CHAPTER 12 Shareholders' Equity SYNOPSIS In this chapter, the author discusses the theoretical issues and accounting treatment for both contributed capital and earned capital. Equity is compared and contrasted with debt, and the economic incentives for raising capital through debt versus equity are discussed. The primary contributed capital topics discussed are (1) issuing stock; (2) the rationale for a company repurchasing its own common stock; (3) the cost method of accounting for treasury stock; and (4) stock options. The primary earned capital topics discussed are (1) dividend strategies, (2) accounting for dividends, and (3) stock splits. The ethics vignette considers whether boards of directors acted ethically if it attempted to delay an inevitable stock price collapse by issuing a stock dividend. The Internet research exercise examines the main transactions between Kellogg Company and its shareholders over a three-year period. The following key points are emphasized in Chapter 12: 1. The three forms of financing and their relative importance to major U.S. corporations. 2. Distinctions between debt and equity. 3. Economic consequences associated with the methods used to account for shareholders'

equity. 4. Rights associated with preferred and common stock and the methods used to account for

stock issuances. 5. Distinctions among the market value, book value, and par (stated) value of a share of

common stock. 6. Treasury stock. 7. Cash dividends and dividend strategies followed by corporations. 8. Stock dividends and stock splits. TEXT/LECTURE OUTLINE Stockholders' equity.

I. Nature of shareholders' equity. A. Stockholders have a residual interest in the company. Stockholders' equity

consists primarily of:

1. Contributed capital—contributions from the company's owners.

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2. Earned capital—measure of the net assets the company generated through its operations not yet disbursed to the owners as dividends.

B. The most common forms of business entities are sole proprietorships,

partnerships, and corporations. The primary differences among these three business forms are:

1. Liability of the owners. 2. Income taxes. 3. Returns to owners.

II. Debt and equity distinguished.

A. Characteristics of debt.

1. Formal legal contract. 2. Fixed maturity date (as specified in the contract). 3. Fixed periodic interest payments (as specified in the contract). 4. Security (i.e., collateral) in case of default (as specified in the contract). 5. Debt holders have no direct voice in management, but they can influence

management through debt covenants. 6. Interest is an expense.

B. Characteristics of equity.

1. No formal, legal contract. 2. No fixed maturity date. 3. Dividend payments are at the discretion of the company's board of directors. 4. Residual asset interest. 5. Stockholders have a voice in management through their right to vote for the

board of directors. 6. Dividends are not an expense.

C. Why is it important to distinguish debt from equity? 1. Debt vs. equity: the capital provider's perspective. 2. Equity: higher risk.

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3. Equity: higher returns.

D. Debt vs. equity: Management's perspective. 1. Debt: contractual restrictions. 2. Debt: less expensive. 3. Equity: dilution of ownership.

E. Debt vs. equity: The accountant's and auditor's perspective.

III. The economic consequences associated with accounting for shareholders' equity. A. Effects of financial ratios. B. Managing the debt to equity ratio. C. Strengthening the balance sheet. D. Restrictions on dividend payments. E. Interests of creditors.

IV. Accounting for shareholders' equity. A. Contributed capital.

1. Authorized, issued, and outstanding shares.

a) Authorized shares represent the number of shares of stock that the

company is legally entitled to issue as stated in the corporate charter. b) Issued shares represent the total number of shares that have been

distributed by the company and not retired. Issued shares equal the shares outstanding plus shares held in treasury.

c). Outstanding shares represent the shares currently held by shareholders.

2. Market value, book value, par value, and stated value.

a) Market value is the value at which the stock is currently trading on the open

market. b) Book value represents shareholders' equity per share of common stock

outstanding. Book value is computed as: (Stockholders' equity - Preferred capital) ÷ Number of common shares outstanding.

c) Market-to-book ratio.

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i. The market-to-book ratio is computed by dividing the market value of a company's common stock by its book value.

ii. Ratios equal to 1 indicate that a company's net book value (as

measured by the balance sheet) is perceived by the market to be a fair reflection of the company's true value. Ratios larger than 1 indicate that the balance sheet is perceived to be conservative.

d) Par (or stated) value.

i. Par value is a legal concept and was created to protect creditors. It

no longer has significant economic or legal meaning. ii. Owners' contributions in excess of par value are allocated to

additional paid-in capital.

B. Preferred stock.

1. Preferred as to dividends.

2. Preferred as to assets.

3. Preferred stock is usually issued with a par value. Dividends on preferred stock are either stated as a dollar amount or as a percentage of par value.

4. Preferred shareholders are entitled to certain preferences (such as on

dividends and assets) over common shareholders. In exchange for these preferences, preferred shareholders usually sacrifice certain rights, such as the right to vote for board members.

5. Characteristics of preferred stock.

a) Cumulative versus noncumulative. b) Participating versus nonparticipating.

6. Preferred stocks: debt or equity? C. Earned capital.

1. Retained earnings 2. Accumulated comprehensive income

D. Common stock.

1. Fundamental rights of common shareholders.

a) Right to receive dividends declared by the board of directors.

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b) Right to share proportionately in residual corporate assets in the event of liquidation.

c) Right to exert control over management.

2. Common stock is the riskiest ownership interest. 3. Market value. 4. Book value. 5. Market-to-book ratio. 6. Par value

V. Accounting for common and preferred stock issuances.

A. Recording stock issuances

1. No-par value stock. 2. Par value stock.

B. Repurchasing stock—treasury stock.

1. Treasury stock is not considered an asset. 2. Reasons companies repurchase common stock.

a) To provide a sufficient number of shares to support employee compensation plans.

b) To concentrate ownership of outstanding shares to make it more difficult

for a takeover. c) To increase the market price of a company's outstanding stock. d) To increase the company's earnings per share. e) To retire preferred or common stock. Once common stock has been

retired, the shares are considered authorized but not issued.

3. Accounting for treasury stock.

a) Cost method.

(1) The cost method is the more common method used to account for treasury stock. Under GAAP, using the cost method is appropriate if the company intends to eventually reissue the shares.

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(2) The treasury stock account has a debit balance and is disclosed in the shareholders' equity section after retained earnings.

(3) When purchasing treasury stock, Treasury Stock is debited and

Cash is credited for the cost of the shares. (4) Reissuing treasury stock for more than acquisition cost.

(a) Treasury Stock is credited for the cost of the shares reissued. (b) The excess received over the acquisition cost is credited to

Additional Paid-in-Capital, Treasury Stock.

(5) Reissuing treasury stock for less than acquisition cost.

(a) Treasury Stock is credited for the cost of the shares reissued. (b) The excess of acquisition cost over proceeds is debited to

Additional Paid-in-Capital, Treasury Stock. If its account balance is insufficient to absorb the entire excess, the residual excess is debited to Retained Earnings.

b) Par value method - acceptable under GAAP but not widely used.

C. Stock options.

1. Stock options give the right to purchase equity securities at a fixed price over a

specified time period. Stock options are widely used as a form of executive compensation.

2. No compensation expense is recorded when granted (except when options

are granted at prices below the current market price). An issuance of common stock is recorded when options are exercised.

3. Disclosure is required of the amount of compensation expense that would

have been recorded if the value of the options granted during the year was recognized.

VI. Retained earnings.

A. Dividends.

1. Dividend strategies. 2. Important dates.

a) Date of declaration—the date that the board of directors declares a dividend and the company incurs a liability for the dividend.

b) Date of record—the legal owner of the stock on this date is the person or

entity entitled to the dividend.

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c) Date of payment—the date that the company pays the dividend.

3. The dividend account is a temporary account that is closed directly into retained earnings during the closing process.

4. Cash dividends. 5. Stock dividends and stock splits.

a) Stock splits.

(1) A company issues additional shares of common stock to its shareholders and splits the outstanding shares into smaller units.

(2) Stock splits cause the number of shares classified as outstanding to

change and the par value per share and market value per share to change. These changes are documented in a memorandum entry. However, the total value of the shares outstanding should, theoretically, remain the same.

b). Stock dividends.

(1) A company issues additional shares of common stock to its

shareholders as a dividend. No assets are distributed to the shareholders.

(2) After the stock dividend, each shareholder retains the same

percentage of ownership interest in the corporation. (3) Ordinary stock dividends.

(a) A stock dividend should be accounted for as an ordinary stock dividend if the number of additional shares to be issued is less than 25 percent of the shares outstanding prior to the stock dividend.

(b) An amount equal to the fair market value of the common stock

issued is allocated from retained earnings to the common stock and additional paid-in-capital accounts.

(4) Stocks splits in the form of a stock dividend.

(a) A stock dividend should be accounted for as an ordinary stock dividend if the number of additional shares to be issued is greater than 25 percent of the shares outstanding prior to the stock dividend.

(b) An amount equal to the par value of the stock is allocated from

retained earnings to the common stock account.

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c) Reasons companies declare stock dividends and stock splits.

(1) To reduce the market price per share. (2) Publicity gesture. (3) To capitalize a portion of retained earnings.

B. Appropriations of retained earnings.

1. A book entry partitioning retained earnings into restricted and unrestricted retained earnings.

2. Appropriated retained earnings arise from either the board of directors'

discretion or the terms of debt covenants.

C. Negative retained earnings.

1. The retained earnings account is negative if a company's accumulated net losses plus dividends from previous years exceeds the accumulation of its past profits.

2. Negative retained earnings (deficits) generally indicate serious problems

because they indicate losses. In today's changing environment there are notable exceptions of start-up, high-tech, and Internet companies with accumulated deficits, yet the companies enjoy favorable stock prices, reflecting the market's confidence in their future prospects.

D. Retained earnings and prior period adjustments.

1. Few items are booked directly to retained earnings. These include net income (loss), dividends, appropriations, and certain treasury stock transactions.

2. Additionally, correction in the current period of a prior period’s accounting error

is made by adjusting the misstated asset and/or liability, with a corresponding and offsetting adjustment to retained earnings. The entry to retained earnings is called a prior period adjustment.

VII. Statement of shareholders' equity. VIII. International perspective: the rise of international equity markets. IX. ROE exercise: return on equity and value creation. X. ROE analysis XI. Review problem XII. Ethics in the real world. XIII. Internet research exercise.

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LECTURE TIPS 1. A conceptual understanding of why companies would repurchase their own stock and why

treasury stock reduces shareholders' equity (as opposed to being an asset) needs to be developed. End-of-chapter issues for discussion 12–3, 12-4, and 12–12 and 12-15 are helpful in developing this understanding. Accounting for treasury stock can be demonstrated with examples such as provided by end-of-chapter exercises 12–4 through 12–8 and problems 12–2 and 12–13.

2. Students usually need extra help in understanding why a company would declare either a

stock split or a stock dividend (and the economic difference between the two) as a basis for understanding how to account for each. It should be stressed that the differences in accounting for stock dividends and stock splits arise from the legal differences between the two. End-of-chapter exercises 12–14 and 12–15, problems 12-4, 12-7 and 12–9, and issue for discussion 12–1, and the ethics vignette at the end of the chapter are useful for this demonstration.

ANSWERS TO IN-TEXT DISCUSSION QUESTIONS 541. The information presented indicates that Amazon.com owed its creditors investors a

total of $5.6 billion, of which $4.8 billion was current as of year-end 2008. The current liabilities would include the current amount of long-term liabilities as well as accounts payable and accrued expenses. Contributed capital of $3.4 billion represents the amount that was raised from shareholders. The negative retained earnings of $.73 billion arose from Amazon’s unprofitable operations since inception.

543. Interest incurred is a financing cost (versus an operating cost) and is deducted as an

expense on the income statement. Dividends are not considered a component of net income, but rather represent a distribution of net income to shareholders. Therefore dividends are deducted directly from retained earnings and do appear on the income statement.

545. From the perspective of an investor or creditor, bonds represent a lower investment risk

than stocks, and enjoy a fixed amount of cash receipts (contractual interest and principal payments) determined by the bond instrument, if the instrument is held to maturity. This safety and certainty is in contrast to equity investments which pose a higher investment risk, and uncertain cash receipts in the form of discretionary dividends and stock appreciation.

545. Internet companies such as Google are inherently risky (especially when they are just

starting up) and debt in the capital structure only serves to magnify that risk. With no debt, the company could build a stronger credit rating and gain some future financial flexibility. Debt instruments require contractual future cash payments of interest and principal, whereas equity does not, given that dividend payments are discretionary. Equity investors do not expect dividends from internet companies, but rather expect earnings to be retained for future growth. Also, debt instruments often involve restrictive covenants by which Google’s management may not want to be constrained.

546. The effect on the accounting equation of each form of honeywell’s payment to capital

providers is shown below:

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ASSETS = LIABILITIES +SHRHLDR’ EQ Interest: -$456 million -$456 million (Exp; RE) Reduction of debt: -$754 million -$754 million Repurchase stock: -$1.459 billion -$1.459 billion (contra SE) Dividends -$811 million -$811 million (-RE) Interest on debt is considered a cost of doing business and is treated a deduction in

arriving at net income. Repayments of outstanding debt are a reduction of a liability. Dividends are a distribution of net income to shareholders and are deducted directly from retained earnings; dividends do not appear as expenses in the income statement. Common stock repurchases are also a form of return to shareholders, but not on a pro-rata basis as in the case of dividends. If shares are retired, common stock, additional paid in capital, and possibly retained earnings are reduced. If repurchased shares are held in the treasury for possible reissuance, the reduction is in the form of an increase to a contra account that offsets shareholders’ equity. A company does not have an investment in itself; treasury shares are not assets.

547. If Proctor & Gamble issued equity on the last day of the year, the denominator in the

formula for return on equity would increase, and the return percentage itself would decrease. In the case of both share repurchases and dividend payments, the denominator would decrease, and the return on equity percentage would increase. Analysts who especially value return on equity as an important measure of corporate performance must be alert to a company’s ability to “manage” the return on equity. Management discretion over the timing of transactions (share issuances and repurchases, and dividends) which affect the formula used to compute return on equity.

548 The US government injected $70 billion into Citigroup to prop it up and keep if from

failing. This investment was recorded as preferred stock. The TARP funds were returned before the end of 2009. Without getting into the details of the terms of the preferred stock investment, it is probable that there were significant promises made by Citigroup to the US government in connection with this preferred stock. The political ramifications of the $700 billion TARP bailout will effect the political and economic landscape of the US for years.

549. Preferred shareholders would insist on a policy such as the one described for Sears.

Preferred shareholders generally receive specified annual dividends and have rights in liquidation, both of which have priority over claims of common shareholders. In exchange for those preferences, preferred stock is usually non-voting. As a protection to their interests, preferred shareholders would insist on provisions for cumulative dividends, with priority over common dividends, and the right to vote if dividends are missed for an extended period of time.

551. Preferred stocks are hybrid securities which have characteristics of both debt and equity.

“Mandatorily redeemable preferred stock” is preferred stock that has a mandatory redemption feature that is outside of the control of the issuing corporation. In this case, the preferred shareholders must be “paid back” as in the case of debt. This feature

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would lead to the conclusion that the preferred stock has more closely resembles debt, and should be classified as such in the balance sheet.

551. The $100 paid for the shares in the initial public offering went to Google. Investors who

purchased their shares in the IPO and held them until February 25, 2010 had a cumulative (net) unrealized gain of $426.43 as of February 25, 2010, but only those that actually sold their shares had a trading profit. The other shareholders have an unrealized gain, but not a trading profit. The company does not directly benefit from the increase in it's share prices but the indirect benefits are many. The success of the enterprise, as manifested by the increased share price has numerous positive effects on employees, creditors, shareholders and other stakeholders. Those holding stock (and stock options) in the company benefit directly. One of the benefits to the company is that future stock sales will generate market interest, bringing a higher price and making it easier to raise capital when needed.

552. Par value, or stated value, of a share of common stock is a legal rather than an

economic concept, and is often only an arbitrary, nominal value. JP Morgan Chase's par value is only $1.00 per share. Book value per share represents the total stockholders’ equity on the books (minus any preferred capital), divided by the number of common shares outstanding. Market value per share is the price for which a share of stock may be exchanged on the open market. The marketplace takes into account factors such as a company’s future earnings prospects, interest rates, and so, in arriving at a market price. The market price is often larger than book value, reflecting changes in asset values not recognized in the accounts, both for tangible assets, notably land and buildings, and for intangibles such as goodwill.

553. When Jet Blue issued the shares, cash increased by $182.4 million (15.2 million shares

at $12 per share), and shareholders’ equity (common stock and additional paid-in capital) increased by a like amount. The amount of the increase that was allocated to common stock was $152,000 ($.01 per share) and the amount allocated to additional paid-in capital was $182,248,000.

555. A company would buy back its own stock for a variety of reasons, the most common of

which is to support employee compensation plans. By buying back shares for reissuance in compensation plans, a company avoids the dilution that would otherwise occur if new shares were issued. A company may also use stock repurchases as a takeover defence, to deploy excess capital, or to increase its stock price by reducing dilution.

556. The capital structure leverage computations for 2007 and 2009 are as follows: In billions of $

Total Assets

Shareholders' Equity

Leverage (Assets/Equity)

2007 80.9 43.3 1.87

2009 94.6 50.5 1.87

Proforma 108.9 64.6 1.69

As can be seen in this example, the decision to purchase treasury stock had the effect of increasing the company's leverage. The relationship between total assets and total equity would have resulted in a lower leverage ratio, had the company kept its cash and left it's equity section alone. The increased leverage helps to improve earnings per share, earnings on assets, and return on equity.

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557. Boston Scientific must have received cash of $90 million from the sale of the treasury

shares, which was below the original cost of the shares. The $142 million represents the cost of the treasury shares, and the $52 million decrease in additional paid-in capital represents the difference between the proceeds and the cost. The reissuance price was below the original cost of the treasury stock. This transaction would be reflected on the statement of cash flows as a financing transaction providing cash flows of $90 million.

in millions of $ ASSETS = +SHRHLDRS’ EQ CASH PD IN CAP T-STOCK T stock repurchase +$90 million - $52 +$142

Note: The $142 reduction in the treasury stock account is an addition in this analysis

because treasury stock is a contra account, offsetting the other equity accounts. 559. Stock options and other forms of equity-based pay are used by many corporations in

their incentive compensation plans for their executives. These items are treated as expenses in the financial statements of the corporations that have such compensation plans. Backdating stock options is a crime that benefits the executives that received the options and is a theft of money from the shareholders.

560. The goals of a corporation and its nature will be reflected in its dividend policy. Young

growing companies rarely pay dividends. They need to use the profits they generate to fund their continued growth. Shareholders of these corporations expect to be rewarded with increases in the market price of their shares as the business grows and becomes ever more profitable. Such companies are referred to a “growth companies”. Mature companies are much more likely to pay dividends consistently. Shares in dividend paying corporations are known as “income” stocks. Cisco Systems has the characteristics of a “growth company”. Stock in Intel has the characteristics of an “income stock”. Microsoft appears to be making the transition from a growth company to a mature, dividend paying corporation.

562. In a stock split, the number of outstanding shares is simply “split” into smaller units, and

the corporation distributes additional shares. Concurrent with a split, the price of the stock goes down proportionately. For instance, in a 2 for 1 split, a shareholder would have two shares rather than the original one, but the price per share would be one-half of the pre-split price. Stock splits serve to reduce the per-share price of the outstanding shares so that small investors can more easily afford to purchase them. The suggested 5:1 split of Google would have resulted in 5 shares valued at $114 replacing each share previously valued at $570.

563. Neither a large stock dividend nor a stock split has any effect on the basic accounting

equation. Assets and liabilities are not affected; only the details within the shareholders’ equity section are changed. Stock dividends provide extra shares to shareholders without requiring the payment of cash. The benefit to shareholders is largely psychological rather than economic. A stock split (or a large stock dividend) reduces the per-share price of shares so that small investors can more easily purchase them (especially a round lot of 100 shares). In both stock dividends and stock splits, the

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shareholder has the same proportionate interest in the corporation after the dividend or split as before.

565. Yahoo may be well-known, but that does not mean that they were profitable in their start-

up years. The $50 million deficit in retained earnings at the beginning of 2002 consisted of Yahoo’s accumulated losses since inception. For that deficit to have been reduced to $7.5 million by year-end 2002, Yahoo must have reported a profit for 2002 of $42.5 million, followed by a profit for 2003 of $237.5 million.