978-0078025549 Chapter 10 Lecture Note Part 2

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Forever Young has the following beginning balances in its stockholders’ equity accounts on

and retained earnings, $10,000. Net income for the year ended December 31, 2015 is $16,000.

January 1, 2015: Preferred stock, $0, common stock, $5,000; additional paid-in capital, $20,000;

Taking into consideration all of the transactions during 2015, prepare the following:

1. The stockholders’ equity section as of December 31, 2015.

2. The statement of stockholders’ equity for the year ended December 31, 2015.

The primary advantages of the corporate form of business are limited liability, ability to raise

capital, and lack of mutual agency. The primary disadvantages are additional taxes and more

paperwork.

LO10-2 Record the issuance of common stock.

If no-par value stock is issued, the corporation debits Cash and credits Common Stock. If par

value or stated value stock is issued, the corporation debits Cash and credits two equity accounts

—Common Stock at the par value per share and Additional Paid-in Capital for the portion above

par or stated value.

LO10-3 Contrast preferred stock with common stock and bonds payable.

Preferred stock has features of both common stock and bonds and is usually included in

stockholders’ equity. However, mandatorily redeemable preferred stock is so similar to bonds

that we include it with bonds payable in the liability section of the balance sheet.

LO10-4 Account for treasury stock.

We include treasury stock in the stockholders’ equity section of the balance sheet as a reduction

in stockholders’ equity. When we reissue treasury stock, we report the difference between its cost

and the cash received as an increase or decrease in Additional Paid-in Capital.

LO10-5 Describe retained earnings and record cash dividends.

The declaration of cash dividends decreases Retained Earnings and increases Dividends Payable.

The payment of dividends decreases Dividends Payable and decreases Cash. The net effect, then,

is a reduction in both Retained Earnings and Cash.

LO10-6 Explain the effect of stock dividends and stock splits.

Declaring stock dividends and stock splits is like cutting a pizza into more slices. Everyone has

more shares, but each share is worth proportionately less than before.

LO10-7 Prepare and analyze the stockholders’ equity section of a balance sheet and the

statement of stockholders’ equity.

The stockholders’ equity section of the balance sheet presents the balance of each equity account

at a point in time. The statement of stockholders equity shows the change in each equity account

balance over time.

Analysis

LO10-8 Evaluate company performance using information on stockholders’ equity.

The return on equity measures the ability to generate earnings from the owners’ investment. It is

calculated as net income divided by average stockholders’ equity. The return on the market value

of equity is another useful measure, especially when the recorded balance in stockholders’ equity

and the market value of equity differ substantially. Earnings per share measures the net income

earned per share of common stock. The price-earnings ratio indicates how the stock is trading in

relationship to current earnings.

Common Mistakes

Common Mistake

Some students confuse par value with market value. Par value is the legal capital per share that is

set when the corporation is first established and actually is unrelated to “value.” The market

value per share is equal to the current share price. In most cases, the market value per share far

exceeds the par value.

Common Mistake

Sometimes students confuse the purchase of treasury stock with investments in another company.

An equity investment is the purchase of stock in another corporation, and we record it as an

increase in assets. Treasury stock is the repurchase of a corporation’s own stock, and we record it

as a reduction in stockholders’ equity. It is not an asset; a company cannot invest in itself.

Common Mistake

Some students think, incorrectly, that retained earnings represent a cash balance set aside by the

company. In fact, the size of retained earnings has no relationship to the balance in the cash

account. American Eagle reported $1.7 billion in retained earnings, but only $720 million in

cash.

Common Mistake

Some students record a journal entry on the date of record. There is no entry. This is simply the

date on which investors holding stock are entitled to receive the dividend.

Decision Points

Question Accounting Information Analysis & Decision

How many of a

company’s shares

are authorized,

issued, and

outstanding?

Balance sheet The number of authorized,

issued, and outstanding shares

is normally reported in the

stockholders’ equity section of

the balance sheet. If the

number of issued and

outstanding shares differ, look

for a separate line in the equity

section called treasury stock.

Question Accounting Information Analysis & Decision

How much did the

company pay in

cash dividends?

Statement of

stockholders’ equity

The statement of stockholders’

equity provides a summary of

the activity in each equity

account during the period. Any

dividends declared and paid

during the year will be reported

in this statement.

Question Accounting Information Analysis & Decision

Do investors

expect future

earnings to grow?

Price-earnings ratio (PE

ratio)

A high PE ratio indicates

investors expect future

earnings to be higher. A low PE

ratio indicates investors’ lack

of confidence in future

earnings growth.

Ethical Dilemma

Intercontinental Clothing Distributors has paid cash dividends every year since the company was

founded in 1990. The dividends have steadily increased from $0.05 per share to the latest

dividend declaration of $1.00 per share. The board of directors is eager to continue this trend

despite the fact that earnings fell significantly during the recent quarter as a result of worsening

economic conditions and increased competition. The chair of the board proposes a solution. He

suggests a 5% stock dividend in lieu of a cash dividend, to be accompanied by the following

press announcement: “In place of our regular $1.00 per share cash dividend, Intercontinental will

distribute a 5% stock dividend on its common shares, currently trading at $20 per share.

Changing the form of the dividend will permit the company to direct available cash resources to

the modernization of facilities and other capital improvements.

Is a 5% stock dividend on shares trading at $20 per share equivalent to a $1.00 per share cash

dividend? Is the chair’s suggestion ethical?

Key issues

Is a stock dividend equivalent to a cash dividend?

Is the chair of the board ethical in replacing the cash dividend with a stock dividend?

Option 1: Replace the cash dividend with a stock dividend

Replacing the cash dividend with a stock dividend frees up available cash.

Intercontinental is able to replace a significant cost to the company in the form of cash

dividends with a stock dividend that essentially costs the company nothing at all.

Announcing a stock dividend in place of the cash dividend may be better received than

having to announce a decrease in or the complete elimination of cash dividends.

Option 2: Decrease the cash dividend payment with no replacement stock dividend

It may appear deceptive to replace something of real substance (cash dividends) with

something of no real substance (stock dividends).

Investors with a background in financial accounting are likely to see through the

announcement, realizing that a stock dividend is nothing more than redistributing the

ownership of the company into more shares.

Intercontinental could announce a decrease in dividends with the intention of increasing

cash dividends once earnings increase.

Option 3: Eliminate dividend payments entirely

Eliminating the dividend payments also frees up available cash without any perceived

element of deception.

Intercontinental may be better off to be completely open with investors about the

situation and announce that the regular cash dividends will need to be decreased or

entirely suspended for a period of time.

Often, the direct approach is the best approach.