Financial accounting 9th jamie pratt chapter 12

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Chapter 12

Shareholders’ Equity

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Shareholders’ Equity
How to Finance a Corporation:
Borrow
 Notes, Bonds, Leases
 The debt holders are legally entitled to repayment of their principal and interest claims

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Issue Equity
 Common and Preferred Stock
 The shareholders, as owners, have voting rights, limited liability, and a residual interest in the
corporate assets

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Retained Earnings (profitable operations)

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Relative Importance of Liabilities, Contributed Capital, and Earned Capital

Figure 12-2 The
relative importance
of liabilities,
contributed capital,
and retained
earnings
(percentage of total
assets)

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Debt and Equity Distinguished - Characteristics
Debt

Equity

Formal legal contract No legal contract
Fixed maturity date

No fixed maturity date

Fixed periodic payments

Discretionary dividends

Security in case of default

Residual asset interest

No voice in management

Voting rights - common

Interest expense deductible Dividends not deductible
Double taxation

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Distinctions Between Debt and Equity
Interested Party

Debt

Investors /

Lower investment risk

Creditors

Fixed cash receipts

Contractual future cash

Equity______
Higher investment risk
Variable cash receipts

Dividends are discretionary

payments

Management

Effects on credit

Effects of dilution/ takeover

rating
Interest is tax deductible

Dividends are not tax deductible

Accountants/

Liabilities section

Shareholders’ equity

Auditors

of the balance sheet

of the balance sheet

Income statement

No income statement

effects from debt

effects from equity
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The Economic Consequences Associated with Accounting for Shareholders’
Equity
 Key business ratios rely on Shareholders’ equity which affects credit ratings and analysts evaluation of a company

Figure 12-5
Shareholders’
equity section
of balance
sheet

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Preferred Stock vs. Common Stock
Preferred Stock
Advantages

Common Stock

Preference over common in liquidation

Voting Rights

Stated dividend

Rights to residual profits (after preferred)

Preference over common in dividend payout

Disadvantages

Subordinate to debt in liquidation

Last in liquidation

Stated dividend can be skipped

No guaranteed return

No voting rights (versus common)
Debt or Equity?

Components of both

Usually classified as equity

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Sample Co. Shareholders’ Equity
(Used for Examples)
Common stock, $1 par value, 500,000 shares
authorized, 80,000 shares issued, and
75,000 shares outstanding
$ 80,000
Common stock dividends distributable
2,000
Preferred stock, $100 par value, 1,000 shares
authorized, 100 shares issued and
outstanding
10,000
Paid in capital on common
$ 20,000
Paid in capital on preferred
3,000

Paid in capital on treasury stock
2,000
25,000
Retained earnings:
Unappropriated
$18,000
Appropriated
4,000
22,000
Less: Treasury stock, 5,000 shares (at cost) (6,000)
Less: Other comprehensive income items
(unrealized loss on AFS securities) (2,000)
Total Shareholders’ Equity
$131,000

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Accounting for Common and Preferred Stock Issuances
Using Sample Company’s information, record the following additional issues of common (CS) and
preferred stock (PS). Par value of PS is $100 and par value of CS is $1.
Issued 100 shares of PS at $102 per share:
Cash (100 x $102)
10,200
PS (100 x $100 par)
10,000
APIC* - PS
200

Issued 500 shares of CS at $5 per share:
Cash (500 x $5)
2,500
CS (500 x $1 par)
APIC* - CS

500
2,000

APIC – Additional Paid-in Capital

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Treasury Stock
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Created when a company buys back shares of its own common stock.

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Reasons for buyback are numerous and include

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Maintain leverage
Raise EPS
Return money to shareholders

The debit balance account called “Treasury Stock” is reported in shareholders’ equity as a contra account to
SE.

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Support compensation plans

Note: Treasury Stock is not an asset.

The stock remains issued, but is no longer outstanding.

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does not have voting rights
cannot receive cash dividends

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May be reissued (to the market or to employees) or retired.

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No gains or losses are ever recognized from these equity transactions.
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Treasury Stock Example from Sample Co.
Note that Sample Company (from previous slide) has 5,000 shares of Treasury Stock (TS) at a total
cost of $6,000, or a cost of $1.20 per share. The journal entry to record that purchase would have
been:

TS

6,000
Cash

6,000

Note that Sample Company also has APIC - TS of $2,000 in the balance sheet. This must be from
previous TS transactions, where the TS was purchased, then reissued for more than original cost. All
that remains of those transactions is the APIC -TS.

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Treasury Stock - Example Problem
Tiger Corporation has 100,000 shares of $1 par value stock authorized, issued and outstanding at January 1,

2014. The stock had been issued at an average market price of $5 per share, and there have been no
treasury stock transactions to this point.
Assume that, in February of 2014, Tiger Corp. repurchases 10,000 shares of its own stock at $7 per share. In
July of 2014, Tiger Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2014,
Tiger Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2014
regarding the treasury stock.

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Treasury Stock Example - Journal Entries
Feb: repurchase 10,000 sh. @ $7 = $70,000.

TS

70,000
Cash

70,000

July: reissue 2,000 sh. @ $ 8 = $16,000
(cost = 2,000sh. @ $7 = 14,000)

Cash

16,000

TS

APIC - TS

14,000
2,000
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Treasury Stock Example -Journal Entries
Dec: reissue 8,000 sh. @ $ 6 = $48,000
(cost = 8,000 sh.@ $7 = 56,000)
Cash

48,000

APIC - TS (1) 2,000
RE (2)

6,000

TS

56,000

Now we need to debit one or more accounts to compensate for the difference.
(1) debit APIC -TS (but lower limit is to -0-).
(2) debit RE if necessary for any remaining balance (this is only necessary when
we are decreasing equity).

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Stock Options

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Give employees (typically executives) the right to purchase company stock at a given price
for a period of time.

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The idea is that if the stock price rises the executives purchase stock at a price less than its
market value thereby getting a benefit.

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Since value is given up in the lower than market stock price and existing stockholders
give up a percentage of ownership, GAAP requires that an expense be booked when the
options are granted

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Retained Earnings

We will be expanding the basic retained earnings formula in this chapter. Now the Statement of Retaine
Earnings will include the following:

RE, beginning (unadjusted)

xx

Add/Subtract: Prior period adjustment

xx

RE, beginning (restated)

xx

Add: net income

xx

Less dividends:
Cash dividends-common

xx

Cash dividends - preferred xx
Stock dividends

xx

Property dividends

xx

Less: Adjustment for TS transactions
Appropriation of RE
RE, ending

xx
xx

xx
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Example of Stock Split
IZM Company has 100,000 shares of $2 par value stock authorized, 10,000
shares issued and outstanding.
The SE section of the balance sheet shows:
 Common stock $20,000
 Retained earnings 80,000
The market price of the outstanding shares is $50 per share before the split
is distributed.

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Example of Stock Split

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If IZM declared a 2 for 1 stock split, the old shares would be turned in and new shares would be
issued with the following description:

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Common stock, $1 par value, 200,000 shares authorized, 20,000 shares issued and outstanding.

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The total SE is still $100,000:

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The market price per outstanding share would now be $25 per share.

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Note: No journal entry is necessary.

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Common stock
Retained earnings

$20,000
80,000

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Stock Dividends vs Stock Splits
Going back to the original IZM information. Assume instead that IZM declared a 100% stock
dividend.
First, prepare the JEs to record the declaration and distribution of the stock dividend for new shares
(10,000 shares x 100% = 10,000 new shares x $2 per share = $20,000):

Stock Dividends (RE)

20,000

Stock Div. Distributable

20,000

Stock Div. Distributable 20,000
Common Stock

20,000

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Stock Dividends vs Stock Splits

Note the new description for the stock dividend:
Common stock, $2 par value, 100,000 shares authorized, 20,000 shares issued and
outstanding

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 The total value in SE is still $100,000:
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Common Stock
$40,000
Retained Earnings
60,000
$20,000 has been moved from RE to Common Stock

 Note that the total market price per share would change to $25 per share.
 Thus, a 2 for 1 stock split and a 100% stock dividend have the same effect on:
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total shareholders’ equity and
market price per share

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Stock Dividends vs Stock Splits
To summarize the effects on IZM Company:
100% Stock
2 for 1
After:
Dividend
Stock Split
Total sh. outstanding 20,000 sh.
20,000 sh.
Par value per share
$2
$1
Market price per share $25
$25
Total shareholders’ eq: $100,000
$100,000
General ledger results:
CS account
$ 40,000
$ 20,000
RE account
$ 60,000
$ 80,000
CS was $20,000 and RE was $80,000 before the split or dividend. The stock dividend required journal entries, and the
amounts for CS and RE changed. The stock split does not require a journal entry and the amounts for CS and RE do
not change.

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Comprehensive Class Problem - Shareholders’ Equity
Given the following SE balances for Company G at 1/1/15:
Common stock, $10 par, 50,000 shares authorized,
20,000 shares issued and outstanding
$200,000
APIC on common stock
Retained earnings

400,000
400,000

During 2015, Company G had the following activity:
1. Net income for the year was $250,000.
2. Cash dividends of $2 per share were declared and paid on February 1.
3. On June 1, Company G repurchased 2,000 shares of its own stock at $20 per share (using the cost
method).
4. On December 1, Company G reissued 500 shares of treasury stock at $18 per share.
5. On December 15, Company G declared a 100% stock dividend, to be distributed to all of its shareholders
(including treasury), on Jan. 15, 2016.

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Comprehensive Class Problem Shareholders’ Equity (continued)
Required:
A. Prepare journal entries for items 2 through 5 (item 1 would require detailed information for

revenues and expenses to prepare - just know that the credit is to retained earnings for
$250,000).

B. the Statement of Stockholders’ Equity for Company G for 2015.

C. Prepare the stockholders’ equity section of the balance sheet for Company G for 2015,
including the appropriate description for the common stock.

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Comprehensive Class Problem - Solution
A. Journal entries
1. No entry required.
2. Calc: 20,000 x $2 = 40,000
Cash Dividends (RE) 40,000

 

Dividends Payable
Dividends Payable

40,000

40,000

Cash

40,000

3. Calc: 2,000 shares x $20 = $40,000
Treasury Stock
Cash

40,000
40,000

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