CHAPTER 11

 

 

Reporting and Analyzing Stockholders’ Equity

 

 

Study Objectives

 

v      Identify and discuss the major characteristics of a corporation.

 

v      Record the issuance of common stock.

 

v      Explain the accounting for the purchase of treasury stock.

 

v      Differentiate preferred stock from common stock.

 

v      Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

 

v      Identify the items that affect retained earnings.

 

v      Prepare a comprehensive stockholders' equity section.

 

v      Evaluate a corporation's dividend and earnings performance from a stockholder's perspective.


Chapter Outline

 

 

Study Objective 1 - Identify and Discuss the Major Characteristics of a Corporation

 

¨       As a legal entity, a corporation has most of the rights and privileges of a person.

 

¨       Corporations may be classified in a variety of ways.  Two common classifications are by purpose and by ownership.

 

¨       A corporation is:

§         A legal entity.

§         Created by law.

§         Enjoys most of the rights and privileges of a person.

§         May be classified by purpose and by ownership.

 

Teaching suggestion - Ask students to think of corporations operated for a profit (i.e. McDonald's, Sears, Ford, etc.)  Then ask them to focus on corporations with objectives other than profit (i.e. Red Cross, United Way, Salvation Army, American Heart Association, etc.)

 

§         Classification by ownership differentiates publicly held or privately held corporations.

·         A publicly held corporation is regularly traded on a national securities market and may have thousands of stockholders.

·         A privately held corporation, often referred to as a closely held corporation, does not offer its stock for sale to the general public and may have only a few stockholders.

 

¨       Several characteristics distinguish corporations from proprietorships and partnerships.

§         Separate legal existence:

·         An entity separate and distinct from owners.

·         Acts under its own name rather than name of stockholders.

·         May buy, own, and sell property; borrow money; and enter into legally binding contracts; may sue or be sued; and pays its own taxes.

·         The acts of owners (stockholders) cannot bind the corporation unless owners are agents of the corporation.

 

§         Limited liability of stockholders:

·         Creditors have recourse only to corporate assets to satisfy their claims.

·         Liability of stockholders is limited to investment in corporation.

·         Creditors have no legal claim on personal assets of owners unless fraud has occurred.

 

§         Transferable ownership rights:

·         Ownership evidenced by shares of stock, which are transferable units.

·         The transfer of stock is at the discretion of the stockholder; it does not require the approval of either the corporation or other stockholders.

·         Transfer of ownership rights among stockholders has no effect on operating activities of the corporation.

·         Transfer of ownership rights among stockholders has no effect on a corporation's assets, liabilities and total stockholders' equity.

·         Corporation does not participate in transfer of ownership rights after original sale of capital stock.

 

§         Ability to acquire capital:

·         It is relatively easy for a corporation to obtain capital through the issuance of stock.

·         Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable.

·         Numerous individuals can become stockholders by investing small amounts of money.

 

§         Continuous life:

·         The life of a corporation is stated in its charter.  It may be perpetual or limited to a specific number of years.

·         If limited, its period of existence can be extended through renewal of charter.

·         Since a corporation is a separate legal entity, continuance as a going concern is not affected by withdrawal, death, or incapacity of a stockholder, employee, or officer.

 

§         Corporation management:

·         Stockholders manage the corporation indirectly through a board of directors, which they elect.

·         The board of directors formulates operating policies and selects officers to execute policy and to perform daily management functions.

·         The president is the chief executive officer (CEO) and has direct responsibility for managing the business.

·         The chief accounting officer is the controller.  The controller’s responsibilities include (1) maintaining the accounting records and an adequate system of internal control and (2) preparing financial statements, tax returns, and internal reports.

·         The treasurer has custody of the corporation’s funds and is responsible for maintaining the company’s cash position.

 

§         Government Regulations:

·         A corporation is subject to state and federal regulations.

·         State laws prescribe the requirements for issuing stock, the distribution of earnings permitted to stockholders, and acceptable methods of retiring stock.

·         Federal securities laws govern the sale of capital stock to the general public; disclosure of financial affairs to the Securities and Exchange Commission through quarterly and annual reports; and, if publicly traded, the reporting requirements of the various securities markets.

 

§         Additional Taxes:

·         Corporations, as separate legal entities, must pay federal and state income taxes.

·         Stockholders must pay taxes on cash dividends.  Thus, it may be argued that corporate income is taxed twice, once at the corporate level and again at the individual level. 

 

§         Advantages of a corporation:

·         Separate legal existence.

·         Limited liability of stockholders.

·         Transferable ownership rights.

·         Ability to acquire capital.

·         Continuous life.

·         Corporation management—professional managers.

 

§         Disadvantages of a corporation:

·         Corporation management—separation of ownership and management.

·         Government regulations.

·         Additional taxes.

 

Teaching suggestion - Ask students to consider starting a business, any business.  Ask them what type organization—sole proprietorship, partnership, or corporation—they will choose for their hypothetical business.  Why did they choose the type organization they chose?  Prompt a discussion of the advantages and disadvantages of the corporate form of organization. 

 

¨       Forming a corporation:

§         A corporation is formed by grant of a state charter.

§         Although a corporation may have operating divisions in a number of states, it is incorporated in only one state.

§         Some states have laws favorable to the corporate form of business organization.  (i.e. In the state of Delaware defense tactics against takeovers can be approved by the board of directors without a vote by shareholders.)

§         Upon receipt of its charter, the corporation establishes by-laws.

§         The by-laws establish the internal rules and procedures for conducting the affairs of the corporation.

§         A corporation must obtain from each state in which it does business a license that subjects the corporation's operating activities to the general corporation laws of the state. 

 

¨       Stockholder rights:

§         Once it is chartered, the corporation sells ownership rights in the form of shares of stock.

§         When a corporation has only one class of stock it is common stock.

§         Ownership rights are specified in the articles of incorporation or in the by-laws.

§         Proof of stock ownership is evidenced by a printed or engraved form known as a stock certificate.

§         The stock certificate shows the name of the corporation, the stockholder's name, the class and special features of the stock, the number of shares owned, and the signatures of duly authorized corporate officials.

§         Stock certificates are prenumbered to facilitate accountability.

 

¨       Stock issue considerations:

§         When a corporation decides to issue stock it must answer the following questions: How many shares should be authorized for sale?  How should the stock be issued?  What value should be assigned to the shares?

 

¨       Authorized stock:

§         The amount of stock a corporation is authorized to sell is indicated in the corporate charter.

§         If all authorized stock is sold, a corporation must obtain consent of the state to amend its charter before issuing additional shares.

§         The authorization of common stock does not result in a formal accounting entry because the event has no immediate effect on either corporate assets or stockholders' equity. 

§         Disclosure of the number of shares authorized is required in the stockholders' equity section of the balance sheet.

 

¨       Issuance of stock:

§         A corporation has the option of issuing common stock directly to investors or indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors.

§         Direct issue is typical in closely held companies.

§         Indirect issue is customary for publicly held companies.

§         New issues of stock may be offered for sale to the public through various organized U.S. securities exchanges: the New York Stock Exchange, the American Stock Exchange, and 13 regional exchanges. 

§         Stock may also be traded on the NASDAQ national market.

 

¨       Par and no-par value stocks:

§         Par value stock is capital stock that has been assigned a value per share in the corporate charter.

§         Years ago, par value was used to determine the legal capital per share that must be retained in the business for the protection of corporate creditors.  It is the amount that is not available for withdrawal by stockholders.

§         Because par value has no relationship with market value and in most cases is an immaterial amount, today many states do not require a par value.

§         No-par value stock is capital stock that has not been assigned a value per share in the corporate charter.

§         In many states the board of directors is permitted to assign a stated value to the no-par shares, which then becomes the legal capital per share.

 

Teaching suggestion - Stress to students that there is no relationship between par value or stated value and market value.  Pick some corporations in which students would have an interest - Nike, Circuit City, or Mattel.  Find the par or stated value of the common stock of these companies.  Take this information along with a current Wall Street Journal to class.  Look at the difference in the par or stated value and the market value.  Ask students when the par value was set.  Then ask when the market price was set.

 

 

Study Objective 2 - Record the Issuance of Common Stock

 

¨       The stockholders’ equity section of a corporation’s balance sheet includes paid-in  (contributed) capital and retained earnings (earned capital).

 

¨       The distinction between paid-in capital and retained earnings is important from a legal and an economic point of view.

§         Paid-in capital is the amount paid in to the corporation by stockholders in exchange for shares of ownership.

§         Retained earnings is earned capital held for future use in the business.

 

¨       The primary objectives in accounting for the issuance of common stock are to (1) identify the specific sources of paid-in capital and (2) maintain the distinction between paid-in capital and retained earnings.

 

¨       The issuance of common stock affects only paid-in capital accounts.

§         When the issuance of common stock for cash is recorded, the par value of the shares is credited to Common Stock, and the portion of the proceeds that is above or below par value is recorded in a separate paid-in capital account.

§         Assume Hydro-Slide, Inc., issues 1,000 shares of $1 par value common stock at par for cash.  The entry to record the transaction is:

              Cash                                                                             1,000

Common Stock                                                              1,000

(To record issuance of 1,000 shares of $1 par

  common stock at par)

 

§         If Hydro-Slide, Inc., issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share, the entry is:

 

 

 

 

*        Cash                                                                                   5,000

Common Stock                                                              1,000

Paid-in Capital in Excess of Par Value                               4,000

(To record issuance of 1,000 shares of common

  stock in excess of par)

 

§         The total paid-in capital from these two transactions is $6,000. Assuming Hydro-Slide, Inc., has retained earnings of $27,000, the stockholders' equity section of the balance sheet would be:

 

HYDRO-SLIDE, INC.

Balance Sheet (partial)

 

Stockholders' equity

  Paid-in capital

    Common stock                                                          $  2,000

    Paid-in capital in excess of par value                            4,000

      Total paid-in capital                                                      6,000

  Retained earnings                                                           27,000

Total stockholders' equity                                                $33,000

 

§         If, in the previous example, the stock had been no-par stock with a stated value of $1, the entries would be the same as those for the par stock except the term “Par Value” would be replaced with “Stated Value.”

§         If the company issues no-par stock that does not have a stated value, the full amount received is credited to the Common Stock account and there is no need for the Paid-in Capital in Excess of Stated Value account.

 

 

Study Objective 3 - Explain the Accounting for the Purchase of Treasury Stock

 

¨       Treasury stock is a corporation's own stock that has been issued, fully paid for, reacquired by the corporation and held in its treasury for future use.

 

¨       A corporation may acquire treasury stock to meet the following objectives:

§         To reissue the shares to officers and employees under bonus and stock compensation plans.

§         To increase trading of the company's stock in the securities market in the hopes of enhancing its market value by signaling that management believes the stock is underpriced.

§         To have additional shares available for use in the acquisition of other companies.

§         To reduce the number of shares outstanding and thereby increase earnings per share.

§         Treasury stock may be purchased if management is trying to eliminate hostile shareholders by buying them out.

 

¨       The purchase of treasury stock is generally accounted for by the cost method.

§         With the cost method the Treasury Stock is maintained at the cost of the shares purchased.

§         Under the cost method Treasury Stock is increased (debited) by the price paid to reacquire the shares.  Treasury Stock decreases by the same amount when the shares are later sold.

§         To illustrate, assume on January 1, 2004, the stockholders' equity section for Mead, Inc., has 100,000 shares of $5 par value common stock outstanding (all issued at par value) and Retained Earnings of $200,000.  The stockholders' equity section of the balance sheet before purchase of treasury stock is shown as follows:

 

                                             MEAD, INC.

                                                             Balance Sheet (partial)

 

Stockholders' equity

  Paid-in capital

    Common stock, $5 par value, 100,000 shares

    issued and outstanding                                                $500,000

  Retained earnings                                                           200,000

Total stockholders' equity                                                $700,000          

 

§         On February 1, 2004, Mead acquires 4,000 shares of its stock at $8 per share.  The entry is:

 

Feb 1.         Treasury Stock                                     32,000

                      Cash                                                                32,000

(To record purchase of 4,000 shares of

  treasury stock at $8 per share)

 

§         The Treasury Stock account would increase by the cost of the shares purchased - $32,000.

§         The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change.

§         Treasury stock is deducted from total paid-in capital and retained earnings in the stockholders' equity section of the balance sheet as follows:

 

                                             MEAD, INC.

                                                             Balance Sheet (partial)

 

Stockholders' equity

  Paid-in capital

    Common stock, $5 par value, 100,000 shares

    issued and 96,000 shares outstanding                           $500,000

  Retained earnings                                                           200,000

Total paid-in capital and retained earnings              $700,000

Less:  Treasury stock (4,000 shares)                                32,000

Total stockholders' equity                                                $668,000

 

§         Both the number of shares issued (100,000) and the number in the treasury (4,000) are disclosed. The difference is the number of shares of stock outstanding (96,000).  

§         The term outstanding stock means the number of shares of issued stock that are being held by stockholders.

 

 

Study Objective 4 - Differentiate Preferred Stock from Common Stock

 

¨       Preferred stock has contractual provisions that give it preference or priority over common stock.

§         Preferred stockholders have a priority in relation to: (1) dividends and (2) assets in the event of liquidation.

§         Preferred stockholders sometimes do not have voting rights.

§         When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates.

§         For example, assume Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share.  The entry to record the issuance is:

 

 

*        Cash                                                                                         120,000

Preferred Stock                                                                                      100,000

Paid-in Capital in Excess of Par Value—Preferred Stock                              20,000

(To record issuance of 10,000 shares of $10 par

  value preferred stock)

 

§         Preferred stock may have either a par value or no-par value.

 

¨       Preferred stockholders have the right to share in the distribution of corporate income before common stockholders.

§         If the dividend rate of preferred stock is $5 per share, common shareholders will not receive any dividends in the current year until preferred stockholders have received $5 per share.

§         The first claim to dividends does not guarantee dividends. 

§         Dividends depend on factors such as adequate retained earnings and availability of cash.

§         For preferred stock, the per share dividend amount is stated as a percentage of the stock or as a specified amount. 

§         For example, EarthLink specifies a 3% dividend, whereas Nike pays 10 cents per share on its $1 par preferred stock.

 

¨       Preferred stock contracts often contain a cumulative dividend feature.

§         If preferred stock is cumulative, preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders receive dividends.

§         When preferred stock is cumulative, preferred dividends not declared in a given period are called dividends in arrears.

§         To illustrate dividends in arrears, assume that Scientific Leasing has 5,000 shares of 7%, $100 par value cumulative preferred stock outstanding.  The annual dividend is $35,000 (5,000 x $7 per share).  If dividends are two years in arrears, preferred stockholders are entitled to receive dividends of $105,000 shown below before any distribution may be made to common stockholders.

 

Dividends in arrears ($35,000 x 2 years)               $  70,000

Current-year dividends                                            35,000

Total preferred dividends                                  $105,000

 

§         Dividends in arrears are not a liability because no obligation exists until the board of directors declares a dividend.

§         The amount of dividends in arrears should be disclosed in the notes to the financial statements.

 

¨       Liquidation preference

§         Most preferred stocks have a preference on corporate assets if the corporation fails.

§         The preference to assets may be for the par value of the shares or for a specified liquidating value.

 

 

Study Objective 5 - Prepare the Entries for Cash Dividends and Understand the Effect of Stock Dividends and Stock Splits

 

¨       A dividend is a distribution by a corporation to its stockholders on a pro rata basis. 

 

¨       Pro rata means that if you own, say, 10% of the common shares, you will receive 10% of the dividend.

 

¨       Dividends can take four forms: cash, property, script (promissory note to pay cash), or stock.

 

¨       Cash dividends, which predominate in practice, and stock dividends, which are declared with some frequency are discussed in this chapter.

 

¨       Dividends are generally reported quarterly as a dollar amount per share, although sometimes they are reported on an annual basis.

 

¨       A cash dividend is a pro rata distribution of cash to stockholders.

 

¨       For a corporation to pay a cash dividend, it must have the following:

§         Retained earnings. 

·         In many states, payment of dividends from legal capital is illegal.

·         Payment of dividends from paid-in capital in excess of par is legal in some states.

·         Payment of dividends from retained earnings is legal in all states.

·         Companies are frequently constrained by agreements with lenders to pay dividends only from retained earnings.

 

§         In addition to retained earnings, a corporation must have adequate cash to pay a dividend.

 

§         Declared dividends.

·         The board of directors has full authority to determine the amount of income to be distributed in the form of dividends and the amount to be retained in the business.

·         Dividends do not accrue, and they are not a liability until they are declared.

 

§         The amount and timing of a dividend are important issues for management to consider;

·         The payment of a large cash dividend could lead to liquidity problems.

·         A small dividend or a missed dividend may cause unhappiness among stockholders who expect to receive a reasonable cash payment from the company on a periodic basis.

·         In order to remain in business, companies must honor their interest payments to creditors.  But the payment of dividends to stockholders is another matter.

 

¨                   Entries for Cash dividends - Three dates are important in connection with dividends:

§         The declaration date:

·         The declaration date is the date the board of directors formally declares the cash dividend and announces it to stockholders. 

·         The declaration of a cash dividend commits the corporation to a binding legal obligation.

·         An entry is required to recognize the decrease in retained earnings and the increase in the liability Dividends Payable.

·         Assume that on December 1, 2004, the directors of Media General declare a $.50 per share cash dividend on 100,000 shares of $10 par value common stock.  The dividend is $50,000 (100,000 x $.50), and the entry to record the declaration is:

 

Declaration Date

Dec. 1.  Retained Earnings (or Cash Dividends Declared)                50,000

 Dividends Payable                                                                     50,000             

(To record declaration of cash dividend)

 

§         The record date:

·         The record date marks the time when ownership of the outstanding shares is determined for dividend purposes.

·         The record date is important in determining the dividend to be paid to each stockholder but not the total dividend.

·         For Media General, the record date is December 22.  No entry is required on the record date.

 

Record Date

            Dec. 22             No entry necessary

 

§         The payment date:

·         On the payment date, dividend checks are mailed to the stockholders and the payment of the dividend is recorded.

·         If January 20 is the payment date for Media General, the entry on that date is:

 

Payment Date

Jan. 20  Dividends Payable                                                                      50,000

*                           Cash                                                                                         50,000             

(To record payment of cash dividend)

 

 

¨       A stock dividend is a pro rata distribution of the corporation's own stock to stockholders.

 

¨       Whereas a cash dividend is paid in cash, a stock dividend is paid in stock.

 

¨       A stock dividend results in a decrease in retained earnings and an increase in paid-in capital.

 

¨       Unlike a cash dividend, a stock dividend does not decrease total stockholders' equity or total assets.

 

¨       Stock dividends are often issued by companies that do not have adequate cash to issue a cash dividend.

 

¨       To illustrate a stock dividend, assume that you have a 2% ownership interest in Cetus Inc., owning 20 of its 1,000 shares of common stock.  In a 10% stock dividend, 100 shares (1,000 x 10%) of stock would be issued.  You would receive two shares (2% x 100), but your ownership interest would remain at 2% (22 ¸ 1,100).  You now own more shares of stock, but your ownership interest has not changed.

 

¨       Corporations issue stock dividends for the following reasons:

§         To satisfy stockholders' dividend expectations without spending cash.

§         To increase the marketability of its stock by increasing the number of shares outstanding and thereby decreasing the market price per share.  Decreasing the market price of the stock makes it easier for smaller investors to purchase the shares.

§         To emphasize that a portion of stockholders' equity has been permanently reinvested in the business and therefore is unavailable for cash dividends.

 

¨       A small stock dividend (less than 20%-25% of the corporation's issued stock) is recorded at the fair market value per share.

 

¨       A large stock dividend (greater than 20%-25% of the corporation's issued stock) is recorded at par or stated value per share.

 

¨       Stock dividends change the composition of stockholders’ equity because a portion of retained earnings is transferred to paid-in capital.  However total stockholders’ equity remains the same.

 

¨       Assume Medland Corp. declares a 10% stock dividend on its $10 par common stock when 50,000 shares were outstanding.  The market price was $15 per share.

 

 

 

                                                  Before                          After

                                                Dividend                       Dividend

            Stockholders’ equity

               Paid-in capital

                  Common stock, $10 par                                $500,000                       $550,000

                  Paid-in capital in excess of par value                                                    25,000

                     Total paid-in capital                                     500,000                         575,000

               Retained earnings                                              300,000                         225,000

            Total stockholders’ equity                                $800,000                       $800,000

            Outstanding shares                                              50,000                          55,000

 

¨       A stock split is very much like a stock dividend in that it involves the issuance of additional shares of stock to stockholders according to their percentage ownership.

 

¨       However, a stock split results in a reduction in the par or stated value per share.

 

¨       The purpose of stock split is to increase the marketability of the stock by lowering its market value per share, making it easier for the corporation to issue additional shares of stock.

 

¨       In a stock split, the number of shares is increased in the same proportion that the par or stated value per share is decreased.  (i.e. in a 2-for-1 split, one share of $10 par value stock is exchanged for two shares of $5 par value stock.)

 

¨       A stock split does not have any effect on total paid-in capital, retained earnings, and total stockholders' equity.

 

¨       With a stock split the number of shares outstanding increases.

 

¨       Assume that instead of issuing a 10% stock dividend Medland splits its 50,000 shares of common stock on a 2-for-1 basis.  The effects of Medland's stock dividend are shown as follows:

 

    Before                          After

Stock Split                   Stock Split

Stockholders’ equity

   Paid-in capital

      Common stock                                                        $500,000                       $500,000

      Paid-in capital in excess of par value                                        0                                  0

         Total paid-in capital                                                 500,000                         500,000

   Retained earnings                                                          300,000                         300,000

Total stockholders’ equity                                            $800,000                       $800,000

Outstanding shares                                                          50,000                        100,000

 

¨       Because a stock split does not affect the balances in any stockholders’ equity accounts, it is not necessary to journalize a stock split.

 

¨       Differences between the effects of stock splits and stock dividends are shown:

 

Item                                                                 Stock Dividend Stock Split

Total paid-in capital                                     Increase                    No change

Total retained earnings                                 Decrease                  No change

Total par value (common stock)                   Increase                   No change

Par value per share                                      No change                Decrease

Number of shares                                        Increase                   Increase

 

 

Study Objective 6 - Identify the Items that Affect Retained Earnings

 

¨       Retained earnings is net income that is retained in the business.

 

¨       The balance in retained earnings is part of the stockholders' claim on the total assets of the corporation.

 

¨       Retained earnings does not represent a claim on any specific asset.

 

¨       The amount of retained earnings cannot be associated with the balance of any asset account.  For example, a $100,000 balance in retained earnings does not mean that there should be $100,000 in cash.

 

¨       In contrast to net income, net losses decrease (are debited to) retained earnings. 

 

¨       Net losses do not decrease (are not debited to) paid-in capital accounts.

 

¨       A debit balance in retained earnings is identified as a deficit and is reported as a deduction in the stockholders' equity section of the balance sheet as shown below:

 

AMAZON.COM

Balance Sheet (partial)

December 31, 2000

(in thousands)

 

                                    Stockholders' equity

                                          Paid-in capital

         Common stock                                                 $        3,571

         Paid-in capital in excess of par value                     1,322,479

                                          Total paid-in capital                                               1,326,050

      Accumulated deficit                                             (2,293,301)         

Total stockholders' equity (deficit)                                $ (967,251)         

 

¨       Although the balance in retained earnings is generally available for dividend declarations, there may be retained earnings restrictions that make a portion of the balance currently unavailable for dividends.

 

¨       Restrictions may result from one or more of the following causes: legal, contractual, or voluntary.

 

¨       Retained earnings restrictions are generally disclosed in the notes to the financial statements.

 

 

 

Study Objective 7 - Prepare a Comprehensive Stockholders' Equity Section

 

¨       In the stockholders' equity section of the balance sheet, paid-in capital and retained earnings are reported, and the specific sources of paid-in capital are identified.

 

¨       Within paid-in capital, two classifications are recognized:

§         Capital stock consists of preferred and common stock.

·         Preferred stock is shown before common because of its preferential rights.

·         Information about the par value, shares authorized, shares issued, and shares outstanding is reported for each class of stock.

 

§         Additional paid-in capital includes the excess of amounts paid in over par or stated value and paid-in capital from treasury stock.

 

Teaching suggestion - Go through each section of the stockholders' equity section on Graber's partial income statement in illustration 11-15.

 

¨       Subclassifications within the stockholders equity sections are seldom presented in published annual reports.

 

¨       Individual sources of additional paid-in capital are often combined and reported as a single amount as shown in the following illustration:

 

KMART INC.

Balance Sheet (partial)

January 30, 2002

(in millions)

                  Stockholders' equity

Common stock, $1 par value; 1,500,000,000 shares authorized;  

   503,294,515 shares issued                                                                     $      503

  Capital in excess of par value                                                                       1,695

  Retained earnings                                                                                       1,261

Total stockholders' equity                                                                                $3,459

 

¨       Information regarding cash inflows and outflows during the year that resulted from equity transactions is reported in the “Financing Activities” section of the statement of cash flows.

 

Teaching suggestion - Go through Illustration 11-17 showing the Financing Activities section of Sara Lee Corporation’s Statement of Cash Flows.

 

 

Study Objective 8 - Evaluate a Corporation's Dividend and Earnings Performance from a Stockholder's Perspective

 

¨       One way that companies reward stock investors for their investment is to pay them dividends.

 

¨       The payout ratio measures the percentage of earnings distributed in the form of cash dividends to common stockholders and is computed by dividing total cash dividends declared to common shareholders by net income.

 

¨       The payout ratios for Nike in 2001 and 2000 are shown below:

 

  2001                 2000  

                        Dividends (in millions)                $129.6              $131.5

                        Net income (in millions)                589.7                579.1

 

                                Payout Ratio = Cash Dividends Declared on Common Stock

            Net Income

                       

                                                                   2001                                          2000          

Payout Ratio                              $129.6 = 22%                            $131.5 = 23%

                                                            $589.7                                      $579.1

 

¨       Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business.  Thus, a low payout ratio is not necessarily bad news.

 

Teaching suggestion – Ask students to look at the payout ratios of four companies shown in Illustration 11-19.  In which companies are students more be willing to invest?  Why?

 

¨       The return on common stockholders' equity is a widely used ratio that measures profitability from the common stockholders’ viewpoint.

 

¨       This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders.

 

¨       Return on common stockholders' equity is computed by dividing net income available to common stockholders (Net income - Preferred stock dividends) by average common stockholders' equity.

 

¨       The return on common stockholders’ equity for Nike in 2001 and 2000 are shown below:

 

(in thousands)                                                              2001                2000                 1999           

Net Income                                                 $   589,700        $   579,100        $   451,400

Preferred stock dividends                                            30                     30                     30

Common stockholders’ equity                         3,494,500          3,136,000          3,334,600

 

                                                      2001                                               2000

Return on common                   $589,700 - $30             = 17.8%            $579,100 - $30           = 17.9%

stockholders' equity         ($3,494,500 + $3,136,000)/2                  ($3,136,000+$3,334,600)/2

ratio

 

¨       Debt versus equity decisions - To obtain large amounts of long-term capital, corporate managers must decide whether to issue bonds or to sell common stock.

 

¨       Bonds have three primary advantages relative to common stock:

§         Stockholders’ control is not affected.  Bondholders do not have voting rights, so current owners (stockholders) retain full control of the company.

§         Tax savings result.  Bond interest is deductible for tax purposes; dividends on stock are not.

§         Return on common stockholders’ equity may be higher.  Although bond interest expense reduces net income, return on common stockholders’ equity often is higher under bond financing because no additional shares of common stock are issued.

 

¨       The return on common stockholders’ equity is affected by the return on assets ratio and the amount of leverage a company uses—that is, by the company’ reliance on debt (often measured by the debt to total assets ratio).  If a company wants to increase its return on common stockholders’ equity, it can either increase its return on assets or increase its reliance on debt financing.

 

¨       To illustrate the potential effect of debt financing on the return on common stockholders’ equity, assume that Microsystems, Inc. is considering two plans for financing the construction of a new $5 million plant.  Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share.  Plan B involves issuing $5 million of 12% bonds at face value.  Income before interest and taxes on the new plant will be $1.5 million; income taxes are expected to be 30%.  Microsystems currently has 100,000 shares of common stock outstanding issued at $25 per share. The alternative effects on the return on common stockholders’ equity are shown below:

 

 

 

  Plan A                           Plan B

Issue stock                   Issue bonds

 

            Income before interest and taxes                          $1,500,000                    $1,500,000

            Interest (12% x $5,000,000)                                                                      600,000

            Income before income taxes                                  1,500,000                         900,000

            Income tax expense (30%)                                       450,000                         270,000

            Net income                                                        $1,050,000                    $   630,000

            Common stockholders’ equity                             $7,500,000                    $2,500,000

            Return on common stockholders’ equity                      14%                             25.2%

 

¨       In general, as long as the return on assets rate exceeds the rate paid on debt, the return on common stockholders’ equity will be increased by the use of debt.

 

¨       Debt has one major disadvantage:  The company locks in fixed payments that must be made in good times and bad.  Interest must be paid on a period basis, and the principal (face value) of the bonds must be paid at maturity.

 

 

Appendix – Entries for Stock Dividends

 

¨       To illustrate the accounting for stock dividends, assume that Medland Corporation has a balance of $300,000 in retained earnings and declares a 10% stock dividend on its 50,000 shares of $10 par value common stock.  The current fair market value of its stock is $15 per share.  The number of shares to be issued is 5,000 (10% x 50,000), and the total amount to be debited to Retained Earnings is $75,000 (5,000 x $15).  The entry to record this transaction at the declaration date is:

 

Retained Earnings (or Stock Dividends Declared)   75,000

            Common Stock Dividends Distributable                            50,000

            Paid-in Capital in Excess of Par Value                               25,000

            (To record declaration of 10% stock dividend)

 

¨       Note that at the declaration date Retained Earnings is decreased for the fair market value of the stock issued:  Common Stock Dividends Distributable is increased for the par value of the dividend shares; and the excess over par is credited to an additional paid-in capital account.

 

¨       Common Stock Dividends Distributable is a stockholders’ equity account; it is not a liability account because assets will not be used to pay the dividend. 

 

¨       If a balance sheet is prepared before the dividend shares are issued, the distributable account is reported in paid-in capital as an addition to common stock issued as shown below:

 

 

MEDLAND CORPORATION

Balance Sheet (partial)

 

 Paid-in capital

    Common stock                                              $500,000

    Common stock dividends distributable             50,000          $550,000

 

 

 

¨       When the dividend shares are issued, Common Stock Dividends Distributable is decreased and Common Stock is increased as follows:

 

Common Stock Dividends Distributable                            50,000

  Common Stock                                                            50,000 

(To record issuance of 5,000 shares in a stock dividend)


 Chapter 11 Review

 

 

ü       Identify the major characteristics of a corporation and classify the characteristic as being advantageous or detrimental to a business.

 

 

 

 

ü       Describe the accounting treatment for the issuance of stock.

 

 

 

 

ü       Know what treasury stock is, know why corporations buy back their own stock, and explain the accounting for the purchase of treasury stock.

 

 

 

 

ü       Know how preferred stock is different from common stock.

 

 

 

 

ü       Understand what is to be done when declaring a dividend and be able to prepare the entries for cash dividends and stock dividends.

 

 

 

 

ü       How do net income, net loss, and dividends affect retained earnings?

 

 

 

 

ü       Have a thorough understanding of the items listed in the stockholders' equity section of the balance sheet.

 

 

 

 

ü       Use the ratios discussed in this chapter—dividend payout ratio and return on common stockholders' equity—to evaluate a corporation's dividend and earnings performance from a stockholder's perspective.

 


Reading Comprehension Check I                                                Name _______________

 

Chapter 11

 

A corporation is created by                      .  As a                                                    , a corporation has most of the rights and privileges of a                           .  The major exceptions relate to privileges that can be exercised only by a living person, such as the right to                 or                                                                     .  Similarly, a corporation is subject to the same                              and                             as a person; for example, it must abide by the                              and it must                                                       .

            Corporations may be classified in a variety of ways.  Two common classifications are by                                      and by                         .  A corporation may be organized for the purpose of                        a                           (such as Nike or General Motors), or it may be a                                                    , medical, or educational corporation (such as the Salvation Army or the American Cancer Society).

            Classification by                             differentiates publicly held and privately held corporations.  A                                                                                    may have thousands of                           and its stock is regularly traded on a                                                                               such as the New York Stock Exchange.  In contrast, a                                                                              , often referred to as a                               held corporation, usually has only a few                              , and it does not offer its stock for sale to the                                                                      .                                                                              are generally much smaller than                                                                                     , although some notable exceptions exist.


Solutions - Reading Comprehension Check I  

 
Chapter 11

A corporation is created by           law         .  As a          legal                 entity       , a corporation has most of the rights and privileges of a        person      .  The major exceptions relate to privileges that can be exercised only by a living person, such as the right to        vote         or         hold                 public                   office      .  Similarly, a corporation is subject to the same          duties        and  responsibilities  as a person; for example, it must abide by the          laws          and it must           pay                      taxes        .

            Corporations may be classified in a variety of ways.  Two common classifications are by                  purpose      and by     ownership   .  A corporation may be organized for the purpose of     making     a        profit        (such as Nike or General Motors), or it may be a      nonprofit          charitable  , medical, or educational corporation (such as the Salvation Army or the American Cancer Society).

            Classification by     ownership     differentiates publicly held and privately held corporations.  A       publicly              held            corporation    may have thousands of   stockholders  and its stock is regularly traded on a     national         securities            market       such as the New York Stock Exchange.  In contrast, a       privately               held             corporation    , often referred to as a         closely           held corporation, usually has only a few      stockholders   , and it does not offer its stock for sale to the        general               public      .       Privately              held              companies     are generally much smaller than         publicly                 held               companies   , although some notable exceptions exist.


Reading Comprehension Check II                                              Name _______________

 

Chapter 11

 

To appeal to a larger segment of potential investors, a corporation may issue a class of stock in addition to common stock, called                                                              .  Preferred stock has contractual provisions that give it preference or priority over                                                             in certain areas.  Typically, preferred stockholders have a priority in relation to (1)                              and (2)                       in the event of liquidation.  However they generally do not have                                                           . 

            As indicated earlier, preferred stockholders have the right to share in the distribution of corporate income before                                                    .  For example, if the dividend rate on preferred stock is $5 per share,                                            will not receive any dividends in the current year until preferred                                                have received $5 per share.  The first claim to dividends does not, however,                                              dividends.  Dividends depend on many factors, such as                                                             and availability of                             .

            Preferred stock contracts often contain a                                                             feature.  This right means that                                                              must be paid both current-year dividends and any unpaid prior-year dividends before                                                                 receive dividends.  When preferred stock is cumulative, preferred dividends not declared in a given period are called                               in                                         .


Solutions - Reading Comprehension Check II  

 
Chapter 11

 

To appeal to a larger segment of potential investors, a corporation may issue a class of stock in addition to common stock, called      preferred                stock       .  Preferred stock has contractual provisions that give it preference or priority over       common               stock         in certain areas.  Typically, preferred stockholders have a priority in relation to (1)      dividends     and (2)         assets       in the event of liquidation.  However they generally do not have         voting                  rights       . 

            As indicated earlier, preferred stockholders have the right to share in the distribution of corporate income before       common          stockholders   .  For example, if the dividend rate on preferred stock is $5 per share,      common          shareholders   will not receive any dividends in the current year until           preferred    stockholders    have received $5 per share.  The first claim to dividends does not, however,      guarantee      dividends.  Dividends depend on many factors, such as         retained               earnings      and availability of          cash         .

            Preferred stock contracts often contain a       cumulative             dividend       feature.  This right means that       preferred           stockholders    must be paid both current-year dividends and any unpaid prior-year dividends before        common             stockholders    receive dividends.  When preferred stock is cumulative, preferred dividends not declared in a given period are called       dividends       in                     arrears      .

 


Vocabulary Quiz                                                                              Name _______________

 

Chapter 11

 

 

                                     1.        Net income that is retained in the business.

 

 

                                     2.        The amount per share of stock that must be retained in the business for the protection of corporate creditors.

 

 

                                     3.        Capital stock that has contractual preferences over common stock in certain areas.

 

 

                                     4.        A corporation that may have thousands of stockholders and whose stock is regularly traded on a national securities market.

 

 

                                     5.        Capital stock that has been issued and is being held by stockholders.

 

 

                                     6.        Capital stock that has been assigned a value per share in the corporate charter.

 

 

                                     7.        A corporation's own stock that has been issued, fully paid for, and reacquired by the corporation but not retired.

 

 

                                     8.        The issuance of additional shares of stock to stockholders accompanied by a reduction in the par or stated value per share.

 

 

                                     9.        The date when ownership of outstanding shares is determined for dividend purposes.

 

 

                                    10.        A feature of preferred stock entitling the stockholder to receive current and unpaid prior-year dividends before common stockholders receive any dividends.

 


Solutions to Vocabulary Quiz       

  

Chapter 11

 

1.         Retained earnings

 

2.         Legal capital

 

3.         Preferred stock

 

4.         Publicly held corporation

 

5.         Outstanding stock

 

6.         Par value stock

 

7.         Treasury stock

 

8.         Stock split

 

9.         Record date

 

10.        Cumulative dividend


Multiple Choice Quiz                                                                   Name _______________

 

Chapter 11

 

1.         All the following are true about a corporation except:

a.          must abide by the laws.

b.         is a legal entity.

c.         has the right to vote.

d.         must pay taxes.

 

2.         Proof of stock ownership is evidenced by a printed or engraved form known as a:

a.          stock dividend.

b.         note.

c.         debenture.

d.         stock certificate.

 

3.         All of the following statements are true concerning treasury stock except:

a.          is accounted for by the cost method.

b.         does not change the number of shares issued.

c.         does not change the number of shares outstanding.

d.         reduces stockholder claims on corporate assets.

 

4.         In order to pay a cash dividend:

a.          the corporation must have adequate retained earnings.

b.         the board of directors must declare a dividend.

c.         the corporation must have adequate cash.

d.         all of the above.

 

5.         Dividends can take the following forms:

a.          cash

b.         property

c.         script

d.         all of the above

 

6.         When issuing cash dividends, the board of directors commits the corporation to a binding legal obligation on:

a.          the declaration date.

b.         the date of record.

c.         the date of payment.

d.         none of the above.

 

7.         A stock dividend results in:

a.          a decrease in retained earnings.

b.         an increase in paid-in capital.

c.         a decrease in stockholder's equity and total assets.

d.         both a and b above.

 


8.         Upon receiving a stock dividend:

a.          a stockholder owns more shares.

b.         a stockholder’s interest has increased.

c.         a stockholder’s  interest has not changed.

d.         both a and c above.

 

9.         Corporations issue stock dividends

a.          to satisfy stockholders’ dividend expectations without spending cash.

b.         to increase the marketability of its stock by increasing the number of shares outstanding and thereby decreasing the market price per share.

c.         to emphasize that a portion of stockholders' equity has been permanently reinvested in the business and therefore is unavailable for cash dividends.

d.         all of the above.

 

10.        A small stock dividend

a.          is less than 20%-25% of the corporation’s issued stock.

b.         is recorded at market value per share.

c.         is recorded at par or stated value per share.

d.         both a and b above.


Solutions to Multiple Choice Quiz                            

 

Chapter 11

 

1.         c

 

2.         d

 

3.         c

 

4.         d

 

5.         d

 

6.         a

 

7.         d

 

8.         d

 

9.         d

 

10.        d

 


Exercise 1 - Library or World Wide Web Research and Forming a Corporation Activity

 

Chapter 11

 

In chapter 11 of the text you will find a sentence that reads, "A corporation is formed by grant of a state charter."  Conduct research in your school library or on the World Wide Web to find the "basic steps to incorporating a corporation."  If researching the web, go to www.bizfiling.com and search for What are the costs.  Click on Mississippi.

 

 

1.         What are the corporate requirements relating to officer information, stock information, and corporate records?

 

 

 

2.         When must annual reports be filed and what is the filing fee?

 

 

 

3.         What are the income tax rates for corporations?

 

 

 

4.         What is the franchise tax rate for corporations?

 

 

 

 

 

 

 

 

 

 

 

Solutions:  Information available on website.

 

 

Note:  The website is constantly being updated.  Please check to see that the information requested in this exercise is available.


Exercise 2 - World Wide Web Research and Forming a Corporation Activity

 

Chapter 11

 

For over a century, Delaware has been the home for America’s premier corporations.  More than half of the Fortune 500 companies are incorporated in Delaware.  To learn more about incorporating, go to www.accessincorp.com.

 

 

1.         What are the advantages and disadvantages of incorporating your business? 

 

 

 

 

2.         What is a registered agent and why does your corporation need one?

 

 

 

 

3.         Do you need an attorney to incorporate?

 

 

 

 

4.         What are the advantages of incorporating your business in Delaware?

 

 

 

 

5.         What are a C corporation, an S corporation, and a close corporation?

 

 

 

 

 

 

 

 

 

 

Solutions:  Information available on website.

 

 

Note:  The website is constantly being updated.  Please check to see that the information requested in this exercise is available.


Exercise 3 - Library or World Wide Web Research Activity

 

Chapter 11

 

Listed below are 20 well-known Corporations.  In the space provided, indicate the stock exchange on which each of the companies is listed--New York Stock Exchange, NASDAQ, or American Stock Exchange.  In addition, show the current market value of the common stock of the company listed.

 

 

Companies                     Exchange                                              Current Price per Share

 

American Vanguard                                                                                                       

 

Applebee’s                                                                                                                   

                                   

Bristol-Myers Squibb                                                                                                     

 

Brookstone                                                                                                                   

           

Chiquita Brand                                                                                                             

 

Community Banks                                                                                                         

 

Daimler-Benz                                                                                                                

 

Delta Airlines                                                                                                                

 

Eastman Kodak                                                                                                            

 

Gap, Inc.                                                                                                                     

 

Glacier Water Services                                                                                                   

 

Harley-Davidson                                                                                               

 

Hollywood Casino                                                                                                         

 

Papa John’s                                                                                                                  

 

Pfizer                                                                                                                          

 

Piccadilly Cafeterias                                                                                                      

 

Rawlings Sporting                                                                                                        

 

Snap-On, Inc.                                                                                                               

 

Tootsie Roll                                                                                                                  

 

Wyndham Intl.                                                                                                              


Solutions to Exercise 3 - Library or World Wide Web Research Activity

 

Chapter 11

 

Companies                                           Exchange

 

American Vanguard                             American Stock Exchange

 

Applebee’s                                           NASDAQ

 

Bristol-Myers Squibb                            New York Stock Exchange

 

Brookstone                                          NASDAQ

 

Chiquita Brand                         New York Stock Exchange

 

Community Banks, Inc.                       NASDAQ

 

Daimler-Benz                                       New York Stock Exchange

 

Delta Airlines                                       New York Stock Exchange

 

Eastman Kodak                                    New York Stock Exchange

 

Gap, Inc.                                              New York Stock Exchange

 

Glacier Water Services                         American Stock Exchange

 

Harley-Davidson                                   New York Stock Exchange

 

Hollywood Casino Corp             American Stock Exchange

 

Papa John’s                                          NASDAQ

 

Pfizer                                                   New York Stock Exchange

 

Piccadilly Cafeterias                             American Stock Exchange

 

Rawlings Sporting Goods                      NASDAQ

 

Snap-On, Inc.                                       New York Stock Exchange

 

Tootsie Roll                                          New York Stock Exchange

 

Wyndham International, Inc.               American Stock Exchange


Exercise 4 – Stockholders’ Equity Activity

 

Chapter 11

 

Morgan’s Rating Service has the following amounts at December 31:  Common Stock, $1 par, 500 shares issued, $500; Paid-in Capital in Excess of Par Value, $10,000; Retained Earnings, $7,000; and Treasury Stock, 20 shares, $450. 

 

1.                  Prepare the stockholders’ equity section of the balance sheet.

 

 

 

 

2.                  List three reasons why Morgan’s Rating Service may have Treasury Stock.

 

 

 

 

 

 

 

 

 

 

 

 

 

Solutions:

 

1.                                             Morgan’s Rating Service

  Balance Sheet (partial)

         December 31

 

            Stockholders’ equity

                Paid-in Capital

                    Common stock, $1 par, 500 shares

                        issued and 480 shares outstanding                    $      500

                        Paid-in Capital in Excess of Par Value                 10,000

                Retained Earnings                                                         7,000

                Total paid-in capital and retained earnings                  17,500

                Less:  Treasury stock (20 shares)                                      450

            Total stockholders’ equity                                            $17,050

 

2.         To reissue the shares under bonus and stock compensation plans; to increase trading by signaling that management believes the stock is underpriced; to have additional shares available for use in acquiring other companies; and to reduce the number of shares outstanding and thereby increase earnings per share.

 

 


Exercise 5 - Library or World Wide Web Research and Stockholders' Equity Activity

 

Chapter 11

 

Obtain a copy of Colgate's Annual Report from your school library or research the World Wide Web to find information to answer the following questions.  If researching the web, go to www.colgate.com.

 

 

1.         What accounting firm is responsible for Colgate's independent audit?

 

 

 

 

2.         How much did Colgate pay out in dividends during the last fiscal year?  Did the dividends go to preferred or common stockholders? 

 

 

 

 

3.         On which financial statement(s) did you find information concerning the amount of dividends paid?

 

 

 

 

4.         Does Colgate own treasury stock?  If so, how much did Colgate pay for the treasury stock? 

 

 

 

 

5.         On which financial statement(s) did you find information concerning Colgate's treasury stock?

 

 

 

 

 

 

 

 

 

Solutions:  Information available on website.

 

 

Note:  The website is constantly being updated.  Please check to see that the information requested in this exercise is available.


Exercise 6 - Library or World Wide Web Research, Stockholders' Equity Activity

 

Chapter 11

 

Research your school library or the World Wide Web for an Annual Report(s) of Pfizer, Inc.  If researching the web, go to www.pfizer.com.  Use the information in Pfizer's annual report to answer the following questions.

 

 

1.         What was the last year in which Pfizer bought back its own stock?

 

 

 

 

2.         What was the reason for buying the stock?

 

 

 

 

3.         How much did Pfizer pay per share for the stock purchased?

 

 

 

 

4.         Describe the provisions of Pfizer’s preferred stock.

 

 

 

 

 

 

 

 

 

 

Solutions:  Information available on website.

 

 

Note:  The website is constantly being updated.  Please check to see that the information requested in this exercise is available.


Exercise 7 - World Wide Web Research and Stock Exchange Vocabulary Activity

 

Chapter 11

 

Stock ownership has grown dramatically in the 1990s.  As a student and a potential investor you should be familiar with terms associated with corporate stocks and the exchanges on which they are traded.  Go to www.nyse.com, scroll down and click on ABOUT THE NYSE and Glossary.  Find the definitions to the following terms:

 

 1.        American Stock Exchange

 2.        Blue Chip

 3.        Bull Market

 4.        Common Stock

 5.        Dividend

 6.        Dow Jones Industrial Average (DJIA)

 7.        Equity

 8.        Fiscal Year

 9.        Listed Stock

10.        Market Value

11.        Member

12.        NASDAQ

13.        New York Stock Exchange

14.        Over-the-Counter

15.        Record Date

16.        Round Lot

17.        SEC

18.        Secondary Distribution

19.        Stock Exchange

20.        Stock Split

21.        Ticker Symbol

22.        Treasury Stock

 

 

Solutions:  Information available on website.

 

 

Note:  The website is constantly being updated.  Please check to see that the information requested in this exercise is available.

 


Exercise 8 - Library and/or World Wide Web Research and Initial Public Offering Activity

 

Chapter 11

 

A company may choose one of several ways to raise needed capital for growth and expansion.  A popular alternative for raising capital is to sell stock to the public.  Research your school library and/or the Internet to find an initial public offering (IPO) of common stock within the last three years.  Answer the following questions for the company you select.

 

 

1.         What is the name of the business?

 

 

 

 

2.         What is the primary business of the company?

 

 

 

 

3.         What was the initial selling price of the stock?

 

 

 

 

4.         What was the number of shares originally offered for sale?

 

 

 

 

5.         What is the current selling price of these shares?