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REPORTING AND ANALYZING STOCKHOLDERS’ EQUITY

Accounting, Fifth Edition

11

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After studying this chapter, you should be able to:

1. Identify and discuss the major characteristics of a corporation.

2. Record the issuance of common stock.

3. Explain the accounting for the purchase of treasury stock.

4. Differentiate preferred stock from common stock.

5. Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

6. Identify the items that affect retained earnings.

7. Prepare a comprehensive stockholders’ equity section.

8. Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

Learning ObjectivesLearning Objectives

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Preview of Chapter 11

AccountingFifth Edition

Kimmel Weygandt Kieso

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The Corporate Form of OrganizationThe Corporate Form of Organization

An entity separate and distinct from its owners.

Classified by Purpose

Not-for-Profit

For Profit

Classified by Ownership

Publicly held

Privately held

► Facebook► IBM► Caterpillar► General Electric

► Salvation Army► American Cancer

Society

► Cargill Inc.

LO 1 Identify and discuss the major characteristics of a corporation.

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Separate Legal Existence

Limited Liability of Stockholders

Transferable Ownership Rights

Ability to Acquire Capital

Continuous Life

Corporate Management

Government Regulations

Additional Taxes

Characteristics that distinguish corporations from

proprietorships and partnerships.

LO 1 Identify the major characteristics of a corporation.

Characteristics of a CorporationCharacteristics of a Corporation

Advantages

Disadvantages

11-7 LO 1 Identify the major characteristics of a corporation.

Corporation acts under its own name rather than in the name of its stockholders.








Continuous Life



Additional Taxes


Limited to their investment.








Continuous Life



Additional Taxes


Shareholders may sell their stock.








Continuous Life



Additional Taxes


Corporation can obtain capital through the issuance of stock.








Continuous Life



Additional Taxes


Continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer.








Continuous Life



Additional Taxes

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Continuous Life



Additional Taxes


Separation of ownership and management prevents owners from having an active role in managing the company.




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Continuous Life



Additional Taxes





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Continuous Life



Additional Taxes


Corporations pay income taxes as a separate legal entity and in addition, stockholders pay taxes on cash dividends.




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Stockholders

Chairman and Board of Directors

President andChief Executive

Officer

General Counsel/Secretary

Vice PresidentMarketing

Vice PresidentFinance/Chief

Financial Officer

Vice PresidentOperations

Vice PresidentHuman

Resources

Treasurer Controller

Illustration 11-1 Corporation organization chart



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Other Forms of Business Organization

Limited partnerships

Limited liability partnerships (LLPs)

Limited liability companies (LLCs)

S Corporation

► No double taxation.

► Cannot have more than 75 shareholders.

Other Forms of Business OrganizationOther Forms of Business Organization


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Forming a Corporation

File application with the Secretary of State.

State grants charter.

Corporation develops by-laws.

Initial Steps:

Companies generally incorporate in a state whose laws are

favorable to the corporate form of business (Delaware, New Jersey).

Corporations engaged in interstate commerce must obtain a license

from each state in which they do business.



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1. Vote in election of board of

directors and on actions that

require stockholder approval.

Stockholders Rights

2. Share the corporate earnings

through receipt of dividends.

Illustration 11-3



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3. Keep the same percentage ownership when new shares of stock are issued (preemptive right).


Stockholders Rights


Illustration 11-3

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4. Share in assets upon liquidation in proportion to their holdings. This is called a residual claim.


Stockholders Rights


Illustration 11-3

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Stock Issue ConsiderationsStock Issue Considerations

Charter indicates the amount of stock that a

corporation is authorized to sell.

Number of authorized shares is often reported in the

stockholders’ equity section.

Authorized Stock

LO 2 Record the issuance of common stock.

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Name of corporation

Stockholder’s name

Shares

Signature of corporate official

Prenumbered Illustration 11-4


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Corporation can issue common stock

► directly to investors or

► indirectly through an investment banking firm.

Top five exchanges by value of shares traded:

1. New York Stock Exchange

2. Nasdaq stock market

3. London Stock Exchange

4. Tokyo Stock Exchange

5. Euronext

Issuance of Stock


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Capital stock that has been assigned a value per share.

Years ago, par value determined the legal capital per

share that a company must retain in the business for the

protection of corporate creditors.

Today many states do not require a par value.

No-par value stock is fairly common today.

In many states the board of directors assigns a stated

value to no-par shares.

Par and No-Par Value Stocks


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Review Question

Which of these statements is false?

a. Ownership of common stock gives the owner a voting right.

b. The stockholders’ equity section begins with paid-in capital.

c. The authorization of capital stock does not result in a formal accounting entry.

d. Legal capital is intended to protect stockholders.


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Indicate whether each of the following statements is

true or false.

______ 1. Similar to partners in a partnership, stockholders of a

corporation have unlimited liability.

______ 2. It is relatively easy for a corporation to obtain capital

through the issuance of stock.

______ 3. The separation of ownership and management is an

advantage of the corporate form of business.

______ 4. The journal entry to record the authorization of capital stock

includes a credit to the appropriate capital stock account.

______ 5. All states require a par value per share for capital stock.

False


True

False

False

False

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Paid-in CapitalPaid-in CapitalPaid-in CapitalPaid-in Capital

Retained EarningsRetained EarningsAccountAccount


Paid-in Capital in Paid-in Capital in Excess of ParExcess of Par

AccountAccount


AccountAccount

Two Primary Sources of

Equity

Common StockCommon StockAccountAccount


Preferred StockPreferred StockAccountAccount


Paid-in capital is the total amount of cash and other assets paid in to

the corporation by stockholders in exchange for shares of ownership.



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Equity





Retained earnings is net income (earned capital) that a corporation

retains for future use in the business.




AccountAccount


AccountAccount

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Primary objectives:

1) Identify the specific sources of paid-in capital.

2) Maintain the distinction between paid-in capital and

retained earnings.


Other than consideration received, the issuance of common stock

affects only paid-in capital accounts.


Accounting for Issues of Common Stock

11-32 LO 2 Record the issuance of common stock.


Illustration: Assume that Hydro-Slide, Inc. issues 2,000 shares of $1 par value common stock. Prepare Hydro-Slide’s journal entry if (a) 1,000 share are issued for $1 per share, and (b) 1,000 shares are issued for $5 per share.

Cash 1,000

Common stock (1,000 x $1) 1,000

Cash 5,000

Common stock (1,000 x $1) 1,000

Paid-in capital in excess of par value 4,000

a)

b)

Accounting for Issues of Common Stock

11-33 LO 2 Record the issuance of common stock.

Illustration 11-5


Stockholders’ equity section assuming Hydro-Slide, Inc. has

retained earnings of $27,000.

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ABC Corp. issues 1,000 shares of $10 par value common stock at $12 per share. When the transaction is recorded, credits are made to:

a. Common Stock $10,000 and Paid-in Capital in Excess of Stated Value $2,000.

b. Common Stock $12,000.

c. Common Stock $10,000 and Paid-in Capital in Excess of Par Value $2,000.

d. Common Stock $10,000 and Retained Earnings $2,000.



Review Question

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AccountAccount


AccountAccount

Less:Less:Treasury StockTreasury Stock

Account

Less:Less:Treasury StockTreasury Stock

Account


Equity





Accounting for Treasury StockAccounting for Treasury Stock

LO 3 Explain the accounting for the purchase of treasury stock.

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Treasury stock - corporation’s own stock that it has reacquired from shareholders, but not retired.

Corporations purchase their outstanding stock:

1. To reissue shares to officers and employees under bonus and stock compensation plans.

2. To increase trading of the company’s stock in the securities market.

3. To have additional shares available for use in acquiring other companies.

4. To increase earnings per share.

Another infrequent reason is to eliminate hostile shareholders.



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Purchase of Treasury Stock

Generally accounted for by the cost method.

Debit Treasury Stock for the price paid.

Treasury stock is a contra stockholders’ equity account,

not an asset.

Treasury Stock decreases by the same amount when the

company later sells the shares.



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Treasury stock (4,000 x $8) 32,000

Cash 32,000

Illustration: On February 1, 2014, Mead acquires 4,000 shares of its stock at $8 per share. Prepare the entry.


Illustration 11-6


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Stockholders’ Equity with Treasury stock

Both the number of shares issued (100,000), outstanding (96,000), and

the number of shares held as treasury (4,000) are disclosed.

Illustration 11-7


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Review Question

Treasury stock may be repurchased:

a. to reissue the shares to officers and employees under bonus and stock compensation plans.

b. to signal to the stock market that management believes the stock is underpriced.

c. to have additional shares available for use in the acquisition of other companies.

d. more than one of the above.

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Typically, preferred stockholders have a priority in relation to

1. dividends and

2. assets in the event of liquidation.

However, they sometimes do not have voting rights.

LO 4 Differentiate preferred stock from common stock.

Preferred StockPreferred Stock

Each paid-in capital account title should identify the stock to

which it relates:

Paid-in Capital in Excess of Par Value—Preferred Stock

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

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Illustration: Stine Corporation issues 10,000 shares of

$10 par value preferred stock for $12 cash per share. Journalize

the issuance of the preferred stock.



Cash 120,000

Preferred stock (10,000 x $10) 100,000

Paid-in capital in excess of par –

Preferred stock 20,000

Preferred stock may have a par value or no-par value.

11-44 LO 4 Differentiate preferred stock from common stock.


Right to receive dividends before common stockholders.

Per share dividend amount is stated as a percentage of

the preferred stock’s par value or as a specified amount.

Cumulative dividend – holders of preferred stock must be

paid their annual dividend plus any dividends in arrears

before common stockholders receive dividends.

Dividend Preferences


Cumulative Dividend

Illustration: Scientific Leasing has 5,000 shares of 7%, $100 par

value, cumulative preferred stock outstanding. Each $100 share

pays a $7 dividend (.07 x $100). The annual dividend is $35,000

(5,000 x $7 per share). If dividends are two years in arrears,

preferred stockholders are entitled to receive the following

dividends in the current year.


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Preference on corporate assets if the corporation fails.

Preference may be

► for the par value of the shares or

► for a specified liquidating value.



Liquidation Preference



M-Bot Corporation has 10,000 shares of 8%, $100 par value, cumulative preferred stock outstanding at December 31, 2014. No dividends were declared in 2012 or 2013. If M-Bot wants to pay $375,000 of dividends in 2014, common stockholders will receive:

a. $0.

b. $295,000.

c. $215,000.

d. $135,000.

Review Question

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A distribution to stockholders on a pro rata (proportional to ownership) basis.

Types of Dividends:

DividendsDividends

LO 5 Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits.

1. Cash dividends.

2. Property dividends.

Dividends expressed: (1) as a percentage of the par or stated value, or (2) as a dollar amount per share.

3. Stock dividends.

4. Scrip (promissory note)

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For a corporation to pay a cash dividend, it must have:

1. Retained earnings - Payment of dividends from retained

earnings is legal in all states.

2. Adequate cash.

3. Declaration by the Board of Directors.

DividendsDividends


Cash Dividends

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Dividends require information concerning three dates:

DividendsDividends


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Illustration: On Dec. 1, the directors of Media General declare a $0.50 per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is payable on Jan. 20 to shareholders of record on Dec. 22:

December 1 (Declaration Date)

Cash dividends 50,000

Dividends payable 50,000

December 22 (Record Date)

January 20 (Payment Date)

DividendsDividends

Dividends payable 50,000

Cash 50,000

No entry


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DividendsDividends


Entries for cash dividends are required on the:

a. declaration date and the record date.

b. record date and the payment date.

c. declaration date, record date, and payment date.

d. declaration date and the payment date.

Review Question

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Pro rata distribution of the corporation’s own stock.

DividendsDividends

Results in decrease in retained earnings and increase in paid-in capital.

Illustration 11-10


Stock Dividends

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Reasons why corporations issue stock dividends:

1. Satisfy stockholders’ dividend expectations without

spending cash.

2. Increase the marketability of the corporation’s stock.

3. Emphasize that a portion of stockholders’ equity has been

permanently reinvested in the business.

DividendsDividends


Stock Dividends

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Effects of Stock Dividends

Changes the composition of stockholders’ equity.

Total stockholders’ equity remains the same.

No effect on the par or stated value per share.

Increases the number of shares outstanding.

DividendsDividends


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Illustration: Medland Corp. declares a 10% stock dividend on its

$10 par common stock when 50,000 shares were outstanding. The

market price was $15 per share.

DividendsDividends


Illustration 11-9

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Reduces the market value of shares.

No entry recorded for a stock split.

Decrease par value and increase number of shares.

DividendsDividends


Stock Splits

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Illustration: Assuming that instead of issuing a 10% stock dividend, Medland splits its 50,000 shares of common stock on a 2-for-1 basis.

DividendsDividends


Illustration 11-11

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Differences between the effects of stock dividends and stock splits.

DividendsDividends


Illustration 11-12

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DividendsDividends


Which of these statements about stock dividends is true?

a. Stock dividends reduce a company’s cash balance.

b. A stock dividend has no effect on total stockholders’ equity.

c. A stock dividend decreases total stockholders’ equity.

d. A stock dividend ordinarily will increase total stockholders’ equity.

Review Question

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Retained earnings is net income that a company

retains for use in the business.

Net income increases Retained Earnings and a net

loss decreases Retained Earnings.

Retained earnings is part of the stockholders’ claim

on the total assets of the corporation.

A debit balance in Retained Earnings is identified as a

deficit.

Retained EarningsRetained Earnings

LO 6 Identify the items that affect retained earnings.

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Illustration 11-14

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Restrictions can result from:

1. Legal restrictions.

2. Contractual restrictions.

3. Voluntary restrictions.

Retained Earnings Restrictions



Illustration 11-15Disclosure of unrestrictedretained earnings

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Balance Sheet Presentation

Presentation of Stockholders’ EquityPresentation of Stockholders’ Equity

LO 7 Prepare a comprehensive stockholders’ equity section.

Two classifications of paid-in capital:

1. Capital stock

2. Additional paid-in capital

11-67 LO 7 Prepare a comprehensive stockholders’ equity section.

Presentation of Stockholders’ EquityPresentation of Stockholders’ Equity

Balance Sheet Presentation

Illustration 11-16

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Dividend Record

Measuring Corporate PerformanceMeasuring Corporate Performance

LO 8 Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective.

Illustration: The following is the calculation of the payout ratio for Nike in 2011 and 2010.

The payout ratio measures the percentage of earnings a company distributes in the form of cash dividends.

Illustration 11-18

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This ratio shows how many dollars of net income a company earned for each dollar of common stockholders’ equity.

Illustration 11-20

Earnings Performance

Illustration: The following is the calculation of Nike’s return on common stockholders’ equity ratios for 2011 and 2010.

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Debt Versus Equity Decision



Illustration 11-21

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Illustration 11-22

Debt Versus Equity Decision

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LO 8

Illustration: Microsystems Inc. currently has 100,000 shares ofcommon stock outstanding issued at $25 per share and no debt. It is considering two alternatives for raising an additional $5 million: Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuing $5 million of 12% bonds at face value. Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%.

Illustration 11-23

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Illustration: Medland Corporation declares a 10% stock dividend on its

50,000 shares of $10 par value common stock. The current fair market

value of its stock is $15 per share. Record the entry on the declaration

date:

Stock dividends (50,000 x 10% x $15) 75,000

Common stock dividends distributable 50,000

Paid-in capital in excess of par 25,000

LO 9 Prepare entries for stock dividends.

Illustration 11A-1

Appendix 11AAppendix 11A Entries for Stock Dividends

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Common stock dividends distributable 50,000

Common stock 50,000

LO 9 Prepare entries for stock dividends.

Illustration: Record the journal entry when Medland issues the dividend

shares.

Appendix 11AAppendix 11A Entries for Stock Dividends

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Key Points

Under IFRS, the term reserves is used to describe all equity accounts other than those arising from contributed capital. This would include, for example, reserves related to retained earnings, asset revaluations, and fair value differences.

Many countries have a different mix of investor groups than in the United States. For example, in Germany, financial institutions like banks are not only major creditors of corporations but often are the largest corporate stockholders as well. In the United States, Asia, and the United Kingdom, many companies rely on substantial investment from private investors.

LO 10 Compare the accounting for transactions related to stockholders’ equity under GAAP and IFRS.

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Key Points

LO 10

There are often terminology differences for equity accounts. The following summarizes some of the common differences in terminology.

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The accounting for treasury stock differs somewhat between IFRS and GAAP. (However, many of the differences are beyond the scope of this course.) Like GAAP, IFRS does not allow a company to record gains or losses on purchases of its own shares. One difference worth noting is that, when a company purchases its own shares, IFRS treats it as a reduction of stockholders’ equity, but it does not specify which particular stockholders’ equity accounts are to be affected. Therefore, it could be shown as an increase to a contra equity account (Treasury Stock) or a decrease to retained earnings or share capital. IFRS requires that the number of treasury shares held be disclosed.

Key Points


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A major difference between IFRS and GAAP relates to the account Revaluation Surplus. Revaluation surplus arises under IFRS because companies are permitted to revalue their property, plant, and equipment to fair value under certain circumstances. This account is part of general reserves under IFRS and is not considered contributed capital.

As indicated earlier, the term reserves is used in IFRS to indicate all noncontributed (non–paid-in) capital. Reserves include retained earnings and other comprehensive income items, such as revaluation surplus and unrealized gains or losses on available-for-sale securities.

Key Points


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Key Points

Under GAAP, some contingent liabilities are recorded in the

financial statements, others are disclosed, and in some cases no

disclosure is required. Unlike GAAP, IFRS reserves the use of the

term contingent liability to refer only to possible obligations that are

not recognized in the financial statements but may be disclosed if

certain criteria are met.

For those items that GAAP would treat as recordable contingent

liabilities, IFRS instead uses the term provisions. Provisions are

defined as liabilities of uncertain timing or amount. Under IFRS, the

measurement of a provision related to an uncertain obligation is

based on the best estimate of the expenditure required to settle the

obligation.LO 10

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Key Points

IFRS often uses terms such as retained profits or accumulated profit

or loss to describe retained earnings. The term retained earnings is

also often used.

The accounting related to prior period adjustments is essentially the

same under IFRS and GAAP. IFRS addresses the accounting for

errors in IAS 8 (“Accounting Policies, Changes in Accounting

Estimates, and Errors”). One area where IFRS and GAAP differ in

reporting relates to error corrections in previously issued financial

statements. While IFRS requires restatement with some exceptions,

GAAP does not permit any exceptions.


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Key Points

Equity is given various descriptions under IFRS, such as

shareholders’ equity, owners’ equity, capital and reserves, and

shareholders’ funds.


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Looking to the Future

The FASB and IASB are currently involved in two projects. One project is

investigating approaches to differentiate between debt and equity

instruments. The other project, the elements phase of the conceptual

framework project, will evaluate the definitions of the fundamental building

blocks of accounting. In addition to these projects, the FASB and IASB

have also identified leasing as one of the most problematic areas of

accounting. A joint project will initially focus primarily on lessee accounting.

One of the first areas to be studied is, “What are the assets and liabilities

to be recognized related to a lease contract?” Should the focus remain on

the leased item or the right to use the leased item? This question is tied to

the Boards’ joint project on the conceptual framework—defining an “asset” and a “liability.”


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IFRS Practice


Under IFRS, a purchase by a company of its own shares is recorded

by:

a) an increase in Treasury Stock.

b) a decrease in contributed capital.

c) a decrease in share capital.

d) All of these are acceptable treatments.

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IFRS Practice


The term reserves is used under IFRS with reference to all of the

following except:

a) gains and losses on revaluation of property, plant, and

equipment.

b) capital received in excess of the par value of issued shares.

c) retained earnings.

d) fair value differences.

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IFRS Practice


Under IFRS, the amount of capital received in excess of par value

would be credited to:

a) Retained Earnings.

b) Contributed Capital.

c) Share Premium-Ordinary.

d) Par value is not used under IFRS.

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