Equity Financing

Learning Objectives 1. Identify the rights associated with ownership of common and preferred stock. 2. Record the issuance of stock for cash, on a subscription basis, and in exchange for noncash assets or for services. 3. Use both the cost and par value methods to account for stock repurchases. 4. Account for the issuance of stock rights and stock warrants.

Learning Objectives 5. Explain the difference between the intrinsic value and fair value methods, and use both in accounting for a fixed stock option plan. 6. Distinguish between stock conversions that require a reduction in retained earnings and those that do not. 7. List the factors that impact the retained earnings balance.

Learning Objectives 8. Properly record cash dividends, property dividends, small and large stock dividends, and stock splits. 9. Explain the background of unrealized gains and losses recorded as direct equity adjustments, and list the major types of equity reserves founds in foreign balance sheets. 10. Prepare a statement of changes in stockholders’ equity.

Learning Objectives EXPANDED MATERIAL 11. Eliminate a retained earnings deficit through a quasi-reorganization. 12. Use both the intrinsic value and fair value methods to account for performance-based stock option plans and plans calling for a cash settlement.

Components of Stockholders’ Equity Retained Earnings Contributed Capital Other Legal Capital Additional Paid-In

Common Stock The owners of common stock of a corporation can be thought of as the true owners of the business.

Common Stock Unless restricted by terms of the articles of incorporation, the common stockholder has certain basic rights.

Common Stock The right to vote in the election of directors and in the determination of certain corporate polices such as the management compensation plan or major corporate acquisitions. The right to maintain one’s proportional interest in the corporation through purchase of additional common stock if and when it is issued.

Preferred Stock The title “preferred” stock is somewhat misleading. Preferred isn’t better; it’s different. The title “preferred” stock is somewhat misleading.

The protection enjoyed by preferred stockholders is: Preferred stockholders are entitled to receive their full cash dividend before any cash dividend can be issued to common stockholders. If the company goes bankrupt, preferred stockholders are entitled to have their investment repaid in full, before common stockholders receive anything.

Preferred Stock Cumulative Has the right to receive accumulated dividends before any dividends may be paid to common stockholders. Non- Cumulative Has no right to “passed” dividends. Participating Has claim to a portion of common dividends after receiving preferred dividends.

Preferred Stock Convertible Callable Redeemable Permits the holder to exchange preferred stock for common stock. Callable Permits the issuing company to redeem the preferred stock. Redeemable Permits the holder to redeem the stock--usually with some restrictions.

Issuance of Capital Stock Goode Corporation issued 4,000 shares of $1 par common stock on April 1, 2002, for $45,000 cash. Apr. 1 Cash 45,000 Common Stock 4,000 Paid-In Capital in Excess of Par 41,000

Issuance of Capital Stock Goode Corporation issued 4,000 shares of no-par common stock with a stated value of $1 on April1, 2002, for $45,000 cash. Apr. 1 Cash 45,000 Common Stock 4,000 Paid-In Capital in Excess of Stated Value 41,000

Issuance of Capital Stock On April 1, Goode Corporation issued 4,000 shares of no-par common stock without a stated value on April1, 2002, for $45,000 cash. Apr. 1 Cash 45,000 Common Stock 45,000

Capital Stock Sold on Subscription On November 1, 2002, a firm received subscriptions for 5,000 shares of $1 par common at $12.50 per share with 50% down, balance due in 60 days. Nov. 1 Cash 31,250 Common Stock Subscription Receivable 31,250 Common stock Subscribed 5,000 Paid-In Capital in Excess of Par 57,500

Capital Stock Sold on Subscription On December 9, received balance due on one-half of subscribers and issued stock to fully paid subscribers, 2,500 shares. Dec. 9 Cash 15,625 Common Stock Subscription Receivable 15,625 Common stock Subscribed 2,500 Common Stock 2,500

Stock Issued for Consideration Other Than Cash AC Company issues 200 shares of $0.50 par value common stock in return for land. The company’s stock is currently selling for $50 per share. Dec. 5 Land 10,000 Common Stock 100 Paid-In Capital in Excess of Par 9,900

Stock Issued for Consideration Other Than Cash Assume that the land has a readily determinable market price of $12,000, but AC Company’s common stock has no established fair market value. Dec. 5 Land 12,000 Common Stock 100 Paid-In Capital in Excess of Par 11,900

Stock Repurchases To provide shares for incentive compensation and employee savings plans. To obtain shares needed to satisfy requests by holders of convertible securities. To reduce the amount of equity relative to the amount of debt. To invest excess cash temporarily. Why repurchase shares?

Stock Repurchases To remove some shares from the open market in order to protect against a hostile takeover. To improve per-share earnings by reducing the number of shares outstanding and returning inefficiently used assets to shareholders. To display confidence that the stock is currently undervalued by the market.

Treasury Stock Stock issued by a corporation but subsequently reacquired by the corporation and held for possible future reissuance or retirement. Reported as a contra-equity account, not as an asset. Does not create a gain or loss on reacquisition, reissuance, or retirement. May decrease Retained Earnings, but cannot increase it.

Treasury Stock--Example: Both Accounting Methods Issued 100, $10 par value shares at $15 per share Cost Method Cash 1,500 Common Stock. 1,000 Paid-In Capital in Excess of Par 500 Par Value Method Cash 1,500 Common Stock 1,000 Paid-In Capital in Excess of Par 500

Reacquired ten shares at $16 per share. Treasury Stock--Example: Both Accounting Methods Reacquired ten shares at $16 per share. Cost Method Treasury Stock 160 Cash 160 Par Value Method Treasury Stock 100 Paid-In Capital in Excess of Par 50 Retained Earnings 10 Cash 160

Sold two shares of treasury stock at $20 per share. Treasury Stock--Example: Both Accounting Methods Sold two shares of treasury stock at $20 per share. Cost Method Cash 40 Treasury Stock 32 Paid-In Capital from Treasury Stock 8 Par Value Method Cash 40 Treasury Stock 20 Paid-In Capital in Excess of Par 20

Sold five shares of treasury stock at $14 per share. Treasury Stock--Example: Both Accounting Methods Sold five shares of treasury stock at $14 per share. Cost Method Cash 70 Paid-In Capital from Treasury Stock 8 Retained Earnings 2 Treasury Stock 80 Par Value Method Cash 70 Treasury Stock 50 Paid-In Capital in Excess of Par 20

Retired remaining three shares of stock. Treasury Stock--Example: Both Accounting Methods Retired remaining three shares of stock. Cost Method Common Stock 30 Paid-In Capital in Excess of Par 15 Retained Earnings 3 Treasury Stock 48 Par Value Method Common Stock 30 Treasury Stock 30

Stock Rights, Warrants, and Options Stock rights--Issued to existing shareholders to permit them to maintain their proportionate ownership interests when new shares are to be issued. Stock warrants--Sold by the corporation for cash, generally in conjunction with the issuance of another security. Stock options--Granted to officers or employees, usually as part of a compensation plan.

Stock Warrants Stewart Co. sells 1,000 shares of $50 par preferred stock for $58 per share. Stewart Co. gives the purchaser detachable warrants enabling the holders to subscribe to 1,000 shares of $2 par common stock for $25 per share. Immediately following the issuance of the stock, the warrants are selling for $3, and the fair market value of a preferred share without the warrant attached is $57.

Stock Warrants = $3 $57 + $3 Value assigned to warrants Total issue price Market value of warrants x = Market value of security without warrants Market value of warrants + $57 + $3 Value assigned to warrants = $58,000 x $3 = $2,900

Stock Warrants The entry on Stewart’s book to record the sale of the preferred stock with detachable warrants is: Cash 58,000 Preferred Stock, $50 par 50,000 Paid-In Capital in Excess of Par--Preferred Stock 5,100 Common Stock Warrants 2,900

Stock Warrants If the warrants are exercised, the entry to record the issuance of common stock is: Common Stock Warrants 2,900 Cash 25,000 Common Stock, $2 par 2,000 Paid-In Capital in Excess of Par--Common Stock 25,900

Stock-Based Compensation 3434 Stock-Based Compensation Yes No All employees eligible? No Compensatory Plan Shares offered equally? No Determine compensation expense; amortize over period employee is to provide service. Reasonable exercise period? Grant and Measurement dates same? Yes Yes No No Exercise Prices » Market Price? Estimate compensation expense; amortize over period employee is to provide service. No Number of shares and Exercise Price known? Non-compen- satory Plan Adapted from Jarnagin, Bill D. Financial Accounting Standards; Explanation and Analysis. 16 ed.--1994.(CCH Inc., Chicago, Ill. 1994) pp 584-585 Yes Record shares issued when stock is purchased. Determine actual expense; amortize over remaining period employee is to provide service. Record shares issued when stock is purchased. Adjust for Unearned Compensation, if any.

Factors Affecting Retained Earnings Error corrections Changes in accounting principle Net income Quasi-reorganizations Increases Retained Earnings

Factors Affecting Retained Earnings Decreases Changes in accounting principles Dividends Error corrections Prior period adjustments Treasury stock Net loss Retained Earnings

Accounting for Dividends Declaration date: The date the corporation’s board of directors formally declares a dividend will be paid. Date of record: The date on which stockholders of record are identified as those who will receive a dividend. Date of payment: The date when the dividend is actually distributed to stockholders.

Cash Dividend ABC Corporation declares a $2,000 dividend; the following journal entries should be made: Declaration Date Dividends (Retained Earnings) 2,000 Dividends Payable 2,000 Payment Date Dividends Payable 2,000 Cash 2,000

What is a property dividend?

Property Dividend It is a distribution to stockholders that is payable in some asset other than cash.

Property Dividend XYZ Corporation declares a dividend of 1,000 shares of Gondor, Inc. stock (cost $3,000; fair market value, $5,000). Date of Declaration Dividend (or Retained Earnings) 5,000 Property Dividends Payable 3,000 Gain on Distribution of Property Dividend 2,000

Entry on the Books of a 50% Shareholder Property Dividend Date of Payment Property Dividends Payable 3,000 Investment in Gordor, Inc. Stock 3,000 Entry on the Books of a 50% Shareholder Investment in Gordor, Inc. Stock 2,500 Dividend Revenue 2,500

Stock Dividends: Small or Large? Less than 20-25% of the outstanding shares. Debit Retained Earnings for the MARKET value of the shares. Large Greater than 20-25% of the shares outstanding. Debit Retained Earnings for the PAR value of the shares.

Example 1: Stock Dividend Assume the following about Gean, Inc.: Common stock ($2 par, 10,000 shares outstanding) $20,000 Additional paid-in capital $24,200 Retained earnings $12,500 Stock dividend declared 1,500 shares Market price of stock $10/share Assume the following about Gean, Inc.: Common stock ($2 par, 10,000 shares outstanding) $20,000 Additional paid-in capital $24,200 Retained earnings $12,500 Stock dividend declared 1,500 shares Market price of stock $10/share Is this a large or small stock dividend?

Example 1: Stock Dividend Because 1,500 shares represent 15% of the outstanding stock, it is a small stock dividend. Assume the following about Gean, Inc.: Common stock ($2 par, 10,000 shares outstanding) $20,000 Additional paid-in capital $24,200 Retained earnings $12,500 Stock dividend declared 1,500 shares Market price of stock $10/share

Example 1: Stock Dividend Declaration Date Retained Earnings 15,000 Stock Dividends Distributable 3,000 Paid-In Capital in Excess of Par 12,000 Issuance Date Stock Dividends Distributable 3,000 Common Stock 3,000

Example 2: Stock Dividend Assume the following about Gimli’s Corp.: Common Stock ($5 par, 20,000 shares outstanding) $100,000 Additional Paid-In Capital $100,000 Retained Earnings $52,000 Stock Dividend Declared 10,000 shares Market Price of Stock $20/share 50% = large dividend Is this a large or small stock dividend?

Example 2: Stock Dividend Declaration Date Retained Earnings 50,000 Stock Dividends Distributable 50,000 Issuance Date Stock Dividends Distributable 50,000 Common Stock 50,000

Liquidating Dividend A liquidating dividend is a distribution representing a return to stockholders of a portion of contributed capital.

Disclosures Related to the Equity Section Capital stock may be: Authorized but unissued. Subscribed for and held for issuance pending receipt of cash for the full amount of the subscription price. Outstanding in the hands of stockholders. Reacquired and held by the corporation for subsequent reissuance. Canceled by appropriate corporate action.

Quasi-Reorganization Where state law permits, a company may eliminate a deficit through a restatement of invested capital balances. This provides a fresh start for the company with a zero balance in Retained Earnings.

Quasi-Reorganization Balance Sheet for Anon., Inc. Before Quasi-Reorganization Current assets................................ $ 250 Land, building, and equipment........ 1,500 Accumulated depreciation............... (600) Total assets................................…. $ 1,150 Liabilities......................................... $ 300 Common stock ($10 par, 100 shares) 1,000 Retained earnings........................... (150) Total liabilities and equity............ $ 1,150

Quasi-Reorganization Quasi-Reorganization Plan for Anon., Inc. Reduce land, building, and equipment to fair market value of $600. Reduce par value of stock to $5; create $500 of “additional paid-in capital.” Apply $450 deficit ($150 from Retained Earnings and $300 from fixed asset revaluation) against Paid-In Capital.

Quasi-Reorganization Journal Entries for Anon., Inc. Quasi-Reorganization Fixed Asset Revaluation Retained Earnings 300 Accumulated Depreciation 200 Land, Building, and Equipment 500

Quasi-Reorganization Revalue Common Stock Common Stock, $10 par 1,000 Common Stock, $5 par 500 Paid-In Capital from Stock Revaluation 500 Erase Deficit Paid-In Capital 450 Retained Earnings 450

Quasi-Reorganization Balance Sheet After Quasi-Reorganization Current assets..................................... $ 250 Land, building, and equipment............ 1,000 Accumulated depreciation................... (400) Total assets....................................... $ 850 Liabilities.............................................. $ 300 Common stock ($5 par, 100 shares)... 500 Paid-in capital...................................... 50 Total liabilities and equity.................. $ 850

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