978-0136115274 Chapter 8 Lecture Notes

CHAPTER 8

ACCOUNTING FOR SHAREHOLDERS’ EQUITY

CHAPTER OVERVIEW

The chapter begins with a discussion of contributed capital, including common stock, par value,

additional paid-in capital, and dividends. The next part of the chapter covers treasury stock.

Possible reasons for purchasing treasury stock, along with the effect on the financial statements,

are presented. This is followed by examples of selling treasury stock. Finally, there is a section

on stock dividends and stock splits, including the difference between the two, the financial

statement effects of both, and the reasons corporations issue stock dividends or split their stock.

Retained earnings is covered, including the reasons for its increases and decreases.

The chapter includes a summary problem that continues the Team Sports example from previous

chapters and presents the student with transactions for the eighth month of business. The student

is then shown how to make adjusting entries at the end of August and prepare the four financial

statements for the business.

At the end of the chapter there is a discussion of how to use information about shareholders’

equity for analysis (return on equity and earnings per share), and the business risks associated

with investing in a company.

LEARNING OBJECTIVES

After completing Chapter 8, your students should be able to answer these questions:

1. Explain how a company finances its business with equity.

2. Account for the payment of cash dividends and calculate the allocation of dividends

between common and preferred shareholders.

3. Define treasury stock, explain why a company would purchase treasury stock, and

account for its purchase.

4. Explain stock dividends and stock splits.

5. Define retained earnings and account for its increases and decreases.

6. Prepare financial statements that contain equity transactions.

7. Compute return on equity and earnings per share, and explain what these ratios mean.

8. Recognize the business risks associated with equity and the related controls.

CHAPTER OUTLINE

Components of Shareholders’ Equity in a Corporation: Contributed Capital (LO 1)

I. Owners’ claims to the assets of a firm are called shareholders’ equity or stockholders’

equity.

II. There are two major parts to shareholders’ equity:

a. Contributed capital

b. Retained earnings

III. Contributed capital

a. Amount owners have invested in the corporation

b. Two parts of contributed capital:

i. Common stock – this is the most widespread form of ownership in a

corporation; common shareholders have a vote in the election of the firm’s

board of directors. Also called capital stock.

ii. Additional paid-in capital

IV. Stock – authorized, issued, and outstanding

a. In return for their contribution, owners receive shares of stock, representing

ownership equal to the value of those contributions.

b. Authorized shares are shares of stock that are available for a firm to issue per its

corporate charter.

i. Established by the charter issued by the state

ii. Maximum number of shares of stock that can be issued

c. Issued shares are shares of stock that have been offered and sold to shareholders.

d. Outstanding shares are shares of stock that are owned by stockholders.

i. Actually in the hands of the stockholders

e. Treasury stock is shares of stock that have been repurchased by the issuing firm.

i. Difference between issued and outstanding will be shares held in treasury.

Teaching Tip

Use Exhibit 8.2 to illustrate authorized, issued, outstanding, and treasury stock.

V. Common stock is the most common and widespread form of ownership in a corporation.

a. What is usually meant when someone refers to a company’s stock?

b. Common shareholder can vote for the board of directors, share in profits, share in any

assets left if the company is dissolved and acquire more shares when the company

issues more stock.

c. Par value is the monetary amount assigned to a share of stock in the corporate

charter.

i. Par value has no relationship to market value of stock.

ii. Par value defines the maximum responsibility of stockholder if company goes

out of business.

iii. When a share is sold, the par value amount equals the increase in the stock

account.

iv. Additional paid-in capital (or paid-in capital in excess of par) is increased by

the amount received above par value.

v. Common stock + additional paid-in capital = total contributed capital

Teaching Tip

Is the issuance of stock recorded as a revenue? No, the issuance of stock is recorded as paid-in

capital since this amount is “paid-in” by the investors.

Teaching Tip

Exhibit 8.3 shows an example of stock issuance.

VI. Preferred stock are shares of stock that represent a special kind of ownership in a

corporation.

a. Owners have certain preferences over the common shareholders:

i. Receive dividends before common shareholders

ii. Receive assets before common shareholders if corporation dissolves

b. Owners do not have many of the rights that common shareholders have (e.g., voting

rights).

Cash Dividends (LO 2)

I. Cash dividends

a. Dividends are the distributions of a corporation’s earnings to shareholders.

b. Board of directors decides if, when, and how much to distribute.

c. There are three important dates related to dividends:

i. Declaration date

ii. Record date

iii. Payment date

d. Declaration date

i. Date on which the board of directors decides a dividend will be paid

ii. Establishes a legal liability called dividends payable

iii. Reduces retained earnings

iv. NOT an expense of the corporation

e. Record date

i. Used to determine exactly who will receive the dividends

ii. Whoever owns the stock on this date will receive the dividend.

f. Payment date

i. When cash is actually paid to the stockholders

ii. Assets (cash) and liabilities (dividends payable) are reduced.

Teaching Tip

Remind students that declaration of cash dividends increases liabilities because a cash dividend

requires a transfer of assets. Declaration of a stock dividend does not increase liabilities because

stock dividends require a distribution of stock, which is not an asset.

II. Distribution of dividends between common and preferred shareholders

a. Preferred stock has preference over common stock for dividends.

b. Preferred stock dividends are paid first, then if there is cash and retained earnings

available, common stockholders may receive a dividend.

c. Dividends on preferred stock are usually calculated as a fixed percentage of the par

value.

d. Cumulative preferred stock means the fixed dividend amount accumulates from year

to year if not paid, and the entire amount of all past dividends must be paid before any

dividends can be paid to common shareholders.

e. Noncumulative preferred stock means it is up to the board of directors to determine

whether or not to make up any missed dividends.

f. Dividends in arrears are dividends owed from past years but undeclared and unpaid.

Teaching Tip

Use the example that begins on page 378 to illustrate the declaration and payment of dividends.

Treasury Stock (LO 3)

I. Companies can buy and sell their own stock on the open market just like other investors.

a. Stock that has been issued and later reacquired by the company is called treasury

stock.

b. This stock can be resold or retired.

II. Companies purchase shares of their own stock for several reasons:

a. To have stock on hand to distribute to employees for compensation plans

b. To return cash to the shareholders using a way that is more flexible than paying cash

dividends

c. To increase the company’s earnings per share

d. To reduce the cash needed to pay future dividends

e. To reduce the chances of a hostile takeover

III. Accounting for the purchase

a. Purchase of treasury stock reduces assets (cash) and stockholders’ equity.

b. Treasury stock is shown as a reduction in total stockholders’ equity (a contra-equity

account).

IV. Selling treasury stock

a. No gains or losses are recorded when a company buys or sells treasury stock.

b. Most common way to account for treasury stock is at cost.

Teaching Tip

On January 1, ABC had 10,000 shares of $5 par common issued and outstanding. The stock was

originally issued for $20 per share. Total stockholders’ equity was $400,000. During the year,

ABC reacquired 1,000 shares of its own stock for $15 per share and subsequently reissued 500

shares for $16 per share. Net income and dividends paid during the year are $75,000 and

$25,000, respectively. What is ending stockholders’ equity? $443,000 {$400,000 – [(1,000 x

$15) + (500 x $16)] +$75,000 – $25,000} Emphasize that issuance of stock, sale of treasury

stock, and net income increase stockholders’ equity while purchase of treasury stock and

dividends decrease stockholders’ equity.

Stock Dividends and Stock Splits (LO 4)

I. Stock dividends are new shares of stock that are distributed to the company’s current

shareholders.

a. If a corporation wants to pay a dividend, but does not have sufficient cash on hand, it

can issue a stock dividend.

b. Retained earnings is decreased.

c. Contributed capital is increased.

d. The accounting equation is affected only by the way in which the equity accounts are

distributed.

e. There are no income tax effects for the corporation.

f. Stock dividends do not increase any shareholder’s percentage of ownership in the

company.

g. The dividend dates are still important: declaration, record, and payment.

h. A small stock dividend is less than 25% of the company’s outstanding stock.

i. The market value of the new shares is used to record the transaction.

i. A large stock dividend is more than 25% of the company’s outstanding stock.

i. The par value of the new shares is used to record the transaction.

II. A stock split is the division of the current shares of stock by a specific number to

increase the number of shares.

a. The number of shares of stock increases.

b. The par value decreases.

c. Different than a stock dividend because no new shares are issued

d. One reason for a stock split is to lower the market price of the stock.

e. A stock split may signal “good news” to the market.

f. No entry is recorded in the accounting system to reflect a stock split.

Teaching Tip

Use the following chart to help compare large stock dividends and stock splits.

Large Stock Stock

Dividends Splits

Par value per share no effect decreases

Market price decreases decreases

Number of issued shares increases increases

Number of outstanding shares increases increases

Number of treasury shares no effect increases

Total stockholders’ equity no effect no effect

Balance of Common Stock increases no effect

Retained Earnings (LO 5)

I. Retained earnings

a. The amount of all of the earnings of the firm that have not been distributed

b. May be called earned capital

c. Includes:

i. Profits since the day the company began

ii. Minus losses since the day the company began

iii. Minus dividends paid to stockholders since the company began

Team Shirts Issues New Stock (LO 6)

I. The summary problem uses the Team Shirts example developed in previous chapters.

II. Transactions for the month of August are introduced, including taking the business

public.

III. The students are shown the necessary adjusting entries and financial statements for the

month of August.

Applying Your Knowledge: Ratio Analysis (LO 7)

I. Return on equity (ROE)

a. Measures how well a company produces income with the amount of investment the

common shareholders have made in the company

b. Equal to net income minus preferred dividends divided by average common

shareholders’ equity

c. Only meaningful in comparison with other companies, industry standards, or other

years

Teaching Tip

The financial statements of the XYZ Co. reported the following information at the end of 20X2:

20X9 20X8

Net income $ 20,000 $ 22,500

Interest expense 5,000 6,000

6% Preferred stock 25,000 25,000

Common stock 50,000 50,000

Retained earnings 45,000 40,000

Total assets 210,000 190,000

XYZ declared and paid $13,500 and $10,000 to the common stockholders in 20X2 and 20X1,

respectively. What is the return on equity?

Return on equity: 20% [$20,000 – (6% x $25,000)]  [($90,000 + $95,000)  2]

II. Earnings per share (EPS)

a. Perhaps the most well known and used ratio

b. Analysts and investors use current earnings to predict future dividends and stock

prices.

c. Most common indicator of a company’s overall performance

d. Equal to net income minus preferred dividends divided by weighted average number

of common shares outstanding

e. Required to be calculated and presented on the financial statements of all public

companies

f. Basic EPS

i. This is equal to the EPS defined in part d above.

g. Diluted EPS

i. This measure is based on a “what-if” assumption.

ii. What if all of the potential securities that could have been converted into

common stock actually had converted to common stock at year end?

iii. These calculations are complex and beyond the scope of this course.

Business Risk, Control, and Ethics (LO 8)

I. Owners of a company take a risk that a company will not be successful.

II. Owners invest their money in hopes that they can make more money.

a. Appreciation in the market price of the stock

b. Dividends

III. Since the passage of the Sarbanes-Oxley Act of 2002, many firms are rethinking the costs

and benefits of being a publicly traded company.

CHAPTER 8 NAME ___________________________________

TEN-MINUTE QUIZ SECTION _____________ DATE____________

_____________________________________________________________________________

_

_____ 1. Shareholders’ equity is made up of:

a. Contributed capital and preferred stock

b. Assets and liabilities

c. Contributed capital and retained earnings

d. Common stock and capital stock

_____ 2. Common stockholders generally have which of the following rights?

a. Right to vote for members of the board of directors

b. Right to share in the corporation’s profits

c. Right to acquire more shares when the corporation issues new stock

d. All of the above

_____ 3. Preferred stock generally has a preference over common stock for:

a. Dividends

b. Voting

c. Buying more stock

d. All of the above

_____ 4. Shares of stock that are owned by shareholders rather than by the corporation are:

Authorized shares

Issued shares

Outstanding shares

Treasury shares

_____ 5. Anyone owning a corporation’s stock on the _______ date is entitled to receive

the dividend.

a. Declaration

b. Record

c. Payment

d. Issue

_____ 6. The purchase of treasury stock reduces the company’s assets (cash) and:

a. Reduces the company’s stockholders’ equity

b. Increases the company’s stockholders’ equity

c. Increases the company’s assets (investments)

d. None of the above

_____ 7. Stock dividends:

a. Increase the number of shares outstanding

b. Increase some shareholders’ percentage of ownership in the company

c. Reduce a company’s cash

d. Do not affect retained earnings

_____ 8. Which of the statements about a 2-for-1 stock split is true?

The number of shares will be cut in half.

The common stock account will double.

Total stockholders’ equity will increase.

The number of treasury shares will double.

_____ 9. Basic earnings per share is earnings divided by:

The ending number of shares issued

The weighted average number of shares issued

The ending number of shares outstanding

The weighted average number of shares outstanding

_____ 10. Return on equity is calculated as:

a. Net income (less preferred dividends) divided by average common stockholders’ equity

b. Net income divided by preferred stockholders’ equity

c. Retained earnings divided by average common stockholders’ equity

d. Net income (less preferred dividends) divided by average preferred stockholders’ equity

ANSWER KEY – CHAPTER 8 – TEN-MINUTE QUIZ

C

D

A

C

B

A

D

A