The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter Eleven Accounting For Equity Transactions

Formation of Business Organizations A sole proprietorship is owned by a single individual. A partnership is owned by two or more individuals. Partnerships require clear agreements about authority, risks, and the sharing of profits and losses. A partnership is owned by two or more individuals. Partnerships require clear agreements about authority, risks, and the sharing of profits and losses. A corporation is a separate legal entity created by the authority of a state government. Each state has separate laws governing establishing corporations. A corporation is a separate legal entity created by the authority of a state government. Each state has separate laws governing establishing corporations.

Regulation Few laws govern the operations of proprietorships and partnerships. Corporations are subject to regulations. Large, publicly traded corporations are much more heavily regulated than smaller closely held corporations.  SEC Acts of 1933 and 1934  Sarbanes-Oxley Act of 2002  Exchange listing requirements. Corporations are subject to regulations. Large, publicly traded corporations are much more heavily regulated than smaller closely held corporations.  SEC Acts of 1933 and 1934  Sarbanes-Oxley Act of 2002  Exchange listing requirements.

Corporate Advantages  Separate legal Entity  Limited liability of stockholders  Continuous life  Easily transferable ownership rights  Ability to raise capital Corporate Disadvantages  Governmental regulation  Corporate double taxation Corporate Advantages  Separate legal Entity  Limited liability of stockholders  Continuous life  Easily transferable ownership rights  Ability to raise capital Corporate Disadvantages  Governmental regulation  Corporate double taxation Comparing Corporations with Proprietorships and Partnerships

Elected by shareholders Appointed by directors Corporate Management Structure

Appearance of Capital Structure in Financial Statements The ownership interest (equity) in a business is composed of:  Owner/investor contributions.  Retained earnings. The ownership interest (equity) in a business is composed of:  Owner/investor contributions.  Retained earnings.

Legal capital is the amount of capital, required by the state of incorporation, that must remain invested in the business. Par Value Nominal Amount Legal capital Characteristics of Capital stock

Some states do not require a par value to be stated in the charter. No-par Stock Characteristics of Capital stock

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.  Characteristics of Capital stock

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

Authorized, Issued, and Outstanding Capital Stock Issued shares are authorized shares of stock that have been sold. Unissued shares are authorized shares of stock that never have been sold. Authorized Shares

Authorized, Issued, and Outstanding Capital Stock 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. Authorized Shares

Common stockholders have the rights to:  Buy and sell stock.  Share in the distribution of profits.  Share in the distribution of assets in the case of liquidation.  Vote on significant matters that affect the corporate charter.  Participate in the election of directors. Common stockholders have the rights to:  Buy and sell stock.  Share in the distribution of profits.  Share in the distribution of assets in the case of liquidation.  Vote on significant matters that affect the corporate charter.  Participate in the election of directors. Classes of Stock – Common Stock

A separate class of stock, typically having priority over common shares in...  Dividend distributions.  Distribution of assets in case of liquidation. A separate class of stock, typically having priority over common shares in...  Dividend distributions.  Distribution of assets in case of liquidation. Classes of Stock – Preferred Stock Usually has a stated dividend rate. Normally has no voting rights.

NoncumulativeCumulative Dividends in arrears must be paid before dividends may be paid on common stock. Undeclared dividends from current and prior years do not have to be paid in future years. Most preferred stock is cumulative. Preferred Stock Dividends

In addition to common stock, Dillion, Incorporated has the following stock outstanding: Preferred stock, 4%, $10 par, 10,000 shares Common stock, $10 par, 20,000 shares Dividends have not been paid in two years. In the current year, the board of directors declared dividends of $22,000. How much will each class of stock receive? In addition to common stock, Dillion, Incorporated has the following stock outstanding: Preferred stock, 4%, $10 par, 10,000 shares Common stock, $10 par, 20,000 shares Dividends have not been paid in two years. In the current year, the board of directors declared dividends of $22,000. How much will each class of stock receive? Preferred Stock Dividends

The distribution depends on whether the preferred stock is cumulative or noncumulative. First, let’s assume the preferred stock is cumulative.

Preferred Stock Dividends Now, let’s assume the preferred stock is noncumulative.

Issuing Par Value Stock Nelson, Incorporated issued 100 shares of $10 par value stock for $22 per share. Let’s record this transaction. Nelson, Incorporated issued 100 shares of $10 par value stock for $22 per share. Let’s record this transaction. 100 shares × $22 per share = $2, shares × $10 par value = $1,000

Stock Classification Assume that Nelson has another class of common stock, $20 par value Class B. The company issues 150 shares of Class B common stock at $25 per share. Let’s record this transaction. Assume that Nelson has another class of common stock, $20 par value Class B. The company issues 150 shares of Class B common stock at $25 per share. Let’s record this transaction. 150 shares × $25 per share = $3, shares × $20 par value = $3,000

Assume that Nelson issues 100 shares of 7 percent cumulative preferred stock with a stated value of $10 per share at a price of $22 per share. Let’s record this transaction. Assume that Nelson issues 100 shares of 7 percent cumulative preferred stock with a stated value of $10 per share at a price of $22 per share. Let’s record this transaction. 100 shares × $22 per share = $2, shares × $10 par value = $1,000 Stock Issued at Stated Value

Stock Issued with No Par Value Assume that Nelson issues 100 shares of no par common stock at a price of $22 per share. Let’s record this transaction. Assume that Nelson issues 100 shares of no par common stock at a price of $22 per share. Let’s record this transaction. 100 shares × $22 per share = $2,200

Financial Statement Presentation

No voting or dividend rights Contra equity account When stock is reacquired, the corporation records the treasury stock at cost. Treasury shares are issued shares that have been reacquired by the corporation. Treasury Stock

Why would a company buy its own stock? Treasury Stock  Common reasons include:  Employee stock option plans.  Preparation for a merger.  To increase earnings per share.  Supporting the stock price.  To avoid a hostile takeover.  Common reasons include:  Employee stock option plans.  Preparation for a merger.  To increase earnings per share.  Supporting the stock price.  To avoid a hostile takeover.

Treasury Stock 50 shares × $20 per share = $1,000 Assume that Nelson paid $20 per share to buy back 50 shares of the $10 par value stock that it originally issued at a price of $22 per share. Let’s record this transaction. Assume that Nelson paid $20 per share to buy back 50 shares of the $10 par value stock that it originally issued at a price of $22 per share. Let’s record this transaction.

Treasury Stock 30 shares × $25 per share = $750 Assume Nelson resells 30 shares of its treasury stock at a price of $25 per share. Let’s record this transaction. Assume Nelson resells 30 shares of its treasury stock at a price of $25 per share. Let’s record this transaction. 30 shares × $20 cost = $600 No gain or loss is recognized on sale of treasury stock.

Corporations are not required to pay dividends, but once declared, dividends are legal obligations. Dividends Stockholders Cash Dividends Corporation

Three important dates Cash Dividends Date of Record No entry required. Payment Date Record payment of cash to stockholders. Declaration Date Record liability for dividend. Dividends

Declaration Date Record liability for dividend. Dividends On October 15, 2006, Nelson’s Board of Directors declared a cash dividend on the 100 outstanding shares its 7 percent, $10 par preferred stock. The dividend will be paid on December 15 to stockholders of record on November 15. Let’s record the entries × $10 par × 100 shares = $70

Date of Record No entry required on November 15. On October 15, 2006, Nelson’s Board of Directors declared a cash dividend on the 100 outstanding shares its 7 percent, $10 par preferred stock. The dividend will be paid on December 15 to stockholders of record on November 15. Let’s record the entry Date of Record No entry required.

Payment Date On October 15, 2006, Nelson’s Board of Directors declared a cash dividend on the 100 outstanding shares its 7 percent, $10 par preferred stock. The dividend will be paid on December 15 to stockholders of record on November 15. Let’s record the entry Payment Date Record payment of cash to stockholders.

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.

Stock Dividends The journal entry moves an amount from Retained Earnings to other equity accounts. Nelson’s Board of Directors decided to issue a 10 percent stock dividend on the 150 outstanding shares of its $20 par value, Class B common stock. Market value at the time of the stock dividend was $30 per share. Let’s record the entry × 150 shares × $30 per share = $ × 150 shares × $20 par = $300

Stock Splits  Stock splits replace existing shares with a greater number of new shares.  Companies use stock splits to reduce market price per share of their outstanding stock.  The number of outstanding shares increase and par value is decreased proportionately.  Retained earnings is not affected.  Stock splits replace existing shares with a greater number of new shares.  Companies use stock splits to reduce market price per share of their outstanding stock.  The number of outstanding shares increase and par value is decreased proportionately.  Retained earnings is not affected.

Stock Splits Nelson’s Board of Directors declared a 2-for-1 stock split on the 165 outstanding shares of its $20 par value, Class B common stock.

Stock Splits Increase Decrease No Change No journal entry required – Change par value and number of shares authorized and outstanding. Nelson’s Board of Directors declared a 2-for-1 stock split on the 165 outstanding shares of its $20 par value, Class B common stock.

A corporation’s directors can voluntarily limit dividends because of a special need for cash. Assume that Nelson’s Board of Directors appropriated $1,000 of retained earnings for future expansion. Let’s record the entry. A corporation’s directors can voluntarily limit dividends because of a special need for cash. Assume that Nelson’s Board of Directors appropriated $1,000 of retained earnings for future expansion. Let’s record the entry. Appropriation of Retained Earnings

Financial Statement Presentation

The Financial Analyst Dividends Increase in market price per share Stockholders benefit in two ways when a company generates earnings.

End of Chapter Eleven