2. Suppose you own 1,500 shares, which is 3o/o, of ABC Company's out- standing stock. lf ABC declares a2-for-l stock split, how many shares will you own? What percentage ownership will your shares now represent?
Retained Earnings
Retained earnings is the amount of all the earnings of the firm-since its beginning-that have not been distributed to the stockholders. Retained eamings may also be called eamed capital.
Retained earnings includes
1. Net incomes since the day the company began, minus 2, Any net losses since the day the company began, minus 3. Any dividends declared since the company began.
Because retained earnings is a part of shareholders' equity, the change in retained earnings during the period is contained in the statement of changes in shareholders' equity. Some- times the part of the shareholders' equity statement that provides the details of the changes in retained earnings is shown separately and called a statement ofretained earnings.
Suppose B&B Company started the year with retained earnings of $84,500.
During the yea4 B&B had net income of $25,500 and declared cash dividends of $12,200. What was the ending balance in retained earnings?
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Tom's Wear lssues New Stock
When a privately owned company decides it wants to offer ownership to the public-to raise a significant amount of capital, the form of the business organization must be a cor- poration. (A sole proprietorship or a partnership wanting to offer ownership to the public must first change its form to a corporation.) The first public offering of stock on one of the stock exchanges is called an initial public offering (IPO). Much like the work done before a company issues bonds, a company must do a great deal of work to prepare for an IPO.
The Securities and Exchange Commission (SEC) requires the company to provide many re- ports, including a set of financial statements contained in a report called a prospectus. Re- member, the job of the SEC is to protect the public.
In August, Tom decides his company could raise agreat deal ofcapital by "going pub- lic." The company has a substantial amount of debt, and Tom decides it would be a good long- term strategy to increase the company's equity. As you know, a company's creditors and owners have claim to the company's assets, and the relationship between the amount of debt and the amount of equity in a company is called the company's capital structure. Tom decides that his company's capital structure is weighted too heavily toward debt, and he wants to in- crease the cash available to pay off some of that debt. To increase his company's equity, Tom will offer the opportunity to the general public to become part owners in Tom's Wear.
Exhibit 8.8 shows the balance sheet for Tom's Wear at the beginning of August. This is the July 31 balance sheet you saw in Chapter 7 (Exhibit 7.14). The first transaction for August is the Tom's Wear IPO. Although the form of the company has been a corporation, Tom's Wear has a lot of work to do to prepare to go public. The SEC requirements for this IPO are extensive, and we will let the investment bankers do the work behind the scenes.
These are finance, accounting, and legal experts in the area of IPOs. The accounting changes in the balance sheet depend on the characteristics ofthe debt and equity ofthe com- pany and the agreements the creditors and owners make. We will make it very simple for Tom's Wear, but in a real-world IPO, transactions could be much more complicated.
Tom's Wear, Inc.
Balance Sheet At August 1
C H A P T E R 8 . T O M ' S W E A R I S S U E S N E W S T O C K 397
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P r e p a r e f i n a n c i a l statements that contain equity transactions.
E X H I B I T 8 . 8
Balance Sheet for Tom's Wear at August 1
Assets Current assets Cash
Accounts receivable (net of $3,290 allowance foruncollectible accounts) ....
Inventory
Prepaid insurance Prepaid rent
Prepaid Web services Total current assets Land
Equipment (net of $500 accumulated depreciation) Van (net of $4,205 accumulated depreciation) Building (net of $130 accumulated depreciation)
Liabilities & Shareholder's Equity Current liabilities
Accounts payable Interest payable Warranty liability Salaries payable
Mortgage payable Notes payable
$ 20,651 h
101,810 8,910
bU
600 150 t32,t7l
7,500 3,500 25,795
36,000 1,500 2,239 2,352 O t h e r p a y a b l e s . . . . . 1 , 1 4 8 Current portion of
mortgage payable 2,710
Current portion of
long-term notes payable 6,000 Total current liabilities 51,949
72,290 24,000 148,239
5,000 83,097 Total liabilities
Shareholder's Equity 67,370
Common stock Retained earnings Total liabilities and
Totalassets .. $236,336 shareholder'sequity .. $236,336
3 9 8 C H A P T E R 8 . A C C O U N T I N G F O R S H A R E H O L D E R S ' E Q U I T Y
Tom works with an investment banking firm and an accounting firm to prepare the stock offering-the IPO. The investment bankers do the legal work and essentially buy the stock and then offer it to the public. The accountants prepare extensive financial informa- tion, required by the SEC, in a document called a prospectus. (For simplicity, we will as- sume that all of their fees have been deducted from the issue price of the stock.) Tom's Wear's corporate charter has 50,000,000 shares of common stock authorized with a par value of $0.01. Tom's personal ownership, which we have simply referred to as common stock without any details of the number of shares, is actually 500,000 shares. (Recall, his contribution was $5,000.) Tom wants to retain a majority of the stock so that he can retain control of the company, so Tom's Wear decides to issue 250,000 additional common shares in this initial offering. The shares are issued at $5 per share.
Assets = Liabilities + Shareholders'equity Contributed + Retained
capital earnings 2,500 common
stock I,247 ,500 additional
paid-in capital
The remaining August transactions for Tom's Wear are given in Exhibit 8.9. Trace each one to the accounting equation worksheet in Exhibit 8.10. Then, study the list of adjustments. To make the necessary adjustments, you will need the following information.
1. Tom's Wear employees drove the van 20,000 miles in August. So the depreciation on the van is $2,900 (20,000 miles X 0.145 per mile).
E X H I B I T 8 . 9
1,250,000 cash
August Transactions for Tom's Wear, Inc.
I August 1 Tom's Wear issues stock for $1,250,000.
2 August 2 Tom's Wear pays the salaries payable of $2,352 and the payroll taxes of $1,148 recorded as "Other Payables."
3 August 10 Collects cash on accounts receivable of $96,000 4 August 12 Pays accounts payable of$30,000
5 August 14 Tom has been concentrating on increasing sales, so he must increase inventory purchases as well. With the new inflow of cash from the stock offering, Tom's Wear decides to buy 25,000 shirts. He gets a quantity discount from the vendor, paying $3.50 for each shirt. He pays cash for the purchase.
6 August 20 Tom's Wear flnds out that PIay Ball Sports Shop has closed and filed bankruptcy. He writes off the account, which has a balance of $3,000.
7 August 15-30 Tom's sales efforts continue to pay off with the addition of several more customers. Tom's Wear lowers the price slightly, and he is able to dramatically increase sales. During August, Tom's Wear sells 20,151 shirts at $10 each. AII sales af,e on account.
8 August 15-30 During August, 300 shirts are returned with defects, and Tom's Wear replaces them with new shirts.
9 August 15-30 Miscellaneous operating expenses amount to $42,500 for the month, paid in cash.
l0 August 30 The pay'roll has grown considerably because Tom has hired several new employees, including an on-site manager to run the warehouse. He has also put himself on the management payroll. Tom's Wear has hired a firm to handle his payroll because he has hired several new employees. The firm sends the payroll company a check for $22,000 by the 30th of each month to cover the monthly payroll and payroll tax expenses. The payroll company pays the employees and the payroll taxes and charges a fee based on the number of employees. Tom's Wear records the total expense as salary expense for financial statement purposes.
I 1 August 30 Tom's Wear pays for insurance to cover the business from August 15 to December 31 for a total of $675.
12 August 31 By the end of the month, Tom sees that he needs to increase the number of delivery vans and purchase - some new office equipment. Tom's Wear pays cash for two vans for a total cost of $100,000 and new offlrce equipment for $100,000.
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2. Due to fewer than expected warranty issues, Tom's Wear has decided to record only 17o of sales for potential wafranty problems. Warranty expense will be $2'015 ( $ 2 0 1 ' 5 1 0 x I V o ) '
3. Allowance for uncollectible accounts will remain at 3Vo of credit sales. So bad debts expense will be $6,045 ($201,510 x 37o).
In addition to these adjustments, Tom's Wear must make the following routine month-end adjustments.
4. Rent-$600 for August
5. Insurance-$125 ($50 + $75) forAugust 6. Web service-$5O for August
7. Depreciation on computer ($100 per month)
E X H I B I T 8 . 1 1
t0m'swGal Financial Statements for Tom's Wear for August 2006
Tom's Wear, Inc.
Income Statement For the Month Ended August 31
Tom's Wear, Inc.
Statement of Changes in Shareholder's Equity For the Month Ended August 31
Revenues:
s a l e s .. . . . . . $ 2 0 1 ' 5 1 0 Expenses:
Cost ofgoods sold .. 70,776
Insurance expense L26
Rent expense 600
Depreciationexpeme ... 3,130
22,000 750 2,0r5 Salary expense .
Common stock Beginning balmce
New issue of stock-Par value Additional paid-in capital for new issue Ending ba.lmce
Retained emings:
Beginning balance lnterest expense
Wmmty expense
$ 5,000 2,600 7,600 1,247,500
$ 1,256,000
$ 83,097 5 3 , 6 1 9
$ 130,616
$ 1,391,616
Bad debts expense 6'045
Other operating expenses . . 42'660 147 '99L
Netincome .... $-6iLEXl
Tom's Wear, Inc.
Statement of Cash Flows For the Month Ended August 31
Caeh from operating activities:
C6h collected from customerc
Cashpaidtovendors . .
Cffih paid for operating expense Cash ftom investing octivities:
Puchroe of vms and office equipment
Cash from fmmcing activitiesl New stock issue Increase in cffih Add begiming cmh Ending cmh balmce
. . 9 6 , 0 0 0 . (117,500)
(68,675) (90,175)
Assets Cufrent assets
Cash $ 980'476
Accounts receivable (net of $6,335 for mcollectible
Liabilities & Shareholders' Equity Cwent liabilities
Accountspayable ...
Interest payable WilrmWliability Current portion of mortgagepayable ,.
Cuent portion of long-tem notes payable Total curent liabilities Mortgage payable Notes payable Totalliabilities ...
Shtreholdere' Equiry
. . $ 6 , 0 0 0 2,250 3,204
(200,000) Prepaid Inventory ",
201,275 24,584
600 100 r,207,036
7,500 I03,400 t22,895 67,240
Retained emings Total liabilities md shaeholdere' equity
2,7r0 6,000 20,164 72,290 24,000 116,464
7,500 1 tL7
, 136,61ri
. $_1,54&!zs
1,250,000 '. $ 959,825 , 20,651
seMces cwent 6sets
Lmd
Equipment (net of $600 accmulated depreciation) Vatr (net of $7,105 accmulated depreciation) Building (net of $260 accrmulated depreciation)
Tom's Wear, Inc.
Balance Sheet At August 31
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Total trsets . $ 1,508,070
C H A P T E R 8 . A P P L Y I N G Y O U R K N O W L E D G E : R A T I O A N A L Y S I S 4 O 1
8. Depreciation on buildinC 662,400/40: $1,560 per year; $130 per month) 9. Interest on van loan ($30,000 x 0.10 : $3000 per year; $250 per month) L0. Interest on mortgage ($75,000 x 0.08 : $6,000; $500 per month)
All of these adjustments are shown on the accounting equation worksheet in Exhibit 8.10.
After you understand all of the entries on the worksheet, trace the numbers to the financial statements shown in Exhibit 8.11.
Applying Your Knowledge: Ratio Analysis
The shareholders' equity of a firm can provide information useful for financial statement analysis. There are two ratios that help us evaluate the return to shareholders.
L. Return on equity 2. Earnings per share
Return on Equity
Return on equity (ROE) measures the amount of income earned with each dollar of com- mon shareholders'investment in the firm. To calculate ROE, we need the amount of com- mon shareholders'equity at the beginning and at the end of the accounting period. Common shareholders'equity is all the equity except the prefened shareholders' equity. The ratio uses common shareholders' equity because common shareholders are considered to be the true owners of the firm. Then, we use the net income, reduced by the amount of preferred dividends declared, for the numerator. The reason for deducting prefened dividends from net income is that we are calculating the return to the common shareholder. The ratio takes preferred shareholders out of both the numerator and denominator. Recall that common shareholders are entitled to the earnings of the firm only after preferred dividends are paid.
Return on equity tells us how well the company is using the common shareholders' confri- butions and earnings retained in the business.
Exhibit 8.12 shows the information needed to calculate Papa John's return on equity for two consecutive years. The size of the return needs to be compared to other similar com- panies or to industry standards for a meaningful analysis of a firm's performance. Notice that Papa John's ROE has increased quite significantly-from abolt 15.6Vo to about 30.7Vo.
Any analyst would want to get more information about such a significant increase, Remem- ber that when we calculate the ratios, we use a simple average of beginning and ending com- mon shareholders' equity for the denominator.
Earnings Per Share
Earnings per share (EPS) is perhaps the most well-known and used ratio because analysts and investors use current earnings to predict future dividends and stock prices. This ratio is the per-share portion of net income of each common shareholder.
Earnings per share : Net income-Preferred dividends
Weighted average number of common shares outstanding
E X H | B | T 8 . 1 2
L.O.7