Chapter 11
Stockholders’ Equity
After studying this chapter, students should be able to:
◼ Understand the concept of stockholders’ equity and identify the components of the Stockholders’
Equity category of the balance sheet and the accounts found in each component (Module 1–LO1).
◼ Show that they understand the characteristics of common and preferred stock and the differences
between the classes of stock (Module 1–LO2).
◼ Determine the financial statement impact when stock is issued for cash or for other consideration
(Module 1–LO3).
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Chapter Outline
MODULE 1 STOCKHOLDERS’ EQUITY, ISSUANCE OF STOCK,
AND TREASURY STOCK
Module 1
LO1
Stockholders’ Equity, Issuance of Stock, and Treasury Stock
◼ Financing can be divided into two general categories:
• Debt (borrowing from banks or other creditors).
• Equity (issuing stock).
◼ Disadvantages of issuing stock (Exhibit 11-1):
• Control of the company is more widely distributed since stock generally has voting rights.
Existing shareholders may not want to share control of company.
• Tax disadvantage to the company since dividends are not tax deductible, whereas interest on
debt can be deducted.
Stockholders’ Equity on the Balance Sheet
◼ Remember the accounting equation is stated as Assets = Liabilities + Stockholders’ Equity.
• Stockholders’ equity is viewed as a residual amount.
• Owners have a claim to all assets after the liabilities to creditors have been satisfied.
CHAPTER 11 STOCKHOLDERS’ EQUITY
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◼ Stockholders’ Equity category has two major components: contributed capital and retained
earnings.
How Income and Dividends Affect Retained Earnings
◼ Retained Earnings account serves as a link between the income statement and the balance sheet
(Exhibit 11–2).
Identifying Components of the Stockholders’ Equity Section of the Balance Sheet
◼ Two general categories of stock:
• Common stock.
◼ Number of Shares.
• Authorized shares: maximum number of shares a corporation may issue as indicated in the
corporate charter.
Corporation applies for more shares authorized than needed to allow for future growth.
• Issued: number of shares which have been sold or transferred to stockholders.
However, this does not necessarily mean the number of shares currently outstanding.
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Reduces the number of shares outstanding.
◼ Par value is an arbitrary amount stated on the face of the stock certificate and represents the legal
capital of the corporation.
• Generally set at very low amounts because there are legal difficulties if sold at less that par
value.
◼ Additional paid-in-capital is the amount received for stock in addition to par value. May also be
called:
• Paid-in capital in excess of par or Premium on stock.
• Often recorded on the balance sheet on a single line, for all classes of stock.
IFRS and Stockholders’ Equity
◼ IFRS similar to U.S. accounting standards.
◼ Major difference is treatment of items that have characteristics of both debt and equity.
Module 1
LO 2
Preferred Stock
◼ Preferred stock is flexible, with provisions tailored to company’s needs.
CHAPTER 11 STOCKHOLDERS’ EQUITY
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◼ The greater the obligation to preferred stock, the less attractive the common stock.
◼ If corporation is liquidated or dissolved, preferred stockholders have a right to the company’s
assets before the common stockholders.
◼ Participating: When preferred stock carries a participating feature, it allows the preferred
stockholders to receive a dividend in excess of the regular rate when the firm has been particularly
profitable and declares an abnormally large dividend.
◼ Preferred stock is attractive to investors:
• Offers a return in the form of a dividend at a level of risk that is lower than that of most
common stocks.
Module 1
LO 3
Issuance of Stock
Stock Issued for Cash
◼ When stock is issued for cash, the amount of its par value should be reported in the Stock account
and the amount in excess of par should be reported in the Additional Paid-In Capital account. The
total amount increases cash.
• Journal entry is a debit to Cash, credit to Common (or Preferred) Stock and a credit to
Additional Paid-In Capital (Common or Preferred). (Example 11–1)
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Stock Issued for Noncash Consideration
◼ Must be recorded at the fair market value of the stock or the assets received, whichever is most
readily determined.
Module 1
LO 4
What Is Treasury Stock?
Treasury stock is stock issued by the firm and then repurchased but not retired.
◼ In order to be considered treasury stock, it:
• Must be the corporation’s own stock.
• Must have been issued to the stockholders’ at some point.
◼ Treasury stock is not outstanding stock, has no voting rights, and does not receive dividends.
◼ Two methods to account for treasury stock transactions – cost method and par value method. Cost
method is most common method and is the one discussed. See Example 11-3 for recording the
purchase of treasury stock.
• Debit to Treasury Stock, a contra-equity account (not an asset) and a credit to Cash.
Cash is decreased, and stockholders’ equity is decreased. No impact on net income.
• Treasury Stock, a contra-equity account, has a debit balance.
Company is contracting its size and reducing the equity of the stockholders.
CHAPTER 11 STOCKHOLDERS’ EQUITY
Retirement of Stock
◼ The stock is repurchased with no intention of reissuing it at a later date.
◼ Company may wish to eliminate a particular class of stock or group of stockholders.
MODULE 2 CASH DIVIDENDS, STOCK DIVIDENDS, AND STOCK
SPLITS
Module 2
LO 5
Cash Dividends
◼ Cash dividends are the most common type of dividend.
◼ Can be declared quarterly, annually, or at other intervals.
◼ Several important dates related to cash dividends:
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◼ Most firms have an established policy concerning the portion of income that will be declared as
dividends.
◼ The dividend payout ratio is the annual dividend amount divided by the annual net income.
◼ Cash dividends become a liability on the date they are declared. (Example 11-4)
Cash Dividends for Preferred and Common Stock
◼ When more than one class of stock is outstanding, cash dividends must be allocated to each class
of stock.
◼ Calculate amount due preferred shareholders first, per the terms and provisions of the preferred
stock.
• Noncumulative preferred stock receives only this year’s dividend (Example 11–5):
Step 1: Distribute current-year dividend to preferred shareholders.
• Dividends per share = dividend paid/number of shares outstanding.
Module 2
LO 6
Stock Dividends
Corporations may use stock dividends instead of or in addition to paying cash dividends to stockholders.
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• Reduces the market price of the stock.
Lower stock price may be more attractive to a wider range of investors.
• Dooes not represent taxable income to recipients, so wealthier investors may find it attractive.
◼ Small stock dividend (less than 20–25% of the number of shares of stock outstanding) is usually
recorded at market value of stock on date of declaration, since it is considered unlikely to have a
material effect on stock price. (Example 11–7)
• On date of declaration, debit Retained Earnings, credit Common Stock Dividend Distributable
(par value) and credit Additional Paid-In Capital – Common.
• Common Stock Dividend Distributable is not a liability since no assets will be required to
satisfy it.
• On date of issuance – Debit Common Stock Dividend Distributable and credit Common
Stock.
◼ Large stock dividend (greater than 20–25% of the number of shares of stock outstanding) is
reported at par value, rather than market value. (Example 11-8)
Module2
LO 7
Stock Splits
Similar to a stock dividend, a stock split increases the number of shares outstanding and is nontaxable.
◼ The creation of additional shares of stock with a reduction of the par value of the stock
◼ May be used for same reasons as a stock dividend:
• Increases the number of shares.
INSTRUCTOR’S MANUAL
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• Accounting difference – stock dividend requires a journal entry, a stock split requires no
entry; no equity accounts are affected.
Footnote required to disclose additional shares and new par value.
Does not affect total par value of the stock – number of shares increased, par value per
share decreased, but total par value remains the same as before the stock split.
MODULE 3 ANALYSIS AND CASH FLOW ISSUES
Module 3
LO 8
Analysis and Cash Flow Issues
◼ The purpose of the statement of stockholders’ equity is to explain the difference between the
beginning and the ending balances of each of the accounts in the Stockholders’ Equity section of
the balance sheet.
What is Comprehensive Income?
◼ The income statement should reflect an all-inclusive approach.
• All transactions included on income statement to prevent manipulation of income.
Prevents companies from putting “good news” on the income statement and “bad news”
directly in retained earnings.
CHAPTER 11 STOCKHOLDERS’ EQUITY
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◼ Comprehensive income is the total change in net assets from all sources except investments or
distributions to the owners. Exhibit 11-4 also shows the relationship between the income statement
and the statement of comprehensive income.
Module 3
LO 9
What Analyzing Stockholders’ Equity Reveals About a Firm’s Value
Book Value per Share:
◼ Rights of each share of stock to net assets (assets – liabilities).
◼ Does not indicate the market value of the common stock.
◼ If only common stock is present:
Calculating Book Value When Preferred Stock Is Present
◼ Focus on book value per share is always on the value per share of common stock.
◼ If preferred stock is present:
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Market Value per Share
◼ The selling price of the stock as indicated by the most recent transactions.
◼ A more meaningful measure of the value of the stock to those interested in buying or selling the
stock.
Module 3
LO 10
How Changes in Stockholders’ Equity Affect the Statement of Cash
Flows
Issuance and repurchase of stock and payment of dividends are financing items on the statement of cash
flows. (Exhibit 11-6)
◼ Issuance of stock results in cash inflow.
CHAPTER 11 STOCKHOLDERS’ EQUITY
MODULE 4 SOLE PROPEIETROSHIPS AND PARTNERSHIPS Appendix
Module 4
Appendix
LO 11
Sole Proprietorships and Partnerships
Equity section of the balance sheet for partnerships and sole proprietorships differs from that of a
corporation, which has a legal and an economic existence separate from that of its owner(s).
Sole Proprietorships
A sole proprietorship is a business owned by one person.
◼ Primary advantage is simplicity.
• Not a separate entity for legal purposes.
Unlimited liability: owner’s personal assets, as well as business assets, can be used to
settle business debts
• For accounting purposes, the entity principle is observed, and owner’s assets remain distinct
from business assets.
Typical Transactions
◼ Investment in a proprietorship simply involves the owner’s contributing cash or assets as needed.
• Debit Cash (or other assets) and credit Capital.
INSTRUCTOR’S MANUAL
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Partnerships
A partnership is similar to a proprietorship, but with more than one owner. Important characteristics of
partnerships include:
◼ Unlimited liability.
• Legally the assets of the business are not separate from the personal assets of the partners.
◼ Limited life.
• Partnerships do not have a separate legal existence and unlimited life. Life of partnership
exists only as long as contract between partners is valid.
• Partnership ends when a partner withdraws, or a new partner is added.
New partnership must be created for the business to continue.
◼ Not taxed as a separate entity.
Investments and Withdrawals
◼ Separate capital account is maintained for each partner, as well as separate drawing account.
◼ See Exhibit 11-11 for recording investments in a partnership.
Distribution of Income
The partnership agreement governs the manner in which income should be allocated to the partners.