Chapter 14 Lecture and Notes

Explain the Process of Securing Equity Financing through the Issuance of Stock

• A corporation is a legal business structure involving one or more individuals (owners) who are legally distinct (separate) from the business that is created under state laws.
• The owners of a corporation are called stockholders (or shareholders) and may or may not be employees of the corporation. 
• Incorporation is the process of forming a company into a corporate legal entity.
• The process of incorporating requires filing the appropriate paperwork and receiving approval from a governmental entity to operate as a corporation.
• Each state has separate requirements for creating a corporation.

 

Companies generally incorporate in a state whose laws are favorable to the corporate form of business (Delaware, New Jersey). Corporations engaged in interstate commerce must obtain a license from each state in which they do business.

 

Advantages of a Corporation

• Separate legal entity: As a separate legal entity, a corporation can obtain funds by selling shares of stock, it can incur debt, it can become a party to a contract, it can sue other parties, and it can be sued. The owners are separate from the corporation.
• Limited liability: A corporation usually limits the liability of an investor to the amount of his or her investment in the corporation.
• Transferable ownership: Shareholders in a corporation can transfer shares to other parties without affecting the corporation’s operations.
• Continuing existence: A corporation is granted existence forever with no termination date; Because ownership of shares in a corporation is transferrable, re-incorporation is not necessary when ownership changes hands.
• Ease of raising capital: Because shares of stock can be easily transferred, corporations have a sizeable market of investors from whom to obtain capital.

Disadvantages of a Corporation

• Costs of organization: Corporations incur costs associated with organizing the corporate entity, which include attorney fees, promotion costs, and filing fees paid to the state.
• Regulation: Compared to partnerships and sole proprietorships, corporations are subject to considerably more regulation both by the states in which they are incorporated and the states in which they operate.
• Taxation: Corporations are subject to federal and state income taxes (in those states with corporate taxes) based on the income they earn. Stockholders are also subject to income taxes, both on the dividends they receive from corporations and any gains they realize when they dispose of their stock. The income taxation of both the corporate entity’s income and the stockholder’s dividend is referred to as double taxation because the income is taxed to the corporation that earned the income and then taxed again to stockholders when they receive a distribution of the corporation’s income.

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Financing Options: Debt versus Equity

A corporation should consider the advantages and disadvantages of acquiring capital through debt. When deciding whether to raise capital by issuing debt or equity, a corporation needs to consider the following:

• Dilution of ownership: Equity dilutes ownership; debt does not.
• Repayment of debt: Debt must be repaid, both principal and interest, whereas equity does not need to be directly repaid.
• Cash obligations: Debt requires cash to meet the interest expense as well as the repayment of principal; equity does not require a cash obligation other than if dividends will be paid.
• Budgeting: Debt financing requires budgeting for the cash expenditures, whereas equity does not.
• Cost differences: Both debt and equity have costs; debt cost is the interest that must be paid, and equity cost is the cost of managing and evolving the company to make the company, and therefore the stock value, more valuable.
• Risk assessment by creditors: Debt financing affects credit ratings; equity financing does not.

 

How Stocks Work

Private versus public corporations

• A private corporation is usually owned by a relatively small number of investors. Its shares are not publicly traded, and the ownership of the stock is restricted to only those allowed by the board of directors.
• As defined by the SEC, a publicly traded company is a company that “discloses certain business and financial information regularly to the public” and whose “securities trade on public markets.”1

The secondary market

• This is an organized market where previously issued stocks and bonds can be traded after they are issued.

Marketing a company’s stock

• Have a trusted and reliable management team.
• Have a financial reporting system in place. Accurate financial reporting is key to providing potential investors with reliable information.
• Choose an investment banker to provide advice and to assist in raising capital. Investment bankers are individuals who work in a financial institution that is primarily in the business of raising capital for corporations.
• Write the company’s story. This adds personality to the corporation. What is the mission, why it will be successful, and what sets the corporation apart?
• Approach potential investors. Selecting the right investment bankers will be extremely helpful with this step

 

Capital Stock and Common Stock

• Capital stock: A company’s corporate charter specifies the classes of shares and the number of shares of each class that a company can issue. There are two classes of capital stock—common stock and preferred stock.
• Common stock: a company’s primary class of stock   
  • Common stockholders have the right to vote on corporate matters, including the selection of corporate directors and other issues requiring the approval of owners. Each share of stock owned by an investor generally grants the investor one vote.
  • Common stockholders have the right to share in corporate net income proportionally through dividends.  
  • If the corporation should have to liquidate, common stockholders have the right to share in any distribution of assets after all creditors and any preferred stockholders have been paid.
  • In some jurisdictions, common shareholders have a preemptive right, which allows shareholders the option to maintain their ownership percentage when new shares of stock are issued by the company.
  •  For example, suppose a company has 1,000 shares of stock issued and plans to issue 200 more shares. A shareholder who currently owns 50 shares will be given the right to buy a percentage of the new issue equal to his current percentage of ownership. His current percentage of ownership is 5%

 

Preferred Stock

The classification of preferred stock is often a controversial area in accounting, as some researchers believe that preferred stock has characteristics closer to those of a stock/bond hybrid security, with characteristics of debt rather than a true equity item. Although there may be characteristics of both debt and equity, preferred stock is still reported as part of stockholders’ equity on the balance sheet.

• Preferred stock has unique rights that are “preferred,” or more advantageous, to shareholders than common stock.
• Preferred shareholders typically do not have voting rights; in this way, they are similar to bondholders.
• Preferred shares do not share in the common stock dividend distributions. Instead, the “preferred” classification entitles shareholders to a dividend that is fixed (assuming sufficient dividends are declared), similar to the fixed interest rate associated with bonds and other debt items.
• Preferred stock also mimics debt in that preferred shareholders have a priority of dividend payments over common stockholders.

 

The Status of Shares of Stock

The corporate charter specifies the number of authorized shares, which is the maximum number of shares that a corporation can issue to its investors as approved by the state in which the company is incorporated.

• Once shares are sold to investors, they are considered issued shares.
• Shares that are issued and are currently held by investors are called outstanding shares because they are “out” in the hands of investors.
• Occasionally, a company repurchases shares from investors. While these shares are still issued, they are no longer considered to be outstanding. These repurchased shares are called treasury stock.

 

Stock Values

 Two of the most important values associated with stock are market value and par value.

Factors in Setting Price for New Issue of Stock Company’s anticipated future earnings. Expected dividend rate per share. Current financial position. Current state of the economy. Current state of the securities market.

• Market value of stock is the price at which the stock of a public company trades on the stock market. This amount does not appear in the corporation’s accounting records, nor in the company’s financial statements.
• Par value is the value printed on the stock certificates and is often referred to as a face value.
• Incorporators typically set the par value at a very small arbitrary amount because it is used internally for accounting purposes and has no economic significance.
• Because par value often has some legal significance, it is considered to be legal capital. In some states, par value is the minimum price at which the stock can be sold.

 

 

Analyze and Record Transactions for the Issuance and Repurchase of Stock

 

Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock. Retained earnings is net income that a corporation retains for future use.

   

 

 

Accounting for Common Stock

Primary Objectives:

1. 1. Identify the specific sources of paid-in capital. 
   2. Maintain the distinction between paid-in capital and retained earnings.

Other than consideration (something of value) received, the issuance of common stock affects only paid-in capital accounts.

 

Issuing Common Stock

 

Accounting for Preferred Stock

Typically, preferred stockholders have a priority as to:

1. 1. Distributions of earnings (dividends).
   2. Assets in event of liquidation.

 Accounting for preferred stock at issuance is similar to that for common stock.

 

Accounting for Treasury Stock

 

  

 

Treasury stock is a corporation’s own stock that it has reacquired from shareholders but not retired.

Corporations acquire treasury stock for various reasons:

1. 1. To reissue the shares to officers and employees under bonus and stock compensation plans.
   2. To enhance the stock’s market value.
   3. To have additional shares available for use in the acquisition of other companies.
   4. To increase earnings per share.

Purchase of Treasury Stock

• •  Companies generally use the cost method.
  • Debit Treasury Stock for the price paid to reacquire the shares.
  • Treasury stock is a contra stockholders’ equity account. Reduces stockholders’ equity.

 

 

 

 

Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits

  The nature and purposes of dividends

Cash dividends: These are corporate earnings that companies pass along to their shareholders. To pay a cash dividend, the corporation must have: 1.Retained earnings - Payment of cash dividends from retained earnings is legal in all states. 2.Adequate cash. 3.A declaration of dividends by the Board of Directors.

• Stock investors are typically driven by two factors—a desire to earn income in the form of dividends and a desire to benefit from the growth in the value of their investment.
• Some companies choose not to pay dividends and instead reinvest all of their earnings back into the company. One common scenario for this situation occurs when a company is experiencing rapid growth. 
• Other companies pay dividends regularly. For example, Johnson Controls has paid dividends consistently since 1887.
• Dividends are distributed or paid only to shares of stock that are outstanding. Treasury shares are not outstanding, so no dividends are declared or distributed for these shares.

 

Dividend Dates

• A company’s board of directors has the power to formally vote to declare dividends. The date of declaration is the date on which the dividends become a legal liability, or the date on which the board of directors votes to distribute the dividends.
• The date of record establishes who is entitled to receive a dividend; stockholders who own stock on the date of record are entitled to receive a dividend even if they sell it prior to the date of payment
• The date of payment is the date that payment is issued to the investor for the amount of the dividend declared.

  

 

Cash Dividends

 

 

 

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Comparing Small Stock Dividends, Large Stock Dividends, and Stock Splits

Companies that do not want to issue cash or property dividends but still want to provide some benefit to shareholders may choose between small stock dividends, large stock dividends, and stock splits.

 

Stock Dividends

• Both small and large stock dividends occur when a company distributes additional shares of stock to existing stockholders.
• There is no change in total assets, total liabilities, or total stockholders’ equity when a small stock dividend, a large stock dividend, or a stock split occurs.
• Both types of stock dividends impact the accounts in stockholders’ equity.
• Reasons why corporations issue stock dividends:
  1. Satisfy stockholders’ dividend expectations without spending cash.
  2. Increase marketability of the corporation’s stock.
  3. Emphasize a portion of stockholders’ equity has been permanently reinvested in the business.

 

Effect of Stock Dividends

  

 

A small stock dividend occurs when a stock dividend distribution is less than 25% of the total outstanding shares based on the shares outstanding prior to the dividend distribution. The dividend is valued at the current market rate of the stock.

A large stock dividend occurs when a distribution of stock to existing shareholders is greater than 25% of the total outstanding shares just before the distribution. The accounting for large stock dividends differs from that of small stock dividends because a large dividend impacts the stock’s market value per share. While there may be a subsequent change in the market price of the stock after a small dividend, it is not as abrupt as that with a large dividend.

 

Stock Split

Companies often make the decision to split stock when the stock price has increased enough to be out of line with competitors, and the business wants to continue to offer shares at an attractive price for small investors. A split indicates that share value has been increasing, suggesting growth is likely to continue and result in further increase in demand and value.

• A traditional stock split occurs when a company’s board of directors issue new shares to existing shareholders in place of the old shares by increasing the number of shares and reducing the par value of each share.
• For example, in a 2-for-1 stock split, two shares of stock are distributed for each share held by a shareholder. 
• When a split occurs, the market value per share is reduced to balance the increase in the number of outstanding shares. Although the number of outstanding shares and the price change, the total market value remains constant.
• A stock split is much like a large stock dividend in that both are large enough to cause a change in the market price of the stock.
• No journal entry is recorded for a stock split. Instead, the company prepares a memo entry in its journal that indicates the nature of the stock split and the new par value.
• A stock split causes no change in any of the accounts within stockholders’ equity.

 

   

 

 

 

Compare and Contrast Owners’ Equity versus Retained Earnings

The stockholders’ equity section of the balance sheet for corporations contains two primary categories of accounts.

1. Contributed capital (also called paid-in-capital): This consists of amounts paid in by owners. On the balance sheet stock accounts such as common stock, preferred stock, and additional paid-in capital are the primary components of the contributed capital section.
2. Earned capital: This consists of amounts earned by the corporation as part of business operations. On the balance sheet, retained earnings is a key component of the earned capital section.

• • Retained earnings is the primary component of a company’s earned capital.
    • It generally consists of the cumulative net income minus any cumulative losses less dividends declared.
    • A basic statement of retained earnings is referred to as an analysis of retained earnings because it shows the changes in the retained earnings account during the period.

 

Restricted retained earnings is the portion of a company’s earnings that has been designated for a particular purpose due to legal or contractual obligations.

• Some of the restrictions reflect the laws of the state in which a company operates. Many states restrict retained earnings by the cost of treasury stock, which prevents the legal capital of the stock from dropping below zero.
• Other restrictions are contractual, such as debt covenants and loan arrangements; these exist to protect creditors, often limiting the payment of dividends to maintain a minimum level of earned capital

 

Appropriated retained earnings: occurs when a company’s board of directors designates a portion of a company’s retained earnings for a particular purpose such as future expansion, special projects, or as part of a company’s risk management plan.

• Two options in accounting for appropriated retained earnings:
• Make no journal entry and disclose the amount of appropriation in the notes to the financial statement.
• Record a journal entry.

 

Prior period adjustments are corrections of errors that appeared on previous periods’ financial statements.

• These errors can stem from mathematical errors, misinterpretation of GAAP, or a misunderstanding of facts at the time the financial statements were prepared.
• Since the financial statements have already been issued, they must be corrected.
• The correction involves changing the financial statement amounts to the amounts they would have been had no errors occurred, a process known as restatement.
• The correction may impact both balance sheet and income statement accounts, requiring the company to record a transaction that corrects both.
• Since income statement accounts are closed at the end of every period, the journal entry will contain an entry to the Retained Earnings account.
• Prior period adjustments are reported on a company’s statement of retained earnings as an adjustment to the beginning balance of retained earnings.
• The goal is to separate the error correction from the current period’s net income to avoid distorting the current period’s profitability.

 

Discuss the Applicability of Earnings per Share as a Method to Measure Performance

Earnings per share

• Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock.
• Many financial analysts believe that EPS is the single most important tool in assessing a stock’s market price.
• A high or increasing earnings per share can drive up a stock price.
• A falling earnings per share can lower a stock’s market price.
• EPS is also a component in calculating the price-to-earnings ratio (the market price of the stock divided by its earnings per share), which many investors find to be a key indicator of the value of a company’s stock.

 

Earnings per Share (EPS) = (Net Income - Preferred Dividends) $\div$  Weighted Average Common Shares Outstanding Note:  The denominator can fluctuate throughout the year as a company issues and buys back shares of its own stock. The weighted average number of shares is used on the denominator because of this fluctuation.

 

 

 

 

Effect of Treasury Stock Purchase on EPS Since earnings per share is directly affected by the number of outstanding share ( the denominator in the formula), EPS increases with a decrease of outstanding shares. When a company repurchases shares, it is in effect reducing the number of outstanding shares, thus increasing the EPS

 

• The corporate form has several advantages, which include the ability to function as a separate legal entity, limited liability, transferable ownership, continuing existence, and ease of raising capital.
• The disadvantages of operating as a corporation include the costs of organization, regulation, and potential double taxation.
• Capital stock consists of two classes of stock—common and preferred, each providing the company with the ability to attract capital from investors.
• Shares of stock are categorized as authorized, issued, and outstanding.
• A company’s primary class of stock issued is common stock, and each share represents a partial claim to ownership or a share of the company’s business. Common shareholders have four rights: right to vote, the right to share in corporate net income through dividends, the right to share in any distribution of assets upon liquidation, and a preemptive right.
• Treasury stock is a corporation’s stock that the corporation purchased back. A company may buy back its stock for strategic purposes against competitors, to create demand, or to use for employee stock option plans. A corporation may reissue the treasury stock shares.
• Dividends are a distribution of corporate earnings, though some companies reinvest earnings rather than declare dividends.
• There are three types of dividends: cash, property, or stock. Each are accounted for slightly differently.
• Some corporations employ stock splits to keep their stock price competitive in the market. A traditional stock split occurs when a company’s board of directors issues new shares to existing shareholders in place of the old shares by increasing the number of shares and reducing the par value of each share.
• Retained earnings is the primary component of a company’s earned capital. It generally consists of the cumulative net income minus any cumulative losses less dividends declared. A statement of retained earnings shows the changes in the retained earnings account during the period.
• The statement of stockholders’ equity provides the changes between the beginning and ending balances of each of the stockholders’ equity accounts, including retained earnings.
• Prior period adjustments are corrections of errors that occurred on previous periods’ financial statements. They are reported on a company’s statement of retained earnings as an adjustment to the beginning balance.
• Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock.
• EPS is calculated by dividing the profit earned for common shareholders by the weighted average common shares of stock outstanding.