Background on
Stockholders’ Equity
• The rights of shareholders usually include
the right to:
– Vote in affairs of the corporation
– Share in corporate profits
– Share in any assets left upon
liquidation
– Acquire shares of subsequent
issues of stock
Background on
Stockholders’ Equity
• Corporations hold annual meetings of
shareholders where votes are taken on
important matters.
• Naturally not all shareholders can attend
every meeting.
– Corporate proxy - a written authority
granted by individual shareholders to
others to cast the shareholders’ votes
Background on
Stockholders’ Equity
• One of the most important rights of
shareholders is limited liability.
– Creditors of the corporation have claims on the
assets owned by the corporation, not on the
assets of the owners of the corporation.
Authorized, Issued, and
Outstanding Stock
• Authorized shares - the total number of
shares that may legally be issued under the
corporation’s articles of incorporation
– Not all authorized shares are always issued.
• Issued shares - the aggregate
number of shares sold to the
public
Authorized, Issued, and
Outstanding Stock
• Outstanding shares - shares in the hands of
shareholders
– Equal to issued shares less treasury stock
• Treasury stock - a corporation’s issued stock
that has subsequently been repurchased by
the company and not retired
– Treasury stock has been issued, but it is no
longer outstanding.
Accounting for Stock Issuance
• To account for an issuance of stock, the
receipt of cash is recorded and an account is
created to represent the ownership interest.
– Most companies separate this ownership
interest into two categories
• Par value
• Additional paid-in capital
Accounting for Stock Issuance
Alex Corporation issues 100,000 shares of
$2 par value stock for $5 per share. The
journal entry to record the issuance is as
follows:
Cash
Common stock
Additional paid-in capital
500,000
200,000
300,000
• Common stock is always credited for the par value of the
shares issued.
• Any amount in excess of the par value is credited to the
Additional Paid-in Capital account.
Accounting for Stock Issuance
• Par value was originally conceived as a
measure of protection for stockholders.
– Par value established the minimum legal
liability of a stockholder.
– Creditors were assured that the corporation
would have at least a minimum amount of
ownership capital because the shareholders
were required to invest at least the amount of
the par value per share.
Cash Dividends
• Dividends are a means of proportionally
distributing income to shareholders of a
corporation.
– Dividends are usually paid in cash.
– Distributions of other assets are
not very common, but distributions
of stock are more common.
– Dividends must be approved by the board of
directors.
Cash Dividends
• Three important dates regarding dividends:
– Declaration date - the date the board of
directors declares a dividend
– Date of record - a future date that determines
which stockholders will receive the dividend
• Only persons actually owning stock on this date will
receive the dividend.
– Payment date - the date the dividends are paid
to the shareholders of record
Cash Dividends
• Journal entries to record dividends:
Declaration date:
Retained income
Dividends payable
20,000
20,000
Date of record:
No entry required
Payment date:
Dividends payable
Cash
20,000
20,000
Cash Dividends
• The amount of cash distributed depends on
several factors such as market expectations,
current and predicted earnings, and the
corporation’s cash position and financial
plans for the future.
– The biggest factor is the amount of cash that the
company has available for distributions.
– Another factor is the amount of retained
income.
• Companies generally cannot pay more dividends
than they have retained income.
Preferred Stock
• Corporations can issue two types of stock.
– Common stock - the most basic and common
type of stock
• Owners have all the basic rights previously
discussed.
– Preferred stock - stock that offers owners
different rights and preferential treatment
• Owners do not usually have voting rights, but they
have priority in events such as liquidations and
dividends.
Cumulative Dividends
• The amount of preferred stock dividends is usually
specified and does not change over time.
• Just because a corporation decides not to pay
dividends in a given year does not mean that the
company can avoid the obligation.
– Cumulative preferred stock - a characteristic of
preferred stock that requires that undeclared
dividends accumulate and must be paid in the
future to preferred shareholders before common
shareholders
Preference in Liquidation
• Liquidating value - a measure of the
preference to receive assets in the event of
corporate liquidation
– The company must pay the liquidating value to
all preferred stockholders before it can
distribute any assets to common stockholders.
– Also, any preferred dividends in arrears must
be paid before common stockholders receive
any assets.
• If there is not enough cash, the common
Comparing Bonds and
Preferred Stock
• Bonds and preferred stock are similar in the
sense that they are both contracts between
an investor and an issuer that spells out each
party’s rights and responsibilities.
• Bonds and preferred stock are also similar
in the sense that they provide investors with
a specific return.
Comparing Bonds and
Preferred Stock
• The size and nature of the return to the
investors differs greatly.
– Bonds pay interest which appears on the
income statement of the company as an
expense.
• Interest is tax deductible to the issuing company and
taxable to the recipient.
– Preferred stocks pay dividends which represent
distributions of profits and reduce the Retained
Income account directly.
• Dividends are not considered expenses and are not
tax deductible by the issuing company but are still
taxable to the recipient.
Comparing Bonds and
Preferred Stock
• Bonds and preferred stocks differ in the
sense that bonds have specific maturity
dates, at which time they must be repaid,
but preferred stock generally has unlimited
life.
– Preferred stock is somewhat riskier than bonds
because it never matures (the investor does not
get the original investment back) and dividends
are not required to be paid.
Additional Stock Issuance
• Stocks can be issued after the original
formation of the company for several
reasons.
– The firm may wish to raise additional equity capital.
– Shares are made available to employees in the form of
stock options to encourage employees to work harder in
order to raise the market price of the stock.
– Shares are sometimes issued to existing shareholders in
order to signal something about the company, to change
the market price, or to alter the dividend payments.
Stock Splits and Stock Dividends
• Several events exist that allow the company
to issue additional shares to existing
shareholders without receiving any cash.
– Stock splits and stock dividends are two
examples.
Accounting for Stock Splits
• Stock split - issuance of additional shares to
existing stockholders for no payments by
the stockholders
– When a stock split occurs, the total amount of
paid-in capital does not change.
• The number of shares outstanding increases.
• The par value and market value of the stock are both
decreased in proportion to the increase in the
number of shares.
– Stock splits are often done to reduce the market
value of a stock to make it more attractive to
investors.
Accounting for Stock Splits
Walters Corporation has 100,000 shares of
$2 par common stock outstanding when the
corporation issues a 2-for-1 stock split.
What is the effect on common stock?
Accounting for Stock Splits
Before the 2-for-1 stock split:
Shares outstanding
Par value per share
Total common stock
100,000
$2
$200,000
====================
After the 2-for-1 stock split:
Shares outstanding
Par value per share
Total common stock
200,000
$ 1*
$200,000
====================
*The market value should also decrease by one-half.
Accounting for Stock Splits
• Generally, no entry is necessary for
recording a stock split because amounts in
the paid-in capital accounts have not
changed.
– Usually a note in the general journal will suffice.
• Sometimes a company will keep the par
value the same after the stock split.
– The company is merely rearranging owners’ equity
from Additional Paid-in Capital to Common Stock or
from Retained Income to Common Stock.
Accounting for Stock Dividends
• Stock dividends - distributions to
stockholders of a small of additional shares
for each share owned, without any payment
to the company by the stockholders
– The number of shares issued is
less than in a stock split, and the
par value does not change.
Accounting for Stock Dividends
• With stock dividends, new shares are issued
and the Common Stock account is increased
to recognize this increase.
• The dollar amount of the increase to
Common Stock depends on the size of the
dividend.
– Large-percentage stock dividend - 20% or more
of the outstanding shares of common stock
– Small-percentage stock dividend - less than
20% of the outstanding shares of common stock
Small-Percentage Stock
Dividends
• Small-percentage stock dividends are
accounted for at market value, not at par or
stated value.
– An entry is made to transfer the market value of
the new shares from Retained Income to
Common Stock and Additional Paid-in Capital.
– This is often justified because a smallpercentage stock dividend is often accompanied
by an increase in the total cash dividends
distributed.
Small-Percentage Stock
Dividends
• The proportional ownership of shares does
not change because the stock is distributed
proportionally based on ownership.
• The journal entry to record a smallpercentage stock dividend is:
Retained income (# shares x market value)
Common stock (# shares x par value)
Additional paid-in capital
xxx
xxx
xxx
Why Use Stock Splits
and Dividends?
• Stock splits and dividends effectively
decrease the market price of the stock.
– This attracts more investors because it is easier to get
investors to pay the lower stock prices.
• Companies often wish to retain cash for
expansion.
– Stock dividends allow the company to retain cash and
still give the stockholders a dividend that will entitle
them to more cash dividends in the future.
Repurchase of Shares
• Companies repurchase their own shares for
two main purposes.
– To permanently reduce shareholder claims
(retire the stock)
– To temporarily hold shares for later use, usually
to be granted as part of employee bonus or
stock purchase plans
• These temporarily held shares are called treasury
stock.
Repurchase of Shares
• By repurchasing its own shares, a company
can effectively increase the market value
per share of the remaining shareholders.
• Firms also buy back shares to change the
proportion of debt and equity.
– Buying back shares increases the relative
importance of debt.
Repurchase of Shares
• Buybacks also allow the company to return
cash to the shareholders without creating
expectations of future dividends.
• Another benefit of stock buybacks is that
investors pay taxes only on the gain on the
sale of the stock instead of the entire
dividend.
– Also, the tax rate on a long-term gain is less
than on a dividend.
Treasury Stock
• Treasury stock that is held temporarily is
not an asset to the company.
– It is a contra account to Owners’ Equity, much
like Accumulated Depreciation is a contra
account to Plant Assets
• It is a deduction from total stockholders’ equity on
the balance sheet.
– Cash dividends are not paid on treasury stock
because treasury stock is not considered to be
outstanding shares of stock.
Treasury Stock
• When treasury stock is repurchased, it is
recorded in a separate account called
Treasury Stock.
– Common Stock, Additional Paid-in Capital, and
Retained Income are untouched by treasury
stock purchases.
• Calculation of outstanding shares:
Shares issued
Less: Treasury stock
Total shares outstanding
1,000,000
50,000
950,000
=====================
Disposition of Treasury Stock
Assume that 10,000 shares of treasury stock
are purchased for $10 per share; 5,000 of
the shares are then resold for $12 per share.
A year later, the remaining 5,000 shares are
sold for $9 per share. How are these
transactions recorded?
Disposition of Treasury Stock
Repurchase of the 10,000 shares of treasury stock:
Treasury stock (10,000 x $10)
Cash
100,000
100,000
Sale of 5,000 shares at $12 per share:
Cash
Treasury stock (5,000 x $10)
Additional paid-in capital (5,000 x $2)
60,000
50,000
10,000
Sale of 5,000 shares at $9 per share
Cash
Additional paid-in capital* (5,000 x $1)
Treasury stock (5,000 x $10)
45,000
5,000
50,000
*If the balance in Additional Paid-in Capital is insufficient,
Retained Income
is debited.
Disposition of Treasury Stock
• Any differences between the acquisition
costs and the resale proceeds of treasury
stock must never be reported as losses,
expenses, revenues, or gains in the income
statement.
– Treasury stock is not an asset of the company,
nor is it intended to be treated like inventory to
be resold; a company cannot make profits or
losses by buying or selling its own stock.
Effects of Repurchases on
Earnings per Share
• As stated before, when shares are
repurchased by a corporation, the number of
shares outstanding is decreased.
– This decrease in the number of shares tends to
increase earnings per share.
Conversion of Securities
• For the issuer, when convertible preferred
stock is converted into common stock, the
transaction merely converts one form of
stock into another.
• The accounts are adjusted as if the common
stock had been originally issued.
– The convertible preferred stock and any additional
paid-in capital is taken off the books, and the common
stock and additional paid-in capital is put on as if it had
been issued originally instead of the convertible
preferred stock.
Conversion of Securities
• The investor may make a journal entry to
show that the investment in convertible
preferred stock is now an investment in
common stock.
• The investor may also change any
subsidiary records that document the
composition of the Investments general
ledger account.