Stockholders’ Equity

CHAPTER 
10
Learning Objectives
After studying this chapter, you should be able to
•	Describe the rights of shareholders
•	Differentiate among authorized, issued, and outstanding shares
•	Contrast bonds, preferred stock, and common stock
•	Identify the economic characteristics of and accounting for stock splits
•	Account for both large- and small-percentage stock dividends
•	Explain and report stock repurchases and other treasury stock transactions
Learning Objectives
After studying this chapter, you should be able to
•	Record conversion of debt for equity or of preferred stock into common stock
•	Use the rate of return on common equity and book value per share
Background on Stockholders’ Equity
•	Corporations are business entities authorized in accordance with state laws
•	Stockholders have the right to:
–	Vote
–	Share in corporate profits
–	Share in any assets left at liquidation
–	Acquire more shares of subsequent issues of stock
•	Stockholders vote to elect the board of directors
Background on Stockholders’ Equity
•	A corporate proxy is a written authority granted by shareholders to have another party cast their votes at the annual meeting 
•	A preemptive right is the right to acquire a proportional amount of any new issue of capital stock
•	Stockholders have limited liability
–	Creditors have claims only on the assets owned by the corporation
–	Stockholders’ personal assets are not at risk

Authorized, Issued, 
and Outstanding Stock
•	The articles of incorporation detail the number of shares and types of capital stock
•	Shares can be:
–	Authorized—the total number of shares that can be issued
–	Issued—the number of shares exchanged with stockholders
–	Outstanding—the number of shares still held by the stockholders
•	Treasury shares are shares of the corporation’s own stock which have been repurchased
Accounting for Stock Issuance
•	Many companies separate their common stock recognition into two categories:
–	Par value—a measure of protection of creditors establishing the minimum legal capital liability
–	Additional paid-in capital—the amount above par value
•	If UPS issues an additional 1 million shares of its $.01 par value stock at $63, the journal entry is:
Cash Dividends
•	Dividends are proportional distributions of income to shareholders
•	To pay cash dividends a corporation must have:
–	Cash
–	Retained earnings
•	Dividends must be declared by the board of directors—they are not automatic
Cash Dividends
•	There are three important dates associated with dividends:
–	Date of declaration—the date when dividends are announced by the board
–	Date of record—stockholders owning stock on this date receive the dividend
–	Date of payment—the date the company makes payment
Cash Dividends
•	A company declares a $20,000 cash dividend on September 26 to be paid on November 15 to the October 25 stockholders of record.  The journal entries are:
Preferred Stock
•	Preferred stock offers owners different rights and preferential treatment
–	Dividend preference—preference over dividend claims of common stockholders
–	Liquidation preference—preference to assets in the event of a liquidation
–	Preferred stock does not normally have voting rights
Cumulative Dividends
•	Cumulative preferred stock requires that undeclared dividends accumulate and must be paid before common stockholders can receive dividends
•	Accumulated unpaid dividends are called dividend arrearages
•	Cumulative preferred shares typically pay a lower dividend than noncumulative shares
Preference in Liquidation
•	Preferred stock usually has a liquidation value
–	The liquidation value (plus any dividends in arrears) must be paid to preferred stockholders before distributions to common stockholders when a company is liquidated
–	The liquidation value is often the same as par value
•	The company must pay off all debts first
•	There is less risk associated with preferred stock than common stock
Other Features of Preferred Stock
•	Participating preferred stock receives a fixed dividend but can receive dividends above this amount if the company has a good year
•	Callable preferred stock gives the company the right to redeem the stock at a certain call price
•	Convertible preferred stock gives the owner the option to exchange the preferred shares for common shares
Comparing Bonds and 
Preferred Stock
Employee Stock Options
•	Stock options are rights to purchase a specific number of shares of a corporation's capital stock at a specific price for a specific time period
•	Stock options vest when an employee remains with the company for a specific time period
•	Once vested, an employee may exercise options anytime before they expire (usually about 5 years)
•	Stock options are used as a form of employee compensation (expense)
Employee Stock Options
•	Suppose in 2002 UPS grants options to purchase 30,000 shares of its $.01 par value common stock at $60. The estimated value of each option is $7.  The options can be exercised over a 3-year period starting 5 years from the date of grant.  The 2002 journal entry is:

Employee Stock Options
•	Now suppose executives exercise all options 5 years after the date of grant.  The journal entry in 2007 would be:

Restricted Stock
•	Granting restricted stock is like paying employees with common stock instead of cash
–	Employees cannot sell the stock until it vests
–	The stock is generally sold back to the company at the prevailing market price
•	The company records compensation expense and an increase to paid-in capital
•	Employees holding restricted stock receive dividends if declared
Stock Splits
•	A two-for-one stock split involves issuing an additional share for each share currently owned
•	The number of shares outstanding double and the par value decreases by 50%
•	Total stockholders’ equity remains unchanged
•	The market price should drop 50%
•	Companies split their stock in order to make their shares more affordable to small investors
Stock Dividends
•	Stock dividends are dividends paid in the corporation’s own shares of common stock
•	Stock dividends require the transfer of an amount from retained earnings to paid-in capital
•	The measurement of the amount depends upon whether the stock dividend is large or small
–	A large stock dividend is one that issues 20% or more additional shares (measured at par value)
–	A small stock dividend is one that issues less than 20% additional shares (measured at market value)

Stock Dividends
•	The entries below illustrate a 100% stock dividend vs. a 2% stock dividend for a company with 100,000 shares of $10 par value common stock with a market value of $150
Repurchase of Shares
•	Companies repurchase shares because they:
–	Want to retire the stock
–	Think the stock is undervalued by the market
–	Want to change to proportion of debt and equity in the company
–	Need shares to distribute in a stock option plan
–	Want to return cash to shareholders without creating expectations for permanent increases in dividends
•	Repurchased shares also increases EPS
Retirement of Shares
•	Suppose Allstar company purchases and retires 5,000 of its outstanding $10 par value shares at $150 for a total of $750,000 cash.  Allstar originally issued the shares at $50 per share.  The following journal entry reverses the original paid-in capital and charges the additional amount to retained earnings:
Treasury Stock
•	Now suppose Allstar in the previous example decides to temporarily hold the repurchased shares rather than retiring them. The journal entry for the repurchase of the shares is:

•	Treasury stock is a contra stockholder equity account—not an asset
Treasury Stock
•	The entries below show reissuance of Allstar’s treasury shares at an amount above or below the acquisition cost ($150):
Other Issuances of Common Stock
•	Common stock is not always issued for cash
•	Common stock can also be issued in:
–	Noncash exchanges for assets or services
–	Conversions of convertible bonds or preferred stock
–	Exchanges for tracking shares
Retained Earnings Restrictions
•	State laws or contractual obligations often restrict retained earnings (and assets) for the protection of creditors
•	Example: Dividends cannot be paid out to the point that retained earnings is less than the cost of treasury stock
•	Companies can disclose restrictions by:
–	Footnotes
–	A line item on the balance sheet called restricted or appropriated retained earnings
Other Components of 
Stockholders’ Equity
•	Two other elements can appear in stockholders’ equity:
–	Accumulated Other Comprehensive Income (Loss), which can arise from:
•	Foreign currency translation adjustments
•	Unrealized investment gains and losses (Chapter 12)
•	Certain pension liability adjustments
–	Deferred Compensation Agreements where there is an obligation to deliver shares in the future

Financial Ratios Related to 
Stockholders’ Equity
•	The rate of return on common equity (ROE) measures a company’s profitability based on the book value of the company

•	ROE provides a way to compare profitability across companies or examine trends across time for a given company
Financial Ratios Related to 
Stockholders’ Equity

•	The market value of a stock is usually different from the book value
•	Calculating a market-to-book ratio often helps highlight the causes behind the difference in values
•	A market value well above the book value may indicate unrecorded or appreciated assets