1. Chapter 10 Stockholders’ Equity McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Stockholders’ Equity Stockholders’ Equity = Assets - Liabilities Primary Sections of Stockholders’ Equity Paid-in capitalRetained EarningsTreasury Stock Amount stockholders have invested in the corporation Amount of earnings the corporation has retained Corporation’s own stock that it has reacquired 10-2

3. Part A Invested Capital 10-3

4. LO1 Corporations oArticles of incorporation (or corporate charter) describe a)the nature of the firm’s business activities b)the shares to be issued c)the initial board of directors oCorporation’s stockholders control the corporation - By voting their shares, they determine the makeup of the board of directors - which in turn appoints the management to run the corporation. 10-4

5. Stages of Equity Financing oThe progression leading to a public offering might include some or all of these steps: oInvestment by the founders of the business. oInvestment by friends and family of the founders. oOutside investment by “angel” investors (wealthy individuals in the business community willing to provide investment funds) and venture capital firms (provide additional financing for a percentage ownership in the corporation). oInitial public offering (IPO), the first time a corporation issues stock to the public. 10-5

6. Public or Private  Stocks trade on a stock exchanges such as NYSE, AMEX, NASDAQ; or by over-the-counter (OTC) trading.  Regulated by the Securities and Exchange Commission (SEC)  Examples – Wal-Mart, Microsoft, Intel  Does not allow investment by the general public and has fewer stockholders  Not regulated by the Securities and Exchange Commission (SEC) and do not need to file financial statements with it  Examples - Cargill (agricultural commodities) Koch Industries (oil and gas), Chrysler (cars) Corporations may be either public or private PublicPrivate 10-6

7. Stockholder Rights  Whether public or private, stockholders are the owners of the corporation and have certain rights: oRight to vote oRight to receive dividends oRight to share in distribution of assets oPreemptive right – allows a stockholder to maintain his or her percentage share of ownership. 10-7

8. Advantages and Disadvantages of a Corporation  Additional taxes  More paperwork  Limited liability  Ability to raise capital  Lack of mutual agency Advantages Disadvantages 10-8

9. LO2 Common Stock Type of Stock Definition Authorized Shares available to sell (issued and unissued) Issued Shares actually sold (includes treasury stock) Outstanding Shares held by investors (excludes treasury stock) Authorized – Unissued = Issued Issued – Treasury Stock = Outstanding oIf a corporation has only one kind of stock, it usually is labeled as common stock. 10-9

10. Par Value oThe legal capital per share of stock that’s assigned when the corporation is first established Has no significant meaning today. Has no relationship to the market value of the common stock NO PAR VALUE Common stock that has not been assigned a par value STATED VALUE Treated in the same manner as par value shares 10-10

11. Accounting for Common Stock Issues When a corporation receives cash from issuing common stock, it debits cash. If it issues no-par value stock, the corporation credits the equity account entitled common stock. Cash (1,000 shares x $30)30,000 Common Stock30,000 (Issue no-par value common stock) The entry changes slightly if the corporation issues par value stock rather than no-par value stock. In that case, we credit common stock and additional paid-in capital. Cash (1,000 shares x $30)30,000 Common Stock (1,000 shares x $0.01)10 Additional Paid-in Capital (difference)29,990 (Issue common stock above par) 10-11

12. LO3 Preferred Stock  Usually have first rights to a specified amount of Dividends.  Receive preference over common stockholders in the distribution of assets in the event the corporation is dissolved. Factor Common Stock Preferred StockBonds Voting rightsYesUsually NoNo Risk to the investorHighestMiddleLowest Expected return to the investorHighestMiddleLowest Risk of contract violationsLowestMiddleHighest Preference for paymentsLowestMiddleHighest Tax deductibility of paymentsNoUsually NoYes Comparison of common stock, preferred stock, and bonds 10-12

13. Accounting for Preferred Stock Issues The entries to record the issuance of preferred stock are similar to those for the issue of common stock Cash (1,000 shares x $40)40,000 Preferred Stock (1,000 shares x $30)30,000 Additional Paid-in Capital10,000 (Issue preferred stock above par) 10-13

14. Features of Preferred Stock Flexibility allowed in its contractual provisions ConvertibleRedeemableCumulative Shares can be exchanged for common stock Shares can be returned to the corporation at a fixed price Shares receive priority for future dividends, if dividends are not paid in a given year 10-14

15. LO4 Treasury Stock  Why corporations repurchase their stock  To boost under-priced stock.  To distribute surplus cash without paying dividends.  To boost earnings per share.  To offset issuance of shares under stock- based compensation plans. A corporation’s own stock that it has reacquired 10-15

16. Accounting for Treasury Stock Treasury Stock (100 shares x $30)3,000 Cash3,000 (Repurchase treasury stock) Cash (100 shares x $35)3,500 Treasury Stock (100 shares x $30)3,000 Additional Paid-in Capital (difference)500 (Reissue treasury stock above cost) Cost Reissue price oTreasury stock is reported as a contra-equity (negative equity account). oWhen a corporation repurchases its own stock, it increases, or debits treasury stock and vice versa when it sells. 10-16

17. Accounting for Treasury Stock Cash (100 x $25)2,500 Additional Paid-in Capital (100 x $5)500 Treasury Stock (100 x $30)3,000 (Sell treasury stock below cost) Cost Reissue price What if the stock price goes down and we reissue the treasury stock for less than we paid to buy back the shares? 10-17

18. Part B Earned Capital 10-18

19. LO5 Retained Earnings and Dividends RETAINED EARNINGS o Represents the earnings retained in the corporation – earnings not paid out as dividends to stockholders. oEquals all net income, less all dividends, since the corporation began. oHas a normal credit balance consistent with other stockholders’ equity accounts. oIf losses exceed income since the corporation began, retained earnings will have a debit balance and is called an accumulated deficit. 10-19

20. Dividends Distributions by a corporation to its stockholders Not paid on treasury shares repurchased by the corporation Investors pay careful attention to cash dividends DECLARATION DATE Date on which dividend is declared RECORD DATE Date on which the registered owners of stock are determined PAYMENT DATE Date on which the cash dividend is paid 10-20

21. Dividends Lets consider the following dividend example A corporation declares a $0.25 per share dividend on its 2,000 outstanding shares March 15 (declaration date) Retained Earnings (2,000 shares x $0.25)500 Dividends Payable500 (Declaration of cash dividends) April 15 (payment date) Dividends Payable (2,000 shares x $0.25)500 Cash500 (Payment of cash dividends) March 31 (No entry for Record date) 10-21

22. LO6 Stock Dividends and Stock Splits Sometimes, corporations distribute to shareholders additional shares of the companies’ own stock rather than cash. These are known as stock dividends or stock splits depending on the size of the stock distribution. You own 100 shares and assume a You will get 10% stock dividend10 additional shares 20% stock dividend20 additional shares 100% stock dividend100 additional shares Small stock dividend Large stock dividend or stock split (2-for-1) 10-22

23. Since the corporation’s shares double following a 100% stock dividend, we make an entry to reflect the increase in the par value of the common shares. Stock Dividends Retained Earnings (1,000 shares x $0.01)10 Common Stock10 (100% stock dividend, large stock dividend) Small stock dividends are recorded by debiting retained earnings for the market value, rather than the par value, per share. Retained Earnings (1,000 x 10% x $30)3,000 Common Stock (1,000 x 10% x $0.01)1 Additional Paid-In Capital (difference)2,999 (10% stock dividend, small stock dividend) 10-23

24. Stock Splits oA stock distribution of 25% or higher, although it’s technically a “large” stock dividend, is more often referred to as a stock split. oA 100% stock dividend is effectively the same as a 2-for-1 stock split, although the accounting for a 100% stock dividend and a 2-for-1 stock split differs. oMake no journal entry to record a stock split. oAfter a 2-for-1 stock split, the common stock account balance (total par) represents twice as many shares and the par value per share is reduced by one-half. 10-24

25. Part C Reporting and Analyzing Stockholders’ Equity 10-25

26. LO7 Stockholders’ Equity 10-26

27. Statement of Stockholders’ Equity Summarizes the changes in the balance in each stockholders’ equity account over a period of time. 10-27

28. LO8 Equity Analysis Equity Analysis Return on Equity Return on the Market Value of Equity Price-Earnings Ratio Earnings Per Share 10-28

29. Return on Equity Measures the ability of company management to generate earnings from the resources that owners provide. Return on equity = Net income Average stockholders’ equity 10-29

30. Return on Market Value of Equity To supplement the return on equity ratio, analysts often relate earnings to the market value of equity calculated as the ending stock price times the number of shares outstanding. Return on the market value of equity = Net income Market value of equity 10-30

31. Earnings Per Share Earnings per share= Net income Average shares outstanding during the period oMeasures the net income earned per share of common stock. oUseful in evaluating the earnings performance of a company over time. oNot useful in comparing earnings performance across companies. 10-31

32. Price-Earnings Ratio (PE Ratio) oA high PE ratio indicates investors expect future earnings to be higher. oA low PE ratio indicates investors lack of confidence in future earnings growth. Price-Earnings Ratio = Stock price Earnings per share GROWTH STOCKS Priced high in relation to current earnings VALUE STOCKS Priced low in relation to current earnings 10-32

33. End of chapter 10 10-33