Chapter 12 Shareholders Equity:

Capital Contributions,
Distributions, and Earnings
FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
12th Edition
Clyde P. Stickney and Roman L. Weil

Learning Objectives
1.

Understand the different priority claims

of common and preferred shareholders
on the assets of a firm and the disclosure
of those claims in the shareholders
equity section of the balance sheet.

2.

Understand the concepts underlying and

apply the accounting procedures for, the
issuance of capital stock, particularly
with respect to capital stock issued under
various option arrangements.

3.

Understand the concepts underlying, and

apply the accounting procedures for,
cash, property, and stock dividends.

Learning Objectives
4.

Understand the concepts underlying, and

apply the accounting procedures for, the
acquisition and reissue of treasury stock.

5.

Understand why the format for reporting

income matters and master the concept
that different kinds of income require
different formats.

6.

Understand the distinction between

earnings and comprehensive income.

7.

Develop the skills to interpret disclosures

about changes in shareholders equity
accounts.

Chapter Outline
1.

Capital Contributions

2.

Issuing Capital Stock

3.

Corporate Distributions

4.

Reporting Earnings Transactions

5.

Earnings and Book Value per Share

6.

An International Perspective

7.

Disclosure of Changes in Shareholders Equity

Chapter Summary
8.

Appendix 12.1: Effects on the Statement of Cash

Flows of Transactions Involving Shareholders
Equity

Define These Terms

Capital Contributions:
Firms issue common or preferred stock to obtain
funds to finance various operating and investing
activities.

Earnings Transactions:
Firms use assets financed by creditors and
owners to generate earnings.

Distributions:
Firms distribute assets to shareholders either in
the form of a dividend or the repurchase of
common or preferred stock.

Review of Important Concepts

1.

Shareholders equity is a residual

interest, representing the shareholders
claims on the assets of a firm in excess
of the claims of creditors.

2.

All firms issue common stock. Firms may

also issue preferred stock which has a
senior but limited claim on assets.

3.

Common and preferred stock usually

have a par or a stated value.

Review of Important Concepts

4.

Firms accumulate information about

revenues and expenses to support the
income statement. Revenues and
expenses are closed to retained
earnings at the end of the accounting
period.

5.

Firms may distribute assets to

shareholders as a dividend which
reduces retained earnings and assets.

6.

Retained earnings is the accumulation

of earnings reduced by dividends.

Capital Contributions

The Corporate form:

1. Limits the liability of owner
2. Allows for raising funds by issuing
shares
3. Makes transfer of ownership easy in
secondary markets

Financing a corporation:
a. Preferred stock
b. Common stock

Preferred Shareholders Equity

Preferred shareholders generally have a

claim on assets that is superior or senior
to any claim by common shareholders.

Their claims are often limited so that

preferred shareholders look more like
creditors than owners.

Some preferred is convertible into

common shares.

Firms do not have to issue preferred

stock and many firms have not.

Common Shareholders Equity

All corporations have common stock;

they need not have preferred stock.

Common shareholders are the residual

interest owners; that is, they own
everything that is left after all other
obligations have been fulfilled.

Balance sheet disclosure includes:

1. Capital contributions
2. Earnings and dividends
3. Accumulated other comprehensive income
4. Treasury share transactions

Issuing Capital Stock

1.

Issue for Cash.

2.

Issue for non-cash Assets.

3.

Issue under Option Arrangements.

4.

Employee Stock Option Plans.

5.

Stock Rights.

6.

Stock Warrants.

7.

Convertible Bonds or Preferred

Stock.

Capital Contributions -- Issue for Cash

A firm needing financing may issue new shares of

stock. In return for the shares, the firm gets
cash.

This is not disadvantageous to previous owners

of shares because even though ownership goes
up, the total assets go up.

For historical and legal reasons, the increase in

equity is separated into an increase in common
stock at par and the remainder, an increase in
additional paid-in capital.

Cash
Common stock ($10 par)
Additional P.I.C.

100,000
10,000
90,000

Capital Contributions
-- Issue for Non-Cash Assets

A firm may find it desirable to trade stock

for an asset other than cash.

In this case, the question is what is the

value of the transactions?

We look first to a reliable market based

value of the asset and record that stock
and the asset at this price. If the value of
the asset is hard to measure, we may take
the market value of the stock instead.

Capital Contributions -- Issued Under

Options Arrangements
Firms

sometimes give stock at

reduced prices or free in exchange for
goods or services or as compensation.

Top

management is often
compensated in stock or stock options
so that they will have strong
incentives to make decisions which
will increase the price of shares.

Employee Stock Option Plans

A stock option is a contract that allows the holder

to buy a stated number of shares of stock for a
fixed price, called the exercise price. If the
market price is above the exercise price, then the
option have value. Otherwise, the holder will just
ignore the option and it has no value.

On the grant date, the firm transfers options to

an employee, for free or a reduced price.

The employee typically cannot sell the stock

immediately but must wait until the vesting date.

When the employee does buy shares of stock

using the option (to get the lower price), this is
called exercising the option.

Employee Stock Option Plans (cont.)

How do you value an option? If the price of the

stock falls, it is valueless. If the price goes up, then
the amount of increase is the value.

One cannot know the ultimate value until the

exercise date.

Two GAAP methods:

Market Value Method.
APB Opinion 25 Method.

Firms have argued (under APB 25) that if the

exercise price is above the current stock price, then
the option has no value and requires no recording.

Define Stock Rights.

Like stock options, stock rights give the

holder the right to acquire shares at a
specified price.
Stock Options are generally granted to
employees and cannot be transfer until vested.
Stock Rights are generally granted to current
shareholders who can trade them in secondary
public markets.

GAAP ignore any value inherent in the stock

right on the date of the grant and make no
entry when granted. Of course, the exercise
of a stock right is recorded like the sale of
shares.

Why issue stock warrants?

Firms

issue stock warrants to the

investing public for cash.

When

sold, the warrants are recorded

in a manner similar to a liability.

When

warrant holders exercise their

rights, the firm records the
transaction like the sale of stock
except that the warrant account
created when granted is reduced.

Convertible Security

A convertible security may be exchanged at

the holders option for another security.

For example, a convertible bond may be

exchangeable for a share of common stock.

This feature allows the holder to choose the

option that has the greater benefit and is a
desirable feature.

Convertible securities are recorded as

regular securities until they are converted.

Corporate Distributions

A dividend is the distribution of assets

to the owners.

The amount of any dividend may be

limited by statue or by contract.

Three forms of dividends:

Cash dividends.

Stock dividends.

Stock splits.

A company may repurchase its own

stock as treasury stock.

Restrictions on Dividends
1. Legal limits on dividends -- statutory
some states limit the payment of dividends:
they are not allowed if retained earnings
were to be forced to below zero.

2. Legal limits on dividends -- contractual

contracts with debtors or others may further
restrict the payment of dividends.

3. Dividends and corporate financial policy

4. Accounting for dividends
a. cash dividends

c. stock dividends

b. property dividends

d. stock splits

How to Record Cash Dividends

a. Cash dividends -- dividends paid in cash
When dividends are declared, they give rise to a
liability and a reduction in retained earnings
Dividends of $150,00 are declared. Please Record.

Retained earnings
Dividends payable

150,000
150,000

When the cash is sent out, the liability is fulfilled

Dividends payable
Cash

150,000
150,000

How to Record Non-Cash Dividends

b. Property dividends -- dividends paid in assets
other than cash. A non-cash dividend of
$150,00 is declared. Please record.

The accounting is similar to cash dividends except

when the dividend is paid, the credit is to the asset
rather than to cash.

Dividends payable
Asset

150,000
150,000

Dividends in Stock
c. Stock dividends

Technically this is a dividend paid in new

shares of stock and not general dividends.

However the term is often used to refer to all

kinds of dividends including cash dividends in
the sense of dividends on stock rather than
dividends paid in stock.

Retained earnings are reduced (debited) and

common stock and a.p.i.c. are increased
(credited).

The effect of this is to move equity from

retained earnings to common stock and a.p.i.c.

Stock Splits
d. Stock splits or split-ups

Theoretically this is just a large stock dividend.

It has long been debated whether there is any

difference between a stock dividend and a
stock split other than the size.

GAAP does consider the two different and

requires a different accounting treatment for
stock splits.

Specifically, no journal entry is required for a

stock split.

Many believe that a stock split will result in an

increase in the market price of the shares.
Empirical evidence seems to support this, but a
causal relationship has not been established.

Stock Repurchase

Treasury shares are common shares that

have been repurchased by the firm.

Treasury shares are not assets or

investments.

Instead, they are a reversal of the

issuance of common shares.

Recall that when stock was issued, the

firm received cash and issued stock:

Cash
Common stock ($10 par)
Additional P.I.C.

100,000
10,000
90,000

Treasury Shares

The purchase of treasury shares is the reverse of the

issuance; the firm gives up cash and gets back the shares:

Treasury shares (cost)

Cash

110,000
110,000

Treasury shares are recorded at cost and kept in a

separate account so that the firm can more easily
resell them, if they desire.

Treasury shares are a contra account to the

shareholders equity section.

Treasury shares do not receive cash dividends or

vote. They may split or receive dividends in stock.

Treasury Shares (Cont.)

If treasury shares are later resold, there is

no gain or loss on the sale.

Rather any difference increases or

decreases the additional paid in capital
account.
Cash
14,000
Treasury shares (cost)
11,000
Additional p.i.c. from
sale of treasury shares
3,000

Reporting Earnings Transactions

The term Earnings has no precise

definition. It is used to refer to profits in a
general sense but not a technical sense. It
is often used as a broader view of profit
which might include changes in economic
wealth not captured by net income.

Net Income is a measure of earnings using

accrual accounting methods as defined by
GAAP.

Reporting Earnings Transactions

Earnings

and net income are gauges

of the operating activities of the firm.

We

assume that investors desire

earnings information so that they can
forecast future cash flows as input to
their investment decision.

Reporting Earnings Transactions

Reporting earnings transactions

Recurring/nonrecurring and
central/peripheral
Measurement of earnings effect
Classification in the income statement
Unrealized gains and losses from changes
in market values
An international perspective

Comprehensive income

Recurring/Nonrecurring
and Central/Peripheral

Recurring/nonrecurring refers whether

earnings can be expected to repeat in
the future.

Central/peripheral refers to how closely

earnings are related to the core activities
of the firm. The firm may be more
efficient in core activities than in
peripheral activities. Sometimes the term
core competencies is used.

Measurement of Earnings Effect

Revenues and expenses result from recurring

primary activities of the firm.

Gains and losses result from either peripheral or

nonrecurring activities.

Revenue and gains result in increases in

shareholders equity.

Expenses and losses result in decreases in

shareholders equity.

Revenues and expenses are gross concepts in that

nothing is subtracted.

Gains and losses are net concepts in that a cost

basis is subtracted from an inflow in defining the
gain or loss.

Discuss Classification

Earnings from continuing operations are revenues,

gains, expenses and losses from activities of the
firm that can be expected to continue in the near
future.

Earnings, gains and losses from discontinued

operations are separate reports of activities that
will be discontinued in the near future.

Extraordinary gains and losses are gains and losses

from events which are both
Unusual in nature, and
Infrequent in occurrence.

Adjustments for changes in Accounting Principles

are disclosures of the effects of a change in the use
of accounting rules.

Unrealized Gains and Losses from

Changes in Market Values

The FASB has increasingly required

firms to report certain assets and
liabilities at their current market values:
Inventories at lower of cost or market
Plant assets and intangibles at current
market value when asset impairment has
occurred
Financial instruments including derivatives
at market value
Marketable equity securities at market
value

Unrealized Gains and Losses from

Changes in Market Values (Cont.)

When an asset (or liability) account is changed to

market value, double entry accounting systems
require an offset.

The offset is generally to an unrealized gain or loss.

Unrealized means that the gain or loss was not the

result of an economic transaction, but rather a
market adjustment.

Marketable securities
nnn
Unrealized gain (or loss)

nnn

What is the nature of the unrealized gain or

loss account?

Unrealized Gains and Losses from

Changes in Market Values (Cont.)

The unrealized gain or loss account is part

of earnings because it changes the wealth
of the firm.

It may or may not be part of net income

depending of the accounting rules.

Unrealized gains or losses may be closed

at the end of the accounting period and
appear on the income statement.

Or they may bypass the income statement

and appear on the balance sheet.

Earnings Per Share

Publicly traded firms must show earningsper-share data in the body of the income
statement.

Earnings per common share is net

earnings divided by the average number of
outstanding common shares.

Firms that report more than one of the four

categories of earnings must disclose
earnings per common share for each
category.

Earnings Per Share

Securities

(such as preferred shares)

that are convertible into common
shares complicate the meaning of
this number. This is an advanced
accounting topic.

Disclosure of Changes in Shareholders

Equity

Annual reports must explain the changes in

all shareholders equity accounts.

For retained earnings, this means that a

reconciliation must be presented. This
reconciliation may be in the income
statement, the balance sheet or as a
separate statement.

Also, this means that other comprehensive

income accounts must also be reconciled.

An International Perspective Capital

Contributions
Accounting

for shareholders equity is

similar the world over.

Foreign

financial statements often use

the term reserve in the equity section
to show a restriction on equity.

U.S.

GAAP discourages the use the the

word reserve because it may seem to
some that there is a cash or asset fund
available -- there is not.

An International Perspective -Earnings

Almost all industrial countries require income

statements.

The format and classification of earnings items

on those income statements vary.

Revenue and expense recognition rules may vary

in detail but most countries require a form of
accrual accounting rather than cash basis.

The nature of what can by-pass the income

statements may vary.

A few countries require inflation adjustments to

items on the income statement.

Chapter Summary

This chapter has presented issues in

accounting for earnings and its effect on
shareholders equity.

Careful distinctions were made between

results of operations and other changes
in the firms wealth.

These distinctions are presented as

separate parts of the income statement.

The shareholders equity section is

likewise divided into different sections
reflections distinctions among sources
of capital.

Appendix 12.1: Effects on Cash Flows

of Transactions Involving Shareholders
Equity

Capital contributions (including cash

received from the issuance of stock options
or warrants and treasury stock transactions)
are a source of cash in the financing section.

The conversion of convertible securities into

common stock is a financing activity but is
not reported unless it does not involves
cash.

Dividends are use of cash in the financing

section.

Rapid Review Yes No

1. Claims against assets after settling all
liabilities can be called residual interest.

2. A stock option allows the holder to

buy a stated number of shares of stock
for the market price.

3. Treasury shares are common shares

that have been repurchased by the firm.