Learning Objectives (LO

)
After studying this chapter, you should be able to

Stockholders’ Equity

CHAPTER

10

1. Describe the rights of shareholders 2. Account for common stock, including payment of dividends 3. Contrast bonds, preferred stock, and common stock 4. Identify the economic characteristics of and accounting for stock splits 5. Account for both large- and small-percentage stock dividends 6. Explain and report stock repurchases and other treasury stock transactions
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Introduction to Financial Accounting, 10/e

© 2010 Pearson Education Inc. Publishing as Prentice Hall © 2006 Prentice Hall Business Publishing 2006 Prentice Hall Business Publishing Introduction to Financial Introduction to 9/e Introduction Introduction to Financial Accounting, 9/e Financial Accounting, Financial Accounting, 10/e Horngren/Sundem/Elliott/Philbrick Horngren/Sundem/Elliott/Philbrick

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Learning Objectives (LO)
After studying this chapter, you should be able to
7. Record conversion of debt for equity or of preferred stock into common stock 8. Use the rate of return on common equity and book value per share

LO 1 – Shareholder Rights
• Stockholders are residual claimants to the corporation. • They benefit the most when the company performs well, but they are the first to suffer when things go badly. • They have certain rights:
– Vote – Share in corporate profits (dividends) – Share in any assets left at liquidation (after paying of claims by debt holders) – Preemptive rights – acquire more shares of subsequent issues of stock so that ownership proportions are maintained – Limited liability (creditors have claims only on the corporation’s assets; stockholders’ personal assets are not at risk)

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LO 2 – Common Stock
• Articles of incorporation, the founding document of the corporation, defines the number and the type of the capital stock it can issue at the time of incorporation. • Authorized shares – total number of shares that may be issued • Issued shares – shares sold to stockholders • Outstanding shares – number of shares issued and held by the stockholders • Treasury stocks – shares reacquired by the company by purchasing them from shareholders. These shares are issued but not outstanding • Par Value – stated value of the stock; originally meant to serve as legal protection for the creditors, as it established the minimum legal liability of a stockholder
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LO 2 – Common Stock
• Issue common stock
– Par value = $.01 – Issue 1M shares, each share is bought for $50 Cash 50,000,000 Common stock at par 10,000 Additional paid-in capital * 49,990,000

• Amount above par value. If state does not require usage of par value, credit the common stock account for $50 million

• Issue preferred stock – Same as above only change the account names
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LO 2 – Common Stock
• Dividends – proportional distributions of income to shareholders, usually in the form of cash. • Dividends are not automatic; they must be approved by the board of directors. • Declaration date – the date on which the board formally announces that it will pay a dividend. • Date of record – a future date specified by the board on which stockholders will receive the dividend . • Payment day – the day when checks are mailed; it follows the date of record by a few days or weeks.

LO 2 – Common Stock
• The journal entries are:
Retained Earnings 20,000 Dividends Payable 20,000 To record the declaration of dividends Date of record – no entry Dividends Payable Cash To pay dividends declared 20,000 20,000

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LO 2 – Common Stock
• Elimination or initiation of dividends build expectation with the stockholders. • Dividend distribution decisions are based on:
– – – – – Market expectations, The current and predicted earnings, The corporation’s current cash position, Plans on reinvesting into plant assets and growth Repayments of debt.

LO 3 – Preferred Stock
• Preferred stock – offers owners different rights and preferential treatment.
– Right to receive cash dividend each year – Right to dividend takes precedent over that of common stockholders

• To pay cash dividends a corporation must have:
– Cash (uncommitted to current/future needs) – Retained earnings (state laws often limit the amount of dividends payable to the amount of unrestricted retained earnings) – Bond covenants that allow dividends
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• Cumulative preferred stock – undeclared dividends accumulate and must be paid before common stockholders can receive any dividends or liquidation proceeds. • Liquidating value – the amount a company must pay to the preferred stockholder upon liquidation, in addition to dividends in arrears, before it pays anything to the common stockholders.
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LO 3 – Preferred Stock
• Participating preferred stock – receive a minimum dividend payment but also receives higher dividends when the company has a good year • Callable preferred stock – gives the company the right to redeem the stock at a certain call price • Convertible preferred stock – gives the owner the option to exchange preferred for common shares (benefit to the holder, if common stock prices go up)

LO 3 – Preferred Stock
• Stock Options - rights granted by the company to buy a specified number of shares at a specific price for a specific period of time. • Incentive for the employees to perform well and to stay with the company till the stock option becomes vested. • Employees can exercise their right to purchase the vested stock option at the specified price until the expiration of the stock option. • Stock options are a form of compensation, in addition to the regular salary, and should be treated as an expense under both U.S. GAAP and IFRS.

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LO 4 - Stock Splits
• Stock split – issuance of additional shares to existing shareholders without any additional cash payments. A two-for-one split is the issuance of one additional share for each outstanding share with a corresponding adjustment to the par value. • Stock dividends – issuances of additional shares to existing shareholders without additional cash payments, but the number of new shares is usually smaller than in a split, and the original par value is typically retained. • Splits allow the company to maintain the stock price in the trading range accessible to small investors and company’s employees (under $100).

LO 6 - Repurchase of Shares
• Companies repurchase shares because they:
– Want to retire the stock (reduce shareholder claims permanently) – Want to hold shares temporarily for later use

• Motivations behind purchasing own stock:
– Stock may be undervalued by the market – Need shares to distribute in a stock option plan – Company has excessive cash that cannot be consumed in growth projects – Want to return cash to shareholders without creating expectations for permanent increases in dividends – Want to change EPS performance
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LO 6 - Repurchase of Shares
• Retire
– Originally issued the shares at $50 per share – Purchase 5,000 shares ($10 par value) at $150 for a total of $750,000 cash. Common stock (5,000 × $10) 50,000 Additional paid-in capital (5,000 × $40) 200,000 Retained earnings (difference) 500,000 Cash (5,000 × $150) 750,000

LO 6 - Treasury Stock
• Treasury Stock – buy back for subsequent reissue
– Need shares for employee stock options or bonuses Treasury stock (5,000 shares × $150) 750,000 Cash 750,000 – Treasury stock is a contra account to the Owner’s Equity account. – Shares are not entitled to vote or receive dividends

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LO 6 - Treasury Stock
• At the resale of treasury stock at a price higher than the price of purchase, the journal entries are: Cash Treasury Stock Additional Paid-In Capital 1,000,000 750,000 250,000

LO 8 - Stockholders’ Equity Ratios
• Return on (common) Equity (ROE) measures a company’s profitability based on the common stockholders’ investment ROE = Net income – Preferred dividends Average common equity *
* Beginning owners ’ equity Less beginning preferred equity + Ending owners ’ equity Less ending preferred equity
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Introduction to Financial Accounting, 10/e

• At the resale of treasury stock at a price lower than the price of purchase, the journal entries are: Cash Additional Paid-In Capital Treasury Stock 500,000 250,000 750,000

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LO 8 - Stockholders’ Equity Ratios
Book value per share = Total stockholders’ equity of common stock – Book value of preferred stock Average common equity

• Market value per share – daily quoted price
Book value to = Market value per share common Market value Book value per share of common – A market value well above the book value may indicate unrecorded or appreciated assets such as R&D, patents developed in house, etc. – Or overpricing in the market
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