1. 1 Chapter 9 Stockholders’ Equity

2. 2 Learning Objective 1 Explain the advantages and disadvantages of a corporation.

3. 3 Characteristics of a Corporation  Separate legal entity  Continuous life and transferability of ownership  Limited liability for shareholders—limited to their investment  Separation of ownership and management  Corporations, unlike other businesses, are separate taxable entities  Government regulation

4. 4 Advantages of a Corporation 1.Can raise more capital than a proprietorship or partnership can 2.Continuous life 3.Ease of transferring ownership 4.Limited liability of stockholders

5. 5 Disadvantages of a Corporation 1. Separation of ownership and management Tyco CEO allegedly looted the company Tyco CEO allegedly looted the company Enron special purpose entitites [SPE’s] abuses Enron special purpose entitites [SPE’s] abuses 2. Corporate taxation: Double taxation Double taxation Franchise taxes to remain incorporated Franchise taxes to remain incorporated 3. Government regulation: State regulation State regulation Federal legislation for public corporations Federal legislation for public corporations

6. 6 Stockholders Board of Directors Chairperson of the Board President Authority Structure of a Corporation

7. 7 Vote Dividends Liquidation Preemption Stockholders’ Rights

8. 8 Stockholders’ Equity Two main components: 1.Paid-in capital (contributed capital) 2.Retained earnings

9. 9 Capital Stock  Authorized number of shares is limited by corporate charter  Outstanding shares are those which have been sold

10. 10 Capital Stock Common Stock Most basic form of capital stock - issued by every corporation Preferred Stock Has several preferences over common stock

11. 11 Capital Stock Par Value Stock An arbitrary amount assigned to a share of stock Does not have par value, but may have stated value No-par Stock

12. 12 Learning Objective 2 Measure the effect of issuing stock on a company’s financial position.

13. Common Stock at Par Jan 8Cash (6,200 x $10)62,000 Common Stock62,000 To record issuance of stock Suppose IHOP’s common stock has a par value of $10 per share. The company issues 6,200 shares of common stock at par. What is the entry? ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

14. Common Stock at Par Jul 23Cash (6,200 x $10)62,000 Common Stock62 Paid-in Capital in Excess of Par61,938 To record issuance of stock Suppose IHOP’s common stock has a par value of $0.01 per share. The company issues 6,200 shares of common stock for $10 per share. What is the entry? ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

15. Common Stock Above Par Common Stock, $.01 par; 40,000 shares authorized, 6,200 shares issued$ 62 Paid-in capital in excess of par 61,938 Total paid-in capital$ 62,000 Retained earnings 194,000 Total stockholders’ equity$256,000 Stockholders’ Equity ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

16. Common Stock at Par Suppose IHOP’s common stock is no par value stock. The company issues 6,200 shares of common stock for $20 per share. What is the entry? Jul 23Cash (6,200 x $10)124,000 Common Stock124,000 To record issuance of stock ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

17. 17 Preferred Stock  Accounting for preferred stock follows the pattern illustrated for common stock.

18. 18 Learning Objective 3 Describe how treasury stock transactions affect a company.

19. 19 Treasury Stock Transactions  Shares that a company has issued and later reacquired.  Reasons –Stock purchase (options) plan distribution –Increase net assets by later selling stock again at a higher price –Avoidance of a takeover by precluding a hostile outside controlling interest

20. 20 IHOP Corp. Before Purchase of Treasury Stock Common Stock$ 203 Paid-in capital in excess of par69,655 Retained earnings 193,632 Total equity$263,490 Stockholder’s Equity at December 31, 2005 (if no treasury stock purchased)

21. IHOP Corp. Purchase of Treasury Stock During 2005, IHOP paid $5,170 to purchase 288 shares of its common stock as treasury stock. Nov 1Treasury Stock5,170 Cash5,170 Purchased treasury stock ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

22. IHOP Corp. After Purchase of Treasury Stock Common Stock$ 203 Paid-in capital in excess of par69,655 Retained earnings193,632 Less: Treasury stock (288 shares at cost) (5,170) Total equity$258,320 Stockholder’s Equity at December 31, 2005 (with treasury stock purchased) ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

23. Sale of Treasury Stock Assume that on July 22, 2006, the shares of treasury stock are sold for $5,300. Jul 22Cash5,300 Treasury Stock5,170 Paid-in Capital from Treasury Stock Transactions130 Sold treasury stock ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

24. IHOP Corp. After Sale of Treasury Stock Common Stock$ 203 Paid-in capital in excess of par69,785 Retained earnings 193,632 Total equity$263,620 Equity before purchase of treasury stocks 263,490 Increase in stockholders’ equity$ 130 Stockholder’s Equity at December 31, 2006 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

25. 25 A Company Cannot Have a Gain or Profit in Dealing in it’s Own Capital Stock  Note the credit for proceeds above cost of the treasury stock sold was additional paid in capital  Not a gain or profit

26. 26 Retirement of Stock  Decreases the outstanding stock of the corporation  Retired shares cannot be reissued  There is no gain or loss on retirement

27. 27 Retained Earnings Account Balance = Net income less -Net losses -Dividends declared

28. 28 Dividends and Splits  Dividend - corporation’s return to its stockholders of some of the benefits of earnings  Stock split - increase in the number of authorized, issued, and outstanding shares; decrease in par value

29. 29 Dividend Dates  Declaration date: –board authorizes dividend –Once declared, dividend becomes a legal liability  Date of record: –A stock goes “ex-dividend” on this date, i.e… –Secondary market purchaser does not get the declared dividend after this date  Payment date

30. 30 Learning Objective 4 Account for dividends and measure their impact on a company.

31. Preferred Stock Dividends Pinecraft Industries, Inc., has both common stock and 100,000 shares of preferred stock outstanding. Preferred dividends are paid at the annual rate of $1.50 per share. In 20x9, the company declares an annual dividend of $1,000,000. Preferred dividend (100,000 × $1.50 per share) $150,000 Common dividend (remainder: $1,000,000 – $150,000) 850,000 Total dividend$1,000,000 ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

32. Preferred Stock Dividends The preferred stock of Pinecraft is cumulative. Suppose the company passed the 20x6 preferred dividend of $150,000. In 20x7, the company declares a $500,000 dividend. Retained Earnings500,000 Dividends Payable-Preferred300,000* Dividends Payable-Common200,000 Declared a cash dividend *$150,000 x 2 years ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

33. 33 Stock Dividends  Small stock dividends: 25% or less  Large stock dividends: above 25%

34. 34 Stock Dividend IHOP declared a 10% stock dividend in 2006. Assume IHOP had 20,000,000 shares of common stock outstanding. The stock is trading for $15 per share. How would this stock dividend be recorded?

35. Stock Dividend For a large stock dividend, debit Retained Earnings and credit Common Stock for the par value of the shares. Retained Earnings (20,000,000 X 10% X $15 mkt value)30,000 Common Stock (20,000,000 X 10% X $0.01) 20 Paid-in Capital in Excess of Par Common29,980 Distributed a 10% stock dividend ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

36. 36 Stock Splits  Increases number of authorized, issued, and outstanding shares of stock  Proportionate reduction in stock’s par value  Decrease of market price is the usual motivation for a stock split  Stockholder receiving has more shares, but the total shares would be worth no more in the market than before the split, ceteris paribus

37. 37 Stock Splits  The market price of a share of Quaker Oats has been approximately $25. Assume that the company wants to decrease it to $12.50. This 2- for-1 split means that the company would have twice as many shares outstanding after the split as is had before the split.  No accounting entries are made, except: –Par value is changed –Number of shares authorized changes –Number of issued shares changes –(Total stockholder’s equity does not change)

38. 38 Learning Objective 5 Use different stock values in decision making.

39. 39 Stock Values  Market value: most relevant measure  Redemption value: –amount issuer must pay to retire the preferred shares, if redeemable –Are redeemable preferreds, in substance, debt or equity?  Liquidation value: what must be paid a preferred holder in liquidation, if adequate cash is available after creditors paid  Book value

40. 40 Book Value Per Share  Preferred stock equity = (Redemption value + Any Dividends in arrears) (Redemption value + Any Dividends in arrears)  Common stock = (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding

41. Book Value Preferred stock, 6%, $100 par, 5,000 shares authorized, 400 shares issued, redemption value $130 per share$ 40,000 Additional paid-in capital in excess of par – preferred 4,000 Common stock, $10 par, 20,000 shares authorized, 5,500 shares issued55,000 Additional paid-in capital in excess of par – common [note separated from P.S. addtl cap.]72,000 Retained earnings85,000 Treasury stock – common, 500 shares at cost ( 15,000) Total stockholders’ equity$241,000 Stockholders’ Equity ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

42. 42 Book Value Suppose that four years’ (including the current year) cumulative preferred dividends are in arrears and that preferred stock has a redemption value of $130 per share.

43. Book Value Preferred equity: Redemption value (400 shares × 130)$ 52,000 Cumulative dividends ($40,000 × $0.06 × 4 yrs) 9,600 Preferred equity$ 61,600 Common equity: Total stockholders’ equity$241,000 Less preferred equity – 61,600 Common equity$179,400 Book value per share: $179,400 ÷ 5,000 shares* $ 35.88 *5,500 shares issued minus 500 treasury shares ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

44. 44 Learning Objective 6 Evaluate a company’s return on assets and return on stockholders’ equity.

45. 45 Rate of Return on Total Assets (Net income + Interest expense) ÷ Average total assets Measure of a company’s ability to generate profits from the use of its assets. (10% or more is considered strong)

46. 46 Return on Equity Rate of return on common stockholders’ equity = (Net income – Preferred dividends) ÷ Average common stockholders’ equity Measure of income earned from common stockholders’ investment in the company. (15% or more is strong)

47. 47 Learning Objective 7 Report stockholders’ equity transactions on the statement of cash flows.

48. Reporting Stockholders’ Equity Transactions Proceeds from issuance of common stock$172,000 Purchase of treasury stock (5,170,000) Net cash used by financing activities$(4,998,000) During 2003, IHOP issued stock, repurchased stock, but paid no dividends. Cash flows from financing activities: ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren