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Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Text © The McGraw−Hill Companies, 2004

Learning Objectives AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:

C H A P T E R

11 Stockholders’ Equity: Paid-In Capital

Discuss the advantages and disadvantages of organizing a business as a corporation.

Distinguish between publicly owned and closely held corporations.

Explain the rights of stockholders and the roles of corporate directors and officers.

Account for paid-in capital and prepare the equity section of a corporate balance sheet.

Contrast the features of common stock with those of preferred stock.

Discuss the factors affecting the market price of preferred stock and common stock.

Explain the significance of par value, book value, and market value of capital stock.

Explain the purpose and effects of a stock split.

Account for treasury stock transactions.

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Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Text © The McGraw−Hill Companies, 2004

Companies frequently invest large

amounts of cash in the securities of

other companies. These investments

often earn returns in the form of inter-

est, dividends, and capital appreciation.

While it is common for businesses to

purchase shares of stock in other companies, would a company ever purchase shares of its own stock on the

open market?

The answer is a definite yes. Each year, for example, Sears, Roebuck & Company spends billions of

dollars to repurchase shares of its own stock. Referred to as treasury shares, these shares of stock have

been repurchased by the company, which intends to resell them in the future. One of the reasons compa-

nies such as Sears purchase their own shares of stock is to satisfy the requirements of stock option plans.

Stock option plans allow employees to purchase stock in the company they work for, often at a favorable

price. Because these plans are an important part of employees’ compensation, the company is required to

have shares available to meet its commitment under these plans. Sears is not unique in this regard. In fact,

it is difficult to find a major corporation that does not engage in treasury stock transactions on a regular ba-

sis, and in many cases the primary motivation is for stock option plans.

465

SEARS, ROEBUCK & COMPANY

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Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Text © The McGraw−Hill Companies, 2004

In this chapter we explore numerous issues related to stockholders’ equity, including trea- sury stock transactions, preferred stock, and stock splits. We also discuss why businesses in- corporate and describe the factors that influence the price of their stock in the open market.

CORPORATIONS

The corporate form is the organization of choice for many businesses—large and small. The owners of a corporation are called stockholders. In many small corporations, there are only one or two stockholders. But in large corporations, such as IBM and AT&T, there are literally millions of stockholders.

A corporation is the only form of business organization recognized under the law as a separate legal entity, with rights and responsibilities apart from those of its owners. The assets of a corporation belong to the corporation itself, not to the stockholders. The cor- poration is responsible for its own debts and must pay income taxes on its earnings. As a separate legal entity, a corporation has status in court; it may enter into contracts, and it may sue and be sued as if it were a person. The major advantages and disadvantages of this form of business organization are summarized in Exhibit 11–1.

466 Chapter 11 Stockholders’ Equity: Paid-In Capital

Exhibit 11–1

ADVANTAGES AND DISADVANTAGES OF THE

CORPORATE FORM

LO1 Discuss the advantages and disadvantages of organizing a business as a corporation.

Advantages

1. Stockholders are not personally liable for the debts of a corporation. Thus the most that a stockholder can lose by investing in a corporation is the amount of his or her investment. This concept is called limited personal liability and often is cited as the greatest advantage of the corporate form of organization.

2. Transferability of ownership. Ownership of a corporation is evidenced by transferable shares of stock, which may be sold by one investor to another. Investment in these shares has the advantage of liquidity, because investors easily may convert their corporate ownership into cash by selling their shares.

3. Professional management. The stockholders own a corporation, but they do not manage it on a daily basis. To administer the affairs of the corporation, the stockholders elect a board of directors. The directors, in turn, hire professional managers to run the business. An individual stockholder has no right to participate in management unless he or she has been hired by the directors as a corporate manager.

4. Continuity of existence. Changes in the names and identities of stockholders do not directly affect the corporation. Therefore, the corporation may continue its operations without disruption, despite the retirement or death of individual stockholders. This characteristic is essential in the undertaking of most large-scale business ventures.

Disadvantages

1. Heavy taxation. Corporate earnings are subject to double taxation. First, the corporation must pay corporate income taxes on its earnings. Second, stockholders must pay personal income taxes on any portion of these earnings that they receive as dividends. Together, these two levels of taxation may consume from 60% to 70% of a corporation’s pretax earnings.

2. Greater regulation. Corporations are affected by state and federal laws to a far greater extent than are unincorporated businesses. For example, the owners’ ability to remove business assets from a corporation is restricted by law. A corporation must obtain authorization from government agencies to issue capital stock. Also, federal laws require publicly owned corporations to make extensive public disclosure of their financial activities.

3. Cost of formation. An unincorporated business can be formed at little or no cost. Forming a corporation, however, normally requires the services of an attorney.

4. Separation of ownership and management. The separation of ownership and management is an advantage in many cases, but may be a disadvantage in others. If stockholders do not approve of the manner in which management runs the business, they may find it difficult to take the united action necessary to remove that management group.

What types of businesses choose the corporate form of organization? The answer, basically, is all kinds. When we think of corporations, we often think of large, well-known companies such as ExxonMobil, General Motors, and Procter & Gamble. Indeed, almost

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Text © The McGraw−Hill Companies, 2004

all large businesses are organized as corporations. Limited shareholder liability, transfer- ability of ownership, professional management, and continuity of existence make the cor- poration the best form of organization for pooling the resources of a great many equity investors. Not all corporations, however, are large and publicly owned. Many small busi- nesses are organized as corporations.

Corporations 467

C A S E I N P O I N T

Many locally owned stores, gas stations, and restaurants are organized as corporations and have a small number of stockholders—sometimes two or three members of the same family. Large, publicly held corporations, on the other hand, have many stockholders. For example, recent annual reports of Dow Chemical and Aluminum Company of America (ALCOA) indicate that they have approximately 97,200 and 95,800 stockholders, respectively.

1 These securities exchanges include, among others, the New York Stock Exchange, the National Association of Securities Dealers’ Automated Quotations (Nasdaq), the Tokyo Stock Exchange, and Mexico’s Bolsa. Collectively, stock exchanges often are described simply as the stock market.

Why Businesses Incorporate

Businesses incorporate for many reasons, but the two of greatest importance are (1) lim- ited shareholder liability and (2) transferability of ownership.

We have previously discussed the concept of limited personal liability. This simply means that shareholders are not personally responsible for the debts of the corporation. Thus, if the corporation becomes illiquid, the most that a stockholder usually can lose is the amount of his or her equity investment. In this era of multimillion-dollar lawsuits, lim- ited personal liability appeals to the owners of large and small businesses alike.

Another special feature of the corporation is the transferability of ownership—the idea that ownership is represented by transferable shares of capital stock. For a small, family-owned business, this provides a convenient means of gradually transferring own- ership and control of the business from one generation to the next. For a large company, it makes ownership of the business a highly liquid investment, which can be purchased and sold in organized securities exchanges.1 This liquidity is essential to a large corpo- ration’s ability to raise equity capital from thousands—perhaps millions—of individual investors.

Y O U R T U R N

You as a Loan Officer

GOTCHA! is a small business that manufactures board games. It is one of the many business ventures of Gayle Woods, who is very wealthy and one of your bank’s most valued customers. She has done business with your bank for more than 20 years, and the balance in her personal checking, savings, and money market accounts normally exceeds $500,000. GOTCHA! is organized as a corporation, and Woods is the only stockholder.

GOTCHA! has applied for a $200,000 line of credit, which it intends to use to purchase copyrights to additional board games. Although the company is profitable, its most recent balance sheet shows total assets of only $52,000, including $47,000 in copyrights. The corporation has just under $3,000 in liabilities and over $49,000 in stock- holders’ equity.

Do you consider GOTCHA! a good credit risk? Would you make the loan? Under what conditions?

(Our comments appear on page 500.)

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Text © The McGraw−Hill Companies, 2004

Publicly Owned Corporations

The capital stock of most large corporations can be bought and sold (traded) through or- ganized securities exchanges. As these shares are available for purchase by the general public, these large corporations are said to be publicly owned.

Far more people have a financial interest in the shares of publicly owned companies than one might expect. If you purchase the stock of such a corporation, you become a stockholder with a direct ownership interest—that is, you are a stockholder. But mutual funds and pension funds invest heavily in the stocks of many publicly owned corpora- tions. Thus, if you invest in a mutual fund or you are covered by a pension plan, you prob- ably have an indirect financial interest in the stocks of many publicly owned corporations.

468 Chapter 11 Stockholders’ Equity: Paid-In Capital

LO2 Distinguish between publicly owned and closely held corporations.

C A S E I N P O I N T

Corporations whose shares are not traded on any organized stock exchanges are said to be closely held. Because there is no organized market for buying and selling their shares, these corporations usually have relatively few stockholders. Often, a closely held corpo- ration is owned by one individual or by the members of one family.

Publicly Owned Corporations Face Different Rules The government seeks to pro- tect the interests of the public. Therefore, publicly owned corporations are subject to more regulation than those that are closely held. For example, publicly owned corporations are required by law to:

• Prepare and issue quarterly and annual financial statements in conformity with gen- erally accepted accounting principles. (These statements are public information.)

• Have their annual financial statements audited by an independent firm of certified public accountants.

• Comply with federal securities laws, which include both criminal penalties and civil liability for deliberately or carelessly distributing misleading information to the public.

• Submit much of their financial information to the Securities and Exchange Commission for review.

Closely held corporations normally are exempt from these requirements. But our discussions will focus primarily on the accounting and reporting issues confronting pub- licly owned companies. These are the companies whose financial statements you are most likely to see—and the companies in which you are likely to invest.

FORMATION OF A CORPORATION

In the United States, a corporation is brought into existence under the laws of a particular state. The state in which the corporation is formed is called the state of incorporation.

The state of incorporation is not necessarily where the corporation does business. Rather, a state often is selected because of the leniency of its laws regulating corporate ac- tivities. Indeed, many corporations conduct most—sometimes all—of their business ac- tivities outside the state in which they are incorporated.

The first step in forming a corporation is to obtain a corporate charter from the state of incorporation. To obtain this charter, the organizers of the corporation submit an application called the articles of incorporation. Once the charter is obtained, the stock- holders in the new corporation hold a meeting to elect a board of directors and to pass

The stockholders in General Motors include more than one million men and women, as well as many pension funds, mutual investment funds, labor unions, universities, and other organizations. Almost every person covered by an employee pension plan has an indirect ownership interest in GM.

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bylaws that will govern the corporation’s activities. The directors in turn hold a meeting at which the top corporate officers and managers are appointed.

Organization Costs Forming a corporation is more costly than starting a sole propri- etorship. The costs may include, for example, attorneys’ fees, incorporation fees paid to the state, and other outlays necessary to bring the corporation into existence. Concep- tually, organization costs are an intangible asset that will benefit the corporation over its entire life. As a practical matter, however, most corporations expense those costs immediately, even though they are often spread over a five-year period for income tax purposes.

Thus you will seldom see organization costs in the balance sheet of a publicly owned corporation. They have long since been recognized as an expense.

Rights of Stockholders A corporation is owned collectively by its stockholders. Each stockholder’s ownership interest is determined by the number of shares that he or she owns. Assume that a corporation issues 10,000 shares of capital stock. If you own 1,000 of these shares, you own 10 percent of the corporation. If you acquire another 500 shares from another stockholder, you will own 15 percent.

Each stockholder, or the stockholder’s brokerage firm, receives from the corporation a stock certificate indicating the number of shares he or she owns.

The ownership of capital stock in a corporation usually carries the following basic rights:

1. To vote for directors and on certain other key issues. A stockholder has one vote for each share owned. The issues on which stockholders may vote are specified in the cor- poration’s bylaws.

Any stockholder—or group of stockholders—that owns more than 50 percent of the capital stock has the power to elect the board of directors and to set basic corporate policies. Therefore, these stockholders control the corporation. Beyond their voting rights, stockholders have no managerial authority unless they have been appointed by the board to a management role.

2. To participate in any dividends declared by the board of directors. Stockholders in a corporation may not make withdrawals of company assets, as may the owners of unin- corporated businesses. However, the directors may elect to distribute some or all of the earnings of a profitable corporation to its stockholders in the form of cash dividends.

Dividends can be distributed only after they have been formally declared (authorized) by the board of directors. Dividends are paid to all shareholders in pro- portion to the number of shares owned.

3. To share in the distribution of assets if the corporation is liquidated. When a corpora- tion ends its existence, the creditors must first be paid in full. Any remaining assets are divided among the shareholders—again, in proportion to the number of shares owned.

Stockholders’ meetings usually are held once each year. At these meetings, stockhold- ers may ask questions of management and vote on certain issues. In large corporations, these meetings usually are attended by relatively few people—often less than 1 percent of the company’s stockholders. Prior to these meetings, however, the management group re- quests that stockholders who do not plan to attend send in proxy statements, granting management the voting rights associated with their shares.

Through this proxy system, management usually can secure the voting rights from enough shares to ensure its control of the corporation. In a publicly owned corpora- tion, dissatisfied stockholders seldom are able to muster the voting power to overrule management. Therefore, dissatisfied stockholders normally sell their shares and invest in a company more to their liking.

Functions of the Board of Directors The primary functions of the board of directors are to set corporate policies and to protect the interests of the stockholders. Spe- cific duties of the directors include hiring corporate officers and setting these officers’

Formation of a Corporation 469

LO3 Explain the rights of stockholders and the roles of corporate directors and officers.

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salaries, declaring dividends, and reviewing the findings of both internal auditors and in- dependent auditors.

A closely held corporation might have only one active director—who is also the prin- cipal stockholder. But publicly owned corporations have larger boards—usually a dozen people or more.

The board of a large corporation always includes several members of top management. In recent years, increasing importance has been attached to the inclusion of “outside” di- rectors. The term outside directors refers to individuals who are not officers of the corpo- ration and, therefore, bring an independent perspective to the board.

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C A S E I N P O I N T

Functions of the Corporate Officers The top management of a corporation is ap- pointed (hired) by the board of directors. These individuals are called the corporate offi- cers, or, more simply, “top management.” Individual stockholders do not have the right to transact corporate business unless they have been properly appointed to a managerial post.

The top level of management usually includes a chief executive officer (CEO) or president, a chief financial officer (CFO) or controller, a treasurer, and a secretary. In ad- dition, a vice president usually oversees each functional area, such as sales, personnel, and production.

The responsibilities of the CFO (controller), treasurer, and secretary are most directly related to the accounting phase of business operation. The CFO is responsible for the maintenance of adequate internal control and for the preparation of accounting records and financial statements. Such specialized activities as budgeting, tax planning, and preparation of tax returns are usually placed under the CFO’s jurisdiction. The treasurer has custody of the company’s funds and is generally responsible for planning and con- trolling the company’s cash position. The treasurer’s department also has responsibility for relations with the company’s financial institutions and major creditors.

The secretary represents the corporation in many contractual and legal matters and maintains minutes of the meetings of directors and stockholders. Other responsibilities of the secretary are to coordinate the preparation of the annual report and to manage the in- vestor relations department. In small corporations, one officer frequently acts as both sec- retary and treasurer.

The organization chart in Exhibit 11–2 indicates lines of authority extending from stockholders to the directors to the CEO and other officers.

Y O U R T U R N

You as the Vice President of Human Relations

Assume you have been the vice president of human relations for a large auto parts supply company for the past five years. Recently, you have been en-

gaged in negotiation talks with the company’s major union. These talks are not going well and, as a result, the union is planning to strike early in December. As part of your compensation each year, you are awarded 2,000 shares of the company’s stock. You normally sell 1,000 shares each December to pay for your holiday shopping. What should you do?

(Our comments appear on page 501.)

A recent annual report of General Mills includes a report from the audit committee of the company’s board of directors. The first paragraph of this report describes the committee’s responsibilities:

The Audit Committee of the Board of Directors is composed of six outside directors. Its primary

function is to oversee the Company’s system of internal controls, financial reporting practices and

audits to ensure their quality, integrity and objectivity are sufficient to protect stockholders’ assets.

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Stockholder Records in a Corporation

A large corporation with shares listed on the New York Stock Exchange usually has millions of shares outstanding and hundreds of thousands of stockholders. Each day many stockholders sell their shares; the buyers of these shares become new members of the company’s family of stockholders.

A corporation must have an up-to-date record of the names and addresses of this constantly changing group of stockholders so that it can send dividend checks, financial statements, and voting forms to the right people.

Formation of a Corporation 471

Exhibit 11–2 CORPORATE ORGANIZATION CHART

Stockholders

Board of Directors

CEO or President

Treasurer or Vice Pres. (finance)

Corporate Secretary

CFO or Controller

Vice Pres. (sales)

Vice Pres. (production)

Vice Pres. (human

relations)

C A S E I N P O I N T

There are numerous stock exchanges around the world. Europe is the second largest equity market region in the world after North America. The significant European stock exchanges are in London, Frankfurt, and Paris. Other stock ex-

changes around the world are more thinly traded such as the Bolsa Mexicana de Valore in Mexico. Each exchange has different financial reporting requirements for companies that list shares on the exchange.

Stockholders Subsidiary Ledger When there are numerous stockholders, it is not practical to include a separate account for each stockholder in the general ledger. Instead, a single controlling account entitled Capital Stock appears in the general ledger, and a stockholders subsidiary ledger is maintained. This ledger contains an account for each individual stockholder. Entries in the stockholders subsidiary ledger are made in number of shares, rather than in dollars. Thus each stockholder’s account shows the number of shares owned and the dates of acquisitions and sales. This record enables the corporation to send each stockholder a single dividend check, even though the stockholder may have acquired shares on different dates.

A corporation that has more than one type of capital stock will maintain a separate set of stockholders subsidiary records for each issue.

Stock Transfer Agent and Stock Registrar Many large, publicly owned corpora- tions use an independent stock transfer agent and a stock registrar to maintain their stockholder records and to establish strong internal control over the issuance of stock cer- tificates. These transfer agents and registrars are usually banks or trust companies. When

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stock certificates are transferred from one owner to another, the old certificates are sent to the transfer agent, who cancels them, makes the necessary entries in the stockholders sub- sidiary ledger, and prepares a new certificate for the new owner of the shares. This new certificate then must be registered with the stock registrar before it represents valid and transferable ownership of stock in the corporation.

Small, closely held corporations generally do not use the services of independent registrars and transfer agents. In these companies, the stockholder records usually are maintained by a corporate officer. To prevent the accidental or fraudulent issuance of an excessive number of stock certificates, the corporation should require that each certificate be signed by at least two designated corporate officers.

PAID-IN CAPITAL OF A CORPORATION

Stockholders’ equity of a corporation is normally increased in one of two ways: (1) from contributions by investors in exchange for capital stock—called paid-in capital or con- tributed capital—and (2) from the retention of profits earned by the corporation over time—called retained earnings. As previously noted, our focus in this chapter is primar- ily on issues related to paid-in capital. In Chapter 12, we shift our attention to issues con- cerning retained earnings.

Authorization and Issuance of Capital Stock

The articles of incorporation specify the number of shares that a corporation has been au- thorized to issue by the state of incorporation. Issues of capital stock that will be sold to the general public must be approved by the federal Securities and Exchange Commission, as well as by state officials.

Corporations normally obtain authorization for more shares than they initially plan to issue. This way, if more capital is needed later, the corporation already has the authoriza- tion to issue additional shares.

Shares that have been issued and are in the hands of stockholders are called the out- standing shares. At any time, these outstanding shares represent 100 percent of the stock- holders’ investment in the corporation.

When a large amount of stock is to be issued, most corporations use the services of an investment banking firm, frequently referred to as an underwriter. The underwriter guar- antees the issuing corporation a specific price for the stock and makes a profit by selling the shares to the investing public at a slightly higher price. The corporation records the is- suance of the stock at the net amount received from the underwriter. The use of an under- writer assures the corporation that the entire stock issue will be sold without delay and that the entire amount of funds to be raised will be available on a specific date.

The price that a corporation will seek for a new issue of stock is based on such factors as (1) expected future earnings and dividends, (2) the financial strength of the company, and (3) the current state of the investment markets. If the corporation asks too high a price, it simply will not find an underwriter or other buyers willing to purchase the shares.

State Laws Affect the Balance Sheet Presentation of Stockholders’ Equity The number of different accounts that a corporation must use in the stockholders’ equity sec- tion of its balance sheet is determined largely by state laws. We have seen that corporations use separate stockholders’ equity accounts to represent (1) contributed capital, or paid-in capital; and (2) earned capital, or retained earnings. Up to this point we have assumed that all paid-in capital is presented in a single account entitled Capital Stock. But this often is not the case.

Some corporations issue several different types (or classes) of capital stock. In these situations, a separate account is used to indicate each type of stock outstanding. A legal concept called par value also affects the balance sheet presentation of paid-in capital.

Par Value Par value (or stated value) represents the legal capital per share—the amount below which stockholders’ equity cannot be reduced, except by losses from

472 Chapter 11 Stockholders’ Equity: Paid-In Capital

LO4 Account for paid-in capital and prepare the equity section of a corporate balance sheet.

My Mentor

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business operations (or by special legal action). The directors cannot declare a dividend that would cause total stockholders’ equity to fall below the par value of the outstand- ing shares. Par value, therefore, may be regarded as a minimum cushion of equity cap- ital existing for the protection of creditors.

Because of the legal restrictions associated with par value, state laws require cor- porations to show separately in the stockholders’ equity section of the balance sheet the par value of shares issued. This special balance sheet presentation has led some people to believe that par value has some special significance. In many corporations, however, the par value of the shares issued is a small portion of total stockholders’ equity.

A corporation may set the par value of its stock at $1 per share, $5 per share, or any other amount that it chooses. Most large corporations set the par value of their common stocks at nominal amounts, such as 1 cent per share or $1 per share. The par value of the stock is not an indication of its market value; the par value merely indicates the amount per share to be entered in the Capital Stock account. The stocks of Ford and AT&T have par values of $1, and Microsoft’s stock has a par value of only one-tenth of a cent. The market value of each of these securities is far above its par value. Microsoft’s stock, for example, has traded at a market value in excess of $100 per share, or more than 100,000 times its par value.

Issuance of Par Value Stock Authorization of a stock issue does not bring an asset into existence, nor does it give the corporation any capital. The obtaining of authorization from the state for a stock issue merely affords a legal opportunity to obtain assets through the sale of stock. Additional capital is created for the company only when that stock is sold to stockholders.

When par value stock is issued, the Capital Stock account is credited with the par value of the shares issued, regardless of whether the issuance price is more or less than par. Assuming that 50,000 shares of $2 par value stock have been authorized and that 10,000 of these authorized shares are sold at a price of $2 each, Cash would be debited and Capital Stock would be credited for $20,000. When stock is sold for more than par value, the Capital Stock account is credited with the par value of the shares issued, and a separate account, Additional Paid-in Capital, is credited for the excess of selling price over par. If, for example, our 10,000 shares were issued at a price of $10 per share, the entry would be:

Paid-In Capital of a Corporation 473

MY NOTES

Stockholders’ investment in excess of par value

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Capital Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Additional Paid-in Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Issued 10,000 shares of $2 par value stock at a price of $10 a share.

The additional paid-in capital does not represent a profit to the corporation. It is part of the invested capital and it is added to the capital stock in the balance sheet to show the to- tal paid-in capital. The stockholders’ equity section of the balance sheet follows. (The $150,000 in retained earnings is assumed in order to have a complete illustration.)

Stockholders’ equity:

Capital stock, $2 par value; authorized, 50,000 shares; issued and outstanding, 10,000 shares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $250,000

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If stock is issued by a corporation for less than par, the account Discount on Capital Stock should be debited for the difference between the issuance price and the par value. A discount on capital stock reduces, rather than increases, the amount of stockholders’ eq- uity in the balance sheet. The issuance of stock at a discount is seldom encountered be- cause it is illegal in many states.

In some cases, stock is issued in exchange for assets other than cash. When this occurs, the appropriate asset account is debited (for example, inventory or land) and the stock ac- counts are credited as if the stock had been sold for cash. Establishing a value for recording a transaction of this type is sometimes difficult, but should be based on either the fair value of the assets received or the stock issues, whichever can be more objectively determined.

No-Par Stock Some states allow corporations to issue stock without designating a par or stated value. When this “no-par” stock is issued, the entire issue price is credited to the Capital Stock account and is viewed as legal capital not subject to withdrawal.

Common Stocks and Preferred Stocks

The account title Capital Stock is widely used when a corporation has issued only one type of stock. In order to appeal to as many investors as possible, however, some corpo- rations issue several types (or classes) of capital stock, each providing investors with dif- ferent rights and opportunities.

The basic type of capital stock issued by every corporation often is called common stock. Common stock possesses the traditional rights of ownership—voting rights, par- ticipation in dividends, and a residual claim to assets in the event of liquidation. When the rights of stockholders are modified, the term preferred stock is normally used to describe the resulting type of capital stock. A few corporations issue two or more classes of pre- ferred stock, with each class having distinctive features designed to appeal to a particular type of investor. In summary, we may say that every corporation has common stock and that some corporations also have one or more types of preferred stock.

The following stockholders’ equity section illustrates the balance sheet presentation for a corporation having both preferred and common stock. As before, a retained earnings amount is assumed so we can provide a complete example.

474 Chapter 11 Stockholders’ Equity: Paid-In Capital

Stockholders’ equity:

9% cumulative preferred stock, $100 par value, authorized 100,000 shares, issued 50,000 shares. . . . . . . . . . . . . . . . . . . . . $ 5,000,000

Common stock, $5 par value, authorized 3 million shares, issued 2 million shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000,000

Additional paid-in capital:

Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000,000

Total paid-in capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35,500,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $49,500,000

LO5 Contrast the features of common stock with those of preferred stock.

My Mentor

MY NOTES

Balance sheet presentation of common stock and of preferred stock

Characteristics of Preferred Stock

Most preferred stocks have the following distinctive features:

1. Preference over common stock as to dividends. 2. Cumulative dividend rights. 3. Preference over common stock as to assets in event of the liquidation of the company. 4. Callable at the option of the corporation. 5. No voting power.

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Another important but less common feature of some preferred stocks is a clause per- mitting the conversion of preferred stock into common stock at the option of the holder. Preferred stocks vary widely with respect to the special rights and privileges granted. Careful study of the terms of the individual preferred stock contract is a necessary step in the evaluation of any preferred stock.

Stock Preferred as to Dividends Corporations often make periodic cash pay- ments, called dividends, to stockholders.2 Dividends normally represent a distribution of accumulated profit and therefore cannot exceed the amount of a corporation’s re- tained earnings.

Preferred stock is said to have dividend preference because preferred stock investors are entitled to receive a specified amount each year before any dividend is paid to common stock investors. The specified dividend may be stated as a dollar amount, such as $5 per share. Some preferred stocks, however, state the specified dividend as a per- centage of par value. For example, a share of preferred stock with a par value of $100 and a dividend preference of 9 percent must provide a $9 dividend each year to each share of preferred stock before any dividends can be paid on the common shares. (Preferred stocks often have par values substantially higher than common stocks. This is largely a matter of tradition and has little significance.)

Paid-In Capital of a Corporation 475

C A S E I N P O I N T

Consolidated Edison has two issues of preferred stock that are publicly traded on the New York Stock Exchange. The first issue is a $5 preferred stock that pays annual divi- dends of $5 per share and has no par value. The other issue is a 4.65 percent preferred with a $100 par value that pays annual dividends of $4.65 per share.

Dividends on both of these issues of preferred stock must be paid in full before Con- solidated Edison pays any dividend on its common stock.

2 In Chapter 12, we will discuss specific accounting issues related to cash dividends and other forms of dis- tributions to stockholders. For the purposes of this chapter, dividends may be viewed simply as the distribu- tion to stockholders of accumulated profits that reduce both cash and retained earnings.

The holders of preferred stock have no guarantee that they will always receive the in- dicated dividend. A corporation is obligated to pay dividends to stockholders only when the board of directors declares a dividend. Dividends must be paid on preferred stock be- fore anything is paid to the common stockholders, but if the corporation is not prospering, it may decide not to pay any dividends at all. For a corporation to pay dividends, profits must be earned and cash must be available. Despite this limitation, preferred stocks gen- erally offer investors more assurance of regular dividend payments than do common stocks.

Cumulative Preferred Stock The dividend preference carried by most preferred stocks is a cumulative one. If all or any part of the regular dividend on the preferred stock is omitted in a given year, the amount omitted is said to be in arrears and must be paid in a subsequent year before any dividend can be paid on the common stock.

Assume that a corporation is organized on January 1, 2003, with 10,000 shares of $8 preferred stock and 50,000 shares of common stock. If the preferred stock is noncumula- tive, the $8 per share dividend does not carry forward if it is not paid each year. On the other hand, if the preferred stock is cumulative, the $8 per share dividend carries forward to future years if it is not paid and the accumulated amount must be paid before any div- idend can be paid on common stock. Assume that the $8 preferred dividend is paid in 2003, a partial dividend of $2 per share is paid on preferred stock in 2004, and no pre- ferred dividend is paid in 2005. Following is an analysis of the status of the preferred div- idend at the end of 2005.

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In the case of noncumulative preferred stock, the unpaid dividend does not carry for- ward to future years and has no effect on the company’s ability to pay dividends on com- mon stock in the future. In the case of cumulative preferred stock, however, any unpaid dividend on preferred stock carries forward and must be paid before dividends can be paid on common stock. In 2004, the partial unpaid dividend of $60,000 would have to have been paid before any dividend could have been paid on common stock. At the end of 2005, this amount has grown to $140,000 (the $60,000 carried forward from 2004, plus the $80,000 that was not paid in 2005). Before a dividend could have been paid on com- mon stock in 2005, the $60,000 preferred dividend in arrears from 2004 and the current preferred dividend of $80,000 for 2005 would have to have been paid. Before a dividend can be paid on common stock in 2006, the $140,000 in arrears from 2004 and 2005 and the $80,000 dividend on preferred for 2006 would have to be paid (total of $220,000). From this illustration, you can see why the label “cumulative” is used—the dividend ac- cumulates from year to year and must be paid before any dividend can be paid on com- mon stock.

Dividends in arrears are not listed among the liabilities of a corporation, because no li- ability exists until a dividend is declared by the board of directors. The amount of any div- idends in arrears on preferred stock is an important factor to investors and should always be disclosed. This disclosure is usually made by a note accompanying the balance sheet such as the following:

Note 6: Dividends in arrears As of December 31, 2005, dividends on the $8 cumulative preferred stock were in arrears to the extent of $14 per share and amounted in total to $140,000.

In 2006, we shall assume that the company earned large profits, has available cash, and wished to pay dividends on both the preferred and common stocks. Before paying a div- idend on the common, the corporation must pay the $140,000 in arrears on the cumulative preferred stock plus the regular $8 per share applicable to the current year. The preferred stockholders would, therefore, receive a total of $220,000 in dividends in 2006 ($22 per share); the board of directors would then be free to declare dividends on the common stock.

For a noncumulative preferred stock, any unpaid or omitted dividend is lost forever. However, few preferred stocks are noncumulative.

Other Features of Preferred Stock To add to the attractiveness of preferred stock as an investment, corporations sometimes offer a conversion privilege that entitles the pre- ferred stockholders to exchange their shares for common stock at a stipulated ratio. If the corporation prospers, its common stock will probably rise in market value, and dividends on the common stock will probably increase. The investor who buys a convertible pre- ferred stock rather than common stock has greater assurance of regular dividends. In ad- dition, through the conversion privilege, the investor is assured of an opportunity to share in any substantial increase in value of the company’s common stock.

Occasionally you may encounter preferred stock with some unusual characteristics. For example, there are “participating preferreds,” allowing preferred stockholders to re- ceive dividends that are greater than the stated dollar amount or percentage. There also are “super preferreds,” granting enormous voting rights—perhaps the controlling interest—

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2003 2004 2005

If preferred stock is noncumulative

Dividend paid $80,000 $20,000 —

Dividend in arrears –——————–Not applicable—–———–—

If preferred stock is cumulative

Dividend paid $80,000 $20,000 —

Dividends in arrears — $60,000 $140,000

MY NOTES

Footnote disclosure of dividends in arrears

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to the preferred stockholders. And there are “redeemable preferreds,” allowing preferred shareholders to sell their shares back to the corporation at an agreed-upon price. We will leave further discussion of such unusual features of preferred stock to more advanced courses in accounting and corporate finance.

The three primary elements of stockholders’ equity for most companies are common stock, preferred stock, and retained earnings. While important, other elements that we learn about later in this chapter, as well as in Chapter 12, are typically smaller in amount than these three primary elements. The relationship of common stock, preferred stock, and retained earnings is depicted in Exhibit 11–3.

Paid-In Capital of a Corporation 477

Common Stock

Characteristics

1. Voting rights. 2. Participation in dividends. 3. Residual claim to assets.

Characteristics

1. Amount earned and retained by the corporation over time.

Typical Characteristics

1. Preferred as to dividends. 2. Cumulative dividend rights. 3. Preferred in liquidation. 4. Callable by the corporation. 5. No voting power.

Preferred Stock Retained Earnings

Net Income

Corporation’s Capital Classified by Source— Stockholders’ Equity

Par Value—legal capital per share

Additional Paid- In Capital

Earnings

Exhibit 11–3

PRIMARY SOURCES OF CORPORATE EQUITY

When a corporation’s managers consider making a major acquisition, they must weigh the strategic implications of a change in the corporation’s financial structure as it appears on the financial statements. For example, corporations can pay for an acquisition by using cash or debt financing or by issuing stock. Sometimes, agreements with existing creditors limit the amount of additional preferred stock that can be issued. Other restrictions im- posed by creditors may limit the acquisition of additional debt financing. Most of these re- strictions are based on numbers from audited financial statements.

M A N A G E M E N T S T R A T E G Y

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Book Value per Share of Common Stock

Because the equity of each stockholder in a corporation is determined by the number of shares he or she owns, an accounting measurement of interest to some stockholders is book value per share of common stock. Book value per share is the amount of net assets represented by each share of stock. The term net assets means total assets minus total liabilities; in other words, net assets are equal to total stockholders’ equity. Thus, in a corporation that has issued common stock only, the book value per share is com- puted by dividing total stockholders’ equity by the number of shares outstanding.

For example, assume that a corporation has 4,000 shares of common stock outstanding and the stockholders’ equity section of the balance sheet is as follows:

478 Chapter 11 Stockholders’ Equity: Paid-In Capital

Stockholders’ equity:

Common stock, $1 par value (4,000 shares outstanding) . . . . . . . . . . . . . . . . . . . $ 4,000

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000

Stockholders’ equity:

8% preferred stock, $100 par value, 10,000 shares authorized and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Common stock, $10 stated value, authorized 100,000 shares, issued and outstanding 50,000 shares . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Additional paid-in capital: Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,250,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,380,000

MY NOTES

How much is book value per share?

MY NOTES

Two classes of stock

The book value per share is $30; it is computed by dividing the stockholders’ equity of $120,000 by the 4,000 shares of outstanding stock. In computing book value, we are not concerned with the number of authorized shares but rather with the outstanding shares, because the total of the outstanding shares represents 100 percent of the stock- holders’ equity.

Book Value When a Company Has Both Preferred and Common Stock Book value is usually computed only for common stock. If a company has both preferred and common stock outstanding, the computation of book value per share of common stock re- quires two steps. First, the amount assigned to preferred stock and any dividends in ar- rears are deducted from total stockholders’ equity. Second, the remaining amount of stockholders’ equity is divided by the number of common shares outstanding to determine book value per common share. This procedure reflects the fact that the common stock- holders are the residual owners of the corporate entity.

To illustrate the computation of book value per share when preferred stock is out- standing, assume that the stockholders’ equity of Hart Company at December 31 is as follows:

Because of a weak cash position, Hart Company has paid no dividends during the cur- rent year. As of December 31, dividends in arrears on the cumulative preferred stock to- tal $80,000.

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Market Value 479

All the equity belongs to the common stockholders, except the $1,000,000 applicable to the preferred stock and the $80,000 of dividends in arrears on preferred stock. The cal- culation of book value per share of common stock is as follows:

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,380,000

Less: Equity of preferred stockholders:

Par value of preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Dividends in arrears . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 1,080,000

Equity of common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300,000

Number of common shares outstanding . . . . . . . . . . . . . . . . . . . . 50,000

Book value per share of common stock ($1,300,000 � 50,000 shares) . . . . . . . . . . . . . . . . . . . . . . . . . $26

In a statement of cash flows, transactions with the stockholders of a corporation are classi- fied as financing activities. Thus the issuance of capital stock for cash represents a receipt from financing activities. Distributions of cash to stockholders— including the payment of cash dividends— represent a cash outlay, which is also classified under financing activities.

Transactions with owners do not always have an immediate effect on cash flows. Consider an exchange of the corporation’s capital stock for a noncash asset, such as land. Cash is not increased or decreased by this event. These types of noncash transactions are described in a special schedule that accompanies the statement of cash flows.

CASH EFFECTS

MARKET VALUE

After shares of stock have been issued, they may be sold by one investor to another. The price at which these shares change hands represents the current market price of the stock. This market price may differ substantially from such amounts as par value, the original is- sue price, and the current book value. Which is the most relevant amount? That depends on your point of view.

After shares are issued, they belong to the stockholder, not to the issuing corporation. Thus changes in the market price of these shares directly affect the financial position of the stock- holder, but not that of the issuing company. This concept explains why the issuing company and stockholders apply different accounting principles to the same outstanding shares.

Accounting by the Issuer From the viewpoint of the issuing company, outstanding stock represents an amount invested in the company by its owners at a particular date. While the market value of the stockholders’ investment may change, the amount of re- sources that they originally invested does not change.

Thus the company issuing stock records the issue price—that is, the proceeds received from issuing the stock—in its paid-in capital accounts. The balances in these accounts re- main unchanged unless (1) more shares are issued or (2) outstanding shares are perma- nently retired (for example, preferred stock is called or stock is purchased on the open market and then retired).

Accounting by the Investor From the investor’s point of view, shares owned in a publicly owned company are an asset, usually called Marketable Securities.

To the investor, the current market value of securities owned is more relevant than the original issue price—or than the securities’ par values or book values. The market value indicates what the securities are worth today. Changes in market value directly affect the investor’s liquidity, financial position, and net worth. For these reasons, investors show investments in marketable securities at current market value in their balance sheets.

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Because market prices are of such importance to investors, we will briefly discuss the factors that most affect the market prices of preferred and common stocks.

Market Price of Preferred Stock

Investors buy preferred stocks primarily to receive the dividends that these shares pay. Thus dividend rate is one important factor in determining the market price of a preferred stock. A second important factor is risk. In the long run, a company must be profitable enough to pay dividends. If there is a distinct possibility that the company will not operate profitably and pay dividends, the price of its preferred stock will probably decline.

A third factor greatly affecting the value of preferred stocks is the level of interest rates. What happens to the market price of an 8 percent preferred stock, originally issued at a par value of $100, if government policies and other factors cause long-term interest rates to rise to, say, 15 percent or 16 percent? If investments offering a return of 16 percent with the same level of risk are readily available, investors will no longer pay $100 for a share of preferred stock that provides a dividend of only $8 per year. Thus the market price of the preferred stock will fall to about half of its original issue price, or about $50 per share. At this market price, the stock offers a 16 percent return (called the dividend yield) to an investor purchasing the stock.

However, if the prevailing long-term interest rates should again decline to the 8 percent range, the market price of an 8 percent preferred stock should rise to approximately par value. In summary, the market price of preferred stock varies inversely with interest rates. As inter- est rates rise, preferred stock prices decline; as interest rates fall, preferred stock prices rise.

480 Chapter 11 Stockholders’ Equity: Paid-In Capital

C A S E I N P O I N T

LO6 Discuss the factors affecting the market price of preferred stock and common stock.

C A S E I N P O I N T

In a single day, the market price of IBM’s capital stock dropped over $31 per share, falling from $135 to $103.25. Of course, this was not a typical day. The date, October 19, 1987, will long be remembered as “Black Monday.” On this day, stock prices around the world suffered the greatest one-day de- cline in history.

Stocks listed on the New York Stock Ex- change lost about 20 percent of their value in less than six hours. Given that the annual dividends on these stocks averaged about 2 percent of their market value, this one-day market loss was approximately equal to the loss by investors of all dividend revenue for about 10 years.

How did this disastrous decline in IBM’s stock price affect the balance sheet of IBM? Ac- tually, it didn’t. IBM’s stock isn’t owned by IBM—it is owned by the company’s stockholders.

The Image Bank/Getty Images

The preceding point is illustrated by the performance of Philadelphia Electric’s 91�2 per- cent, $100 par value, preferred stock as interest rates have fluctuated over four noncon- secutive years:

*The long-term interest rates cited in this example are the market yields of federally insured 30-year, fixed- rate mortgages over a selected 13-year period.

Long-Term Interest Stock Rates* Price

Year 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151/4% $ 60

Year 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131/2 68

Year 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91/4 99

Year 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71/4 106

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Market Price of Common Stock

Prevailing interest rates also affect the market price of common stock. However, divi- dends paid to common stockholders are not fixed in amount. Both the amount of the dividend and the market price of the stock may increase dramatically if the corporation is successful. Alternatively, if the company is unsuccessful, the common stockholders may not even recover their original investment. Therefore, the most important factors in the market price of common stock are investors’ expectations as to the future profitability of the business and the risk that this level of profitability may not be achieved.

Bear in mind that after shares have been issued they belong to the stockholders, not to the issuing corporation. Therefore, changes in the market price of the shares do not affect the financial statements of the corporation, and these changes are not recorded in the cor- poration’s accounting records. The paid-in capital shown in a corporate balance sheet rep- resents the amount received when the stock was issued, not the current market value of shares.

Market Value 481

Y O U R T U R N

You as an Investor

Assume that you are considering making a short-term investment in one of two stocks, a common stock or a preferred stock. You expect that the return on the two investments will be similar, and they have similar amounts of risk. In addition, you believe that interest rates will be increasing significantly in the next six months. Make a decision as to which stock is the better investment and support your choice.

(Our comments appear on page 501.)

Book Value and Market Price

To some extent, book value is used in evaluating the reasonableness of the market price of a stock. However, it must be used with caution; the fact that a stock is selling at less than book value does not necessarily indicate a bargain.

Book value is a historical concept, representing the amounts invested by stockhold- ers plus the amounts earned and retained by the corporation. If a stock is selling at a price above book value, investors believe that management has created a business worth more than the historical cost of the resources entrusted to its care. This, in essence, is the sign of a successful corporation. If the excess of market price over book value becomes great, however, investors should consider whether the company’s prospects really justify a market price so much above the underlying book value of the company’s resources.

On the other hand, if the market price of a stock is less than book value, investors be- lieve that the company’s resources are worth less than their cost while under the control of current management. Thus the relationship between book value and market price is one measure of investors’ confidence in a company’s management.

LO7 Explain the significance of par value, book value, and market value of capital stock.

C A S E I N P O I N T

Shortly after the introduction of its Windows software, the common stock of Microsoft Corp. rose to a market value of more than $100 per share, although its book value per share was only about $6.50. Investors believed that Microsoft’s products—and its management—made the business worth far more than the historical amounts of capital that had been invested.

In contrast, the common stock of Tucson Electric Power at one point sold at a market price of $5 per share, although its book value was more than $20 per share. This utility company had invested heavily in plant assets intended to generate more electrical power. Unfortunately, demand for this power did not develop, and the company found itself unable to sell its additional output. These new facilities produced very little revenue but increased operating expenses substantially. Although these new facilities had a high book value, investors did not consider them to be worth the amounts that management had invested.

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Stock Splits

Over time, the market price of a corporation’s common stock may increase in value so much that it becomes too expensive for many investors. When this happens, a corporation may split its stock by increasing the number of its common shares outstanding. The purpose of a stock split is to reduce substantially the market price of the company’s com- mon stock, with the intent of making it more affordable to investors.

For example, assume that Felix Corporation has outstanding 1 million shares of $10 par value common stock. The market price is currently $90 per share. To make the stock more affordable, the corporation decides to increase the number of outstanding shares from 1 million to 2 million. This action is called a 2-for-1 stock split. A stockholder who owned 100 shares of the stock before the split will own 200 shares after the split. Since the number of outstanding shares has been doubled without any change in total assets or total stockholders’ equity, the market price of the stock should drop immediately from $90 to approximately $45 per share. In splitting its stock, a corporation is required to reduce the par value per share in proportion to the size of the split. As this was a 2-for-1 split, the company must reduce the par value of the stock from $10 to $5 per share. Had it been a 4-for-1 split, the par value would have been reduced from $10 to $2.50 per share and the stock price would have declined to approximately 25 percent of its former amount.

A stock split does not change the balance of any accounts in the balance sheet; conse- quently, the transaction is recorded merely by a memorandum entry. For Felix Corpora- tion, this memorandum entry might read as follows:

Sept. 30 Memorandum: Issued additional 1 million shares of common stock in a 2-for-1 stock split. Par value reduced from $10 per share to $5 per share.

The description of common stock also is changed in the balance sheet to reflect the lower par value and the greater number of shares outstanding.

Another form of stock distribution to current stockholders is a stock dividend. While stock dividends are similar to stock splits in some respects, they are much smaller in size and have a different intent. Stock dividends usually result in an increase of 5 percent to 20 percent of outstanding stock as compared with distributions of 2�1 (100 percent increase) or 3�1 (200 percent increase) that are typical of stock splits. By distributing a stock dividend management can make a distribution to owners while preserving the company’s current cash balance. Because stock dividends are important considerations in a company’s dividend policy, we defer the detailed coverage of stock dividends to Chapter 12.

TREASURY STOCK

Treasury stock is defined as shares of a corporation’s own capital stock that have been issued and later reacquired by the issuing company but that have not been canceled or per- manently retired. Treasury shares may be held indefinitely or may be issued again at any time. Shares of capital stock held in the treasury are not entitled to receive dividends, to vote, or to share in assets upon dissolution of the company. In the computation of earn- ings per share, shares held in the treasury are not regarded as outstanding shares.

Stock option plans are an important part of employee compensation for many compa- nies. They permit employees to purchase stock in the company, often at advantageous prices, and are a means of creating employee loyalty to the company. Employees who are also owners are motivated to perform at a high level, which, in turn, makes the company more successful. Treasury stock purchases are one means by which the company can have available the shares of stock needed to satisfy the requirement of stock option plans to is- sue shares of stock to employees. Rather than increasing the total number of outstanding shares, thereby reducing or diluting the ownership of each share, the company purchases shares of stock from the current owners from the stock market and then sells the same shares a second time to its employees. Stock option plans are a primary purpose for trea- sury stock purchases for many companies.

482 Chapter 11 Stockholders’ Equity: Paid-In Capital

LO8 Explain the purpose and effects of a stock split.

MY NOTES

Memorandum entry to record a stock split

LO9 Account for treasury stock transactions.

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Recording Purchases of Treasury Stock

Purchases of treasury stock are usually recorded by debiting the Treasury Stock account with the cost of the stock. For example, if Riley Corporation reacquires 1,600 shares of its own $5 par stock at a price of $90 per share, the entry is as follows:

Treasury Stock 483

My Mentor

Treasury Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,000

Purchased 1,600 shares of $5 par treasury stock at $90 per share.

Stockholders’ equity:

Common stock, $5 par value, authorized 250,000 shares, issued 100,000 shares (of which 1,600 are held in treasury) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000

Additional paid-in capital: Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,400,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000

Less: Treasury stock (1,600 shares of common, at $90 cost) . . . . . . . . . . . . . . . 144,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,856,000

Note that the Treasury Stock account is debited for the cost of the shares purchased, not their par value.

When treasury stock is purchased, the corporation is eliminating part of its stockhold- ers’ equity by a payment to one or more stockholders. The purchase of treasury stock should be regarded as a reduction of stockholders’ equity, not as the acquisition of an as- set. For this reason, the Treasury Stock account appears in the balance sheet as a deduc- tion in the stockholders’ equity section.

The presentation of treasury stock in Riley Corporation’s balance sheet appears as fol- lows, based on assumed numbers except for treasury stock:

Reissuance of Treasury Stock

When treasury shares are reissued, the Treasury Stock account is credited for the cost of the shares reissued and Additional Paid-in Capital from Treasury Stock Transactions is debited or credited for any difference between cost and the reissue price. To illustrate, as- sume that 1,000 of the treasury shares acquired by Riley Corporation at a cost of $90 per share are now reissued at a price of $115 per share. The entry to record the reissuance of these shares at a price above cost is:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000

Treasury Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000

Additional Paid-in Capital: Treasury Stock Transactions . . . . . . . . . . . 25,000

Sold 1,000 shares of treasury stock, which cost $90,000, at a price of $115 per share.

MY NOTES

Treasury stock reissued at a price above cost

The $25,000 of additional paid-in capital resulting from the reissuance of Riley’s trea- sury stock is reported in the stockholders’ equity section of the company’s balance sheet. It appears immediately after additional paid-in capital from common stock, as shown here:

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If treasury stock is reissued at a price below cost, additional paid-in capital from pre- vious treasury stock transactions is reduced (debited) by the excess of cost over the reis- sue price. To illustrate, assume that Riley Corporation reissues its remaining 600 shares of treasury stock (cost $90 per share) at a price of $75 per share. The entry is:

484 Chapter 11 Stockholders’ Equity: Paid-In Capital

Stockholders’ equity:

Common stock, $5 par value, authorized 250,000 shares, issued 100,000 shares (of which 600 are held in treasury) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500,000

Additional paid-in capital:

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,425,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,025,000

Less: Treasury stock (600 shares of common, at $90 cost) . . . . . . . . . . . . . . . . 54,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,971,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,000

Additional Paid-in Capital: Treasury Stock Transactions . . . . . . . . . . . . . . . 9,000

Treasury Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,000

Sold 600 shares of treasury stock, which cost $54,000, at a price of $75 each.

MY NOTES

Reissued at a price below cost

If there is no additional paid-in capital from previous treasury stock transactions, the excess of the cost of the treasury shares over the reissue price is recorded as a debit to the Additional Paid-in Capital: Common Stock account.

No Gain or Loss on Treasury Stock Transactions Notice that no gain or loss is recognized on treasury stock transactions, even when the shares are reissued at a price above or below cost. A corporation earns profits by selling goods and services to out- siders, not by issuing or reissuing shares of its own capital stock. When treasury shares are reissued at a price above cost, the corporation receives from the new stockholder an amount of paid-in capital that is larger than the reduction in stockholders’ equity that oc- curred when the corporation acquired the treasury shares. Conversely, if treasury shares are reissued at a price below cost, the corporation has less paid-in capital as a result of the purchase and reissuance of the shares. Thus any changes in stockholders’ equity resulting from treasury stock transactions are regarded as changes in paid-in capital and are not in- cluded in the measurement of net income.

Restriction of Retained Earnings for Treasury Stock Owned Purchases of trea- sury stock, like cash dividends, are distributions of assets to the stockholders in the corporation. Many states have a legal requirement that distributions to stockholders (in- cluding purchases of treasury stock) cannot exceed the balance in the Retained Earnings account. Therefore, retained earnings usually are restricted by an amount equal to the cost of any shares held in the treasury.

Stock Buyback Programs

Historically, most treasury stock transactions involved relatively small dollar amounts. Hence, the topic was not of much importance to investors or other users of financial state- ments. Recently, however, many corporations initiated buyback programs, in which they

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repurchased large amounts of their own common stock.3 As a result of these programs, treasury stock has become a material item in the balance sheets of many corporations.

Financial Analysis 485

Shown below is the cost of the treasury stock listed in the balance sheets of several publicly owned corporations at the end of a recent year.

C A S E I N P O I N T

Treasury Stock

As a % of Other Elements of

At Cost Stockholders’ Company (in thousands) Equity*

Coca-Cola . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,201,194 57

ExxonMobil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,887,000 33

King World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162,054 32

Home Depot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 9

*To place these holdings in perspective, we have shown the cost of the treasury stock as a percentage of total stock- holders’ equity before deducting the cost of the repurchased shares.

Stock buyback programs serve several purposes. First, by creating demand for the com- pany’s stock in the marketplace, these programs tend to increase the market value of the shares. Also, reducing the number of shares outstanding usually increases earnings per share. When stock prices are low, some companies find that they can increase earnings per share by a greater amount through repurchasing shares than through expanding business operations.

Transactions between the corporation and its stockholders are classified in the statement of cash flows as financing activities. When treasury stock is purchased, a financing cash out- flow is reported in the statement of cash flows. When treasury stock is reissued, the amount of cash received is reported as a financing cash inflow in the statement of cash flows.

Because treasury stock transactions do not give rise to gains or losses, they have no ef- fect on the corporation’s net income. Any difference between the purchase price of the trea- sury stock and the cash received when it is reissued is reported as an increase or decrease in the corporation’s paid-in capital.

CASH EFFECTS

3 On October 19, 1987, a date known as “Black Monday,” stocks around the world suffered a record one-day de- cline. Within hours of the market’s close on Black Monday, many large corporations announced their intention to enter the market and spend hundreds of millions of dollars repurchasing their own shares. In the opinion of the au- thors, these announcements helped stabilize the investment markets and avoided a possible stock market collapse.

FINANCIAL ANALYSIS

The following information was taken from a recent annual report of Microsoft Corporation (in millions):

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,421 Preferred stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13 Average number of common shares outstanding . . . . . . . . . . . . . . . . . . . . . 5,196 Average common stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,520 Average total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $34,903

Several frequently used measures of profitability that are based, in part, on capital stock concepts covered in this chapter can be derived from the above figures:

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Using the figures provided, Microsoft’s three profitability measures would be:

Earnings per share: ($9,421 � $13) � 5,196 shares � $1.81 Return on common stockholders’ equity: ($9,421 � $13) � $18,520 � 51% Return on equity: $9,421 � $34,903 � 27%

CONCLUDING REMARKS

In this chapter, we covered the aspects of stockholders’ equity that result primarily from various transactions between the company and its stockholders, including the sale and re- purchase of capital stock. We explored different characteristics of stock, including the unique features of preferred stock.

Another major source of stockholders’ equity is the accumulated earnings of previ- ous years that have been retained for purposes of expansion and meeting other business objectives. This is the subject of Chapter 12, which follows. While paid-in capital and retained earnings are two distinct aspects of stockholders’ equity, they are closely re- lated and, therefore, are virtually impossible to discuss totally independently of each other. For that reason, in this chapter there are occasional references to retained earn- ings. Similarly, in Chapter 12 you will find references to common and preferred stock, additional paid-in capital, treasury stock, and other aspects of stockholders’ equity that we covered primarily in Chapter 11. Combining the content of Chapters 11 and 12, you will have a good working knowledge of stockholders’ equity and how it fits together with assets and liabilities to form the basis for a company’s balance sheet.

486 Chapter 11 Stockholders’ Equity: Paid-In Capital

Profitability Measure Computation Significance

Earnings per share Net income applicable to each share of common stock

Return on common The rate of return earned on the common stockholders’ equity stockholders’ equity appropriate when company

has both common and preferred stock

Return on equity The rate of return earned on the stockholders’ equity in the business

Net income � Preferred Dividends Average Number of Common Shares Outstanding

Net income Average Total Equity

Net income � Preferred Dividends Average Common Stockholders’ Equity

We began this chapter by looking at Sears and observing that this company, like many others, has a policy of investing in its own stock. An unusual feature of Sears is that the amount of treasury stock in the 2002 balance sheet is greater than the amount of its out- standing common stock. Combining the par value of common stock with the additional paid-in capital in excess of par value, the balance sheet includes $3,828 million for com- mon stock issued. Treasury stock is included in the same balance sheet at $4,474 million. Does this mean that Sears has repurchased more stock than it issued?

The answer to this question is obviously no. A company could not repurchase more shares of its own stock than it originally sold. The explanation lies in the fact that the stock originally sold at lower prices than the prices that were paid to repurchase the treasury shares. The $3,828 million represents the amount received from the original sale of ap- proximately 317 million shares. This means that the stock was originally sold at an average price of slightly over $12 per share. The treasury stock amount of $4,474 million represents the cost of shares repurchased in recent years at higher prices than the prices at which the shares originally sold. Therefore, even though the 2002 balance sheet shows more dollars of stockholders’ equity in treasury shares than in the paid-in capital accounts for common stock, Sears still has a significant number of outstanding shares of common stock.

A SECOND LOOK

LOOK LOOK LOOK

SEARS, ROEBUCK & COMPANY

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SUMMARY OF LEARNING OBJECTIVES

Discuss the advantages and disadvantages of organizing a business as a corporation. The primary advantages are no personal liability of stockholders for the debts of the business, the transferability of ownership shares, continuity of existence, ability to hire professional man- agement, and the relative ease of accumulating large amounts of capital. The primary disadvantages are double taxation of earn- ings and greater governmental regulation.

Distinguish between publicly owned and closely held corporations. The stock of publicly owned corporations is available for pur- chase by the general public, usually on an organized stock ex- change. Stock in a closely held corporation, in contrast, is not available to the public.

Publicly owned corporations tend to be so large that individ- ual stockholders seldom control the corporation; in essence, most stockholders in publicly owned companies are investors, rather than owners in the traditional sense. Closely held corpora- tions usually are quite small, and one or two stockholders often do exercise control. Publicly owned corporations are subject to more government regulation than are closely held companies, and they must disclose to the public much information about their business operations.

Explain the rights of stockholders and the roles of corporate directors and officers. Stockholders in a corporation normally have the right to elect the board of directors, to share in dividends declared by the direc- tors, and to share in the distribution of assets if the corporation is liquidated.

The directors formulate company policies, review the actions of the corporate officers, and protect the interests of the company’s stockholders. Corporate officers are professional managers appointed by the board of directors to manage the business on a daily basis.

Account for paid-in capital and prepare the equity section of a corporate balance sheet. When capital stock is issued, appropriate asset accounts are deb- ited for cash or the market value of the goods or services re- ceived in exchange for the stock. A capital stock account (which indicates the type of stock issued) is credited for the par value of the issued shares. Any excess of the market value received over the par value of the issued shares is credited to an Additional Paid-in Capital account.

The equity section of a corporate balance sheet shows for each class of capital stock outstanding (1) the total par value (legal capital) and (2) any additional paid-in capital. Together,

these amounts represent the corporation’s total paid-in capital. In addition, the equity section shows separately any earned capital—that is, retained earnings.

Contrast the features of common stock with those of preferred stock. Common stock represents the residual ownership of a corpora- tion. These shares have voting rights and cannot be called. Also, the common stock dividend is not fixed in dollar amount—thus it may increase or decrease based on the com- pany’s performance.

Preferred stock has preference over common stock with re- spect to dividends and to distributions in the event of liquidation. This preference means that preferred stockholders must be paid in full before any payments are made to holders of common stock. The dividends on preferred stock usually are fixed in amount. In addition, the stock often has no voting rights. Pre- ferred stocks sometimes have special features, such as being convertible into shares of common stock.

Discuss the factors affecting the market price of preferred stock and common stock. The market price of preferred stock varies inversely with interest rates. As interest rates rise, preferred stock prices decline; as in- terest rates fall, preferred stock prices rise. If a company’s abil- ity to continue the preferred dividend is in doubt, this may affect preferred stock prices.

Interest rates also affect the market price of common stock. However, common stock dividends are not fixed in amount. Both the amount of the dividend and the market value of the stock may fluctuate, based on the prosperity of the company. Therefore, the principal factor in the market price of common stock is investors’ expectations as to the future profitability of the company.

Explain the significance of par value, book value, and market value of capital stock. Par value has the least significance. It is a legal concept, repre- senting the amount by which stockholders’ equity cannot be re- duced except by losses. Intended as a buffer for the protection of creditors, it usually is so low as to be of little significance.

Book value per share is the net assets per share of common stock. This value is based on amounts invested by stockholders, plus retained earnings. It often provides insight into the reason- ableness of market price.

To investors, market price is the most relevant of the three values. This is the price at which they can buy or sell the stock today. Changes in market price directly affect the financial posi- tion of the stockholder, but not of the issuing company. There- fore, market values do not appear in the equity section of the issuing company’s balance sheet—but they are readily available in the daily newspaper and on the Internet.

End-of-Chapter Review

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Explain the purpose and effects of a stock split. When the market price of a corporation’s common stock appre- ciates in value significantly, it may become too expensive for many investors. When this happens, the corporation may split its stock by increasing the number of its common shares outstand- ing. The purpose of a stock split is to reduce the market price of the company’s common stock, with the intent of making it more affordable to investors. A stock split does not change the balance of any ledger account; consequently, the transaction is recorded merely by a memorandum entry.

Account for treasury stock transactions. Purchases of treasury stock are recorded by establishing a contra-equity account entitled Treasury Stock. No profit or loss is recorded when the treasury shares are reissued at a price above or below cost. Rather, any difference between the reis- suance price and the cost of the shares is debited or credited to a paid-in capital account. While treasury stock transactions may affect cash flow, they have no effect on the net income of the corporation.

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KEY TERMS INTRODUCED OR EMPHASIZED IN CHAPTER 11

Additional Paid-in Capital (p. 473) An account showing the amounts invested in a corporation by stockholders in excess of par value or stated value. In short, this account shows paid-in capital in excess of legal capital.

board of directors (p. 469) Persons elected by common stock- holders to direct the affairs of a corporation.

book value per share (p. 478) The stockholders’ equity repre- sented by each share of common stock, computed by dividing common stockholders’ equity by the number of common shares outstanding.

capital stock (p. 467) Transferable units of ownership in a cor- poration. A broad term that can refer to common stock, preferred stock, or both.

closely held corporation (p. 468) A corporation owned by a small group of stockholders. Not publicly owned.

common stock (p. 474) A type of capital stock that possesses the basic rights of ownership, including the right to vote. Repre- sents the residual element of ownership in a corporation.

contributed capital (p. 472) The stockholders’ equity that results from capital contributions by investors in exchange for shares of common or preferred stock. Also referred to as paid-in capital.

corporation (p. 466) A business organized as a legal entity separate from its owners. Chartered by the state with ownership divided into shares of transferable stock. Stockholders are not li- able for debts of the corporation.

dividends (p. 475) Distribution of assets (usually cash) by a corporation to its stockholders. Normally viewed as a distribu- tion of profits, dividends cannot exceed the amount of retained earnings. Must be formally declared by the board of directors and distributed on a per-share basis. Note: Stockholders cannot simply withdraw assets from a corporation at will.

dividend yield (p. 480) The annual dividend paid to a share of stock, expressed as a percentage of the stock’s market value. In- dicates the rate of return represented by the dividend.

double taxation (p. 466) The fact that corporate income is taxed to the corporation when earned and then again taxed to the stockholders when distributed as dividends.

legal capital (p. 472) Equal to the par value or stated value of capital stock issued. This amount represents a permanent com-

mitment of capital by the owners of a corporation and cannot be removed without special legal action. Of course, it may be eroded by losses.

limited personal liability (p. 467) The concept that the own- ers of a corporation are not personally liable for the debts of the business. Thus stockholders’ potential financial losses are lim- ited to the amount of their equity investment.

paid-in capital (p. 472) The amounts invested in a corporation by its stockholders.

par value (or stated value) (p. 472) The legal capital of a cor- poration. Represents the minimum amount per share invested in the corporation by its owners and cannot be withdrawn except by special legal action.

preferred stock (p. 474) A class of capital stock usually hav- ing preferences as to dividends and in the distribution of assets in event of liquidation.

public information (p. 468) Information that, by law, must be made available to the general public. Includes the quarterly and annual financial statements—and other financial information— about publicly owned corporations.

publicly owned corporation (p. 468) Any corporation whose shares are offered for sale to the general public.

retained earnings (p. 472) The element of owners’ equity in a corporation that has accumulated through profitable business op- erations. Net income increases retained earnings; net losses and dividends reduce retained earnings.

state of incorporation (p. 468) The state in which the corpo- ration is legally formed. This may or may not be the state in which the corporation conducts most or any of its business.

stock certificate (p. 469) A document issued by a corporation (or its transfer agent) as evidence of the ownership of the num- ber of shares stated on the certificate.

stockholders (p. 466) The owners of a corporation. The name reflects the fact that their ownership is evidenced by transferable shares of capital stock.

stockholders subsidiary ledger (p. 471) A record showing the number of shares owned by each stockholder.

stock registrar (p. 471) An independent fiscal agent, such as a bank, retained by a corporation to provide assurance against overissuance of stock certificates.

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stock split (p. 482) An increase in the number of shares out- standing with a corresponding decrease in par value per share. The additional shares are distributed proportionately to all com- mon shareholders. The purpose of a stock split is to reduce mar- ket price per share and encourage wider public ownership of the company’s stock. A 2-for-1 stock split will give each stockholder twice as many shares as previously owned.

stock transfer agent (p. 471) A bank or trust company re- tained by a corporation to maintain its records of capital stock ownership and make transfers from one investor to another.

treasury stock (p. 482) Shares of a corporation’s stock that have been issued and then reacquired, but not canceled.

underwriter (p. 472) An investment banking firm that handles the sale of a corporation’s stock to the public.

Demonstration Problem 489

DEMONSTRATION PROBLEM

The stockholders’ equity section of Elmwood Corporation’s balance sheet appears as follows:

Stockholders’ equity:

8% preferred stock, $100 par value, 200,000 shares authorized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000,000

Common stock, $5 par value, 5,000,000 shares authorized . . . . . . . . . . . . . . . 14,000,000

Additional paid-in capital:

Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 360,000

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,800,000 31,160,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,680,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $59,840,000

Par value of common shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,000,000

Additional paid-in capital on common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,800,000

Total issue price of common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $44,800,000

Number of common shares issued (part c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,800,000

Average issue price per share ($44,800,000 � 2,800,000 shares) . . . . . . . . . . $16

Instructions On the basis of this information, answer the following questions and show any necessary support- ing computations: a. How many shares of preferred stock have been issued? b. What is the total annual dividend requirement on the outstanding preferred stock? c. How many shares of common stock have been issued? d. What was the average price per share received by the corporation for its common stock? e. What is the total amount of legal capital? f. What is the total paid-in capital? g. What is the book value per share of common stock? (Assume no dividends in arrears.)

Solution to the Demonstration Problem a. 120,000 shares ($12,000,000 total par value, divided by $100 par value per share) b. $960,000 (120,000 shares outstanding � $8 per share) c. 2,800,000 shares ($14,000,000 total par value, divided by $5 par value per share) d.

e. $26,000,000 ($12,000,000 preferred, $14,000,000 common) f. $57,160,000 ($26,000,000 legal capital, plus $31,160,000 additional paid-in capital)

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The answers to these questions appear on page 501.

1. When a business is organized as a corporation, which of the following is true?

a. Stockholders are liable for the debts of the business in proportion to their percentage own- ership of capital stock.

b. Stockholders do not have to pay personal income taxes on dividends received, because the corporation is subject to income taxes on its earnings.

c. Fluctuations in the market value of outstanding shares of capital stock do not affect the amount of stockholders’ equity shown in the balance sheet.

d. Each stockholder has the right to bind the corporation to contracts and to make other managerial decisions.

2. Western Moving Corporation was organized with authorization to issue 100,000 shares of $1 par value common stock. Forty thousand shares were issued to Tom Morgan, the company’s founder, at a price of $5 per share. No other shares have yet been issued. Which of the fol- lowing statements is true?

a. Morgan owns 40 percent of the stockholders’ equity of the corporation.

b. The corporation should recognize a $160,000 gain on the issuance of these shares.

c. If the balance sheet includes retained earnings of $50,000, total paid-in capital amounts to $250,000.

d. In the balance sheet, the Additional Paid-in Capital account will have a $160,000 balance, regardless of the profits earned or losses incurred since the corporation was organized.

3. Which of the following is not a characteristic of the common stock of a large, publicly owned corporation?

a. The shares may be transferred from one investor to another without disrupting the conti- nuity of business operations.

b. Voting rights in the election of the board of directors.

c. A cumulative right to receive dividends.

d. After issuance, the market value of the stock is unrelated to its par value.

4. Tri-State Electric is a profitable utility company that has increased its dividend to common stockholders every year for 42 consecutive years. Which of the following is least likely to affect the market price of the company’s preferred stock by a significant amount?

a. A decrease in long-term interest rates.

b. An increase in long-term interest rates.

c. The board of directors announces its intention to increase common stock dividends in the current year.

d. Whether or not the preferred stock carries a conversion privilege.

5. The following information is taken from the balance sheet and related disclosures of Maxwell, Inc.:

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Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $59,840,000

Less: Claims of preferred stockholders (120,000 shares � $100) . . . . . . . . . . . 12,000,000

Equity of common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $47,840,000

Number of common shares outstanding (part c) . . . . . . . . . . . . . . . . . . . . . . . . 2,800,000

Book value per share ($47,840,000 � 2,800,000 shares) . . . . . . . . . . . . . . . . . $17.09

SELF-TEST QUESTIONS

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Which of the following statements is (are) true? (For this question, more than one answer may be correct.)

a. The preferred dividends in arrears amount to $120,000 and should appear as a liability in the corporate balance sheet.

b. The book value per share of common stock is $35.

c. The stockholders’ equity section of the balance sheet should indicate a deficit (negative amount in retained earnings) of $700,000.

d. The company has paid no dividend on its common stock during the past two years.

6. On December 10, 2004, Smitty Corporation reacquired 2,000 shares of its own $5 par stock at a price of $60 per share. In 2005, 500 of the treasury shares are reissued at a price of $70 per share. Which of the following statements is correct?

a. The treasury stock purchased is recorded at cost and is shown in Smitty’s December 31, 2004, balance sheet as an asset.

b. The two treasury stock transactions result in an overall net reduction in Smitty’s stock- holders’ equity of $85,000.

c. Smitty recognizes a gain of $10 per share on the reissuance of the 500 treasury shares in 2005.

d. Smitty’s stockholders’ equity was increased by $110,000 when the treasury stock was acquired.

Discussion Questions 491

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,400,000

Outstanding shares:

Common stock, $5 par value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 shares

6% preferred stock, $100 par value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 shares

Preferred dividends in arrears . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 years

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,700,000

DISCUSSION QUESTIONS

Assignment Material

1. Why are large corporations often said to be publicly owned?

2. Distinguish between corporations and sole proprietorships in terms of the following charac- teristics:

a. Owners’ liability for debts of the business.

b. Transferability of ownership interest.

c. Continuity of existence.

d. Federal taxation on income.

3. What are the basic rights of the owner of a share of corporate stock? In what way are these ba- sic rights commonly modified with respect to the owner of a share of preferred stock?

4. Explain the meaning of the term double taxation as it applies to corporate profits.

5. Distinguish between paid-in capital and retained earnings of a corporation. Why is such a dis- tinction useful?

6. Explain the significance of par value. Does par value indicate the reasonable market price for a share of stock? Explain.

7. Describe the usual nature of the following features as they apply to a share of preferred stock: (a) cumulative, and (b) convertible.

8. Why is noncumulative preferred stock often considered an unattractive form of investment?

9. State the balance sheet or income statement classification (asset, liability, stockholders’ equity, revenue, or expense) of each of the following accounts:

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a. Cash (received from the issuance of capital stock)

b. Organization Costs

c. Preferred Stock

d. Retained Earnings

e. Additional Paid-in Capital

f. Income Taxes Payable

10. Explain the following terms:

a. Stock transfer agent

b. Stockholders subsidiary ledger

c. Underwriter

d. Stock registrar

11. What does book value per share of common stock represent? Does it represent the amount com- mon stockholders would receive in the event of liquidation of the corporation? Explain briefly.

12. How is book value per share of common stock computed when a company has both preferred and common stock outstanding?

13. What would be the effect, if any, on book value per share of common stock as a result of each of the following independent events: (a) a corporation obtains a bank loan; (b) a dividend is declared (to be paid in the next accounting period)?

14. In the stock market crash of October 19, 1987, the market price of IBM’s capital stock fell by over $31 per share. Explain the effects, if any, of this decline in share price on IBM’s balance sheet.

15. Assume that you asked your stockbroker to purchase 100 shares of ExxonMobil Corporation stock. How would this transaction affect the financial statements of ExxonMobil? Explain.

16. What is the purpose of a stock split?

17. What is treasury stock? Why do corporations purchase their own shares? Is treasury stock an asset? How should it be reported in the balance sheet?

18. In many states, the corporation law requires that retained earnings be restricted for dividend purposes to the extent of the cost of treasury shares. What is the reason for this legal rule?

19. The basic accounting equation for a corporation is Assets � Liabilities � Stockholders’ Eq- uity. Stockholders’ equity is further divided into two categories, paid-in capital and retained earnings. What are the major transactions and other financial activities that impact the amount of paid-in capital of a corporation? Identify for each major type of transaction or activity whether it increases or decreases the amount of paid-in capital.

20. If you were going to start a corporation and expected to need to raise capital from several in- vestors, would you include preferred stock in your capital structure? Why or why not? If your answer is that you would include preferred stock, what features would you incorporate into this class of stock?

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EXERCISES

EXERCISE 11.1

Form of Organization

Assume that you have recently obtained your scuba instructor’s certification and have decided to start a scuba diving school.

a. Describe the advantages and disadvantages of organizing your scuba diving school as a:

1. Sole proprietorship

2. Corporation

b. State your opinion about which form of organization would be best and explain the basis for your opinion.

Listed below are 12 technical accounting terms discussed in this chapter:

Par value Board of directors Double taxation Book value Paid-in capital Dividends in arrears

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EXERCISE 11.2

Accounting Terminology

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Market value Preferred stock Closely held corporation Retained earnings Common stock Publicly owned corporation

Each of the following statements may (or may not) describe one of these technical terms. For each statement, indicate the term described, or answer “None” if the statement does not correctly de- scribe any of the terms.

a. A major disadvantage of the corporate form of organization.

b. From investors’ point of view, the most important value associated with capital stock.

c. Cash available for distribution to the stockholders.

d. The class of capital stock that normally has the most voting power.

e. A distribution of assets that may be made in future years to the holders of common stock.

f. The group of stockholders that controls more than 50 percent of a corporation’s voting shares.

g. A corporation whose shares are traded on an organized stock exchange.

h. Equity arising from investments by owners.

i. The element of stockholders’ equity that is increased by net income.

j. Total assets divided by the number of common shares outstanding.

k. The class of stock whose market price normally rises as interest rates increase.

When Resisto Systems, Inc., was formed, the company was authorized to issue 5,000 shares of $100 par value, 8 percent cumulative preferred stock, and 100,000 shares of $2 stated value com- mon stock.

Half of the preferred stock was issued at a price of $103 per share, and 70,000 shares of the common stock were sold for $13 per share. At the end of the current year, Resisto has retained earn- ings of $382,000.

a. Prepare the stockholders’ equity section of the company’s balance sheet at the end of the cur- rent year.

b. Assume Resisto Systems’ common stock is trading at $24 per share and its preferred stock is trading at $107 per share at the end of the current year. Would the stockholders’ equity section prepared in part a be affected by this additional information?

A portion of the stockholders’ equity section from the balance sheet of Walland Corporation ap- pears as follows:

Exercises 493

EXERCISE 11.3

Stockholders’ Equity Section of a Balance Sheet

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EXERCISE 11.4

Dividends: Preferred and Common

LO4 LO5 Stockholders’ equity:

Preferred stock, 9% cumulative, $50 par, 40,000 shares authorized and issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000

Preferred stock, 12% noncumulative, $100 par, 8,000 shares authorized and issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Common stock, $5 par, 400,000 shares authorized and issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,800,000

Assume that all the stock was issued on January 1 and that no dividends were paid during the first two years of operation. During the third year, Walland Corporation paid total cash dividends of $736,000.

a. Compute the amount of cash dividends paid during the third year to each of the three classes of stock.

b. Compute the dividends paid per share during the third year for each of the three classes of stock.

c. What was the average issue price of each type of preferred stock?

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

The number of issued and outstanding shares of both preferred and common stock have been the same for the last two years. Dividends on preferred stock are 8 percent of par value and have been paid each year the stock was outstanding except for the immediate past year. In the current year, management declares a total dividend of $50,000. Indicate the amount that will be paid to both pre- ferred and common stockholders assuming (a) the preferred stock is not cumulative and (b) the pre- ferred stock is cumulative.

Three events pertaining to Lean Manufacturing Co. are described below.

a. Issued common stock for cash.

b. The market value of the corporation’s stock increased.

c. Declared and paid a cash dividend to stockholders.

Indicate the immediate effects of the events on the financial measurements in the four columnar headings listed below. Use the code letters I for increase, D for decrease, and NE for no effect.

The year-end balance sheet of Jackson Products, Inc., includes the following stockholders’ equity section (with certain details omitted):

494 Chapter 11 Stockholders’ Equity: Paid-In Capital

EXERCISE 11.6

Preferred Stock Alternatives

LO5 LO6

EXERCISE 11.7

Reporting the Effects of Transactions

LO4 LO7

Stockholders’ equity:

Capital stock:

7% cumulative preferred stock, $100 par value, . . . . . . . . . . . . . . . . . . . . . . $ 15,000,000

Common stock, $5 par value, 5,000,000 shares authorized, 4,000,000 shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000,000

Additional paid-in capital:

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,000,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,450,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $143,450,000

Preferred stock— $25 par value, 10,000 shares authorized, 7,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . $175,000

Common stock — $10 par value, 100,000 shares authorized, 80,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . 800,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $975,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,525,000

Net Cash Flow Current Stockholders’ Net (from any

Event Assets Equity Income source)

From this information, compute answers to the following questions:

a. How many shares of preferred stock have been issued?

b. What is the total amount of the annual dividends paid to preferred stockholders?

c. What was the average issuance price per share of common stock?

d. What is the amount of legal capital and the amount of total paid-in capital?

e. What is the book value per share of common stock?

f. Is it possible to determine the fair market value per share of common stock from the stock- holders’ equity section above? Explain.

Walker, Inc., has the following capital structure:

EXERCISE 11.5

Analyzing Stockholders’ Equity

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Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

The following information is necessary to compute the net assets (stockholders’ equity) and book value per share of common stock for Rothchild Corporation:

Exercises 495

EXERCISE 11.8

Computing Book Value

LO4 LO7through

EXERCISE 11.9

Recording Treasury Stock Transactions

LO9

EXERCISE 11.10

Effects of a Stock Split

LO8

EXERCISE 11.12

Authorized Stock

LO4

EXERCISE 11.13

Using the Tootsie Roll Industries, Inc., Annual Report

LO4 LO7

EXERCISE 11.11

Treasury Stock Presentation

LO9

8% cumulative preferred stock, $100 par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000

Common stock, $5 par, authorized 100,000 shares, issued 60,000 shares . . . . . . 300,000

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452,800

Deficit (negative amount in retained earnings) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146,800

Dividends in arrears on preferred stock, 1 full year . . . . . . . . . . . . . . . . . . . . . . . . . 16,000

a. Compute the amount of net assets (stockholders’ equity).

b. Compute the book value per share of common stock.

c. Is book value per share (answer to part b) the amount common stockholders should expect to receive if Rothchild Corporation were to cease operations and liquidate? Explain.

Johnston, Inc., engaged in the following transactions involving treasury stock:

Feb. 10 Purchased for cash 17,000 shares of treasury stock at a price of $25 per share.

June 4 Reissued 6,000 shares of treasury stock at a price of $33 per share.

Dec. 22 Reissued 4,000 shares of treasury stock at a price of $22 per share.

a. Prepare general journal entries to record these transactions.

b. Compute the amount of retained earnings that should be restricted because of the treasury stock still owned at December 31.

c. Does a restriction on retained earnings affect the dollar amount of retained earnings reported in the balance sheet? Explain briefly.

The common stock of Fido Corporation was trading at $45 per share on October 15, 2004. A year later, on October 15, 2005, it was trading at $80 per share. On this date, Fido’s board of directors decided to split the company’s common stock.

a. If the company decides on a 2-for-1 split, at what price would you expect the stock to trade im- mediately after the split goes into effect?

b. If the company decides on a 4-for-1 split, at what price would you expect the stock to trade im- mediately after the split goes into effect?

c. Why do you think Fido’s board of directors decided to split the company’s stock?

Albert Company was experiencing financial difficulty late in the current year. The company’s in- come was sluggish, and the market price of its common stock was tumbling. On December 21, the company began to buy back shares of its own stock in an attempt to boost its market price per share and to improve its earnings per share.

a. Is it unethical for a company to purchase shares of its own stock to improve measures of fi- nancial performance? Defend your answer.

b. Assume that the company classified the shares of treasury stock as short-term investments in the current asset section of its balance sheet. Is this appropriate? Explain.

The 2002 balance sheet for Sears indicates that the company has 1,000 million shares of common stock authorized of which approximately 317 million are outstanding.

a. How many additional shares of common stock could Sears sell?

b. How are the shares that have not yet been issued included in the company’s balance sheet? Do they represent an asset of the company?

The annual report of Tootsie Roll Industries, Inc., appears in Appendix A of this text. This report contains information describing the details of the company’s stockholders’ equity.

a. What are the par values of the company’s two classes of common stock? Did the common stock originally sell at, above, or below par value? How do you know this?

b. For the most current year shown, how many shares of each class of common stock are autho- rized? What is the meaning of authorized shares?

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

c. What is the total stockholders’ equity amount for Tootsie Roll for the most recent year re- ported? Does this figure mean that the total outstanding stock is actually worth this amount? Explain your answer.

496 Chapter 11 Stockholders’ Equity: Paid-In Capital

PROBLEMS

PROBLEM 11.1

Stockholders’ Equity in a Balance Sheet

Early in 2002, Robbinsville Press was organized with authorization to issue 100,000 shares of $100 par value preferred stock and 500,000 shares of $1 par value common stock. Ten thousand shares of the preferred stock were issued at par, and 170,000 shares of common stock were sold for $15 per share. The preferred stock pays an 8 percent cumulative dividend.

During the first four years of operations (2002 through 2005), the corporation earned a total of $1,085,000 and paid dividends of 75 cents per share in each year on its outstanding common stock.

Instructions a. Prepare the stockholders’ equity section of the balance sheet at December 31, 2005. Include a

supporting schedule showing your computation of the amount of retained earnings reported. (Hint: Income increases retained earnings, whereas dividends decrease retained earnings.)

b. Are there any dividends in arrears on the company’s preferred stock at December 31, 2005? Explain your answer.

Waller Publications was organized early in 2000 with authorization to issue 20,000 shares of $100 par value preferred stock and 1 million shares of $1 par value common stock. All of the preferred stock was issued at par, and 300,000 shares of common stock were sold for $20 per share. The pre- ferred stock pays a 10 percent cumulative dividend.

During the first five years of operations (2000 through 2004) the corporation earned a total of $4,460,000 and paid dividends of $1 per share each year on the common stock. In 2005, however, the corporation reported a net loss of $1,750,000 and paid no dividends.

Instructions a. Prepare the stockholders’ equity section of the balance sheet at December 31, 2005. Include a

supporting schedule showing your computation of retained earnings at the balance sheet date. (Hint: Income increases retained earnings, whereas dividends and net losses decrease retained earnings.)

b. Draft a note to accompany the financial statements disclosing any dividends in arrears at the end of 2005.

c. Do the dividends in arrears appear as a liability of the corporation as of the end of 2005? Explain.

Maria Martinez organized Manhattan Transport Company in January 2002. The corporation im- mediately issued at $8 per share one-half of its 200,000 authorized shares of $2 par value com- mon stock. On January 2, 2003, the corporation sold at par value the entire 5,000 authorized shares of 8 percent, $100 par value, cumulative preferred stock. On January 2, 2004, the com- pany again needed money and issued 5,000 shares of an authorized 10,000 shares of no-par, cu- mulative preferred stock for a total of $512,000. The no-par shares have a stated dividend of $9 per share.

The company declared no dividends in 2002 and 2003. At the end of 2003, its retained earnings were $170,000. During 2004 and 2005 combined, the company earned a total of $890,000. Divi- dends of 50 cents per share in 2004 and $1.60 per share in 2005 were paid on the common stock.

Instructions a. Prepare the stockholders’ equity section of the balance sheet at December 31, 2005. Include a

supporting schedule showing your computation of retained earnings at the balance sheet date. (Hint: Income increases retained earnings, whereas dividends decrease retained earnings.)

b. Assume that on January 2, 2003, the corporation could have borrowed $500,000 at 8 percent interest on a long-term basis instead of issuing the 5,000 shares of the $100 par value cumula- tive preferred stock. Identify two reasons a corporation may choose to issue cumulative pre- ferred stock rather than finance operations with long-term debt.

LO4 LO6through

PROBLEM 11.2

Stockholders’ Equity Section

LO4 LO6through

PROBLEM 11.3

Stockholders’ Equity in a Balance Sheet

LO4 LO6through

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Early in the year Bill Barnes and several friends organized a corporation called Barnes Communi- cations, Inc. The corporation was authorized to issue 50,000 shares of $100 par value, 10 percent cumulative preferred stock and 400,000 shares of $2 par value common stock. The following trans- actions (among others) occurred during the year:

Jan. 6 Issued for cash 20,000 shares of common stock at $14 per share. The shares were is- sued to Barnes and 10 other investors.

Jan. 7 Issued an additional 500 shares of common stock to Barnes in exchange for his ser- vices in organizing the corporation. The stockholders agreed that these services were worth $7,000.

Jan. 12 Issued 2,500 shares of preferred stock for cash of $250,000.

June 4 Acquired land as a building site in exchange for 15,000 shares of common stock. In view of the appraised value of the land and the progress of the company, the directors agreed that the common stock was to be valued for purposes of this transaction at $15 per share.

Nov. 15 The first annual dividend of $10 per share was declared on the preferred stock to be paid December 20. (Hint: Record the dividend by debiting Dividends and crediting Dividends Payable.)

Dec. 20 Paid the cash dividend declared on November 15.

Dec. 31 After the revenue and expenses were closed into the Income Summary account, that account indicated a net income of $147,200.

Instructions a. Prepare journal entries in general journal form to record the above transactions. Include entries

at December 31 to close the Income Summary account and the Dividends account.

b. Prepare the stockholders’ equity section of the Barnes Communications, Inc., balance sheet at December 31.

The year-end balance sheet of Smithfield Products includes the following stockholders’ equity sec- tion (with certain details omitted):

Problems 497

PROBLEM 11.4

Stockholders’ Equity: A Short Comprehensive Problem

LO4 LO5

PROBLEM 11.5

Analysis of an Equity Section of a Balance Sheet

LO4 LO5 Stockholders’ equity:

7 1/2% cumulative preferred stock, $100 par value, 100,000 shares authorized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,400,000

Common stock, $2 par value, 900,000 shares authorized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000

Additional paid-in capital: Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,325,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,595,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $14,220,000

Instructions From this information, compute answers to the following questions:

a. How many shares of preferred stock have been issued?

b. What is the total amount of the annual dividends paid to preferred stockholders?

c. How many shares of common stock are outstanding?

d. What was the average issuance price per share of common stock?

e. What is the amount of legal capital?

f. What is the total amount of paid-in capital?

g. What is the book value per share of common stock? (There are no dividends in arrears.)

h. Assume that retained earnings at the beginning of the year amounted to $717,500 and that net income for the year was $3,970,000. What was the dividend declared during the year on each share of common stock? (Hint: Net income increases retained earnings, whereas dividends de- crease retained earnings.)

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Quanex Corporation is a publicly owned company. The following information is excerpted from a recent balance sheet. Dollar amounts (except for per share amounts) are stated in thousands.

498 Chapter 11 Stockholders’ Equity: Paid-In Capital

Stockholders’ equity:

Convertible $17.20 preferred stock, 250 par value, 1,000,000 shares authorized; 345,000 shares issued and outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 86,250

Common stock, par value $0.50; 25,000,000 shares authorized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,819

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,260

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,263

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $237,592

Instructions From this information, answer the following questions:

a. How many shares of common stock have been issued?

b. What is the total amount of the annual dividends paid to preferred stockholders?

c. What is the total amount of paid-in capital?

d. What is the book value per share of common stock?

e. Briefly explain the advantages and disadvantages to Quanex of being publicly owned rather than operating as a closely held corporation.

f. What is meant by the term convertible used in the caption of the preferred stock? Is there any more information that investors need to know to evaluate this conversion feature?

g. Assume that the preferred stock currently is selling at $248 per share. Does this provide a higher or lower dividend yield than an 8 percent, $50 par value preferred with a market price of $57 per share? Show computations (round to the nearest tenth of 1 percent). Explain why one preferred stock might yield less than another.

Techno Corporation is the producer of popular business software. Recently, an investment service published the following per-share amounts relating to the company’s only class of stock:

PROBLEM 11.6

Analysis of an Equity Section—More Comprehensive

LO1 LO7through

PROBLEM 11.7

Par, Book, and Market Values

LO4 LO7

PROBLEM 11.8

Reporting Stockholders’ Equity with Treasury Stock

LO4 LO5 LO7 LO9

Par value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 0.001

Book value (estimated) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.50

Market value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $65.00

Instructions a. Without reference to dollar amounts, explain the nature and significance of par value, book

value, and market value.

b. Comment on the relationships, if any, among the per-share amounts shown for the company. What do these amounts imply about Techno Corporation and its operations? Comment on what these amounts imply about the security of creditors’ claims against the company.

Early in 2003, Feller Corporation was formed with authorization to issue 50,000 shares of $1 par value common stock. All shares were issued at a price of $8 per share. The corporation reported net income of $82,000 in 2003, $25,000 in 2004, and $78,000 in 2005. No dividends were declared in any of these three years.

In 2004, the company purchased $35,000 of its own shares in the open market. In 2005, it reis- sued all of its treasury stock for $40,000.

Instructions a. Prepare the stockholders’ equity section of the balance sheet at December 31, 2005. Include a

supporting schedule showing your computation of retained earnings at the balance sheet date. (Hint: Income increases retained earnings.)

b. As of December 31, compute the company’s book value per share of common stock.

c. Explain how the treasury stock transactions in 2004 and 2005 were reported in the company’s statement of cash flows.

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Early in 2001, Herndon Industries was formed with authorization to issue 200,000 shares of $10 par value common stock and 30,000 shares of $100 par value cumulative preferred stock. During 2001, all the preferred stock was issued at par, and 120,000 shares of common stock were sold for $16 per share. The preferred stock is entitled to a dividend equal to 10 percent of its par value be- fore any dividends are paid on the common stock.

During its first five years of business (2001 through 2005), the company earned income totaling $3,700,000 and paid dividends of 50 cents per share each year on the common stock outstanding.

On January 2, 2003, the company purchased 20,000 shares of its own common stock in the open market for $400,000. On January 2, 2005, it reissued 10,000 shares of this treasury stock for $250,000. The remaining 10,000 were still held in treasury at December 31, 2005.

Instructions a. Prepare the stockholders’ equity section of the balance sheet for Herndon Industries at De-

cember 31, 2005. Include supporting schedules showing (1) your computation of any paid-in capital on treasury stock and (2) retained earnings at the balance sheet date. (Hint: Income in- creases retained earnings, whereas dividends reduce retained earnings. Dividends are not paid on shares of stock held in treasury.)

b. As of December 31, compute Herndon’s book value per share of common stock. (Hint: Book value per share is computed only on the shares of stock outstanding.)

c. At December 31, 2005, shares of the company’s common stock were trading at $30. Ex- plain what would have happened to the market price per share had the company split its stock 3-for-1 at this date. Also explain what would have happened to the par value of the common stock and to the number of common shares outstanding.

Critical Thinking Cases and Problems 499

PROBLEM 11.9

Reporting Stockholders’ Equity with Treasury Stock and Stock Splits

LO4 LO5

LO7 LO9through

CRITICAL THINKING CASES AND PROBLEMS

CASE 11.1

Factors Affecting the Market Prices of Preferred and Common Stocks

LO5 LO7

CASE 11.2

Factors Affecting the Market Prices of Common Stocks

LO7

ADM Labs is a publicly owned company with several issues of capital stock outstanding. Over the past decade, the company has consistently earned modest profits and has increased its common stock dividend annually by 5 or 10 cents per share. Recently the company introduced several new products that you believe will cause future sales and profits to increase dramatically. You also ex- pect a gradual increase in long-term interest rates from their present level of about 11 percent to, perhaps, 12 percent to 121�2 percent.

Instructions Based on these forecasts, explain whether you would expect to see the market prices of the fol- lowing issues of ADM capital stock increase or decrease. Explain your reasoning in each answer.

a. 10 percent, $100 par value, preferred stock (currently selling at $90 per share).

b. $5 par value common stock (currently paying an annual dividend of $2.50 and selling at $40 per share).

c. 7 percent, $100 par value, convertible preferred stock (currently selling at $125 per share).

Each of the following situations describes an event that affected the stock market price of a partic- ular company.

a. The price of a common share of McDonnell Douglas, Inc., increased by 51�8 dollars per share in the several days after it was announced that Saudia Airlines would order $6 billion of com- mercial airliners from Boeing and McDonnell Douglas.

b. Citicorp’s common stock price fell 35�8 per share shortly after the Federal Reserve Board in- creased the discount rate by 1�4 percent. The discount rate is the rate charged to banks for short- term loans they need to meet their reserve requirements.

c. The price of a common share of Ventitex, Inc., a manufacturer of medical devices, fell 101�4 (27.7 percent) after it was announced that representatives of the Federal Drug Administration paid a visit to the company.

Instructions For each of the independent situations described, explain the likely underlying rationale for the change in market price of the stock.

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Interview the owners of two local small businesses. One business should be organized as a corpo- ration and the other as either a sole proprietorship or a partnership. Inquire as to:

• Why this form of entity was selected.

• Have there been any unforeseen complications with this form of entity?

• Is the form of entity likely to be changed in the foreseeable future? And if so, why?

500 Chapter 11 Stockholders’ Equity: Paid-In Capital

CASE 11.3

Selecting a Form of Business Organization

LO1 LO3through

CASE 11.4

GM Acquisition and Preferred Stock

LO5 LO6

In “GM May Have Landed a Dandy Daewoo Deal,” in the October 8, 2001, Business Week issue, Moon Ihlwan and David Welch explained details of the purchase agreement between General Mo- tors Corp. and Korea’s Daewoo Motor Co. GM and its partners were to put $400 million into a joint venture that took control of the Daewoo assets. Daewoo’s creditors were to receive $1.2 bil- lion in preferred stock, paying 3.5 percent in the new company. Reports familiar with the deal say that GM had the option of buying back those preferred shares sometime after 2001. In addition, the agreement called for assuming just $830 million of Daewoo Motors’ $17 billion debt.

Instructions a. Define a preferred stock and identify the typical characteristics of preferred stock.

b. What are the advantages to General Motors Corporation of using preferred stock (rather than cash) in its acquisition of Daewoo? Why would the creditors of Daewoo desire preferred stock rather than common stock?

INTERNET ASSIGNMENT

INTERNET 11.1

Stockholders’ Equity Items

LO4 LO5 LO7 LO9

Visit the home page of Staples, Inc., at the following Internet address:

www.staples.com

Locate the company’s most current balance sheet by selecting Corporate Information.

Instructions

Answer the following questions:

a. Does the company report preferred stock in its balance sheet? If so, how many shares are cur- rently outstanding?

b. How much common stock does the company report in its most recent balance sheet? What is the par value of each?

c. Does the company report any treasury stock? Has this amount changed since the previous year?

Internet sites are time and date sensitive. It is the purpose of these exercises to have you explore the Internet. You may need to use the Yahoo! search engine http://www.yahoo.com (or another favorite search engine) to find a company’s current Web address.

BUSINESS WEEK ASSIGNMENT

You as a Loan Officer (p. 467) GOTCHA! does not appear to be a good credit risk for a $200,000 loan. The company has few liquid assets that can be used to repay a loan. Also, the pro- posed loan is very large in relation to the small corporation’s assets and owners’ equity. Because GOTCHA! is organized as a corporation, Woods is not personally responsible for the company’s debts—unless she agrees to be.

OUR COMMENTS ON THE “YOUR TURN” CASES

Williams−Haka−Bettner: Financial & Managerial Accounting, 13/e

11. Stockholders’ Equity: Paid−In Capital

Answers to Self-Test Questions 501

ANSWERS TO SELF-TEST QUESTIONS

1. c 2. d 3. c 4. c 5. c, d 6. b [(2,000 � $60) � (500 � $70)]

Most loan officers would want to find a way to make this loan. They certainly would not want to refuse a 20-year customer of the bank a loan that amounts to less than half of the normal balance she maintains in her checking, savings, and money market accounts. But they would ask that Woods personally guarantee the loan, rather than depend solely on GOTCHA! for repayment. Woods should not be offended by this requirement; in situations such as this, it is standard business practice.

You as the Vice President of Human Relations (p. 470) Do not consider selling the stock before the information about the strike becomes public. The Securities Exchange Act of 1934 precludes trading referred to as “insider trading.” Specifically, insider trading occurs when a mem- ber of the board of directors, an employee of the corporation, or a major stockholder has inside in- formation. Inside information is generally defined as any knowledge that could have a sig- nificant effect on share prices if it were to become publicly known. If the director or employee ex- ecutes trades to take advantage of this private information, it is referred to as insider trading. In- sider trading is unethical and prohibited by law in the United States. However, in some countries, insider trading is an accepted business practice. (For more information, visit www.sec.gov.)

You as an Investor (p. 481) While rising interest rates are not favorable for the market price on any type of stock, the market value of preferred stock is likely to be affected more so than com- mon stock. If interest rates increase, the value of the preferred stock will fall. Because you are in- vesting for the short term, you probably should invest in the common stock rather than the preferred stock.

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