Contributed Capital Chapter 14

Contributed Capital Chapter 14
Multimedia Slides by: Gail A. Mestas, MAcc, New Mexico State University

Learning Objectives Identify and explain the management issues related to contributed capital. Identify the components of stockholders’ equity. Account for cash dividends. Identify the characteristics of preferred stock, including the effect on distribution of dividends. Copyright © Houghton Mifflin Company. All rights reserved.

Learning Objectives (cont’d)
Account for the issuance of stock for cash and other assets. Account for treasury stock. Copyright © Houghton Mifflin Company. All rights reserved.

Management Issues Related to Contributed Capital
Objective 1 Identify and explain the management issues related to contributed capital Copyright © Houghton Mifflin Company. All rights reserved.

A Corporation … is defined as a body of persons granted a charter recognizing them as a separate legal entity having its own rights, privileges, and liabilities distinct from those of its members In other words, a corporation is a legal entity separate and distinct from its owners Management of contributed capital is a critical component in financing the corporation Copyright © Houghton Mifflin Company. All rights reserved.

Management Issues Related to Contributed Capital
Managing under the corporate form of business Using equity financing Determining dividend policies Evaluating performance using return on equity Using stock options as compensation Copyright © Houghton Mifflin Company. All rights reserved.

Managing under the Corporate Form of Business
Corporations dominate the economy in total dollars of assets and output of goods and services Even though sole proprietorships and partnerships outnumber corporations in the U.S. Contributed capital New funds are raised by issuing bonds, new common stock, and preferred stock Copyright © Houghton Mifflin Company. All rights reserved.

Sources of Capital Raised by Corporations in the United States

Advantages of the Corporate Form of Business
Separate legal entity Limited liability Ease of capital generation Ease of transfer of ownership Lack of mutual agency Continuous existence Centralized authority and responsibility Professional management Copyright © Houghton Mifflin Company. All rights reserved.

Disadvantages of the Corporate Form of Business
Government regulation Taxation Limited liability Separation of ownership and control Copyright © Houghton Mifflin Company. All rights reserved.

Using Equity Financing
A share of stock is a unit of ownership in a corporation A stock certificate is issued to the owner Stockholders can transfer their ownership at will Independent registrars and transfer agents are often used to keep track of stockholders’ records Authorized stock The maximum number of shares a corporation is allowed to issue Copyright © Houghton Mifflin Company. All rights reserved.

… is an arbitrary amount assigned to each share of stock
Par Value … is an arbitrary amount assigned to each share of stock Usually bears little or no relationship to the market value or book value of shares Constitutes the legal capital of the corporation Legal capital The number of shares issued times the par value Is the minimum amount that can be reported as contributed capital Copyright © Houghton Mifflin Company. All rights reserved.

Initial Public Offering (IPO)
… is the initial offering of capital stock Often, an underwriter is used for an IPO Intermediary between the corporation and the investing public Guarantees the sale of the stock for a fee Usually less than one percent of the selling price The corporation records the net proceeds of the offering Amount paid by public less underwriter fees and any other direct costs of the offering Copyright © Houghton Mifflin Company. All rights reserved.

Start-Up and Organization Costs
… are the costs of forming a corporation Are incurred before the corporation begins operations Include State incorporation fees Attorneys’ fees Cost of printing stock certificates Accountant fees related to registering the firm’s stock Are expensed because the life of the corporation is unknown Copyright © Houghton Mifflin Company. All rights reserved.

… are distributions of a corporation’s assets to its stockholders
Dividends … are distributions of a corporation’s assets to its stockholders Stockholders receive assets in proportion to their ownership Copyright © Houghton Mifflin Company. All rights reserved.

Determining Dividend Policies
The board of directors has sole authority to declare dividends But is influenced by senior managers, usually board members Factors other than earnings that affect the decision to pay dividends Expected volatility of earnings Level of dividends affects cash flows Copyright © Houghton Mifflin Company. All rights reserved.

Determining Dividend Policies
Stockholders earn a return on their investment by Receiving dividends By selling shares of stock for more than they paid for them Investors may prefer companies that reinvest their profits rather than pay high dividends if this leads to an increase in share prices Because investors pay less tax on capital gains than dividend income Copyright © Houghton Mifflin Company. All rights reserved.

Ratio Analysis Dividends yield Price/earnings (P/E) ratio
Used by investors to evaluate the amount of dividends received Price/earnings (P/E) ratio A measure of investors’ confidence in a company’s future Copyright © Houghton Mifflin Company. All rights reserved.

Evaluating Performance Using Return on Equity (ROE)
Most important ratio associated with stockholders’ equity It is a common measure of management’s performance Compensation of top executives is often tied to this measure Affected by Net income The level of stockholders’ equity, which can be affected by management decisions, such as repurchasing shares (treasury stock) Purchase of treasury stock can improve ROE, increase earnings per share, and lower the P/E ratio Copyright © Houghton Mifflin Company. All rights reserved.

Using Stock Options as Compensation
Stock option plan An agreement to issue stock to employees according to specified terms Usually offered only to management personnel Compensates and motivates management because market value of the stock is tied to the company’s performance As market value increases, difference between option price and market price grows, which increases management’s compensation Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Stock Options
On date granted Estimate fair value Amount in excess of fair value must be either Recorded as compensation expense over the grant period Additional paid-in capital will increase as a result Or reported in notes to financial statements Most commonly used method When option is exercised and stock is issued, the entry is the same as issuance for any outsider Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Stock Options
July 1, 20x4: A company grants options to purchase 50,000 shares of $10 par value common stock at current market value of $15 per share The company will report stock options in the notes to the financial statements March 30, 20x7: An employee exercises the option to purchase 2,000 shares. The market price is $25 per share Determine the gain on stock options Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Identify whether each of the following characteristics is an advantage or a disadvantage of the corporate form of business Ease of transfer of ownership Taxation Separate legal entity Lack of mutual agency Government regulation Continuous existence Advantage Disadvantage Advantage Advantage Disadvantage Advantage Copyright © Houghton Mifflin Company. All rights reserved.

Components of Contributed Capital
Objective 2 Identify the components of stockholders’ equity Copyright © Houghton Mifflin Company. All rights reserved.

… represents owners’ claims to a business
Stockholders’ Equity … represents owners’ claims to a business On the balance sheet, the equity section is divided into two parts Contributed Capital Investments made by stockholders Provides information about the corporation’s stock Types; par value; number of shares authorized, issued, and outstanding Retained Earnings Earnings since inception, less any losses, dividends, or transfers to contributed capital Earnings reinvested in the corporation Represent stockholders’ claims to the assets from earnings reinvested in the company Copyright © Houghton Mifflin Company. All rights reserved.

Contributed Capital Common stock Preferred stock
The company’s residual equity In case of liquidation, all creditors and usually preferred stockholders’ claims to the company’s assets rank ahead of common stockholders’ claims Carries voting rights A means of controlling the corporation Preferred stock Has preference over common stock in one or more ways Copyright © Houghton Mifflin Company. All rights reserved.

Status of Shares of Stock
Issued stock Shares sold or otherwise transferred to stockholders Once stock has been authorized, the company decides how many shares to issue and when Unissued stock has no rights or privileges associated with it until it is issued Outstanding stock Stock that has been issued and is still in circulation Stock that is not outstanding is either Stock given back to the company Treasury stock Repurchased and held by the company Copyright © Houghton Mifflin Company. All rights reserved.

Relationship of Authorized, Unissued, Issued, Outstanding, and Treasury Shares
Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What kind of information does the contributed capital section of stockholders’ equity provide? The contributed capital section provides information about the corporation’s stock Types of stock Their par value The number of shares authorized, issued, and outstanding Copyright © Houghton Mifflin Company. All rights reserved.

Dividends Objective 3 Account for cash dividends
Copyright © Houghton Mifflin Company. All rights reserved.

Dividends Can be paid at any time decided by the board of directors
The board usually cannot pay a liquidating dividend Dividend that exceeds retained earnings Is normally paid when a company is going out of business Sufficient cash must be available to pay a dividend Board members want to avoid borrowing to pay dividends Copyright © Houghton Mifflin Company. All rights reserved.

Dividends (cont’d) Three important dates associated with dividends
Date of declaration Date board of directors formally declares a dividend will be paid Date of Record Date on which ownership and right to receive dividend is determined Between the date of record and the payment date the stock is said to be ex-dividend Date of payment Date on which dividend is paid to stockholders of record Copyright © Houghton Mifflin Company. All rights reserved.

Example of Dividends A cash dividend of $56,000 is declared on February 21, 20xx, for stockholders of record on March 1, 20xx, to be paid on March 11, 20xx Date of Declaration The Cash Dividends Declared account is a temporary stockholders’ equity account that is closed to Retained Earnings at the end of the accounting period Copyright © Houghton Mifflin Company. All rights reserved.

Example of Dividends A cash dividend of $56,000 is declared on February 21, 20xx, for stockholders of record on March 1, 20xx, to be paid on March 11, 20xx. Date of Record No entry is required This date is used to determine the owners of stock who will receive dividends After this date, until dividend payment, shares are ex-dividend Date of Payment Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Explain the accounting treatment of cash dividends
Date of declaration The total amount of the cash dividend is recorded by a debit to Cash Dividends Declared and a credit to Cash Dividends Payable Date of payment A debit is made to Cash Dividends Payable and a credit is made to Cash At the end of the accounting period The Cash Dividends Declared account is closed to Retained Earnings with a debit to Retained Earnings and a credit to Cash Dividends Declared

The Characteristics of Preferred Stock
Objective 4 Identify the characteristics of preferred stock, including the effect on distribution of dividends Copyright © Houghton Mifflin Company. All rights reserved.

Preferred Stock Has one or more of the following characteristics
Preference as to dividends Preference as to assets of the business in liquidation Convertibility Callable option Copyright © Houghton Mifflin Company. All rights reserved.

Preference as to Dividends
… means that holders of preferred shares receive dividends before common stockholders Preferred stockholders are not guaranteed dividends Company must declare dividends on preferred stock for liability to exist If dividends not declared to preferred shareholders, consequences depend on terms under which shares were issued Noncumulative preferred stock Cumulative preferred stock Copyright © Houghton Mifflin Company. All rights reserved.

Preference as to Dividends (cont’d)
Noncumulative preferred stock Receives no dividend if none is declared Cumulative preferred stock Has a fixed dividend that accumulates from year to year Must be paid before common stockholders can be paid Dividends not paid in the year they are due are called dividends in arrears Are not a considered a liability because no liability exists until a dividend is declared Are disclosed in notes to the financial statements Copyright © Houghton Mifflin Company. All rights reserved.

Example of Dividends in Arrears
January 1, 20x4: Issued 10,000 shares of $10 par, 6 percent cumulative preferred stock and 50,000 shares common stock. The board of directors declared a $3,000 dividend to preferred stockholders after the first year of operations Copyright © Houghton Mifflin Company. All rights reserved.

Example of Dividends in Arrears
In 20x5, the board of directors declared a $12,000 dividend to be distributed to preferred and common stockholders Record the journal entry for the declaration of the dividend Copyright © Houghton Mifflin Company. All rights reserved.

Preference as to Assets
… means that preferred stockholders have a right to receive the par value of their stock or a larger stated liquidation value per share before the common stockholders receive any share of the company’s assets They may also be entitled to any dividends in arrears Copyright © Houghton Mifflin Company. All rights reserved.

Convertible Preferred Stock
… is preferred stock that can be exchanged for shares of common stock at a ratio stated in the preferred stock contract Appeals to investors because Owners are more likely to receive dividends than common stockholders If value of common stock rises, preferred stockholders share in the increase Value of preferred shares increases by converting to common shares Copyright © Houghton Mifflin Company. All rights reserved.

Example of Convertible Preferred Stock
A company issued 1,000 shares of 8 percent, $100 par value convertible preferred stock for $100 per share. Each share can be converted into 5 shares of the company’s common stock at any time Copyright © Houghton Mifflin Company. All rights reserved.

The market value of the common stock is now $15 per share and, in the past, the owner of common stock could expect dividends of $1 per share per year At this point, the preferred stockholder receives more in dividends by keeping the preferred shares and is more likely to receive dividends than the common stockholders Copyright © Houghton Mifflin Company. All rights reserved.

A few years later, the dividends paid to common stockholders increase to $3 per share and market value is $30 per share At this point, the market value of each share of convertible preferred stock is equivalent to $150 and converting to common stock would increase dividend payments from $8 per share to the equivalent of $15 per share Copyright © Houghton Mifflin Company. All rights reserved.

Callable Preferred Stock
... can be redeemed or retired at the option of the issuing corporation at a price stated in the preferred stock contract The call price is usually higher than the par value of the stock Reasons to call stock A desire to pay lower dividends Because the corporation has enough profits to retire preferred stock Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Why is it necessary to disclose dividends in arrears?
Disclosure serves to alert potential investors in common stock that those dividends must be paid before common stockholders receive any dividends Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Stock Issuance
Objective 5 Account for the issuance of stock for cash and other assets Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Stock Issuance
Par value The amount per share that is entered into the corporation’s capital stock accounts Makes up the legal capital of the corporation Any amount in excess of par value received from the issuance of stock is recorded in the Paid-in Capital in Excess of Par Value account Copyright © Houghton Mifflin Company. All rights reserved.

Accounting for Stock Issuance (cont’d)
No-par stock Capital stock that has no par value If issued with a stated value Shares are recorded in the Capital Stock account at the stated value Any amount in excess of par value received from the issuance of stock is recorded in the Paid-in Capital in Excess of Stated Value account If issued without a stated value All proceeds are recorded in the Capital Stock account Copyright © Houghton Mifflin Company. All rights reserved.

Par Value Stock Bradley Corporation is authorized to issue 20,000 shares of $10 par value common stock Bradley Corporation issues 10,000 shares at $10 per share on January 1, 20xx Bradley Corporation issues 10,000 shares at $12 per share on January 1, 20xx Copyright © Houghton Mifflin Company. All rights reserved.

No-Par Stock Bradley Corporation is authorized to issue 20,000 shares of no-par common stock Bradley Corporation issues 10,000 shares at $15 per share on January 1, 20xx Bradley’s board puts a $10 stated value on its no-par stock. It issues 10,000 shares at $15 per share on January 1, 20xx Copyright © Houghton Mifflin Company. All rights reserved.

Issuance of Stock for Noncash Assets
Generally preferred rule Record the transaction at the fair market value of what the corporation is giving up (stock) If fair market value of the stock cannot be determined, use the fair market value of the assets or services received Board of directors has the right to determine the fair value of the property Copyright © Houghton Mifflin Company. All rights reserved.

When Bradley Corporation was formed on January 1, 20xx, its attorney agreed to accept 100 shares of its $10 par value common stock for services rendered At the time the stock was issued, its market value could not be determined. For similar services, the attorney would have billed $1,500 Copyright © Houghton Mifflin Company. All rights reserved.

Two years later, Bradley Corporation exchanged 1,000 shares of $10 par value common stock for a piece of land At the time of the exchange, the stock was selling on the market for $16 per share Copyright © Houghton Mifflin Company. All rights reserved.

Discussion How is the value of stock determined when stock is issued for noncash assets? The general rule is to record the transaction at the fair market value of the stock. If the fair market value of the stock cannot be determined, then the fair market value of the assets or services received is used to record the transaction Copyright © Houghton Mifflin Company. All rights reserved.

Treasury Stock … is capital stock, either common or preferred, that has been issued and later reacquired by the issuing company and has not subsequently been resold or retired Shares are normally purchased on the market A purchase of treasury stock Reduces assets and stockholders’ equity Is not a purchase of assets Treasury stock has no rights until it is reissued Copyright © Houghton Mifflin Company. All rights reserved.

Reasons to Purchase Treasury Stock
Have stock available to distribute to employees through stock option plans Maintain a favorable market for its stock Increase earnings per share Maintain additional shares available for such activities as purchasing other companies Prevent a hostile takeover Copyright © Houghton Mifflin Company. All rights reserved.

Purchase of Treasury Stock
Sept. 15: Caprock Corporation purchases 1,000 shares of its common stock on the market for $50 per share When treasury stock is purchased, it is usually recorded at cost Copyright © Houghton Mifflin Company. All rights reserved.

Purchase of Treasury Stock (cont’d)
Balance Sheet Presentation Stockholders’ Equity Section Notice that the number of shares issued, and therefore legal capital, has not changed even though the number of shares outstanding has decreased Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Treasury Stock At Cost
Nov. 15: Caprock Corporation sells 1,000 shares of its treasury stock for $50 per share Paid-in Capital, Treasury Stock Treasury Stock, Common 50,000 50,000 –0– Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Treasury Stock Above Cost
When treasury shares are sold for an amount greater than their cost, the excess of the sales price over cost should be credited to Paid-in Capital, Treasury Stock No gain should be recorded Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Treasury Stock Above Cost (cont’d)
Nov. 15: Caprock Corporation sells 1,000 shares of its treasury stock for $60 per share Paid-in Capital, Treasury Stock Treasury Stock, Common 50,000 50,000 10,000 –0– Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Treasury Stock Below Cost
If treasury shares are sold below cost, the difference is deducted from Paid-in Capital, Treasury Stock If this accent does not exist or is insufficient to cover the excess of cost over reissue price, Retained Earnings absorbs the excess No loss is recorded Copyright © Houghton Mifflin Company. All rights reserved.

Sale of Treasury Stock Below Cost (cont’d)
Sept. 15: Caprock Corporation purchases 1,000 shares of its common stock on the market for $50 per share Paid-in Capital, Treasury Stock Treasury Stock, Common Retained Earnings 50,000 Copyright © Houghton Mifflin Company. All rights reserved.

Oct. 15: Caprock Corporation sells 400 shares of its treasury stock for $60 per share Paid-in Capital, Treasury Stock Treasury Stock, Common Retained Earnings 50,000 20,000 4,000 Copyright © Houghton Mifflin Company. All rights reserved.

Dec. 15: Caprock Corporation sells 600 shares of its treasury stock for $42 per share Paid-in Capital, Treasury Stock Treasury Stock, Common Retained Earnings 50,000 20,000 4,000 30,000 4,000 –0– –0– When treasury shares are sold below cost, the difference is deducted from Paid-in Capital, Treasury Stock In this case, the difference exceeds the balance in the Paid-in Capital, Treasury Stock account by $800 Copyright © Houghton Mifflin Company. All rights reserved.

Dec. 15: Caprock Corporation sells 600 shares of its treasury stock for $42 per share Paid-in Capital, Treasury Stock Treasury Stock, Common Retained Earnings 50,000 20,000 4,000 800 30,000 4,000 –0– –0– The excess is absorbed by the Retained Earnings account Copyright © Houghton Mifflin Company. All rights reserved.

Retirement of Treasury Stock
Treasury stock is retired when the company determines that it will not reissue stock it has purchased If acquisition price < original contributed capital Credit Paid-In Capital, Retirement of Stock If acquisition price > original contributed capital Debit Paid-In Capital, Retirement of Stock Copyright © Houghton Mifflin Company. All rights reserved.

Retirement of Treasury Stock
Nov. 15: Caprock Corporation retires the 1,000 shares of its treasury stock that was acquired for $50,000 on November 15. The $5 par value common stock was originally issued at $6 per share When shares of stock are retired, all items related to those shares are removed from the related capital accounts Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What effect does the purchase of treasury stock have on return on equity? Since treasury stock reduces equity, the return on equity will increase Copyright © Houghton Mifflin Company. All rights reserved.

Time for Review Identify and explain the management issues related to contributed capital Identify the components of stockholders’ equity Account for cash dividends Identify the characteristics of preferred stock, including the effect on distribution of dividends Copyright © Houghton Mifflin Company. All rights reserved.

Contributed Capital Chapter 14

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