Financial Accounting, Sixth Edition

Financial Accounting, Sixth Edition
11 REPORTING AND ANALYZING STOCKHOLDER’S EQUITY Financial Accounting, Sixth Edition

Study Objectives Identify and discuss the major characteristics of a corporation. Record the issuance of common stock. Explain the accounting for the purchase of treasury stock. Differentiate preferred stock from common stock. Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits. Identify the items that affect retained earnings. Prepare a comprehensive stockholders’ equity section. Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

Reporting and Analyzing Stockholders’ Equity
The Corporate Form of Organization Stock Issue Considerations Accounting for Treasury Stock Preferred Stock Dividends and Retained Earnings Financial Statement Presentation and Corporate Performance Characteristics Formation Stockholder rights Authorized stock Issuance Par and no-par value Accounting for common stock issues Purchase of treasury stock Dividend preferences Liquidation preference Cash dividends Stock dividends Stock splits Retained earnings restrictions Balance sheet Statement of cash flows Dividend record Earnings performance Debt vs. equity decision

The Corporate Form of Organization
An entity separate and distinct from its owners. Classified by Purpose Not-for-Profit For Profit Classified by Ownership Publicly held Privately held Nike General Motors IBM General Electric Salvation Army American Cancer Society Gates Foundation Cargill Inc.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Advantages Disadvantages SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Corporation acts under its own name rather than in the name of its stockholders. SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Limited to their investment. SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Shareholders may sell their stock. SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Corporation can obtain capital through the issuance of stock. SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer. SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Separation of ownership and management prevents owners from having an active role in managing the company. SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Separate Legal Existence Limited Liability of Stockholders Transferable Ownership Rights Ability to Acquire Capital Continuous Life Corporate Management Government Regulations Additional Taxes Corporations pay income taxes as a separate legal entity and stockholders pay taxes on cash dividends. SO 1 Identify and discuss the major characteristics of a corporation.

Stockholders Illustration 11-1 Corporation organization chart Chairman and Board of Directors President and Chief Executive Officer General Counsel and Secretary Vice President Marketing Vice President Finance/Chief Financial Officer Vice President Operations Vice President Human Resources Treasurer Controller SO 1 Identify and discuss the major characteristics of a corporation.

Characteristics of a Corporation Other Forms of Business Organization Limited partnerships Limited liability partnerships (LLPs) Limited liability companies (LLCs) S Corporation no double taxation cannot have more than 75 shareholders SO 1 Identify and discuss the major characteristics of a corporation.

Forming a Corporation Initial Steps: File application with the Secretary of State. State grants charter. Corporation develops by-laws. Companies generally incorporate in a state whose laws are favorable to the corporate form of business (Delaware, New Jersey). Corporations engaged in interstate commerce must obtain a license from each state in which they do business. SO 1 Identify and discuss the major characteristics of a corporation.

Stockholders Rights Illustration 11-3 1. Vote in election of board of directors and on actions that require stockholder approval. 2. Share the corporate earnings through receipt of dividends. SO 1 Identify and discuss the major characteristics of a corporation.

Stockholders Rights Illustration 11-3 3. Keep the same percentage ownership when new shares of stock are issued (preemptive right). SO 1 Identify and discuss the major characteristics of a corporation.

Stockholders Rights Illustration 11-3 4. Share in assets upon liquidation in proportion to their holdings. This is called a residual claim. SO 1 Identify and discuss the major characteristics of a corporation.

Stock Issue Considerations
Authorized Stock Charter indicates the amount of stock that a corporation is authorized to sell. Number of authorized shares is often reported in the stockholders’ equity section. SO 1 Identify and discuss the major characteristics of a corporation.

Prenumbered Shares Illustration 11-4 Name of corporation Stockholder’s name Signature of corporate official SO 1 Identify and discuss the major characteristics of a corporation.

Issuance of Stock Corporation can issue common stock directly to investors or indirectly through an investment banking firm. U.S. securities exchanges New York Stock Exchange American Stock Exchange 13 regional exchanges NASDAQ national market SO 1 Identify and discuss the major characteristics of a corporation.

Par and No-Par Value Stocks Capital stock that has been assigned a value per share. Years ago, par value determined the legal capital per share that a company must retain in the business for the protection of corporate creditors. Today many states do not require a par value. No-par value stock is quite common today. In many states the board of directors assigns a stated value to no-par shares. SO 1 Identify and discuss the major characteristics of a corporation.

Review Question Which of these statements is false? Ownership of common stock gives the owner a voting right. The stockholders’ equity section begins with paid-in capital. The authorization of capital stock does not result in a formal accounting entry. Legal capital is intended to protect stockholders. SO 1 Identify and discuss the major characteristics of a corporation.

Common Stock Account Paid-in Capital Paid-in Capital in Excess of Par Account Preferred Stock Account Two Primary Sources of Equity Retained Earnings Account Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock. SO 2 Record the issuance of common stock.

Common Stock Account Paid-in Capital Paid-in Capital in Excess of Par Account Preferred Stock Account Two Primary Sources of Equity Retained Earnings Account Retained earnings is net income that a corporation retains for future use. SO 2 Record the issuance of common stock.

Accounting for Common Stock Issues Primary objectives: Identify the specific sources of paid-in capital. Maintain the distinction between paid-in capital and retained earnings. Other than consideration received, the issuance of common stock affects only paid-in capital accounts. SO 2 Record the issuance of common stock.

Accounting for Common Stock Issues Illustration: Assume that Hydro-Slide, Inc. issues 1,000 shares of $1 par value common stock at par. Prepare the journal entry. Cash 1,000 Common stock (1,000 x $1) 1,000 SO 2 Record the issuance of common stock.

Accounting for Common Stock Issues Illustration: Now assume Hydro-Slide, Inc. issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share. Prepare Hydro-Slide’s journal entry. Cash 5,000 Common stock (1,000 x $1) 1,000 Paid-in capital in excess of par value 4,000 SO 2 Record the issuance of common stock.

Stockholders’ equity section assuming Hydro-Slide, Inc. has retained earnings of $27,000. Illustration 11-5 SO 2 Record the issuance of common stock.

Review Question ABC Corp. issues 1,000 shares of $10 par value common stock at $12 per share. When the transaction is recorded, credits are made to: Common Stock $10,000 and Paid-in Capital in Excess of Stated Value $2,000. Common Stock $12,000. Common Stock $10,000 and Paid-in Capital in Excess of Par Value $2,000. Common Stock $10,000 and Retained Earnings $2,000. SO 2 Record the issuance of common stock.

Accounting for Treasury Stock
Common Stock Account Paid-in Capital Paid-in Capital in Excess of Par Account Preferred Stock Account Two Primary Sources of Equity Retained Earnings Account Less: Treasury Stock Account SO 3 Explain the accounting for the purchase of treasury stock.

Treasury stock - corporation’s own stock that it has reacquired from shareholders, but not retired. Corporations purchase their outstanding stock: To reissue shares to officers and employees under bonus and stock compensation plans. To increase trading of the company’s stock in the securities market. To have additional shares available for use in acquiring other companies. To increase earnings per share. Another infrequent reason is to eliminate hostile shareholders. SO 3 Explain the accounting for the purchase of treasury stock.

Purchase of Treasury Stock Generally accounted for by the cost method. Debit Treasury Stock for the price paid. Treasury stock is a contra stockholders’ equity account, not an asset. Purchase of treasury stock reduces stockholders’ equity. SO 3 Explain the accounting for the purchase of treasury stock.

Illustration 11-6 Illustration: On February 1, 2012, Mead acquires 4,000 shares of its stock at $8 per share. Prepare the entry. Treasury stock (4,000 x $8) 32,000 Cash 32,000 SO 3 Explain the accounting for the purchase of treasury stock.

Stockholders’ Equity with Treasury stock Illustration 11-7 Both the number of shares issued (100,000), outstanding (96,000), and the number of shares held as treasury (4,000) are disclosed. SO 3 Explain the accounting for the purchase of treasury stock.

Review Question Treasury stock may be repurchased: to reissue the shares to officers and employees under bonus and stock compensation plans. to signal to the stock market that management believes the stock is underpriced. to have additional shares available for use in the acquisition of other companies. more than one of the above. SO 3 Explain the accounting for the purchase of treasury stock.

Preferred Stock Features often associated with preferred stock.
Preference as to dividends. Preference as to assets in liquidation. Nonvoting. Each paid-in capital account title should identify the stock to which it relates: Paid-in Capital in Excess of Par Value—Preferred Stock Paid-in Capital in Excess of Par Value—Common Stock SO 4 Differentiate preferred stock from common stock.

Preferred Stock Illustration: Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. Journalize the issuance of the preferred stock. Cash 120,000 Preferred stock (10,000 x $10) ,000 Paid-in capital in excess of par – Preferred stock 20,000 Preferred stock may have a par value or no-par value. SO 4 Differentiate preferred stock from common stock.

Preferred Stock Dividend Preferences
Right to receive dividends before common stockholders. Per share dividend amount is stated as a percentage of the preferred stock’s par value or as a specified amount. Cumulative dividend – holders of preferred stock must be paid their annual dividend plus any dividends in arrears before common stockholders receive dividends. SO 4 Differentiate preferred stock from common stock.

Preferred Stock Liquidation Preference
Preference on corporate assets if the corporation fails. Preference may be for the par value of the shares or for a specified liquidating value. SO 4 Differentiate preferred stock from common stock.

Preferred Stock Review Question
M-Bot Corporation has 10,000 shares of 8%, $100 par value, cumulative preferred stock outstanding at December 31, No dividends were declared in 2008 or If M-Bot wants to pay $375,000 of dividends in 2010, common stockholders will receive: $0. $295,000. $215,000. $135,000. SO 4 Differentiate preferred stock from common stock.

Dividends A distribution of cash or stock to stockholders on a pro rata (proportional to ownership) basis. Types of Dividends: Cash dividends. Property dividends. Stock dividends. Scrip (promissory note) Dividends expressed: (1) as a percentage of the par or stated value, or (2) as a dollar amount per share. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Cash Dividends
For a corporation to pay a cash dividend, it must have: Retained earnings - Payment of cash dividends from retained earnings is legal in all states. Adequate cash. Declaration by the Board of Directors. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Dividends require information concerning three dates:
SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Illustration: On Dec. 1, the directors of Media General declare a 50¢ per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is payable on Jan. 20 to shareholders of record on Dec. 22: December 1 (Declaration Date) Cash dividends 50,000 Dividends payable 50,000 December 22 (Record Date) No entry January 20 (Payment Date) Dividends payable 50,000 Cash 50,000 SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Review Question
Entries for cash dividends are required on the: declaration date and the record date. record date and the payment date. declaration date, record date, and payment date. declaration date and the payment date. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Stock Dividends
Pro rata distribution of the corporation’s own stock. Illustration 11-10 Results in decrease in retained earnings and increase in paid-in capital. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Stock Dividends
Reasons why corporations issue stock dividends: Satisfy stockholders’ dividend expectations without spending cash. Increase the marketability of the corporation’s stock. Emphasize that a portion of stockholders’ equity has been permanently reinvested in the business. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Effects of Stock Dividends
Changes the composition of stockholders’ equity. Total stockholders’ equity remains the same. No effect on the par or stated value per share. Increases the number of shares outstanding. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Illustration: Medland Corp. declares a 10% stock dividend on its $10 par common stock when 50,000 shares were outstanding. The market price was $15 per share. Illustration 11-9 SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Stock Split Reduces the market value of shares.
No entry recorded for a stock split. Decrease par value and increase number of shares. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Illustration: Assuming that instead of issuing a 10% stock dividend, Medland splits its 50,000 shares of common stock on a 2-for-1 basis. Illustration 11-11 SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Differences between the effects of stock dividends and stock splits. Illustration 11-12 SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Dividends Review Question
Which of these statements about stock dividends is true? Stock dividends reduce a company’s cash balance. A stock dividend has no effect on total stockholders’ equity. A stock dividend decreases total stockholders’ equity. A stock dividend ordinarily will increase total stockholders’ equity. SO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

Retained Earnings Retained earnings is net income that a company retains for use in the business. Net income increases Retained Earnings and a net loss decreases Retained Earnings. Retained earnings is part of the stockholders’ claim on the total assets of the corporation. A debit balance in Retained Earnings is identified as a deficit. SO 6 Identify the items that affect retained earnings.

Retained Earnings Illustration 11-14 SO 6 Identify the items that affect retained earnings.

Retained Earnings Retained Earnings Restrictions
Restrictions can result from: Legal restrictions. Contractual restrictions. Voluntary restrictions. SO 6 Identify the items that affect retained earnings.

Presentation of Stockholders’ Equity
Balance Sheet Presentation Two classifications of paid-in capital: Capital stock Additional paid-in capital SO 7 Prepare a comprehensive stockholders’ equity section.

Presentation of Stockholders’ Equity
Balance Sheet Presentation Illustration 11-16 SO 7 Prepare a comprehensive stockholders’ equity section.

Measuring Corporate Performance
Dividend Record Illustration: The following is the calculation of the payout ratio for Nike in 2009 and 2008. Illustration 11-18 Illustration 11-18 The payout ratio measures the percentage of earnings a company distributes in the form of cash dividends. SO 8 Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

Earnings Performance Illustration: The following is the calculation of Nike’s return on common stockholders’ equity ratios for 2009 and 2008. Illustration 11-20 This ratio shows how many dollars of net income a company earned for each dollar of common stockholders’ equity. SO 8 Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

Debt Versus Equity Decision Illustration 11-21 SO 8 Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

Debt Versus Equity Decision Illustration 11-22 SO 8 Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

Illustration: Microsystems Inc. currently has 100,000 shares of common stock outstanding issued at $25 per share and no debt. It is considering two alternatives for raising an additional $5 million: Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuing $5 million of 12% bonds at face value. Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%. Illustration 11-23 SO 8

Entries for Stock Dividends
appendix 11A Illustration: Medland Corporation declares a 10% stock dividend on its 50,000 shares of $10 par value common stock. The current fair market value of its stock is $15 per share. Record the entry on the declaration date: Retained earnings (50,000 x 10% x $15) 75,000 Common stock dividends distributable 50,000 Paid-in capital in excess of par 25,000 Illustration 11A-1 SO 9 Prepare entries for stock dividends.

Entries for Stock Dividends
appendix 11A Illustration: Record the journal entry when Medland issues the dividend shares. Common stock dividends distributable 50,000 Common stock 50,000 SO 9 Prepare entries for stock dividends.

Key Points Under IFRS, the term reserves is used to describe all equity accounts other than those arising from contributed capital. This would include, for example, reserves related to retained earnings, asset revaluations, and fair value differences. Many countries have a different mix of investor groups than in the United States. For example, in Germany, financial institutions like banks are not only major creditors of corporations but often are the largest corporate stockholders as well. In the United States, Asia, and the United Kingdom, many companies rely on substantial investment from private investors.

Key Points There are often terminology differences for equity accounts. The following summarizes some of the common differences in terminology.

Key Points The accounting for treasury stock differs somewhat between IFRS and GAAP. (However, many of the differences are beyond the scope of this course.) Like GAAP, IFRS does not allow a company to record gains or losses on purchases of its own shares. One difference worth noting is that, when a company purchases its own shares, IFRS treats it as a reduction of stockholders’ equity, but it does not specify which particular stockholders’ equity accounts are to be affected. Therefore, it could be shown as an increase to a contra equity account (Treasury Stock) or a decrease to retained earnings or share capital. IFRS requires that the number of treasury shares held be disclosed.

Key Points A major difference between IFRS and GAAP relates to the account Revaluation Surplus. Revaluation surplus arises under IFRS because companies are permitted to revalue their property, plant, and equipment to fair value under certain circumstances. This account is part of general reserves under IFRS and is not considered contributed capital. As indicated earlier, the term reserves is used in IFRS to indicate all noncontributed (non–paid-in) capital. Reserves include retained earnings and other comprehensive income items, such as revaluation surplus and unrealized gains or losses on available-for-sale securities.

Key Points IFRS often uses terms such as retained profits or accumulated profit or loss to describe retained earnings. The term retained earnings is also often used. The accounting related to prior period adjustments is essentially the same under IFRS and GAAP. Equity is given various descriptions under IFRS, such as shareholders’ equity, owners’ equity, capital and reserves, and shareholders’ funds.

Looking into the Future
The IASB and the FASB are currently working on a project related to financial statement presentation. An important part of this study is to determine whether certain line items, subtotals, and totals should be clearly defined and required to be displayed in the financial statements. The options of how to present other comprehensive income under GAAP will change in any converged standard. Also, the FASB has been working on a standard that will likely converge to IFRS in the area of hybrid financial instruments, such as bonds that are convertible to common stock.

Under IFRS, a purchase by a company of its own shares is recorded by:
an increase in Treasury Stock. a decrease in contributed capital. a decrease in share capital. All of these are acceptable treatments.

The term reserves is used under IFRS with reference to all of the following except:
gains and losses on revaluation of property, plant, and equipment. capital received in excess of the par value of issued shares. retained earnings. fair value differences.

Under IFRS, the amount of capital received in excess of par value would be credited to:
Retained Earnings. Contributed Capital. Share Premium. Par value is not used under IFRS.

Copyright “Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”

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