Intermediate Financial Accounting

by Professor Hsieh

Intermediate Financial Accounting

Shareholders' Equity -Contributed Capital

Stockholders' Equity(1)-Contributed Capital 2

Objectives of this Chapter

I. Basic Characteristics of a corporation

II. Accounting for issuance of common stock and preferred stock:

Stock subscription Package sale of stock Characteristics of preferred stock Convertible P.S, callable P.S, redeemable

P.S, P.S. with stock warrants.


Objectives of this Chapter (contd.)

III. Accounting for Treasury stock: Cost method Par value method


I. Corporation

A form of business entity. It is established as a legal entity

separated from its owners. It has all rights as a person has (i.e.,

can sue or be sued, can own property, sign contract) except for voting and holding public office.


Types of Corporations

1. Private corporations.

2. Public corporations.

3. Domestic corporations.

4. Foreign corporations.



1. Private Corporations Private corporations: privately owned

including

a. nonstock companies: companies do not issue stock and do not operate for profit (i.e., universities, hospitals churches).

b. stock companies: companies issue shares of stock to stockholders and operate for profits.



1. Private Corporations (contd.)Stock companies include:

(1)Publicly-traded corporations: stock is available to public on a stock exchange.

(2)Privately-held corporations: do not allow sale of stock to the general public and stock is held by a few stockholders.



2. Public Corporations

Public corporations: owned by

governmental units such as Federal

Deposit Insurance Corporation,

Pension Benefit Guaranty

Corporation.



3. Domestic Corporations

Domestic corporations: as viewed by

an individual state, are those

companies incorporated in that state.

If viewed by the federal government, a

domestic corporation is one that is

incorporated in the U.S.



4. Foreign Corporations

Foreign corporations: as viewed by an

individual state are those operating in

the state but incorporated in another

state.

If viewed by federal government, a

foreign corporation is one incorporated

in another country.


Procedures of Forming a Corporation1. Apply for a charter by submitting

articles of incorporation to the appropriate state officials.

2. If the application is approved, the state will issue a charter.


Procedures of Forming a Corporation (contd.)

3. A stockholders' meeting would be held at which the initial issuance of capital stock is made to the incorporators.

4. A board of directors is elected, a set of rules regulating the operation is established, and the board appoints the executive officers.


Procedures of Forming a Corporation (contd.)4. Ready for operations.

5. Issuance of stock to public to raise more capital (IPO)

Note: Regardless of the number of states in which a corporation operates, it is incorporated in one state.


Organization of a Corporation

a. Stockholders (owners).

b. Board of Directors (elected by stockholders) Decide major operation principles. Arrange major loans, authorize

contract, determine the salaries of executives.

Appoint officers.


Organization of a Corporation (contd.)c. Management: Appointed by the

board of directors.

Responsible for day-to-day operations and the preparations of the financial statements.


Advantages of a Corporation

1. Separated legal entity from its owners: it can buy, sell and own properties.

2. Limited liability for stockholders.

3. Continuous existence.

4. Ease of transfer of ownership.


Advantages of a Corporation (cont.)

5. Ease of capital generation.

6. Centralized authority and responsibility-- to the President, not to numerous owners.

7. Professional management.


Disadvantages of a Corporation

1. Government regulations.

2. Corporation taxes (double taxation).

3. Separation of ownership and management: principal & agent conflicts.


Stockholders' Equity Section of a Corporation Balance Sheet State. Microsfot Corporation

Balance Sheets (6/30)

in millions 1999 2000 Stockholders' equity: Convertible preferred stock- shares authorized 12,000; shares issued and outstanding 13 and 0 980 0 Common stock and paid-in capital -shares authorized 12,000; shares issued and outstanding 5,109 and 5,283 13,844 23,195


Stockholders' Equity Section (cont.)

Microsfot Corporation Balance Sheets (6/30) (contd.)

in millions 1999 2000 Stockholders' equity(contd.) : Retained earnings, including other comprehensive income of $1,787 and $1,527 13,614 18,713

Total stockholders' equity 28,438 41,368


Stockholders' Equity Statements

Microsfot Corporation Stockholders' Equity Statements (year ended 6/30)

in millions 1999 2000 Convertible preferred stock Balance, beginning of year 980 980 Conversion of pref.to com. - (980) Balance, end of year 980 0


Stockholders' Equity Statements (contd.) Microsfot Corporation

Stockholders' Equity Statements (year ended 6/30)

in millions 1999 2000 Com. stock and paid-in capital Balance, beginning of year 8,025 13,844 Common stock issued 2,338 3,554 Common stock repurchased (64) (210) Structured repurch. price differ. (328) - Proceeds from sale of put warrants 766 472 Stock option income tax benefits 3,107 5,535 Balance, end of year 13,844 23,195


Stockholders' Equity Statements(contd.) Microsfot Corporation


in millions 1999 2000 Retained earnings Balance, beginning of years 7,622 13,614 Net income 7,785 9,421 Other comprehensive income: Net unrealized invest. gains/losses 1,052 (283) Translation adjustment 69 23 Comprehensive income 8,906 9,161


Stockholders' Equity Statements(contd.) Microsfot Corporation


in millions 1999 2000 Retained earnings (contd.) Comprehensive income 8,906 9,161 Preferred stock dividends (28) (13) Immaterial pooling of interests - 97 Common stock repurchased (2,631) (4,686) Balance, end of year 13,614 18,173

Total stockholders' equity $28,438 $41,368


Terminologies Related to Stockholders' Equity (contd.)1. Common Stock: a class of stock with

rights such as: (a)To share proportionately in profits

and losses; (b)To share proportionately in

management; Note: more than one class of shares can be

authorized by the articles of incorporation and each class would have specific rights (i.e., voting, dividends, etc.) specified in the articles.


Terminologies Related to Stockholders' Equity (contd.)1. Common Stock: a class of stock with

some rights (contd.): (c) To share proportionately in

corporate assets in liquidation; (d) To share proportionately in any new

issuance of stock of the same class (the preemptive right).


Terminologies Related to Stockholders' Equity (contd.)2. Preferred Stock: a class of stock with

rights such as:

(a) Dividends (with a higher priority than that of common stock);

(b) Sharing assets in liquidation (with a higher priority than that of common stock).


Terminologies Related to Stockholders' Equity (contd.)

3. Par Value Stock: Capital stock with a nominal dollar amount printed on the stock certificate. In the past, some states designate the par value of issued stock as the legal capital.

Note: The concept of par value and legal capital has been entirely eliminated by Model Business Corporation Act.



4. No-Par Stock: capital stock without a Par Value. Many states allow the board of directors to establish a stated value, in general, is the legal capital.

Note: due to the elimination of par value and legal capital concept by Model Business Corporation Act, many companies issue no-par shares these days.



5. Stated Value: a nominal value assigned to no-par stock by board of directors.

6. Additional Paid-in Capital (or Paid-in Capital in Excess of Par Value or Premium on Capital Stock): The excess of the issuance price over the par value or the stated value.


Terminologies Related to Stockholders' Equity 7. Contributed Capital: the portion of

stockholders' equity contributed by investors through the issuance of stock including common stock par value, preferred stock par value and the paid-in capital in excess of the par/stated value of both stocks.

8. Legal Capital (eliminated by Model Business Corporation Act): the amount of contributed capital not available for dividends (usually equal to the par or stated value of outstanding stock).


Terminologies Related to Stockholders' Equity This concept of par value and legal capital has been eliminated entirely by Model Business Corporation Act which is adopted by many states. Thus, many companies issue no-par value shares now days. However, there are companies which issued par value stock prior to the changes in the state law and continued to issue previously authorized par value shares.


Terminologies Related to Stockholders' Equity (contd.)9. Outstanding Stock: issued stock held by

investors (not being repurchased back).

10. Treasury Stock: issued stock repurchased by the corporation and held by the corporation, not retired.

11. Authorized Capital: the number of shares of stock that the corporation can issue as stated in its corporate Charter.


Issuance for Cash

II. Accounting for the Issuance of Stock Stock issued for cash Example 1: (Common Stock with Par) Issued 1,000

shares of $10 par common stock for $50 per share.

Journal EntryCash 50,000

Common Stock10,000

Paid-in Capital in Excess of Par--Common Stock

40,000


Issuance for Cash

Example 2: (Preferred Stock with Par)

Issued 1,000 shares of $10 par preferred stock for $30 per share.


Preferred Stock10,000

Paid-in Capital in Excessof par -- Preferred Stock

20,000


Issuance for Cash Example 3 (Common Stock with Stated Value

Set by the Board of Directors) Issued 1,000 shares of no-par common

stock with a stated value $1 per share. Shares are issued at $5 per share.


Common Stock 1,000Paid-in Capital in Excess of Stated Value 4,000


Issuance for Cash Example 4 (No-par Common Stock

without Stated Value) Issued 1,000 shares of no-par and no

stated value common stock for $5 per share.


Common Stock5,000


Stock Issuance Costs

Costs relate directly to the initial issuance of capital stock (i.e., legal fees, accountants' fees,printing costs, promotion costs, postage, expense of filing with the SEC, etc.) are recorded as reduction of the paid-in capital.

Costs relate to subsequent issuance of stock are expensed.


Stock Subscriptions

Investors agree to buy stock on an "installment" ( or credit) basis.

The corporation and the prospective stockholders enter into a legal binding subscription contract when such an agreement has been made.


Example

Emery 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 shares. The contract requires a $3 down payment per share, with the remaining $10 per share collectible at the end of one month. The stock will be issued to subscribers upon full payment.


Example (contd.)

Journal Entry to record the subscription:

Cash 3,000

Subscription Receivable: C.S. 10,000

C.S. Subscribed (issuable)6,000

Additional Paid-in Capital on C.S.7,000


Example (contd.)

J. E. record the subscription if stock has been issued at time of subscription:

Cash 3,000

Note Receivable: C.S. 10,000

Common Stock6,000

Additional Paid-in Capital on C.S.7,000


Reporting of the Subscription Receivable Account: (a contra account) Subscription Receivable: reported as a

contra - stockholders' equity account due to the uncertainty involved in the collection (supported by the SEC).

Common stock subscribed and the additional paid-in capital accounts are reported in the contributed capital section of stockholders' equity.


Subsequent Recording

Assume that $10 per share final payment was received from subscribers for 950 shares:

Journal Entry

1. Cash 9,500

Subscription Receivable:C.S9500

2. C.S Subscribed 5,700

C.S. $6 Par ($6950)5,700


Subsequent Recording (contd.)

Assume the rest of 50 remaining shares subscribed default on the contract, the following entry will be recorded:

C.S. Subscribed ($650) 300

Additional paid-in capital on C.S ($750) 350

Subscription Receivable 500

Additional Paid-in Capital from Subscription Default ($350) 150


Combined Sales of Stock (Lump-Sum sales) When different classes of securities are

issued in a combined sale, the proceeds are allocated based on the individual relative market values of the separate securities.

If the market value of one class of security is not known, the security with the known market values is assigned a portion of the proceeds equals to its market value.


Example

A corporation issues 100 "package" of securities for $82.8 per package. Each package consists of two shares of $10 par common stock and one share of $50 par preferred stock.

If the separate market values are $16 per share for the common stock and $60 per share for the preferred stock, the following entry will be recorded:


Example (contd.)

Cash 82801. C.S., 10 par 2,000 Additional paid-in capital on C.S. 8802. Preferred Stock, 50 par 5,000 Additional Paid-in capital on P.S 400

Aggregate M.V of both securities:$162100 + $601100 = 9,200

Allocation:1. $8,280 [(162100)/9,200] = 2,8802. $8,280 [(601100)/9,200] = 5,400 2,880 + 5,400 = 8,280


Stock Issued for Noncash Proposition Principle: Stock issued for service or

property should be recorded either at the fair value of the stock or the fair value of the property, whichever is more clearly determinable (reliable).

In most cases, if stock is traded frequently, the fair value of stock is used. Otherwise, use the market value of the property.


Example- Stock Issued for Noncash Proposition Issued 10,000 shares of $5 par C.S. for

building. The market value of the stock is $15 per share and the stock is traded frequently.

Journal Entry:Building 150,000

C.S.50,000

Additional paid-in100,000


Stock Splits

Reasons

(1) To increase the marketability of stock by decreasing the market value and par value per share.

(2) To increase the numbers of shares outstanding.


Example: 2 for 1 split

Shares Par MarketOutstanding value Price

Before Split 1,000 $50 $120

After Split a b c


Accounting for Stock Splits

No entry. A memo is required.

a. 2,000 b.$25 c.$60(likely) Proportionate Stock Split: the memo

indicates the increase in shares outstanding and the reduction of par value.

Disproportionate stock split: the reduction in par value is not proportionate to the increase in the number of shares. A journal entry is required for a disproportionate stock split.


Example

A corporation issued 60,000 shares of C.S of $10 par value. The corporate declared a 2 for 1 split with a reduction of par value to $4 per share.

Journal Entry:

Common Stock, $10 par 600,000

Common Stock, $4 par480,000

Additional Paid-in Capital from Stock Split

120,000


Stock Rights to Current Stockholders When warrants are issued, no entry is

required.

A memo listing the number of additional shares that maybe acquired through the exercise of the stock rights is made.

If the right expires, another memo is made.


Preferred Stock Characteristics

Preference as to dividends: holders have a preference to dividends.

The annual dividends are expressed as percentage of the par value. If no-par preferred stock is issued, the dividend is expressed as a dollar amount per share.


Convertible Preferred Stock Convertible preferred stock allows

stockholders, at their option, to convert the shares of preferred stock into another security of the corporation under specified conditions.

Both the preferred features and the potential for common stock equity are valuable to investors in convertible preferred stock.


Convertible Preferred Stock Therefore, conceptually, the proceeds

received upon issuance should be separated into preferred and common stock equity.

However, APB Opinion No. 14 requires that when convertible preferred stock is issued, no value is assigned to the the conversion feature.

Any difference between the par and market values is recorded as the paid-in capital.


Accounting for the Conversion of Preferred to Common Stock

Book value method is used.

Example: A corporation issued 500 shares of $100 par convertible preferred stock at $120 per share. Each preferred share was converted into 4 shares of $20 par common stock. The following entry will be recorded for this conversion:


Example (contd.)

Preferred Stock 50,000

Additional Paid-in Capital on P.S 10,000

Common Stock40,000

Additional Paid-in capital on Common Stock

20,000


Preferred Stock with Stock Warrants (Rights) Warrants: rights that allow the holder to

purchase additional shares of common stock at a specified price over some future period.

Warrants can be attached to preferred stock to increase the marketability of the stock.


Preferred Stock with Stock Warrants (contd.) Since warrants are detachable and are

traded separately from the preferred stock, APB opinion No. 14 requires that the proceeds from the issuance of preferred stock with attached warrants be allocated to preferred stockholders' equity and to common stockholders' equity, based on the relative market values of the two securities at the time of issuance.


Example A

Landy Corporation issues 1,000 shares of $100 par value preferred stock at $121 per share. A warrant is attached to each share of preferred stock to allow the holder to purchase one share of $10 par common stock at $40 per share.

Immediately after the issuance, the preferred stock begins selling ex rights on the market for $119 per share. The warrants begin selling for $6 per share.


Example A (contd.)

Journal Entry: Cash 121,000

1. Preferred Stock 100,0001. Additional Paid-in Capital on P.S 15,1922. Common Stock Warrants 5,808

Aggregate M.V of two securities = ($1191,000) + ($61,000) = $125,000

1. P.S = [$121,000 (119,000 / 125,000)] = $115,1922. C.S warrants = [121,000 (6,000 / 120,000)]

= $5,808


Example B

Assuming 900 warrants are exercised, the following entry is recorded for the issuance of 900 shares of common stock:

Cash (40 * 900) 36,000

Common Stock warrant 5,227

Common Stock, $10 Par 9,000

Additional paid-in capital on C.S 32,227


Example C

Assuming 100 warrants expired, the following entry will be recorded:

Common Stock Warrant 581

Additional Paid-in capital from Expired Warrants

581


Callable Preferred Stock

Callable Preferred Stock: preferred stock may be retrieved (recalled) under specified conditions by the corporation.

The call price is usually several points (dollars) higher than the issuance price.

Also, the specified conditions and call price are specified in the stock contract. Payments of dividends in arrears before the execution of call option is in general required in the stock contract.


Callable Preferred Stock (contd.)

When callable preferred stock is issued, no value is assigned to the call feature.

Upon recall, the difference between the call price and the original issuance price is NOT treated as a gain or loss, but treated as a reduction of retained earnings (when call price > issuance price) or as an increase of additional paid-in (when call price < issuance price).


Callable Preferred Stock (contd.)

This treatment is to avoid a company from manipulating its earnings by recognizing a gain (or a loss) in transaction involving its own equity securities.


Example

Koden Corporation has outstanding 1,000 shares of $100 par callable preferred stock that was issued at $110 per share and no dividends are in arrears. If the call price is $112, the following entry is made to record the recall of these shares:

Preferred Stock 100,000Additional Paid-in on P.S. 10,000Retained Earnings 2,000

Cash112,000


Redeemable Preferred Stock

Redeemable at the option of the holders for a specified price or mandatory at a specified future maturity date for a specified price.

Thus, redeemable preferred stock has some of the characteristics of a liability.


Redeemable Preferred Stock (cont.)

SEC requires this stock to be reported as a separate component of the balance sheet (i .e., before the stockholders’ equity) and requires the disclosure of the redemption features, shares issued and redeemed.

FASB does not require a separate reporting but requires a similar disclosure.


Treasury Stock

Treasury stock: issued stock that has been purchased back (reacquired) by the issuing corporation.

Treasury stock carries no voting or preemptive rights, no right to dividends, and no right at liquidation.

However, it does participate in stock split.


Reasons of Acquiring Treasury Stock1. To use for stock option plans, bonus and

employee purchase plans;

2. To use in the conversion of convertible preferred stock or bonds;

3. To use excess cash and help maintain the market price of its stock; to increase EPS;


Reasons of Acquiring Treasury Stock (contd.)4. To use in the acquisition of other

companies;

5. To use for stock dividend;

6. To reduce the number of shares held by outside shareholders and thereby reduce the likelihood of being acquired by another company.


Accounting Methods for Treasury Stock

A. Cost method

B. Par value method (rarely used)


A. Cost Method

T.S. is recorded at cost paid for transactions:

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

Cash 72,000

C.S., $10 par60,000

Additional Paid-in Capital on C.S.

12,000


A. Cost Method (contd.)

2. Reacquisition of 1,000 shares of C.S. at $13 per share:

Treasury Stock 13,000Cash 13,000

3. Reissuance of 600 shares of T.S. at $15 per shareCash 9,000

T.S. 7,800Additional Paid-in Capital from T.S. 1,200



4. Reissuance of another 200 shares of T.S. at $8 per share:

Cash 1,600

Additional Paid-in Capital from T.S. 1,000

Treasury Stock2,600



5. Reissuance of another 100 shares of T.S. at $6 per share

Cash 600

Additional Paid-in Capital from T.S. 200

Retained Earnings 500

Treasury Stock1,300



6. Retirement of the last 100 shares of T.S. Common Stock, $10 par 1,000

*Additional Paid-in on Common Stock 200Retained Earnings 100

Treasury Stock 1,300

* [12,000 (100/6,000)] = $200

Original additional Paid-in Capital on common stock for 6,000 shares.


Retirement of Stock

Repurchased stock can be retired immediately. Example: 100 shares of stock were repurchase at $14 per share and retired immediately:

Common Stock, $10 par 1,000Additional Paid-in on Common Stock 200Retained Earningsa 200

Cash1,400

a. If there is a credit balance in the paid-in capital-repurchase of stock account, this paid-in capital account needs to be debited first before debiting R/E.


B. Par Value Method (Rarely Used)

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

Cash 72,000C.S., $10 par

60,000Additional Paid-in Capital on C.S

12,000


B. Par Value Method (contd.)

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

Treasury Stock (1000 shares, par $10) 10,000Additional Paid-in Capital on C.S * 2,000Retained Earnings 1,000

Cash 13,000

* ($12,000/6,000) 1,000 = 2,000



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

Cash 9,000

Treasury Stock 1, $10 par 6,000

Additional Paid-in Capital on C.S. 3,000

1. $10 600



4. Reissuance of 200 shares of Treasury stock at $8 per share:

Cash 1,600

Additional Paid-in

Capital on C. S. 400

Treasury Stock, $10 par2,000



5. Reissuance of 100 shares of Treasury stock at $6 per share

Cash 600

Additional Paid-in Capital on C.S* 400

Treasury Stock, $10 par1,000

* If this account does not have sufficient amount to cover the sale below the par, debit retained earnings account.



6. Retirement of the last 100 shares

Common Stock, $10 par 1,000

Treasury Stock, $10 par

1,000


Balance Sheet Presentation of Treasury Stock Before the last 100 shares of treasury

stock were retired, the stockholders' equity section is prepared after transactions 1-5 as follows:

(The Retained earnings has a credit balance of $40,000 prior to record any treasury stock transaction.)


Cost Method

Contributed Capital: Common stock, $10 par (20,000 shares

authorized, 6,000 shares issued, of which 100 are being held as Treasury Stock) $ 60,000

Additional paid-in capital on C.S. 12,000Total Contributed Capital 72,000Retained Earnings (see Note) 39,500Total Contributed Capital and

Retained Earnings 111,500Less: Treasury Stock (100 shares at cost) (1,300)Total Stockholders' Equity $110,200

Note: Retained Earnings are restricted regarding dividends in the amount of $1,300, the cost of treasury stock.


Par Value Method

Contributed Capital:Common stock, $10 par (20,000 shares authorized,

6,000 shares issued) 60,000Less: Treasury stock (100 shares at par) (1,000)Common stock outstanding 59,000Additional Paid-in Capital

on Common Stock 12,200Total Contributed Capital 71,200Retained Earnings 39,000Total Stockholders' Equity 110,200


Cost Method Par Value Method

Retained Earnings Retained Earnings 500 40,000 1,000 40,000

Paid-In Capital On C.S. Paid-In Capital on C.S. 12,000 2,000 12,000 400 3,000 400 12,200

Related Ledger Accounts


Cost Method Par Value Method

Paid-In Capital from T.S. 1,000 1,200

200 0 Treasury Stock Treasury Stock 13,000 7,800 10,000 6,000 2,600 2,000 1,300 1,000 1,300 1,000

Ledger Accounts for R/E and Paid-in


Donated Treasury Stock : Cost Method 100 shares of common stock, $10 par were

donated by stockholder. At reacquisition: no entry, just prepare a

memo. At reissuance: 100 shares of donated T.S.

reissued for $12 per share.

Cash 1,200

Donated Capital 1,200


Donated Treasury Stock : Par Value Method At reacquisition: Treasury Stock,$10 par 1,000

Donated Capital from Treasury Stock 1,000

At reissuance: 100 shares at $12 per share Cash 1,200

Treasury Stock, $10 par 1,000Donated Capital from Treasury Stock 200


Overview of Treasury Stock

Cost method is widely used due to its simplicity but par value method is theoretically preferable.

Treasury stock is not an asset; it is treated as a reduction of stockholders' equity.

Treasury stock does not have voting rights, no preemptive right; does not participate in dividends; does not participate in assets at liquidation, but participate in stock split.


Overview of Treasury Stock(contd.)

Treasury stock transactions do not result in gains or losses.

Treasury stock transactions may reduce retained earnings but may never increase retained earnings.

Retained earnings may be restricted regarding dividends in the amount of the treasury stock on hand.


Overview of Treasury Stock (T.S.) (contd.) Total amount of stockholders' equity is the

same under cost or par value method However, the subtotals of component

elements (R/E, treasury stock, and additional paid-in capital) are likely to be different when using different method.

Intermediate Financial Accounting

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