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11-2 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 11 Reporting and Interpreting Stockholders’ Equity

11-3 Understanding Corporations 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 Two primary sources of stockholders’ equity Contributed capital Retained earnings Common Stock Additional paid-in capital Understanding Corporations

11-5 Understanding Corporations Excerpt from Ross Stores’ Balance Sheet showing Stockholders Equity at January 31, (Dollar amounts in thousands).

11-6 Because a corporation is a separate legal entity, it can... Own assets. Sue and be sued. Incur liabilities. Enter into contracts. Ownership of a Corporation

11-7 Ownership of a Corporation ¶ Voting (in person or by proxy). · Proportionate distributions of profits. ¸ Proportionate distributions of assets in a liquidation. Stockholder Benefits

11-8 Ownership of a Corporation Elected by shareholders Appointed by directors

11-9 Authorized, Issued, and Outstanding Capital Stock The maximum number of shares of capital stock that can be sold to the public. Authorized Shares

11-10 Authorized, Issued, and Outstanding Capital Stock 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.

11-11 Authorized, Issued, and Outstanding Capital Stock 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.

11-12 Common Stock Transactions 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.

11-13 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

11-14 Common Stock Transactions 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. 

11-15 Common Stock Transactions Some states do not require a par value to be stated in the charter. No-par Stock

11-16 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. Ross Stores issues stock. Ross Stores

11-17 Secondary Markets Transactions between two investors that do not affect the corporation’s accounting records. I’d like to sell some of my Ross stock. I’d like to buy some of your Ross stock.

11-18 Issuance of Stock On January 29, Ross Stores issued 100,000 shares of $0.01 par value common stock for $30 per share. Most sales of stock to the public are cash transactions. Prepare the journal entry to record this transaction.

,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 On January 29, Ross Stores issued 100,000 shares of $0.01 par value common stock for $30 per share.

11-20 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

11-21 Repurchase of Stock Ross Stores 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. Ross Stores

11-22 No voting or dividend rights Contra equity account When stock is reacquired, the corporation records the treasury stock at cost. Repurchase of Stock Treasury stock is not an asset.

11-23 On February 1, Ross Stores reacquired 50,000 shares of its common stock at $25 per share. The journal entry for February 1 is.... Repurchase of Stock When stock is reacquired, the corporation records the treasury stock at cost.

11-24 Reporting Treasury Stock on the Balance Sheet Ross Stores’ Stockholders Equity after treasury stock purchase. (Dollar amounts in thousands).

11-25 Reissuance of Treasury Stock 5,000 shares × $26 = $130,0005,000 shares × $25 cost = $125,000 On March 1, Ross Stores reissued 5,000 shares of the treasury stock at $26 per share. The journal entry for March 1 is... No profit or loss recognized on treasury stock transactions.

11-26 Statement of Stockholders’ Equity A summary of all equity transactions that occur during a period.

11-27 Dividends on Common Stock Declared by board of directors. Not legally required. Creates liability at declaration. Requires sufficient Retained Earnings and Cash.

11-28 Dividend Dates Declaration date Board of directors declares the dividend. Record a liability. Closed to Retained Earnings at the end of the year.

11-29 Dividend Dates X Date of Record Stockholders holding shares on this date will receive the dividend. (No entry)

11-30 Dividend Dates Date of Payment Record the dividend payment to stockholders.

11-31 Stock Dividends 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.

11-32 Stock Dividends Corporation 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. Corporation 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.

11-33 Stock dividend < 25% Stock Dividends 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.

11-34 Stock Dividends 50,000 shares × $0.01 = $500 On March 20, Ross Stores issued a 5 percent stock dividend on its 1,000,000 outstanding shares of $0.01 par value common stock. Market value of the stock on March 20 was $20 per share. The journal entry for March 20 is... 50,000 shares × $20 = $1,000,000

11-35 Stock Dividends On March 20, Ross Stores issued a 100 percent stock dividend on its 1,000,000 outstanding shares of $0.01 par value common stock. Market value of the stock on March 20 was $20 per share. The journal entry for March ,000,000 shares × $0.01 = $10,000 Let’s change the small stock dividend to a 100 percent stock dividend.

11-36 Stock Splits 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.

11-37 Stock Splits Assume that a corporation had 5,000 shares of $1 par value common stock outstanding before a 2–for–1 stock split.

11-38 Stock Splits 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.

11-39 Preferred Stock Preference over common stock Usually has no voting rights Usually has a fixed dividend rate

11-40 Dividends on Preferred Stock ¶ 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.

11-41 Dividends on Preferred Stock If the preferred stock is noncumulative, any dividends not declared in previous years are lost permanently.

11-42 Dividends on Preferred Stock In addition to common stock, assume that Ross Stores 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?

11-43 Dividends on Preferred Stock

11-44 Dividends on Preferred Stock

11-45 Dividends on Preferred Stock

11-46 Net Income Average Number of Shares Outstanding EPS = Assume that MegaMart, a Ross Store competitor, had $472,500,000 income for the year and the average number of shares outstanding is 105,000,000. Compute earnings per share for MegaMart. Earnings per share is probably the single most widely watched financial ratio. Earnings Per Share (EPS)

11-47 Earnings per share reports the amount of income earned for each share of stock outstanding. $472,500, ,000,000 Shares EPS = = $4.50 per share Earnings Per Share (EPS) Net Income Average Number of Shares Outstanding EPS =

11-48 Return on Equity (ROE) Net Income Average Stockholders’ Equity ROE = Ross Stores’ income for the year is $228,102,000 and the average Stockholder’s Equity is $699,303,000. Compute return on equity for Ross. Return on equity is the amount earned for each dollar invested by stockholders.

11-49 Return on Equity (ROE) Net Income Average Stockholders’ Equity ROE = $228,102,000 $699,303,000 ROE = = percent

11-50 Equity Versus Debt Advantages Equity does not have to be repaid. Dividends are optional. Disadvantages Change in stockholder control. Dividends are not tax deductible. Advantages and disadvantages of equity financing relative to debt financing.

11-51 Equity Versus Debt 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.

11-52 Restrictions on Retained Earnings 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.

11-53 Stock Options and Diluted Earnings Per Share Good news Employees are motivated to increase financial performance which can increase the stock price. Investor/owner wealth increases when the stock price increases. Bad news When options are exercised, the additional shares reduce current investors' ownership percentage. Earnings per share is reduced as net income is divided by more shares outstanding.

11-54 End of Chapter 11