CHAPTER 12 Contributed Capital, the management issues related to contributed capital

CHAPTER 12 Contributed Capital

OBJECTIVE 1: Identify and explain the management issues related to contributed capital.

Summary Statement

As previously discussed, a corporation is a business organization authorized by the state (through a corporate charter) to conduct business and is a separate legal entity from its owners. It is the dominant form of American business because it makes possible the accumulation of large quantities of capital.

An initial public offering (IPO) is a corporation's first-time issuance of stock to the public. A share of stock represents ownership in the corporation.

Contributed capital is an integral part of the financing of a corporation. The major features of managing contributed capital are management under the corporate form of business, using equity financing, determining dividend policies, evaluating business performance based on return on equity, and using stock options as compensation.

The corporate form of business has several advantages over the sole proprietorship and the partnership: separate legal entity, limited liability of owners, ease of capital generation, ease of transfer of ownership, lack of mutual agency, continuous existence, centralized authority and responsibility, and professional management.

The corporate form of business also has several distinct disadvantages compared with the sole proprietorship and the partnership: government regulation, double taxation, difficulty in raising funds because of limited liability of owners, and separation of ownership and control.

Ownership in a corporation is shown by documents called stock certificates. The owners are the firm’s stockholders. A stockholder sells stock by endorsing the stock certificate and sending it to the corporation’s secretary or transfer agent. The secretary or transfer agent is responsible for transferring the corporation’s stock, maintaining stockholders’ records, preparing a list of stockholders for stockholders’ meetings, and paying dividends.

Par value is an arbitrary amount assigned to each share and is the legal value of a share of stock. Legal capital equals the number of shares issued times the par value; it is the minimum amount that can be reported as contributed capital.

Corporations often hire an underwriter, an intermediary between the corporation and the investing public, to help in the initial issue of stock.

The costs of forming a corporation (such as attorneys’ fees and incorporation fees) are called start-up and organization costs. These costs typically are expensed when incurred.

A dividend is a distribution among stockholders of the assets that a corporation’s earnings have generated. These assets are normally distributed in cash.

Dividends can be paid quarterly, semiannually, annually, or at other times as declared by the board of directors. A dividend that exceeds retained earnings is not allowed in most states. When such a dividend is declared, it is called a liquidating dividend and is usually paid when a company is going out of business or reducing its operations.

Dividends are declared on the declaration date, specifying that the owners of the stock on the record date will receive the dividends on the date of payment.

When cash dividends are declared, the Cash Dividends Declared account is debited and Cash Dividends Payable is credited; when they are paid, Cash Dividends Payable is debited and Cash is credited. The Cash Dividends Declared account is closed to Retained Earnings at the end of the period. No journal entry is made on the record date. After the record date, stock is sold ex-dividend (without dividend rights).

The current return to stockholders in the form of dividends is measured with the ratio dividends yield. It is computed by dividing the dividends per share by the market price per share.

The return on equity is a ratio that measures management performance by dividing net income by average stockholders’ equity. It is used to evaluate companies and even to determine top executives’ compensation.

Management can reduce the number of shares in public hands by buying back shares on the open market. The cost of these shares, which are known as treasury stock, reduces stockholders' equity and increases return on equity.

The price/earnings (P/E) ratio, a measure of investors’ confidence in a company’s future, is calculated by dividing the market price per share by the earnings per share.

Stock option plans are agreements whereby employees may purchase a specified quantity of the company’s stock at a fixed price for a stated period. If only certain employees (usually management) are eligible for this benefit, the plan is said to be compensatory. The amount of compensation equals the market price on the date the option is granted minus the option price. The amount in excess of the exercise price must be either recorded as compensation expense over the grant period or reported in the notes to the financial statements.

New Concepts and Terminology

initial public offering (IPO); share of stock; double taxation; stock certificate; par value; legal capital; underwriter; start-up and organization costs; dividend; liquidating dividend; declaration date; record date; ex-dividend; date of payment; treasury stock; stock option plans

Key Ratios

dividends yield; return on equity; price/earnings (P/E) ratio

Related Text Illustrations

Figure 1: The Corporate Organization

Figure 2: Dividend Dates

Figure 3: Stock Quotations on the NASDAQ

Focus on Business Practice: How Did Accounting for Stock Options Become Political?

Lecture Outline

I. A corporation is a business organization authorized by the state and considered a separate legal entity from its owners.

II. An IPO is a company's first public issuance of its stock.

III. There are several advantages to the corporate form of business.

A. Separate legal entity

B. Limited liability of owners

C. Ease of capital generation

D. Ease of transfer of ownership

E. Lack of mutual agency

F. Continuous existence

G. Centralized authority and responsibility

H. Professional management

IV. There are several disadvantages to the corporate form of business.

A. Government regulation

B. Double taxation

C. Limited liability of owners

D. Separation of ownership and control

V. Par value is an arbitrary amount assigned to each share of stock; legal capital equals the number of shares issued times the par value.

VI. In IPOs, stock is generally issued through an underwriter.

VII. Start-up and organization costs consist of all costs of forming a corporation.

VIII. Start-up and organization costs usually are expensed when incurred.

IX. Stockholders can earn a return on their investment in one of two ways.

A. Through dividends paid by the corporation

B. By selling their shares of stock for more than they paid for them

X. The board of directors has sole authority to declare dividends.

A. Dividend policies are usually influenced by top management.

B. Dividends are usually paid when a company has experienced profitable operations; however, two other considerations will affect the decision to make dividend payments.

1. The expected volatility of earnings

2. The level of cash flows

XI. Dividends can be paid quarterly, semiannually, annually, or as decided by the board of directors.

XII. A liquidating dividend is the return of contributed capital to the stockholders and is normally paid when a company is going out of business or reducing operations.

XIII. There are three dates associated with a cash dividend.

A. Declaration date

B. Record date

C. Date of payment

XIV. Stock sold after the date of record is sold ex-dividend.

XV. Common ratios

A. Dividends yield

B. Return on equity

C. Price/earnings ratio

XVI. The return on equity ratio is the most important ratio associated with stockholders’ equity.

A. The return on equity ratio is affected by the following:

1. The amount of net income the company earns

2. The company’s level of average stockholders’ equity

B. Stockholders’ equity is affected by management decisions.

1. How much stock a company sells to the public

2. How many shares the company buys back on the open market (reducing the number of shares held by the public), known as treasury stock

XVII. A stock option plan gives corporate employees the right to purchase stock in a certain quantity and at a certain price.

A. Most plans are intended to compensate employees (usually management).

B. The amount of compensation equals the market price on the date the option is granted minus the option price.

Teaching Strategy

Write “Advantages” and “Disadvantages” (of the corporate form of business) on the board, and ask students to give examples of each. Be sure students say why an item is an advantage or a disadvantage. Note that limited liability is both an advantage and a disadvantage.

Explain what costs are included in the start-up and organization costs account, and either make up some facts for a journal entry or refer students to the entry in the text.

Case 1 deals with the reasons for issuing common stock, and Case 12 deals with the choice of debt or equity financing. Short Exercise 3 pertains to start-up and organization costs.

Explain declaration date, record date, ex-dividend, and date of payment.

Compare a cash dividend paid to a stockholder with a cash withdrawal made by a sole proprietor. One difference is that usually no payable is set up for the sole proprietor. Emphasize that the Cash Dividends Declared account must be closed, just as the Withdrawals account must be.

Short Exercise 6 and Exercises 7 and 8 pertain to cash dividends.

Use Short Exercise 4 to show the journal entry when a stock option is exercised. Explain that the journal entry when the option is exercised would have been the same even if the option price had been less than the market price on the option-granting date.

Note that the journal entry for the compensation at the option-granting date is covered in more advanced courses.

OBJECTIVE 2: Identify the components of stockholders’ equity.

Summary Statement

A corporation’s balance sheet contains assets, liabilities, and a stockholders’ equity section. Stockholders’ equity is made up of contributed capital (the stockholders’ investment) and retained earnings (earnings that have remained in the business).

When only one type of stock is issued by a corporation, it is called common stock. Because common stockholders’ claim to assets in case of liquidation ranks behind that of creditors and preferred stockholders, common stock is considered the residual equity of a corporation.

The second kind of stock a company can issue is preferred stock. Preferred stock has preference over common stock in one or more areas. The maximum number of shares that can be issued is stipulated in the corporation's state charter. This maximum amount is known as the authorized shares. The shares sold or otherwise transferred to stockholders are the issued shares of a corporation. Shares that have been issued to stockholders and remain in circulation, having been neither bought back by the corporation nor given back by the stockholder, are called outstanding shares. Treasury stock consists of shares bought back and being held by the corporation.

New Concepts and Terminology

common stock; residual equity; preferred stock; authorized shares; issued shares; outstanding shares

Related Text Illustrations

Exhibit 1: Stockholders’ Equity Section of a Balance Sheet

Focus on Business Practice: Are You a First-Class or Second-Class Stockholder?

Figure 5: Relationship of Authorized Shares to Unissued, Issued, Outstanding, and Treasury Shares

Lecture Outline

I. Stockholders’ equity is composed of contributed capital and retained earnings.

II. When only one type of stock is issued, it is called common stock.

III. The second kind of stock a company can issue is preferred stock.

IV. Authorized shares are the maximum number of shares the corporation is allowed to issue according to its state charter.

V. Issued shares represent the number of shares sold or otherwise transferred to stockholders.

VI. Outstanding shares are shares that have been issued and are still held by stockholders.

Teaching Strategy

Show students the balance sheet that follows. Then conceal the asset part while discussing the components of stockholders’ equity. Each time a new account is introduced, show this balance sheet and locate the new account with the students. At this point, do not go into detail about each account; simply emphasize that there are two major categories—contributed capital and retained earnings. Show how the credit to capital is specifically stated when an owner contributes to (buys stock in) a corporation. (Short Exercise 5 is a good illustration.) Case 6 deals with alternate means of financing.

Balance Sheet Corporation Name 12/31/x1

Current Assets

Current Liabilities

Cash

Notes Payable

Marketable Securities

Accounts Payable

Notes Receivable

Salaries Payable

Accounts Receivable

Dividends Payable

Subscriptions Receivable

Inventory

Total Current Liabilities

Prepaid Expenses

Long-Term Liabilities

Total Current Assets

Bonds Payable

Total Liabilities

Property, Plant, and Equipment

Land

Stockholders’ Equity

Building

Less Accumulated Depreciation

Contributed Capital

Equipment

Preferred Stock

Less Accumulated Depreciation

Common Stock

Common Stock Distributable

Total Property, Plant, and Equipment

Additional Paid-in Capital

Total Contributed Capital

Intangible Assets

Trademarks

Retained Earnings

Patents

Total Contributed Capital and Retained Earnings

Goodwill

Less Treasury Stock

Total Intangible Assets

Total Stockholders’ Equity

Total Assets

Total Liabilities and Stockholders’ Equity

OBJECTIVE 3: Identify the characteristics of preferred stock.

Summary Statement

Holders of preferred stock are given preference over common shareholders when dividends (and liquidating dividends) are declared; that is, the holders of preferred shares must receive a certain amount of dividends before the holders of common shares can receive dividends. This dividend is a specific dollar amount or percentage of par value. Preferred stockholders receive their dividends before common stockholders receive anything. Once preferred stockholders have received the annual dividends to which they are entitled, however, common stockholders generally receive the remainder.

At times, preferred stockholders do not receive the full amount of their annual dividends. When the stock is noncumulative preferred stock, unpaid dividends are not carried over to the next period. When the stock is cumulative preferred stock, the unpaid amount is carried over to the next year. Unpaid “back dividends” are called dividends in arrears and should be disclosed either on the balance sheet or in a note.

When a dividend is declared by the board of directors, Cash Dividends Declared is debited and Cash Dividends Payable is credited.

An owner of convertible preferred stock has the option to exchange each share of preferred stock for a set number of shares of common stock.

Most preferred stocks are callable preferred stock, meaning that the corporation has the right to buy the stock back for cancellation at a specified call or redemption price. Holders of convertible preferred stock can choose instead to convert it to common stock.

New Concepts and Terminology

noncumulative preferred stock; cumulative preferred stock; dividends in arrears; convertible preferred stock; callable preferred stock

Related Text Illustration

Focus on Business Practice: How Does a Stock Become a Debt?

Lecture Outline

I. Compute the distribution of dividends to common and preferred shareholders, assuming the different features of preferred stock.

II. Dividends in arrears are unpaid “back dividends” on cumulative preferred stock.

III. Journalize the declaration of a dividend.

IV. Convertible preferred stock can be exchanged for common stock at a predetermined ratio.

V. Callable preferred stock can be redeemed or retired at the option of the issuing corporation.

Teaching Strategy

Explain preferred stock as stock that has preference over common stock when dividends are paid and when assets are distributed if the corporation is liquidated. Note that preferred stock usually has no voting rights.

List the following and explain each characteristic:

Characteristics of preferred stock

Cumulative—stockholder’s advantage

Noncumulative—corporation’s advantage

Convertible—stockholder’s advantage

Callable—corporation’s advantage

Refer back to the terms cumulative and noncumulative. Use Short Exercise 7 and Exercises 9 and 10 to show the effect of each. Use or assign Case 2 to illustrate the reasons for issuing preferred stock.

OBJECTIVE 4: Account for the issuance of stock for cash and other assets.

Summary Statement

Par value is the legal value established for a share of stock. Capital stock (common or preferred) may or may not have a par value, depending on the specifications in the charter. When par value stock is issued, the Capital Stock account is credited for the legal capital (par value), and any excess is recorded as Paid-in Capital in Excess of Par Value. In the stockholders’ equity section of the balance sheet, the entire amount is labeled Total Contributed Capital.

No-par stock is stock for which par value has not been established; it may be issued with or without a stated value. Stated value (which is established by the board of directors) constitutes the legal capital for a share of no-par stock. The total stated value is recorded in the Capital Stock account. Any amount received in excess of the stated value is recorded as Additional Paid-in Capital. If no stated value is set, however, the entire amount received constitutes legal capital and is credited to Capital Stock.

When stock is issued in exchange for assets or for services rendered, the stock should be recorded at the fair market value of the assets or services, unless the fair market value of the stock is more easily determined.

The following journal entries are introduced in this learning objective:

Cash

XX (amount invested)

Common Stock

XX (legal capital amount)

Additional Paid-in Capital

XX (excess of par)

Issued par value common stock for amount in excess of par value

Cash

XX (amount invested)

Common Stock

XX (legal capital amount)

Issued no-par common stock (no stated value established)

Cash

XX (amount invested)

Common Stock

XX (legal capital amount)

Additional Paid-in Capital

XX (excess of stated value)

Issued no-par common stock with stated value for amount in excess of stated value

Start-Up and Organization Expense

XX (fair market value of services)

Common Stock

XX (par value)

Additional Paid-in Capital

XX (excess of par)

Issued par value common stock for attorney's services

Land

XX (fair market value of stock)

Common Stock

XX (par value)

Additional Paid-in Capital

XX (excess of par)

Issued par value common stock with a market value in excess of par value for a piece of land

New Concepts and Terminology

no-par stock; stated value

Lecture Outline

I. Common and preferred stock may or may not have a par value.

A. Journalize the issuance of par value stock at greater than par value.

II. No-par stock may be issued with or without a stated value.

A. Journalize the issuance of no-par stock with a stated value.

B. Journalize the issuance of no-par stock with no stated value.

III. Journalize the issuance of stock in exchange for assets or services.

Teaching Strategy

Remind students of the journal entry used when a sole proprietor contributed cash or other assets to a company. Generally, an asset account is debited and an equity account is credited.

Show the balance sheet used in Objective 2 so that students can see the number of choices for the equity account to be credited.

Explain par value and stated value and how they limit the dollar amount to credit the stock accounts. Use Short Exercise 8 and Exercise 11 to demonstrate the issuance of stock.

When stock is issued for noncash assets, students have difficulty understanding the amount to debit the noncash asset the corporation receives. The misunderstanding seems to arise because the amount is the fair market value of what is given up if the fair market value is known. If it is not known, then the amount of the debit is the fair market value of what is received. Show the following chart:

Noncash Asset Received

Stock Issued

Amount to Debit the Asset Received

Fair Market Value (FMV) unknown FMV known

FMV known FMV unknown

FMV of stock FMV of asset

Use Short Exercise 9 and Exercise 12 to demonstrate the issuance of stock for noncash assets.

OBJECTIVE 5: Account for treasury stock.

Summary Statement

A company's treasury stock, as explained earlier, comprises common or preferred shares that are issued but no longer outstanding. Treasury stock may be purchased for a variety of reasons: (1) to distribute to employees through stock option plans, (2) to maintain a favorable market for the company’s stock, (3) to increase earnings per share, (4) to use in purchasing other companies, and (5) to prevent a hostile takeover of the company.

Treasury stock can be held indefinitely, reissued, or retired; it has no rights until it is reissued. Treasury stock appears on the balance sheet as the last item in the stockholders’ equity section, as a deduction.

When treasury stock is purchased, Treasury Stock, Common is debited for the purchase cost. The stock may be reissued at cost, above cost, or below cost. When cash received from reissuance exceeds the cost, the difference is credited to Paid-in Capital, Treasury Stock. When cash received from reissuance is less than the cost, Paid-in Capital, Treasury Stock (and Retained Earnings, if needed) is debited for the difference. In no instance should a gain or loss account be established.

When treasury stock is retired, all the contributed capital associated with the retired shares must be removed from the accounts. When less was paid on reacquisition than was contributed originally, the difference is credited to Paid-in Capital, Retirement of Stock. When more is paid, the difference is debited to Retained Earnings.

Focus on Business Practice: When Are Share Buybacks a Bad Idea?

Lecture Outline

I. Treasury stock is issued stock that the issuing corporation has reacquired for any of the following reasons:

A. To use for stock option plans

B. To maintain a favorable market for the company’s stock

C. To increase earnings per share

D. To use to purchase other companies

E. To prevent a hostile takeover of the company

II. Treasury stock is the last item (a deduction) in the stockholders’ equity section of the balance sheet.

III. Journalize the purchase of treasury stock.

IV. Journalize the reissuance of treasury stock (at cost, above cost, and below cost).

V. Gains and losses are not recognized on treasury stock transactions.

VI. When stock is retired, all the contributed capital associated with it must be removed from the accounts.

A. Journalize the retirement of stock at the original issue price.

B. Journalize the retirement of stock at less than the original issue price.

C. Journalize the retirement of stock at greater than the original issue price.

Teaching Strategy

To place treasury stock in perspective, show the balance sheet from Objective 2. After explaining why a company purchases its stock, if time permits and if students need the visual presentation, write out the journal entries as follows:

Purchase:

Treasury Stock at cost

Cash at cost

Reissue at cost:

Cash at cost, which equals reissue price

Treasury Stock

Reissue at more than cost:

Cash at reissue price

Treasury Stock at cost

Paid-in Capital, Treasury Stock

Reissue at less than cost:

Cash at reissue price

Paid-in Capital, Treasury Stock if there is a credit balance in the account large enough to accommodate the debit needed to balance the journal entry.

Retained Earnings if the credit balance in Paid-in Capital, Treasury Stock is not large enough to accommodate the debit balance needed to balance the journal entry.

Treasury Stock at cost

Work Short Exercises 10 and 11 and Exercises 13 and 14 for practice. Exercise 14 includes the retirement of treasury stock. Use Case 3 to illustrate the purposes of treasury stock or Case 11 as a group activity on the decision to buy treasury stock or issue a dividend