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How to Finance the Corporation? Borrow

– Notes, Bonds, Leases– The debt holders are legally entitled to repayment of

their principal and interest claims Issue Equity

– Common and Preferred Stock– The shareholders, as owners, have voting rights,

limited liability, and a residual interest in the corporate assets

Retain Earnings

Chapter 12: Shareholders’ EquityChapter 12: Shareholders’ Equity

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Relative Importance of Liabilities, Relative Importance of Liabilities, Capital, and Retained Earnings Capital, and Retained Earnings

(% of total assets)(% of total assets)

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Debt versus EquityDebt versus Equity

Debt Equity

Formal legal contract No legal contract

Fixed maturity date No fixed maturity date

Fixed periodic payments Discretionary dividends

Security in case of default Residual asset interest

No voice in management Voting rights - common

Interest expense deductible Dividends not deductible

Double taxation

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Interested Party Debt Equity

Investors / Creditors

Lower investment risk Higher investment risk

Management

Fixed cash receipts Variable cash receipts

Contractual future cash payments

Dividends are discretionary

Effects on credit rating

Effects of dilution/ takeover

Interest is tax deductible

Dividends are not tax deductible

Accountants/Auditors

Liabilities section of the balance sheet

Shareholders’ equity of the balance sheet

Income statement effects from debt

No income statement effects from equity

Distinctions between Debt and EquityDistinctions between Debt and Equity

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Preferred Stock vs Common StockPreferred Stock vs Common Stock

Preferred Stock Common Stock

Advantages Preference over common in liquidation

Voting Rights

Stated dividend Rights to residual profits (after preferred)

Preference over common in dividend payout

Disadvantages Subordinate to debt in liquidation Last in liquidation

Stated dividend can be skipped No guaranteed return

No voting rights (versus common)

Debt or Equity? Components of both

Usually classified as equity

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Sample Co. Shareholders’ EquitySample Co. Shareholders’ EquityCommon stock, $1 par value, 500,000 shares

authorized, 80,000 shares issued, and75,000 shares outstanding $ 80,000

Common stock dividends distributable 2,000Preferred stock, $100 par value, 1,000 shares

authorized, 100 shares issued and outstanding 10,000

Paid in capital on common $ 20,000Paid in capital on preferred 3,000Paid in capital on treasury stock 2,000 25,000Retained earnings:

Unappropriated $18,000Appropriated 4,000 22,000

Less: Treasury stock, 5,000 shares (at cost) (6,000)Less: Other comprehensive income items

(unrealized loss on AFS securities) (2,000)Total Shareholders’ Equity $131,000

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Journal Entries-Sample Co.Journal Entries-Sample Co.Now, using Sample Company information,

record the following additional issues of common and preferred stock:

Issued 100 shares of PS at $102 per share: Cash (100 x $102) 10,200

PS (100 x $100 par) 10,000APIC - PS (plug) 200

Issued 500 shares of CS at $5 per share:Cash (500 x $5) 2,500

CS (500 x $1 par) 500APIC - CS (plug) 2,000

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Treasury StockTreasury Stock Created when a company buys back shares of its own

common stock. Reasons for buyback? The debit balance account called “Treasury Stock” is reported

in shareholders’ equity as a contra to SE. – Note: Treasury Stock is not an asset.

The stock remains issued, but is no longer outstanding.– does not have voting rights– cannot receive cash dividends

May be reissued (to the market or to employees) or retired. No gains or losses are ever recognized from these equity

transactions.

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TS Example from Sample Co.TS Example from Sample Co.Look again at the information for Sample Co.Note that Sample Company has 5,000 shares of TS at a total cost of $6,000, or a cost of $1.20 per share. The journal entry to record that purchase would have been:

TS 6,000Cash 6,000

Note that Sample Company also has APIC - TS of $2,000 in the balance sheet. This must be from previous TS transactions, where the TS was purchased, then reissued for more than original cost. All that remains of those transactions is the APIC -TS.

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Sample Co. Shareholders’ EquitySample Co. Shareholders’ EquityCommon stock, $1 par value, 500,000 shares

authorized, 80,000 shares issued, and75,000 shares outstanding $ 80,000

Common stock dividends distributable 2,000Preferred stock, $100 par value, 1,000 shares

authorized, 100 shares issued and outstanding 10,000

Paid in capital on common $ 20,000Paid in capital on preferred 3,000Paid in capital on treasury stock 2,000 25,000Retained earnings:

Unappropriated $18,000Appropriated 4,000 22,000

Less: Treasury stock, 5,000 shares (at cost) (6,000)Less: Other comprehensive income items

(unrealized loss on AFS securities) (2,000)Total Shareholders’ Equity $131,000

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TS - Example ProblemTS - Example ProblemTiger Corporation has 100,000 shares of $1 par value

stock authorized, issued and outstanding at January 1, 2007. The stock had been issued at an average market price of $5 per share, and there have been no treasury stock transactions to this point.

Assume that, in February of 2007, Tiger Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2007, Tiger Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2007, Tiger Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2007 regarding the treasury stock.

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TS Example -Journal EntriesTS Example -Journal EntriesFeb: repurchase 10,000 sh. @ $7 =

$70,000.

July: reissue 2,000 sh @ $ 8 = $16,000

(cost = 2,000 @ $7 = 14,000)

TS 70,000Cash 70,000

Cash 16,000TS 14,000APIC - TS 2,000

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TS Example -Journal EntriesTS Example -Journal EntriesDec: reissue 8,000 sh. @ $ 6 = $48,000

(cost = 8,000 sh.@ $7 = 56,000)

Now we need to debit one or more accounts to compensate for the difference.

(1) debit APIC -TS (but lower limit is to -0-).(2) debit RE if necessary for any remaining

balance (this is only necessary when we are decreasing equity).

Cash 48,000APIC - TS (1) 2,000RE (2) 6,000

TS 56,000

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Retained Earnings Retained Earnings We will be expanding the basic retained earnings

formula in this chapter. Now the Statement of Retained Earnings will include the following:RE, beginning (unadjusted) xxAdd/Subtract: Prior period adjustment xxRE, beginning (restated) xxAdd: net income xxLess dividends:

Cash dividends-common xx Cash dividends - preferred xx Stock dividends xx Property dividends xx

Less: Adjustment for TS transactions xx Appropriation of RE xx

RE, ending xx

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Example of Stock SplitExample of Stock Split

IZM Company has 100,000 shares of $2 par value stock authorized, 10,000 shares issued and outstanding.

The SE section of the balance sheet shows: – Common stock $20,000– Retained earnings 80,000

The market price of the outstanding shares is $50 per share before the split is distributed.

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Example of Stock SplitExample of Stock Split If IZM declared a 2 for 1 stock split, the old

shares would be turned in and new shares would be issued with the following description:

Common stock, $1 par value, 200,000 shares authorized, 20,000 shares issued and outstanding.

The total SE is still $100,000: – Common stock $20,000– Retained earnings 80,000

The market price per outstanding share would now be $25 per share.

Note: No journal entry is necessary.

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Stock Dividends vs Stock SplitsStock Dividends vs Stock Splits Going back to the original IZM information.

Assume instead that IZM declared a 100% stock dividend.

First, prepare the JEs to record the declaration and distribution of the stock dividend for new shares (10,000 shares x 100% = 10,000 new shares x $2 per share = $20,000):Stock Dividends (RE) 20,000

Stock Div. Distributable 20,000Stock Div. Distributable 20,000

Common Stock 20,000

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Stock Dividends vs Stock SplitsStock Dividends vs Stock Splits Now note the new description for the stock dividend: Common stock, $2 par value, 100,000 shares

authorized, 20,000 shares issued and outstanding The total value in SE is still $100,000:

– Common Stock $40,000– Retained Earnings 60,000

Note that the total market price per share would change to $25 per share.

Thus, a 2 for 1 stock split and a 100% stock dividend have the same effect on:– total shareholders’ equity and– market price per share

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Stock Dividends vs Stock SplitsStock Dividends vs Stock Splits To summarize the effects on IZM Company:

100% Stock 2 for 1After: Dividend Stock SplitTotal sh. outstanding 20,000 sh. 20,000 sh.Par value per share $2 $1Market price per share$25 $25Total shareholders’ eq: $100,000 $100,000General ledger results: CS account $ 40,000 $ 20,000 RE account $ 60,000 $ 80,000

Reminder: CS was $20,000 and RE was $80,000 before the split or dividend. Since the stock dividend required journal entries, the amounts for CS and RE changed. Since the stock split does not require a journal entry, the amounts for CS and RE do not change.

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Other Comprehensive IncomeOther Comprehensive Income“Other Comprehensive Income” includes

certain direct equity adjustments that are not part of the current income statement, but which may have an eventual effect on income.

We already discussed one of these direct equity adjustments when reviewing Available-for-sale Investments. We found that any unrealized gains/losses from revaluation to market are shown in SE (as “other comprehensive income”) rather than on the income statement.

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Comprehensive Class Problem - Comprehensive Class Problem - Shareholders’ EquityShareholders’ Equity

Given the following SE balances for Company G at 1/1/07:Common stock, $10 par, 50,000 shares authorized, 20,000 shares issued and outstanding $200,000APIC on common stock 400,000Retained earnings 400,000During 2007, Company G had the following activity:1. Net income for the year was $250,000.2. Cash dividends of $2 per share were declared and paid on

February 1.3. On June 1, Company G repurchased 2,000 shares of its

own stock at $20 per share (using the cost method).4. On December 1, Company G reissued 500 shares of

treasury stock at $18 per share.5. On December 15, Company G declared a 100% stock

dividend, to be distributed to all of its shareholders (including treasury), on Jan. 15, 2008.

6. At Dec. 31, Company G recorded an AJE to revalue its available for sale investments from $20,000 to $32,000.

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Comprehensive Class Problem - Comprehensive Class Problem - Shareholders’ Equity (continued)Shareholders’ Equity (continued)

Required:A.Prepare journal entries for items 2 through 6

(item 1 would require detail information for revenues and expenses to prepare - just know that the credit is to retained earnings for $250,000).

B.Prepare the Statement of Stockholders’ Equity for Company G for 2007.

C.Prepare the stockholders’ equity section of the balance sheet for Company G for 2007, including the appropriate description for the common stock.

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Comprehensive Class Problem - SolutionComprehensive Class Problem - Solution

A. Journal entries1. No entry required.2. Calc: 20,000 x $2 = 40,000

 

3. Calc: 2,000 shares x $20 = $40,000

Cash Dividends (RE) 40,000Dividends Payable 40,000

Dividends Payable 40,000Cash 40,000

Treasury Stock 40,000Cash 40,000  

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Comprehensive Class Problem - SolutionComprehensive Class Problem - SolutionPart A: Journal EntriesPart A: Journal Entries

4. Calc: 500 shares x $18 market = $9,000 500 shares x $20 cost = $10,000

5. Calc: 20,000 new shares x $10 par = $200,000  

Note: in Item 5, the stock has not yet been distributed, so we cannot credit common stock, or show it issued yet. This “Stock Dividends Distributable” account is a related equity account, and indicates that there are shares of stock to be distributed in the future.

Cash 9,000 marketRetained Earnings 1,000 plug

Treasury Stock 10,000 cost

Stock Dividend (RE) 200,000Stock Div. Distributable 200,000

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Comprehensive Class Problem - SolutionComprehensive Class Problem - SolutionPart A: Journal EntriesPart A: Journal Entries

6. Calc: value up $12,000

 

Note that the Unrealized Gain account is part of shareholders’ equity (not the income statement), and it is located at the bottom of the shareholders’ equity section of the balance sheet, in Other Comprehensive Income (OCI).

AFS Investment 12,000Unrealized Gain on AFS 12,000

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Comprehensive Class Problem - SolutionComprehensive Class Problem - SolutionPart B: Statement of SE (in thousands)Part B: Statement of SE (in thousands)

CS CSDD APIC RE OCI TS

Balance 1/1/07 $200 $400 $400Net income 250Cash dividends (40)Stock dividends $200 (200)Purchase of TS $(40)Reissue of TS ( 1) 10Revalue AFS Invest. $12Balance, 12/31/07 $200 $200 $400 $409 $12

$(30)

Note: CSDD is Common Stock Dividends Distributable. When shares are distributed, then CS is increased.

Note: OCI is Other Comprehensive Income and reflects the unrealized gain on Available-for-sale investments.

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Comprehensive Class Problem - SolutionComprehensive Class Problem - SolutionPart C: Shareholders’ Equity Section of B/SPart C: Shareholders’ Equity Section of B/S

Common stock, $10 par value, 50,000 shares authorized, 20,000 shares issued,18,500 shares outstanding $ 200,000Common stock dividends distributable, 20,000 shares 200,000Additional paid-in capital, common stock 400,000Retained earnings 409,000Other comprehensive income

(unrealized gain on AFS investment) 12,000Less: Treasury stock, 1,500 shares at cost (30,000)

Total shareholders’ equity $1,191,000