Stockholders' Equity - ACCT 2010 Lecture Notes

Accounting Principles - Stockholders' Equity

Course and Context

  • Institution: Southern Utah University

  • Course: ACCT 2010

  • Chapter Focus: Stockholders' Equity

  • Instructor: Professor Ford

  • Date of Coverage: November 13 - 18, 2019

Learning Objectives

  • Gain an understanding of the difference between debt and equity.

  • Recognize the basic transactions associated with equity, including:

    • Issuance and repurchase of stock

    • Distribution of dividends

    • Impact of stock splits

  • Contemplate the implications of preferred equity.

Debt vs. Equity

Fundamental Equation

  • The relationship between a firm’s assets, liabilities, and equity can be expressed by the accounting equation:
    ext{Assets} = ext{Liabilities} + ext{Owners' Equity}

  • Both liabilities and equity represent claims against the firm’s assets, signifying the following:

    • Distinction in the nature of the claims between debt (liabilities) and equity (owners).

    • The priority of claims determines which creditors are honored first during liquidation events.

Characteristics of Debt

  • Debt represents cash that a firm has borrowed which is obligated to be paid back, typically with interest.

Characteristics of Equity

  • Shareholders’ equity signifies the ownership stake in the firm, defined as:

    • Residual Claim: Equity holders are paid after all debt obligations are settled.

    • Equity contributions do not require repayment.

  • Equity Ownership Privileges:

    • Voting rights (for common stockholders)

    • Dividend entitlement (when declared)

    • Claim over net assets during liquidation

    • Limited liability if the firm declares bankruptcy.

  • Disadvantages of Equity:

    • There is no contractual obligation for a return of cash, indicating that owning stock comes with investment risk.

Terminology in Equity Structure

  • Authorized Shares: The total number of shares that the firm's board of directors permits to be sold.

  • Issued Shares: The count of authorized shares that have been sold to investors.

  • Outstanding Shares: The issued shares that are currently held by investors, with the notion that

    • ext{Issued Shares} ext{ (≥)} ext{ Outstanding Shares}

Stock Issuance

  • The process in which a firm sells common stock is referred to as equity issuance.

    • Initial Public Offering (IPO): The first occasion a firm sells its stock to the public.

    • Seasoned Equity Offering: Subsequent stock sales occurring after the IPO.

  • Secondary Market Transactions:

    • After the initial issuance, shares are traded among investors without the firm’s involvement, resulting in no journal entries.

Common Stock Characteristics

  • Common Stock: The fundamental form of ownership in a corporation.

    • Provides basic ownership and the right to receive distributions from the business.

    • Enables owners to engage in the management indirectly through voting for the board of directors.

    • Offers a residual claim to the firm’s net assets in case of liquidation.

Par Value of Stock

  • Par Value: A nominal value set at the issuance of stock,

    • Example: McDonald’s common stock has a par value of $0.01.

    • Historically intended to safeguard firm capital; however, it has limited current relevance.

    • Once established, the firm must maintain the same par value for future stock issuances.

Accounting for Stock Issuance

  • When a firm sells shares, the transaction is recorded as follows:

    • The cash amount received ($ ext{Sale Price} imes ext{Number of Shares}$) and the par value recorded as common stock ($ ext{Par Value} imes ext{Number of Shares}$) result in additional paid-in capital (APIC).

    • Journal Entry:

    • ext{Cash} (+A) = X

    • ext{Common Stock} (+SE) = Y

    • ext{APIC} (+SE) = X - Y

    • Example: If ABC sells 3,000,000 shares at $90 per share with a par value of $1:
      Total proceeds: 3,000,000 imes 90 = 270,000,000
      Par value total: 3,000,000 imes 1 = 3,000,000
      Excess amount: 3,000,000 imes (90-1) = 267,000,000

    • Journal Entries for stock issuance:

      • Cash 270,000,000

      • Common Stock 3,000,000

      • APIC 267,000,000

No Par Stock Issuance

  • No Par Common Stock: If issued, the entire received amount is recorded as common stock.

  • Journal Example:

    • ext{Cash} (+A) = 270,000,000

    • ext{Common Stock} (+SE) = 270,000,000

Statement of Stockholders’ Equity Preparation

Context of Usage

  • A statement that details all changes in a company’s equity accounts over a given period, concluding with balances of each equity account.

  • Example: For Mesa Industries:

    • Prior Year Ending Balances:

    • 7,000 shares of Common Stock at $105,000

    • Paid-in Capital of $9,000

    • Retained Earnings of $48,000

    • Expected transactions during the year include revenues, dividends declared, and stock issuance.

Journal Entries for Stockholders’ Equity

  • Balances are calculated after considering:

    • Net income reported for the current period: $46,000.

    • Dividends declared at $1 per share on beginning shares outstanding: 7,000 (7,000 shares).

    • Issued 1,500 shares at year-end at $26:
      ext{Common Stock} = 1,500 imes 26 = 39,000

Effects of Dividends on Stockholders’ Equity

  • Cash dividends create a liability on the declared date and reduce retained earnings:

    • Journal Entries:

    • October 12: Retained Earnings (-SE) 3,125,000; Dividend Payable (+L) 3,125,000

    • December 4: No journal entry; record date for determining eligible shareholders.

    • January 3: Dividend Payable (-L) 3,125,000; Cash (-A) 3,125,000

Stock Splits

  • Stock Split Definition: The process whereby a company increases its total outstanding shares by subdividing existing shares into additional ones.

    • Often executed in common ratios (e.g., 2-for-1, 3-for-2).

  • No journal entries are needed, but they are disclosed as footnotes in the financial statements.

    • Effects include increasing total shares while reducing par value per share.

    • Stock splits do not impact retained earnings, stockholders' equity total, or any dollar value in equity accounts.

    • Rationale for firms executing splits includes making stocks more affordable for trading and increasing share liquidity.

Preferred Equity

Preferred Stock Explained

  • Represents a class of ownership that differs from common equity, offering certain advantages:

    • No voting rights.

    • Often provides fixed dividends (e.g., 8% on a $20 par value stock results in a $1.60 dividend per share per year).

    • Less risky compared to common stock, holding priority in both dividends and liquidation payments.

Cumulative vs. Non-Cumulative Preferred Stock

  • Cumulative Preferred Stock: Requires that if any dividend payments are missed, they must be paid before any dividends to common stockholders.

  • Non-Cumulative Preferred Stock: Does not require missed dividends to be paid in arrears before common stockholder dividends.

Key Ratios Related to Equity

1. Return on Equity (ROE)

  • Defined as:
    ext{ROE} = rac{ ext{Net Income}}{ ext{Average Stockholders' Equity}}

  • A measure to gauge a firm’s efficiency in generating profit from owners' equity. Higher ratios generally indicate better profitability.

2. Earnings Per Share (EPS)

  • Computed as:
    ext{EPS} = rac{ ext{Net Income} - ext{Dividends for Preferred Stock}}{ ext{Average Number of Shares of Common Stock Outstanding}}

  • Used by stakeholders to assess overall performance of the company.

3. Price to Earnings (P/E) Ratio

  • Calculated by:
    ext{P/E Ratio} = rac{ ext{Stock Price}}{ ext{Earnings Per Share}}

  • Assists in evaluating the stock’s valuation based on earnings, frequently compared across time and industry.

4. Dividend Yield Ratio

  • Defined as:
    ext{Dividend Yield} = rac{ ext{Dividends per Share}}{ ext{Market Price per Share}}

  • Represents the return on investment, viewed in the context of stock price increases and stability.

Summary of Key Points

  • Common stock embodies the foundational ownership of a corporation, with issuance reflecting in Specific equity accounts (Common Stock and APIC).

  • A company can repurchase its shares, classifying these as Treasury Stock.

  • Cash dividends provide income to equity holders, with alternatives like stock dividends also available.

  • Preferred equity offers higher claims on earnings and assets than common equity, posing different risk and reward dynamics for investors.