Equity Financing 13-1

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1 Ch.13 Equity Financing 1. Stock Rights (common and preferred stock) 2. Stock Issuance for cash, noncash assets or for services 3. Treasury stock 4. Stock rights and warrants 5. Compensation expense with stock options 6. Equity-related items reported as liabilities 7. Stock conversions 8. Factors affecting retained earnings 9. Cash dividends, property dividends, stock dividends, and stock splits 10.Unrealized gains and losses recorded as OCI and major types of equity reserves 11.Statement of changes in stockholders equity 13-1

2 1. Rights associated with ownership of common and preferred stock Nature and Classifications of Paid-In Capital A corporation is a legal artificial entity separate from its owners. Individuals contribute capital for which the corporation issues stock certificates evidencing ownership interests. Stockholders elect a board of directors whose members oversee the strategic and long-run planning of the corporation. 13-2

3 Common and Preferred Stock When a corporation is formed, a single class of stock, known as common stock, is usually issued. Corporations may later find that there are advantages to issuing one or more additional classes of stock with varying rights and priorities. Stock with certain preferences (rights) over common stock is called preferred stock. 13-3

4 Common Stock Unless restricted by terms of the articles of incorporation, certain basic rights are held by each common stockholder: 1. To vote in the election of directors and in the determination of certain corporate policies. 2. To maintain one s proportional interest in the corporation through purchase of additional common stock if and when it is issued. This right is known as the preemptive right. 13-4

5 Par or Stated Value of Stocks The journal entry to record the issuance of common stock in exchange for cash frequently looks something like this: Cash Common Stock (at par value) Additional Paid-In Capital XXX XXX XXX Historically, par value was equal to the market value of the shares at issuance. Today, most stocks have a nominal par value or no par value at all. No-par stock sometimes has a stated value that for financial reporting purposes acts like a par value. (continued) 13-5

6 Preferred Stock The term preferred stock is somewhat misleading because it gives the impression that preferred stock is better than common stock. Preferred stock isn t better it s different. Preferred stockholders give up many of the rights of ownership in exchange for some of the protection enjoyed by creditors. (continued) 13-6

7 Preferred Stock Rights of ownership given up by preferred stockholders: Voting. In most cases, preferred stockholders are not allowed to vote for the board of directors. Sharing in success. The cash dividends received by preferred stockholders are usually fixed in amount. Therefore, if the company does exceptionally well, preferred stockholders do not get to share in the success. (continued) 13-7

8 Preferred Stock The protections enjoyed by preferred stockholders, relative to common stockholders, are: Cash dividend preference. Preferred stockholders are entitled to receive the full cash dividend before any cash dividends are paid to common stockholders. Liquidation preferences. If the company goes bankrupt, preferred stockholders are entitled to have their investment repaid, in full, before common stockholders receive anything. 13-8

9 Cumulative and Noncumulative Preferred Stock When a corporation fails to declare dividends on cumulative preferred stock, such dividends accumulate and require payment in the future before any dividends may be paid to common stockholders. Dividends on cumulative preferred stock that are passed are referred to as dividends in arrears. With noncumulative preferred stock, it is not necessary to provide for passed dividends. (continued) 13-9

10 Cumulative and Noncumulative Preferred Stock Good Time Corporation has outstanding 100,000 shares of 9% cumulative preferred stock, $10 par. Dividends were last paid in Total dividends of $300,000 are declared in 2013 by the board of directors. (continued) 13-10

11 Cumulative and Noncumulative Preferred Stock Dividends may be declared on common stock as long as the preferred stock receives its preferred rate for the current period. If the preferred stock were noncumulative, the 2013 dividends would be distributed as follows: 13-11

12 Participating Preferred Stock Participating preferred stock issues provide for additional dividends to be paid to preferred stockholders after dividends of a specified amount are paid to the common stockholders. A participating provision makes preferred stock more like common stock. Participating preferred stocks are now relatively rare

13 Convertible Preferred Stock Preferred stock is convertible when it can be exchanged by its owner for some other security of the issuing corporation. Conversion rights generally provide for the exchange of preferred stock into common stock. In some instances, preferred stock may be converted into bonds

14 Callable Preferred Stock Many preferred issues are callable, meaning they may be called and canceled at the option of the corporation. The call price is usually specified in the original agreement and provides for payment of dividends in arrears as part of the repurchase price. Redeemable Preferred Stock Redeemable preferred stock is preferred stock that is redeemable at the option of the stockholder or upon other conditions not within the control of the issuer. Redeemable preferred stock is somewhat like a loan in that the issuing corporation may be forced to repay the stock proceeds

15 Current Development in The Accounting for Preferred Stock In the Preliminary Views document, the FASB recommends the basic ownership approach to identifying equity. This approach hinges on the idea that equity claims are those that remain when all other claims have been satisfied. The basic ownership approach would be very restrictive. In fact, all preferred stock, whether redeemable or not, would be reported as a liability under this approach. (continued) 13-15

16 Current Development in The Accounting for Preferred Stock Users prefer a perpetual approach, which describes an equity instrument as one for which there is no requirement to repay the invested funds, and the holder of the instrument is entitled to some assets if the company is liquidated. Both the FASB and IASB are leaning toward the perpetual approach

17 2. Issuance of stock for cash, on a subscription basis, and in exchange for noncash assets or for services Capital Stock Issued for Cash The issuance of stock for cash is recorded by a debit to Cash and a credit to Capital Stock for the par value. When the amount of cash received for the stock is more than the par value, the excess is recorded as a credit to an additional paid-in capital account. (continued) 13-17

18 Capital Stock Issued for Cash Goode Corporation issued 4,000 shares of $1 par common stock on April 1, 2011, for $45,000 cash Par Value Stock Apr. 1 Cash 45,000 Common Stock 4,000 Paid-In Capital in Excess of Par 41,000 (continued) 13-18

19 Capital Stock Issued for Cash Stated Value Stock On April 1, 2011, Goode Corporation issued 4,000 shares of no-par common stock with a $1 stated value Apr. 1 Cash 45,000 Common Stock 4,000 Paid-In Capital in Excess of Stated Value 41,000 (continued) 13-19

20 Capital Stock Issued for Cash No-Par Stock On April 1, 2011, Goode Corporation issued 4,000 shares of no-par common stock for $45,000 cash Apr. 1 Cash 45,000 Common Stock 45,

21 Capital Stock Sold on Subscription A subscription is a legally binding contract between the subscriber (purchaser of stock) and the corporation (issuer of stock). The contract states the number of shares subscribed, the subscription price, the terms of payment, and other conditions of the transaction. Ordinarily, stock certificates are not issued until the full subscription price has been received by the corporation. (continued) 13-21

22 Capital Stock Sold on Subscription November 1-30: Received subscriptions on November 1 for 5,000 shares of $1 par common stock at $12.50 per share with 50% down, balance due in 60 days. The entries for November 1 are as follows: Common Stock Subscriptions Receivable 62,500 Common Stock Subscribed 5,000 Paid-In Capital in Excess of Par 57,500 Cash 31,250 Common Stock Subscriptions Receivable 31,250 (continued) 13-22

23 Capital Stock Sold on Subscription December 1-31: Received balance due on onehalf of subscriptions and issued stock to the fully paid subscribers, 2,500 shares. Cash 15,625 Common Stock Subscriptions Receivable 15,625 Common Stock Subscribed 2,500 Common Stock 2,500 (continued) 13-23

24 Capital Stock Sold on Subscription Contributed capital would be reported in the Stockholders Equity section of the December 31 balance sheet as follows: Common Stock Subscriptions Receivable should normally be shown as an offset to equity

25 Subscription Defaults If a subscriber defaults on a subscription, a corporation may: 1) return to the subscriber the amount paid, 2) return to the subscriber the amount paid less any reduction in price or expense incurred on the resale of the stock, 3) declare the amount paid by the subscriber as forfeited, or 4) issue to the subscriber shares equal to the number paid for in full

26 Capital Stock Issued for Consideration Other Than Cash AC Company issues 200 shares of $0.50 par value common stock in return for land. The company s stock is currently selling for $50 per share. Land 10,000 Common Stock 100 Paid-In Capital in Excess of Par 9,900 When other than cash is received, the fair market value of the stock or the fair market value of the property or service, whichever is more determinable is used

27 Capital Stock Issued for Consideration Other Than Cash The land has a readily determinable market price of $12,000, but AC Company s common stock has no established fair market value. Land 12,000 Common Stock 100 Paid-In Capital in Excess of Par 11,900 If no readily determinable value is available for either, the accepted procedure is to have the value of the property or services appraised

28 3. Use both the cost and par value methods to account for stock repurchases Reasons Companies Repurchase Stock 1. Provide shares for incentive compensation and employee savings plans. 2. Obtain shares needed to satisfy requests by holders of convertible securities. 3. Reduce the amount of equity relative to the amount of debt. 4. Invest excess cash temporarily. 5. Remove some shares from the open market in order to protect against a hostile takeover. 6. Improve per-share earnings by reducing the number of shares outstanding and returning inefficiently used assets to shareholders. 7. Display confidence that the stock is currently undervalued by the market

29 Treasury Stock Treasury stock is stock issued by a corporation and subsequently reacquired by the corporation and held for possible future reissuance or retirement. Treasury stock should not be viewed as an asset; report as a reduction in owner s equity. There is no income or loss on the reacquisition, reissuance, or retirement of treasury stock. Retained Earnings can be decreased by treasury stock transactions but never increased by such transactions

30 Cost Method of Accounting for Treasury Stock 2012 Newly organized corporation issued 10,000 shares of common stock, $1 par, at $15: Cash 150,000 Common Stock 10,000 Paid-In Capital in Excess of Par 140, Reacquired 1,000 shares of common stock at $40 per share: Treasury Stock 40,000 Cash 40,000 (continued) 13-30

31 Cost Method of Accounting for Treasury Stock 2013 Sold 200 shares of treasury stock at $50 per share: Cash 10,000 Treasury Stock (200 $40) 8,000 Paid-In Capital from Treasury Stock 2,000 Note: No gain is recorded on the sale. The excess is credited to Paid-in Capital from Treasury Stock. (continued) 13-31

32 Cost Method of Accounting for Treasury Stock 2013 Sold 500 shares of treasury stock at $34 per share: Cash 17,000 Paid-In Capital from Treasury Stock 2,000 Retained Earnings 1,000 Treasury Stock (500 $40) 20,000 Note: No loss is recorded on the sale. The difference is debited to Retained Earnings. (continued) 13-32

33 Cost Method of Accounting for Treasury Stock 2013 Retired remaining 300 shares of treasury (3% of original issue of 10,000 shares): Common Stock 300 Paid-In Capital in Excess of Par 4,200 Retained Earnings [300 ($40 $15)] 7,500 Treasury Stock (300 $40) 12,000 Alternatively, the entire $11,700 difference between Common Stock and the cost to acquire the treasury stock may be debited to Retained Earnings

34 Par (or Stated) Value Method of Accounting for Treasury Stock 2012 Newly organized corporation issued 10,000 shares of common stock, $1 par, at $15: Same entry as the cost method (Slide 13-30) Reacquired 1,000 shares of common stock at $40 per share: Treasury Stock 1,000 Paid-In Capital in Excess of Par 14,000 Retained Earnings [1,000 x ($40 $15)] 25,000 Cash 40,000 (continued) 13-34

35 Par (or Stated) Value Method of Accounting for Treasury Stock 2013 Sold 200 shares of treasury stock at $50 per share: Cash 10,000 Treasury Stock 200 Paid-In Capital in Excess of Par 9, Sold 500 shares of treasury stock at $34 per share: Cash 17,000 Treasury Stock 500 Paid-In Capital in Excess of Par 16,500 (continued) 13-35

36 Par (or Stated) Value Method of Accounting for Treasury Stock 2013 Retired remaining 300 shares of treasury stock: Common Stock 300 Treasury Stock

37 Evaluating the Cost and Par Value Methods Less than 10% of large US. Companies use the par value method 13-37

38 4. Account for the issuance of stock rights and stock warrants Stock Rights, Warrants, and Options Stock rights issued to existing shareholders to permit them to maintain their proportionate ownership interests when new shares are to be issued. Stock warrants sold by the corporation for cash, generally in conjunction with the issuance of another security. Stock options granted to officers or employees, usually as part of a compensation plan

39 Stock Rights When announcing rights to purchase additional shares of stock, the directors of a corporation specify a date on which the rights will be issued. All stockholders of record on the issue date are entitled to the rights. Thus, between the announcement date and the issue date, the stock is said to sell rights-on. After the rights are issued, the stock sells ex-rights, and the rights may be sold separately by those receiving them from the corporation. An expiration date is also designated when the rights are announced, and rights not exercised by this date are worthless

40 Stock Warrants Detachable warrants are similar to stock rights because they can be traded separately from the security with which they were originally issued. Nondetachable warrants cannot be separated from the security with which they were issued. The value assigned to the warrants is determined by the relative fair value method which is illustrated in the following equation: Value assigned to warrants (continued) = Total issue price x Market value of warrants Market value of security without warrants + Market value of warrants 13-40

41 Stock Warrants Stewart Co. sells 1,000 shares of $50 par preferred stock for $58 per share. Stewart Co. gives the purchaser detachable warrants enabling the holders to subscribe to 1,000 shares of $2 par common stock for $25 per share. Immediately following the issuance of the stock, the warrants are selling for $3, and the fair market value of a preferred share without the warrant attached is $57. (continued) 13-41

42 Stock Warrants Value assigned to warrants Value assigned to warrants = Total issue price x = $58,000 x Market value of warrants Market value of security + without warrants $3 $57 + $3 Market value of warrants = $2,900 (continued) 13-42

43 Stock Warrants The entry on Stewart s books to record the sale of the preferred stock with detachable warrants is as follows: Cash 58,000 Preferred Stock, $50 par 50,000 Paid-In Capital in Excess of Par Preferred Stock 5,100 Common Stock Warrants 2,900 (continued) 13-43

44 Stock Warrants If the warrants are exercised: Common Stock Warrants 2,900 Cash 25,000 Common Stock, $2 par 2,000 Paid-In Capital in Excess of Par Common Stock 25,900 If the warrants expire: Common Stock Warrants 2,900 Paid-In Capital from Expired Warrants 2,

45 5. Compute the compensation expense associated with the granting of employee stock options Stock Option Compensation Expense Whether or not to expense stock options is a hot potato issue in accounting. The FASB kept bringing up the issue of stock option accounting only to find that there were strong feelings against expensing the cost of stock options. Recognition of a stock option compensation expense would reduce reported earnings. (continued) 13-45

46 Stock Option Compensation Expense In December 2004, the FASB adopted pre- Codification Statement No. 123 which requires the expensing of the fair value of stock options granted as compensation. This standard is now found in FASB ASC Topic

47 Basic Stock Option Compensation Plan Neff Company estimates a grant date value of $10 for each of the employee stock options. The total fair value of the options granted is $100,000 (10,000 x $10) as of the grant date. Compensation expense is allocated over three years from January 1, 2011 (the grant date) to January 1, 2014 (the vesting date). The year-end entry is shown in Slide (continued) 13-47

48 Basic Stock Option Compensation Plan 2011 Dec. 31 Compensation Expense 33,333 Paid-In Capital from Stock Options 33,333 $100,000/3 Note that this paid-in capital is not from the investment of cash in the business but instead represents an investment of work by the employees covered under the stock option plan. (continued) 13-48

49 Basic Stock Option Compensation Plan On December 31, 2014, all 10,000 of the options are exercised to purchase Neff s no-par common stock: 2014 Dec. 31 Cash (10,000 x $50) 500,000 Paid-In Capital from Stock Options 100,000 Common Stock (no par) 600,

50 Basic Stock Option Compensation Plan The following note disclosure is required each year: 13-50

51 Accounting for Performance-Based Plans In a performance-based stock option plan, the plan terms are dependent on how well the individual performs after the date the options are granted or how well the company performs during the vesting period. (continued) 13-51

52 Accounting for Performance-Based Plans On January 1, 2011, the board of directors of Neff Company authorized the granting of stock options to supplement the salaries of certain employees. Each stock option permits the purchase of one share of Neff common stock at a price of $50 per share; the market price on January 1, 2011, is also $50 per share. (continued) 13-52

53 Accounting for Performance-Based Plans The options vest, or become exercisable, beginning on January 1, 2012, and only if the employee stays with the company for the entire 3-year period. The options expire on December 31, The number of options granted is contingent on Neff s level of sales for If Neff sales are less than $50 million, only 10,000 options will vest. If Neff s sales are between $50 million and $80 million, an additional 2,000 options will vest. If sales exceed $80 million, 15,000 vest. (continued) 13-53

54 Accounting for Performance-Based Plans As of December 31, Neff forecasts that 2013 sales will be around $60 million, indicating that 12,000 options will vest. Recognition of compensation expense for 2013 involves recognizing one-third of the $120,000 (12,000 x $10) total estimated expense for the 3-year service period. The change in Neff s stock price during the year (from $50 to $60) does not affect the calculation. (continued) 13-54

55 Accounting for Performance-Based Plans Recognition of compensation of $40,000 for each of the three years [(12,000 options $10)/3]: 2011 Dec. 31 Compensation Expense 40,000 Paid-In Capital from Stock Options 40,000 (continued) 13-55

56 Accounting for Performance-Based Plans Events in 2012 lead Neff to lower its forecast of 2013 sales. Sales are expected to be only $40 million, so only 10,000 options will vest on January 1, Because two-thirds of the service period has elapsed, aggregate compensation expense should be $66,667 ($100,000 x 2/3) Dec. 31 Compensation Expense ($66,667 $40,000) 26,667 Paid-In Capital from Stock Options 26,667 (continued) 13-56

57 Accounting for Performance-Based Plans Actual sales for 2013 are $85 million, so 15,000 options will vest on January 1, Because compensation expense of $66,667 ($40,000 + $26,667) has already been recognized in 2011 and 2012, the necessary journal entry in 2013 is as follows: 2013 Dec. 31 Compensation Expense ($150,000 $66,667) 83,333 Paid-In Capital from Stock Options 83,333 (continued) 13-57

58 Accounting for Performance-Based Plans On December 31, 2014, all 15,000 options are exercised to purchase Neff s no-par common stock Dec. 31 Cash ($15,000 $50) 750,000 Paid-In Capital from Stock Options 150,000 Common Stock (no par) 900,

59 Accounting for Awards That Call for Cash Settlement Assume that Neff Company has decided instead of granting its employees 10,000 stock options, it will grant an equal number of cash stock appreciation rights (SARs). A cash SAR awards an employee a cash amount equal to the market value of the issuing firm s shares above a specified threshold price. (continued) 13-59

60 Accounting for Awards That Call for Cash Settlement Fair value of one SAR: January 1, 2011 $10 December 31, December 31, December 31, As of December 31, 2011, the estimated fair value of each SAR is $6. The best estimate of the amount of cash that will be transferred when the cash SARs are exercised is $60,000 (10,000 x $6). (continued) 13-60

61 2011 Dec. 31 Compensation Expense ($60,000/3 years) 20,000 Share-Based Compensation Liability 20,000 As of December 31, 2012 the estimated fair value of each SAR is $7. The new estimation for compensation expense is $70,000 (10,000 $7) Accounting for Awards That Call for Cash Settlement Dec. 31 Compensation Expense ($46,667 $20,000) 26,667 Share-Based $70,000 x 2/3 Compensation Liability 26,667 (continued) 13-61

62 Accounting for Awards That Call for Cash Settlement The estimated fair value of each SAR is $9 on December 31, Aggregate compensation expense for the 3-year service period is $90,000 ($10,000 x $9). Because the compensation expense of $46,667 has been recognized in 2011 and 2012, the necessary journal entry in 2013 is as follows: 2013 Dec. 31 Compensation Expense (90,000 $46,667) 43,333 Share-Based Compensation Liability 43,333 (continued) 13-62

63 Accounting for Awards That Call for Cash Settlement The share price on December 31, 2014 is $61, meaning that Neff will pay $11 ($61 threshold price of $50) for each SAR Dec. 31 Compensation Expense 20,000 Share-Based Compensation Liability 20,000 Cash payments are made to the holders of the 10,000 SARs on December 31, Dec. 31 Share-Based Compensation Liability 110,000 Cash [10,000 ($61 $50)] 110,

64 6. Determine which equity-related items should be reported in the balance sheet as liabilities Mandatorily Redeemable Preferred Shares Historically, the SEC required that firms not include mandatorily redeemable preferred stock under the Stockholders Equity heading. Given a mezzanine treatment. The FASB now requires mandatorily redeemable preferred shares to be reported as liabilities in the balance sheet. (continued) 13-64

65 Mandatorily Redeemable Preferred Shares On January 1, 2011, Tarazi Company issued mandatorily redeemable preferred shares in exchange for $100 cash. The shares must be redeemed on January 1, 2012, for $110. The interest rate implicit in this agreement is 10% Jan. 1 Cash 100 Mandatorily Redeemable Preferred Shares (liability) 100 Dec. 31 Interest Expense ($100 x 0.10) 10 Mandatorily Redeemable Preferred Shares (liability) Jan. 1 Mandatorily Redeemable Preferred Shares (liability) 110 Cash

66 Written Put Options A put option is an agreement that allows investors to sell the issuing corporation shares they hold at set prices on specific dates. If the stock price stays above a set level per share, the issuing corporation pays nothing. Historically, companies have recorded these put options as part of equity. The FASB now instructs companies to record the fair value of the obligation as a liability. (continued) 13-66

67 Written Put Options On January 1, 2011, Kamili Company wrote a put option agreeing to purchase one share of its own stock for $100 on December 31, 2012 at the option of the purchaser. The market price of Kamili s shares on January 1, 2011, was $100. On January 1, 2011, this put option has a fair value of $ Jan. 1 Cash 20 Put Option (liability) 20 (continued) 13-67

68 Written Put Options An option-pricing formula suggests that the fair value of the put option on December 31, 2011, is $30, up from $20 at the beginning of the year Dec. 31 Loss on Put Option 10 Put Option (liability)($30 $20 already recognized) 10 On December 31, 2012, the put option expiration date, the market price of Kamili stock is $82 per share. The put option holder decides to exercise the option and sell one share of Kamili stock to Kamili for $100. (continued) 13-68

69 Written Put Options Kamili would record the purchase of one share of its stock in conjunction with the exercise of the put option Dec. 31 Treasury Stock (the fair value of the share repurchased) 82 Put Option (liability) 30 Gain on Put Option 12 Cash

70 Obligation to Issue Shares of a Certain Dollar Value Companies occasionally agree to satisfy their obligations by delivering shares of their own stock rather than by paying cash. This is especially true for startup companies trying to conserve their limited cash supply. Depending on how the contract is written, this promise to deliver shares of one s stock to satisfy the obligation can be recorded as equity or as a liability. (continued) 13-70

71 Obligation to Issue Shares of a Certain Dollar Value Example 1: On October 1, 2011, Lily Company experienced trouble with its office air conditioning system. The repair bill is $5,000. Lily agrees to deliver 200 shares of no-par common stock to the repairperson on February 1, On October 1, 2011, Lily s shares have a market value of $ Oct. 1 Maintenance Expense (200 x $25) 5,000 Common Stock Issuance Obligation (equity) 5,000 (continued) Similar to Common Stock Subscribed 13-71

72 Obligation to Issue Shares of a Certain Dollar Value 2012 Feb. 1 Common Stock Issuance Obligation (equity) 5,000 Common Stock 5,000 Example 2: On October 1, 2011, Lily Company received air conditioning repair services costing $5,000. Lily agrees to deliver shares of Lily s nopar common stock with a market value of $5,000 to the repairperson on February 1, On October 1, 2011, Lily s shares have a market value of $25, and on February 1, 2012, the shares have a market value of $20. (continued) 13-72

73 Obligation to Issue Shares of a Certain Dollar Value Oct. 1 Maintenance Expense 5,000 Common Stock Issuance Obligation (liability) 5,000 Feb. 1 Common Stock Issuance Obligation (liability) 5,000 Common Stock (250 x $20) 5,

74 Noncontrolling Interest Financing provided by minority stockholders is called minority interest. Minority interest is the amount of equity investment made by outside shareholders to consolidated subsidiaries that are not 100% owned by the parent. The FASB uses the term noncontrolling interest to replace minority interest in the consolidated balance sheet

75 7. Distinguish between stock conversions that require a reduction in retained earnings and those that do not Stock Conversions The capital section of Sorensen Corporation on December 31, 2013, is as follows: Preferred stock, $50 par, 10,000 $ 500,000 Paid-in capital in excess of par preferred 100,000 Common stock, $1 par, 100,000 shares 100,000 Paid-in capital in excess of par common 2,900,000 Retained earnings 1,000,

76 Stock Conversions Case 1: One Preferred for Four Common ($1) On December 31, 2013, 1,000 shares of preferred stock (par $50) are exchanged for 4,000 shares of common stock (par $1) Dec. 31 Preferred Stock, $50 par 50,000 Paid-In Capital in Excess of Par Preferred 10,000 Common Stock, $1 par 4,000 Paid-In Capital in Excess of Par Common 56,000 (continued) 13-76

77 Stock Conversions Case 2: One Preferred for Four Common ($20) On December 31, 2011, 1,000 shares of preferred stock (par $50) are exchanged for 4,000 shares of common stock (par $20) Dec. 31 Preferred Stock, $50 par 50,000 Paid-In Capital in Excess of Par Preferred 10,000 Retained Earnings 20,000 Common Stock, $20 par 80,

78 8. List the factors that impact the Retained Earnings balance Factors Affecting Retained Earnings A number of factors can affect retained earnings in addition to net income, losses, and dividends. These transactions and events that affect retained earnings are summarized as follows: 13-78

79 Net Income and Dividends The primary source of retained earnings is the net income generated by a business. When operating losses or other debits to retained earnings produce a debit balance in the account, the debit balance is referred to as a deficit. Use of the term dividends without qualification normally implies the distribution of cash

80 Prior-Period Adjustments In some situations, errors made in past years are discovered and corrected in the current year by an adjustment to Retained Earnings, referred to as a prior-period adjustment: Mathematical mistakes Failure to apply appropriate accounting procedures Misstatement or omission of certain information Change from a non-gaap principle to a GAAP principle 13-80

81 Appropriated Retained Earnings Retained Earnings may be restricted at the discretion of the board of directors. Example: Expansion of plant facilities The restricted portion may be designed as appropriated retained earnings and the unrestricted portion as unappropriated (or free) retained earnings. The main idea behind this restriction is to notify stockholders that some of the assets may not be available for dividends

82 9. Properly record cash dividends, property dividends, small and large stock dividends, and stock splits Accounting for Dividends In setting dividend policy, the board of directors must answer two questions: 1. Do we have the legal right to declare a dividend? 2. Is a dividend distribution financially advisable? The board of directors must observe the state incorporation laws governing the payment of dividends

83 Recognition and Payment of Dividends Declaration date date the corporation s board of directors formally declares a dividend will be paid Date of record date on which stockholders of record are identified as those who will receive a dividend Date of payment date when the dividend is actually distributed to stockholders 13-83

84 Cash Dividends Entries to record the declaration and payment of a $100,000 cash dividend by a corporation follows: Declaration of Dividend: Dividends (or Retained Earnings) 100,000 Dividends Payable 100,000 Payment of Dividend: Dividends Payable 100,000 Cash 100,

85 Property Dividends A dividend to stockholders that is payable in some asset other than cash is generally referred to as a property dividend. Frequently, the assets to be distributed are securities of other companies owned by the corporation. The corporation thus transfers to stockholders the ownership interest in such securities. This type of transfer is sometimes referred to as a nonreciprocal transfer to owner inasmuch as nothing is received by the company in return for its distribution to stockholders. (continued) 13-85

86 Property Dividends Bigler Corporation owns 100,000 shares in Tri-State Oil Co, carrying value $2,700,000, current market value $3,000,000, or $30 per share. There are 1,000,000 shares of Bigler stock outstanding. A dividend of 1/10 of a share of Tri-State Oil Co. is declared for each share of Bigler stock outstanding. The entries for Bigler for the dividend declaration and payment are on Slide (continued) 13-86

87 Property Dividends Declaration of Dividend: Dividends (or Retained Earnings) 3,000,000 Property Dividends Payable 2,700,000 Gain on Distribution of Property Dividends 300,000 Payment of Dividend: Property Dividends Payable 2,700,000 Investment in Tri-State Oil Co. Stock 2,700,

88 Stock Dividends A corporation may distribute to stockholders shares of the company s own stock as a stock dividend. A stock dividend involves no transfer of cash or any other asset to stockholders. From a shareholder s standpoint, receipt of a stock dividend is an economic nonevent

89 Small versus Large Stock Dividends Small: Less than 20 25% of the outstanding shares. Debit Retained Earnings for the market value of the shares. Large: Greater than 20 25% of the shares outstanding. Debit Retained Earnings for the par value of the shares

90 Small Dividend Example The stockholders equity section for the Fuji Company on July 1 is as follows: Common Stock, $1 par, 100,000 shares outstanding $ 100,000 Paid-In Capital in Excess of Par 1,100,000 Retained Earnings 750,000 The company declares a 10% stock dividend. Before the stock dividend, the stock is selling for $22 per share. After the stock dividend, each share will have a value of $20 ($22/1.1). (continued) 13-90

91 Small Dividend Example Declaration of Dividend: Retained Earnings 200,000 Stock Dividends Distributable 10,000 Paid-In Capital in Excess of Par 190,000 Payment of Dividend: Stock Dividends Distributable 10,000 Common Stock, $1 par 10,

92 Large Dividend Example The stockholders equity section for the Fuji Company on July 1 is as follows: Common Stock, $1 par, 100,000 shares outstanding $ 100,000 Paid-In Capital in Excess of Par 1,100,000 Retained Earnings 750,000 The company declares a 50% stock dividend. Before the stock dividend, the stock is selling for $22 per share. Entries for declaring of the dividend and issuance of the 50,000 new shares (100,000 x 0.50) are on Slide (continued) 13-92

93 Large Dividend Example Declaration of Dividend: Retained Earnings 50,000 Stock Dividends Distributable 50,000 OR Paid-In Capital in Excess of Par 50,000 Stock Dividends Distributable 50,000 Issuance of Dividend: Stock Dividends Distributable 50,000 Common Stock, $1 par 50,

94 Stock Dividends versus Stock Splits A corporation may effect a stock split by reducing the par or stated value of each share of capital stock and proportionately increasing the number of shares outstanding. A stock dividend results in an increase in the number of shares outstanding. The par or stated value remains unchanged. A stock split divides the existing Capital Stock balance into more parts, with a reduction in par or stated value of each share

95 Reverse Stock Split A reverse stock split is the consolidation of shares outstanding into a smaller number of shares. Share of stock trading for less than $10 are viewed with some skepticism, and a reverse split can make the stock look more respectable. A reverse split is almost always viewed as bad news by investors

96 13-96

97 Liquidating Dividends A liquidating dividend is a distribution representing a return to stockholders of a portion of contribution capital. Example: Stubbs Corporation declared and paid a cash dividend ($10 cash dividend on 10,000 shares of common stock) totaling $100,000 and a partial liquidating dividend of $50,000. The liquidating dividend is a $5-per-share dividend. The declaration and payment entries are on Slide (continued) 13-97

98 Liquidating Dividends Declaration of Dividend: Dividends 100,000 Paid-In Capital in Excess of Par 50,000 Dividends Payable 150,000 Payment of Dividend: Dividends Payable 150,000 Cash 150,

99 10. Explain the background of unrealized gains and losses recorded as part of accumulated other comprehensive income, and list the major types of equity reserves found in foreign balance sheets Statement of Comprehensive Income FASB ASC Topic 220 requires that all companies provide a statement of comprehensive income. An example of Microsoft s 2009 statement of comprehensive income is included on Slide

100 13-100

101 Equity Items That Bypass the Income Statement and are Reported as Part of Accumulated Other Comprehensive Earnings Since 1980, the Equity sections of the U.S. balance sheets have begun to fill up with a strange collection of times, each the result of an accounting controversy. These items are summarized in the following slides. (continued)

102 Foreign Currency Translation Adjustment The foreign currency translation adjustment arises from the change in the equity of foreign subsidiaries (as measured in terms of U.S. dollars) that occurs as a result of changes in foreign currency exchange rates. These changes are recorded as direct adjustments to equity, insulating the income statement from the aspect of foreign currency fluctuations

103 Unrealized Gains and Losses on Available-for-Sale Securities Available-for-sale securities are those that were not purchased with immediate intention to resell, but that a company also doesn t necessarily plan to hold forever. The unrealized gains and losses from market value fluctuations in trading securities are included in the income statement. The unrealized gains and losses from market value fluctuations in available-for-sale securities are shown as a direct adjustment to equity. (continued)

104 Unrealized Gains and Losses on Derivatives A derivative is a financial instrument, such as an option or a future, that derives its value from the movement of a price, an exchange rate, or an interest rate associated with some other item. Derivatives are used to manage risk associated with sales or purchases that will not occur until a future period. (continued)

105 Unrealized Gains and Losses on Derivatives The last few lines of Kendall Company s income statement were as follows: (continued)

106 Unrealized Gains and Losses on Derivatives Kendall had the following items impacting comprehensive income:

107 Unrealized Gains and Losses on Derivatives Assume that the income tax rate for all items is 40%. Kendall Company would report its comprehensive income for the year as follows:

108 Balance Sheet Reporting The accumulated amount of comprehensive income is reflected in the Equity section of the balance sheet in two ways: Net income (less dividends) is cumulated in retained earnings. Other comprehensive income is cumulated in accumulated other comprehensive income

109 International Accounting: Equity Reserves In foreign countries, the payment of cash dividends is linked to the amount of distributable equity. Equity is divided among various equity reserve accounts, each with legal restrictions dictating whether it can be distributed to stockholders. (continued)

110

111 11. Prepare a statement of changes in stockholders equity Disclosures Related to the Equity Section In accounting for capital stock, it should be recognized that stock may be: Authorized but unissued Subscribed for and held for issuance pending receipt of cash for the full amount of the subscription price Outstanding in the hands of stockholders Reacquired and held by the corporation for subsequent reissuance Canceled by appropriate corporate action

112 13-112

113 13-113

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