Chapter 11: Stockholders' Equity

Objective 11.1: Explain the role of stock in financing a corporation.

Corporate Ownership

• The major advantage of the corporate form of business is the ease of raising capital as both large and small investors can participate in corporate ownership.
• Advantages include:
  • It is simple to become an owner of a corporation:
  • You just have to buy a share of the company’s stock.
  • You can easily transfer ownership:
  • Sell the stock to someone else.
  • A corporation provides limited liability.
  • A shareholder is not responsible for a company’s debt.
  • It the company goes bankrupt, you lose the amount you paid for the initial stock, but you are not liable for company’s liabilities.
• Because a corporation is a separate legal entity, it can:
  • Own assets
  • Incur liabilities
  • Sue and can be sued
  • Enter into contracts
• Corporations are $regulated by law$.
• You must submit an application to the state government to create a corporation. When a corporation is approved, the state issues the articles of incorporation which holds information about the corporation.
• Stockholder benefits include:
  • Voting rights - being able to vote on important issues at annual meetings.
  • Dividends - Stockholders have the right to receive dividends when declared by the board of directors.
  • Residual claims (liquidation rights) - If the corporation goes bankrupt, stockholders share in any remaining assets after creditors are paid.
  • Preemptive rights - Existing stockholders have the first chance to purchase newly issued stock before it is issued to the public.

Equity vs Debt Financing

• Equity financing is issuing new stock to investors.
  • Advantages:
  • Equity does not have to be repaid, but debt does.
  • Dividends are optional, but there is interest on debt.
• Debt financing is borrowing money from lenders.
  • Advantages:
  • Interest on debt is tax deductible.
  • Debt does not change shareholder control.

Objective 11.2: Explain and analyze common stock transaction.

Stockholders’ Equity

• $The four elements of stockholders’ equity:$
  • Contributed Capital
  • Retained Earnings
  • Treasury Stock
  • Accumulated Other Comprehensive Income or Loss
• Contributed Capital (Common Stock and APIC)
  • The company receives capital from investors when they sell stock to them.
  • APIC is Additional Paid in Capital, which is the amount collected over par.
• Retained Earnings
  • It is earned capital.
  • Cumulative net income means less cumulative dividends.
• Treasury Stock
  • Shares that were issued, but the company decided they wanted to buy them back.
  • This is a contra accounts that has a normal DEBIT balance and reduces Stockholders’ Equity.
  • It is a $permanent$ account.
  • A contra account that is “stuck like glue” to Common Stock and APIC.
• Accumulated Other Comprehensive Income or Loss
  • Recorded unrealized gains and losses that cause temporary changes in the value of assets and liabilities of the company.
  • The may involve pensions, foreign currencies, and financial investments.
  • It holds everything else (what we can’t squeeze into Common Stock because it can only hold par value).

Authorization, Issuance, and Repurchase of Stock

• A corporation can only issue a certain number of shares, which are known as authorized shares.
• Issued shares are permanently for the stockholder unless:
  • They sell them to another company
  • The corporation buys them back (treasury stock)
• Unissued shares are shares that haven’t been traded.
• Outstanding shares are owned by stockholders. They are $the only shares that can’t get dividends$.

Stock Authorization

• Par value is assigned to each share of stock that is authorized.
• It is not the same at market price, which is the value of what shares can sell for to the public.
• It is always a small number, like $0.01 per share.
• Some states require par value.
• No-Par value stock does not have a determined price.
• $No PAR = No APIC$

Stock Issuance

• The first time a corporation’s stock is available to the public is called an initial public offering (IPO).
• When new stock is issued to the public, this is called seasoned new issue.
• Issuing stock at par value, $always the same journal entry:$
  • Debit cash
  • Credit Common Stock (shares x par value amount)
  • Credit Additional Paid In Capital (cash - common stock)
• Example: A company issued 100,000 shares of $0.01 par value common stock for $30 per share.
  • Step 1: Calculate cash received.
  • Shares x Price per share
  • 100,000 x $30
  • Cash = 3,000,000
  • Step 2: Calculate Common Stock.
  • Shares x Par value
  • 100,000 x $0.01
  • Common Stock = $1,000
  • Step 3: Calculate Additional Paid-In Capital (APIC).
  • Cash - Common stock
  • 3,000,000 - $1,000
  • APIC = 2,999,000
  • Step 4: Make the journal entry.

Stock Exchanged Between Investors

• A transaction between two investors does not involve the corporation, so the corporation does not need to record anything.
• The corporation still has the same amount of shares issued to shareholders.

Stock Used to Compensate Employees

• Employees pay packages may include exclusive stock options for a “discount” price compared to what the market price is.
• Employees are later able to buy stock and the value will be higher.
• They can also sell their stock at a higher price.

Repurchase of Stock

• Treasury stock is the repurchase of issued stock.
• $The purpose of repurchases can be$:
  • Making a company believe the stock is worth getting.
  • Buy back the shares just to reissue them at a higher price to other companies.
  • Buy back shares to reissue them to employees.
  • Reduce the number of outstanding shares to increase per-share measures of earnings.
• When it is bought back, it is $recorded at cost$.
• It has no voting or dividend rights.
  • Cash dividends paid is reduced when Treasury Stock is purchased.
  • Stock transactions are only on the balance sheet.
• $Journal entry for reacquiring stock$:
  • Debit Treasury Stock
  • Credit Cash
• Example for reacquiring stock: A company reacquires 20,000 shares of its common stock at $20 per share.
  • Step 1: Calculate cash paid.
  • 20,000 x $20
  • $400,000 is paid.
  • Step 2: Make the journal entry.

• $Journal entry for reissued stock$:
  • Debit Cash (shares x new price of share)
  • Credit Treasury Stock (shares x initial price of stock)
  • Credit Additional Paid-In Capital (shares x (new price - old price))
• Example for reissuing stock: A company reissues 10,000 shares of Treasury Stock at $35 per share.
  • Step 1: Calculate cash received.
  • Shares x New cost per share
  • 10,000 x $25
  • Cash = $250,000
  • Step 2: Calculate Treasury Stock that will be issued.
  • Shares x Initial price of stock (from reacquiring example)
  • 10,000 x $20
  • Treasury Stock = $200,000
  • Step 3: Calculate APIC.
  • (Shares x (new price - old price))
  • (10,000 x ($25 - $20))
  • 10,000 x $5
  • APIC = $50,000
  • Step 4: Make the journal entry.

• Stock transactions NEVER generates gains or losses.

Objective 11.3: Explain and analyze cash dividends, stock dividends, and stock split transactions.

Cash Dividends on Common Stock

• If investors get common stock then they will get a return on their investment.
• Returns on Common Stock investments can come in two forms:
  • Dividends
  • Increases in stock price
• Growth investment is buying stock that pay a small amount of dividends or no dividends at all.
• Income investments are from common stock that do pay dividends.
• Before a dividend is declared, a company must have:
  • Enough retained earnings
  • Enough cash
• Dividends are…..
  • Declared by a board of directors.
  • Not legally required.
  • Liabilities once declared
• $Dividends are not an expense$.

Dividend Dates

• The declaration date is the day when the Board of Directors decide to issue a cash dividend. This is the day the liability is established. Journal entry:
  • Debit Dividends
  • Credit Dividends Payable
• The date of record is an administrative responsibility.
  • No journal entry
• The date of payment reduces the liability and cash. Journal entry:
  • Debit Dividends Payable
  • Credit Cash
• The year end is when the temporary accounts are closed to Retained Earnings. Journal entry:
  • Debit Retained Earnings
  • Credit Dividends
• Example:
  • Declaration Date: A company declares a cash dividends of $115,000,000 during its 2021 fiscal year.

• Date of record: NO JOURNAL ENTRY
• Date of payment: The previously declared dividend is paid off by the company.

• Year end: The company’s temporary accounts are closed into Retained Earnings at the end of their accounting period.

The Common Stock Triangle 🔽

• Authorized shares are the max amount of shares that can be issued.
• Issued shares are given to shareholders.
• Outstanding shares are what has not been issued.

• ==Equation to calculate outstanding shares:==
  • Issued - Treasury shares = Outstanding Shares
• Example:

Objective 11.4: Describe the characteristics of preferred stock and analyze transactions affecting preferred stock.

Preferred Stock

• Preferred stock is given to a special group of investors.
• Preferred stock has different features such as:
  • It has different voting rights (none or a lot).
  • Dividends may be paid at a fixed rate.
  • It has priority over normal common stock.
• Preferred Stock Issuance increases cash and stockholders’ equity.

Preferred Stock Redemption

• Preferred stock that was issued can be bought back.
• This redemption means the preferred stock is retired, which results in the issuance being reversed.

Preferred Stock Dividends

• Preferred stock gives two dividends preferences:
  • Current dividend preference
  • Cumulative dividend preference
• A current dividend preference states that preferred dividends must be paid before paying dividends to stockholders.
• A cumulative dividend preference states if a current dividends is not paid, the unpaid amount has to be paid before other common dividends.
• Dividends in arrears regard cumulative preferred stock that has not been paid yet. They are not on the balance sheet.

Retained Earnings

• Retained Earnings are the collective earnings of a company.
• Net income increases Retained Earnings.
• Net loss decreases Retained Earnings.
• Giving cash or dividends to stockholders also decreases Retained Earnings.
• The negative balance of Retained Earnings is called accumulated deficit.

Statement of Stockholders’ Equity

• The statement of stockholders’ equity shows each stockholders’ equity account so we can track increases and decreases for each account.
• Examples of what may be included:
  • Issued shares
  • Treasury stock
  • Net income
  • Cash dividends
  • Stock dividends
  • Common stock
  • APIC
  • Retained Earnings

Objective 11.5: Analyze the earnings per share (EPS), return on equity (ROE), and price/earnings (P/E) ratios.

Earnings Per Share (EPS)

• Earnings per share provides information on the profit earned from common stock that is outstanding.
• Recent earning ratios can look into how dividends and stock prices may be in the future.
• Using EPS, you can compare the financial ratio to other years.
• You can not compare companies using this ratio.
• The higher that ratio, the better.
• ==Equation to calculate earnings per share:==
  • (Net Income - Preferred Dividends)/ Average number of Common Shares Outstanding
• Example: A company’s income for 2022 was $160,100,000. It has $0 of preferred dividends. The average number of its outstanding shares was 50,400,000.

Return on Equity (ROE)

• Return on Equity reports a company’s return to stockholders.
• The ratio can be compared across companies.
• The higher the ratio, the better.
• ==Equation to calculate return on equity:==
  • (Net Income - Preferred Dividends)/ Average Common Stockholders’ Equity
• Example: A company’s income for 2022 was $160,100,000. It has $0 of preferred dividends. The average common stockholders equity was $315,600,000.

Price/Earnings (P/E) Ratio

• The Price/Earnings ratio is a measure of the value that investors place on a company’s common stock.
• The current stock price comes from the stock exchange.
• With this ratio, you need to calculate EPS before calculating P/E.
• ==Equation to calculate the price/earning ratio:==
  • Current Stock Price (per share)/ Earning Per Share (annual)
• Example: A company’s stock price was $38.44 when the company reported its 2022 EPS of $3.07.