CHAPTER 12
Shareholders' Equity
SYNOPSIS
In this chapter, the author discusses the theoretical issues and accounting treatment for both
contributed capital and earned capital. Equity is compared and contrasted with debt, and the
economic incentives for raising capital through debt versus equity are discussed. The primary
contributed capital topics discussed are (1) issuing stock; (2) the rationale for a company
repurchasing its own common stock; (3) the cost method of accounting for treasury stock; and
(4) stock options. The primary earned capital topics discussed are (1) dividend strategies, (2)
accounting for dividends, and (3) stock splits.
The ethics vignette considers whether boards of directors acted ethically if it attempted to delay
an inevitable stock price collapse by issuing a stock dividend.
The Internet research exercise examines the main transactions between Kellogg Company and
its shareholders over a three-year period.
The following key points are emphasized in Chapter 12:
1.
The three forms of financing and their relative importance to major U.S. corporations.
2.
Distinctions between debt and equity.
3.
Economic consequences associated with the methods used to account for shareholders'
equity.
4.
Rights associated with preferred and common stock and the methods used to account for
stock issuances.
5.
Distinctions among the market value, book value, and par (stated) value of a share of
common stock.
6.
Treasury stock.
7.
Cash dividends and dividend strategies followed by corporations.
8.
Stock dividends and stock splits.
TEXT/LECTURE OUTLINE
Stockholders' equity.
I. Nature of shareholders' equity.
A.
Stockholders have a residual interest in the company.
consists primarily of:
1.
Stockholders' equity
Contributed capital—contributions from the company's owners.
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2.
B.
II.
Earned capital—measure of the net assets the company generated through its
operations not yet disbursed to the owners as dividends.
The most common forms of business entities are sole proprietorships,
partnerships, and corporations. The primary differences among these three
business forms are:
1.
Liability of the owners.
2.
Income taxes.
3.
Returns to owners.
Debt and equity distinguished.
A.
B.
Characteristics of debt.
1.
Formal legal contract.
2.
Fixed maturity date (as specified in the contract).
3.
Fixed periodic interest payments (as specified in the contract).
4.
Security (i.e., collateral) in case of default (as specified in the contract).
5.
Debt holders have no direct voice in management, but they can influence
management through debt covenants.
6.
Interest is an expense.
Characteristics of equity.
1.
No formal, legal contract.
2.
No fixed maturity date.
3.
Dividend payments are at the discretion of the company's board of directors.
4.
Residual asset interest.
5.
Stockholders have a voice in management through their right to vote for the
board of directors.
6.
Dividends are not an expense.
C. Why is it important to distinguish debt from equity?
1.
Debt vs. equity: the capital provider's perspective.
2.
Equity: higher risk.
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3.
Equity: higher returns.
D. Debt vs. equity: Management's perspective.
E.
1.
Debt: contractual restrictions.
2.
Debt: less expensive.
3.
Equity: dilution of ownership.
Debt vs. equity: The accountant's and auditor's perspective.
III. The economic consequences associated with accounting for shareholders' equity.
A.
Effects of financial ratios.
B.
Managing the debt to equity ratio.
C. Strengthening the balance sheet.
D. Restrictions on dividend payments.
E.
Interests of creditors.
IV. Accounting for shareholders' equity.
A.
Contributed capital.
1.
Authorized, issued, and outstanding shares.
a) Authorized shares represent the number of shares of stock that the
company is legally entitled to issue as stated in the corporate charter.
b) Issued shares represent the total number of shares that have been
distributed by the company and not retired. Issued shares equal the shares
outstanding plus shares held in treasury.
c). Outstanding shares represent the shares currently held by shareholders.
2.
Market value, book value, par value, and stated value.
a) Market value is the value at which the stock is currently trading on the open
market.
b) Book value represents shareholders' equity per share of common stock
outstanding. Book value is computed as: (Stockholders' equity - Preferred
capital) ÷ Number of common shares outstanding.
c) Market-to-book ratio.
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i.
The market-to-book ratio is computed by dividing the market value
of a company's common stock by its book value.
ii.
Ratios equal to 1 indicate that a company's net book value (as
measured by the balance sheet) is perceived by the market to be a
fair reflection of the company's true value. Ratios larger than 1
indicate that the balance sheet is perceived to be conservative.
d) Par (or stated) value.
B.
i.
Par value is a legal concept and was created to protect creditors. It
no longer has significant economic or legal meaning.
ii.
Owners' contributions in excess of par value are allocated to
additional paid-in capital.
Preferred stock.
1.
Preferred as to dividends.
2.
Preferred as to assets.
3.
Preferred stock is usually issued with a par value. Dividends on preferred
stock are either stated as a dollar amount or as a percentage of par value.
4.
Preferred shareholders are entitled to certain preferences (such as on
dividends and assets) over common shareholders. In exchange for these
preferences, preferred shareholders usually sacrifice certain rights, such as
the right to vote for board members.
5.
Characteristics of preferred stock.
a) Cumulative versus noncumulative.
b) Participating versus nonparticipating.
6.
Preferred stocks: debt or equity?
C. Earned capital.
1.
Retained earnings
2.
Accumulated comprehensive income
D. Common stock.
1.
Fundamental rights of common shareholders.
a) Right to receive dividends declared by the board of directors.
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b) Right to share proportionately in residual corporate assets in the event of
liquidation.
c) Right to exert control over management.
V.
2.
Common stock is the riskiest ownership interest.
3.
Market value.
4.
Book value.
5.
Market-to-book ratio.
6.
Par value
Accounting for common and preferred stock issuances.
A.
B.
Recording stock issuances
1.
No-par value stock.
2.
Par value stock.
Repurchasing stock—treasury stock.
1.
Treasury stock is not considered an asset.
2.
Reasons companies repurchase common stock.
3.
a)
To provide a sufficient number of shares to support employee
compensation plans.
b)
To concentrate ownership of outstanding shares to make it more difficult
for a takeover.
c)
To increase the market price of a company's outstanding stock.
d)
To increase the company's earnings per share.
e)
To retire preferred or common stock. Once common stock has been
retired, the shares are considered authorized but not issued.
Accounting for treasury stock.
a)
Cost method.
(1)
The cost method is the more common method used to account for
treasury stock. Under GAAP, using the cost method is appropriate
if the company intends to eventually reissue the shares.
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(2)
The treasury stock account has a debit balance and is disclosed in
the shareholders' equity section after retained earnings.
(3)
When purchasing treasury stock, Treasury Stock is debited and
Cash is credited for the cost of the shares.
(4)
Reissuing treasury stock for more than acquisition cost.
(a) Treasury Stock is credited for the cost of the shares reissued.
(b) The excess received over the acquisition cost is credited to
Additional Paid-in-Capital, Treasury Stock.
(5)
Reissuing treasury stock for less than acquisition cost.
(a) Treasury Stock is credited for the cost of the shares reissued.
(b) The excess of acquisition cost over proceeds is debited to
Additional Paid-in-Capital, Treasury Stock. If its account
balance is insufficient to absorb the entire excess, the residual
excess is debited to Retained Earnings.
b)
Par value method - acceptable under GAAP but not widely used.
C. Stock options.
1.
Stock options give the right to purchase equity securities at a fixed price over a
specified time period. Stock options are widely used as a form of executive
compensation.
2.
No compensation expense is recorded when granted (except when options
are granted at prices below the current market price). An issuance of common
stock is recorded when options are exercised.
3.
Disclosure is required of the amount of compensation expense that would
have been recorded if the value of the options granted during the year was
recognized.
VI. Retained earnings.
A.
Dividends.
1.
Dividend strategies.
2.
Important dates.
a)
Date of declaration—the date that the board of directors declares a
dividend and the company incurs a liability for the dividend.
b)
Date of record—the legal owner of the stock on this date is the person or
entity entitled to the dividend.
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c)
Date of payment—the date that the company pays the dividend.
3.
The dividend account is a temporary account that is closed directly into
retained earnings during the closing process.
4.
Cash dividends.
5.
Stock dividends and stock splits.
a)
Stock splits.
(1)
A company issues additional shares of common stock to its
shareholders and splits the outstanding shares into smaller units.
(2)
Stock splits cause the number of shares classified as outstanding to
change and the par value per share and market value per share to
change. These changes are documented in a memorandum entry.
However, the total value of the shares outstanding should,
theoretically, remain the same.
b). Stock dividends.
(1)
A company issues additional shares of common stock to its
shareholders as a dividend. No assets are distributed to the
shareholders.
(2)
After the stock dividend, each shareholder retains the same
percentage of ownership interest in the corporation.
(3)
Ordinary stock dividends.
(a) A stock dividend should be accounted for as an ordinary stock
dividend if the number of additional shares to be issued is less
than 25 percent of the shares outstanding prior to the stock
dividend.
(b) An amount equal to the fair market value of the common stock
issued is allocated from retained earnings to the common stock
and additional paid-in-capital accounts.
(4)
Stocks splits in the form of a stock dividend.
(a) A stock dividend should be accounted for as an ordinary stock
dividend if the number of additional shares to be issued is
greater than 25 percent of the shares outstanding prior to the
stock dividend.
(b) An amount equal to the par value of the stock is allocated from
retained earnings to the common stock account.
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c)
B.
Reasons companies declare stock dividends and stock splits.
(1)
To reduce the market price per share.
(2)
Publicity gesture.
(3)
To capitalize a portion of retained earnings.
Appropriations of retained earnings.
1.
A book entry partitioning retained earnings into restricted and unrestricted
retained earnings.
2.
Appropriated retained earnings arise from either the board of directors'
discretion or the terms of debt covenants.
C. Negative retained earnings.
1.
The retained earnings account is negative if a company's accumulated net
losses plus dividends from previous years exceeds the accumulation of its
past profits.
2.
Negative retained earnings (deficits) generally indicate serious problems
because they indicate losses. In today's changing environment there are
notable exceptions of start-up, high-tech, and Internet companies with
accumulated deficits, yet the companies enjoy favorable stock prices,
reflecting the market's confidence in their future prospects.
D. Retained earnings and prior period adjustments.
1.
Few items are booked directly to retained earnings. These include net income
(loss), dividends, appropriations, and certain treasury stock transactions.
2.
Additionally, correction in the current period of a prior period’s accounting error
is made by adjusting the misstated asset and/or liability, with a corresponding
and offsetting adjustment to retained earnings. The entry to retained earnings
is called a prior period adjustment.
VII. Statement of shareholders' equity.
VIII. International perspective: the rise of international equity markets.
IX. ROE exercise: return on equity and value creation.
X.
ROE analysis
XI. Review problem
XII. Ethics in the real world.
XIII. Internet research exercise.
Chapter 12
LECTURE TIPS
1.
A conceptual understanding of why companies would repurchase their own stock and why
treasury stock reduces shareholders' equity (as opposed to being an asset) needs to be
developed. End-of-chapter issues for discussion 12–3, 12-4, and 12–12 and 12-15 are
helpful in developing this understanding. Accounting for treasury stock can be
demonstrated with examples such as provided by end-of-chapter exercises 12–4 through
12–8 and problems 12–2 and 12–13.
2.
Students usually need extra help in understanding why a company would declare either a
stock split or a stock dividend (and the economic difference between the two) as a basis for
understanding how to account for each. It should be stressed that the differences in
accounting for stock dividends and stock splits arise from the legal differences between the
two. End-of-chapter exercises 12–14 and 12–15, problems 12-4, 12-7 and 12–9, and issue
for discussion 12–1, and the ethics vignette at the end of the chapter are useful for this
demonstration.
ANSWERS TO IN-TEXT DISCUSSION QUESTIONS
541.
The information presented indicates that Amazon.com owed its creditors investors a
total of $5.6 billion, of which $4.8 billion was current as of year-end 2008. The current
liabilities would include the current amount of long-term liabilities as well as accounts
payable and accrued expenses. Contributed capital of $3.4 billion represents the amount
that was raised from shareholders. The negative retained earnings of $.73 billion arose
from Amazon’s unprofitable operations since inception.
543.
Interest incurred is a financing cost (versus an operating cost) and is deducted as an
expense on the income statement. Dividends are not considered a component of net
income, but rather represent a distribution of net income to shareholders. Therefore
dividends are deducted directly from retained earnings and do appear on the income
statement.
545.
From the perspective of an investor or creditor, bonds represent a lower investment risk
than stocks, and enjoy a fixed amount of cash receipts (contractual interest and principal
payments) determined by the bond instrument, if the instrument is held to maturity. This
safety and certainty is in contrast to equity investments which pose a higher investment
risk, and uncertain cash receipts in the form of discretionary dividends and stock
appreciation.
545.
Internet companies such as Google are inherently risky (especially when they are just
starting up) and debt in the capital structure only serves to magnify that risk. With no
debt, the company could build a stronger credit rating and gain some future financial
flexibility. Debt instruments require contractual future cash payments of interest and
principal, whereas equity does not, given that dividend payments are discretionary.
Equity investors do not expect dividends from internet companies, but rather expect
earnings to be retained for future growth. Also, debt instruments often involve restrictive
covenants by which Google’s management may not want to be constrained.
546.
The effect on the accounting equation of each form of honeywell’s payment to capital
providers is shown below:
Chapter 12
ASSETS
=
LIABILITIES
+SHRHLDR’ EQ
Interest:
-$456 million
-$456 million (Exp; RE)
Reduction of debt:
-$754 million
Repurchase stock:
-$1.459 billion
-$1.459 billion (contra SE)
Dividends
-$811 million
-$811 million (-RE)
-$754 million
Interest on debt is considered a cost of doing business and is treated a deduction in
arriving at net income. Repayments of outstanding debt are a reduction of a liability.
Dividends are a distribution of net income to shareholders and are deducted directly
from retained earnings; dividends do not appear as expenses in the income statement.
Common stock repurchases are also a form of return to shareholders, but not on a prorata basis as in the case of dividends. If shares are retired, common stock, additional
paid in capital, and possibly retained earnings are reduced. If repurchased shares are
held in the treasury for possible reissuance, the reduction is in the form of an increase to
a contra account that offsets shareholders’ equity. A company does not have an
investment in itself; treasury shares are not assets.
547.
If Proctor & Gamble issued equity on the last day of the year, the denominator in the
formula for return on equity would increase, and the return percentage itself would
decrease. In the case of both share repurchases and dividend payments, the
denominator would decrease, and the return on equity percentage would increase.
Analysts who especially value return on equity as an important measure of corporate
performance must be alert to a company’s ability to “manage” the return on equity.
Management discretion over the timing of transactions (share issuances and
repurchases, and dividends) which affect the formula used to compute return on equity.
548
The US government injected $70 billion into Citigroup to prop it up and keep if from
failing. This investment was recorded as preferred stock. The TARP funds were
returned before the end of 2009. Without getting into the details of the terms of the
preferred stock investment, it is probable that there were significant promises made by
Citigroup to the US government in connection with this preferred stock. The political
ramifications of the $700 billion TARP bailout will effect the political and economic
landscape of the US for years.
549.
Preferred shareholders would insist on a policy such as the one described for Sears.
Preferred shareholders generally receive specified annual dividends and have rights in
liquidation, both of which have priority over claims of common shareholders. In
exchange for those preferences, preferred stock is usually non-voting. As a protection to
their interests, preferred shareholders would insist on provisions for cumulative
dividends, with priority over common dividends, and the right to vote if dividends are
missed for an extended period of time.
551.
Preferred stocks are hybrid securities which have characteristics of both debt and equity.
“Mandatorily redeemable preferred stock” is preferred stock that has a mandatory
redemption feature that is outside of the control of the issuing corporation. In this case,
the preferred shareholders must be “paid back” as in the case of debt. This feature
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would lead to the conclusion that the preferred stock has more closely resembles debt,
and should be classified as such in the balance sheet.
551.
The $100 paid for the shares in the initial public offering went to Google. Investors who
purchased their shares in the IPO and held them until February 25, 2010 had a
cumulative (net) unrealized gain of $426.43 as of February 25, 2010, but only those that
actually sold their shares had a trading profit. The other shareholders have an unrealized
gain, but not a trading profit. The company does not directly benefit from the increase in
it's share prices but the indirect benefits are many. The success of the enterprise, as
manifested by the increased share price has numerous positive effects on employees,
creditors, shareholders and other stakeholders. Those holding stock (and stock options)
in the company benefit directly. One of the benefits to the company is that future stock
sales will generate market interest, bringing a higher price and making it easier to raise
capital when needed.
552.
Par value, or stated value, of a share of common stock is a legal rather than an
economic concept, and is often only an arbitrary, nominal value. JP Morgan Chase's par
value is only $1.00 per share. Book value per share represents the total stockholders’
equity on the books (minus any preferred capital), divided by the number of common
shares outstanding. Market value per share is the price for which a share of stock may
be exchanged on the open market. The marketplace takes into account factors such as
a company’s future earnings prospects, interest rates, and so, in arriving at a market
price. The market price is often larger than book value, reflecting changes in asset
values not recognized in the accounts, both for tangible assets, notably land and
buildings, and for intangibles such as goodwill.
553.
When Jet Blue issued the shares, cash increased by $182.4 million (15.2 million shares
at $12 per share), and shareholders’ equity (common stock and additional paid-in
capital) increased by a like amount. The amount of the increase that was allocated to
common stock was $152,000 ($.01 per share) and the amount allocated to additional
paid-in capital was $182,248,000.
555.
A company would buy back its own stock for a variety of reasons, the most common of
which is to support employee compensation plans. By buying back shares for reissuance
in compensation plans, a company avoids the dilution that would otherwise occur if new
shares were issued. A company may also use stock repurchases as a takeover defence,
to deploy excess capital, or to increase its stock price by reducing dilution.
556.
The capital structure leverage computations for 2007 and 2009 are as follows:
In billions of $
Total
Shareholders'
Leverage
Assets
Equity
(Assets/Equity)
2007
80.9
43.3
1.87
2009
94.6
50.5
1.87
Proforma
108.9
64.6
1.69
As can be seen in this example, the decision to purchase treasury stock had the effect of
increasing the company's leverage. The relationship between total assets and total
equity would have resulted in a lower leverage ratio, had the company kept its cash and
left it's equity section alone. The increased leverage helps to improve earnings per
share, earnings on assets, and return on equity.
Chapter 12
557.
Boston Scientific must have received cash of $90 million from the sale of the treasury
shares, which was below the original cost of the shares. The $142 million represents the
cost of the treasury shares, and the $52 million decrease in additional paid-in capital
represents the difference between the proceeds and the cost. The reissuance price was
below the original cost of the treasury stock. This transaction would be reflected on the
statement of cash flows as a financing transaction providing cash flows of $90 million.
in millions of $
ASSETS
CASH
T stock repurchase
+$90 million
=
+SHRHLDRS’ EQ
PD IN CAP
- $52
T-STOCK
+$142
Note: The $142 reduction in the treasury stock account is an addition in this analysis
because treasury stock is a contra account, offsetting the other equity accounts.
559.
Stock options and other forms of equity-based pay are used by many corporations in
their incentive compensation plans for their executives. These items are treated as
expenses in the financial statements of the corporations that have such compensation
plans. Backdating stock options is a crime that benefits the executives that received the
options and is a theft of money from the shareholders.
560.
The goals of a corporation and its nature will be reflected in its dividend policy. Young
growing companies rarely pay dividends. They need to use the profits they generate to
fund their continued growth. Shareholders of these corporations expect to be rewarded
with increases in the market price of their shares as the business grows and becomes
ever more profitable. Such companies are referred to a “growth companies”. Mature
companies are much more likely to pay dividends consistently. Shares in dividend
paying corporations are known as “income” stocks.
Cisco Systems has the
characteristics of a “growth company”. Stock in Intel has the characteristics of an
“income stock”. Microsoft appears to be making the transition from a growth company to
a mature, dividend paying corporation.
562.
In a stock split, the number of outstanding shares is simply “split” into smaller units, and
the corporation distributes additional shares. Concurrent with a split, the price of the
stock goes down proportionately. For instance, in a 2 for 1 split, a shareholder would
have two shares rather than the original one, but the price per share would be one-half
of the pre-split price. Stock splits serve to reduce the per-share price of the outstanding
shares so that small investors can more easily afford to purchase them. The suggested
5:1 split of Google would have resulted in 5 shares valued at $114 replacing each share
previously valued at $570.
563.
Neither a large stock dividend nor a stock split has any effect on the basic accounting
equation. Assets and liabilities are not affected; only the details within the shareholders’
equity section are changed. Stock dividends provide extra shares to shareholders
without requiring the payment of cash. The benefit to shareholders is largely
psychological rather than economic. A stock split (or a large stock dividend) reduces the
per-share price of shares so that small investors can more easily purchase them
(especially a round lot of 100 shares). In both stock dividends and stock splits, the
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shareholder has the same proportionate interest in the corporation after the dividend or
split as before.
565.
Yahoo may be well-known, but that does not mean that they were profitable in their startup years. The $50 million deficit in retained earnings at the beginning of 2002 consisted
of Yahoo’s accumulated losses since inception. For that deficit to have been reduced to
$7.5 million by year-end 2002, Yahoo must have reported a profit for 2002 of $42.5
million, followed by a profit for 2003 of $237.5 million.