1 Chapter 12: Stockholders’ Equity

2 1. Debt versus equity 2. Preferred stock 3. Common stock 4. Accounting for preferred and common 5. Treasury stock 6. Stock options 7. Retained earnings - dividends - appropriations - prior period adjustments 8. Comprehensive income 9. Statement of stockholders’ equity

3 1. Debt versus Equity DebtEquity Formal legal contractNo legal contract Fixed maturity dateNo fixed maturity date Fixed periodic paymentsDiscretionary dividends Security in case of defaultResidual asset interest No voice in managementVoting rights - common Interest expense deductibleDividends not deductible Double taxation

4 2. 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

5 3. 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

6 4. 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.

7 4.Journal Entries Issue PS at greater than par value: Cashxxmkt. value Preferred Stockxxtotal par APIC - PSxxexcess(plug) Issue CS at greater than par value: Cashxxmkt. value Common Stockxxtotal par APIC - CSxxexcess(plug) Note: most states do not allow companies to issue at less than par value.

8 4.Journal Entries -continued Issue no par common stock: Cashxxmkt. value Common Stockxxmkt. value 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 (yellow handout) illustrates many of the components of SE discussed in this chapter.

9 Sample Co. Stockholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding$ 80,000 Common stock dividends distributable 2,000 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 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income items (unrealized loss on AFS securities) (2,000) Total Stockholders’ Equity $131,000

10 4.Journal Entries-Sample Co. Now, using Sample Company information, record the following additional issues of common and preferred stock: Issued 100 shares of PS at $102 per share: Cash (100 x $102)10,200 PS (100 x $100 par) 10,000 APIC - PS (plug) 200 Issued 500 shares of CS at $5 per share: Cash (500 x $5) 2,500 CS (500 x $1 par)500 APIC - CS (plug) 2,000

11 5. 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.

12 5.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.

13 5. Treasury Stock(TS) - Journal Entries There are two techniques for recording TS transactions (Par Value method and Cost method). We will use only the Cost method. This technique establishes a “cost” for TS equal to the amount paid to acquire the TS. Par value is not used for TS transactions. To record purchase of TS from market: TSxx “cost” Cashxx market (cost equals the cash paid)

14 5. Treasury Stock(TS) - Journal Entries To reissue TS to market at greater than cost: Cashxx market APIC - TSxx over cost TSxx cost To reissue TS to market at less than cost: Cashxx market APIC - TSxx if available Retained Earningsxx if needed* TSxx cost *debit RE if no APIC-TS available to absorb the remaining debit difference.

15 5. TS Example from Sample Co. Look again at the information for Sample Co. Note that Sample Company has 5,000 shares of TS at a total cost of $6,000, or a cost of $1.20 per share. The journal entry to record that purchase would have been: TS6,000 Cash 6,000 Note that Sample Company also has APIC - TS of $2,000 in the balance sheet. This must be from previous TS transactions, where the TS was purchased, then reissued for more than original cost. All that remains of those transactions is the APIC -TS.

16 Sample Co. Stockholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding$ 80,000 Common stock dividends distributable 2,000 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 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income items (unrealized loss on AFS securities) (2,000) Total Stockholders’ Equity $131,000

17 5.TS - Example Problem Tiger Corporation has 100,000 shares of $1 par value stock authorized, issued and outstanding at January 1, The stock had been issued at an average market price of $5 per share, and there have been no treasury stock transactions to this point. Assume that, in February of 2005, Tiger Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2005, Tiger Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2005, Tiger Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2005 regarding the treasury stock.

18 5. TS Example -Journal Entries Feb: repurchase 10,000 $7 = $70,000. July: reissue 2,000 $ 8 = $16,000 (cost = $7 = 14,000)

19 5. TS Example -Journal Entries Dec: reissue 8,000 $ 6 = $48,000 (cost = 8,000 $7 = 56,000) Now we need to debit one or more accounts to compensate for the difference. (1) debit APIC -TS (but lower limit is to -0-). (2) debit RE if necessary for any remaining balance (this is only necessary when we are decreasing equity).

20 6. Employee Stock Options Stock options represent the right of the holder to purchase common stock at a designated price, and during a designated time frame. Stock options are given to employees as a means of compensation. Historically, two kinds of employee stock options (compensation is defined at the date of grant): – compensatory, because the exercise price is below the market price at the date of grant. – noncompensatory, because the exercise price is equal to the market price at the date of grant.

21 6. Employee Stock Options APB Opinion 25 states that “compensation” is measured at the date of grant (market price - exercise price), and any difference is allocated to compensation expense over the life of the option. If there is no difference, there is no comp. expense. The APB Opinion 25 method is known as the intrinsic value method, because it measures the value of the stock options at the date of grant (the intrinsic value at inception). This method has been the default method for recording employee stock options, even after SFAS 123 (discussed later) was issued.

22 6. Stock Options- APBO 25 Given the following information: Em Company adopted a stock option plan that granted options to employees to purchase 30,000 shares of the company’s $10 par value common stock. The options were granted on January 2, 2005, and were exercisable 2 years after the date of grant if the employee was still employed at the company. The exercise price was set at $40 in the option contract. At the date of exercise January 2, 2007, the market price was $80 per share.

23 6. Stock Options - Illustration 1 Illustration 1 (intrinsic value method): Assume the market price at the date of grant was $45 per share. Therefore, the stock options are compensatory, and total compensation expense is measured as: $45 mkt - $40 exercise = $5 per share x 30,000 shares = $150,000. Since total compensation expense = $150,000, we will recognize it over the life of the option (150,000 / 2 = $75,000 per year). For 2005: Compensation expense 75,000 APIC - stock options 75,000 For 2006: Compensation expense 75,000 APIC - stock options 75,000

24 6. Stock Options - Illustration 1 Note that, for the previous entries, the company is not paying the employees with cash, it is paying the employees with the promise of equity. Also, the employee is contributing time in exchange for future equity (thus the credit to APIC as the employee “pays in” time). Now, when the options are exercised at Jan. 2, 2007, at the exercise price of $40 per share: Cash ($40 x 30,000) 1,200,000 APIC - stock options 150,000 Common stock ($10 x 30,000) 300,000 APIC - common stock (plug) 1,050,000 Note that, even though the market price of the stock at 1/2/07 is $80 per share, the transaction is recorded at the market price at the date of grant ($45 per share). The company never recognizes the additional “value” that it has given to the employees.

25 6. Stock Options - Illustration 2 Illustration 2 (intrinsic value method): Assume the market price at the date of grant was $40 per share. Therefore, the stock options are noncompensatory, and total compensation expense is measured as:$40 mkt - $40 exercise = - 0- (Since total compensation expense = -0-, no expense is recognized on the options, not now, not ever.) For 2005 Compensation expense -0- APIC - stock options -0- For 2006: Compensation expense -0- APIC - stock options -0-

26 6. Stock Options - Illustration 2 Now, when the options are exercised at Jan. 2, 2007, at the exercise price of $40 per share Cash ($40 x 30,000) 1,200,000 APIC - stock options -0- Common stock ($10 x 30,000)300,000 APIC - common stock (plug)900,000 Most stock options have been issued as “noncompensatory” at the date of grant, primarily to avoid the recognition of compensation expense. Note that, even though the market price of the stock at 1/2/07 is $80 per share, the transaction is recorded at the market price at the date of grant ($40 per share). The company never recognizes the additional “value” that it has given to the employees.

27 6. Stock Options and SFAS No. 123 In 1993 (its second attempt), the FASB tried to rectify the lack of recognition of compensation expense in the financials for “noncompensatory” options. It proposed that companies “estimate” the present value of the future cash flows that was being promised to employees, then recognize that estimate as compensation expense over the life of the contract. There were many protests, particularly in the high tech industry, where employment and growth were tied heavily to stock options.

28 6. Stock Options and SFAS No. 123 The FASB eventually modified the standard, so that SFAS 123 recommended recognition of expense in the financial statements for noncompensatory (as well as compensatory) stock option plans. However, it allowed companies to continue using the APB Opinion 25 method for recording expense in the financials. The SFAS 123 technique is known as the fair value method. Illustration 3 shows the recommended journal entries using SFAS 123.

29 6. Stock Options - Illustration 3 Illustration 3 (fair value method): Assume the market price at the date of grant was $40 per share, and the stock options are, therefore, noncompensatory. However, compensation expense is estimated using the Black-Scholes option pricing model (other models are acceptable), and the present value of the estimated total compensation expense (based on the projected market price at exercise) is $200,000.

30 6. Stock Options - Illustration 3 Basically, the pricing model assumes a number of factors which could affect the growth in the price of the stock, and also incorporates probabilities for the number of employees that would actually exercise the option. Since total compensation expense = $200,000, we will recognize it over the life of the option ($200,000 / 2 = $100,000 per year).

31 6. Stock Options - Illustration 3 (SFAS 123: recommended journal entries) For 2005: Compensation expense 100,000 APIC - stock options100,000 For 2006: Compensation expense 100,000 APIC - stock options100,000 Jan. 2, 2007: Cash ($40 x 30,000) 1,200,000 APIC - stock options 200,000 Common stock ($10 x 30,000) 300,000 APIC - common stock (plug) 1,100,000 Note that, even though the market price of the stock at 1/2/07 is $80 per share, the transaction is recorded at the PV of the estimated future price at the date of exercise ($46.67 per share). The company never recognizes the additional “value” that it has given to the employees.

32 6. Stock Options and SFAS No. 123 However, if companies chose not to recognize the expense in the income statement, SFAS 123 also required that companies disclose the “pro forma” effect on net income, as if the estimated compensation expense had been recognized. Since the issue of SFAS 123, most companies have chosen to disclose, rather than accrue, compensation expense. The disclosure helped the financial statement reader to ascertain several things: – what income would have been if SFAS 123 had been fully implemented. – how much equity the company is promising to the employees.

33 6. Stock Options and Recent Changes In 2003 and 2004, many companies began voluntarily recording option compensation as an expense on the income statement. There were several reasons, including the desire to be more transparent with shareholders. FASB has approved a standard that will tentatively become effective mid-2005, and will require the recognition of expense through journal entries, using the fair value method.

34 6. Stock Options and Expense Recognition Should compensation expense be recognized in the financial statements? 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. – If companies had to recognize expense, they would stop offering stock options. – Options are given as work incentives, rather than straight compensation. Remember: the value can go down as well as up (unlike traditional compensation).

35 7. Retained Earnings We will be expanding the basic retained earnings formula in this chapter. Now the Statement of Retained Earnings will include the following: RE, beginning (unadjusted)xx Add/Subtract: Prior period adjustmentxx RE, beginning (restated)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

36 7. RE - Cash Dividends As cash dividends are declared: Dividends (RE) - commonxx Dividends (RE)- preferredxx Dividends Payablexx As cash dividends are paid: Dividends Payablexx Cashxx

37 7. 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.

38 7. 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. As property dividends are declared: Property Dividends (RE)xx Property Div. Payablexx As property dividends are distributed: Property Div. Payablexx Investmentxx

39 7. 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.

40 7. RE - Stock Dividends Large stock dividends (> 25% of the outstanding common shares) are recorded at par value. As stock dividends are declared: Stock Dividends (RE) xx par Stock Div. Distributablexx par As stock dividends are distributed: Stock Div. Distributablexx par Common Stockxx par Note that Stock Dividends Distributable is not a liability, it is another equity account (see Sample Company) which indicates that there are additional shares of stock that will be issued but are not currently outstanding.

41 7. RE - Stock Dividends Analyze the effect of the transactions on the balance sheet: Stock Dividends (RE) xx - SE Stock Div. Distributablexx + SE As stock dividends are distributed: Stock Div. Distributablexx - SE Common Stockxx + SE 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 do journal entries here.

42 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 certificates are turned in, and “new” stock certificates with a new description are issued to the same shareholders. 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.

43 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.

44 Example of Stock Split If IZM declared a 2 for 1 stock split, the old shares would be turned in 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.

45 7. Stock Dividends vs Stock Splits Going back to the original IZM information. Assume instead that IZM declared a 100% stock dividend. First, prepare the JEs to record the declaration and distribution of the stock dividend for new shares (10,000 shares x 100% = 10,000 new shares x $2 per share = $20,000): Stock Dividends (RE)20,000 Stock Div. Distributable 20,000 Common Stock 20,000

46 7. 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: – Common Stock $40,000 – Retained Earnings 60,000 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

47 7. 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. Most companies use a stock split to change the market price per share, but some companies use the large stock dividend to achieve the same result. This action is called a “stock split in the form of a dividend.”

48 7. 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 42). Since the stock dividend required journal entries (see slide 44), 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.

49 7. 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.

50 7. RE - Appropriations If reclassification is used, the following journal entry is necessary: RExx RE-Appropriatedxx This entry will create “two” retained earnings in the SE section of the balance sheet. (See page 527 of your text for a full example.) The debit side of the entry reduces “unappropriated” or “unrestricted” RE in the Statement of RE, and the credit side creates a new RE account. Note that the JE does not change total SE, or even change total RE.

51 A prior period adjustment is an adjustment to current retained earnings for an error in a prior year’s income statement. The error was closed to prior RE, so the error is corrected at the beginning of the year (net of tax). The error can go in either direction, depending on the nature of the error (ex: omitted expense versus omitted revenue). 7. RE - Prior Period Adjustments

52 8. 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 again in Chapter 13), and it also includes “Other Comprehensive Income.”

53 8. Other Comprehensive Income “Other Comprehensive Income” includes certain direct equity adjustments that are not part of the current income statement, but which may have eventual effect on income. We already discussed one of these direct equity adjustments when reviewing Available-for-sale Investments. We found that any unrealized gains/losses from revaluation to market are shown in SE (as “other comprehensive income”) rather than on the income statement.

54 8. Other Comprehensive Income Another item 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. More on this subject in Chapter 8 Appendix.

55 9. 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.

56 Comprehensive Class Problem - Stockholders’ Equity Given the following SE balances for Company G at 1/1/05: Common stock, $10 par, 50,000 shares authorized, 20,000 shares issued and outstanding $200,000 APIC on common stock 400,000 Retained earnings 400,000 During 2005, Company G had the following activity: 1.Net income for the year was $250, Cash dividends of $2 per share were declared and paid on February 1. 3.On June 1, Company G repurchased 2,000 shares of its own stock at $20 per share (using the cost method). 4.On December 1, Company G reissued 500 shares of treasury stock at $18 per share. 5.On December 15, Company G declared a 100% stock dividend, to be distributed to all of its shareholders (including treasury), on Jan. 15, At Dec. 31, Company G recorded an AJE to revalue its available for sale investments from $20,000 to $32,000.

57 Comprehensive Class Problem - Stockholders’ Equity (continued) Required: A.Prepare journal entries for items 2 through 6 (item 1 would require detail information for revenues and expenses to prepare - just know that the credit is to retained earnings for $250,000). B.Prepare the Statement of Stockholders’ Equity for Company G for C.Prepare the stockholders’ equity section of the balance sheet for Company G for 2005, including the appropriate description for the common stock.

58 Comprehensive Class Problem - Solution A. Journal entries 1. No entry required. 2. Calc: 20,000 x $2 = 40, Calc: 2,000 shares x $20 = $40,000

59 Comprehensive Class Problem - Solution Part A: Journal Entries 4. Calc: 500 shares x $18 market = $9, shares x $20 cost = $10, Calc: 20,000 new shares x $10 par = $200,000 Note: in Item 5, the stock has not yet been distributed, so we cannot credit common stock, or show it issued yet. This “Stock Dividends Distributable” account is a related equity account, and indicates that there are shares of stock to be distributed in the future.

60 Comprehensive Class Problem - Solution Part A: Journal Entries 6. Calc: value up $12,000 Note that the Unrealized Gain account is part of stockholders’ equity (not the income statement), and it is located at the bottom of the stockholders’ equity section of the balance sheet, in Other Comprehensive Income (OCI).

61 Comprehensive Class Problem - Solution Part B: Statement of SE (in thousands) CS CSDD APIC RE OCI TS Balance 1/1/05 $200 $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, 12/31/05 $200 $200 $400 $409 $12 $(30) Note: CSDD is Common Stock Dividends Distributable. When shares distributed, then CS is increased. Note: OCI is Other Comprehensive Income and reflects the unrealized gain on Available-for -sale investment.

62 Comprehensive Class Problem - Solution Part C: Stockholders’ Equity Section of B/S Common stock, $10 par value, 50,000 shares authorized, 20,000 shares issued, 18,500 shares outstanding $200,000 Common stock dividends distributable, 20,000 shares200,000 Additional paid-in capital, common stock 400,000 Retained earnings 409,000 Other comprehensive income (unrealized gain on AFS investment) 12,000 Less: Treasury stock, 1,500 shares at cost(30,000) Total stockholders’ equity $1,191,000