Lecture

Equity Part 1 Dr Winston Kwok

Lecture Learning Objectives

1. Explain the characteristics of a corporation 2. Measure the effect of issuing stock on a corporations financial position 3. Contrast dividends for common stock with dividends for preferred stock 4. Account for treasury stock and other items in equity

Learning Objective 1 Explain the characteristics of a corporation

What is the Best Way to Organize a Business?

Proprietorship

Partnership Corporation or Company

Corporations: An Overview
May be fewer in number than sole

proprietorships and partnerships, yet ... Generate greatest dollar volume of sales revenues Largest in terms of total assets and owners equity

Corporate Form of Organization

An entity created by law Existence is separate from owners Has rights and privileges Privately Held Ownership can be

Publicly Held

Company accounting
Going public means selling shares to

general public. Initial public offering or IPO is first offer of shares. Going public allowed a company to raise large amounts of capital for current and future expansion Less risky (and less costly) to obtain money from investors than borrowing it from one or more lenders Company going public typically enlists services of financial professionals such as underwriters

Characteristics of Corporations
Advantages

Separate legal entity Limited liability of stockholders Transferable ownership rights Continuous life Lack of mutual agency for stockholders Ease of capital accumulation
Disadvantages

Governmental regulation Corporate taxation

Organizing a Corporation
Incorporators Charter

Set bylaws

Authority Structure of a Corporation

Stockholders Board of Directors Chairperson of the Board (CEO) President (Chief Operating Officer)

Authority Structure of a Corporation

President (Chief Operating Officer)

VP Sales

VP Manufacturing

CFO

VP Personnel

Secretary

Controller (Accounting Officer)

Treasurer (Finance Officer)

Rights of Stockholders
Vote at stockholders meetings Sell stock Purchase additional shares of stock (preemptive right) Receive dividends, if any Share equally in any assets remaining after creditors are paid in a liquidation

Stockholders Equity
Owners equity in a corporation has two main components: Capital stock

Retained earnings

Capital Stock
Common Stock Preferred Stock

The most basic form of capital stock issued by every corporation.

A class of stock that has several preferences over common stock.

Capital Stock
Par Value Stock No-par Stock

It is an arbitrary amount assigned by a company to a share of its stock.

Does not have a par value, but may have a stated value (an arbitrary amount).

Learning Objective 2 Measure the effect of issuing stock on a corporations financial position

Authorization and Issuance of Capital Stock

Authorized Shares

The maximum number of shares of capital stock that can be sold to the public.

Authorization and Issuance of Capital Stock

Authorized Shares
Issued shares are authorized shares of stock that have been sold. Unissued shares are authorized shares of stock that never have been sold.

Usually shares are sold through an underwriter.

Issuing Stock
Corporations need money to operate from sources other than borrowing.
Par Value No-Par Value Stated Value

Common Stock at Par

Suppose IHOPs common stock carries a par value of $10 per share. The company issues 6,200,000 shares of common stock at par. What is the entry?

Common Stock at Par

Cash (6,200,000 $10) 62,000,000 Common Stock Issued common stock at par

62,000,000

Common Stock at Par

IHOP can also give shares of its common stock to underwriters or promoters for their services. The company gave promoters 1,000,000 shares of common stock at par. What is the entry?

Common Stock at Par

Organization Expenses (1m $10) 10,000,000 Common Stock 10,000,000 Gave promoters 1 million shares of $10 par value in exchange for their services

Common Stock Above Par

IHOPs common stock has a par value of $0.01 per share. The company issues 6,200,000 shares of common stock at $10 per share. What is the entry?

Common Stock Above Par

Cash (6,200,000 $10) 62,000,000 Common Stock (6,200,000 $0.01) Paid-in Capital in Excess of Par Value, Common Stock (6,200,000 $9.99) Issued common stock above par

62,000 61,938,000

Paid-in Capital in Excess of Par Value also known as Contributed Capital in Excess of Par Value or Additional Paid-in Capital

Common Stock Above Par

Stockholders Equity Common Stock, $.01 par; 40 million shares authorized, 6.2 million shares issued $ 62,000 Paid-in Capital in Excess of Par Value, Common Stock 61,938,000 Total Paid-in Capital $ 62,000,000 Retained Earnings 194,000,000 Total Stockholders Equity $256,000,000

No-Par Common Stock

When a company issues no-par stock with a stated value of $20 per share, it debits the asset received and credits the stock account.

Cash (3,000 $20) 60,000 Common Stock 60,000 Issue 3,000 no-par common stock at $20 per share

Preferred Stock
A separate class of stock, typically having priority over common stock in . . . Dividend distributions (rate is usually stated). Distribution of assets in case of liquidation.

Other Features Include:

Cumulative dividend rights.
Usually callable or redeemable by the company.

Normally has no voting rights.

Preferred Stock

Reasons for issuing: To raise capital without sacrificing control To boost the return earned by common
stockholders through financial leverage

To appeal to investors who may believe the

common stock is too risky or that the expected return on common stock is too low

Accounting for preferred stock follows the

pattern illustrated for common stock

Issuing Stock for Assets Other than Cash

Investors sometimes contribute long-term

assets to company instead of cash Determine, through independent appraisal, assets fair value (market value) or, the shares fair value (market value) whichever is more readily determinable

Issuing Common Stock for Assets Other than Cash

An investor contributes land and a

building in exchange for 5,000 shares of Asian Art, Inc., common stock, with a par value of $2 per share Real estate appraisals Land = $25,000 Building = $150,000 Whats the journal entry to recognize this transaction?

Issuing Common Stock for Assets Other than Cash

Land 25,000 Building 150,000 Common Stock (a) 10,000 Paid-in Capital in Excess of Par Value, Common Stock (b) 165,000
(a) Common Stock = 5,000 shares @ $2.00 par (b) Paid-in Capital in Excess of Par Value, Common Stock = $175,000 fair value of PP&E less $10,000 par value of shares

Issuing Preferred Stock

Asian Art Inc. would follow same system

of recording share transactions when issuing preferred stock Debit = Cash or assets Credit = Preferred Stock and Paid-in Capital in Excess of Par Value, Preferred Stock (if necessary)

Ethical Considerations
Issuing stock for assets other than cash can pose an ethical challenge. The company issuing the stock often wishes to record a large amount for the noncash asset received and for the stock that it is issuing.

Learning Objective 3 Contrast dividends for common stock with dividends for preferred stock

Entries for Cash Dividends

Three important dates

Date of Declaration Record liability for dividend.

Date of Record No entry required.

Date of Payment Record payment of cash to stockholders.

Entries for Cash Dividends

On January 19, a $1 per share cash dividend is declared on Dana, Inc.s 10,000 common shares outstanding. The dividend will be paid on March 19 to stockholders of record on February 19.
Jan. 19 Retained earnings Common dividend payable Dr 10,000 Cr 10,000

Declared $1 per share cash dividend

Instead of debiting RE, can debit a temporary account Dividends which will be closed at end of period

Date of Declaration
Record liability for dividend.

Entries for Cash Dividends

On January 19, a $1 per share cash dividend is declared on Dana, Inc.s 10,000 common shares outstanding. The dividend will be paid on March 19 to stockholders of record on February 19.

Date of Record
No entry required.

No entry required on February 19.

Entries for Cash Dividends

On January 19, a $1 per share cash dividend is declared on Dana, Inc.s 10,000 common shares outstanding. The dividend will be paid on March 19 to stockholders of record on February 19.
Mar. 19 Common dividend payable Cash Dr 10,000 Cr 10,000

Paid $1 per share cash dividend

Date of Payment
Record payment of cash to stockholders.

Deficits and Cash Dividends

Created when a company incurs cumulative losses or pays dividends greater than total profits earned in other years.
Dana, Inc. Balance Sheet (Stockholders' Equity Section) December 31, 2008 Stockholders' Equity Common stock $10 par value, 10,000 shares authorized and outstanding $ 100,000 Retained earnings deficit (8,500) Total stockholders' equity $ 91,500

Cash Dividends
When a company has issued both preferred and common stock, the preferred stockholders receive their dividends first. Pinecraft Industries, Inc., has both common stock and 90,000 shares of preferred stock outstanding.

Expressing the Dividend Rate on Preferred Stock

Percentage rate

Dollar amount

Cash Dividends
Preferred dividends are paid at the annual rate of $1.75 per share. Assume that in 2004, the company declares an annual dividend of $1,500,000.
Preferred dividend (90,000 $1.75 per share) $157,500 Common dividend (remainder: $1,500,000 $157,500) 1,342,500 Total dividend $1,500,000

Cumulative Preferred Stock

Cumulative
Dividends in arrears must be paid before dividends may be paid on common stock.

Vs.

Noncumulative
Undeclared dividends from current and prior years do not have to be paid in future years.

Cash Dividends
The preferred stock of Pinecraft is cumulative. Suppose the company did not pay the 2004 preferred dividend of $157,500. In 2005, the company declares a $500,000 dividend. Retained Earnings 500,000 Preferred Dividend Payable 315,000* Common Dividend Payable ($500,000 $315,000) 185,000 Declare a cash dividend
*($157,500 2 years)

Stock Preferred as to Dividends

Example: Consider the following partial Statement of Stockholders Equity.

Preferred stock, 9%, $100 par value; 1,000 shares authorized and issued Common stock, $50 par value; 4,000 shares authorized and issued Total contributed capital

100,000 $ 200,000 $ 300,000

During 2007, the directors declare cash dividends of $5,000. In 2008, the directors declare cash dividends of $42,000.

Stock Preferred as to Dividends

Preferred If Preferred Stock is Noncumulative: Year 2007 $5,000 dividends declared $ Year 2008 Step 1: Current preferred dividend $ Step 2: Remainder to common shareholders If Preferred Stock is Cumulative: Year 2007 $5,000 dividends declared $ Year 2008 Step 1: Dividends in arrears $ Step 2: Current preferred dividend Step 3: Remainder to common shareholders Totals $ Common -

5,000 $

Stock Preferred as to 9,000 $ 33,000 Dividends

5,000 $ 4,000 9,000 $ 29,000 13,000 $ 29,000 -

Other Features of Preferred Stock

I just converted 100 shares of preferred stock into 1,000 shares of common stock Gee, I cant do that with MY preferred stock!

Some preferred stock is convertible into shares of common stock.

Book Value per Share of Common Stock

Preferred stock and preferred dividends in arrears are deducted from total stockholders equity.

Total Stockholders Equity Number of Common Shares Outstanding

Book Value =

Market Value

Learning Objective 4 Account for treasury stock and other items in equity

Authorization and Issuance of Capital Stock

Authorized Shares Outstanding Shares Treasury Stock
Outstanding shares are issued shares that are owned by stockholders.

Issued Shares

Unissued Shares
Treasury stock are issued shares that have been reacquired by the corporation.

Treasury Stock Transactions

Treasury stock are shares that a company has issued and later reacquired. Some reasons for purchasing own stock: Stock option distribution
(assuming at maximum authorized stock)

Increase share price Avoidance of a takeover

Treasury Stock
No voting or dividend rights Contra equity account
Treasury shares are issued shares that have been reacquired by the corporation.

When stock is reacquired, the corporation records the treasury stock at cost.

Treasury Stock - Example

On May 1, 2007, East, Inc. reacquires 3,000 shares of its common stock at $55 per share. Prepare the journal entry for May 1.
Date Da te Description De scription Debit De bit Credit Cre dit

May 1 Treasury Stock Cash

3,000 shares $55 = $165,000

165,000 165,000

Treasury Stock - Example

On December 3, 2007, East Corp. reissued 1,000 shares of the stock at $75 per share. Prepare the journal entry for December 3.
1,000 shares $75 = $75,000
Date Description Debit Credit

Dec. 3 Cash Treasury Stock Paid-in Capital, Additional Paid-in Capital: Treasury stock transactions Stock

75,000 55,000 20,000

1,000 shares $55 cost = $55,000

Selling Treasury Stock Below Cost

Debit the excess of cost over selling price to Paid-in capital, treasury stock. If not sufficient, then debit to RE

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

Stockholders Equity Presentation

Stockholders' Equity Contributed capital: Preferred Stock - $100 par value; 1,000 shares authorized; 50 shares issued Common Stock - $10 par value; 50,000 shares authorized; 30,000 shares issued Additional Paid-in Capital: Common Retained earnings Subtotal Less: Treasury stock Total Stockholders' equity

5,000

300,000 21,000 65,000 $ 391,000 110,000 $ 281,000

Contra-equity

Restricted Retained Earnings

Legal
Most states restrict the amount of treasury stock purchases to the amount of retained earnings.

Contractual
Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings.

Appropriated Retained Earnings

A corporations directors can voluntarily limit dividends because of a special need for cash such as the purchase of new facilities.
Reed, Inc. Statement of Retained Earnings For Year Ended December 31, 2008 Retained earnings, 1/1/08 Plus: net income Less: dividends declared Retained earnings, 12/31/08 Appropriated retained earnings Unappropriated retained earnings $ $ 875,000 155,600 (80,000) 950,600 (450,000) $ 500,600

Prior Period Adjustments

Correction of material errors in past years financial statements. If an amount is incorrectly expensed, add amount to Retained Earnings.
Reed, Inc. Statement of Retained Earnings For Year Ended December 31, 2008 Retained earnings, 12/31/07, as previously reported $ Prior period adjustment: Cost of land incorrectly expensed Retained earnings, 12/31/07, as adjusted Plus: net income Less: dividends declared Retained earnings, 12/31/08 875,000

72,000 947,000 155,600 (80,000) $ 1,022,600

Statement of Stockholders Equity

Matrix, Inc. Statement of Stockholders' Equity For the Year Ended December 31, 2008 Common stock and (In millions) capital in excess of par Shares Amount Balance at January 1, 2008 821 $ 2,500 Stock issuances 17 500 Stock repurchases and retirement (17) (260) Cash dividends declared Other, net Net income Balance at December 31, 2008 821 $ 2,740 Retained Earnings $ 9,500 (925) (150) 70 5,100 $ 13,595

Total $ 12,000 500 (1,185) (150) 70 5,100 $ 16,335

This is a more inclusive statement than the statement of retained earnings.