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Chapter 10:
Stockholders’ Equity
Financial and Managerial Accounting:
The Cornerstones of Business Decisions, 2e
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in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Stockholders’ Equity
► Stockholders’ equity, which also is called equity, represents
the owners’ claims against the assets of a corporation after all
liabilities have been deducted.
► The stockholders’ equity section of the balance sheet clearly
identifies various elements of equity according to their
source.
► The most common sources are:
► capital stock—split between (1) preferred and common stock and (2)
the associated additional paid-in capital
► retained earnings or deficit
► accumulated other comprehensive income
► treasury stock
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Authorization to Issue Stock
► Corporations are authorized, or chartered, in accordance with
the provisions of state laws that govern the structure and
operation of corporations.
► These laws differ from state to state and a corporation can
charter in any state.
► All states require persons who wish to form a corporation to
apply to a prescribed state official for the issuance of a
charter.
► The corporate charter, which is sometimes called the articles
of incorporation, is a document that authorizes the creation
of the corporation, setting forth its name and purpose and
the names of the incorporators.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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1
Determination of Share Quantities
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1
Common Stock
► All classes of stock are designated as either common stock or
preferred stock.
► These come with different financial benefits and provide
different rights regarding the governance of the corporation.
► The primary rights for owners of common stock are:
► Voting in the election of the board of directors. You will recall that the
board controls the operating and financial policies of the company.
► Sharing in the profits and dividends of the company. We will talk more
about this below.
► Keeping the same percentage of ownership if new stock is issued
(preemptive right).
► Sharing in the assets in liquidation in proportion to their holdings. This is
referred to as the ‘‘residual claim’’ because common stockholders are
only paid after all creditors and preferred stockholders are paid in full
(which is very rare in liquidation).
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Preferred Stock
► Preferred stock generally pays a regular dividend.
► In this regard, preferred stock is similar to debt, with the
preferred stock dividend equating to interest payments.
► Additionally, the value of preferred stock, like the value of
debt, is most closely tied to interest rate levels and the
company’s overall creditworthiness, while the value of
common stock is most closely tied to the performance of the
company.
► In this respect, preferred stock is a less risky investment than
common stock.
► Preferred shareholders also receive priority over common
shareholders in the payment of dividends and the distribution
of assets in the event of liquidation.
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Comparison of
Common and Preferred Stock
► Differences between preferred and common stock are
designated in the company’s corporate charter and
generally include:
►Dividend preferences, including cumulative and
participating characteristics of dividends.
►Conversion privileges of preferred stock into common
stock.
►Liquidation preferences when a company is dissolved.
►Call provisions which may authorize the company to
repurchase preferred shares at a certain price and date.
►Denial of voting rights, where preferred stockholders
cannot vote but common stockholders can.
Advantage
for
Preferred
Stock
Advantage
for
Common
Stock
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Accounting for Issuance of
Common and Preferred Stock
► Par value is an arbitrary monetary amount printed on each
share of stock that establishes a minimum price for the stock
when issued, but does not determine its market value.
► The par value multiplied by the number of shares sold is
recorded in an account that describes the type of stock—for
example, common stock or preferred stock.
► The amount received in excess of the par value is recorded in
an account called additional paid-in capital.
► These accounts are the first accounts shown in the
stockholders’ equity section of the balance sheet and taken
together are known as capital stock.
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Stated Capital and
No-Par Stock
►Stated capital (legal capital) is the amount of capital that,
under law, cannot be returned to the corporation’s owners
unless the corporation is liquidated.
►Even when state law permits the issuance of no-par stock
(stock without a par value), it frequently requires that nopar stocks have a stated (legal) value, set by the
corporation, in order to establish the corporation’s stated
or legal capital.
►Stated value, like par value, is recorded separately in the
Common (or Preferred) Stock account, while any excess
paid over its stated value is recorded in Additional Paid-In
Capital—Common (or Preferred) Stock.
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2
Stock Warrants and Stock Options
► A stock warrant is the right granted by a corporation to
purchase a specified number of shares of its common stock at a
stated price and within a stated time period.
► Corporations also grant employees and executives the right to
buy stock at a set price as compensation for their services.
► These ‘‘rights’’ are called stock options.
► Stock options are frequently given to employees and executives
as compensation for their services.
► The compensation expense recorded by a company when they
grant stock options depends on many factors including the
price at which employees can buy the stock (called the exercise
or strike price) and the market value of the stock on the date of
grant.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Accounting for
Distributions to Stockholders
► Corporations can distribute cash to stockholders in the
following ways:
►The corporation can repurchase the shares from owners.
►The corporation can pay dividends.
► In the past, dividends were the most common method of
distributing cash.
► But repurchasing shares has become a more frequent method
due to its tax advantages.
► Dividends, however, have the advantage of allowing
shareholders to receive assets from the corporation without
reducing their ownership share.
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3
Stock Repurchases
(Treasury Stock)
► When a corporation purchases its own previously issued
stock, the stock that it buys is called treasury stock.
► Corporations purchase treasury stock for many reasons:
►to buy out the ownership of one or more stockholders
►to reduce the size of corporate operations
►to reduce the number of outstanding shares of stock in an attempt
to increase earnings per share and market value per share
►to acquire shares to be transferred to employees under stock
bonus, stock option, or stock purchase plans
►to satisfy the terms of a business combination in which the
corporation must give a quantity of shares of its stock as part of
the acquisition of another business
►to reduce vulnerability to an unfriendly takeover
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Dividends
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Liquidating Dividends
►When retained earnings has been reduced to zero,
any additional dividends must come from capital
stock. Such dividends are called liquidating dividends
and must be charged first against additional paid-in
capital, then the common (or preferred) stock
accounts.
►The payment of liquidating dividends usually
accompanies the dissolution of the corporation and is
regulated by various laws designed to protect the
interests of creditors and other holders of
nonresidual equity.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Stock Dividends and Stock Splits
► A cash dividend transfers cash from the corporation to its
stockholders.
► In contrast, a stock dividend transfers shares of stock from the
corporation to its stockholders—additional shares of the corporation’s
own stock.
► The amount of retained earnings capitalized for each new share
depends on the size of the stock dividend:
►Small stock dividends increase the number of outstanding shares
by less than 25 percent; they are capitalized using the stock’s
market value just before the dividend.
►Large stock dividends increase the number of outstanding shares
by 25 percent or more and are capitalized at par.
► A stock split, like a stock dividend, increases the number of
outstanding shares without altering the proportionate
ownership of a corporation.
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
Preferred Dividend Preferences
►Preferred dividend
preferences can take
three forms:
►current dividend
preference
►cumulative dividend
preference
►participating dividend
preference
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Accounting for Retained Earnings
and Accumulated Other
Comprehensive Income
►Retained earnings (or deficit) is the accumulated
earnings (or losses) over the entire life of the
corporation that have not been paid out in
dividends.
►Generally, ending retained earnings is calculated
with a simple formula as follows:
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Accounting for Accumulated
Other Comprehensive Income
►Financial accounting theory suggests that income
represents the changes in the assets and liabilities of
the company as a result of transactions with
nonowners.
►However, over time the FASB has allowed the gains
and losses from certain nonowner transactions to
bypass the income statement and go directly to
stockholders’ equity.
►Companies are required to include these gains and
losses, along with net income in a measure called
comprehensive income.
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Equity Analysis
►Equity analysis helps
stockholders
understand:
►how the value of their
shares of stock will
change
►how the company will
distribute any excess
cash to stockholders
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
Stockholder Profitability Ratios
► A primary driver of an increase in stock price is profitability.
► Profitability refers to the return that the company earns (in
other words, its net income).
► Two common ratios are used to evaluate stockholder
profitability:
►Return on common equity
►Earnings per share (EPS)
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5
Stockholder Payout
► Stockholders not only experience an increase in wealth
through an increasing stock price, but may also receive cash, or
a payout, from the company.
► The most common stockholder payout ratios relate to
dividends.
► Dividend yield considers the ratio of dividends paid to stock
price.
► Another common dividend ratio calculates the proportion of
dividends to earnings:
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5
Stockholder Payout
(continued)
► Payouts to stockholders can also take the form of stock
repurchases. As such, the stock repurchase payout ratio is:
► By using these two ratios, stockholders can easily calculate
the total payout:
► Alternatively, it can be calculated directly as:
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.