Equity Securities

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. . . . Chapter 18--Learning Objectives. 1.Record the issuance of capital stock . . . . . Equity. The residual(or owners')interest in enterprise assetsafter deducting its liabilities. Equity = Assets - Liabilities. Major Components of Equity. Contributed (Paid in) capitalFocus of this chapterA

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Equity Securities

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1. Equity Securities Chapter 18

2. Chapter 18--Learning Objectives 1. Record the issuance of capital stock

3. Equity The residual (or owners’) interest in enterprise assets after deducting its liabilities

4. Major Components of Equity Contributed (Paid in) capital Focus of this chapter Accumulated other comprehensive income Retained earnings Focus of next chapter Treasury stock Also in next chapter

5. Contributed Capital Legal capital Additional paid in capital

6. Legal Capital Par or stated value Issued stock Stock that is subscribed for Stock dividends distributable No par stock Legal capital = issue price

7. Additional Paid in Capital in excess of par Shares issued Subscribed for Stock dividends distributable From Defaulting subscribers Treasury stock (gains) Reacquiring stock Stock options

8. Other Items in SE Minority interest FASB proposal Accumulated other comprehensive income Unrealized gains & losses Translation adjustments Unrealized losses on pension plan assets

9. Classes of Stock Common Stock Preferred Stock

10. Common Stock Characteristics Limited Liability Contingent Liability for Discount Basic Rights participate ratably in management Vote participate ratably in earnings Dividend participate ratably in liquidation preemptive right

11. Stock Transactions Issuance - This chapter Cash On subscription basis Retire stock - Next chapter Treasury stock - Next chapter

12. Issuing Stock for Cash Record sources of capital, e.g., Common stock Preferred stock Separate: Legal capital Additional paid-in capital Why the separation? Legal capital cannot be impaired

13. Example Quincy Corp. began operations 1/1/x1 Charter authorizes 500,000 shares, $10 par common stock 100,000 shares, $50, 5% preferred stock

14. 200,000 shares CS issued for Cash @ $19

15. 50,000 shares PS issued for Cash @ $69

16. 1,000 sh CS & 1,600 sh PS issued for Cash, $120,000

17. Market Values CS = 1,000 @ 22 PS = 1,600 @ 65

18. Total Paid in Capital = $120,000

19. Issue costs include items such as: Fees for underwriters--organizations who perform the administrative functions involved in selling or issuing stock Legal fees Registration fees with the Securities and Exchange Commission (SEC) Printing costs

20. Accounting for Issue Costs Deduct issue costs from the proceeds of the stock sale and record the net proceeds as contributed capital Expense immaterial issue costs in the period the stock is issued Record as organization costs

21. Chapter 18--Learning Objectives 2. Interpret the features of different types of preferred stock

22. What is “preferred” about preferred stock ? Preferred stock usually has preferential treatment in dividend distributions in case of liquidation But preferred stock usually has no voting rights And dividends are typically limited to the stated dividend rate

23. Preferred Stock Contractual dividend preferences First in line Cumulative Participating

24. Preferred Stock Callable Redeemable Convertible

25. Convertible Preferred Stock Preferred shares may be converted to (exchanged for) common shares Usually sells at a higher price than preferred stock without the conversion feature

26. Accounting for Convertible Preferred Stock At issuance, assign no value to the conversion right Upon conversion, the common stock issued is valued at the book value of the preferred shares exchanged i.e., no gain or loss on conversion If cash is received in a conversion, increase contributed capital

27. Callable Preferred Stock The corporation may “call” the stock to retire it This is usually done at a specified price after some specified date The stockholders must turn in or redeem their shares if they are called

28. Redeemable Preferred Stock is Similar, but Different Redeemable stock must be redeemed by the shareholders and retired by the corporation at a prespecified date and price Under GAAP redeemable preferred stock may be classified as equity But the SEC requires that it not be included in equity

29. Chapter 18--Learning Objectives 3. Evaluate and record transactions for other equity securities and adjustments, such as those for options, warrants, and stock subscriptions

30. Rights, Options & Warrants? Entitle holder to Buy a specified number of shares of stock Over a specified time period For a specified price Option price Strike price

31. Stock Options/Warrants Issued to existing shareholders Attached to other securities Bonds Preferred stock Stock-based compensation

32. Options Issued to Existing Stockholders Enables stockholders to exercise their preemptive right Accounting treatment At issuance No cash is received No journal entry is made Upon exercise Treat as stock issued for cash

33. Example Assume the following stockholders’ equity Common Stock, $10 par $2,000,000 PIC>Par-CS 6,000,000 Retained Earnings 1,600,000 Total Equity $9,600,000

34. Plan to issue 100,000 shares of Common Stock Issue options to existing stockholders to buy the common stock at $25 per share

35. When the Options are issued The corporation has an obligation to honor these rights But, no cash is received Therefore, no journal entry is made

36. 80,000 Options are Exercised Effect on stockholders’ equity? Cash received upon exercise? 80,000 x 25 $2,000,000 Increase in contributed capital $2,000,000

37. The Rest of the Options Lapse Effect on Stockholders’ Equity?

38. Preferred Stock with Options Attached A lump sum issuance of two securities Must allocate issued price between the preferred stock and the options Use relative fair values, if available If the options are exercised, add the basis of the options to the paid-in capital of the stock that is issued If they lapse, report paid-in capital from expired options

39. Same Example - New Assumptions Issued 10,000 shares of $100 par value preferred stock for $1,150,000 Each share has a detachable option to buy one share of common stock for $25 Preferred stock without options is selling for $112/share The fair value of the options is not readily determinable

40. Allocation between Options and PS Issue price $1,150,000 Total to preferred stock 10,000 x 112 1,120,000 Balance to options $ 30,000

41. 8,000 Options are Exercised Effect of stockholders’ equity? Cash received 8,000 x 25 $ 200,000 Increase in contributed capital $200,000

42. Contributed Capital per share Exercise price PIC - Options/share Contributed capital/share $ 25 3 $ 28

43. The Rest of the Options Lapse Effect on Individual SE Accounts? PIC Options At issuance of options $30,000 Transferred to CS (24,000) Balance $ 6,000

44. Stock-based Compensation Employee stock options SARs - Stock appreciation rights

45. Accounting for Employee Stock Options Two GAAP approaches: Fair value method - SFAS No. 123 Intrinsic value method - APB No. 25 Both approaches Determine total compensation Allocate total compensation to benefit period

46. Intrinsic Method - Total Compensation Number of shares multiplied by The excess of Market price on the measurement date over the option price If no excess Compensation is zero

47. Measurement Date The first date when the following is known: The option price The number of shares the employee is entitled to receive

48. Measurement Date Usually the grant date May be the exercise date May be some other date, contingent upon the occurrence of an event.

49. If Measurement Date = Grant Date Total compensation is known with certainty Allocation is like straight-line depreciation

50. If Measurement Date is in the future Estimate total compensation each year based on year end information Spread the remaining compensation over the remaining service period, straight-line. That is, the procedure is an annual change in estimate, handled prospectively

51. Service Period May be given If not, use period between the grant date and the beginning of the exercise period If immediately exercisable Expense total compensation immediately

52. Stock Option Example Stockholders’ Equity Common Stock, $10 par $2,000,000 PIC>Par-CS 6,000,000 Retained Earnings 1,600,000 Total Equity $9,600,000

53. Stock Options Granted to - 5 top Executives 1/1/x1 Each granted options To buy 1,000 shares of common stock @ $20 per share Exercisable on 1/1/x2 Exercise period ends 12/31/x3

54. The Measurement Date is? 1/1/x1 - The grant date Why? Know Number of shares: 1,000 per employee Option price - $20

55. Intrinsic Value Method Market price = $18 Total compensation? None Why? MP < Option Price

56. When the Options are Exercised Cash Received? $20 x 5 x 1,000 $100,000 Par Value? $10 x 5 x 1,000 50,000 PIC > Par $ 50,000

57. New Assumption 1/1/x1 Market Price = $27

58. Total Compensation? 5 x 1,000 x (27 - 20) = $35,000

59. Compensation Expense Expense each year? 35,000 / 2 = $17,500

60. When the Options are Exercised Cash Received? $20 x 5 x 1,000 $100,000 PIC - Options 35,000 Par Value? $10 x 5 x 1,000 ( 50,000) PIC > Par $ 85,000

61. New Assumption One executive quits in year x2 Forfeits options

62. Total Compensation Was? (27 - 20) x 5 x 1,000 = $35,000 Is? (27 - 20) x 4 x 1,000 = $28,000 Treat as change in estimate

63. Compensation Exp - year x2 Total compensation Amount expensed - year x1 Compensation exp. - year x2 $ 28,000 17,500 $ 10,500

64. Fair Value Method Total compensation is computed based on an option pricing model It is possible to have zero compensation under the intrinsic method and compensation expense under the fair value method

65. New Assumption 1/1/x1 Fair value of an option = $12 Total compensation: 12 x 5 x 1,000 = $60,000

66. Compensation Expense Expense each year? 60,000 / 2 = $30,000

67. SAR - Stock Appreciation Rights Employee receives appreciation above a predetermined amount, usually in cash. Hence, a liability is reported in the balance sheet for the annual accrual

68. New Assumptions Top 5 executives 1/1/x1 Each executive is granted 1,000 options To receive the difference Between the market price per share at the date of exercise and $10 Exercisable on 1/1/x4 Exercise period ends 12/31/x5

69. The Measurement Date is? The date of exercise Why? At grant date, only know # of Options - 1,000 per employee But amount due = ? - $10

70. 12/31/x1 - Total Compensation? MP of Stock, $13 Your Estimate? (13 - 10) x 5 x 1,000 $ 15,000

71. Compensation Expense - year x1 Total compensation Service period Expense 15,000 3 years 5,000

72. 12/31/x2 - Total Compensation? MP of Stock, $16 Your Estimate? (16 - 10) x 5 x 1,000 $ 30,000

73. Expense - year x2 Total compensation Proportion of service period Cumulative expense Already recognized Expense 30,000 2/3 20,000 5,000 15,000

74. 12/31/x3 - Total Compensation? MP of Stock, $14.50 Your Estimate? (14.50 - 10) x 5 x 1,000 $ 22,500

75. Expense - year x3 Total compensation Proportion of service period Cumulative expense Already recognized Expense 22,500 100 % 22,500 20,000 2,500

76. 1/1/4 - Rights are Exercised Market Price $ 15.50 Total Compensation? (15 - 10) x 5 x 1,000 $ 27,500

77. Expense - 19x4 Total compensation Already recognized Expense 27,500 22,500 5,000

78. Stock Subscriptions

79. Stock Subscriptions

82. 2,000 shares CS Subscribed at $21/share - 25% paid down

90. Defaults on Subscriptions Action taken depends on contract Possibilities Cash is returned to subscriber Subscriber forfeits cash paid in Subscriber receives stock for cash paid in Subscriber guarantees subscription price

91. Cash is Returned to Subscriber Eliminate Receivable CS Subscribed PIC > Par Difference = Cash paid in Cr. Cash

92. Example: Default - 100 Shares - Deposit Returned Subscription price 100 x 21 2,100 Down payment 25% x 2,100 525 Receivable 1,575 CS Subscribed 100 x 10 1,000 PIC > Par - CS 1,100

93. Journal Entry CS Subscribed 1,000 PIC > Par - CS 1,100 CS Sub Rec 1,575 Cash 525

94. Subscriber forfeits Cash Eliminate Receivable CS Subscribed PIC > Par Difference = Cash paid in Cr. PIC - Default

95. Example: Default - 100 Shares - Deposit Forfeited Subscription Price 100 x 21 2,100 Down Payment 25% x 2,100 525 Receivable 1,575 CS Subscribed 100 x 10 1,000 PIC > Par - CS 1,100

96. Journal Entry CS Subscribed 1,000 PIC > Par - CS 1,100 CS Sub Rec 1,575 PIC > Default 525

97. Issue Stock to Subscriber Equal to Amount Paid in Eliminate Receivable CS Subscribed PIC > Par Difference = Cash paid in Cr. CS Cr. PIC > Par

98. Subscriber Guarantees Subscription Price Two Scenarios Stock issue price >= subscription price Stock issue price < subscription price

99. Stock Issue Price >= Subscription Price Return cash paid in to subscriber Eliminate Receivable CS Subscribed PIC > Par Difference = Cash paid in Cr. Cash Record the issuance of new shares

100. Stock Issue Price < Subscription Price Keep the shortage Debit Cash received at issuance Eliminate Receivable CS Subscribed Credit CS for shares issued Don’t eliminate PIC > Par Difference = Cash to subscriber Cr. Cash

101. Default - 100 Shares Subscription Price Guaranteed Stock issued at $20 2,000 Subscription price 100 x 21 2,100 Loss to subscriber 100 Down payment 25% x 2,100 525 Due to subscriber 425

102. Total PIC Received - 100 Sh Issue price 2,000 Subscriber loss 100 Total PIC 2,100 Par value 1,000 PIC > Par 1,100 No need to eliminate PIC > Par

103. Journal Entry CS Subscribed 1,000 Cash 2,000 CS Sub Rec 1,575 Cash 425 CS 1,000

104. Rest of Subscribers Paid Stock was Issued No. of shares subscribed for 2,000 No. of shares defaulted on 300 No. of shares issued to subscribers 1,700 Subscription price/share x 21 Total subscription 35,700 Down payment @25% 8,925 Balance received 26,775

105. Journal Entry Cash 26,775 CS Sub Rec 26,775 CS Subscribed 17,000 CS 17,000

106. Chapter 18--Learning Objectives 4. Interpret supplemental disclosures related to equity

107. Required Disclosure Notes Describe all sources of equity Describe each class of stock, e.g. Type of stock Number of shares authorized & issued dividend preferences Potential equity sources such as stock options, warrants, subscriptions and convertible securities

108. Chapter 18--Learning Objectives 5. Prepare and analyze key solvency and profitability ratios that use equity information

109. Two popular measures of profitability based on equity are Earnings per share and Return on equity

110. Earnings Per Share In its simplest form is Net income No. of shares Potential complications are: 1. Changes in the number of shares 2. Existence of preferred stock 3. Other securities that could change the number of shares

111. Return on equity Potential complications are: 1. Changes in equity during the period 2. Existence of preferred stock 3. Non-routine items affecting income

112. Changes in equity during the period are dealt with by using average equity ( usually [ beginning + ending ] / 2 ) whenever possible

113. Preferred Stock An alternative calculation of return on equity deletes preferred stock and focuses only on common stockholders’ equity

114. Non-routine Items Affecting Income Are dealt with by some analysts by calculating income from continuing operations rather than net income

115. What about market value ? Return on equity is based on book value amounts A widely used indicator of profitability relative to the market price is the price-earnings ( P / E ) ratio

116. The price / earnings ratio is simply Market price of stock Earnings per share

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