Shareholders' Equity
Chapter 10
Corporations
• A corporation is an entity which is
owned by its shareholders and which
raises equity capital by selling shares
of stock to investors.
Corporations
• Each share of stock represents a
fractional interest in the issuing
company.
Corporations
• Large business firms prefer to
organize as corporations.
Corporations
• A primary advantage of the corporate
form of business organization is the
ability to raise large amounts of cash
by selling stock to many different
individuals and institutions on the
major security exchanges.
Corporations
• Stockholders expect to receive
dividends or to earn capital gains on
their investment.
Corporations
• Dividends are distributions of
corporate assets, usually cash, to
shareholders.
Corporations
• Capital gains (or losses) occur when
the shares of stock increase (or
decrease) in price while investors own
the shares.
Corporations
• Each state has laws governing the
formation of corporations.
Corporations
• The state issues to a new corporation a
charter which lists various items,
among them the businesses’ purpose
and the number and types of shares of
stock the corporation is allowed to
sell.
Corporations
• The most basic type of ownership is
common stock.
Corporations
• Common shareholders are residual
owners of a corporation.
Corporations
• If a business liquidates, then the order
of distribution of assets (if any) is
creditors, preferred shareholders,
common shareholders.
Shareholders' Equity
• Shareholders' equity, or net assets
consists of invested capital and
retained earnings.
Shareholders' Equity
• Invested capital (usually consisting of
par value and paid-in capital) is the
amount received by the corporation
upon the sale of its stock to investors.
Shareholders' Equity
• Retained earnings is the amount of
prior earnings that the firm has not
paid to shareholders in the form of
dividends.
Shares of Stock
• Shares of stock are classified as
authorized, issued, or outstanding.
Shares of Stock
• Authorized shares are the shares that
the firm is permitted to issue
according to its corporate charter.
Shares of Stock
• Issued and outstanding shares are
those presently held by investors.
Shares of Stock
• All issued shares may not necessarily
be outstanding.
Shares of Stock
• The term "issued" means that the
shares of stock have at one time been
sold into the marketplace but does not
necessarily mean that the shares are
currently still in the marketplace.
Shares of Stock
• At times, a business may buy back its
own shares from investors in the
marketplace.
Shares of Stock
• For legal purposes, the shares of most
firms have a par or stated value.
Shares of Stock
• Par value is usually a very small
amount, such as $.25, and bears no
relation whatsoever to the dollar
amount for which the shares are
selling in the marketplace (called the
fair market value).
Transactions Affecting
Shareholders' Equity
• Three basic transactions account for
most of the changes in shareholders'
equity.
Transactions Affecting
Shareholders' Equity
• Sale of stock to investors
• Recognition of net income or loss
• Declaration of cash dividends to
shareholders
Sale of Stock to Investors
• If a corporation sells 100,000 shares of
its $1.00 par value common stock for
$5.00 per share, then cash and
shareholders' equity both increase by
$500,000.
Sale of Stock to Investors
• There is a further subdivision within
shareholders' equity.
Sale of Stock to Investors
• Par value increases by $100,000 while
the remaining $400,000 increases
capital in excess of par value.
Sale of Stock to Investors
ASSETS = LIABILITIES + OWNERS’ EQUITY
Cash
+$700
million
Par value
+$3 million
Additional paid-in
capital
+$697 million
Sale of Stock to Investors
• The corporation may issue stock for
noncash assets, too, such as land or
equipment.
Recognition of Periodic Net
Income or Loss
• Net income (loss) represents an
increase (decrease) in a firm's
shareholders' equity due to its
revenues, expenses, gains, and losses
during the accounting period.
Recognition of Periodic Net
Income or Loss
• Firms prepare statements of retained
earnings which are reconciliations of
the beginning and ending balance in
the retained earnings account.
Recognition of Periodic Net
Income or Loss
• The ending balance reflects the net
income earned by the firm less net loss
incurred and dividends paid over the
entire life of the firm.
Declaration and Payment of
Cash Dividends
• There are three dates which are
important in the declaration and
distribution of cash dividends.
Declaration and Payment of
Cash Dividends
• On the date of declaration, the
dividend becomes a liability.
Declaration and Payment of
Cash Dividends
• Retained Earnings is decreased and
Dividends Payable is increased by the
amount of the dividend.
Declaration and Payment of
Cash Dividends
• Shareholders who own the stock on
the date of record are eligible to
receive the dividend.
Declaration and Payment of
Cash Dividends
• Shareholders who purchase the stock
after the date of record but before the
date of payment buy the stock "ex
dividend," which means "without the
dividend."
Declaration and Payment of
Cash Dividends
• Shareholders who purchase the stock
after the date of record but before the
date of payment buy the stock "ex
dividend," which means "without the
dividend."
Declaration and Payment of
Cash Dividends
• On the date of payment, both the
liability and cash are reduced by the
amount of the dividend.
Date of Declaration of
Dividends
ASSETS = LIABILITIES + OWNERS’ EQUITY
Dividends
payable
+$xxxxx
Retained earnings
–$xxxxx
Date of Payment of
Dividends
ASSETS = LIABILITIES + OWNERS’ EQUITY
Dividends
payable
–$xxxxx
Retained earnings
+$xxxxx
Additional Transactions
• A variety of less frequent occurrences
may affect the amount and
composition of shareholders’ equity.
Stock Dividends
• Stock dividends are dividends issued
to shareholders in the form of shares
of stock, not cash.
Stock Dividends
• A corporation has outstanding 10
million shares of common stock and
decides to issue a 2% stock dividend
when the market price of the stock is
$45 per share.
Stock Dividends
• The firm will issue 200,000 new shares
(10 million shares X 2%), and the total
value of the dividend is $9 million
(200,000 X $45).
Stock Dividends
• Retained Earnings will decrease and
Invested Capital will increase by $9
million.
Stock Dividends
• Invested Capital will be further
subdivided into par value and capital
in excess of par value.
Stock Dividends
• Only the shareholders' equity section
of the accounting equation is affected.
Stock Dividends
• A dollar amount is transferred from
Retained Earnings into Invested
Capital.
Stock Dividends
• Since it is the same dollar amount,
nothing happens to the total of
shareholders' equity because of the
stock dividend.
Stock Dividends
ASSETS = LIABILITIES + OWNERS’ EQUITY
Paid-in capital
+$9 million
Retained earnings
–$9 million
Stock Dividends
• A stock dividend gives nothing of
present value to the investor when he
receives the shares of stock.
Stock Dividends
• However, the investor now has more
shares of stock which can appreciate
in price in the future.
Stock Splits
• Stock splits also increase the number
of outstanding shares but, unlike
dividends, they do not entail a
reduction in retained earnings or an
increase in paid-in capital.
Stock Splits
• The description of the firm's stock is
changed to reflect the new par value
and the number of shares authorized,
issued, and outstanding.
Stock Splits
• If a firm had 500,000 shares of $2.00
par value common stock outstanding
when the market price was $100 per
share, then the following will happen
when the firm declares a 2-for-1 stock
split.
Stock Splits
• The number of shares will double to
1,000,000, the par value will decrease
by half to $1.00, and the market price
will decrease by half to $50 per share.
Stock Splits
• The description of the firm's stock is
changed to reflect the new par value
and the number of shares authorized,
issued, and outstanding.
Stock Splits
• The total of invested capital,
$1,000,000, will be exactly the same
before and after the split.
Stock Splits
• Companies often split their stock
when the market price becomes so
high that small investors cannot afford
to buy the stock.
Stock Splits
• Companies usually do not like that
only large, institutional investors hold
their shares.
Treasury Stock
• If a company buys back its own shares
of stock, the repurchased shares of
stock are called treasury stock.
Treasury Stock
• They have issued but not outstanding
status.
Treasury Stock
• Companies buy back stock for various
reasons.
– To support the stock price.
– To have available shares for employee
stock option plans.
– To take off the market shares which could
be purchased by a hostile buyer.
Treasury Stock
• Wall Street analysts usually view
treasury stock purchases very
favorably and as a sign of strength for
the repurchasing company.
Treasury Stock
• The acquisition of treasury reduces
cash and shareholders' equity, and
treasury stock is a contra-equity
account (subtracted from
shareholders' equity).
Treasury Stock
• Consider the following example of the
acquisition of treasury stock.
Treasury Stock
• A corporation has repurchased
$6,722,000 of its shares.
Treasury Stock
• Cash and shareholders' equity have
both decreased by $6,722,000.
Purchase of Treasury Stock
ASSETS = LIABILITIES + OWNERS’ EQUITY
Cash
Treasury stock
-$6,722,000
–$6,722,000
Treasury Stock
• If the corporation later sells the same
stock for $10 million.
Treasury Stock
• Cash will increase by $10 million;
Treasury Stock will increase by the
original $6,722,000; and Paid-in
Capital will increase by the difference
of $3,278,000.
Sale of Treasury Stock
ASSETS = LIABILITIES + OWNERS’ EQUITY
Cash
Treasury stock
+$10
+$6,722,000
million
Paid-in capital
+$3,278,000
Employee Stock Options
• Stock options are rights to purchase a
firm's stock at a specific price over
some designated future period.
Employee Stock Options
• Stock options are usually granted as
part of the compensation paid to key
executives and other employees.
Employee Stock Options
• There are several benefits of stock
options for employees and firms.
Employee Stock Options
• They usually highly motivate option
holders to improve the performance of
the firm.
Employee Stock Options
• Option holders avoid the downside
risk of loss if the stock price declines.
Employee Stock Options
• Current accounting rules allow firms
to choose between two ways to report
the cost of employee stock options.
Employee Stock Options
• Under the intrinsic value method,
companies do not recognize any
compensation expense associated with
the options.
Employee Stock Options
• In the year in which options are
granted, no compensation expense is
recorded.
Employee Stock Options
• When they are exercised, the company
increases Cash and Invested Capital
for the appropriate dollar amount.
Employee Stock Options
• Under the fair value method,
compensation expense is measured at
the grant date based on the estimated
fair market value of the award.
Exercise of Employee Stock
Option
ASSETS = LIABILITIES + OWNERS’ EQUITY
Cash
Invested Capital
+$10
+$10 million
million
Preferred Stock
• Preferred stock has a priority claim
over common stock with respect to
dividends and in the event of a
liquidation of a company's assets.
Preferred Stock
• Preferred stock may be cumulative
and/or convertible.
Preferred Stock
• Cumulative means that any dividend
not paid to preferred shareholders will
not be forever lost — it will be paid in
a year in which the firm has money to
pay that dividend.
Preferred Stock
• Convertible indicates that preferred
shares may be exchanged for common
shares at the preferred shareholders'
option.
Convertible Debt
• Convertible bonds allow the
bondholder to exchange bonds for a
specified number of shares of stock.
Convertible Debt
• Investors usually view this
convertibility feature very favorably.
Convertible Debt
• Convertible bonds are an example of
hybrid securities which are neither
clearly debt nor clearly equity.
Convertible Debt
• The proper accounting for hybrid
securities is a matter of sharp debate.
Conversion to Common
Stock
ASSETS = LIABILITIES + OWNERS’ EQUITY
Bonds
Payable
-$150 million
Paid-in Capital
+$150 million
Shareholders’ Equity Ratios
• Shareholders’ equity is used
extensively in ratio analysis of
financial statements.
Shareholders’ Equity Ratios
• Four widely employed measures are
used.
Earnings Per Share
• Earnings per share indicates the
portion of company income applicable
to a single share of common stock.
Earnings Per Share
• It is such a highly regarded ratio that
it is the only ratio required to be
reported on the front of a financial
statement (the income statement).
Earnings Per Share
• It is computed by dividing net income
available to common shareholders by
the weighted average number of
common shares outstanding.
Net income available for common shareholders
EPS =
Weighted average number of common shares
Earnings Per Share
• Consider the following example to
compute the weighted average
number of shares.
Earnings Per Share
• A company had outstanding 100,000
shares of stock on January 1.
Earnings Per Share
• On July 1 it issued another 20,000
shares of stock, and on October 1 it
bought back 30,000 shares.
Earnings Per Share
• The weighted average number of
shares is computed as follows:
Jan. 1
July 1
Oct. 1
100,000 x 6/12 = 50,000
120,000 x 3/12 = 30,000
90,000 x 3/12 = 22,500
102,500
Earnings Per Share
• If net income for the above company is
$550,000, then earnings per share is
$5.37 (rounded).
$550,000
Earnings per share =
102,500
 $5.37
Earnings Per Share
• If preferred stock is present in the
capital structure, then its dividend
must be subtracted from net income
before dividing by the weighted
average number of common shares.
Earnings Per Share
• Using the same example, if the annual
preferred dividend is $30,000, then
earnings per share is $5.07 (rounded).
$550,000 - $30,000
Earnings per share =
102,500
$520,000
=
102,500
 $5.07
Financial Leverage Ratio
• The financial leverage, or debt-tototal-assets ratio is computed by
dividing total assets into total
liabilities.
Financial Leverage Ratio
• The financial leverage, or debt-tototal-assets ratio is computed by
dividing total assets into total
liabilities.
Total liabilities
Financial leverage =
Total assets
Financial Leverage Ratio
• This ratio is widely used by analysts
in assessing the risks of debt and
equity securities.
Financial Leverage Ratio
• High financial leverage is associated
with lower bond quality ratings and,
therefore, higher borrowing costs.
Financial Leverage Ratio
• The share prices of highly leveraged
firms tend to be more volatile than the
share prices of firms with lower
financial leverage.
Financial Leverage Ratio
• Just as is true with other ratios, care
must be taken when comparing firms
in different industries.
Market-to-Book-Value Ratio
• The market-to-book-value ratio is
computed by dividing book value per
share into market price per share.
Market price per share
Market to book value ratio =
Book value per share
Market-to-Book-Value Ratio
• Market price measures the economic
value of the stock while book value
reflects the methods used to identify
and measure assets and liabilities.
Price-to-Earnings Ratio
• The price-to-earnings ratio is
computed by dividing earnings per
share into the market price per share.
Price per share
P/ E=
Earnings per share
Price-to-Earnings Ratio
• This ratio is often used to assess
growth, risk and earnings quality.
Price-to-Earnings Ratio
• Earnings quality refers to the
sustainability of currently reported
earnings in future periods.
Price-to-Earnings Ratio
• Firms using conservative methods of
income measurement are more likely
to be viewed as having higher
earnings quality than firms using
more liberal income measurement
methods.
Shareholders' Equity
End of Chapter 10