Equity is equal to what we own (assets) minus what we owe (liabilities). We use the term stockholders’ equity (as opposed to owners’ equity) because our focus is on corporations. Stockholders’ equity consists of three primary classifications: paid-in capital, retained earnings, and treasury stock. Paid-in capital is the amount stockholders have invested in the company. Retained earnings is the amount of earnings the corporation has kept or retained—that is, the earnings not paid out in dividends. Treasury stock is the corporation’s own stock that it has reacquired.
In this section, we discuss transactions involving paid-in capital. A better description might be “invested capital” since it’s the amount stockholders invest when they purchase a company’s stock. Invested capital is the amount of money paid into a company by its owners.To better understand the composition of invested capital, it is helpful to know more about the corporate form of ownership.
Corporations are formed in accordance with the laws of individual states. The state incorporation laws guide corporations as they write their articles of incorporation (sometimes called the corporate charter). The articles of incorporation describe (a) the nature of the firm’s business activities, (b) the shares of stock to be issued, and (c) the initial board of directors. The board of directors establishes corporate policies and appoints officers who manage the corporation.
This illustration presents an organization chart tracing the line of authority for a typical corporation.
Most corporations first raise money by selling stock to the founders of the business and to their friends and family. As the equity financing needs of the corporation grow, companies prepare a business plan and seek outside investment from “angel” investors and venture capital firms. Angel investors are wealthy individuals in the business community, like those featured in the television show Shark Tank, willing to risk investment funds on a promising business venture. Individual angel investors may invest from a few thousand dollars to over a million dollars in the corporation. Venture capital firms provide additional financing, often in the millions, for a percentage ownership in the company. Many venture capital firms look to invest in promising companies to which they can add value through business contacts, financial expertise, or marketing channels.The first time a corporation issues stock to the public is called an initial public offering (IPO). Future stock issues by the company are called seasoned equity offerings (SEOs).
Most corporations that end up selling stock to the general public don’t begin that way. Instead, there’s usually a progression of equity financing stages leading to a public offering, as summarized in this illustration.
Corporations may be either public or private. The stock of a publicly held corporation trades on the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotations (NASDAQ), or by over-the-counter (OTC) trading. All publicly held corporations are regulated by the Securities and Exchange Commission (SEC), resulting in significant additional reporting and filing requirements.A privately held corporation does not allow investment by the general public and normally has fewer stockholders than a public corporation. Corporations whose stock is privately held do not need to file financial statements with the SEC.Frequently, companies begin as smaller, privately held corporations. Then, as success broadens opportunities for expansion, the corporation goes public. For example, Facebook was a private corporation until it went public in May 2012 and raised $16 billion of outside investment funds. The result was the largest technology IPO ever.
Whether public or private, stockholders are the owners of the corporation and have certain rights: the right to vote (including electing the board of directors), the right to receive dividends, and the right to share in the distribution of assets if the company is dissolved. This illustration further explains these stockholder rights.
This illustration summarizes the primary advantages and disadvantages of a corporation compared to a sole proprietorship or partnership.Advantages-Limited liability:Limited liability guarantees that stockholders in a corporation can lose no more than the amount they invested in the company, even in the event of bankruptcy. In contrast, owners in a sole proprietorship or a partnership can be held personally liable for debts the company has incurred, above and beyond the investment they have made.Ability to raise capital and transfer ownership:Because corporations sell ownership interest in the form of shares of stock, ownership rights are easily transferred. An investor can sell his or her ownership interest (shares of stock) at any time and without affecting the structure of the corporation or its operations. As a result, attracting outside investment is easier for a corporation than for a sole proprietorship or a partnership.Disadvantages-Additional taxes: Owners of sole proprietorships and partnerships are taxed once, when they include their share of earnings in their personal income taxreturns. However, corporations have double taxation: As a legal entity separate from its owners, a corporation pays income taxes on its earnings. Then, when it distributes the earnings to stockholders in dividends, the stockholders—the company’s owners—pay taxes a second time on the corporate dividends they receive. In other words, corporate income is taxed once on earnings at the corporate level and again on dividends at the individual level.More paperwork:To protect the rights of those who buy a corporation’s stock or who lend money to a corporation, the federal and state governments impose extensive reporting requirements on the company. The additional paperwork is intended to ensure adequate disclosure of the information investors and creditors need.
Authorized stock is the total number of shares available to sell, stated in the company’s articles of incorporation. The authorization of stock is not recorded in the accounting records. However, the corporation is required to disclose in the financial statements the number of shares authorized. Issued stock is the number of shares that have been sold to investors. A company usually does not issue all its authorized stock. Outstanding stock is the number of shares held by investors. Issued and outstanding shares are the same as long as the corporation has not repurchased any of its own shares.Treasury stock refers to repurchased shares that are included as part of shares issued, but excluded from shares outstanding.
This illustration summarizes the differences between authorized, issued, and outstanding shares.
Par value is the legal capital per share of stock that’s assigned when the corporation is first established. Par value originally indicated the real value of a company’s shares of stock. Today, par value has no relationship to the market value of the common stock.Laws in most states permit corporations to issue no-par stock. No-par value stock is common stock that has not been assigned a par value. Most new corporations, and even some established corporations such as Nike or Procter & Gamble, issue no-par value common stock. In some cases, a corporation assigns a stated value to the shares. Stated value is treated and recorded in the same manner as par value shares.
When a company receives cash from issuing common stock, it debits Cash. If it issues no-par value stock, the corporation credits the equity account entitled Common Stock.If the company issues par value stock rather than no-par value stock, we credit two equity accounts. We credit the Common Stock account for the number of shares issued times the par value per share (as before), and we credit Additional Paid-in Capital for the portion of the cash proceeds above par value.If no-par value stock is issued, the corporation debits Cash and credits Common Stock. If par value or stated value stock is issued, the corporation debits Cash and credits two equity accounts—Common Stock at the par value or stated value per share and Additional Paid-in Capital for the portion above par or stated value.
In order to attract wider investment, some corporations issue preferred stock in addition to common stock.Preferred stock is “preferred” over common stock in two ways:Preferred stockholders usually have first rights to a specified amount of dividends (a stated dollar amount per share or a percentage of par value per share). If the board of directors declares dividends, preferred shareholders will receive the designated dividend before common shareholders receive any.Preferred stockholders receive preference over common stockholders in the distribution of assets in the event the corporation is dissolved. However, unlike common stock, most preferred stock does not have voting rights, leaving control of the company to common stockholders.However, unlike common stock, most preferred stock does not have voting rights, leaving control of the company to common stockholders.
Preferred stockholders have characteristics of both common stock and bonds. This illustration provides a comparison of common stock, preferred stock, and bonds along several dimensions. Note that preferred stock falls in the middle between common stock and bonds for each of these factors.
Preferred stock is especially interesting due to the flexibility allowed in its contractual provisions. For instance, preferred stock might be convertible, redeemable, and/or cumulative:Preferred stock may be convertible, which allows the stockholder to exchange shares of preferred stock for common stock at a specified conversion ratio. Occasionally, preferred stock is redeemable at the option of either stockholders or the corporation. A redemption privilege might allow preferred stockholders the option, under specified conditions, to return their shares for a predetermined redemption price. Similarly, shares may be redeemable at the option of the issuing corporation.Preferred stock usually is cumulative. If the specified dividend is not paid in a given year, unpaid dividends (called dividends in arrears) accumulate, and the firm must pay them in a later year before paying any dividends on common stock.
Assume that a company issues 1,000 shares of 8%, $30 par value preferred stock and 1,000 shares of $1 par value common stock at the beginning of 2013. If the preferred stock is cumulative, the company owes a dividend on the preferred stock of $2,400 each year (= 1,000 shares × 8% × $30 par value).If the dividend is not paid in 2013 or 2014, dividends in arrears for the two years will total $4,800. Now, let’s say the company declares a total dividend of $10,000 in 2015. How will the total dividend of $10,000 be allocated between preferred stockholders and common stockholders? It depends on whether the preferred stock is cumulative or noncumulative as outlined in this illustration.Before it can pay dividends to common stockholders, if the preferred stock is cumulative, the company must pay the $4,800 in unpaid dividends for 2013 and2014 and then the current dividend on preferred stock of $2,400 in 2015. After paying the preferred stock dividends, the company can pay the remaining balance of $2,800 (= $10,000 − $4,800 − $2,400) in dividends on common stock. However, if the preferred stock is noncumulative, any dividends in arrears are lost. The dividend of $10,000 in 2015 will be split, with $2,400 paid to preferred stockholders for the current year and the remaining $7,600 paid to common stockholders.Because dividends are not an actual liability until they are declared by the board of directors, dividends in arrears are not reported as a liability in the balance sheet. However, information regarding any dividends in arrears is disclosed in the notes to the financial statements.
This illustration displays the stockholders’ equity section of the balance sheet for Canadian Falcon following the issuance of both common and preferred stock.
Treasury stock: A corporation’s own stock that it has reacquired.We just examined the issuance of common and preferred stock. Next, we look at what happens when companies reacquire shares they have previously issued. Treasury stock is the name given to a corporation’s own stock that it has reacquired. Over two-thirds of all publicly traded companies report treasury stock in their balance sheets. The reasons why a company would want to buy back its own stock are:To boost underpriced stock: When company management feels the market price of its stock is too low, it may attempt to support the price by decreasing the supply of stock in the marketplace. An announcement by Johnson & Johnson that it planned to buy up to $5 billion of its outstanding shares triggered a public buying spree that pushed the stock price up by more than 3%.To distribute surplus cash without paying dividends: While dividends usually are a good thing, investors do pay personal income tax on them. Another way for a firm to distribute surplus cash to shareholders without giving them taxable dividend income is to use the excess cash to repurchase its own stock. Under a stock repurchase, only shareholders selling back their stock to the company at a profit incur taxable income.To boost earnings per share: Stock repurchases reduce the number of shares outstanding, thereby increasing earnings per share. However, with less cash in the company, it’s more difficult for companies to maintain the same level of earnings following a share repurchase.To satisfy employee stock ownership plans:Another motivation for stock repurchases is to acquire shares used in employee stock award and stock option compensation programs.
Assume that Canadian Falcon repurchases 100 shares of its own $0.01 par value common stock at $30 per share. We record this transaction as:Just as issuing shares increases stockholders’ equity, buying those shares back decreases stockholders’ equity. Rather than reducing the stock accounts directly, though, we record treasury stock as a “negative” or “contra” account. Recall thatstockholders’ equity accounts normally have credit balances. So, treasury stock is included in the stockholders’ equity section of the balance sheet with an opposite, or debit, balance. When a corporation repurchases its own stock, it increases (debits) Treasury Stock, while it decreases (credits) Cash.Notice that the stock’s par value has no effect on the entry to record treasury stock. We record treasury stock at its cost, which is $30 per share in this example. The debit to Treasury Stock reduces stockholders’ equity.
This illustration displays the stockholders’ equity section of the balance sheet before and after the repurchase of treasury stock.Treasury stock is reported as a contra equity, or negative amount, since treasury stock reduces total stockholders’ equity.
Assume that Canadian Falcon reissues the 100 shares of treasury stock for $35. Recall that these shares originally were purchased for $30 per share, so the $35 reissue price represents a $5 per share increase in additional paid-in capital. It’s not recorded as a $5 per share gain in the income statement, as we would for the sale of an investment in another company, since the company is reissuing its own stock. We record this transaction using the entry shown here.We debit Cash at $35 per share to record the inflow of cash from reissuing treasury stock. We recorded the 100 shares of treasury stock in the accounting records at a cost of $30 per share at the time of purchase. Now, when we reissue the treasury shares, we must reduce the Treasury Stock account at the same $30 per share. We record the $500 difference (= 100 shares × $5 per share) as Additional Paid-in Capital.Note that some companies credit “Additional Paid-in Capital from Treasury Stock Transactions” as a separate account from “Additional Paid-in Capital from Common Stock Transactions.”
This illustration presents the stockholders’ equity section of the balance sheet before and immediately after the sale of treasury stock.
Assume Canadian Falcon later purchases and reissues the 100 shares of treasury stock for only $25 rather than $35. We record this transaction using the entry shown here.By purchasing 100 shares of its own stock for $30 per share and reselling them for only $25 per share, Canadian Falcon experienced a decrease in additional paid-in capital. This is reflected in the entry as a debit to the Additional Paid-in Capital account. It’s not recorded as a $5 per share loss in the income statement, as we would for the sale of an investment in another company, since the company is reissuing its own stock.
In this section, we examine transactions involving retained earnings. We might refer to this source of stockholders’ equity as “earned capital,” because it represents the net assets of the company that have been earned for the stockholders rather than invested by the stockholders.
Retained earnings represent the earnings retained in the corporation—earnings not paid out as dividends to stockholders. In other words, the balance in retained earnings equals all net income, less all dividends, since the company began.In a company’s early years, the balance in retained earnings tends to be small, and total paid-in capital—money invested into the corporation—tends to be large. As the years go by, the earnings retained in the business continue to grow and, for many profitable companies, can exceed the total amount originally invested in the corporation. Unfortunately, for some companies, expenses sometimes are more than revenues, so a net loss rather than net income is recorded. Just as net incomeincreases retained earnings, a net loss decreases retained earnings.Retained Earnings has a normal credit balance, consistent with other stockholders’ equity accounts. However, if losses exceed income since the company began, Retained Earnings will have a debit balance. A debit balance in Retained Earnings is called an accumulated deficit. We subtract an accumulated deficit from total paid-in capital in the balance sheet to arrive at total stockholders’ equity. Many companies in the startup phase or when experiencing financial difficulties report an accumulated deficit.Companies debit Retained Earnings rather than Additional Paid-in Capital if there is not a sufficient prior credit balance in Additional Paid-in Capital from treasury stock transactions. The details are covered in intermediate financial accounting courses.
Dividends are distributions by a corporation to its stockholders. Investors pay careful attention to cash dividends. A change in the quarterly or annual cash dividend paid by a company can provide useful information about its future prospects. For instance, an increase in dividends often is perceived as good news. Companies tend to increase dividends when the company is doing well and future prospects look bright. Many investors choose to automatically reinvest their dividends. Automatic dividend reinvestment works similar to compound interest in a savings account. The investor does not receive dividends directly as cash; instead, his or her dividends are directly reinvested into more shares of the company. This allows the investment to grow at a faster rate.The board of directors declares the cash dividend to be paid. The day this occurs is known as the declaration date. The declaration of a cash dividend creates a binding legal obligation for the company declaring the dividend. On that date, we (a) increase Dividends, a temporary account that is closed into Retained Earnings at the end of each period, and (b) increase the liability account, Dividends Payable. The board of directors also indicates a specific date on which the company will determine the registered owners of stock and therefore who will receive the dividend. This date is called the record date. Investors who own stock on the date of record are entitled to receive the dividend. The date of the actual cash distribution is the payment date.
Assume that on March 15 Canadian Falcon declares a $0.25 per share dividend on its 2,000 outstanding shares—1,000 shares of common stock and 1,000 shares of preferred stock. The declaration of cash dividends decreases Retained Earnings and increases Dividends Payable. The payment of cash dividends decreases Dividends Payable and decreases Cash. The net effect, then, is a reduction in both Retained Earnings and Cash.Because cash is the asset most easily distributed to stockholders, most corporate dividends are cash dividends. In concept, though, any asset can be distributed to stockholders as a dividend. When a noncash asset is distributed to stockholders, it is referred to as a property dividend. Securities held as investments are the assets most often distributed in a property dividend. The actual recording of property dividends is covered in intermediate accounting.
To understand stock splits, let’s look at an example. Assume Canadian Falcon declares a 2-for-1 stock split on its 1,000 shares of $0.01 par value common stock. The balance in the Common Stock account is 1,000 shares times $0.01 par value per share, which equals $10. With no journal entry, the balance remains $10 despite the number of shares doubling. As a result, the par value per share is reduced by one-half to $0.005 (2,000 shares times $0.005 par per share still equals $10).Having the par value per share change in this way is cumbersome and expensive. All records, printed or electronic, that refer to the previous amount must be changed to reflect the new amount.To avoid changing the par value per share, most companies report stock splits in the same way as a large stock dividend. We account for a large stock dividend by recording an increase in the Common Stock account in the amount of the par value of the additional shares distributed and close the Stock Dividends account into Retained Earnings. So, a stock dividend entry decreases one equity account, Retained Earnings, and increases another equity account, Common Stock. This does not change total assets, total liabilities, or total stockholders’ equity.
We record large stock dividends at the par value per share, but we record small stock dividends at the market value. This is because some believe that a small stock dividend will have little impact on the market price of shares currently outstanding. However, this reasoning is contrary to research evidence, which finds the market price adjusts for both large and small stock dividends. A 10% stock dividend will result in 10% more shares, but each share will be worth 10% less, so the investor is no better off. Note that the above entry still does not change total assets, total liabilities, or total stockholders’ equity.
In this section, we show the financial statement presentation of stockholders’ equity in the balance sheet and differentiate it from the statement of stockholders’ equity.
This illustration presents the stockholders’ equity section of the balance sheet for American Eagle.Preferred stock is usually listed before common stock in the balance sheet. American Eagle has 5 million shares of preferred stock authorized but has not yet issued any preferred shares. Common stock is reported at its par value of $0.01 per share. If we take the Common Stock account balance of $2,496,000 ($2,496 in thousands) and divide it by $0.01 per share, we find that the company has issued just under 250 million shares (249,600,000). The number of shares outstanding is equal to the number of shares issued (249,600,000) minus the number of shares bought back (the 55,718,000 treasury shares), or 193,882,000 shares.Notice that the Additional Paid-in Capital account balance is much larger than the Common Stock account balance. American Eagle has a par value of only $0.01 per share, so most of the money invested in the company was credited to Additional Paid-in Capital rather than Common Stock.Now look at retained earnings. The balance in retained earnings is so large that it actually exceeds total stockholders’ equity. American Eagle has been very profitable over the years, building retained earnings. It has used a portion of cash generated from earnings to buy back treasury shares, which decreases stockholders’ equity. American Eagle has applied this strategy to such an extent that the balancein treasury stock (representing the cost of shares repurchased by the company) now exceeds total paid-in capital (representing the total cost of shares originally issued).American Eagle has been very active in acquiring treasury shares. Dividing the treasury stock balance of $938,565 by the 55,718 shares repurchased, we can estimate an average purchase cost of $16.84 per share. That average purchase price is higher than the trading price of $13.82 per share at January 28, 2012. Thus, at this point in time, it looks like American Eagle has not benefited from the treasury stock repurchase. However, if stock prices should again rise above $16.84 per share, the company could sell the treasury shares for more than the average purchase price.
The statement of stockholders’ equity summarizes the changes in the balance in each stockholders’ equity account over a period of time. The stockholders’ equity section of the balance sheet presents the balance of each equity account at a point in time.
Compare that snapshot of stockholders’ equity at the end of 2015 with this illustration, showing the statement of stockholders’ equity for Canadian Falcon.Each of the beginning balances in this illustration is zero because this is the first year of operations. (The beginning balances for the following year, January 1, 2016, are the same as the ending balance this year, December 31, 2015.) The statement of stockholders’ equity reports how each equity account changed during the year. For instance, the Common Stock account increased because Canadian Falcon issued common stock and declared a 100% stock dividend. The Additional Paid-in Capital account increased from the issuance of common stock, the issuance of preferred stock, and the sale of treasury stock for more than its original cost. Retained Earnings increased due to net income and decreased due to both cash and stock dividends. The retained earnings column is sometimes shown separately and referred to as a statement of retained earnings. The repurchase of treasury stock is shown as a reduction because treasury stock reduces total stockholders’ equity. The ending balance in Treasury Stock is zero, since all the treasury stock purchased was resold by the end of the year.The stockholders’ equity section of the balance sheet presents the balance of each equity account at a point in time. The statement of stockholders’ equity shows the change in each equity account balance over time.
The return on equity (ROE) measures the ability of company management to generate earnings from the resources that owners provide. We compute the ratio by dividing net income by average stockholders’ equity.
To supplement the return on equity ratio, analysts often relate earnings to the market value of equity, which is calculated as the ending stock price times the number of shares outstanding. The return on the market value of equity is computed as net income divided by the market value of equity.
Earnings per share (EPS) measures the net income earned per share of common stock. We calculate earnings per share as net income minus preferred stock dividends divided by the average shares outstanding during the period.The upper half of the fraction measures the income available to common stockholders. We subtract any dividends paid to preferred stockholders from net income to arrive at the income available to the true owners of the company—the common stockholders. If a company does not issue preferred stock, the top half of the fraction is simply net income. We then divide income available to common stockholders by the average shares outstanding during the period to calculate earnings per share. Earnings per share is useful in comparing earnings performance for the same company over time. It is not useful for comparing earnings performance of one company with another because of wide differences in the number of shares outstanding among companies.Investors use earnings per share extensively in evaluating the earnings performance of a company over time. Investors are looking for companies with the potential to increase earnings per share. Analysts also forecast earnings on a per share basis. If reported earnings per share fall short of analysts’ forecasts, this is considered negative news, usually resulting in a decline in a company’s stock price.
Another measure widely used by analysts is the price-earnings ratio (PE ratio). It indicates how the stock is trading relative to current earnings. We calculate the PE ratio as the stock price divided by earnings per share, so that both stock price and earnings are expressed on a per share basis.Price-earnings ratios commonly are in the range of 15 to 20. A high PE ratio indicates that the market has high hopes for a company’s stock and has bid up the price. Growth stocks are stocks whose future earnings investors expect to be higher. Their stock prices are high in relation to current earnings because investors expect future earnings to be higher. Value stocks are stocks that are priced low in relation to current earnings. The low price in relation to earnings may be justified due to poor future prospects, or it might suggest an underpriced “sleeper” stock that could boom in the future.The return on equity measures the ability to generate earnings from the owners’ investment. It is calculated as net income divided by average stockholders’ equity. The return on the market value of equity is another useful measure, especially when the recorded balance in stockholders’ equity and the market value of equity differ substantially. Earnings per share measures the net income earned per share of common stock. The price-earnings ratio indicates how the stock is trading relative to current earnings.