McGraw-Hill/Irwin
Reporting and
Interpreting
Stockholders’ Equity
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1
11-2

Corporate Ownership
The major advantage of the corporate form of business is the ease of raising large amounts of money because both large and small investors can participate in corporate ownership.
Simple to become an owner
Easy to transfer ownership
Provides limited liability
11-3

Corporate Ownership
Because a corporation is a separate legal entity , it can . . .
11-4

Corporate Ownership
Stockholder
Benefits
 Voting rights.
 Dividends.
 Residual claims.
 Preemptive rights.
11-5

Corporate Ownership
Stockholders
(Owners of voting shares)
Board of Directors
Internal (managers) and
External (non-managers)
Elected by shareholders
Appointed by directors
President
Vice President
(Production)
Vice President
(Marketing)
Vice President
(Finance)
Vice President
(Personnel)
11-6

Equity Versus Debt Financing
Advantages of equity and debt financing.
Advantages of equity
• Equity does not have to be repaid.
• Dividends are optional.
Advantages of debt
• Interest on debt is tax deductible.
• Debt does not change stockholder control.
11-7

Equity Versus Debt Financing
Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. Consider the following example with
$100,000 of debt financing.
Income before interest and taxes
Interest expense (8% of $100,000)
Income before taxes
Income taxes at 40 perent
Net Income
Average stockholders' equity
Return on equity
Financing
Without Debt
$ 50,000
With Debt
$ 50,000
-
50,000
20,000
30,000
8,000
42,000
16,800
25,200
$ 250,000
12.00%
$ 150,000
16.80%
11-8

Learning Objective 2
11-9

Common Stock Transactions
Two primary sources of stockholders’ equity
Contributed capital
Common
Stock
Additional paid-in capital
Retained earnings
11-10

Authorization, Issuance, and
Repurchase
Authorized
Shares
The maximum number of shares of capital stock that can be sold to the public.
11-11

Authorization, Issuance, and
Repurchase
Authorized
Shares
Issued shares are authorized shares of stock that have been sold.
Unissued shares are authorized shares of stock that never have been sold.
11-12

Authorization, Issuance, and
Repurchase
Authorized
Shares
Outstanding shares are issued shares that are owned by stockholders.
Outstanding
Shares
Issued
Shares
Treasury
Shares
Unissued
Shares
Treasury shares are issued shares that have been reacquired by the corporation.
11-13

Common Stock Transactions
Excerpt from Sonic Corporation’s Balance Sheet showing Stockholders Equity at August 31, 2005.
(Dollar amounts in thousands).
Stockholders' Equity
Contributed Capital
Common stock. Par Value $0.01 per share
Authorized; 100,000,000 Shares
Issued: 75,800,000 Shares
Additional paid-in capital
Preferred Stock. Par Value $0.01 per share
none outstanding
Retained earnings
Treasury Stock, at cost: 16,500,000 Common Shares
Total stockholders' equity
$ 758
121,982
-
122,740
426,783
549,523
(164,984)
$ 384,539
11-14

Common Stock Transactions
All corporations are required to issue common stock at incorporation.
Common stockholders have the right to vote on important issues and the right to share in corporate profits.
Profits are shared through dividends that are set by the board of directors.
11-15

Common Stock Transactions
Legal capital is the amount of capital, required by the state of incorporation, that must remain invested in the business.
11-16

Common Stock Transactions
Par value is an arbitrary amount assigned to each share of stock when it is authorized.

Market price is the amount that each share of stock will sell for in the market.
11-17

Common Stock Transactions
No-par Stock
Some states do not require a par value to be stated in the charter.
11-18

Issuance of Stock
Initial public offering
(IPO)
Seasoned new issue
The first time a corporation sells stock to the public.
Sonic
Subsequent sales of new stock to the
Sonic issues stock.
public.
11-19

Secondary Markets
Transactions between two investors that do not affect the corporation’s accounting records.
I’d like to sell some of my
Sonic stock.
I’d like to buy some of your
Sonic stock.
11-20

Issuance of Stock
Most sales of stock to the public are cash transactions.
Sonic Corporation issued 100,000 shares of
$0.01 par value common stock for $30 per share.
Prepare the journal entry to record this transaction.
Accounts Debit Credit
11-21

Issuance of Stock
Most sales of stock to the public are cash transactions.
Sonic Corporation issued 100,000 shares of
$0.01 par value common stock for $30 per share.
100,000 shares × $0.01 par value = $1,000
100,000 shares × $30 per share = $3,000,000
Accounts
Cash (+A)
Common Stock (+SE)
Additional Paid-in Capital (+SE)
Debit
3,000,000
Credit
1,000
2,999,000
11-22

Repurchase of Stock
A corporation repurchases its stock to:
 Send a signal that the company believes its stock is undervalued.
 Obtain shares to reissue for the purchase of other companies.
 Obtain shares to reissue to employees as part of stock purchase or stock option plans.
Treasury Stock
11-23

Repurchase of Stock
Sonic
Employee compensation package includes salary plus stock options .
Sonic buys its own stock in the secondary market.
(Treasury stock)
Stockholders
Stock options allow employees to purchase stock from the corporation at a fraction of the stock’s value in the secondary market.
Employee
11-24

Repurchase of Stock
No voting or dividend rights
Contra equity account
Treasury stock is not an asset.
When stock is reacquired, the corporation records the treasury stock at cost .
11-25

Repurchase of Stock
Ross Stores reacquired 50,000 shares of its common stock at $25 per share.
The journal entry for this transaction is . . . .
Accounts
Treasury Stock (+xSE, -SE)
Cash (-A)
Debit
1,250,000
Credit
1,250,000
When stock is reacquired, the corporation records the treasury stock at cost .
11-26

Reissuance of Treasury Stock
Sonic Corporation reissued 5,000 shares of the treasury stock at $26 per share.
The journal entry for this transaction is . . .
5,000 shares × $25 cost = $125,000
5,000 shares × $26 = $130,000
Accounts
Cash (+A)
Treasury Stock (-xSE, +SE)
Additional Paid-in Capital (+SE)
Debit
130,000
Credit
125,000
5,000
No profit or loss recognized on treasury stock transactions.
11-27

Learning Objective 3
11-28

Dividends on Common Stock
Declared by board of directors.
Not legally required.
Creates liability at declaration.
Requires sufficient
Retained Earnings and Cash.
11-29

Restrictions on Retained Earnings
If I loan your company $1,000,000,
I will want you to restrict your retained earnings in order to limit dividend payments.
Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings.
11-30

Dividends Dates
Declaration date

Board of directors declares the dividend.

Record a liability.
Closed to Retained Earnings at the end of the year.
Accounts
Dividends Declared (+D, -SE)
Dividends Payable (+L)
Debit
XXX
Credit
XXX
11-31

Dividends Dates
Date of Record
 Stockholders holding shares on this date will receive the dividend. (No entry)
X
11-32

Dividends Dates
Date of Payment
 Record the dividend payment to stockholders.
Accounts
Dividends Payable (-L)
Cash (-A)
Debit
XXX
Credit
XXX
11-33

Stock Dividends
Distribution of additional shares of stock to stockholders.
No change in total stockholders’ equity.
All stockholders retain same percentage ownership.
No change in par values.
11-34

Stock Dividends
Corporations issue stock dividends to:
 Remind stockholders of the accounting wealth in the company.
 Reduce the market price per share of stock.
 Signal that the company expects strong financial performance in the future.
11-35

Stock Dividends
Small
Stock dividend < 25%
Large
Stock dividend > 25%
Record at current market value of stock.
Record at par value of stock.
The journal entry moves an amount from
Retained Earnings to other equity accounts.
11-36

Stock Dividends
Sonic Corporation issued a 5 percent stock dividend on its 75,000,000 outstanding shares of $0.01 par value common stock. Market value of the shares issued was
$10 per share. The journal entry for transaction is . . .
3,750,000 shares × $0.01 = $37,500
3,750,000 shares × $10 = $37,500,000
Accounts
Retained Earnings (-SE)
Common Stock (+SE)
Additional Paid-in Capital (+SE)
Debit
37,500,000
Credit
37,500
37,462,500
11-37

Stock Dividends
Let’s change the small stock dividend to a 100 percent stock dividend.
Sonic Corporation issued a 100 percent stock dividend on its 75,000,000 outstanding shares of $0.01 par value common stock. Market value of the shares issued was
$20 per share. The journal entry for this transaction is . . .
75,000,000 shares × $0.01 = $750,000
Accounts
Retained Earnings (-SE)
Common Stock (+SE)
Debit
750,000
Credit
750,000
11-38

Stock Splits
A stock split creates more pieces of the same pie.
11-39

Stock Splits
Assume that a corporation had 5,000 shares of $1 par value common stock outstanding before a 2 –for–1 stock split.
Before
Split
Common Stock Shares 5,000
After
Split
Par Value per Share
Total Par Value
$ 1.00
$ 5,000 $ 5,000
11-40

Stock Splits
Assume that a corporation had 5,000 shares of $1 par value common stock outstanding before a 2 –for–1 stock split.
Before
Split
Common Stock Shares 5,000
After
Split
10,000 Increase
Par Value per Share
Total Par Value
$ 1.00
$ 5,000
$ 0.50
Decrease
$ 5,000 No Change
No journal entry required – Change par value and number of shares authorized and outstanding.
11-41

Comparison of Distributions to Stockholders
2-for-1 Stock
Split
After
100% Stock
Dividend Stockholders' Equity
Contributed Capital
Number of common shares outstanding
Par value per common share
Common stock, at par
Additional paid-in capital
Retained Earnings
Total stockholders' equity
Before
1,000,000
$ 0.01
$ 10,000
30,000
650,000
$ 690,000
2,000,000
$ 0.005
$ 10,000
30,000
650,000
$ 690,000
2,000,000
$
$
$
0.01
20,000
30,000
640,000
690,000
$10,000 Cash
Dividend
1,000,000
$ 0.01
$ 10,000
30,000
640,000
$ 680,000
11-42

Learning Objective 4
11-43

Preferred Stock
Preference over common stock
Usually has no voting rights
Usually has a fixed dividend rate
11-44

Preferred Stock Issuance
Sonic Corporation issued 1,000,000 shares of
$0.01 par value preferred stock for $5 per share.
1,000,000 shares × $0.01 par value = $10,000
1,000,000 shares × $5 per share = $5,000,000
Accounts
Cash (+A)
Preferred Stock (+SE)
Additional Paid-in Capital (+SE)
Debit
5,000,000
Credit
10,000
4,990,000
11-45

Preferred Stock Dividends
 Current Dividend Preference: The current preferred dividends must be paid before paying any dividends to common stock.
 Cumulative Dividend Preference: Any unpaid dividends from previous years
( dividends in arrears ) must be paid before common dividends are paid.
11-46

Preferred Stock Dividends
11-47

Preferred Stock Dividends
In addition to common stock, assume that Sonic
Corporation has 100,000 shares of $1 par cumulative preferred stock outstanding with a 10 percent dividend rate. Dividends were not paid last year. In the current year, the board of directors declared dividends of $400,000.
How much will each class of stock receive?
11-48

Preferred Stock Dividends
Total dividend declared
Preferred stock (cumulative)
Arrearage
Current Yr.
Remainder
Common stock
Remainder
$ 400,000
11-49

Preferred Stock Dividends
Total dividend declared
Preferred stock (cumulative)
Arrearage ($1 par × 10% × 100,000 shares)
Current Yr.
Remainder
Common stock
Remainder
$ 10,000
$ 400,000
11-50

Preferred Stock Dividends
Total dividend declared
Preferred stock (cumulative)
Arrearage ($1 par × 10% × 100,000 shares)
Current Yr. ($1 par × 10% × 100,000 shares)
Remainder
Common stock
Remainder
$ 10,000
10,000
$ 400,000
20,000
$ 380,000
380,000
$ -
11-51

Retained Earnings
Total cumulative amount of reported net income less any net losses and dividends declared since the company started operating.
Sample Company
Statement of Retained Earnings
For Year Ended December 31, 2008
Retained earnings, January 1
Plus: net income
Less: dividends declared
Retained earnings, December 31
$ 800,000
150,000
(100,000)
$ 850,000
11-52

Learning Objective 5
11-53

Earnings Per Share (EPS)
EPS =
Net Income
Average Number of Common Shares Outstanding
Earnings per share is probably the single most widely watched financial ratio.
Sonic Corporation’s income for the year was
$75,400,000 and the average number of shares outstanding during the year was 60,000,000.
Compute earnings per share for Sonic.
11-54

Earnings Per Share (EPS)
EPS =
Net Income
Average Number of Common Shares Outstanding
EPS =
$75,400,000
60,000,000 Shares
= $1.26 per share
During the year, Sonic
Corporation earned $1.26 for each share of its common stock.
11-55

Return on Equity (ROE)
ROE =
Net Income
Average Stockholders’ Equity
Return on equity is the amount earned for each dollar invested by stockholders.
Sonic Corporation’s income for the year was $75,400,000 and the average
Stockholder’s Equity was $359,650,000.
Compute return on equity for Sonic.
11-56

Return on Equity (ROE)
ROE =
Net Income
Average Stockholders’ Equity
ROE =
$75,400,000
$359,650,000
= 21.0 percent
Return on Equity tells us that
Sonic Corporation earned 21 cents for each dollar of its stockholders equity.
11-57

Price/Earnings (P/E) Ratio
P/E =
Current Stock Price (per share)
Earnings Per Share (annual)
The P/E ratio is a measure of the value that investors place on a company’s common stock.
Sonic Corporation’s stock price is
$29.50. Recall that we calculated earnings per share for the year to be $1.26.
11-58

Price/Earnings (P/E) Ratio
P/E =
Current Stock Price (per share)
Earnings Per Share (annual)
P/E =
$29.50
= 23.4
$1.26
The P/E ratio tells us that investors are willing to pay 23.4 times the current year’s earnings for a share of Sonic
Corporation’s common stock.
11-59

Comparison of EPS, ROE, and P/E Ratios
Sonic
Checkers
2005 EPS
$ 1.26
$ 0.85
2005 ROE
20.96%
2005 P/E
23.4
11.40% 17.8
11-60

Owners’ Equity for Other
Forms of Business
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Owner’s Equity for a Sole
Proprietorship
Only two owner’s equity accounts.
A capital account to record the owner’s investments and the period income or loss.
No separate retained earnings account.
A withdrawal account to record the owner’s withdrawals of assets.
Closed to the capital account at the end of each period.
11-62

Accounting for Owner’s Equity for a Sole Proprietorship
To record a $150,000 investment by H. Simpson, the owner.
Accounts
Cash (+A)
H. Simpson, Capital (+OE)
Debit
150,000
Credit
150,000
To record H. Simpson’s $1,000 monthly withdrawal.
Accounts
H. Simpson, Drawings (+D), (-OE)
Cash (-A)
Debit
1,000
Credit
1,000
11-63

Accounting for Owner’s Equity for a Sole Proprietorship
To close revenue and expense accounts to capital.
Accounts
Revenue Accounts (-R)
Expense Accounts (-E)
H. Simpson, Capital (+OE)
Debit
48,000
Credit
30,000
18,000
To close the $1,000 monthly drawings to capital.
Accounts Debit
H. Simpson, Capital (-OE)
H. Simpson, Drawings (-D), +(OE)
12,000
Credit
12,000
11-64

Accounting for Partnership Equity
Accounting for assets, liabilities, revenues and expenses follows the same accounting principles as any other form of business.
Accounting for partners’ equity follows the same pattern as for a sole proprietorship.
Separate capital and drawings accounts are maintained for each partner.
11-65

Accounting for Partnership Equity
To record investments by partners Able and Baker who will divide net income as follows: Able, 60 percent and Baker 40 percent.
Accounts
Cash (+A)
Able, Capital (+OE)
Baker, Capital (+OE)
Debit
100,000
Credit
60,000
40,000
To record the partners’ monthly withdrawal.
Credit Accounts
Able, Drawings (+D), (-OE)
Baker, Drawings (+D), (-OE)
Cash (-A)
Debit
1,000
650
1,650
11-66

Accounting for Partnership Equity
To close revenue and expense accounts to partners’ capital.
Accounts
Revenue Accounts (-R)
Expense Accounts (-E)
Able, Capital (+OE)
Baker, Capital (+OE)
Debit
78,000
Credit
48,000
18,000
12,000
60% of $30,000 40% of $30,000
To close the monthly drawings to partners’ capital.
Accounts
Able, Capital (-OE)
Baker, Capital (-OE)
Able, Drawings (-D), +(OE)
Baker, Drawings (-D), +(OE)
Debit
12,000
7,800
Credit
12,000
7,800
11-67

Other Business Forms
Limited
Liability
Partnership
(LLP)
• Protects innocent partners from malpractice or negligence claims.
• Most states hold all partners personally liable for partnership debts.
Limited
Liability
Corporation
(LLC)
• Owners have same limited liability feature as owners of a corporation.
• A limited liability corporation typically has a limited life.
11-68

Other Business Forms
Business entity
Legal entity
Limited liability
Business taxed
One owner allowed
Proprietorship Partnership LLP LLC S Corp. Corporation yes no no no yes yes no no no no yes no yes yes limited* yes no no no yes yes yes yes no yes yes yes yes yes yes
*A partner's personal liability for LLP debts is lim ited. Most LLPs carry insurance to protect against m alpractice.
Many factors should be considered when choosing the proper business form.
11-69

End of Chapter 11
11-70