Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 11 Reporting and Interpreting Stockholders’ Equity

11-2 Learning Objective 1 Explain the role of stock in financing a corporation.

11-3 Corporate Ownership Simple to become an owner Easy to transfer ownership Provides limited liability The major advantage of the corporate form of business is the ease of raising large amounts of money because both large and small investors can participate in corporate ownership.

11-4 Because a corporation is a separate legal entity, it can... Own assets. Sue and be sued. Incur liabilities. Enter into contracts. Corporate Ownership

11-5  Voting rights.  Dividends.  Residual claims. Stockholder Benefits Corporate Ownership  Preemptive rights.

11-6 Elected by shareholders Appointed by directors Corporate Ownership

11-7 Equity Versus Debt Financing Advantages of equity Equity does not have to be repaid. Dividends are optional. Advantages of debt Interest on debt is tax deductible. Debt does not change stockholder control. Advantages of equity and debt financing.

11-8 Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. Consider the following example with $100,000 of debt financing. Equity Versus Debt Financing

11-9 Learning Objective 2 Explain and analyze common stock transactions.

11-10 Two primary sources of stockholders’ equity Contributed capital Retained earnings Common Stock Additional paid-in capital Common Stock Transactions

11-11 Authorization, Issuance, and Repurchase The maximum number of shares of capital stock that can be sold to the public. Authorized Shares

11-12 Authorized Shares Issued shares are authorized shares of stock that have been sold. Unissued shares are authorized shares of stock that never have been sold. Authorization, Issuance, and Repurchase

11-13 Authorized Shares Unissued Shares Treasury Shares Outstanding Shares Issued Shares Treasury shares are issued shares that have been reacquired by the corporation. Outstanding shares are issued shares that are owned by stockholders. Authorization, Issuance, and Repurchase

11-14 Excerpt from Sonic Corporation’s Balance Sheet showing Stockholders Equity at August 31, (Dollar amounts in thousands). Common Stock Transactions

11-15 All corporations are required to issue common stock at incorporation. Common stockholders have the right to vote on important issues and the right to share in corporate profits. Profits are shared through dividends that are set by the board of directors. Common Stock Transactions

11-16 Legal capital is the amount of capital, required by the state of incorporation, that must remain invested in the business. Par Value Nominal value Legal capital Common Stock Transactions

11-17 Par value is an arbitrary amount assigned to each share of stock when it is authorized. Market price is the amount that each share of stock will sell for in the market.  Common Stock Transactions

11-18 Some states do not require a par value to be stated in the charter. No-par Stock Common Stock Transactions

11-19 Issuance of Stock Initial public offering (IPO) The first time a corporation sells stock to the public. Seasoned new issue Subsequent sales of new stock to the public. Sonic issues stock. Sonic

11-20 Secondary Markets Transactions between two investors that do not affect the corporation’s accounting records. I’d like to sell some of my Sonic stock. I’d like to buy some of your Sonic stock.

11-21 Prepare the journal entry to record this transaction. Most sales of stock to the public are cash transactions. Issuance of Stock Sonic Corporation issued 100,000 shares of $0.01 par value common stock for $30 per share.

,000 shares × $30 per share = $3,000,000100,000 shares × $0.01 par value = $1,000 Most sales of stock to the public are cash transactions. Issuance of Stock Sonic Corporation issued 100,000 shares of $0.01 par value common stock for $30 per share.

11-23 Repurchase of Stock A corporation repurchases its stock to:  Send a signal that the company believes its stock is undervalued.  Obtain shares to reissue for the purchase of other companies.  Obtain shares to reissue to employees as part of stock purchase or stock option plans. A corporation repurchases its stock to:  Send a signal that the company believes its stock is undervalued.  Obtain shares to reissue for the purchase of other companies.  Obtain shares to reissue to employees as part of stock purchase or stock option plans. Treasury Stock

11-24 Repurchase of Stock Sonic buys its own stock in the secondary market. (Treasury stock) Stockholders Employee Employee compensation package includes salary plus stock options. Stock options allow employees to purchase stock from the corporation at a fraction of the stock’s value in the secondary market. Sonic

11-25 No voting or dividend rights Contra equity account When stock is reacquired, the corporation records the treasury stock at cost. Treasury stock is not an asset. Repurchase of Stock

11-26 Ross Stores reacquired 50,000 shares of its common stock at $25 per share. The journal entry for this transaction is.... When stock is reacquired, the corporation records the treasury stock at cost. Repurchase of Stock

11-27 Reissuance of Treasury Stock 5,000 shares × $26 = $130,0005,000 shares × $25 cost = $125,000 Sonic Corporation reissued 5,000 shares of the treasury stock at $26 per share. The journal entry for this transaction is... No profit or loss recognized on treasury stock transactions.

11-28 Learning Objective 3 Explain and analyze cash dividends, stock dividends, and stock split transactions.

11-29 Dividends on Common Stock Declared by board of directors. Not legally required. Creates liability at declaration. Requires sufficient Retained Earnings and Cash.

11-30 If I loan your company $1,000,000, I will want you to restrict your retained earnings in order to limit dividend payments. Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings. Restrictions on Retained Earnings

11-31 Declaration date  Board of directors declares the dividend.  Record a liability. Closed to Retained Earnings at the end of the year. Dividends Dates

11-32 X Date of Record Stockholders holding shares on this date will receive the dividend. (No entry) Dividends Dates

11-33 Date of Payment Record the dividend payment to stockholders. Dividends Dates

11-34 Distribution of additional shares of stock to stockholders. No change in total stockholders’ equity. No change in par values. All stockholders retain same percentage ownership. Stock Dividends

11-35 Corporations issue stock dividends to:  Remind stockholders of the accounting wealth in the company.  Reduce the market price per share of stock.  Signal that the company expects strong financial performance in the future. Corporations issue stock dividends to:  Remind stockholders of the accounting wealth in the company.  Reduce the market price per share of stock.  Signal that the company expects strong financial performance in the future. Stock Dividends

11-36 Stock dividend < 25% Stock dividend > 25% Record at current market value of stock. Record at par value of stock. SmallLarge The journal entry moves an amount from Retained Earnings to other equity accounts. Stock Dividends

,750,000 shares × $0.01 = $37,500 Sonic Corporation issued a 5 percent stock dividend on its 75,000,000 outstanding shares of $0.01 par value common stock. Market value of the shares issued was $10 per share. The journal entry for transaction is... 3,750,000 shares × $10 = $37,500,000 Stock Dividends

11-38 Sonic Corporation issued a 100 percent stock dividend on its 75,000,000 outstanding shares of $0.01 par value common stock. Market value of the shares issued was $20 per share. The journal entry for this transaction is... 75,000,000 shares × $0.01 = $750,000 Let’s change the small stock dividend to a 100 percent stock dividend. Stock Dividends

11-39 An increase in the number of shares and a corresponding decrease in par value per share. Retained earnings is not affected. A stock split creates more pieces of the same pie. Stock Splits

11-40 Assume that a corporation had 5,000 shares of $1 par value common stock outstanding before a 2–for–1 stock split. Stock Splits

11-41 Increase Decrease No Change Assume that a corporation had 5,000 shares of $1 par value common stock outstanding before a 2–for–1 stock split. No journal entry required – Change par value and number of shares authorized and outstanding. Stock Splits

11-42 Comparison of Distributions to Stockholders

11-43 Learning Objective 4 Describe the characteristics of preferred stock and analyze transactions affecting preferred stock.

11-44 Preference over common stock Usually has no voting rights Usually has a fixed dividend rate Preferred Stock

11-45 Preferred Stock Issuance 1,000,000 shares × $5 per share = $5,000,0001,000,000 shares × $0.01 par value = $10,000 Sonic Corporation issued 1,000,000 shares of $0.01 par value preferred stock for $5 per share.

11-46 Preferred Stock Dividends ¶ Current Dividend Preference: The current preferred dividends must be paid before paying any dividends to common stock. · Cumulative Dividend Preference: Any unpaid dividends from previous years (dividends in arrears) must be paid before common dividends are paid. ¶ Current Dividend Preference: The current preferred dividends must be paid before paying any dividends to common stock. · Cumulative Dividend Preference: Any unpaid dividends from previous years (dividends in arrears) must be paid before common dividends are paid.

11-47 If the preferred stock is noncumulative, any dividends not declared in previous years are lost permanently. Preferred Stock Dividends

11-48 In addition to common stock, assume that Sonic Corporation has 100,000 shares of $1 par cumulative preferred stock outstanding with a 10 percent dividend rate. Dividends were not paid last year. In the current year, the board of directors declared dividends of $400,000. How much will each class of stock receive? Preferred Stock Dividends

11-49 Preferred Stock Dividends

11-50 Preferred Stock Dividends

11-51 Preferred Stock Dividends

11-52 Retained Earnings Total cumulative amount of reported net income less any net losses and dividends declared since the company started operating.

11-53 Learning Objective 5 Analyze the earnings per share (EPS), return on equity (ROE), and price/earnings (P/E) ratios.

11-54 Net Income Average Number of Common Shares Outstanding EPS = Sonic Corporation’s income for the year was $75,400,000 and the average number of shares outstanding during the year was 60,000,000. Compute earnings per share for Sonic. Earnings per share is probably the single most widely watched financial ratio. Earnings Per Share (EPS)

11-55 During the year, Sonic Corporation earned $1.26 for each share of its common stock. $75,400,000 60,000,000 Shares EPS = = $1.26 per share Earnings Per Share (EPS) Net Income Average Number of Common Shares Outstanding EPS =

11-56 Return on Equity (ROE) Net Income Average Stockholders’ Equity ROE = Sonic Corporation’s income for the year was $75,400,000 and the average Stockholder’s Equity was $359,650,000. Compute return on equity for Sonic. Return on equity is the amount earned for each dollar invested by stockholders.

11-57 Return on Equity (ROE) Net Income Average Stockholders’ Equity ROE = $75,400,000 $359,650,000 ROE = = 21.0 percent Return on Equity tells us that Sonic Corporation earned 21 cents for each dollar of its stockholders equity.

11-58 Price/Earnings (P/E) Ratio Current Stock Price (per share) Earnings Per Share (annual) P/E = The P/E ratio is a measure of the value that investors place on a company’s common stock. Sonic Corporation’s stock price is $ Recall that we calculated earnings per share for the year to be $1.26.

11-59 Price/Earnings (P/E) Ratio $29.50 $1.26 P/E = = 23.4 Current Stock Price (per share) Earnings Per Share (annual) P/E = The P/E ratio tells us that investors are willing to pay 23.4 times the current year’s earnings for a share of Sonic Corporation’s common stock.

11-60 Comparison of EPS, ROE, and P/E Ratios

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 11 Supplement Owners’ Equity for Other Forms of Business

11-62 Owner’s Equity for a Sole Proprietorship Only two owner’s equity accounts. A withdrawal account to record the owner’s withdrawals of assets. A withdrawal account to record the owner’s withdrawals of assets. A capital account to record the owner’s investments and the period income or loss. Closed to the capital account at the end of each period. No separate retained earnings account.

11-63 Accounting for Owner’s Equity for a Sole Proprietorship To record a $150,000 investment by H. Simpson, the owner. To record H. Simpson’s $1,000 monthly withdrawal.

11-64 Accounting for Owner’s Equity for a Sole Proprietorship To close revenue and expense accounts to capital. To close the $1,000 monthly drawings to capital.

11-65 Accounting for assets, liabilities, revenues and expenses follows the same accounting principles as any other form of business. Accounting for partners’ equity follows the same pattern as for a sole proprietorship. Separate capital and drawings accounts are maintained for each partner. Accounting for Partnership Equity

11-66 Accounting for Partnership Equity To record investments by partners Able and Baker who will divide net income as follows: Able, 60 percent and Baker 40 percent. To record the partners’ monthly withdrawal.

11-67 Accounting for Partnership Equity To close revenue and expense accounts to partners’ capital. To close the monthly drawings to partners’ capital. 40% of $30,000 60% of $30,000

11-68 Other Business Forms Limited Liability Partnership (LLP) Protects innocent partners from malpractice or negligence claims. Most states hold all partners personally liable for partnership debts. Protects innocent partners from malpractice or negligence claims. Most states hold all partners personally liable for partnership debts. Limited Liability Corporation (LLC) Owners have same limited liability feature as owners of a corporation. A limited liability corporation typically has a limited life. Owners have same limited liability feature as owners of a corporation. A limited liability corporation typically has a limited life.

11-69 Other Business Forms Many factors should be considered when choosing the proper business form.

11-70 End of Chapter 11