1 chapter 9 stockholders’ equity. 2 learning objective 1 explain the advantages and disadvantages...

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Chapter 9Chapter 9

Stockholders’ EquityStockholders’ Equity

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Learning Objective 1Learning Objective 1

Explain the advantages and disadvantages of Explain the advantages and disadvantages of a corporation.a corporation.

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Characteristics of a CorporationCharacteristics of a Corporation

Separate legal entitySeparate legal entity Continuous life and transferability of ownershipContinuous life and transferability of ownership Limited liability for shareholders—limited to their Limited liability for shareholders—limited to their

investmentinvestment Separation of ownership and managementSeparation of ownership and management Corporations, unlike other businesses, are Corporations, unlike other businesses, are

separate taxable entitiesseparate taxable entities Government regulationGovernment regulation

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Advantages of a CorporationAdvantages of a Corporation

1.1. Can raise more capital than a proprietorship or Can raise more capital than a proprietorship or partnership canpartnership can

2.2. Continuous lifeContinuous life

3.3. Ease of transferring ownershipEase of transferring ownership

4.4. Limited liability of stockholdersLimited liability of stockholders

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Disadvantages of a CorporationDisadvantages of a Corporation

1. Separation of ownership and management1. Separation of ownership and management Tyco CEO allegedly looted the companyTyco CEO allegedly looted the company Enron special purpose entitites [SPE’s] abusesEnron special purpose entitites [SPE’s] abuses

2. Corporate taxation:2. Corporate taxation: Double taxationDouble taxation Franchise taxes to remain incorporatedFranchise taxes to remain incorporated

3. Government regulation:3. Government regulation: State regulationState regulation Federal legislation for public corporationsFederal legislation for public corporations

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Stockholders

Board of Directors

Chairperson of the Board

President

Authority Structure of a Authority Structure of a CorporationCorporation

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Vote

Dividends

Liquidation

Preemption

Stockholders’ RightsStockholders’ Rights

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Stockholders’ EquityStockholders’ Equity

Two main components:Two main components:

1.1. Paid-in capital (contributed capital)Paid-in capital (contributed capital)

2.2. Retained earningsRetained earnings

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Capital StockCapital Stock

Authorized number of shares is limited by Authorized number of shares is limited by corporate chartercorporate charter

Outstanding shares are those which have Outstanding shares are those which have been sold been sold

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Common Stock

Most basic formof capital stock -issued by every

corporation

Preferred Stock

Has several preferences over

common stock

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Par Value Stock

An arbitraryamount assigned

to a share of stock

Does not have par value, but

may havestated value

No-par Stock

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Measure the effect of issuing stock on a Measure the effect of issuing stock on a company’s financial position.company’s financial position.

Common Stock at ParCommon Stock at Par

General Journal

Date Accounts and Explanations PR Debit Credit

Jan 8 Cash (6,200 x $10) 62,000Common Stock 62,000

To record issuance of stock

Suppose IHOP’s common stock has a par value of Suppose IHOP’s common stock has a par value of $10 per share. The company issues 6,200 shares $10 per share. The company issues 6,200 shares of common stock of common stock at parat par. . What is the entry?What is the entry?

©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Common Stock at ParCommon Stock at Par

General Journal


Jul 23 Cash (6,200 x $10) 62,000 Common Stock 62 Paid-in Capital in Excess of Par 61,938To record issuance of stock

Suppose IHOP’s common stock has a par value of Suppose IHOP’s common stock has a par value of $0.01 per share. The company issues 6,200 $0.01 per share. The company issues 6,200 shares of common stock for $10 per share. shares of common stock for $10 per share. What What is the entry?is the entry?


Common Stock Above ParCommon Stock Above Par

Common Stock, $.01 par; 40,000 shares authorized, 6,200 shares issued $ 62Paid-in capital in excess of par 61,938Total paid-in capital $ 62,000Retained earnings 194,000Total stockholders’ equity $256,000

Stockholders’ Equity


Common Stock at ParCommon Stock at ParSuppose IHOP’s common stock is no par value Suppose IHOP’s common stock is no par value

stock. The company issues 6,200 shares of stock. The company issues 6,200 shares of common stock for $20 per share. common stock for $20 per share. What is the What is the entry?entry?

General Journal


Jul 23 Cash (6,200 x $10) 124,000 Common Stock 124,000To record issuance of stock


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Preferred StockPreferred Stock

Accounting for preferred stock follows the Accounting for preferred stock follows the pattern illustrated for common stock.pattern illustrated for common stock.

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Describe how treasury stock transactions Describe how treasury stock transactions affect a company.affect a company.

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Treasury Stock TransactionsTreasury Stock Transactions

Shares that a company has issued and later Shares that a company has issued and later reacquired.reacquired.

Reasons Reasons – Stock purchase (options) plan distributionStock purchase (options) plan distribution– Increase net assets by later selling stock again Increase net assets by later selling stock again

at a higher priceat a higher price– Avoidance of a takeover by precluding a hostile Avoidance of a takeover by precluding a hostile

outside controlling interestoutside controlling interest

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IHOP Corp. Before PurchaseIHOP Corp. Before Purchaseof Treasury Stockof Treasury Stock

Common Stock $ 203Paid-in capital in excess of par 69,655Retained earnings 193,632Total equity $263,490

Stockholder’s Equity at December 31, 2005(if no treasury stock purchased)

IHOP Corp. PurchaseIHOP Corp. Purchaseof Treasury Stockof Treasury Stock

During 2005, IHOP paid $5,170 to purchase 288 During 2005, IHOP paid $5,170 to purchase 288 shares of its common stock as treasury stock.shares of its common stock as treasury stock.

General Journal


Nov 1 Treasury Stock 5,170 Cash 5,170Purchased treasury stock


IHOP Corp. After PurchaseIHOP Corp. After Purchaseof Treasury Stockof Treasury Stock

Common Stock $ 203Paid-in capital in excess of par 69,655Retained earnings 193,632Less: Treasury stock (288 shares at cost) (5,170)Total equity $258,320

Stockholder’s Equity at December 31, 2005(with treasury stock purchased)


Sale of Treasury StockSale of Treasury Stock

Assume that on July 22, 2006, the shares of treasury Assume that on July 22, 2006, the shares of treasury stock are sold for $5,300.stock are sold for $5,300.

General Journal


Jul 22 Cash 5,300Treasury Stock 5,170Paid-in Capital from Treasury Stock Transactions 130

Sold treasury stock


IHOP Corp. After Sale of IHOP Corp. After Sale of Treasury StockTreasury Stock

Common Stock $ 203Paid-in capital in excess of par 69,785Retained earnings 193,632Total equity $263,620Equity before purchase of treasury stocks 263,490Increase in stockholders’ equity $ 130

Stockholder’s Equity at December 31, 2006


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A Company Cannot Have a Gain or A Company Cannot Have a Gain or Profit in Dealing in it’s Own Capital Profit in Dealing in it’s Own Capital

StockStock

Note the credit for proceeds above cost of Note the credit for proceeds above cost of the treasury stock sold was additional paid the treasury stock sold was additional paid in capitalin capital

Not a gain or profitNot a gain or profit

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Retirement of StockRetirement of Stock

Decreases the outstanding stock of the Decreases the outstanding stock of the corporationcorporation

Retired shares cannot be reissuedRetired shares cannot be reissued There is no gain or loss on retirementThere is no gain or loss on retirement

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Retained Earnings AccountRetained Earnings Account

Balance = Balance =

Net income lessNet income less

-Net losses-Net losses

-Dividends declared-Dividends declared

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Dividends and SplitsDividends and Splits

DDividendividend - corporation’s return to its - corporation’s return to its stockholders of some of the benefits of stockholders of some of the benefits of earningsearnings

Stock splitStock split - - increase in the number of increase in the number of authorized, issued, and outstanding shares; authorized, issued, and outstanding shares; decrease in par valuedecrease in par value

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Dividend DatesDividend Dates

Declaration date: Declaration date: – board authorizes dividendboard authorizes dividend– Once declared, dividend becomes a legal Once declared, dividend becomes a legal

liabilityliability Date of record: Date of record:

– A stock goes “ex-dividend” on this date, i.e…A stock goes “ex-dividend” on this date, i.e…– Secondary market purchaser does not get the Secondary market purchaser does not get the

declared dividend after this date declared dividend after this date Payment datePayment date

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Account for dividends and measure their Account for dividends and measure their impact on a company.impact on a company.

Preferred Stock DividendsPreferred Stock DividendsPinecraft Industries, Inc., has both common stock and 100,000 shares of Pinecraft Industries, Inc., has both common stock and 100,000 shares of

preferred stock outstanding. Preferred dividends are paid at the annual preferred stock outstanding. Preferred dividends are paid at the annual rate of $1.50 per share. In 20x9, the company declares an annual rate of $1.50 per share. In 20x9, the company declares an annual dividend of $1,000,000.dividend of $1,000,000.

Preferred dividend (100,000 × $1.50 per share) $150,000 Common dividend (remainder: $1,000,000 – $150,000) 850,000 Total dividend $1,000,000


Preferred Stock DividendsPreferred Stock Dividends

The preferred stock of Pinecraft is cumulative. Suppose the The preferred stock of Pinecraft is cumulative. Suppose the company passed the 20x6 preferred dividend of $150,000. company passed the 20x6 preferred dividend of $150,000. In 20x7, the company declares a $500,000 dividend. In 20x7, the company declares a $500,000 dividend.

General Journal


Retained Earnings 500,000Dividends Payable-Preferred 300,000*Dividends Payable-Common 200,000

Declared a cash dividend

*$150,000 x 2 years


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Stock DividendsStock Dividends

Small stock dividends: 25% or lessSmall stock dividends: 25% or less Large stock dividends: above 25%Large stock dividends: above 25%

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Stock DividendStock Dividend

IHOP declared a 10% stock dividend in 2006. IHOP declared a 10% stock dividend in 2006. Assume IHOP had 20,000,000 shares of Assume IHOP had 20,000,000 shares of common stock outstanding. The stock is common stock outstanding. The stock is trading for $15 per share. trading for $15 per share. How would this How would this stock dividend be recorded?stock dividend be recorded?

Stock DividendStock Dividend

For a large stock dividend, debit Retained Earnings andcredit Common Stock for the par value of the shares.

General Journal In thousands


Retained Earnings(20,000,000 X 10% X $15 mkt value) 30,000

Common Stock (20,000,000 X 10% X $0.01) 20

Paid-in Capital in Excess of ParCommon 29,980

Distributed a 10% stock dividend


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Stock SplitsStock Splits

Increases number of authorized, issued, and Increases number of authorized, issued, and outstanding shares of stockoutstanding shares of stock

Proportionate reduction in stock’s par valueProportionate reduction in stock’s par value Decrease of market price is the usual Decrease of market price is the usual

motivation for a stock splitmotivation for a stock split Stockholder receiving has more shares, but Stockholder receiving has more shares, but

the total shares would be worth no more in the total shares would be worth no more in the market than before the split, ceteris the market than before the split, ceteris paribusparibus

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Stock SplitsStock Splits

The market price of a share of Quaker Oats has The market price of a share of Quaker Oats has been approximately $25. Assume that the been approximately $25. Assume that the company wants to decrease it to $12.50. This 2-company wants to decrease it to $12.50. This 2-for-1 split means that the company would have for-1 split means that the company would have twice as many shares outstanding after the split as twice as many shares outstanding after the split as is had before the split.is had before the split.

No accounting entries are made, except:No accounting entries are made, except:– Par value is changedPar value is changed– Number of shares authorized changesNumber of shares authorized changes– Number of issued shares changesNumber of issued shares changes– (Total stockholder’s equity does not change)(Total stockholder’s equity does not change)

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Use different stock values in decision making.Use different stock values in decision making.

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Stock ValuesStock Values

Market value: most relevant measureMarket value: most relevant measure Redemption value: Redemption value:

– amount issuer must pay to retire the preferred shares, if amount issuer must pay to retire the preferred shares, if redeemableredeemable

– Are redeemable preferreds, in substance, debt or Are redeemable preferreds, in substance, debt or equity?equity?

Liquidation value: what must be paid a preferred Liquidation value: what must be paid a preferred holder in liquidation, if adequate cash is available holder in liquidation, if adequate cash is available after creditors paidafter creditors paid

Book valueBook value

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Book Value Per ShareBook Value Per Share

Preferred stock equity = Preferred stock equity = (Redemption value (Redemption value + Any + Any DividendsDividends in arrears) in arrears)

Common stock = Common stock =

(Total stockholders’ equity (Total stockholders’ equity –– Preferred equity) ÷ Number of Preferred equity) ÷ Number of shares of common stock outstandingshares of common stock outstanding

Book ValueBook Value

Preferred stock, 6%, $100 par, 5,000 shares authorized, 400 shares issued, redemption value $130 per share $ 40,000Additional paid-in capital in excess of par –

preferred 4,000Common stock, $10 par, 20,000 shares

authorized, 5,500 shares issued 55,000Additional paid-in capital in excess of par –

common [note separated from P.S. addtl cap.] 72,000Retained earnings 85,000Treasury stock – common, 500 shares at cost ( 15,000)Total stockholders’ equity $241,000

Stockholders’ Equity


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Book ValueBook Value

Suppose that four years’ (including the current Suppose that four years’ (including the current year) cumulative preferred dividends are in year) cumulative preferred dividends are in arrears and that preferred stock has a arrears and that preferred stock has a redemption value of $130 per share.redemption value of $130 per share.

Book ValueBook ValuePreferred equity:Redemption value (400 shares × 130) $ 52,000Cumulative dividends ($40,000 × $0.06 × 4 yrs) 9,600Preferred equity $ 61,600

Common equity:Total stockholders’ equity $241,000Less preferred equity – 61,600Common equity $179,400Book value per share: $179,400 ÷ 5,000 shares* $ 35.88

*5,500 shares issued minus 500 treasury shares


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Evaluate a company’s return on assets and Evaluate a company’s return on assets and return on stockholders’ equity.return on stockholders’ equity.

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Rate of Return on Total AssetsRate of Return on Total Assets

(Net income + Interest expense)÷ Average total assets

Measure of a company’s ability togenerate profits from the use of its assets.

(10% or more is considered strong)

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Return on EquityReturn on Equity

Rate of return on common stockholders’ equity= (Net income – Preferred dividends)

÷ Average common stockholders’ equity

Measure of income earned from common stockholders’ investment in the company.

(15% or more is strong)

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Report stockholders’ equity transactions on Report stockholders’ equity transactions on the statement of cash flows.the statement of cash flows.

Reporting Stockholders’Reporting Stockholders’Equity TransactionsEquity Transactions

Proceeds from issuance of common stock $172,000Purchase of treasury stock (5,170,000)Net cash used by financing activities $(4,998,000)

During 2003, IHOP issued stock,repurchased stock, but paid no dividends.

Cash flows from financing activities:


1 chapter 9 stockholders’ equity. 2 learning objective 1 explain the advantages and disadvantages...

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shares of common stock

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parsuppose ihops common

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