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C H A P T E R
Reporting
and Analyzing
Stockholders’ Equity
S T U D Y
O B J E C T I V E S
F E AT U R E
After studying this chapter,
you should be able to:
1 Identify and discuss the major characteristics of a
corporation.
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.
NAVIGATOR
●
Scan Study Objectives
●
Read Feature Story
●
Read Preview
●
Read text and answer Before You Go On
p. 539
p. 543
p. 545
p. 552
p. 556
p. 560
●
Work Using the Decision Toolkit
●
Review Summary of Study Objectives
●
Work Demonstration Problem
●
Answer Self-Study Questions
●
Complete Assignments
✓
❍
● THE
NAVIGATOR
S T O R Y
What’s
Cooking?
2 Record the issuance of common stock.
✔T H E
❍
●
11
W
hat major U.S. corporation got its start
35 years ago with a waffle iron? Hint: It
doesn’t sell food. Another hint: Swoosh. Another
hint: “Just do it.” That’s right, Nike. In 1971 Nike cofounder Bill Bowerman put a piece of rubber into a
kitchen waffle iron, and the trademark waffle sole
was born. It seems fair to say that at Nike, “They
don’t make ’em like they used to.”
Nike was co-founded by Bowerman and Phil
Knight, a member of Bowerman’s University of Oregon track team. Each began in the shoe business independently during the early 1960s. Bowerman got
his start by making hand-crafted running shoes for
his University of Oregon track team. Knight, after
completing graduate school, started a small business
importing low-cost, high-quality shoes from Japan.
In 1964 the two joined forces, each contributing
$500, and formed Blue Ribbon Sports, a partnership,
marketing Japanese shoes.
It wasn’t until 1971 that the company began
manufacturing its own line of shoes. With the new
shoes came a new corporate name—Nike—the
Greek goddess of victory. It is hard to imagine that
the company that now boasts a stable full of worldclass athletes as promoters at one time had parttime employees selling shoes out of car trunks at
track meets. Nike has achieved its success through
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Last #1 Head
relentless innovation combined with unbridled
promotion.
By 1980 Nike was sufficiently established that
it was able to issue its first stock to the public. In
that same year it also created a stock ownership
program for its employees, allowing them to
share in the company’s success. Since then Nike
has enjoyed phenomenal growth, with 2004 sales
reaching $12.3 billion and total dividends paid of
$179 million.
Nike is not alone in its quest for the top of the
sport shoe world. Competitor Reebok pushes Nike
every step of the way. However, Nike’s recent success has resulted in sales that are three times
those of Reebok.
Is the race over? Probably not. The shoe market is fickle, with new styles becoming popular
533
almost daily and vast international markets still
lying untapped. Whether one of these two giants
does eventually take control of the planet remains
to be seen. Meanwhile the shareholders sit anxiously in the stands as this Olympic-size drama
unfolds.
✓
❍
●
THE
NAVIGATOR
On the World Wide Web
Nike: www.nike.com
Reebok: www.reebok.com
533
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O F
C H A P T E R
1 1
Corporations like Nike and Reebok have substantial resources at their disposal.
In fact, the corporation is the dominant form of business organization in the
United States in terms of sales, earnings, and number of employees. All of the
500 largest U.S. companies are corporations. In this chapter we look at the essential features of a corporation and explain the accounting for a corporation’s
capital stock transactions.
The content and organization of the chapter are as follows.
REPORTING AND ANALYZING STOCKHOLDERS’ EQUITY
The Corporate
Form of
Organization
• Characteristics
• Formation
• Stockholder rights
Stock Issue
Considerations
• Authorized stock
• Issuance
• Par and no-par
value
• Accounting for
common stock
issues
Accounting for
Treasury Stock
• Purchase of
treasury stock
Preferred Stock
• Dividend
preferences
• Liquidation
preference
Financial
Statement
Presentation and
Corporate
Performance
Dividends and
Retained Earnings
•
•
•
•
Cash dividends
Stock dividends
Stock splits
Retained
earnings
restrictions
• Balance sheet
• Statement of cash
flows
• Dividend record
• Earnings
performance
• Debt vs. equity
decision
✓
❍
● THE
NAVIGATOR
The Corporate Form of Organization
A corporation is created by law. As a legal entity, a corporation has most of the
rights and privileges of a person. The major exceptions relate to privileges that
can be exercised only by a living person, such as the right to vote or to hold public office. Similarly, a corporation is subject to the same duties and responsibilities as a person. For example, it must abide by the law and it must pay taxes.
We can classify corporations in a variety of ways. Two common classifications are by purpose and by ownership. A corporation may be organized for
the purpose of making a profit (such as Nike or General Motors), or it may be
a nonprofit charitable, medical, or educational corporation (such as Salvation
Army or the American Cancer Society).
Classification by ownership differentiates publicly held and privately held
corporations. A publicly held corporation may have thousands of stockholders, and its stock is regularly traded on a national securities market such as the
New York Stock Exchange. Examples are IBM, Caterpillar, and General Electric. In contrast, a privately held corporation, often referred to as a closely
held corporation, usually has only a few stockholders and does not offer its stock
for sale to the general public. Privately held companies are generally much smaller
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The Corporate Form of Organization
than publicly held companies, although some notable exceptions exist. Cargill
Inc., a private corporation that trades in grain and other commodities, is one of
the largest companies in the United States. This chapter deals primarily with
issues related to publicly held companies.
CHARACTERISTICS OF A CORPORATION
535
STUDY OBJECTIVE
1
Identify and discuss the
major characteristics of a
corporation.
In 1964, when Nike’s founders, Knight and Bowerman, were just getting started
in the running shoe business, they formed their original organization as a partnership. In 1968 they reorganized the company as a corporation. A number of
characteristics distinguish a corporation from sole proprietorships and partnerships. The most important of these characteristics are explained below.
WKK
Corp.
Separate Legal Existence
As an entity separate and distinct from its owners, the corporation acts under its
own name rather than in the name of its stockholders. Nike, for example, may buy,
own, and sell property, borrow money, and enter into legally binding contracts in
its own name. It may also sue or be sued. It pays taxes as a separate entity.
In contrast to a partnership, in which the acts of the owners (partners) bind
the partnership, the acts of the owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you owned
shares of Nike stock, you would not have the right to purchase inventory for the
company unless you were designated as an agent of the corporation.
Limited Liability of Stockholders
Since a corporation is a separate legal entity, creditors ordinarily have recourse
only to corporate assets to satisfy their claims. The liability of stockholders is
normally limited to their investment in the corporation. Creditors have no legal
claim on the personal assets of the stockholders unless fraud has occurred. Thus,
even in the event of bankruptcy of the corporation, stockholders’ losses are generally limited to the amount of capital they have invested in the corporation.
Transferable Ownership Rights
Ownership of a corporation is held in shares of capital stock, which are transferable units. Stockholders may dispose of part or all of their interest in a corporation simply by selling their stock. The transfer of an ownership interest in
a partnership requires the consent of each partner. In contrast, the transfer of
stock is entirely at the discretion of the stockholder. It does not require the
approval of either the corporation or other stockholders.
The transfer of ownership rights among stockholders normally has no effect
on the operating activities of the corporation. Nor does it affect the corporation’s
assets, liabilities, and total stockholders’ equity. The transfer of ownership rights
is a transaction between individual owners. The company does not participate in
the transfer of these ownership rights after the original sale of the capital stock.
Stockholders
Legal existence separate
from owners
WKK
Corp.
Stockholders
Limited liability
of stockholders
Transferable
ownership rights
Ability to Acquire Capital
It is relatively easy for a corporation to obtain capital through the issuance of
stock. Buying stock in a corporation is often attractive to an investor because a
stockholder has limited liability and shares of stock are readily transferable. Also,
numerous individuals can become stockholders by investing small amounts of
money.
Ability to acquire capital
Continuous Life
The life of a corporation is stated in its charter. The life may be perpetual or it
may be limited to a specific number of years. If it is limited, the company can
extend the period of existence through renewal of the charter. Since a corporation
is a separate legal entity, its continuance as a going concern is not affected by
Continuous life
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Reporting and Analyzing Stockholders’ Equity
the withdrawal, death, or incapacity of a stockholder, employee, or officer. As a
result, a successful corporation can have a continuous and perpetual life.
Corporation Management
Although stockholders legally own the corporation, they manage it indirectly
through a board of directors they elect. Philip Knight is the chairman of Nike’s
board of directors. The board, in turn, formulates the operating policies for the
company. The board also selects officers, such as a president and one or more
vice-presidents, to execute policy and to perform daily management functions.
As a result of the Sarbanes-Oxley Act, the board is now required to monitor management’s actions more closely. Many feel that the failures at Enron and
WorldCom could have been avoided by more diligent boards.
Illustration 11-1 depicts a typical organization chart showing the delegation
of responsibility.
Illustration 11-1
Corporation organization
chart
Stockholders
Chairman and
Board of
Directors
President and
Chief Executive
Officer
General
Counsel and
Secretary
Vice President
Marketing
Vice President
Finance/Chief
Financial Officer
Treasurer
Vice President
Operations
Vice President
Human
Resources
Controller
The chief executive officer (CEO) has overall responsibility for managing the
business. As the organization chart shows, the CEO delegates responsibility to
other officers. The chief accounting officer is the controller. The controller’s
responsibilities are to (1) maintain the accounting records, (2) maintain an
adequate system of internal control and (3) prepare financial statements, tax returns, and internal reports. The treasurer has custody of the corporation’s funds
and is responsible for maintaining the company’s cash position.
The organizational structure of a corporation enables a company to hire professional managers to run the business. On the other hand, the separation of
ownership and management often reduces an owner’s ability to actively manage
the company.
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The Corporate Form of Organization
Government Regulations
State laws
A corporation is subject to numerous state and federal regulations. For example, state laws usually prescribe the requirements for issuing stock, the distributions of earnings permitted to stockholders, and acceptable methods for retiring stock. Federal securities laws govern the sale of capital stock to the general
public. Also, most publicly held corporations are required to make extensive disclosure of their financial affairs to the Securities and Exchange Commission
(SEC) through quarterly and annual reports. The Sarbanes-Oxley Act increased
the company’s responsibility for the accuracy of these reports. In addition, when
a corporate stock is listed and traded on organized securities exchanges, the corporation must comply with the reporting requirements of these exchanges.
537
SEC laws
WKK
Corp.
Stock
Federal
exchange
regulations
requirements
Government regulations
Accounting across
the Organization
During the hot stock market of the late 1990s, the dream of nearly every entrepreneur was to “take the company public.” But times have changed, and now
top managers at small- to medium-sized companies are reevaluating the costs
versus the benefits of being a publicly traded company.
In 2004 and 2005 a record number of publicly traded companies repurchased
all of their shares and took their companies private. Most cited the increased
regulatory costs associated with Sarbanes-Oxley as the reason for going private.
Estimates of these costs were about $2.3 million per year— roughly ten times
what they were a few years earlier. In about two-thirds of the deals it was the
managers themselves who bought the company’s shares.
Source: Emily Thorton, “A Little Privacy Please,” Business Week (May 24, 2004), pp. 74–75.
In addition to regulatory cost, what is another reason why some owners
choose not to take their companies public?
Additional Taxes
Owners of proprietorships and partnerships report their share of earnings on
their personal income tax returns. The individual owner then pays taxes on this
amount. Corporations, on the other hand, must pay federal and state income
taxes as a separate legal entity. These taxes are substantial: They can amount to
as much as 40% of taxable income.
In addition, stockholders are required to pay taxes on cash dividends. Thus,
many argue that corporate income is taxed twice (double taxation)—once at
the corporate level and again at the individual level.
Illustration 11-2 shows the advantages and disadvantages of a corporation
compared to a sole proprietorship and partnership.
Advantages
•
•
•
•
•
•
Separate legal existence
Limited liability of stockholders
Transferable ownership rights
Ability to acquire capital
Continuous life
Corporation management—
professional managers
Disadvantages
• Corporation management—separation
of ownership and management
• Government regulations
• Additional taxes
Additional taxes
Illustration 11-2
Advantages and disadvantages of a corporation
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Other Forms of Business Organization
A variety of “hybrid” organizational forms—forms that combine different attributes of partnerships and corporations—now exist. For example, one type of corporate form, called an S corporation, allows for legal treatment as a corporation
but tax treatment as a partnership—that is, no double taxation. Because of
changes to the S corporation’s rules, more small- and medium-sized businesses
now may choose S corporation treatment. One of the primary criteria is that the
company cannot have more than 75 shareholders. Other forms of organization
include limited partnerships, limited liability partnerships (LLPs), and limited
liability corporations (LLCs).
Decision Toolkit
Decision Checkpoints
Should the company incorporate?
Info Needed for Decision
Capital needs, growth expectations, type of business, tax
status
Tool to Use for Decision
Corporations have limited liability, easier capital raising ability,
and professional managers; but
they suffer from additional
taxes, government regulations,
and separation of ownership
from management.
How to Evaluate Results
Must carefully weigh the costs
and benefits in light of the
particular circumstances.
FORMING A CORPORATION
A corporation is formed by grant of a state charter. Regardless of the number
of states in which a corporation has operating divisions, it is incorporated in
only one state. It is to the company’s advantage to incorporate in a state whose
laws are favorable to the corporate form of business organization. For example,
although General Motors has its headquarters in Michigan, it is incorporated in
New Jersey. In fact, more and more corporations have been incorporating in
states with rules that favor existing management. For example, Gulf Oil changed
its state of incorporation to Delaware to thwart possible unfriendly takeovers.
There, certain defensive tactics against takeovers can be approved by the board
of directors alone, without a vote by shareholders.
Upon receipt of its charter from the state of incorporation, the corporation
establishes by-laws. The by-laws establish the internal rules and procedures for
conducting the affairs of the corporation. Corporations engaged in interstate
commerce must also obtain a license from each state in which they do business. The license subjects the corporation’s operating activities to the general
corporation laws of the state.
STOCKHOLDER RIGHTS
When chartered, the corporation may begin selling shares of stock. When a corporation has only one class of stock, it is identified as common stock. Each
share of common stock gives the stockholder the ownership rights pictured in
Illustration 11-3 (page 539). The articles of incorporation or the by-laws state
the ownership rights of a share of stock.
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The Corporate Form of Organization
Illustration 11-3
Ownership rights of
stockholders
Stockholders have the right to:
1. Vote in election of board
of directors at annual
meeting and vote on actions
that require stockholder
approval.
2. Share the corporate
earnings through receipt
of dividends.
dividends
Before
3. Keep the same
percentage ownership
when new shares of
stock are issued
(preemptive right1).
4. Share in assets upon
liquidation in proportion
to their holdings. This is
called a residual claim
because owners are paid
with assets that remain
after all claims have
been paid.
After
New shares issued
14%
14%
Lenders
GON Corp.
Stockholders
Creditors
Proof of stock ownership is evidenced by a printed or engraved form known
as a stock certificate. As shown in Illustration 11-4 (page 540), the face of the
certificate shows the name of the corporation, the stockholder’s name, the class
and special features of the stock, the number of shares owned, and the signatures
of authorized corporate officials. Certificates are prenumbered to ensure proper
control over their use; they may be issued for any quantity of shares.
B E F O R E
Y O U
G O
O N
.
.
.
Review It
1. What are the advantages and disadvantages of a corporation compared to a
proprietorship and a partnership?
2. Identify the principal steps in forming a corporation.
3. What are the ownership rights of owning a share of stock in a
corporation?
❍
● THE
✓
NAVIGATOR
1
A number of companies have eliminated the preemptive right because they believe it places an
unnecessary and cumbersome demand on management. For example, IBM, by stockholder
approval, has dropped its preemptive right for stockholders.
539
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Illustration 11-4
A stock certificate
Stock Issue Considerations
Although Nike incorporated in 1968, it did not sell stock to the public until
1980. At that time Nike evidently decided it would benefit from the infusion of
cash that a public sale of its shares would bring. When a corporation decides
to issue stock, it must resolve a number of basic questions: How many shares
should it authorize for sale? How should it issue the stock? What value should
it assign to the stock? We address these questions in the following sections.
AUTHORIZED STOCK
International Note
U.S. and U.K. corporations raise
most of their capital through
millions of outside shareholders
and bondholders. In contrast,
companies in Germany, France,
and Japan acquire financing
mostly from large banks or
other financial institutions.
Consequently, in the latter
environment, shareholders are
less important, and external
reporting and auditing receive
less emphasis.
The amount of stock that a corporation is authorized to sell is indicated in its
charter. If the corporation has sold all of its authorized stock, then it must obtain consent of the state to amend its charter before it can issue additional shares.
The authorization of common stock does not result in a formal accounting entry. The reason is that the event has no immediate effect on either corporate assets or stockholders’ equity. However, the corporation must
disclose in the stockholders’ equity section of the balance sheet the number
of shares authorized.
ISSUANCE OF STOCK
A corporation can issue common stock directly to investors. Alternatively, it can
issue common stock indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation.
New issues of stock may be offered for sale to the public through various
organized U.S. securities exchanges: the New York Stock Exchange, the American
Stock Exchange, and 13 regional exchanges. Stock may also be traded on the
NASDAQ national market.
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541
Stock Issue Considerations
PAR AND NO-PAR VALUE STOCKS
Par value stock is capital stock that has been assigned a value per share in the
corporate charter. Years ago, par value was used to determine the legal capital
per share that must be retained in the business for the protection of corporate
creditors. That amount is not available for withdrawal by stockholders. Thus, in
the past, most states required the corporation to sell its shares at par or above.
However, the usefulness of par value as a protective device to creditors was
questionable because par value was often immaterial relative to the value of the
company’s stock in the securities markets—even at the time of issue. For example, Reebok’s par value is $0.01 per share, yet a new issue in 2004 would
have sold at a market value in the $38 per share range. Thus, par has no relationship with market value and in the vast majority of cases is an immaterial
amount. As a consequence, today many states do not require a par value. Instead, they use other means to determine legal capital to protect creditors.
No-par value stock is capital stock that has not been assigned a value in
the corporate charter. No-par value stock is quite common today. For example, Nike, Procter & Gamble, and North American Van Lines all have no-par
stock. In many states the board of directors assigns a stated value to the nopar shares.
ACCOUNTING FOR COMMON STOCK ISSUES
The stockholders’ equity section of a corporation’s balance sheet includes: (1) paidin (contributed) capital and (2) retained earnings (earned capital). The distinction between paid-in capital and retained earnings is important from both a
legal and an economic point of view. Paid-in capital is the amount stockholders
paid to the corporation in exchange for shares of ownership. Retained earnings
is earned capital held for future use in the business. In this section we discuss the
accounting for paid-in capital. In a later section we discuss retained earnings.
Let’s now look at how to account for new issues of common stock. The
primary objectives in accounting for the issuance of common stock are: (1) to
identify the specific sources of paid-in capital and (2) to maintain the distinction between paid-in capital and retained earnings. As shown below, the
issuance of common stock affects only paid-in capital accounts.
As discussed earlier, par value does not indicate a stock’s market value. The
cash proceeds from issuing par value stock may be equal to, greater than, or less
than par value. When a company records the issuance of common stock for cash,
it credits the par value of the shares to Common Stock, and records in a separate
paid-in capital account the portion of the proceeds that is above or below par value.
To illustrate, assume that Hydro-Slide, Inc. issues 1,000 shares of $1 par
value common stock at par for cash. The entry to record this transaction is:
Cash
Common Stock
(To record issuance of 1,000 shares of $1 par
common stock at par)
STUDY OBJECTIVE
2
Record the issuance of
common stock.
Helpful Hint Stock is sometimes issued in exchange for
services (payment to attorneys
or consultants, for example) or
other noncash assets (land or
buildings). The value recorded
for the shares issued is determined by either the market
value of the shares, or the
value of the good or service
received depending upon which
value the company can more
readily determine.
A 1,000
1,000
L
SE
1,000 CS
1,000
Cash Flows
1,000
If Hydro-Slide, Inc. issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share, the entry is:
Cash
Common Stock
Paid-in Capital in Excess of Par Value
(To record issuance of 1,000 shares of common
stock in excess of par)
A 5,000
5,000
L
SE
1,000 CS
4,000 CS
1,000
4,000
Cash Flows
5,000
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The total paid-in capital from these two transactions is $6,000. If Hydro-Slide,
Inc. has retained earnings of $27,000, the stockholders’ equity section of the balance sheet is as shown in Illustration 11-5.
Illustration 11-5
Stockholders’ equity—
paid-in capital in excess
of par value
HYDRO-SLIDE, INC.
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Common stock
Paid-in capital in excess of par value
Total paid-in capital
Retained earnings
$ 2,000
4,000
6,000
27,000
Total stockholders’ equity
$33,000
Some companies issue no-par stock with a stated value. For accounting purposes, companies treat the stated value in the same way as the par value. For
example, if in our Hydro-Slide example the stock was no-par stock with a stated
value of $1, the entries would be the same as those presented for the par stock
except the term “Par Value’’ would be replaced with “Stated Value.’’ If a company issues no-par stock that does not have a stated value, then it credits to the
Common Stock account the full amount received. In such a case, there is no
need for the Paid-in Capital in Excess of Stated Value account.
Business Insight
Investor Perspective
Organized exchanges trade the stock of publicly held companies at dollar prices
per share established by the interaction between buyers and sellers. For each
listed security the financial press reports the high and low prices of the stock
during the year, the total volume of stock traded on a given day, the high and
low prices for the day, and the closing market price, with the net change for
the day. Nike is listed on the New York Stock Exchange. Here is a recent listing for Nike:
52 Weeks
Stock
High
Low
Volume
High
Low
Close
Net Change
Nike
92.43
68.61
263,000
87.49
86.80
87.03
+.09
These numbers indicate the following: The high and low market prices for the
last 52 weeks have been $92.43 and $68.61. The trading volume for the previous
day was 263,000 shares. The high, low, and closing prices for that date were
$87.49, $86.80, and $87.03, respectively. The net change for the day was an increase of $0.09 per share.
For stocks traded on organized exchanges, how are the dollar prices per
share established? What factors might influence the price of shares in the
marketplace?
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Accounting for Treasury Stock
B E F O R E
Y O U
G O
O N
.
.
543
.
Review It
1. Of what significance to a corporation is the amount of authorized stock?
2. What alternative approaches may a corporation use to sell new shares to
investors?
3. Distinguish between par value and market value.
4. Explain the accounting for par and no-par common stock issued for cash.
Do It
Cayman Corporation begins operations on March 1 by issuing 100,000 shares
of $10 par value common stock for cash at $12 per share. Journalize the issuance
of the shares.
Action Plan
• In issuing shares for cash, credit Common Stock for par value per share.
• Credit any additional proceeds in excess of par value to a separate paid-in capital account.
Solution
Mar. 1
Cash
Common Stock
Paid-in Capital in Excess of Par Value
(To record issuance of 100,000 shares at
$12 per share)
1,200,000
1,000,000
200,000
✓
❍
● THE
NAVIGATOR
Accounting for Treasury Stock
Treasury stock is a corporation’s own stock that has been issued, fully paid for,
and reacquired by the corporation and is being held in its treasury for future
use. A corporation may acquire treasury stock for various reasons:
1. To reissue the shares to officers and employees under bonus and stock compensation plans.
2. To increase trading of the company’s stock in the securities market. Companies
expect that buying their own stock will signal that management believes the
stock is underpriced, which they hope will enhance its market value.
3. To have additional shares available for use in acquiring other companies.
4. To reduce the number of shares outstanding and thereby increase earnings
per share.
Another infrequent reason for purchasing treasury shares is that management
may want to eliminate hostile shareholders by buying them out.
Many corporations have treasury stock. For example, in the United States
approximately 68% of companies have treasury stock.2 Specifically, in 2004 Nike
purchased 6.4 million treasury shares, IBM, 78.6 million, and Limited Brands,
125 million shares. Stock repurchases have been so substantial that a recent
study by two Federal Reserve economists suggested that a sharp reduction in
2
Accounting Trends & Techniques—2004 (New York: American Institute of Certified Public
Accountants).
STUDY OBJECTIVE
3
Explain the accounting for
the purchase of treasury
stock.
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corporate purchases of treasury shares might result in a sharp drop in the value
of the U.S. stock market.
PURCHASE OF TREASURY STOCK
The purchase of treasury stock is generally accounted for by the cost method. This
method derives its name from the fact that the Treasury Stock account is maintained at the cost of shares purchased. Under the cost method, companies increase
(debit) Treasury Stock by the price paid to reacquire the shares. Treasury
Stock decreases by the same amount when the company later sells the shares.
To illustrate, assume that on January 1, 2007, the stockholders’ equity section
for Mead, Inc. has 100,000 shares of $5 par value common stock outstanding (all
issued at par value) and Retained Earnings of $200,000. Illustration 11-6 shows the
stockholders’ equity section of the balance sheet before purchase of treasury stock.
Illustration 11-6
Stockholders’ equity with
no treasury stock
MEAD, INC.
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares
issued and outstanding
Retained earnings
$500,000
200,000
Total stockholders’ equity
$700,000
On February 1, 2007, Mead acquires 4,000 shares of its stock at $8 per share.
The entry is:
A
L
SE
32,000 TS
32,000
Cash Flows
32,000
Feb. 1
Treasury Stock
Cash
(To record purchase of 4,000 shares of
treasury stock at $8 per share)
32,000
32,000
Helpful Hint Treasury Stock is
a contra stockholders’ equity
account.
The Treasury Stock account would increase by the cost of the shares purchased
($32,000). The original paid-in capital account, Common Stock, would not be
affected because the number of issued shares does not change.
Companies show treasury stock as a deduction from total paid-in capital and
retained earnings in the stockholders’ equity section of the balance sheet. Illustration 11-7 shows this presentation for Mead, Inc. Thus, the acquisition of treasury
stock reduces stockholders’ equity.
Illustration 11-7
Stockholders’ equity with
treasury stock
MEAD, INC.
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares
issued and 96,000 shares outstanding
Retained earnings
Total paid-in capital and retained earnings
Less: Treasury stock (4,000 shares)
Total stockholders’ equity
$500,000
200,000
700,000
32,000
$668,000
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Accounting for Treasury Stock
Companies disclose in the balance sheet both the number of shares issued
(100,000) and the number in the treasury (4,000). The difference is the number
of shares of stock outstanding (96,000). The term outstanding stock means the
number of shares of issued stock that are being held by stockholders.
Accounting across
the Organization
In a bold (and some would say risky) move, Reebok at one time bought back
nearly a third of its shares. This repurchase of shares dramatically reduced
Reebok’s available cash. In fact, the company borrowed significant funds to
accomplish the repurchase. In a press release, management stated that it was
repurchasing the shares because it believed that the stock was severely underpriced. The repurchase of so many shares was meant to signal management’s
belief in good future earnings.
Skeptics, however, suggested that Reebok’s management was repurchasing
shares to make it less likely that the company would be acquired by another
company (in which case Reebok’s top managers would likely lose their jobs).
Acquiring companies like to purchase companies with large cash reserves so they
can pay off debt used in the acquisition. By depleting its cash, Reebok became
a less likely acquisition target.
What signal might a large stock repurchase send to investors regarding
management’s belief about the company’s growth opportunities?
B E F O R E
Y O U
G O
O N
.
.
.
Review It
1. What is treasury stock, and why do companies acquire it?
2. How do companies record treasury stock?
3. Where in the financial statements do companies report treasury stock?
Do It
Santa Anita Inc. purchases 3,000 shares of its $50 par value common stock for
$180,000 cash on July 1. It expects to hold the shares in the treasury until resold.
Journalize the treasury stock transaction.
Action Plan
• Record the purchase of treasury stock at cost.
• Report treasury stock as a deduction from stockholders’ equity (contra account)
at the bottom of the stockholders’ equity section.
Solution
July 1
Treasury Stock
Cash
(To record the purchase of 3,000 shares
at $60 per share)
180,000
180,000
✓
❍
● THE
NAVIGATOR
545
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Preferred Stock
STUDY OBJECTIVE
4
Differentiate preferred stock
from common stock.
A 120,000
L
To appeal to a larger segment of potential investors, a corporation may issue an
additional class of stock, called preferred stock. Preferred stock has contractual
provisions that give it preference or priority over common stock in certain areas. 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. Reebok has no outstanding preferred stock, whereas Nike has a
very minor amount outstanding. Approximately 15% of U.S. companies have one
or more classes of preferred stock.3
Like common stock, companies may issue preferred stock for cash or for
noncash consideration. The entries for these transactions are similar to the
entries for common stock. When a corporation has more than one class of
stock, each paid-in capital account title should identify the stock to which it
relates (e.g., Preferred Stock, Common Stock, Paid-in Capital in Excess of Par
Value—Preferred Stock, and Paid-in Capital in Excess of Par Value—Common
Stock).
Assume that Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. The entry to record the issuance is:
SE
Cash
Preferred Stock
Paid-in Capital in Excess of Par Value—Preferred Stock
(To record the issuance of 10,000 shares of $10 par
value preferred stock)
100,000 PS
20,000 PS
Cash Flows
120,000
120,000
100,000
20,000
Preferred stock may have either a par value or no-par value. In the stockholders’ equity section of the balance sheet, companies show preferred stock first
because of its dividend and liquidation preferences over common stock.
DIVIDEND PREFERENCES
As indicated above, preferred stockholders have the right to share in the distribution of corporate income before common stockholders. For example,
if the dividend rate on preferred stock is $5 per share, common shareholders
will not receive any dividends in the current year until preferred stockholders
have received $5 per share. The first claim to dividends does not, however, guarantee dividends. Dividends depend on many factors, such as adequate retained
earnings and availability of cash.
For preferred stock, companies state the per share dividend amount as a
percentage of the par value of the stock or as a specified amount. For example,
EarthLink specifies a 3% dividend, whereas Nike pays 10 cents per share on its
$1 par preferred stock.
Cumulative Dividend
Preferred stock contracts often contain a cumulative dividend feature. This
right means that preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders receive
dividends. When preferred stock is cumulative, preferred dividends not declared
in a given period are called dividends in arrears.
3
Accounting Trends & Techniques—2004 (New York: American Institute of Certified Public
Accountants).
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547
To illustrate, assume that Scientific Leasing has 5,000 shares of 7%, $100
par value cumulative preferred stock outstanding. Each $100 share pays a $7
dividend (.07 $100). The annual dividend is $35,000 (5,000 $7 per share).
If dividends are two years in arrears, preferred stockholders are entitled to receive
in the current year the dividends as shown in Illustration 11-8.
Dividends in arrears ($35,000 2)
Current-year dividends
$ 70,000
35,000
Total preferred dividends
$105,000
Illustration 11-8
Computation of total
dividends to preferred
stock
No distribution can be made to common stockholders until Scientific Leasing pays this entire preferred dividend. In other words, companies cannot pay
dividends to common stockholders while any preferred stock dividend is in
arrears.
Dividends in arrears are not considered a liability. No obligation exists
until the board of directors formally “declares” that the corporation will
pay a dividend. However, companies should disclose in the notes to the financial statements the amount of dividends in arrears. Doing so enables investors
to assess the potential impact of this commitment on the corporation’s financial
position.
The investment community does not look favorably upon companies that
are unable to meet their dividend obligations. As a financial officer noted in discussing one company’s failure to pay its cumulative preferred dividend for a period of time, “Not meeting your obligations on something like that is a major
black mark on your record.”
LIQUIDATION PREFERENCE
Most preferred stocks have a preference on corporate assets if the corporation
fails. This feature provides security for the preferred stockholder. The preference
to assets may be for the par value of the shares or for a specified liquidating
value. For example, Commonwealth Edison issued preferred stock that entitles
the holders to receive $31.80 per share, plus accrued and unpaid dividends, in the
event of involuntary liquidation. The liquidation preference is used in litigation
pertaining to bankruptcy lawsuits involving the respective claims of creditors
and preferred stockholders.
Dividends
As noted earlier, a dividend is a distribution by a corporation to its stockholders on a pro rata basis. Pro rata means that if you own, say, 10% of the
common shares, you will receive 10% of the dividend. Dividends can take four
forms: cash, property, script (promissory note to pay cash), or stock. Cash dividends, which predominate in practice, and stock dividends, which are declared
with some frequency, are the focus of our discussion.
Investors are very interested in a company’s dividend practices. In the
financial press, dividends are generally reported quarterly as a dollar
amount per share. (Sometimes they are reported on an annual basis.) For example, Nike’s quarterly dividend rate in the fourth quarter of 2004 was 20 cents
per share; the dividend rate for that quarter for Target was 7 cents, and for PepsiCo
it was 23 cents.
STUDY OBJECTIVE
5
Prepare the entries for cash
dividends and understand
the effect of stock dividends
and stock splits.
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CASH DIVIDENDS
A cash dividend is a pro rata distribution of cash to stockholders. For a corporation to pay a cash dividend, it must have the following.
1. Retained earnings. Many states prohibit payment of dividends from legal
capital. However, payment of dividends from paid-in capital in excess of par
is legal in some states. Payment of dividends from retained earnings is
legal in all states. In addition, loan agreements frequently constrain companies to pay dividends only from retained earnings.
2. Adequate cash. Recently Nike had a balance in retained earnings of $3,983
million but a cash balance of only $828 million. If it had wanted to pay a
dividend equal to its retained earnings, Nike would have had to raise $3,155
million more in cash. It would have been unlikely to do this because it would
not be able to pay this much in dividends in future years. In addition, such
a dividend would completely deplete Nike’s balance in retained earnings, so
it would not be able to pay a dividend in the next year unless it had positive
net income.
3. Declared dividends. The board of directors has full authority to determine the amount of income to distribute in the form of dividends and the
amount to retain in the business. Dividends do not accrue like interest on
a note payable, and they are not a liability until they are declared.
In order to remain in business, companies must honor their interest payments to creditors, bankers, and bondholders. But the payment of dividends
to stockholders is another matter. Many companies can survive, and even
thrive, without such payouts. “Why give money to those strangers?” was the
response of one company president.
The amount and timing of a dividend are important issues for management
to consider. The payment of a large cash dividend could lead to liquidity problems for the company. Conversely, a small dividend or a missed dividend may
cause unhappiness among stockholders who expect to receive a reasonable cash
payment from the company on a periodic basis. Many companies declare and pay
cash dividends quarterly. On the other hand, a number of high-growth companies
pay no dividends, preferring to retain earnings and use them to finance capital
expenditures.
Investors must keep an eye on the company’s dividend policy and understand what it may mean. For most companies, for example, regular dividend
boosts in the face of irregular earnings can be a warning signal. Companies with
high dividends and rising debt may be borrowing money to pay shareholders.
On the other hand, low dividends may not be a negative sign because they may
mean the company is reinvesting in itself, which may result in high returns
through increases in the stock price. Presumably, investors for whom regular
dividends are important tend to buy stock in companies that pay periodic dividends, and those for whom growth in the stock price (capital gains) is more important tend to buy stock in companies that retain their earnings.
Entries for Cash Dividends
Three dates are important in connection with dividends: (1) the declaration date,
(2) the record date, and (3) the payment date. Companies make accounting entries on the declaration date and the payment date.
On the declaration date, the board of directors formally authorizes the cash
dividend and announces it to stockholders. The declaration of a cash dividend
commits the corporation to a binding legal obligation. Thus, the company
must make an entry to recognize the decrease in retained earnings and the increase in the liability Dividends Payable.
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549
To illustrate, assume that on December 1, 2007, 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 $50,000 (100,000 $0.50). The entry to record
the declaration is:
Declaration Date
Dec. 1
Retained Earnings (or Cash Dividends)
Dividends Payable
(To record declaration of cash dividend)
A
L
50,000
50,000
SE
50,000 Div
50,000
Cash Flows
no effect
Dividends Payable is a current liability: It will normally be paid within the next
several months.
You may recall that in Chapter 3, instead of decreasing Retained Earnings,
we used the account Dividends. The Dividends account provides additional information in the ledger. For example, a company may have separate dividend
accounts for each class of stock or each type of dividend. When a company uses
a separate dividend account, it transfers the account’s balance to Retained Earnings at the end of the year by a closing entry. Whichever account is used for the
dividend declaration, the effect is the same: The company decreases retained
earnings and increases a current liability. To avoid additional detail in the textbook, we have chosen to use the Retained Earnings account. For homework
problems, you should use the Retained Earnings account for recording dividend
declarations.
At the record date, the company determines ownership of the outstanding
shares for dividend purposes. The stockholders’ records maintained by the corporation supply this information.
For Media General, the record date is December 22. No entry is required on
the record date.
Helpful Hint The record date is
important in determining the
dividend to be paid to each
stockholder but not the total
dividend.
Record Date
Dec. 22
No entry necessary
On the payment date, the company mails dividend checks to the stockholders on record as of December 22, and it also records the payment of the dividend. If January 20 is the payment date for Media General, the entry on that
date is:
Payment Date
Jan. 20
Dividends Payable
Cash
(To record payment of cash dividend)
A
50,000
50,000
Note that payment of the dividend reduces both current assets and current liabilities, but it has no effect on stockholders’ equity. The cumulative effect of the
declaration and payment of a cash dividend on a company’s financial statements is to decrease both stockholders’ equity and total assets.
L
50,000
50,000
Cash Flows
50,000
SE
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Accounting across
the Organization
The decision whether to pay a cash dividend, and how much, is a very important management decision. During 2004 cash dividend payments were a record
$181 billion—not including a one-time $32.6 billion dividend by Microsoft. The
$181 billion does include a 44% dividend increase by Wal-Mart and a doubling
of the dividend payment by Intel.
One explanation for the increase is that Congress lowered, from 39% to 15%,
the tax rate paid by investors on dividends received, making dividends more attractive to investors. Another driving force for the dividend increases was that
companies were sitting on record amounts of cash. Because they did not see a
lot of good expansion opportunities, companies decided to return the cash to
shareholders.
Bigger dividends are still possible in the future. Large companies paid out
34% of their earnings as dividends in 2004—well below the historical average
payout of 54% of earnings.
Source: Alan Levinsohn, “Divine Dividends,” Strategic Finance (May 2005), pp. 59–60.
What factors must management consider in deciding how large a dividend
to pay?
STOCK DIVIDENDS
A stock dividend is a pro rata distribution of the corporation’s own stock to
stockholders. Whereas a cash dividend is paid in cash, a stock dividend is paid
in stock. A stock dividend results in a decrease in retained earnings and an
increase in paid-in capital. Unlike a cash dividend, a stock dividend does not
decrease total stockholders’ equity or total assets.
Because a stock dividend does not result in a distribution of assets, many
view it as nothing more than a publicity gesture. Stock dividends are often issued
by companies that do not have adequate cash to issue a cash dividend. These
companies may not want to announce that they are not going to be issuing a cash
dividend at their normal time to do so. By issuing a stock dividend they “save
face” by giving the appearance of distributing a dividend. Note that since a stock
dividend neither increases nor decreases the assets in the company, investors are
not receiving anything they didn’t already own. In a sense it is like asking for two
pieces of pie and having your host take one piece of pie and cut it into two smaller
pieces. You are not better off, but you got your two pieces of pie.
To illustrate a stock dividend, assume that you have a 2% ownership interest in Cetus Inc.; you own 20 of its 1,000 shares of common stock. If Cetus declares a 10% stock dividend, it would issue 100 shares (1,000 10%) of stock.
You would receive two shares (2% 100), but your ownership interest would
remain at 2% (22 1,100). You now own more shares of stock, but your
ownership interest has not changed. Moreover, the company disburses no
cash, and assumes no liabilities.
What, then, are the purposes and benefits of a stock dividend? Corporations
generally issue stock dividends for one of the following reasons.
Helpful Hint Because of its
effects, a stock dividend is also
referred to as capitalizing
retained earnings.
1. To satisfy stockholders’ dividend expectations without spending cash.
2. To increase the marketability of the stock by increasing the number of shares
outstanding and thereby decreasing the market price per share. Decreasing
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551
the market price of the stock makes it easier for smaller investors to purchase the shares.
3. To emphasize that the company has permanently reinvested in the business
a portion of stockholders’ equity, which therefore is unavailable for cash
dividends.
When the dividend is declared, the board of directors determines the size of
the stock dividend and the value to be assigned to each dividend share. In order to meet legal requirements, the per share amount must be at least equal to
the par or stated value.
The accounting profession distinguishes between a small stock dividend
(less than 20%–25% of the corporation’s issued stock) and a large stock dividend (greater than 20%–25%). It recommends that the directors assign the fair
market value per share for small stock dividends. The recommendation is based
on the assumption that a small stock dividend will have little effect on the market price of the shares previously outstanding. Thus, many stockholders consider
small stock dividends to be distributions of earnings equal to the fair market
value of the shares distributed. The accounting profession does not specify the
amount to be assigned for a large stock dividend. However, companies normally
assign par or stated value per share. Small stock dividends predominate in
practice. In the appendix at the end of the chapter, we illustrate the journal entries for small stock dividends.
Effects of Stock Dividends
How do stock dividends affect stockholders’ equity? They change the composition of stockholders’ equity because they result in a transfer of a portion
of retained earnings to paid-in capital. However, total stockholders’ equity
remains the same. Stock dividends also have no effect on the par or stated
value per share, but the number of shares outstanding increases.
To illustrate, assume that 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.
Stockholders’ equity
Paid-in capital
Common stock, $10 par
Paid-in capital in excess of par value
Total paid-in capital
Retained earnings
Total stockholders’ equity
Outstanding shares
Before
Dividend
After
Dividend
$ 500,000
—
$ 550,000
25,000
500,000
300,000
575,000
225,000
$800,000
$800,000
50,000
55,000
Illustration 11-9
Stock dividend effects
In this example, total paid-in capital increased by $75,000 (50,000 shares 10% $15), and retained earnings is decreased by the same amount. Note also that total stockholders’ equity remains unchanged at $800,000.
STOCK SPLITS
A stock split, like a stock dividend, involves the issuance of additional shares
of stock to stockholders according to their percentage ownership. However, a
stock split results in a reduction in the par or stated value per share. The
purpose of a stock split is to increase the marketability of the stock by lowering
Helpful Hint A stock split
changes the par value per
share but does not affect any
balances in stockholders’
equity.
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its market value per share. This, in turn, makes it easier for the corporation to
issue additional stock.
The effect of a split on market value is generally inversely proportional to
the size of the split. For example, after a recent 2-for-1 stock split, the market
value of Nike’s stock fell from $111 to approximately $55.
In a stock split, the company increases the number of shares in the same
proportion that it decreases the par or stated value per share. For example, in a
2-for-1 split, the company exchanges one share of $10 par value stock for two
shares of $5 par value stock. A stock split does not have any effect on paidin capital, retained earnings, and total stockholders’ equity. However, the
number of shares outstanding increases. These effects are shown in Illustration
11-10, assuming that instead of issuing a 10% stock dividend, Medland splits its
50,000 shares of common stock on a 2-for-1 basis.
Illustration 11-10 Stock
split effects
Stockholders’ equity
Paid-in capital
Common stock (Before: 50,000 $10 par shares;
after: 100,000 $5 par shares)
Paid-in capital in excess of par value
Before
Stock Split
After
Stock Split
$ 500,000
0
$ 500,000
0
500,000
300,000
500,000
300,000
$800,000
$800,000
50,000
100,000
Total paid-in capital
Retained earnings
Total stockholders’ equity
Outstanding shares
Because a stock split does not affect the balances in any stockholders’ equity accounts, a company does not need to journalize a stock split. However, a memorandum entry explaining the effect of the split is typically made.
The differences between the effects of stock dividends and stock splits are
shown in Illustration 11-11.
Illustration 11-11 Effects
of stock splits and stock
dividends differentiated
Item
Stock Dividend
Stock Split
Total paid-in capital
Total retained earnings
Total par value (common stock)
Par value per share
Increase
Decrease
Increase
No change
No change
No change
No change
Decrease
B E F O R E
Y O U
G O
O N
.
.
.
Review It
1. What factors affect the size of a company’s cash dividend?
2. Why do companies issue stock dividends? Why do companies declare stock
splits?
3. Distinguish between a small and a large stock dividend and indicate the basis
for valuing each kind of dividend.
4. Contrast the effects of a small stock dividend and a 2-for-1 stock split on
(a) stockholders’ equity and (b) outstanding shares.
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Retained Earnings
553
Do It
Due to five years of record earnings at Sing CD Corporation, the market price
of its 500,000 shares of $2 par value common stock tripled from $15 per share
to $45. During this period, paid-in capital remained the same at $2,000,000. Retained earnings increased from $1,500,000 to $10,000,000. President Joan Elbert
is considering either a 10% stock dividend or a 2-for-1 stock split. She asks you
to show the before and after effects of each option on retained earnings.
Action Plan
• Calculate the stock dividend’s effect on retained earnings by multiplying the
number of new shares times the market price of the stock (or par value for a
large stock dividend).
• Recall that a stock dividend increases the number of shares without affecting
total equity.
• Recall that a stock split only increases the number of shares outstanding and
decreases the par value per share without affecting total equity.
Solution
The stock dividend amount is $2,250,000 [(500,000 10%) $45]. The new balance in retained earnings is $7,750,000 ($10,000,000 $2,250,000). The retained
earnings balance after the stock split is the same as it was before the split:
$10,000,000. The effects on the stockholders’ equity accounts are as follows.
Original
Balances
After
Dividend
After
Split
Paid-in capital
Retained earnings
$ 2,000,000
10,000,000
$ 4,250,000
7,750,000
$ 2,000,000
10,000,000
Total stockholders’ equity
$12,000,000
$12,000,000
$12,000,000
500,000
550,000
1,000,000
Shares outstanding
✓
❍
●
THE
NAVIGATOR
Retained Earnings
Retained earnings is net income that a company retains in the business. The
balance in retained earnings is part of the stockholders’ claim on the total assets of the corporation. It does not, however, represent a claim on any specific
asset. Nor can the amount of retained earnings be associated with the balance
of any asset account. For example, a $100,000 balance in retained earnings does
not mean that there should be $100,000 in cash. The reason is that the company
may have used the cash resulting from the excess of revenues over expenses to
purchase buildings, equipment, and other assets. Illustration 11-12 shows recent
amounts of retained earnings and cash in selected companies.
(in millions)
Company
Circuit City Stores, Inc.
Nike, Inc.
Starbucks Coffee Company
Amazon.com
Retained
Earnings
Cash
$1,199
3,983
1,449
(2,386)
$783
828
299
1,303
When expenses exceed revenues, a net loss results. In contrast to net income, a net loss decreases retained earnings. In closing entries a company debits a net loss to the Retained Earnings account. It does not debit net losses to
STUDY OBJECTIVE
6
Identify the items that affect
retained earnings.
Illustration 11-12
Retained earnings and
cash balances
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paid-in capital accounts. To do so would destroy the distinction between paidin and earned capital. If cumulative losses exceed cumulative income over a company’s life, a debit balance in Retained Earnings results. A debit balance in retained earnings, such as that of Amazon.com in 2004, is a deficit. A company
reports a deficit as a deduction in the stockholders’ equity section of the balance
sheet, as shown in Illustration 11-13.
Illustration 11-13
Stockholders’ equity with
deficit
AMAZON.COM
Balance Sheet (partial)
December 31, 2004
(in thousands)
Stockholders’ equity
Paid-in capital
Common stock
Paid-in capital in excess of par value
$
Total paid-in capital
Accumulated deficit
Total stockholders’ equity (deficit)
4,097
2,154,669
2,158,766
(2,385,977)
$
(227,211)
RETAINED EARNINGS RESTRICTIONS
The balance in retained earnings is generally available for dividend declarations.
Some companies state this fact. In some cases, however, there may be retained
earnings restrictions. These make a portion of the balance currently unavailable for dividends. Restrictions result from one or more of these causes: legal,
contractual, or voluntary.
Companies generally disclose retained earnings restrictions in the notes to
the financial statements. For example, Tektronix Inc., a manufacturer of electronic measurement devices, recently had total retained earnings of $774 million, but the unrestricted portion was only $223.8 million.
Illustration 11-14
Disclosure of unrestricted
retained earnings
TEKTRONIX INC.
Notes to the Financial Statements
Certain of the Company’s debt agreements require compliance with debt covenants.
Management believes that the Company is in compliance with such requirements
for the fiscal year ended May 26, 2001. The Company had unrestricted retained
earnings of $223.8 million after meeting those requirements.
Financial Statement Presentation
of Stockholders’ Equity
BALANCE SHEET PRESENTATION
STUDY OBJECTIVE
7
Prepare a comprehensive
stockholders’ equity section.
In the stockholders’ equity section of the balance sheet, companies report paid-in
capital and retained earnings and identify the specific sources of paid-in capital.
Within paid-in capital, two classifications are recognized:
1. Capital stock, which consists of preferred and common stock. Companies
show preferred stock before common stock because of its preferential rights.
They report information about the par value, shares authorized, shares issued, and shares outstanding for each class of stock.
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555
2. Additional paid-in capital, which includes the excess of amounts paid in
over par or stated value.
Illustration 11-15 presents the stockholders’ equity section of the balance
sheet of Graber Inc. The company discloses a retained earnings restriction in
the notes.
Illustration 11-15
Comprehensive
stockholders’ equity
section
GRABER INC.
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Capital stock
9% preferred stock, $100 par value, cumulative,
10,000 shares authorized, 6,000 shares issued
and outstanding
Common stock, no par, $5 stated value,
500,000 shares authorized, 400,000 shares
issued, and 390,000 outstanding
Total capital stock
Additional paid-in capital
In excess of par value—preferred stock
In excess of stated value—common stock
$ 600,000
2,000,000
2,600,000
International Note
In Switzerland, there are no
specific disclosure requirements for stockholders’ equity.
However, companies typically
disclose separate categories of
capital on the balance sheet.
$ 30,000
1,050,000
Total additional paid-in capital
1,080,000
Total paid-in capital
Retained earnings (see Note R)
3,680,000
1,160,000
Total paid-in capital and retained earnings
Less: Treasury stock—common (10,000 shares)
4,840,000
(80,000)
Total stockholders’ equity
$4,760,000
Note R: Retained earnings is restricted for the cost of treasury stock, $80,000.
The stockholders’ equity section for Graber Inc. includes most of the accounts discussed in this chapter. The disclosures pertaining to Graber’s common
stock indicate that 400,000 shares are issued; 100,000 shares are unissued
(500,000 authorized less 400,000 issued); and 390,000 shares are outstanding
(400,000 issued less 10,000 shares in treasury).
In published annual reports, companies seldom present subclassifications
within the stockholders’ equity section. Moreover, they often combine and report
as a single amount the individual sources of additional paid-in capital. Notes often
provide additional detail. Illustration 11-16 is an excerpt from Columbia Sportswear Company’s 2004 balance sheet.
Illustration 11-16
Stockholders’ equity
section
Columbia Sportswear Company
Balance Sheet (partial)
December 31, 2004
(in thousands)
Shareholders’ equity
Preferred stock; 10,000 shares authorized;
none issued and outstanding
Common stock; 125,000 shares authorized; 40,126 and
40,253 issued and outstanding (Note 9)
Retained earnings
Accumulated other comprehensive income (Note 15)
Total shareholders’ equity
$
—
164,317
573,988
41,945
$780,250
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STATEMENT OF CASH FLOWS PRESENTATION
The balance sheet presents the balances of a company’s stockholders’ equity
accounts at a point in time. Companies report in the “Financing Activities” section of the statement of cash flows information regarding cash inflows and
outflows during the year that resulted from equity transactions. Illustration
11-17 presents the cash flows from financing activities from the statement of
cash flows of Sara Lee Corporation. From this information we learn that the
company’s purchases of treasury stock during the period far exceeded its
issuances of new common stock, and its financing activities resulted in a net
reduction in its cash balance.
Illustration 11-17
Financing activities of
statement of cash flows
SARA LEE CORPORATION
Statement of Cash Flows (partial)
For the Year Ended June 30, 2004
(in millions)
Cash Flows from Financing Activities
Issuances of common stock
Purchases of common stock
Payments of dividends
Borrowings of long-term debt
Repayments of long-term debt
Short-term (repayments) borrowings, net
$
139
(350)
(714)
1
(1,288)
15
Net cash used in financing activities
B E F O R E
Y O U
G O
O N
$(2,197)
.
.
.
Review It
1. Identify the classifications within the paid-in capital section and the totals
that are stated in the stockholders’ equity section of a balance sheet.
2. What is a retained earnings restriction?
3. What was the total cost of Tootsie Roll’s treasury stock in 2004? What was
the total value of the 2004 cash dividend? What was the total charge to
retained earnings of the 2004 stock dividend? The answer to
these questions appears on p. 583.
❍
● THE
✓
NAVIGATOR
Measuring Corporate Performance
Investors are interested in both a company’s dividend record and its earnings
performance. Although those two measures are often parallel, that is not always
the case. Thus, investors should investigate each one separately.
STUDY OBJECTIVE
8
Evaluate a corporation’s
dividend and earnings
performance from a
stockholder’s perspective.
DIVIDEND RECORD
One way that companies reward stock investors for their investment is to pay
them dividends. The payout ratio measures the percentage of earnings a company distributes in the form of cash dividends to common stockholders. It is computed by dividing total cash dividends declared to common shareholders by
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557
net income. Using the information shown below, the payout ratio for Nike in
2004 and 2003 is calculated in Illustration 11-18.
Dividends (in millions)
Net income (in millions)
2004
2003
$194.9
945.6
$142.7
740.1*
Illustration 11-18 Nike’s
payout ratio
Cash Dividends Declared on Common Stock
Payout
Ratio
Net Income
($ in millions)
2004
2003
Payout Ratio
$194.9
21%
$945.6
$142.7
19%
$740.1*
*Nike’s reported net income for 2003 included a one-time charge of $266.1 due to an accounting change. Net income of $740.1
was used to make 2003 more comparable to 2004. Using reported net income of $474.0 produces a payout ratio of 30%.
Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business. Thus, a low
payout ratio is not necessarily bad news. Companies that believe they have many
good opportunities for growth, such as Nike and Reebok, will reinvest those
funds in the company rather than pay high dividends. In fact, dividend payout
ratios for the 500 largest U.S. companies currently are very low relative to historical rates. However, low dividend payments, or a cut in dividend payments,
might signal that a company has liquidity or solvency problems and is trying to
free up cash by not paying dividends. Thus, investors and analysts should investigate the reason for low dividend payments.
Illustration 11-19 lists recent payout ratios of four well-known companies.
Company
Payout Ratio
Microsoft
Kellogg
Johnson & Johnson
Sears Holdings Corp.
312.7%
45.0%
37.9%
0%
Illustration 11-19
Variability of payout ratios
among companies
Decision Toolkit
Decision
Checkpoints
What portion of its
earnings does the
company pay out in
dividends?
Info Needed
for Decision
Net income and total
cash dividends on
common stock
Tool to Use for Decision
Cash dividends declared on common stock
Payout
ratio
Net income
How to Evaluate
Results
A low ratio may suggest that the company
is retaining its earnings for investment in
future growth.
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EARNINGS PERFORMANCE
Another way to measure corporate performance is through profitability. A
widely used ratio that measures profitability from the common stockholders’
viewpoint is return on common stockholders’ equity. This ratio shows how
many dollars of net income a company earned for each dollar invested by common stockholders. It is computed by dividing net income available to common
stockholders (Net income Preferred stock dividends) by average common stockholders’ equity.
Using the additional information presented below, Illustration 11-20 shows
Nike’s return on common stockholders’ equity ratios, calculated for 2004 and 2003.
(in thousands)
Illustration 11-20 Nike’s
return on common
stockholders’ equity
Net income
Preferred stock dividends
Common stockholders’ equity
2004
2003
2002
$ 945,600
30
4,781,400
$ 740,100
30
3,990,400
$ 668,300
30
3,838,700
Net Income Preferred Stock Dividends
Return on Common
Stockholders’ Equity Ratio
Average Common Stockholders’ Equity
($ in thousands)
2004
2003
$945,600 $30
$740,100 $30
Return on Common
21.6% 18.9%
Stockholders’ Equity Ratio ($4,781,400 $3,990,400)2
($3,990,400 $3,838,700)2
From 2003 to 2004, Nike’s return on common shareholders’ equity increased
more than 14%. As a company grows larger, it becomes increasingly hard to sustain a high return. In Nike’s case, since many believe the U.S. market for expensive
sports shoes is saturated, it will need to grow either along new product lines, such
as hiking shoes and golf equipment, or in new markets, such as Europe and Asia.
DEBT VERSUS EQUITY DECISION
To obtain large amounts of long-term capital, corporate managers must decide
whether to issue bonds or to sell common stock. Bonds have three primary advantages relative to common stock, as shown in Illustration 11-21.
Illustration 11-21
Advantages of bond
financing over common
stock
Bond Financing
Advantages
1. Stockholder control is not affected.
Bondholders do not have voting rights, so current owners
(stockholders) retain full control of the company.
2. Tax savings result.
Bond interest is deductible for tax purposes; dividends on
stock are not.
3. Return on common stockholders' equity may be higher.
Although bond interest expense reduces net income, return on
common stockholders' equity often is higher under bond financing
because no additional shares of common stock are issued.
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559
How does the debt versus equity decision affect the return on common
stockholders’ equity ratio? Illustration 11-22 shows that the return on common
stockholders’ equity is affected by the return on assets ratio and the amount of
leverage a company uses—that is, by the company’s reliance on debt (often measured by the debt to total assets ratio). If a company wants to increase its return
on common stockholders’ equity, it can either increase its return on assets or increase its reliance on debt financing.
Return on
common
stockholders’ equity
ratio
Illustration 11-22
Components of the return
on common stockholders’
equity
Return on assets
ratio
Leverage
(debt to total assets
ratio)
To illustrate the potential effect of debt financing on the return on common
stockholders’ equity, assume that Microsystems Inc. is considering two plans for
financing the construction of a new $5 million plant: 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 on the new plant will be $1.5 million; income taxes are expected to be 30%. Microsystems currently has 100,000 shares of common stock
outstanding issued at $25 per share. The alternative effects on the return on
common stockholders’ equity are shown in Illustration 11-23.
Plan A:
Issue stock
Plan B:
Issue bonds
$1,500,000
—
$1,500,000
600,000
1,500,000
450,000
900,000
270,000
Net income
$1,050,000
$ 630,000
Common stockholders’ equity
Return on common stockholders’ equity
$7,500,000
14%
$2,500,000
25.2%
Income before interest and taxes
Interest (12% $5,000,000)
Income before income taxes
Income tax expense (30%)
Note that with long-term debt financing (bonds), net income is $420,000
($1,050,000 $630,000) less. However, the return on common stockholders’
equity increases from 14% to 25.2% with the use of debt financing because
there is less common stockholders’ equity to spread the income across. In general, as long as the return on assets rate exceeds the rate paid on debt,
a company will increase the return on common stockholders’ equity by
the use of debt.
After seeing this illustration, one might ask, why don’t companies rely
almost exclusively on debt financing, rather than equity? Debt has one major
disadvantage: The company locks in fixed payments that it must make in
good times and bad. The company must pay interest on a periodic basis,
Illustration 11-23
Effects on return on
common stockholders’
equity of issuing debt
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and must pay the principal (face value) of the bonds at maturity. A company
with fluctuating earnings and a relatively weak cash position may experience
great difficulty in meeting interest requirements in periods of low earnings. In
the extreme, this can result in bankruptcy. With common stock financing, on
the other hand, the company can decide to pay low (or no) dividends if earnings are low.
Decision Toolkit
Decision
Checkpoints
What is the company’s
return on common
stockholders’ investment?
Info Needed
for Decision
Tool to Use for Decision
How to Evaluate
Results
Earnings available to
common stockholders
and average common
stockholders’ equity
Return on
common
Net income Preferred stock dividends
stockholders’ Average common stockholders’ equity
equity ratio
A high measure suggests strong earnings
performance from
common stockholders’
perspective.
B E F O R E
Y O U
G O
O N
.
.
.
Review It
1. What measure can be used to evaluate a company’s dividend record, and
how is it calculated?
2. What factors affect the return on common stockholders’ equity ratio?
3. What are the advantages and disadvantages of debt and
equity financing?
❍
● THE
✓
NAVIGATOR
Using the Decision Toolkit
Reebok remains one of Nike’s fiercest competitors. In such a competitive and rapidly
changing environment, one wrong step can spell financial disaster. After bottoming
out at the end of 1999, Reebok’s stock has rebounded.
Instructions
The following facts are available for Reebok. Using this information, evaluate its
(1) dividend record and (2) earnings performance, and contrast them with those for
Nike for 2003 and 2004. Nike’s earnings per share were $3.59 in 2004 and $2.80 in
2003.
(in thousands except per share data)
Dividends declared
Net income
Preferred stock dividends
Shares outstanding at end of year
Common stockholders’ equity
2004
$ 17,839
$ 192,425
0
101,827
$1,219,956
2003
$
8,847
$ 157,254
0
101,081
$1,033,710
2002
0
$126,458
0
99,235
$884,570
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Summary of Study Objectives
561
Solution
1. Dividend record: A measure to evaluate dividend record is the payout ratio. For
Reebok, this measure in 2004 and 2003 is calculated as shown below.
Payout ratio
2004
2003
$17,839
9.3%
$192,425
$8,847
5.6%
$157,254
Nike’s payout ratio remained nearly constant at 21%. Reebok’s payout ratio increased significantly from 2003 to 2004 but was still less than half Nike’s ratio.
2. Earnings performance: There are many measures of earnings performance. Some
of those presented thus far in the book were earnings per share (page 55) and
the return on common stockholders’ equity ratio (this chapter). These measures
for Reebok in 2004 and 2003 are calculated as shown here.
Earnings per
share
Return on
common
stockholders’
equity ratio
2004
2003
$192,425 0
$1.90
(101,827 101,081)/2
$157,254 0
$1.57
(101,081 99,235)/2
$192,425 0
17.1%
($1,219,956 $1,033,710)2
$157,254 0
($1,033,710 $884,570)2 16.4%
From 2003 to 2004, Reebok’s net income improved 22% and its earnings per
share increased 21%. During the same time period Nike’s earnings per share increased 28%.
Reebok’s return on common stockholders’ equity increased from 16.4% to
17.1%. While this represents a healthy increase, it is still less than Nike’s 21.6%.
✓
❍
●
THE
NAVIGATOR
Summary of Study Objectives
1
Identify and discuss the major characteristics of a
corporation. The major characteristics of a corporation are separate legal existence, limited liability
of stockholders, transferable ownership rights, ability to acquire capital, continuous life, corporation
management, government regulations, and additional taxes.
2
Record the issuance of common stock. When a company records issuance of common stock for cash,
it credits the par value of the shares to Common
Stock; it records in a separate paid-in capital account the portion of the proceeds that is above par
value. When no-par common stock has a stated
value, the entries are similar to those for par value
stock. When no-par common stock does not have
a stated value, the entire proceeds from the issue
are credited to Common Stock.
3
Explain the accounting for the purchase of treasury
stock. Companies generally use the cost method in
accounting for treasury stock. Under this approach,
a company debits Treasury Stock at the price paid
to reacquire the shares.
4
Differentiate preferred stock from common stock. Preferred stock has contractual provisions that give it
priority over common stock in certain areas. Typically, preferred stockholders have a preference as to
(1) dividends and (2) assets in the event of liquidation. However, they often do not have voting rights.
5
Prepare the entries for cash dividends and understand
the effect of stock dividends and stock splits. Companies make entries for dividends at the declaration date
and the payment date. At the declaration date the entries for a cash dividend are: debit Retained Earnings
and credit Dividends Payable. The effects of stock dividends and splits: Small stock dividends transfer an
amount equal to the fair market value of the shares
issued from retained earnings to the paid-in capital
accounts. Stock splits reduce the par value per share
of the common stock while increasing the number of
shares so that total par value remains the same.
6
Identify the items that affect retained earnings. Additions to retained earnings consist of net income.
Deductions consist of net loss and cash and stock
dividends. In some instances, portions of retained
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earnings are restricted, making that portion unavailable for the payment of dividends.
7
8
Prepare a comprehensive stockholders’ equity section. In
the stockholders’ equity section of the balance sheet,
companies report paid-in capital and retained earnings and identify specific sources of paid-in capital.
Within paid-in capital, companies show two classifications: capital stock and additional paid-in capital. If
a corporation has treasury stock, it deducts the cost of
treasury stock from total paid-in capital and retained
earnings to determine total stockholders’ equity.
Evaluate a corporation’s dividend and earnings performance from a stockholder’s perspective. A company’s
dividend record can be evaluated by looking at what
percentage of net income it chooses to pay out in
dividends, as measured by the dividend payout ratio
(dividends divided by net income). Earnings performance is measured with the return on common
stockholders’ equity ratio (income
available to common shareholders
❍
● THE
divided by average common shareNAVIGATOR
holders’ equity).
✓
Decision Toolkit—A Summary
Decision
Checkpoints
Info Needed
for Decision
Tool to Use for Decision
How to Evaluate
Results
Should the company
incorporate?
Capital needs, growth
expectations, type of
business, tax status
Corporations have limited liability, easier capital raising
ability, and professional managers; but they suffer from
additional taxes, government regulations, and separation
of ownership from management.
Must carefully weigh
the costs and benefits
in light of the particular circumstances.
What portion of its
earnings does the
company pay out in
dividends?
Net income and total
cash dividends on
common stock
Cash dividends declared on common stock
Payout
ratio
Net income
A low ratio may suggest that the company
is retaining its earnings for investment in
future growth.
What is the company’s
return on common
stockholders’ investment?
Earnings available to
common stockholders
and average common
stockholders’ equity
Return on
Net income Preferred stock dividends
common
stockholders’
Average common stockholders’ equity
equity ratio
A high measure
suggests strong
earnings performance
from common stockholders’ perspective.
APPENDIX
ENTRIES
FOR
STUDY OBJECTIVE
9
Prepare entries for stock
dividends.
A
Cash Flows
no effect
L
SE
75,000 Div
50,000 CS
25,000 CS
STOCK DIVIDENDS
To illustrate the accounting for stock dividends, assume that Medland Corporation has a balance of $300,000 in retained earnings and 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. The number of shares to be issued is
5,000 (10% 50,000), and the total amount to be debited to Retained Earnings
is $75,000 (5,000 $15). The entry to record this transaction at the declaration
date is:
Retained Earnings (or Stock Dividends)
Common Stock Dividends Distributable
Paid-in Capital in Excess of Par Value
(To record declaration of 10% stock dividend)
75,000
50,000
25,000
At the declaration date Medland decreases (debits) Retained Earnings for the
fair market value of the stock issued; increases (credits) Common Stock Dividends Distributable for the par value of the dividend shares (5,000 $10); and
credits the excess over par (5,000 $5) to an additional paid-in capital account.
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Glossary
563
Common Stock Dividends Distributable is a stockholders’ equity account; it
is not a liability because assets will not be used to pay the dividend. If Medland
prepares a balance sheet before it issues the dividend shares, it reports the distributable account in paid-in capital as an addition to common stock issued, as
shown in Illustration 11A-1.
Illustration 11A-1
Statement presentation of
common stock dividends
distributable
MEDLAND CORPORATION
Balance Sheet (partial)
Paid-in capital
Common stock
Common stock dividends distributable
$500,000
50,000
$550,000
When Medland issues the dividend shares, it decreases Common Stock
Dividends Distributable and increases Common Stock as follows.
Helpful Hint Note that the
dividend account title is
distributable, not payable.
A
Common Stock Dividends Distributable
Common Stock
(To record issuance of 5,000 shares in a stock
dividend)
50,000
50,000
L
SE
50,000 CS
50,000 CS
Cash Flows
no effect
Summary of Study Objective for Appendix
9
Prepare entries for stock dividends. To record the declaration of a small stock dividend (less than 20%),
reduce Retained Earnings for an amount equal to
the fair value of the shares issued. Record a credit to
a temporary stockholders’ equity account—Common
Stock Dividends Distributable—for the par value of
the shares, and credit the balance to Paid-in Capital
in Excess of Par Value. When the shares are issued,
debit Common Stock Dividends Distributable and
credit Common Stock.
Glossary
Authorized stock The amount of stock that a corporation is authorized to sell as indicated in its charter.
(p. 540)
Cash dividend A pro rata distribution of cash to stockholders. (p. 548)
Corporation A company organized as a separate legal
entity, with most of the rights and privileges of a person.
(p. 534)
Cumulative dividend A feature of preferred stock entitling the stockholder to receive current and unpaid
prior-year dividends before common stockholders receive
any dividends. (p. 546)
Declaration date The date the board of directors formally authorizes the dividend and announces it to stockholders. (p. 548)
Deficit A debit balance in retained earnings. (p. 554)
Dividend A distribution by a corporation to its stockholders on a pro rata (proportional) basis. (p. 547)
Dividends in arrears Preferred dividends that were
supposed to be declared but were not declared during a
given period. (p. 546)
Legal capital The amount per share of stock that must
be retained in the business for the protection of corporate creditors. (p. 541)
No-par value stock Capital stock that has not been assigned a value in the corporate charter. (p. 541)
Outstanding stock Capital stock that has been issued
and is being held by stockholders. (p. 545)
Paid-in capital The amount stockholders paid in to the
corporation in exchange for shares of ownership. (p. 541)
Par value stock Capital stock that has been assigned
a value per share in the corporate charter. (p. 541)
Payment date The date dividend checks are mailed to
stockholders. (p. 549)
Payout ratio A measure of the percentage of earnings
a company distributes in the form of cash dividends to
common stockholders. (p. 556)
Preferred stock Capital stock that has contractual
preferences over common stock in certain areas. (p. 546)
Privately held corporation A corporation that has
only a few stockholders and whose stock is not available
for sale to the general public. (p. 534)
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view; computed by dividing net income minus preferred
stock dividends by average common stockholders’ equity.
(p. 558)
Publicly held corporation A corporation that may
have thousands of stockholders and whose stock is regularly traded on a national securities market. (p. 534)
Record date The date when the company determines
ownership of outstanding shares for dividend purposes.
(p. 549)
Retained earnings Net income that a company retains
in the business. (p. 553)
Stated value The amount per share assigned by the
board of directors to no-par stock. (p. 541)
Stock dividend A pro rata distribution of the corporation’s own stock to stockholders. (p. 550)
Stock split The issuance of additional shares of stock
to stockholders accompanied by a reduction in the par
or stated value per share. (p. 551)
Treasury stock A corporation’s own stock that has been
issued, fully paid for, and reacquired by the corporation
and is being held in the treasury for future use. (p. 543)
Retained earnings restrictions Circumstances that
make a portion of retained earnings currently unavailable for dividends. (p. 554)
Return on common stockholders’ equity ratio A
measure of profitability from the stockholders’ point of
Demonstration Problem
Rolman Corporation is authorized to issue 1,000,000 shares of $5 par value common
stock. In its first year the company has the following stock transactions.
Jan. 10
Sept. 1
Dec. 24
Issued 400,000 shares of stock at $8 per share.
Purchased 10,000 shares of common stock for the treasury at $9 per share.
Declared a cash dividend of 10 cents per share on common stock
outstanding.
Instructions
(a) Journalize the transactions.
(b) Prepare the stockholders’ equity section of the balance sheet assuming the company had retained earnings of $150,600 at December 31.
Solution to Demonstration Problem
Action Plan
• When common stock has a par
value, credit Common Stock for
par value and Paid-in Capital in
Excess of Par Value for the
amount above par value.
• Debit the Treasury Stock account
at cost.
(a) Jan. 10
Sept. 1
Dec. 24
(b)
Cash
Common Stock
Paid-in Capital in Excess of Par Value
(To record issuance of 400,000 shares
of $5 par value stock)
Treasury Stock
Cash
(To record purchase of 10,000 shares
of treasury stock at cost)
Retained Earnings
Dividends Payable
(To record declaration of 10 cents per
share cash dividend)
3,200,000
2,000,000
1,200,000
90,000
90,000
39,000
ROLMAN CORPORATION
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Capital stock
Common stock, $5 par value, 1,000,000 shares
authorized, 400,000 shares issued, 390,000 outstanding
Additional paid-in capital
In excess of par value—common stock
Total paid-in capital
Retained earnings
✓ THE
❍
●
NAVIGATOR
39,000
Total paid-in capital and retained earnings
Less: Treasury stock (10,000 shares)
Total stockholders’ equity
$2,000,000
1,200,000
3,200,000
150,600
3,350,600
90,000
$3,260,600
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Questions
565
*Note: All Questions, Exercises, and Problems marked with an asterisk relate to material in the
appendix to the chapter.
Self-Study Questions
(SO 1)
Answers are at the end of the chapter.
1. Which of these is not a major advantage of a
corporation?
(a) Separate legal existence.
(b) Continuous life.
(c) Government regulations.
(d) Transferable ownership rights.
(SO 1)
2. A major disadvantage of a corporation is:
(a) limited liability of stockholders.
(b) additional taxes.
(c) transferable ownership rights.
(d) None of the above.
(SO 1)
3. 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.
(SO 2)
(SO 4)
(SO 5)
4. 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.
5. Preferred stock may have which of the following features?
(a) dividend preference.
(b) preference to assets in the event of
liquidation.
(c) cumulative dividends.
(d) all of the above.
6. 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.
7. 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.
(SO 5)
8. In the stockholders’ equity section, the cost of
treasury stock is deducted from:
(a) total paid-in capital and retained
earnings.
(b) retained earnings.
(c) total stockholders’ equity.
(d) common stock in paid-in capital.
(SO 7)
9.
The return on stockholders’ equity
is increased by all of the following, except:
(a) an increase in the return on assets ratio.
(b) an increase in the use of debt financing.
(c) an increase in the company’s stock price.
(d) an increase in the company’s net income.
(SO 8)
10.
Roger is nearing retirement and
would like to invest in a stock that will provide
a good steady income supply. Roger should
choose a stock with a:
(a) high current ratio.
(b) high dividend payout.
(c) high earnings per share.
(d) high price-earnings ratio.
(SO 8)
Go to the book’s website, www.wiley.com/
college/kimmel, to access additional SelfStudy Questions.
✓
❍
● THE
NAVIGATOR
Questions
1. Warren, a student, asks your help in understanding
some characteristics of a corporation. Explain each
of these to Warren.
(a) Separate legal existence.
(b) Limited liability of stockholders.
(c) Transferable ownership rights.
2. (a)
Your friend R. L. Duran cannot understand how the characteristic of corporate management is both an advantage and a disadvantage. Clarify this problem for R. L.
(b) Identify and explain two other disadvantages of
a corporation.
3. Ann Adler believes a corporation must be incorporated in the state in which its headquarters office is
located. Is Ann correct? Explain.
4. What are the basic ownership rights of common
stockholders in the absence of restrictive provisions?
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5. A corporation has been defined as an entity separate
and distinct from its owners. In what ways is a corporation a separate legal entity?
15. Three dates associated with Mega Company’s cash dividend are May 1, May 15, and May 31. Discuss the significance of each date and give the entry at each date.
6. What are the two principal components of stockholders’ equity?
16. Contrast the effects of a cash dividend and a stock
dividend on a corporation’s balance sheet.
7. The corporate charter of Clio Corporation allows the
issuance of a maximum of 100,000 shares of common
stock. During its first 2 years of operation, Clio sold
60,000 shares to shareholders and reacquired 4,000
of these shares. After these transactions, how many
shares are authorized, issued, and outstanding?
17. Wendy Naylor asks, “Since stock dividends don’t
change anything, why declare them?” What is your
answer to Wendy?
8. Which is the better investment—common stock with
a par value of $5 per share or common stock with a
par value of $20 per share?
9.
For what reasons might a company like IBM
repurchase some of its stock (treasury stock)?
10. Malon, Inc. purchases 1,000 shares of its own previously issued $5 par common stock for $11,000. Assuming the shares are held in the treasury, what
effect does this transaction have on (a) net income,
(b) total assets, (c) total paid-in capital, and (d) total stockholders’ equity?
11. (a) What are the principal differences between common stock and preferred stock?
(b) Preferred stock may be cumulative. Discuss this
feature.
(c) How are dividends in arrears presented in the
financial statements?
18. Flynn Corporation has 10,000 shares of $15 par
value common stock outstanding when it announces
a 2-for-1 split. Before the split, the stock had a market price of $120 per share. After the split, how many
shares of stock will be outstanding, and what will be
the approximate market price per share?
19. The board of directors is considering a stock split or a
stock dividend. They understand that total stockholders’ equity will remain the same under either
action. However, they are not sure of the different
effects of the two actions on other aspects of stockholders’ equity. Explain the differences to the directors.
20. (a) What is the purpose of a retained earnings restriction?
(b) Identify the possible causes of retained earnings
restrictions.
21. Reo Inc.’s common stock has a par value of $1 and
a current market value of $15. Explain why these
amounts are different.
12. Identify the events that result in credits and debits
to retained earnings.
22.
What is the formula for the payout ratio?
What does it indicate?
13. Indicate how each of these accounts should be classified in the stockholders’ equity section of the balance sheet.
(a) Common Stock.
(b) Paid-in Capital in Excess of Par Value.
(c) Retained Earnings.
(d) Treasury Stock.
(e) Paid-in Capital in Excess of Stated Value.
(f) Preferred Stock.
23.
Explain the circumstances under
which debt financing will increase the return on
stockholders’ equity ratio.
14. What three conditions must be met before a cash
dividend is paid?
24. Under what circumstances will the return on assets
ratio and the return on common stockholders’ equity ratio be equal?
25.
Kirk Corp. has a return on assets ratio of 12%.
It plans to issue bonds at 8% and use the cash to
retire debt. What effect will this have on its debt to
total assets ratio and on its return on common stockholders’ equity?
Brief Exercises
Cite advantages and disadvantages of a corporation.
(SO 1)
Journalize issuance of par
value common stock.
(SO 2)
Journalize issuance of no-par
common stock.
(SO 2)
Journalize issuance of
preferred stock.
(SO 4)
Prepare entries for a cash
dividend.
(SO 5)
BE11-1
Jeni Phelps is planning to start a business. Identify for Jeni the advantages and disadvantages of the corporate form of business organization.
BE11-2 On May 10 McLain Corporation issues 1,000 shares of $5 par value common
stock for cash at $13 per share. Journalize the issuance of the stock.
BE11-3 On June 1 Harmon Inc. issues 2,000 shares of no-par common stock at a cash
price of $6 per share. Journalize the issuance of the shares.
BE11-4 Duggen Inc. issues 5,000 shares of $100 par value preferred stock for cash at
$108 per share. Journalize the issuance of the preferred stock.
BE11-5 Michelle Corporation has 7,000 shares of common stock outstanding. It declares a $1 per share cash dividend on November 1 to stockholders of record on December
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Exercises
567
1. The dividend is paid on December 31. Prepare the entries on the appropriate dates to
record the declaration and payment of the cash dividend.
BE11-6 The stockholders’ equity section of Saber Corporation’s balance sheet consists
of common stock ($10 par) $1,000,000 and retained earnings $400,000. A 10% stock dividend (10,000 shares) is declared when the market value per share is $19. Show the before and after effects of the dividend on (a) the components of stockholders’ equity and
(b) the shares outstanding.
Show before and after effects
of a stock dividend.
(SO 5)
BE11-7 Indicate whether each of the following transactions would increase (), decrease
(), or not affect (N/A) total assets, total liabilities, and total stockholders’ equity.
Compare impact of cash
dividend, stock dividend, and
stock split.
(SO 5)
Transaction
(a)
(b)
(c)
(d)
(e)
Assets
Liabilities
Stockholders’
Equity
Declared cash dividend.
Paid cash dividend declared in (a).
Declared stock dividend.
Distributed stock dividend declared in (c).
Split stock 3-for-1.
BE11-8 Duffy Corporation has these accounts at December 31: Common Stock, $10
par, 5,000 shares issued, $50,000; Paid-in Capital in Excess of Par Value $18,000; Retained
Earnings $32,000; and Treasury Stock—Common, 500 shares, $12,000. Prepare the stockholders’ equity section of the balance sheet.
Prepare a stockholders’
equity section.
(SO 7)
BE11-9 Nick Gross, president of Gross Corporation, believes that it is a good practice
for a company to maintain a constant payout of dividends relative to its earnings. Last
year net income was $600,000, and the corporation paid $150,000 in dividends. This year,
due to some unusual circumstances, the corporation had income of $1,500,000. Nick expects next year’s net income to be about $700,000. What was Gross Corporation’s payout
ratio last year? If it is to maintain the same payout ratio, what amount of dividends would
it pay this year? Is this necessarily a good idea—that is, what are the pros and cons of
maintaining a constant payout ratio in this scenario?
Evaluate a company’s
dividend record.
(SO 8)
BE11-10 SUPERVALU, one of the largest grocery retailers in the United States, is headquartered in Minneapolis. The following financial information (in millions) was taken
from the company’s 2005 annual report. Net sales $19,543.2; net income $385.8; beginning stockholders’ equity $2,209.6; ending stockholders’ equity $2,510.6. Compute the return on stockholders’ equity ratio. Provide a brief interpretation of your findings.
Calculate the return on
stockholders’ equity.
(SO 8)
*BE11-11 Howell Corporation has 100,000 shares of $10 par value common stock outstanding. It declares a 10% stock dividend on December 1 when the market value per
share is $17. The dividend shares are issued on December 31. Prepare the entries for the
declaration and distribution of the stock dividend.
Prepare entries for a stock
dividend.
(SO 9)
Exercises
E11-1 During its first year of operations, Ritter Corporation had these transactions pertaining to its common stock.
Jan. 10
July 1
Issued 90,000 shares for cash at $5 per share.
Issued 50,000 shares for cash at $7 per share.
Journalize issuance of
common stock.
(SO 2)
Instructions
(a) Journalize the transactions, assuming that the common stock has a par value of $5
per share.
(b) Journalize the transactions, assuming that the common stock is no-par with a stated
value of $1 per share.
E11-2
June 12
July 11
Nov. 28
Somer Co. had these transactions during the current period.
Issued 60,000 shares of $1 par value common stock for cash of $300,000.
Issued 1,000 shares of $100 par value preferred stock for cash at $104 per share.
Purchased 2,000 shares of treasury stock for $11,000.
Journalize issuance of
common stock and preferred
stock and purchase of
treasury stock.
(SO 2, 3, 4)
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Instructions
Prepare the journal entries for the transactions shown on page 567.
Journalize preferred stock
transactions and indicate
statement presentation.
(SO 4, 7)
E11-3 Oritz Corporation is authorized to issue both preferred and common stock. The
par value of the preferred is $50. During the first year of operations, the company had
the following events and transactions pertaining to its preferred stock.
Feb. 1
July 1
Issued 40,000 shares for cash at $51 per share.
Issued 20,000 shares for cash at $56 per share.
Instructions
(a) Journalize the transactions.
(b) Post to the stockholders’ equity accounts. (Use T accounts.)
(c) Discuss the statement presentation of the accounts.
Answer questions about
stockholders’ equity section.
(SO 2, 3, 4, 7)
E11-4 The stockholders’ equity section of MaiStyle Corporation’s balance sheet at
December 31 is presented here.
MAISTYLE CORPORATION
Balance Sheet (partial)
Stockholders’ equity
Paid-in capital
Preferred stock, cumulative, 10,000 shares authorized,
6,000 shares issued and outstanding
Common stock, no par, 750,000 shares authorized,
600,000 shares issued
$ 900,000
1,800,000
Total paid-in capital
Retained earnings
2,700,000
1,158,000
Total paid-in capital and retained earnings
Less: Treasury stock (8,000 common shares)
3,858,000
(32,000)
Total stockholders’ equity
$3,826,000
Instructions
From a review of the stockholders’ equity section, answer the following questions.
(a) How many shares of common stock are outstanding?
(b) Assuming there is a stated value, what is the stated value of the common stock?
(c) What is the par value of the preferred stock?
(d) If the annual dividend on preferred stock is $36,000, what is the dividend rate on
preferred stock?
(e) If dividends of $72,000 were in arrears on preferred stock, what would be the balance reported for retained earnings?
Prepare correct entries for
capital stock transactions.
(SO 2, 3, 4)
E11-5 Yanik Corporation recently hired a new accountant with extensive experience in
accounting for partnerships. Because of the pressure of the new job, the accountant was
unable to review what he had learned earlier about corporation accounting. During the
first month, he made the following entries for the corporation’s capital stock.
May 2
10
15
Cash
Capital Stock
(Issued 10,000 shares of $5 par value
common stock at $12 per share)
Cash
Capital Stock
(Issued 10,000 shares of $50 par value
preferred stock at $53 per share)
Capital Stock
Cash
(Purchased 600 shares of common
stock for the treasury at $12 per share)
120,000
120,000
530,000
530,000
7,200
7,200
Instructions
On the basis of the explanation for each entry, prepare the entries that should have been
made for the capital stock transactions.
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Exercises
E11-6 On January 1 Weiss Corporation had 75,000 shares of no-par common stock issued and outstanding. The stock has a stated value of $5 per share. During the year, the
following transactions occurred.
Apr. 1
June 15
July 10
Dec. 1
15
Issued 8,000 additional shares of common stock for $11 per share.
Declared a cash dividend of $1.50 per share to stockholders of record on
June 30.
Paid the $1.50 cash dividend.
Issued 4,000 additional shares of common stock for $12 per share.
Declared a cash dividend on outstanding shares of $1.70 per share to
stockholders of record on December 31.
569
Journalize cash dividends
and indicate statement
presentation.
(SO 5)
Instructions
(a) Prepare the entries, if any, on each of the three dates that involved dividends.
(b) How are dividends and dividends payable reported in the financial statements prepared at December 31?
E11-7 On October 31 the stockholders’ equity section of Davis Company’s balance sheet
consists of common stock $648,000 and retained earnings $400,000. Davis is considering
the following two courses of action: (1) declaring a 5% stock dividend on the 54,000 $12
par value shares outstanding or (2) effecting a 3-for-1 stock split that will reduce par value
to $4 per share. The current market price is $15 per share.
Compare effects of a stock
dividend and a stock split.
(SO 5)
Instructions
Prepare a tabular summary of the effects of the alternative actions on the company’s
stockholders’ equity and outstanding shares. Use these column headings: Before Action,
After Stock Dividend, and After Stock Split.
E11-8 Wells Fargo & Company, headquartered in San Francisco, is one of the nation’s
largest financial institutions. It reported the following selected accounts (in millions) as
of December 31, 2004.
Retained earnings
Preferred stock
Common stock—$132 par value, authorized 6,000,000,000 shares;
issued 1,736,381,025 shares
Treasury stock—41,789,388 shares
Additional paid-in capital—common stock
Prepare a stockholders’
equity section.
(SO 7)
$27,143
270
2,894
(2,247)
9,806
Instructions
Prepare the stockholders’ equity section of the balance sheet for Wells Fargo as of
December 31, 2004.
E11-9 The following stockholders’ equity accounts, arranged alphabetically, are in the
ledger of Marvel Corporation at December 31, 2007.
Common Stock ($5 stated value)
Paid-in Capital in Excess of Par Value—Preferred Stock
Paid-in Capital in Excess of Stated Value—Common Stock
Preferred Stock (8%, $100 par, noncumulative)
Retained Earnings
Treasury Stock—Common (8,000 shares)
Prepare a stockholders’
equity section.
(SO 7)
$1,500,000
45,000
1,050,000
500,000
1,134,000
78,000
Instructions
Prepare the stockholders’ equity section of the balance sheet at December 31, 2007.
E11-10 The following accounts appear in the ledger of Sycamore Inc. after the books
are closed at December 31, 2007.
Common Stock (no-par, $1 stated value, 400,000 shares authorized,
200,000 shares issued)
Paid-in Capital in Excess of Stated Value—Common Stock
Preferred Stock ($50 par value, 8%, 40,000 shares authorized, 12,000
shares issued)
Retained Earnings
Treasury Stock (10,000 common shares)
Paid-in Capital in Excess of Par Value—Preferred Stock
$ 200,000
1,200,000
600,000
900,000
64,000
24,000
Prepare a stockholders’
equity section.
(SO 7)
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Instructions
Prepare the stockholders’ equity section at December 31, assuming $100,000 of retained
earnings is restricted for plant expansion. (Use Note R.)
Calculate ratios to evaluate
dividend and earnings
performance.
(SO 8)
E11-11
The following financial information is available for Sara Lee Corporation.
(in millions)
Average common stockholders’ equity
Dividends declared for common stockholders
Dividends declared for preferred stockholders
Net income
2004
2003
$2,500
594
0
1,272
$1,897
497
10
1,221
Instructions
Calculate the payout ratio and return on common stockholders’ equity ratio for 2004 and
2003. Comment on your findings.
Calculate ratios to evaluate
dividend and earnings
performance.
(SO 8)
E11-12
The following financial information is available for Walgreen Company.
(in millions)
Average common stockholders’ equity
Dividends declared for common stockholders
Dividends declared for preferred stockholders
Net income
2004
2003
$7,628.8
186.4
0
1,349.8
$6,640.4
159.6
0
1,165.1
Instructions
Calculate the payout ratio and return on common stockholders’ equity ratio for 2004 and
2003. Comment on your findings.
Calculate ratios to evaluate
profitability and solvency.
(SO 8)
E11-13 Mann Corporation decided to issue common stock and used the $400,000 proceeds to retire all of its outstanding bonds on January 1, 2007. The following information
is available for the company for 2006 and 2007.
Net income
Average stockholders’ equity
Total assets
Current liabilities
Total liabilities
2007
2006
$ 182,000
1,100,000
1,200,000
100,000
100,000
$ 150,000
700,000
1,200,000
100,000
500,000
Instructions
(a) Compute the return on stockholder’s equity ratio for both years.
(b) Explain how it is possible that net income increased, but the return on common
stockholders’ equity decreased.
(c) Compute the debt to total assets ratio for both years, and comment on the implications of this change in the company’s solvency.
Journalize stock dividends.
(SO 5, 9)
*E11-14 On January 1, 2007, Kern Corporation had $1,500,000 of common stock outstanding that was issued at par and retained earnings of $750,000. The company issued
30,000 shares of common stock at par on July 1 and earned net income of $400,000 for
the year.
Instructions
Journalize the declaration of a 15% stock dividend on December 10, 2007, for the following two independent assumptions.
(a) Par value is $10 and market value is $12.
(b) Par value is $5 and market value is $9.
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571
Problems: Set A
P11-1A Norris Corporation was organized on January 1, 2007. It is authorized to issue
20,000 shares of 6%, $50 par value preferred stock and 500,000 shares of no-par common
stock with a stated value of $1 per share. The following stock transactions were completed
during the first year.
Jan. 10
Mar. 1
May 1
Sept. 1
Nov. 1
Issued
Issued
Issued
Issued
Issued
60,000 shares of common stock for cash at $4 per share.
12,000 shares of preferred stock for cash at $54 per share.
100,000 shares of common stock for cash at $5 per share.
5,000 shares of common stock for cash at $6 per share.
2,000 shares of preferred stock for cash at $56 per share.
Instructions
(a) Journalize the transactions.
(b) Post to the stockholders’ equity accounts. (Use T accounts.)
(c) Prepare the paid-in capital portion of the stockholders’ equity section at December
31, 2007.
P11-2A The stockholders’ equity accounts of Alpha Corporation on January 1, 2007,
were as follows.
Preferred Stock (8%, $100 par noncumulative, 5,000 shares authorized)
Common Stock ($5 stated value, 300,000 shares authorized)
Paid-in Capital in Excess of Par Value—Preferred Stock
Paid-in Capital in Excess of Stated Value—Common Stock
Retained Earnings
Treasury Stock—Common (5,000 shares)
$ 400,000
1,000,000
15,000
480,000
688,000
40,000
Journalize stock
transactions, post, and
prepare paid-in capital
section.
(SO 2, 4, 7)
GL S
(c) Tot. paid-in capital
$1,530,000
Journalize transactions, post,
and prepare a stockholders’
equity section; calculate
ratios.
(SO 2, 3, 5, 7, 8)
GL S
During 2007 the corporation had the following transactions and events pertaining to its
stockholders’ equity.
Feb. 1
Mar. 20
Oct. 1
Nov. 1
Dec. 1
31
Issued 3,000 shares of common stock for $18,600.
Purchased 1,000 additional shares of common treasury stock at $7 per
share.
Declared an 8% cash dividend on preferred stock, payable November 1.
Paid the dividend declared on October 1.
Declared a $0.50 per share cash dividend to common stockholders of
record on December 15, payable December 31, 2007.
Determined that net income for the year was $280,000. Paid the
dividend declared on December 1.
Instructions
(a) Journalize the transactions. (Include entries to close net income to Retained Earnings.)
(b) Enter the beginning balances in the accounts and post the journal entries to the stockholders’ equity accounts. (Use T accounts.)
(c) Prepare the stockholders’ equity section of the balance sheet at December 31, 2007.
(d) Calculate the payout ratio, earnings per share, and return on common stockholders’
equity ratio. (Note: Use the common shares outstanding on January 1 and December
31 to determine the average shares outstanding.)
P11-3A On December 31, 2006, Pepp Company had 1,300,000 shares of $5 par common
stock issued and outstanding. The stockholders’ equity accounts at December 31, 2006,
had the balances listed here.
Common Stock
Additional Paid-in Capital
Retained Earnings
$6,500,000
1,800,000
1,200,000
Transactions during 2007 and other information related to stockholders’ equity accounts
were as follows.
1. On January 10, 2007, issued at $109 per share 100,000 shares of $100 par value, 8%
cumulative preferred stock.
(c) Tot. paid-in capital
$1,913,600
Prepare a stockholders’
equity section.
(SO 7)
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2. On February 8, 2007, reacquired 15,000 shares of its common stock for $11 per share.
3. On June 8, 2007, declared a cash dividend of $1.20 per share on the common stock
outstanding, payable on July 10, 2007, to stockholders of record on July 1, 2007.
4. On December 9, 2007, declared the yearly cash dividend on preferred stock, payable
January 10, 2008, to stockholders of record on December 15, 2007.
5. Net income for the year was $3,600,000.
Tot. stockholders’ equity
$21,493,000
Instructions
Prepare the stockholders’ equity section of Pepp’s balance sheet at December 31, 2007.
Reproduce retained earnings
account, and prepare a
stockholders’ equity section.
(SO 5, 6, 7)
P11-4A The ledger of Omega Corporation at December 31, 2007, after the books have
been closed, contains the following stockholders’ equity accounts.
Preferred Stock (10,000 shares issued)
Common Stock (450,000 shares issued)
Paid-in Capital in Excess of Par Value—Preferred Stock
Paid-in Capital in Excess of Stated Value—Common Stock
Retained Earnings
$1,000,000
2,250,000
200,000
1,600,000
3,060,000
A review of the accounting records reveals this information:
1. Preferred stock is 7%, $100 par value, noncumulative. Since January 1, 2006, 10,000
shares have been outstanding; 20,000 shares are authorized.
2. Common stock is no-par with a stated value of $5 per share; 600,000 shares are
authorized.
3. The January 1, 2007, balance in Retained Earnings was $2,580,000.
4. On October 1, 60,000 shares of common stock were sold for cash at $8 per share.
5. A cash dividend of $400,000 was declared and properly allocated to preferred and com-
mon stock on November 1. No dividends were paid to preferred stockholders in 2006.
6. Net income for the year was $880,000.
7. On December 31, 2007, the directors authorized disclosure of a $130,000 restriction
of retained earnings for plant expansion. (Use Note A.)
Instructions
(b) Tot. paid-in capital
$5,050,000
(a) Reproduce the retained earnings account (T account) for the year.
(b) Prepare the stockholders’ equity section of the balance sheet at December 31.
Prepare entries for stock
transactions, and prepare a
stockholders’ equity section.
(SO 2, 3, 4, 7)
P11-5A Milner Corporation has been authorized to issue 20,000 shares of $100 par
value, 10%, noncumulative preferred stock and 1,000,000 shares of no-par common stock.
The corporation assigned a $5 stated value to the common stock. At December 31, 2007,
the ledger contained the following balances pertaining to stockholders’ equity.
Preferred Stock
Paid-in Capital in Excess of Par Value—Preferred Stock
Common Stock
Paid-in Capital in Excess of Stated Value—Common Stock
Treasury Stock—Common (5,000 shares)
Retained Earnings
$ 130,000
20,000
2,000,000
1,850,000
55,000
82,000
The preferred stock was issued for $150,000 cash. All common stock issued was for cash.
In November 5,000 shares of common stock were purchased for the treasury at a per
share cost of $11. No dividends were declared in 2007.
Instructions
(a) Prepare the journal entries for the following.
(b) Tot. stockholders’ equity
$4,027,000
Prepare a stockholders’
equity section.
(SO 7)
(1) Issuance of preferred stock for cash.
(2) Issuance of common stock for cash.
(3) Purchase of common treasury stock for cash.
(b) Prepare the stockholders’ equity section of the balance sheet at December 31, 2007.
P11-6A
On January 1, 2007, Rothchild Inc. had these stockholders’ equity balances.
Common Stock, $1 par (2,000,000 shares authorized, 800,000
shares issued and outstanding)
Paid-in Capital in Excess of Par Value
Retained Earnings
$800,000
1,500,000
600,000
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Problems: Set A
573
During 2007, the following transactions and events occurred.
1.
2.
3.
4.
5.
Issued 50,000 shares of $1 par value common stock for $3 per share.
Issued 40,000 shares of common stock for cash at $4 per share.
Purchased 15,000 shares of common stock for the treasury at $3.50 per share.
Declared and paid a cash dividend of $115,000.
Earned net income of $300,000.
Instructions
Prepare the stockholders’ equity section of the balance sheet at December 31, 2007.
Tot. stockholders’ equity
$3,342,500
P11-7A Stuffitt Company manufactures backpacks. During 2007 Stuffitt issued bonds at
10% interest and used the cash proceeds to purchase treasury stock. The following financial
information is available for Stuffitt Company for the years 2007 and 2006.
Evaluate a company’s
profitability and solvency.
(SO 8)
Sales
Net income
Interest expense
Tax expense
Dividends paid
Total assets (year-end)
Average total assets
Total liabilities (year-end)
Average total stockholders’ equity
2007
2006
$ 9,000,000
2,340,000
500,000
670,000
890,000
14,500,000
14,937,500
6,000,000
9,400,000
$ 9,000,000
2,700,000
140,000
780,000
1,026,000
16,875,000
17,647,000
3,000,000
14,100,000
Instructions
(a) Use the information above to calculate the following ratios for both years: (i) return
on assets ratio, (ii) return on common stockholders’ equity ratio, (iii) payout ratio,
(iv) debt to total assets ratio, (v) times interest earned ratio.
(b) Referring to your findings in part (a), discuss the changes in the company’s profitability from 2006 to 2007.
(c) Referring to your findings in part (a), discuss the changes in the company’s solvency
from 2006 to 2007.
(d) Based on your findings in (b), was the decision to issue debt to purchase common
stock a wise one?
*P11-8A On January 1, 2007, Aglar Corporation had these stockholders’ equity
accounts.
Common Stock ($10 par value, 60,000 shares issued and outstanding)
Paid-in Capital in Excess of Par Value
Retained Earnings
$600,000
500,000
620,000
During the year, the following transactions occurred.
Jan. 15
Feb. 15
Apr. 15
May 15
Dec. 1
31
Prepare dividend entries,
prepare a stockholders’ equity
section, and calculate ratios.
(SO 5, 7, 8, 9)
GL S
Declared a $0.50 cash dividend per share to stockholders of record on
January 31, payable February 15.
Paid the dividend declared in January.
Declared a 10% stock dividend to stockholders of record on April 30,
distributable May 15. On April 15 the market price of the stock was $14
per share.
Issued the shares for the stock dividend.
Declared a $0.55 per share cash dividend to stockholders of record on
December 15, payable January 10, 2006.
Determined that net income for the year was $370,000.
Instructions
(a) Journalize the transactions. (Include entries to close net income to Retained
Earnings.)
(b) Enter the beginning balances and post the entries to the stockholders’ equity T
accounts. (Note: Open additional stockholders’ equity accounts as needed.)
(c) Prepare the stockholders’ equity section of the balance sheet at December 31.
(d) Calculate the payout ratio and return on common stockholders’ equity ratio.
(c) Tot. stockholders’ equity
$2,023,700
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Problems: Set B
Journalize stock
transactions, post, and
prepare paid-in capital
section.
(SO 2, 4, 7)
GL S
(c) Tot. paid-in capital
$1,288,000
Journalize transactions, post,
and prepare a stockholders’
equity section; calculate
ratios.
(SO 2, 3, 5, 7, 8)
GL S
P11-1B Hawes Corporation was organized on January 1, 2007. It is authorized to issue 10,000 shares of 8%, $100 par value preferred stock and 500,000 shares of no-par
common stock with a stated value of $2 per share. The following stock transactions were
completed during the first year.
Jan. 10
Mar. 1
May 1
Sept. 1
Nov. 1
Issued
Issued
Issued
Issued
Issued
80,000 shares of common stock for cash at $3.50 per share.
5,000 shares of preferred stock for cash at $102 per share.
60,000 shares of common stock for cash at $4 per share.
10,000 shares of common stock for cash at $5 per share.
2,000 shares of preferred stock for cash at $104 per share.
Instructions
(a) Journalize the transactions.
(b) Post to the stockholders’ equity accounts. (Use T accounts.)
(c) Prepare the paid-in capital section of stockholders’ equity at December 31, 2007.
P11-2B The stockholders’ equity accounts of Sosa Corporation on January 1, 2007, were
as follows.
Preferred Stock (7%, $50 par cumulative, 10,000 shares authorized)
Common Stock ($1 stated value, 2,000,000 shares authorized)
Paid-in Capital in Excess of Par Value—Preferred Stock
Paid-in Capital in Excess of Stated Value—Common Stock
Retained Earnings
Treasury Stock—Common (10,000 shares)
$ 400,000
1,000,000
80,000
1,400,000
1,716,000
30,000
During 2007 the corporation had these transactions and events pertaining to its stockholders’ equity.
Feb. 1
Nov. 10
Nov. 15
Dec. 1
15
31
Issued 15,000 shares of common stock for $60,000.
Purchased 4,000 shares of common stock for the treasury at a cost of
$18,000.
Declared a 7% cash dividend on preferred stock, payable December 15.
Declared a $0.30 per share cash dividend to stockholders of record on
December 15, payable December 31, 2007.
Paid the dividend declared on November 15.
Determined that net income for the year was $408,000. The market
price of the common stock on this date was $5 per share. Paid the
dividend declared on December 1.
Instructions
(c) Tot. paid-in capital
$2,940,000
(a) Journalize the transactions. (Include entries to close net income to Retained Earnings.)
(b) Enter the beginning balances in the accounts, and post the journal entries to the
stockholders’ equity accounts. (Use T accounts.)
(c) Prepare the stockholders’ equity section of the balance sheet at December 31, 2007.
(d) Calculate the payout ratio, earnings per share, and return on common stockholders’
equity ratio. (Hint: Use the common shares outstanding on January 1 and December 31
to determine average shares outstanding.)
Prepare a stockholders’
equity section.
(SO 7)
P11-3B On December 31, 2006, Klein Company had 1,000,000 shares of $1 par common stock issued and outstanding. The stockholders’ equity accounts at December 31,
2006, had the balances listed here.
Common Stock
Additional Paid-in Capital
Retained Earnings
$1,000,000
100,000
800,000
Transactions during 2007 and other information related to stockholders’ equity accounts
were as follows.
1. On January 9, 2007, issued at $8 per share 100,000 shares of $5 par value, 9% cumu-
lative preferred stock.
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Problems: Set B
575
2. On February 8, 2007, reacquired 12,000 shares of its common stock for $9 per share.
3. On June 10, 2007, declared a cash dividend of $1 per share on the common stock out-
standing, payable on July 10, 2007, to stockholders of record on July 1, 2007.
4. On December 15, 2007, declared the yearly cash dividend on preferred stock, payable
December 28, 2007, to stockholders of record on December 15, 2007.
5. Net income for the year is $2,400,000. At December 31, 2007, the market price of the
common stock was $12 per share.
Instructions
Prepare the stockholders’ equity section of Klein Company’s balance sheet at December
31, 2007.
Tot. stockholders’ equity
$3,959,000
P11-4B The post-closing trial balance of Mantelle Corporation at December 31, 2007,
contains these stockholders’ equity accounts.
Reproduce retained earnings
account, and prepare a
stockholders’ equity section.
(SO 5, 6, 7)
Preferred Stock (8,000 shares issued)
Common Stock (250,000 shares issued)
Paid-in Capital in Excess of Par Value—Preferred Stock
Paid-in Capital in Excess of Par Value—Common Stock
Retained Earnings
$ 400,000
2,500,000
250,000
700,000
1,215,000
A review of the accounting records reveals this information:
1. Preferred stock is $50 par, 10%, and cumulative; 8,000 shares have been outstanding
since January 1, 2006.
2. Authorized stock is 20,000 shares of preferred and 500,000 shares of common with a
$10 par value.
3. The January 1, 2007, balance in Retained Earnings was $960,000.
4. On July 1, 20,000 shares of common stock were sold for cash at $16 per share.
5. A cash dividend of $220,000 was declared and properly allocated to preferred and com-
mon stock on October 1. No dividends were paid to preferred stockholders in 2006.
6. Net income for the year was $475,000.
7. On December 31, 2007, the directors authorized disclosure of a $150,000 restriction
of retained earnings for plant expansion. (Use Note X.)
Instructions
(a) Reproduce the retained earnings account for the year.
(b) Prepare the stockholders’ equity section of the balance sheet at December 31.
P11-5B The following stockholders’ equity accounts, arranged alphabetically, are in the
ledger of Aaron Corporation at December 31, 2007.
Common Stock ($5 stated value, 800,000 shares authorized)
Paid-in Capital in Excess of Par Value—Preferred Stock
Paid-in Capital in Excess of Stated Value—Common Stock
Preferred Stock (8%, $50 par, noncumulative, 50,000 shares
authorized)
Retained Earnings
Treasury Stock—Common (20,000 shares)
(b) Tot. paid-in capital
$3,850,000
Prepare a stockholders’
equity section.
(SO 7)
$2,600,000
108,000
1,500,000
900,000
1,958,000
150,000
Instructions
Prepare the stockholders’ equity section of the balance sheet at December 31, 2007.
Tot. stockholders’ equity
$6,916,000
P11-6B
Prepare a stockholders’
equity section.
(SO 7)
On January 1, 2007, Willow Inc. had these stockholder equity balances.
Common Stock, $1 par (1,000,000 shares authorized;
500,000 shares issued and outstanding)
Paid-in Capital in Excess of Par Value
Retained Earnings
$ 500,000
1,000,000
600,000
During 2007, the following transactions and events occurred.
1.
2.
3.
4.
5.
Issued 50,000 shares of $1 par common stock for $125,000.
Issued 30,000 common shares for cash at $4 per share.
Purchased 10,000 shares of common stock for the treasury at $4 per share.
Declared and paid a cash dividend of $160,000.
Reported net income of $400,000.
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Tot. stockholders’ equity
$2,545,000
Instructions
Prepare the stockholders’ equity section of the balance sheet at December 31, 2007.
Evaluate a company’s
profitability and solvency.
(SO 8)
P11-7B Gene Kelly Company manufactures raingear. During 2007 Gene Kelly Company
decided to issue bonds at 8% interest and then used the cash to purchase a significant amount of treasury stock. The following information is available for Gene Kelly
Company.
Sales
Net income
Interest expense
Tax expense
Total assets
Average total assets
Total liabilities
Average total stockholders’ equity
Dividends
2007
2006
$3,000,000
830,000
120,000
166,000
5,000,000
5,312,500
2,000,000
3,312,500
270,000
$3,000,000
900,000
50,000
200,000
5,625,000
6,250,000
1,000,000
5,250,000
300,000
Instructions
(a) Use the information above to calculate the following ratios for both years: (i) return
on assets ratio, (ii) return on common stockholders’ equity ratio, (iii) payout ratio,
(iv) debt to total assets ratio, (v) times interest earned ratio.
(b) Referring to your findings in part (a), discuss the changes in the company’s profitability from 2006 to 2007.
(c) Referring to your findings in part (a), discuss the changes in the company’s solvency
from 2006 to 2007.
(d) Based on your findings in (b), was the decision to issue debt to purchase common
stock a wise one?
Prepare dividend entries,
*P11-8B On January 1, 2007, Frenz Corporation had these stockholders’ equity
prepare a stockholders’ equity
accounts.
section, and calculate ratios.
(SO 5, 7, 8, 9)
GL S
Common Stock ($20 par value, 60,000 shares issued and outstanding)
Paid-in Capital in Excess of Par Value
Retained Earnings
$1,200,000
240,000
750,000
During the year, the following transactions occurred.
Feb.
1
Mar.
July
1
1
Dec.
31
1
31
Declared a $0.50 cash dividend per share to stockholders of record on
February 15, payable March 1.
Paid the dividend declared in February.
Declared a 10% stock dividend to stockholders of record on July 15, distributable July 31. On July 1 the market price of the stock was $26 per
share.
Issued the shares for the stock dividend.
Declared a $1 per share dividend to stockholders of record on December
15, payable January 5, 2008.
Determined that net income for the year was $440,000. The market
price of the common stock on this date was $32.
Instructions
(a) Journalize the transactions. (Include entries to close net income to Retained Earn-
ings.)
(b) Enter the beginning balances and post the entries to the stockholders’ equity T
accounts. (Note: Open additional stockholders’ equity accounts as needed.)
(c) Tot. stockholders’ equity
$2,534,000
(c) Prepare the stockholders’ equity section of the balance sheet at December 31.
(d) Calculate the payout ratio and return on common stockholders’ equity ratio.
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m
i mme l
www
i l e y. co
Visit the book’s website at www.wiley.com/college/kimmel and choose the Student Companion site to access Problem Set C.
/k
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Problems: Set C
/ co l l ege
Comprehensive Problem
Comprehensive Problem
CP11
Servo Corporation’s balance sheet at December 31, 2006, is presented below.
SERVO CORPORATION
Balance Sheet
December 31, 2006
Cash
$ 24,600
Accounts receivable
45,500
Allowance for doubtful
accounts
(1,500)
Supplies
4,400
Land
40,000
Building
142,000
Accumulated depreciationbuilding
(22,000)
Accounts payable
Common stock ($10 par)
Retained earnings
$ 25,600
80,000
127,400
$233,000
$233,000
During 2007, the following transactions occurred.
1. On January 1, 2007, Servo issued 1,500 shares of $20 par, 7% preferred stock for
$33,000.
2. On January 1, 2007, Servo also issued 600 shares of the $10 par value common stock
for $21,000.
3. Servo performed services for $280,000 on account.
4. On April 1, 2007, Servo collected fees of $48,000 in advance for services to be per-
formed from April 1, 2007, to March 31, 2008.
Servo collected $267,000 from customers on account.
Servo bought $30,100 of supplies on account.
Servo paid $32,200 on accounts payable.
Servo reacquired 400 shares of its common stock on June 1, 2007, for $38 per share.
Paid other operating expenses of $188,200.
On December 31, 2007, Servo declared the annual preferred stock dividend and a
$1.20 per share dividend on the outstanding common stock, all payable on January
15, 2008.
11. An account receivable of $1,300 which originated in 2006 is written off as uncollectible.
5.
6.
7.
8.
9.
10.
Adjustment data:
A count of supplies indicates that $5,900 of supplies remain unused at year-end.
Recorded revenue earned from item 4 above.
The allowance for doubtful accounts should have a balance of $3,500 at year end.
Depreciation is recorded on the building on a straight-line basis based on a 30-year
life and a salvage value of $10,000.
5. The income tax rate is 30%. (Hint: Prepare the income statement up to income before
taxes and multiply by 30% to compute the amount.)
1.
2.
3.
4.
Instructions
(You may want to set up T accounts to determine ending balances.)
(a) Prepare journal entries for the transactions listed above and adjusting entries.
(b) Prepare an adjusted trial balance at December 31, 2007.
(c) Prepare an income statement and a retained earnings statement for the year ending
December 31, 2007, and a classified balance sheet as of December 31, 2007.
(b) Totals $670,250
(c) Net income $64,050
Tot. assets $373,200
577
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Reporting and Analyzing Stockholders’ Equity
Continuing Cookie Chronicle
(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 10.)
CCC11
Part 1 Because Natalie has been so successful with Cookie Creations and Curtis has
been just as successful with his coffee shop, they both conclude that they could benefit
from each other’s business expertise. Curtis and Natalie next evaluate the different types
of business organization, and because of the advantage of limited personal liability, decide to form a new corporation.
Curtis has operated his coffee shop for 2 years. He buys coffee, muffins, and cookies from a local supplier. Natalie’s business consists of giving cookie-making classes and
selling fine European mixers. The plan is for Natalie to use the premises Curtis currently
rents as a location for her cookie-making classes and demonstrations of the mixers that
she sells. Natalie will also hire, train, and supervise staff hired to bake cookies and muffins
sold in the coffee shop. By offering her classes on the premises, Natalie will save on travel,
and the coffee shop will provide one central location for selling the mixers. Combining
forces will also allow Natalie and Curtis to pool their resources and buy a few more assets to run their new business venture.
The current market values of the assets of both businesses are as follows.
Description
Curtis’ Coffee
Cookie Creations
Cash
Accounts receivable
Merchandise inventory
Equipment
$ 7,500
100
450
2,500
$10,000
500
1,130
1,000
$10,550
$12,630
Curtis and Natalie meet with a lawyer and form their corporation, called Cookie &
Coffee Creations Inc., on November 1, 2007. The new corporation is authorized to issue
50,000 shares of $1 par common stock and 10,000 shares of no par, $6 cumulative preferred stock.
The assets held by each business will be transferred into the corporation at current
market value of $1 per share. Curtis will receive 10,550 common shares, and Natalie will
receive 12,630 common shares in the corporation.
Natalie and Curtis are very excited about this new business venture. They come to
you with the following questions.
1. Curtis’ Dad and Natalie’s grandmother are interested in investing $5,000 each in the
new business venture. Curtis and Natalie are considering issuing them preferred shares.
What would be the advantage of issuing them preferred stock instead of common?
2. What would be the advantages and disadvantages of issuing cumulative preferred?
3. “Our lawyer sent us a bill for $750. When we talked the bill over with her, she said
she would be willing to receive common stock in our corporation instead of cash. We
would be happy to issue her stock, but we’re worried about accounting for this transaction. Can we do this? If so, how do we determine how many shares to give her?”
Instructions
(a) Answer Natalie and Curtis’ questions.
(b) Prepare the journal entries required on November 1, 2007, the date when Natalie and
Curtis transfer the assets of their respective businesses into Cookie & Coffee Creations Inc.
(c) Assume that Cookie & Coffee Creations Inc. issues 1,000 $6 cumulative preferred
shares to Curtis’ Dad and the same number to Natalie’s grandmother, in both cases
for $5,000. Also assume that Cookie & Coffee Creations Inc. issues 750 common
shares to its lawyer. Prepare the journal entries required for each of these transactions that also occurred on November 1.
(d) Prepare the opening balance sheet for Cookie & Coffee Creations Inc. as of November 1, 2007, including the journal entries in (b) and (c) above.
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Broadening Your Perspective
579
Part 2 After establishing their company’s fiscal year-end to be October 31, Natalie and
Curtis began operating Cookie & Coffee Creations Inc. on November 1, 2007. The company had the following selected transactions during its first year of operations, 2008.
Jan.
1
June 30
Oct. 15
Oct. 31
Instructions
(a) Prepare
(b) Prepare
(c) Prepare
(d) Prepare
Issued an additional 500 preferred shares to Natalie’s brother for $2,500
cash.
Repurchased 750 shares issued to the lawyer, for $500 cash. The lawyer
had decided to retire and wanted to liquidate all of her assets.
The company had a very successful first year of operations and as a result declared dividends of $25,000, payable November 15, 2008.
(Indicate the amounts payable to the preferred stockholders and to the
common stockholders.)
The company earned revenues of $462,500 and incurred expenses of
$406,500 (including the $750 legal expense from November 1 but
excluding income tax). Record income tax expense, assuming the company has a 20% income tax rate.
the journal entries to record each of the above transactions.
all of the closing entries required on October 31, 2008.
the retained earnings statement for the year ended October 31, 2008.
the stockholders’ equity section of the balance sheet as of October 31, 2008.
BROADENING
Y O U R
(d) Tot. stockholders’ equity
$55,730
P E R S P E C T I V E
Financial Reporting and Analysis
FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries, Inc.
BYP11-1 The stockholders’ equity section of Tootsie Roll Industries’ balance sheet is
shown in the Consolidated Statement of Financial Position in Appendix A. You will also
find data relative to this problem on other pages of Appendix A. (Note that Tootsie Roll
has two classes of common stock. To answer the following questions, add the two classes
of stock together.)
Instructions
Answer the following questions.
(a) What is the par or stated value per share of Tootsie Roll’s common stock?
(b) What percentage of Tootsie Roll’s authorized common stock was issued at December
31, 2004? (Round to the nearest full percent.)
(c) How many shares of common stock were outstanding at December 31, 2003, and at
December 31, 2004?
(d) Calculate the payout ratio, earnings per share, and return on common stockholders’
equity ratio for 2004.
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey Foods
BYP11-2 The financial statements of Hershey Foods are presented in Appendix B, following the financial statements for Tootsie Roll in Appendix A.
Instructions
(a) Based on the information in these financial statements, compute the 2004 return on
common stockholders’ equity, debt to total assets ratio, and return on assets ratio for
each company.
(b) What conclusions concerning the companies’ profitability can be drawn from these ratios? Which company relies more on debt to boost its return to common shareholders?
(c) Compute the payout ratio for each company. Which pays out a higher percentage of
its earnings?
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RESEARCH CASE
BYP11-3 The May 2003 edition of Strategic Finance has an article by Alan Levinsohn
titled “Does it Make Sense to Pay Dividends?”
Instructions
Read the article and answer the following questions.
(a) According to the author of the article, what are some potential benefits of paying
dividends?
(b) What are some potential disadvantages of paying dividends?
(c) If a company has excess cash that it would like to distribute, what alternative exists
to paying a dividend? Why might this alternative be preferred by some investors?
(d) What is meant by “double taxation of dividends,” and what implications does this
have for the choice that companies make between debt and equity financing?
INTERPRETING FINANCIAL STATEMENTS
BYP11-4 Marriott Corporation split into two companies: Host Marriott Corporation
and Marriott International. Host Marriott retained ownership of the corporation’s vast
hotel and other properties, while Marriott International, rather than owning hotels,
managed them. The purpose of this split was to free Marriott International from the
“baggage” associated with Host Marriott, thus allowing it to be more aggressive in its
pursuit of growth. The following information (in millions) is provided for each
corporation for their first full year operating as independent companies.
Sales
Net income
Total assets
Total liabilities
Stockholders’ equity
Host Marriott
Marriott International
$1,501
(25)
3,822
3,112
710
$8,415
200
3,207
2,440
767
Instructions
(a) The two companies were split by the issuance of shares of Marriott International to all
shareholders of the previous combined company. Discuss the nature of this transaction.
(b) Calculate the debt to total assets ratio for each company.
(c) Calculate the return on assets and return on common stockholders’ equity ratios for
each company.
(d) The company’s debtholders were fiercely opposed to the original plan to split the two
companies because the original plan had Host Marriott absorbing the majority of the
company’s debt. They relented only when Marriott International agreed to absorb a
larger share of the debt. Discuss the possible reasons the debtholders were opposed
to the plan to split the company.
BYP11-5 The January 25, 2005, edition of the Wall Street Journal has an article by Mary
Kissel (on p. C1) titled “Known for Growth, Asian Firms Answer Call of the Dividend.”
Instructions
Read the article and answer the following questions.
(a) What is the “dividend yield”? How does the dividend yield of Asian companies compare to that of companies in other regions?
(b) What has happened to Asian company debt levels in recent years? What implications
has this had for return on equity? Explain why this would be the case.
(c) What measure is used to determine whether a company is paying out a high percentage of its earnings in the form of dividends? What percentage of their earnings
are Asian firms paying out? According to the article, how have the stock prices of
dividend-paying companies performed relative to non-dividend-paying companies?
What explanations are given for this?
FINANCIAL ANALYSIS ON THE WEB
BYP11-6 Purpose: Use the stockholders’ equity section of an annual report and identify the major components.
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Broadening Your Perspective
Address: www.reportgallery.com (or go to www.wiley.com/college/kimmel)
Steps
1. From Report Gallery Homepage, choose Viewing Library.
2. Select a particular company.
3. Choose Annual Report.
4. Follow instructions below.
Instructions
Answer the following questions.
(a) What is the company’s name?
(b) What classes of capital stock has the company issued?
(c) For each class of stock:
(1) How many shares are authorized, issued, and/or outstanding?
(2) What is the par value?
(d) What are the company’s retained earnings?
(e) Has the company acquired treasury stock? How many shares?
Critical Thinking
DECISION MAKING ACROSS THE ORGANIZATION
BYP11-7 In recent years the fast-food chain Wendy’s International has purchased many
treasury shares. From January 3, 1999, to December 30, 2001, the number of shares outstanding has fallen from 124 million to 105 million. The following information was drawn
from the company’s financial statements (in millions).
Year ended
Dec. 30, 2001
Jan. 3, 1999
Net income
Total assets
Average total assets
Total common stockholders’ equity
Average common stockholders’ equity
Total liabilities
Average total liabilities
Interest expense
Income taxes
Cash provided by operations
Cash dividends paid on common stock
Preferred stock dividends
Average number of common shares outstanding
$ 193.6
2,076.0
2,016.9
1,029.8
1,078.0
1,046.3
939.0
30.2
113.7
305.2
26.8
0
$ 123.4
1,837.9
1,889.8
1,068.1
1,126.2
769.9
763.7
19.8
84.3
233.8
31.0
0
109.7
119.9
Instructions
Use the information provided to answer the following questions.
(a) Compute earnings per share, return on common stockholders’ equity, and return
on assets for both years. Discuss the change in the company’s profitability over this
period.
(b) Compute the dividend payout ratio. Also compute the average cash dividend paid per
share of common stock (dividends paid divided by the average number of common
shares outstanding). Discuss any change in these ratios during this period and the
implications for the company’s dividend policy.
(c) Compute the debt to total assets ratio and interest coverage ratio. Discuss the change
in the company’s solvency.
(d) Based on your findings in (a) and (c), discuss to what extent any change in the
return on common stockholders’ equity was the result of increased reliance on
debt.
(e) Do the purchase of treasury stock and the shift toward more reliance on debt appear
to have been wise strategic moves?
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CHAPTER 11
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Reporting and Analyzing Stockholders’ Equity
COMMUNICATION ACTIVITY
BYP11-8 Scott Kreiter, your uncle, is an inventor who has decided to incorporate. Uncle
Scott knows that you are an accounting major at U.N.O. In a recent letter to you, he ends
with the question, “I’m filling out a state incorporation application. Can you tell me the
difference among the following terms: (1) authorized stock, (2) issued stock, (3) outstanding stock, and (4) preferred stock?”
Instructions
In a brief note, differentiate for Uncle Scott the four different stock terms. Write the letter to be friendly, yet professional.
ETHICS CASES
BYP11-9 The R&D division of Renew Corp. has just developed a chemical for sterilizing the vicious Brazilian “killer bees” which are invading Mexico and the southern United
States. The president of Renew is anxious to get the chemical on the market because
Renew profits need a boost—and his job is in jeopardy because of decreasing sales and
profits. Renew has an opportunity to sell this chemical in Central American countries,
where the laws are much more relaxed than in the United States.
The director of Renew’s R&D division strongly recommends further research in the
laboratory to test the side effects of this chemical on other insects, birds, animals, plants,
and even humans. He cautions the president, “We could be sued from all sides if the
chemical has tragic side effects that we didn’t even test for in the lab.” The president answers, “We can’t wait an additional year for your lab tests. We can avoid losses from such
lawsuits by establishing a separate wholly owned corporation to shield Renew Corp. from
such lawsuits. We can’t lose any more than our investment in the new corporation, and
we’ll invest just the patent covering this chemical. We’ll reap the benefits if the chemical
works and is safe, and avoid the losses from lawsuits if it’s a disaster.” The following week
Renew creates a new wholly owned corporation called Offspring Inc., sells the chemical
patent to it for $10, and watches the spraying begin.
Instructions
(a) Who are the stakeholders in this situation?
(b) Are the president’s motives and actions ethical?
(c) Can Renew shield itself against losses of Offspring Inc.?
BYP11-10 Greenwood Corporation has paid 60 consecutive quarterly cash dividends
(15 years). The last 6 months have been a real cash drain on the company, however, as
profit margins have been greatly narrowed by increasing competition. With a cash balance sufficient to meet only day-to-day operating needs, the president, Gil Mailor, has decided that a stock dividend instead of a cash dividend should be declared. He tells Greenwood’s financial vice-president, Vicki Lemke, to issue a press release stating that the
company is extending its consecutive dividend record with the issuance of a 5% stock
dividend. “Write the press release convincing the stockholders that the stock dividend is
just as good as a cash dividend,” he orders. “Just watch our stock rise when we announce
the stock dividend; it must be a good thing if that happens.”
Instructions
(a) Who are the stakeholders in this situation?
(b) Is there anything unethical about president Mailor’s intentions or actions?
(c) What is the effect of a stock dividend on a corporation’s stockholders’ equity accounts?
Which would you rather receive as a stockholder—a cash dividend or a stock dividend? Why?
Answers to Business Insight and Accounting across the Organization Questions
p. 537
Q: In addition to regulatory cost, what is another reason why some owners choose not to
take their companies public?
A: One reason for being a private company is that managers then have more control over
the company’s future. For example, they can make decisions that they feel might be
best for the company over the long-term, and not have to worry about the short-term
stock price implications.
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Broadening Your Perspective
p. 542
Q: For stocks traded on organized stock exchanges, how are the dollar prices per share
established? What factors might influence the price of shares in the marketplace?
A: The dollar prices per share are established by the interaction between buyers and sellers of the shares. The prices of shares are influenced by a company’s earnings and dividends as well as by factors beyond a company’s control, such as changes in interest
rates, labor strikes, scarcity of supplies or resources, and politics. The number of willing buyers and sellers (demand and supply) also plays a part in the price of shares.
p. 545
Q: What signal might a large stock repurchase send to investors regarding management’s
belief about the company’s growth opportunities?
A: When a company has many growth opportunities it will normally conserve its cash in
order to be better able to fund expansion. A large use of cash to buy back stock (and
essentially shrink the company) would suggest that management was not optimistic
about its growth opportunities.
p. 550
Q: What factors must management consider in deciding how large a dividend to pay?
A: Management must consider the size of its retained earnings balance, the amount of
available cash, its expected near-term cash needs, its growth opportunities, and what
level of dividend it will be able to sustain based upon its expected future earnings.
Answer to Tootsie Roll Review It Question 3, p. 556
The cost of Tootsie Roll’s treasury stock in 2004 was $1,992,000. It declared cash dividends of $14,547,000. The stock dividend reduced retained earnings by $57,358,000.
Answers to Self-Study Questions
1. c
2. b
✔
❍
●
3. d
4. c
5. d
6. d
7. b
8. a
9. c
10. b
REMEMBER TO GO BACK TO THE NAVIGATOR BOX ON THE CHAPTER-OPENING PAGE
AND CHECK OFF YOUR COMPLETED WORK.
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