Int Acct ll Ch 15 Accounting for Stockholder's Equity

Overview of Stockholder’s Equity

• Sum of all residual claims against the assets of the firm measured as the difference between the assets and the liabilities of the entity.

• Also called “net assets” or “book value” of the firm.

• Represents the interest held by the investors.

Equity = Contributed capital + RE + Accumulated Other comprehensive Income

Contributed capital = Common stock + preferred stock

Retained earnings includes dividends + prior-period adjustments

OCI includes pension adjustments, foreign exchange adjustments, and changes in fair value of AFS debt securities.

• Authorized shares

  • #shares that the firm can legally issue

• Issued shares: #shares sold or otherwise distributed

• Unissued shares: authorized but not issued

• Treasury shares: corporation’s own shares repurchased by the corporation and held in “treasury”

• Outstanding shares are the number of shares still in the hands of the stockholders, computed as issued shares less treasury shares.

  • Used for financial statistics, such as earnings per share and book value per share, cash dividend

Three Components of Stockholder’s Equity

1. Contributed capital

• Common shareholders are the residual claimants

• Preferred shareholders have preferential rights over common shares.

• Par value: face or stated value on the share certificate, and

• Additional paid-in capital in excess of par or stated value

2. Retained Earnings—firm’s cumulative earnings or losses that it has not distributed as dividends.

3. Accumulated other comprehensive income (AOCI) —includes items such as unrealized gains and losses on available-for-sale investment securities, foreign currency translation adjustments, and certain pension cost adjustments.

Events other than dividends, net income, or loss can also impact retained earnings.

Items are reported in other comprehensive income as opposed to net income due to the low probability of short-term cash realization

Legal Issues: Par Va;ue and Stated Values

• Concept: required corporations to maintain a minimum amount of capital that they could not distribute to shareholders. An original purchaser of the company’s shares could be liable for any amounts contributed below par value in the event of corporate liquidation.

• Many states no longer require minimum capital and permit no par stock.

• Par values are usually set at an immaterial amount.

Other states still specify some form of legal capital. For example, legal capital can be par value, the total proceeds on original issue, or stated value, which is an amount specified by the board of directors. In states requiring legal capital, a firm cannot distribute the amount designated as legal capital until it has settled all prior creditor claims.

Although the designation of par values is no longer required in some states, many currently outstanding common shares that were issued in previous accounting periods have a par value associated with them. As a result, firms continue to allocate the proceeds from a stock issuance to the stock’s par value and any additional capital paid in.

Common Stock Issued for Noncash Consideration

• Value the goods and services received at the fair value of the consideration given up in the exchange.

• Records the noncash assets or services at the fair value of the stock issued in the exchange.

• If no reliable value for the stock, use the fair value of the consideration received

The determination of fair value in a transaction exchanging common stock for noncash consideration involves management’s judgment. In some cases, the fair value of the stock or the noncash consideration is apparent. However, in many situations it is not. For example, if the company issuing the stock is not publicly traded, the fair value of the stock may not be easily and reliably determined. Similarly, if the services are provided on a regular basis, such as legal services, then a rate is probably easy to determine by using the rate charged to other clients of the law firm. However, if the services provided are more customized, it may be difficult to determine a fair value. In these cases, management exercises judgment to determine an appropriate fair value at which to record the transaction.

Share Repurchase

A company can hold or retire repurchased shares. 

• Treasury shares are a corporation’s own stock that are authorized, issued, and previously outstanding that the corporation buys back. Still considered issued shares.

• Retired shares: treasury shares “retired” and are no longer considered issued

• No “gains” and “losses” on the income statement when dealing with treasury shares. They are considered capital transactions, all effects in equity.

• Rationale

  • For stock option plans, stock bonus plans, and employee stock purchase plans

  • For exchanges for another firm’s voting shares in a merger or acquisition

  • To support the market price of the stock

  • To prevent takeover attempts

  • To distribute cash to shareholders

Accounting for Treasury Stock Transactions

• Recorded in a contra-stockholders’ equity account

• Treasury shares

  • Reduce the number of shares outstanding.

Cost method

• Acquisition: Debit treasury stock for the cost of the repurchased shares. Credit cash for the amount paid.

• Reissuance

• Above Cost: Excess over cost recorded as Additional Paid In Capital (APIC)—TS

• Below Cost:

  • Reduce APIC—TS if possible.

  • If not possible, reduce RE.

Under the cost method, the repurchase of shares does not change the common stock account or the additional paid-in capital account. The repurchased shares are still considered issued, but they are no longer outstanding

Accounting for Retained Earnings

Retained earnings are the cumulative earnings of the firm that it has not distributed as dividends.

• Items affecting retained earnings include:

  • Net income (loss).

  • Dividends.

  • The sale of treasury stock below cost.

  • Prior-period adjustments.

Retained earnings are amounts earned by the firm, as opposed to contributed capital, which are amounts invested by the equity holders of the firm.

Dividends

• Represent a return to shareholders on their investment in the corporation.

• Types

  • Cash

  • Stock

  • Property—any asset other than cash

  • Liquidating—any distribution that the firm pays from contributed capital instead of retained earnings.

• Key Dates

  • Declaration date—done by the board of directors, record liability

  • Record date—to determine stockholders entitled to dividend

  • Ex-dividend date—generally two business days before the record date. Investors purchasing the stock on or after this date will not receive the dividend.

  • Payment date—firm distributes the dividend.

Cash is the most common type of dividend.

Cash, stock, and property dividends are all distributed from retained earnings.

Property and liquidating dividends are rare

Accounting for Stock Dividends 

• Declaration not a legal liability

• Do not change the total equity balance

  • Retained earnings decrease.

  • Contributed capital increases.

• Accounting depends on size of stock dividend

  • Small (<20-25%)

    • Low impact on ownership & share price

    • Value at FMV of shares (like buying shares from the market)

  • Large (>20-25%)

    • Likely to impact share price and ownership

    • Value at par

Stock dividends can also be used to supplement a cash dividend without increasing cash dividends. Unlike cash dividends, when a board of directors declares a stock dividend, it is not under any legal obligation to distribute the dividend. Thus, firms do not increase a liability account when declaring a stock dividend.

The stock dividend permanently capitalizes retained earnings by transferring amounts from retained earnings to contributed capital. The amount of the transfer from retained earnings to contributed capital depends on the size of the dividend

Judgements in Accounting: Stock Dividends

Because FASB does not specify an exact percentage cutoff to distinguish between small stock dividends and large stock dividends, there is some room for judgment in accounting for stock dividends.

• The difference in accounting between small stock dividends and large stock dividends affects the balance in the retained earnings account, and thus, investors may be influenced by the accounting treatment.

• Now assume that Wallace Company from Examples 15.20 and 15.21 declared a stock dividend of 300,000 shares, which represents 23% of the current outstanding shares. Compare the differences between treating it as small dividends or large dividends.

Overview of Preferred Shares

• Priority over receiving dividends

• Priority claim to assets in liquidation

• Usually nonvoting

• Advantages over debt and common equity financing

  • Raise private equity capital without giving up control of the corporation

  • Less risky than debt because as dividends are not mandatory

• Taxation disadvantage because dividends are not tax deductible; interest on debt is tax deductible.

• Par values usually higher since dividends paid as a % of par

  • Ex.: A 5% preferred share with a $100 par value would pay an annual dividend of $5.

With a dividend preference, the firm must pay preferred shareholders before declaring any dividends to common shareholders. However, preferred shareholders have no right to dividends if the firm does not declare dividends for a given period. There is never a legal liability for the corporation to pay dividends, unless the board of directors declares a dividend

Features of Preferred Shares

• Cannot pay CS dividends until all PS dividends paid

• Cumulative

  • If no dividend declared, dividends accumulate

  • Footnote disclosure of these “dividends in arrears”

  • NOT liabilities

• Participating

  • PS share ratably with CS

  • Allows for more upside potential for PS than just dividend

• Convertible

• Callable

  • Must pay any dividends

Prior Peroid Adjustments 

• If a company finds an error after releasing the financial statements + material à corrections to past years’ financial statements are necessary (prior-period adjustment).

• A retroactive adjustment correctly recognizes, measures, and provides disclosures as if the error never occurred.

Firms are only required to report material errors that would influence the economic decisions of financial statements users. Errors corrected using a prior-period adjustment include mathematical mistakes and incorrect application of accounting standards. For instance, a company could make a mathematical error in the calculation of its bad debt expense. The accounting method used to correct an error depends on when the firm made the error. Companies commonly report 1 or 2 years of prior years’ financial statements to enhance comparability.

For example, in the 2022 annual report, a company provides income statements for 2022, 2021, and 2020 and balance sheets for 2022 and 2021. If the error was made in one of these prior-year financial statements (2021 or 2020) that are presented with the current-year financial statements, the firm retroactively changes relevant financial statement line items and includes a disclosure in the footnotes explaining the error in the 2022 annual report. A retroactive adjustment correctly recognizes, measures, and provides disclosures as if the error never occurred. Correcting financial statements in this way is also referred to as a restatement

Accounting for OCI

• Comprehensive income

A measure of changes in equity that result from recognized transactions and all economic events of the period other than transactions with owners

Comprehensive income = net income + OCI

For example, unrealized gains and losses on adjusting the carrying value of investments to fair value are not always reported in net income.

Reporting comprehensive income assists investors, creditors, and others in assessing a company’s activities and the timing and magnitude of a company’s future cash flows

Conceptual Framework - OCI

Reasons that support the presentation of OCI:

1. OCI items have a low probability of cash flow realization in the short term and therefore should not be included in net income. Including these items would further remove net income from the underlying cash flows of the firm.

2. The temporary nature of OCI items would create earnings volatility (when these temporary events reverse) if included in net income.

3. OCI events are not part of normal business operations, so they should not be included in net income.

Reporting OCI

A company has two options for reporting OCI:

1. Include components of OCI after net income on one continuous statement summing to comprehensive income.

2. Separate statement (in addition to Income Stmt)

   1. Begins with net income on the first line

   2. Details the components of OCI.

Facebook, Inc., the online social media company, uses the second approach, as illustrated in Exhibit 15.8. In 2023, Facebook’s comprehensive income was $12 million higher than its net income, due to other comprehensive income items.

Accumulated OCI

• Aggregation of OCI over the years

• Third component of stockholders’ equity

• Reported on the balance sheet in the stockholders’ equity section, along with contributed capital and retained earnings