Horngren Introduction to Financial Accounting 9e ch_10

© 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e © 2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick

Stockholders’ Equity

CHAPTER

10


2 of 31

Learning Objectives

After studying this chapter, you should be able to

1. Describe the rights of shareholders

2. Differentiate among authorized, issued, and outstanding shares

3. Contrast bonds, preferred stock, and common stock

4. Identify the economic characteristics of and accounting for stock splits

5. Account for both large- and small-percentage stock dividends

6. Explain and report stock repurchases and other treasury stock transactions


3 of 31

Learning Objectives

After studying this chapter, you should be able to

7. Record conversion of debt for equity or of preferred stock into common stock

8. Use the rate of return on common equity and book value per share


4 of 31

Background on Stockholders’ Equity

• Corporations are business entities authorized in accordance with state laws

• Stockholders have the right to:

– Vote– Share in corporate profits– Share in any assets left at liquidation– Acquire more shares of subsequent issues of stock

• Stockholders vote to elect the board of directors


5 of 31

Background on Stockholders’ Equity

• A corporate proxy is a written authority granted by shareholders to have another party cast their votes at the annual meeting

• A preemptive right is the right to acquire a proportional amount of any new issue of capital stock

• Stockholders have limited liability

– Creditors have claims only on the assets owned by the corporation

– Stockholders’ personal assets are not at risk


6 of 31

Authorized, Issued, and Outstanding Stock

• The articles of incorporation detail the number of shares and types of capital stock

• Shares can be:– Authorized—the total number of shares that can be

issued– Issued—the number of shares exchanged with

stockholders– Outstanding—the number of shares still held by the

stockholders

• Treasury shares are shares of the corporation’s own stock which have been repurchased


7 of 31

Accounting for Stock Issuance

• Many companies separate their common stock recognition into two categories:

– Par value—a measure of protection of creditors establishing the minimum legal capital liability

– Additional paid-in capital—the amount above par value

• If UPS issues an additional 1 million shares of its $.01 par value stock at $63, the journal entry is:

Cash 63,000,000Common stock at par 10,000

Additional paid-in capital 62,990,000

Cash 63,000,000Common stock at par 10,000

Additional paid-in capital 62,990,000


8 of 31

Cash Dividends

• Dividends are proportional distributions of income to shareholders

• To pay cash dividends a corporation must have:

– Cash– Retained earnings

• Dividends must be declared by the board of directors—they are not automatic


9 of 31

Cash Dividends

• There are three important dates associated with dividends:

– Date of declaration—the date when dividends are announced by the board

– Date of record—stockholders owning stock on this date receive the dividend

– Date of payment—the date the company makes payment


10 of 31

Cash Dividends

• A company declares a $20,000 cash dividend on September 26 to be paid on November 15 to the October 25 stockholders of record. The journal entries are:

Sept. 26 Retained earnings 20,000Dividends payable 20,000

To record the dividend declaration

Sept. 26 Retained earnings 20,000Dividends payable 20,000

To record the dividend declaration

Nov. 15 Dividends payable 20,000Cash 20,000

To record payment of dividends

Nov. 15 Dividends payable 20,000Cash 20,000

To record payment of dividends


11 of 31

Preferred Stock

• Preferred stock offers owners different rights and preferential treatment

– Dividend preference—preference over dividend claims of common stockholders

– Liquidation preference—preference to assets in the event of a liquidation

– Preferred stock does not normally have voting rights


12 of 31

Cumulative Dividends

• Cumulative preferred stock requires that undeclared dividends accumulate and must be paid before common stockholders can receive dividends

• Accumulated unpaid dividends are called dividend arrearages

• Cumulative preferred shares typically pay a lower dividend than noncumulative shares


13 of 31

Preference in Liquidation

• Preferred stock usually has a liquidation value

– The liquidation value (plus any dividends in arrears) must be paid to preferred stockholders before distributions to common stockholders when a company is liquidated

– The liquidation value is often the same as par value

• The company must pay off all debts first

• There is less risk associated with preferred stock than common stock


14 of 31

Other Features of Preferred Stock

• Participating preferred stock receives a fixed dividend but can receive dividends above this amount if the company has a good year

• Callable preferred stock gives the company the right to redeem the stock at a certain call price

• Convertible preferred stock gives the owner the option to exchange the preferred shares for common shares


15 of 31

Comparing Bonds and Preferred Stock

Bonds Preferred Stock

Pays a specific return to investor?

Yes Yes

Taxable to recipient?

Interest: Yes Dividends: Yes

Tax deductible for issuer?

Interest: Yes Dividends: No

Specific maturity date?

Yes No

Level of risk? Less than stock More than bonds


16 of 31

Employee Stock Options

• Stock options are rights to purchase a specific number of shares of a corporation's capital stock at a specific price for a specific time period

• Stock options vest when an employee remains with the company for a specific time period

• Once vested, an employee may exercise options anytime before they expire (usually about 5 years)

• Stock options are used as a form of employee compensation (expense)


17 of 31


• Suppose in 2002 UPS grants options to purchase 30,000 shares of its $.01 par value common stock at $60. The estimated value of each option is $7. The options can be exercised over a 3-year period starting 5 years from the date of grant. The 2002 journal entry is:

Compensation expense, stock options 210,000*Additional paid-in capital 210,000

Compensation expense, stock options 210,000*Additional paid-in capital 210,000

*30,000 x $7 = $210,000*30,000 x $7 = $210,000


18 of 31


• Now suppose executives exercise all options 5 years after the date of grant. The journal entry in 2007 would be:

Cash 1,800,000*Common stock 300**Additional paid-in capital 210,000

Cash 1,800,000*Common stock 300**Additional paid-in capital 210,000

*30,000 x $60 = $1,800,000

**30,000 x $.01 = $300

*30,000 x $60 = $1,800,000

**30,000 x $.01 = $300


19 of 31

Restricted Stock

• Granting restricted stock is like paying employees with common stock instead of cash

– Employees cannot sell the stock until it vests– The stock is generally sold back to the company at

the prevailing market price

• The company records compensation expense and an increase to paid-in capital

• Employees holding restricted stock receive dividends if declared


20 of 31

Stock Splits

• A two-for-one stock split involves issuing an additional share for each share currently owned

• The number of shares outstanding double and the par value decreases by 50%

• Total stockholders’ equity remains unchanged

• The market price should drop 50%

• Companies split their stock in order to make their shares more affordable to small investors


21 of 31

Stock Dividends

• Stock dividends are dividends paid in the corporation’s own shares of common stock

• Stock dividends require the transfer of an amount from retained earnings to paid-in capital

• The measurement of the amount depends upon whether the stock dividend is large or small

– A large stock dividend is one that issues 20% or more additional shares (measured at par value)

– A small stock dividend is one that issues less than 20% additional shares (measured at market value)


22 of 31

Stock Dividends

• The entries below illustrate a 100% stock dividend vs. a 2% stock dividend for a company with 100,000 shares of $10 par value common stock with a market value of $150

Large Stock Dividend (100%) Retained earnings (100,000 x $10) 1,000,000

Common stock 1,000,000

Large Stock Dividend (100%) Retained earnings (100,000 x $10) 1,000,000

Common stock 1,000,000

Small Stock Dividend (2%)Retained earnings (2,000 x $150) 300,000

Common stock (2,000 x $10) 20,000 Additional paid-in capital 280,000

Small Stock Dividend (2%)Retained earnings (2,000 x $150) 300,000

Common stock (2,000 x $10) 20,000 Additional paid-in capital 280,000


23 of 31

Repurchase of Shares

• Companies repurchase shares because they:

– Want to retire the stock– Think the stock is undervalued by the market– Want to change to proportion of debt and equity in the

company– Need shares to distribute in a stock option plan– Want to return cash to shareholders without creating

expectations for permanent increases in dividends

• Repurchased shares also increases EPS


24 of 31

Retirement of Shares

• Suppose Allstar company purchases and retires 5,000 of its outstanding $10 par value shares at $150 for a total of $750,000 cash. Allstar originally issued the shares at $50 per share. The following journal entry reverses the original paid-in capital and charges the additional amount to retained earnings:

Common stock (5,000 x $10) 50,000Additional paid-in capital (5,000 x $40) 200,000 Retained earnings 500,000

Cash (5,000 x $150) 750,000

Common stock (5,000 x $10) 50,000Additional paid-in capital (5,000 x $40) 200,000 Retained earnings 500,000

Cash (5,000 x $150) 750,000


25 of 31

Treasury Stock

• Now suppose Allstar in the previous example decides to temporarily hold the repurchased shares rather than retiring them. The journal entry for the repurchase of the shares is:

• Treasury stock is a contra stockholder equity account—not an asset

Treasury stock (5,000 x $150) 750,000Cash 750,000

Treasury stock (5,000 x $150) 750,000Cash 750,000


26 of 31

Treasury Stock

• The entries below show reissuance of Allstar’s treasury shares at an amount above or below the acquisition cost ($150):

Reissue at $180Cash (5,000 x $180) 900,000

Treasury stock (original cost) 750,000Additional paid-in capital 150,000

Reissue at $180Cash (5,000 x $180) 900,000

Treasury stock (original cost) 750,000Additional paid-in capital 150,000

Reissue at $120Cash (5,000 x $120) 600,000Additional paid-in capital 150,000

Treasury stock (original cost) 750,000

Reissue at $120Cash (5,000 x $120) 600,000Additional paid-in capital 150,000

Treasury stock (original cost) 750,000


27 of 31

Other Issuances of Common Stock

• Common stock is not always issued for cash

• Common stock can also be issued in:

– Noncash exchanges for assets or services– Conversions of convertible bonds or preferred stock– Exchanges for tracking shares


28 of 31

Retained Earnings Restrictions

• State laws or contractual obligations often restrict retained earnings (and assets) for the protection of creditors

• Example: Dividends cannot be paid out to the point that retained earnings is less than the cost of treasury stock

• Companies can disclose restrictions by:

– Footnotes– A line item on the balance sheet called restricted or

appropriated retained earnings


29 of 31

Other Components of Stockholders’ Equity

• Two other elements can appear in stockholders’ equity:

– Accumulated Other Comprehensive Income (Loss), which can arise from:

• Foreign currency translation adjustments• Unrealized investment gains and losses (Chapter

12)• Certain pension liability adjustments

– Deferred Compensation Agreements where there is an obligation to deliver shares in the future


30 of 31

Financial Ratios Related to Stockholders’ Equity

• The rate of return on common equity (ROE) measures a company’s profitability based on the book value of the company

• ROE provides a way to compare profitability across companies or examine trends across time for a given company

ROE = Net income – Preferred dividends Average common equity

ROE = Net income – Preferred dividends Average common equity


31 of 31

Financial Ratios Related to Stockholders’ Equity

• The market value of a stock is usually different from the book value

• Calculating a market-to-book ratio often helps highlight the causes behind the difference in values

• A market value well above the book value may indicate unrecorded or appreciated assets

Book value per share of common stock = Total stockholders’ equity - Book value of preferred stock

Average common equity

Book value per share of common stock = Total stockholders’ equity - Book value of preferred stock

Average common equity

Documents

Horngren Introduction to Financial Accounting 9e ch_10