Lecture

Equity Part 1

Dr Winston Kwok

Lecture Learning Objectives

1. Explain the characteristics of a corporation

2. Measure the effect of issuing stock on acorporation’s financial position

3. Contrast dividends for common stock withdividends for preferred stock

4. Account for treasury stock and other items inequity

Learning Objective 1

Explain the characteristics

of a corporation

What is the Best Way toOrganize a Business?

Proprietorship

Partnership

Corporation orCompany

Corporations: An Overview

May be fewer in number than soleproprietorships and partnerships, yet ...

Generate greatest dollar volume of salesrevenues

Largest in terms of total assets andowners’ equity

Privately HeldPrivately Held

Publicly HeldPublicly Held

Ownershipcan be

Corporate Form of Organization

Existence isseparate from

owners

An entitycreated by law

Has rights andprivileges

Company accounting

Going public means selling shares togeneral public.

Initial public offering or IPO is first offerof shares.

Going public allowed a company to raiselarge amounts of capital for current andfuture expansion

Less risky (and less costly) to obtainmoney from investors than borrowing itfrom one or more lenders

Company going public typically enlistsservices of financial professionals suchas underwriters

Advantages

Separate legal entity

Limited liability of stockholders

Transferable ownership rights

Continuous life

Lack of mutual agency for stockholders

Ease of capital accumulation

Disadvantages

Governmental regulation

Corporate taxation

Characteristics of Corporations

Organizing a Corporation

CharterIncorporators

Set bylaws

Authority Structureof a Corporation

Stockholders

Board of Directors

Chairperson of the Board (CEO)

President (Chief Operating Officer)

Authority Structureof a Corporation

President (Chief Operating Officer)

VPSales

VPManufacturing CFO

VPPersonnel Secretary

Controller(Accounting Officer)

Treasurer(Finance Officer)

Vote at stockholders’ meetings

Sell stock

Purchase additional shares ofstock (preemptive right)

Receive dividends, if any

Share equally in any assetsremaining after creditors are paidin a liquidation

Rights of Stockholders

Stockholders’ Equity

Capital stock

Retained earnings

Owners’ equity in a corporationhas two main components:

Capital Stock

Common Stock

The most basic formof capital stockissued by every

corporation.

Preferred Stock

A class of stockthat has severalpreferences overcommon stock.

Capital Stock

Par Value Stock

It is an arbitraryamount assigned

by a company to ashare of its stock.

No-par Stock

Does not have a parvalue, but may have

a stated value (anarbitrary amount).

Learning Objective 2

Measure the effect of issuingstock on a corporation’s

financial position

The maximumnumber of

shares of capitalstock that can be

sold to thepublic.

AuthorizedAuthorizedShares

Authorization and Issuanceof Capital Stock

Issuedshares areauthorizedshares ofstock thathave been

sold.

Unissuedshares areauthorizedshares ofstock thatnever havebeen sold.

Usuallyshares are

soldthrough anunderwriter.

AuthorizedAuthorizedShares

Authorization and Issuanceof Capital Stock

Issuing Stock

Corporations need money to operatefrom sources other than borrowing.

Par Value

No-Par Value

Stated Value

Common Stock at Par

Suppose IHOP’s common stockcarries a par value of $10 per share.

The company issues 6,200,000shares of common stock at par.

What is the entry?

Common Stock at Par

Cash (6,200,000 × $10) 62,000,000Common Stock 62,000,000

Issued common stock at par

Common Stock at Par

IHOP can also give shares of itscommon stock to underwriters or

promoters for their services.

The company gave promoters1,000,000 shares ofcommon stock at par.

What is the entry?

Common Stock at Par

Organization Expenses (1m × $10) 10,000,000Common Stock 10,000,000

Gave promoters 1 million shares of $10 par valuein exchange for their services

Common Stock Above Par

IHOP’s common stock has apar value of $0.01 per share.

The company issues 6,200,000 sharesof common stock at $10 per share.

What is the entry?

Common Stock Above Par

Cash (6,200,000 × $10) 62,000,000Common Stock

(6,200,000 × $0.01) 62,000Paid-in Capital in Excess of Par Value,

Common Stock (6,200,000 × $9.99) 61,938,000Issued common stock above par

Paid-in Capital in Excess of Par Valuealso known as Contributed Capital in Excess of Par Value or

Additional Paid-in Capital

Common Stock Above Par

Common Stock, $.01 par;40 million shares authorized,6.2 million shares issued $ 62,000

Paid-in Capital in Excess of Par Value,Common Stock 61,938,000Total Paid-in Capital $ 62,000,000Retained Earnings 194,000,000Total Stockholders’ Equity $256,000,000

Stockholders’ Equity

No-Par Common Stock

When a company issues no-par stock with astated value of $20 per share, it debits

the asset received and credits the stock account.

Cash (3,000 × $20) 60,000Common Stock 60,000

Issue 3,000 no-par common stock at $20 per share

A separate class of stock, typically havingpriority over common stock in . . .

Dividend distributions (rate is usuallystated).

Distribution of assets in case of liquidation.

Cumulativedividendrights.

Normally hasno voting

rights.

Usually callableor redeemable

by the company.

Other Features Include:

Preferred Stock

Preferred Stock

Reasons for issuing:

To raise capital without sacrificing control

To boost the return earned by commonstockholders through financial leverage

To appeal to investors who may believe thecommon stock is too risky or that theexpected return on common stock is toolow

Accounting for preferred stock follows thepattern illustrated for common stock

Issuing Stock for Assets Otherthan Cash

Investors sometimes contribute long-termassets to company instead of cash

Determine, through independentappraisal, asset’s fair value (market value)

or, the shares’ fair value (market value)

whichever is more readily determinable

An investor contributes land and abuilding in exchange for 5,000 shares ofAsian Art, Inc., common stock, with a parvalue of $2 per share

Real estate appraisals

Land = $25,000

Building = $150,000

What’s the journal entry to recognize thistransaction?

Issuing Common Stock forAssets Other than Cash

Land 25,000

Building 150,000

Common Stock (a) 10,000

Paid-in Capital in Excess of Par Value,Common Stock (b) 165,000

(a) Common Stock = 5,000 shares @ $2.00 par

(b) Paid-in Capital in Excess of Par Value, Common Stock =$175,000 fair value of PP&E less $10,000 par value of shares

Issuing Common Stock forAssets Other than Cash

Issuing Preferred Stock

Asian Art Inc. would follow same systemof recording share transactions whenissuing preferred stock

Debit = Cash or assets

Credit = Preferred Stock and Paid-inCapital in Excess of Par Value, PreferredStock (if necessary)

Ethical Considerations

Issuing stock for assets other than cashcan pose an ethical challenge.

The company issuing the stock often wishesto record a large amount for the noncash asset

received and for the stock that it is issuing.

Learning Objective 3

Contrast dividends for common stockwith dividends for preferred stock

Three important datesThree important dates

Date of Declaration

Record liabilityfor dividend.

Date of Record

No entryrequired.

Date of Payment

Record payment ofcash to stockholders.

Entries for Cash Dividends

Date of DeclarationRecord liability

for dividend.

On January 19, a $1 per share cash dividend isOn January 19, a $1 per share cash dividend isdeclared on Dana, Inc.’s 10,000 common sharesdeclared on Dana, Inc.’s 10,000 common sharesoutstanding. The dividend will be paid on March 19 tooutstanding. The dividend will be paid on March 19 tostockholders of record on February 19.stockholders of record on February 19.

Entries for Cash Dividends

Dr Cr

Jan. 19 Retained earnings 10,000

Common dividend payable 10,000

Declared $1 per share cash dividend

Instead of debiting RE, can debit a temporary accountDividends which will be closed at end of period

Date of RecordNo entryrequired.

Entries for Cash Dividends

On January 19, a $1 per share cashOn January 19, a $1 per share cashdividend is declared on Dana, Inc.’sdividend is declared on Dana, Inc.’s10,000 common shares outstanding.10,000 common shares outstanding.The dividend will be paid on MarchThe dividend will be paid on March19 to stockholders of record on19 to stockholders of record onFebruary 19.February 19.

No entry required onFebruary 19.

Date of PaymentRecord payment of

cash to stockholders.

Entries for Cash Dividends

On January 19, a $1 per share cashOn January 19, a $1 per share cashdividend is declared on Dana, Inc.’s 10,000dividend is declared on Dana, Inc.’s 10,000common shares outstanding. The dividendcommon shares outstanding. The dividendwill be paid on March 19 to stockholders ofwill be paid on March 19 to stockholders ofrecord on February 19.record on February 19.

Dr Cr

Mar. 19 Common dividend payable 10,000

Cash 10,000

Paid $1 per share cash dividend

Created when a company incurs cumulativelosses or pays dividends greater than total

profits earned in other years.

Stockholders' Equity

10,000 shares authorized and outstanding 100,000$

(8,500)

91,500$

Retained earnings deficit

Total stockholders' equity

Dana, Inc.

Balance Sheet (Stockholders' Equity Section)

December 31, 2008

Common stock $10 par value,

Deficits and Cash Dividends

Cash Dividends

When a company has issued bothpreferred and common stock,

the preferred stockholdersreceive their dividends first.

Pinecraft Industries, Inc., has bothcommon stock and 90,000 shares

of preferred stock outstanding.

Expressing the Dividend Rateon Preferred Stock

Percentage rate

Dollar amount

Cash Dividends

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

(remainder: $1,500,000 – $157,500) 1,342,500Total dividend $1,500,000

Preferred dividends are paid at the annualrate of $1.75 per share.

Assume that in 2004, the company declaresan annual dividend of $1,500,000.

Vs. NoncumulativeCumulative

Dividends inarrears must be

paid beforedividends may bepaid on common

stock.

Undeclareddividends from

current and prioryears do not haveto be paid in future

years.

Cumulative Preferred Stock

Cash Dividends

The preferred stock of Pinecraft is cumulative.

Retained Earnings 500,000Preferred Dividend Payable 315,000*Common Dividend Payable($500,000 – $315,000) 185,000

Declare a cash dividend*($157,500 × 2 years)

Suppose the company did not pay the 2004preferred dividend of $157,500.

In 2005, the company declares a $500,000 dividend.

Preferred stock, 9%, $100 par value; 1,000

shares authorized and issued 100,000

Common stock, $50 par value; 4,000 shares

authorized and issued 200,000$

Total contributed capital 300,000$

Example: Consider the following partial Statement ofStockholders’ Equity.

During 2007, the directors declare cash dividendsof $5,000. In 2008, the directors declare cash

dividends of $42,000.

Stock Preferred as to Dividends

Stock Preferred as toDividends

Preferred Common

If Preferred Stock is Noncumulative:

Year 2007 $5,000 dividends declared 5,000$ -$

Year 2008

Step 1: Current preferred dividend 9,000$

Step 2: Remainder to common shareholders 33,000$

If Preferred Stock is Cumulative:

Year 2007 $5,000 dividends declared 5,000$ -$

Year 2008

Step 1: Dividends in arrears 4,000$

Step 2: Current preferred dividend 9,000

Step 3: Remainder to common shareholders 29,000$

Totals 13,000$ 29,000$

Stock Preferred as to Dividends

I just converted 100 sharesof preferred stock into

1,000 shares of commonstock

Gee, I can’tdo that with

MYMY preferredstock!

Some preferredstock is convertible

into shares ofcommon stock.

Other Features of PreferredStock

Book Value per Shareof Common Stock

Total Stockholders’ EquityNumber of Common Shares Outstanding

Preferred stock and preferreddividends in arrears are deductedfrom total stockholders’ equity.

Book Value Market Value=

Learning Objective 4

Account for treasury stock and otheritems in equity

UnissuedUnissuedSharesShares

TreasuryStock

OutstandingShares

Treasury stock areissued shares that

have been reacquiredby the corporation.

IssuedShares

Outstanding shares areissued shares that are

owned bystockholders.

AuthorizedAuthorizedShares

Authorization and Issuanceof Capital Stock

Treasury Stock Transactions

Treasury stock are shares that a companyhas issued and later reacquired.

Stock option distribution(assuming at maximum authorized stock)

Increase share price

Avoidance of a takeover

Some reasons for purchasing own stock:

No votingNo votingoror

dividenddividendrightsrights

Contraequity

account

When stock is reacquired, the corporationrecords the treasury stock at cost.

Treasuryshares are

issuedshares thathave beenreacquired

by thecorporation.

Treasury Stock

Date Description Debit CreditDate Description Debit Credit

May1 TreasuryStock 165,000

Cash 165,000

3,000 shares × $55 = $165,000

On May 1, 2007, East, Inc. reacquires 3,000 sharesof its common stock at $55 per share.

Prepare the journal entry for May 1.

Treasury Stock - Example

Date Description Debit Credit

Dec. 3 Cash 75,000

TreasuryStock 55,000

Additional Paid-in Capital:

Treasurystock transactions 20,000

On December 3, 2007, East Corp. reissued 1,000shares of the stock at $75 per share.

Prepare the journal entry for December 3.

Treasury Stock - Example

Date Description Debit Credit

Dec. 3 Cash 75,000

Treasury Stock 55,000

Paid-in Capital,

Treasury Stock 20,000

1,000 shares × $55 cost = $55,000

1,000 shares × $75 = $75,000

Debit the excess of cost over sellingprice to Paid-in capital, treasury stock.

If not sufficient, then debit to RE

Selling Treasury StockBelow Cost

Retirement of Stock

It decreases the outstanding stockof the corporation.

Retired shares cannot be reissued.

There is no gain or loss on retirement.

Stockholders' Equity

Contributed capital:

Preferred Stock - $100 par value; 1,000 shares

authorized; 50 shares issued 5,000$

Common Stock - $10 par value; 50,000 shares

authorized; 30,000 shares issued 300,000

Additional Paid-in Capital: Common 21,000

Retained earnings 65,000

Subtotal 391,000$

Less: Treasury stock 110,000

Total Stockholders' equity 281,000$

Stockholders’ Equity -Presentation

Contra-equity

Legal Contractual

Most states restrictthe amount oftreasury stock

purchases to theamount of retained

earnings.

Loan agreements

retained earnings.

Loan agreementscan include

restrictions onpaying

dividends below acertain amount ofretained earnings.

Restricted Retained Earnings

A corporation’s directors can voluntarily limitdividends because of a special need for cash

such as the purchase of new facilities.

Retained earnings, 1/1/08 875,000$

Plus: net income 155,600

Less: dividends declared (80,000)

Retained earnings, 12/31/08 950,600$

Appropriated retained earnings (450,000)

Unappropriated retained earnings 500,600$

Reed, Inc.

Statement of Retained Earnings

For Year Ended December 31, 2008

Appropriated RetainedEarnings

Correction of material errors in past years’ financialstatements. If an amount is incorrectly expensed,

add amount to Retained Earnings.

Retained earnings, 12/31/07, as previously reported 875,000$

Prior period adjustment: Cost of land incorrectly

expensed 72,000

Retained earnings, 12/31/07, as adjusted 947,000

Plus: net income 155,600

Less: dividends declared (80,000)

Retained earnings, 12/31/08 1,022,600$

Reed, Inc.

Statement of Retained Earnings

For Year Ended December 31, 2008

Prior Period Adjustments

(In millions) Retained

Shares Amount Earnings Total

Balance at January 1, 2008 821 2,500$ 9,500$ 12,000$

Stock issuances 17 500 500

Stock repurchases and retirement (17) (260) (925) (1,185)

Cash dividends declared (150) (150)

Other, net 70 70

Net income 5,100 5,100

Balance at December 31, 2008 821 2,740$ 13,595$ 16,335$

Common stock and

capital in excess of par

Matrix, Inc.

Statement of Stockholders' Equity

For the Year Ended December 31, 2008

Statement of Stockholders’Equity

This is a more inclusive statement than the statement ofretained earnings.