Slide 1 of 33 Chapter Eleven

Chapter 11

Owners Equity



Slide 2 of 33 Chapter Eleven

Learning Objectives

Several Organization forms
Proprietorship; partnership; and corporation.
Several concepts of common (and preferred) shares:
Authorized shares, issued shares, treasury stock and
outstanding shares
Major transactions of common (and preferred) stocks
Issuance; repurchase
Dividends: cash dividends; stock dividends;
Stock splits
Several key financial indicators and ratios
EPS; P/E ratio; dividends yield.
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Organization Forms
Proprietorships
Partnerships
Corporations

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Proprietorships and Partnerships
Proprietorship
A business owned by one person.
Partnership
An association of two or more
individuals or organizations to carry
on an economic activity.
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Characteristics Shared by Proprietorships and
Partnerships
Ease of Formation
Both types of businesses are easy to start.

Limited Life
The business can decide to dissolve at any
time.

Unlimited Liability
The proprietors or partners are personally
responsible for all of the business debts.
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Corporation
A legal entity chartered by a government.
Legally distinct from the persons responsible
for its creation.
Accorded the same rights as individuals:
Can conduct business.
Can be sued.
Can enter into contracts.
Can own property.
Ownership is represented by transferable
shares of stock.
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Corporation Characteristics
Limited Liability
The maximum financial loss to shareholders is their investment in the
corporation.

Easy transfer of ownership
Shares can be transferred without affecting the legal and economic status.

Ability to raise large amount of capital
Investors population contribute wealth and share risk.

Double taxation
Corporate income tax and personal income tax.

Close government regulation
Political and social effect.
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Corporation Organization
Board of
Directors
Corporate
Officers
Corporation
Shareholders
Owned By
Appoint
and Oversee
Manage
Elect
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Stock transactions
Corporation
Common Stock Preferred Stock
Issuance or
repurchase
Dividend
Stock
split
Cash
Dividend
Stock
Dividend
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The rights of common stock owners
Voting

Dividends: Proportionate distribution of profits

Residual claim: Proportionate distribution of
remaining assets in a liquidation (creditors will be
paid before stockholders)
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Authorized, issued and outstanding Shares
Authorized Shares
The maximum number of shares of capital stock that can be sold to
the public.

Issued Shares
authorized shares of stock that have been sold.

Unissued Shares
authorized shares of stock that have not been sold.

Treasury stock
Stock that has been bought back and held by the issuing corporation

Outstanding shares
Difference between issued shares and treasury stock


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Authorized
Shares
Unissued
Shares
Treasury
Shares
Outstanding
Shares
Issued
Shares
Treasury shares are
issued shares that have
been bought back by the
corporation.
Outstanding shares are
issued shares that are
owned by stockholders.
Authorized, Issued, and Outstanding Shares
Slide 13 of 33 Chapter Eleven
E 11-1
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Sale and Issuance of Capital Stock
Initial public offering
(IPO)
Seasoned new issue
(SEO)
The first time a
corporation sells
stock to the public.
Subsequent sales of
new stock to the
public.
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Par Value and No-par Value Stock
Legal capital is the amount of capital, required by
the state, that must remain invested in the
business.
Par Value
Nominal
value
Legal capital
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Par
Value
Market
Value
Par Value and No-par Value Stock
Some states do
not require that a
par value be
stated in the
charter.
Some states
do not
require a par
value to be
stated in the
charter.
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Accounting for Capital Stock
Two primary sources of
stockholders equity
Retained
earnings
Contributed
capital
Common
stock, par
value
Capital in
excess of
par value
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Sale and Issuance of Capital Stock
Prepare the journal entry to
record this transaction.
On July 6, Sonic issued 100,000 shares of $0.01
par value common stock for $20 per share.
Date Description Debit Credit
July 6 Cash (+A) 2,000,000
Common stock (+SE) 1,000
Capital In excess of par value (+SE) 1,999,000
GENERAL JOURNAL
100,000 shares $20 per share = $2,000,000
100,000 shares $0.01 par value = $1,000
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Secondary Markets
Transactions between two investors
that do not affect the corporations
accounting records.
Id like to sell
some of my
Sonic stock.
Id like to buy
some of your
Sonic stock.
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Purchase by Li
Ka-shing
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1/1/2008-6/30/2009
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Cheung Kong Holding 2008 annual report
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Repurchase of stock
To reissue them to employees as a compensation
To show management confidence in the current price
To purchase shares to avoid a hostile takeover



Treasury stock
No voting or dividend rights
Contra- equity account




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Treasury Stock
When stock is bought back, the corporation records the
treasury stock at cost.


Dr. Treasury Stock 20,000
Cr. Cash 20,000

When a company sells its treasury stock, it does not report
an accounting profit or loss on the transaction, just
increase or decrease capital in excess of par


Dr. Cash 30,000
Cr. Treasury stock 20,000 (=2,000*10)
Cr. Capital in excess of par value 10,000

Acquire 2,000 shares at $10 per share

Reissue 2,000 shares at $15 per share
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Treasury Stock
When a company sells its treasury stock, it does not report
an accounting profit or loss on the transaction, just
increase or decrease capital in excess of par


Dr. Cash 10,000
Dr. Capital in excess of par value 10,000
Cr. Treasury stock 20,000
(=2,000*10)


Acquire 2,000 shares at $5 per share

Reissue 2,000 shares at $5 per share
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O-net communications (group) ltd.
(stock code: 877)
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E11-9 Isodor
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Dividends on Common Stock
Declared by board of
directors.
Not legally
required.
Creates liability at
declaration.
Requires sufficient Retained
Earnings and Cash.
Declaration date
Board of directors declares the dividend.
Record a liability.
Date Description Debit Credit
Retained earnings (-SE) XXX
Dividends payable (+L) XXX
GENERAL JOURNAL
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Date of Record
Stockholders holding shares on this date will
receive the dividend. (No entry)
Dividend Dates
Date of Payment
Record the dividend payment to stockholders.
Date Description Debit Credit
Dividends payable (-L) XXX
Cash (-A) XXX
GENERAL JOURNAL
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Stock dividends

Pro rata basis: each shareholder received additional
shares equal to the percentage of shares held

No change in total shareholders equity

No change in par value

Decrease in stock price

Journal entry

Dr Retained earnings
Cr Common stock
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Large Stock dividends


Additional shares 20-25% outstanding shares


transfer the par value of the additional shares from retained
earnings to the common stock of stockholders' equity


a corporation has 2,000 shares of common stock outstanding
when it declares a 50% stock dividend, par value is $0.10 per
share and the market price is $12 per share after the dividends


Dr. Retained earnings (2000 shares*50%*$0.10) $100
Cr. Common stock $100

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Small Stock dividends


Additional shares < 20-25% outstanding shares



transfer the market value of additional shares from retained
earnings to common stock and Capital in excess of par
value



a corporation has 2,000 shares of common stock outstanding
when it declares a 5% stock dividend, par value is $0.10 per
share and the market price is $12 per share after the dividends

Dr. Retained earnings (2000 shares*5%*$12) $1,200
Cr. Common stock (2000 shares*5%*$0.1) $10
Capital in excess of par value $1,190

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Why the small and large stock dividends are
recorded at different value?
Case A:
100 shares outstanding, traded at $100/share
Issue 10% stock dividends
If the prices do not change, then investors receive $10 for
each share
Case B:
100 shares outstanding, traded at $100/share
Issue 100% stock dividends, price (most likely) halved to
$50/share.
By holding one share,
Total value is $100 before the stock dividends
Still $100 = $50*2 after the stock dividends
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Why the small and large stock dividends are
recorded at different value?
The underlying logics
Do the stock dividends affect stock prices?
If no, investors have received real money.
If yes, investors do not receive (or receive less) real
money.
Will the stock dividends affect the stock prices?
In reality, the stock prices may not drop proportionately.
The answer is more likely yes if the stock dividends are
larger.
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A stock split is an increase in the total outstanding shares
by a specified ratio, such as 2-for-1.

A stock split change the par value per share, but the total
par value or any equity amount is unchanged.

A stock split does not require a journal entry but is
disclosed in the notes to the financial statements.

A stock dividend requires a journal entry.

Stock Splits
Slide 37 of 33 Chapter Eleven
Stock splits change the par value per share,
but the total par value is unchanged.
Stock Splits
Assume that a corporation had 3,000
shares of $2 par value common stock
outstanding before a 2for1 stock split.
Increase
Decrease
No
Change
Before
Split
After
Split
Common Stock Shares 3,000 6,000
Par Value per Share 2.00 $ 1.00 $

Total Par Value 6,000 $ 6,000 $
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Why stock dividends (and stock split)?
Retained earnings are sufficient but cash is not enough
To reduce the nominal prices of shares so that
More investors can offer to trade
HSBCs price last trading day: HK$80.25
To buy one lot (400 shares), you need $32,000!
If one share is split into 10 shares, you only need $3,200
to buy one lot.
More people can afford to trade.
More people to share the risk
Higher total market value.

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Preferred stock
No voting right

priority over common stock in dividend distributions and
distribution of assets in a liquidation.

Fixed dividend rate, as a percentage of par value

Current Dividend Preference: The current preferred
dividends must be paid before paying any dividends to
common stock.

Cumulative Dividend Preference: Any unpaid dividends
from previous years (dividends in arrears) must be paid
before common dividends are paid

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Example: Preferred Dividend
Lobster Company did not pay dividends last year, but it has
declared a $5,000 dividend in the current year. Outstanding
stock includes the following. Calculate the dividend for
preferred shares and common shares.
Preferred, 5% Cumulative, $20 par 2,000 shares
Common, $5 par 5,000 shares
Dividends in arrears $2,000
Current-dividend preference
($20 x 0.05 x 2,000 shares) 2,000
Total for preferred stockholders $4,000
Total left for common stockholders 1,000
Total $5,000
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Example: Preferred Dividend
Lobster Company did not pay dividends last year, but it has
declared a $5,000 dividends in the current year. Outstanding stock
was previously listed. Given this calculation, provide the
appropriate journal entries.
Declaration Date
Dividends, preferred . . . . . . . . . . 4,000
Dividends, common . . . . . . . . . . 1,000
Dividends Payable. . . . . . . . . . . . . . 5,000
To record declaration of cash dividends, $5,000.

Payment Date
Dividends Payable. . . . . . . . . . . . . . . . . . . 5,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . 5,000
To record payment of cash dividends, $5,000.
Slide 44 of 33 Chapter Eleven

Example: Preferred Dividend
Lobster Company did not pay dividends last year, but it has
declared a $5,000 dividends in the current year. Outstanding stock
was previously listed. Given this calculation, provide the
appropriate journal entries.
If Lobster has dividends account, then at the end of
accounting period, it should close dividends accounts to
retained earnings account.
Retained earnings . . . . . . . . . . . . . 5,000
Dividends, preferred . . . . . . . . . . 4,000
Dividends, common . . . . . . . . . . 1,000

If Lobster does not set dividends accounts
Declaration Date
Retained earnings . . . . . . . . . . 5,000
Dividends Payable. . . . . . . . . . . . . . 5,000
To record declaration of cash dividends, $5,000.
Slide 45 of 33 Chapter Eleven

P11-9 Vassily Biogenics
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Earnings per share (EPS)
Net Income
Average Number of Shares Outstanding
EPS =
Probably the most widely watched financial ratio.
Slide 47 of 33 Chapter Eleven

Earnings per share (EPS)
Time period Outstanding Fraction Average
Shares of Year
Jan June 5,000 X 6/12 = 2,500
July Oct 9,000 X 4/12 = 3,000
Nov Dec 6,000 X 2/12 = 1,000
Average shares outstanding 6,500

EPS = 32,500 / 6,500 = $5


Outback earns $32,500 in 2005. At Jan 1, 2005, it has 5,000
common shares outstanding, sells 4,000 additional shares on July 1,
and purchases 3,000 treasury shares on Nov 1.
Slide 48 of 33 Chapter Eleven
P/E ratio (page 57)
P/E = Price/EPS
How much are investors willing to pay for a
company stock given current years earnings
per share? It depends on investors perception
of earnings persistence and earnings
growth.
Slide 49 of 33 Chapter Eleven

Cash dividends
only part of the return on investment
growth firms usually pay little dividends and many firms
keep a sticky dividend distribution

Dividend
Yield
Dividends Per Share
Market Price Per Share
=
This ratio is often used to compare the dividend-paying
performance of different investment alternatives.
This ratio tells only part of the return on investment
story.