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Chapter 15: Stockholders' Equity

I. The Corporate Form of Organization
A. State Laws Governing Corporations
1. If you want to incorporate your business in a particular state, you submit
your articles of incorporation to that state. The state then issues a
Corporate Charter, recognizing your company as a separate legal
entity subject to state law.
a) Each state has its own laws regarding the incorporation of
businesses. Businesses may "shop" these laws when deciding
where to incorporate, e.g., Gulf Oil moved to Delaware, where the
Board of Directors can approve certain tactics against takeovers
without shareholder approval.
2. Since state laws differ with regard to stockholders equity requirements; in
this chapter we therefore have to focus on what is typical.
B. The System of Capital Accumulation
1. Characteristics of Stock
a) Shares of stock represent ownership units (certificates of title) in
the net assets of the corporation.
b) Stockholders Ledger: The list of current shareholders, which is
maintained by the corporate registrar.
c) Transfer Agent: Responsible for the transfer of shares.
2. Typical Rights of the Common Stockholder
a) Right to share in profits (distributed as dividends) in proportion to
the shares held.
b) Right to vote for the board of directors and other matters at the
annual meeting. Proxy votes do not require physical attendance at
the meeting, but are mailed in.
c) Right to maintain ownership proportion upon new issuances of
stock, referred to as a preemptive right.
1) However, shareholders generally do not have preemptive
rights in any new securities issued as part of a board
approved employee equity incentive plan or other
benefit program where the primary purpose is not to
raise additional capital for the company. This exception
allows the companys board to incentivize management by
offering them stock options and other interests in securities.
d) Right to share proportionately in the assets of the corporation in
the event of liquidation.
3. Classes of Stock
a) Common Stock: Typically entitles the holder to the four rights
listed above.
b) Preferred Stock: Typically entitles dividend and/or liquidation
preferences in exchange for voting privileges.
C. Legal Capital: Assets cannot be distributed to shareholders if the distribution
would impair legal capital, which is variously defined by state law. This is the
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minimum capital that must remain in the corporation to protect creditors;
dividends cannot legally be paid out of legal capital. The two most
common definitions are:
1. Par Value or Stated Value: An antiquated legal concept that sets an
arbitrary minimum per share value. This is stipulated in the corporate
charter.
2. Contributed Capital: Par value plus any amounts paid to the corporation
in excess of par. The excess is referred to as additional paid-in capital.
D. Limited Liability: Shareholder liability is generally limited to the amount of their
investment
1. An exception is if stock is issued at a discount (below par value). In the
event of reorganization or liquidation the original or current holder of
shares may have a contingent liability to creditors for the discount. For
this reason, most par values are purposely set very low (one dollar or less).
E. Preferred Stock Characteristics: May include one or more of the following
preferences:
1. Cumulative Feature: Dividends not declared in a particular year become
dividends in arrears, which must be paid before common shareholders
can receive dividends. Preferred dividends are usually a % of par.
2. Participation Feature: Preferred shareholders receive additional
dividends after both common and preferred have been allocated a dividend
equal to the preferred dividend rate.
a) Fully Participating
b) Partially Participating
3. Call Feature: Shares can be redeemed by the corporation at its option at a
pre-specified call price after a specified date.
4. Redemption Feature: Shares can be cashed in at the option of the
shareholders at a pre-specified redemption price after a specified date
(may need to be classified as debt on the balance sheet according to SFAS
No. 150 (Accounting for Certain Financial Liabilities with Characteristics of
Liabilities and Equity).
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5. Conversion Feature: Preferred shareholders can convert their shares into
common shares at a pre-specified conversion ratio after a specified date.
F. Corporate Dividend Policy
1. Assets are retained (plowed back) for internal financing by growing
companies because internal financing is generally much less costly to the
firm than external financing.
2. Aside from tax reasons and signaling issues, investors should be
indifferent between receiving dividends or capital gains.
3. There may be a desire by managements to smooth dividends by
retaining assets in profitable years for distribution in less profitable years.
4. Restrictions on or appropriations of retained earnings may exist. For
example, dividends may be restricted in debt covenants to protect creditor
interests.

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"A mandatorily redeemable financial instrument shall be classified as a liability unless the redemption is
required to occur only upon the liquidation or termination of the reporting entity" SFAS 150, Paragraph 9.
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5. Note that the balance in retained earnings says nothing about the
availability of cash to pay dividends.
II. New Stock Issuances
A. Stock Issuances for Cash
1. Par Value Stock: The par value of issued shares is credited to the Capital
Stock account, with any excess over par credited to Additional Paid-In
Capital (APIC).
2. Stated Value Stock: Treated the same as par value.
3. No-Par Stock: Some states do not require a par value to be assigned. No
Additional Paid-In Capital account is used.
4. Issue Costs: Costs of issuing shares are not an expense or an asset, but are
a reduction of contributed capital from the shares sold.

ILLUSTRATION OF THE ISSUANCE OF STOCK FOR CASH


Creative Capital Corporation issued the following stocks for cash:

Shares Stock Price
4,000 Series A Preferred, 5%, $25 par $ 26
1,500 Series B Preferred, 5%, $100 par,
convertible into 5 shares of common $ 130
10,000 Common, no-par $ 25

Record the entry for the series A preferred stock:



Cash (4,000*$26) 104,000
Preferred Stock - Series A (4,000*$25) 100,000
APIC - Preferred - Series A 4,000





Record the entry for the series B preferred stock:



Cash (1,500*$130) 195,000
Preferred Stock - Series B (1,500*$100) 150,000
APIC - Preferred - Series B 45,000







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Record the entry for the no par common stock:



Cash (10,000*$25) 250,000
Common Stock 250,000







B. Stock Issuances for Noncash Consideration
1. Recorded at the fair value of the consideration received or the fair value of
the stock issued, whichever is more clearly evident.
2. If neither value is readily determinable, value must still be assigned,
usually by an average of values set by independent appraisers of the asset.

ILLUSTRATION OF THE ISSUANCE OF STOCK FOR NONCASH CONSIDERATION


Creative Capital Corporation issued 20,000 shares of its no-par common
stock in exchange for a building and land. A commercial real estate
appraisal placed the estimated fair values of the building and land at
$600,000 and $300,000, respectively. Legal fees and other transactions
costs associated with the issuance totaled $5,000. The currently quoted
NASDAQ market price per share is $28.



Value of the transaction = (20,000 * $28) + $5,000 = $565,000



Building ($565,000 * 600/900) 376,667
Land ($565,000 * 300/900) 188,333
Common Stock 560,000
Cash, A/P, etc. 5,000







C. Lump-Sum Issuances: The proceeds are allocated among the classes of securities
on the basis of their relative estimated market values.
1. Proportional Method: Used if the market values of all securities is
known or reasonably estimated.
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2. Incremental Method: If less than all market values are known or
estimable, value is first assigned to the known market values. The
remainder proceeds are allocated to the other securities.

ACCOUNTING FOR LUMP-SUM ISSUANCES


Rayburn Corporation issued 2,000 security units for $2.2 million cash.
Each unit consists of 100 shares of $5 par common stock and one $500
par value bond. Transactions costs associated with the issuance were
$11,000. Record the issuance under each of the following independent
assumptions:

Immediately after the issuance the market price of the common stock was
$6 per share and the bonds were trading at par.



Value of common stock = 2,000*100*$6 = $1,200,000
Value of bonds = 2,000*1*$500 = 1,000,000
Total $2,200,000

Cash 2,200,000
Common Stock (2,000*100*$5) 1,000,000
APIC - Common 200,000
Bonds Payable 1,000,000

Bond Issue Costs ($11,000 * 1,000/2,200) 5,000
APIC - Common ($11,000-$5,000) 6,000
Cash 11,000




The market price per share of common immediately after the issuance was
$6.50, while the market price of the bonds is unknown.

Discount on B/P (plug) 100,000
Cash 2,200,000
Common Stock (2,000*100*$5) 1,000,000
APIC - Common (2,000*100*$1.50) 300,000
Bonds Payable 1,000,000

Bond Issue Costs ($11,000 * 900/2,200) 4,500
APIC - Common ($11,000-$4,500) 6,500
Cash 11,000



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III. Buybacks of Capital Stock
A. Retirement of Capital Stock
-Although it is rare to retire shares of common stock, the retirement of
preferred stock often takes place via open market purchase or by
exercising a call provision.
B. Treasury Stock: Stock may be reacquired for the treasury. For accounting
purposes, treasury stock is a contra stockholders equity account. It is not an asset
since a corporation cannot own part of itself.
1. Reasons for Stock Buybacks:
a) Use for employee stock ownership plans (ESOPs). If a preemptive
right of common shareholders exists, the corporation cannot
simply issue new shares for this purpose without a special
provision in the bylaws. This comment holds also for b, c, and d
below.
b) Use for possible conversion of preferred stock or bonds.
c) Use for stock dividends.
d) Make available shares for a merger.
e) Eliminate a particular stockholders ownership interest.
f) Increase earnings per share (a window-dressing reason).
g) Management believes shares are currently underpriced.
h) Reduce size of entity (no positive NPV projects can be found for
existing cash).
i) Defend against a possible takeover by eliminating soft
shareholders.
j) Investor tax preference for capital gains over dividends.
2. Methods of Accounting
a) Cost Method: This is by far the most popular method and,
therefore, the only method I will illustrate.
1) Used when the purchase of treasury stock is regarded to be
a temporary reduction in stockholders equity.
2) Treasury Stock is debited for its buyback cost.
3) Reissuance Gains: A reissuance above cost increases
contributed capital (APIC) from treasury stock transactions.
4) Reissuance Losses: A reissuance below cost first reduces
contributed capital from treasury stock transactions. Any
further loss is debited to retained earnings.
5) The Treasury Stock account is presented in the balance
sheet as a reduction of total stockholders equity.
b) Par Value Method: Rarely used in practice and therefore not
illustrated here.
1) Appropriate when the purchase of treasury stock is
regarded as a de facto permanent reduction in stockholders
equity (without actually canceling the shares).
2) Treasury Stock is debited for the par or stated value of the
acquired shares. The average additional paid-in capital
from original issuance is debited.
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3) If the buyback price is less than the average paid-in price,
the difference represents additional paid-in capital from
treasury stock transactions.
4) If the buy-back price is greater than the average paid-in
price, the difference is a reduction of additional paid-in
capital from previous treasury stock transactions. Any
additional debit needed is made to retained earnings.

ILLUSTRATION OF TREASURY STOCK TRANSACTIONS: COST METHOD


The Downsize Right Company had 1,000 shares of $100 par common stock
outstanding at the beginning of the year which were issued at an
average price of $110. During the year the firm engaged in various
treasury stock transactions.

Transaction Description
A 40 shares reacquired @ $112.
B 60 shares reacquired @ $114.
C 70 shares resold @ $114.
D 20 shares resold @ $105.
E 10 shares resold @ $108.

Using the cost method, prepare the entries for each transaction under
a FIFO cost flow assumption:

A:

Treasury Stock (40*$112) 4,480
Cash 4,480

B:

Treasury Stock (60*$114) 6,840
Cash 6,840

C:

Cash (70*114) 7,980
APIC-Treasury Stock (plug) 80
Treasury Stock [(40*$112) + (30*$114)] 7,900

D:

Cash (20*$105) 2,100
APIC-Treasury Stock
(balance to soak up "gain") 80
R/E (plug) 100
Treasury Stock(20*$114) 2,280

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E:
Cash (10*$108) 1,080
R/E (plug) 60
Treasury Stock (10*$114) 1,140







IV. Retained Earnings
A. Definition: The sum total earnings that have been reinvested in the firm since its
inception (accumulated net income less accumulated dividends declared). The use
of the term surplus is discouraged.
B. Transactions That Affect Retained Earnings
1. Net income (loss).
2. Prior period adjustments (Chapter 22).
3. Changes in accounting principle applied retrospectively (Chapter 22).
4. Dividends declared.
5. Some losses on treasury stock transactions (discussed above).
6. Quasi-reorganizations (beyond the scope of this course).
C. Dividends
1. Terminology
a) Declaration Date: The date that a dividend is formally declared by
the board of directors. On this date a liability is created and a
journal entry is made.
b) Ex-Dividend Date: Buyers of a stock on or after the ex-dividend
date are not entitled to the dividend payment.
c) Date of Record: Two business days after the ex-dividend date. It
takes two business days for orders to clear and therefore the
company does not have a record of buyers and sellers of stock
between the ex-dividend date and the record date. The record of
shareholders on this date thus only includes owners of the stock the
day before the ex-dividend date.
d) Date of Payment: The date that cash is paid and the liability is
discharged.
2. Types of Dividends
a) Cash Dividends
1) Dividends paid in cash.
2) Debit Retained Earnings or Dividends (which is closed to
Retained Earnings at the end of the period). Credit
Dividends Payable.




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ILLUSTRATION OF CASH DIVIDENDS


Woolford Inc. declared a cash dividend of $1.00 per share on its 2
million outstanding shares. The dividend was declared on August 1,
payable on September 9 to all stockholders of record on August 15.
Prepare all journal entries necessary on those three dates.








b) Property Dividends
1) Dividends paid in assets other than cash.
2) First, at declaration date, restate at fair value the property to
be distributed. A gain or loss is recognized for difference
between the book value and the fair value of assets to be
distributed.
3) Second, debit Retained Earnings for the fair market value
of asset(s) on the declaration date, credit Property
Dividends Payable
4) Lastly, when distributed, credit the account containing the
property distributed (restated to fair value) and debit
Property Dividends Payable.

ILLUSTRATION OF PROPERTY DIVIDENDS


Cole Inc. owns shares of Marlin Corporation stock classified as
available-for-sale securities. At December 31, 2012, the available-
for-sale securities were carried in Coles accounting records at their
cost of $875,000, which equaled their fair value. On September 21,
2013, when the fair value of the securities was $1,200,000, Cole
declared a property dividend whereby the Marlin securities are to be
distributed on October 23, 2013, to stockholders of record on October
8, 2013. Prepare all journal entries necessary on those three dates.

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c) Liquidating Dividends: Distribution of assets to shareholders in
excess of the balance in retained earnings. Contributed capital is
debited for the liquidating portion of the dividend.

ILLUSTRATION OF LIQUIDATING DIVIDENDS


Graves Mining Company declared, on April 20, a dividend of $500,000
payable on June 1. Of this amount, $125,000 is a return of capital.
Prepare the April 20 and June 1 entries for Graves.








d) Stock Dividends
1) Distribution of additional shares to stockholders in
proportion to the percentage of shares held. Theoretically,
shareholders do not receive value from a stock dividend.
2) Increases the total par value of shares outstanding, but has
no effect on the per share par value or the totality of
stockholders equity.
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3) Small Stock Dividends: Stock dividends of less than 20-
25 percent of outstanding shares. Retained Earnings is
debited for at the fair value of shares on the declaration
date.
4) Large Stock Dividends
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: Stock dividends of more than
20 to 25 percent. Retained Earnings is debited for the
states legal minimum (may be par value, stated value, or
average paid-in value, depending on the state law).
5) On the declaration date, credit Stock Dividends
Distributable, a contributed capital account, not a liability.

ILLUSTRATION OF STOCK DIVIDENDS


On March 15, 20x1, the Reams Paper Company declared a two for nine
stock dividend (22.2 percent) on its 360,000 shares of outstanding, $1
par, common stock, to be distributed on March 30, 20x1. The market
price on the declaration date was $12. The firm's controller pointed
out to the board that the books could be done in one of two ways:

Record the dated entries assuming treatment as a small Stock
dividend:

3/15/x1

Retained Earnings (360,000*(2/9)*$12) 960,000
Stock Dividends Distributable 960,000

3/30/x1

Stock Dividends Distributable 960,000
Common Stock (360,000*(2/9)*$1) 80,000
APIC - Common 880,000

Record the dated entries assuming treatment as a large stock
dividend:

3/15/x1

Retained Earnings (360,000*(2/9)*$1) 80,000
Stock Dividends Distributable 80,000

3/30/x1

Stock Dividends Distributable 80,000
Common Stock (360,000*(2/9)*$1) 80,000

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Large stock dividends often resemble stock splits in terms of the number of new shares issued (for instance, a
100% stock dividend results in the same increase in shares outstanding as a 2-for-1 stock split). The SEC therefore
requires that a large stock dividend be considered as a "split up effected in the form of a dividend."
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D. Stock Splits
1. Increase in the number of shares outstanding with a corresponding
decrease in the par value of a share of stock. A reverse stock split does
the opposite.
2. Typically there is no change in total par value outstanding.
3. Usually, no journal entry is required. Memorandum note only to indicate
the changed par value of the shares and the increased number of shares.
4. Although reverse stock splits are an effective way to increase stock price,
they are often followed by poor returns.
E. Appropriation of Retained Earnings
1. The board may restrict distributions of retained earnings for the following
reasons:
a) Legal Restrictions: The state may require retained earnings be
restricted, for example, for the cost of treasury shares since
buybacks are essentially a dividend.
b) Contractual Restrictions: Debt covenants may require dividend
restrictions to protect creditor interests.
c) Retention of assets for expansion.
d) Retention for future contingencies (e.g., losses from inventories,
lawsuits, and so on).
2. A journal entry to record the appropriation is optional, though disclosure is
required.
IV. The Statement of Stockholders Equity: Shows a reconciliation of the beginning and
ending balances of each stockholders equity account. See text for example.







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Some Key Differences: IFRS vs. U.S. GAAP

IAS or
IFRS
Topic IFRS US GAAP
IAS 1 Presentation of Financial
Statements
IFRS refers to the
"Statement of Changes in
Equity"
GAAP refers to the
"Statement of
Stockholders' Equity"
IAS 1 Presentation of Financial
Statements
IFRS uses "reserves" as a
dumping ground for other
comprehensive income
items and other unusual
items.
GAAP relies on the
account Accumulated
Other Comprehensive
Income (Loss).
IAS
16/38
Revaluation of PPE,
mineral resources and
intangible assets
Under IFRS, revaluation
of PPE, mineral resources
and intangible assets is
allowed. A "Revaluation
Surplus" account is used.
The term "Surplus" is
generally not used.
Recognition of unrealized
gains on these assets is not
allowed.