10-1 ©2006 Prentice Hall, Inc.. 10-2 ©2006 Prentice Hall, Inc. REPORTING & UNDERSTANDING SHAREHOLDERS’ EQUITY (1 of 2) Learning objectives Learning

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©2006 Prentice Hall, Inc.

10-2©2006 Prentice Hall, Inc.

REPORTING & REPORTING & UNDERSTANDING UNDERSTANDING

SHAREHOLDERS’ EQUITYSHAREHOLDERS’ EQUITY (1 (1 of 2)of 2)

Learning objectivesContributed capitalCash dividendsTreasury stockStock dividends and stock splits


REPORTING & REPORTING & UNDERSTANDING UNDERSTANDING

SHAREHOLDERS’ EQUITYSHAREHOLDERS’ EQUITY (2 (2 of 2)of 2)

Retained earningsFinancial statement analysisBusiness risk, control, and

ethics


Learning ObjectivesLearning Objectives(1 of 3)(1 of 3)

Explain how a company finances its business with equity

Account for the payment of cash dividends and calculate the allocation of dividends between common and preferred shareholders



Define treasury stock, explain why a company would purchase treasury stock, and account for its purchase

Explain stock dividends and stock splits

Define retained earnings and account for its increases and decreases



Compute return on equity and earnings per share, and explain what these ratios mean

Recognize the business risks associated with equity and the related controls


Contributed CapitalContributed Capital

Three general forms of businessSole proprietorshipsPartnershipsCorporations

Stock—authorized, issued, & outstanding

Common stockPreferred stock


Stock—Authorized Issued and Outstanding (1 of 2)

Authorized sharesMaximum # of shares of stock a

corp is authorized to offer to the publicSpecified in the corporate charter

Issues sharesShares of stock that have been

offered and sold to shareholders


Stock—Authorized Issued and Outstanding (2 of 2)

Outstanding sharesIssued shares of stock owned by

shareholders rather than the corpTreasury stock

Stock that a corp buys back from shareholders

Outstanding shares = shares issued less treasury stock

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Common Stock(1 of 3)

Owners’ rightsVote for board of directorsShare in pro rata portion of corp profits

Dividends Share in assets in bankruptcy after

creditors and preferred shareholdersRight to acquire more shares when

corp issues new shares Pre-emptive right

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Par valueArbitrary amount, usually small,

and has no real meaning in today’s business environment

Not required by most statesExcess of stock issue proceeds

above par value increases Additional Paid-in Capital account

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Caffinators Coffee issued 500 shares of $1 par value stock for $8 per share

Date Transaction Debit Credit

Assets = Liab. + Cont. Cap. + R/E

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Preferred Stock

Owners receive dividends before common shareholders

Priority claim on assets over common shareholders in bankruptcy

Usually do not have voting rights

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Cash DividendsCash Dividends

Distributions of earnings to ownersBoard of directors decide amount

and dates of dividend distributionsImportant dividend-related datesDistribution of dividends between c

ommon and preferred shareholdersDividend payment example

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Important Dividend-related Dates(1 of 2)

Declaration dateDate Board of directors decides it

will pay a dividendLegal obligation to pay dividends

is created, giving rise to Dividends Payable and increases Dividends (contra-equity)

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Important Dividend-related Dates(2 of 2)

Date of recordAll shareholders on date of record

entitled to receive dividendsPurchaser of stock after this date will not

receive the dividend declared

Payment dateDate dividend actually paid, Decreases cash and Dividends Payable

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Distribution of Dividends Between Common &

Preferred Shareholders

Cumulative preferred stockShareholders must receive any past,

unpaid dividends (dividends in arrears) before a company can pay current dividends to common shareholders

Noncumulative preferred stockPast, unpaid dividends do not

accumulate to preferred shareholders

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Dividend Payment Example(1 of 6)

Caffinators Coffee (CC) has the following stock outstanding on 1/1/2008100 shares of 8% 100 par, cumulative

preferred stock20,000 shares of $1/share common

stockCC has not paid a dividend since 2005

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On 10/31/08 CC declared $5,000 annual dividends to be paid 11/15/08 to shareholders of record on 10/15/08

Annual dividend for preferred shareholders100 shares x 8% x $100 = $800

Total dividends payable to preferred shareholders3 years (2006-2008) x $800 = $2,400

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Dividends payable to common shareholders$5,000 - $2,400 = $2,600Dividend per share

$2,600/20,000 shares = $0.13/share

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Record the dividend declaration


10/31/08


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Record the dividend payment


11/15/08


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Assume the pref stock is noncumulative?


10/31/08

11/15/08


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Treasury StockTreasury Stock

Stock a company purchases on the open market

Why firms buy their own stockAccounting for treasury stock pur

chaseSelling treasury stockReporting treasury stock

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Why Firms Buy Their Own Stock(1 of 3)

Have stock to distribute to employees for compensation plans

Use excess cash to increase shareholder wealthTo return cash to the shareholders if

they choose to sell shares to the firmMore flexible for firm and shareholders

than paying cash dividends

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Reduce equityTreasury stock is contra-equity account

Increase the company’s earnings per share (EPS)EPS = Net income / # shares outstanding

How does buyback affect interest income?How does buyback affect # of shares?

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To reduce the cash needed to pay future dividendsHow does this work?

To reduce chances of a hostile takeoverWhat makes a company an attractive

target for a hostile takeover?Stock repurchase program disclosed in

notes to financial statements

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Accounting for Treasury Stock Purchase (1 of 2)

Treasury stock accounted for at costSeparate treasury stock accounts

for common and preferred stockNo gain or loss reported on

purchase or sale of treasury stockIf a firm sells its treasury stock for

more than the purchase price, in which account would it go? Why?

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Accounting for Treasury Stock Purchase (2 of 2)

CC repurchased 50 shares for $15/share It believed its stock was undervalued



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Selling Treasury Stock(1 of 3)

Treasury stock account reduced by the cost of the shares soldHow do you reduce a contra-equity

account?Sales price > acquisition cost

Excess increases Paid-in-capital-TSSales price < acquisition cost

Decrease Paid-in-capital account

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CC sold the 25 shares of its treasury stock for $18/share



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CC sold the other 25 shares of its treasury stock for $12/share



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Reporting Treasury Stock

Treasury stock, a contra-equity account, is reported as a reduction to stockholders equity

Why aren’t gains and losses reported on the income statement?

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Stock Dividends and Stock Dividends and Stock SplitsStock Splits

(1 of 4)(1 of 4)

Stock dividendsDistribution of stock instead of cash

to shareholdersCapitalizing earningsLike using retained earnings to issue

new sharesReduce Retained EarningsIncrease Common StockIncrease Additional Paid in Capital

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(2 of 4)(2 of 4)

CC declares 10% stock dividend on its 500 shares, $1 par, mkt value $14/sh



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(3 of 4)(3 of 4)

Stock splitSplit original shares into two or more

sharesWhy would a firm split its stock?

No accounts are affected by stock splitPar value decreases so total par value is the

same ([par value per share] x [# of shares])Total shares outstanding increases

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(4 of 4)(4 of 4)

CC did a 5 for 1 stock split on its 500 shares of $1 par stockHow many shares will be outstanding

after the stock split?What will the new par value be?If market value before the split was

$10/share, what should be the market value/share after the split? Is this usually the case?

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Retained EarningsRetained Earnings

What is the affect of the following on retained earnings?Net incomeNet lossDividends

Statement of retained earningsShows activity in retained earnings

for the period

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Financial Statement Financial Statement AnalysisAnalysis

(1 of 3)(1 of 3)

Return on equity (ROE)Measures return to common shareholders

Net income – preferred dividends _ Average common shareholders’ equity

Why are preferred dividends subtracted from net income?

How does ROA compare to ROE?Numerator? Denominator?

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(2 of 3)(2 of 3)

Earnings per share (EPS)Measures return to common

shareholders

Net income – preferred dividends _ Weighted avg # shares outstanding

Basic earnings per share Assumes no securities that could be

converted into common stock are converted

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(3 of 3)(3 of 3)

Earnings per share (continued)Diluted earnings per share

Assumes all securities that could be converted into common stock are converted

Which EPS will be greater, basic or diluted EPS?

Why is a comparison of EPS between firms not meaningful?

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Business Risk Control and Business Risk Control and EthicsEthics

(1 of 2)(1 of 2)

Risks faced by ownersStock may decrease in value or

become worthlessHow can investors reduce the risk of

stock ownership?Why do some companies choose to

be publicly traded?

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Business Risk Control and Business Risk Control and EthicsEthics

(2 of 2)(2 of 2)

Why have many publicly traded companies decided to go private after 2002?

How can a stockholder earn a return on their investment if the company does not pay dividends?

Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’s

Kenneth W. Monfort College of [email protected] 10-

44©2006 Prentice Hall, Inc.

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10-1 ©2006 Prentice Hall, Inc.. 10-2 ©2006 Prentice Hall, Inc. REPORTING & UNDERSTANDING SHAREHOLDERS’ EQUITY (1 of 2) Learning objectives Learning