cornerstones

1. cornerstones of Financial Accounting, 3e

2. Chapter 10:Stockholders’ Equity Cornerstones of Financial Accounting, 3e

3. Stockholders’ Equity • Stockholders’ equity, which also is called equity, represents the owners’ claims against the assets of a corporation after all liabilities have been deducted. • The stockholders’ equity section of the balance sheet clearly identifies various elements of equity according to their source. LO-1

4. Stockholders’ Equity (cont.) • The most common sources are: • capital stock—split between (1) preferred and common stock and (2) the associated additional paid-in capital • retained earnings or deficit • accumulated other comprehensive income • treasury stock LO-1

5. Authorization to Issue Stock • Corporations are authorized, or chartered, in accordance with the provisions of state laws that govern the structure and operation of corporations. • These laws differ from state to state and a corporation can charter in any state. • All states require persons who wish to form a corporation to apply to a prescribed state official for the issuance of a charter. LO-1

6. Authorization to Issue Stock (cont.) • The corporate charter, which is sometimes called the articles of incorporation, is a document that authorizes the creation of the corporation, setting forth its name and purpose and the names of the incorporators. LO-1

7. Authorization to Issue Stock (cont.) • The maximum number of shares the business may issue in each class of stock is referred to as authorized shares. • This must be distinguished from the number of issued shares, which is the number of shares actually sold to stockholders. • A corporation rarely issues all of its authorized shares. • Outstanding shares is the number of issued shares actually in the hands of stockholders.

8. Determination of Share Quantities LO-1

9. Common Stock • All classes of stock are designated as either common stock or preferred stock. • These come with different financial benefits and provide different rights regarding the governance of the corporation. • The primary rights for owners of common stock are: • Voting in the election of the board of directors. You will recall that the board controls the operating and financial policies of the company. LO-1

10. Common Stock (cont.) • Sharing in the profits and dividends of the company. • Keeping the same percentage of ownership if new stock is issued (preemptive right). • Sharing in the assets in liquidation in proportion to their holdings. This is referred to as the ‘‘residual claim’’ because common stockholders are only paid after all creditors and preferred stockholders are paid in full (which is very rare in liquidation). LO-1

11. Preferred Stock • Preferred stock generally pays a regular dividend. • Preferred stock is similar to debt, with the preferred stock dividend equating to interest payments. • The value of preferred stock, like the value of debt, is most closely tied to interest rate levels and the company’s overall creditworthiness, while the value of common stock is most closely tied to the performance of the company. LO-1

12. Preferred Stock (cont.) • In this respect, preferred stock is a less risky investment than common stock. • Preferred shareholders also receive priority over common shareholders in the payment of dividends and the distribution of assets in the event of liquidation. LO-1

13. Comparison of Common and Preferred Stock • Most differences between preferred and common stock are designated in the company’s corporate charter and take one or more of the following forms: • Dividend Preferences • Conversion Privileges • Liquidation Preferences • Call Provisions (redeemable) • Denial of voting rights LO-1

14. Accounting for Issuance of Common & Preferred Stock • Par value is an arbitrary monetary amount printed on each share of stock that establishes a minimum price for the stock when issued, but does not determine its market value. • The par value multiplied by the number of shares sold is recorded in an account that describes the type of stock—for example, common stock or preferred stock. LO-2

15. Accounting for Issuance of Common & Preferred Stock (cont.) • The amount received in excess of the par value is recorded in an account called additional paid-in capital. • These accounts are the first accounts shown in the stockholders’ equity section of the balance sheet and taken together are known as capital stock. LO-2

16. Stated Capital and No-Par Stock • Stated capital (legal capital) is the amount of capital that, under law, cannot be returned to the corporation’s owners unless the corporation is liquidated. • Even when state law permits the issuance of no-par stock (stock without a par value), it frequently requires that no-par stocks have a stated (legal) value, set by the corporation, in order to establish the corporation’s stated or legal capital. LO-2

17. Stated Capital and No-Par Stock (cont.) • Stated value, like par value, is recorded separately in the Common (or Preferred) Stock account, while any excess paid over its stated value is recorded in Additional Paid-In Capital—Common (or Preferred) Stock. LO-2

18. Stock Warrants • A stock warrant is the right granted by a corporation to purchase a specified number of shares of its common stock at a stated price and within a stated time period. • Corporations also grant employees and executives the right to buy stock at a set price as compensation for their services. LO-2

19. Options • Corporations also grant employees and executives the right to buy stock at a set price as compensation for their services. • These ‘‘rights’’ are called stock options. • The compensation expense recorded by a company when they grant stock options depends on many factors including the price at which employees can buy the stock (called the exercise or strike price) and the market value of the stock on the date of grant. LO-2

20. Accounting for Distributions to Stockholders • Corporations can distribute cash to stockholders in the following ways: • The corporation can repurchase the shares from owners. • The corporation can pay dividends. • In the past, dividends were the most common method of distributing cash. LO-3

21. Accounting for Distributions to Stockholders (cont.) • Repurchasing shares has become a more frequent method due to its tax advantages. • Dividends, however, have the advantage of allowing shareholders to receive assets from the corporation without reducing their ownership share. LO-3

22. Stock Repurchases (Treasury Stock) • When a corporation purchases its own previously issued stock, the stock is called treasury stock. • Corporations purchase treasury stock for many reasons: • to buy out the ownership of one or more stockholders • to reduce the size of corporate operations • to reduce the number of outstanding shares of stock in an attempt to increase earnings per share and market value per share LO-3

23. Stock Repurchases (Treasury Stock) (cont.) • to be transferred to employees under stock bonus, stock option, or stock purchase plans • to satisfy the terms of a business combination in which the corporation must give a quantity of shares of its stock as part of the acquisition of another business • to reduce vulnerability to an unfriendly takeover LO-3

24. Dividends LO-3

25. Cash Dividends • Cash dividends are by far the most common form of dividend. • There are three important dates related to cash dividends: • Declaration Date • Date of Record • Payment Date LO-3

26. Liquidating Dividends • When retained earnings has been reduced to zero, any additional dividends must come from capital stock. Such dividends are called liquidating dividends and must be charged first against additional paid-in capital, then the common (or preferred) stock accounts. • The payment of liquidating dividends usually accompanies the dissolution of the corporation and is regulated by various laws designed to protect the interests of creditors and other holders of nonresidual equity. LO-3

27. Stock Dividends and Stock Splits • A cash dividend transfers cash from the corporation to its stockholders. • In contrast, a stock dividend transfers shares of stock from the corporation to its stockholders—additional shares of the corporation’s own stock. • The amount of retained earnings capitalized for each new share depends on the size of the stock dividend: LO-3

28. Stock Dividends and Stock Splits (cont.) • Small stock dividends increase the number of outstanding shares by less than 25 percent; they are capitalized using the stock’s market value just before the dividend. • Large stock dividends increase the number of outstanding shares by 25 percent or more and are capitalized at par. • A stock split, like a stock dividend, increases the number of outstanding shares without altering the proportionate ownership of a corporation. LO-3

29. Preferred Dividend Preferences • Preferred dividend preferences can take three forms: • current dividend preference • cumulative dividend preference • participating dividend preference LO-3

30. Retained Earnings and Accumulated Other Comprehensive Income • Retained earnings (or deficit) is the accumulated earnings (or losses) over the entire life of the corporation that have not been paid out in dividends. • Generally, ending retained earnings is calculated with a simple formula as follows: Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings LO-4

31. Accounting for Accumulated Other Comprehensive Income • Financial accounting theory suggests that income represents the changes in the assets and liabilities of the company as a result of transactions with nonowners. • However, over time the FASB has allowed the gains and losses from certain nonowner transactions to bypass the income statement and go directly to stockholders’ equity. • Companies are required to include these gains and losses, along with net income in a measure called comprehensive income. LO-4

32. Equity Analysis • Equity analysis helps stockholders understand: • how the value of their shares of stock will change • how the company will distribute any excess cash to stockholders LO-5

33. Stockholder Profitability Ratios • A primary driver of an increase in stock price is profitability. • Profitability refers to the return that the company earns (in other words, its net income). LO-5

34. Stockholder Profitability Ratios (cont.) • Two common ratios are used to evaluate stockholder profitability: • Return on common equity Return on Common Equity = (Net Income – Preferred Dividends) / Average Common Stockholders’ Equity • Earnings per share (EPS) EPS = (Net Income – Preferred Dividends) / Average Common Shares Outstanding LO-5

35. Stockholder Payout • Stockholders not only experience an increase in wealth through an increasing stock price, but may also receive cash, or a payout, from the company. • The most common stockholder payout ratios relate to dividends. LO-5

36. Stockholder Payout (cont.) • Dividend yield considers the ratio of dividends paid to stock price. Dividend Yield = Dividends per Common Share / Common Stock Price • Another common dividend ratio calculates the proportion of dividends to earnings. Dividend Payout = Common Dividends / Net Income LO-5

37. Stockholder Payout (cont.) • Payouts to stockholders can also take the form of stock repurchases. As such, the stock repurchase payout ratio is: Stock Repurchase Payout = Common Stock Repurchase / Net Income • By using these two ratios, stockholders can easily calculate the total payout: Total Payout = Dividend Payout + Stock Repurchase Payout LO-5

38. Stockholder Payout (cont.) • Alternatively, it can be calculated directly as: Total Payout = Common Dividends + Common Stock Repurchases / Net Income (or Comprehensive Income LO-5