9b-1 © 2001 prentice hall business publishing financial accounting, 4/e harrison and horngren...

9B-1© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CHAPTER 9

Measuring and Reporting Stockholders’ Equity

PART B

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren 9B-2

• A corporation may purchase its own stock and retire it by canceling the stock certificates

• Retired stock cannot be reissued

RETIREMENT OF STOCK

StockStock


• Retiring stock decreases the corporation’s outstanding stock and decreases the number of shares issued

• In retiring stock, the corporation removes the balances from all paid-in capital accounts related to the retired shares

RETIREMENT OF STOCK


RETAINED EARNINGS AND DIVIDENDS

• The Retained Earnings account carries the balance of the business’s net income less its net losses and less any declared dividends accumulated over the corporation's lifetime

• The Retained Earnings account is notnot a reservoir of cash waiting for the board of directors to pay dividends to the stockholders


• A retained earnings deficit arises when a corporation’s lifetime losses and dividends exceed its lifetime earnings

• The deficit is subtracted from the sum of the other equity accounts to determine total stockholders’ equity



• A dividend is a corporation’s return to its stockholders of some of the benefits of earnings, most commonly in the form of cash payments

• Three relevant dates for dividends are– Declaration date

• The board of directors announces the intention to pay the dividend

• The declaration creates a liability for the corporation



– Date of record• As part of the declaration, the corporation

announces the record date, which determines who receives the dividends

• The corporation makes no journal entry on the date of record because no transaction occurs

– Payment date• Payment of the dividend usually follows the

record date by two to four weeks



Dividends on Preferred and Common StockDividends on Preferred and Common Stock

Declaration of a $50,000 cash dividend is recorded by debiting Retained Earnings and crediting Dividends Payable, as follows:

Declaration of a $50,000 cash dividend is recorded by debiting Retained Earnings and crediting Dividends Payable, as follows:

June 19 Retained Earnings 50,000

Dividends Payable 50,000

To declare a cash dividend

June 19 Retained Earnings 50,000

Dividends Payable 50,000



Dividends on Preferred and Common StockDividends on Preferred and Common Stock

Payment of the dividend is recorded by debiting Dividends Payable and crediting Cash:

Payment of the dividend is recorded by debiting Dividends Payable and crediting Cash:

July 2 Dividends Payable 50,000

Cash 50,000

To pay a cash dividend

July 2 Dividends Payable 50,000

Cash 50,000

To pay a cash dividend


• Dividends on preferred stock are paid first– When a company has issued both

preferred and common stock, the preferred stockholders receive their dividends first

– The common stockholders receive dividends only if the total declared dividend is large enough to pay the preferred stockholders first



Pine Industries, Inc., has both common stock and 90,000 shares of preferred stock outstanding. Preferred dividends are paid at the annual rate of $1.75 per share. Assume that in 2001, Pine Industries declares an annual dividend of $1,500,000. The allocation to preferred and common stockholders is as follows:

Preferred dividend (90,000 x $1.75 per share) 157,500

Common dividend (remainder: $1,500,000 - $157,500) 1,342,500

Total dividend $1,500,000

Preferred dividend (90,000 x $1.75 per share) 157,500

Common dividend (remainder: $1,500,000 - $157,500) 1,342,500

Total dividend $1,500,000



• Differences between preferred stock and common stock– To an investor, preferred stock is safer

because it receives dividends first– The earnings potential from an investment in

common stock is much greater than the earnings potential of an investment in preferred stock

– There is no upper limit on the amount of common dividends



• The different ways to express the dividend rate on preferred stock are– Percentage rate

• “6% preferred” means that owners of the preferred stock receive an annual dividend of 6% of the stock’s par value

– Dollar amount• “$3 preferred” means that stockholders receive an

annual dividend of $3 per share regardless of the preferred stock’s par value



• Dividends on cumulative and noncumulative preferred stock– The owners of cumulative preferred stock

must receive all dividends in arrears plus the current year’s dividend before the corporation can pay dividends to the common stockholders



– The law considers preferred stock cumulative unless it is specifically labeled as noncumulative

– Dividends in arrears (passing the dividend) occurs when a corporation fails to pay a dividend to preferred stockholders

• If the preferred stock is noncumulative, the corporation is not obligated to pay dividends in arrears



• Having dividends in arrears on cumulative preferred stock is not a liability to the corporation

• A corporation must report cumulative preferred dividends in arrears in a note to the financial statements


arrearsarrears


Dividends on Cumulative and Noncumulative Preferred Stock

Dividends on Cumulative and Noncumulative Preferred Stock

Suppose Pine Industries passed the 2001 preferred dividend of $157,500. Before paying dividends to its common stockholders in 2002, the company must first pay preferred dividends of $157,500 for both 2001 and 2002, a total of $315,000. If the company declares a $500,000 dividend in 2002, the entry to record the declaration is as follows:

Suppose Pine Industries passed the 2001 preferred dividend of $157,500. Before paying dividends to its common stockholders in 2002, the company must first pay preferred dividends of $157,500 for both 2001 and 2002, a total of $315,000. If the company declares a $500,000 dividend in 2002, the entry to record the declaration is as follows:

Sep. 6 Retained Earnings 500,000

Dividends Payable, Preferred ($157,500 x 2) 315,000

Dividends Payable, Common ($500,000 - $315,000) 185,000


Sep. 6 Retained Earnings 500,000

Dividends Payable, Preferred ($157,500 x 2) 315,000

Dividends Payable, Common ($500,000 - $315,000) 185,000



STOCK DIVIDENDS

• A stock dividend– Is a proportional distribution by a

corporation of its own stock to its stockholders

– Increases the stock account and decreases Retained Earnings

– Is different from cash dividends because stock dividends do not transfer the corporation’s assets to the stockholders

Common Common StockStock


– Is distributed to stockholders in proportion to the number of shares they already own

• The reasons for stock dividends are– To continue dividends but conserve cash– To reduce the market price of its stock

STOCK DIVIDENDS


• Generally accepted accounting principles distinguish between a– Large stock dividend (25% or more of

issued stock)• Significantly increases the number of shares

available in the market and usually decreases the stock price

• Transfers the par value of the dividend shares from Retained Earnings to Common Stock

STOCK DIVIDENDS



– Small stock dividend (less than 20-25% of issued stock)

• It is less likely to significantly affect the price of the company’s stock

• Retained Earnings is decreased for the market value of the dividend shares, Common Stock is credited for the stock’s par value, and Paid-in Capital in Excess of Par is credited for the remainder

STOCK DIVIDENDS



Assume that Louisiana Lumber Corporation has the following stockholders’ equity prior to a stock dividend:

Common stock $10 par, 50,000 shares authorized, 20,000 shares issued $200,000

Paid-in capital in excess of par--common 70,000

Retained earnings 85,000

Total stockholders’ equity $355,000

Stockholders’ Equity

STOCK DIVIDENDS


If the market value of the company’s common stock is $16 per share, the following entries illustrate the accounting if the dividend is large (a 50% dividend) or small (a 10% dividend):

Large Stock Dividend - 50% (Accounted for at parpar value)Large Stock Dividend - 50% (Accounted for at parpar value)

Retained Earnings 100,000

Common Stock (20,000 shares x .50 x $10 par) 100,000

Retained Earnings 100,000

Common Stock (20,000 shares x .50 x $10 par) 100,000

Small Stock Dividend - 10% (Accounted for at marketmarket value)Small Stock Dividend - 10% (Accounted for at marketmarket value)

Retained Earnings (20,000 x .10 x $16 market) 32,000

Common Stock (20,000 x .10 x $10 par) 20,000

Paid-in Capital in Excess of Par 12,000

Retained Earnings (20,000 x .10 x $16 market) 32,000

Common Stock (20,000 x .10 x $10 par) 20,000

Paid-in Capital in Excess of Par 12,000

STOCK DIVIDENDS


STOCK SPLITS

• A stock split is an increase in the number of authorized, issued, and outstanding shares of stock, coupled with a proportionate reduction in the stock’s par value

• A stock split decreases the market price of stock--with the intention of making the stock more attractive to investors


• If a company splits its stock 2-for-1, the number of outstanding shares is doubled and each share’s par value is halved

STOCK SPLITS


$10 par$10 par$5 par$5 par


Assume that IBM wishes to decrease the market price from $100 to approximately $25. IBM splits the common stock 4-for-1. Assume that IBM had 140 million shares of $5 common stock issued and outstanding before the split:

Common stock, $5 par, 187.5 million shares authorized, 140 million share issued

Capital in excess of par

Retained earnings

Other

Total stockholders’ equity

$ 700

6,800

11,630

3,293

$22,423

Common stock, $1.25 par, 750 million shares authorized, 560 million share issued

Capital in excess of par

Retained earnings

Other

Total stockholders’ equity

$ 700

6,800

11,630

3,293

$22,423

Before 4-for-1 Stock Split:

IBM Stockholders’ Equity (Adapted):

After 4-for-1 Stock Split:In millions In millions


STOCK SPLITS

After the 4-for-1 stock split, IBM would have 750 million shares authorized and 560 million shares (140 million shares x 4) of $1.25 par ($5/4) common stock. No formal journal entry is necessary, the split is recorded in a memorandum entry such as the following:

After the 4-for-1 stock split, IBM would have 750 million shares authorized and 560 million shares (140 million shares x 4) of $1.25 par ($5/4) common stock. No formal journal entry is necessary, the split is recorded in a memorandum entry such as the following:

Called in the outstanding $5 par common stock and distributed four shares of $1.25 par common stock for each old share previously outstanding

Aug. 19


• Similarities and differences between stock dividends and stock splits– Both increase the corporation’s number of

shares of stock issued and outstanding• A 100% stock dividend and a 2-for-1 stock split

both double the number of outstanding shares and cut the stock’s market price per share in half

– They differ in that a stock dividend shifts an amount from retained earnings to paid-in capital, leaving the par value per share unchanged

STOCK SPLITS


Effects of Dividends and Stock Splits on Total Stockholders’ Equity

Declaration of cash dividend Decrease

Payment of previously declared cash dividend No effect

Declaration of stock dividend No effect

Distribution of stock dividend No effect

Stock split No effect

EventEffect on Total



DIFFERENT VALUES OF STOCK

• Market Value– A stock’s market value is the price for

which a person could buy or sell a share of the stock

– In almost all cases, stockholders are more concerned about the market value of a stock than about any of the other values


• Redemption value– Preferred stock that requires the company

to redeem (pay to retire) the stock at a set price is called redeemable preferred stock

– The price the corporation agrees to pay for the stock, which is set when the stock is issued, is called the redemption value



• Book value– Book value is computed by dividing total

stockholders’ equity by the number of shares of common outstanding

– If the company has both preferred stock and common stock outstanding, the preferred stockholders have the first claim to owners’ equity

– The preferred equity is its redemption value plus any cumulative preferred dividends in arrears



Book value per share of common is computed as follows:

Book value per Book value per share of common share of common stockstock

Total stockholders’ equityTotal stockholders’ equity Preferred equityPreferred equity--==

Number of shares of common stock outstandingNumber of shares of common stock outstanding



Assume a company’s balance sheet reports the following amounts:

Preferred stock, 6%, $100 par, 5,000 shares authorized, 400 shares issued, redemption value $130 per share $ 40,000

Paid-in capital in excess of par--preferred 4,000

Common stock, $10 par, 20,000 shares authorized, 5,500 shares issued 55,000

Paid-in capital in excess of par--common 72,000

Retained earnings 85,000

Treasury stock--common, 500 shares at cost (15,000)




Suppose that four years’ (including the current year) cumulative preferred dividends are in arrears and that preferred stock has a redemption value of $130 per share. The book-value-per-share computations for this corporation are as follows:

Redemption value (400 shares x 130) $ 52,000

Cumulative dividends ($40,000 x $0.06 x 4 years) 9,600

Preferred equity $ 61,600


Less preferred equity (61,600)

Common equity $179,400

Book value per share [$179,400/5000 sharesoutstanding (5,500 share issued - 500 treasury shares)] $ 35.88

Preferred equity

Common equity


• Book value and decision making– Companies negotiating the purchase of a

corporation may wish to know the book value of its stock

– Some investors compare the book value of a share of a company’s stock with the stock’s market value

– A stock selling below its book value may be underpriced and, thus, a good buy


9B-37© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Evaluating Operations:

Rate of Return on Total Assets and Rate of Return on Common



• The rate of return on total assets (return on assets) measures a company’s success in using its assets to earn income for– Creditors– Stockholders

RETURN ON ASSETS

ThemThem

UsUs


Rate of return on Rate of return on total assetstotal assets Average total assetsAverage total assets

Net Net IncomeIncome

Interest Interest ExpenseExpense++

26,111 + 17,41726,111 + 17,417

(382,593 + 445,879) /2(382,593 + 445,879) /2

43,52843,528

414,246414,246

0.1050.105

Return on assets is computed as follows, using data from the 1998 annual report of IHOP Corp. (dollar amounts in thousands):

Rule of Thumb: Rates of return vary widely by industry. Compare the company’s rate of return with the industry average or that of competitors.

Rule of Thumb: Rates of return vary widely by industry. Compare the company’s rate of return with the industry average or that of competitors.

==

==

==

==


RETURN ON EQUITY

• Rate of return on common stockholders’ equity (return on equity) shows the relationship between net income and average common stockholders’ equity– The numerator is net income minus

preferred dividends– The denominator is average common

stockholders’ equity--total stockholders’ equity minus preferred equity


Rate of return on Rate of return on common common stockholders’ stockholders’ equityequity

Average common stockholders’ equityAverage common stockholders’ equity

Net Net IncomeIncome

Preferred Preferred dividendsdividends--

==

26,111 - 026,111 - 0

(156,184 + 187,868) /2(156,184 + 187,868) /2==

26,11126,111

172,026172,026==

0.1520.152==

IHOP Corp.’s rate of return on common stockholders’ equity for 1998 is computed as follows (dollar amounts in thousands):

Rule of Thumb: The higher the rate of return, the more successful the company. Investors also compare a company’s return on stockholders’ equity with interest rates available in the market.

Rule of Thumb: The higher the rate of return, the more successful the company. Investors also compare a company’s return on stockholders’ equity with interest rates available in the market.


• IHOP’s return on equity (15.2%) is higher than its return on assets (10.5%)– This difference results from the interest-

expense component of return on assets

• Borrowing at a lower rate than the company’s return on investments is called using leverage

RETURN ON EQUITY


REPORTING ON THE STATEMENT OF CASH FLOWS

• Stockholders’ equity transactions are financing activities:– Issuance of stock increases cash– Purchase of treasury stock decreases cash– Sale of treasury stock increases cash– Payment of dividends decreases cash– Stock dividends are not reported on the

statement of cash flows because the company receives no cash


Proceeds from issuance of common stock $ 16.9

Proceeds from issuance of stock to employees 41.4

Sale of treasury stock 37.0

Purchase of treasury stock (24.0)

Repurchase and retirement of common stock (1,034.0)

Payment of dividends (351.5)

Net cash used by financing activities $(1,314.2)

Cash Flows from Financing Activities

(In millions)


VARIATIONS IN REPORTING STOCKHOLDERS’ EQUITY

• Businesses often use terminology and formats in reporting stockholders’ equity that differ from the general examples in this chapter

• A more detailed format is used in the text• The next slide presents a side-by-side

comparison of our general teaching format and the format that you are more likely to encounter in real-world balance sheets


Stockholders’ equityPaid in capital:

Preferred stock 8%, $10 par, 30,000 shares authorized and issued $300,000Paid-in capital in excess of par—preferred 10,000

Common stock, $1 par, 100,000 shares authorized, 60,000 shares issued 60,000

Paid-in capital in excess of par–common 2,140,000Paid-in capital from treasury stock transactions, common 9,000Paid in capital from retirement of preferred stock 4,000Donated capital 7,000

Total paid-in capital 2,530,000Retained earnings 1,565,000 Subtotal 4,095,000Less treasury stock, common (1,400 shares at cost) (42,000)Total stockholders’ equity $4,053,000

Stockholders’ equity

Preferred stock, 8%, $10 par, 30,000 shares authorized and issued $310,000Common stock $1 par, 100,000 shares authorized, 60,000 shares issued 60,000Additional paid-in capital 2,160,000Retained earnings 1,565,000Less treasury stock, common (1,400 shares at cost) (42,000)

$4,053,000

General Teaching Format Real-World Format


END OF CHAPTER 9

9b-1 © 2001 prentice hall business publishing financial accounting, 4/e harrison and horngren...

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