Chapter 11 – Reporting and Analyzing Equity
11-1
Chapter 11
Reporting and Analyzing Equity
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
(A &B set)**
Beyond the
Numbers
Conceptual objectives:
C1. Identify characteristics of
corporations and their
organization.
1, 2, 3
11-1
11-1
TTN
C2. Explain characteristics of, and
distribute dividends between,
common and preferred stock.
4, 5, 6, 7, 8,
9
11-6,11-10
11-5, 11-8,
11-9
11-1, 11-5
RIA, ED
C3. Explain the items reported in
retained earnings.
11-13
11-11, 11-17,
11-18
11-2, 11-4
EC, GD,
TTN
Analytical objectives:
A1 Compute earnings per share
and describe its use.
17
11-14, 11-15
11-12, 11-13
RIA, CA,
CIP, HTR,
GD
A2. Compute price-earnings ratio
and describe its use in analysis.
11-16
11-14
CA, CIP,
HTR
A3. Compute dividend yield and
explain its use in analysis.
11-17
11-15
CA, HTR
A4.Compute book value and
explain its use in analysis.
19
11-18
11-16
11-5
RIA, CA
Procedural objectives:
P1. Record the issuance of
corporate stock.
10, 21, 22,
20
11-2, 11-3,
11-4, 11-5,
11-12, 11-19
11-2, 11-3,
11-4, 11-17
11-1
P2. Record transactions involving
cash dividends, stock dividends,
and stock splits.
11, 12, 13,
14
11-7, 11-8,
11-9,11-12
11-6, 11-7,
11-18
11-2, 11-3,
11-4
ED
P3. Record purchases and sales
of treasury stock and the
retirement of stock.
15, 16
11-11,11-12
11-10, 11-18
11-2, 11-4
TIA
Notes appear on next page.
Chapter 11 – Reporting and Analyzing Equity
* Assignment materials that can be completed by students using:
Chapter 11 – Reporting and Analyzing Equity
11-3
Chapter Outline
Notes
I. Corporate Form of Organization—An entity created by law that is
separate from its owners. Owners are called stockholders. A publicly
held corporation offers its stock for public sale (organized stock
market) whereas a privately held corporation does not.
A. Characteristics of Corporations
Advantages of Corporate Characteristics:
1. Separate legal entity—a corporation, through its agents
(officers and managers), conducts business affairs with the
same rights, duties, and responsibilities of a person.
2. Limited liability of stockholders—generally limited to
investment. Stockholders are not liable for corporate acts or
corporate debt.
3. Transferable ownership rights—through stock sale has no
effect on the corporation.
4. Continuous life⎯perpetual life as long as it continues to be
successful.
5. Lack of mutual agency for stockholders—stockholders do
not have the power to bind the corporation to contracts.
6. Ease of capital accumulation—enables a corporation to
accumulate large amounts of capital from the combined
investments of many stockholders.
Disadvantages of Corporate Characteristics:
7. Governmental regulation—must meet requirements of a
state’s incorporation laws.
8. Corporate taxation—corporate income is taxed; and when
income is distributed to shareholders as dividends, it is taxed a
second time as personal income (double taxation).
B. Corporate Organization and Management
1. Incorporation—a charter application must be filed with the
state. Upon payment of fees and issuance of the charter, the
corporation is formed.
2. Organizational Expenses are the costs to organize a
corporation and include legal fees, promoters’ fees, and
amounts paid to obtain a charter; these costs are expensed as
incurred because it is difficult to determine the amount and
timing of future benefits.
3. Management of a Corporation
a. Stockholders have ultimate control through vote to elect
board of directors.
b. Board of directors has final managing authority, but it
usually limits its actions to establishing broad policy.
c. Day-to-day direction of corporate business is delegated to
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Chapter Outline
Notes
executive officers appointed by the board.
C. Stockholders of Corporations
1. Rights of stockholders
Specific rights are granted by the charter and general rights by
state laws. Common stockholders rights include right to:
a. Vote at stockholders’ meeting.
b. Sell or otherwise dispose of their stock.
c. Purchase their proportional share of any common stock
later issued; this preemptive right protects stockholders’
proportionate interest in the corporation.
d. Share with other common stockholders in any dividends.
e. Share equally in any assets remaining after creditors and
preferred stockholders are paid when, and if the
corporation is liquidated.
f. Receive timely financial reports.
2. Stock Certificates and Transfer—a stock certificate is
sometimes received as proof of share ownership.
3. Registrar and Transfer Agents—if stock is traded on a major
exchange, the corporation must have:
a. Registrar who keeps stockholder records and prepares
official lists of stockholders for stockholders’ meetings
and dividend payments.
b. Transfer agent who assists purchases and sales of shares
by receiving and issuing certificates as necessary.
D. Basics of Capital Stock
Capital stock refers to any shares issued to obtain capital (owner
financing).
1. Authorized stock—the total amount of stock that charter
authorizes for sale.
a. Outstanding stock refers to issued stock held by
stockholders.
b. No formal journal entry is required for stock
authorization; the number of shares authorized is disclosed
in the financial statements.
2. Selling (Issuing) Stock—can be sold directly or indirectly to
stockholders
a. To sell directly, the corporation advertises its stock
issuance to potential buyers.
b. To sell indirectly, a corporation pays a brokerage house
(investment banker) to issue its stock.
c. A brokerage house may underwrite issuance (buy the
stock from the corporation and take all gains or losses
from its resale).
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Chapter Outline
Notes
3. Market Value of Stock—market value per share is the price
at which a stock is bought or sold.
a. Influenced by expected future earnings, dividends,
growth, and other company and economic events.
b. Current market value of previously issued shares does not
impact that corporation’s stockholders’ equity accounts.
4. Classes of Stock
a. Common—stock is called common stock when all classes
have the same rights and privileges.
b. Additional classes—corporation is sometimes authorized
to issue more than one class of stock.
5. Par Value Stock—assigned a value per share by the
corporation in its charter. No minimum legal capital.
a. Printed on the stock certificate.
b. Establishes the minimum legal capital which is the least
amount that the buyers of stock must contribute to the
corporation or be subject to paying at a future date.
Creditor’s claims are limited to the corporation’s assets
and any minimum legal capital.
6. No-Par Value Stock—not assigned a value per share by the
corporate charter.
7. Stated Value Stock—no-par stock that is assigned a “stated”
value per share by the directors; becomes the minimum legal
capital per share.
8. Stockholders’ Equity—has two parts
a. Paid-in (or contributed) capital—the total amount of cash
and other assets received by the corporation from its
stockholders in exchange for stock.
b. Retained earnings—the cumulative net income (and loss)
retained by a corporation.
II. Common Stock—Issuance of stock affects only paid-in capital
accounts, not retained earnings accounts.
Note: When the corporation issues par value stock, it can only credit
the stock account for the par value of shares issued.
A. Issuing Par Value Stock
1. Issuing Par Value Stock at Par—debit Cash, credit Common
Stock (both for the amount received which is the total par
value of the shares issued).
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Chapter Outline
Notes
2. Issuing Par Value Stock at a Premium
a. A premium on stock is an amount paid in excess of par
by the purchasers of newly issued stock.
b. Entry to record issuance of par value stock at a premium:
debit Cash (for amount received or issue price), credit
Common Stock (for par value), credit Paid-in capital in
Excess of Par Value, Common Stock (for the amount of
the premium).
3. Issuing Par Value Stock at a Discount
a. A discount on stock occurs when stock corporation sells
its stock for less than its par (or stated) value.
b. Entry to record issuance of par value stock at a discount:
debit Cash (for amount received or issue price), debit
Discount on Common Stock, a contra to the common
stock account (for the amount of the discount), credit
Common Stock (for par value).
c. Issuance of par value stock at a discount is prohibited in
most states since investment is below the minimum legal
capital. When allowed, the purchasers usually become
contingently liable to the corporation’s creditors for the
amount of the discount.
B. Issuing No-Par Value Stock
1. When no-par stock is issued and is not assigned a stated value,
the entire amount received becomes legal capital and is
recorded as Common Stock.
2. Entry to record issuance of no-par value stock: debit Cash,
credit Common Stock (for the entire proceeds).
C. Issuing Stated Value Stock
1. Stated value becomes legal capital and is credited to a stated
value stock account. If stock is issued at an amount in excess
of stated value, this excess is credited to Paid-in Capital in
Excess of Stated Value, Common Stock.
2. Entry to record issuance of no-par value stock: debit Cash,
credit Common Stock, credit Contributed Capital in Excess of
Stated Value, Common Stock (for the excess).
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Chapter Outline
Notes
D. Issuing Stock for Noncash Assets
1. Issuing par value stock for other assets
Entry to record: debit the accounts relating to the asset(s)
received (at market value(s) as of the date of the transaction),
credit Common Stock, credit Paid-in Capital in Excess of Par
Value, Common Stock (for the amount of the premium, if
any).
2. Issuing par value stock for organizational expenses
Entry to record: debit Organization Expenses, credit Common
Stock , credit Paid-in Capital in Excess of Par Value, Common
Stock (for the amount of the premium, if any).
III. Dividends
A. Cash Dividends
Many corporations pay cash dividends to their stockholders at
regular dates. Cash dividends reduce, in equal amounts, both cash
and the retained earnings component of stockholders’ equity.
1. Accounting for Cash Dividends
Generally a cash dividend requires:
a. Retained earnings (requirement of many states).
b. Sufficient cash.
c. Decision by the board of directors.
2. Dividend dates
a. Date of Declaration—date the directors vote to declare
and pay a dividend (legal liability created). Journal entry
required.
b. Date of Record—date specified for identifying
stockholders (owners on this date) who will receive the
dividend. No journal entry required.
c. Date of Payment—date stockholders receive payment.
Journal entry required.
3. Cash Dividend Entries
a. Entry at declaration date: debit Retained Earnings, credit
Dividends Payable.
b. Entry at distribution date: debit Dividends Payable, credit
Cash
4. Deficits and Cash Dividends
A corporation with a debit (abnormal) balance in its Retained
Earnings account has a retained earnings deficit.
a. Arises when cumulative losses and/or dividends are
greater than total earnings from current and prior years;
reported as a deduction on the balance sheet.
Chapter 11 – Reporting and Analyzing Equity
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Chapter Outline
Notes
b. Most states prohibit a corporation with a deficit from
paying cash dividends.
c. Some states allow a liquidating cash dividend where
capital contributed by stockholders is returned to the
investors.
B. Stock Dividends
A stock dividend is a distribution of additional shares of the
corporation’s own stock to its stockholders without receipt of any
payment in return.
1. Reasons for Stock Dividends
a. Keep the market price of stock affordable.
b. Provide evidence of management’s confidence that the
company is doing well.
2. Accounting for Stock Dividends—A stock dividend affects the
components of equity by transferring part of retained earnings
to contributed capital accounts.
a. A small stock dividend is a distribution of 25% or less of
the previously outstanding shares.
i. The market value of the shares to be distributed is
capitalized.
ii. Entry to record a small stock dividend upon
declaration: debit Retained Earnings (for the current
market value of the stock to be distributed), credit
Common Stock Dividend Distributable (for the par
value of the stock to be distributed), credit Paid-in
Capital in Excess of Par Value, Common Stock (for
the excess).
iii. Entry to record a small stock dividend at date of
payment: debit Common Stock Dividend
Distributable, credit Common Stock.
b. A large stock dividend is a distribution of more than 25%
of the shares outstanding before the dividend.
i. Only the legally required minimum amount (par or
stated value of shares) must be capitalized.
ii. Entry to record a large stock dividend upon
declaration: debit Retained Earnings, credit Common
Stock Dividend Distributable (for the par value of the
stock to be distributed).
iii. Entry to record a large stock dividend at date of
payment: debit Common Stock Dividend
Distributable, credit Common Stock.
Chapter 11 – Reporting and Analyzing Equity
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Chapter Outline
Notes
C. Stock Splits
A stock split is the distribution of additional shares of stock to
stockholders according to their percent ownership. The
corporation “calls in” the outstanding shares of stock and issues
more than one share in exchange for each old share. A stock split
reduces the par or stated value per share.
1. No journal entry is made – only a memorandum entry is
required.
2. Total par value of outstanding shares does not change;
retained earnings is not capitalized.
IV. Preferred Stock—Has special rights that give it priority over common
stock in one or more areas such as preference for receiving dividends
and for the distribution of assets if the corporation is liquidated.
Usually does not have right to vote.
A. Issuance of Preferred Stock
Usually has a par value; can be sold at a price different from par.
1. Separate capital accounts are used to record preferred stock.
2. Preferred Stock account is used to record the par value of
shares issued; Paid-in Capital in Excess of Par Value,
Preferred Stock is used to record any value received above the
par value.
3. Entry to record issuance of preferred stock: debit Cash, credit
Preferred Stock account (for the par value of shares issued),
credit Paid-in Capital in Excess of Par Value, Preferred Stock
(for the value received above the par value).
B. Dividend Preference of Preferred Stock
Preferred stockholders are allocated their dividends before any
dividends are allocated to common stockholders.
1. Cumulative or Noncumulative Dividend
a. Cumulative preferred stock has a right to be paid both
current and all prior periods‘ unpaid dividends before any
dividend is paid to common stockholders. Unpaid
dividends are referred to as dividends in arrears.
b. Noncumulative preferred stock confers no right to prior
periods’ unpaid dividends if they were not declared in
those prior periods.
c. Full-disclosure principle requires that the amount of
preferred dividends in arrears be reported as of the balance
sheet date, normally in a note to the financial statements.
Chapter 11 – Reporting and Analyzing Equity
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Chapter Outline
Notes
2. Participating or Nonparticipating Dividend
a. Nonparticipating preferred stock—dividends are
limited each year to a maximum amount determined by
applying either the stated percentage or the stated specific
dollar amount per share to the par value.
b. Participating preferred stock—allows its owners the
right to share with common stockholders in any dividends
paid in excess of the stated percentage or dollar amount.
C. Convertible Preferred Stock
1. Convertible preferred stock gives holders the option of
exchanging their preferred shares into common shares at a
specified rate.
2. If a company’s common stock increases in value, the
convertible preferred stockholders can share in this success by
converting their stock into more valuable common stock.
D. Callable Preferred Stock
1. Callable preferred stock gives the issuing corporation the
right to purchase (retire) this stock from its holders at
specified future prices and dates.
2. Amount paid to call and retire a preferred share is its call
price, or redemption value, and is set when the stock is issued.
3. Any dividends in arrears must also be paid when stock is
called.
E. Reasons for Issuing Preferred Stock
1. Raise capital without sacrificing control of the corporation.
2. Boost the return earned by common stockholders; called
financial leverage or trading on equity.
V. Treasury Stock—A corporation acquires its own shares for several
reasons such as to acquire another company, to avoid a hostile
takeover, or to use for employee compensation. A corporation’s
treasury stock does not receive any cash or stock dividends, nor do
they allow the corporation voting rights.
A. Purchasing Treasury Stock—reduces the corporation’s assets and
stockholders’ equity by equal amounts.
1. Debit Treasury Stock (contra equity) and credit Cash for full
cost (reduces total assets and total equity).
2. Treasury Stock is a contra equity account; the equity reduction
is reported by deducting the cost of treasury stock in the equity
section of the balance sheet.
3. The resulting restriction on retained earnings must be
disclosed.