Chapter 10 Lecture Notes

Corporation Features

• An entity separate from its owners.
• Individuals/companies purchase ownership shares by issuing stock.

Ownership

• Shareholders own the corporation.
• Example: Bill Gates owns approximately 5% of Microsoft stock, controlling 5% of the company.
• Millions of individual and institutional investors control the remaining 95%.

Other Business Forms

• Single Proprietorship: Owned and operated by one person; the owner is responsible for all debt and transactions.
• Partnership: Two or more individuals; each partner is responsible for the debt and transactions of other partners.

Advantages of Corporations

• Easy Transfer of Ownership: Shares are traded daily without needing approval from other owners.
• Limited Liability: Stockholders are not personally responsible for the corporation's debts.
• Easy Generation of Capital: Investors are attracted to the corporate structure.
• Separation of Owners and Company: One stockholder's poor decisions do not jeopardize others.

Disadvantages of Corporations

• Double Taxation:
  • Earnings are taxed at the corporate level.
  • Dividends are taxed again at the individual level.
  • Example:
  • Earnings before taxes: 1.00
  • Taxes (35% corporate rate): 0.35
  • Net Income: 0.65
  • Dividend paid to stockholder: 0.65
  • Taxes (15% individual rate): 0.10
  • Net income: 0.55
• Government Regulation: Corporations face closer scrutiny.
• Difficulty Raising Debt Capital: Limited liability makes it less attractive for creditors to lend money.

Corporate Authority Structure

• Stockholders elect the Board of Directors.
• The Board elects the Chairperson of the Board (CEO) and President (COO).
• Vice Presidents (Sales, Manufacturing, Personnel), CFO, Controller (Accounting Officer), Secretary, and Treasurer (Finance Officer) manage day-to-day operations.

Shareholder Rights

• Voting: Participate in managing by voting on important issues.
• Dividends: Receive a proportionate share of profits.
• Liquidation: Receive a proportionate share of assets after liabilities are paid in liquidation.
• Preemption: Maintain proportionate ownership in the corporation.

Stockholders’ Equity

• Represents shareholders’ ownership interest in the corporation’s assets.
• Accounting Equation: Assets = Liabilities + Stockholders’ Equity.
• Resources = Claims to Resources.
• Resources = Creditors’ Claims + Residual Claims.
• Paid-In (Contributed) Capital: Contributed by stockholders; includes Common Stock, Preferred Stock, and Paid-In Capital in Excess of Par.
• Retained Earnings: Earned through profitable operations before dividends.

Trading Shares of Stock

1. Petition the SEC: The company petitions the Securities and Exchange Commission.
2. SEC Approval: The SEC approves the stock issue.
3. Transfer Shares: Shares are transferred, and money is received through Investment Banker.
4. Initial Public Offering (IPO): Shares are offered to investors for money.
5. Secondary Market: Investors buy and sell from each other via stock exchanges (e.g., NYSE).
6. Dividends: Company pays dividends to shareholders.

Classes of Stock

• Common Stock: Stock with voting rights; the basic form of capital stock.
  • Stockholders have all four rights unless specifically withheld.
• Preferred Stock: Stock with preferential treatment related to dividends and liquidation.
  • It's a hybrid security between common stock and long-term debt.
  • Pays a fixed dividend, similar to interest on debt.
  • Stockholders have all four rights unless specifically withheld.

Par Value vs. No-Par Value Stock

• Par Value: Legal capital; an arbitrary amount assigned to stock historically used to protect creditors.
  • Par value ≠ market value (or stock price).
• No-Par Value Stock: Stocks without a par value; in some cases, they have stated values.

Number of Shares

• Authorized: The total number of shares allowed to be issued by the SEC.
• Issued: The total number of shares sold.
• Outstanding: The total number of shares held by stockholders, not the company itself.

Stock Issuance Examples

• Issued 9,000 shares of $2 par value common stock for $22/share:
  • Cash (+A): 9,000 \times $22 = $198,000
  • Common Stock (+SE): 9,000 \times $2 = $18,000
  • Paid-In Capital in Excess of Par (+SE): 180,000
• Issued 600 shares of $5 par value common stock for $45/share:
  • Cash: 600 \times $45 = $27,000
  • Common Stock: 600 \times $5 = $3,000
  • Paid-In Capital in Excess of Par: 24,000
• Issued 500 shares of no-par value common stock for $100,000:
  • Cash: 100,000
  • Common Stock – No Par: 100,000
• Issued 6,000 shares of $10 par value preferred stock for $35/share:
  • Cash: 6,000 \times $35 = $210,000
  • Preferred Stock (+SE): 6,000 \times $10 = $60,000
  • Paid-In Capital in Excess of Par: 150,000
• Issued 1,000 shares of common stock ($1 par) for $12 and 500 shares of preferred stock ($10 par) for $40:
  • Cash: (1,000 \times $12) + (500 \times $40) = $32,000
  • Common Stock: 1,000 \times $1 = $1,000
  • Preferred Stock: 500 \times $10 = $5,000
  • Paid-In Capital in Excess of Par: 26,000

Stock Issued for Non-Cash Assets

• Issued 80,000 shares of $1 par value common stock for equipment valued at $100,000:
  • Equipment (+A): 100,000
  • Common Stock (+SE): 80,000
  • Paid-In Capital in Excess of Par (+SE): 20,000
• Stock Issued for Services: An attorney billed the company $25,000 and accepted 2,500 shares of $1 par value stock, valued at $10/share:
  • Legal Expenses (+E; −SE): 25,000
  • Common Stock (+SE): 2,500
  • Paid-In Capital in Excess of Par (+SE): 22,500

Convertible Preferred Stock

• Convertible to common stock at the preferred stockholders’ discretion.

Example

• Issuance of convertible preferred stock of $50,000 for cash:
  • Cash (+A): 50,000
  • Convertible Preferred Stock (+SE): 50,000
• Converting to 5,000 shares of $1 par value common stock:
  • Convertible Preferred Stock (−SE): 50,000
  • Common Stock (+SE): 5,000
  • Paid-In Capital in Excess of Par (+SE): 45,000

Treasury Stock

• Companies can return cash to owners by purchasing back their shares instead of paying cash dividends.
• Stock purchased by its own company is called treasury stock.
• Recorded as a contra-equity account with a negative balance.
• Not recorded as an asset.
• Gains and losses on the sale of treasury stock are not reported in the income statement.

Reasons for Buying Own Shares

1. Available for employee stock options.
2. Believes its stock is undervalued.
3. Wants to distribute cash to shareholders.
4. A “good” investment for idle cash.
5. Avoid hostile takeovers.
6. Increase earnings per share.

Treasury Stock Examples

• Buys 100 shares of its own stock for $8 per share:
  • Treasury Stock (−SE): -800
  • Cash (−A): -800
• Resells 60 shares for $10 per share:
  • Cash (+A): 600
  • Treasury Stock (at cost) (+SE): -480
  • Paid-In Capital in Excess of Par (+SE): 120
• Resells the remaining 40 shares for $7 per share:
  • Cash (+A): 280
  • Paid-In Capital in Excess of Par (−SE): -40
  • Treasury Stock (at cost) (+SE): -320

Treasury Stock Transactions

1. Purchased 20,000 own shares for $45: Assets = Liabilities + Stockholders’ Equity ↓ 900,000
2. Sold 5,000 treasury shares for $50 (gain of $5 per share): Assets = Liabilities + Stockholders’ Equity ↑ 250,000
3. Sold 10,000 treasury shares for $37 (loss of $8 per share): Assets = Liabilities + Stockholders’ Equity ↑ 370,000

• No gain or loss recorded in the income statement.

Retained Earnings

• Definition: All net income less dividends over the life of a company.
  • Net income = all revenues minus all expenses.
  • Dividends = cash payments to stockholders (owners).

Retained Earnings Example

• Consider a company that has existed for 4 years:
  • Year 1: Net Income 500, Dividends 100, Retained Earnings 400.
  • Year 2: Net Income (200), Dividends 100, Retained Earnings 100.
  • Year 3: Net Income 200, Dividends 100, Retained Earnings 200.
  • Year 4: Net Income 400, Dividends 100, Retained Earnings 500.

Statement of Stockholders’ Equity

• Summarizes the changes in each stockholders’ equity account over a period of time.

Example

• Beginning balances: Preferred Stock = $30,000, Common Stock = $20,000, Paid-In Capital in Excess of Par = $160,000, Retained Earnings = $80,000, Treasury Stock = $10,000.
  1. Issuance of common stock: Par = $5,000, Excess PIC = $30,000.
  2. Net income = $24,000 and dividends = $7,000.
  3. Sold treasury stock for $8,000 (cost = $6,000); Excess PIC = $2,000.

Dividends

• Definition: Distribution by a corporation to its shareholders.
  • Forms of Dividends: Cash, Stock, and Noncash assets.
  • Cash dividends are the most common form.

Cash Dividends

• Declaration date: Date board of directors announces the dividend (creates a liability).

  • DR Dividends 50,000
  • CR Dividends Payable (+L) 50,000

• Date of record: Stockholders on this date receive dividends. (No journal entry).

• Payment date: Cash is paid to stockholders.

  • DR Dividends Payable (−L) 50,000
  • CR Cash (−A) 50,000

Effect of Dividends on Company’s Value

• Dividends are payments to stockholders.
  • If a company pays a cash dividend, its stock price typically decreases (all else equal).
• Dividends are distributions of capital, reducing the company's value.

Dividends Example

On April 15, board declares cash dividend of $1.00 per share, record date May 20, payment June 14, and 500,000 shares outstanding:

• April 15:

  • Retained Earnings (−SE) 500,000
  • Dividends Payable (+L) 500,000

• May 20: Stock price drops by $1.00.

• June 14:

  • Dividends Payable (−L) 500,000
  • Cash (−A) 500,000

Dividends on Preferred Stock

• Paid before common stockholders.
  • Stated as a percentage of par value or a dollar amount per share.

Example 1

Preferred stockholders offered an annual dividend of 6% of the stock’s $10 par value with 10,000 shares outstanding:

• Retained Earnings 6,000
• Dividend Payable, Preferred (10,000 * $10 * 6%) 6,000

Example 2

Preferred stockholders are offered an annual dividend of $2 per share with 10,000 shares outstanding:

• Retained Earnings 20,000
• Dividend Payable, Preferred (10,000 * $2) 20,000

Cumulative Dividends

• Past dividends accumulated but not paid (dividends in arrears).
  • Owners of cumulative preferred stock must receive all dividends in arrears plus current year dividends before any dividends go to common stockholders.

Cumulative Dividends Example

Declares $500,000 dividends in 2012, with $150,000 in arrears for preferred stockholders in 2011:

• Retained Earnings 500,000
• Dividends Payable, Preferred ($150,000 * 2) 300,000
• Dividends Payable, Common ($500,000 − $300,000) 200,000

Stock Dividends

• Proportional distribution of stock to shareholders.
  • Increase common/preferred stock and decrease retained earnings.
  • Total shareholders’ equity is unchanged.
• Reasons: Maintain dividend payouts, Reduce market price of shares
• Stock dividends conserve cash

Stock Dividends Sizes

• Small: 25% or less; recorded as market value.
• Large: Greater than 25%; recorded as par value.

Stock Dividend Example

Conrad Sports Co. declared a 10% common stock dividend on March 31, 2012. The company has 200,000 shares of $1 par value common stock outstanding. The stock was traded at $10 per share on March 31, 2012:

• 3/31/2012:

  • Retained Earnings (200,000 * 10% * $10) 200,000
  • Common Stock – Par Value (200,000 * 10% * $1) 20,000
  • Paid-In Capital in Excess of Par – Common 180,000

• The effect on the accounting equation is Assets = Liabilities + Stockholders’ Equity

  • −$200,000 + $20,000 + $180,000

Stock Splits

• Increase the number of shares of stock authorized, issued, and outstanding.
  • Decrease the par value of shares proportionally.
  • Decrease market price of shares proportionally.
• Improves attractiveness to potential investors.

Stock Splits Example

10,000 shares of common stock with $10 par value, trading at $15 per share. Split the stock 2 for 1:

• Shares after split = 20,000
• Par value after split = $5 per share
• Stock price after split = $7.5 per share
• No journal entry is needed.

Stock Dividends vs. Stock Splits

• Both, stock dividends and stock splits do not impact:
  • Total assets. liabilities, and stockholders' equity
  • Total market value of shares
  • Reduce price per share
• Stock dividends do not impact the number of authorized shares, but stock splits increase the number of authorized shares.
• A journal entry is needed for stock dividends, but not for stock splits.

Stock with High Prices

• Berkshire Hathaway (NYSE: BRK.A) $185,149 (3/28/2014).
  • Because it doesn't split its shares.
  • Famous investor Warren Buffett keeps the price high to deter short- term traders from creating excessive volatility.
  • At this high price, it trades about only 400 shares per day.

Google Stock Split – April 2, 2014

• The Class C shares, which trade under the old ticker symbol “GOOG” do not give investors the right to vote at Google's annual shareholder meeting.
• This could be why the price is lower than the Class A stock, which does have voting rights.
• Google shareholders were issued two shares for every one share they owned at half the price.
• April 3, 2014 closing price for GOOGL (class A) is $571.50 and for GOOG (class C) is $569.74.

Value of the Stock

• Market Value (market price): The price an investor can buy or sell one share of the stock for.
  • Redemption Value: The price at which the issuer redeems the preferred stock for.
  • Liquidation Value: The amount the company has to pay a preferred stockholder when the company liquidates (going out of business).
• Book Value per share of common stock = \frac{(Total\ stockholders’\ equity – preferred \ equity)}{Number \ of\ shares\ of\ common\ stock\ outstanding}

Ratio Analysis

• Return on Equity (ROE)

  • Only for common stockholders
  • Measures the relation between profitability and stockholder investment.
  • ROE =\frac{(Net \ Income − Preferred \ Dividends)}{Average \ Common \ Stockholders’ \ Equity}
  • Average = \frac{(Beginning \ Bal. + Ending \ Bal.)}{2}

Recall Return on Assets from Chapter 7

• ROA = \frac{Net \ Income}{Average \ Total \ Assets}

• Sometimes interest expense is added back to net income to calculate ROA, when companies have significant debt.