Chapter 12: Stockholders

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Chapter 12: Stockholders

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Title: Chapter 12: Stockholders

1
Chapter 12Stockholders Equity
2
Chapter 12 Stockholders Equity

1. Debt versus equity
2. Preferred stock
3. Common stock
4. Accounting for preferred and common
5. Treasury stock
6. Stock options
7. Retained earnings
- dividends
- appropriations
- prior period adjustments
8. Comprehensive income
9. Statement of stockholders equity

3
1. Debt versus Equity
4
2. Preferred Stock

Advantages
Preference over common in liquidation
Stated dividend
Variety of features regarding dividends
Preference over common in dividend payout
Disadvantages
Subordinate to debt in liquidation
Stated dividend can be skipped
No voting rights (versus common)
Debt or equity?
components of both
usually (but not always) classified with equity

5
3. Common Stock

Advantages
Voting rights
election of board of directors
vote on significant activities of management
Rights to residual profits (after preferred)
Disadvantages
Last in liquidation
No guaranteed return

6
4. Accounting for Common Stock (CS) and
Preferred Stock (PS)

Par value - initially established to create a
minimum legal capital.
Ex Minimum legal capital in some states is
1,000 for new corporations, so issue
1,000 shares at 1par, or
100 shares at 10 par, or other combination. . .
Par value is not market value.
Credit CS or PS for par value.
Excess over par credited to Paid in Capital in
Excess of Par or Stated Value or abbreviated
Additional Paid-in Capital (APIC).
Some newer stock issues (for common stock) are
no par stock.

7
4. Journal Entries

Issue PS at greater than par value
Cash xx mkt. value
Preferred Stock xx total par
APIC - PS xx excess(plug)
Issue CS at greater than par value
Cash xx mkt. value
Common Stock xx total par
APIC - CS xx excess(plug)
Note most states do not allow companies to issue
at less than par value.

8
4. Journal Entries -continued

Issue no par common stock
Cash xx mkt. value
Common Stock xx mkt. value
Note Many companies have newer stock issues
that are no par, but most companies still have
older stock issues which contain a par value and
APIC.
The Stockholders Equity section of the balance
sheet of Sample Company (yellow handout)
illustrates many of the components of SE
discussed in this chapter.

9
Sample Co. Stockholders 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 Stockholders Equity 131,000

10
4. Journal Entries-Sample Co.

Now, using Sample Company information, record the
following additional issues of common and
preferred stock
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

11
5. Treasury Stock

Created when a company buys back shares of its
own common stock.
Reasons for buyback
reissue to employees for compensation.
hold in treasury (or retire) to increase market
price and earnings per share.
reduce total dividend payouts while maintaining
per share payouts.
thwart takeover attempts by reducing proportion
of shares available for purchase.
give cash back to existing shareholders.

12
5. Treasury Stock - continued

The debit balance account called Treasury Stock
is reported in stockholders equity as a contra
(reduces SE). Note 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.

13
5. Treasury Stock(TS) - Journal Entries

There are two techniques for recording TS
transactions (Par Value method and Cost method).
We will use only the Cost method. This technique
establishes a cost for TS equal to the amount
paid to acquire the TS. Par value is not used
for TS transactions.
To record purchase of TS from market
TS xx cost
Cash xx market
(cost equals the cash paid)

14
5. Treasury Stock(TS) - Journal Entries

To reissue TS to market at greater than cost
Cash xx market
APIC - TS xx over cost
TS xx cost
To reissue TS to market at less than cost
Cash xx market
APIC - TS xx if available
Retained Earnings xx if needed
TS xx cost
debit RE if no APIC-TS available to absorb the
remaining debit difference.

15
5. 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.

16
Sample Co. Stockholders 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 Stockholders Equity 131,000

17
5. TS - Example Problem

Tiger Corporation has 100,000 shares of 1 par
value stock authorized, issued and outstanding at
January 1, 2005. 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 2005, Tiger Corp.
repurchases 10,000 shares of its own stock at 7
per share. In July of 2005, Tiger Corp.
reissues 2,000 shares of the treasury stock for
8 per share. In December of 2005, Tiger Corp.
reissues the remaining 8,000 shares for 6 per
share. Prepare the journal entries for 2005
regarding the treasury stock.

18
5. TS Example -Journal Entries

Feb repurchase 10,000 sh. _at_ 7 70,000.
July reissue 2,000 sh _at_ 8 16,000
(cost 2,000 _at_ 7 14,000)

19
5. TS Example -Journal Entries

Dec reissue 8,000 sh. _at_ 6 48,000
(cost 8,000 sh._at_ 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).

20
6. Employee Stock Options

Stock options represent the right of the holder
to purchase common stock at a designated price,
and during a designated time frame.
Stock options are given to employees as a means
of compensation.
Historically, two kinds of employee stock options
(compensation is defined at the date of grant)
compensatory, because the exercise price is below
the market price at the date of grant.
noncompensatory, because the exercise price is
equal to the market price at the date of grant .

21
6. Employee Stock Options

APB Opinion 25 states that compensation is
measured at the date of grant (market price -
exercise price), and any difference is allocated
to compensation expense over the life of the
option. If there is no difference, there is no
comp. expense.
The APB Opinion 25 method is known as the
intrinsic value method, because it measures the
value of the stock options at the date of grant
(the intrinsic value at inception).
This method has been the default method for
recording employee stock options, even after SFAS
123 (discussed later) was issued.

22
6. Stock Options- APBO 25

Given the following information Em Company
adopted a stock option plan that granted options
to employees to purchase 30,000 shares of the
companys 10 par value common stock. The
options were granted on January 2, 2005, and were
exercisable 2 years after the date of grant if
the employee was still employed at the company.
The exercise price was set at 40 in the option
contract. At the date of exercise January 2,
2007, the market price was 80 per share.

23
6. Stock Options - Illustration 1

Illustration 1 (intrinsic value method) Assume
the market price at the date of grant was 45 per
share. Therefore, the stock options are
compensatory, and total compensation expense is
measured as 45 mkt - 40 exercise 5 per
share x 30,000 shares 150,000.
Since total compensation expense 150,000, we
will recognize it over the life of the option
(150,000 / 2 75,000 per year).
For 2005
Compensation expense 75,000
APIC - stock options 75,000
For 2006
Compensation expense 75,000
APIC - stock options 75,000

24
6. Stock Options - Illustration 1

Note that, for the previous entries, the company
is not paying the employees with cash, it is
paying the employees with the promise of equity.
Also, the employee is contributing time in
exchange for future equity (thus the credit to
APIC as the employee pays in time). Now, when
the options are exercised at Jan. 2, 2007, at the
exercise price of 40 per share
Cash (40 x 30,000) 1,200,000
APIC - stock options 150,000
Common stock (10 x 30,000) 300,000
APIC - common stock (plug) 1,050,000
Note that, even though the market price of the
stock at 1/2/07 is 80 per share, the transaction
is recorded at the market price at the date of
grant (45 per share). The company never
recognizes the additional value that it has
given to the employees.

25
6. Stock Options - Illustration 2

Illustration 2 (intrinsic value method) Assume
the market price at the date of grant was 40 per
share. Therefore, the stock options are
noncompensatory, and total compensation expense
is measured as40 mkt - 40 exercise -0-
(Since total compensation expense -0-, no
expense is recognized on the options, not now,
not ever.)
For 2005
Compensation expense -0-
APIC - stock options -0-
For 2006
Compensation expense -0-
APIC - stock options -0-

26
6. Stock Options - Illustration 2

Now, when the options are exercised at Jan. 2,
2007, at the exercise price of 40 per share
Cash (40 x 30,000) 1,200,000
APIC - stock options -0-
Common stock (10 x 30,000) 300,000
APIC - common stock (plug) 900,000
Most stock options have been issued as
noncompensatory at the date of grant, primarily
to avoid the recognition of compensation
expense.
Note that, even though the market price of the
stock at 1/2/07 is 80 per share, the transaction
is recorded at the market price at the date of
grant (40 per share). The company never
recognizes the additional value that it has
given to the employees.

27
6. Stock Options and SFAS No. 123

In 1993 (its second attempt), the FASB tried to
rectify the lack of recognition of compensation
expense in the financials for noncompensatory
options. It proposed that companies estimate
the present value of the future cash flows that
was being promised to employees, then recognize
that estimate as compensation expense over the
life of the contract.
There were many protests, particularly in the
high tech industry, where employment and growth
were tied heavily to stock options.

28
6. Stock Options and SFAS No. 123

The FASB eventually modified the standard, so
that SFAS 123 recommended recognition of expense
in the financial statements for noncompensatory
(as well as compensatory) stock option plans.
However, it allowed companies to continue using
the APB Opinion 25 method for recording expense
in the financials.
The SFAS 123 technique is known as the fair value
method.
Illustration 3 shows the recommended journal
entries using SFAS 123.

29
6. Stock Options - Illustration 3

Illustration 3 (fair value method) Assume the
market price at the date of grant was 40 per
share, and the stock options are, therefore,
noncompensatory. However, compensation expense is
estimated using the Black-Scholes option pricing
model (other models are acceptable), and the
present value of the estimated total compensation
expense (based on the projected market price at
exercise) is 200,000.

30
6. Stock Options - Illustration 3

Basically, the pricing model assumes a number of
factors which could affect the growth in the
price of the stock, and also incorporates
probabilities for the number of employees that
would actually exercise the option.
Since total compensation expense 200,000, we
will recognize it over the life of the option
(200,000 / 2 100,000 per year).

31
6. Stock Options - Illustration 3(SFAS 123
recommended journal entries)

For 2005
Compensation expense 100,000
APIC - stock options 100,000
For 2006
Compensation expense 100,000
APIC - stock options 100,000
Jan. 2, 2007
Cash (40 x 30,000) 1,200,000
APIC - stock options 200,000
Common stock (10 x 30,000) 300,000
APIC - common stock (plug) 1,100,000
Note that, even though the market price of the
stock at 1/2/07 is 80 per share, the transaction
is recorded at the PV of the estimated future
price at the date of exercise (46.67 per share).
The company never recognizes the additional
value that it has given to the employees.

32
6. Stock Options and SFAS No. 123

However, if companies chose not to recognize the
expense in the income statement, SFAS 123 also
required that companies disclose the pro forma
effect on net income, as if the estimated
compensation expense had been recognized.
Since the issue of SFAS 123, most companies have
chosen to disclose, rather than accrue,
compensation expense.
The disclosure helped the financial statement
reader to ascertain several things
what income would have been if SFAS 123 had been
fully implemented.
how much equity the company is promising to the
employees.

33
6. Stock Options and Recent Changes

In 2003 and 2004, many companies began
voluntarily recording option compensation as an
expense on the income statement. There were
several reasons, including the desire to be more
transparent with shareholders.
FASB has approved a standard that will
tentatively become effective mid-2005, and will
require the recognition of expense through
journal entries, using the fair value method.

34
6. Stock Options and Expense Recognition

Should compensation expense be recognized in the
financial statements?
Proponents say yes
It is a cost to the company of employing the
workers.
If the company had issued stock, then paid the
employees in cash, the amount would have been
recognized as comp. expense.
Opponents say no
The employee is essentially working as an owner
of the company, and contributing sweat equity
owners do not receive salary distributions.
If companies had to recognize expense, they would
stop offering stock options.
Options are given as work incentives, rather than
straight compensation. Remember the value can
go down as well as up (unlike traditional
compensation).

35
7. 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

36
7. RE - Cash Dividends

As cash dividends are declared
Dividends (RE) - common xx
Dividends (RE)- preferred xx
Dividends Payable xx
As cash dividends are paid
Dividends Payable xx
Cash xx

37
7. RE - Cash Dividends

Note that stated dividends to preferred
shareholders must be paid before any dividends
can be paid to common shareholders (including
dividends in arrears if cumulative).
Preferred dividends may be cumulative, which
means that, if no dividend is declared in the
current year, they must be caught up (based on
stated dividend rate) for the preferred
shareholders in a future year before common
shareholders get any dividends.
However, cumulative preferred dividends in
arrears are not recognized as a liability until a
dividend is finally declared by the board of
directors. A company might go for a number of
years without declaring a dividend, and there is
no liability until a dividend is actually
declared.

38
7. RE - Property Dividends

Property dividends are distribution of non-cash
property by a company to its shareholders. The
most common type of property dividend is a
spin-off where the shares of stock of a
subsidiary are distributed to the shareholders of
the parent company.
As property dividends are declared
Property Dividends (RE) xx
Property Div. Payable xx
As property dividends are distributed
Property Div. Payable xx
Investment xx

39
7. RE - Stock Dividends

Stock dividends are distribution of additional
shares of a companys own stock to its
shareholders. Note that the distribution of
additional shares does not result in any value
being given to the shareholders.
Example 4 shareholders, each having 10 shares
of common stock. Each owner has 25 of total
(10/40). If I give each shareholder 1 additional
share of stock, each shareholder still owns 25
of the same company (11/44). Nothing has
changed, except the number of the pieces of paper.

40
7. RE - Stock Dividends

Large stock dividends (gt 25 of the outstanding
common shares) are recorded at par value.
As stock dividends are declared
Stock Dividends (RE) xx par Stock Div.
Distributable xx par
As stock dividends are distributed
Stock Div. Distributable xx par
Common Stock xx par
Note that Stock Dividends Distributable is not a
liability, it is another equity account (see
Sample Company) which indicates that there are
additional shares of stock that will be issued
but are not currently outstanding.

41
7. RE - Stock Dividends

Analyze the effect of the transactions on the
balance sheet
Stock Dividends (RE) xx - SE Stock
Div. Distributable xx SE
As stock dividends are distributed
Stock Div. Distributable xx - SE
Common Stock xx SE
Note that the total effect on stockholders
equity is zero. However, retained earnings
decreases and common stock increases by the par
value of the stock dividend.
Small stock dividends (lt 25 of the outstanding
common shares) are recorded at market value.
Since small stock dividends are rare, we will not
do journal entries here.

42
Stock Splits

Stock splits are commonly declared by a company
to reduce its market price per share. This makes
the stock more accessible to small investors.
The process for stock splits is that the old
stock certificates are turned in, and new stock
certificates with a new description are issued to
the same shareholders.
The total par value of the new shares is equal to
the total par value of the old shares, but the
number of shares (and par value per share changes.

43
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.

44
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.

45
7. 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

46
7. 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 stockholders equity and
market price per share

47
7. Stock Dividends vs Stock Splits

However, a stock dividend requires a journal
entry, which changes the components of SE (RE and
CS).
A stock split changes the description of the
shares, including the par value per share.
Most companies use a stock split to change the
market price per share, but some companies use
the large stock dividend to achieve the same
result. This action is called a stock split in
the form of a dividend.

48
7. 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 stockholders 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 ( see slide 42).
Since the stock dividend required journal entries
(see slide 44), 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.

49
7. RE - Appropriations

Companies may choose to restrict a portion of
their RE for dividend payout.
Reasons for this restriction may include
activities such as plans for corporate expansion
or plans for the retirement of debt.
The restriction does not create a cash balance
for these plans. It simply indicates intentions.
The restriction, or appropriation may be
indicated through disclosure, or through a
reclassification of retained earnings.

50
7. RE - Appropriations

If reclassification is used, the following
journal entry is necessary
RE xx
RE-Appropriated xx
This entry will create two retained earnings in
the SE section of the balance sheet. (See page
527 of your text for a full example.)
The debit side of the entry reduces
unappropriated or unrestricted RE in the
Statement of RE, and the credit side creates a
new RE account.
Note that the JE does not change total SE, or
even change total RE.

51
7. RE - Prior Period Adjustments

A prior period adjustment is an adjustment to
current retained earnings for an error in a prior
years income statement.
The error was closed to prior RE, so the error is
corrected at the beginning of the year (net of
tax). The error can go in either direction,
depending on the nature of the error (ex omitted
expense versus omitted revenue).

52
8. Other Comprehensive Income

Comprehensive Income is a term that was defined
in the Statements of Financial Accounting
Concepts (SFAC 6).
It consists of all non-owner changes in equity.
This includes net income as we have been defining
revenues and expenses throughout the semester
(and again in Chapter 13), and it also includes
Other Comprehensive Income.

53
8. Other Comprehensive Income

Other Comprehensive Income includes certain
direct equity adjustments that are not part of
the current income statement, but which may have
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.

54
8. Other Comprehensive Income

Another item in Other Comprehensive Income is the
Cumulative Translation Adjustment.
This adjustment occurs when a company owns a
foreign subsidiary, and must translate the
foreign subsidiary to U. S. dollars before
consolidating.
The adjustment would only be realized as part of
the income statement if the foreign subsidiary
was sold or liquidated for U.S. dollars.
More on this subject in Chapter 8 Appendix.

55
9. Statement of Stockholders Equity

In this chapter, we have discussed the Statement
of Retained Earnings as the link between the
balance sheet and the income statement.
However, earlier chapters introduced the
Statement of Stockholders Equity, which has
become the default statement for large companies
in recent years.
The Statement of Stockholders Equity details the
change in retained earnings, including all the
changes discussed in this chapter, and it also
shows the change during the year in all of the
stockholders equity accounts.

56
Comprehensive Class Problem - Stockholders
Equity

Given the following SE balances for Company G at
1/1/05
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 2005, 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,
2006.
6. At Dec. 31, Company G recorded an AJE to
revalue its available for sale investments from
20,000 to 32,000.

57
Comprehensive Class Problem - Stockholders
Equity (continued)

Required
A.Prepare journal entries for items 2 through 6
(item 1 would require detail information for
revenues and expenses to prepare - just know that
the credit is to retained earnings for 250,000).
B.Prepare the Statement of Stockholders Equity
for Company G for 2005.
C.Prepare the stockholders equity section of the
balance sheet for Company G for 2005, including
the appropriate description for the common stock.

58
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

59
Comprehensive Class Problem - SolutionPart 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.

60
Comprehensive Class Problem - SolutionPart A
Journal Entries

6. Calc value up 12,000
Note that the Unrealized Gain account is part
of stockholders equity (not the income
statement), and it is located at the bottom of
the stockholders equity section of the balance
sheet, in Other Comprehensive Income (OCI).

61
Comprehensive Class Problem - SolutionPart B
Statement of SE (in thousands)

CS CSDD APIC RE OCI TS
Balance 1/1/05 200 400 400
Net income 250
Cash dividends (40)
Stock dividends 200 (200)
Purchase of TS (40)
Reissue of TS ( 1) 10
Revalue AFS Invest. 12
Balance, 12/31/05 200 200 400 409
12 (30)
Note CSDD is Common Stock Dividends
Distributable. When shares distributed, then CS
is increased.
Note OCI is Other Comprehensive Income and
reflects the unrealized gain on Available-for
-sale investment.