Chapter 8

Chapter 8

Stockholders’ EquityStockholders’ Equity

1. Account for the issuance of capital stock.2. Describe a compensatory stock option plan.3. Account for share appreciation rights.4. Describe the characteristics of preferred stock.5. Know the components of contributed capital.6. Understand the accounting for treasury stock.7. Recognize compensation expense for a

compensatory stock option plan using the fair value method. Account for a fixed compensatory stock option plan.

8. Account for a performance-based compensatory stock option plan.

Represents the owners’ residual interest in total assets after liabilities are recognized.

Difference between the assets and the liabilities of a company.

Is sometimes referred to as net assets.

Owners’or Stockholders’EquityOwners’or Stockholders’Equity

State laws dictate the incorporation process. Articles of incorporation are filed with the state.

-- Specify the purpose of the business, its location, classes and number of shares of capital stock authorized, etc.

The state issues a corporate charter. A board of directors is selected.

Formation of a CorporationFormation of a Corporation

Public corporations-- Government-owned: FDIC, TVA

Private corporations-- Nonstock corporations

Nonprofit organizations that do not issue stock: churches, colleges, charities

-- Stock corporations Closed corporations: few stockholders Open corporations: publicly traded

Classifications of CorporationsClassifications of Corporations

Ownership of common stock usually entitles the holder to the . . . ◦ Right to vote.◦ Right to participate in earnings through declared

dividends.◦ Right to participate in distribution of assets at

liquidation.◦ Right to retain percentage of ownership in the

corporation when new shares are issued (preemptive right).

Characteristics of Capital StockCharacteristics of Capital Stock

Corporations are a separate legal entity.

Issues of stock are recorded in conformity with the cost principle.

Sales and repurchases of shares do not affect periodic net income.

Stockholders’equity is separated from debt of the entity.

Concepts and DefinitionsConcepts and Definitions

Categories of equity-- Contributed capital (Paid-in capital)

Capital Stock: Preferred and Common Additional paid-in capital

-- Retained earnings Unappropriated and appropriated

-- Unrealized capital Increases or decreases in equity that do

not result from stock transactions or from the retention of retained earnings.


Classification of capital stock◦ Authorized◦ Issued◦ Unissued◦ Treasury stock◦ Outstanding◦ Subscribed


AuthorizedShares

The maximum number of shares of capital

stock that can be sold to the public is called

the authorized number of shares.

Authorized, Issued, and Outstanding Capital Authorized, Issued, and Outstanding Capital StockStock

AuthorizedShares Issued

shares are authorized shares of stock that have been

sold.

Unissued shares are authorized shares of stock that have never been sold.


AuthorizedShares

UnissuedShares

TreasuryShares

OutstandingShares

Treasury shares are issued shares that have been reacquired by the

corporation.

IssuedShares

Outstanding shares are issued shares that are owned

by stockholders.


Advantages-- Limited liability-- Capital accumulation-- Ease of ownership transfer

Disadvantages-- Increased taxation-- Difficulties of control-- Regulation

CorporationsCorporations

Par value stock-- Designated dollar amount per share stated in the

corporate charter.-- No relationship to market value.

Nopar stock-- Dollar amount per share not designated in

corporate charter.-- Corporations can assign a stated value per share

(treated as if par value).

Features of Equity SecuritiesFeatures of Equity Securities

Legal capital is . . .-- That portion of stockholders’equity that must be

contributed to the firm at the issuance of stock.-- The amount of capital, required by state law, that

must remain invested in the business. -- Refers to par value, stated value, or full amount

paid for nopar stock.


Common stock . . .-- Is the basic voting stock of the corporation.-- Ranks after preferred stock for dividend and

liquidation distribution.-- Has dividend rates determined by the board of

directors based on the corporation’s profitability.


Preferred stock . . .-- Has dividend and liquidation preference over

common stock.-- Generally does not have voting rights.-- Usually has a par or stated value.-- May be convertible, callable, and/or redeemable.


Preferred stock dividends . . . -- Are usually stated as a percentage of the par

or stated value.-- May be cumulative or noncumulative.-- May be partially participating, fully

participating, or nonparticipating.


Provides that dividends not declared in previous years accumulate and must be paid in full when dividends are declared in later years before dividends can be paid on common stock.

Dividends in arrears are not liabilities until declared. However, the per share and aggregate amounts must be disclosed.

Preferred StockPreferred StockCumulative DividendsCumulative Dividends

Kites, Inc. has the following stock outstanding: Common, $1 par value, 100,000 shares Preferred, 3%, $100 par value, cumulative, 5,000 shares Preferred, 6%, $50 par value, noncumulative, 3,000 shares

Dividends were paid every year except for the prior year. In the current year the board of directors declares dividends of $50,000.

How much in dividends does each class of stock receive?

Preferred StockPreferred Stock Example Example

Preferred stock (cumulative)Arrearage ($100 par ×3% ×5,000 shares) 15,000$ Current Yr. ($100 par ×3% ×5,000 shares) 15,000 30,000$



Preferred stock (noncumulative)Current Yr. ($50 par ×6% ×3,000 shares) 9,000



Preferred stock (noncumulative)Current Yr. ($50 par ×6% ×3,000 shares) 9,000

Common stockCurrent Yr. ($50,000 dividend - $39,000 to preferred) 11,000

Total dividend declared 50,000$


NonparticipatingLimits the yearly dividends to the specified rate

plus any arrearage for cumulative stock.

Partially participatingAllows dividends above the specified rate on a pro rata basis with common stock up to a limit specified in the corporate charter.

Preferred StockPreferred Stock Participating Preferences Participating Preferences

Fully participating Allows dividends above the specified rate on a pro rata basis with common stock without any limits.

Preferred StockPreferred Stock Participating Preferences Participating Preferences

Kites, Inc. has the following stock outstanding:Common, $1 par value, 100,000 sharesPreferred, 3%, $100 par value, noncumulative, 5,000 shares

Dividends were paid every year except for the prior year. The preferred is partially participating up to 5%. In the current year the board of directors declares dividends of $60,000. How much in dividends does each class of stock receive?


Preferred Common TotalPreferred stock (noncumulative) ($100 par ×3% ×5,000 shares) 15,000$ 15,000$ Common stock (3% matching) ($1 par ×100,000 shares = $100,000 ×3%) 3,000$ 18,000


Preferred Common TotalPreferred stock (noncumulative) ($100 par ×3% ×5,000 shares) 15,000$ 15,000$ Common stock (3% matching) ($1 par ×100,000 shares = $100,000 ×3%) 3,000$ 18,000 Preferred stock (participating 2%) ($100 par ×2% ×5,000 shares) 10,000 28,000 Common stock (2% matching) ($100,000 ×2%) 2,000 30,000


Preferred Common TotalPreferred stock (noncumulative) ($100 par ×3% ×5,000 shares) 15,000$ 15,000$ Common stock (3% matching) ($1 par ×100,000 shares = $100,000 ×3%) 3,000$ 18,000 Preferred stock (participating 2%) ($100 par ×2% ×5,000 shares) 10,000 28,000 Common stock (2% matching) ($100,000 ×2%) 2,000 30,000 Common stock (remainder) ($60,000 - $30,000) 30,000 60,000

Total dividend declared 25,000$ 35,000$


Par value stock: Cash (DEBIT)

Common Stock, par value (CREDIT) Additional Paid-in Capital, Common Stock (CREDIT)

In this entry, Common Stock is credited for the par value of the stock issued. The excess over par is credited to the Contributed Capital in Excess of Par account.

Issuing Stock for CashIssuing Stock for Cash

Nopar stock: Cash (DEBIT) Common Stock (CREDIT)

Stated value stock: Cash (DEBIT) Common Stock, stated value (CREDIT) Additional Paid-in Capital, Common Stock (CREDIT) In this entry, Common Stock is credited for the stated

value of the stock issued. The excess over stated value is credited to the Contributed Capital in Excess of Stated Value account.

Issuing Stock for CashIssuing Stock for Cash

A corporation enters into a subscription contract with several subscribers that calls for the purchase of 1,000 shares of $6 par common stock at a price of $13 per share. A $3 per share down payment is required, with the remaining $10 due in one month.

Cash 3,000Subscription Receivable: Common Stock 10,000

Common Stock Subscribed 6,000Additional Paid-in Capital on Common Stock 7,000

$6 $6 x 1,000x 1,000

Stock SubscriptionsStock Subscriptions

The $10 per share final payment was received from subscribers to 950 of the 1,000 shares.

Cash 9,500Subscription Receivable: Common Stock 9,500

Common Stock Subscribed 5,700Common Stock, $6 par 5,700

950 950 x $6x $6


1. Return to the subscriber the entire amount paid in.

2. Return to the subscriber the entire amount paid in, less any costs incurred to reissue the stock.

3. Issue to the subscriber a lesser number of shares based upon the total amount of payment received.

4. Require the forfeiture of all amounts paid in.

When a default occurs, the accounting is determined by the relevant contract provisions, such as--


The subscriber to the 50 remaining shares defaults on the contract. The contract requires the forfeiture of all amounts paid in.

Common Stock Subscribed 300Additional Paid-in Capital on Common Stock 350

Subscription Receivable: Common Stock 500Additional Paid-in Capital from

Subscription Default 150

50 50 X $7X $7

50 50 X $6X $6

50 50 X $10X $10


Use the current market value of the stock issued or the noncash consideration received, whichever is most reliably determinable.

If market values cannot be determined, use appraised values.

Issuing StockIssuing Stockfor Noncash Assetsfor Noncash Assets

Total proceeds must be allocated among the classes of stock issued:◦ Proportional method

Allocate the lump-sum received among the classes of stock issued based on their relative market values.

◦ Incremental method Allocate a portion of the lump-sum received to one

security based on that security’s market value and allocate the remainder to the other security.

Combined Sales of Stock Combined Sales of Stock

Common Stock: $16 x 2 shares x 100 = $ 3,200Preferred Stock: $60 x 1 share x 100 = 6,000 Total market value $9,200

A corporation issues 100 packages of securities for $82.80 per package. Each package consists of two shares of $10 par common stock (market value, $16 per share) and one share of $50 par preferred stock (market value, $60 per share).

Combined Sales of StockCombined Sales of StockExample Example


Common Stock: x $8,280 = $2,880$3,200$9,200

Preferred Stock: x $8,280 = 5,400$6,000$9,200

$8,280



Cash 8,280Common Stock 2,000Additional Paid-in Capital on Com. Stock 880Preferred Stock, $50 par 5,000Additional Paid-in Capital on Pref. Stock 400


Costs incurred to issue stock◦ Registration fees◦ Underwriter commissions◦ Attorney and accountant fees◦ Printing costs◦ Clerical costs◦ Promotional costs

Stock Issue CostsStock Issue Costs

Two methods of accounting for stock issue costs:Offset method

Debit costs to Contributed Capital in Excess of Par.Deferred charge method

Debit an intangible asset and amortize over a reasonable

period.

Stock Issue CostsStock Issue Costs

The FASB is planning to change GAAP so that all stock issuance costs are expensed as incurred.

Stock Issuance CostsStock Issuance Costs

Represents an increase or decrease in stockholders’equity not arising from earnings, dividend payments, or a change in contributed capital. Examples include:◦ Unrealized holding gains and losses on available for sale

securities.◦ Gains and losses resulting from translating foreign-

denominated financial statements into US currency.◦ Guarantees of ESOP debt.◦ Pension liability adjustments.

Unrealized CapitalUnrealized Capital

Any questions?

Repurchased shares of a corporation’s own stockThe shares are retired or used to:

Issue in employee stock option programs. Establish a market for the company’s stock. Purchase assets. Issue as a stock dividend. Increase earnings per share. Reduce ownership. Thwart takeover attempts. Reduce dividend payments.

Treasury StockTreasury Stock

Usually does not have:-- Voting rights-- Dividends rights-- Preemptive rights-- Liquidation rights

Reduces both assets and stockholders’ equity Is classified as a contra account to stockholders’

equity

Treasury StockTreasury StockCharacteristicsCharacteristics

Cost method(one-transaction concept)

Par value method(dual-transaction concept)

Treasury StockTreasury StockRecording and ReportingRecording and Reporting

The purchase and subsequent sale of treasury stock are viewed as one transaction with two parts.

Treasury StockTreasury StockCost MethodCost Method

Acquisition of Treasury Stock-- Recorded at cost to acquire.

Treasury Stock (DEBIT) Cash (CREDIT)

Issuance of Treasury Stock-- Treasury Stock credited for cost.-- Difference between cost and issuance price is

(generally) recorded in Additional Paid-in Capital-Treasury Stock.

Treasury StockTreasury StockCost MethodCost Method

Cost MethodCost Method

Ball issues 6,000 shares of $10 par common stock for $12 per share:

Cash 72,000Common Stock $10 par 60,000Additional Paid-in Capital on Common Stock 12,000



Reacquisition of 1,000 shares of common stock at $13 per share:

Treasury Stock 13,000Cash 13,000



Reissuance of 600 shares of treasury stock at $15 per share:

Cash 9,000Treasury Stock 7,800Additional Paid-in Capital from Treasury Stock 1,200



Reissuance of another 200 shares of treasury stock at $8 per share:

Cash 1,600Additional Paid-in Capital from Treasury Stock 1,000

Treasury Stock 2,600



Reissuance of another 100 shares of treasury stock at Reissuance of another 100 shares of treasury stock at $10 per share:$10 per share:

Cash 1,000Additional Paid-in Capital from Treasury Stock 200Retained Earnings 100



Date of acquisition◦ Debit Treasury Stock for the par value, stated value, or

average amount previously credited to the capital stock account for nopar stock.

◦ Debit Additional Paid-in Capital for the proportionate amount of any excess over par or stated value that was paid by stockholders when the shares were originally issued.

◦ Debit or credit Additional Paid-in Capital from Treasury Stock as required. -- Debit cannot exceed the credit balance in the account.

Any excess is debited to Retained Earnings.◦ Credit Cash.

Treasury StockTreasury StockPar Value MethodPar Value Method

Date of resale◦ Debit Cash.◦ Credit Treasury Stock for the par value, stated

value, or average amount previously credited to the capital stock account for nopar stock.

◦ Credit Additional Paid-in Capital fromTreasury Stock or debit Additional Paid-in Capital from Treasury Stock (and Retained Earnings, if necessary).

Treasury StockTreasury StockPar Value MethodPar Value Method

Par Value MethodPar Value Method

Issuance of 6,000 shares of $10 par common stock for $12 per share:

Cash 72,000Common Stock $10 par 60,000Additional Paid-in Capital on Common Stock 12,000



Reacquisition of 1,000 shares of common stock at $13 per share:

Treasury Stock 10,000Additional Paid-in Capital on Common Stock 2,000Retained Earnings 1,000

Cash 13,000



Reissuance of 600 shares of treasury stock at $15 per share:

Cash 9,000Treasury Stock 6,000Additional Paid-in Capital on Common Stock 3,000




Cash 1,600Additional Paid-in Capital on Common Stock 400




Cash 1,000Treasury Stock 1,000

Par Value Method



Contributed Capital:Common stock, $10 par (20,000 shares authorized, 6,000 shares issued , of which 100 are being held in treasury) $ 60,000 Additional paid-in capital on common stock 12,000 Total contributed capital $ 72,000

Retained earnings 39,900 Accumulated other comprehensive income 10,000 Total contributed capital, retained earnings, and $121,900 accumulated other comprehensive income Less: Treasury stock (100 shares at cost) (1,300)

Total Stockholders’ Equity $120,600


Par Value Method

Contributed Capital:Common stock, $10 par (20,000 shares authorized, 6,000 shares issued) $ 60,000 Less: Treasury stock (100 shares at par) (1,000)Common stock outstanding (5,900 shares) $ 59,000 Additional paid-in capital on common stock 12,600 Total paid-in capital $ 71,600

Retained earnings 39,000 Accumulated other comprehensive income 10,000

Total Stockholders’ Equity $120,600


When stockholders donate shares to the

corporation, the corporation debits Treasury Stock and credits a revenue or

gain account.

Stock Received by DonationStock Received by Donation

When treasury shares are formally retired, the corporation credits the Treasury Stock account and debits all capital accounts related to the treasury shares on a proportional basis.

Retirement of Treasury StockRetirement of Treasury Stock

Provides stockholders an option to exchange their shares, within a specified time period, for other classes of stock, usually common stock, at a specified rate.

Accounting treatment is the same as convertible bonds.

Convertible Preferred StockConvertible Preferred Stock

Ness Corporation originally issued 500 shares of $100 par convertible preferred stock at $120 per share. Each share of preferred stock may be converted into four shares of $20 par common stock.

Preferred Stock, $100 par 50,000Additional Paid-in Capital on Preferred Stock 10,000

Common Stock, $20 par 40,000Additional Paid-in Capital from Preferred Stock Conversion 20,000

ContinuedContinued


Alternatively, assume each preferred share may be converted into seven shares of common stock.

Preferred Stock, $100 par 50,000Additional Paid-in Capital on Preferred Stock 10,000Retained Earnings 10,000

Common Stock, $20 par 70,000


Rights issued by the corporation that give the holder an option to acquire a specified number of shares of capital stock under prescribed conditions within a stated period of time.The document of ownership is called a stock warrant.

Normally arise:1.As compensation to employees 2.As compensation to employees 3.As fractional share rights4.To make a security more attractive

Stock RightsStock Rights

Announcement date of the rights offering Issuance date of the rights Expiration date of the rights Between the issuance date and the expiration

date, the rights and the related stock are sold separately and each have a separate price.

Stock RightsStock RightsImportant DatesImportant Dates

Stock rights issued to existing shareholders in advance of a new stock issuance.

No entries required on announcement date or on issuance date of the rights.

On exercise date◦ debit Cash.◦ credit Capital Stock and Additional Paid-in Capital.

Stock RightsStock RightsPreemptive RightsPreemptive Rights

Used to-- recruit and retain outstanding employees.-- encourage employee ownership.-- obtain additional capital from equity owners.

Most critical accounting issue is whether the program causes additional expenses for the corporation (or grantor).

Stock Compensation PlansStock Compensation Plans

New FASB standard requires companies to recognize compensation cost using the fair-value method.*

Under fair-value method, companies use acceptable option-pricing models to value the options at the date of grant.


*“Accounting for Stock-Based Compensation,”Statement of Financial Accounting Standards No. 123 (Norwalk, Conn: FASB, 1995); and “Share-Based Payment,”Statement of Financial Accounting Standard No. 123(R) (Norwalk, Conn: FASB, 2004).

Noncompensatory plans allow employees to purchase stock at a price that

is not significantly lower than the current market price.

Compensatory plans allow employees to purchase stock at a price that

is significantly lower than the current market price at the measurement date.


Criteria stated in APB Opinion No. 25

1. Includes substantially all full-time employees meeting certain criteria.

2. Stock is offered to eligible employees either equally or on the basis of a uniform percentage of salary or wages.

3. Exercise time is limited to a reasonable period.4. The discount from market price is not

significant.

Stock OptionsStock OptionsNoncompensatory PlansNoncompensatory Plans

Criteria stated in FASB No. 123(R)

1. Substantially all full-time employees participate on an equitable basis.

2. The discount from market is small. 3. The plan offers no substantive option feature.


Accounted for based on the cost principle. Record a liability at the time of issuance

-- Valued at amount contributed by employees. On date of issuance of stock

-- debit the liability.-- credit Capital Stock (for par value) and

contributed capital.


Any plan that fails to meet one of the four criteria for noncompensatory plans is classified as a compensatory plan.

The measurement date is the first date when the grantor knows-- the number of shares an employee is eligible to

receive.-- the option price.

Stock OptionsStock OptionsCompensatory PlansCompensatory Plans

Determining ExpenseCompensation expense based on the fair value of the options expected to vest on the date the options are granted to the employee(s) (i.e., the grant date).

Allocating Compensation Expense

Over the periods in which employees perform the service—the service period.

Stock OptionsStock OptionsCompensatory PlansCompensatory Plans

On January 1, 2006, Nichols Corporation granted 10,000 options to key executives. Each option allows the executive to purchase one share of Nichols’ $5 par value common stock at a price of $20 per share. The options were exercisable within a 2-year period beginning January 1, 2008, if the grantee is still employed by the company at the time of the exercise. On the grant date, Nichols’ stock was trading at $25 per share, and a fair value option-pricing model determines total compensation to be $400,000. On May 1, 2008, 8,000 options were exercised when the market price of Nichols’ stock was $30 per share. The remaining options lapsed in 2010 because executives decided not to exercise their options.

Stock Compensation PlansStock Compensation PlansExampleExample

No entry on date of grantNo entry on date of grant..

Prepare the necessary journal entries related to the stock option plan for the years 2006 through 2010.

1/1/061/1/06

Compensation expenseCompensation expense 200,000200,000

Paid-in capital-stock options Paid-in capital-stock options

200,000200,000

12/31/0612/31/06

Compensation expenseCompensation expense 200,000200,000Paid-in capital-stock options Paid-in capital-stock options

200,000200,000

12/31/0712/31/07

($400,000 x ½)


Prepare the necessary journal entries related to the stock option plan for the years 2006 through 2010.

Cash Cash (8,000 x $20)(8,000 x $20) 160,000160,000

Common stock Common stock (8,000 x $5)(8,000 x $5)

40,00040,000

5/1/085/1/08

Paid-in capital-stock options Paid-in capital-stock options 80,00080,000Paid-in capital-expired options Paid-in capital-expired options

80,00080,000

1/1/101/1/10

($400,000 x 8,000 / 10,000 = $320,000)

Paid-in capital-stock options Paid-in capital-stock options 320,000320,000

Paid-in capital in excess of par Paid-in capital in excess of par

440,000440,000

($400,000 – $320,000)


Requires the application of a complex pricing model.

Variables include:Exercise priceCurrent market price of the stockRisk-free rate of interestExpected life of the optionsExpected volatility of the stock priceExpected dividend yield of the stock

Measuring the Fair Value of Fixed Stock OptionsMeasuring the Fair Value of Fixed Stock Options

Total Compensation

Cost

Fair Value of an option

Number of options

Expected annual forfeiture rate

Service Period

Measuring the Fair Value of Fixed Stock OptionsMeasuring the Fair Value of Fixed Stock Options

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Chapter8

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Chapter 8

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