978-1133939283 Chapter 13 Lecture Note Part 2

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Summary

A corporation’s balance sheet contains assets, liabilities, and a stockholders’ equity section.

Stockholders’ equity is made up of contributed capital (the stockholders’ investments)

and retained earnings (earnings that have remained in the business), and sometimes

treasury stock.

A corporation may disclose more detail in a statement of stockholders equity, which

summarizes changes in components of the stockholders equity section of the balance sheet.

When only one type of stock is issued by a corporation, it is called common stock. Because

common stockholders’ claim to assets in case of liquidation ranks behind that of creditors

and preferred stockholders, common stock is considered the residual equity of a corporation.

The second kind of stock a company can issue is preferred stock. Preferred stock has

preference over common stock in one or more areas.

The maximum number of shares that can be issued is stipulated in the corporation‘s state

charter. This maximum amount is known as the authorized shares. The shares sold or

otherwise transferred to stockholders are the issued shares of a corporation. Shares that

have been issued to stockholders and remain in circulation, having been neither bought

back by the corporation nor given back by the stockholder, are called outstanding shares.

Treasury stock consists of shares bought back and being held by the corporation.

Holders of preferred stock are given preference over common shareholders when dividends

(and liquidating dividends) are declared; that is, the holders of preferred shares must receive

a certain amount of dividends before the holders of common shares can receive dividends.

This dividend is a speci)c dollar amount or percentage of par value. At times, preferred

stockholders do not receive the full amount of their annual dividends. When the stock is

noncumulative preferred stock, unpaid dividends are not carried over to the next period.

When the stock is cumulative preferred stock, the unpaid amount is carried over to the

next year. Unpaid “back dividends” are called dividends in arrears and should be

disclosed either on the balance sheet or in a note.

An owner of convertible preferred stock has the option to exchange each share of

preferred stock for a set number of shares of common stock.

Most preferred stock is callable preferred stock, meaning that the corporation has the

right to buy the stock back for cancellation at a speci)ed call or redemption price. Holders of

convertible preferred stock can choose instead to convert it to common stock.

Par value is the legal value established for a share of stock. Capital stock (common or

preferred) may or may not have a par value, depending on the speci)cations in the charter.

When par value stock is issued, the Capital Stock account is credited for the legal capital

(par value), and any proceeds received in excess of par value are recorded as Additional

Paid-in Capital. Both accounts appear in the stockholders’ equity section of the balance

sheet as part of contributed capital.

No-par stock is stock for which par value has not been established; it may be issued with

or without a stated value. Stated value (which is established by the board of directors)

constitutes the legal capital for a share of no-par stock. The total stated value is recorded in

the Capital Stock account. Any amount received in excess of the stated value is recorded as

Additional Paid-in Capital. If no stated value is set, however, the entire amount received

constitutes legal capital and is credited to Capital Stock.

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 2

When stock is issued in exchange for assets or for services rendered, the assets should be

recorded at the fair market value of the stock given up. If the stock’s fair market value

cannot be determined, the transaction is recorded at the fair market value of the assets or

services.

The following journal entries are introduced in this section for the issuance of stock:

Cash XX (amount invested)

Common Stock XX (legal capital amount)

Additional Paid-in Capital XX (excess of par)

Issued par value common stock for amount in excess

of par value

Cash XX (amount invested)

Common Stock XX (legal capital amount)

Issued no-par common stock (no stated value

established)

Cash XX (amount invested)

Common Stock XX (legal capital amount)

Additional Paid-in Capital XX (excess of stated value)

Issued no-par common stock with stated value for

amount in excess of stated value

Legal(or Other) Expenses XX (fair market value of

services)

Common Stock XX (par value)

Additional Paid-in Capital XX (excess of par)

Issued par value common stock for services when no

market value for the stock exists.

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 3

Land (or Other Asset) XX (fair market value of stock)

Common Stock XX (par value)

Additional Paid-in Capital XX (excess of par)

Issued par value common stock with a market value

in excess of par value for an asset

A company’s treasury stock, as explained earlier, comprises common or preferred shares

that are issued but no longer outstanding. Treasury stock may be purchased for a variety of

reasons: (1) to distribute to employees through stock option plans, (2) to maintain a

favorable market for the company’s stock, (3) to increase earnings per share, (4) to use in

purchasing other companies, and (5) to prevent a hostile takeover of the company.

Treasury stock can be held inde)nitely, reissued, or retired; it carries no rights until it is

reissued. Treasury stock appears on the balance sheet as the last item in the stockholders’

equity section as a deduction.

When treasury stock is purchased, Treasury Stock, Common is debited for the purchase cost.

The stock may be reissued at cost, above cost, or below cost. When cash received from

reissuance exceeds the cost, the di?erence is credited to Paid-in Capital, Treasury Stock.

When cash received from reissuance is less than the cost, Paid-in Capital, Treasury Stock is

debited for the di?erence up to its credit balance. If an insu@cient credit balance, Retained

Earnings is debited for the remaining di?erence. In no instance should a gain or loss account

be established.

When treasury stock is retired, all the contributed capital associated with the retired shares

must be removed from the accounts. When less was paid on reacquisition than was

contributed originally, the di?erence is credited to Paid-in Capital, Retirement of Stock. When

more is paid, the di?erence is debited to Retained Earnings.

The following journal entries are introduced in this section for treasury stock transactions:

Treasury Stock, Common XX (cost)

Cash XX (amount paid)

Acquired shares of the company’s common stock

Cash XX (resale price)

Treasury Stock, Common XX (cost)

Reissued shares of treasury stock at cost

Cash XX (resale price)

Treasury Stock, Common XX (cost)

Paid-in Capital, Treasury Stock XX (“gain”)

Sold shares of treasury stock at above cost

Cash XX (resale price)

Paid-in Capital, Treasury Stock XX (“loss”)

Retained Earnings XX (“loss”)

Treasury Stock, Common XX (cost)

Sold shares of treasury stock at below cost when

Paid- in Capital, Treasury Stock has insu@cient credit

balance to cover di?erence.

Common Stock XX (par value)

Additional Paid-in Capital XX (excess of par)

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 4

Retained Earnings XX (premium paid)

Treasury Stock—Common XX (cost)

Retired treasury stock; cost exceeded original

issue proceeds

If the above treasury stock had been retired for an amount less than the original investment

amount, then instead of Retained Earnings being debited for the excess paid, Paid-in Capital,

Retirement of Stock would be credited for the di?erence.

A dividend is a distribution among stockholders of the assets that a corporation’s earnings

have generated. These assets are normally distributed in cash.

Dividends can be paid quarterly, semiannually, annually, or at other times as declared by

the board of directors. A dividend that exceeds retained earnings is not allowed in most

states. When such a dividend is declared, it is called a liquidating dividend and is usually

paid when a company is going out of business or reducing its operations.

Dividends are declared on the declaration date, specifying that the owners of the stock on

the record date will receive the dividends on the date of payment.

When cash dividends are declared, the Dividends account is debited and Dividends Payable

is credited; when they are paid, Dividends Payable is debited and Cash is credited. The

Dividends account is closed to Retained Earnings at the end of the period. No journal entry is

made on the record date. After the record date, stock is sold ex-dividend (without dividend

rights).

The following journal entries were introduced in this section for cash dividends transactions:

Dividends XX

Dividends Payable XX

Declared a cash dividend on common stock

Dividends Payable XX

Cash XX

Paid cash dividend on common stock

A stock dividend is a pro rata distribution of shares of stock to a corporation’s

stockholders. The main reasons that stock dividends are declared are to (1) e?ect a noncash

distribution, (2) reduce the stock’s market price, (3) allow a nontaxable distribution, and (4)

increase the company’s permanent capital by transferring an amount from retained earnings

to contributed capital. The result of a stock dividend is the transfer of a portion of retained

earnings to contributed capital. For a small stock dividend (less than 20 to 25 percent), the

market value of the shares distributed is transferred from retained earnings. For a large

stock dividend (greater than 20 to 25 percent), the par or stated value is transferred. A stock

dividend does not change total stockholders’ equity, nor does it change each stockholder’s

proportionate equity in the company.

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 5

A stock split is an increase in the number of shares of stock outstanding with a

corresponding decrease in the par or stated value of the stock. For example, a 3-for–1 split

on 40,000 shares of $30 par value stock results in the distribution of 80,000 additional

shares (that is, a former owner of 1 share now owns 2 more shares) and the reduction of par

value to $10. The amount for each component of stockholders’ equity is not a?ected.

The purpose of a stock split is to improve the stock’s marketability by decreasing the stock’s

market price. Thus, if a stock were selling for $180 per share, a 3-for-1 split would probably

cause the market price to decline to approximately $60 per share. A memorandum entry

should be made for a stock split, disclosing the decrease in par or stated value as well as the

increase in shares of stock outstanding.

The following journal entries were introduced in this section for stock dividend transactions:

Stock Dividends XX (amount transferred)

Common Stock Distributable XX (par value amount)

Additional Paid-in Capital XX (excess of par)

Declared a stock dividend on common stock (less

than 25 percent)

Common Stock Distributable XX (par value amount)

Common Stock XX (par value amount)

Distributed a stock dividend

The statement of stockholders’ equity (also called the statement of changes in

stockholders’ equity) can be used in place of the statement of retained earnings. It is

basically a labeled computation of the changes in the stockholders’ equity accounts during

the accounting period. It contains all the components of the statement of retained earnings

as well as a summary of the period’s stock transactions.

The book value of a company’s stock represents the total assets of the company less its

liabilities. The book value per share is the equity of the owner of one share of stock in the

net assets of the corporation. It is calculated by dividing stockholders’ equity by the number

of outstanding and subscribed shares. When a company also has preferred stock, the call or

par value of the preferred stock plus any dividends in arrears is deducted from stockholders’

equity in calculating the book value per share of common stock.

Relevant Examples and Exhibits

Exhibit 2 Stockholders’ Equity Section of a Balance Sheet

Exhibit 3 Relationship of Authorized Shares to Unissued, Issued, Outstanding, and

Treasury Shares

Example: Dividends in Arrears

Example: Dividend Distribution

Example: Issuing Stock Above Par Value

Example: Issuing No-Par Stock with No State Value

Example: Issuing No-Par Stock with a Stated Value

Example: Issuing Stock for Noncash Assets When No Market Value for the Stock Exists

Example: Issuing Stock for Noncash Assets When Market Value for the Stock Exists

Example: Purchase of Treasury Stock

Example: Sale of Treasury Shares at Cost

Example: Sale of Treasury Shares Above Cost

Example: Sale of Treasury Shares Below Cost

Example: Retiring Treasury Stock

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 6

Example: Cash Dividends at the Declaration Date, Record Date, and Payment Date

Example: Stock Dividends at the Declaration Date, Record Date, and Payment Date

Example: Stock Split

Example: E?ect of a Stock Split on Stockholders’ Equity

Exhibit 4 Statement of Stockholders’ Equity

Exhibit 5 Stockholders’ Equity Section of a Balance Sheet

Example: Book Value for Common and Preferred Stock

Example: Book Value for Dividends in Arrears

Exhibit 6 Stockholders’ Equity Section of the Balance Sheet

Teaching Strategy

Show students the balance sheet that follows. Then conceal the asset part while discussing

the components of stockholders’ equity. Each time a new account is introduced, show this

balance sheet and locate the new account with the students. At this point, do not go into

detail about each account; simply emphasize that there are two major categories—

contributed capital and retained earnings. Show how the credit to capital is speci)cally

stated when an owner contributes to (buys stock in) a corporation. (Short Exercise 4 is a

good illustration.) Case 5 deals with stockholders’ equity.

Balance Sheet

Corporation Name

12/31/x1

Current Assets: Current Liabilities:

Cash Notes Payable

Marketable Securities Accounts Payable

Notes Receivable Salaries Payable

Accounts Receivable Dividends Payable

Subscriptions Receivable

Inventory Total Current Liabilities

Prepaid Expenses

Long-Term Liabilities:

Total Current Assets Bonds Payable

Total Liabilities

Property, Plant, and Equipment:

Land Stockholders’ Equity

Building

Less Accumulated Depreciation Contributed Capital:

Equipment Preferred Stock

Less Accumulated Depreciation Common Stock

Common Stock Distributable

Total Property, Plant, and Equipment Additional Paid-in Capital

Total Contributed Capital

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 7

Intangible Assets:

Trademarks Retained Earnings

Patents

Goodwill

Total Contributed Capital and

Retained Earnings

Less Treasury Stock

Total Intangible Assets

Total Stockholders’ Equity

Total Assets Total Liabilities and Stockholders’

Equity

Explain preferred stock as stock that has preference over common stock when dividends are

paid and when assets are distributed if the corporation is liquidated. Note that preferred

stock usually has no voting rights.

List the following and explain each characteristic:

Characteristics of preferred stock:

Cumulative—stockholder’s advantage

Noncumulative—corporation’s advantage

Convertible—stockholder’s advantage

Callable—corporation’s advantage

Refer back to the terms cumulative and noncumulative. Use Short Exercise 5 and Exercises

3A, 4A and 5A to show the e?ect of each. Use or assign Case 3 to illustrate issuing stock.

Explain par value and stated value and how they limit the dollar amount to credit the stock

accounts. Use Short Exercise 6 and Exercises 6A and 7A to demonstrate the issuance of

stock.

When stock is issued for noncash assets, students have di@culty understanding the amount

to debit the noncash asset the corporation receives. The misunderstanding seems to arise

because the amount is the fair market value of what is given up if the stock’s fair market

value is known. If it is not known, then the amount of the debit is the fair market value of

what is received. Show the following chart:

Noncash Asset

Received Stock Issued

Amount to Debit the

Asset Received

Fair Market Value (FMV) unknown

FMV known

FMV unknown

FMV known

FMV of stock

FMV of asset

FMV of stock

Use Short Exercise 7 and Exercise 8A to demonstrate the issuance of stock for noncash

assets.

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 8

After explaining why a company purchases its own stock, if time permits and if students

need the visual presentation, write out the journal entries as follows:

Purchase: Treasury Stock at cost

Cash at cost

Reissue at cost: Cash at cost, which equals reissue price

Treasury Stock

Reissue at more than cost: Cash at reissue price

Treasury Stock at cost

Paid-in Capital, Treasury Stock

Reissue at less than cost: Cash at reissue price

Paid-in Capital, Treasury Stock for

di?erence between cost and reissue

price, not to exceed its credit balance

Retained Earnings if the credit balance in

Paid-in Capital, Treasury Stock is

insu@cient

Treasury Stock, Common

Work Short Exercises 8 and 9 and Exercises 9A and 10A for practice. Exercise 10A includes

the retirement of treasury stock. Use Case 2 to illustrate the purposes of treasury stock.

After explaining what a stock dividend is and why it is given, “walk” the students through the

entries in the text for Wing Corporation. Also, use the illustrations in the text to show the

“before” and “after” e?ect on stockholders’ equity of declaring a stock dividend. Show that

a stock dividend represents, in e?ect, a reshuLing of stockholders’ equity.

Use the illustrations in the text to show the “before” and “after” e?ect on stockholders’

equity of declaring a stock split. Show that there is no change in the numerical totals.

There is only a change in the par value, shares issued, and shares outstanding.

Short Exercises 11, 12, 13 and Exercises 13A, 14A, and 15A cover stock dividend and stock

split transactions.

After de)ning book value and book value per share, use the following model to show how

book value is calculated. Short Exercise 15 and Exercise 17A cover this topic.

Section 3: Business Applications

Business Applications

Evaluate dividend policies

oDividend yield

Evaluate pro)tability

oReturn on equity

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 9

Evaluate investors’ con)dence in a company’s future

oPrice/earnings ratio

Evaluate stock options

Lecture Outline

I. Investors use the dividend yield ratio to evaluate the amount of dividends they receive.

A. The dividend yield is computed as: Dividends per Share ÷ Market Price per

II. The return on equity ratio is a common measure of management’s performance.

A. The return on equity is computed as: Net Income ÷ Average Total

Stockholders’ Equity

III. The price/earnings (P/E) ratio is a measure of investors’ con)dence in a company’s

future.

A. The P/E ratio is computed as: Market Price per Share ÷ Earnings per Share

IV. The best information regarding cash Oows related to equity transactions is found in the

)nancing section of the statement of cash Oows.

A. The following a reOections of a company’s success:

1. Increasing treasury stock purchases

2. Decreasing new stock issues

3. Cash dividends

V. Stock option plans give employees the right to purchase stock in the future at a )xed

price.

A. These plans are a means of both motivating and compensating employees.

B. Investors evaluate these plans to determine their e?ect on:

1. Current and future )nancial statements.

2. The value of their investments.

Summary

The dividend yield is a ratio that measures the return on a stock investment from

dividends. The dividend yield is calculated by dividing dividends per share by market price

per share.

The return on equity is a ratio that measures management’s performance by dividing net

income by average stockholders’ equity. It is used to evaluate companies and even to

determine top executives’ compensation.

The price/earnings (P/E) ratio, a measure of investors’ con)dence in a company’s future,

is calculated by dividing the market price per share by the earnings per share.

Stock option plans are agreements whereby employees may purchase a speci)ed quantity

of the company’s stock at a )xed price for a stated period. If only certain employees (usually

management) are eligible for this bene)t, the plan is said to be compensatory. The amount

of compensation equals the market price on the date the option is granted minus the option

price. The amount in excess of the exercise price must be either recorded as compensation

expense over the grant period or reported in the notes to the )nancial statements.

Relevant Examples and Exhibits

Ratio: Dividend Yield

Ratio: Return on Equity

or posted to a publicly accessible website, in whole or in part.

Chapter 13: Accounting for Corporations Instructor’s Manual, p. 10

Ratio: Price/Earnings Ratio

Teaching Strategy

Use Short Exercise 16 and Exercise 18A to demonstrate dividend yield and price/earnings

ratios. Problem 9 can be used to demonstrate preferred and common stock dividends and

dividend yield. Problem 10 provides comprehensive stockholders’ equity transactions and

)nancial ratios.

Student Engagement Tactics

00. Assign Case 6 to small groups in class. Use previously established groups or assign

groups randomly. Each group should select a representative to speak for the group.

00. Be clear on the expected output of the learning activity. Identify questions to address

and determine whether written answers are necessary. For example, ask one person

from each group to present one alternative and explain why that alternative would be

best.

00. Elicit as many alternatives as possible for the class to consider. After each group has

presented one alternative, if time permits, ask if any other alternatives might be

available.

00. Allow groups one or two minutes to consider which alternative they prefer and why. Poll

the class as to their preferred response.

or posted to a publicly accessible website, in whole or in part.