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 unique 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.

Exhibit 10-1: Advantages and Disadvantages of a Corporation

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.

• Incorporators must pay fees, sign the charter, file documents, and agree to bylaws.

Authority Structure of a Corporation

The authority structure typically includes stockholders, a board of directors, executive officers, and other management roles.

• Stockholders elect the board of directors.

• Board appoints executive officers (e.g., CEO, CFO).

• Officers manage day-to-day 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 dividends.

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

4. Preemption: Right to maintain proportionate ownership when new shares are issued.

Stockholders’ Equity

Stockholders’ equity represents the owners’ claims on the corporation’s assets.

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

• Retained earnings: Profits earned and retained by the corporation, reduced by dividends.

Types of Stock

Common Stock

Common stock is the basic form of stock, representing ownership in the corporation.

• Holders have voting rights and benefit most if the corporation succeeds.

Preferred Stock

Preferred stock provides certain advantages over common stock.

• Receives dividends and assets first in liquidation.

• Has the same four basic rights as common stock.

• Rare in practice.

Exhibit 10-4: 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

Stock may be issued with or without a par value.

• Par-value stock: Has an arbitrary value assigned; states often require a minimum legal capital.

• No-par-value stock: No assigned par value; may have a stated value; rare in practice.

Issuance of Stock

Common Stock at Par

When stock is issued at par value, the cash received equals the par value times the number of shares.

• Journal Entry Example:

$\begin{align*} \text{Cash} & \quad 100,000,000 \\ \text{Common Stock} & \quad 100,000,000 \\ \end{align*}$

Common Stock Issued Above Par

If stock is issued above par, the excess is credited to "Capital in Excess of Par Value."

• Journal Entry Example:

$\begin{align*} \text{Cash} & \quad 100,000,000 \\ \text{Common Stock} & \quad 10,000,000 \\ \text{Capital in Excess of Par Value} & \quad 90,000,000 \\ \end{align*}$

• "Capital in Excess of Par Value" is reported in the equity section of the balance sheet.

• Sale of stock does not result in a gain or loss for the corporation.

Common Stock Issued for Assets Other Than Cash

Stock may be issued in exchange for assets or services, recorded at the fair market value of the assets/services received.

• Example: Issuing stock for equipment and building.

$\begin{align*} \text{Equipment} & \quad 4,000 \\ \text{Building} & \quad 120,000 \\ \text{Common Stock} & \quad 15,000 \\ \text{Paid-in Capital in Excess of Par} & \quad 109,000 \\ \end{align*}$

Common Stock Issued for Services

Stock may be issued to pay for services, such as legal fees, at the fair market value of the stock or services.

• Example: Issuing stock to an attorney for services rendered.

$\begin{align*} \text{Legal Expense} & \quad 25,000 \\ \text{Common Stock} & \quad 2,500 \\ \text{Paid-in Capital in Excess of Par} & \quad 22,500 \\ \end{align*}$

Preferred Stock Issuance

Accounting for preferred stock follows the same pattern as common stock, with possible separate accounts for paid-in capital.

• May include conversion features to exchange preferred for common shares.

• Balance sheet order: Preferred stock, common stock, additional paid-in capital, retained earnings.

Journal Entry Example:

$\begin{align*} \text{Cash} & \quad 50,000 \\ \text{Convertible Preferred Stock} & \quad 50,000 \\ \end{align*}$

Authorized, Issued, and Outstanding Stock

Corporations may authorize more shares than they issue. Outstanding shares are those held by stockholders.

• Authorized: Maximum shares allowed by charter.

• Issued: Shares actually issued to stockholders.

• Outstanding: Shares currently owned by stockholders.

Formula:

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

Treasury Stock

Definition and Purpose

Treasury stock is a corporation’s own stock that it has issued and later reacquired.

• Reasons for buying treasury stock include employee distributions, resale, takeover prevention, increasing EPS, and returning excess cash to shareholders.

Recording Treasury Stock

Treasury stock is recorded at cost, disregarding par value, and is a contra equity account with a debit balance.

• Reported beneath retained earnings on the balance sheet.

Example Balance Sheet Presentation

Account	Amount (in millions)
Common stock	881
Capital in excess of par value	4,224
Retained earnings	15,774
Treasury stock (at cost)	(10,631)
Total stockholders’ equity	10,414

Journal Entry for Treasury Stock Purchase

$\begin{align*} \text{Treasury Stock} & \quad 451,000,000 \\ \text{Cash} & \quad 451,000,000 \\ \end{align*}$

Resale of Treasury Stock

When treasury stock is resold, assets and equity increase by the cash received. No gain or loss is recognized; excess amounts are credited to "Paid-in Capital from Treasury Stock Transactions."

• Journal Entry Example:

$\begin{align*} \text{Cash} & \quad 60,000,000 \\ \text{Treasury Stock} & \quad 36,180,000 \\ \text{Paid-in Capital from Treasury Stock Transactions} & \quad 23,820,000 \\ \end{align*}$

Summary of Treasury-Stock Transactions

• Buying treasury stock decreases assets and equity.

• Reselling treasury stock increases assets and equity.

Retained Earnings, Dividends, and Splits

Retained Earnings

Retained earnings are the accumulated net income of a corporation, less net losses and dividends declared.

• 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 may be cash, stock, or noncash assets.

• Most common: Cash dividends.

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

• Three key dates:

  • Declaration date: Liability is created.

  • Date of record: Determines eligible stockholders (no journal entry).

  • Payment date: Dividend is paid.

Journal Entries for Cash Dividends

Declaration Date:

$\begin{align*} \text{Retained Earnings} & \quad 50,000 \\ \text{Dividends Payable} & \quad 50,000 \\ \end{align*}$

Payment Date:

$\begin{align*} \text{Dividends Payable} & \quad 50,000 \\ \text{Cash} & \quad 50,000 \\ \end{align*}$

Analyzing the Retained Earnings Account

• Net income increases retained earnings.

• Net losses and dividends decrease retained earnings.

• Other adjustments are rare.

Example Retained Earnings Calculation

	Dec. 31, 2019	Dec. 31, 2018
Retained Earnings	17,945	15,967

• Beg bal: 15,967

• Adjustment: 55

• Net income: 2,300

• End bal: 17,945

Dividends on Preferred Stock

Preferred stockholders receive dividends before common stockholders. Dividends may be cumulative or noncumulative.

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

• Noncumulative: No obligation to pay missed dividends.

• Dividends stated as percent of par or dollar amount per share.

Journal Entry Example for Cumulative Preferred Dividends

$\begin{align*} \text{Retained Earnings} & \quad 500,000 \\ \text{Dividends Payable, Preferred} & \quad 300,000 \\ \text{Dividends Payable, Common} & \quad 200,000 \\ \end{align*}$