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Chapter 13 Stockholders’ Equity What is a Corporation? • A corporation is a business organized under state law that is a separate legal entity. • Corporations dominate business activity in the United States. • Most well-known companies are corporations. • Unique characteristics of corporations: – – – – – – Separate legal entity Number of owners No personal liability of the owner(s) Indefinite life Taxation Capital accumulation What is a Corporation? Corporations – Important Terms • Authorized stock: the maximum number of shares of stock a corporation may issue. • Outstanding stock: stock held by the stockholders. • Stockholders are issued stock certificates. • Capital stock represents a stockholder’s ownership. • Share: basic unit of stock Stockholders’ Rights • Vote: issues related to corporate decisions. • Dividends: a distribution of a corporation’s earnings. Capital Stock • Corporations issue different classes of stock: – Common stock – Preferred stock • Common stock – basic ownership of a corporation. Every corporation issues common stock. • Preferred stock – given certain advantages over common stock. – Dividend preference – if a dividend is paid, they receive dividends first. – Usually do not have the right to vote. Capital Stock • Stock may carry a par value or may be no-par stock. • Par value – is an amount assigned by a company to a share of stock. Most companies set this amount very low. There is no relation to par value and market value. • Stockholders’ equity: corporations equity that has two components – Paid-in capital: amounts received from stockholders in exchange for stock. – Retained earnings: equity earned by a company and not distributed to stockholders. Journalize the Issuance of Stock • Companies raise capital by issuing stock. • A company can sell its stock directly to stockholders, or it can use the services of an underwriter. • The issue price is the amount a corporation receives from issuing stock. Issuing Common Stock at Par Value Jan. 1 - Smart Touch Learning’s common stock carries a par value of $1 per share, and the charter authorizes 20,000,000 shares of common stock. The stock issuance of 15,000 shares of stock at par value is recorded as Issuing Common Stock at a Premium • Most of the time, stock is issued above par value. • The issuance of stock is not considered a gain or income. • Jan. 15 - Smart Touch Learning issues an additional 3,000 shares for $5 per share. The $4 difference between the issue price ($5) and the par value ($1) is a premium, recorded in Paid-in Capital in Excess of Par. • Paid-in Capital in Excess of Par is also called additional paid-in capital Stockholder’s Equity on the Balance Sheet Issuing Stock for Assets Other Than Cash • The transaction would be recorded at the market value of the stock issued or of the asset received, whichever is more determinable. • Feb. 1 - Smart Touch Learning receives furniture with a market value of $18,000 in exchange for 5,000 shares of its $1 par common stock. Issuing Preferred Stock • Follows the same procedure as issuing common stock. • Smart Touch Learning issues 1,000 shares of its $50 par, 6% preferred stock on January 3, 2017, at $55 per share. Treasury Stock • Treasury stock is a company’s stock that it has previously issued and later reacquired. • Companies purchase treasury stock to: – Increase net assets by buying low and selling high – Support the company’s stock price – Avoid a takeover – Reward valued employees with stock Treasury Stock • The basics of accounting for treasury stock: – The Treasury Stock account has a normal debit balance. Treasury Stock is a contra equity account. – Treasury stock is recorded at cost, without reference to par value. – The Treasury Stock account is reported beneath Retained Earnings on the balance sheet as a reduction to equity. • Treasury stock is not outstanding stock – so it is not carry a vote and does not receive dividends. Purchase of Treasury Stock • On March 31, Smart Touch Learning purchased 1,000 shares of previously issued common stock, paying $5 per share. Sale of Treasury Stock • If treasury stock is sold for cost – the same price the corporation paid for it – the entry is similar to other sales at cost • On April 1st, sold 100 shares of treasury stock ($5 cost) for $5 per share. Sale of Treasury Stock • If stock is resold for more than cost, the difference is credited to a new account – Paid-In Capital from Treasury Stock Transactions. • This amount does not affect net income – it only increases equity. • Smart Touch Learning resold 200 of its treasury shares for $6 per share on April 2. (Recall the cost was $5 per share.) Sale of Treasury Stock • The resale of treasury stock can be below the cost. • The shortfall is debited to Paid-In Capital from Treasury Stock Transactions. • On April 3, Smart Touch Learning resold 200 treasury shares for $4.30 each. Sale of Treasury Stock • The paid-in capital from treasury stock account cannot fall below zero. • If a sale of treasury stock (below cost) would make this account have a debit balance, the difference is debited to Retained Earnings. • Smart Touch Learning resells an additional 200 shares of common stock for $4.50 each. Assume they were purchased at $5 and the balance in paid-in capital from treasury stock is $60. Balance Sheet with Treasury Stock Transactions Cash Dividends • A profitable corporation may make distributions to stockholders in the form of dividends. • Dividends can be paid in the form of cash, stock, or other property. • Three dividend dates are relevant: – Declaration date: board of directors announces the intention to pay dividends. A liability is created. – Date of record: date the corporation records the stockholders that will receive dividend checks – Payment date: date the dividends are paid to stockholders Declaring and Paying Dividends • On May 1, Smart Touch Learning declares a $0.05 per share cash dividend on 22,700 outstanding shares of common stock. Declaring and Paying Dividends • On May 15, the date of record, no journal entry is recorded. On May 30, Smart Touch Learning pays the dividend to its shareholders. Declaring and Paying Dividends – Preferred Stock • The dividend rate on preferred stock is expressed as a percentage of the preferred stock par value. • Preferred stock dividend = Outstanding shares * par value * dividend rate • The journal entry to record the declaration and payment of dividends is the same as it was for common stock . • On Dec. 31st Smart Touch Learning declared dividends. It has 1,000 outstanding shares of 6%, $50 par value preferred stock. Declaring and Paying Dividends – Preferred Stock Date Account Title 12/31 Cash Dividends Debit 3,000 Dividends Payable – Preferred Credit 3,000 • Suppose Smart Touch Learnings declared $50,000 in dividends. It has 1,000 outstanding shares of 6%, $50 par value preferred stock. It also has 94,000 shares of common stock outstanding. Date Account Title 12/31 Cash Dividends Dividends Payable – Preferred Dividends Payable – Common Debit 50,000 Credit 3,000 47,000 How Is Equity Reported for a Corporation? • The statement of retained earnings reports how the company’s retained earnings balance changed from the beginning of the period to the end of the period. • Companies can report a negative amount in retained earnings. • This is called a deficit. Prior-Period Adjustments • Occasionally a company may make an accounting error as a result of mathematical mistakes or other errors not discovered until the following period. • Corrections to Retained Earnings for errors of an earlier period are called prior-period adjustments. How Do We Use Stockholders’ Equity Ratios to Evaluate Business Performance? • Investors are constantly comparing companies’ profits. • Three important ratios used for comparison are: – Earnings per share (EPS) – Rate of return on common stock – Price/earnings ratio Earnings Per Share (EPS) • EPS is the most widely used of all business statistics. • EPS reports the amount of net income (loss) for each share of the company’s outstanding common stock. • Formula: (Net income – preferred dividends) Average # of common shares outstanding Earnings Per Share • Green Mountain Coffee Roasters, Inc., Fiscal 2013 Annual Report reports the following amounts: Green Mountain Coffee Roasters, Inc., earnings per share for 2013 is computed as follows: Price/Earnings Ratio • The price/earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings per share. • This ratio tells investors how much they should be willing to pay for $1 of a company’s earnings. • The higher the number – the better the return on investment. Better to use as a comparison to other stocks. Rate of Return on Common Stock • Rate of return on common stockholders’ equity, (return on equity), shows the relationship between net income to common stockholders and their average common equity invested in the company. • Most industries consider a rate of 15-20% good.