Chapter 10: Stockholders' Equity
Chapter 10: Stockholders' Equity
Core Concept of Stockholders' Equity
Definition: Stockholders' Equity = Assets - Liabilities
Primary Sections of Stockholders’ Equity:
Paid-in capital: Total amount stockholders have invested in the corporation.
Retained Earnings: Accumulated earnings the corporation has retained (not distributed as dividends).
Treasury Stock: Corporation's own stock that it has reacquired.
Part A: Invested Capital
Corporations
Articles of Incorporation (Corporate Charter): Describes the following:
(a) Nature of the firm’s business activities
(b) Shares to be issued
(c) Initial board of directors
Stockholder Control: Stockholders control the corporation through voting their shares, determining the makeup of the board of directors, which in turn appoints management to run the corporation.
Stages of Equity Financing
Steps in Progression to Public Offering:
Investment by founders of the business
Investment by friends and family of founders
Outside investment from angel investors and venture capital firms
Initial public offering (IPO): The first time a corporation issues stock to public investors
Public vs. Private Corporations
Public Corporations:
Stock trades on exchanges such as NYSE, AMEX, NASDAQ, or OTC
Regulated by Securities and Exchange Commission (SEC)
Examples: General Motors, Microsoft, Walmart
Private Corporations:
Do not allow investment by the general public
Tend to have fewer stockholders
Not regulated by the SEC
Examples: Koch Industries, Mars, Cargill
Stockholder Rights
Rights of Stockholders:
Right to Vote: Vote on matters including election of corporate directors
Right to Receive Dividends: Share in profits when corporation declares dividends; amount is proportionate to shares owned
Right to Share in Distribution of Assets: Receive assets if corporation dissolves, according to share percentage
Preemptive Right: Allow stockholders to maintain ownership percentage when new shares are issued; many corporations have dropped this right due to complications.
Advantages and Disadvantages of Corporations
Advantages
Limited Liability: Stockholder's loss is limited to investment amount.
Ability to Raise Capital: Attracting outside investment is generally easier.
Lack of Mutual Agency: Stockholders cannot bind the corporation to contracts.
Disadvantages
Additional Taxes: Corporate earnings are taxed twice (corporate level and individual stockholder level).
More Paperwork: Greater regulatory requirements from federal and state levels.
Potential for Complicated Governance: The structure can lead to complex and burdensome decision-making processes.
Types of Stock
Definitions:
Authorized: Maximum number of shares a corporation may sell (includes issued and unissued).
Issued: Shares actually sold (includes treasury stock).
Outstanding: Shares held by investors (excludes treasury stock).
Math Relation:
Authorized – Unissued = Issued
Issued – Treasury Stock = Outstanding
Common Stock
Typical representation of corporate ownership. If a corporation has only one kind of stock, it is labeled as common stock.
Par Value
Definition: Legal capital per share, assigned at establishment, with no significant meaning today.
No Par Value: Common stock without assigned par value.
Stated Value: Treated similarly to par value.
Accounting for Common Stock Issues
General Journal Entries:
When issuing no-par value stock:
Cash: (1,000 shares x $30) = $30,000
Common Stock: $30,000
When issuing par value stock:
Cash: (1,000 shares x $30) = $30,000
Common Stock: (1,000 shares x $0.01) = $10
Additional Paid-in Capital: $29,990 (the difference)
Preferred Stock
Characteristics:
Preferred stock is “preferred” over common stock and mixes attributes between equity and bonds.
Comparison with Common Stock and Bonds:
Factor
Common Stock
Preferred Stock
Bonds
Voting Rights
Yes
Usually No
No
Risk to Investor
Highest
Middle
Lowest
Expected Return
Highest
Middle
Lowest
Risk of Contract Violations
Lowest
Middle
Highest
Payment Preference
Lowest
Middle
Highest
Tax Deductibility
No
Usually No
Yes
Accounting for Preferred Stock Issues
Entry for Issuance of Preferred Stock:
Cash: (1,000 shares x $40) = $40,000
Preferred Stock: (1,000 shares x $30) = $30,000
Additional Paid-in Capital: $10,000 (issue above par)
Features of Preferred Stock
Flexibility in Contractual Provisions:
Convertible: Can be exchanged for common stock.
Redeemable: Can be returned to corporation at a fixed price.
Cumulative: Receives priority for future dividends if dividends are missed.
Treasury Stock
Reasons Corporations Repurchase Their Stock:
To support under-priced stock.
To distribute surplus cash without paying dividends (avoiding tax implications).
To increase earnings per share (reduce number of shares outstanding).
To offset shares issued under stock-based compensation plans.
Definition: Treasury stock is a contra-equity account reducing total stockholders’ equity.
Accounting for Treasury Stock
Repurchase:
Entry for repurchase:
Treasury Stock: (100 shares x $30) = $3,000
Cash: $3,000
Entry for sale of treasury stock at a higher price:
Cash: (100 shares x $35) = $3,500
Treasury Stock: (100 shares x $30) = $3,000
Additional Paid-in Capital: $500 (difference)
Sale Below Cost:
Cash: (100 x $25) = $2,500
Additional Paid-in Capital: (100 x $5) = $500
Treasury Stock: (100 x $30) = $3,000
Part B: Earned Capital
Retained Earnings and Dividends
Retained Earnings:
Represents earnings retained in the corporation. Equals total net income minus total dividends since inception.
Normal credit balance; if losses exceed income, it becomes an accumulated deficit (debit balance).
Dividends
Definition: Distributions to stockholders, generally not paid on treasury shares.
Key Dates:
Declaration Date: When dividend is declared.
Record Date: When registered stock owners are identified.
Payment Date: When cash dividend is paid.
Example of Dividend Declaration
March 15 (Dividend Declared):
Retained Earnings (2,000 shares x $0.25) = $500
Dividends Payable = $500
April 15 (Dividend Paid):
Dividends Payable (2,000 shares x $0.25) = $500
Cash = $500
Stock Dividends and Stock Splits
Distributions: Corporations may distribute additional shares instead of cash—known as stock dividends (smaller distributions) or stock splits (larger distributions).
Examples:
10% stock dividend yields 10 additional shares for each 100 owned.
100% stock dividend or a 2-for-1 stock split effectively doubles the shares.
Accounting for Stock Dividends
Large Stock Dividend (100%):
Retained Earnings: (1,000 shares x $0.01) = $10
Common Stock: $10 (common stock increase)
Small Stock Dividend (10%):
Retained Earnings: (1,000 x 10% x $30) = $3,000
Common Stock: (1,000 x 10% x $0.01) = $1
Additional Paid-In Capital: $2,999 (the difference)
Stock Splits
Definition: A stock distribution over 25%, commonly referred to as a stock split; similar effect to issuing a large stock dividend but with different accountability.
Entry: No journal entry needed for splits. After a stock split, total par stays the same, but shares increase, and par value per share decreases.
Part C: Reporting and Analyzing Stockholders' Equity
Example of Stockholders’ Equity (American Eagle Outfitters Balance Sheet as of February 3, 2007)
Preferred Stock: $0.01 par value
Common Stock: $0.01 par value: $2,461
Additional Paid-in Capital: $453,418
Total Paid-in Capital: $455,879
Retained Earnings: $1,324,059
Less: Treasury Stock (25,699 shares): ($362,626)
Total Stockholders’ Equity: $1,417,312
Statement of Stockholders’ Equity
Purpose: Summarizes changes in equity accounts over time. Example format includes:
Preferred Stock
Common Stock
Additional Paid-in Capital
Retained Earnings
Treasury Stock
Total Stockholders’ Equity
Example: Canadian Falcon - showing details over the year, including Issued and Repurchase stock and Net Income.
Equity Analysis
Metrics include:
Return on Equity: Measures net income produced from resources provided by owners.
Formula:
Return on the Market Value of Equity: Relation to market value calculated as end stock price multiplied by outstanding numbers.
Formula:
Earnings Per Share (EPS): Measures net income per share; significant for performance evaluation over time but limited for comparisons across companies.
Formula:
Price-Earnings Ratio (PE Ratio): Indicates investor expectations regarding earnings growth.
Formula:
High PE signals higher expected earnings; low indicates lack of confidence.
Appendix: Equity Investments
Investment in Equity Securities
Degrees of Influence Based on Ownership:
0%: Insignificant influence (Fair Value Method)
20%: Significant influence (Equity Method)
50% to 100%: Controlling influence (Consolidation Method)
Percentage of stock held is a guideline for determining influence on company operations.
Fair Value Method
Purchase of Investments:
Entry Example: For buying 1,000 shares of Canadian Falcon at $30/share
Investment in Canadian Falcon = $30,000
Cash = $(1,000 shares imes $30) = $30,000
Receipt of Dividends:
Entry Example: For $0.50 dividends per share
Cash (1,000 shares x $0.50) = $500
Dividend Revenue = $500
Sale of Investments:
Above Cost:
Cash (100 x $36) = $3,600
Gain on Sale of Investments (difference) = $600
Investment in Canadian Falcon (100 x $30) = $3,000
Below Cost:
Cash (100 shares x $28) = $2,800
Loss on Sale of Investments = $200
Investment in Canadian Falcon (100 x $30) = $3,000
Adjustments to Fair Value
At period end, adjust equity investments to fair value.
Fall in value example and journal entries for adjusting investment to become more or less valuable reflect changes in equity and comprehensive income.
Comprehensive income includes all changes in equity not from transactions with shareholders.