Financial Accounting - Stockholders’ Equity

Accounting Equation and Stockholders’ Equity

• The accounting equation is: Assets = Liabilities + Stockholders’ Equity
  • Assets are resources.
  • Liabilities are creditors’ claims.
  • Stockholders’ Equity is owners’ claims.
• Primary Components of Stockholders' Equity:
  • Paid-in capital: Amount stockholders have invested in the company.
  • Retained earnings: Amount of earnings the company has kept or retained (earnings not distributed in dividends to stockholders over the life of the company).
  • Treasury stock: A company’s own issued stock that it has repurchased.

Invested Capital

• Paid-in capital (or invested capital) is the amount of money paid into a company by its owners.
• Types of business entities:
  • Sole proprietorship: Owned by one person.
  • Partnership: Owned by two or more persons.
  • Corporation: Legally separate from its owners and pays its own income taxes.

Corporation Structure

• Stockholders: Control the company by voting their shares to determine the board of directors.
• Board of Directors: Appoints management to run the company.
• Management: Includes CEO, COO, CFO, executive vice presidents, and legal counsel.

Stages of Equity Financing

• Step 1: Investment by the founders of the business.
• Step 2: Investment by friends and family of the founders.
• Step 3: Investment by "angel" investors and venture capital firms.
• Step 4: Initial public offering (IPO).

Corporations and Investments

• Corporations raise money from founders, friends, and family.
• To grow, companies seek investments from:
  • Angel investors: Wealthy investors.
  • Venture capital firms: Provide funding and business expertise.
  • Initial Public Offering (IPO): The first time a corporation issues stock to the general public.

Public vs. Private Corporations

• Publicly Held Corporation:
  • Allows public investment.
  • More stockholders.
  • Regulated by the SEC.
  • Examples: Wal-Mart, ExxonMobil, General Electric, Apple, Microsoft, and Intel.
• Privately Held Corporation:
  • No public investment.
  • Fewer stockholders.
  • Not regulated by the SEC.
  • Examples: Cargill, Koch Industries, and Mars.

Stockholder Rights

• Right to Vote: Stockholders vote on matters, including the election of corporate directors.
• Right to Receive Dividends: Stockholders share in profits when the company declares dividends. The percentage of shares a stockholder owns determines his or her share of the dividends distributed.
• Right to Share in the Distribution of Assets: Stockholders share in the distribution of assets if the company is dissolved. The percentage of shares a stockholder owns determines his or her share of the assets, which are distributed after creditors and preferred stockholders are paid.

Advantages and Disadvantages of a Corporation

• Advantages:
  • Limited liability: A stockholder can lose no more than the amount invested.
  • Ability to raise capital and transfer ownership: Attracting outside investment and transferring ownership is easier for a corporation.
• Disadvantages:
  • Additional taxes: Corporate earnings are taxed twice—at the corporate level and individual stockholder level.
  • More paperwork: Federal and state governments impose additional reporting requirements.

Key Points on Corporate Form

• Primary advantages: limited liability and the ability to raise capital.
• Primary disadvantages: additional taxes and more paperwork.

Common Stock

• Types of Common Stock
  • Authorized: Shares available to sell (= Issued + Unissued)
  • Issued: Shares actually sold (= Outstanding + Treasury)
  • Outstanding: Shares issued and held by investors
  • Treasury: Shares issued and repurchased by the company.

Par Value

• Legal capital per share of stock that’s assigned when the corporation is first established.
• Par value has no relationship to the market value of the common stock.

Common Mistake

• Par value is the legal capital per share that is set when the corporation is first established and actually is unrelated to “value.”
• The market value per share is equal to the current share price.
• In most cases, the market value per share will far exceed the par value.

Accounting for Common Stock

• Assume Canadian Falcon issues 1,000 shares of no-par common stock at $30 per share.

  Debit  Credit
  Cash (= 1,000 shares × $30) …….  30,000  
  Common Stock …………………………………  30,000   
  (Issue no-par value common stock)
  

• Assume Canadian Falcon issues 1,000 shares of $0.01 par value common stock at $30 per share.
  latex Debit Credit Cash (= 1,000 shares × $30) ……. 30,000 Common Stock (= 1,000 shares × $0.01) ……… 10 Additional Paid-in Capital (difference) ………... 29,990 (Issue common stock above par)

Key Points on Common Stock Accounting

• If no-par value stock is issued, the corporation records the full amount to Cash and credits Common Stock.
• If par value or stated value stock is issued, the corporation records two equity accounts—Common Stock at the par value or stated value per share and Additional Paid-in Capital for the portion above par or stated value.

Preferred Stock

• Preferred stock is “preferred” over common stock in two ways:
  • Preferred stockholders usually have first rights to a specified amount of dividends (a stated dollar amount per share or a percentage of par value per share). If the board of directors declares dividends, preferred shareholders will receive the designated dividend before common shareholders receive any.
  • Preferred stockholders receive preference over common stockholders in the distribution of assets in the event the corporation is dissolved.

Accounting for Preferred Stock Issues

• Assume Canadian Falcon issues 1,000 shares of $30 par value preferred stock for $40 per share.
  latex Debit Credit Cash (= 1,000 shares × $40) ……. 40,000 Preferred Stock(= 1,000 shares × $30) …… 30,000 Additional Paid-in Capital (difference) …… 10,000 (Issue preferred stock above par)

Features of Preferred Stock

• Convertible: Shares can be exchanged for common stock.
• Redeemable: Shares can be returned to the corporation at a fixed price.
• Cumulative: Shares receive priority for future dividends if dividends are not paid in a given year.

Comparison of Financing Alternatives

Key Points on Preferred Stock

• Preferred stock has preference over common stock in receiving dividends and in the distribution of assets in the event the corporation is dissolved.
• We record the issuance of preferred stock similar to the way we did for the issuance of common stock.
• Some preferred stock is cumulative, meaning any dividends not declared in a given year accumulate to be paid in a later year.

Dividends versus Stock Buybacks

• Companies buy back their own stock for various reasons:
  • To boost underpriced stock
  • To distribute surplus cash without paying dividends
  • To boost earnings per share
  • To satisfy employee stock ownership plans

Accounting for Treasury Stock

• Treasury stock is the purchase of a company’s own issued stock.
• Just as issuing shares increases stockholders’ equity, buying back those shares decreases stockholders’ equity.
• Rather than reducing the stock accounts directly, though, we record treasury stock as a separate “negative” or “contra” account.

Common Mistake

• An equity investment is the purchase of stock in another corporation, and we record it as an increase in assets.
• Treasury stock is the purchase of a corporation’s own stock, and we record it as a reduction in stockholders’ equity. It is not an asset; a company cannot invest in itself.

Purchase of Treasury Stock

• Canadian Falcon repurchases 100 shares of its own $0.01 par value common stock at $30 per share.

  Debit  Credit
  Treasury Stock (= 100 shares × $30)  3,000  
  Cash  3,000  
  (Purchase treasury stock)
  

Resale of Treasury Stock (above cost)

• Canadian Falcon resells the 100 shares of treasury stock for $35. Recall that these shares originally were purchased for $30 per share.

  Debit  Credit
  Cash (= 100 shares × $35)  3,500  
  Treasury Stock (= 100 shares × $30)  3,000  
  Additional Paid-in Capital (= 100 shares × $5)  500
  (Resell treasury stock above cost)
  

• When we resell the treasury shares at $35, we must reduce the Treasury Stock account at the same $30 per share. We record the $500 difference (= 100 shares × $5 per share) as a credit to Additional Paid-in Capital.

Resale of Treasury Stock (below cost)

• Assume Canadian Falcon resells the 100 shares of treasury stock for only $25 rather than $35. Recall that these shares originally were purchased for $30 per share.

  Debit  Credit
  Cash (= 100 shares × $35)  2,500
  Additional Paid-in Capital (= 100 shares × $5)  500  
  Treasury Stock (= 100 shares × $30)  3,000
  (Resell treasury stock below cost)
  

• When we resell the treasury shares for $25, we must reduce the Treasury Stock account at the same $30 per share. We record the $500 difference (= 100 shares × $5 per share) as a decrease to Additional Paid-in Capital.

Key Points on Treasury Stock

• We include treasury stock in the stockholders’ equity section of the balance sheet as a reduction in stockholders’ equity (increases in treasury stock will decrease stockholders’ equity).
• When we resell treasury stock, the amount of the sale price above (below) the stock’s original purchase cost is reported as an increase (decrease) in additional paid-in capital.

Retained Earnings

• Earnings retained in the corporation and not paid out as dividends
• Equals all net income less all dividends, since the company began operations
• Has a normal credit balance

Common Mistake

• Some students think, incorrectly, that retained earnings represents a cash balance set aside by the company. In fact, the size of retained earnings can differ greatly from the balance in the Cash account.

Key Point

• Retained earnings represent all net income, less all dividends, since the company began operations.

Cash Dividends

• Distributions by a corporation to its stockholders
• A change in a quarterly or annual cash dividend paid by a company can provide useful information about future prospects
• Not all companies pay dividends; for example, growth companies prefer to reinvest earnings rather than distribute them

Dividend Dates

• Declaration date: Date on which board of directors announces the next dividend to be paid.
• Record date: The date on which the company looks at its records to determine who the stockholders of the company are.
• Payment date: The date of the actual distribution of dividends.

Common Mistake

• Some students incorrectly calculate dividends based on the number of issued shares. Dividends are based on the number of outstanding shares since dividends are not paid on treasury stock.

Recording Cash Dividends

• On March 15, Canadian Falcon declares a $0.25 per share dividend on its 2,000 outstanding shares. The dividend declared by Canadian Falcon is paid on April 15.
• Text Alternative:
  • The tables show the recording of cash dividends. The illustration has 2 tables. The table above contains 3 columns with the following headings: March 15 (declaration date); Debit; Credit. The row entries are as follows:
    • Row 1. Dividends (=2,000 shares x $0.25); 500; blank.
    • Row 2. Dividends payable; blank; 500.
    • Row 3. (Declare cash dividends); blank; blank. The table below contains 3 columns with the following headings: April 15 (payment date); Debit; Credit. The row entries are as follows:
    • Row 1. Dividends payable (=2,000 shares x $0.25); 500; blank.
    • Row 2. Cash; blank; 500.
    • Row 3. (Pay cash dividends); blank; blank. An arrow from row 2 column 3 from the table above points to row 1 columns 2 of the table below.

Key Point

• The declaration of cash dividends decreases Retained Earnings and increases Dividends Payable. The payment of cash dividends decreases Dividends Payable and decreases Cash. The net effect, then, is a reduction in both Retained Earnings and Cash.

Stock Dividends and Stock Splits

• Stock dividends or stock splits are additional shares of stock distributed by corporations to stockholders rather than cash
• Large stock dividends (25% or more of the shares outstanding) and stock splits are declared primarily due to the effect they have on stock prices.

Stock Splits

• A large stock dividend that includes a reduction in the par or stated value per share. When a company declares a stock split, we do not record a transaction.
• Assume Canadian Falcon declares a 2-for-1 stock split on its 1,000 shares of $0.01 par value common stock. The balance in the Common Stock account is 1,000 shares times $0.01 par value per share, which equals $10.
  • With no journal entry, the balance remains $10 despite the number of shares doubling. The par value per share is reduced by one-half to $0.005.

Large Stock Dividends

• Records a decrease in retained earnings and an increase in common stock; recorded at par value.

  Debit  Credit
  Stock Dividends*(= 1,000 shares x $0.01)  10  
  Common Stock  10
  (*Debiting Stock Dividends reduces Retained Earnings)
  

Small Stock Dividends

• Recorded at market value, not par value.

• Do not change total assets, total liabilities, or total stockholders’ equity.

• Decreases one equity account, Retained Earnings, increases two other equity accounts, Common Stock and Additional Paid-in Capital.

  Debit  Credit
  Stock Dividends (= 1,000 × 10% × $30)  3,000  
  Common Stock (= 1,000 × 10% × $0.01)  1  
  Additional Paid-in Capital (difference)  2,999
  (Distribute 10% [small] stock dividend)
  

Key Point

• Declaring stock dividends and stock splits is like cutting a pizza into more slices.
• Everyone has more shares, but each share is worth proportionately less than before.

Stockholders’ Equity Section

• The stockholders’ equity section of the balance sheet presents the balance of each equity account at a point in time.
• The statement of stockholders’ equity shows the change in each equity account balance over time.

Return on Equity

• Measures the ability of company management to generate earnings from the resources that owners provide.

Earnings per Share

• Measures net income earned per share of common stock
• Earnings \, per \, share = {Net \, income – Dividends \, on \, preferred \, stock \over Average \, shares \, of \, common \, stock \,outstanding}

Price-Earnings Ratio (PE ratio)

• Indicates how the stock is trading relative to current earnings
• Price-earnings \, ratio = {Stock \, price \over Earnings \, per \, share}

Key points

• The return on equity measures the ability to generate earnings from the owners’ investment.
  • It is calculated as net income divided by average stockholders’ equity.
• The dividend yield measures how much a company pays out in dividends in relation to its stock price.
• Earnings per share measures the net income per share of common stock.
• The price-earnings ratio indicates how the stock is trading relative to current earnings.