Ch.11 Shareholders’ Equity Prof. J. Wang

Assets = Liabilities + Owners’ Equity Part I: Introduction Assets = Liabilities + Owners’ Equity

Part I: Introduction Equity v. Debt Financing Advantage of equity financing: flexibility Advantage of debt financing: tax deductible, Benefit shareholders if the borrowing rate is lower than the rate of return using the borrowed money Shareholders’ ownership interest is not diluted

Expanded Accounting Equation Assets = Liabilities + Owners’ Equity Assets = Liabilities + Stockholders’ Equity Contributed Capital Retained Earnings Ch.9&10 Ch.11

Part II: Contributed Capital Common Stock Basic stock of corporation Normally carries voting rights Preferred Stock Optional No voting rights

Preferred Stock In exchange for giving up voting rights, have dividend preference over common stock Stated dividend rate Percentage of the stock’s par value Per-share amount Preferred dividends usually are cumulative $100 par, 7% preferred stock LO2

Number of Shares of Stock Authorized 1,000 Maximum Allowable Issued: sold or distributed Outstanding: not repurchased or retired

Par Value “Legal capital” Arbitrary amount (usually small) stated on stock certificate Also called “stated value” Certificate of Stock $1.00 Par Value

Additional Paid-in Capital Amount received in excess of par when stock was issued Certificate of Stock $1.00 Par Value 15

Stock Issued for Cash Example: Common Stock $ 10,000 1,000 shares of $10 par value stock sold for $15 per share Common Stock $ 10,000 ( $10 par value × 1,000 shares) Additional Paid-In Capital $5,000 (($15 – $10) × 1,000 shares) Example: Journal entry: Cash 15,000 Common Stock 10,000 Additional Paid-In Capital—Common 5,000 To record the issuance of 1,000 shares of $10 common stock at $15 per share. LO3

Stock Issued for Noncash Consideration Record at fair market value of consideration given or received, whichever is more readily determinable Certificate of Stock Title to land, building, etc.

Stock Issued for Non-cash Assets issued1,000 shares of $10 par value stock For land with a fair value of $15,000 Common Stock $ 10,000 ( $10 par value × 1,000 shares) Additional Paid-In Capital $5,000 Example: Journal entry: Land 15,000 Common Stock 10,000 Additional Paid-In Capital—Common 5,000 To record the issuance of 1,000 shares of $10 common stock for land. LO3

Part III: Retained Earnings

Retained Earnings Net income retained in the business (not paid out as dividends) since its inception Reinvested in a variety of assets (not necessarily liquid)

Retained Earnings Increases when net income is earned Decreases when dividends are paid

Retained Earnings Connects the Income Statement and the Balance Sheet Revenues $ xxx Less: Expenses xxx Net Income $ inc Statement of Retained Earnings Retained Earnings, Beginning Balance $ xxx Add: Net Income inc Deduct: Dividends xxx Retained Earnings, Ending Balance $ end Balance Sheet Total Assets $ xxx Total Liabilities xxx Stockholders’ Equity xxx Retained Earnings end Total Liabilities and Stockholders' Equity $ xxx

Cash Dividend Requirements Sufficient cash Positive retained earnings

Cash Dividends Payment date on Date of declaration Paid to dividend check for Date Dept.. of Treasurer Jane Doe Payment date on 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 Date of declaration 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 Paid to Stockholders on date of record

Dividends (2) 1/15/07, $5,000 cash dividends were paid 12/31/06 Journal entry required to record: (1) 12/31/06, $5,000 cash dividends declared (2) 1/15/07, $5,000 cash dividends were paid 12/31/06 1/15/07 Reduce retained earnings Pay dividends

Recording Cash Dividends dividend check for Date Dept.. of Treasurer Jane Doe Recording Cash Dividends Retained Earnings 5,000 Cash Dividend Payable 5,000 To record the declaration of a cash dividend on 12/31/06. Cash Dividend Payable 5,000 Cash 5,000 To record the payment of a cash dividend on 1/15/07.

If the company has preferred stocks outstanding then dividends must be divided between common and preferred shareholders If preferred dividends are cumulative, preferred shareholders will receive dividends in arrears and for the current year before common shareholders receive any dividends. If preferred dividends are non-cumulative, preferred shareholders will only receive dividends for the current year before common shareholders receive theirs.

Allocation of Cash Dividends when preferred stock is cumulative Distribute dividends in arrears, if any, to preferred Distribute current year’s dividends to preferred Distribute remainder to common (or to both if preferred is participating) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 2004 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 2005 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 2006 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 2007 LO5

Cash Dividends Example Stricker Company declares a $70,000 dividend in 2007 (no dividends were paid in 2005 or 2006). There are 10,000 shares of $10 par, 8% preferred stock and 40,000 shares of $5 par common stock outstanding.

Cash Dividends Example Noncumulative Preferred Stock To Preferred To Common Step 1: Distribute current-year dividend to preferred (10,000 shares × $10 par × 8% × 1 year) $8,000 Step 2: Distribute remaining dividend to common ($70,000 – $8,000) $62,000 Total allocated $8,000 $62,000 $0.80 per share $1.55 per share

Cash Dividends Example Cumulative Preferred Stock To Preferred To Common Step 1: Distribute dividends in arrears to preferred (10,000 shares × $10 par × 8% × 2 years) $16,000 Step 2: Distribute current-year dividend 8% × 1 year) 8,000 Step 3: Distribute remainder to common ($70,000 – $8,000) $46,000 Total allocated $24,000 $46,000 $0.80 per share $1.55 per share

Stock Dividends Issue of additional shares proportionately to existing stockholders Certificate of Stock Certificate of Stock Certificate of Stock Certificate of Stock Certificate of Stock Certificate of Stock Reasons: Insufficient cash Market price reduction Nontaxable to recipients LO6

Small Stock Dividend Example Stockholders’ Equity: Common stock, $10 par, 5,000 shares issued and outstanding $ 50,000 Additional paid-in capital—Common 30,000 Retained earnings 70,000 Total stockholders’ equity $150,000 Before Dividend Assume Shah Company declares a 10% stock dividend; 500 additional shares will be issued. Assume that market value Per share at the time is $40.

Assets = Liabilities + Stockholders’ Equity Contributed Capital Retained Earnings +$20,000 - $20,000

Small Stock Dividend Example Stockholders’ Equity: Common stock, $10 par, 5,500 shares $ 50,000 $ 55,000 Additional paid-in capital—Common 30,000 45,000 Retained earnings 70,000 50,000 Total stockholders’ equity $150,000 $150,000 Before After + + – $20,000 ($40*500) market value deducted from retained earnings; allocated between Common Stock (initially Common Stock Dividend Distributable) ($10*500) and Additional Paid-In Capital ($30*500).

Small Stock Dividend Example Before After Stockholders’ Equity: Common stock, $10 par, 5,500 shares $ 50,000 $ 55,000 Additional paid-in capital—Common 30,000 45,000 Retained earnings 70,000 50,000 Total stockholders’ equity $150,000 $150,000 + + – Total S/E is unchanged

Large Stock Dividend Example Stockholders’ Equity: Common stock, $10 par, 5,000 shares issued and outstanding $ 50,000 Additional paid-in capital—Common 30,000 Retained earnings 70,000 Total stockholders’ equity $150,000 Before Dividend Assume Shah Company declares 100% stock dividend That is, additional 5,000 shares will be issued

Large Stock Dividend Example Stockholders’ Equity: Common stock, $10 par, 10,000 shares $ 50,000 $100,000 Additional paid-in capital—Common 30,000 30,000 Retained earnings 70,000 20,000 Total stockholders’ equity $150,000 $150,000 Before After + – Retained earnings is reduced by the total par value It’s recorded in the Common Stock account at par. Additional Paid-In Capital account is unaffected.

Large Stock Dividend Example Before After Stockholders’ Equity: Common stock, $10 par, 10,000 shares $ 50,000 $100,000 Additional paid-in capital—Common 30,000 30,000 Retained earnings 70,000 20,000 Total stockholders’ equity $150,000 $150,000 + – Total S/E is unchanged

Stock Splits Results in additional issuance of shares Reduces par value per share No change in Stockholders’ Equity accounts Certificate of Stock $1 par value Certificate of Stock $3 par value LO 7

Stock Splits Not recorded in accounts Disclose in notes Not recorded in accounts Reduce market price per share and make the stock more accessible to a wider range of investors

2-for-1 Stock Split Example Stockholders’ Equity: Common stock, $10 par, 5,000 shares issued and outstanding $ 50,000 Additional paid-in capital—Common 30,000 Retained earnings 70,000 Total stockholders’ equity $150,000 Before Split Assume Shah Company declares 2-for-1 stock split

2-for-1 Stock Split Example Before After Stockholders’ Equity: Common stock, $5 par, 10,000 shares $ 50,000 $ 50,000 Additional paid-in capital—Common 30,000 30,000 Retained earnings 70,000 70,000 Total stockholders’ equity $150,000 $150,000 All accounts are unchanged Only disclosures are affected

Part IV: Treasury Stock Company buys back its own stock Contra-equity account (debit balance) Not outstanding (no voting rights) Certificate of Stock LO4

Reasons for Repurchasing Stock Provide for employee bonuses or benefit plans Maintain a favorable market price Improve financial ratios Maintain control of ownership Prevent unwanted takeover or buyout attempts

Assets = Liabilities + Stockholders’ Equity For example, the company purchased 100 shares of its own outstanding stock at $25 per share Dr. Treasury Stock 2,500 Cr. Cash 2.500 Assets = Liabilities + Stockholders’ Equity -$2,500 -$2,500

Presentation of Treasury Stock Common stock, $10 par value, 1,000 shares issued, 900 outstanding $10,000 Additional paid-in capital—Common 12,000 Retained earnings 15,000 Total contributed capital and retained earnings 37,000 Less: Treasury stock, 100 shares at cost ($25 per share) 2,500 Total stockholders’ equity $34,500