Stockholders’ Equity – Comprehensive Study Notes

Characteristics & Forms of a Corporation

  • Separate Legal Entity
    • Corporation exists apart from owners; may enter contracts, sue/be sued, obtain financing.
  • Classification
    • By purpose (profit / not-for-profit)
    • By ownership (publicly traded / privately held)
  • Advantages over Sole-Proprietorship & Partnership
    • Limited liability for stockholders (loss limited to investment only)
    • Easier capital acquisition (creditors & investors)
    • Continuous life (death of owner ≠ dissolution; e.g., AT&T after Alexander Graham Bell)
    • Easy transferability of ownership when shares are publicly traded (less true for private corps)
  • Disadvantages
    • Extensive government regulation & filings
    • Double taxation:
    • Corporation pays income tax on earnings
    • Dividends paid to stockholders taxed again at individual level
    • Separation of ownership & management (can be + or –)

Corporate Governance Structure

  • Board of Directors
    • Hired by and responsible to stockholders
    • Elected on a “1 share = 1 vote” basis
  • Executive Management
    • Board appoints CEO ➔ CEO appoints other senior officers
  • State Charter & By-laws
    • Corporation formed under a state charter (Delaware popular for favorable laws)
    • Charter specifies authorized share limits, governance rules, etc.

Stockholders: Rights & Terminology

  • Terminology: “Stockholder” ≡ “Shareholder” (interchangeable)
  • Rights
    • Vote for directors (& possibly major policies)
    • Receive dividends proportional to ownership
    • Pre-emptive right (first chance to buy new shares to preserve % ownership; seldom exercised in practice)
    • Residual claim on assets upon liquidation (after creditors)
  • Key Share Counts
    • Authorized = max shares allowed per charter
    • Issued = shares ever sold (≤ authorized)
    • Treasury = shares repurchased by company
    • Outstanding = Issued−Treasury\text{Issued} - \text{Treasury} (only outstanding shares vote & receive dividends)

Stockholders’ Equity on the Balance Sheet

  • Two primary subsections:
    1. Paid-in (Contributed) Capital
    • Common Stock, Preferred Stock, additional paid-in capital (APIC) accounts
    1. Retained Earnings (RE)
    • Cumulative earnings not yet distributed as dividends

Common Stock: Issuance Mechanics

  • Methods of Sale
    • Direct to investors or through investment bank (Initial Public Offering = IPO)
    • Post-IPO price determined by supply & demand
  • Par Value Concepts
    • Historical legal value; arbitrary (often 0.01−1.000.01 - 1.00)
    • Many states now permit no-par stock; may assign “stated value” internally
  • Accounting Entries
    • Always credit Common Stock for par or stated value only
    • Excess over par ➔ “Paid-in Capital in Excess of Par (or Stated) – Common”
  • Illustrative Journal Entries
    • Issue 15,000 shares, $1\$1 par, at $15,000\$15,000 (at par)
    • Debit Cash 15,00015{,}000
    • Credit Common Stock 15,00015{,}000
    • Same shares issued for $50,000\$50,000 (above par)
    • Debit Cash 50,00050{,}000
    • Credit Common Stock 15,00015{,}000
    • Credit PIC > Par – Common 35,00035{,}000
    • No-par issuance for $40,000\$40,000
    • Debit Cash 40,00040{,}000
    • Credit Common Stock 40,00040{,}000
    • No-par with $2\$2 stated value, sold for $60,000\$60,000
    • Debit Cash 60,00060{,}000
    • Credit Common Stock 30,00030{,}000 (15,000 × 22)
    • Credit PIC > Stated – Common 30,00030{,}000
    • Issuance for non-cash asset (equipment FMV $60,000\$60,000)
    • Debit Equipment 60,00060{,}000
    • Credit Common Stock 15,00015{,}000
    • Credit PIC > Par 45,00045{,}000

Preferred Stock

  • Economic Characteristics
    • Priority over common in dividends & liquidation
    • Usually no voting rights
    • Fixed dividend rate ➔ resembles debt (hybrid security)
  • Accounting Differences
    • Par value meaningful (often equals issuance price)
  • Entries
    • Issue 1,000 shares, $50\$50 par, at $50,000\$50,000
    • Debit Cash 50,00050{,}000
    • Credit Preferred Stock 50,00050{,}000
    • Same shares sold for $75,000\$75,000
    • Debit Cash 75,00075{,}000
    • Credit Preferred Stock 50,00050,000
    • Credit PIC > Par – Preferred 25,00025,000

Treasury Stock

  • Definition: Corporation’s own issued common shares repurchased and held
  • Purpose Examples
    • Signal undervaluation, supply shares for employee plans, thwart takeover attempts
  • Accounting
    • Contra-equity account with normal debit balance (reduces total equity)
    • Recorded at cost
  • Transactions
    1. Purchase 10,000 shares @ $10\$10
    • Debit Treasury Stock 100,000100,000
    • Credit Cash 100,000100,000
    1. Reissue 2,000 shares @ $10\$10 (cost)
    • Debit Cash 20,00020,000
    • Credit Treasury Stock 20,00020,000
    1. Reissue 4,000 shares @ $12\$12 (above cost)
    • Debit Cash 48,00048,000
    • Credit Treasury Stock 40,00040,000
    • Credit PIC – Treasury Stock 8,0008,000
    1. Reissue 4,000 shares @ $5\$5 (below cost)
    • Debit Cash 20,00020,000
    • Credit Treasury Stock 40,00040,000
    • Debit PIC – Treasury (max 8,0008,000 remaining balance)
    • Debit Retained Earnings 12,00012,000 (plug to balance)
  • Effects: Reduces equity when purchased; increases equity when reissued. Selling below cost can reduce RE if PIC-TS balance exhausted.

Cash Dividends

  • Prerequisites: Sufficient retained earnings and cash; declaration decided by Board.
  • Key Dates & Entries
    1. Date of Declaration
    • Liability created
    • Entry: Debit Retained Earnings, Credit Dividends Payable
    1. Date of Record – determines eligible shareholders (no entry)
    2. Date of Payment – Debit Dividends Payable, Credit Cash
  • Example: $1\$1 dividend on 100,000 shares
    • Declaration (Dec 1): Debit RE 100,000100,000 | Credit Div Pay 100,000100,000
    • Record (Dec 22): No entry
    • Payment (Jan 20): Debit Div Pay 100,000100,000 | Credit Cash 100,000100,000

Preferred Dividends: Cumulative vs Non-cumulative

  • Cumulative (common)
    • Unpaid prior-year amounts = “dividends in arrears” and must be paid before any common dividend
  • Non-cumulative (rare)
    • Only current-year dividend is owed; arrears are lost
  • Maximum Preferred Dividend
    • Quoted as % of par or $ per share
    • Max=Par (or shares)×Rate\text{Max} = \text{Par (or shares)} \times \text{Rate}
  • Allocation Table Approach (yearly columns: Dividend Declared | Max Preferred | Preferred Paid | Dividends in Arrears | Common Paid)
    • Example results:
    • Year 1 dividend $5,000\$5,000, Max Pref $8,000\$8,000 ⇒ Pref gets 5,0005,000, Arrears 3,0003,000, Common 00
    • Year 2 dividend $15,000\$15,000 ⇒ Pref gets 11,00011,000 (arrears + current), Common 4,0004,000

Stock Dividends (Small < 25 %)

  • Definition: Proportional distribution of additional shares; ownership % unchanged
  • Reasons: Conserve cash, satisfy dividend expectations, lower market price, signal growth
  • Accounting Steps
    1. Calculate new shares: \text{Issued} \times \text{Dividend %}
    2. Record:
    • Debit Retained Earnings = New Shares × Market Price
    • Credit Common Stock = New Shares × Par Value
    • Credit PIC > Par (plug)
  • Example: 10 % dividend on 100,000 shares, 11 par, 1515 market
    • New shares = 10,000
    • Debit RE 150,000150,000
    • Credit Common Stock 10,00010,000
    • Credit PIC > Par 140,000140,000
    • Total equity unchanged; amounts shift from RE → PIC.

Stock Splits

  • Purpose: Reduce per-share price to improve perceived marketability (e.g., 2-for-1 split)
  • Effect: Increases shares outstanding, proportionally decreases par value; no journal entry (equity unchanged)
  • Illustration: Starbucks 2-for-1 (shares doubled, price halved); contrast Berkshire Hathaway (never split; trades >$200k\$200k/share)

Financial Analysis Ratios

  • Return on Equity (ROE)
    • Profitability measure: income earned per 11 of common equity
    • Formula: ROE=Net Income−Preferred DividendsAverage Common Stockholders’ EquityROE = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Average Common Stockholders’ Equity}}
    • Example: NI $?\$?, preferred div 100100, average common equity calculated from balance sheet ⇒ ROE 0.670.67 (earnings of $0.67\$0.67 per 11 invested)
  • Earnings per Share (EPS)
    • Net income earned per common share; only ratio shown on financial statements
    • Formula: EPS=Net Income−Preferred DividendsAverage Common Shares OutstandingEPS = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Average Common Shares Outstanding}}
    • Shares outstanding = Common Stock Par Value $Par per Share\frac{\text{Common Stock Par Value \$}}{\text{Par per Share}} if share count not provided directly
    • Example yields EPS $1.71\$1.71

Ethical, Practical & Real-World Notes

  • Manager–Owner Separation may create agency issues (management decisions vs shareholder interests)
  • Tax Considerations influence dividend policy (double taxation) & choice between cash vs stock dividends
  • Market Signaling
    • Share buybacks or treasury stock often interpreted as management belief in undervaluation
    • Stock splits sometimes perceived as positive signal, though empirical support mixed
  • State of Incorporation affects legal flexibility & cost; Delaware remains dominant due to friendly corporate statutes.