Financial accounting 9th jamie pratt chapter 12

How to Finance a Corporation: Borrow  Notes, Bonds, Leases  The debt holders are legally entitled to repayment of their principal and interest claims  Issue Equity  Common and Prefe

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Chapter 12

Shareholders’ Equity

How to Finance a 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 (profitable operations)

Shareholders’ Equity

Relative Importance of Liabilities, Contributed Capital, and Earned Capital

Figure 12-2 The relative importance

of liabilities, contributed capital, and retained

Debt and Equity Distinguished - Characteristics

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

Distinctions Between Debt and Equity

Interested Party Debt Equity

Investors /

Creditors

Management

Contractual future cash

payments

Dividends are discretionary

Effects on credit rating

Effects of dilution/ takeover

Interest is tax deductible Dividends are not tax deductible

The Economic Consequences Associated with Accounting for Shareholders’

Equity

 Key business ratios rely on Shareholders’ equity which affects credit ratings and analysts evaluation of a company

Figure 12-5 Shareholders’ equity section

of balance sheet

Preferred Stock vs Common Stock

Advantages Preference over common in liquidation Voting Rights

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

(Used for Examples)

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

authorized, 80,000 shares issued, and

Common stock dividends distributable 2,000

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

authorized, 100 shares issued and

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:

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

Accounting for Common and Preferred Stock Issuances

Using Sample Company’s information, record the following additional issues of common (CS) and preferred stock (PS) Par value of PS is $100 and par value of CS is $1

Issued 100 shares of PS at $102 per share:

Treasury Stock

 Created when a company buys back shares of its own common stock.

 Reasons for buyback are numerous and include

 Support compensation plans

 Maintain leverage

 Raise EPS

 Return money to shareholders

 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.

Treasury Stock Example from Sample Co.

Note that Sample Company (from previous slide) has 5,000 shares of Treasury Stock (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:

Cash 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

Treasury Stock - Example Problem

Tiger Corporation has 100,000 shares of $1 par value stock authorized, issued and outstanding at January 1,

2014 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 2014, Tiger Corp repurchases 10,000 shares of its own stock at $7 per share In July of 2014, Tiger Corp reissues 2,000 shares of the treasury stock for $8 per share In December of 2014, Tiger Corp reissues the remaining 8,000 shares for $6 per share Prepare the journal entries for 2014

regarding the treasury stock

Treasury Stock Example - Journal Entries

Treasury Stock 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

Stock Options

 Give employees (typically executives) the right to purchase company stock at a given price for a period of time.

 The idea is that if the stock price rises the executives purchase stock at a price less than its

market value thereby getting a benefit

 Since value is given up in the lower than market stock price and existing stockholders

give up a percentage of ownership, GAAP requires that an expense be booked when the options are granted

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

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:

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 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.

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

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:

 Retained Earnings 60,000

 $20,000 has been moved from RE to Common Stock

 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

Stock Dividends vs Stock Splits

To summarize the effects on IZM Company:

100% Stock 2 for 1After: 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

CS was $20,000 and RE was $80,000 before the split or dividend The stock dividend required journal entries, and the

amounts for CS and RE changed The stock split does not require a journal entry and the amounts for CS and RE do not change.

Comprehensive Class Problem - Shareholders’ Equity

Given the following SE balances for Company G at 1/1/15:

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

20,000 shares issued and outstanding $200,000

During 2015, 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, 2016

Comprehensive Class Problem -

Shareholders’ Equity (continued)

Required:

A Prepare journal entries for items 2 through 5 (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 2015.

C Prepare the stockholders’ equity section of the balance sheet for Company G for 2015, including the appropriate description for the common stock.

Comprehensive Class Problem - Solution

Cash 40,000

Treasury Stock 40,000

Cash 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

Treasury Stock 10,000 cost

Stock Dividend (RE) 200,000

Stock Div Distributable 200,000

Comprehensive Class Problem - Solution

Part B: Statement of SE (in thousands)

     CS   CSDD   APIC     RE      TS

 Balance 1/1/15         $200       $400      $400

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,

18,500 shares outstanding $ 200,000

Common stock dividends distributable, 20,000 shares 200,000

Additional paid-in capital, common stock 400,000

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

Total shareholders’ equity $1,179,000

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