Chapter 11: Reporting and Interpreting Owners’ Equity
The corporate form of organization has several advantages. The major advantage is the ease of raising large amounts of money because both large and small investors can participate in corporate ownership. It is simple to become an owner of corporate shares of stock and it is just as simple to sell the shares. Organized exchanges, such as the New York Stock Exchange, maintain markets in which shares in thousands of companies are bought and sold each business day. Another advantage is limited liability. Stockholders’ losses are limited to the amount invested in the corporation. Corporate creditors cannot make claims on the personal assets of shareholders to satisfy corporate debt. Corporations are entities created by law that exist separately from their owners and that have rights and privileges. As separate entities, corporations can: Own assets. Incur liabilities. Sue and be sued. Enter into contracts. Stockholders are not agents of the corporation and cannot enter into contracts on the corporation’s behalf.
In addition to voting on important issues at annual meetings, stockholders have other benefits. Stockholders have the right to receive dividends when declared by the board of directors. In the event of liquidation, stockholders share, according to their percentage ownership, in any remaining assets after creditors are paid.
Ultimate control of a corporation rests with the stockholders. At their annual meeting, stockholders elect the Board of Directors and vote on important management issues facing the company. The members of the board of directors hire the executive officers of the corporation. Finally, officers of the corporation empower others to hire needed employees. Employees, officers, and members of the board of directors may also be owners of the corporation.
Authorized shares are the maximum number of shares of stock that can be sold to the public. The number of authorized shares is identified in the corporate charter of the corporation that is issued by the state. Authorized shares are either issued or unissued. Unissued shares are shares of stock that have never been sold to the public. Issued shares are shares of stock that have been sold to the public.
Issued shares can be classified as either outstanding shares or treasury shares. Outstanding shares are shares that have been issued and are currently owned by stockholders. Treasury shares are shares that have been issued to stockholders, but have since been repurchased by the corporation.
Earnings per share is one of the most widely quoted financial ratios. It is a measure of the company’s ability to produce income for each common share outstanding. Earnings per share is equal to income (less preferred dividends, if any) divided by the average number of common shares outstanding for the period. Kroger’s income for 2009 is $1,249,000,000 and the average number of shares outstanding is 652,000,000. Let’s calculate Kroger’s earnings per share for 2009. Kroger’s earnings per share for 2009 is $1.92, obtained by dividing income of $1,249,000,000 by 652,000,000, the average number of shares outstanding for the year.
Kroger has increased earnings per share from $1.56 in 2007 to $1.92 in 2009. We also see a comparison of 2009 earnings per share for Kroger and two competitors.
Corporations have two primary sources of equity. The first is contributed capital. The two accounts in contributed capital, common stock, par value, and capital in excess of par value, represent amounts that shareholders have invested by buying shares of stock from the company. The second source of equity is retained earnings. The retained earnings account reports the cumulative amount of net income the corporation has earned since its organization less the cumulative amount of dividends declared since organization. This is the portion of the net income that has been reinvested in the business rather than distributed to the owners in dividends.
Common stock is the basic voting stock of the corporation. It represents the residual claim on assets in liquidation. Dividends paid must first satisfy preferred stock agreements before any distribution can be made to common stockholders.
Common stock normally has a par value which is usually a very small amount, typically less than one dollar per share. In states that require a par value per share, the par value is also the legal capital that must remain invested in the business.
Par value is an arbitrary amount assigned to each share of stock in the corporate charter. Par value is a nominal amount, and is not related in any manner to market value which is the selling price of a share of stock. In addition to par value stock, some states permit no-par value common stock.
At the initial public offering, shares of stock are sold to the public for the first time, usually through major securities brokerage firms with retail offices in cities across the country. At a later date, the company may wish to raise additional capital with another sale of stock to the public. This is referred to as a seasoned new issue.
When par value stock is sold for cash, the common stock account is credited for the par value of the stock sold. Remember that par value and market value are not related. The difference between the par value of the stock and the market value of the stock is credited to capital in excess of par value. When added together, the amount of par value in the common stock account and the amount in the contributed capital in excess of par value account is equal to the market value of the sale of the stock. We will look at how to account for par value stock. Accounting entries for stated value stock is very similar to accounting for par value stock. When a company has no-par stock, all the proceeds are credited to the common stock account. Let’s look at an example. On July 6, Kroger issued 100,000 shares of $1 par value common stock for $20 per share. Let’s prepare the journal entry to record this transaction. To record this stock issue, we debit cash for the market value of the stock sold: 100,000 shares times $20 per share. We credit common stock for the par value of the share sold: 100,000 shares times $1 per share. Next, we credit capital in excess of par value for the excess of market over par value, $1,900,000.
Once shares of stock are owned by the public, they may be bought and sold in the open market. Such transactions do not involve the company or its accounting records. The millions of shares that are bought and sold on the New York Stock Exchange each business day are examples of this type of transaction.
Many corporations have employee compensation packages that include both salary and stock options. Most stock option plans allow employees to buy shares of stock from the corporation at a predetermined, fixed price. If the market price of the company’s stock rises, holders of stock options can exercise those options and then sell the stock at a profit. Stock option compensation plans can motivate employees to increase financial performance which can increase the stock price. All investors in the company benefit when the stock price increases. If the company granting the options to its employees does not have unissued shares of stock to sell to employees when the stock options are exercised, the company can buy the shares in the open market.
Kroger buys its own shares from current stockholders in a secondary market to make them available for employee stock option plans. The repurchased shares are called treasury stock. In addition to repurchasing shares for employee stock option plans, companies buy their own stock to support the market price, to increase shares needed to use in the acquisition of another company, to limit the shares available for a hostile takeover, and to return cash to shareholders who wish to sell their shares. Treasury stock has no voting or dividend rights. Treasury stock is not an asset. It is a contra equity account and is subtracted from the stockholders’ equity section on the balance sheet. Treasury stock is usually recorded at the cost to purchase it, and the total cost of all shares of treasury stock held by the company is the amount reported as a reduction in stockholders’ equity.
On May 1, Kroger reacquired 100,000 shares of its common stock at $20 per share. The journal entry for May 1 requires a debit to treasury stock and a credit to cash for the cost of the shares, 100,000 shares times $20 per share equals $2,000,000.
On December 3, Kroger reissued 10,000 shares of the treasury stock for $30 per share. Remember that the original cost of the treasury stock was $20 per share. The entry to record the sale of the treasury stock includes a debit to cash for $300,000, a credit to treasury stock for $200,000, and a credit to capital in excess of par value for $100,000. The credit to treasury stock is the original cost of $20 per share times the 10,000 sold. The difference between the selling price and the cost of the treasury stock is the credit to capital in excess of par value. No profit or loss is recognized on treasury stock transactions.
Cash dividends are declared by the board of directors. There is no legal obligation to declare a cash dividend, but once declared, there is a legal obligation to pay the dividend. Most corporations that pay cash dividends pay them quarterly. To pay a cash dividend, a corporation must have two things: Sufficient retained earnings to absorb the dividend without going negative and Enough cash to pay the dividend. There are three important dates to remember when discussing dividends: The date of declaration. The date of record. The date of payment. The date of declaration is the date the directors declare the dividend. At this time a liability is created and must be recorded. The entry at the date of declaration includes a debit to retained earnings and a credit to dividends payable.
The date of record is important because it is the date when the corporation determines the owners of record who will receive the dividend. No entry is required in the accounting records on this date. The date of payment is the date the corporation pays the dividend to the stockholders who owned the stock on the record date. The entry on the date of payment includes a debit to dividends payable and credit to cash for the total amount of cash paid to the owners of record.
Investors are interested in the amount of income that they will receive in the form of dividends. One comparison that investors make is based on dividend yield. To calculate the dividend yield ratio, we divide the annual dividend per share by the market price per share of the company’s common stock. In 2009, Kroger paid a dividend of $0.36 per share and the market price of a share of Kroger stock was $22. The dividend yield for 2009 is 1.6 percent, an increase from 1 Percent ion 2007 and 2008. Kroger’s dividend yield is slightly less than its two competitors.
A stock dividend is a distribution of additional shares of stock to stockholders. All stockholders retain the same percentage ownership. The stockholders have more shares of stock representing the same ownership as they had before the stock dividend. There is no change in total stockholders’ equity and par value per share does not change. Why do corporation issue stock dividends which are merely more pieces of paper evidencing the same percentage ownership? Corporations may issue stock dividends to: Reduce the market price per share of stock to make the shares more affordable for investors to purchase. Signal that the management expects strong financial performance in the future. A stock dividend can be classified as small or large. A small stock dividend is a distribution of stock that is less than 20-25 percent of the outstanding shares. Small stock dividends are recorded at the market value of the stock. A large stock dividend is a distribution of stock that is greater than 20-25 percent of the outstanding shares. Large stock dividends are recorded at the par value of the stock.
A stock split is the distribution of additional shares of stock to stockholders according to their percent ownership. When a stock split occurs, the corporation calls in the outstanding shares and issues new shares of stock. In the process of a stock split, the par value per share of the stock changes. Each shareholder has the same percentage ownership of the company after the split as before the split. So we sometimes say that a stock split creates more, but smaller, pieces of the same pie. Let’s look at an example. Assume that a corporation had 3,000 shares of $2 par value common stock outstanding before a 2–for–1 stock split. After the two-for-one split, the number of shares doubled and the par value was cut in half. Notice that an accounting entry is not required, and that retained earnings is not reduced. In many respects a 100 percent stock dividend and a two-for-one stock split result in similar impacts to the price per share in the stock market. The stock split usually requires more administrative tasks to call in and reissue stock certificates.
Preferred stock is a separate class of stock that typically has priority over common stock in dividend distributions and distribution of assets in a liquidation. Preferred stock usually has a stated dividend that is expressed as a percentage of its par value. It normally does not have voting rights and is often callable by the corporation at a stated value.
US GAAP and International Financial Accounting Standards use different words to describe the same corporate equity accounts. Don’t be misled by the different terminology when there is no difference in substance.
Preferred stock has a current dividend preference when compared to common stock. Current preferred dividends must be paid to preferred stockholders before any dividends are paid to common stockholders. Cumulative preferred stockholders have the right to be paid both the current and all prior periods’ unpaid dividends before any dividends are paid to common stockholders. When the preferred stock is cumulative and the directors do not declare a dividend to preferred stockholders, the unpaid dividend is called a dividend in arrears and must be disclosed in the financial statements. Noncumulative preferred stock has no rights to prior periods’ dividends if they were not declared in those prior periods. Let’s look at an example.
Kites, Inc. has the following stock outstanding: Common stock: $1 par, 100,000 shares Preferred stock: 3%, $100 par, cumulative, 5,000 shares Preferred stock: 6%, $50 par, noncumulative, 3,000 shares Dividends were not paid last year. In the current year, the board of directors declared dividends of $50,000. How much will each class of stock receive? Note that this company has both common stock and two classes of preferred stock. Let’s see how the $50,000 dividend is distributed.
Recall that preferred stockholders receive any declared dividends before common stockholders. In addition, cumulative preferred stockholders have rights to the dividends in arrears from last year in addition to the current year’s dividends. First, we compute the amount of dividends in arrears on the preferred stock. This amount will be paid before any other dividend consideration. The cumulative preferred stockholders have rights to the dividends in arrears from last year in addition to dividends for the current year. The arrearage for last year is $15,000 computed by multiplying 3 percent times the $100 par value times 5,000 shares. The current year’s dividend on the cumulative preferred is also $15,000. Of the original total $50,000 dividend, we now have $20,000 remaining for the noncumulative preferred and the common. Next, we calculate the noncumulative preferred dividend for the current year. It must be paid before common stockholders receive a dividend. The current year’s dividend on the noncumulative preferred is $9,000 computed by multiplying 6 percent times the $50 par value times 3,000 shares. Of the original total $50,000 dividend, we now have $11,000 remaining for the common stockholders. Now, let’s look at a question about dividend declarations.
Retained earnings can have legal or contractual restrictions. In most states, the corporate charters will not allow companies to purchase treasury stock in excess of the balance in retained earnings. Some loan agreements place restrictions on how much dividends can be, based on the balance in retained earnings. Restrictions on retained earnings are generally disclosed in the notes to the financial statements.
Issuing stock for cash and selling treasury stock for cash results in cash inflows. Purchasing treasury stock with cash and paying cash dividends results in cash outflows. These cash flows are reported in the financing activities section of the statement of cash flows.
In addition to corporations, there are two other forms of business organizations: sole proprietorships and partnerships. A sole proprietorship is owned by one person. There are two equity accounts for a sole proprietorship: capital and drawings. Capital is the equivalent of common stock and retained earnings combined for a corporation. Drawings are the equivalent of dividends for a corporation. Let’s look at an example.
On January 2, J. Doe started a retail store by investing $150,000 of his own money. The journal entry on the books of the proprietorship to record this business formation is a debit to cash and a credit to J. Doe, Capital for $150,000. Each month, J. Doe withdraws $1,000 from the business for personal living expenses. The January 30 journal entry to record the first withdrawal is a debit to J. Doe, Drawings and a credit to cash for $1,000.
During the first year, J. Doe’s income totaled $18,000, and his withdrawals totaled $12,000. The equity section of J. Doe’s balance sheet at the end of the first year shows an ending balance in the capital account of $156,000. We arrive at this amount by adding the $18,000 of income to the $150,000 beginning capital balance and subtracting the $12,000 of drawings from the total.
A partnership is owned by two or more individuals. Partnerships require clear agreements about authority, risks, and the sharing of profits and losses. Separate capital and drawings accounts are maintained for each partner. Partnership income is divided among the partners according to the partnership agreement. Partnerships have some advantages and disadvantages when compared to corporations. The primary advantages are ease of formation, complete control by the partners, and the avoidance of income taxes on the partnership income. Each partner pays taxes on his or her share of partnership income. The primary disadvantage of a partnership is unlimited liability. Creditors can make claims against partners’ personal assets to satisfy partnership debts. Let’s look at an example.
On January 2, Able and Baker formed a partnership. Able contributed $60,000 cash. Baker contributed $40,000 cash. The partners agreed to divide partnership income in the ratio of their contributions (60:40). The journal entry to record this business formation on the books of the partnership is a debit to cash for $100,000, a credit to Able, Capital for $60,000, and a credit to Baker, Capital for $40,000.
The partners agreed that each month Able would withdraw $1,000 and Baker would withdraw $650. The January 30 journal entry to record the first withdrawal is a debit to Able, Drawings for $1,000, a debit to Baker, Drawings for $650, and a credit to cash for $1,650.
During the first year, partnership income totaled $30,000. The $30,000 of partnership income is credited to the partners’ capital accounts in the agreed upon 60:40 ratio, with Able receiving $18,000 and Baker receiving $12,000. Withdrawals totaled $12,000 for Able and $7,800 for Baker. The equity section of the partnership balance sheet at the end of the first year shows ending capital balances of $66,000 for Able and $44,200 for Baker. We get these amounts similar to the way we did for the proprietorship, by adding investments and income to the beginning capital balances and deducting withdrawals from the total.
Here’s a convenient summary of the accounting and reporting issues for the three forms of business that we have discussed in this chapter.
Understanding The Business Because a corporation is a separate legal entity , it can . . . Simple to become an owner Easy to transfer ownership Provides limited liability Advantages of a corporation Own assets. Sue and be sued. Incur liabilities. Enter into contracts.
Ownership of a Corporation Voting (in person or by proxy ). Proportionate distributions of profits (dividends). Proportionate distributions of assets in a liquidation. Rights Stockholders’
Ownership of a Corporation Appointed by directors
Authorized, Issued, and Outstanding Shares Authorized shares are the maximum number of shares of capital stock that can be sold to the public. Issued shares are authorized shares of stock that have been sold. Unissued shares are authorized shares of stock that never have been sold.
Authorized, Issued, and Outstanding Shares Unissued Shares Treasury Shares Outstanding Shares Treasury shares are issued shares that have been reacquired by the corporation. Outstanding shares are issued shares that are owned by stockholders.
Earnings Per Share (EPS) Kroger’s income for 2009 is $1,249,000,000 and the average number of shares outstanding is 652,000,000. Earnings per share is probably the single most widely watched financial ratio. *If there are preferred dividends, the amount is subtracted from net income. $1,249,000,000 652,000,000 Shares EPS = = $1.92 per share Net Income * Average Number of Shares Outstanding for the Period EPS =
Common Stock Transactions Two primary sources of stockholders’ equity Retained earnings Contributed capital Common stock, par value Capital in excess of par value
Common Stock Transactions Dividend set by board of directors Basic voting stock Ranks after preferred stock
Common Stock Transactions Legal capital is the amount of capital, required by the state, that must remain invested in the business. Par Value Nominal value Legal capital
Common Stock Transactions Par Value Market Value Some states do not require that a par value be stated in the charter. Some states do not require a par value to be stated in the charter.
Initial Sale of Stock Initial public offering (IPO) Seasoned new issue The first time a corporation sells stock to the public . Subsequent sales of new stock to the public. Kroger issues new stock. Kroger
Initial Sale of Stock Prepare the journal entry to record this transaction. On July 6, Kroger issued 100,000 shares of $1 par value common stock for $20 per share. 100,000 shares × $20 per share = $2,000,000 100,000 shares × $1 par value = $100,000
Transactions between two investors that do not affect the corporation’s accounting records.
I’d like to sell some of my Kroger stock. I’d like to buy some of your Kroger stock.
Stock Issued for Employee Compensation Employee Stock options allow employees to purchase stock from the corporation at a predetermined, fixed price. Employee compensation package includes salary and stock options . If Kroger does not have new stock to issue when the stock options are exercised, then . . Kroger
Repurchase of Stock Kroger buys its own stock in the secondary market. (Treasury stock) Repurchased stock is called treasury stock. A corporation records treasury stock at cost . Treasury stock has no voting or dividend rights. Treasury stock is not an asset. It is a contra equity account. Stockholders Kroger
Repurchase of Stock On May 1, Kroger reacquired 100,000 shares of its common stock at $20 per share. The journal entry for May 1 is . . . .
Reissuance of Treasury Stock 10,000 shares × $30 = $300,000 10,000 shares × $20 cost = $200,000 On December 3, Kroger reissued 10,000 shares of the treasury stock at $30 per share. The journal entry for December 3 is . . .
Dividends on Common Stock Declared by board of directors. Not legally required. Creates liability at declaration. Requires sufficient Retained Earnings and Cash.
Stockholders holding shares on this date will receive the dividend. (No entry)
Date of Payment
Record the dividend payment to stockholders.
Dividend Yield Ratio This ratio is often used to compare the dividend-paying performance of different investment alternatives. In 2009, Kroger paid a dividend of $0.36 per share and the market price of a share of Kroger stock was $22. Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.36 per share $22 per share = = 1.6%
Stock Dividends Distribution of additional shares of stock to owners. No change in total stockholders’ equity. All stockholders retain same percentage ownership. No change in par values. Stock dividend < 20-25% Record at current market value of stock. Small
Stock Splits Stock splits change the par value per share, but the total par value is unchanged. Assume that a corporation had 3,000 shares of $2 par value common stock outstanding before a 2–for–1 stock split. Increase Decrease No Change
Preferred Stock Preference over common stock Usually has no voting rights Usually has a fixed dividend rate
International Perspective—IFRS What’s in a Name?
Issued capital or share capital
US GAAP and IFRS use different words to describe the same corporate equity accounts.
Chapter Supplement ─ Accounting for Owners’ Equity for Sole Proprietorships and Partnerships A sole proprietorship is owned by a one person. Two equity accounts Capital Drawings
Sole Proprietorships On January 2, J. Doe started a retail store by investing $150,000 of his own money. The journal entry to record this business formation is: Each month, J. Doe withdraws $1,000 for personal living expenses. The January 30 journal entry to record the first withdrawal is:
Sole Proprietorships During the first year, J. Doe’s income totaled $18,000, and his withdrawals totaled $12,000. The equity section of J. Doe’s balance sheet at the end of the first year is:
Partnerships A partnership is owned by two or more individuals. Partnerships require clear agreements about authority, risks, and the sharing of profits and losses. Separate capital and drawings accounts are maintained for each partner. Partnership income is divided among the partners according to the partnership agreement. Complete control by partners No income taxes on business Unlimited liability Ease of formation Advantages Primary disadvantage
On January 2, Able and Baker formed a partnership. Able contributed $60,000 cash. Baker contributed $40,000 cash. The partners agreed to divide partnership income in the ratio of their contributions (60:40). The journal entry to record this business formation is:
Partnerships The partners agreed that each month Able would withdraw $1,000 and Baker would withdraw $650. The January 30 journal entry to record the first withdrawal is:
Partnerships During the first year, partnership income totaled $30,000. Withdrawals totaled $12,000 for Able and $7,800 for Baker. The equity section of the partnership balance sheet at the end of the first year is:
Accounting and Reporting for Three Types of Businesses