CHAPTER 24
CORPORATE STOCK
AND EARNINGS
ISSUES
1
Chapter Overview
 What are the rights of a corporation’s
stockholders?
 What is important for an external users to
know about a corporation’s capital stock
transactions?
 What are the characteristics of a
corporation’s treasury stock, and how does it
record and report this stock?
 What are compensatory stock options, and
how does a corporation report them?
2
Chapter Overview
 How does a corporation report its results
from discontinued operations and
extraordinary items?
 How does a corporation compute and report
its earnings per share?
 What kind of dividends can a corporation
distribute, and what are their characteristics?
 How and why does a corporation report the
changes in its stockholders’ equity?
3
Corporate Capital Structure
 Recall from Chapter 10 that the owners’ equity
section for a corporation is called stockholders’
equity, because stockholders are the owners.
Contributed
capital is the
total investment
made by
stockholders
Net income
each year
becomes part
of retained
earnings
Retained earnings reports the corporation’s total lifetime reinvested
net income not distributed to stockholders as dividends.
4
Capital Stock and Legal Capital
 Capital stock is the ownership unit in a
corporation.
 Stockholders (or shareholders) are the
owners of a corporation and their evidence
of ownership is a stock certificate.
 A stock certificate is a serially numbered
legal document that indicates the number of
shares of capital stock owned by the
stockholder, as well as other information.
5
Stockholders’ Rights
 Shares of stock are transferable between
individuals stockholders or other investors.
 The owners of a corporation may be a
diverse set of stockholders who are not
involved in its management.
 Because of the separation of ownership and
management, each stockholder may have
certain rights of ownership.
6
Stockholders’ Rights
 A stockholder usually has the right to attend and
vote at stockholders’ meetings in setting and
approving major policies and actions of the
corporation.
 A stockholder usually has the right to vote in the
election of the board of directors, the group of
individuals with the fiduciary responsibility to the
stockholders.
 A stockholder is entitled to share in net income
of the corporation, provided the board of
directors authorizes the payment of dividends.
7
Stockholders’ Rights
 A stockholder has the right to purchase
additional capital stock if it is issued – a right
know as preemptive right, a right to maintain
a proportionate (pro rata) share of additional
capital stock if it is issued.
 A stockholders is entitled to share in the
distribution of the corporation’s assets if it is
liquidated and creditors have been paid.
8
Legal Capital
 Legal capital is
the amount of
stockholders’
equity that a
corporation
cannot
distribute; it is
the minimum
which must be
maintained to
protect the
interest of
creditors.
Legal capital is the minimum
monetary amount per share
of common stock issued,
called par value.
Additional PIC represents
the difference between
the market value (selling
price) of the stock issued
and the par value or
amount attributable to
legal capital.
9
Classes of Capital Stock
 Corporations
may issue two
(or more)
classes of
capital stock:
common stock
and preferred
stock.
Common stock is the basic
ownership unit in the corporation
that contains shareholders’ rights
(voting, etc.)
In exchange for giving up
basic shareholders’ right that
exist in common stock,
preferred stock has a stated
dividend rate and preferential
dividend and liquidation rights
10
Capital Stock Transactions
 Authorized capital stock is the number of
shares of capital stock that a corporation
may legally issue.
 Issued capital stock is the number of shares
of capital stock that a corporation has legally
issued to its shareholders as of the balance
sheet date.
 Outstanding capital stock is the number of
shares the corporation has issued to
stockholders and that the stockholders still
hold as of a specified date.
11
Stockholders’ Equity Section of the
Balance Sheet: Preferred Stock
Stockholders Equity
Contributed capital
Preferred stock, $100 par, 2000 shares authorized,
600 shares issued and outstanding
$ 60,000
Additional paid in capital on preferred stock
$ 72,000
Common stock, $10 par. 30,000 shares authorized,
The preferred stock has a stated par value of
9,000 shares issued and outstanding
$ 90,000
$100 per share. 2,000 shares have been legally
The excess of the selling price of
Additional
paid
in
capital
on
common
stock
$ 43,000
authorized for issue but only 600 shares have
the preferred over the par value
contributed
capital
265,000
been soldTotal
to and
are in the hands
of investors
was $72,000$(total
average selling
(outstanding).
par value recorded in the
RetainedThe
earnings
$ 173,000
price was $60,000
+ $72,000/600
accounts is
the legal
capital (600Equity
shares X
Total
Stockholders'
438,000
shares,$or
$220 share).
$100/share = $60,000).
12
Stockholders’ Equity Section of the
Balance Sheet: Common Stock
The common stock hasStockholders
a stated par value
of $10 per share;
Equity
30,000 shares have been legally authorized for issue but only
Contributed capital
9,000 have been sold to and are currently in the hands of
stock,
$100
shares
authorized,
investorsPreferred
(outstanding).
The
par par,
value2000
recorded
in the
accounts
and outstanding
$ 60,000
is the600
legalshares
capitalissued
(9,000 shares
X $10/share = $90,000).
Additional paid in capital on preferred stock
$ 72,000
Common stock, $10 par. 30,000 shares authorized,
9,000 shares issued and outstanding
$ 90,000
Additional paid in capital on common stock
$ 43,000
Total contributed capital
$ 265,000
The excess of the selling
price of the
Retained earnings
$ 173,000
common over the par value
was $43,000
Total Stockholders' Equity (total average selling price
$ 438,000
was $90,000 +
$43,000/9000 shares, or $14.77 share).
13
Issuance of Stock for Cash
 If Unlimited Decadence issues 3,000
shares of its $3 par common stock for $20
per share, how is this recorded?
The excess over par value of the stock is recorded in a separate account
called “Additional Paid-in-Capital: 3,000 shares X $17 per share
The total cash received: 3,000
shares X $20/share
Only the par value of the stock is recorded in the
stock account: 3,000 shares X $3 per share
14
Noncash Issuance of Stock
 If Unlimited Decadence issues 1,000 shares
of its $3 par common stock in exchange for a
patent when the stock is selling for $18 per
share, how is this recorded?
The total cost of the patent is equal to the market value of the stock issued or
the value of the assets received, whichever is more reliable; generally if stock
The excess
is traded, the asset will be recorded at the market price.
over par
value of the
stock
The par value of the stock
15
Preferred Stock
 Convertible preferred stock is preferred
stock that is exchangeable into common
stock at the option of the individual
stockholder.
 Callable preferred stock is stock that the
corporation may recall (or retire) at its
option.
 Redeemable preferred stock is stock that is
subject to a mandatory retirement date at a
specified maturity date and price, at the
option of the owner.
16
Treasury Stock
 Treasury stock is a corporation’s own capital
stock that (1) stockholders fully paid for and the
corporation issued, and (2) the corporation later
reacquired, and (3) the corporation currently
holds.
 Treasury stock is not an asset of the corporation
because a corporation cannot “own itself.”
Rather, when treasury stock is purchased, it
reduces the amount of stock outstanding and
reduces the total amount of stockholders’ equity.
 If there is a difference between the number of
shares a company has issued and the number
outstanding, the difference is likely due to
treasury stock acquired.
17
Treasury Stock
 Treasury stock may be acquired to have shares
available to issue for employee-purchase plans
or to issue in conversion of convertible preferred
stock.
 Some companies acquire treasury stock to use
for the acquisition of other companies, or to
reduce the number of shares outstanding,
increasing earnings per share and helping to
maintain the market price of the stock.
 Other companies may acquire treasury stock as
a defense against hostile takeovers
18
Acquisition of Treasury Stock
 Suppose Duong Corporation previously issued 5,000
shares of $10 par value common stock for $12 per share
and has Retained Earnings of $35,000. The corporation
reacquires 400 of its common shares at $14 per share.
How is this recorded?
The total cash paid to acquire the
treasury shares ($14 X 400 = $5,600)
Before the treasury shares were acquired, there were 5,000
shares outstanding; now there are only 4,600 shares outstanding
and 400 are held in treasury for reissue at another time. Total SE
now equals $50,000+$10,000+$35,000-$5,600 = $89,400.
19
Reissue of Treasury Stock
 Suppose Duong Corporation now reissues 300 shares of
the treasury stock for $15 per share. Recall that the
treasury shares were originally purchased for $14 per
share. How is this recorded?
The total cash received when the shares
were reissued $15 X 300 = $4,500
The total cost of the treasury stock
reissued was $14 X 300 = $4,200
Duong received $1 more/share on reissue than the stock originally cost, so their
additional paid-in-capital increases for this amount $1 X 300 shares = $300
20
Stock Options
 Another way a corporation can issue stock is
through stock options.
 A corporation’s compensatory stock options
are intended to provide additional
compensation to employees in exchange for
their services.
 Under a compensatory stock option plan,
employees receive options to buy shares of
the corporation’s common stock at a fixed
price for a certain period of time.
21
Stock Options
 Compensatory stock options are designed to
encourage employees to make decisions that
cause the market price of the stock to increase,
thereby providing benefit to all of the
stockholders.
 These type of plans are particularly popular in
“start-up” companies, as well as high-technology
and bio-technology companies where there is
usually not sufficient cash to pay high salaries to
attract the best employees.
 Under GAAP, corporation’s that issue stock
options do not have to currently report an
expense on the income statement even though
the options are compensatory in nature.
22
Stock Options
 When an employee exercises an option, say for
10,000 shares at a price of $20 per share (when
the market price of the stock is $100 per share),
the employee pays the company only $200,000.
 The company increases its cash and its
stockholders equity as if it had sold stock on the
open market, except that the increase is only
$200,000 (not $1 million which would have been
the price received on the open market).
 This is an opportunity cost of $800,000 to the
corporation and an $800,000 windfall to the
employee.
23
Stock Options
 The GAAP treatment of stock options is highly
controversial, particularly with the corporate
scandals which have arisen in the last several
years.
 A corporation must disclose in the notes to its
financial statement the amount that its net
income would be if it had included the expense
of the stock options it grants.
 As an example, Microsoft reports in 2001 that its
net income would have been $2.262 million less
if stock options had been included as an
expense. This would have reduced reported net
income by almost 31%!
24
Corporate Income Statement
 Corporate income statements present
information in three different sections.
 Earnings from continuing operations is
shown in the first section. If applicable,
earnings from nonrecurring activities is
shown second.
 Lastly, a company reports its earnings per
share of common stock for each of the major
components of earnings.
25
Income from Continuing Operations
$ 100,000
$ 60,000
$ 40,000
$ 20,000
$ 20,000
Profit from the
company’s
basic
operating
business
Sales
Cost of goods sold
Gross profit
Operating expenses
Exhibit
income10-6
Operating
Nonoperating
items
Other revenues (expenses):
$ 10,000
Interest income
Loss on sale of equipment $ (5,000) $ 5,000
Taxes on
continuing
operations
Income from continuing operations
before tax
Income tax expense
Income from continuing operations
Operating
results of a
company’s
ongoing
operations
$ 25,000
$ 10,000
$ 15,000
26
Income
Statement
for Unlimited
Decadence
Corporation
Exhibit 24-1
27
Results of Discontinued
Operations
 Many corporations, sometimes called
conglomerates, have several major divisions
(components) that sell different products or
services.
 A corporation occasionally sells one of these
components called a “sale of a discontinued
component.”
 Examples include the sale by a
communications company of all of its radio
stations or the sale by a food distributor of its
wholesale supermarket division.
28
Results of Discontinued
Operations
 Since these sales are not usual, they are
important events that need to be highlighted
for financial statement users.
 For this reason, a corporations reports
certain information about the sale separately
on its income statement in a section called
results from discontinued operations. This
section is below income from continuing
operations.
 This allows users to assess the impact of the
sale on the company earnings.
29
Extraordinary Gains and Losses
 Sometimes an event or transaction causes
an extraordinary gain or loss for a
corporation.
 An extraordinary item is an event that is (1)
unusual in nature and, (2) infrequent in
occurrence.
 Examples of events that are likely to be
extraordinary items are earthquakes,
tornados, floods, expropriation of assets by a
foreign country, or prohibitions under newly
enacted law.
30
Extraordinary Gains and Losses
 Like discontinued operations, extraordinary
gains and losses are required to be
highlighted in a separate section of the
income statement.
 Extraordinary items fall below continuing
operations and discontinued operations (if
applicable).
 Like discontinued operations, a corporation
reports extraordinary items separately so
external users can assess the impact on
earnings.
31
Earnings Per Share (EPS)
 Since a corporation earns its net income over an
entire year, it relates the earnings to the weighted
average number of common shares outstanding
during the year.
 EPS is widely used to predict a corporation’s
future earnings, dividends and stock market
price. This ratio is so important that GAAP
requires it to be included on the income
statement and to be computed for the major
components of earnings.
Net income – Preferred Dividends
Weighted Average Number of Common Shares
Outstanding
32
Weighted Average Common Shares
 Assume Unlimited Decadence had 1,200,000 shares of
common stock outstanding during all of 2005. However, on
August 1, 2005, it issued an additional 240,000 common
shares so that it had a total of 1,440,000 shares
outstanding at the end of the year. How would the
weighted average number of shares be computed?
Months Shares
Are Outstanding
January-December
August-December
Total
Shares
Outstanding
1,200,000
240,000
X
Fraction of Year
Outstanding
12/12
5/12
This would be the denominator in
the EPS calculation for 2005
=
Weighted
Average
1,200,000
100,000
1,300,000
33
Earnings Per Share (EPS)
 Using Exhibit 24-1, Unlimited Decadence’s basic
earnings per share for income from continuing
operations is computed as follows:
Net income – Preferred Dividends
Weighted Average Number of Common Shares Outstanding
$4,800 - $690
1,300
= $3.16 per
share
For every share of common stock owned in
Unlimited Decadence, stockholders earned $3.16
34
Price Earnings (PE) Ratio
 Since one of the important results of a
corporation’s performance is the market price
of its common stock, another important and
widely used financial ratio is the
price/earnings (PE) ratio.
 This ratio indicates how much investors are
willing to pay per dollar of current earnings.
Market Price Per Share
Earnings Per Share
35
Price Earnings (PE) Ratio
 A higher PE ratio is thought to mean that
investors are optimistic about the future and that
the corporation has better prospects for future
growth.
 For example, at the time of writing this book, the
PE ratio for Pepsi was 27 times earnings and
Coca-Cola was 32 times earnings.
 This means that investors were willing to pay 27
times as much for the stock of Pepsi and 32
times as much for the stock of Coca-Coca as
each company had reflected in current earnings.
In general, the marketplace viewed Coca-Coca
as having better prospects for the future.
36
Cash Dividends
 A corporation must meet legal requirements and
have enough cash available to pay dividends. In
addition, the board of directors is responsible for
setting a corporation’s dividend policy.
 In setting the dividend, a board of directors
determines the amount and timing of the
dividends, considering legal requirements,
compliance with contractual agreements, and the
financial well-being of the corporation.
 The payment of dividends should be in the
financial long- and short-term interests of the
corporation and its stockholders.
37
Cash Dividends
 Three dates are significant for a cash dividend
(or any type of dividend).
 The date of declaration is the date the board of
directors declares that a dividend will be paid.
The corporation becomes legally liable to pay it
on this date.
 The date of record is the date that is used to
determine which investors own stock in the
corporation and will be entitled to the dividend.
 The date of payment is the date the corporation
mails the dividend checks to the investors who
were owners on the date of record.
38
Recording a Cash Dividend
 Assume on November 15, 2004, Unlimited
Decadence declares a 60 cent per-share dividend
on its 1,200,000 outstanding common shares. The
dividend is payable on December 29, 2004 to
stockholders of record as of December 15, 2004.
 How much is the dividend and how is it recorded?
60 cents X 1,200,000 = $720,000
dividend to be paid; liability
accrued on the declaration date
Assets
=
Retained Earnings is
decreased on the
date of declaration
Liabilities + Stockholders’ Equity
+$720,000
Dividends
Payable)
-$720,000
(Retained
Earnings)
39
Payment of a Cash Dividend
Previously Declared
 When Unlimited Decadence pays the
$720,000, the liability is liquidated. How is it
recorded?
Assets
-$720,000
(Cash)
=
Liabilities + Stockholders’ Equity
-$720,000
Dividends
Payable)
40
Cash Dividends on
Preferred Stock
 Holders of preferred stock have preference as to
dividends. This means that their dividend must be
paid before anything can be paid common
stockholders. It does not mean that the dividend is
guaranteed.
 A corporation issues preferred stock with a par
value and expresses the dividend as a percentage
of this value. For example, preferred stock that is
issued with a $50 par value and pays 10% means
that a dividend of $5 per share is paid ($50 X 10%).
 The total preferred dividend is equal to the dividend
per share times the number of preferred shares that
are outstanding when the dividend is declared.
41
Cumulative Preferred Stock
 Holders of cumulative preferred stock have
preference as to dividends and the right to
received all prior, unpaid dividends once a
dividend is declared payable by the Board of
Directors.
 Most preferred stock is cumulative. All
cumulative preferred stock dividends must be
paid before any dividend can be paid on common
stock.
 The total cumulative preferred dividend is equal
to the dividend per share X the number of
preferred shares X the number of outstanding
years when the dividend is declared.
42
Stock Dividends
 Occasionally, a corporation may declare and
distribute a stock dividend.
 A stock dividend is a proportional (pro rata)
distribution of additional shares of a corporation’s
own stock to stockholders instead of paying cash.
 For example, assume a corporation has 10,000
shares of stock outstanding and one shareholder
owns 2,000 shares. If a 10% stock dividend is
declared, the corporation will now have 11,000
shares outstanding (10,000 x 1.10) and the
stockholder will now own 2,200 shares (2,000 x
1.10).
43
Small Stock Dividends
 For reporting purposes, GAAP distinguishes
between small and large stock dividends. Small
stock dividends are assumed to have no
significant affect on the stock market price of
outstanding shares.
 A small stock dividend is 20% or less of the
previously outstanding common shares.
 When a small stock dividend is declared, a
company reduces retained earnings for the
current market value of the dividend and
increases its contributed capital by a like amount,
resulting in no net change to stockholders’ equity.
44
Payment of a Small Stock Dividend
 Assume Crabtree Corporation declares and issues a 10% stock
dividend. Before the dividend, Crabtree has 10,000 shares of its $10 par
common stock outstanding. The common stock is selling for $19 per
share, so the 1,000 share stock dividend (10,000 X 10%) has a current
market value of $19,000 (1,000 shares X $19). 11,000 shares of
common stock are outstanding after the stock dividend. How does this
affect stockholders’ equity?
The par value of new shares issued
(1,000 shares @ $10 par value)
Excess over par
value of new
Contributed capital:
Common stock shares issued
(1,000 shares @
Additional PIC
$9)
Total contributed capital
Retained earnings
Total Stockholders' Equity
11,000 shares @ $10 par value)
Before Stock
Dividend
$
$
$
$
$
100,000
70,000
170,000
140,000
310,000
After Stock
Dividend
Change
+
+
-
$ 10,000
$ 9,000
$ 19,000
$ 19,000
$
-
=
=
=
=
=
$
$
$
$
$
110,000
79,000
189,000
121,000
45
310,000
Large Stock Dividends
and Stock Splits
 Sometimes the market price of a corporation’s
common stock increases to the point where it is
not as attractive to certain investors.
 To reduce the market price so that it falls within
the trading range of most investors, a corporation
may authorize a large stock dividend or a stock
split.
 Unlike a small stock dividend, a large stock
dividend is recorded at its par value not at its
market value.
46
Payment of a Large Stock Dividend
 Assume Crabtree Corporation declares and issues a 100% stock
dividend. Before the dividend, Crabtree has 10,000 shares of its $10 par
common stock outstanding. The common stock is selling for $19 per
share, but the dividend is recorded at its par value (10,000 X $10).
20,000 shares of common stock are outstanding after the dividend. How
does this affect stockholders’ equity?
The par value of new shares issued
(10,000 shares @ $10 par value)
Contributed capital:
Common stock
Additional PIC
Total contributed capital
Retained earnings
Total Stockholders' Equity
20,000 shares @ $10 par value)
Before Stock
Dividend
$
$
$
$
$
100,000
70,000
170,000
140,000
310,000
Change
+
-
$ 100,000
=
=
$ 100,000 =
$ (100,000) =
$
- =
After Stock
Dividend
$
$
$
$
$
200,000
70,000
270,000
40,000
310,000
47
Comprehensive Income
 Comprehensive income is a measure of a
company’s performance that includes items
other than net income from the income
statement.
 Basically, the idea is to give users a better
picture of the items that affected
stockholders’ equity of the company that may
not have been reported in net income.
 It includes unrealized gains and losses from
adjusting to the market value method for
investments and other similar items.
48
Statement of Changes in
Stockholders’ Equity
 A statement of stockholders’ equity is a
supporting schedule to the stockholders’ equity
section of the balance sheet.
 It bridges the gap between the income statement
and balance sheet to identify changes that have
occurred during an accounting period that
affected stockholders’ equity.
 External users are interested in this statement
because it provides information that may have an
impact on the corporation’s risk and financial
flexibility.
49
Reporting
Changes
in
Stockholders’
Equity
and Ending
Stockholders’
Equity
50