Download Treasury Stock

Chapter 11
Contributed
Capital
Skyline College
Lecture Notes
What Is a Corporation?
A body of persons who have been granted a
charter that recognizes the entity as having
separate legal rights, privileges, and liabilities
distinct from those of its members
Investments by stockholders, called
contributed capital, is a major means of
financing for a corporation
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11–2
Corporate Form of Business
Advantages
Disadvantages
Separate legal entity
More government regulation
Limited liability
Double taxation
Ease of raising capital
Limited liability
Ease of transferring stock
Separation of ownership and
control
Lack of mutual agency
Continuous existence
Centralized authority
Professional management
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11–3
Using Equity Financing
Stock Certificate Shows units of
ownership in a corporation
 A stock certificate is issued to the owner
 Stockholder can transfer ownership at will
 Independent registrars and transfer agents can
be used to keep track of stockholders’ records
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11–4
Par Value
An arbitrary amount assigned to each share of stock
 Usually bears little or no relationship to the market
value or book value of shares
 Constitutes the legal capital of the corporation
 Legal capital
– The number of shares issued times the par value
– The minimum amount that can be reported as
contributed capital
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11–5
Initial Public Offering (IPO)
The initial offering of capital stock
Underwriter
Used between the corporation and
investing public for an IPO
Guarantees the sale of the stock for a fee
The corporation records the net
proceeds of the offering
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11–6
Costs to Start a Corporation?
Start-up and
Organization
Costs




A corporation’s life
normally is not known,
so these costs are
expensed as incurred.
State incorporation fees
Attorneys’ fees
Cost of printing stock certificates
Accountants’ fees for registering the firm’s stock
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11–7
Dividends
Distribution among stockholders of the assets
that a corporation’s earnings have generated
Stockholders
receive these
assets, usually
cash, in
proportion to the
number of shares
they own
 Board of directors has sole
authority to declare dividends
 Decision to declare dividends
affected by
cash flows,
pending lawsuits,
 economic situation,
or debt levels.
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11–8
Dividend Dates
Date of
Declaration
Date of
Record
Board of
Persons who
directors formally own the stock
declares that the on the record
corporation is
date will
going to pay a
receive the
dividend
dividend
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Date of
Payment
Date on which
the dividend is
paid to the
stockholders of
record
11–9
Evaluating Dividend Policies
Dividends Yield Ratio
Tells investors how much they received in dividends as a
percentage of the market price per share
Dividends per Share
Dividends Yield 
Market Price per Share
$0.32
Microsoft 
 1.3%
$24.20
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11–10
Return on Equity
 Most important ratio associated with stockholders’ equity
 Compensation of top executives often tied to return on
equity
Return on
Equity
=
Net Income
Average Stockholders’ Equity
Microsoft
=
$105,548
($588,770 + $173,953) / 2
=
27.7%
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11–11
Price/Earnings (P/E) Ratio
A measure of investors’ confidence in a company’s future
Price Earnings (P/E) Ratio 
Market Price per Share
Earnings per Share
$24.20
Microsoft 
 25 times
$0.968
Because the market price is 25 times earnings, investors are paying a
high price in relation to earnings. They do so in the expectation that
this software company will continue to be successful
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11–12
Discussion: Ethics in the
Business World
Companies with a code of ethics experienced far
less P/E volatility over a four-year period, than
those without them. This suggests that they may be
a more secure investment in the longer term.
Source: Institute on Business Ethics, “Does Business Ethics Pay?” by Simon
Webley & Elise More
Q. If the P/E ratio is volatile, what factors may be at
play?
A. Questionable management or accounting
practices, dips in economic conditions
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11–13
Stock Option Plans
 Give employees the right to purchase stock in the
future at a fixed price
 A means of both motivating and compensating
employees
On date of
grant:
estimate fair
value of
options
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Amount in excess
of exercise price is
recorded as
compensation
expense over the
grant period
11–14
Stockholders’ Equity
Three basic components:
Contributed
Stockholders’ investments
capital
Retained earnings Earnings since corporation’s
inception, less any losses,
dividends, or transfers to
contributed capital
Treasury stock
Shares of its own stock that the
corporation has bought back
on the open market
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11–15
Contributed Capital
Common Stock
Basic form of stock that a
corporation issues
Also called residual
equity
Preferred Stock
Gives owners preference
over common stockholders
 receiving dividends
claims in liquidation
Voting stockholders
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11–16
Authorized, Issued, and
Outstanding Shares
Authorized
shares: Maximum
number that the
corporation’s
charter allows it
to issue
Issued shares:
Sold or
transferred to
stockholders
Stockholders’ Equity
Contributed capital
Preferred stock, $50 par value,
1,000 shares authorized, issued,
and outstanding
Common stock, $5 par value,
30,000 shares authorized,
20,000 shares issued,
18,000 shares outstanding
Additional paid-in capital
Total contributed capital
$50,000
$100,000
50,000
150,000
$200,000
Outstanding shares:
Shares issued and still in
circulation (unlike
treasury stock)
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11–17
What Are the Characteristics of
Preferred Stock?
One or more of the following:
 Preference as to dividends
 Convertibility
 Rights to assets on liquidation
 Callable option
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11–18
Dividend Preference
Preferred stockholders must receive a dividends
before common stockholders receive anything
 No guarantee of ever receiving dividends
 Consequences of missing an annual dividend depends on
whether the preferred stock is cumulative or noncumulative
Cumulative
Dividend amount per share
accumulates from year to year;
Company must pay the whole
amount before it pays any
dividends on common stock
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Noncumulative
Company is under no obligation to
make up the missed dividend in
future years
11–19
Dividends in Arrears
Dividends not paid to cumulative preferred stock in
the year they are due
A corporation has 10,000 shares of $100 par, 5 percent
cumulative preferred stock, its first year of operations
outstanding. If the corporation pays no dividends in 20x7, its
first year of operations, preferred dividends in arrears at the
end of the year would amount to $50,000.
(10,000 shares × $100 × .05)
If the corporation’s board declares dividends in 20x8, the
corporation must pay preferred stockholders the dividends in
arrears plus their current year’s dividends before paying any
dividends to common stockholders.
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11–20
Dividends in Arrears Illustrated
January 1, 20x7: A corporation issued 10,000 shares of $10 par, 6
percent cumulative preferred stock and 50,000 shares common stock.
The board of directors declared a $3,000 dividend to preferred
stockholders after the first year of operations.
20x7 dividends due preferred stockholders ($100,000 x .06)
Less 20x7 dividends declared to preferred stockholders
20x7 preferred stock dividends in arrears
$6,000
3,000
$3,000
In 20x8, the board of directors declared a $12,000 dividend to be
distributed to preferred and common stockholders.
How much of the $12,000 can be given to common stockholders and
how much belongs to preferred stockholders?
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11–21
Dividends in Arrears
Illustrated (cont’d)
20x8 declaration of dividends
Less 20x7 preferred stock dividends in arrears
Available for 20x8 dividends
Less 20x8 dividends due preferred stockholders
($100,000 x .06)
Remainder available to common stockholders
$12,000
3,000
$ 9,000
6,000
$ 3,000
Record the journal entry for the declaration of the dividend:
Dec. 31
Dividends
12,000
Dividends Payable
Declared a $9,000 cash dividend to preferred
stockholders and a $3,000 cash dividend to
common stockholders
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12,000
11–22
Convertible Preferred Stock
Stockholder’s may exchange their
shares of preferred stock for shares of
common stock at a ratio stated in the
company’s preferred stock contract
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11–23
Convertible Preferred Stock Illustrated
A company issued 1,000 shares of 8 percent, $100 par value convertible
preferred stock for $100 per share. Each share can be converted into 5
shares of the company’s common stock at any time.
The market value of the common stock is now $15 per share and, in the
past, the owner of common stock could expect dividends of $1 per share
per year.
Per Share
Dividends
$1
Stock
Market Value
Common
$15
Preferred if converted
to common
75 (5 shares x $15)
Convertible preferred
100
5 ( 5 shares x $1)
8
At this point, the preferred stockholder receives more in dividends by
keeping the preferred shares and is more likely to receive dividends than
the common stockholders.
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11–24
Convertible Preferred Stock
Illustrated (cont’d)
A few years later, the dividends paid to common stockholders increase to
$3 per share and market value is $30 per share.
Stock
Common
Preferred if converted
to common
Convertible Preferred
Market Value
$30
Per Share
Dividends
$3
150 (5 shares x $30)
100
15 ( 5 shares x $3)
8
At this point, the market value of each share of convertible preferred
stock is equivalent to $150 and converting to common would increase
dividend payments from $8 per share to the equivalent of $15.
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11–25
Callable Preferred Stock
Retired at the option of the corporation at a
price stated in the preferred stock contract
The call price is usually higher than the par
value of the stock
Reasons to call stock
– A desire to pay lower dividends
– Because the corporation has enough cash
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11–26
Par Value Stock
Par value is the amount per share that is recorded in a
corporation’s capital stock accounts
Xon Corporation is authorized to issue 20,000 shares of $10 par
value common stock. The company issues 10,000 shares at $12 per
share on January 1, 20xx.
Jan. 1
Cash
120,000
Common Stock
Additional Paid-in Capital
Issued 10,000 shares of $10 par value
common stock for $12 per share
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100,000
20,000
11–27
Par Value Stock (continued)
Balance Sheet Presentation
Stockholders’ Equity Section
Contributed capital
Common stock, $10 par value, 20,000 shares
authorized, 10,000 shares issued and outstanding
Additional paid-in capital
Total contributed capital
Retained earnings
Total stockholders’ equity
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$100,000
20,000
$120,000
—
$120,000
11–28
No-Par Stock
Xon Corporation is authorized to issue 20,000 shares of no-par
common stock. Suppose the company issues 10,000 shares at $15 per
share on January 1, 20xx.
Jan. 1
Cash
150,000
Common Stock
Issued 10,000 shares of no-par
common stock for $15 per share
Assume Xon’s board puts a $10 stated value
on its no-par stock. It issues 10,000 shares at
$15 per share on January 1, 20xx.
Jan. 1
Cash
150,000
Stated value of stock can
be any value set by the
board unless the state
specifies a minimum
amount.
150,000
Common Stock
Additional Paid-in Capital
Issued 10,000 shares of no-par value
common stock with $10 stated value for
$15 per share
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100,000
50,000
11–29
Issuance of Stock for
Noncash Assets
May issue stock for services or assets
 Record the transaction at the fair market value of
what the corporation is giving up (stock)
 If fair market value of the stock cannot be
determined, use the fair market value of the assets
or services received
 Board of directors has the right to determine the fair
value of the property
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11–30
Issuance of Stock for Noncash Assets
When Xon Corporation was formed on January 1, 20xx, its attorney
agreed to accept 100 shares of its $10 par value common stock for
services rendered.
At the time the stock was issued, its market value could not be determined.
For similar services, the attorney would have billed $1,500.
Jan. 1
Start-up and Organization Expense
Common Stock
Additional Paid-in Capital
Issued 100 shares of $10 par
common stock for attorney’s
services
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1,500
1,000
500
11–31
Treasury Stock
Why do more than 67 percent of large
companies repurchase their own stock?
 Use the stock for employee stock option plans
 To maintain a favorable market for their stock
 To increase earnings per share or market price
 To have shares of stock available for purchasing
other companies
 Attempt to prevent hostile takeovers
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11–32
Purchase of Treasury Stock Illustrated
On Sept. 15, Caprock Corporation purchases 1,000 shares
of its common stock on the market for $50 per share.
When treasury stock is purchased, it is usually recorded at cost:
Sept. 15 Treasury Stock, Common
Cash
Acquired 1,000 shares of the
company’s common stock for
$50 per share
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50,000
50,000
11–33
Purchase of Treasury Stock
(cont’d)
Balance Sheet Presentation
Stockholders’ Equity Section
Contributed capital
Common stock, $5 par value, 100,000 shares
authorized, 30,000 shares issued, 29,000 shares
outstanding
Additional paid-in capital
Total contributed capital
Retained earnings
Total contributed capital and retained earnings
Less treasury stock, common (1,000 shares at cost)
Total stockholders’ equity
$150,000
30,000
$180,000
900,000
$1,080,000
50,000
$1,030,000
Notice that the number of shares issued, and therefore legal capital, has not changed
even though the number of shares outstanding has decreased.
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11–34
Sale of Treasury Stock Below Cost
Dec. 15: Caprock Corporation sells 600 shares of its treasury stock for
$42 per share. (Cost was $50 per share.)
Dec. 15
Cash
Paid-in Capital, Treasury Stock
Retained Earnings
Treasury Stock, Common
Sold 600 shares of the treasury stock for
$42 per share; cost was $50 per share
When treasury shares are sold
below cost, the difference is
deducted from Paid-in Capital,
Treasury Stock
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25,200
4,000
800
30,000
If the Paid-in Capital, Treasury
Stock account cannot absorb the full
amount of the difference, or doesn’t
exist, Retained Earnings absorbs the
remainder.
11–35
Retirement of Treasury Stock
When the company determines that it will not
reissue stock it has purchased
If acquisition price < original contributed
capital
Credit Paid-In Capital, Retirement of Stock
 If acquisition price > original contributed
capital
Debit Retained Earnings
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11–36