Stockholders Equity Flashcards
Equity Capital
Ownership dilution
Buy-backs vs. Dividends
Impact on EPS
Debt Financing
No ownership dilution
Net Income Impacts
Leverage and Credit Risk
3 primary forms of business organization
Proprietorship
Partnership
Corporation
Special characteristics of the corporate form
Influence state of corporate law
Use of capital stock or share system
Development of a variety of ownership interests
Corporate form of organization
Corporation must submit articles of incorporation to the state in which incorporation is desired
State issues charter
Advantage to incorporate in a state that favors corporate organization (Delaware)
Accounting for SE follows the rules of each state
Two primary sources of equity
Contributed Capital (Common stock, Preferred Stock, APIC)
Retained Earnings (Less: Treasury Stock)
Fundamental Accounting Equation (broken down SE)
A = L + SE A = L + Contributed Capital + Retained Earnings A = L + Contributed Capital + Net Income - Dividends A = L + Contributed Capital + Rev - Exp - Dividends
Capital Stock (Share System Privileges)
To share proportionately in profits and losses
To vote for directors
To share proportionately assets upon liquidation
Preemptive right to subscribe to new share
Common Stock
Claim on firm’s assets after the stated obligations (bear risk, but share in success)
Voting and Dividend rights attached
Preferred Stock
Entitled to a fixed rate of dividend that is senior
Dividends can be cumulative (paid before common stock)
Usually do not have voting rights
Convertible to common stock (optional)
Authorized shares
Number of shares that can be issued as stated in company’s articles of incorporation
Issued shares
Number of authorized shares that a company has distributed to shareholders
Outstanding shares
Number of issued shares still owned by shareholders
shares issued - treasury stock
APIC
Amount of par value received by company upon share issuance in excess of par value
Par value
Maximum responsibility of shareholders in the event of insolvency (ceremonial/irrelevant)
Legal capital per share must be retained in the business
No relation to issue price (very low)
Accounting for market prices
Only changes in issued share capital, not the ownership f this share capital relevant
Accounts only reflect the money originally paid to purchase the share (not market value)
Share capital figure in accounts will change if:
- new shares are issued
- the company repurchases its own shares
Advantages of “No-Par Value” Stock
Avoids contingent liability
Avoids confusion over recording par value vs. market value
Disadvantages of “No-Par Value” Stock
Some states levy high tax on these issues
The total issue price for no-par stock may be considered legal capital, reduces flexibility of paying dividends
Some states require “stated-value” per share… which is basically like par value anyway
Issuing multiple classes of stock
Proportional method: market value of all securities are known
Incremental method: market value of at least one, but not all securities are known.
Stock issued in non-cash transaction
Companies should record at fair value of the stock issued OR fair value of the non cash consideration received (whichever is more determinable)
Hidden risks of non-cash transaction
Watered stock: overvaluation of assets
Secret reserves: undervaluation of assets
Direct costs incurred to sell stock
Underwriting costs
Accounting and legal fees
Printing costs
Taxes
Should be reported as reduction of APIC
Motives to stock buybacks
Signal undervaluation (improve market efficiency)
Less stocks –> higher EPS
Efficient return of cash in the absence of investment opportunities
To re-issue shares to directors/employees under bonus and stock compensation plans, and/or use in future acquisitions
“Gear up” balance sheet (increase leverage) to make an unattractive takeover target
Clean-up share register/manage costs
Two forms of buyback
Cost method (widely/preferred) Par (Stated) value method
Treasury shares
Stocks that company buys back
Treasury Stock account
Contra-equity account that reduces shareholders equity for buybacks
Accounting for share buy-backs
After eliminating Paid-in Capital from Treasury Stock, we debit any excess of cost over selling price to RE
Treasury stock transaction can never increase RE, but it can reduce
Transactions in treasury stock will never increase or decrease current year earnings
Dividend Policy
Covered by state specific laws and tax laws
Generally paid out of RE
Don’t need profits in the current year
Cannot be paid out of legal capital (par value)
Company should not pay dividends unless both the present and future financial position warrant the distribution
Why don’t companies pay dividends in amounts equal to their legally available retained earnings?
Maintain agreements with creditors Meet state incorporation requirements To finance growth or expansion To smooth out dividend payments To build up cushion against possible losses
SEC and dividends
SEC encourages companies to disclose their dividend policy in their annual report, especially if:
- have earnings but
- do not expect to pay dividends in the foreseeable future
Types of stock of dividends
Cash dividends
Property dividends
Liquidating dividends
Stock dividends
All dividends (except stock) dividends, reduce total stockholders’ equity
Stock Dividends
Pro rata basis
Used when management wishes to “capitalize” part of the earnings
Small Stock Dividends
If stock dividend is less than 20-25 percent of the common shares outstanding, company transfers fair market value from RE (small stock dividend)
Large Stock Dividends
Accounting based on par value of the stock issued
When declared, transfer amount equal to par value of stock issued from RE to contributed capital
Stock Splits
Issue additional shares of stock to shareholders based on number of shares currently owned
No effect on total paid-in capital, RE, or total SE
Number of shares increase as par/stated value per shares decrease
Preferred Stock
Unlike common stock, preferred stock can have the following features:
- fixed dividend
- preference as to dividends (may be cumulative)
- preference as to assets in the event of liquidation
- absence of voting rights
- participating (dividends)
- convertible to common stock
- callable (mandatory buy-backs)
- redeemable (debt-like securities)
Presentation of SE
Analysts use SE ratios to evaluate a company’s profitability and long-term solvency
3 SE Ratios
Rate of return on common stock equity
Payout ratio
Book value per share
