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Financial Accounting:Tools for Business Decision Making, 3rd Ed. ELS Kimmel, Weygandt, Kieso
Chapter 11 Reporting and Analyzing Stockholders’ Equity After studying Chapter 11, you should be able to: • Identify and discuss the major characteristics of a corporation. • Record the issuance of common stock. • Explain the accounting for purchase of treasury stock. • Differentiate preferred stock from common stock.
Chapter 11 Reporting and Analyzing Stockholders’ Equity After studying Chapter 11, you should be able to: • Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits. • Identify the items that affect retained earnings. • Prepare a comprehensive stockholders' equity section. • Evaluate a corporation's dividend and earnings performance from a stockholder's perspective.
Corporation • Possess legal entity • Created by law • Has most of the rights and privileges of a person • Classified by purpose and ownership • Purpose - profit or nonprofit • Ownership - publicly or privately held
Publicly Held Corporation... May have thousands of stockholders and its stock is regularly traded on national securities markets.
Privately Held Corporation... May have few stockholders and does not offer its stock for sale to general public.
Characteristics of a Corporation • Separate legal existence • Limited liability of stockholders • Transferable ownership rights • Ability to acquire capital • Continuous life • Corporation management • Government regulations • Additional taxes
Separate Legal Existence • Separate and distinct from owners. • Acts under its own name. • May buy, own, sell property; borrow money; enter into legally binding contracts; may sue or be sued; pays its own taxes. • Owners (stockholders) cannot bind corporation unless owners are agents of the corporation.
Limited Liability of Stockholders • Creditors have recourse only to corporate assets to satisfy claims. • Liability of stockholders limited to investment in corporation. • Creditors have no legal claim on personal assets of owners unless fraud has occurred.
Transferable Ownership Rights • Ownership evidenced by shares of stock • Transfer of ownership among stockholders has no effect on corporation’s operating activities or assets, liabilities and total stockholders' equity. • Corporation does not participate in transfer of ownership rights after original sale.
Ability to Acquire Capital Limited liability of stockholders coupled with transferable ownership rights make it easy to raise capital.
Continuous Life • Life of corporation stated in charter - may be perpetual or limited to specific number of years (can be extended). • Corporation is separate legal entity, thus life not affected by withdrawal, death, or incapacity of stockholder.
Forming a Corporation • A corporation can operate in various states (must have a license from each state in which it does business) but can be incorporated in only one state.
Corporation Management • The corporation establishes by-laws upon receipt of its charter from the state of incorporation. • Stockholders manage corporation indirectly through board of directors. • Board of directors • formulates operating policies • selects officers to execute policy and to perform daily management functions.
Additional Taxes • Corporations pay federal and state income taxes. • Stockholders pay taxes on cash dividends. Corporate income is taxed twice.
Stockholder Rights • Once chartered, the corporation sells stock . • If only one class of stock - called common stock. • Ownership rights specified in the articles of incorporation or by-laws. • Proof of stock ownership is a printed or engraved form known as stock certificate.
Stock Certificate Shows... • name of the corporation • stockholder's name • class and special features of the stock • the number of shares owned • the signatures of duly authorized corporate officials.
Questions in Issuing Stock... • How many shares should be authorized for sale? • How should the stock be issued? • At what price should the shares be issued? • What value should be assigned to the stock?
Authorized Stock... Maximum amount of stock a corporation is allowed to sell as authorized by corporate charter. OutstandingStock... Number of shares of issued stock that are being held by stockholders.
Corporations Can Issue Stock... • Directly to investors (typical in privately held corporations). • Indirectly through an investment banking firm (customary with publicly held corporations).
Factors Involved in Setting Price of Stock... • Company's anticipated future earnings • Its expected dividend rate per share • Its current financial position • Current state of the economy • Current state of the securities market
Par Value Stock... • Is capital stock that has been assigned an arbitrary value per share in the corporate charter. • Is usually low because some states levy a tax on the corporation based on par value. • The legal capital per share that must be retained in the business.
No-Par Value Stock... • Capital stock that has not been assigned a value per share in the corporate charter. Stated Value of No-Par Stock • Amount per share assigned by the board of directors to no-par stock. Par Value and Stated Value have NO relationship to market value.
Stockholders’ Equity Section of a Corporation’s Balance Sheet... Two Parts: • Paid-in (contributed) capital • Retained earnings (earned capital).
Paid-in Capital... Amount paid to corporation by stockholders for shares of ownership. Retained Earnings... Earned capital held for future use in the business.
Accounting for Common Stock Issues • The issue of common stock affects only paid-in capital accounts. • When the issuance of common stock for cash is recorded, the par value of the shares is credited to common stock. • The portion of the proceeds above or below par value is recorded in a separate paid-in capital account.
Issuing Stock at Par Hydro-Slide, Inc., issues 1,000 shares of $1 par value of common stock at par for cash. Cash 1,000 Common Stock 1,000
Issuing Stock Above Par If Hydro-Slide, Inc., issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share, the entry is: Cash 5,000 Common Stock 1,000 Paid-in Capital in 4,000 Excess of Par Value
Hydro-Slide, Inc. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock $ 2,000 Paid-in capital in excess of par 4,000 Total paid-in capital $ 6,000 Retained earnings 27,000 Total stockholders' equity $33,000
Mead, Inc. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock,$5par value, 100,000 shares issued and outstanding $ 500,000 Retained Earnings 200,000 Total stockholders’ equity $ 700,000 BEFORE TREASURY STOCK TRANSACTION
Treasury Stock... Is a corporation's own stock • that has been issued • fully paid for • reacquired by the corporation • held in its treasury for future use.
Corporations Acquire Treasury Stock to... • Reissue shares to officers and employees under bonus and stock compensation plans. • Increase trading of company's stock in securities market in hopes of enhancing market value. • Have additional shares available for use in acquisition of other companies. • Reduce number of shares outstanding thereby increasing earnings per share. • Prevent a hostile takeover.
Purchase of Treasury Stock On February 1, 2004, Mead acquires 4,000 shares of its stock at $8 per share. Treasury Stock 32,000 Cash 32,000
Treasury Stock • The Treasury Stock account would increase by the cost of the shares purchased - $32,000. • The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change. • Treasury stock is deducted from total paid-in capital and retained earnings in the stockholders' equity section of the balance sheet.
Mead, Inc. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock,$5par value, 100,000 shares issued and 96,000 outstanding $ 500,000 Retained Earnings 200,000 Total stockholders’ equity 700,000 Less: Treasury Stock 32,000 Total stockholders’ equity $ 668,000 AFTER TREASURY STOCK TRANSACTION
Preferred Stock... Capital stock that has contractual preferences over common stock in certain areas. • Dividends • Assets in the event of liquidation Preferred stockholders do not have voting rights.
Preferred Stock • Assume Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. Cash 120,000 Preferred Stock 100,000 Paid-in Capital in Excess 20,000 of Par Value--Preferred Stock (Preferred stock may have either a par value or no-par value.)
Dividend Preferences • Preferred stockholders have the right to share in the distribution of corporate income before common stockholders. • The first claim to dividends does not guarantee dividends.
Cumulative Dividend... Is a feature of preferred stock entitling the stockholder to receive current and unpaid prior-year dividends before common stockholders receive any dividends.
Dividends in Arrears... • Are preferred dividends that were scheduled to be declared but were not declared during a given period. • Are not a liability. No liability exists until a dividends is declared by board of directors. • Must be disclosed in the notes to the financial statements.
Scientific-Leasing has 5,000 shares of 7%, $100 par value cumulative preferred stock outstanding. The annual dividend is $35,000 (5,000 x $7 per share). Dividends are 2 years in arrears Dividends in Arrears Dividends in arrears ($35,000 x 2 years) $ 70,000 Current-year dividends 35,000 Total preferred dividends $105,000
Liquidation Preference Is a feature that gives preferred stockholders preference to corporate assets in the event of liquidation.
Dividend... • Is a distribution by a corporation to its stockholders on a pro rata basis. • Pro rata means that if you own 10% of the common shares, you will receive 10% of the dividend. • Dividend forms: • cash • property • script (promissory note to pay cash) • stock
Cash Dividend • Is a pro rata distribution of cash to stockholders. • A corporation must have 3 things to pay cash dividends: • Retained earnings • Adequate cash • Declared dividends
Cash Dividend • In many states, payment of dividends from legal capital is illegal. • Payment of dividends from paid-in capital in excess of par is legal in some states. • Payment of dividends from retained earnings is legal in all states. • Companies are frequently constrained by agreements with lenders to pay dividends only from retained earnings.
Entries for Cash Dividends Three dates are important in connection with dividends: • the declaration date • the record date • the payment date