Comprehensive Notes on Stockholders’ Equity.

Learning Objectives

• LO10–1: Identify the advantages and disadvantages of the corporate form of ownership.

• LO10–2: Record the issuance of common stock.

• LO10–3: Contrast preferred stock with common stock and bonds payable.

• LO10–4: Account for treasury stock.

• LO10–5: Describe retained earnings and record cash dividends.

• LO10–6: Explain the effect of stock dividends and stock splits.

• LO10–7: Prepare and analyze the stockholders’ equity section of a balance sheet and the statement of stockholders’ equity.

• LO10–8: Evaluate company performance using information on stockholders’ equity.

Stockholders’ Equity Overview

• The accounting equation can be stated as: $ext{Assets} = ext{Liabilities} + ext{Stockholders’ Equity}$

  • Assets represent resources of the company.

  • Liabilities are creditors’ claims to those resources.

  • Stockholders’ equity is the owners’ residual claim to the resources.

Definitions of Stockholders' Equity Components:

• Stockholders' Equity (also known as shareholders' equity) is composed of:

  1. Paid-in Capital: Amount stockholders have invested in the company.

  2. Retained Earnings: Earnings retained in the corporation (not paid out as dividends).

  3. Treasury Stock: Corporation’s own stock that it has reacquired.

Example: American Eagle Outfitters, Inc. Balance Sheet (as of January 31, 2015)

• Stockholders’ equity:

  • Preferred stock, $0.01 par value: $0

  • Common stock, $0.01 par value: $2,496,000

  • Additional paid-in capital: $559,731,000

  • Total paid-in capital: $562,227,000

  • Retained earnings: $1,543,085,000

  • Less: Treasury stock (55,050 shares at $17.54 per share): ($965,566,000)

  • Total stockholders’ equity: $1,139,746,000

Corporations and Ownership

• Corporation: A legal entity separate from its owners, usually owned by multiple stockholders.

  • Governed by articles of incorporation detailing business activities, share issuance, and initial board setup.

Advantages of Corporations:

1. Limited Liability: Stockholders are personally protected from corporate debts; they can only lose their investment.

2. Ability to Raise Capital: Corporations can easily issue shares to attract investors; ownership can be transferred without affecting the corporation’s operations.

Disadvantages of Corporations:

1. Additional Taxes: Corporations face double taxation (corporation pays tax on income; stockholders pay tax on dividends).

2. More Paperwork: Corporations are subject to extensive regulatory requirements, influencing decision-making and increasing operational complexity.

Stock Financing Stages

1. Investment by Founders/Family: Initial funding from founders and their close connections.

2. Angel Investors/Venture Capital: Wealthy individuals and firms invest in exchange for equity as companies seek growth.

3. Initial Public Offering (IPO): Offering shares to the public when funding needs exceed $20 million; regulated by the SEC.

Stockholder Rights

1. Right to Vote: Shareholders participate in electing the board of directors.

2. Right to Receive Dividends: Shareholders receive their share of profits when dividends are declared.

3. Right to Distribution of Assets: In case of liquidation, shareholders receive a portion of the remaining assets after creditors are paid.

Common Stock Characteristics

• Authorized Stock: Maximum number of shares specified in the articles of incorporation.

• Issued Stock: Number of shares sold to stockholders.

• Outstanding Stock: Shares currently held by stockholders (excludes treasury stock).

Par Value and Market Value

• Par Value: The legal capital per share set when the corporation is formed; often has no correlation to market value.

• Market Value: Current value trading on the stock market, which can fluctuate based on market conditions.

Accounting for Common Stock

• Issuing No-Par Value Stock:

  • Debit: Cash for total amount received

  • Credit: Common Stock for the full received amount.

• Issuing Par Value Stock:

  • Debit: Cash

  • Credit: Common Stock (at par value)

  • Credit: Additional Paid-in Capital (for amount over par value).

Example of Issuing Common Stock:

For 1,000 shares at $30 each:

• No-Par Value:
  $ext{Debit Cash: } 30,000$
  $ext{Credit Common Stock: } 30,000$

• Par Value Scenario ($0.01 par value):

1. Cash:
   $ext{Debit Cash: } 30,000$

2. Common Stock:
   $ext{Credit Common Stock: } 10 (1,000 imes 0.01)$

3. Additional Paid-in Capital:
   $ext{Credit Additional Paid-in Capital: } 29,990$

Preferred Stock

• Features:

  1. Priority for Dividends: Preferred stockholders typically receive dividends before common stockholders.

  2. Preference in Liquidation: In a corporate liquidation, preferred stockholders receive their investment back before common stockholders.

Characteristics of Preferred Stock

1. Convertible: Can be exchanged for common stock.

2. Redeemable: May be sold back to the corporation at a specific price.

3. Cumulative: Unpaid dividends accumulate and must be paid before common dividends are distributed.

Treasury Stock

• Definition: Shares previously issued that have been repurchased by the company.

• Impact on Equity: Reduces stockholders' equity and is recorded as a contra account (a negative entry in the equity section).

  • Example of Repurchasing Stock: For 100 shares repurchased at $30/share:

  • Debit: Treasury Stock: $3,000

  • Credit: Cash: $3,000

Reissuing Treasury Stock

• If treasury stock is reissued at a gain or loss, the difference is accounted through Additional Paid-in Capital.

  • Example: Reissuing 100 of the same shares for $35, then a $500 goes to Additional Paid-in Capital.