Accounting Fundamentals Dr. Yan Xiong Department of Accountancy CSU Sacramento The lecture notes are primarily based on Reimers (2003). 7/11/03

Chapter 9: Financing with Equity Agenda  Equity  Common Stock  Preferred Stock  Accounting for Financing with Equity

Agenda t Equity

Equity in Proprietorships t Contributed capital and retained earnings are combined into a single capital account: John Doe, Capital$XXXX t Distributions are called withdrawals.

Equity in Partnerships t Each partner has her/his own separate capital account, each containing the partner’s invested capital and share of retained earnings. t As with proprietorships, partnerships use withdrawal accounts for the distributions made to the owners.

Equity in Corporations The equity section for a corporation is divided into two parts: u Contributed Capital (a.k.a. paid-in- capital)--this is the amount that owners have contributed v Capital Stock v Additional paid-in-capital u Retained Earnings--this is what the company has earned over its whole life, less any dividends paid out

Authorized, Issued, and Outstanding Capital Stock The maximum number of shares of capital stock that can be sold to the public is called the authorized number of shares. Authorized Shares

Authorized, Issued, and Outstanding Capital Stock Authorized Shares Issued shares have been sold. Unissued shares have never been sold.

Authorized, Issued, and Outstanding Capital Stock Authorized Shares Unissued Shares Outstanding Shares Issued Shares Owned by stockholders

Authorized, Issued, and Outstanding Capital Stock Authorized Shares Unissued Shares Treasury Shares Outstanding Shares Issued Shares Owned by stockholders Reacquired by corporation

Sale and Issuance of Capital Stock An initial public offering (IPO) is the very first time a corporation sells stock to the public.

Agenda t Common Stock

Common Stock t Basic voting stock of the corporation t Ranks after preferred stock for dividend and liquidation distribution. t Dividend rates are determined by the board of directors based on the corporation’s profitability.

Par Value and No-par Value Stock t Par value u Is a nominal value per share of capital stock specified in the charter. u Has no relationship to market value. u Serves as the basis for legal capital. t Legal capital is the amount of capital, required by the state, that must remain invested in the business. u It serves as a cushion for creditors.

Par Value and No-par Value Stock t No-par value is capital stock that does not have an amount per share specified in the charter. t When no-par stock is issued by a corporation, the amount of legal capital is defined by the state. t Stated value is an amount per share that is specified by the corporation when it issues no-par stock.

Agenda t Preferred Stock

t Has dividend and liquidation preference over common stock. t Cumulative preferred stock has a preference for all past dividends over any paid to common shareholders. t Generally does not have voting rights. t Usually has a par or stated value. t Usually has a fixed dividend rate that is stated as a percentage of the par value. Preferred Stock

Special Features of Preferred Stock t Convertible preferred stock may be exchanged for common stock. t Callable preferred stock may be repurchased by the corporation at a predetermined price.

Agenda t Accounting for Financing with Equity

Accounting for Capital Stock Transactions t Two primary sources of stockholders’ equity: u Contributed capital v Par or stated value of issued stock. v Additional paid-in capital in excess of par or stated value. u Retained earnings v The cumulative net income earned by the corporation less the cumulative dividends declared by the corporation.

Accounting for the Issue of Common Stock t When stock is issued, the equity account Common Stock is credited for the par or stated value of the stock. t If the stock sold for more than par, the additional amount is credited to the equity account Paid in Capital in Excess of Par, Common Stock.

On Feb 23, ABC Co. issued 300 shared of $10 par common stock for $12 per share. Assets= Liab. + Cont. Cap. + Ret. Earnings Assets= Liab. + Cont. Cap. + Ret. Earnings (Cash)+3000 (Common Stock at par) (PIC in excess of par) Income Statement: Statement of Changes in Equity: Statement of Cash Flows: No effect on Income Increases equity Increases cash flow

Accounting for the Issue of Common Stock t How would the issuance of common stock be recorded in the journal? DateTransaction DebitCredit Feb 23 Cash 3,600 Common stock 3,000 Paid-in capital in excess of par 600

Treasury Stock t A corporation’s own stock that had been issued but was subsequently reacquired and is still being held by that corporation. t Why would a corporation reacquire its own stock? u To reduce the shares outstanding. u Because the market price is low. u To increase earnings per share. u To use in employee stock option programs.

Treasury Stock t is considered issued stock but not outstanding stock. t has no voting or dividend rights. t is a contra-equity account. t reduces total stockholders’ equity on the Balance Sheet.

On April 10, ABC Co. bought back 20 shares of its $10 par common stock for $11 per share (issued in previous transaction) Assets= Liab. + Cont. Cap. + Ret. Earnings Assets= Liab. + Cont. Cap. + Ret. Earnings -$220 (Cash) -$220 (Treasury Stock) -$220 (Cash) -$220 (Treasury Stock) Income Statement: Statement of Changes in Equity: Statement of Cash Flows: No effect on Income Decreases equity Decreases cash flow

Accounting for Treasury Stock t How would the purchase of treasury stock be recorded in the journal? DateTransaction DebitCredit Apr 10 Treasury stock 220 Cash 220

Treasury Stock Transactions t Treasury stock is recorded at cost. t The account, Treasury Stock, is contra to all of Equity and subtracted at the end of the section on the Balance Sheet. t If the treasury stock is subsequently resold for more than the cost, another equity account, PIC Treasury Stock, would be credited for the excess over cost t NO gains or losses are recorded on the purchase or on the reissue of treasury stock.

Accounting for Cash Dividends t Dividends must be declared by the board of directors before they can be paid. t The corporation is not legally required to declare (and subsequently pay) dividends. t Once a dividend is declared, a liability is created. t Cash dividends require sufficient cash and retained earnings to cover the dividend.

Dividend Dates t Date of declaration t Date of actual payment to shareholders

Dividends on Preferred Stock t Current preferred dividends must be paid before paying any dividends to common stock. t If a preferred dividend is not paid, the unpaid amount is either cumulative (a dividend in arrears) or noncumulative. u Cumulative : Unpaid dividends must be paid before common dividends. u Noncumulative : Unpaid dividends are lost.

Calculating Preferred and Common Dividends t Suppose ABC Co. has 1000 shares of $100 par, 6% cumulative preferred stock outstanding and that NO dividends were paid in t At the end of 1997, the Board of Directors declares a total of $20,000 worth of dividends for its preferred and common shareholders. t How much will go to the preferred shareholders?

Preferred Shareholders Get Their Dividends First t Cumulative means that the preferred shareholders get all the past dividends that they were not paid. t 1000 x $100 x.06 = 6,000 t They get a total of $12,000 : $6,000 for 1996 and $6,000 for t Common shareholders get the remaining $8,000.

The Effect of Declaring the Dividends Assets = Liabilities + CC + RE + 12,000 div/payable, (20,000) dividends preferred SHs + 8,000 div/payable common SHs  There is no effect on the income statement, but both the statement of shareholders’ equity and the balance sheet will be affected by the transaction.  When the cash is paid, the liability is removed and CASH is decreased. Again, there is no income statement effect.

Accounting for The Declaration of Dividends t How would the declaration of dividends be recorded in the journal? DateTransaction DebitCredit Dec 31 Dividends 20,000 Dividends payable, preferred12,000 Dividends payable, common 8,000

But what if the stock is NONcumulative? t Then, the past is past. t Only the current year’s dividends are due to the preferred shareholders. t So the preferred shareholders will get $6,000 (the current year’s dividend) and the common shareholders will get the rest--$14,000.

Accounting for the Declaration of Dividends t How would the declaration of dividends be recorded in the journal? DateTransaction DebitCredit Dec 31 Dividends 20,000 Dividends payable, preferred6,000 Dividends payable, common 14,000

Cash Dividends t Needed to pay cash dividends u retained earnings u cash u no restrictions from outsiders t Effects of cash dividends on financial statements u decreases Assets (when they are actually paid) and Retained Earnings

ABC Co. declared the dividends of $20,000 payable to preferred ($12,000) and common ($8,000) shareholders of record as of 12/31/97 Assets= Liab. + Cont. Cap. + Ret. Earnings +20,000-20, ,000-20,000 Income Statement: Statement of Changes in Equity: Statement of Cash Flows: Income Statement: Statement of Changes in Equity: Statement of Cash Flows: No effect on Income Decreases equity No effect on cash flow No effect on Income Decreases equity No effect on cash flow

Effects On Financial Statements On Payment Date Assets= Liab. + Cont. Cap. + Ret. Earnings Assets= Liab. + Cont. Cap. + Ret. Earnings -20,000-20, ,000-20,000 Income Statement: Statement of Changes in Equity: Statement of Cash Flows: No effect on Income No effect on equity Decreases cash flow

Accounting for Stock Dividends t Stock dividends are distributions to stockholders of additional shares of stock. t Why issue a stock dividend? v Low on cash. v To decrease market price of stock. v To increase number of stockholders (assuming some of the newly issued stock will be sold).

Accounting for Stock Dividends t All stockholders receive the same percentage increase in the number of shares they own (pro rata basis). t No change in total stockholders’ equity. t No change in par values. t Effect on financial statements?

ABC Co. declared a 10% stock dividend on its 200 shares of $1 par common stock. The market value at the time of distribution is $20. Assets= Liab. + Cont. Cap. + Ret. Earnings Assets= Liab. + Cont. Cap. + Ret. Earnings + 20 (C/S) (C/S) (Add’l P-I-C) Income Statement: Statement of Changes in Equity: Statement of Cash Flows: No effect on Income No effect on equity No effect on cash flow

Accounting for The Declaration of Stock Dividends t How would the declaration of dividends be recorded in the journal? DateTransaction DebitCredit Dec 31 Dividends 400 Common stock (par)20 Paid-in capital in excess of par 380

Accounting for Stock Splits t Distributions of 100% or more of stock to stockholders. t Decreases par value of stock. t Increases number of outstanding shares. t No change in total stockholders’ equity.

Retained Earnings Represents the income that has been earned less dividends that have been paid out since the first day of operations for the company. Balance January 1, 19X3 $ 500,000 Net income 25,000 Cash dividends (10,000) Balance January 31, 19X3 $ 515,000

Retained Earnings t What affects Retained Earnings? u net income u cash dividends u stock dividends u prior period adjustments t Appropriating Retained Earnings u Board of Directors can restrict portions of retained earnings (a communication device)

The Business Cycle: Basic Business Processes Chapters 8 & 9: Obtain Financing: Debt and Equity Chapter 5: Acquisition/Payment: PPE Chapters 7: Sales/Collection: Cash, Accounts Receivable Chapters 6: Acquisition/Payment: Inventory and Human Resources The Cycle Starts Here:But We Started Here: Return to Owners