1 Module 9: Stockholders’ Equity 1.Accounting for preferred and common 2.Treasury stock 3.Stock compensation plans 4.Retained earnings -cash dividends -stock dividends (and stock splits) -property dividends (and other carve outs) 5.Other comprehensive income 6.Statement of stockholders’ equity 7.Convertible securities

2 1. Preferred Stock Advantages – Preference over common in liquidation – Stated dividend – Variety of features regarding dividends – Preference over common in dividend payout Disadvantages – Subordinate to debt in liquidation – Stated dividend can be skipped – No voting rights (versus common) Debt or equity? – components of both – usually (but not always) classified with equity

3 1. Common Stock Advantages – Voting rights: election of board of directors vote on significant activities of management – Rights to residual profits (after preferred) Disadvantages – Last in liquidation – No guaranteed return

4 1. Accounting for Common Stock (CS) and Preferred Stock (PS) Par value - initially established to create a “minimum legal capital”. – Ex: Minimum legal capital in some states is $1,000 for new corporations, so issue: 1,000 shares at $1par, or 100 shares at $10 par, or other combination... Par value is not market value. Credit CS or PS for par value. Excess over par credited to “Paid in Capital in Excess of Par or Stated Value” or abbreviated: “Additional Paid-in Capital” (APIC). Some newer stock issues (for common stock) are “no par” stock.

5 1.Par versus No Par Note: many companies have newer stock issues that are no par, but most companies still have older stock issues which contain a par value and APIC. The Stockholders’ Equity section of the balance sheet of Sample Company illustrates many of the components of SE discussed in this chapter.

6 Sample Co. Stockholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding$ 80,000 Preferred stock, $100 par value, 1,000 shares authorized, 100 shares issued and outstanding 10,000 Paid in capital on common $ 20,000 Paid in capital on preferred 3,000 Paid in capital on treasury stock 4,000 27,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income (2,000) Total Stockholders’ Equity $131,000

7 2. Treasury Stock Created when a company buys back shares of its own common stock. Reasons for buyback: – reissue to employees for compensation. – hold in treasury (or retire) to increase market price and earnings per share. – reduce total dividend payouts while maintaining per share payouts. – thwart takeover attempts by reducing proportion of shares available for purchase. – give cash back to existing shareholders.

8 2.Treasury Stock - continued The debit balance account called “Treasury Stock” is reported in stockholders’ equity as a contra (reduces SE). Note: not an asset. The stock remains issued, but is no longer outstanding. – does not have voting rights – cannot receive cash dividends May be reissued (to the market or to employees) or retired. No gains or losses are ever recognized from these equity transactions.

9 3. Employee Stock Compensation Plans Historically, companies granted stock options to employees as a means of compensating employees, without having to recognize any compensation expense. Recently, the FASB required compensation expense to be recognized on the income statement, based on estimated fair value of the option. Many companies have been shifting to restricted stock plans to compensate and motivate employees. The restricted stock plans require a recognition of compensation expense, but based on the value of the stock at the date of grant (rather than fair value at date of full vesting).

10 3. Employee Stock Options-History Since 1970, APB Opinion 25 allowed the issue of employee stock options. When the options were granted at the market price at grant date, no compensation expense was necessary. SFAS No. 123 was issued in 1995, and introduced the fair value method for calculating the compensation expense relating to employee stock options. SFAS No. 123 recommended that expense be recognized in the income statement, but did not require this recognition. SFAS No. 123R was issued in 2004, to require the recognition of expense in the income statement, for public companies whose fiscal year begins after June 15, 2005.

11 3. Equity Compensation and Expense Recognition Should compensation expense from stock options and restricted stock plans be recognized in the income statement? Proponents say yes: – It is a cost to the company of employing the workers. – If the company had issued stock, then paid the employees in cash, the amount would have been recognized as comp. expense. Opponents say no: – The employee is essentially working as an “owner” of the company, and contributing “sweat equity”; owners do not receive salary distributions. – Options and restricted stock are given as work incentives, rather than straight compensation. Remember: the value can go down as well as up (unlike traditional compensation). – These equity grants do not meet the definition of an expense. See page 2-12.

12 4. Retained Earnings We will be expanding the basic retained earnings formula in this chapter. Now, the Retained Earnings Column of the Statement of Stockholders’ Equity will include the following: RE, beginning xx Add: net incomexx Less dividends: Cash dividends-commonxx Cash dividends - preferredxx Stock dividends xx Property dividendsxx Less: Adjustment for TS transactionsxx Appropriation of RExx RE, endingxx

13 4. RE - Cash Dividends Note that stated dividends to preferred shareholders must be paid before any dividends can be paid to common shareholders (including dividends in arrears if cumulative). Preferred dividends may be cumulative, which means that, if no dividend is declared in the current year, they must be “caught up” (based on stated dividend rate) for the preferred shareholders in a future year before common shareholders get any dividends. However, cumulative preferred dividends in arrears are not recognized as a liability until a dividend is finally declared by the board of directors. A company might go for a number of years without declaring a dividend, and there is no liability until a dividend is actually declared.

14 4. RE - Property Dividends Property dividends are distribution of non-cash property by a company to its shareholders. The most common type of property dividend is a “spin-off” where the shares of stock of a subsidiary are distributed to the shareholders of the parent company. This is also called a form of “carve out”, as the company carves out a segment and divests it.

15 4. Other Carve Outs Other forms of carve outs (though not considered dividends) are sell-offs and split- offs. In a sell-off, the company sells its equity interest in the investment/subsidiary to an outside party. In a split-off, the company sells its equity interest in the subsidiary back to the subsidiary. Thus the subsidiary is buying back its own shares (for treasury or retirement) and the parent is no longer an owner.

16 4. RE - Stock Dividends Stock dividends are distribution of additional shares of a company’s own stock to its shareholders. Note that the distribution of additional shares does not result in any value being given to the shareholders. Example: 4 shareholders, each having 10 shares of common stock. Each owner has 25% of total (10/40). If I give each shareholder 1 additional share of stock, each shareholder still owns 25% of the same company (11/44). Nothing has changed, except the number of the pieces of paper.

17 4. RE - Stock Dividends Large stock dividends (> 25% of the outstanding common shares) are recorded at par value. The transfer is out of retained earnings and into common stock (no cash is involved). Note that the total effect on stockholders’ equity is zero. However, retained earnings decreases and common stock increases by the par value of the stock dividend. Small stock dividends (< 25% of the outstanding common shares) are recorded at market value. Since small stock dividends are rare, we will not discuss here.

18 Stock Splits Stock splits are commonly declared by a company to reduce its market price per share. This makes the stock more accessible to small investors. The process for stock splits is that the “old” stock is voided, and new shares are granted with a “new” description. The total par value of the new shares is equal to the total par value of the old shares, but the number of shares (and par value per share changes.

19 Example of Stock Split IZM Company has 100,000 shares of $2 par value stock authorized, 10,000 shares issued and outstanding. The SE section of the balance sheet shows: – Common stock $20,000 – Retained earnings 80,000 The market price of the outstanding shares is $50 per share before the split is distributed.

20 Example of Stock Split If IZM declared a 2 for 1 stock split, the old shares would be voided and new shares would be issued with the following description: Common stock, $1 par value, 200,000 shares authorized, 20,000 shares issued and outstanding. The total SE is still $100,000: – Common stock $20,000 – Retained earnings 80,000 The market price per outstanding share would now be $25 per share. Note: No journal entry is necessary.

21 4. Stock Dividends vs Stock Splits Going back to the original IZM information. Assume instead that IZM declared a 100% stock dividend. First, total par value for new shares (10,000 shares x 100% = 10,000 new shares x $2 per share = $20,000) Transfer $20,000 from Retained Earnings to the Common Stock account.

22 4. Stock Dividends vs Stock Splits Now note the new description for the stock dividend: Common stock, $2 par value, 100,000 shares authorized, 20,000 shares issued and outstanding The total value in SE is still $100,000, but: – Common Stock $40,000 (up $20,000) – Retained Earnings 60,000 (down $20,000) Note that the total market price per share would change to $25 per share. Thus, a 2 for 1 stock split and a 100% stock dividend have the same effect on: – total stockholders’ equity and – market price per share

23 4. Stock Dividends vs Stock Splits However, a stock dividend requires a journal entry, which changes the components of SE (RE and CS). A stock split changes the description of the shares, including the par value per share. Many companies use a stock split to change the market price per share, but about half of the companies use the large stock dividend to achieve the same result. This action is called a “stock split effected in the form of a dividend.”

24 4. Stock Dividends vs Stock Splits To summarize the effects on IZM Company: 100% Stock 2 for 1 After: DividendStock Split Total sh. outstanding 20,000 sh. 20,000 sh. Par value per share$2 $1 Market price per share$25 $25 Total stockholders’ eq: $100,000$100,000 General ledger results: CS account $ 40,000$ 20,000 RE account $ 60,000$ 80,000 Reminder: CS was $20,000 and RE was $80,000 before the split or dividend ( see slide 35). Since the stock dividend required journal entries (see slide 36), the amounts for CS and RE changed. Since the stock split does not require a journal entry, the amounts for CS and RE do not change.

25 4. RE - Appropriations Companies may choose to “restrict” a portion of their RE for dividend payout. Reasons for this restriction may include activities such as plans for corporate expansion or plans for the retirement of debt. The restriction does not create a cash balance for these plans. It simply indicates intentions. The restriction, or appropriation may be indicated through disclosure, or through a reclassification of retained earnings.

26 5. Other Comprehensive Income Comprehensive Income is a term that was defined in the Statements of Financial Accounting Concepts (SFAC 6). It consists of all non-owner changes in equity. This includes net income as we have been defining revenues and expenses throughout the semester, and it also includes “Other Comprehensive Income.”

27 5. Other Comprehensive Income “Other Comprehensive Income” (OCI) includes certain direct equity adjustments that are not part of the current income statement, but which may have eventual effect on income. The amount is recorded in OCI, until the effect is transferred to the income statement.

28 5. Other Comprehensive Income One of the items in Other Comprehensive Income is the Cumulative Translation Adjustment. This adjustment occurs when a company owns a foreign subsidiary, and must translate the foreign subsidiary to U. S. dollars before consolidating. The adjustment would only be realized as part of the income statement if the foreign subsidiary was sold or liquidated for U.S. dollars. The adjustment can be an increase or decrease, depending on the cumulative direction of change in the exchange rate.

29 5. Other Comprehensive Income Other items in Other Comprehensive Income include: Unrealized Gain/Loss on Available-for-Sale Investments. These long term investments are allowed to revalue each period up or down to market. The revaluation causes a gain or loss to be recognized (it is unrealized since the investment has not been sold). However, since the investment is long-term, the gain or loss is NOT recognized in the income statement. Instead, it is recognized cumulatively in OCI, until the investment is finally sold. Similar treatment is given to certain kinds of derivatives (a special form of investments).

30 5. Other Comprehensive Income One other item that will be discussed comes from a recent standard (SFAS 158), and is part of the new requirement by FASB to fully recognize all pension assets and liabilities in the balance sheet. However, FASB allows companies to defer recognition of a portion of the pension components, and spread the effects over future periods. These components (costs, losses, and gains) are deferred to OCI, until they are recognized in future income. (More in Module 10.) In the past, some companies recognized an OCI adjustment for “Minimum Liability”, but this requirement is no longer in effect (ignore comment in your text).

31 6. Statement of Stockholders’ Equity In this chapter, we have discussed the Statement of Retained Earnings as the link between the balance sheet and the income statement. However, earlier chapters introduced the Statement of Stockholders’ Equity, which has become the default statement for large companies in recent years. The Statement of Stockholders’ Equity details the change in retained earnings, including all the changes discussed in this chapter, and it also shows the change during the year in all of the stockholders’ equity accounts.

32 Example of Statement of SE (in thousands) CS PS APIC RE OCI TS Balance 1/1/10 $200 $ 50 $400 $400 Net income 250 Cash dividends (40) Stock dividends $200 (200) Purchase of TS $(40) Reissue of TS ( 1) 10 Revalue AFS Invest. $12 Balance, 12/31/10 $400 $ 50 $400 $409 $12 $(30) CS = common stock; PS = preferred stock; APIC= additional paid-in capital; RE = retained earnings OCI = other comprehensive income; and TS = treasury stock.

33 7. Convertible Securities Certain types of stocks and bonds may affect stockholders’ equity. Preferred stock may be issued with a convertible privilege, which allows investors to convert to common stock at a predetermined ratio. This conversion is usually recorded at book value of the preferred stock, and no cash is required in the exchange. Convertible bonds allow the investor to convert the bonds to common stock at a predetermined ratio. The conversion is similar to that for preferred stock, but in this case, liabilities go down and equity goes up. These convertible securities will have an effect on earnings per share calculations, particularly diluted earnings per share (see Module 5).