Stockholders’ Equity | Intermediate Accounting | CPA Exam FAR | Chapter 15

The chapter covers stockholders’ equity,  including common stock, paid in capital, treasury stock, preferred stock and retained earnings.

CPA Exam Questions Financial Accounting and Reporting FAR

Corporate Capital Structure

Characteristics of a Corporation

Issuance of Common Stock

Accounting for Treasury Stock

Accounting for Preferred Stock

Cash Dividends, Property Dividends, Liquidating Dividends

Large & Small Stock Dividends | Stock Splits

Book Value per Share | Equity Ratio Analysis

Preferred Dividend Computation

Examples BE 15-1 & 15-2: Issuing Stocks for Cash

Example BE 15-3 (Wilco): Statement of Stockholders' Equity

Ex. BE 15-5 (Buffalo) & 15-6 (Moonwalker): Issuing Stocks for Non-Cash Consideration

Ex. BE 15-7 (Hinges) & 15-10 (Woolford): Cash Dividend

Example BE 15-7 (Sprinkle) & 15-8 (Arantxa): Treasury Stocks

Example BE 15-11 (Cole Inc): Property Dividend

Example BE 15-12 (Graves Mining Co): Liquidating Dividend

Ex. 15-13 & 14 (Green Day Corp): Large & Small Stock Dividend

Example E15-24 (Morgan Sondgeroth Inc): Book Value Per Share

Chapter 15 focuses on the stockholders’ equity section of the corporate form of business organization. Stockholders’ equity represents the amount that was contributed by the shareholders and the portion that was earned and retained by the enterprise. There is
a definite distinction between liabilities and stockholders’ equity that must be understood if one is to effectively grasp the accounting treatment for equity issues. This chapter addresses the accounting issues related to capital contributed by owners of a business organization, and the means by which profits are distributed through dividends.

Corporate Capital

The corporate form of business organization requires submitting of articles of incorporation to the state in which incorporation is desired. Assuming the requirements are properly fulfilled, the corporation charter is issued and the corporation is recognized as a legal entity subject to state law. The laws of the state of incorporation that govern owners’ equity transactions are normally set out in the state’s business corporation act.

Within a given class of stock, each share is exactly equal to every other share. A person’s percent of ownership in a corporation is determined by the number of shares possessed in relation to the total number of shares owned by all stockholders.

In the absence of restrictive provisions, each share carries the right to share proportionately in: (a) profits, (b) management, (c) corporate assets upon liquidation, and (d) any new issues of stock of the same class (preemptive right).

Share System

The transfer of ownership between individuals in the corporate form of organization is accomplished by one individual selling or transferring shares to another individual. The only requirement in terms of the corporation involved is that it be made aware of the name of the individual owning the stock. A subsidiary ledger of stockholders is maintained by the corporation for the purpose of dividend payments, issuance of stock rights, and voting proxies. Many corporations employ independent registrars and transfer agents who specialize in providing services for recording and transferring stock.

The basic ownership interest in a corporation is represented by common stock. Common stock is guaranteed neither dividends nor assets upon dissolution of the corporation. Common stockholders are considered to hold a residual interest in the corporation. However, common stockholders generally control the management of the corporation and tend to profit most if the company is successful. In the event that a corporation has only one authorized issue of capital stock, that issue is by definition common stock, whether or not it is so designated in the charter.

Components of Stockholders’ Equity

Owners’ equity in a corporation is defined as stockholders’ equity, share­holders’ equity, or corporate capital. The following categories normally appear as part of stockholders’ equity.

  1. Capital stock.
  2. Additional paid-in capital.
  3. Retained earnings.

Stockholders’ Equity: Contributed Capital

Capital stock and additional paid-in capital constitute contributed (paid-in) capital; retained earnings represents the earned capital of the company not distributed as dividends. Contributed capital (paid-in capital) is the total amount paid in on capital stock. Earned capital is the capital that develops from profitable operations.

Stockholders’ equity is the difference between the assets and the liabilities of the company—also known as the residual interest. Stockholders’ equity is not a claim to specific assets, but a claim against a portion of the total net assets.

Accounting for the Issuance of Stock

The par value of a stock has no relationship to its fair value. Par value associated with most capital stock issues is generally very low. Low par values help companies avoid the contingent liability associated with stock that is issued below par.

When par value stock is issued, the capital stock (common or preferred) account is credited for an amount equal to par value times the number of shares issued. Any amount received in excess of par value is credited to additional paid-in capital. For example, if 200 shares of common stock with a par value of $2 per share are sold for $500, the following journal entry would be made:

Cash…………………………………………………………………………………….. 500

Common Stock (200 × $2)……………………………………………………..               400

Paid-in Capital in Excess of Par…………………………………………….               100

The capital stock account is always credited at the issue date for the par value of the stock times the number of shares issued.

When no-par stock is issued, the capital stock account is credited for an amount equal to the value of the consideration received. If no-par stock has a stated value, it may be accounted for in the same way as true no-par stock with the entire proceeds from issuance credited to the capital stock account, or the stated value may be treated similar to par value with any excess above stated value being accounted for as additional paid-in capital.

Lump-Sum Sales

More than one class of stock is sometimes issued for a single payment or lump sum amount. Such a transaction requires allocation of the proceeds between the classes of securities involved.

The two methods of allocation used are (a) the proportional method and (b) the incremental method. The proportional method is used when the fair value for each class of security is readily determinable, and the incremental method is used the fair value of only one class of stock is known.

Stock Issued in Noncash Transactions

Stock issued for services or property other than cash should be recorded by using the fair value of the property or services received or the fair value of the stock issued, whichever is more clearly determinable. In cases where the fair value of neither item is clearly determinable, the board of directors has the authority to establish a value for the transaction.

Costs of Issuing Stock

Direct costs incurred to sell stock such as underwriting costs, accounting and legal fees, and printing costs should be debited to Paid-in Capital in Excess of Par. Management salaries and other indirect costs related to the stock issue should be expensed as incurred.

Preferred Stock

Preferred stock is the term used to describe a class of stock that possesses certain preferences or features not possessed by the common stock. The dividend preference of preferred stock is normally stated as a per­centage of the preferred stock’s par value. However, a preference as to dividends does not assure the payment of dividends; it merely assures that corporations must pay the applicable amount to the preferred stock prior to paying any dividends on common stock.

The following features are those most often associated with preferred stock issues:

  1. Preference as to dividends.
  2. Preference as to assets in the event of liquidation.
  3. Convertible into common stock.
  4. Callable at the option of the corporation.
  5. Nonvoting.

Some features used to distinguish preferred stock from common stock tend to be restrictive. For example, preferred stock may be nonvoting, noncumulative, and nonparticipating. A corporation may attach whatever preferences or restrictions in whatever combination it desires to a preferred stock issue, so long as it does not specifically violate its state incorporation laws.

Certain terms are used to describe various features of preferred stock. These terms are the following:

  1. Cumulative. Dividends not paid in any year must be paid first in a later year before paying any dividends to common stockholders. Unpaid annual dividends on cumu­lative preferred stock are referred to as dividends in arrears and are disclosed in a note to the financial statements.
  2. Participating. Holders of participating preferred stock share with the common stockholders in any profit distribution beyond the prescribed preference rate. This participation involves a pro rata distribution based on the total par value of the outstanding preferred and common stock.
  3. Convertible. Preferred stockholders may, at their option, exchange their preferred shares for common stock on the basis of a predetermined ratio.
  4. Callable. At the option of the issuing corporation, preferred shares can be redeemed at specified future dates and at stipulated prices.
  5. Redeemable. Redeemable stock has a mandatory redemption period or a redemption feature that the issuer cannot control. Debt-like securities, such as redeemable preferred stock, are classified as liabilities and measured and accounted for similar to liabilities.

Accounting and Reporting of Preferred Stock

Preferred stock is accounted for similar to common stock at issuance. The proceeds are allocated between par value and additional paid-in capital.

Preferred stock generally has no maturity date and no legal obligation exists to pay preferred stock dividends. As a result, preferred stock is classified as part of stockholders’ equity. Mandatory redeemable preferred stock is reported as a liability.

Treasury Stock

Treasury stock is a corporation’s own stock that (a) was outstanding, (b) has been reacquired by the corporation, and (c) is not retired. Treasury stock is not an asset and is reported in the balance sheet as a reduction of stockholders’ equity.

The reasons corporations purchase their outstanding stock include: (a) to provide tax–efficient distributions of excess cash to shareholders; (b) to increase earnings per share and return on equity; (c) to provide stock for employee stock compensation contracts; (d) to thwart takeover attempts or to reduce the number of stockholders; and (e) to make a market in the stock.

Two methods are used in accounting for treasury stock, the cost method and the par value method. Under the cost method, treasury stock is recorded in the accounts at acquisition cost. When the treasury stock is reissued, the Treasury Stock account is credited for the acquisition cost. If treasury stock is reissued for more than its acquisition cost, the excess amount is credited to Paid-in Capital from Treasury Stock. If treasury stock is reissued for less than its acquisition cost, the difference is debited to any paid-in capital account from previous treasury stock transactions. If the balance in this account is insufficient, the remaining difference is charged to retained earnings.

The following example shows the accounting for treasury stock under the cost method. No previous acquisitions or sales of treasury stock have occurred.

10,000 shares of common stock with a par value of $5 per share were originally issued at $12 per share.

  1. Entry for Purchase: 2,000 shares of common stock are reacquired for $20,000.

Treasury Stock………………………………………………………..           20,000

Cash………………………………………………………………….                                  20,000

  1. Entry for Resale: 1,000 shares of treasury stock are resold for $8,000.

Cash……………………………………………………………………….             8,000

Retained Earnings…………………………………………………             2,000

Treasury Stock…………………………………………………..                                  10,000

Retirement of Treasury Stock. The retirement of treasury stock is similar to the sale of treasury stock except that the corporation debits the paid-in capital accounts applicable to the retired shares instead of cash.

The cost of treasury stock is shown in the balance sheet as a deduction from the total of all stockholders’ equity accounts.

Dividend Policy

Very few companies pay dividends in amounts equal to their legally available retained earnings. The major reasons are: (a) to maintain agreements with creditors, (b) to meet state corporate laws, (c) to finance growth or expansion, (d) to provide for continuous dividends whether in good or bad years, and (e) to build a cushion against possible future losses.

Before a dividend is declared, the Board of Directors (who declare the dividend) must consider the availability of funds to pay the dividend. Directors must also consider economic conditions, most importantly, liquidity.

The SEC encourages companies to disclose their dividend policy in their annual reports. For example, companies that (a) have earnings but fail to pay dividends or (b) do not expect to pay dividends in the foreseeable future are encouraged to report this information. In addition, companies that have had a consistent pattern of paying dividends are encouraged to indicate whether they intend to continue this practice in the future.

Types of Dividends

Dividends may be paid in cash (most common means), stock, or some other asset. Dividends other than stock dividends reduce stockholders’ equity through an immediate or promised distribution of assets. When a stock dividend is declared, the corporation does not pay out assets or incur a liability. It issues additional shares of stock to each shareholder and nothing more.

Cash Dividends

The accounting for a cash dividend requires information concerning three dates: (a) date of declaration, (b) date of record, and (c) date of payment. A liability is established by a charge to retained earnings on the declaration date for the amount of the dividend declared. No accounting entry is required on the date of record. The stockholders who have earned the right to the dividend are those who o the shares on the date of record. The liability is liquidated on the payment date through a distribution of cash. The following journal entries would be made by a corporation that declared a $50,000 cash dividend on March 10, payable on April 6 to shareholders of record on March 25.

Declaration Date (March 10)

Retained Earnings (Cash Dividends Declared)……………. 50,000

Dividends Payable………………………………………………………………        50,000

Record Date (March 25)

No entry

Payment Date (April 6)

Dividends Payable……………………………………………………….. 50,000

Cash……………………………………………………………………………………        50,000

Property Dividends

Property dividends represent distributions of corporate assets other than cash. A property dividend is a nonreciprocal transfer of nonmonetary assets between an enterprise and its owners. Such transfers should be recorded at the fair value of the assets transferred. Fair value is measured by the amount that would be realized in an outright sale near the time of distribution. Just before a property dividend is declared, the value of the property is adjusted to fair value and a gain or loss is recognized. The fair value then serves as the basis used in accounting for the property dividend.

For example, if a corporation held stock in another company that it intended to distribute to its own stockholders as a property dividend, it would first adjust the carrying amount to reflect current fair value. If on the date the dividend was declared, the difference between the cost and fair value of the stock to be distributed was $75,000, the following additional entry would be made.

Equity Investments……………………………………………………….. 75,000

Unrealized Holding Gain or Loss—Income…………………………        75,000

Liquidating Dividends

Liquidating dividends represent a return of the stockholders’ investment rather than
a distribution of profits. In a more general sense, any dividend not based on profits must be a reduction of corporate capital, and to that extent, it is a liquidating dividend.

Stock Dividends

A stock dividend can be defined as a capitalization of retained earnings that results in a reduction in retained earnings and a corresponding increase in certain contributed capital accounts. Total stockholders’ equity remains unchanged when a stock dividend is distributed. All stockholders retain their same proportionate share of ownership in the corporation.

When the stock dividend is less than 20–25% of the common shares outstanding at the time of the dividend declaration, GAAP require that the accounting for stock dividends be based on the fair value of the stock issued. When declared, Retained Earnings is debited for the fair value of the stock to be distributed. The entry includes a credit to Common Stock Dividend Distributable for par value times the number of shares, with any excess credited to Paid-in Capital in Excess of Par. Common Stock Dividend Distributable is reported in the stockholders’ equity section of the balance sheet once declared and prior to issuance.

For example, Vonesh Corporation, which has 50,000 shares of $10 par value common stock outstanding, declares a 10% stock dividend on December 3. On the date of declaration the stock has a fair value of $25 per share. The following entry is made when the stock dividend is declared:

Retained Earnings (5,000 × $25)………………………………… 125,000

Common Stock Dividend Distributable……………………………….        50,000

Paid-in Capital in Excess of Par………………………………………….        75,000

When the stock is issued, the entry is:

Common Stock Dividend Distributable…………………………. 50,000

Common Stock……………………………………………………………………        50,000

Large Stock Dividend

If the number of shares issued in a stock dividend exceeds 20 or 25% of the shares outstanding, calling it a “stock split” is warranted, and only the par value of the shares issued is transferred from retained earnings.

Stock Split

A stock split results in an increase or decrease in the number of shares outstanding with a corresponding decrease or increase in the par or stated value per share. In general, no accounting entry is required for a stock split as the total dollar amount of all stockholders’ equity accounts remains unchanged. A stock split is usually intended to improve the marketability of the shares by reducing the market price of the stock being split. In general, the difference between a stock split and a stock dividend is based upon the size of the distribution.

Restrictions on Retained Earnings

In many corporations restrictions on retained earnings or dividends exist, but no formal journal entries are made. Such restrictions are best disclosed by note.

Presentation of Stockholders’ Equity

An example of a comprehensive stockholders’ equity section of a balance sheet is provided in the textbook. A company should disclose the pertinent rights and privileges of the various securities outstanding. Examples of information that should be disclosed are dividend and liquidation preferences, participation rights, call prices, and dates

Statements of stockholders’ equity are frequently presented in the following basic format:

  1. Balance at the beginning of the period.
  2. Additions.
  3. Deductions.
  4. Balance at the end of the period.

Analysis of Stockholders’ Equity

Several ratios use stockholders’ equity related amounts to evaluate a company’s profitability and long-term solvency. The following three ratios are discussed and illustrated in the chapter: (1) return on common stock equity, (2) payout ratio, (3) book value per share.

Dividend Preferences

Preferred stock generally has a preference in the receipt of dividends. Preferred stock can also carry features that require consideration at the time a dividend is declared and at the time of payment. These features are (a) the cumulative feature, and (b) the participating feature.

Book Value per Share

Book value per share is computed as net assets divided by outstanding common shares at the end of the year. There are complications that impact book value such as the number of authorized and unissued shares, the number of treasury shares on hand, commitments with respect to the issuance of unissued shares, and the relative rights of various types of authorized stock.