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Chapter 12

Shareholders’ Equity

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How to Finance the Corporation?

Borrow – Notes, Bonds, Leases

– The debt holders are legally entitled to repayment of their principal and interest claims

Issue Equity – Common and Preferred Stock

– The shareholders, as owners, have voting rights, limited liability, and a residual interest in the corporate assets

Retained Earnings

Chapter 12: Shareholders’ Equity

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Relative Importance of Liabilities,

Capital, and Retained Earnings (% of total assets)

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Debt versus Equity

Debt Equity

Formal legal contract No legal contract

Fixed maturity date No fixed maturity date

Fixed periodic payments Discretionary dividends

Security in case of default Residual asset interest

No voice in management Voting rights - common

Interest expense deductible Dividends not deductible

Double taxation

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Interested Party Debt Equity

Investors /

Creditors

Lower investment risk Higher investment risk

Management

Fixed cash receipts Variable cash receipts

Contractual future

cash payments

Dividends are

discretionary

Effects on credit

rating

Effects of dilution/

takeover

Interest is tax

deductible

Dividends are not

tax deductible

Accountants/

Auditors Liabilities section

of the balance sheet

Shareholders’ equity

of the balance sheet

Income statement

effects from debt

No income statement

effects from equity

Distinctions between Debt and Equity

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Preferred Stock vs Common Stock

Preferred Stock Common Stock

Advantages Preference over common in

liquidation

Voting Rights

Stated dividend Rights to residual profits

(after preferred)

Preference over common in

dividend payout

Disadvantages Subordinate to debt in liquidation Last in liquidation

Stated dividend can be skipped No guaranteed return

No voting rights (versus common)

Debt or Equity? Components of both

Usually classified as equity

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Sample Co. Shareholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 Common stock dividends distributable 2,000 Preferred stock, $100 par value, 1,000 shares authorized, 100 shares issued and outstanding 10,000 Paid in capital on common $ 20,000 Paid in capital on preferred 3,000 Paid in capital on treasury stock 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income items (unrealized loss on AFS securities) (2,000) Total Shareholders’ Equity $131,000

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Journal Entries-Sample Co. Now, using Sample Company information,

record the following additional issues of common (CS) and preferred stock (PS):

Issued 100 shares of PS at $102 per share:

Cash (100 x $102) 10,200

PS (100 x $100 par) 10,000

APIC - PS (plug) 200

Issued 500 shares of CS at $5 per share:

Cash (500 x $5) 2,500

CS (500 x $1 par) 500

APIC - CS (plug) 2,000

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Treasury Stock

Created when a company buys back shares of its own

common stock.

Reasons for buyback?

The debit balance account called “Treasury Stock” is reported

in shareholders’ equity as a contra account to SE.

– Note: Treasury Stock is not an asset.

The stock remains issued, but is no longer outstanding.

– does not have voting rights

– cannot receive cash dividends

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

No gains or losses are ever recognized from these equity

transactions.

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TS Example from Sample Co. Look again at the information for Sample Co.

Note that Sample Company has 5,000 shares of TS at a total cost of $6,000, or a cost of $1.20 per share. The journal entry to record that purchase would have been:

TS 6,000

Cash 6,000

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

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Sample Co. Shareholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 Common stock dividends distributable 2,000 Preferred stock, $100 par value, 1,000 shares authorized, 100 shares issued and outstanding 10,000 Paid in capital on common $ 20,000 Paid in capital on preferred 3,000 Paid in capital on treasury stock 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 4,000 22,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Less: Other comprehensive income items (unrealized loss on AFS securities) (2,000) Total Shareholders’ Equity $131,000

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TS - Example Problem Tiger Corporation has 100,000 shares of $1 par

value stock authorized, issued and outstanding at January 1, 2007. The stock had been issued at an average market price of $5 per share, and there have been no treasury stock transactions to this point.

Assume that, in February of 2007, Tiger Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2007, Tiger Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2007, Tiger Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2007 regarding the treasury

stock.

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TS Example -Journal Entries

Feb: repurchase 10,000 sh. @ $7 =

$70,000.

July: reissue 2,000 sh @ $ 8 = $16,000

(cost = 2,000 @ $7 = 14,000)

TS 70,000

Cash 70,000

Cash 16,000

TS 14,000

APIC - TS 2,000

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TS Example -Journal Entries Dec: reissue 8,000 sh. @ $ 6 = $48,000

(cost = 8,000 sh.@ $7 = 56,000)

Now we need to debit one or more accounts to compensate for the difference.

(1) debit APIC -TS (but lower limit is to -0-). (2) debit RE if necessary for any remaining

balance (this is only necessary when we are decreasing equity).

Cash 48,000

APIC - TS (1) 2,000

RE (2) 6,000

TS 56,000

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Retained Earnings

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

RE, beginning (unadjusted) xx Add/Subtract: Prior period adjustment xx RE, beginning (restated) xx Add: net income xx Less dividends: Cash dividends-common xx Cash dividends - preferred xx Stock dividends xx Property dividends xx Less: Adjustment for TS transactions xx Appropriation of RE xx RE, ending xx

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Example of Stock Split

IZM Company has 100,000 shares of $2 par value stock authorized, 10,000 shares issued and outstanding.

The SE section of the balance sheet shows: – Common stock $20,000

– Retained earnings 80,000

The market price of the outstanding shares is $50 per share before the split is distributed.

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Example of Stock Split

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

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

The total SE is still $100,000: – Common stock $20,000

– Retained earnings 80,000

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

Note: No journal entry is necessary.

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Stock Dividends vs Stock Splits Going back to the original IZM information.

Assume instead that IZM declared a 100% stock dividend.

First, prepare the JEs to record the declaration and distribution of the stock dividend for new shares (10,000 shares x 100% = 10,000 new shares x $2 per share = $20,000):

Stock Dividends (RE) 20,000

Stock Div. Distributable 20,000

Stock Div. Distributable 20,000

Common Stock 20,000

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Stock Dividends vs Stock Splits Now note the new description for the stock dividend:

Common stock, $2 par value, 100,000 shares authorized, 20,000 shares issued and outstanding

The total value in SE is still $100,000:

– Common Stock $40,000

– Retained Earnings 60,000

Note that the total market price per share would change to $25 per share.

Thus, a 2 for 1 stock split and a 100% stock dividend have the same effect on:

– total shareholders’ equity and

– market price per share

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Stock Dividends vs Stock Splits To summarize the effects on IZM Company:

100% Stock 2 for 1

After: Dividend Stock Split

Total sh. outstanding 20,000 sh. 20,000 sh.

Par value per share $2 $1

Market price per share $25 $25

Total shareholders’ eq: $100,000 $100,000

General ledger results:

CS account $ 40,000 $ 20,000

RE account $ 60,000 $ 80,000

Reminder: CS was $20,000 and RE was $80,000 before the split or dividend. Since the stock dividend required journal entries, the amounts for CS and RE changed. Since the stock split does not require a journal entry, the amounts for CS and RE do not change.

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Other Comprehensive Income

“Other Comprehensive Income” includes certain direct equity adjustments that are not part of the current income statement, but which may have an eventual effect on income.

We already discussed one of these direct equity adjustments when reviewing Available-for-sale Investments. We found that any unrealized gains/losses from revaluation to market are shown in SE (as “other comprehensive income”) rather than on the income statement.

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Comprehensive Class Problem - Shareholders’ Equity

Given the following SE balances for Company G at 1/1/07: Common stock, $10 par, 50,000 shares authorized, 20,000 shares issued and outstanding $200,000 APIC on common stock 400,000 Retained earnings 400,000 During 2007, Company G had the following activity: 1. Net income for the year was $250,000. 2. Cash dividends of $2 per share were declared and paid on

February 1. 3. On June 1, Company G repurchased 2,000 shares of its

own stock at $20 per share (using the cost method). 4. On December 1, Company G reissued 500 shares of

treasury stock at $18 per share. 5. On December 15, Company G declared a 100% stock

dividend, to be distributed to all of its shareholders (including treasury), on Jan. 15, 2008.

6. At Dec. 31, Company G recorded an AJE to revalue its available for sale investments from $20,000 to $32,000.

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Comprehensive Class Problem - Shareholders’ Equity (continued)

Required: A. Prepare journal entries for items 2 through

6 (item 1 would require detailed information for revenues and expenses to prepare - just know that the credit is to retained earnings for $250,000).

B. the Statement of Stockholders’ Equity for Company G for 2007.

C. Prepare the stockholders’ equity section of the balance sheet for Company G for 2007, including the appropriate description for the common stock.

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Comprehensive Class Problem - Solution

A. Journal entries 1. No entry required. 2. Calc: 20,000 x $2 = 40,000

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

Cash Dividends (RE) 40,000 Dividends Payable 40,000 Dividends Payable 40,000 Cash 40,000

Treasury Stock 40,000 Cash 40,000

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Comprehensive Class Problem - Solution Part A: Journal Entries

4. Calc: 500 shares x $18 market = $9,000 500 shares x $20 cost = $10,000 5. Calc: 20,000 new shares x $10 par = $200,000 Note: in Item 5, the stock has not yet been distributed, so we cannot credit common stock, or show it issued yet. This “Stock Dividends Distributable” account is a related equity account, and indicates that there are shares of stock to be distributed in the future.

Cash 9,000 market Retained Earnings 1,000 plug Treasury Stock 10,000 cost

Stock Dividend (RE) 200,000 Stock Div. Distributable 200,000

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Comprehensive Class Problem - Solution Part A: Journal Entries

6. Calc: value up $12,000 Note that the Unrealized Gain account is part

of shareholders’ equity (not the income statement), and it is located at the bottom of the shareholders’ equity section of the balance sheet, in Other Comprehensive Income (OCI).

AFS Investment 12,000 Unrealized Gain on AFS 12,000

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Comprehensive Class Problem - Solution Part B: Statement of SE (in thousands)

CS CSDD APIC RE OCI TS Balance 1/1/07 $200 $400 $400 Net income 250 Cash dividends (40) Stock dividends $200 (200) Purchase of TS $(40) Reissue of TS ( 1) 10 Revalue AFS Invest. $12 Balance, 12/31/07 $200 $200 $400 $409 $12 $(30) Note: CSDD is Common Stock Dividends Distributable. When

shares are distributed, then CS is increased. Note: OCI is Other Comprehensive Income and reflects the

unrealized gain on Available-for-sale investments.

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Comprehensive Class Problem - Solution Part C: Shareholders’ Equity Section of B/S

Common stock, $10 par value, 50,000 shares authorized, 20,000 shares issued, 18,500 shares outstanding $ 200,000 Common stock dividends distributable, 20,000 shares 200,000 Additional paid-in capital, common stock 400,000 Retained earnings 409,000 Other comprehensive income (unrealized gain on AFS investment) 12,000 Less: Treasury stock, 1,500 shares at cost (30,000) Total shareholders’ equity $1,191,000

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