Lecture 12

Shareholders Equity

Components of Stockholders Equity

on the Balance Sheet
Contributed Capital
Preferred
Stock

Earned Capital

Accumulated
Other
Comprehensive
Income

Retained
Earnings

Common
Stock (at par)
Additional Paid
In Capital
Subtract

Treasury Stock

Common Stock
Common stock is the basic unit of ownership of a company.
Owners of common stock, called common shareholders, have
voting rights to elect the board of directors and vote on matters
brought up during the annual shareholders meeting. It is through
this mechanism that they participate in the management of the firm.
Common shareholders bear the majority of the risk of the firm; their
claim to the assets of the business is a residual one which is only
exercisable after other claims have been satisfied.
Similarly, their claim to the earnings of the company, in the form of dividends,
may only be exercised after the claims of the firms creditors have been satisfied.

Typically, common shares are assigned a par value. Par value

has a book-keeping purpose, but has no relation to market value.
Note: while the par value of common stock is not an important feature of a
stock, the par value or face value of preferred stock (and bonds) is a very
important feature.

Market value of one share is the market value of the firm divided by
total shares outstanding.
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Common Stock
Common stock is the basic voting stock issued by a
company
Shares Authorized total number of shares that may be
legally issued under the articles of incorporation
Shares Issued The aggregate number of shares that have
been sold to public
Includes IPOs and SEOs
Shares Outstanding Shares remaining in the hands of
shareholders on a particular date
Shares Outstanding = Shares issued Shares of
treasury stock
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Illustration
Authorized
Shares
Issued
Shares

Outstanding
Shares
Treasury
Shares

Unissued
Shares
Treasury shares are issued shares
that have been reacquired by the
corporation.

Common Stock

Shares Outstanding
= 2,600 million 637.8 million = 1,962.2 million
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Common Stock
Par Value A nominal amount stated on the stock certificate

On the balance sheet, called Common Stock

Total value = number of shares issued * par value per share
Arbitrarily set by company organizers at time of incorporation
Has no economic meaning from a financial analysis perspective

Additional Paid-In Capital The difference between the

total amount the company receives when issuing stock and
the par value
Can also be called Capital in excess of par or capital surplus

Common Stock Practice Problem

Common stock, 335,200 shares issued in 2007

Additional paid-in capital

$3,352

$812,224

What is par value?

Par value is $0.01 = $3,352/335,200
How much in total did HD receive from stock issuances?
$815,576 = $812,224 +$3,352
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Common Stock Issuance Journal

Entries
Groupon Inc raised $700 million after increasing the size of
its initial public offering to 35 million shares at $20 each. The
stocks have a a par value of $0.0001.
Cash (35m shares * $20)
700,000,000
Common Stock (35m shares * $0.0001) 3,500
Additional Paid-in Capital
699,996,500

Notes:
Same journal entry for any additional stock issuances.

Preferred Stock
Preferred stock also represents ownership in a company, but some
of the rights supercede (or, are preferred to) those of common stock.
The right to receive dividends precedes that of common shares.
When dividends are declared, preferred shareholders must be paid the full
amount of their dividends before any is paid to common shareholders.
Generally, the dividend amount is specified in the preferred share contract.
Generally, the dividend preference is cumulative.
If a dividend is not declared for a year, the preferred shareholders will not receive any
dividends for that year. However, their right to receive the dividend for that year carries
forward and must be satisfied in some later period, before any dividend can be paid to
common shares.
Unpaid dividends are said to be in arrears and must be reported in the footnotes of
the statements.

The right to assets precede those of the common shareholders in a bankruptcy

and/or liquidation proceeding.
Par value is relevant to preferred stock and the dividend is expressed as a
percentage of the par value.
The disadvantage? Preferred stockholders cannot vote like common
shareholders.
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Preferred Stock Example

Gladstone issues 1,400,000 shares of $25 par value, 7.125% preferred shares.
IF management declares dividends, then each share entitles the holder to receive
$25*0.07125 = $1.78125 of dividends before any common shareholders receive
dividends.
Lets imagine that at the end of the year, management decides not to declare any
dividends at all.
No preferred stock dividends payable liability is recorded, but a footnote is made that
dividends are in arrears for the Cumulative Preferred shareholders = $1.78125 *
1,400,000 shares = $2,493,750.
At the end of the second year, management decides again to not issue dividends.
No liability is recorded, but Cumulative Preferred dividends in arrears add an
additional amount of $2,493,750.
IF management declares total dividends of $7,500,000 in the third year, then:

$2,493,750 + $2,493,750 = $4,987,500 goes to Preferred shareholders to settle dividends in

arrears.
$2,493,750 goes to Preferred shareholders to settle current year dividends.
Only $18,750 ($7,500,000 3*$2,493,750) is left for dividends to Common shareholders.

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Preferred Stock
Preferred stock also represents ownership in a company :

Usually have a fixed dividend rate

Usually no voting rights
Sometimes can be converted to common stock
Often considered a hybrid of debt and equity

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Stock Buy-Backs
Apple Announces Plans to Initiate Dividend and Share Repurchase
Program
Expects to Spend $45 Billion Over Three Years
CUPERTINO, CaliforniaMarch 19, 2012Apple today announced plans to
initiate a dividend and share repurchase program commencing later this year.
Subject to declaration by the Board of Directors, the Company plans to initiate
a quarterly dividend of $2.65 per share sometime in the fourth quarter of its
fiscal 2012, which begins on July 1, 2012.
Additionally, the Companys Board of Directors has authorized a $10 billion
share repurchase program commencing in the Companys fiscal 2013, which
begins on September 30, 2012. The repurchase program is expected to be
executed over three years, with the primary objective of neutralizing the
impact of dilution from future employee equity grants and employee stock
purchase programs.
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Treasury Stock
Stock that is bought-back is called Treasury Stock.
It is a contra equity account and, thus, reduces total
owners equity
Reasons companies repurchase their own stock:
Signal that the market is undervaluing the company
Need shares for stock compensation plans
Artificially inflate EPS
Thwart take-over

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Treasury Stock Journal Entries

The journal entry for when a company buys back its shares
only considers the cost to the company to repurchase the
share, not the par value or the original issue price (i.e., IPO
price).
Suppose Napa Corp buys back 1,000 shares of its $1 par
stock at a price of $7.50 per share.
Treasury Stock (1,000 * $7.50)
Cash

7,500
7,500

Purchased 1,000 shares of treasury stock at $7.50 per share

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Treasury Stock Journal Entries

When the company re-issues the treasury stock for a price
different from the repurchase price, there is no profit or loss that
shows up on the income statement. Instead, there is an addition
(credit) or subtraction (debit) to Additional Paid-in Capital.
Suppose Napa Corp then resells the treasury stock for $9.00 per
share
Cash (1,000 * $9)
9,000
Treasury Stock
Additional Paid-in Capital

7,500
1,500

Instead, suppose Napa Corp resells the treasury stock for $5.00
per share
Cash (1,000 * $5)
5,000
Additional Paid-in Capital
2,500
Treasury Stock

7,500
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Common Stock & Treasury Stock

Final Comments
Note that the company does not make any journal
entries when the stock trades in the secondary market
The company only records transaction when it sells
(issues) or buys (repurchases) its stock
The company never records any gains or losses on its
own stock; rather differences are recorded in additional
paid-in capital

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Retained Earnings
The cumulative amount of profits kept for use in
the firm
Retained earnings is affected by:
Revenues - increases in retained earnings from
delivering goods or services
Expenses - decreases in retained earnings that result
from operations
Dividends decreases in retained earnings due to
payments back to shareholders
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Dividends
Distribution to shareholders, usually in the form of cash
No legal requirement that firms pay dividends but once they start,
dividends are sticky

Declaration date Date board announces firms will pay a

dividend; once announced it becomes a formal liability
Date of record -- Date on which you must own the stock in
order to receive the dividends
Payment date Date on which the company actually pays
the dividends

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Example: Dividend date

Date of
payment
Declaration of
$2 dividend

Buy stock for

$10 (Incl. div)

Date of record
(Ex-dividend)

Sell stock for

$??? (Excl. div)

I bought a stock for $10 before the date of record (ex-dividend)

I sold it after date of record but before the date of payment. For
how much ?
In total, assuming stock price did not change (except for the exdiv effect)
I bought for $10
I sold for $8
I received a dividend of $2
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Dividends Journal Entries

Declaration date
Retained Earnings (or Dividends)
Dividends Payable

50,000
50,000

Date of record
The corporation makes no journal entry on the
date of record because no transaction occurs

Payment date

Dividends Payable
Cash

50,000
50,000

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A quick note on Accumulated Other

Comprehensive Income
There are some increases (decreases) in the firms net
assets that are not reported on the income statement.
Instead these activities are directly recorded in an account
call Other Comprehensive Income which is reported on the
balance sheet as part of owners equity.
Primarily considered by FASB to be events outside of
managements control:

Foreign currency fluctuations

Unrealized changes in market value of securities available for sale
Minimum pension liability adjustments
Change in the market value of derivatives used as cash flow hedges

Mostly beyond the scope of this class

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Review Questions
Shares authorized, shares issued, shares outstanding
True or False
If the reissue price of the treasury stock is higher than
the repurchase price, then the company can realized
a gain on this transaction.
On the date of record, the company should debit to
dividends payable, credit to cash.
Suppose the company declares dividends $100,000.
Shares issued is 12,000 and Shares outstanding is
10,000. Then dividend per share is $10.
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Stock dividends
Sometimes firms choose to distribute
additional shares to shareholders instead
of giving them cash.
Thus, dividends can also be in the form of
stocks.
Another occasion where firms distribute
additional stocks to shareholders is stock
splits.
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Stock Splits and Stock Dividends

Imagine Firm ABC with common stock with $10 par value, 10,000
shares authorized, and 1,000 shares issued and outstanding.
Stock Split: You get Y shares to replace every X shares you own.
There is no active or passive journal entry to record the transaction.
The only adjustment is to par value and the number of shares
authorized, issued, and outstanding.
If Firm ABC splits its stock 2-for-1, then after the split, the par
value becomes $5, there will be 20,000 shares authorized, and
2,000 shares issued and outstanding.
Stock Dividend: You get Y new shares for every X shares you own.
There WILL BE an active journal entry that transfers $$$ from Retained
Earnings to Common Stock and Additional Paid-in Capital.
If Firm ABC declares a 5% stock dividend, then 5% of 1,000 shares
outstanding means there will be 50 new shares distributed. After
the stock dividend, there are 1,050 shares issued and outstanding;
no change to par value or authorized shares.
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Stock Dividends vs. Stock Splits

Similarities
Distributions of additional shares to existing
shareholders, both results in a greater
number of shares outstanding.
No change in total shareholders equity.
No change in ownership stakes of
shareholders.

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Stock Dividends vs. Stock Splits

Stock splits

Stock dividends

Par value per share

Decrease

Unchanged

Total par value

(#shares * Par PS)

Unchanged

Increase

Retained earnings

Unchanged

Decrease
Movement between
retained earnings
and common stock

No Journal Entry

Journal Entry

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Stock Splits
Assume that a corporation had 5,000 shares of $1 par value
common stock outstanding before a 2for1 stock split.
Before
Common stock shares

5,000

Par value per share

$1.00

Total Par value

$5,000

Retained earnings

$8,000

After 2:1
Split

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Stock Splits
Assume that a corporation had 5,000 shares of $1 par value
common stock outstanding before a 2for1 stock split.
Before

After 2:1
Split

Common stock shares

5,000

10,000

Increase

Par value per share

$1.00

$0.50

Decrease

Total Par value

$5,000

$5,000

No change

Retained earnings

$8,000

$8,000

No change

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Stock Dividends vs. Stock Splits

Before

After 2:1
Split

After 100%
div

Common stock shares

5,000

10,000

10,000

Par value per share

$1.00

$0.50

$1.00

Total Par value

$5,000

$5,000

$10,000

Retained earnings

$8,000

$8,000

$3,000

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Reverse Stock Split

New York (TheStreet) Citigroup Inc. today announced the effectiveness
of its 1-for-10 reverse stock split of Citigroup common stock as of 4:10 p.m.
Friday, May 6, 2011. The stocks closed at $4.52/share that day. Vikram
Pandit, Chief Executive Officer of Citigroup said the reverse split will allow
Citigroup stock to be more attractive to a broader range of institutional
and other investors," cut costs and allow the company to keep its
stock listed on the New York Stock Exchange.
The number of outstanding shares of Citigroup common stock will shrink
from 29 billion to approximately 2.9 billion. Instead of trading for less
than $5 a share, where Citigroup has languished despite improvements in
profits and capital, the New York financial behemoth instantly became a
$40 stock. The shares closed the following trading day at $44.16 a share

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Employee Stock Options

Employee Stock options represent rights granted or awarded by
the firm to employees to acquire shares of common stock at a
specified price over a stipulated interval of time.
Typically awarded to employees (high level and low level
employees) under a stock-based compensation plan.
Options vest over some period of time (several years). This
means that employees can exercise their right only after working for
some period of time.
For example, if an employee is awarded 1,000 options to purchase
1,000 shares of common stock at price $X, vested over 5 years,
then that means after each year of employment, the employee
earns the right to exercise another 200 out of the 1,000 options.
Options are not transferable (to other employees or outsiders) and
generally issued with an exercise price equal to the market price on
the date of the grant.

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Accounting for Stock Options

There has been a long and furious debate over the
accounting treatment for these options.
Stock options given as a form of compensation.
Should companies expense the options in their financial
statements?

FAS123 gave companies the option to:

Record the intrinsic value (which was usually $0) on I/S
Just report the fair value of options in a footnote

As for fiscal years starting after June 15, 2005,

FAS123R calls for:
Mandatory expensing of all stock-based compensation
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Cisco Adopts FAS 123R

Note that this is where you find most

non-cash expenses.

The non-cash SBC

begins showing up
in Fiscal 2006 for
the first time.

Effects on Total Stockholders Equity

Event

Effect on Total
Stockholders Equity

Issue Shares of Stock for cash

Increase

Repurchase Shares -Treasury Stock

Decrease

Re-issue Treasury Stock for cash

Increase

Earn income (incur loss)

Increase (decrease)

Declaration of cash dividend

Decrease

Payment of previously declared cash dividend No effect

Stock split
No effect
Stock Dividend

No effect

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Summary of Accounting for Owners

Equity
Issue Common Stock
Dr Cash
Cr Common Stock (# of shares * par value)
Cr Additional Paid-in Capital
Repurchase Stock
Dr Treasury Stock
Cr Cash
Re-Issue Treasury Stock
Dr Cash
Cr Treasury Stock (at cost)
Cr Additional Paid-in Capital
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Summary of Accounting for Owners

Equity
Cash Dividends at Declaration
Dr Retained Earnings (or Dividends)
Cr
Dividends Payable
Cash Dividends at Payment
Dr Dividends Payable
Cr Cash
Stock Dividends
Dr Retained Earnings (or Dividends)
Cr Common Stock
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Practice Problem 1
The following is the Statement of Shareholders Equity for
Alethea Inc.:
Common Stock

Treasury Stock

Shares

Par Value

APIC

Retained
Earnings

Balance, December
31, 2008

50,000

$50,000

$140,000

$65,000

Stock issued

20,000

20,000

54,000

Net Income

Shares
3,500

Cost
($7,000)

Total
$248,000
74,000

86,500

86,500

Dividends Declared

(12,800)
(12,800)

Repurchased
Re-issued
Balance, December
31, 2009

2,250
70,000

$70,000

$196,250

$138,700

1,250

(5,000)

(5,000)

(1,000)

2,000

4,250

3,750
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$394,950
$(10,000)

Practice Problem 1
Did Alethea Inc. have a profit or loss?

$86,500
profit

What is the total dollar amount of dividends declared?

$12,800
What is the par value of a share of common stock? $1
What price did they issue new shares of common stock at?
$74,000/20,000 = $3.70
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Practice Problem 1
How many shares did Alethea Inc. repurchase? 1,250
At what price did Alethea Inc. resell treasury stock?
$4,250/1,000 = $4.25
Prepare the journal entry to record the re-issuance of
treasury stock. Cash
4,250
Treasury Stock
2,000
APIC
2,250
How many shares are outstanding at 12/31/2009?
70,000 3,750 = 66,250

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Practice Problem 2
On Jan. 1, 2010, the stockholders equity section of ALM Corps
balance sheet showed the following
Common Stock, par $10, authorized 100,000 shares,
issued 10,000 shares
Additional Paid-in Capital
Retained Earnings

$100,000
50,000
160,000

During the year, 2010, the following transactions occurred (in order):
1. Issued a 50% stock dividends.
2. Purchased treasury stock (200 shares at $11).
3. Declared and paid a cash dividend of $19,800.
4. Net income, $30,000.
Prepare the stockholders equity section of the balance sheet at December 31, 2010.

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