A company may finance its operations through debt, equity, or both.
Debts that are owed to others are liabilities. Liabilities to be paid out of current assets and are due within a short time are reported as current liabilities on the balance sheet. Long-term liabilities are debts due beyond one year. Contingent liabilities are liabilities that are dependent on certain events occurring in the future.
Notes payable are often issued to satisfy an account payable or to purchase merchandise or other assets. The issuer of the note is the borrower and the party receiving the note is the lender. Notes are usually for a longer period of time and supported by a written document. This makes the obligation a more formal instrument than an account payable. Because of the longer time frame, interest is usually also due when the note is due.
At the time the note is issued, accounts payable is reduced and the $1,000 is moved to Notes Payable. At the time the note is due on October 30, interest is due along with the face value of the note. The interest is equal to: $1,000 * .12 * 90/360 = $30 of interest due On October 30, to satisfy the note, $1,030 of cash must be disbursed to satisfy the note payable obligation and also record the $30 of interest expense on the Income Statement.
Under the US tax code, corporations are taxable entities and must complete a tax return and pay federal income taxes on corporate income. Most corporations pay estimated federal income taxes in four installments throughout the year. The tax return is completed for the corporations using the rules set for in the Internal Revenue Code. These rules are different than the generally accepted accounting rules that govern corporate accounting and result in differences between taxable income and net income.
The tax implications that arise from differences between a company’s taxable income and the income before taxes reported on the Income Statement may need to be allocated between financial statement periods. The difference may be the result of certain items being recognized in one period for tax purposes and in another period for income statement purposes. These differences are called temporary differences because they will reverse or turn around in later years. Temporary differences do not change the total amount of taxes paid, they only change the timing of when the taxes are to be paid. Some differences arise because some income is exempt from tax or some expenses are not deductible. These differences are called permanent differences. Permanent differences do not create any special financial reporting issues.
Since temporary differences do not affect the total taxes to be paid, just the timing of the payment of taxes, most corporations will have two tax liabilities: Current income tax liability which is due on the current year’s taxable income Postponed or deferred tax liability, which is due in the future when the temporary differences reverse The tax expense reported on the income statement is calculated by multiplying the 40% tax rate by the income before taxes of $300,000, or $120,000. This matches current year expenses properly against current year income. If the company has $200,000 of temporary differences, perhaps from the company using MACRS depreciation for tax purposes but straight-line depreciation for financial reporting purposes. These temporary differences result in taxable income equal to $100,000. Income tax payable is based on the 40% tax rate applied against the taxable income of $100,000, or $40,000. The difference between the $120,000 tax expense and the $80,000 income tax payable represents the tax liability deferred to future years.
Some liabilities may arise from past transactions if certain events occur in the future. These potential liabilities are called contingent liabilities. The first step in evaluating contingent liabilities involves determining the likelihood of the future event occurring. If the likelihood is probable and the amount can be estimated, the liability must be recorded. An example of this would be the liability for warranty repairs. If an event is probably but not estimable, the accounting treatment is to simply disclose the liability in the notes to the financial statements. An example of this would be if an oil company was responsible for an oil spill. The same is true if the likelihood of the future event is only reasonably possible. If the likelihood is remote, no recording or disclosure is necessary.
The term payroll refers to the amount paid to employees for services they provide during a period. Expenses for payroll and the related payroll taxes account for a significant expense for most businesses.
Total earnings for an employee for a payroll period, including bonuses and overtime pay, is called gross pay. That is the amount recorded to wages and salary expense for the pay period. In this illustration, gross pay is $13,800. From gross pay, one or more deductions are subtracted to arrive at an employee’s net pay. Net pay is what is deducted from cash and paid to employees, in this transaction, $10,830. The deductions made include FICA taxes payable, Employee Federal Income Tax Payable, and Employee State Tax Payable. The FICA, federal, and state taxes withheld from the employees’ earnings are not expenses of the employer. Rather, these amounts are withheld on behalf of the employee and must be remitted periodically to the state and federal agencies. Other deductions may also be made on behalf of the employee for medical insurance, union dues, 401K contributions, etc.
Most employers are subject to federal and state payroll taxes. Such taxes are an operating expense of the business. For example, employers are requires to match the employees’ contributions to FICA. In addition, most companies are liable for federal and state unemployment taxes. The payroll taxes due from employers become liabilities when the related payroll is paid to the employees. However, the liabilities may not be paid to the appropriate taxing authorities until a later time.
Many large corporations finance their operations through the issuance of bonds. A bond is simply a form of an interest-bearing note. Like a note, bonds require periodic interest payments to be made and, at maturity, the face value of the bond must be repaid to the bondholders. A corporation that issues bonds enters into a contract, called a bond indenture, with the bondholders. Each individual bond bears a face value, usually $1,000 per bond. Interest on the bond may be payable annually, semi-annually, or quarterly.
Bond prices are determined by the amount investors are willing to pay. Prices of bonds are quoted on bond exchanges as a percentage of the bonds’ face value. When a corporation issues a bond, the issue price of the bond is dependent on: The face amount of bonds due at the maturity date The periodic interest to be paid on the bonds, also called the contract rate The market rate of interest on the date the bonds are issued, also called the effective rate
Since the contract rate and the market rate of interest are the same, the bonds will sell at their face amount. When the bonds are issued, cash increases by $100,000 and the Bond Payable is established on the Balance Sheet as a liability.
This bond pays interest on a semi-annual basis. Six months after the bonds are issued, the first interest payment is made to the bondholders in the amount of $6,000. Interest expense is recorded on the Income Statement and Cash is decreased to reflect the payment made. The second transaction illustrates the impact of the entry which would be made at the maturity date of the bond. Cash is decreased to represent the repayment of the face value of the bonds to the bondholders. The bond payable is also eliminated from the liability account.
The market and contract rates of interest determine whether the selling price of a bone will be equal to, less than, or greater than the face amount. A bond sells at a discount because buyers are not willing to pay more than full face value for a bond where the contract rate is lower than the market rate. A bond sells at a premium when the contract rate exceeds the market rate. Investors are willing to pay more than face value when the contract rate is higher than market rate.
Companies also finance their operations through equity financing and a major means of equity financing for a corporation involves the issuance of stock. The equity in the assets that results from issuing stock is called paid-in-capital or contributed capital. Another major means of equity financing for operations is through retained earnings. Retained earnings represents earnings retained in the business and not distributed to stockholders as dividends. The number of authorized shares for a corporation is determined in the company charter, filed in the state of incorporation. The term issued relates to the number of shares issued to stockholders. Since corporations may reacquire some of the stock has been issued, the stock remaining in the shareholders’ hands is called outstanding stock.
Shares of stock are often assigned a monetary value, called par. Upon request, companies may issue stock certificates to stockholders to document their ownership interest in the company. Because corporations have limited liability, creditors have no claim against the personal assets of the stockholders. However, some state laws require that corporations maintain a minimum stockholder contribution to protect creditors. This is call legal capital and the amount will vary state to state, but it usually includes the par value of the stock issued.
The major rights that accompany ownership of a share of stock are: Right to vote in matters concerning the corporation- this is usually voting for board of director members and any other major corporate issues the bylaws may require to be voted on by the entire stockholder group. Right to share in distributions of earnings- if earnings are distributed, shareholders have the right to participate in the distribution of earnings. Some shareholders may have certain preferences in the distribution based on the type of stock they own. This will be discussed in a later slide. Right to share in assets on liquidation – creditors of a company have first claim on any liquidation of assets. After that, shareholders maintain a right to share in any remaining assets upon liquidation of the corporation.
If only one class of stock is issued, it is called common stock. Each share of common stock has equal rights, and these rights include voting rights. Corporations can offer one or more classes of stock with various preference rights – usually called preferred stock. Preferred shareholders have first rights (preference) to any dividends and any asset distribution as a result of liquidation. Preferred dividend rights are usually stated in monetary terms or a percentage of par. However, since dividends are normally based on earnings, dividends are not guaranteed even to preferred shareholders.
Because different classes of stock have different rights, when stock is issued to investors, separate accounts are used to record each issuance. Stock is often issued by a corporation at a price that is different from the par value of a share of stock. The issue price will depend on several factors: The financial condition, earnings record, and dividend record of the corporation. Investor expectations of the corporation’s potential earning power. General business and economic conditions and prospects. Normally, a stock is issued at a price greater than the par value per share.
When stock is issued at a premium (a price above par value), Cash will be increased for the total amount received from the issuance of the shares. In the illustration, 2,000 shares at $55 per share will results in an increase to cash of $110,000. Common stock is increased for $2,000, which is the 2,000 shares at the par value per share of $1. The difference between the issue price and the par value (premium) is recorded in the account Paid-In Capital in Excess of Par. In this illustration the amount of $108,000 is calculated by multiplying the 2,000 shares by $54, the difference between the issue price of $55 per share and the $1 par value per share. Stock can also be issued in exchange for assets other than cash. If stock is exchanged for assets such as land, buildings, or equipment, the fair market value of the non-cash assets is used to value the exchange. If that value can not be objectively determined, the fair market price of the shares of stock issued may be used.
Treasury stock is stock that a corporation has issued then reacquires. A corporation may reacquire its stock for a variety of reasons: To provide shares for resale to employees To reissue as bonuses or stock options for employees To support the market price of the stock The purchase of treasury stock decreases a company’s cash. An equity account called Treasury Stock is increased. At the end of an accounting period, the balance of the treasury stock account is reported as a reduction of stockholders’ equity. If treasury stock is subsequently sold or reissued, Cash is increased by the proceeds, Treasury Stock is decreased by the repurchase cost. Any difference between the cash received and the repurchase cost increases or decreases an account called Paid-In Capital from Treasury Stock.
When a company’s board of directors declares a dividend, it authorizes the distribution of retained earnings to the stockholders. Distributions in the form of cash (cash dividends) are the most common form of distribution. Three conditions must be met in order for a cash dividend to be declared: Sufficient retained earnings Sufficient cash Formal action by the board of directors Even if there are sufficient retained earnings and cash, a company’s board of directors is not required to pay dividends. Nevertheless, many corporations pay quarterly cash dividends to make their stock more attractive to future investors.
Since a dividend declaration requires formal action by the board of directors of a corporation, there is often delay between when the dividend is declared and when it is actually paid out in cash. The date of declaration is the date the board of directors takes the formal action to authorize the payment of the dividend. On this date, the company records the liability to the stockholders to pay the amount of the dividend. The date of record is the date the corporation uses to determine which stockholders will receive the dividend. During the period between the date of declaration and the date of record, the stock is said be selling with-dividends. This means any investor purchasing the stock during this period will be stockholders on the date of record and will utlimately received the declared dividend. This usually impacts the selling price of the share of stock. The date of payment is the date the corporation pays the dividend to the stockholders who owned the stock on the date of record. Any stock sold during the period between the date of record and the date of payment is said to be sold ex-dividends. This means since the date of record has passed, any new investors will not receive the dividend. This also usually impacts the selling price of the share of stock.
On the declaration date of December 1, the company records the liability for the dividends declared. Since dividends are distributions of Retained Earnings, Retained Earnings are decreased for the amount of the dividend as the liability Cash Dividends Payable is established. On January 2, when the dividend is actually paid in cash, Cash would be decreased and the liability Cash Dividends Payable would be eliminated. The date of record would not result in any transactions on the books of the corporation.
When a company’s board of directors declares a dividend, it authorizes the distribution of retained earnings to the stockholders. While distributions in the form of cash (cash dividends) are the most common form of distribution, a corporation may also elect to distribute a dividend in a distribution of shares of stock. This is called a stock dividend. Stock dividends are normally only declared on common stock and issued to common shareholders. There is still the requirement of sufficient Retained Earnings and a formal action of declaration by the board of directors. A stock dividend does not change the assets, liabilities or total stockholders’ equity of a corporation. There is not a distribution of cash or other assets- nor is there a liability to distribute a payment at a future date. The effect of a stock dividend is to transfer retained earnings to paid-in capital, so overall total stockholders’ equity does not change. The amount transferred from Retained Earnings to paid-in capital accounts is normally the fair value (market value) of the shares issued as a result of the stock dividend.
A stock split is the process by which a corporation reduces the par or stated value of its common stock. A stock split will also increase the number of shares outstanding and the split will apply to all shares of common stock: issued, unissued, and shares of treasury stock. The objective of a stock split is to impact the stock’s market price per share. The goal is to attract more shareholders to the organization.
In this illustration, a 5 for 1 stock split is declared by the board of directors of a corporation. A stockholder who held four shares of stock with a par value of $100 per share before the split holds a total par value of $400. After the split, that same shareholder will now hold 20 shares of common stock (4 * 5 = 20 shares). Each share will now carry a par value of $20 per share. The total par value of the 20 shares will be the same as the original par value of the 4 shares. Since there are more shares outstanding after a stock split, the market price of the stock should decrease in proportion to the split. For example, a share of stock selling at $150 before the split might be expected to decrease in price per share to approximately $30 per share ($150 / 5 = $30). Stock splits do not impact any of the financial statements and do not require any specific entry into the accounting records since only the par value per share and number of shares outstanding have changed. The details of the split should be disclosed in the notes to the financial statements.
Liabilities and stockholders’ equity represent on the balance sheet how the assets of a company are financed. Detailed information on these items can be found in the notes to the financial statements. On the balance sheet, liabilities are classified into current and non-current, depending upon when they are due. Current liabilities can be compared to current assets of a company to begin to determine short-term bill paying ability of a company. Stockholders’ Equity is reported on the Balance Sheet, but detailed information is also usually included on a Stockholders’ Equity statement that analyzes changes to the stockholder equity accounts.
The balance sheet illustrated here shows the liabilities of the Escoe Corporation split between current and long-term liabilities. Within current liabilities, there is a further break-out of the main types of current liabilities, including accounts payable and notes payable. Within the long-term liability classification, the bonds payable reporting includes the contract rate, the due date, and the market value of the bond. Further information on all the liabilities would be included in the footnotes to the financial statements. The stockholders’ equity section of the balance sheet displays the ending balances in the stockholders’ equity accounts. For stock, this includes shares authorized and issued, par values, and, in the case of preferred stock, the stated dividend rate. As you can see, Escoe is reporting $75,000 of Treasury Stock as a deduction to stockholders’ equity. Although stockholders’ equity is reported on the balance sheet, significant changes in stockholders’ equity during the year should also be disclosed. Changes in retained earnings are often reported in a separate Retained Earnings Statement. Footnotes to the financial statements are also used to disclose information regarding stockholder equity activity. Additional details of the stockholder equity accounts may also be presented in a Stockholders’ Equity statement.
While the Balance Sheet only reports the ending balances in the stockholder equity accounts, the Statement of Stockholders’ Equity reports the activity in the stockholder equity accounts during the year. On this statement, significant changes or activity in the equity accounts are reported.
One of the many factors that influence a company’s decision of whether to finance operations using debt or equity is the impact of the decision on earnings per share. Earnings per share is a major profitability measure reported on the financial statements and followed closely by the press. Corporations often make earnings projections for both the quarter and on an annual basis. Since these projections are so closely followed, managers must monitor the potential impact of decisions on earning per share. In its most basic form, earnings per share (EPS) is calculated by dividing net income remaining after preferred dividends by the number of common shares of stock outstanding. EPS measures the income earned by each share of common stock.
Each of the plans illustrated finances the company’s operations by issuing stock. However, the percentage financed by stock varies from 100% in Plan 1 to 25% in Plan 3. Plan 2 issues both common and preferred stock, plan 3 issues common and preferred stock and includes a bond issue. The impact of the plans on a company with $800,000 of earnings is illustrated. In plan one, where 400,000 shares are issued, the EPS would be $1.20. In plan 2, the shares of common stock issued is 200,000 shares. Preferred shares of stock are also issued as a part of financing. These preferred shares would have a 9% dividend rate on $2,000,000 par value, or a dividend of $180,000. This dividend must be subtracted from Net Income to arrive at the income available for common stock. When the income available for common stock of $300,000 is divided by the 200,000 shares of common stock, EPS is $1.50. Finally, in plan 3, the issuance of bonds impacts Income before income tax because of interest expense. Because Income before tax is lower than in the alternate two plans, income tax and net income is also lower. Plan 3 also includes the issuance of $1,000,000 of preferred stock which would result in a preferred dividend of $90,000 (9%). The dividends on preferred stock is subtracted from net income to arrive at income available for dividends on common stock of $246,000. Under plan 3, 100,000 shares of common stock would be issued, resulting in EPS Of $2.46. In this illustration, Plan 3 provides the most favorable impact on EPS.
Chapter 8 Liabilities and Stockholders’ Equity
Learning ObjectivesAfter studying this chapter, you should be able to… Describe how businesses finance their operations. Describe and illustrate current liabilities, notes payable, taxes, contingencies, and payroll. Describe and illustrate the financing of operations through issuance of bonds. Describe and illustrate the financing of operations through issuance of stock. Describe and illustrate the accounting for cash and stock dividends. Describe the effects of stock splits on the financial statements. Describe financial statement reporting of liabilities and stockholders’ equity. Analyze the impact of debt or equity financing on earnings per share.
Learning Objective 1 Describe how businesses finance their operations
Financing Operations• Businesses must finance operations through one of two ways: – Debt Financing – includes all liabilities owed by a business – Equity Financing – investments from owners of the business. Stock is issued to represent ownership interest in a corporation.
Learning Objective 2 Describe and illustrate current liabilities, notes payable, taxes, contingencies, and payroll
Liabilities• Debts owed to others• Current liabilities – due within a short time, usually 1 year• Long-term liabilities – due beyond 1 year• Some liabilities are contingent on the outcome of future events
Notes Payable• Longer and more formal than accounts payable• Usually bear interest• Issued to creditors when merchandise or other assets are purchased
Assume that a business issues a 90-day, 12% note for $1,000,dated August 1, 2008 to satisfy an open account payable
Income Taxes• Includes federal income taxes and possibly state and local income taxes• Most corporations are required to pay federal income taxes in four installments throughout the year
Taxable Income vs. Income Before Taxes• Taxable Income – determined according to federal tax laws (IRS Code)• Income Before Taxes – determined according to generally accepted accounting procedures (GAAP)• Differences between the two may need to be allocated between various financial statement periods
Payroll• The amount paid to employees for services they provide during a period – Salary – payment for managerial, administrative, or similar services – Wages – payment for manual labor, both skilled and unskilled• Payroll and related taxes significantly impact the net income of most businesses
Payroll TaxesEmployer Taxes Employee Taxes• FICA • FICA• Federal and State • Federal and State Unemployment Taxes Income TaxesPayroll taxes become a liability when the related payroll is paid to employees. The liability is relieved when the taxes are paid to the appropriate agencies.
Learning Objective 3 Describe and illustrate the financing of operations through issuance of bonds
Bonds• A form of interest-bearing note• Bonds include interest that must be paid on a regular basis• Bonds face value must be repaid at maturity.• Bond indenture – contract between the company issuing the bonds and the bondholders• A bond issue is normally divided into several individual bonds. The most common face value is $1,000 per bond.
Calculating the Bond Issue Price• Based on the price buyers are willing to pay Depends on three factors: – The face amount of the bonds due at the maturity date. – The periodic interest to be paid on the bonds – stated in the bond indenture. Is called the contract or coupon rate. – The market (effective) rate of interest
Recording Bond IssuanceCoupon and effective interest rates will be the same.Assume that a business issues $100,000 of 12%,5-year bonds, with interest of $6,000 payable semiannually.
Bonds Not Issued at Face Value• Discount on Bonds Payable – Market rate of interest > contract rate – Buyers are not willing to pay face value for the bonds• Premium on Bonds Payable – Market rate of interest < contract rate – Buyers are willing to pay more than face value for the bonds
Learning Objective 4 Describe and illustrate the financing of operations through issuance of stock
Stock• Major means of equity financing• Shares – Authorized – total number allowed to issue – Issued – shares issued to shareholders – Outstanding – shares currently in the hands of stockholders
Shares of Stock• Can be issued with or without a monetary amount: – Par: monetary value stated on stock certificate – No-par: some states might require a stated value• Legal Capital – Minimum stockholder contribution required by some states
Stock Rights• Right to vote in matters concerning the corporation• Right to share in distributions of earnings• Right to share in assets on liquidation
Common and Preferred Stock Common Preferred Stock Stock • Each share has • Has preference equal rights rights over • Each share has common stock voting rights • Dividend rights stated in monetary terms or % of par
Issuance of Stock• The price at which stock sells depends on a variety of factors: – The financial condition, earnings record, and dividend record of the corporation. – Investor expectations of the corporation’s potential earning power. – General business and economic conditions and prospects.
Stock IssuanceAssume that a corporation issues 2,000 shares of $1 par valuecommon stock for $55 per share.
Reacquired Stock• Treasury Stock – Stock that a corporation has issued and then reacquires – Balance at year-end is reported as a reduction of stockholders’ equity
Learning Objective 5 Describe and illustrate the accounting for cash and stock dividends
Cash Dividends• Cash distribution of earnings by a corporation to its shareholders• Most common form of dividend• Usually three conditions: – Sufficient retained earnings – Sufficient cash – Formal action by the board of directors
Cash DividendsAssume a company declares the following cash dividend onDecember 1 for payment on January 2:
Stock Dividends• Distribution of stock to stockholders (usually common shares)• No distribution of cash or other assets• Requirements: – Sufficient retained earnings – Formal action by board of directors• Amount transferred for small stock dividends (<25% of outstanding shares) is market value per share
Learning Objective 6 Describe the effects of stock splits on the financial statements
Stock Splits• Reduces the par value per share• Increase the number of shares outstanding• Major objective is to reduce the stock’s market price per share in order to attract more investors
Learning Objective 7 Describe financial statement reporting of liabilities and stockholders’ equity
Financial Reporting of Liabilities and Equity• Liabilities – Current are due within 1 year – Long-term are due beyond 1 year• Stockholders’ Equity – Part of the balance sheet – Details of the changes in stockholders’ equity are disclosed in a separate statement