Chapter 10: Stockholders' Equity

Formation and Structure of Corporations

• Nature of Corporations     * Corporations are considered separate legal entities, distinct from their owners.     * The formation process involves founders applying for a charter by filing articles of incorporation, which detail the purpose of the business and other essential information.     * Once approved, organizers elect a Board of Directors and adopt bylaws to govern the entity.     * Ownership is established through the issuance of stock to shareholders in exchange for assets (usually cash).

• Primary Corporate Stakeholders Hierarchical Structure     * Stockholders: The owners of the corporation. Those holding voting shares are responsible for electing the Board of Directors.     * Board of Directors: They establish overall corporate policies, declare dividends, and select corporate officers.     * Officers: Responsible for implementing operating policies and managing the day-to-day operations of the company.     * Employees: Responsible for executing the operating plans and procedures set forth by management.

Advantages and Disadvantages of Coronation

• Advantages of the Corporate Form     * Separate Legal Entity: The corporation exists independently of its owners.     * Limited Liability: Stockholders are generally only liable for the amount they invested; their personal assets are protected from corporate creditors.     * Transferability of Ownership: Shares can be easily bought and sold.     * Continuity of Existence: The corporation's life is not tied to the lives of its owners.     * Ability to Raise Large Amounts of Capital: This capability is primarily driven by limited liability and the ease of transferring ownership.

• Disadvantages of the Corporate Form     * Organization Costs: Initial setup and legal fees can be high.     * Double Taxation:         * The corporation is taxed on its corporate income.         * Dividends paid to shareholders from that income are taxed again as personal income for the shareholders.     * Regulation and Supervision: Corporations are subject to various government regulations and oversight.

Par Value and Legal Capital

• Par Value Stock     * Most stocks are initially issued with a par value, which serves as a benchmark for pricing.     * Investors often pay higher than par value when purchasing shares.     * Paid-In Capital in Excess of Par Value (Additional Paid-in Capital or APIC): This account records the amount received above the par value.     * Market Value: The price at which the stock is currently bought, sold, or traded in the open market.

• No-Par Value Stock     * Some stocks are issued without a designated par value.     * In these cases, the Board of Directors often declares a "stated value."

• Legal Capital     * Par value or stated value is referred to as legal capital.     * This represents the minimum amount of capital that must be maintained within the company by law.

Types of Capital Stock: Common and Preferred

• Common Stock     * The most basic type of capital stock; every corporation must have at least one common stockholder.     * Voting Rights: Shareholders vote on significant matters such as director elections, mergers, management compensation, and the appointment of outside auditors.     * Net Income Rights: Shareholders have a right to a proportional share of the corporation's net income.     * Preemptive Right: The right to purchase new shares in future issuances to maintain their current ownership proportion.     * Residual Claim: In the event of liquidation, common stockholders have a claim on assets remaining after all creditors and preferred stockholders have been paid.

• Preferred Stock     * Dividend Preference: Preferred shareholders are entitled to receive dividends before any dividends are paid to common stockholders.     * Cumulative Preference: If dividends are not paid in a given year, they become "dividends in arrears." These must be paid in full to preferred shareholders before common shareholders receive anything in the future.     * Non-cumulative Preference: Preferred shares that do not accumulate unpaid dividends from past years.     * Asset Distribution Preference: Preferred shareholders have a higher "pecking order" than common stockholders during liquidation.     * Other Features:         * Convertible: Can be exchanged for common stock.         * Participating: May receive special dividends beyond the stated rate.         * Callable: The corporation has the right to buy back the shares at a set price.

• Example: Dividend Allocation (Artemis Inc.)     * Data: $1,000$ shares of $\$100$ par value, $6\%$ preferred stock ($\$6,000$ annual dividend total); $100,000$ shares of $\$1$ par value common stock.     * Scenario: No dividends paid last year. Current year dividend declared: $\$27,000$.     * If Cumulative: Preferred gets $\$12,000$ ($\$6,000$ for last year + $\$6,000$ for current year). Common gets $\$15,000$.     * If Non-cumulative: Preferred gets $\$6,000$ (current year only). Common gets $\$21,000$.

Accounting for Stock Issuance

• Standard Issuance     * The appropriate capital stock account is increased by the par value or stated value ($\text{Par Value} \times \text{Number of Shares}$).     * The asset received (usually cash) is increased.     * Any amount received above par is recorded in Paid-In Capital in Excess of Par Value.

• Issuance Examples     * Lester Corp: Issues $100$ shares of $\$100$ par value preferred stock for $\$13,000$.         * Preferred Stock increases by $\$10,000$ ($100 \times \$100$).         * APIC−Preferred increases by $\$3,000$.         * Cash increases by $\$13,000$.     * Common Stock: Issues $100$ shares of no-par common stock with a $\$10$ stated value for $\$3,000$.         * Common Stock increases by $\$1,000$ ($100 \times \$10$).         * APIC−Common increases by $\$2,000$.         * Cash increases by $\$3,000$.

• Noncash Stock Issuances     * For Services: Often used by start-ups. Example: Start Up Corp issues $100$ shares of $\$10$ par common stock for $\$8,000$ in legal services. Professional Services Expense increases by $\$8,000$, Common Stock increases by $\$1,000$, and APIC−Common increases by $\$7,000$.     * For Operating Assets: Land or equipment accounts are increased instead of expenses.     * For Convertible Bonds: The value of the stock issued is assumed to be equal to the book value of the bonds. Bonds Payable (and any related discount/premium) are decreased, while Common Stock and APIC are increased.

Stock Splits

• Forward Stock Split     * Increases the number of shares outstanding to reduce the market price of the stock.     * The par value per share is reduced proportionally.     * No change occurs in the total dollar balance of stockholders' equity accounts.     * Example (Los Altos Inc.): $10,000$ shares at $\$10$ par value ($\$100,000$ total). After a 2-for-1 split: $20,000$ shares at $\$5$ par value ($\$100,000$ total).

• Reverse Stock Split     * Reduces the number of shares outstanding to increase the market price per share.     * The par value per share is increased proportionally.     * No change occurs in the total dollar balance of stockholders' equity accounts.

Treasury Stock

• Definition: Shares of a corporation's own stock that were previously outstanding but have been repurchased by the company and are being held (not retired).

• Characteristics: Treasury stock has no voting rights, receives no dividends, and has no claim on assets during liquidation.

• Accounting Treatment:     * Treasury Stock is a contra-stockholders' equity account.     * Acquisition costs reduce Cash and increase the Treasury Stock account (which reduces total SHE).     * Purchase Example (Pitzer Corp): Acquires $200$ shares of its $\$10$ par stock for $\$15$ per share. Treasury Stock increases (debits) by $\$3,000$ ($200 \times \$15$).     * Resale Example (Pitzer Corp): Resells $100$ shares of treasury stock for $\$20$ per share ($\$2,000$ total cash). The Treasury Stock account is reduced by the original cost ($100 \times \$15 = \$1,500$). The remaining $\$500$ increases Paid-In Capital from Treasury Stock.     * Important Rule: Selling treasury stock never results in a formal accounting gain or loss. Excess proceeds increase paid-in capital and have no effect on net income.

Repurchase and Retirement of Stock

• If a company repurchases shares and officially retires them (instead of holding them as treasury stock):     * Cash is reduced by the acquisition cost.     * Common Stock is decreased by the par value.     * The difference (excess of purchase price over par) reduces Additional Paid-in Capital and/or Retained Earnings.     * Example (Pitzer Corp): Repurchases and retires $200$ shares of $\$10$ par value stock for $\$15$ per share. Cash decreases $\$3,000$. Common Stock decreases $\$2,000$ ($200 \times \$10$). APIC or Retained Earnings decreases $\$1,000$.

Dividends

• General Concepts     * Dividends represent a distribution of assets or shares to shareholders.     * They are not an expense; they are a distribution of income and directly reduce Retained Earnings.     * They are not legally required until they are formally declared by the board.

• Three Important Dividend Dates     1. Declaration Date: The board formally commits to the dividend. Effects: Increase Dividends Payable, Decrease Retained Earnings.     2. Record Date: The date on which a shareholder must officially own the stock to receive the dividend. Effect: No accounting entry, no balance sheet effect.     3. Payment Date: The date the dividend is actually paid. Effects: Decrease Cash, Decrease Dividends Payable.

• Stock Dividends     * A distribution of additional shares of stock rather than cash.     * Used by companies lacking cash or young, growing companies.     * Effect: Retained Earnings is reduced, Contributed Capital is increased. Total Stockholders' Equity remains unchanged.

Equity Financial Statements and Analysis

• Statement of Retained Earnings: Analyzes changes in the account over a period (typically adding net income and subtracting dividends).

• Statement of Stockholders' Equity: A more comprehensive analysis of all equity accounts, including contributed capital and treasury stock.

• Financial Ratios     * Return on Common Stockholders' Equity: Measures profitability for common investors.         * $\text{Return on Common SHE} = \frac{\text{Net Income} - \text{Preferred Stock Dividends}}{\text{Average Common Stockholders' Equity}}$     * Dividend Yield: Measures the rate of return in cash dividends.         * $\text{Dividend Yield} = \frac{\text{Average Dividend per Share}}{\text{Market Price per Share}}$     * Dividend Payout Ratio: Measures the percentage of available earnings paid out as dividends.         * $\text{Dividend Payout Ratio} = \frac{\text{Annual Dividend per Share}}{\text{Earnings per Share}}$     * Growth Factors: Growth companies typically have low payout ratios to fund expansion, while mature companies have higher ratios due to fewer growth opportunities.

Practice Calculation (Norma Co.)

• Data:     * Net Income: $\$100,000$     * Average Common SHE: $\$400,000$     * Preferred Dividends: $\$20,000$     * Common Dividends: $\$10,000$

• Calculation:     * $\frac{\$100,000 - \$20,000}{\$400,000} = \frac{\$80,000}{\$400,000} = 20\%$

• Result: Norma's Return on Common Stockholders' Equity is $20\%$.