Stockholders' Equity
Financial Accounting - Stockholders' Equity Study Notes
Learning Objectives
10.1 Explain the features of a corporation
10.2 Account for the issuance of stock
10.3 Explain how treasury stock affects a company
10.4 Account for retained earnings, dividends, and splits
10.5 Evaluate a company’s performance using new ratios
10.6 Report stockholders’ equity transactions in the financial statements
10.7 Describe appropriate formatting for financial statements
Stockholders' Equity Overview
Southwest Airlines Co. Condensed Balance Sheet (as of December 31, 2022)
Assets (in millions of $):
Current assets: $14,808 (2022), $18,036 (2021)
Property, plant, and equipment, net: $17,342 (2022), $14,842 (2021)
Other assets: $3,219 (2022), $3,442 (2021)
Total Assets: $35,369 (2022), $36,320 (2021)
Liabilities and Stockholders' Equity
Total Liabilities:
Total current liabilities: $10,378 (2022), $9,164 (2021)
Total noncurrent liabilities: $14,304 (2022), $16,742 (2021)
Total Liabilities: $24,682 (2022), $25,906 (2021)
STOCKHOLDERS' EQUITY:
Common stock, $1.00 par value: 2,000,000,000 shares authorized; 888,111,634 shares issued
Capital in excess of par value: $4,037
Retained earnings: $16,261
Accumulated other comprehensive income (loss): $344
Treasury stock, at cost: (10,843) (2022), (10,860) (2021)
Total Stockholders' Equity: $10,687 (2022), $10,414 (2021)
Total Liabilities and Stockholders' Equity: $35,369 (2022), $36,320 (2021)
Features of a Corporation
Characteristics
Separate Legal Entity: Stockholders or shareholders are the owners of the corporation.
Continuous Life and Transferability of Ownership: The corporation continues to exist independently of the lifespan of its shareholders.
Limited Liability: Shareholders' liability is limited to their investment, protecting personal assets from corporate debts.
Separation of Ownership and Management: The board of directors, elected by stockholders, manages the business.
Taxation
Corporate Taxation:
Double Taxation: Corporations are taxed on income, and shareholders are taxed on dividends received.
Government Regulation: Corporations are subject to various regulations, which can affect operations.
Advantages and Disadvantages of a Corporation
Advantages:
Ability to raise more capital than proprietorships or partnerships.
Continuous life.
Ease of transferring ownership.
Limited liability of stockholders.
Disadvantages:
Separation of ownership and management.
Double taxation of distributed profits.
Government regulations.
Organizing a Corporation
Corporate Organizers (Incorporators):
Obtain a charter from the state authorizing the corporation to issue stock.
Responsibilities include paying fees, signing the charter, filing documents, and agreeing to the bylaws.
Stockholder Rights
Four Basic Rights
Vote: Right to vote on corporate matters.
Dividends: Right to receive dividends proportionate to ownership.
Liquidation: Right to a proportionate share of assets upon liquidation.
Preemption: Right to maintain ownership percentage when new shares are issued.
Stockholders' Equity Components
Paid-In Capital (Contributed Capital)
Represents the total stockholders' equity contributed to the corporation, encompassing both stock accounts and additional paid-in capital.
Retained Earnings
Reflects the accumulated profits retained in the business after deducting dividends.
Common Stock vs. Preferred Stock
Common Stock
The basic form of stock with four basic rights; benefits most if the corporation succeeds.
Preferred Stock
Advantages:
Receives dividends before common stockholders.
Entitled to assets before common stockholders upon liquidation.
Considerations: Rare in practice, often cumulative.
Comparison Table
Attributes | Common Stock | Preferred Stock | Long-Term Debt |
|---|---|---|---|
Obligation to repay principal | No | No | Yes |
Dividends/interest | Non-tax-deductible | Non-tax-deductible | Tax-deductible |
Obligation to pay dividends/interest | Only after declaration | Only after declaration | At fixed rates, |
dates only |
Stock Issuance
Accounting for Common Stock at Par
If $100 million is needed, issuing 10 million shares at $10 per share results in no gain or income recognized by the corporation. The equivalent journal entry must be made.
Accounting for Common Stock Issued Above Par
When issuing stock above its par value, the additional value is recorded as "Capital in Excess of Par Value" in stockholders' equity.
No-Par Common Stock
Example: Krispy Kreme issued no-par common stock for a large total, recorded accordingly in stockholders' equity.
Preferred Stock Accounting
Similar procedures to common stock; positions listed in the balance sheet by preference level, such as Preferred stock, Common stock, followed by other capital accounts.
Treasury Stock
Definition and Purchase Rationale
Treasury Stock: The company’s own shares that were issued and later reacquired. Reasons for purchasing include:
Need stock for employee distributions.
Rebuying shares at low prices and reselling at higher ones.
Avoiding hostile takeovers.
Increasing earnings per share (EPS).
Returning excess cash to shareholders.
Recording Treasury Stock
Recorded at cost; treated as a contra stockholders’ equity account with a debit balance, reported under Retained Earnings on the balance sheet.
Retirement of Treasury Stock
Involves canceling stock certificates. Retired stocks cannot be reissued; total assets and liabilities remain unaffected. A memorandum entry is made to decrease shares issued.
Resale of Treasury Stock
When treasury stock is resold, it increases both assets and equity based on cash received without realizing gains or losses; differences recorded as "Paid-in Capital from Treasury Stock Transactions."
Stock Issuance to Employees
Companies may issue treasury shares as part of employee compensation plans, and gains from exercising options are treated as compensation.
Retained Earnings, Dividends, and Splits
Retained Earnings
Calculated as net income less net losses minus declared dividends. Can show credit balance (earnings exceed dividends) or debit balance (losses exceed earnings).
Dividend Types
Cash Dividends: Most common, need sufficient retained earnings and cash availability for declaration by the board.
Record Dates: Involves three dates — Declaration, Date of Record, and Payment Date, ensuring the stockholders who own stock on the record date get dividends.
Analyzing Retained Earnings
The primary contributors to increasing retained earnings are net incomes; losses and dividends reduce it.
Dividends on Preferred Stock
Paid before common stock dividends. Stated as a percent of par value or as a dollar amount per share; may be cumulative.
Stock Dividends and Splits
Stock Dividend: Proportional distribution of stock; increases common stock while decreasing retained earnings, leaving total equity unchanged.
Stock Split: Increases the number of shares while lowering par value, reducing the stock price without changing account balances.
Evaluating Company Performance with Ratios
Earnings Per Share (EPS)
Defined as net income attributable to each share of a company’s outstanding common stock. For example, EPS calculations for Southwest Airlines based on their stock and income details were illustrated.
Preferred Dividends Impact on EPS
Preferred dividends must be deducted from net income when calculating EPS for common stock.
Reporting Stockholders' Equity Transactions
Reporting Formats
Distinction between General Teaching Format and Real-World Format, with specifics on how stockholders’ equity should be presented in financial statements.
Guidelines for Financial Statements
Preferred Stock: Reported first.
Common Stock: Includes par value, shares authorized, issued, and outstanding.
Retained Earnings: Follows paid-in capital.
Treasury Stock: Reported at cost, typically as a deduction from total equity.
Accumulated Other Comprehensive Income: May either be added or deducted depending on classification.