Chapter 11 Reporting and Analyzing Stockholders’ Equity

Chapter 11: Reporting and Analyzing Stockholders’ Equity (Note: This worksheet is intended as an optional study guide. Do not submit to the instructor.) Learning Objectives: 1. Identify and discuss the major characteristics of a corporation. 2. Record the issuance of common stock. 3. Explain the accounting for the purchase of treasury stock. 4. Differentiate preferred stock from common stock. 5. Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits. 6. Identify the items that affect retained earnings. 7. Prepare a comprehensive stockholders’ equity section. 8. OMIT-Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective. 9. Appendix 11A - Entries for Stock Dividends. LO 1 1. The Corporate Form of Organization: Define the following: Concept Corporation Publicly held corporation Privately held corporation Definition A company organized as a separate legal entity, with most of the rights and privileges of a person A corporation that may have thousands of stockholders and whose stock is traded on a national securities market A corporation that has only a few stockholders and whose stock is not available for sale to the general public Characteristics of a Corporation:  Separate _Legal_ Existence o As an entity separate and distinct from its _owners_, the corporation acts under its own name rather than in the name of its stockholders.  Limited Liability of _Stockholders_ o Even in the event of bankruptcy of the corporation, stockholders’ losses are generally limited to the amount of _capital_ they have invested in the corporation.  _Transferable_ Ownership Rights o Stockholders may dispose of part or all of their interest in a corporation simply by _selling_ their stock. o The company does not participate in the transfer of these ownership rights after the _original_ sale of the capital stock.  Ability to Acquire _Capital_ o It is relatively easy for a corporation to obtain capital through the _issuance_ of stock. Page 1 of 9  Continuous _Life_ o Since a corporation is a separate legal entity, its continuance as a going _concern_ is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer.  Corporation _Management_ o Although stockholders legally own the corporation, they manage it _indirectly_ through a board of directors they elect. o The chief accounting officer is the _controller_. o What are some of the controller’s main duties? Maintains the accounting records, maintains an adequate system of internal control, and prepares financial statements, tax returns, and internal reports o The _treasurer_ has custody of the corporation’s funds and maintains the company’s cash position.  _Government_ Regulations o Publicly held corporations must disclose their financial affairs to the _Securities and Exchange Commission_ (SEC) through quarterly and annual reports.  Additional _Taxes_ o Corporations must pay federal and state taxes as a separate legal entity. o In addition, stockholders are required to pay taxes on cash dividends. o Thus, many argue that corporate income is taxed _twice_ (double taxation) – once at the corporate level and again at the individual level. Other Forms of Business Organization: What is an S corporation? A “hybrid” organizational form; it allows for legal treatment as a corporation, but tax treatment as a partnership – that is, no double taxation. What are some other forms of organization? Limited partnerships, limited liability partnerships (LLPs) and limited liability companies (LLCs) Forming a Corporation: What is a charter? A document that describes a corporation’s name and purpose, types of stock and number of shares authorized, names of individuals involved in the formation, and number of shares each individual has agreed to purchase It is to the company’s advantage to incorporate in a state whose laws are _favorable_ to the corporate form of business organization. Stockholder Rights: What are some of the ownership rights of stockholders? 1) Vote in election of board of directors at annual meeting and vote on actions that require stockholder approval Page 2 of 9 2) Share the corporate earnings through receipt of dividends 3) Keep the same percentage ownership when new shares of stock are issued (preemptive right) 4) Share in assets upon liquidation in proportion to their holdings. This is called residual claim because owners are paid with assets that remain after all other claims have been paid. LO 2 2. Stock Issue Considerations: Define authorized stock: The amount of stock that a corporation is authorized to sell as indicated in its charter The authorization of common stock does not result in a formal accounting _entry_. A corporation can issue common stock _directly_ to investors. Alternatively, it can issue common stock indirectly through an investment banking firm that specializes in bringing securities to the _attention_ of prospective investors. Define the following: Concept Definition Par value stock Capital stock that has been assigned a value per share in the corporate charter Legal capital The amount of capital that must be retained in the business for the protection of corporate creditors *Par value has no relationship with market price. Concept Definition No-par value stock Capital stock that has not been assigned a value in the corporate charter Stated value The amount per share assigned by the board of directors to no-par stock Paid-in capital The amount stockholders paid in to the corporation in exchange for shares of ownership The stockholders’ equity section of a balance sheet includes: 1) Paid-in (contributed) capital 2) Retained _Earnings_ What are the 2 primary objectives in accounting for the issuance of common stock? 1) To identify the specific sources of paid-in capital 2) To maintain the distinction between paid-in capital and retained earnings Page 3 of 9 The issuance of common stock affects _only_ paid-in capital accounts. Journal Entry Debit $1,000 Cash Common Stock Credit $1,000 (To record issuance of 1,000 shares of $1 par common stock at par) Journal Entry Debit 5,000 Cash Credit Common Stock (1000 x $1) 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 (at $5 per share) Some companies issue no-oar stock with a _stated_ value. For accounting purposes, companies treat the stated value in the same way as the par value. LO 3 3. Accounting for Treasury Stock: Define treasury stock: A corporation’s own stock that has been reacquired by the corporation and is being held for future use What are a couple reasons why a corporation may acquire treasury stock?  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  To have additional shares available for use in acquiring other companies  To reduce the number of shares outstanding and thereby increase earnings per share The purchase of treasury stock is generally accounted for by the _cost_ method. Companies increase (debit) Treasury Stock by the price paid to _reacquire_ the shares. Treasury Stock decreases by the same amount when the company later _sells_ the shares. Journal Entry Debit Credit Page 4 of 9 Treasury Stock 32,000 Cash 32,000 (To record purchase of 4,000 shares of treasury stock at $8 per share) The original paid-in capital account, Common Stock, would not be affected because the _number_ of issued shares does not change. Companies show treasury stock as a _deduction_ from total paid-in capital and retained earnings in the stockholders’ equity section of the balance sheet. Thus, the acquisition of treasury stock _reduces_ stockholders’ equity. Define outstanding stock: Capital stock that has been issued and is being held by stockholders LO 4 4. Preferred Stock: Define preferred stock: Capital stock that has contractual preferences 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 sometimes do not have _voting_ rights. Journal Entry Debit 120,000 Cash Preferred Stock Credit 100,000 Paid-in Capital in Excess of Par Value-Preferred Stock 20,000 (To record the issuance of 10,000 shares of $10 par value preferred stock) Preferred stockholders have the right to share in the _distribution_ of corporate income before common stockholders. The first claim to dividends does not, however, _guarantee_ dividends. Define the following: Concept Cumulative dividend Dividends in arrears Definition A feature of preferred stock entitling the stockholder to receive current and unpaid prioryear dividends before common stockholders receive any dividends Preferred dividends that were supposed to be declared but were not declared during a given period Page 5 of 9 Dividends in arrears are _not_ considered a liability. No _obligation_ exists until the board of directors formally “declares” that the corporation will pay a dividend. LO 5 5. Dividends: What is a dividend? A distribution by a corporation to its stockholders on a pro rata (proportional to ownership) basis Dividends can take four forms:  Cash  Property  Scrip (promissory note to pay cash  Stock Define cash dividend: A pro rata (proportional to ownership) distribution of cash to stockholders For a corporation to pay a cash dividend, it must have the following: 1) Retained Earnings 2) Adequate Cash 3) Declared Dividends Entries for Cash Dividends: Three dates are important in connection with dividends; Define each: Concept Definition Declaration date The date the board of directors formally authorizes the dividend and announces it to stockholders Record date The date when the company determines ownership of outstanding shares for dividend purposes Payment date The date cash dividend payments are made to stockholders The declaration of a cash dividend commits the corporation to a binding _legal_ obligation. Entry on the Declaration Date: Journal Entry Debit Cash Dividends Credit xx Dividends Payable xx Page 6 of 9 (To record declaration of cash dividend) ********NO ENTRY IS REQUIRED ON THE RECORD DATE********** Entry on the Payment Date: Journal Entry Debit Dividends Payable Cash Credit xx xx (To record payment of cash dividend) The cumulative effect of the declaration and payment of a cash dividend on a company’s financial statements is to _decrease_ both stockholders’ equity _and_ total assets. Define stock dividend: A pro rata (proportional to ownership) distribution of the corporation’s own stock to stockholders A stock dividend results in a _decrease_ in retained earnings and an _increase_ in paid-in capital. You now own more shares of stock, but your _ownership_ interest has not changed. What are some reasons why a corporation would issue stock dividends? 1) To satisfy stockholders’ dividend expectations without spending cash 2) To increase the marketability of the stock by increasing the number of shares outstanding and thereby decreasing the market price per share 3) To emphasize that the company has permanently reinvested in the business a portion of stockholders’ equity, which therefore is unavailable for cash dividends How do stock dividends affect stockholders’ equity? They change the composition of stockholders’ equity because they result in a transfer of a portion of retained earnings to paid-in capital. However, total stockholders’ equity stays the same. *See Appendix 11A (LO9) for entries for stock dividends Define stock split: The issuance of additional shares of stock to stockholders accompanied by a reduction in the par or stated value per share Like a stock dividend, a stock split increases the _number_ of shares owned a shareholder, but it does not change the percentage of the total company that the shareholder _owns_. Page 7 of 9 A stock split does not have any effect on _paid-in_ capital, retained earnings, and total stockholders’ equity. However, the number of shares _outstanding_ increases. *A company does not need to journalize a stock split. LO 6 6. Retained Earnings: Define the following: Concept Definition Retained earnings Net income that a company retains in the business Deficit A debit balance in Retained Earnings Retained earnings restrictions Circumstances that make a portion of retained earnings currently unavailable for dividends What is a net loss? When expenses exceed revenues Restrictions result from one or more of these causes: legal _contractual_, or voluntary. They are disclosed in the notes to the financial statements. LO 7 7. Balance Sheet Presentation: In the _stockholders’ equity_ section of the balance sheet, companies report paid-in capital and retained earnings. Within paid-in capital, two classifications are recognized: 1) _Capital_ stock, which consists of preferred and common stock. Preferred stock is listed first. 2) Additional paid-in capital, which includes the _excess_ of amounts paid in over par or stated value. LO 9 8. Appendix 11A – Entries for Stock Dividends: Journal Entry Stock Dividends Common Stock Dividends Distributable Debit 75,000 Credit 50,000 Page 8 of 9 Paid-in Capital in Excess of Par Value 25,000 (To record declaration of 10% stock dividend) As the declaration date, the corporation increases (debits) Stock Dividends for the fair value of the stock issued, increases (credits) Common Stock Dividends Distributable for the par value of the dividend shares (5,000 × $10), and increases (credits) the excess over par (5,000 × $5) to an additional paidin capital account. Common Stock Dividends Distributable is a _stockholders’ equity_ account. On the balance sheet, it is shown as an addition to common stock issued. Journal Entry Debit Common Stock Dividends 50,000 Distributable Common Stock Credit 50,000 (To record the issuance of 5,000 shares in a stock dividend) 9. Know all terms and definitions. Page 9 of 9