Chapter 10 – Stockholders’ Equity
10-1
Chapter 10
Stockholders’ Equity
INSTRUCTOR’S MANUAL
Learning Objectives
LO10-1 Identify the advantages and disadvantages of the corporate form of ownership.
LO10-2 Record the issuance of common stock.
LO10-3 Contrast preferred stock with common stock and bonds payable.
LO10-4 Account for treasury stock.
LO10-5 Describe retained earnings and record cash dividends.
LO10-6 Explain the effect of stock dividends and stock splits.
LO10-7 Prepare and analyze the stockholders’ equity section of a balance sheet and the
statement of stockholders’ equity.
Analysis
LO10-8 Evaluate company performance using information on stockholders’ equity.
Chapter 10 – Stockholders’ Equity
10-2
Teaching Suggestions
Chapter 10 is divided into three parts: invested capital, earned capital, and reporting
stockholders’ equity. The chapter uses American Eagle, one of the top companies in retail
clothing, to provide real-world examples in reporting stockholders’ equity. An underlying theme
in the chapter and end-of-chapter material is clothing stores you would find in a mall, a favorite
hangout for college students (and many instructors).
Part A, titled “Invested Capital,” provides background information on the corporate form of
business and describes the accounting for common stock, preferred stock, and treasury stock.
The section describes the advantages and disadvantages of a corporation relative to sole
proprietorships and partnerships. Illustration 10-5 provides a summary of advantages and
disadvantages of a corporation. This section also includes a brief discussion on the stages of
equity financing not found in competing financial accounting texts. We think it is important for
students to understand that companies do not form and then immediately offer stock to the
general public. Rather, companies go through several stages of equity financing prior to selling
shares to the general public. The reporting of common stock, preferred stock, and treasury stock
are illustrated using one continuing example, Canadian Falcon.
Part B is titled “Earned Capital” and examines transactions related to retained earnings. The
recording of cash dividends is covered first including a discussion as to why many profitable
companies pay little or no dividends. Stock dividends and stock splits are covered in a little more
depth using the continuing example of Canadian Falcon. It’s important to emphasize the reason
for most large stock dividends and stock splits—to lower the trading price of the stock to a more
acceptable trading range, making it attractive to a larger number of potential investors (see the
decision maker’s perspective in this section).
Part C analyzes the stockholders’ equity section for American Eagle. The decision maker’s
perspective in this section is designed to help students understand why stockholders’ equity
reported on the balance sheet doesn’t usually equal the true market value of equity. This section
also demonstrates how a separate statement of stockholders’ equity differs from the
stockholders’ equity section reported in the balance sheet. The stockholders’ equity section
reported in the balance sheet shows the balance in each equity account at a point in time. In
contrast, the statement of stockholders’ equity summarizes the changes in the balance in each
equity account over a period of time.
The chapter ends with the calculation of financial ratios for Ralph Lauren vs. Abercrombie &
Fitch. Ratios include the return on equity, dividend yield, earnings per share, and the price-
earnings ratio.
Chapter 10 – Stockholders’ Equity
10-3
A
As
ss
si
ig
gn
nm
me
en
nt
t
C
Ch
ha
ar
rt
ts
s
Questions
Learning
Objective(s)
Topic
Time
(Min.)
1
LO10-1
Describe stages of equity financing
5
2
LO10-1
Provide examples of public and private corporations
5
3
LO10-1
Describe the four basic ownership rights of common
stockholders
5
4
LO10-1
Compare forms of business
5
5
LO10-1
Describe the primary advantages and disadvantages
of a corporation
5
6
LO10-1
Explain the benefits of an LLC or an S corporation
5
7
LO10-2
Explain the difference between authorized, issued,
and outstanding shares
5
8
LO10-2
Identify how many shares are authorized, issued,
and outstanding
5
9
LO10-2
Describe par value and how it used in recording the
issuance of stock
5
10
LO10-3
Discuss the three potential features of preferred
stock
5
11
LO10-3
Explain why preferred stock is a mixture of
attributes between common stock and bonds
5
12
LO10-4
Discuss what would motivate a company to buy
back its own stock
5
13
LO10-4
Describe how treasury stock differs from the
purchase of stock in another corporation
5
14
LO10-5
Explain why some companies choose not to pay
dividends
5
15
LO10-5
Describe the declaration date, record date, and
payment date for a cash dividend
5
16
LO10-6
Explain the effects of a 100% stock dividend or a 2-
for-1 stock split
5
17
LO10-6
Contrast the effects of a cash dividend with a stock
dividend
5
18
LO10-6
Describe the effects of a 2-for-1 stock split on par
value, share price, and shares outstanding
5
19
LO10-7
Indicate the correct order to report accounts within
stockholders’ equity
5
20
LO10-7
Contrast the stockholders’ equity section of the
balance sheet with the statement of stockholders’
equity
5
21
LO10-7
Discuss why stockholders’ equity doesn’t equal the
value of the firm
5
22
LO10-8
Explain the use of earnings per share in making
comparisons
5
23
LO10-8
Explain how investors use the PE ratio
5
Chapter 10 – Stockholders’ Equity
10-4
Brief
Exercises
Learning
Objective(s)
Topic
Time
(Min.)
BE10-1
LO10-1
Cite advantages and disadvantages of a corporation
10
BE10-2
LO10-1
Understand an S corporation
10
BE10-3
LO10-2
Record issuance of common stock
5
BE10-4
LO10-2
Record issuance of common stock
5
BE10-5
LO10-3
Record issuance of preferred stock
5
BE10-6
LO10-3
Recognize preferred stock features
5
BE10-7
LO10-3
Determine the amount of preferred stock dividends
5
BE10-8
LO10-4
Record purchase of treasury stock
5
BE10-9
LO10-4
Record sale of treasury stock
5
BE10-10
LO10-5
Record cash dividends
5
BE10-11
LO10-6
Record stock dividends
5
BE10-12
LO10-6
Analyze a stock split
5
BE10-13
LO10-7
Indicate effects on total stockholders’ equity
5
BE10-14
LO10-7
Prepare the stockholders’ equity section
10
BE10-15
LO10-8
Calculate the return on equity
5
Exercises
Learning
Objective(s)
Topic
Time
(Min.)
E10-1
LO10-1
Match terms with their definitions
10
E10-2
LO10-2, 10-3,
10-4
Explain the meaning of terms used in stockholders’
equity
15
E10-3
LO10-2
Record the issuance of common stock
25
E10-4
LO10-3
Determine the amount of preferred stock dividends
15
E10-5
LO10-2, 10-3,
10-5
Record common stock, preferred stock, and
dividend transactions
15
E10-6
LO10-2, 10-3,
10-4
Record issuance of stock and treasury stock
transactions
15
E10-7
LO10-7
Prepare the stockholders’ equity section
20
E10-8
LO10-5
Record cash dividends
10
E10-9
LO10-2, 10-4,
10-5
Record common stock, treasury stock, and cash
dividends
15
E10-10
LO10-6
Record stock dividends and stock splits
20
E10-11
LO10-7
Prepare the stockholders’ equity section
20
E10-12
LO10-7
Prepare a statement of stockholders’ equity
20
E10-13
LO10-7
Indicate effects on total stockholders’ equity
15
E10-14
LO10-7
Prepare the stockholders’ equity section
20
E10-15
LO10-8
Calculate and analyze ratios
15
E10-16
LO10-8
Calculate and analyze ratios
15
E10-17
LO10-2, 10-4,
10-5, 10-8
Complete the accounting cycle including
stockholders’ equity transactions
60
Chapter 10 – Stockholders’ Equity
10-5
Problems
Learning
Objective(s)
Topic
Time
(Min.)
P10-1A
LO10-1
Match terms with their definitions
15
P10-2A
LO10-2, 10-3,
10-4, 10-5
Record equity transactions and indicate the effect on
the balance sheet equation
30
P10-3A
LO10-6
Indicate effect of stock dividends and stock splits
10
P10-4A
LO10-7
Analyze the stockholders’ equity section
15
P10-5A
LO10-7
Understand stockholders’ equity and the statement
of stockholders’ equity
40
P10-6A
LO10-2, 10-3,
10-4, 10-5,
10-7
Record equity transactions and prepare the
stockholders’ equity section
35
P10-7A
LO10-8
Calculate and analyze ratios
20
P10-1B
LO10-1 to
LO10-8
Match terms with their definitions
15
P10-2B
LO10-2, 10-3,
10-4, 10-5
Record equity transactions and indicate the effect on
the balance sheet equation
30
P10-3B
LO10-6
Indicate effect of stock dividends and stock splits
10
P10-4B
LO10-7
Analyze the stockholders’ equity section
15
P10-5B
LO10-7
Understand stockholders’ equity and the statement
of stockholders’ equity
40
P10-6B
LO10-2, 10-3,
10-4, 10-5,
10-7
Record equity transactions and prepare the
stockholders’ equity section
35
P10-7B
LO10-8
Calculate and analyze ratios
20
Additional
Perspectives
Topic
Time
(Min.)
AP10-1
Continuing Problem: Great Adventures
35
AP10-2
Financial Analysis: American Eagle Outfitters, Inc.
15
AP10-3
Financial Analysis: The Buckle, Inc.
15
AP10-4
Comparative Analysis: American Eagle Outfitters, Inc. vs. The
Buckle, Inc.
20
AP10-5
Ethics
20
AP10-6
Internet Research
20
AP10-7
Written Communication
20
AP10-8
Earnings Management
30
Chapter 10 – Stockholders’ Equity
10-6
Chapter Quiz Questions
The following multiple-choice questions are 10 unique quiz questions that correspond to the 10
questions at the end of each chapter. Each question covers the same learning objective but with a
little different twist. The correct answer is highlighted in bold for each item.
LO10-1
LO10-1
2. The advantages of owning a corporation include all of the following except:
LO10-2
LO10-3
4. Which of the following is not a potential feature of preferred stock?
LO10-4
5. When treasury stock is purchased, what is the effect on total shareholders’ equity?
10-7
LO10-5
6. Retained earnings:
LO10-5
7. Entries for cash dividends are recorded on all of the following dates except:
LO10-6
8. What effect does a stock dividend have on total stockholders’ equity?
LO10-7
9. Which of the following summarizes the changes in the balance in each stockholders’ equity
account over a period of time?
LO10-8
10. Return on equity is calculated as:
Chapter 10 – Stockholders’ Equity
10-8
Alternate Let’s Review
Problem #1
Forever Young has two classes of stock authorized: $100 par preferred and $1 par common. As
of the beginning of the year, 5,000 shares of common stock and no preferred shares have been
issued. The following transactions affect stockholders’ equity during the year:
January 10 Issue 1,000 additional shares of common stock for $30 per share.
March 1 Issue 1,000 shares of preferred stock for $105 per share.
July 1 Declare a cash dividend of $5 per share on preferred stock and $1.25 per share on
common stock to all stockholders of record on July 15.
July 31 Pay the cash dividend declared on July 1.
October 10 Purchase 500 shares of treasury stock for $28 per share.
November 1 Issue 200 shares of the treasury stock purchased on October 10 for $26 per share.
Forever Young has the following beginning balances in its stockholders’ equity accounts:
Preferred stock, $0; common stock, $5,000; additional paid-in capital, $20,000; and retained
earnings, $10,000.
Required:
1. Record each of these transactions.
2. Indicate whether each of these transactions increases (+), decreases (−), or has no effect
(NE), on total assets, total liabilities, and total stockholders’ equity.
Solution:
1.
January 10
Debit
Credit
Cash (1,000 x $30)
30,000
Common Stock (1,000 x $1)
1,000
Additional Paid-in Capital (difference)
29,000
March 1
Cash (1,000 x $105)
Preferred Stock (1,000 x $100)
Additional Paid-in Capital (difference)
5,000
Dividends*
12,500
Dividends Payable
12,500
Chapter 10 – Stockholders’ Equity
July 31
Dividends Payable
12,500
12,500
October 10
Treasury Stock (500 shares x $28)
14,000
14,000
November 1
2.
Transaction
Issue common stock
Issue preferred stock
Declare cash dividends
Pay cash dividends
Purchase treasury stock
Reissue treasury stock
Total
Total
Total
Stockholders’
10-10
Problem #2
This is a continuation of problem #1. Forever Young has two classes of stock authorized: $100
par preferred and $1 par value common. As of the beginning of 2018, no preferred stock has
been issued and 5,000 shares of common stock have been issued. The following transactions
affect stockholders’ equity during 2018:
January 10 Issue 1,000 additional shares of common stock for $30 per share.
March 1 Issue 1,000 shares of preferred stock for $105 per share.
July 1 Declare a cash dividend of $5 per share on preferred stock and $1.25 per share on
common stock to all stockholders of record on July 15.
July 31 Pay the cash dividend declared on July 1.
October 10 Repurchase 500 shares of treasury stock for $25 per share.
November 1 Reissue 200 shares of the treasury stock purchased on October 10 for $26 per
share.
Forever Young has the following beginning balances in its stockholders’ equity accounts on
January 1, 2018: Preferred stock, $0; common stock, $5,000; additional paid-in capital, $20,000;
and retained earnings, $10,000. Net income for the year ended December 31, 2018, is $16,000.
Required:
Taking into consideration the beginning balances and all of the transactions during 2018, prepare
the following:
1. The stockholders’ equity section as of December 31, 2018.
2. The statement of stockholders’ equity for the year ended December 31, 2018.
Solution:
1.
Forever Young
Balance Sheet (partial)
December 31, 2018
Stockholders’ equity:
Preferred stock, $100 par value
100,000
Common stock, $1 par value
6,000
Additional paid-in capital
159,600
Retained earnings
Treasury stock
164,700
Chapter 10 – Stockholders’ Equity
10-11
2.
Forever Young
Statement of Stockholders’ Equity
For the year ended December 31, 2018
Preferred
Stock
Common
Stock
Additional
Paid-in
Capital
Retained
Earnings
Treasury
Stock
Total
Stockholders’
Equity
Balance, January 1
-0-
5,000
20,000
10,000
-0-
35,000
Issue common stock
1,000
29,000
30,000
Issue preferred stock
5,000
Cash dividends
Sale of treasury stock
Net income
16,000
Balance, December 31
Chapter 10 – Stockholders’ Equity
10-12
Key Points by Learning Objective
LO10-1 Identify the advantages and disadvantages of the corporate form of ownership.
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
LO10-3 Contrast preferred stock with common stock and bonds payable.
LO10-4 Account for treasury stock.
LO10-5 Describe retained earnings and record cash dividends.
LO10-6 Explain the effect of stock dividends and stock splits.
LO10-7 Prepare and analyze the stockholders’ equity section of a balance sheet and the
statement of stockholders’ equity.
Analysis
10-13
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
Chapter 10 – Stockholders’ Equity
10-14
Common Mistakes
Common Mistake
Some students confuse par value with market value. Par value is the legal capital per share that is
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
Common Mistake
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 can differ greatly from the balance in the Cash
Chapter 10 – Stockholders’ Equity
10-15
Decision Points
Question
Accounting Information
Analysis
and outstanding?
section of the balance sheet. If the
How many of a
company’s shares are
authorized, issued,
Balance sheet
The number of authorized, issued, and
outstanding shares is normally
reported in the stockholders’ equity
Question
Accounting Information
Analysis
How much profit has the
Balance in Retained Earnings
The balance in Retained Earnings
Question
Accounting Information
Analysis
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
Chapter 10 – Stockholders’ Equity
10-16
Ethical Dilemma
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. 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.
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