Chapter 10 Stockholders Equity

L10 1
IDENTIFY THE ADVANTAGES AND DISADVANTAGES OF THE CORPORATE FORM OF OWNERSHIP

Section Topics:

Stages of Equity Financing

Stockholder rights
Advantages and Disadvantages of corporate ownership

Equity Financing
Review the basic accounting equation:
ASSETS

LIABILITIES

Stockholders Equity

Assets are resources that the company owns. These assets are financed either by liabilities or
stockholders equity. Liabilities represent creditors claims to the assets, and equity represents the
owners residual claim to those assets.
Stockholders Equity is comprised of paid-in capital, retained earnings, and treasury stock.
Paid-in Capital: The amount stockholders have invested in the company.
Retained Earnings: Cumulative amount of net income earned over the life of the company that
has not been distributed to stockholders as dividends.
Treasury Stock: A corporation's own stock that it has reacquired.
Different Types of Companies:

Sole Proprietorship
Partnership
Corporation

Corporations
A Corporation is: an entity that is legally separate from its owners and even pays its own incomes taxes.
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Most corporations are owned entirely by one individual

Owners of a corporation are the stockholders
Some corporations are owned entirely by one individual
Dominate in terms of total sales, assets, earnings, and employees
Not as common as Sole proprietorships

Articles of incorporation: Describes the nature of the firm's business activities, the shares to be issued,
and the composition of the initial board of directors.
Organization Chart: Traces the line of authority for a typical corporation.

Stages of Equity Financing

Initial stages before a company become public:
1.
2.
3.
4.
5.
6.

Raise money
Sell stock to founders of business
Sell stock to founders family members and friends
Outside investments from angel investors and venture capital firms.
IPO, initial public offering
SEO, seasoned equity offerings

Angel Investors: Wealthy individuals in the business community willing to risk investment funds on a
promising business venture.
Venture Capital Firms: Provide additional financing, often in the millions, for a percentage ownership in
the company.

Public or Private
Initial Public Offering: The first time a corporation issues stock to the public.
Publicly Held Corporation: Allows investment by the general public and is regulated by the Securities
and Exchange Commission.
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All publicly held corporations are regulated by the Securities and Exchange Commission, or
the SEC
Trades on the NYSE or on the NASDAQ

Privately Held Corporation: Does not allow investment by the general public and normally has fewer
stockholders.
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Does not need to file financial statements with the SEC

Most companies begin as a privately held corporation before going public.

Stockholder Rights
Stockholders are the owners of a corporation and have certain rights.
Rights of a stockholder:
1.
2.
3.
4.
5.

Right to vote
Elect board of directors
Right to receive dividends
Share in distribution of assets if company is dissolved
Percentage of shares owned determines share of assets and distribution of dividends

Dividends: Cash payments to stockholders.

Advantages VS Disadvantages of a Corporation

Advantages
Two primary advantages:
1. Limited Liability
2. Ability to raise capital and transfer ownership
Limited Liability: Stockholders in a corporation can lose no more than the amount they invested in the
company.
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Even in the event of bankruptcy

Ownership rights are easily transferred through shares of stock
Investors can sell their ownership interest or shares of stock at any time and without
affecting the structure of the corporation or its operation

Sole Proprietorships and Partnerships

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Can be held accountable for more than their initial investment

Ownership not as easily transferred
Changing ownership does affect the structure and operations of the company

Disadvantages
Two primary disadvantages:
1. Additional taxes
2. More paperwork
Corporations
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Have double taxation: A corporation pays income taxes on its earnings, and when dividends
are distributed to stockholders, the stockholders pay taxes a second time on the corporate
dividends they receive.
Paper work, extensive reporting requirements

L10 2
RECORD THE ISSUANCE OF COMMON STOCK
Stockholders = true owners
Authorized stock: The total number of shares available to sell, stated in the company's articles of
incorporation.
Issued stock: The number of shares sold to investors; includes treasury shares.
Outstanding stock: The number of shares held by investors; excludes treasury shares.
Treasury stock: A corporation's own stock that it has reacquired.
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included as part of shares issued, but excluded from shares outstanding.

Par Value: The legal capital assigned per share of stock.

No-par value stock: Common stock that has not been assigned a par value.
Stated value: The legal capital assigned per share to no-par stock.
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Stated value is treated and recorded in the same manner as par value.

Additional Paid-in Capital: The portion of the cash proceeds above par value.

Recording no-par value stock issuance
Date MM/DD/YYYY

Debit

Credit

$50,000

$50,000

Debit

Credit

Cash (=1000 share x $50)

Common Stock (=1000 shares x $1)

Additional Paid-in Capital (difference)
(Issue no-par value common stock)

$50,000

$1,000
$49,000

Cash (=1000 x $50 per share)

Common Stock


(Issue no-par value common stock)

Recording par value (or stated value) stock issuance

Date MM/DD/YYYY

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For accounting purposes, stated value is treated in the same manner as par value
Record same entry as in par value example

L10 3
CONTRAST PREFERRED STOCK WITH COMMON STOCK AND BONDS PAYABLE
Preferred Stock: preferred over common stock.
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Preferred stock holders usually have first rights to a specified amount of dividends.
The dividends are a stated dollar amount per share or a percentage of par value per share
If board agrees, preferred shareholders will receive the designated dividend before common
shareholders receive any
Preferred stockholders receive preference over common stockholders in the distribution of
assets
No voting rights
Mix between common stock and a bond

Features of preferred stock:

Convertible: Shares can be exchanged for common stock. Also, a bond feature that allows the
lender (or investor) to convert each bond into a specified number of shares of common stock.
Redeemable: Shares can be returned to the corporation at a fixed price.
Cumulative: Shares receive priority for future dividends, if dividends are not paid in a given year.
(Dividends in arrears: Unpaid dividends on cumulative preferred stock.)
Stock Dividends: Additional shares of a company's own stock given to stockholders.

Accounting for Preferred Stock Issues
Date MM/DD/YYYY

Debit

Credit

Cash (=1,000 shares x $120)

Preferred Stock (=1,000 shares x $100)
Additional Paid-in Capital (difference)
(Issue preferred stock above par)

$120,000

$100,000
$20,000

Determine Preferred or Common stock payout:
Preferred Distribution = Issued Stock x Par Value x rate x period
(eg. 10,000 shares x $100 par value x 10% x 2 years = $200,000)
Common stock distribution = Declared Divided Preferred Distribution
(eg. $250,000 declared divided - $200,000 = $50,000 common stock distribution)
Note: common stock is considered a risky investment because they are the last to receive distribution in
the event a company is dissolved

L10 4
ACCOUNT FOR TREASURY STOCK
Treasury Stock
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Treasury stock is the name given to a corporation's own stock that it has reacquired
Buying back shares decreases stock holder equity
Recorded in Contra account
Treasury stock account have a normal DEBIT balance
Increases with a DEBIT and decreases with a CREDIT

Recording Repurchase of Treasury Stock
Date MM/DD/YYYY

Treasury Stock (= 100 shares x $50)

Cash


(Repurchases treasury stock)
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Debit

Credit

$5,000

$5,000

Stocks par value has no effect on the entry to record treasury stock
Treasury stock is recorded at its cost

Reissuing Treasury Stock
Date MM/DD/YYYY

Debit

Credit

$6,000

$5,000
$1,000

Debit

Credit

Cash (= 100 shares x $40)

Additional Paid-in Capital (= 100 shares x $10)

Treasury Stock (= 100 shares x $50)


(Reissue treasury stock below cost)

$4,000
$1,000

$5,000

Cash (= 100 shares x $60)

Treasury Stock (= 100 shares x $50)
Additional Paid-in Capital (=100 shares x $10)
(Reissue treasury stock above cost)

Reissuing Treasury Stock (Below Cost)
Date MM/DD/YYYY

L10 5
DESCRIBE RETAINED EARNINGS AND RECORD CASH DIVIDENDS
Retained earnings
Retained earnings represents the earnings retained in the corporationearnings not paid out to
stockholders as dividends.
Retained Earnings = Net income dividends
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has a normal CREDIT balance

Accumulated Deficit: A debit balance in Retained Earnings

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Stockholders Equity = Total Paid-in Capital Accumulated Deficit

Dividends
Dividends are distributions by a corporation to its stockholders.
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an increase in dividends is often perceived as good news

Declaration Date: The day on which the board of directors declares the cash dividend to be paid.
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binding legal obligation for the company declaring the dividend

Dividends is a temporary account that is closed into Retained Earnings at the end of each
period, and increases the liability account, Dividends Payable

Record Date: A specific date on which the company will determine the registered owners of stock
and, therefore, who will receive the dividend.
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Investors who own stock on the date of record are entitled to receive the dividend.

Payment Date: The date of the actual cash distribution of dividends.

Property Dividend: The distribution of a noncash asset to stockholders.
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Securities held as investments are the assets most often distributed in a property dividend.

Note: The net effect of a dividend declaration and payment results in a reduction in both stockholders
equity and assets.

Record Distribution of Dividend

Date of Declaration:
Declaration of Cash Dividends
Date MM/DD/YYYY (Declaration date)

Debit

Credit

Dividends (= 100 shares x $10)

Dividends Payable


(Declare cash dividends)

$1,000

$1,000

Debit

Credit

$1,000

$1,000

Date of Record:
No entry required

Date of Payment:
Declaration of Cash Dividends
Date MM/DD/YYYY (Payment date)
Dividends Payable



Cash



(Pay cash as dividends)

L10 6
EVALUATE COMPANY PERFORMANCE USING INFORMATION ON STOCKHOLDERS EQUITY
Equity Analysis
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Key to companys long-run survival

Evaluate the comparison of earnings vs. size of the investment

Return on Equity: Net income divided by average stockholders' equity; measures the income generated
per dollar of equity.
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measures the ability of company management to generate earnings from the resources that
owners provide

Net Income
ROE =

Average Stockholders Equity








Net Income
Return on Market Value of Equity =
Market Value of Equity

Earnings per share: Measures the net income earned per share of common stock.
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Earnings per share = Net Income Dividends on preferred stock

Average shares of common stock outstanding

The upper half of the fraction measures the income
available to common stockholders

Common stockholders are the true owners
useful in comparing earnings performance for the same company over time
Analysts also forecast earnings on a per share basis
Company stock prices usually decline if reported earnings fall short of analysts forecasts

Price-earnings Ratio: Compares a company's share price with its earnings per share
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indicates how the stock is trading in relation to its current earnings

Stock Price
PE =
Earnings Per Share

Makes it so both stock
price and earnings are expressed on a per share basis
high PE ratio indicates that the market has high hopes for a company's stock and has bid up
the price

Growth Stocks:
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Their stock prices are high in relation to current earnings because investors expect future
earnings to be higher

Value Stocks:
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Stocks that have high expectations of future earnings growth and therefore usually
trade at higher PE ratios.

Stocks that tend to have lower price-earnings ratios and are priced low in relation to
current earnings.

may be justified due to poor future prospects

May suggest an underpriced sleeper stock