CHAPTER 11

REPORTING AND ANALYZING STOCKHOLDERS' EQUITY

PREVIEW OF CHAPTER 11

Corporations like Facebook and Google have substantial resources at their disposal. In fact, the corporation is the dominant form of business organization in the United States in terms of sales, earnings, and number of employees. All of the 500 largest U.S. companies are corporations. In this chapter, we look at the essential features of a corporation and explain the accounting for a corporation's capital stock transactions.

The content and organization of the chapter are as follows.

The Corporate Form of Organization

A corporation is created by law. As a legal entity, a corporation has most of the rights and privileges of a person. The major exceptions relate to privileges that can be exercised only by a living person, such as the right to vote or to hold public office. Similarly, a corporation is subject to the same duties and responsibilities as a person. For example, it must abide by the law and it must pay taxes.

We can classify corporations in a variety of ways. Two common classifications are by purpose and by ownership. A corporation may be organized for the purpose of making a profit (such as Facebook or General Motors), or it may be a nonprofit charitable, medical, or educational corporation (such as the Salvation Army or the American Cancer Society).

Classification by ownership differentiates publicly held and privately held corporations. A publicly held corporation may have thousands of stockholders, and its stock is traded on a national securities market such as the New York Stock Exchange. Examples are IBM, Caterpillar, and General Electric. In contrast, a privately held corporation, often referred to as a closely held corporation, usually has only a few stockholders and does not offer its stock for sale to the general public. Privately held companies are generally much smaller than publicly held companies although some notable exceptions exist. Before going public, Facebook was one example. Also, Cargill Inc., a private corporation that trades in grain and other commodities, is one of the largest companies in the United States. This chapter deals primarily with issues related to publicly held companies.

CHARACTERISTICS OF A CORPORATION

Many businesses start as partnerships or sole proprietorships but eventually convert to the corporate form. For example, Nike's founders formed their original organization as a partnership. In 1968, they reorganized the company as a corporation. A number of characteristics distinguish a corporation from sole proprietorships and partnerships. The most important of these characteristics are explained below.

Separate Legal Existence

As an entity separate and distinct from its owners, the corporation acts under its own name rather than in the name of its stockholders. Facebook, for example, buys, owns, and sells property, borrows money, and enters into legally binding contracts in its own name. It may also sue or be sued. It pays taxes as a separate entity.

In a partnership, the acts of the owners (partners) bind the partnership. In contrast, the acts of corporate owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you own shares of Facebook stock, you do not have the right to purchase inventory for the company unless you are also designated as an agent of the corporation.

Limited Liability of Stockholders

Since a corporation is a separate legal entity, creditors ordinarily have recourse only to corporate assets to satisfy their claims. The liability of stockholders is normally limited to their investment in the corporation. Creditors have no legal claim on the personal assets of the stockholders unless fraud has occurred. Thus, even in the event of bankruptcy of the corporation, stockholders' losses are generally limited to the amount of capital they have invested in the corporation.

Transferable Ownership Rights

Ownership of a corporation is held in shares of capital stock, which are transferable units. Stockholders may dispose of part or all of their interest in a corporation simply by selling their stock. The transfer of an ownership interest in a partnership requires the consent of each partner. In contrast, the transfer of stock is entirely at the discretion of the stockholder. It does not require the approval of either the corporation or other stockholders.

The transfer of ownership rights among stockholders normally has no effect on the operating activities of the corporation. Nor does it affect the corporation's assets, liabilities, and total stockholders' equity. The transfer of ownership rights is a transaction between individual owners. The company does not participate in the transfer of these ownership rights after the original sale of the capital stock.

Ability to Acquire Capital

It is relatively easy for a corporation to obtain capital through the issuance of stock. Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable. Also, numerous individuals can become stockholders by investing small amounts of money.

Continuous Life

The life of a corporation is stated in its charter. The life may be perpetual or it may be limited to a specific number of years. If it is limited, the company extends the period of existence through renewal of the charter. Since a corporation is a separate legal entity, its continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer. As a result, a successful corporation can have a continuous and perpetual life.

Corporation Management

Although stockholders legally own the corporation, they manage it indirectly through a board of directors they elect. Mark Zuckerberg is the chairman of Facebook's board of directors. The board, in turn, formulates the operating policies for the company. The board also selects officers, such as a president and one or more vice presidents, to execute policy and to perform daily management functions. As a result of the Sarbanes-Oxley Act, the board is required to monitor management's actions closely. Many feel that the failures at Enron, WorldCom, and more recently MF Global could have been avoided by more diligent boards.

Illustration 11-1 depicts a typical organization chart showing the delegation of responsibility.

The chief executive officer (CEO) has overall responsibility for managing the business. As the organization chart shows, the CEO delegates responsibility to other officers. The chief accounting officer is the controller. The controller (1) maintains the accounting records, (2) maintains an adequate system of internal control, and (3) prepares financial statements, tax returns, and internal reports. The treasurer has custody of the corporation's funds and maintains the company's cash position.

The organizational structure of a corporation enables a company to hire professional managers to run the business. On the other hand, the separation of ownership and management often reduces an owner's ability to actively manage the company.

Government Regulations

A corporation is subject to numerous state and federal regulations. For example, state laws usually prescribe the requirements for issuing stock, the distributions of earnings permitted to stockholders, and acceptable methods for buying back and retiring stock. Federal securities laws govern the sale of capital stock to the general public. Also, publicly held corporations must disclose their financial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports. The Sarbanes-Oxley Act increased the company's responsibility for the accuracy of these reports. In addition, when a corporate stock is listed and traded on organized securities exchanges, the corporation must comply with the reporting requirements of these exchanges.

Additional Taxes

Owners of proprietorships and partnerships report their share of earnings on their personal income tax returns. The individual owner then pays taxes on this amount. Corporations, on the other hand, must pay federal and state income taxes as a separate legal entity. These taxes can be substantial. They can amount to as much as 40% of taxable income.

In addition, stockholders are required to pay taxes on cash dividends. Thus, many argue that corporate income is taxed twice (double taxation)—once at the corporate level and again at the individual level.

Illustration 11-2 shows the advantages and disadvantages of a corporation compared to a sole proprietorship and partnership.

Other Forms of Business Organization

A variety of “hybrid” organizational forms—forms that combine different attributes of partnerships and corporations—now exist. For example, one type of corporate form, called an S corporation, allows for legal treatment as a corporation but tax treatment as a partnership—that is, no double taxation. Because of changes to the S corporation's rules, more small- and medium-sized businesses now may choose S corporation treatment. One of the primary criteria is that the company cannot have more than 75 shareholders. Other forms of organization include limited partnerships, limited liability partnerships (LLPs), and limited liability companies (LLCs).

FORMING A CORPORATION

A corporation is formed by grant of a state charter. The charter is a document that describes the name and purpose of the corporation, the types and number of shares of stock that are authorized to be issued, the names of the individuals that formed the company, and the number of shares that these individuals agreed to purchase. Regardless of the number of states in which a corporation has operating divisions, it is incorporated in only one state. It is to the company's advantage to incorporate in a state whose laws are favorable to the corporate form of business organization. For example, although General Motors has its headquarters in Michigan, it is incorporated in New Jersey. In fact, more and more corporations have been incorporating in states with rules that favor existing management. For example, Gulf Oil changed its state of incorporation to Delaware to thwart possible unfriendly takeovers. There, certain defensive tactics against takeovers can be approved by the board of directors alone, without a vote by shareholders.

Upon receipt of its charter from the state of incorporation, the corporation establishes by-laws. The by-laws establish the internal rules and procedures for conducting the affairs of the corporation. Corporations engaged in interstate commerce must also obtain a license from each state in which they do business. The license subjects the corporation's operating activities to the general corporation laws of the state.

STOCKHOLDER RIGHTS

When chartered, the corporation begins selling shares of stock. When a corporation has only one class of stock, it is identified as common stock. Each share of common stock gives the stockholder the ownership rights pictured in Illustration 11-3. The articles of incorporation or the by-laws state the ownership rights of a share of stock.

Proof of stock ownership is evidenced by a printed or engraved form known as a stock certificate. As shown in Illustration 11-4, the face of the certificate shows the name of the corporation, the stockholder's name, the class and special features of the stock, the number of shares owned, and the signatures of authorized corporate officials. Certificates are prenumbered to ensure proper control over their use; they may be issued for any quantity of shares.

Stock Issue Considerations

Although Facebook incorporated in 2004, it did not sell stock to the public until 2012. At that time, Facebook evidently decided it would benefit from the infusion of cash that a public sale of its shares would bring. When a corporation decides to issue stock, it must resolve a number of basic questions: How many shares should it authorize for sale? How should it issue the stock? What value should it assign to the stock? We address these questions in the following sections.

AUTHORIZED STOCK

Authorized stock is the amount of stock that a corporation is authorized to sell as indicated in its charter. If the corporation has sold all of its authorized stock, then it must obtain permission from the state to change its charter before it can issue additional shares.

The authorization of common stock does not result in a formal accounting entry. The reason is that the event has no immediate effect on either corporate assets or stockholders' equity. However, the corporation discloses in the stockholders' equity section of the balance sheet the number of shares authorized.

ISSUANCE OF STOCK

A corporation can issue common stock directly to investors. Alternatively, it can issue common stock indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation.

New issues of stock may be offered for sale to the public through various organized U.S. or foreign securities exchanges. Based on recent figures, the top five exchanges by value of shares traded are the New York Stock Exchange, Nasdaq stock market, London Stock Exchange, Tokyo Stock Exchange, and Euronext.

PAR AND NO-PAR VALUE STOCKS

Par value stock is capital stock that has been assigned a value per share in the corporate charter. Years ago, par value determined the legal capital that must be retained in the business for the protection of corporate creditors. That amount is not available for withdrawal by stockholders. Thus, in the past, most states required the corporation to sell its shares at par or above.

However, the usefulness of par value as a device to protect creditors was limited because par value was often immaterial relative to the value of the company's stock in the securities markets—even at the time of issue. For example, Loews Corporation's par value is $0.01 per share, yet a new issue in a recent year would have sold at a market price in the $32 per share range. Thus, par has no relationship with market price. In the vast majority of cases, it is an immaterial amount. As a consequence, today many states do not require a par value. Instead, they use other means to protect creditors.

No-par value stock is capital stock that has not been assigned a value in the corporate charter. No-par value stock is fairly common today. For example, Nike and Procter & Gamble both have no-par stock. In many states, the board of directors assigns a stated value to the no-par shares.

ACCOUNTING FOR ISSUES OF COMMON STOCK

The stockholders' equity section of a corporation's balance sheet includes (1) paid-in (contributed) capital and (2) retained earnings (earned capital). The distinction between paid-in capital and retained earnings is important from both a legal and an economic point of view. Paid-in capital is the amount stockholders paid to the corporation in exchange for shares of ownership. Retained earnings is earned capital held for future use in the business. In this section, we discuss the accounting for paid-in capital. In a later section, we discuss retained earnings.

Let's now look at how to account for new issues of common stock. The primary objectives in accounting for the issuance of common stock are (1) to identify the specific sources of paid-in capital and (2) to maintain the distinction between paid-in capital and retained earnings. As shown below, the issuance of common stock affects only paid-in capital accounts.

As discussed earlier, par value does not indicate a stock's market price. The cash proceeds from issuing par value stock may be equal to, greater than, or less than par value. When a company records the issuance of common stock for cash, it credits the par value of the shares to Common Stock and records in a separate paid-in capital account the portion of the proceeds that is above or below par value.

To illustrate, assume that Hydro-Slide, Inc. issues 1,000 shares of $1 par value common stock at par for cash. The entry to record this transaction is:

Now assume Hydro-Slide, Inc. issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share. The amount received above the par value, in this case $4 ($5 − $1), would be credited to Paid-in Capital in Excess of Par Value. The entry is:

The total paid-in capital from these two transactions is $6,000. If Hydro-Slide, Inc. has retained earnings of $27,000, the stockholders' equity section of the balance sheet is as shown in Illustration 11-5.

Some companies issue no-par stock with a stated value. For accounting purposes, companies treat the stated value in the same way as the par value. For example, if in our Hydro-Slide example the stock was no-par stock with a stated value of $1, the entries would be the same as those presented for the par stock except the term “Par Value” would be replaced with “Stated Value.” If a company issues no-par stock that does not have a stated value, then it credits to the Common Stock account the full amount received. In such a case, there is no need for the Paid-in Capital in Excess of Stated Value account.

Accounting for Treasury Stock

Treasury stock is a corporation's own stock that has been reacquired by the corporation and is being held for future use. A corporation may acquire treasury stock for various reasons:

1. To reissue the shares to officers and employees under bonus and stock compensation plans.
2. To increase trading of the company's stock in the securities market. Companies expect that buying their own stock will signal that management believes the stock is underpriced, which they hope will enhance its market price.
3. To have additional shares available for use in acquiring other companies.
4. To reduce the number of shares outstanding and thereby increase earnings per share.

A less frequent reason for purchasing treasury shares is to eliminate hostile shareholders by buying them out.

Many corporations have treasury stock. For example, in the United States approximately 65% of companies have treasury stock.² In the first quarter of 2007, companies in the Standard & Poor's 500-stock index spent a record of about $118 billion to buy treasury stock. In a recent year, Nike purchased more than 6 million treasury shares. At one point, stock repurchases were so substantial that a study by two Federal Reserve economists suggested that a sharp reduction in corporate purchases of treasury shares might result in a sharp drop in the value of the U.S. stock market.

PURCHASE OF TREASURY STOCK

The purchase of treasury stock is generally accounted for by the cost method. This method derives its name from the fact that the Treasury Stock account is maintained at the cost of shares purchased. Under the cost method, companies increase (debit) Treasury Stock by the price paid to reacquire the shares. Treasury Stock decreases by the same amount when the company later sells the shares.

To illustrate, assume that on January 1, 2014, the stockholders’ equity section for Mead, Inc. has 100,000 shares of $5 par value common stock outstanding (all issued at par value) and retained earnings of $200,000. Illustration 11-6 shows the stockholders' equity section of the balance sheet before purchase of treasury stock.

On February 1, 2014, Mead acquires 4,000 shares of its stock at $8 per share. The entry is:

The Treasury Stock account would increase by the cost of the shares purchased ($32,000). The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change.

Companies show treasury stock as a deduction from total paid-in capital and retained earnings in the stockholders' equity section of the balance sheet. Illustration 11-7 shows this presentation for Mead, Inc. Thus, the acquisition of treasury stock reduces stockholders' equity.

Company balance sheets disclose both the number of shares issued (100,000) and the number in the treasury (4,000). The difference is the number of shares of stock outstanding (96,000). The term outstanding stock means the number of shares of issued stock that are being held by stockholders.

In a bold (and some would say risky) move, Reebok at one time bought back nearly a third of its shares. This repurchase of shares dramatically reduced Reebok's available cash. In fact, the company borrowed significant funds to accomplish the repurchase. In a press release, management stated that it was repurchasing the shares because it believed that the stock was severely underpriced. The repurchase of so many shares was meant to signal management's belief in good future earnings.

Skeptics, however, suggested that Reebok's management was repurchasing shares to make it less likely that the company would be acquired by another company (in which case Reebok's top managers would likely lose their jobs). Acquiring companies like to purchase companies with large cash reserves so they can pay off debt used in the acquisition. By depleting its cash, Reebok became a less likely acquisition target.

Preferred Stock

To appeal to a larger segment of potential investors, a corporation may issue an additional class of stock, called preferred stock. Preferred stock has contractual provisions that give it preference or priority over common stock in certain areas. Typically, preferred stockholders have a priority in relation to (1) dividends and (2) assets in the event of liquidation. However, they sometimes do not have voting rights. Facebook had 543 million preferred shares outstanding at the end of 2011, prior to going public. Approximately 6% of U.S. companies have one or more classes of preferred stock.³

Like common stock, companies issue preferred stock for cash or for noncash consideration. The entries for these transactions are similar to the entries for common stock. When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates (e.g., Preferred Stock, Common Stock, Paid-in Capital in Excess of Par Value—Preferred Stock, and Paid-in Capital in Excess of Par Value—Common Stock).

Assume that Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. The entry to record the issuance is:

Preferred stock has either a par value or no-par value. In the stockholders' equity section of the balance sheet, companies show preferred stock first because of its dividend and liquidation preferences over common stock.

DIVIDEND PREFERENCES

As indicated above, preferred stockholders have the right to share in the distribution of corporate income before common stockholders. For example, if the dividend rate on preferred stock is $5 per share, common shareholders cannot receive any dividends in the current year until preferred stockholders have received $5 per share. The first claim to dividends does not, however, guarantee dividends. Dividends depend on many factors, such as adequate retained earnings and availability of cash.

For preferred stock, companies state the per share dividend amount as a percentage of the par value of the stock or as a specified amount. For example, EarthLink specifies a 3% dividend.

Cumulative Dividend

Preferred stock contracts often contain a cumulative dividend feature. This feature stipulates that preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders are paid dividends. When preferred stock is cumulative, preferred dividends not declared in a given period are called dividends in arrears.

To illustrate, assume that Scientific Leasing has 5,000 shares of 7%, $100 par value cumulative preferred stock outstanding. Each $100 share pays a $7 dividend (.07 × $100). The annual dividend is $35,000 (5,000 × $7 per share). If dividends are two years in arrears, preferred stockholders are entitled to receive in the current year the dividends as shown in Illustration 11-8.

No distribution can be made to common stockholders until Scientific Leasing pays this entire preferred dividend. In other words, companies cannot pay dividends to common stockholders while any preferred stock dividend is in arrears.

Dividends in arrears are not considered a liability. No obligation exists until the board of directors formally “declares” that the corporation will pay a dividend. However, companies should disclose in the notes to the financial statements the amount of dividends in arrears. Doing so enables investors to assess the potential impact of this obligation on the corporation's financial position.

The investment community does not look favorably upon companies that are unable to meet their dividend obligations. As a financial officer noted in discussing one company's failure to pay its cumulative preferred dividend for a period of time, “Not meeting your obligations on something like that is a major black mark on your record.”

LIQUIDATION PREFERENCE

Most preferred stocks have a preference on corporate assets if the corporation fails. This feature provides security for the preferred stockholder. The preference to assets may be for the par value of the shares or for a specified liquidating value. For example, Commonwealth Edison issued preferred stock that entitled the holders to receive $31.80 per share, plus accrued and unpaid dividends, in the event of involuntary liquidation. The liquidation preference is used in litigation pertaining to bankruptcy lawsuits involving the respective claims of creditors and preferred stockholders.

Dividends

As noted earlier, a dividend is a distribution by a corporation to its stockholders on a pro rata (proportional to ownership) basis. Pro rata means that if you own, say, 10% of the common shares, you will receive 10% of the dividend. Dividends can take four forms: cash, property, scrip (promissory note to pay cash), or stock. Cash dividends, which predominate in practice, and stock dividends, which are declared with some frequency, are the focus of our discussion.

Investors are very interested in a company's dividend practices. In the financial press, dividends are generally reported quarterly as a dollar amount per share. (Sometimes they are reported on an annual basis.) For example, the quarterly dividend rate in the fourth quarter of 2011 was 36 cents per share for Nike, 15 cents per share for GE, and 24 cents per share for ConAgra Foods. Facebook does not pay dividends.

CASH DIVIDENDS

A cash dividend is a pro rata (proportional to ownership) distribution of cash to stockholders. Cash dividends are not paid on treasury shares. For a corporation to pay a cash dividend, it must have the following.

1. Retained earnings. Payment of dividends from retained earnings is legal in all states. In addition, loan agreements frequently constrain companies to pay dividends only from retained earnings. Many states prohibit payment of dividends from legal capital. However, payment of dividends from paid-in capital in excess of par value is legal in some states.
2. Adequate cash. Recently, Facebook had a balance in retained earnings of $1,606 million but a cash balance of only $1,512 million. If it had wanted to pay a dividend equal to its retained earnings, Facebook would have had to raise $94 million more in cash. It would have been unlikely to do this because it would not be able to pay this much in dividends in future years. In addition, such a dividend would completely deplete Facebook's balance in retained earnings, so it would not be able to pay a dividend in the next year unless it had positive net income.
3. Declared dividends. The board of directors has full authority to determine the amount of income to distribute in the form of dividends. Dividends are not a liability until they are declared.

The amount and timing of a dividend are important issues for management to consider. The payment of a large cash dividend could lead to liquidity problems for the company. Conversely, a small dividend or a missed dividend may cause unhappiness among stockholders who expect to receive a reasonable cash payment from the company on a periodic basis. Many companies declare and pay cash dividends quarterly. On the other hand, a number of high-growth companies pay no dividends, preferring to conserve cash to finance future capital expenditures.

Investors monitor a company's dividend practices. For example, regular dividend boosts in the face of irregular earnings can be a warning signal. Companies with high dividends and rising debt may be borrowing money to pay shareholders. On the other hand, low dividends may not be a negative sign because it may mean the company is reinvesting in itself, which may result in high returns through increases in the stock price. Presumably, investors seeking regular dividends buy stock in companies that pay periodic dividends, and those seeking growth in the stock price (capital gains) buy stock in companies that retain their earnings rather than pay dividends.

Entries for Cash Dividends

Three dates are important in connection with dividends: (1) the declaration date, (2) the record date, and (3) the payment date. Companies make accounting entries on the declaration date and the payment date.

On the declaration date, the board of directors formally authorizes the cash dividend and announces it to stockholders. The declaration of a cash dividend commits the corporation to a binding legal obligation. Thus, the company must make an entry to recognize the increase in Cash Dividends and the increase in the liability Dividends Payable.

To illustrate, assume that on December 1, 2014, the directors of Media General declare a $0.50 per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is $50,000 (100,000 × $0.50). The entry to record the declaration is:

In Chapter 3, we used an account called Dividends to record a cash dividend. Here, we use the more specific title Cash Dividends to differentiate from other types of dividends, such as stock dividends. Dividends Payable is a current liability. It will normally be paid within the next several months.

At the record date, the company determines ownership of the outstanding shares for dividend purposes. The stockholders' records maintained by the corporation supply this information.

For Media General, the record date is December 22. No entry is required on the record date.

On the payment date, the company makes cash dividend payments to the stockholders on record as of December 22. It also records the payment of the dividend. If January 20 is the payment date for Media General, the entry on that date is:

Note that payment of the dividend on the payment date reduces both current assets and current liabilities, but it has no effect on stockholders' equity. The cumulative effect of the declaration and payment of a cash dividend on a company's financial statements is to decrease both stockholders' equity and total assets.

STOCK DIVIDENDS

A stock dividend is a pro rata (proportional to ownership) distribution of the corporation's own stock to stockholders. Whereas a cash dividend is paid in cash, a stock dividend is paid in stock. A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. Unlike a cash dividend, a stock dividend does not decrease total stockholders' equity or total assets.

Because a stock dividend does not result in a distribution of assets, some view it as nothing more than a publicity gesture. Stock dividends are often issued by companies that do not have adequate cash to issue a cash dividend. These companies may not want to announce that they are not going to be issuing a cash dividend at their normal time to do so. By issuing a stock dividend, they “save face” by giving the appearance of distributing a dividend. Note that since a stock dividend neither increases nor decreases the assets in the company, investors are not receiving anything they didn't already own. In a sense, it is like asking for two pieces of pie and having your host take one piece of pie and cut it into two smaller pieces. You are not better off, but you got your two pieces of pie.

To illustrate a stock dividend, assume that you have a 2% ownership interest in Cetus Inc.; you own 20 of its 1,000 shares of common stock. If Cetus declares a 10% stock dividend, it issues 100 shares (1,000 × 10%) of stock. You receive two shares (2% × 100), but your ownership interest remains at 2% (22 ÷ 1,100). You now own more shares of stock, but your ownership interest has not changed. Moreover, the company disburses no cash and assumes no liabilities.

What, then, are the purposes and benefits of a stock dividend? Corporations generally issue stock dividends for one of the following reasons.

1. To satisfy stockholders' dividend expectations without spending cash.
2. To increase the marketability of the stock by increasing the number of shares outstanding and thereby decreasing the market price per share. Decreasing the market price of the stock makes it easier for smaller investors to purchase the shares.
3. To emphasize that the company has permanently reinvested in the business a portion of stockholders' equity, which therefore is unavailable for cash dividends.

When the dividend is declared, the board of directors determines the size of the stock dividend and the value per share to use to record the transaction. In order to meet legal requirements, the per share amount must be at least equal to the par or stated value.

The accounting profession distinguishes between a small stock dividend (less than 20%–25% of the corporation's issued stock) and a large stock dividend (greater than 20%–25%). It recommends that the company use the fair value per share to record small stock dividends. The recommendation is based on the assumption that a small stock dividend will have little effect on the market price of the shares previously outstanding. Thus, many stockholders consider small stock dividends to be distributions of earnings equal to the fair value of the shares distributed. The accounting profession does not specify the value to use to record a large stock dividend. However, companies normally use par or stated value per share. Small stock dividends predominate in practice. In Appendix 11A at the end of the chapter, we illustrate the journal entries for small stock dividends.

Effects of Stock Dividends

How do stock dividends affect stockholders' equity? They change the composition of stockholders' equity because they result in a transfer of a portion of retained earnings to paid-in capital. However, total stockholders' equity remains the same. Stock dividends also have no effect on the par or stated value per share, but the number of shares outstanding increases.

Illustration 11-9 shows the effects that result when Medland Corp. declares a 10% stock dividend on its $10 par common stock when 50,000 shares were outstanding. The market price was $15 per share.

In this example, total paid-in capital increased by $75,000 (50,000 shares × 10% × $15), and retained earnings decreased by the same amount. Note also that total stockholders' equity remains unchanged at $800,000. The number of shares increases by 5,000 (50,000 × 10%).

STOCK SPLITS

A stock split, like a stock dividend, involves the issuance of additional shares of stock to stockholders according to their percentage ownership. However, a stock split results in a reduction in the par or stated value per share. The purpose of a stock split is to increase the marketability of the stock by lowering its market price per share. This, in turn, makes it easier for the corporation to issue additional stock. After hitting a peak of 114 stock splits in 1986, the number of splits in the United States has fallen to about 30 per year. Google announced a 2-for-1 split in 2012 when its stock was selling for $650 per share.

Like a stock dividend, a stock split increases the number of shares owned by a shareholder, but it does not change the percentage of the total company that the shareholder owns. The effects of a 3-for-1 split are shown in Illustration 11-10.

The effect of a split on market price is generally inversely proportional to the size of the split. For example, after a recent 2-for-1 stock split, the market price of Nike's stock fell from $111 to approximately $55.

In a stock split, the company increases the number of shares in the same proportion that it decreases the par or stated value per share. For example, in a 2-for-1 split, the company exchanges one share of $10 par value stock for two shares of $5 par value stock. A stock split does not have any effect on paid-in capital, retained earnings, and total stockholders' equity. However, the number of shares outstanding increases. The effects of a 2-for-1 stock split of Medland Corporation's common stock are shown in Illustration 11-11.

Because a stock split does not affect the balances in any stockholders' equity accounts, a company does not need to journalize a stock split. However, a memorandum entry explaining the effect of the split is typically made.

The differences between the effects of stock dividends and stock splits are shown in Illustration 11-12.

Retained Earnings

Retained earnings is net income that a company retains in the business. The balance in retained earnings is part of the stockholders' claim on the total assets of the corporation. It does not, however, represent a claim on any specific asset. Nor can the amount of retained earnings be associated with the balance of any asset account. For example, a $100,000 balance in retained earnings does not mean that there should be $100,000 in cash. The reason is that the company may have used the cash resulting from the excess of revenues over expenses to purchase buildings, equipment, and other assets. Illustration 11-13 shows recent amounts of retained earnings and cash in selected companies.

When expenses exceed revenues, a net loss results. In contrast to net income, a net loss decreases retained earnings. In closing entries, a company debits a net loss to the Retained Earnings account. It does not debit net losses to paid-in capital accounts. To do so would destroy the distinction between paid-in and earned capital. If cumulative losses and dividends exceed cumulative income over a company's life, a debit balance in Retained Earnings results. A debit balance in Retained Earnings, such as that of Amazon.com in a recent year, is a deficit. A company reports a deficit as a deduction in the stockholders' equity section of the balance sheet, as shown in Illustration 11-14.

RETAINED EARNINGS RESTRICTIONS

The balance in retained earnings is generally available for dividend declarations. Some companies state this fact. In some circumstances, however, there may be retained earnings restrictions. These make a portion of the balance currently unavailable for dividends. Restrictions result from one or more of these causes: legal, contractual, or voluntary.

Companies generally disclose retained earnings restrictions in the notes to the financial statements. For example, Tektronix Inc., a manufacturer of electronic measurement devices, recently had total retained earnings of $774 million, but the unrestricted portion was only $223.8 million.

Financial Statement Presentation of Stockholders' Equity

BALANCE SHEET PRESENTATION

In the stockholders' equity section of the balance sheet, companies report paid-in capital and retained earnings and identify the specific sources of paid-in capital. Within paid-in capital, two classifications are recognized:

1. Capital stock, which consists of preferred and common stock. Companies show preferred stock before common stock because of its preferential rights. They report information about the par value, shares authorized, shares issued, and shares outstanding for each class of stock.
2. Additional paid-in capital, which includes the excess of amounts paid in over par or stated value.

Illustration 11-16 presents the stockholders' equity section of the balance sheet of Graber Inc. The company discloses a retained earnings restriction in the notes. The stockholders' equity section for Graber Inc. includes most of the accounts discussed in this chapter. The disclosures pertaining to Graber's common stock indicate that 400,000 shares are issued; 100,000 shares are unissued (500,000 authorized less 400,000 issued); and 390,000 shares are outstanding (400,000 issued less 10,000 shares in treasury).

In published annual reports, companies seldom present subclassifications within the stockholders' equity section. Moreover, they often combine and report as a single amount the individual sources of additional paid-in capital. Notes often provide additional detail. Illustration 11-17 is an excerpt from Procter & Gamble Company's balance sheet in a recent year.

Measuring Corporate Performance

Investors are interested in both a company's dividend record and its earnings performance. Although those two measures are often parallel, that is not always the case. Thus, investors should investigate each one separately.

DIVIDEND RECORD

One way that companies reward stock investors for their investment is to pay them dividends. The payout ratio measures the percentage of earnings a company distributes in the form of cash dividends to common stockholders. It is computed by dividing total cash dividends declared to common shareholders by net income. Using the information shown below, the payout ratio for Nike in 2011 and 2010 is calculated in Illustration 11-18 (page 594).

Nike's payout ratio was relatively constant at approximately 27%. Companies attempt to set their dividend rate at a level that will be sustainable.

Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business. Thus, a low payout ratio is not necessarily bad news. Companies that believe they have many good opportunities for growth, such as Facebook, will reinvest those funds in the company rather than pay dividends. However, low dividend payments, or a cut in dividend payments, might signal that a company has liquidity or solvency problems and is trying to conserve cash by not paying dividends. Thus, investors and analysts should investigate the reason for low dividend payments.

Illustration 11-19 lists recent payout ratios of four well-known companies.

EARNINGS PERFORMANCE

Another way to measure corporate performance is through profitability. A widely used ratio that measures profitability from the common stockholders' viewpoint is return on common stockholders' equity (ROE). This ratio shows how many dollars of net income a company earned for each dollar of common stockholders' equity. It is computed by dividing net income available to common stockholders (Net income − Preferred dividends) by average common stockholders' equity. Common stockholders' equity is equal to total stockholders' equity minus any equity from preferred stock.

Using the information on the previous page and the additional information presented below, Illustration 11-20 shows Nike's return on common stockholders' equity.

From 2010 to 2011, Nike's return on common shareholders' equity increased. As a company grows larger, it becomes increasingly hard to sustain a high return. In Nike's case, since many believe the U.S. market for expensive sports shoes is saturated, it will need to grow either along new product lines, such as hiking shoes and golf equipment, or in new markets, such as Europe and Asia.

DEBT VERSUS EQUITY DECISION

When obtaining long-term capital, corporate managers must decide whether to issue bonds or to sell common stock. Bonds have three primary advantages relative to common stock, as shown in Illustration 11-21.

How does the debt versus equity decision affect the return on common stockholders' equity? Illustration 11-22 shows that the return on common stockholders' equity is affected by the return on assets and the amount of leverage a company uses—that is, by the company's reliance on debt (often measured by the debt to assets ratio). If a company wants to increase its return on common stockholders' equity, it can either increase its return on assets or increase its reliance on debt financing.

To illustrate the potential effect of debt financing on the return on common stockholders' equity, assume that Microsystems Inc. currently has 100,000 shares of common stock outstanding issued at $25 per share and no debt. It is considering two alternatives for raising an additional $5 million. Plan A involves issuing 200,000 shares of common stock at the current market price of $25 per share. Plan B involves issuing $5 million of 12% bonds at face value. Income before interest and taxes will be $1.5 million; income taxes are expected to be 30%. The alternative effects on the return on common stockholders' equity are shown in Illustration 11-23.

Note that with long-term debt financing (bonds), net income is $420,000 ($1,050,000 − $630,000) less. However, the return on common stockholders' equity increases from 14% to 25.2% with the use of debt financing because net income is spread over a smaller amount of common stockholders' equity. In general, as long as the return on assets rate exceeds the rate paid on debt, a company will increase the return on common stockholders' equity by the use of debt.

After seeing this illustration, you might ask, why don't companies rely almost exclusively on debt financing rather than equity? Debt has one major disadvantage: Debt reduces solvency. The company locks in fixed payments that it must make in good times and bad. The company must pay interest on a periodic basis and must pay the principal (face value) of the bonds at maturity. A company with fluctuating earnings and a relatively weak cash position may experience great difficulty in meeting interest requirements in periods of low earnings. In the extreme, this can result in bankruptcy. With common stock financing, on the other hand, the company can decide to pay low (or no) dividends if earnings are low.

Summary of Learning Objectives

1. Identify and discuss the major characteristics of a corporation. The major characteristics of a corporation are separate legal existence, limited liability of stockholders, transferable ownership rights, ability to acquire capital, continuous life, corporation management, government regulations, and additional taxes.
2. Record the issuance of common stock. When a company records issuance of common stock for cash, it credits the par value of the shares to Common Stock. It records in a separate paid-in capital account the portion of the proceeds that is above par value. When no-par common stock has a stated value, the entries are similar to those for par value stock. When no-par common stock does not have a stated value, the entire proceeds from the issue are credited to Common Stock.
3. Explain the accounting for the purchase of treasury stock. Companies generally use the cost method in accounting for treasury stock. Under this approach, a company debits Treasury Stock at the price paid to reacquire the shares.
4. Differentiate preferred stock from common stock. Preferred stock has contractual provisions that give it priority over common stock in certain areas. Typically, preferred stockholders have a preference as to (1) dividends and (2) assets in the event of liquidation. However, they sometimes do not have voting rights.
5. Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits. Companies make entries for dividends at the declaration date and the payment date. At the declaration date, the entries for a cash dividend are debit Cash Dividends and credit Dividends Payable. The effects of stock dividends and splits are as follows. Small stock dividends transfer an amount equal to the fair value of the shares issued from retained earnings to the paid-in capital accounts. Stock splits reduce the par value per share of the common stock while increasing the number of shares so that the balance in the Common Stock account remains the same.
6. Identify the items that affect retained earnings. Additions to retained earnings consist of net income. Deductions consist of net loss and cash and stock dividends. In some instances, portions of retained earnings are restricted, making that portion unavailable for the payment of dividends.
7. Prepare a comprehensive stockholders' equity section. In the stockholders' equity section of the balance sheet, companies report paid-in capital and retained earnings and identify specific sources of paid-in capital. Within paid-in capital, companies show two classifications: capital stock and additional paid-in capital. If a corporation has treasury stock, it deducts the cost of treasury stock from total paid-in capital and retained earnings to determine total stockholders' equity.
8. Evaluate a corporation's dividend and earnings performance from a stockholder's perspective. A company's dividend record can be evaluated by looking at what percentage of net income it chooses to pay out in dividends, as measured by the dividend payout ratio (dividends divided by net income). Earnings performance is measured with the return on common stockholders' equity (income available to common stockholders divided by average common stockholders' equity).

Appendix 11A

Entries for Stock Dividends

To illustrate the accounting for stock dividends, assume that Medland Corporation has a balance of $300,000 in retained earnings and declares a 10% stock dividend on its 50,000 shares of $10 par value common stock. The current fair value of its stock is $15 per share. The number of shares to be issued is 5,000 (10% × 50,000), and the total amount to be debited to Retained Earnings is $75,000 (5,000 × $15). The entry to record this transaction at the declaration date is:

At the declaration date, Medland increases (debits) Stock Dividends for the fair value of the stock issued, increases (credits) Common Stock Dividends Distributable for the par value of the dividend shares (5,000 × $10), and increases (credits) the excess over par (5,000 × $5) to an additional paid-in capital account.

Common Stock Dividends Distributable is a stockholders' equity account. It is not a liability because assets will not be used to pay the dividend. If Medland prepares a balance sheet before it issues the dividend shares, it reports the distributable account in paid-in capital as an addition to common stock issued, as shown in Illustration 11A-1.

When Medland issues the dividend shares, it decreases Common Stock Dividends Distributable and increases Common Stock as follows.

Summary of Learning Objective for Appendix 11A

  9. Prepare entries for stock dividends. To record the declaration of a small stock dividend (less than 20%), debit Stock Dividends for an amount equal to the fair value of the shares issued. Record a credit to a temporary stockholders' equity account—Common Stock Dividends Distributable—for the par value of the shares, and credit the balance to Paid-in Capital in Excess of Par Value. When the shares are issued, debit Common Stock Dividends Distributable and credit Common Stock.