Equity Financing C H A P T E R 11

Learning Objective 1 Distinguish between debt and equity financing and describe the advantages and disadvantages of organizing a business as a proprietorship or a partnership.

Time Line of Business Issues ChooseSolicit GenerateReport

Differentiate Between Debt and Equity n Debt Financing u Loans; repay, with interest u Liable for amount of loan u Relationship ends with repayment n Equity Financing u No responsibility to repay u Investor takes risk u Investor rewarded by company’s future success

Define Proprietorships and Partnerships Proprietorship A business owned by one person. Partnership An association of two or more individuals or organizations to carry on an economic activity.

Ease of Formation Both types of businesses are easy to start. Limited Life The business can decide to dissolve at any time. Unlimited Liability The proprietors or partners are personally responsible for all of the business’s debts. What Are Some Characteristics Shared by Proprietorships and Partnerships?

Learning Objective 2 Describe the basic characteristics of a corporation and the nature of common and preferred stock.

What is a Corporation? nA legal entity chartered by a state. nLegally distinct from the persons responsible for its creation. nAccorded the same rights as individuals: 4Can conduct business. 4Can be sued. 4Can enter into contracts. 4Can own property. nOwnership is represented by transferable shares of stock.

List Characteristics of a Corporation Corporation Limited Liability Ability to Raise Capital Perpetual Existence Taxed Separately Government Regulation

What are the Steps to Starting a Corporation? è Study state corporate laws. è Apply for a charter with appropriate state official. è Sell stock to obtain financing. 4 Provide prospectus. ç Outline business plan. ç Detail sources of financing. ç List significant risks. 4 Offer initial public offering (IPO).

Common Stock Basic rights inherent in common stock ownership: w The right to vote in corporate matters such as the election of the board of directors or the undertaking of major actions such as the purchase of another company. w The preemptive right, which permits existing stockholders to purchase additional shares whenever stock is issued by the corporation. w Right to receive dividends if they are paid. w Rights to ownership of all corporate assets once obligations to everyone else have been satisfied.

Preferred Stock Define the following terms. Preferred Stock A class of stock that usually provides dividend and liquidation preferences over common stock. Convertible Preferred Stock Preferred stock that can be converted to common stock at a specified conversion rate.

Learning Objective 3 Account for the issuance and repurchase of common and preferred stock.

Issuing Stock Par Value Nominal value assigned to and printed on the face of each share of a corporation’s stock. Contributed Capital The portion of owners’ equity contributed by investors (the owners) in exchange for shares of stock.

Example: Issuing Stock Cash ,000 Common Stock ,000 Paid-in Capital in Excess of Par. 100,000 Issued 5,000 shares at $40 per share. The Angelfish Corporation issued 5,000 shares of $20 par common stock for $40 per share. Record the transaction.

Example: Issuing Stock Cash ,000 Common Stock ,000 Issued 5,000 shares at $40 per share. The Angelfish Corporation issued 5,000 shares of $20 no-par common stock for $40 per share. Record the transaction.

Example: Issuing Stock Land ,000 Common Stock ,000 Paid-in Capital in Excess of Par.40,000 Issued 2,000 shares at $40 per share for land. The Angelfish Corporation exchanged 2,000 shares of $20 par common stock for land. Market value of the stock is $40 per share. Record the transaction.

What is Treasury Stock? Issued stock that has been subsequently reacquired by the corporation. Stock Investor Corporation

4 To fund a profit-sharing, bonus, or stock-option plan. 4 The stock is selling for a low price and is a good buy. 4 To stimulate trading of company stock. 4 To remove shares from the market to avoid a hostile takeover. 4 To increase reported earnings per share. Why purchase treasury stock? Treasury Stock

Example: Issuing Stock Treasury Stock, Common ,000 Cash ,000 Purchased 1,000 shares at $30 per share. The Goldfish Company purchased 1,000 shares of its own $20 par common stock for $30 per share. Record the transaction.

Treasury Stock Treasury Stock Resold below cost Paid-In Capital, Treasury Stock Resold above cost Debit Paid-In Capital, Treasury Stock If it Exists, Otherwise Debit Retained Earnings

Example: Reissuing Treasury Stock Cash ,500 Treasury Stock, Common ,000 Paid-In Capital, Treasury Stock. 2,500 Reissued 500 shares of treasury stock at $35 per share. The Goldfish Company reissued 500 shares of treasury stock for $35 per share. Record the transaction.

Example: Reissuing Treasury Stock Cash ,500 Paid-In Capital, Treasury Stock. 1,500 Treasury Stock, Common ,000 Reissued 300 shares of treasury stock at $25 per share (original cost was $30 per share). The Goldfish Company reissued 300 shares of treasury stock (originally issued for $30 per share) for $25 per share. Record the transaction.

Example: Reissuing Treasury Stock Cash ,300 Paid-In Capital, Treasury Stock.. 1,000 Retained Earnings Treasury Stock, Common ,500 Reissued 150 shares of treasury stock at $22 per share (original cost was $30 per share). The Goldfish Company reissued 150 shares of treasury stock (originally issued for $30 per share) for $22 per share. Record the transaction.

Learning Objective 4 Understand the factors that impact retained earnings, describe the factors determining whether a company can and should pay cash dividends, and account for cash dividends.

Retained Earnings and Dividends The portion of a corporation’s owners’ equity that has been earned from profitable operations and not distributed to stockholders. Distributions to the owners (stockholders) of a corporation. Cash distribution of earnings to stockholders. Cash Dividends Dividends Retained Earnings

Retained Earnings Accounting for Retained Earnings Net Income Losses Dividends

Match Important Dividend Dates The date the corporation’s board of directors formally decides to pay a dividend to stockholders. The date selected by a corporation’s board of directors on which the stockholders of record are identified as those who will receive dividends. The date on which a corporation pays dividends to its stockholders Declaration Date Payment Date Date of Record

Example: Cash Dividend Declaration Date Dividends ,000 Dividends Payable ,000 Payment Date Dividends Payable ,000 Cash ,000 The Dolphin Company declared a $0.50 dividend on January 1, 2003; 4,000 shares are outstanding. Record the appropriate journal entries.

Dividend Preferences Current-Dividend Preference The right of preferred stockholders to receive current dividends before common stockholders receive dividends. Cumulative-Dividend Preference The right of preferred stockholders to receive current dividends plus all dividends in arrears before common stockholders receive any dividends.

Dividend Preferences Dividends in Arrears l Missed dividends for past years that preferred stockholders have a right to receive under the cumulative-dividend preference if and when dividends are received. l Do not represent actual liabilities and thus are not recorded in the accounts. l Reported in the notes to the financial statements.

Example: Preferred Dividend Lobster Company did not pay dividends last year, but it has declared a $5,000 dividend in the current year. Outstanding stock includes the following. Calculate the dividend. Preferred, 5% Cumulative, $20 par 2,000 shares Common, $5 par 5,000 shares Dividends in arrears$2,000 Current-dividend preference ($20 x 0.05 x 2,000 shares) 2,000 Total for preferred stockholders $4,000 Total left for common stockholders 1,000 Total $5,000

Example: Preferred Dividend Lobster Company did not pay dividends last year, but it has declared a $5,000 dividend in the current year. Outstanding stock was previously listed. Given this calculation, provide the appropriate journal entries. Declaration Date Dividends, Preferred Stock ,000 Dividends, Common Stock ,000 Dividends Payable ,000 Payment Date Dividends Payable ,000 Cash ,000

Learning Objective 5 Describe the purpose of reporting comprehensive income in the equity section of the balance sheet and prepare a statement of stockholders’ equity.

Define These Other Equity Terms Accumulated Other Comprehensive Income Market-related gains and losses that are not reported as part of net income but are instead reported as separate equity items. Statement of Comprehensive Income Statement outlining the changes in accumulated comprehensive income that arose during the period. Statement of Stockholders’ Equity A financial statement that reports all changes in stockholders’ equity.

Comprehensive Income in the Balance Sheet Killer Whale Corp. has the following comprehensive income items in the current year: 1.Investment securities increased in value by $600 during the current year. 2.Assets owned by Killer Whale’s British subsidiary decreased in value by $350 due to a decline in the strength of the British Pound. How would this information appear in the equity section of the balance sheet?

Comprehensive Income in the Balance Sheet Killer Whale Corp. Accumulated other comprehensive income: Unrealized gain from investment securities....$600 Foreign currency translation adjustment (350) Total accumulated other comprehensive income $250

Expanded Material Learning Objective 6 Account for stock dividends and distinguish them from stock splits.

Match Accounting for Stock Dividends A pro rata distribution of additional shares of stock to stockholders. Less than 25 percent. Greater than 25 percent. Small Stock Dividend Large Stock Dividend Stock Dividend Small Stock Dividend Large Stock Dividend

Stock Dividends If the stock dividend is 25 percent or more of the outstanding company stock, the journal entry requires that retained earnings be debited only for par value. Outstanding Stock 25% 75% If the stock dividend is less than 25 percent of the outstanding company stock, the journal entry requires the use of the market value of the stock.

Example: Accounting for Stock Dividends Retained Earnings ,000 Common Stock ,000 Paid-In Capital in Excess of Par. 4,000 Declared and issued a 20% common stock dividend. Oyster Corporation declares a 20 percent stock dividend. The company has 2,000 shares of common stock ($5 par) outstanding. What is the necessary entry if the stock price is $15 when the dividends are declared and issued?

Example: Accounting for Stock Dividends Retained Earnings ,000 Common Stock ,000 Declared and issued a 30% common stock dividend (2,000 x 0.30 = 600 shares). Oyster Corporation declares a 30 percent stock dividend. The company has 2,000 shares of common stock ($5 par) outstanding. What is the necessary entry if the stock price is $15 when the dividends are declared and issued?

Stock Split A stock split is the replacement of outstanding shares of stock with a greater number of new shares. Stock Companies sometimes enact a stock split to encourage more investors to buy stocks (replacing the outstanding shares with a larger number of new shares that sell at a lower price per share). Stock

Differentiate Between a Stock Split vs. a Stock Dividend 4 A stock split is usually bigger. 4 A stock dividend might increase the number of shares outstanding by 10 or 25 percent. 4 A stock split is likely to increase the number of shares outstanding by 50 percent, 100 percent, or more. Stock

Expanded Material Learning Objective 7 Explain prior-period adjustments and prepare a statement of retained earnings.

Define Prior-Period Adjustments and the Statement of Retained Earnings Prior-Period Adjustments Adjustments made directly to Retained Earnings in order to correct errors in the financial statements of prior periods. Statement of Retained Earnings A report that shows the changes in the retained earnings account during a period of time.

Retained earnings, January 1, $300,000 Prior-period adjustment: Deduct adjustment for 2002 inventory correction. (25,000) Balance as restated $275,000 Net income for ,000 Less dividends declared in 2003: Preferred stock $10,000 Common stock ,000 (22,000) Retained earnings, December 31, $303,000 Statement of Retained Earnings Oyster Corporation Statement of Retained Earnings For the Year Ended December 31, 2003

Expanded Material Learning Objective 8 Understand basic proprietorship and partnership accounting.

Proprietorship and Partnership Accounting All owners’ equity transactions are recorded in only two accounts. Capital Account An account where a proprietor’s or partner’s interest in a firm is recorded. Drawings Account The account used to reflect periodic withdrawals of earnings by the owner or owners.

Proprietorship Shelly Seals wants to start a business. On January 1, 2003, she contributes $100,000 for a sole proprietorship. On May 1, she withdraws $2,000 for personal use. Record the transactions. Jan. 1Cash ,000 Shelly Seals, Capital ,000 Invested $100,000 to start a business. May 1Shelly Seals, Drawings.....2,000 Cash ,000 Withdrew cash for personal use. Dec. 31Shelly Seals, Capital ,000 Shelly Seals, Drawings..2,000 To close the drawings account for the year.

Partnership Tina and Tiny agree to start a shrimp business. On January 1, they agree that Tina will contribute land worth $55,000, a truck worth $15,000 and $20,000 cash. Tiny will contribute $25,000 in equipment and $35,000 in cash. At the conclusion of the year, Tina draws $45,000 and Tiny draws $30,000 as salary. Make the journal entries. Jan 1Cash ,000 Equipment ,000 Land ,000 Truck ,000 Tina, Capital ,000 Tiny, Capital ,000 To record the investments of Tina and Tiny in a partnership.

Partnership Dec. 31Tina, Drawings ,000 Tiny, Drawings ,000 Cash ,000 To record cash taken from the partnership as salary. Dec. 31Tina, Capital ,000 Tiny, Capital ,000 Tina, Drawings ,000 Tiny, Drawings ,000 To close the drawings accounts for the year.

Partnership Statement of Partners’ Capital A report showing the changes in the capital balances; similar to a statement of retained earnings for a corporation. Tina’s & Tiny’s Shrimp Statement of Partners’ Capital For the Year Ended December 31, 2003 Tina Tiny Total Investments, January 1, $ 90,000 $ 60,000 $150,000 Add net income for ,000 42, ,000 Subtotal $163,000 $102,000 $265,000 Less withdrawals during ,000 30,000 75,000 Capital balances, Dec. 31, 2003.$118,000 $ 72,000 $190,000