Chapter 18 Shareholders Equity

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1 PAID-IN CAPITAL Fundamental Share Rights One of the most important features of the corporate form of business is the issuance of capital stock in exchange for capital contributions. Each share of capital stock typically carries the following rights: 1. To share proportionately in profits and losses 2. To share proportionately in management by voting for the board of directors 3. To share proportionately in corporate assets upon liquidation 4. To share proportionately in any new issues of stock of the same class (preemptive rights) There can be a large variety of stock issues but in essence there are two kinds of capital stock: common stock and preferred stock. Common stockholders have a residual interest in the corporation and receive the benefits of profitable operations and incur the risks of unprofitable operations. Preferred stockholders have certain preferential rights with respect to the receipt of dividends. In exchange for this preference they sacrifice some if not all of the rights attributed to common shareholders. Preferred Stock This class of stock is preferred because it gives the stockholders certain preferences over common stockholders. There is some discussion as to the true status of preferred shareholders. In many respects they are a special class of creditors but for financial accounting purposes we consider them stockholders. The preferences attributed to preferred stock are: 1. Dividends are paid to preferred stockholders first 2. Priority above common stockholders in the event of liquidation 3. Convertible to common shares at the option of the stockholders 4. Callable at the option of the corporation 5. Preferred shareholders are not able to vote on corporate matters Special Features Cumulative Preferred Stock: If the corporation fails to declare dividends in year 1 and declares and pays dividends in year 2, stockholders with cumulative preferred stock will received their dividends for both year 1 and year 2 before the common stockholders receive any dividends. Any unpaid dividends from prior years are called dividends in arrears. Participating Preferred Stock: If preferred stock is participating, then after receiving the prescribed dividend the stockholders participate in dividends with the common stockholders. Convertible Preferred Stock: At a predetermined ratio preferred stockholders may within a specified period convert their preferred shares for common shares. This gives the preferred stockholders an opportunity to participate in the gain in value of the stock as a result of the success of the company. The conversion is at the option of the stockholder. Callable Preferred Stock: In certain circumstances a corporation might issue callable preferred stock. This gives the corporations option of redeeming the preferred shares of stock at a specific F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 1

2 future date at a specified price. If the shares are redeemed by the corporation, it must first bring current any dividends in arrears. Reporting Preferred Stock in the Financial Statements The par value of preferred stock is listed first in the equity section of the balance sheet followed by the par value of common stock. After the par value of all authorized, issued and outstanding stock is listed then the additional paid-in capital accounts are listed. Again, the additional paidin capital-preferred stock is listed first followed by the additional paid-in capital-common stock account. This following is the format that should be used when preferred stock has been issued by a corporation: Shareholders' Equity Capital stock: Preferred stock, $100 par value, 7% cumulative, 100,000 shares authorized, 30,000 chares issued and outstanding $3,000,000 Common stock, no par, stated value, $10 per share, 500,000 shares authorized, 400,000 shares issued and 398,000 shares outstanding 4,000,000 Common stock, dividend distributable, 20,000 shares 200,000 Total capital stock 7,200,000 Additional paid-in capital: Additional paid-in capital, preferred stock $150,000 Additional paid-in capital, common stock 840, ,000 Total paid-in capital 8,190,000 Retained earnings: Appropriated for plant expansion 2,200,000 Unappropriated 2,160,000 4,360,000 Total paid-in capital and retained earnings 12,550,000 Less: cost of treasury stock (2,000 shares, common) (190,000) accumulated other comprehensive loss (360,000) Total shareholder's equity $12,000,000 Accounting for the Issuance of Shares The balance sheet normally has three categories of stockholders equity. 1. Capital stock a. Common stock-amounts include only the par or stated value of the common stock issued b. Preferred stock- amounts include only the par or stated value of the preferred stock issued 2. Additional paid-in capital a. Common stock- amounts include only the premium paid or discount taken on the issuance of common stock F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 2

3 b. Preferred stock- amounts include only the premium paid or discount taken on the issuance of preferred stock 3. Retained earnings a. Accumulation of net income less or net losses less dividends from the beginning date of business The Concept of Par Value Typically the par value of stock is extremely low as opposed to the market value. Par value is the state mandated legal capital which cannot be distributed to the stockholders. For each class of stock (common and preferred) there will be a credit to the capital stock account and the additional paid-in capital account when stock is initially sold to investors. No-par stock would be carried in the books at the issue price with no additional paid-in capital or discount account. This is very rare. In states that allow no-par stock there is normally a stated value that is handled in the same manner as the par value. Shares Issued for Cash When stock is sold for cash the entry includes a debit to cash and a credit to one or more paid-in capital equity accounts. Example: Spencer Corporation sells 100 shares of common stock with a par value of $1 for $500. The journal entry would be as follows: Cash $500 Common stock $100 Additional paid-in capital, common stock 400 To record the sell of 100 shares of $1 par value common stock for $5 per share. Shares Issued on Credit When an investor purchases stock on a subscription basis prior to incorporation of the business entity, a partial payment is received and the stock is not issued until the final payment is made. Example: Prior to incorporation, the organizers of Spencer Company arranged to sell stock on a subscription basis to one of the organizers. The future shareholder agreed to purchase 200 shares of the company s $1 par value stock for $1,000. A $500 payment was made at the date of subscription and the remaining balance was paid on the date the stock was issued. The journal entries to record the issuance of a subscription and the receipt of the down payment are as follows: F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 3

4 Subscriptions receivable $1,000 Common stock subscribed $200 Additional paid-in capital, common stock 800 To record the subscription of 200 shares of $1 par value common stock for $5 per share. Cash $500 Subscriptions receivable $500 To record the receipt of $500 on the subscription of 200 shares of $1 par value common stock for $5 per share. Once the business entity is incorporated shares sold on contract result in the issuance of the shares and the recording of a share purchase contract receivable. This is a promissory note from the subscriber. The journal entries to record the receipt of the remaining balance on the share purchase contract receivable and the issuance of the shares of common stock are as follows: Cash $500 Subscriptions receivable $500 To record the receipt of $500, the remaining balance on the stock subscription. Common stock subscribed $200 Common stock $200 To record the issuance of 200 shares of subscribed stock. Example: One of the officers of Spencer Company entered into a share purchase contract to purchase 200 shares of the company s $1 par value stock for $1,000. A $500 payment was made at the date of contract and the remaining balance was paid on the date the stock was issued. The journal entries to record the issuance of a share purchase contract and the final issuance of the stock are as follows: F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 4

5 Cash $500 Receivable from share purchase contract 500 Common stock $200 Additional paid in capital, common stock 800 To record the purchase of 200 shares of $1 par value common stock for $5 per share on a share purchase contract. Stock Issued for Other Than Cash Stock issued for services or property other than cash should be recorded at the fair market value of the stock issued OR the fair market value of the non-cash consideration received, whichever is more clearly determinable. Example: Spencer Company enters into a transaction to purchase a patent in exchange for 100 shares of its $1 par value stock. There is no readily determinable market value for the stock or the patent. The company hires an appraiser to determine the fair market value of the patent. The appraiser determines that the patent is worth $6,000, therefore the journal entry to record this non-cash transaction is as follows: Patent $6,000 Common stock $100 Additional paid in capital, common stock 5,900 To record the issuance of 100 shares of $1 par value common stock in exchange for a patent valued at $6,000. Stock Issued with Other Securities There are two methods available to allocate the purchase price in a lump sum sale of more than one class of stock; the proportional method and the incremental method. If the fair market value of each class of stock is known then the allocation can be made using the proportional method. The respective market values are used as a basis for allocation. Example: Spencer Company purchased 100 shares $1 common stock and 100 shares of $1 preferred stock of Fido Chow for $9,000. At the time of the purchase the fair market value of the common stock was $80 per share and the fair market value of the preferred stock was $50 per share. Using the proportional method the allocation of the purchase price would be as follows: Securities Number of Shares Market Value Total Market Relative Value Allocation of Purchase Price Common stock 100 $80 $8,000 62% $5,538 Preferred stock ,000 38% 3,462 Totals 200 $13, % $9,000 F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 5

6 If in the above example we do know that the market value of the common stock is $80 but we don t know the market value of the preferred stock then the allocation would be completed as follows: Lump sum sale $9,000 Allocated to common stock 8,000 Balance allloacted to preferred stock $1,000 Share Issue Costs Share issue costs are those costs that are incurred by the corporation in bringing the stock to market. They include legal, accounting, promotional costs and the fees charged by the investment bankers. All such costs reduce the amount of cash that the company received from the stock issue. Rather than treating this as an expense it is debited to the paid-in capital, excess of par account. Example: Spencer Company issued 10,000 shares $5 par value common stock at a market price of $30 per share. The stock issue costs to bring this stock issue to market were $5,000. The journal entry to record the issuance of this stock is as follows: Cash 295,000 Common stock 50,000 Paid-in capial, excess of par 245,000 To record the issuance of 10,000 shares of common stock Analysis of cash received: Number of shares issued 10,000 Market price per share 30 Gross selling price 300,000 Less: issue costs 5,000 Cash received 295,000 Reacquisition of Shares Accounting for Retired Shares Shares retired are effectively considered shares authorized and not issued. The journal entry to retire shares of stock involves a credit to cash for the purchase price, and a debit to common stock for the par (or stated) value and paid-in capital, excess of par. If there is a gain on the transaction the remaining credit is to paid-in capital, share repurchase. If there is a loss on the transaction the remaining debit is to paid-in capital, share repurchase to the extent that there is an F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 6

7 existing credit balance in the account. If there is a loss, in excess of the balance in the paid-in capital, share repurchase account, it is debited to retained earnings. Example: Spencer Company retired 1,000 shares of $5 par value stock that was originally issued at $30 per share. If the repurchase price is $27 per share the journal entry to record the transaction would be as follows: Common stock 5,000 Paid-in capital, excess of par 25,000 Paid-in capital, share repurchase 3,000 Cash 27,000 To record the repurchase of 1,000 shares of common stock at $27 Assuming that there is no balance in the paid-in capital, share repurchase account, if the stock was repurchased at $32 per share the journal entry to record the transaction would be as follows: Common stock 5,000 Paid-in capital, excess of par 25,000 Retained earnings 2,000 Cash 32,000 To record the repurchase of 1,000 shares of common stock at $32 Accounting for Treasury Stock When a corporation repurchases its own stock and it is not retired, the stock is referred to as treasury stock. Treasury stock is not an asset but rather a contra-equity account. If stock has been repurchased, the balance sheet will reflect this debit balance account in the equity section. The following is an example of the equity section of a balance sheet for Spencer Company after it acquired 100 shares of treasury stock for $7,000. Shareholders' equity Paid-in Capital Common stock, $1 par value, 5,000 shares authorized and issued, 4,900 shares outstanding $5,000 Additional paid-in capital 20,000 Total paid-in capital 25,000 Retained earnings 180,000 Total paid-in capital and retained earnings 205,000 Less: treasury stock (at cost) 100 shares (7,000) Total shareholders' equity $198,000 F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 7

8 There are two methods of recording the purchase of treasury stock. The cost method is the most widely used in practice. In this approach the total reacquisition cost is debited to the treasury stock account. As you can see from the example above the treasury stock account is reported as a reduction in stockholders equity on the balance sheet. The application of the par value method is discussed in appendix 15A of your textbook. Example: Spencer Company acquired 100 shares of its own stock for $7,000. This transaction would be recorded as follows: Treasury stock $7,000 Cash $7,000 To record the purchase of 100 shares of treasury stock. Resale of Shares If treasury stock is sold above the reacquisition cost then there will be an increase in additional paid-in capital to reflect this increase in contributed capital. Note that the credit goes into a separate additional paid-in capital account entitled Additional paid-in capital-treasury stock. In the above example, Spencer Company purchase treasury stock for $7,000. Now if the company resells the treasury stock for $10,000 the following journal entry would record the transaction: Cash $10,000 Treasury stock $7,000 Additional paid-in capital, treasury stock 3,000 To record the sale of 100 shares of treasury stock. There are situations in which the company may be required to resell the treasury stock at a loss. If Spencer Company had to sell the above treasury stock for $5,000 the following journal entry would record the transaction: Cash $5,000 Additional paid-in capital, treasury stock 2,000 Treasury stock $7,000 To record the sale of 100 shares of treasury stock. Now this presents a problem. We can t have a debit balance in an additional paid-in capital account. If the account Additional paid-in capital-treasury stock reaches a zero balance, then the excess loss (debit) must be recorded as a debit to retained earnings. In the above example we only have one transaction so therefore there is no previous balance in the Additional paid-in capital-treasury stock account. Therefore, the correct journal entry in this situation is as follows: F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 8

9 Cash $5,000 Retained earnings 2,000 Treasury stock $7,000 To record the sale of 100 shares of treasury stock. Retiring Treasury Stock When treasury stock is retired it is removed from further circulation. For financial reporting purposes it is authorized but not issued stock. To retire treasury stock the original common stock and additional paid-in capital-common stock accounts are debited for the amounts involved in the original issue. The treasury stock account is credited for the amount paid when the stock was reacquired. If the company paid more for the treasury stock then it received in the original issue the difference is debited to retained earnings. If the company paid less for the treasury stock then it received in the original issue the difference is credited to additional paid-in capital-treasury stock. Example: Spencer Company decides to retire 1,000 shares of treasury stock that it purchased in the open market for $100,000. The stock has a par value of $1 and was originally sold for $80,000. The company paid more for the treasury stock then received in the original issue. Therefore the journal entry would be as follows: TREASURY STOCK > ORIGINAL ISSUE Common stock 1,000 Additional paid-in capital, common stock 79,000 Retained earnings 20,000 Treasury stock 100,000 In the above example, assume that Spencer Company retires 1,000 shares of treasury stock that it purchased in the open market for $60,000. The par value and original selling price are unchanged. In this case the company paid less for the treasury stock then received in the original issue. Therefore the journal entry would be as follows: ORIGINAL ISSUE > TREASURY STOCK Common stock 1,000 Additional paid-in capital, common stock 79,000 Treasury stock 60,000 Additional paid-in capital, treasury stock 20,000 F:\course\ACCT3322\200720\module3\c18\tnotes\c18b.doc 11/10/2006 9