Principles of financial accounting 12e by needles crosson chapter 13

Types of Stock A corporation can issue two types of stock: – Common stock —the basic form of stock  Shares of common stock carry voting rights and usually provide their owners with the

Concepts Underlying the Corporate Form of

Business

 A corporation is a separate entity chartered by

the state and legally separate from its owners, or

– To form a corporation, most states require incorporators

to sign an application and file it with the proper state official This application contains the articles of

incorporation , which form the company charter.

 The articles of incorporation state the maximum number of shares that a corporation is authorized to issue.

Concepts Underlying the Corporate Form

of Business

– To invest in a corporation, a stockholder

transfers cash or other resources to the corporation In return, the stockholder receives shares of stock representing a proportionate share of ownership.

– Stockholders elect a board of directors , which sets corporate policies and chooses the corporation’s officers, who in turn carry out the corporate policies in their

management of the business.

Concepts Underlying the Corporate Form

of Business

– Besides deciding on major business policies, a corporation’s board of directors:

 authorizes contracts.

 sets executive salaries.

 arranges major loans with banks.

 declares dividends , which are distributions, among the stockholders, of the assets that a corporation’s earnings have generated.

– Management of a corporation, which consists of the operating officers, carries out corporate

policies, runs day-to-day operations, and reports the financial results of its administration

to the board of directors and the stockholders.

Advantages of Incorporation

 Separate legal entity

 Limited liability: Creditors can satisfy their claims only against the assets of the corporation, not against the personal property of the corporation’s owners.

 Ease of capital generation

 Ease of transfer of ownership

 Lack of mutual agency: The corporation is not bound

by any contracts that individual stockholders may

enter into.

 Continuous existence

 Centralized authority and responsibility

 Professional management

Disadvantages of Incorporation

 Government regulation: Corporations must file many reports with the state in which they are chartered, and publicly held corporations must also file reports with

the SEC and with their stock exchanges.

 Double taxation : A corporation’s earnings are

subject to federal and state income taxes If any of the corporations’ earnings are paid out as dividends, the earnings are taxed again as income to stockholders.

 Limited liability: This may restrict the ability of a small corporation to borrow money.

 Separation of ownership and control: Management

may make decisions that are not good for the

corporation.

Equity Financing

 Equity financing is accomplished by issuing stock to investors in exchange for assets.

– Once the stock has been issued to them,

stockholders can transfer their ownership at will.

 Large corporations often appoint independent

registrars and transfer agents (usually banks and trust companies) to help perform the transfer duties.

– Two important terms in equity financing are:

 Par value —an arbitrary amount assigned to each share of stock It must be recorded in the capital stock accounts.

 Legal capital —the number of shares issued multiplied by the par value It is the minimum amount that a corporation can report as contributed capital.

Equity Financing

– To help with its initial public offering (IPO), a

corporation often uses an underwriter —an intermediary between the corporation and the investing public.

 The corporation records the amount of the net proceeds of the offering in its Capital Stock and Additional Paid-in Capital accounts The net proceeds are what the public paid less the underwriter’s fees, legal expenses, and other direct costs of the

offering.

 The costs of forming a corporation are called

start-up and organization costs These costs include state incorporation fees, attorneys’ and accountants’ fees, the cost of printing stock certificates, and other expenditures necessary to form the corporation.

Advantages and Disadvantages of

– Increased cash for

operations – Better debt to

equity ratio

 Disadvantages

– Increased tax liability

 Whereas the interest

on debt is deductible, the dividends paid on stock are not.

tax-– Decreased stockholder control

 When a corporation issues more stock, it dilutes its

ownership.

Components of Stockholders’ Equity

 In a corporation’s balance sheet, the owners’

claims to the business are called stockholders’ equity

– This section of a corporate balance sheet

usually has at least three components:

 Contributed capital—the stockholders’ investments in the corporation

 Retained earnings —the earnings of the corporation since its inception, less any losses, dividends, or

transfers to contributed capital These are reinvested

in the business.

 Treasury stock—shares of the corporation’s own stock that it has bought back on the open market

Types of Stock

 A corporation can issue two types of stock:

– Common stock —the basic form of stock

 Shares of common stock carry voting rights and usually provide their owners with the means of controlling the corporation.

 Common stock is also called residual equity because the

claims of all creditors and usually those of preferred stockholders rank ahead of the claims of common stockholders.

– Preferred stock —stock that gives its owners

preference over common stockholders in terms of receiving dividends and in terms of claims to

assets if the corporation is liquidated.

Types of Shares

 Authorized shares are the maximum

number of shares that a corporation’s charter allows it to issue.

 Issued shares are those that a corporation sells or otherwise transfers to stockholders.

 Outstanding shares are shares that a

corporation has issued and that are still in

circulation A corporation may have more

shares issued than are currently outstanding if

it has bought back treasury shares.

Preference as to Dividends

certain amount of dividends before common

stockholders receive anything.

– If the stock is noncumulative preferred stock and the board of directors fails to declare a dividend in any year, the company is under no obligation to make up the missed dividend in future years.

– If the stock is cumulative preferred stock , the

dividend amount per share accumulates from year to year if unpaid, and the company must pay the whole amount before it pays any dividends on common stock.

 Dividends not paid in the year they are due are called

dividends in arrears

Convertible and Callable Preferred Stock

(slide 1 of 2)

 Owners of convertible preferred stock can

exchange their shares of preferred stock for

shares of common stock at a ratio stated in the preferred stock contract.

– If the market value of the common stock

increases, the conversion feature allows these stockholders to share in the increase by

converting their stock to common stock.

 Most preferred stock is callable preferred stock

—that is, the issuing corporation can redeem it at

a price stated in the preferred stock contract.

Convertible and Callable Preferred Stock

(slide 2 of 2)

– The call price, or redemption price, of callable

preferred stock is usually higher than the stock’s par value.

– If the preferred stock is convertible, the

stockholder can either surrender the stock or convert it to common stock.

– When preferred stock is called and surrendered, the stockholder is entitled to:

 The par value of the stock

 The call premium

 Any dividends in arrears

 The current period’s dividend prorated by the proportion

of the year to the call date

Issuance of Common Stock

 A share of capital stock may be par or no-par.

– The value of par stock is stated in the corporate charter

and on each stock certificate.

 A corporation cannot declare a dividend that would cause stockholders’ equity to fall below the legal capital Thus, par value is a minimum cushion of capital that protects a

corporation’s creditors.

– No-par stock does not have a par value

 Most states require that all or part of the proceeds from a corporation’s issuance of no-par stock be designated as legal capital, which cannot be used unless the corporation is

liquidated.

 State laws often require corporations to place a stated value

on each share of stock they issue The stated value can be any value set by the board unless the state specifies a minimum amount, which is sometimes the case.

Accounting for Treasury Stock

 Treasury stock is stock that the issuing

company has reacquired, usually by

purchasing shares on the open market.

– A company may want to buy back its own stock for any of the following reasons:

 To distribute to employees through stock option plans.

 To maintain a favorable market for its stock.

 To increase its earnings per share or stock price per share.

 To have additional shares of stock available for purchasing other companies.

 To prevent a hostile takeover.

Accounting for Cash Dividends

retained earnings to pay a dividend, its board of

directors may not do so for several reasons:

– The corporation may need the cash for expansion.

– It may want to improve its overall financial position by

liquidating debt.

– It may be facing major uncertainties, such as a pending

lawsuit, strike, or a projected decline in the economy.

dividend A corporation usually pays a liquidating dividend only when it is going out of business or

reducing its operations.

Dividend Dates

- Declaration date —the date on which the board of directors formally declares that the corporation is going to pay a

- Payment date —the date on which the dividend is paid to the stockholders of record

 To reduce the stock’s market price by increasing the number

of shares outstanding (a goal more often met by a stock split).

 To make a nontaxable distribution to stockholders.

 To increase the company’s permanent capital by transferring

an amount from retained earnings to contributed capital.

Stock Splits

 A stock split occurs when a corporation increases the number of shares of stock issued and outstanding and reduces the par or stated value proportionally.

– A company may plan a stock split for the

following reasons:

thereby, increase the demand and volume of trading for its stock at this lower price.

operating goals.

Statement of Stockholders’ Equity

The statement of stockholders’ equity

summarizes changes in the components of the

stockholders’ equity section of the balance sheet.

Book Value and Book Value per Share

 The book value of stock represents a company’s total assets less its liabilities (in other words, its net assets).

 The book value per share is the equity of the owner

of one share of stock in the net assets of the company.

– If a company has only common stock outstanding, book value per share is calculated as follows:

Stockholders’ equity ÷ Common Shares Outstanding =

Book Value per Share

– If a company has both preferred and common stock, the preferred stock’s call value and any dividends in arrears are subtracted from stockholders’ equity to determine the equity pertaining to common stock

Dividend Yield

dividing the dividends per share by the market price per share.

– Investors use the dividend yield ratio to

evaluate the amount of dividends they receive.

Return on Equity

to average total stockholders’ equity.

– It is the most important ratio associated with

stockholders’ equity and is a common measure of management’s performance.

– As a company sells more shares of stock,

– Management can reduce stockholders’ equity,

thereby increasing return on equity, by buying back the company’s shares on the open market The cost

of treasury stock has the following effect:

Price Earnings Ratio

measure of investors’ confidence in a

company’s future

– It is calculated by dividing the market price per share by the earnings per share.

Stock Options as Compensation

 Stock option plans give employees the right

to purchase stock in the future at a fixed price.

tied to a company’s performance, these plans are a means of both motivating and compensating

employees.

difference between the option price and the market price grows, which increases the amount of

compensation.

is tax-deductible.