Stockholders’ Equity – Financial Accounting Chapter 10 Study Notes

Stockholders’ Equity

Features of a Corporation

A corporation is a legal entity that is separate from its owners, providing distinct advantages and disadvantages compared to other business forms.

• Advantages:

  • Can raise more capital than a proprietorship or partnership.

  • Continuous life—corporation continues regardless of changes in ownership.

  • Ease of transferring ownership—shares can be bought and sold easily.

  • Limited liability of stockholders—owners are not personally liable for corporate debts.

• Disadvantages:

  • Separation of ownership and management—owners (stockholders) do not directly manage the company.

  • Double taxation of distributed profits—corporate income is taxed, and dividends paid to stockholders are taxed again.

  • Government regulation—corporations are subject to more legal requirements.

Advantages	Disadvantages
Raise more capital	Separation of ownership/management
Continuous life	Double taxation
Ease of transferring ownership	Government regulation
Limited liability

Organizing a Corporation

Corporations are formed by incorporators who obtain a charter from the state, authorizing the corporation to issue a certain number of shares of stock.

• Incorporators must pay fees, sign the charter, file documents with the state, and agree to a set of bylaws.

Authority Structure of a Corporation

The authority structure typically includes stockholders, a board of directors, executive officers, and other management positions. Stockholders elect the board, which appoints executives to manage daily operations.

Stockholders’ Rights

Stockholders have four basic rights:

1. Vote: Right to vote on corporate matters.

2. Dividends: Right to receive a proportionate share of any declared dividend.

3. Liquidation: Right to receive a proportionate share of assets upon liquidation.

4. Preemption: Right to maintain one’s proportionate ownership in the corporation.

Components of Stockholders’ Equity

• Paid-in capital (contributed capital): Amount contributed by stockholders, including stock accounts and additional paid-in capital.

• Retained earnings: Amount earned through profitable operations, reduced by dividends.

Types of Stock

Common Stock

Common stock is the basic form of stock, representing ownership in the corporation. Common stockholders have the four basic rights and stand to benefit most if the corporation succeeds.

Preferred Stock

Preferred stockholders have certain advantages over common stockholders:

• Receive dividends before common stockholders.

• Receive assets first in liquidation.

• Have the same four basic rights.

• Preferred stock is rare in practice.

Comparison of Common Stock, Preferred Stock, and Long-Term Debt

	Common Stock	Preferred Stock	Long-Term Debt
Obligation to repay principal	No	No	Yes
Dividends/Interest	Dividends not tax-deductible	Dividends not tax-deductible	Interest expense is tax-deductible
Obligation to pay dividends/interest	Only after declaration	Only after declaration	At fixed rates and dates

Par-Value and No-Par-Value Stock

• Par-value stock: Has an arbitrary amount assigned to each share when issued. Most states require a minimum legal capital (total par of all shares issued). Par is usually set low.

• No-par-value stock: Does not have a par value, may have a stated value, and is rare in practice.

Issuance of Stock

Common Stock at Par

When stock is issued at par value, the amount received equals the par value. For example, issuing 10 million shares at $10 par value raises $100 million.

Common Stock Issued Above Par

If stock is issued above par, the excess is credited to Capital in Excess of Par Value. For example, issuing 10 million shares of $1 par stock at $10 per share results in $100 million raised, with $10 million credited to Common Stock and $90 million to Capital in Excess of Par Value.

Account	Amount
Common stock, $1 par, 10,000,000 shares	$10,000,000
Capital in excess of par value	$90,000,000
Total stockholders' equity	$100,000,000

Important Note: The sale of stock does not result in a gain or loss for the corporation.

Common Stock Issued for Assets Other Than Cash

Stock can be issued in exchange for assets. The value recorded is the fair market value of the assets received. Example: Issuing 15,000 shares for equipment ($4,000) and a building ($120,000).

Common Stock Issued for Services

Stock may be issued for services rendered. The value recorded is the fair market value of the stock or the services, whichever is more clearly determinable. Example: Attorney accepts 2,500 shares ($10 per share) for $25,000 in services.

Preferred Stock Accounting

• Similar to common stock accounting.

• Separate accounts may be used for paid-in capital in excess of par for preferred and common stock.

• Preferred stock may have a conversion feature, allowing exchange for common shares.

On the balance sheet, stockholders’ equity is reported in the following order:

1. Preferred stock

2. Common stock

3. Additional paid-in capital

4. Retained earnings

Authorized, Issued, and Outstanding Stock

• Authorized: Maximum number of shares a company can issue under its charter.

• Issued: Number of shares actually issued to stockholders.

• Outstanding: Number of shares currently owned by stockholders.

Formula:

$\text{Outstanding shares} = \text{Issued shares} - \text{Treasury shares}$

Treasury Stock

Definition and Purpose

Treasury stock is a company’s own stock that it has issued and later reacquired. Reasons for buying treasury stock include:

• Stock for employee distributions

• Buying low and selling high

• Preventing takeovers

• Increasing earnings per share (EPS)

• Repurchase programs to return excess cash to shareholders

Recording Treasury Stock

• Recorded at cost on the date of purchase; par value is disregarded.

• Treasury stock is a contra stockholders’ equity account with a debit balance.

• Reported beneath Retained Earnings on the balance sheet.

Account	Amount (in millions)
Common stock	881
Capital in excess of par value	4,224
Retained earnings	15,774
Accumulated other comprehensive income (loss)	388
Treasury stock (at cost)	(10,631)
Total stockholders' equity	10,636

Resale of Treasury Stock

• Increases assets and equity by the amount of cash received.

• No gain or loss is recognized on treasury stock transactions.

• Amounts received above or below cost are recorded as Paid-in Capital from Treasury Stock Transactions.

Summary of Treasury-Stock Transactions

• Buying treasury stock decreases assets and equity by the cost of the stock purchased.

• Reselling treasury stock increases assets and equity by the sale price of the stock sold.

Retained Earnings, Dividends, and Stock Splits

Retained Earnings

Retained earnings represent net income less net losses and dividends declared, accumulated over the corporation’s life.

• Credit balance: Lifetime earnings exceed losses and dividends.

• Debit balance: Lifetime losses and dividends exceed earnings (deficit).

Dividends

A dividend is a distribution to stockholders, usually based on earnings. Dividends can be paid in cash, stock, or noncash assets.

Cash Dividends

• Most common type of dividend.

• Corporation must have sufficient retained earnings and cash.

• Board of directors declares dividends; no obligation until declared.

• Three key dates:

  • Declaration date: Board declares dividend; liability is recorded.

  • Date of record: Determines which stockholders receive the dividend; no journal entry.

  • Payment date: Dividend is paid; liability is removed.

Analyzing Retained Earnings

• Net income increases retained earnings.

• Net losses and dividends declared decrease retained earnings.

• Other adjustments are rare.

Item	Amount (in millions)
Beginning balance	15,967
Adjustment	55
Net income	2,300
Ending balance	17,945

Dividends on Preferred Stock

• Preferred stockholders receive dividends before common stockholders.

• Dividends may be stated as a percent of par value or a dollar amount per share.

• Cumulative preferred stock: Unpaid dividends accumulate and must be paid before common dividends.

• Noncumulative preferred stock: Corporation is not obligated to pay passed dividends.

Stock Dividends

A stock dividend is a proportional distribution of additional shares to shareholders. It increases Common Stock and Paid-in Capital in Excess of Par—Common, decreases Retained Earnings, but total equity remains unchanged.

• Reasons: Conserve cash, reduce per-share market price.

• Small stock dividend: 25% or less, recorded at market value.

• Large stock dividend: Greater than 25%, recorded at par value.

Stock Splits

A stock split increases the number of shares issued and outstanding, with a proportionate reduction in par value. It decreases the market price of the stock, making it more attractive, but does not affect any accounts.