Financial Accounting
A Decision-Making Approach, 2nd Edition
King, Lembke, and Smith
*
Prepared by
Dr. Denise English,
Boise State University
John Wiley & Sons, Inc.
CHAPTER
TWELVE
REPORTING
OWNERSHIP INTERESTS
After reading Chapter 12, you should be able to:
1. Distinguish different types of ownership interests
and explain why these differences and the
distinction between debt and equity are important to
decision makers.
2. Describe the different types of stockholders’ equity
elements and explain how disclosure of these
elements assists decision making.
3. Describe the different types of distributions to
owners and explain why this information is
important for decision makers.
CHAPTER
TWELVE
REPORTING
OWNERSHIP INTERESTS
After reading Chapter 12, you should be able to:
4. Explain the purpose of the statement of
stockholders’ equity.
5. Discuss the summary measures related to
stockholders’ equity that are useful for decision
making.
6. Describe what information about ownership
interests can be found in the financial statements of
unincorporated businesses and to what degree that
information is useful for decisions.
Understanding Owners’ Equity




The owner’s equity of a business reflects the owners’
interest in that business and their claim on the assets of
the business.
Owner’s equity is determined by the owners’ direct
investment in the business, in addition to accumulated
profits (less losses) of the business that have been
reinvested (rather than paid out to owners).
Since creditors’ claims have priority over that of owners,
it is referred to as the residual interest.
Owners’ equity is referred to as stockholders’ equity for
a corporation.
Is it debt or equity?
The distinctions between debt and equity are important:
– creditors’ claims are fixed, determinable amounts to be
paid at specified times, while owners’ claims are not
unless at liquidation, when owners receive residual
interest after creditors.
– Interest on debt is an expense and reduces income, but
payments to owners are not expenses and are
considered distributions of income.
– Debt financing is considered riskier than equity
financing due to fixed interest and principal payments.
Elements of Corporate Ownership
The stockholders’ equity section of a corporate
balance sheet may include the following elements:
1) Capital Stock
2) Additional Paid-in Capital
3) Retained Earnings
Stockholders' Equity
4) Other Items
Contributed Capital
Capital Stock
Retained Earnings
Additional
Paid-in Capital
Other Items
Preferred
Stock
AND
Common
Stock
Capital Stock


Owners of corporations hold shares of capital
stock, and these shares of stock possess
different rights depending upon the type of
stock and terms of the stock agreement.
Two major classes of capital stock are
common stock and preferred stock.
Common
Stock
Common stock
Common stock has the following characteristics:
–
–
–
true residual ownership; that is common shareholders
are “last in line” upon receiving assets in a liquidation and
in profit sharing;
the right to participate in the selection of management by
voting for boards of directors and on other significant
matters.
in some cases, the right to buy additional shares of
ownership from new stock issued to maintain
proportionate ownership (the preemptive right).
Preferred
Stock
Preferred Stock
Preferred stock has the following characteristics,
depending upon the terms of the stock issue:
--a stated dividend rate, showing intent to pay a specific
dividend each year before paying common shareholders any
dividend;
--preference upon liquidation ahead of common
shareholders;
--no voting privileges;
--callability, meaning the corporation may, at its option, buy
back the stock at a set price;
Stock
Options
Stock Options
Stock options give the holder the right to purchase shares
of stock at a specified exercise price. These rights are
known as stock warrants if represented by a formal
financial instrument. Some characteristics are:
--the holder anticipates the market price to rise above the
exercise price before the option expires.
--options are often issued as additional compensation to
officers or employees of a company to provide incentive;
--options are not always reported on the balance sheet, but
must be discussed in the notes to the financial statements.
Capital
Stock
Analyzing Capital Stock
Financial statement users want to evaluate each
security the company has outstanding.
–
–
–
Capital stock is reported at its par or stated value, an
arbitrary amount assigned to each share of stock.
Shares issued at more than par are issued at a premium, or
at less than par, a discount. Discount sales are prohibited
in many states, thus par values are often set very low ($1 for
example).
Legal capital refers to the amount of stockholders’ equity
that must be maintained in the corporation; in most states
this equals par value of all shares issued.
Capital
Stock
Analyzing Capital Stock
Financial statement users want to evaluate each
security the company has outstanding.
–
–
–
True no-par stock is sometimes issued; without a par or
stated value, the full issue price may be considered legal
capital.
Preferred stock is usually issued with a par value.
Disclosures required in the body of the balance sheet are:




par or stated value per share
number of shares authorized
number of shares issued
number of shares outstanding.
Typical Characteristics of Debt,
Exhibit 12-1
Preferred Stock, and Common Stock
(partial)
Debt
Description
Reflects a legal
obligation to pay
a specific amount
at a determinable
future time.
Interest/
Dividend
amount and
status
Interest is fixed
and determinable
in amount and
becomes a legal
obligation as it
accrues.
Preferred Stock Common Stock
Reflects a claim
for a specific
amount that must
be paid only if the
the company is
liquidated or the
stock is retired.
Dividends usually
are fixed in amount
but become a legal
obligation only
after declared by the
board of directors.
Represents a
claim on all
assets remaining
after other claims
are satisfied.
Dividends, if any,
are paid at the
discretion of the
board of directors
and become a legal
obligation after
declaration.
Typical Characteristics of Debt,
Exhibit 12-1
Preferred Stock, and Common Stock
(partial)
Debt
Tax status
Interest is taxdeductible by the
company.
Profit sharing Creditors do not
share in profits.
Preferred Stock Common Stock
Dividends are not
tax-deductible.
Shareholders usually
share in profits only
to the extent of the
stated dividend.
Dividends are not
tax-deductible.
All profits and losses
accrue to common
shareholders after
payment of preferred
dividends.
Claim priority Creditors’ claims Preferred claims have Common claims are
have preference have preference over subordinated to those
over all stockcommon shareholders of creditors and preholders’ claims. but not over preferred. ferred shareholders.
Voting rights None.
Usually withheld by
Usually hold sole
agreement.
voting rights.
Typical Characteristics of Debt,
Exhibit 12-1
Preferred Stock, and Common Stock
(partial)
Debt
Transferrability
Preemptive
Callability
Preferred Stock Common Stock
May or may
not be
transferable.
No rights relating to the
acquisition of
stock or additional debt.
Usually transferrable.
Usually transferrable.
No right to purchase
newly issued shares
of stock before
nonowners.
May be
callable.
Usually callable.
Have the right to
purchase newly issued
shares of common
stock before nonowners unless the
right is withheld.
Not callable.
Additional Paid-in Capital


Additional paid-in capital is a stockholders’
equity category that includes capital paid into
or contributed to the corporation over and
above the par or stated value of the capital
stock.
Additional paid-in capital may also come
from other stock transactions, such as the
retirement of stock at a price less than the
original stock price.
Retained Earnings




Retained Earnings is a corporation’s accumulated profits
that have not been distributed to owners. It is not a cash
fund that exists, but has been reinvested in the corporation.
If negative, retained earnings’ balance is an accumulated
deficit.
The Statement of Changes in Stockholders’ Equity or
Retained Earnings Statement reports the two most
important items affecting retained earnings: current income
or loss and distributions of income to owners.
Certain contractual agreements and state laws place
potential restrictions on retained earnings or on the payment
of dividends.
Other Stockholders’
Equity Elements
Several other equity items are also sometimes
included in the balance sheet as part of
comprehensive income, such as:
– the unrealized gains or losses from revaluing
available-for-sale securities);
– foreign currency fluctuations;
– certain employee stock ownership plan
adjustments.
Capital
Stock
Issuance of Stock
The issuance of preferred or common stock has
three basic effects:
+ increases the stock account for the par or
stated value;
+ increases the additional paid-in capital
account for the sale price amount in excess
of par;
+ and increases the cash (or other asset)
account received upon the issuance.
Capital
Stock
Retirement of Stock

Companies may retire stock for a number of reasons:
–
–

the financing is no longer needed;
the company wishes to boost stock prices by lowering
the supply of their stock.
The retirement of preferred or common stock has three
basic effects:
–
–
–
reduces the capital stock by the amount originally
recorded in the stock account for those shares;
reduces additional paid-in capital for amounts in excess
of the par value paid to retire the shares;
if additional paid-in capital is insufficient, retained
earnings is reduced.
Capital
Stock
Treasury Stock Transactions

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When shares are reacquired with the potential to reissue
them again in the future, those shares are held and referred
to as Treasury Stock.
Treasury shares are counted as issued, but not outstanding.
The cost of reacquiring treasury shares is reported at the
bottom of the stockholders’ equity section as a reduction in
equity.
If later resold at a price different than their cost, the
difference is recorded as additional paid-in capital; if
additional paid-in capital is insufficient, retained earnings is
used.
Capital
Stock
Other Contributed Capital

Other stock-related transactions may cause
equity amounts to arise, such as:
–
–
–
stock options that expire without being exercised;
additional paid-in capital left in the corporation when
stock is retired at a reduced price;
treasury stock transactions.
Accounting for Dividends


Dividends are distributions of profits to owners
(stockholders) of the business.
The payment or issuance of dividends
normally requires
–
–

sufficient retained earnings, and
a declaration by the company’s board of directors.
Dividends may be made in cash, other assets,
or the company’s own stock.
Cash Dividends
Cash dividends, when paid, are usually paid quarterly.
Important dates relating to cash dividends are:
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Declaration date: the date the board of directors formally declares
a dividend;
Ex-dividend date: the date the stock trades without the right to the
latest dividend (about 3 days prior to the record date);
Record date: date on which the list of stockholders who will
receive the latest dividend;
Payment date: date on which dividend checks are issued to
stockholders of record as of the record date (usually 1-2 months
after declaration date).
Distribution of a
Cash Dividend
Dividend
Dividend
declaration
Ex-dividend
Date
Exhibit 12-2
Dividend
Recipients
Record
date
Payment
Preferred Stock
Cash Dividends

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Preferred stocks typically have a fixed dividend, stated as a
dollar amount per share or a percentage of the par value.
The company has no legal obligation to pay a dividend until
declared by the board of directors.
If preferred stock is cumulative, no future common dividends
may be declared until all preferred dividends are paid.
A few preferred stocks have a fixed dividend rate, as well as
share earnings distributions in some manner with common
stockholders. This type of stock is called participating
preferred stock.
Evaluating Cash Dividends

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
Companies that do not pay cash dividends are usually
doing either very well (reinvesting profits to grow) or
very poorly (and can’t afford to pay the dividend).
Dividend payout, equal to dividends as a percentage
of net income, is one measure used over time to
evaluate dividends.
Dividend yield, equal to the annual dividends divided
by the stock’s price per share, is another measure of
importance to investors.
10,000 shares
$50 par
Stock Dividends


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10,000 + 2,000
shares, $50 par
20% stock dividend
Stock dividends are dividends declared on a company’s
common stock payable in shares of the same stock.
Stock dividends are proportional distributions of additional
shares, with no additional resources being received by the
company.
Investors may feel as if they have gotten something, even
though it is only paper and the stockholder has the same
percentage ownership as before the stock dividend.
The stock dividend is recognized by the corporation at the
fair value of the shares issued by reducing retained
earnings and increasing contributed capital.
10,000 shares
$50 par
Stock Splits
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20,000 shares
$25 par
2 for 1 split
A stock split occurs when all of a company’s common
stock is replaced with some multiple of the shares
previously outstanding, with a proportional reduction in par
value of each share.
Stock splits reduce the market and par values such that
the price may be in a better “trading range” for investors.
Stock splits differ from stock dividends because no
reduction in retained earnings is recorded.
After a stock dividend or split, comparative financial
information for periods prior to the split or dividend are
restated for the differing number of shares.
The Statement of
Stockholders’ Equity


Statement
of Stockholders’
Equity
The statement of stockholders’ equity reports all
changes in stockholders’ equity including
contributed capital and retained earnings.
Questions addressed by examining the
Statement of Stockholders’ Equity include:
–
–
How did dividends declared compare with earnings?
To what extent did the claims of different classes of
owners on the company’s assets change during the
period?
Analyzing Stockholders’ Equity


The margin of safety for creditors is evaluated
using the debt-to-equity ratio. In general, the
greater a company’s equity, the greater its ability
to borrow.
A measure related to the safety of preferred
dividends is times preferred dividends earned,
calculated as:
Times Preferred =
Dividends Earned
Net Income
-----------------------------Preferred Dividend
Analyzing Stockholders’ Equity
Return on invested capital is an important indicator of a
company’s profitability. This can be measured several
ways:
Return on Total Assets =
Return on
Owners’ Equity
Net Income / Total Assets
=
Net Income / Owners’ Equity
Return on Net Assets
=
Net Income / Net Assets
Return on
Common Equity
Net Income - Preferred Dividends
= ---------------------------------------------------------Stockholders’ Equity - Preferred Claims
Owners’ Equity for
Unincorporated Businesses
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The owners’ equity in an unincorporated business is reflected
in each owners’ capital account.
The capital account accumulates the owner’s original and
subsequent investments, share of cumulative profits, less any
withdrawals.
In a partnership, profits and losses are shared according to a
partnership agreement, or equally if no agreement exists.
Profits increase owner’s capital, while losses and drawings
(removals of assets for personal use) reduce owner’s capital.
A statement of changes in partners’ capital serves the
purpose of a statement of stockholders’ equity.
Copyright
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