Learning Objectives for Owners Equity

1
Learning Objectives for Owners Equity

• Understand the assumptions made about what we
  mean by the firm and how that affects rules for
  income measurement.
• Understand the accounting for issuance of stock
  and related securities.
• Understand why firms issue preferred stock, the
  various features of preferred stock and how to
  account for its issue.
• Understand why companies repurchase their own
  stock.
• Understand the accounting for treasury stock
  transactions.
• Understand the accounting for cash, property, and
  stock dividends, and for stock splits.
• Understand the complexities of financial
  instruments that have attributes of both debt and
  equity and how they should be classified

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Issuing Stock

• Shares of stock
• Authorized approved by the state
• Issued have been sold to shareholders
• Outstanding still held by shareholders
• Record stock at the value of what you received
  for the stock.
• Credit Common Stock for par value
• Credit Additional Paid in Capital for the rest

3
Dividends

• If a company has retained earnings, it can
  distribute earnings to shareholders
• Retained Earnings is accumulated Net Income -- it
  does not reflect the cash available
• At declaration date, dividends reduce retained
  earnings, with offsetting credit to dividends
  payable.
• At distribution date, dividends payable is closed
  out with a credit to cash.

4
Stock Dividend

• Dividend distributed by issuing more stock
• Shareholders receive additional shares of stock
  in proportion to existing holdings
• Really just reclassifying earned capital to
  contributed capital

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Small vs Large Stock Dividend

• For a small stock dividend (value of the stock is transferred from Retained
  Earnings.
• For a large stock dividend (25), the par value
  of the stock is transferred from Retained
  Earnings.

6
Stock Split

• A company may declare a stock split in order to
  reduce the market value of its stock to make it
  more affordable to investors
• A stock split
• (1) increases the number of shares outstanding
• (2) decreases the par value of the stock

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Additional Points on Stock Splits

• There is no journal entry made for stock splits -
  only a memo noting the change in shares and par
  value
• There is really no difference between a 2-for-1
  stock split and a 100 stock dividend. However,
  an entry is made for a dividend but not for a
  split

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Repurchasing and Retiring Stock
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Treasury Stock

• Treasury stock is shares of stock reacquired by a
  firm
• Treasury stock does not receive voting rights,
  dividends or any distributions of assets upon
  liquidation
• Treasury stock is not considered outstanding

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Why Repurchase Stock?

• bonus plans - need stock to distribute
• increase market value of stock
• profit not taxable
• avoid takeovers
• return assets to shareholders
• exercise of employee stock options
• signal investors that stock is underpriced

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Repurchases

• Ikenberry, Lakonishok and Vermaelen (1998) shows
  that an investor can earn 24 abnormal returns
  over 36 months after the announcement of a stock
  buyback.

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. But only about 1/3 of the announced buybacks
ever get completed.

• Power (WSJ, 1995)

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Treasury Stock Journal Entries

• Record purchase of treasury stock at its purchase
  price
• When reissued, remove treasury stock at its cost
• May need a flow assumption (FIFO, LIFO, etc.)
• Gains/losses are not recognized in income and are
  not taxed.

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Retirement of Stock

• Retirement of stock occurs when a company buys
  the stock and cancels the stock certificate.
• The number of shares issued decreases. The stock
  cannot be resold.
• The company must remove the capital account and
  all accounts related to the stock.

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Stock Retirement Example

• Nordstrom retires 1000 shares of 1 par common
  stock that was issued for 18 a share. Nordstrom
  pays 12 a share.
• Common Stock 1,000 (1000 x 1)
• Addl Paid in Capital 17,000 (1000 x 17)
• Cash 12,000 (1,000 x 12)
• APIC - retirement 6,000

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Stock Retirement

• If the company pays more to retire the stock than
  what it received when the stock was issued,
  Retained Earnings is debited for the difference.

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Understanding the Accounting for Owners Equity

• What do we mean when we say the firm, and why
  does it matter?

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Why are some increases/decreases in equity
considered income while others are not?

• Its not a natural or economic law.
• It depends on how you think about the firm.
• The rules are based on assumptions about who is
  the firm.

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The Entity View of the Firm

• One perspective (assumption) the entity view
• Assets Liabilities Owners Equity
• The firm is its assets.
• It doesnt matter what portion of those assets is
  claimed by creditors and what portion is claimed
  by owners.

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The Proprietary View of the Firm

• A different perspective (assumption)
• Owners equity Assets Liabilities
• The firm is the owners.
• This is the perspective adopted by most of GAAP.

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Question Can the firm earn income by buying
and selling its own stock?
Answer It depends on how you define the firm.
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Income Measurement

• The entity view The point of income measurement
  is to explain changes in assets that arise from
  transactions with parties outside the firm.
• The proprietary view The point of income
  measurement is to explain changes in equity that
  arise from transactions with parties outside the
  firm.

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So, is it income when treasury stock is sold for
a profit?

• Entity view
• Yes ... the transaction is between the firm and
  outsiders, and assets have increased.
• Proprietary view
• No the transaction is between the firm and
  its owners, who are one and the same, despite the
  fact that assets have increased.

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Should dividends be expenses?

• It depends on your perspective
• Entity view
• Yes. Dividends are payments to capital suppliers
  (outside the firm) that reduce assets.
• Proprietary view
• No. Dividends are payments to owners (who are
  the firm).

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Are there other possible perspectives?

• What if the firm was defined as its employees?
  Its creditors? Others?
• Employees
• Employees Liabilities Equity non-employee
  assets
• Income statement
• Interest (payments to creditors) and dividends
  (payments to equity investors) are expenses
• Wages and salaries (and benefits) are not
  expenses
• Net income is a residual that belongs to the
  employees.
• Balance sheet
• equity would be the residual claim to assets
  held by employees.

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Which perspective is right?

• Its not a natural or economic law that says that
  shareholders are most importantits assumptions.
• The FASB has adopted the proprietary view in the
  past.
• Do you agree with this view?
• How would we decide?
• Fairness?
• Who are the most important users of the financial
  statements?
• Relative contribution to the firms activities?

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Conclusions

• Perspectives on the firm stem from assumptions
  about who is most important.
• These assumptions lead to accounting policies
  that may or may not make sense when you question
  the assumptions.
• None of the perspectives is right or wrong
  it depends upon your point of view.