Financial accounting in an economic context 8e chapter 012

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 Pr

Chapter 12

Shareholders’ Equity

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

 Retained Earnings

Chapter 12: Shareholders’ Equity

Relative Importance of Liabilities, Capital, and Retained Earnings

(% of total assets)

Debt versus 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

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 Equity

Preferred Stock vs Common Stock

Preferred Stock Common Stock

Advantages Preference over common in

liquidation Voting RightsStated 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

Sample Co Shareholders’ Equity

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

authorized, 80,000 shares issued, and

75,000 shares outstanding $ 80,000

Common stock dividends distributable 2,000

Preferred stock, $100 par value, 1,000 shares

authorized, 100 shares issued and

outstanding 10,000

Paid in capital on common $ 20,000

Paid in capital on preferred 3,000

Paid in capital on treasury stock 2,000 25,000 Retained earnings:

Unappropriated $18,000

Appropriated 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

Journal Entries-Sample Co.

Now, using Sample Company information, record the

following additional issues of common (CS) and preferred stock (PS):

Issued 100 shares of PS at $102 per share:

Cash (100 x $102) 10,200

PS (100 x $100 par) 10,000 APIC - PS (plug) 200 Issued 500 shares of CS at $5 per share:

Cash (500 x $5) 2,500

APIC - CS (plug) 2,000

Treasury Stock

common stock.

 The debit balance account called “Treasury Stock” is

reported in shareholders’ equity as a contra account 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.

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:

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

Sample Co Shareholders’ Equity

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

authorized, 80,000 shares issued, and

75,000 shares outstanding $ 80,000

Common stock dividends distributable 2,000

Preferred stock, $100 par value, 1,000 shares

authorized, 100 shares issued and

outstanding 10,000

Paid in capital on common $ 20,000

Paid in capital on preferred 3,000

Paid in capital on treasury stock 2,000 25,000

Retained earnings:

Unappropriated $18,000

Appropriated 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

TS - Example Problem

Tiger 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

TS Example -Journal Entries

Dec: 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).

APIC - TS (1) 2,000

RE (2) 6,000

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) xx

Add/Subtract: Prior period adjustment xx

RE, beginning (restated) xx

Less 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

Example 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.

Example 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

Stock 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 20,000 Stock Div Distributable 20,000

Common Stock 20,000

Stock 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:

 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:

Stock Dividends vs Stock Splits

To summarize the effects on IZM Company:

100% Stock 2 for 1

After: Dividend Stock Split

Total sh outstanding 20,000 sh 20,000 sh.

Par value per share $2 $1

Market price per share $25 $25

Total shareholders’ eq: $100,000 $100,000

General 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

Other 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.

Comprehensive Class Problem -

During 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

Comprehensive Class Problem - Shareholders’ Equity (continued)

Required:

A Prepare journal entries for items 2 through 6 (item 1

would require detailed information for revenues and

expenses to prepare - just know that the credit is to

retained earnings for $250,000).

B 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.

Comprehensive Class Problem - Solution

Treasury Stock 40,000

Comprehensive Class Problem - Solution

Part A: Journal Entries

4 Calc: 500 shares x $18 market = $9,000

Cash 9,000 market Retained Earnings 1,000 plug

Treasury Stock 10,000 cost Stock Dividend (RE) 200,000

Stock Div Distributable 200,000

Comprehensive Class Problem - Solution

Part 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)

Unrealized Gain on AFS 12,000

Comprehensive Class Problem - Solution

Part B: Statement of SE (in thousands)

Comprehensive Class Problem - Solution Part C: Shareholders’ Equity Section of B/S

Common stock, $10 par value, 50,000 shares

authorized, 20,000 shares issued,

Other comprehensive income

(unrealized gain on AFS investment) 12,000

Less: Treasury stock, 1,500 shares at cost (30,000)

Total shareholders’ equity $1,191,000

30

Copyright © 2011 John Wiley & Sons, Inc All rights reserved

Reproduction or translation of this work beyond that permitted in

Section 117 of the 1976 United States Copyright Act without the

express written permission of the copyright owner is unlawful

Request for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc The purchaser

may make back-up copies for his/her own use only and not for

distribution or resale The Publisher assumes no responsibility for

errors, omissions, or damages, caused by the use of these

programs or from the use of the information contained herein.