Ch.13 Equity Financing - · PDF file11.Statement of changes in stockholders’ equity...

1. Stock Rights (common and preferred stock)

2. Stock Issuance for cash, noncash assets or for services

3. Treasury stock

4. Stock rights and warrants

5. Compensation expense with stock options

6. Equity-related items reported as liabilities

7. Stock conversions

8. Factors affecting retained earnings

9. Cash dividends, property dividends, stock dividends, and

stock splits

10.Unrealized gains and losses recorded as OCI and major

types of equity reserves

11.Statement of changes in stockholders’ equity

Ch.13 Equity Financing

Nature and Classifications of Paid-In Capital

• A corporation is a legal artificial entity separate

from its owners.

• Individuals contribute capital for which the

corporation issues stock certificates

evidencing ownership interests.

• Stockholders elect a board of directors

whose members oversee the strategic and

long-run planning of the corporation.

1. Rights associated with ownership of common

and preferred stock

Common and Preferred Stock

• When a corporation is formed, a single class of

stock, known as common stock, is usually

issued.

• Corporations may later find that there are

advantages to issuing one or more additional

classes of stock with varying rights and priorities.

Stock with certain preferences (rights) over

common stock is called preferred stock.

Common Stock

Unless restricted by terms of the articles of

incorporation, certain basic rights are held by

each common stockholder:

1. To vote in the election of directors and in the

determination of certain corporate policies.

2. To maintain one’s proportional interest in

the corporation through purchase of

additional common stock if and when it is

issued. This right is known as the

preemptive right.

Par or Stated Value of Stocks

The journal entry to record the issuance of

common stock in exchange for cash frequently

looks something like this:

Cash XXX

Common Stock (at par value) XXX

Additional Paid-In Capital XXX

(continued)

• Historically, par value was equal to the market

value of the shares at issuance.

• Today, most stocks have a nominal par value or no

par value at all.

• No-par stock sometimes has a stated value that for

financial reporting purposes acts like a par value.

Preferred Stock

• The term preferred stock is somewhat

misleading because it gives the impression

that preferred stock is better than common

stock.

• Preferred stock isn’t better—it’s different.

• Preferred stockholders give up many of the

rights of ownership in exchange for some of

the protection enjoyed by creditors.

(continued)

Preferred Stock

Rights of ownership given up by preferred

stockholders:

(continued)

• Voting. In most cases, preferred stockholders

are not allowed to vote for the board of

directors.

• Sharing in success. The cash dividends

received by preferred stockholders are usually

fixed in amount. Therefore, if the company

does exceptionally well, preferred stockholders

do not get to share in the success.

Preferred Stock

• Cash dividend preference. Preferred

stockholders are entitled to receive the full

cash dividend before any cash dividends are

paid to common stockholders.

• Liquidation preferences. If the company goes

bankrupt, preferred stockholders are entitled to

have their investment repaid, in full, before

common stockholders receive anything.

The protections enjoyed by preferred stockholders,

relative to common stockholders, are:

Cumulative and Noncumulative Preferred Stock

• When a corporation fails to declare dividends

on cumulative preferred stock, such

dividends accumulate and require payment in

the future before any dividends may be paid to

common stockholders.

• Dividends on cumulative preferred stock that

are passed are referred to as dividends in

arrears.

• With noncumulative preferred stock, it is not

necessary to provide for passed dividends.

(continued)

Good Time Corporation has outstanding

100,000 shares of 9% cumulative preferred

stock, $10 par. Dividends were last paid in 2010.

Total dividends of $300,000 are declared in

2013 by the board of directors.

(continued)

Dividends may be declared on common stock as

long as the preferred stock receives its preferred

rate for the current period. If the preferred stock

were noncumulative, the 2013 dividends would

be distributed as follows:

Participating Preferred Stock

• Participating preferred stock issues provide

for additional dividends to be paid to preferred

stockholders after dividends of a specified

amount are paid to the common stockholders.

• A participating provision makes preferred stock

more like common stock.

• Participating preferred stocks are now

relatively rare.

Convertible Preferred Stock

• Preferred stock is convertible when it can be

exchanged by its owner for some other

security of the issuing corporation.

• Conversion rights generally provide for the

exchange of preferred stock into common

stock.

• In some instances, preferred stock may be

converted into bonds.

Callable Preferred Stock

• Many preferred issues are callable, meaning they

may be called and canceled at the option of the

corporation.

• The call price is usually specified in the original

agreement and provides for payment of dividends in

arrears as part of the repurchase price.

Redeemable Preferred Stock

• Redeemable preferred stock is preferred stock that

is redeemable at the option of the stockholder or upon

other conditions not within the control of the issuer.

• Redeemable preferred stock is somewhat like a loan

in that the issuing corporation may be forced to repay

the stock proceeds.

Current Development in The Accounting for

Preferred Stock

• In the Preliminary Views document, the

FASB recommends the “basic ownership

approach” to identifying equity.

• This approach hinges on the idea that equity

claims are those that remain when all other

claims have been satisfied.

• The basic ownership approach would be very

restrictive. In fact, all preferred stock, whether

redeemable or not, would be reported as a

liability under this approach.

(continued)

Current Development in The Accounting for

Preferred Stock

• Users prefer a “perpetual approach,” which

describes an equity instrument as one for

which there is no requirement to repay the

invested funds, and the holder of the

instrument is entitled to some assets if the

company is liquidated.

• Both the FASB and IASB are leaning toward

the “perpetual approach.”

Capital Stock Issued for Cash

• The issuance of stock for cash is recorded by a

debit to Cash and a credit to Capital Stock for

the par value.

• When the amount of cash received for the stock

is more than the par value, the excess is

recorded as a credit to an additional paid-in

capital account.

(continued)

2. Issuance of stock for cash, on a subscription

basis, and in exchange for noncash assets or

for services

Goode Corporation issued 4,000 shares of $1

par common stock on April 1, 2011, for $45,000

Apr. 1 Cash 45,000

Common Stock 4,000

Paid-In Capital in Excess

of Par 41,000

Par Value Stock Par Value Stock

(continued)

On April 1, 2011, Goode Corporation issued

4,000 shares of no-par common stock with a $1

stated value.

Apr. 1 Cash 45,000

Common Stock 4,000

Paid-In Capital in Excess

of Stated Value 41,000

Stated Value Stock Stated Value Stock

(continued)

On April 1, 2011, Goode Corporation issued

4,000 shares of no-par common stock for

$45,000 cash.

Apr. 1 Cash 45,000

Common Stock 45,000

No-Par Stock No-Par Stock

Capital Stock Sold on Subscription

• A subscription is a legally binding contract

between the subscriber (purchaser of stock)

and the corporation (issuer of stock).

• The contract states the number of shares

subscribed, the subscription price, the terms of

payment, and other conditions of the

transaction.

• Ordinarily, stock certificates are not issued

until the full subscription price has been

received by the corporation.

(continued)

November 1-30: Received subscriptions on

November 1 for 5,000 shares of $1 par common

stock at $12.50 per share with 50% down,

balance due in 60 days. The entries for

November 1 are as follows:

Common Stock Subscriptions Receivable 62,500

Common Stock Subscribed 5,000

Paid-In Capital in Excess of Par 57,500

Cash 31,250

Common Stock Subscriptions

Receivable 31,250

(continued)

December 1-31: Received balance due on one-

half of subscriptions and issued stock to the fully

paid subscribers, 2,500 shares.

Cash 15,625

Common Stock Subscriptions

Receivable 15,625

Common Stock Subscribed 2,500

Common Stock 2,500

(continued)

Contributed capital would be reported in the

Stockholders’ Equity section of the December 31

balance sheet as follows:

Common Stock Subscriptions Receivable should

normally be shown as an offset to equity.

Subscription Defaults

If a subscriber defaults on a subscription, a

corporation may:

1) return to the subscriber the amount paid,

2) return to the subscriber the amount paid less

any reduction in price or expense incurred on

the resale of the stock,

3) declare the amount paid by the subscriber as

forfeited, or

4) issue to the subscriber shares equal to the

number paid for in full.

Capital Stock Issued for Consideration Other

Than Cash

AC Company issues 200 shares of $0.50 par

value common stock in return for land. The

company’s stock is currently selling for $50 per

share.

Land 10,000

Common Stock 100

When other than cash is received, the fair

market value of the stock or the fair market

value of the property or service, whichever

is more determinable is used.

When other than cash is received, the fair

market value of the stock or the fair market

value of the property or service, whichever

is more determinable is used.

The land has a readily determinable market price

of $12,000, but AC Company’s common stock

has no established fair market value.

Land 12,000

Common Stock 100

Capital Stock Issued for Consideration Other

Than Cash

If no readily determinable value is available for

either, the accepted procedure is to have the

value of the property or services appraised.

Reasons Companies Repurchase Stock

1. Provide shares for incentive compensation and employee savings plans.

2. Obtain shares needed to satisfy requests by holders of convertible securities.

3. Reduce the amount of equity relative to the amount of debt.

4. Invest excess cash temporarily.

5. Remove some shares from the open market in order to protect against a hostile takeover.

6. Improve per-share earnings by reducing the number of

shares outstanding and returning inefficiently used assets to

shareholders.

7. Display confidence that the stock is currently undervalued

by the market.

3. Use both the cost and par value methods to

account for stock repurchases

Treasury Stock

• Treasury stock is stock issued by a corporation

and subsequently reacquired by the corporation

and held for possible future reissuance or

retirement.

• Treasury stock should not be viewed as an

asset; report as a reduction in owner’s equity.

• There is no income or loss on the reacquisition,

reissuance, or retirement of treasury stock.

• Retained Earnings can be decreased by

treasury stock transactions but never increased

by such transactions.

2012—Newly organized corporation issued

10,000 shares of common stock, $1 par, at

$15: Cash 150,000

Common Stock 10,000

2013—Reacquired 1,000 shares of common

stock at $40 per share:

Treasury Stock 40,000

Cash 40,000

Cost Method of Accounting for Treasury Stock

(continued)

2013—Sold 200 shares of treasury stock at $50

per share:

Cash 10,000

Treasury Stock (200 × $40) 8,000

Paid-In Capital from Treasury

Stock 2,000

Note: No gain is recorded on the

sale. The excess is credited

to Paid-in Capital from

Treasury Stock.

Note: No gain is recorded on the

sale. The excess is credited

to Paid-in Capital from

Treasury Stock.

(continued)

per share:

Cash 17,000

Paid-In Capital from Treasury Stock 2,000

Retained Earnings 1,000

Treasury Stock (500 × $40) 20,000

(continued)

Note: No loss is recorded on the

sale. The difference is debited

to Retained Earnings.

Note: No loss is recorded on the

sale. The difference is debited

to Retained Earnings.

Common Stock 300

Retained Earnings [300 × ($40 – $15)] 7,500

Treasury Stock (300 × $40) 12,000

2013—Retired remaining 300 shares of

treasury (3% of original issue of 10,000

shares):

Alternatively, the entire $11,700 difference between

Common Stock and the cost to acquire the treasury

stock may be debited to Retained Earnings.

Par (or Stated) Value Method of Accounting for

Treasury Stock

Treasury Stock 1,000

Retained Earnings [1,000 x ($40 – $15)] 25,000

Cash 40,000

Same entry as the cost method (Slide 13-30). Same entry as the cost method (Slide 13-30).

2013—Reacquired 1,000 shares of common

stock at $40 per share:

2012—Newly organized corporation issued

10,000 shares of common stock, $1 par,

at $15:

(continued)

Treasury Stock

per share:

Cash 10,000

Treasury Stock 200

per share:

Cash 17,000

Treasury Stock 500

(continued)

Treasury Stock

2013—Retired remaining 300 shares of

treasury stock:

Common Stock 300

Treasury Stock 300

Evaluating the Cost and Par Value Methods

Less than 10% of large US. Companies

use the par value method

Less than 10% of large US. Companies

use the par value method

Stock Rights, Warrants, and Options

• Stock rights—issued to existing shareholders to

permit them to maintain their proportionate

ownership interests when new shares are to be

issued.

• Stock warrants—sold by the corporation for

cash, generally in conjunction with the issuance

of another security.

• Stock options—granted to officers or

employees, usually as part of a compensation

4. Account for the issuance of stock rights and

stock warrants

Stock Rights

• When announcing rights to purchase additional

shares of stock, the directors of a corporation

specify a date on which the rights will be issued.

• All stockholders of record on the issue date are

entitled to the rights. Thus, between the

announcement date and the issue date, the stock is

said to sell rights-on.

• After the rights are issued, the stock sells ex-rights,

and the rights may be sold separately by those

receiving them from the corporation.

• An expiration date is also designated when the

rights are announced, and rights not exercised by

this date are worthless.

Stock Warrants

The value assigned to the warrants is determined by

the relative fair value method which is illustrated in the

following equation:

assigned to

warrants

Total issue

Market value of warrants

Market value

of security

without

warrants

Market

value of

warrants +

(continued)

• Detachable warrants are similar to stock rights

because they can be traded separately from the

security with which they were originally issued.

• Nondetachable warrants cannot be separated from

the security with which they were issued.

• Stewart Co. sells 1,000 shares of $50 par

preferred stock for $58 per share. Stewart Co.

gives the purchaser detachable warrants

enabling the holders to subscribe to 1,000

shares of $2 par common stock for $25 per

share.

• Immediately following the issuance of the stock,

the warrants are selling for $3, and the fair

market value of a preferred share without the

warrant attached is $57.

Stock Warrants

(continued)

assigned to

warrants =

x Market value of warrants

Market value

of security

without

warrants

Market

value of

warrants

$57 + $3

assigned to

warrants = $58,000 x

$3 = $2,900

Stock Warrants

(continued)

The entry on Stewart’s books to record the sale

of the preferred stock with detachable warrants

is as follows:

Cash 58,000

Preferred Stock, $50 par 50,000

Paid-In Capital in Excess of Par—

Preferred Stock 5,100

Common Stock Warrants 2,900

Stock Warrants

(continued)

If the warrants are exercised: Common Stock Warrants 2,900

Cash 25,000

Common Stock, $2 par 2,000

Common Stock 25,900

If the warrants expire:

Common Stock Warrants 2,900

Paid-In Capital from Expired

Warrants 2,900

Stock Warrants

Stock Option Compensation Expense

• Whether or not to expense stock options is a “hot

potato” issue in accounting.

• The FASB kept bringing up the issue of stock

option accounting only to find that there were

strong feelings against expensing the cost of stock

options.

• Recognition of a stock option compensation

expense would reduce reported earnings. (continued)

5. Compute the compensation expense

associated with the granting of employee stock

options

Stock Option Compensation Expense

• In December 2004, the FASB adopted pre-

Codification Statement No. 123 which

requires the expensing of the fair value of

stock options granted as compensation.

• This standard is now found in FASB ASC

Topic 718.

• Neff Company estimates a grant date value of

$10 for each of the employee stock options. The

total fair value of the options granted is $100,000

(10,000 x $10) as of the grant date.

Compensation expense is allocated over three

years from January 1, 2011 (the grant date) to

January 1, 2014 (the vesting date). The year-end

entry is shown in Slide 13-48.

Basic Stock Option Compensation Plan

(continued)

$100,000/3

Dec. 31 Compensation Expense 33,333

Paid-In Capital from Stock

Options 33,333

Note that this paid-in capital is not from the

investment of cash in the business but instead

represents an investment of work by the

employees covered under the stock option

(continued)

On December 31, 2014, all 10,000 of the options are

exercised to purchase Neff’s no-par common stock:

Dec. 31 Cash (10,000 x $50) 500,000

Options 100,000

Common Stock (no

par) 600,000

The following note disclosure is required each year:

Accounting for Performance-Based Plans

In a performance-based stock option plan,

the plan terms are dependent on how well the

individual performs after the date the options

are granted or how well the company

performs during the vesting period.

(continued)

• On January 1, 2011, the board of directors of

Neff Company authorized the granting of stock

options to supplement the salaries of certain

employees.

• Each stock option permits the purchase of one

share of Neff common stock at a price of $50

per share; the market price on January 1,

2011, is also $50 per share.

(continued)

• The options vest, or become exercisable,

beginning on January 1, 2012, and only if the

employee stays with the company for the entire

3-year period. The options expire on December

31, 2014.

• The number of options granted is contingent on

Neff’s level of sales for 2013. If Neff sales are

less than $50 million, only 10,000 options will

vest. If Neff’s sales are between $50 million and

$80 million, an additional 2,000 options will vest.

If sales exceed $80 million, 15,000 vest.

(continued)

• As of December 31, Neff forecasts that 2013

sales will be around $60 million, indicating

that 12,000 options will vest.

• Recognition of compensation expense for

2013 involves recognizing one-third of the

$120,000 (12,000 x $10) total estimated

expense for the 3-year service period.

• The change in Neff’s stock price during the

year (from $50 to $60) does not affect the

calculation. (continued)

Recognition of compensation of $40,000 for each

of the three years [(12,000 options × $10)/3]:

Paid-In Capital from

Stock Options 40,000

(continued)

Events in 2012 lead Neff to lower its forecast of

2013 sales. Sales are expected to be only $40

million, so only 10,000 options will vest on

January 1, 2014. Because two-thirds of the

service period has elapsed, aggregate

compensation expense should be $66,667

($100,000 x 2/3).

Dec. 31 Compensation Expense–

($66,667 – $40,000) 26,667

Paid-In Capital from

Stock Options 26,667

(continued)

Actual sales for 2013 are $85 million, so 15,000

options will vest on January 1, 2014. Because

compensation expense of $66,667 ($40,000 +

$26,667) has already been recognized in 2011

and 2012, the necessary journal entry in 2013 is

as follows:

Dec. 31 Compensation Expense

($150,000 – $66,667) 83,333

Options 83,333

(continued)

On December 31, 2014, all 15,000 options are

exercised to purchase Neff’s no-par common

stock.

Dec. 31 Cash ($15,000 × $50) 750,000

Options 150,000

Common Stock (no par) 900,000

Accounting for Awards That Call for Cash

Settlement

• Assume that Neff Company has decided

instead of granting its employees 10,000

stock options, it will grant an equal number of

cash stock appreciation rights (SARs).

• A cash SAR awards an employee a cash

amount equal to the market value of the

issuing firm’s shares above a specified

threshold price.

(continued)

• Fair value of one SAR:

– January 1, 2011 $10

– December 31, 2011 6

– December 31, 2012 7

– December 31, 2013 9

• As of December 31, 2011, the estimated fair

value of each SAR is $6. The best estimate of

the amount of cash that will be transferred when

the cash SARs are exercised is $60,000

(10,000 x $6).

Settlement

(continued)

($60,000/3 years) 20,000

Share-Based

Compensation Liability 20,000

As of December 31, 2012 the estimated fair value

of each SAR is $7. The new estimation for

compensation expense is $70,000 (10,000 × $7).

(continued)

($46,667 – $20,000) 26,667

Share-Based

Settlement

$70,000 x 2/3

The estimated fair value of each SAR is $9 on

December 31, 2013. Aggregate compensation

expense for the 3-year service period is $90,000

($10,000 x $9). Because the compensation

expense of $46,667 has been recognized in 2011

and 2012, the necessary journal entry in 2013 is

as follows:

(90,000 –$46,667) 43,333

Share-Based

(continued)

Settlement

The share price on December 31, 2014 is $61,

meaning that Neff will pay $11 ($61 – threshold

price of $50) for each SAR.

Share-Based

Settlement

Cash payments are made to the holders of the

10,000 SARs on December 31, 2014.

Dec. 31 Share-Based

Cash [10,000 × ($61 – $50)] 110,000

Mandatorily Redeemable Preferred Shares

• Historically, the SEC required that firms not

include mandatorily redeemable preferred stock

under the Stockholders’ Equity heading.

• Given a “mezzanine” treatment.

• The FASB now requires mandatorily redeemable

preferred shares to be reported as liabilities in the

balance sheet.

(continued)

6. Determine which equity-related items should

be reported in the balance sheet as liabilities

Mandatorily Redeemable Preferred Shares

On January 1, 2011, Tarazi Company issued mandatorily

redeemable preferred shares in exchange for $100 cash.

The shares must be redeemed on January 1, 2012, for

$110. The interest rate implicit in this agreement is 10%.

Jan. 1 Cash 100

Mandatorily Redeemable

Preferred Shares (liability) 100

Dec. 31 Interest Expense ($100 x 0.10) 10

Mandatorily Redeemable

Jan. 1 Mandatorily Redeemable

Cash 110

Written Put Options

• A put option is an agreement that allows

investors to sell the issuing corporation shares

they hold at set prices on specific dates.

• If the stock price stays above a set level per

share, the issuing corporation pays nothing.

• Historically, companies have recorded these put

options as part of equity. The FASB now

instructs companies to record the fair value of

the obligation as a liability.

(continued)

Written Put Options

On January 1, 2011, Kamili Company wrote a

put option agreeing to purchase one share of its

own stock for $100 on December 31, 2012 at

the option of the purchaser. The market price of

Kamili’s shares on January 1, 2011, was $100.

On January 1, 2011, this put option has a fair

value of $20.

Jan. 1 Cash 20

Put Option (liability) 20

(continued)

Written Put Options

An option-pricing formula suggests that the fair

value of the put option on December 31, 2011, is

$30, up from $20 at the beginning of the year.

Dec. 31 Loss on Put Option 10

Put Option (liability)($30 – $20

already recognized) 10

On December 31, 2012, the put option

expiration date, the market price of Kamili stock

is $82 per share. The put option holder decides

to exercise the option and sell one share of

Kamili stock to Kamili for $100.

(continued)

Written Put Options

Kamili would record the purchase of one share

of its stock in conjunction with the exercise of

the put option.

Dec. 31 Treasury Stock (the fair value

of the share repurchased) 82

Put Option (liability) 30

Gain on Put Option 12

Cash 100

Obligation to Issue Shares of a

Certain Dollar Value

• Companies occasionally agree to satisfy their

obligations by delivering shares of their own

stock rather than by paying cash.

• This is especially true for startup companies

trying to conserve their limited cash supply.

• Depending on how the contract is written, this

promise to deliver shares of one’s stock to

satisfy the obligation can be recorded as equity

or as a liability.

(continued)

Example 1: On October 1, 2011, Lily Company

experienced trouble with its office air conditioning

system. The repair bill is $5,000. Lily agrees to

deliver 200 shares of no-par common stock to

the repairperson on February 1, 2012. On

October 1, 2011, Lily’s shares have a market

value of $25.

Oct. 1 Maintenance Expense (200 x

$25) 5,000

Common Stock Issuance

Obligation (equity) 5,000

(continued) Similar to Common Stock Subscribed

Example 2: On October 1, 2011, Lily Company

received air conditioning repair services costing

$5,000. Lily agrees to deliver shares of Lily’s no-

par common stock with a market value of $5,000

to the repairperson on February 1, 2012. On

October 1, 2011, Lily’s shares have a market

value of $25, and on February 1, 2012, the

shares have a market value of $20.

Feb. 1 Common Stock Issuance

Obligation (equity) 5,000

Common Stock 5,000

(continued)

Feb. 1 Common Stock Issuance

Obligation (liability) 5,000

Common Stock (250 x $20) 5,000

Oct. 1 Maintenance Expense 5,000

Common Stock Issuance

Obligation (liability) 5,000

Noncontrolling Interest

• Financing provided by minority stockholders is

called minority interest.

• Minority interest is the amount of equity

investment made by outside shareholders to

consolidated subsidiaries that are not 100%

owned by the parent.

• The FASB uses the term noncontrolling

interest to replace “minority interest” in the

consolidated balance sheet.

The capital section of Sorensen Corporation on

December 31, 2013, is as follows:

Preferred stock, $50 par, 10,000 $ 500,000

Paid-in capital in excess of par—

preferred 100,000

Common stock, $1 par, 100,000

shares 100,000

Paid-in capital in excess of par—

common 2,900,000

Retained earnings 1,000,000

Stock Conversions

7. Distinguish between stock conversions that

require a reduction in retained earnings and

those that do not

Stock Conversions

On December 31, 2013, 1,000 shares of

preferred stock (par $50) are exchanged for

4,000 shares of common stock (par $1).

Case 1: One Preferred for Four Common ($1) Case 1: One Preferred for Four Common ($1)

Dec. 31 Preferred Stock, $50 par 50,000

Preferred 10,000

Paid-In Capital in Excess of

Par—Common 56,000

(continued)

On December 31, 2011, 1,000 shares of

preferred stock (par $50) are exchanged for

4,000 shares of common stock (par $20).

Dec. 31 Preferred Stock, $50 par 50,000

Preferred 10,000

Stock Conversions

Case 2: One Preferred for Four Common ($20) Case 2: One Preferred for Four Common ($20)

Factors Affecting Retained Earnings

A number of factors can affect retained earnings

in addition to net income, losses, and dividends.

These transactions and events that affect

retained earnings are summarized as follows:

8. List the factors that impact the Retained

Earnings balance

Net Income and Dividends

• The primary source of retained earnings is the

net income generated by a business.

• When operating losses or other debits to

retained earnings produce a debit balance in

the account, the debit balance is referred to as a

deficit.

• Use of the term dividends without qualification

normally implies the distribution of cash.

Prior-Period Adjustments

In some situations, errors made in past years

are discovered and corrected in the current year

by an adjustment to Retained Earnings, referred

to as a prior-period adjustment:

• Mathematical mistakes

• Failure to apply appropriate accounting procedures

• Misstatement or omission of certain information

• Change from a non-GAAP principle to a GAAP

principle

Appropriated Retained Earnings

• Retained Earnings may be restricted at the

discretion of the board of directors.

Example: Expansion of plant facilities

• The restricted portion may be designed as

appropriated retained earnings and the

unrestricted portion as unappropriated (or free)

retained earnings.

• The main idea behind this restriction is to

notify stockholders that some of the assets

may not be available for dividends.

Accounting for Dividends

In setting dividend policy, the board of directors

must answer two questions:

1. Do we have the legal right to declare a dividend?

2. Is a dividend distribution financially advisable?

The board of directors must observe the state

incorporation laws governing the payment of

dividends.

9. Properly record cash dividends, property

dividends, small and large stock dividends,

and stock splits

Recognition and Payment of Dividends

• Declaration date—date the corporation’s board

of directors formally declares a dividend will be

• Date of record—date on which stockholders of

record are identified as those who will receive a

dividend

• Date of payment—date when the dividend is

actually distributed to stockholders

Cash Dividends

Entries to record the declaration and payment of a

$100,000 cash dividend by a corporation follows:

Declaration of Dividend:

Dividends (or Retained Earnings) 100,000

Dividends Payable 100,000

Payment of Dividend:

Cash 100,000

Property Dividends

• A dividend to stockholders that is payable in some

asset other than cash is generally referred to as a

property dividend.

• Frequently, the assets to be distributed are securities

of other companies owned by the corporation. The

corporation thus transfers to stockholders the

ownership interest in such securities.

• This type of transfer is sometimes referred to as a

nonreciprocal transfer to owner inasmuch as

nothing is received by the company in return for its

distribution to stockholders.

(continued)

Property Dividends

Bigler Corporation owns 100,000 shares in

Tri-State Oil Co, carrying value $2,700,000,

current market value $3,000,000, or $30 per

share. There are 1,000,000 shares of Bigler stock

outstanding. A dividend of 1/10 of a share of

Tri-State Oil Co. is declared for each share of

Bigler stock outstanding.

The entries for Bigler for the dividend declaration

and payment are on Slide 13-87.

(continued)

Property Dividends

Dividends (or Retained Earnings) 3,000,000

Property Dividends Payable 2,700,000

Gain on Distribution of Property

Dividends 300,000

Property Dividends Payable 2,700,000

Investment in Tri-State Oil

Co. Stock 2,700,000

Stock Dividends

• A corporation may distribute to stockholders

shares of the company’s own stock as a stock

dividend.

• A stock dividend involves no transfer of cash or

any other asset to stockholders.

• From a shareholder’s standpoint, receipt of a

stock dividend is an economic nonevent.

Small versus Large Stock Dividends

• Small:

Less than 20–25% of the outstanding shares.

Debit Retained Earnings for the market value of the shares.

• Large:

Greater than 20–25% of the shares outstanding.

Debit Retained Earnings for the par value of the shares.

Small Dividend Example

The stockholders’ equity section for the Fuji

Company on July 1 is as follows:

Common Stock, $1 par, 100,000

shares outstanding $ 100,000

Paid-In Capital in Excess of Par 1,100,000

The company declares a 10% stock dividend.

Before the stock dividend, the stock is selling for

$22 per share. After the stock dividend, each

share will have a value of $20 ($22/1.1).

(continued)

Stock Dividends Distributable 10,000

Small Dividend Example

Large Dividend Example

The stockholders’ equity section for the Fuji

Company on July 1 is as follows:

Common Stock, $1 par, 100,000

shares outstanding $ 100,000

Paid-In Capital in Excess of Par 1,100,000

The company declares a 50% stock dividend.

Before the stock dividend, the stock is selling for

$22 per share. Entries for declaring of the

dividend and issuance of the 50,000 new shares

(100,000 x 0.50) are on Slide 13-93.

(continued)

Issuance of Dividend:

Large Dividend Example

Stock Dividends versus Stock Splits

• A corporation may effect a stock split by

reducing the par or stated value of each share

of capital stock and proportionately increasing

the number of shares outstanding.

• A stock dividend results in an increase in the

number of shares outstanding. The par or

stated value remains unchanged.

• A stock split divides the existing Capital Stock

balance into more parts, with a reduction in

par or stated value of each share.

Reverse Stock Split

• A reverse stock split is the consolidation of

shares outstanding into a smaller number of

shares.

• Share of stock trading for less than $10 are

viewed with some skepticism, and a reverse

split can make the stock look more

respectable.

• A reverse split is almost always viewed as bad

news by investors.

13-96 13-96

Liquidating Dividends

• A liquidating dividend is a distribution representing a return to stockholders of a portion of contribution capital.

• Example: Stubbs Corporation declared and paid a cash dividend ($10 cash dividend on 10,000 shares of common stock) totaling $100,000 and a partial liquidating dividend of $50,000. The liquidating dividend is a $5-per-share dividend. The declaration and payment entries are on Slide 13-98.

(continued)

Liquidating Dividends

Dividends 100,000

Cash 150,000

Statement of Comprehensive Income

• FASB ASC Topic 220 requires that all

companies provide a statement of

comprehensive income.

• An example of Microsoft’s 2009 statement of

comprehensive income is included on Slide

13-100.

10. Explain the background of unrealized gains

and losses recorded as part of accumulated

other comprehensive income, and list the

major types of equity reserves found in foreign

balance sheets

13-100 13-100

13-101

Equity Items That Bypass the Income

Statement and are Reported as Part of

Accumulated Other Comprehensive Earnings

Since 1980, the Equity sections of the U.S.

balance sheets have begun to fill up with a

strange collection of times, each the result of an

accounting controversy. These items are

summarized in the following slides.

(continued)

13-102

Foreign Currency Translation Adjustment

• The foreign currency translation

adjustment arises from the change in the

equity of foreign subsidiaries (as measured in

terms of U.S. dollars) that occurs as a result of

changes in foreign currency exchange rates.

• These changes are recorded as direct

adjustments to equity, insulating the income

statement from the aspect of foreign currency

fluctuations.

13-103

Unrealized Gains and Losses

on Available-for-Sale Securities

• Available-for-sale securities are those that

were not purchased with immediate intention to

resell, but that a company also doesn’t

necessarily plan to hold forever.

• The unrealized gains and losses from market

value fluctuations in trading securities are

included in the income statement.

• The unrealized gains and losses from market

value fluctuations in available-for-sale

securities are shown as a direct adjustment to

equity. (continued)

13-104

Unrealized Gains and Losses

on Derivatives

• A derivative is a financial instrument, such as

an option or a future, that derives its value from

the movement of a price, an exchange rate, or

an interest rate associated with some other

• Derivatives are used to manage risk

associated with sales or purchases that will not

occur until a future period.

(continued)

13-105

Unrealized Gains and Losses on Derivatives

The last few lines of Kendall Company’s income

statement were as follows:

(continued)

13-106

Kendall had the following items impacting

comprehensive income:

13-107

Assume that the income tax rate for all items is

40%. Kendall Company would report its

comprehensive income for the year as follows:

13-108

Balance Sheet Reporting

The accumulated amount of comprehensive

income is reflected in the Equity section of the

balance sheet in two ways:

• Net income (less dividends) is cumulated in

retained earnings.

• Other comprehensive income is cumulated in

accumulated other comprehensive income.

13-109

International Accounting: Equity Reserves

• In foreign countries, the payment of cash

dividends is linked to the amount of

distributable equity.

• Equity is divided among various equity

reserve accounts, each with legal restrictions

dictating whether it can be distributed to

stockholders.

(continued)

13-110

13-111

Disclosures Related to the Equity Section

• Authorized but unissued

• Subscribed for and held for issuance pending

receipt of cash for the full amount of the

subscription price

• Outstanding in the hands of stockholders

• Reacquired and held by the corporation for

subsequent reissuance

• Canceled by appropriate corporate action

In accounting for capital stock, it should be

recognized that stock may be:

11. Prepare a statement of changes in

stockholders’ equity

13-112 13-112

13-113

13-114 13-114

Ch.13 Equity Financing - · PDF file11.Statement of changes in stockholders’ equity...

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