' Equity
118
The Emergence of the SFAS 123 ( R )


With the proliferation of stock options
granted to executives, the executives have
more incentive to produce fraudulent reports
to increase their stock price.
When stock price is increased, the
executives’ compensation would also be
increased from exercising their stock
options.
Stockholders' Equity
119
The Emergence of the SFAS 123 ( R )

Thus, not expensing the ESO cost based on
the fair value may have contributed to these
accounting scandals.
Stockholders' Equity
120
The Emergence of the SFAS 123 ( R )


With this renewed interest in expensing the
employee stock option at the fair value from
the public, the FASB proposed and issued
SFAS 123 (R) in 2004 to require the expense
of employee stock option at the fair value,
eliminating the intrinsic value method.
Note: By the end of 2004, hundreds of firms
have volunteering expensed ESO at fair
value.
Stockholders' Equity
121