14.6: Summary

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

• The process of forming a corporation involves several steps, which result in a legal entity that can issue stock, enter into contracts, buy and sell assets, and borrow funds.
• 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.
• There are a number of considerations when choosing whether to finance with debt or equity as a means to raise capital, including dilution of ownership, the repayment obligation, the cash obligation, budgeting reliability, cost savings, and the risk assessment by creditors.
• The Securities and Exchange Commission regulates large and small public corporations.
• There are key differences between public corporations that experience an IPO and private corporations.
• A corporation’s shares continue to be bought and sold by the public in the secondary market after an IPO.
• The process of marketing a company’s stock involves several steps.
• 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.
• Shares of stock are measured based on their market or par value. Some stock is no-par, which carries a stated value.
• 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.
• Preferred stock, by definition, has preferred characteristics, which are more advantageous to shareholders over common stock characteristics. These include dividend preferences such as cumulative and participating and a preference for asset distribution upon liquidation. These shares can also be callable or convertible.

14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock

• The initial issuance of common stock reflects the sale of the first stock by a corporation.
• Common stock issued at par value for cash creates an additional paid-in capital account for the excess of the issue price over the par value.
• Stock issued in exchange for property or services is recorded at the fair market value of the stock or the asset or services received, whichever is more clearly determinable.
• Stock with a stated value is treated as if the stated value is a par value. The entire issue price of no-par stock with no stated value is credited to the capital stock account.
• Preferred stock issued at par or stated value creates an additional paid-in capital account for the excess of the issue price over the par value.
• A corporation reports a stock’s par or stated value, the number of shares authorized, issued, and outstanding, and if preferred, the dividend rate on the face of the balance sheet.
• 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.
• The acquisition of treasury stock creates a contra equity account, Treasury Stock, reported in the stockholders’ equity section of the balance sheet.
• When a corporation reissues its treasury stock at an amount above the cost, it generates a credit to the Additional Paid-in Capital from Treasury stock account.
• When a corporation reissues its treasury stock at an amount below cost, the Additional Paid-in Capital from Treasury stock account is reduced first, then any excess is debited to Retained Earnings.

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

• Dividends are a distribution of corporate earnings, though some companies reinvest earnings rather than declare dividends.
• There are three dividend dates: date of declaration, date of record, and date of payment.
• Cash dividends are accounted for as a reduction of retained earnings and create a liability when declared.
• When dividends are declared and a company has only common stock issued, the reduction of retained earnings is the amount per share times the number of outstanding shares.
• A property dividend occurs when a company declares and distributes assets other than cash. They are recorded at the fair market value of the asset being distributed.
• A stock dividend is a distribution of shares of stock to existing shareholders in lieu of a cash dividend.
• A small stock dividend occurs when a stock dividend distribution is less than 25% of the total outstanding shares based on the outstanding shares prior to the dividend distribution. The entry requires a decrease to Retained Earnings for the market value of the shares to be distributed.
• A large stock dividend involves a distribution of stock to existing shareholders that is larger than 25% of the total outstanding shares just before the distribution. The journal entry requires a decrease to Retained Earnings and a credit to Stock Dividends Distributable for the par or stated value of the shares to be distributed.
• 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.

14.4 Compare and Contrast Owners’ Equity versus Retained Earnings

• Owner’s equity reflects an owner’s investment value in a company.
• The three forms of business utilize different accounts and transactions relative to owners’ equity.
• 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.
• 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.
• A company’s board of directors may designate 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. The amount designated is classified as appropriated retained earnings.
• 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.

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

• 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.
• Because EPS is a key profitability measure that both current and potential common stockholders monitor, it is important to understand how to interpret it.

Key Terms

accounting entity concept

concept indicating that the financial activity of an entity (corporation) must be kept separate from that of the owners

additional paid-in capital

account for recording excess of the proceeds received from the issuance of the stock over the stock’s par value

appropriated retained earnings

portion of a company’s retained earnings designated for a particular purpose such as future expansion, special projects, or as part of a company’s risk management plan

articles of incorporation

(also, charter) define the basic structure and purpose of a corporation and the amount of capital stock that can be issued or sold

authorized shares

maximum number of shares that a corporation can issue to investors; approved by state in which company is incorporated and specified in the corporate charter

brokers

buy and sell issues of stock on behalf of others

capital

cash and other assets owned by a company

cash dividend

corporate earnings that companies pass along to their shareholders in the form of cash payments

common stock

corporation’s primary class of stock issued, with each share representing a partial claim to ownership or a share of the company’s business

contributed capital

owner’s investment (cash and other assets) in the business, which typically comes in the form of common stock

corporation

legal business structure involving one or more individuals (owners) who are legally distinct (separate) from the business

date of declaration

date upon which a company’s board of directors votes and decides to give a cash dividend to all the company shareholders; the date on which the dividends become a legal liability

date of payment

date that cash dividends are paid to shareholders

date of record

date the list of dividend eligible shareholders is prepared; no journal entry is required

debt-to-equity ratio

measures the portion of debt used by a company relative to the amount of stockholders’ equity, calculated by dividing total debt by total equity

deficit in retained earnings

negative or debit balance

dividend smoothing

practice of paying dividends that are relatively equal period after period even when earnings fluctuate

double taxation

occurs when 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 as dividends

earned capital

capital earned by the corporation as part of business operations

earnings per share (EPS)

measurement of the portion of a corporation’s profit allocated to each outstanding share of common stock

ex dividend

status of stock sold between the record date and payment date during which the investor is not entitled to receive dividends

going concern assumption

absent any evidence to the contrary, assumption that a business will continue to operate in the indefinite future

incorporation

process of constituting a company into a legal entity

initial public offering (IPO)

when a company issues shares of its stock to the public for the first time

investment banker

financial professional who provides advice to companies wishing to issue new stock, then purchase the stock from the company issuing the stock and resell the securities to the public

issued shares

authorized shares that have been sold to shareholders

large stock dividend

stock dividend distribution that is larger than 25% of the total outstanding shares just before the distribution

market value of stock

price at which the stock of public companies trades on the stock market

no-par stock

stock issued with no par value assigned to it in a corporate charter

organization costs

costs of organizing the corporate entity that include attorney fees, promotion costs, and filing fees paid to the state

outstanding shares

shares that have been issues and are currently held by shareholders

owners’ equity

business owners’ share of the company

par value

value assigned to stock in the company’s charter and is typically set at a very small arbitrary amount; serves as legal capital

preemptive right

allows stockholders the option to maintain their ownership percentage when new shares of stock are issued by the company

preferred stock

type of stock that entitles the holder to unique preferences that are advantageous over common stock features

prior period adjustments

corrections of errors that occurred on previous periods’ financial statements

private corporation

corporation usually owned by a relatively small number of investors; shares are not traded publicly, and the ownership of the stock is restricted to only those allowed by the board of directors

property dividend

stock dividend distribution of assets other than cash

publicly traded company

company whose stock is traded (bought and sold) on an organized stock exchange

restatement

correction of financial statement amounts due to an accounting error in a prior period

restricted retained earnings

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

reverse stock split

issuance of new shares to existing shareholders in place of the old shares by decreasing the number of shares and increasing the par value of each share

secondary market

organized market where previously issued stocks and bonds can be traded after they are issued

Securities and Exchange Commission (SEC)

federal regulatory agency that regulates corporations with shares listed and traded on security exchanges through required periodic filings

small stock dividend

stock dividend distribution that is less than 25% of the total outstanding shares just before the distribution

special dividend

one-time extra distribution of corporate earnings to shareholders, usually stemming from a period of extraordinary earnings or special transaction, such as the sale of a company division

stated value

is an amount a board of director’s assigns to each share of a company’s stock; functions as the legal capital

statement of stockholders’ equity

provides the changes between the beginning and ending balances of each of the stockholders’ equity accounts during the period

stock discount

amount at which stock is issued below the par value of stock

stock dividend

dividend payment consisting of additional shares rather than cash

stock split

issuance of 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

stock trading

buying and selling of shares by investors and brokers

stockholder

owner of stock, or shares, in a business

treasury stock

company’s own shares that it has repurchased from investors