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©2006 Prentice Hall, Inc.

 REPORTING &
UNDERSTANDING
SHAREHOLDERS’ EQUITY (1 of 2)
 Learning objectives
 Contributed capital
 Cash dividends
 Treasury stock
 Stock dividends and stock splits

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©2006 Prentice Hall, Inc.
 REPORTING &
UNDERSTANDING
SHAREHOLDERS’ EQUITY (2 of 2)
 Retained earnings
 Financial statement analysis
 Business risk, control, and ethics

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©2006 Prentice Hall, Inc.
 Learning Objectives
(1 of 3)

 Explain how a company finances its

business with equity
 Account for the payment of cash
dividends and calculate the allocation of
dividends between common and preferred
shareholders

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©2006 Prentice Hall, Inc.
 Learning Objectives
(2 of 3)

 Define treasury stock, explain why a

company would purchase treasury stock,
and account for its purchase
 Explain stock dividends and stock splits
 Define retained earnings and account for
its increases and decreases

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©2006 Prentice Hall, Inc.
 Learning Objectives
(3 of 3)

 Compute return on equity and earnings

per share, and explain what these ratios
mean
 Recognize the business risks associated
with equity and the related controls

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©2006 Prentice Hall, Inc.
 Contributed Capital
 Three general forms of business
Sole proprietorships
Partnerships
Corporations
 Stock—authorized, issued, & outstanding
 Common stock
 Preferred stock
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©2006 Prentice Hall, Inc.
 Stock—Authorized Issued and
Outstanding (1 of 2)
 Authorized shares
Maximum # of shares of stock a corp is
authorized to offer to the public
Specified in the corporate charter
 Issues shares
Shares of stock that have been offered and
sold to shareholders
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©2006 Prentice Hall, Inc.
 Stock—Authorized Issued and
Outstanding (2 of 2)
 Outstanding shares
Issuedshares of stock owned by
shareholders rather than the corp
Treasury stock
Stock that a corp buys back from shareholders
Outstanding shares = shares issued less
treasury stock
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©2006 Prentice Hall, Inc.
 Common Stock
(1 of 3)

 Owners’ rights
Vote for board of directors
Share in pro rata portion of corp profits
Dividends
Share in assets in bankruptcy after creditors and
preferred shareholders
Right to acquire more shares when corp issues
new shares
Pre-emptive right
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©2006 Prentice Hall, Inc.
 Common Stock
(2 of 3)

 Par value
Arbitrary amount, usually small, and has no
real meaning in today’s business environment
Not required by most states
Excess of stock issue proceeds above par
value increases Additional Paid-in Capital
account

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©2006 Prentice Hall, Inc.
 Common Stock
(3 of 3)

 Caffinators Coffee issued 500 shares of $1 par value stock for $8

per share

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

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©2006 Prentice Hall, Inc.
 Preferred Stock
 Owners receive dividends before
common shareholders
 Priority claim on assets over common
shareholders in bankruptcy
 Usually do not have voting rights

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©2006 Prentice Hall, Inc.
 Cash Dividends
 Distributions of earnings to owners
 Board of directors decide amount and
dates of dividend distributions
 Important dividend-related dates
 Distribution of dividends between com
mon and preferred shareholders
 Dividend payment example
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©2006 Prentice Hall, Inc.
 Important Dividend-related Dates
(1 of 2)

 Declaration date
Date Board of directors decides it will pay
a dividend
Legal obligation to pay dividends is
created, giving rise to Dividends Payable
and increases Dividends (contra-equity)

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©2006 Prentice Hall, Inc.
 Important Dividend-related Dates
(2 of 2)

 Date of record
All shareholders on date of record entitled to
receive dividends
Purchaser of stock after this date will not receive
the dividend declared
 Payment date
Datedividend actually paid,
Decreases cash and Dividends Payable
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©2006 Prentice Hall, Inc.
 Distribution of Dividends Between
Common & Preferred Shareholders
 Cumulative preferred stock
Shareholders must receive any past, unpaid
dividends (dividends in arrears) before a
company can pay current dividends to common
shareholders
 Noncumulative preferred stock
Past, unpaid dividends do not accumulate to
preferred shareholders
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©2006 Prentice Hall, Inc.
 Dividend Payment Example
(1 of 6)

 Caffinators Coffee (CC) has the following

stock outstanding on 1/1/2008
100 shares of 8% 100 par, cumulative
preferred stock
20,000 shares of $1/share common stock
CC has not paid a dividend since 2005

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©2006 Prentice Hall, Inc.
 Dividend Payment Example
(2 of 6)

 On 10/31/08 CC declared $5,000 annual

dividends to be paid 11/15/08 to shareholders of
record on 10/15/08
 Annual dividend for preferred shareholders
100 shares x 8% x $100 = $800
 Total dividends payable to preferred shareholders
3 years (2006-2008) x $800 = $2,400
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©2006 Prentice Hall, Inc.
 Dividend Payment Example
(3 of 6)

 Dividends payable to common

shareholders
$5,000 - $2,400 = $2,600
Dividend per share
$2,600/20,000 shares = $0.13/share

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©2006 Prentice Hall, Inc.
 Dividend Payment Example
(4 of 6)

 Record the dividend declaration

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

10/31/08

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©2006 Prentice Hall, Inc.
 Dividend Payment Example
(5 of 6)

 Record the dividend payment

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

11/15/08

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©2006 Prentice Hall, Inc.
 Dividend Payment Example
(6 of 6)

 Assume the pref stock is noncumulative?

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

10/31/08

11/15/08

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©2006 Prentice Hall, Inc.
 Treasury Stock
 Stock a company purchases on the open
market
 Why firms buy their own stock
 Accounting for treasury stock purchase
 Selling treasury stock
 Reporting treasury stock

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©2006 Prentice Hall, Inc.
 Why Firms Buy Their Own Stock
(1 of 3)

 Have stock to distribute to employees for

compensation plans
 Use excess cash to increase shareholder
wealth
To return cash to the shareholders if they choose
to sell shares to the firm
More flexible for firm and shareholders than paying
cash dividends
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 Why Firms Buy Their Own Stock
(2 of 3)

 Reduce equity
Treasury stock is contra-equity account
 Increase the company’s earnings per
share (EPS)
EPS = Net income / # shares outstanding
How does buyback affect interest income?
How does buyback affect # of shares?
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©2006 Prentice Hall, Inc.
 Why Firms Buy Their Own Stock
(3 of 3)

 To reduce the cash needed to pay future dividends

How does this work?
 To reduce chances of a hostile takeover
What makes a company an attractive target for a
hostile takeover?
 Stock repurchase program disclosed in notes to
financial statements

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©2006 Prentice Hall, Inc.
 Accounting for Treasury Stock
Purchase (1 of 2)
 Treasury stock accounted for at cost
 Separate treasury stock accounts for
common and preferred stock
 No gain or loss reported on purchase or sale
of treasury stock
If a firm sells its treasury stock for more than
the purchase price, in which account would it
go? Why?
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©2006 Prentice Hall, Inc.
 Accounting for Treasury Stock
Purchase (2 of 2)
 CC repurchased 50 shares for $15/share
 It believed its stock was undervalued

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

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©2006 Prentice Hall, Inc.
 Selling Treasury Stock
(1 of 3)

 Treasury stock account reduced by the

cost of the shares sold
How do you reduce a contra-equity account?
Sales price > acquisition cost
Excess increases Paid-in-capital-TS
Sales price < acquisition cost
Decrease Paid-in-capital account

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©2006 Prentice Hall, Inc.
 Selling Treasury Stock
(2 of 3)

 CC sold the 25 shares of its treasury stock for $18/share

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

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©2006 Prentice Hall, Inc.
 Selling Treasury Stock
(3 of 3)

 CC sold the other 25 shares of its treasury stock for $12/share

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

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©2006 Prentice Hall, Inc.
 Reporting Treasury Stock
 Treasury stock, a contra-equity account,
is reported as a reduction to
stockholders equity
 Why aren’t gains and losses reported on
the income statement?

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©2006 Prentice Hall, Inc.
 Stock Dividends and Stock Splits
(1 of 4)

 Stock dividends
Distribution of stock instead of cash to
shareholders
Capitalizing earnings
Like using retained earnings to issue new shares
Reduce Retained Earnings
Increase Common Stock
Increase Additional Paid in Capital

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©2006 Prentice Hall, Inc.
 Stock Dividends and Stock Splits
(2 of 4)

 CC declares 10% stock dividend on its 500 shares, $1 par, mkt

value $14/sh

Assets = Liab. + Cont. Cap. + R/E

Date Transaction Debit Credit

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©2006 Prentice Hall, Inc.
 Stock Dividends and Stock Splits
(3 of 4)

 Stock split
Split original shares into two or more shares
Why would a firm split its stock?
No accounts are affected by stock split
Par value decreases so total par value is the same
([par value per share] x [# of shares])
Total shares outstanding increases

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©2006 Prentice Hall, Inc.
 Stock Dividends and Stock Splits
(4 of 4)

 CC did a 5 for 1 stock split on its 500 shares of

$1 par stock
How many shares will be outstanding after the
stock split?
What will the new par value be?
If market value before the split was $10/share, what
should be the market value/share after the split?
Is this usually the case?

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©2006 Prentice Hall, Inc.
 Retained Earnings
 What is the affect of the following on
retained earnings?
Net income
Net loss
Dividends
 Statement of retained earnings
Shows activity in retained earnings for the
period
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©2006 Prentice Hall, Inc.
 Financial Statement Analysis
(1 of 3)

 Return on equity (ROE)

Measures return to common shareholders
Net income – preferred dividends _
Average common shareholders’ equity
Why are preferred dividends subtracted from net
income?
How does ROA compare to ROE?
Numerator? Denominator?
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©2006 Prentice Hall, Inc.
 Financial Statement Analysis
(2 of 3)

 Earnings per share (EPS)

Measures return to common shareholders
Net income – preferred dividends _
Weighted avg # shares outstanding
Basic earnings per share
Assumes no securities that could be converted into
common stock are converted

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 Financial Statement Analysis
(3 of 3)

 Earnings per share (continued)

Diluted earnings per share
Assumes all securities that could be converted into
common stock are converted
Which EPS will be greater, basic or diluted
EPS?
Why is a comparison of EPS between firms not
meaningful?
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©2006 Prentice Hall, Inc.
 Business Risk Control and Ethics
(1 of 2)

 Risks faced by owners

Stock may decrease in value or become
worthless
How can investors reduce the risk of stock
ownership?
 Why do some companies choose to be
publicly traded?
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 Business Risk Control and Ethics
(2 of 2)

 Why have many publicly traded companies

decided to go private after 2002?
 How can a stockholder earn a return on their
investment if the company does not pay
dividends?

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©2006 Prentice Hall, Inc.
 Comments or questions about PowerPoint Slides?
Contact Dr. Richard Newmark at
University of Northern Colorado’s
Kenneth W. Monfort College of Business
richard.newmark@PhDuh.com
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©2006 Prentice Hall, Inc.