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In this section we will review:
The nature of Stockholders’ Equity – The characteristics of the corporate form of organization – The types of stock a company can have (common and preferred) – The difference between issuing Equity vs. Debt
The accounting for elements of Stockholder’s
– Issuance and repurchases of shares of stock – Dividends
© 1999 by Robert F. Halsey
Corporate Form of Organization limited liability of shareholders
Unlike other forms of business organization, like sole proprietorships and partnerships, a corporation is a legal entity that is separate and distinct from its owners. That means that shareholders of the corporation have limited liability - they can only lose what they have invested in the business. If the debts of the business are greater than its assets, creditors lose; they cannot sue shareholders for the deficit.
© 1999 by Robert F. Halsey
should a company decide to pay out a portion of that profit to its shareholders as a dividend. Halsey 3 . after having earned a profit and paying tax on that profit. regardless whether that income is paid out to shareholders as dividends So.Double taxation The fact that a corporation is a separate legal entity also means that the IRS taxes it like any other taxpayer. the IRS taxes the individual shareholders on the dividends they receive. This is the concept of double taxation. © 1999 by Robert F. It is taxed on the income it earned.
Halsey 4 . © 1999 by Robert F. Stockholder’s equity also represents the resources that have been provided by the company’s owners in the form of capital contributions (purchases of stock) and earnings retained from operations.it is what is left over to the shareholders after the claims of other parties (creditors.Nature of Stockholders Equity Stockholder’s equity is a residual concept . preferred shareholders) have been satisfied.
mature in 10 years (interest paid per year = 10 * $1. • Let’s “issue” these securities -.100 shares.000. Halsey 5 . or Common Stock -. It can either sell. market value = $100 per share (assume total dividends paid = 8% or $800).10 Bonds.000 * 8% = $800). $1 par value.Equity versus Debt • Assume that a company wants to raise $10. $1000 par value. 8% coupon payable annually rate sold at 100. Bonds -.What is the result? © 1999 by Robert F.
are not required to be paid and can be discontinued in a business downturn. Halsey 6 . on the other hand. and creditors can force the company into bankruptcy if interest payments are not paid when due. Dividends.Equity Vs. © 1999 by Robert F. Debt Issue (cont’d) Although the amount of the payment ($800 per year) to the sources of funds (debt holders or stockholders) is the same in both cases. there are important differences: interest payments are a fixed contractual obligation that must be paid even if the business is not earning profits.
In sum. © 1999 by Robert F. indirectly control the corporation. shareholders bear more of the risk and receive more of the benefits of financial outcomes (downside and upside). There is another important difference between the two forms of raising capital: shareholders have a vote in the election of the company’s board of directors and. but at the same time equity-holders can exercise control (votes) with limited liability. through the board of directors. Halsey 7 . Debt holders do not have that right and exercise their share of corporate governance through bond agreements that limit the activities of the company.
Accounting for the Issuance of Common Stock Let’s look at an example to understand the accounting for the issuance of common stock: (Click here to view an example of the accounting for the issuance of common stock) © 1999 by Robert F. Halsey 8 .
448 million shares of $. No preferred stock has been sold. so not all of the authorized shares have been issued.5 million shares. Halsey 9 .10 par common for total proceeds of $880 million ($445 + $435).This is an example of the stockholder’s equity section from Wal-Mart’s balance sheet: Wal-Mart has issued 4. Wal-Mart’s board of directors has authorized its management to issue up to 5. © 1999 by Robert F.
Many of these programs are highlighted in annual reports as a mechanism to increase shareholder value. Halsey 10 .Treasury Stock Stock repurchase programs have become quite common among companies. © 1999 by Robert F. Why do companies repurchase their own stock? To increase the number of shares available for the exercise of stock options by employees or for acquisitions Increase earning per share (the denominator is reduced) To signal the market that management believes the company’s stock is under-valued.
Accounting for the repurchase of common stock Let’s take a look at an example of the accounting for the repurchase of common stock: (Click here to view an example of the accounting for stock repurchases) © 1999 by Robert F. Halsey 11 .
Here is an example of the reporting of treasury stock from Colgate-Palmolive’s annual report. Colgate-Palmolive has repurchased treasury stock with a cumulative cost of $2. © 1999 by Robert F. Halsey 12 .3 billion. Its stockholder’s equity has been reduced by this amount.
The shares have a preference as to assets in liquidation. Halsey 13 . The shares have a preference as to dividends. preferred shareholders will be paid before common shareholders. This means that preferred shareholders receive all of the dividends to which they are entitled before common shareholders are paid. 10 © 1999 by Robert F. If the company becomes insolvent and the assets are liquidated.Preferred Stock What makes preferred stock preferred? Preferred shares have certain “preferences” with respect to common stock.
The shares may be callable at the option of the company to force conversion of the shares into common stock or the shareholders may be able to convert the preferred shares into common at their option.Preferred stock is a “contract” It is important to understand that preferred shares are sold pursuant to a contract between the company and the purchasers of the shares. Halsey 14 . © 1999 by Robert F. The preferred share may have a cumulative dividends preference. plus current preferred dividends. meaning if the required dividends are not paid in any year. For example. Any terms that are agreeable to both parties can be inserted into that contract. these “dividends in arrears” must be paid. before common shareholders are paid The preferred share may have a redemption provision that required the company to repurchase a portion of the shares each year.
are not tax deductible by the company as opposed to interest payments on debt. Halsey .Preferred Stock Vs.click here to see an example ). Like debt. 15 © 1999 by Robert F. Debt Preferred stock has features of both debt and equity: Preferred shareholders receive a yield similar to the interest in debt (the yield is fixed. its dividends are paid before common’s) However. the payments to preferred are avoidable in the event of a business downturn and there is no maturity for repayment of principle (other than for redeemable preferred). and preferred shareholders do not receive additional dividends if the company performs well). Preferred stock is generally accounted for and reported as part of stockholder’s equity (redeemable preferred is reported between liabilities and stockholder’s equity to reflect its debt -like character . like common. however. it is not completely residual (similar to interest paid to bondholders. The preferred dividends.
it must make up the amount due before common shareholders are paid a dividend.50 in dividends per year.5% yield. or a 4.673 million shares of no par cumulative preferred stock for $100 per share.Here is an example of the reporting of preferred stock from DuPont’s annual report: DuPont has sold 1. Halsey 16 . Cumulative means that if the company does not pay dividends on the stock in a year. © 1999 by Robert F. Each share pays $4.
Note that the company does not have to pay dividends. therefore. dividends paid in cash. No liability is.Dividends Dividends are declared by the board of directors (who are elected by the shareholders). and stock dividends. Halsey 17 . reflected in the company’s balance sheet for the payment of dividends until the board of directors declares that a dividends should be paid. The two most common types of dividends are cash dividends. © 1999 by Robert F. dividends paid by issuing additional shares of stock to the shareholder.
000 in cash to its shareholders as a dividend. The required journal entry is as follows: Retained earnings 50. that is. most states permit the payment of dividends as long as the company is solvent.From a legal standpoint. assume a company pays out $50. Halsey 50. able to pay its debts.000 18 . As a result. the basic accounting entry to records the payment of dividends debits retained earnings. For example.000 Cash © 1999 by Robert F. From an accounting standpoint dividends are paid out of the retained profits of the corporation.
Stock Dividends With a stock dividend -. Halsey 19 .from retained earnings to contributed capital. rather a reclassification takes place within owners’ equity -.no assets are distributed. More share are outstanding but each share is worth less. © 1999 by Robert F. Proportional ownership interest does not change.
Halsey 20 .Accounting for Stock Dividends Let’s take a look at the accounting for stock dividends: (Click here to view an example of the accounting for stock dividends) © 1999 by Robert F.
The percentage of the company that they own. From an accounting standpoint. The number of shares outstanding is increased and the par value adjusted to reflect the additional shares issued. For example. each shareholder receives 1 additional share for each share held. 21 © 1999 by Robert F. no journal entries are required since a transaction has not taken place. both before and after the stock split. Halsey . if a company declares a 2 for 1 stock split. is the same since each shareholder receives the same proportionate increase in the number of shares owned.Stock Splits Companies frequently declare stock splits and distribute additional shares to shareholders in proportion to the number of shares previously held.
in 1996. For example.In recent years. Sun Microsystems declared a 2 for 1 stock split in the form of a 100% stock dividend. stock splits are more commonly accomplished in the form of a stock dividend. Halsey 22 . The notes to its annual report describe this transaction: © 1999 by Robert F.
© 1999 by Robert F. Notice that the par value of the shares issues was transferred form retained earnings to common stock.This is how the stock dividend affected stockholder’s equity. Additional paid-incapital was not effected since the par value was used. Halsey 23 .
Halsey 24 .The End © 1999 by Robert F.
Halsey 25 .Here is an example of redeemable preferred stock from VF Corp’s annual report: © 1999 by Robert F.