Financial Accounting: Tools for Business Decision Making, 4th Ed. Kimmel, Weygandt, Kieso CHAPTER 11 Prepared by Ellen L. Sweatt Georgia Perimeter College and Barbara Muller Arizona State University West 1 Chapter 11 REPORTING AND ANALYZING STOCKHOLDERS’ EQUITY Reporting and Analyzing Stockholders’ Equity After studying Chapter 11, you should be able to: Identify and discuss the major characteristics of a corporation. Record the issuance of common stock. Explain the accounting for the purchase of treasury stock. Differentiate preferred stock from common stock. 3 Reporting and Analyzing Stockholders’ Equity Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits. Identify the items that affect retained earnings. Prepare a comprehensive stockholders' equity section. Evaluate a corporation's dividend and earnings performance from a stockholder's perspective. 4 Corporation Created by law Legal entity Has most of the rights and privileges of a person Classified by purpose and ownership Purpose - profit or nonprofit Ownership - publicly or privately held 5 Publicly Held Corporation... May have thousands of stockholders. Its stock is regularly traded on national securities markets. Privately Held Corporation... Usually has only a few stockholders and does not offer its stock for sale to general public. 1 11 Characteristics of a Corporation Separate legal existence Limited liability of stockholders Transferable ownership rights Ability to acquire capital Continuous life Corporation management Government regulations Additional taxes 7 Separate Legal Existence Separate and distinct from its owners. Acts under its own name. May buy, own, sell property; borrow money; enter into legally binding contracts; may sue or be sued; pays its own taxes. Owners (stockholders) cannot bind corporation unless owners are agents of the corporation. 8 Limited Liability of Stockholders Creditors have recourse only to corporate assets to satisfy their claims. Liability of stockholders limited to their investment in their corporation. Creditors have no legal claim on personal assets of stockholders unless fraud has occurred. Stockholders’ losses limited to amount of capital invested. 9 Transferable Ownership Rights Ownership evidenced by shares of stock Transfer of ownership among stockholders has no effect on corporation’s operating activities or assets, liabilities and total stockholders' equity. Corporation does not participate in transfer of ownership rights after original sale. 10 Ability to Acquire Capital Limited liability of stockholders coupled with transferable ownership rights make it easy to raise capital. 11 Continuous Life Life of corporation is stated in its charter may be perpetual or limited to specific number of years (can be extended). Corporation is separate legal entity, thus life not affected by withdrawal, death, or incapacity of a stockholder. 12 Corporation Management The corporation establishes by-laws upon receipt of its charter from the state of incorporation. Stockholders manage corporation indirectly through board of directors. Board of directors formulates operating policies selects officers to execute policy and to perform daily management functions. 13 Corporate Organization Chart 15 Additional Taxes 16 Forming a Corporation A corporation can operate in various states (must have a license from each state in which it does business) but can be incorporated in only one state. 17 Stockholder Rights Once chartered, the corporation sells stock . If only one class of stock - called common stock. Ownership rights specified in the articles of incorporation or by-laws. Proof of stock ownership is a printed or engraved form known as a stock certificate. 18 19 Stock Certificate Shows... Name of the corporation Stockholder's name Class and special features of the stock The number of shares owned The signatures of duly authorized corporate officials. 20 Questions in Issuing Stock... How many shares should be authorized for sale? How should the stock be issued? At what price should the shares be issued? 22 Authorized Stock... Maximum amount of stock a corporation is allowed to sell as authorized by corporate charter. Issued Stock... Number of shares of issued stock have been sold and been paid for. Outstanding Stock... Number of shares of issued stock that are being held by stockholders. 23 Corporations Can Issue Stock... Directly to investors (typical in privately held corporations). Indirectly through an investment banking firm (customary with publicly held corporations). 24 Par Value Stock... Is capital stock that has been assigned a value per share in the corporate charter. Legal capital per share must be retained in the business for the protection of corporate creditors. 25 No-Par Value Stock... Capital stock that has not been assigned a value per share in the corporate charter. Stated Value of No-Par Stock Amount per share assigned by the board of directors to no-par stock. Par Value and Stated Value have NO relationship to market value. 26 Stockholders’ Equity Section of a Corporation’s Balance Sheet Two Parts: Paid-in (contributed) capital - Amount paid to corporation by stockholders in exchange for shares of ownership. Retained earnings (earned capital) Earned capital held for future use in the business. 27 Review Which of the following represents the maximum number of shares a corporation can issue? a. Outstanding shares b.Issued shares c. Authorized Shares d.Treasury Shares 28 Review Which of the following represents the maximum number of shares a corporation can issue? a. Outstanding shares b.Issued shares c. Authorized Shares d.Treasury Shares 29 2 11 Accounting for Common Stock Issues The issue of common stock affects only paid-in capital accounts. When the issuance of common stock for cash is recorded, the par value of the shares is credited to common stock. The portion of the proceeds above or below par value is recorded in a separate paid-in capital account. 30 Issuing Stock at Par Hydro-Slide, Inc., issues 1,000 shares of $1 par value of common stock at par for cash. Cash Common Stock 1,000 1,000 31 Issuing Stock Above Par If Hydro-Slide, Inc., issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share, the entry is: Cash 5,000 Common Stock 1,000 Paid-in Capital in Excess of Par Value 4,000 32 Hydro-Slide, Inc. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock Paid-in capital in excess of par Total paid-in capital Retained earnings Total stockholders' equity $ 2,000 4,000 $ 6,000 27,000 $33,000 Mead, Inc. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock,$5par value, 100,000 shares issued and outstanding Retained Earnings Total stockholders’ equity $ 500,000 200,000 $ 700,000 BEFORE TREASURY STOCK TRANSACTION 3 11 Treasury Stock... Is a corporation's own stock that has been issued fully paid for reacquired by the corporation held in its treasury for future use. 35 Corporations Acquire Treasury Stock to... Reissue shares to officers and employees under bonus and stock compensation plans. Increase trading of company's stock in securities market in hopes of enhancing market value. Have additional shares available for use in acquisition of other companies. Reduce number of shares outstanding thereby increasing earnings per share. Prevent a hostile takeover. 36 Purchase of Treasury Stock On February 1, 2007, Mead acquires 4,000 shares of its stock at $8 per share. Treasury Stock Cash 32,000 32,000 37 Treasury Stock The Treasury Stock account would increase by the cost of the shares purchased - $32,000. The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change. Treasury stock is deducted from total paid-in capital and retained earnings in the stockholders' equity section of the balance sheet. 38 Mead, Inc. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock,$5par value, 100,000 shares issued and 96,000 outstanding Retained Earnings Total stockholders’ equity Less: Treasury Stock Total stockholders’ equity $ 500,000 200,000 700,000 32,000 $ 668,000 AFTER TREASURY STOCK TRANSACTION Review In the stockholders’ equity section, the cost of treasury stock is deducted from: a. total paid-in capital and retained earnings b.retained earnings c. total stockholders’ equity d.common stock in paid-in-capital 40 Review In the stockholders’ equity section, the cost of treasury stock is deducted from: a. total paid-in capital and retained earnings b.retained earnings c. total stockholders’ equity d.common stock in paid-in-capital 41 4 Preferred Stock... 11 Capital stock that has contractual preferences over common stock in certain areas. Dividends Assets in the event of liquidation Preferred stockholders do not have voting rights. 42 Preferred Stock Assume Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. Cash 120,000 Preferred Stock 100,000 Paid-in Capital in Excess 20,000 of Par Value--Preferred Stock (Preferred stock may have either a par value or no-par value.) 43 Dividend Preferences Preferred stockholders have the right to share in the distribution of corporate income before common stockholders. The first claim to dividends does not guarantee dividends. 44 Cumulative Dividend... Is a feature of preferred stock entitling the stockholder to receive current and unpaid prior-year dividends before common stockholders receive any dividends. 45 Dividends in Arrears... Are preferred dividends that were scheduled to be declared but were not declared during a given period. Are not a liability. No obligation exists until a dividend is declared by the board of directors. Must be disclosed in the notes to the financial statements. 46 Dividends in Arrears Scientific-Leasing has 5,000 shares of 7%, $100 par value cumulative preferred stock outstanding. The annual dividend is $35,000 (5,000 x $7 per share). Dividends are 2 years in arrears Dividends in arrears ($35,000 x 2 years) Current-year dividends Total preferred dividends $ 70,000 35,000 $105,000 47 Liquidation Preference Is a feature that gives preferred stockholders preference to corporate assets in the event of liquidation. 48 5 11 Dividend... Is a distribution by a corporation to its stockholders on a pro rata basis. Pro rata means that if you own 10% of the common shares, you will receive 10% of the dividend. Dividend forms: cash property script (promissory note to pay cash) stock 49 Cash Dividend Is a pro rata distribution of cash to stockholders. A corporation must have 3 things to pay cash dividends: Retained earnings Adequate cash Declared dividends 50 Cash Dividend In many states, payment of dividends from legal capital is prohibited. Payment of dividends from paid-in capital in excess of par is legal in some states. Payment of dividends from retained earnings is legal in all states. Companies are frequently constrained by agreements with lenders to pay dividends only from retained earnings. 51 Entries for Cash Dividends Three dates are important in connection with dividends: the declaration date the record date the payment date Mo n th a n d ye a r 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 Monda y Tue sd a y We dne sd a y Thu rs da y Frid a y S a turda y S un da y 52 The Declaration Date... Is the date the board of directors declares the cash dividend. Commits the corporation to a binding legal obligation that cannot be rescinded. On December 1, 2007, the directors of Media General declare a $.50 per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is $50,000 (100,000 x $.50). 12/1 Retained Earnings Dividends Payable 50,000 50,000 53 The Record Date... The date ownership of the outstanding shares is determined for dividend purposes. Dec 20 No Entry Necessary. The Payment Date... The date dividend checks are mailed. January 20 is the payment date for Media General. Jan 20 Dividends Payable Cash 50,000 50,000 54 A Stock Dividend... Is a pro rata distribution of the corporation's own stock to stockholders. Is paid in stock. Results in a decrease in retained earnings and an increase in paid-in capital. Does not decrease total stockholders' equity or total assets. Is often issued by companies that do not have adequate cash to issue a cash dividend. 55 Stock Dividends You have a 2% ownership interest in Cetus Inc., owning 20 of its 1,000 shares of common stock. In a 10% stock dividend, 100 shares (1,000 x 10%) of stock would be issued. You would receive two shares (2% x 100), but your ownership interest would remain at 2% (22 /1,100). You now own more shares of stock, but your ownership interest has not changed. 56 Reasons for Stock Dividends To satisfy stockholders' dividend expectations without spending cash. To increase marketability of its stock by increasing number of shares outstanding and decreasing market price per share. To emphasize that a portion of stockholders' equity has been permanently reinvested in business and is unavailable for cash dividends. 57 Stock Dividends A small stock dividend (less than 20%25% of the corporation's issued stock) is recorded at the fair market value per share. A large stock dividend (greater than 20%-25% of the corporation's issued stock) is recorded at par or stated value per share. 58 Stock Split Because a stock split does not affect the balances in stockholders' equity accounts, it is not necessary to journalize a stock split. 59 Stock Split... Is the issuance of additional shares of stock to stockholders accompanied by: A reduction in the par or stated value. An increase in number of shares. A stock split does not have any effect on total paid-in capital, retained earnings, and total stockholders' equity. 60 Review Vista, Inc. had 300,000 shares of common stock outstanding when a 30% stock dividend was declared and issued. How many shares were outstanding after the stock dividend? a. 390,000 b. 330,000 c. 300,000 d. 309,000 61 Review Vista, Inc. had 300,000 shares of common stock outstanding when a 30% stock dividend was declared and issued. How many shares were outstanding after the stock dividend? a. 390,000 b. 330,000 c. 300,000 d. 309,000 62 6 11 Retained Earnings... Is net income that is retained in the business. The balance in retained earnings is part of the stockholders' claim on the total assets of the corporation. Retained earnings does not represent a claim on any specific asset. 63 Deficit Is a debit balance in retained earnings and is reported as a deduction in the stockholders' equity section of the balance sheet. 64 Retained Earnings Restrictions... Are legal, contractual or voluntary circumstances that make a portion of retained earnings currently unavailable for dividends. 65 Stockholders’ Equity with Deficit 66 8 11 The Payout Ratio = CASH DIVIDENDS DECLARED ON COMMON STOCK NET INCOME … measures the percentage of earnings distributed in the form of cash dividends to common stockholders. 69 Return on Common Stockholders’ Equity Ratio = NET INCOME - PREFERRED STOCK DIVIDENDS AVERAGE COMMON STOCKHOLDERS’ EQUITY ...measures the profitability from the stockholders’ point of view. 70 Advantages of Bond Financing Over Common Stock Relationship of Par and No-Par Value to Legal Capital Stock Par value Legal Capital Per Share Par value No-par value with Stated value stated value No-par value Entire proceeds without stated value 72 Stock Dividends Medland Corporation has $300,000 in retained earnings and declares a 10% stock dividend on its 50,000 shares of $10 par value common stock. The current fair market value of the stock is $15 per share. Retained Earnings 75,000 Common Stock Dividends 50,000 Distributable Paid-in Capital in Excess 25,000 of Par Value 73 Review Roger is nearing retirement and would like to invest in a stock that will provide a good steady income supply. Roger should choose a stock with a: a) high current ratio. b) high dividend payout. c) high earnings per share. d) high price-earnings ratio. 74 Review Roger is nearing retirement and would like to invest in a stock that will provide a good steady income supply. Roger should choose a stock with a: a) high current ratio. b) high dividend payout. c) high earnings per share. d) high price-earnings ratio. 75 COPYRIGHT Copyright © 2007, John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. 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