Intermediate Accounting II Chapter 18 4/3/18 Shareholders’ Equity Intermediate Accounting II Chapter 18 4/3/18

Assets – Liabilities = Shareholders’ equity Shareholders’ equity accounts represent the ownership interests of shareholders. Shareholders’ equity is a residual amount – what’s left over after creditor claims have been subtracted from assets (in other words, net assets). Assets – Liabilities = Shareholders’ equity Ownership interests of shareholders arise primarily from two sources: Paid-in capital - amounts invested by shareholders in the corporation. Retained earnings - amounts earned by the corporation on behalf of its shareholders.

SOURCES OF CAPITAL A company can raise money externally to fund operations in either of two ways: Debt financing Notes, bonds, leases, and other liabilities Creates creditors’ interest in the assets of the business Equity financing Creates ownership interests in the assets of the business Owners of a corporation are it shareholders Shareholders’ equity is a residual amount, the amount that remains after creditor claims have been subtracted from assets Notice that the definition of a liability involves the present, the future, and the past. It is a present responsibility, to sacrifice assets in the future, caused by a transaction or other event that already has happened.

REPORTING SHAREHOLDERS’ EQUITY A Simplified Example In it’s most basic form the Shareholders’ Equity section of the Balance Sheet consists of paid-in capital and retained earnings. Paid-in capital is differentiated into capital stock (par value) and paid-in capital in excess of par with common and preferred shares reported separately. Shareholders’ Equity ($ in millions) Paid-in Capital: Capital Stock: Preferred stock, 10%, $10 par, cumulative $ 100 Common stock, 50 million shares at $1 par 50 Additional Paid-in Capital Paid-in capital – excess of par, preferred 900 Paid-in capital – excess of par, common 75 Retained earnings 2,000 Total shareholders’ equity $ 3,125

RETAINED EARNINGS Retained earnings represents amounts earned by the company that have not been distributed. Retained earnings is an equity account and has a normal credit balance. A debit balance in retained earnings is referred to as a deficit. A restriction of retained earnings indicates management’s intention to withhold assets represented by a specified portion of the retained earnings balance (normally indicated by a disclosure note).

PAR VALUE An arbitrary, often nominal, value assigned to common and preferred shares defined in the corporate charter. Par value has essentially no relationship to a share’s market value. When shares have a designated par value, that amount denotes stated capital. Some stocks do not have a par value. These stocks are known as no-par stocks.

Variations on account name: SHARES SOLD FOR CASH When shares are sold for cash, the capital stock account (usually common or preferred) is credited for the amount representing stated capital (par value). Proceeds in excess of this amount are credited to Paid-in capital – excess of par. Variations on account name: Paid-in capital in excess of par value Additional paid-in capital in excess of par Contributed capital in excess of par

SHARES SOLD FOR CASH - Example Dow Industrial sells 100,000 of its common shares, $1 par per share, for $10 per share: ($ in 000s) Cash (100,000 shares x $10) 1,000 Common Stock (100,000 shares at $1 par) 100 Paid-in capital - excess of par (difference) 900 This entry is the same for common and preferred stock.

SHARES SOLD FOR NONCASH CONSIDERATION Occasionally, a company might issue its shares for noncash consideration like a service or a noncash asset. It is not uncommon for a new company, yet to establish a reliable cash flow, to pay for promotional and legal services with shares rather than with cash. Similarly, shares might be given in payment for land, or for equipment, or for some other noncash asset. When shares are sold for noncash consideration the asset should be recorded at the fair value of the shares or the fair value of the noncash consideration, whichever seems more clearly evident The stock issued in exchange for a noncash asset is credited for par value. Any difference between the value of the noncash asset and par value is credited to paid-in capital.

SHARES SOLD FOR NONCASH CONSIDERATION – Example 1 DuMont Chemicals issues 50,000 of its common shares, $1 par per share, in exchange for legal services for which a market value is not available. Today’s issue of the Wall Street Journal lists DuMont’s stock at $10 per share. Legal Expense (50,000 shares at $10 FV) 500,000 Common stock (50,000 shares at $1 par) 50,000 Paid-in capital – excess of par (difference) 450,000

SHARES SOLD FOR NONCASH CONSIDERATION – Example 2 DuMont Chemicals issues 1 million of its common shares, $1 par per share, in exchange for a custom-built factory. The factory is valued at $10,000,000. ($ in millions) Property, plant, and equipment (fair value) 10 Common stock (1 mill sh at $1 par) 1 Paid-in capital – excess of par (difference) 9

MORE THAN ONE SECURITY SOLD FOR A SINGLE PRICE More than one security might be sold for a single price. The cash received usually is the sum of the separate market values of the two securities. Each is then recorded at its market value. If only one security’s value is known, the second security’s market value is inferred from the total selling price. If the total selling price is not equal to the sum of the two market prices, the total selling price is allocated between the two securities in proportion to their relative market values.

MORE THAN ONE SECURITY SOLD FOR A SINGLE PRICE - Example AP&P issues 4 million of its common shares, $1 par per share, and 4 million of its preferred shares, $10 par, for $100 million. Today’s issue of the Wall Street Journal lists AP&P’s common stock at $10 per share. There is no established market for the preferred shares. ($ in millions) Cash 100 Common Stock (4 million sh X $1 par) 4 Paid-in capital - excess of par, common 36 Preferred stock (4 million sh X $10 par) 40 Paid-in capital – excess of par, preferred 20 Calculation of Paid-in Capital Common: Market value $10 - $1 par value = $9 per share contributed capital x 4 million shares = $36 million Preferred: to balance entry

REACQUIRED SHARES Companies sometimes reacquire shares previously sold. The most common motivation is to support the market price of the shares. 2. All share repurchases are functionally the same. Accounting treatment depends on whether the company states that it is formally retiring the shares or purchasing treasury shares.

TREASURY SHARES When a corporation reacquires some of its stock and does not retire those shares, the shares are known as treasury stock. Treasury stock reflects the difference between the number of shares issued and the number of shares outstanding. When a corporation holds treasury stock, a debit balance exists in the general ledger account Treasury Stock (a contra stockholders' equity account). Essentially, the purchase of treasury stock is viewed as a temporary reduction of shareholders' equity, reversed later when the treasury stock is resold. A company may repurchase shares of its stock from investors for a variety of reasons, such as to make shares available to employees for purchase through an employee stock option plan, or if the company's management believes the current market price of the stock is too low and represents a bargain. Source: http://wiki.fool.com/The_Difference_in_Treasury_Shares_and_Retired_Shares

ACCOUNTING FOR TREASURY STOCK When treasury stock is purchased, the Treasury Stock account is debited for an amount equal to the cash paid to acquire the treasury stock – treasury stock cost. When treasury stock is re-issued, the Treasury Stock account is credited for an amount equal to the cost of the treasury stock. Any difference between the cost of the treasury stock and the amount received is recorded based on whether or not the treasury stock was re-issued at a gain or loss. Treasury Stock Account type: Contra-asset Normal balance: Debit If the stock is sold at a gain, we credit paid-in capital – share repurchase. If the stock is sold at a loss, we debit retained earnings. If treasury stock is sold at a loss but previous shares were sold at a gain, we first debit any existing balance in paid-in capital – share repurchase. Any additional loss is debited to Retained Earnings.

ACCOUNTING FOR TREASURY STOCK Treasury Stock is found in the Equity section of the balance sheet. It reduces total equity. Shareholders’ Equity ($ in millions) Paid-in capital: Common stock, 100 million shares at $1 par $ 100 Paid-in capital – excess of par 900 Paid-in capital – share repurchase 2 Retained earnings 2,000 Less: Treasury stock, 1 million shares (at cost) (13) Total shareholders’ equity $ 2,989

ACCOUNTING FOR TREASURY STOCK – Example 1 AP&P reacquired 1 million of its common shares at $7 per share. AP&P does not intend to retire these shares. Treasury Stock (cost) 7 Cash

ACCOUNTING FOR TREASURY STOCK – Example 2 AP&P subsequently re-issued 500,000 shares of its treasury shares at $9 per share. The treasury shares had been purchased for $7 per share. Cash 4.5 Treasury Stock 3.5 Paid-in Capital – Share Repurchase 1.0 AP&P re-issued the remaining 500,000 shares of its treasury shares at $4 per share. The treasury shares had been purchased for $7 per share. Cash 2.0 Paid-in Capital – Share Repurchase 1.0 Retained Earnings .5 Treasury Stock 3.5

RETIRED SHARES When a corporation reacquires some of its stock and cancels those shares, the shares are known as retired. Payments to retire shares are viewed as a distribution of corporate assets to shareholders. The same accounts that were increased when the shares were sold (capital stock and paid-in capital) are decreased when the shares are retired. Retired shares have no monetary value, and have no ownership representation. Retired shares cannot be re-issued. Shares issued after a share repurchase of retired shares come out of unissued common stock. When shares are retired, the number of authorized shares remains the same, but the number of outstanding shares and the number of issued shares are reduced by the number of shares retired. A company may repurchase shares of its stock from investors for a variety of reasons, such as to make shares available to employees for purchase through an employee stock option plan, or if the company's management believes the current market price of the stock is too low and represents a bargain. Source: http://wiki.fool.com/The_Difference_in_Treasury_Shares_and_Retired_Shares

ACCOUNTING FOR RETIRED STOCK The same accounts that were increased when the shares were sold (capital stock and paid-in capital) are decreased when the shares are retired. Payments to retire shares are viewed as a distribution of corporate assets to shareholders. A company may repurchase shares of its stock from investors and then cancel, or retire, those shares. Retired shares cannot be used for employee stock option plans or any other purpose. Although the number of authorized shares remains the same, the number of outstanding shares and the number of issued shares are reduced by the number of shares retired. - See more at: http://wiki.fool.com/The_Difference_in_Treasury_Shares_and_Retired_Shares#sthash.EiaBopiM.dpuf

ACCOUNTING FOR RETIRED STOCK – Example 1 AP&P reacquired 1 million of its common shares at $7 per share. AP&P intends to retire these shares. Common stock ($1 par X 1 million sh) 1 Paid-in capital – excess of par ($9 per sh) 9 Paid-in capital – share repurchase [difference] 3 Cash 7 If there had been a loss on the retired stock, Retained Earnings would have been debited for the amount of the loss.

ACCOUNTING FOR RETIRED STOCK – Example 2 AP&P reacquired 1 million of its common shares at $13 per share. AP&P intends to retire these shares. AP&P’s balance sheet shows previous balance of $2 million in the Paid-in Capital – Share Repurchase account. Common stock ($1 par X 1 million sh) 1 Paid-in capital – excess of par ($9 per sh) 9 Paid-in capital – share repurchase [*] 2 Retained earnings [difference] Cash 13 *Because there is a $2 million credit balance.

ACCOUNTING FOR RETIRED STOCK – Example 3 AP&P issued 1 million of its common shares at $14 per share. They had previously reaquired 1 million common shares which were retired. Cash 14 Common Stock [par] 1 Paid-in capital – excess of par 13 Recall that the fact that there are retired shares does not impact this transaction at all.

CASH DIVIDENDS Cash dividends are amounts paid to shareholders out of the company’s earnings. Dividends are paid to both common and preferred shareholders. Preferred stock can be cumulative or noncumulative. Dividends reduce Retained Earnings and are recorded on the date of declaration. Corporations have no obligation to pay dividends to shareholders and no liability for dividends exists until dividends are declared.

ACCOUNTING FOR CASH DIVIDENDS – Example On June 1, the board of directors of Craft Industries declares a cash dividend of $2 per share on its 100 million shares, payable to shareholders of record June 15, to be paid July 1. ($ in millions) June 1 – declaration date Retained earnings 200 Cash dividends payable July 1 – payment date Cash dividends payable 200 Cash No entry is made on the date of record.

STOCK DIVIDENDS A stock dividend is the distribution of additional shares of stock out of authorized stock to current shareholders of the corporation. Because each shareholder receives the same percentage increase in shares, shareholders' proportional interest in (percentage ownership of) the firm remains unchanged. For a "small" stock dividend (less than 25%), the fair market value on the date of declaration of the additional shares distributed is debited to retained earnings.

ACCOUNTING FOR STOCK DIVIDENDS – Example Craft Company currently has 100 million common shares outstanding. Craft declares and distributes a 10% common stock dividend when the market value of the $1 par common stock is $12 per share. 1) Determine the number of shares distributed in the stock dividend. 100 million X 10% = 10 million 2) Prepare the journal entry to record the stock dividend on the date of declaration. ($ in millions) Retained earnings (10 mill sh at $12 per sh) 120 Common Stock Div Distributable (10 mill sh at $1 par per sh) 10 Paid-in capital – excess of par 110

PROPERTY DIVIDENDS Occasionally, a noncash asset is distributed to shareholders. In that case it is referred to as a property dividend. The fair market value of the assets to be distributed is the amount recorded for a property dividend. Before recording the property dividend, the asset may need to be written up or down to fair market value. A FMV write-up or down would create a gain or loss to be recognized in the period in which the dividend was declared.

ACCOUNTING FOR PROPERTY DIVIDENDS – Example On October 1, the board of directors of Craft Industries declares a property dividend of 2 million shares of Beaman Corporation’s preferred stock that Craft had purchased in March as an investment (book value: $9 million). The investment shares have a fair market value of $5 per share and are payable to shareholders of record Oct 15, to be distributed Nov 1. ($ in millions) Oct 1 – declaration date Investment in Beaman Preferred Stock 1 Gain on appreciation of investments Retained earnings 10 Property dividend payable Nov 1 – payment date Property dividend payable 10 Investment in Beaman Preferred Stock No entry is made on the date of record.

STOCK SPLITS A stock distribution of 25% or higher is a stock split. A frequent reason for issuing a stock split is to reduce the market price per share (by half in a 2 for 1 split, for example). If referred to merely as a stock split, no journal entry is recorded. If referred to as a "stock split effected in the form of a stock dividend," the par value of the additional shares is reclassified within shareholders’ equity.

ACCOUNTING FOR STOCK SPLITS – Example Craft declares and distributes a 2 for 1 stock split effected in the form of a 100% stock dividend (100 million shares) when the market value of the $1 par common stock is $12 per share: ($ in millions) Paid-in capital – excess of par 100 Common stock (100 mill sh at $1 par) Some companies choose to debit retained earnings instead: Retained earnings 100 Common stock (100 mill sh at $1 par)

REPORTING SHAREHOLDERS’ EQUITY Updating Retained Earnings Year-end As you post transactions, affected shareholders’ equity accounts (capital stock, paid-in capital, treasury stock, retained earnings) will be updated. Report the updated amounts on the balance sheet at year end. Updating Retained Earnings Beginning RE + Net Income – Dividends (cash, stock, property) = Ending RE

Intermediate Accounting II – Chapter 18 END OF PRESENTATION Shareholders’ Equity Intermediate Accounting II – Chapter 18 END OF PRESENTATION