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Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter 11
Reporting and Interpreting Stockholders’ Equity
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Understanding Corporations
Simple to become an
owner
Easy to transfer
ownership
Provides limited liability
The major advantage of the corporate form of business is the ease of raising large amounts of money because both large and small investors
can participate in corporate ownership.
The major advantage of the corporate form of business is the ease of raising large amounts of money because both large and small investors
can participate in corporate ownership.
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Two primary sources of stockholders’ equity
Contributed capital
Retained earnings
CommonStock
Additional paid-in capital
Understanding Corporations
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Understanding Corporations
Excerpt from Ross Stores’ Balance Sheet showingStockholders Equity at January 31, 2004.
(Dollar amounts in thousands).
Excerpt from Ross Stores’ Balance Sheet showingStockholders Equity at January 31, 2004.
(Dollar amounts in thousands).
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Because a corporation is a separatelegal entity, it can . . .
Own assets.
Sue and be sued.
Incur liabilities.
Enter into contracts.
Ownership of a Corporation
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Ownership of a Corporation
Voting (in person or by proxy).
Proportionate distributions of profits.
Proportionate distributions of assets in a liquidation.
StockholderBenefits
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Ownership of a Corporation
Vice President(Production)
V ice President(M arketing)
V ice President(F inance)
V ice President(Personnel)
President
B oard of D irectorsInternal (m anagers) andExternal (non-m anagers)
S tockholders(O w ners of voting shares)
Elected byshareholders
Appointedby directors
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Authorized, Issued, and Outstanding Capital Stock
The maximum number of shares of capital
stock that can be sold to the public.
AuthorizedShares
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Authorized, Issued, and Outstanding Capital Stock
AuthorizedShares
Issued shares are authorized shares of stock that have been
sold.
Unissued shares are authorized shares of stock that
never have been sold.
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Authorized, Issued, and Outstanding Capital Stock
AuthorizedShares
UnissuedShares
TreasuryShares
OutstandingSharesIssued
SharesTreasury shares are
issued shares that have been reacquired by the
corporation.
Outstanding shares are issued shares that are
owned by stockholders.
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Common Stock Transactions
All corporations are required to issuecommon stock at incorporation.
Common stockholders have the rightto vote on important issues and theright to share in corporate profits.
Profits are shared through dividendsthat are set by the board of directors.
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Legal capital is the amount of capital, required by the state of incorporation, that
must remain invested in the business.
Par Value
Nominal value
Legal capital
Common Stock Transactions
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Common Stock Transactions
Par value is an arbitrary amount assigned to each
share of stock when it is authorized.
Par value is an arbitrary amount assigned to each
share of stock when it is authorized.
Market price is the amount that each share of stock will
sell for in the market.
Market price is the amount that each share of stock will
sell for in the market.
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Common Stock Transactions
Some states do not
require a par value to be
stated in the charter.
No-par Stock
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Issuance of Stock
Initial public offering (IPO)
The first time a corporation sells
stock to the public.
Seasoned new issue
Subsequent sales of new stock to the
public.
Ross Stores
issues stock.
Ross Stores
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Secondary Markets
Transactions between two investors that do not affect the corporation’s accounting
records.
I’d like to sell some of myRoss stock.
I’d like to buy some of yourRoss stock.
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Issuance of Stock
On January 29, Ross Stores issued 100,000 shares of $0.01 par value common stock for $30 per share.
Most sales of stock to thepublic are cash transactions.
Prepare the journal entry to record this transaction.
Debit CreditAccounts
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Debit CreditCash (+A) 3,000,000
Common stock (+SE) 1,000 Additional paid-in capital (+SE) 2,999,000
Accounts
100,000 shares × $30 per share = $3,000,000
100,000 shares × $0.01 par value = $1,000
Most sales of stock to thepublic are cash transactions.
Issuance of Stock
On January 29, Ross Stores issued 100,000 shares of $0.01 par value common stock for $30 per share.
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Repurchase of Stock
A corporation repurchases its stock to:
Send a signal that the company believes its stock is undervalued.
Obtain shares to reissue for the purchase of other companies.
Obtain shares to reissue to employees as part of stock purchase or stock option plans.
A corporation repurchases its stock to:
Send a signal that the company believes its stock is undervalued.
Obtain shares to reissue for the purchase of other companies.
Obtain shares to reissue to employees as part of stock purchase or stock option plans.
Treasury Stock
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Repurchase of Stock
Ross Stores buysits own stock in the secondary
market. (Treasury stock) Stockholders
Employee
Employee compensation
package includes salary plus stock
options.
Stock options allow employees to purchase
stock from the corporation at a fraction of the stock’s
value in the secondary market.
Ross Stores
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No voting or
dividend rights
Contra equity
account
When stock is reacquired, the corporation records the treasury stock at cost.
Repurchase of Stock
Treasury stock is not
an asset.
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On February 1, Ross Stores reacquired 50,000shares of its common stock at $25 per share.
The journal entry for February 1 is . . . .
Repurchase of Stock
Debit CreditTreasury stock (+xSE, -SE) 1,250,000
Cash (-A) 1,250,000
Accounts
When stock is reacquired, the corporation records the treasury stock at cost.
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Reporting Treasury Stockon the Balance Sheet
Ross Stores’ Stockholders Equity after treasurystock purchase. (Dollar amounts in thousands).
Ross Stores’ Stockholders Equity after treasurystock purchase. (Dollar amounts in thousands).
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Debit CreditCash (+A) 130,000
Treasury stock (-xSE, +SE) 125,000 Additional paid-in capital (+SE) 5,000
Accounts
Reissuance of Treasury Stock
5,000 shares × $26 = $130,000
5,000 shares × $25 cost = $125,000
On March 1, Ross Stores reissued 5,000shares of the treasury stock at $26 per share.
The journal entry for March 1 is . . .
No profit or loss recognized on treasury stock transactions.
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Statement of Stockholders’ Equity
Additional(In millions) Common Paid-In Retained Treasury
Stock Capital Earnings Stock TotalBalance at January 31, 2005 1,512$ 383,629$ 370,278$ -$ 755,419$ Treasury stock purchases (1,250) (1,250)
Treasury stock issued 5 125 130 Common stock issued 1 2,999 3,000 Net income 200,000 200,000 Cash dividends declared (15,000) (15,000) Balance at January 29, 2005 1,513 386,633$ 555,278$ (1,125)$ 942,299$
Ross Stores
Statement of Stockholders' Equity
For the Year Ended January 29, 2005
Additional(In millions) Common Paid-In Retained Treasury
Stock Capital Earnings Stock TotalBalance at January 31, 2005 1,512$ 383,629$ 370,278$ -$ 755,419$ Treasury stock purchases (1,250) (1,250)
Treasury stock issued 5 125 130 Common stock issued 1 2,999 3,000 Net income 200,000 200,000 Cash dividends declared (15,000) (15,000) Balance at January 29, 2005 1,513 386,633$ 555,278$ (1,125)$ 942,299$
Ross Stores
Statement of Stockholders' Equity
For the Year Ended January 29, 2005
A summary of all equity transactions that occur during a period.A summary of all equity transactions that occur during a period.
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Dividends on Common Stock
Declared by board of directors.
Not legally required.
Creates liability at declaration.
Requires sufficient Retained Earnings
and Cash.
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Dividend Dates
Declaration date Board of directors declares the dividend. Record a liability.
Debit CreditDividends declared (+D, -SE) XXX
Dividends payable (+L) XXX
Accounts
Closed to Retained Earningsat the end of the year.
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Dividend Dates
X
Date of RecordStockholders holding shares on this date will
receive the dividend. (No entry)
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Dividend Dates
Date of PaymentRecord the dividend payment to
stockholders.
Debit CreditDividends payable (-L) XXX
Cash (-A) XXX
Accounts
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Stock Dividends
Distribution of additional sharesof stock to stockholders.
No change in total stockholders’ equity.
No change inpar values.
All stockholders retain same percentage
ownership.
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Stock Dividends
Corporation issue stock dividends to:
Remind stockholders of the accounting wealth in the company.
Reduce the market price per share of stock.
Signal that the company expects strong financial performance in the future.
Corporation issue stock dividends to:
Remind stockholders of the accounting wealth in the company.
Reduce the market price per share of stock.
Signal that the company expects strong financial performance in the future.
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Stock dividend < 25%Stock dividend < 25%
Stock Dividends
Stock dividend > 25%Stock dividend > 25%
Record at currentmarket value
of stock.
Record at currentmarket value
of stock.
Record atpar valueof stock.
Record atpar valueof stock.
Small Large
The journal entry moves an amount fromRetained Earnings to other equity accounts.
The journal entry moves an amount fromRetained Earnings to other equity accounts.
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Stock Dividends
Debit CreditRetained earnings (-SE) 1,000,000
Common stock (+SE) 500 Additional paid-in capital (+SE) 999,500
Accounts
50,000 shares × $0.01 = $500
On March 20, Ross Stores issued a 5 percent stock dividend on its 1,000,000 outstanding shares of $0.01 par value common stock. Market value of the stock on March
20 was $20 per share. The journal entry for March 20 is . . .
50,000 shares × $20 = $1,000,000
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Stock Dividends
Debit CreditRetained earnings (-SE) 10,000
Common stock (+SE) 10,000
Accounts
On March 20, Ross Stores issued a 100 percent stock dividend on its 1,000,000 outstanding shares of $0.01 par value common stock. Market value of the stock on March 20 was $20 per share. The journal entry for March 20 . . .
1,000,000 shares × $0.01 = $10,000
Let’s change the small stock dividendto a 100 percent stock dividend.
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Stock Splits
An increase in the number of shares
and a corresponding decrease in par
value per share. Retained earnings is
not affected. A stock split creates more pieces of the
same pie.
A stock split creates more pieces of the
same pie.
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Stock Splits
Assume that a corporation had 5,000shares of $1 par value common stock
outstanding before a 2–for–1 stock split.
Before Split
After Split
Common Stock Shares 5,000
Par Value per Share 1.00$
Total Par Value 5,000$
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Stock Splits
Increase
Decrease
No Change
Before Split
After Split
Common Stock Shares 5,000 10,000
Par Value per Share 1.00$ 0.50$
Total Par Value 5,000$ 5,000$
Assume that a corporation had 5,000shares of $1 par value common stock
outstanding before a 2–for–1 stock split.
No journal entry required – Change par value and number of shares authorized and outstanding.
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Preferred Stock
Preference over common
stock
Usually hasno voting
rights
Usually has a fixed dividend
rate
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Dividends on Preferred Stock
Current Dividend Preference: The current preferred dividends must be paid before paying any dividends to common stock.
Cumulative Dividend Preference: Any unpaid dividends from previous years (dividends in arrears) must be paid before common dividends are paid.
Current Dividend Preference: The current preferred dividends must be paid before paying any dividends to common stock.
Cumulative Dividend Preference: Any unpaid dividends from previous years (dividends in arrears) must be paid before common dividends are paid.
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Dividends on Preferred Stock
If the preferred stock is noncumulative, any dividends not declared in previous years
are lost permanently.
If the preferred stock is noncumulative, any dividends not declared in previous years
are lost permanently.
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Dividends on Preferred Stock
In addition to common stock, assume that Ross Stores has 100,000 shares of $1 par cumulative
preferred stock outstanding with a 10 percent dividend rate. Dividends were not paid last year. In the current year, the board of directors declared
dividends of $400,000.
How much will each class of stock receive?
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Dividends on Preferred Stock
Total dividend declared 400,000$
Preferred stock (cumulative)ArrearageCurrent Yr.
Remainder
Common stock
Remainder
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Dividends on Preferred Stock
Total dividend declared 400,000$
Preferred stock (cumulative)Arrearage ($1 par × 10% × 100,000 shares) 10,000$ Current Yr.
Remainder
Common stock
Remainder
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Dividends on Preferred Stock
Total dividend declared 400,000$
Preferred stock (cumulative)Arrearage ($1 par × 10% × 100,000 shares) 10,000$ Current Yr. ($1 par × 10% × 100,000 shares) 10,000 20,000
Remainder 380,000$
Common stock 380,000
Remainder -$
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Net Income
Average Number of Shares OutstandingEPS =
Assume that MegaMart, a Ross Store competitor, had $472,500,000 income for the
year and the average number of shares outstanding is 105,000,000. Compute earnings
per share for MegaMart.
Assume that MegaMart, a Ross Store competitor, had $472,500,000 income for the
year and the average number of shares outstanding is 105,000,000. Compute earnings
per share for MegaMart.
Earnings per share is probably the single most widely watched
financial ratio.
Earnings per share is probably the single most widely watched
financial ratio.
Earnings Per Share (EPS)
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Earnings per share reports the amount of income earned for
each share of stock outstanding.
Earnings per share reports the amount of income earned for
each share of stock outstanding.
$472,500,000
105,000,000 SharesEPS = = $4.50 per share
Earnings Per Share (EPS)
Net Income
Average Number of Shares OutstandingEPS =
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Return on Equity (ROE)
Net Income
Average Stockholders’ EquityROE =
Ross Stores’ income for the year is $228,102,000 and the average
Stockholder’s Equity is $699,303,000. Compute return on equity for Ross.
Ross Stores’ income for the year is $228,102,000 and the average
Stockholder’s Equity is $699,303,000. Compute return on equity for Ross.
Return on equity is the amount earned for each dollar invested
by stockholders.
Return on equity is the amount earned for each dollar invested
by stockholders.
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Return on Equity (ROE)
Net Income
Average Stockholders’ EquityROE =
$228,102,000
$699,303,000ROE = = 32.62 percent
TJX Companies Pacific Sunwear Ross Stores44.4% 21.9% 32.6%
2003-04 Return on Equity Comparisons
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Equity Versus Debt
Advantages
• Equity does not have to be repaid.
• Dividends are optional.
Disadvantages
• Change in stockholder control.
• Dividends are not tax deductible.
Advantages and disadvantages ofequity financing relative to debt financing.
Advantages and disadvantages ofequity financing relative to debt financing.
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Equity Versus Debt
Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. Consider the following example with
$100,000 of debt financing.
Financial leverage: Debt financing can increase return on equity when the borrower earns more on the borrowed funds than it pays in interest. Consider the following example with
$100,000 of debt financing.
Without Debt With DebtIncome before interest and taxes 50,000$ 50,000$ Interest expense (8% of $100,000) - 8,000 Income before taxes 50,000 42,000 Income taxes at 40 perent 20,000 16,800 Net Income 30,000 25,200
Average stockholders' equity 250,000$ 150,000$ Return on equity 12.00% 16.80%
FinancingWithout Debt With Debt
Income before interest and taxes 50,000$ 50,000$ Interest expense (8% of $100,000) - 8,000 Income before taxes 50,000 42,000 Income taxes at 40 perent 20,000 16,800 Net Income 30,000 25,200
Average stockholders' equity 250,000$ 150,000$ Return on equity 12.00% 16.80%
Financing
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Restrictions on Retained Earnings
If I loan your company $1,000,000,I will want you to restrict your
retained earnings in order to limit dividend payments.
Loan agreements can include restrictions on paying dividends below a certain
amount of retained earnings.
Loan agreements can include restrictions on paying dividends below a certain
amount of retained earnings.
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Stock Options and DilutedEarnings Per Share
Good news
• Employees are motivated to increase financial performance which can increase the stock price.
• Investor/owner wealth increases when the stock price increases.
Bad news
• When options are exercised, the additional shares reduce current investors' ownership percentage.
• Earnings per share is reduced as net income is divided by more shares outstanding.
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End of Chapter 11
