11–1

Chapter 11

Contributed Capital

11–2Copyright © Cengage Learning. All rights reserved.

Google, Inc.

Click here for information on the history of Google.

Created a national sensation with the largest IPO after the tech bust of 2002

Issued 22.5 million shares at $85 per share for a total of $1.9 billion

As you study this chapter, consider why you think Google decided to offer stock as a means to raise capital.

11–3Copyright © Cengage Learning. All rights reserved.

Management Issues Related to Contributed Capital

LO1

Corporation is a body of persons who have been granted a charter that recognizes the entity as having separate legal rights, privileges, and liabilities distinct from those of its members

Investments by stockholders, called contributed capital, is a major means of

financing for a corporation

11–4Copyright © Cengage Learning. All rights reserved.

Corporate Form of Business

Separation of ownership and control

Limited liability

Double taxation

More government regulation

DisadvantagesAdvantages

Centralized authority

Professional management

Continuous existence

Lack of mutual agency

Ease of transferring stock

Ease of raising capital

Separate legal entity

Limited liability

11–5Copyright © Cengage Learning. All rights reserved.

Using Equity Financing

A stock certificate is issued to the owner

Stockholder can transfer ownership at will

Independent registrars and transfer agents are often used to keep track of stockholders’ records

Stock Certificate Shows units of ownership in a

corporation

11–6Copyright © Cengage Learning. All rights reserved.

Par Value

Usually bears little or no relationship to the market value or book value of shares

Constitutes the legal capital of the corporation

– The number of shares issued times the par value

– The minimum amount that can be reported as contributed capital

An arbitrary amount assigned to each share of stock

11–7Copyright © Cengage Learning. All rights reserved.

Initial Public Offering (IPO)

acts between the corporation and investing public

Guarantees the sale of the stock for a fee

Underwriter

The corporation records the net proceeds of the offering

11–8Copyright © Cengage Learning. All rights reserved.

Costs to Start a Corporation?

Start-up and Organization

Costs

Start-up and Organization

Costs

State incorporation fees

Attorneys’ fees

Cost of printing stock certificates

Accountants’ fees related to registering the firm’s stock

A corporation’s life normally is not known, so these costs are expensed as incurred.

11–9Copyright © Cengage Learning. All rights reserved.

Dividends

Distribute to stockholders the assetsthat a corporation’s earnings have generated

Stockholders receive these assets,

usually cash, in proportion to the number of shares

they own

Board of directors declares dividends

Decision to declare dividends affected by

• cash flows,

• pending lawsuits,

• economic situation,

• or debt levels.

11–10Copyright © Cengage Learning. All rights reserved.

Dividend Dates

Date of Declaration

Date of Record

Payment Date

Board of directors formally declares that the corporation is going to pay a

dividend

Whoever owns the stock on

the record date will receive the

dividend

Date on which the dividend is

paid to the stockholders of

record

11–11Copyright © Cengage Learning. All rights reserved.

Dividend Yield Ratio

Shareper PriceMarket

Shareper Dividends Yield Dividends

%4.1$27.87

$0.40 Microsoft

Tells investors how much they can expect to receive in dividends expressed as a percentage of the

market price per share—what they can sell the stock for

11–12Copyright © Cengage Learning. All rights reserved.

Return on Equity Ratio

Most important ratio associated with stockholders’ equity Compensation of top executives often tied to return on

equity

Net IncomeAverage Stockholders’ Equity

$4,203,720($22,689,679 + $17,039,840) / 2

= 21.2%

=

=

Return on Equity

Google

11–13Copyright © Cengage Learning. All rights reserved.

Price/Earnings (P/E) Ratio

A measure of investors’ confidence in a company’s future

Shareper Earnings

Shareper PriceMarket Ratio (P/E) Earnings Price

times16$1.74

$27.87 Microsoft

Because the market price is 16 times earnings, investors are paying a good price in relation to earnings. They do so in the expectation that

this software company will continue to be successful

11–14Copyright © Cengage Learning. All rights reserved.

Discussion: Ethics in the Business World

Companies with a code of ethics experienced far less P/E volatility over a four-year period, than those without them. This suggests that they may be a more secure investment in the longer term.

Source: Institute on Business Ethics, “Does Business Ethics Pay?” by Simon

Webley & Elise More

Q. If the P/E ratio is volatile, what factors may be at play?

A. Questionable management or accounting practices, dips in economic conditions

11–15Copyright © Cengage Learning. All rights reserved.

Stock Option Plans

Give employees the right to purchase stock in the future at a fixed price

A means of both motivating and compensating employees

On date of grant:

estimate fair value of options

Amount in excess of exercise price is

recorded as compensation

expense over the grant period

11–16Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. How is return on equity computed?

A. Divide net income by average stockholders’ equity.

11–17Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. What are three advantages to the corporate form of business organization?

A. Limited liability, ease of raising capital, ease of transferring ownership

11–18Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. What are the three important dates in regard to dividends?

A. Date of declaration, date of record, date of payment

11–19Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. How should a corporation treat its start-up and organization costs in the accounting records?

A. Expense as incurred

11–20Copyright © Cengage Learning. All rights reserved.

LO2 Components of Stockholders’ Equity

Contributed capital

Stockholders’ investments

Retained earnings Cumulative earnings, less any losses, dividends, or transfers to contributed capital

Treasury stock Shares of its own stock that the corporation has bought back on the open market

Three basic components:

11–21Copyright © Cengage Learning. All rights reserved.

Contributed Capital

Common Stock Preferred Stock

Basic form of stock that a corporation issues

if the corporation is liquidated, the claims of all creditors and of preferred stockholders rank above the claims of common stockholders

Gives owners preference over common stockholders, usually in

• receiving dividends

• in terms of claims to assets if the company is liquidated

11–22Copyright © Cengage Learning. All rights reserved.

Authorized, Issued, and Outstanding Shares

Contributed capitalPreferred stock, $50 par value, 1,000 shares authorized, issued, and outstanding

$50,000

Common stock, $5 par value, 30,000 shares authorized, 20,000 shares issued, 18,000 shares outstanding

$100,000

Additional paid-in capital 50,000 150,000

Total contributed capital $200,000

Stockholders’ Equity

Outstanding shares: Shares issued and still in

circulation (unlike treasury stock)

Issued shares: Sold or

transferred to stockholders

Authorized shares: Maximum number that the corporation’s

charter allows it to issue

11–23Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. Which part of stockholders’ equity shows a corporation’s earnings since its inception, less any losses, dividends, or transfers to contributed capital?

A. Retained earnings

11–24Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. Which class of stockholder has the least amount of claims in the event of liquidation of the corporation?

A. Common stockholders

11–25Copyright © Cengage Learning. All rights reserved.

LO3 Characteristics of Preferred Stock

Preference as to dividends Rights on liquidationConvertibility Callable option

11–26Copyright © Cengage Learning. All rights reserved.

Dividend Preference

Preferred stockholders receive their dividends before common stockholders receive anything

No guarantee of ever receiving dividendsConsequences of not declaring an annual dividend depends

on whether the preferred stock is:

CumulativeDividend amount per share accumulates from year to year; Company must pay the whole amount before it pays any dividends on common stock

NoncumulativeCompany is under no obligation to make up the missed dividend in future years

11–27Copyright © Cengage Learning. All rights reserved.

A corporation has 20,000 shares of $100 par, 5 percent cumulative preferred stock, its first year of operations outstanding. If the corporation pays no dividends in 2011, its first year of operations, preferred dividends in arrears at the end of the year would amount to $100,000.

(20,000 shares × $100 × .05)

Dividends in Arrears

Dividends not paid to cumulative preferred stock in the year they are due

If the corporation’s board declares dividends in 2012, the corporation must pay preferred stockholders the dividends in arrears plus their current year’s dividends before paying any dividends to common stockholders.

11–28Copyright © Cengage Learning. All rights reserved.

January 1, 2011: A corporation issued 20,000 shares of $10 par, 6 percent cumulative preferred stock and 100,000 shares common stock. The board of directors declared a $6,000 dividend to preferred stockholders after the first year of operations.

2011 dividends due preferred stockholders ($200,000 x .06) $12,000 Less 2011 dividends declared to preferred stockholders 6,000 2011 preferred stock dividends in arrears $6,000

Dividends in Arrears Illustrated

In 2012, the board of directors declared a $24,000 dividend to be distributed to preferred and common stockholders.

How much of the $24,000 can be given to common stockholders and how much belongs to preferred stockholders?

11–29Copyright © Cengage Learning. All rights reserved.

Dividends in Arrears Illustrated (cont’d)

2012 declaration of dividends $24,000 Less 2011 preferred stock dividends in arrears 6,000 Available for 2012 dividends $ 18,000 Less 2012 dividends due preferred stockholders ($200,000 x .06)

12,000

Remainder available to common stockholders $ 6,000

Record the journal entry for the declaration of the dividend:

Dec. 31 Dividends 24,000 Dividends Payable 24,000 Declared a $18,000 cash dividend to preferred

stockholders and a $6,000 cash dividend to common stockholders

11–30Copyright © Cengage Learning. All rights reserved.

Convertible Preferred Stock

Stockholder’s may exchange their shares of preferred stock for shares of common stock at the ratio stated in the company’s preferred stock contract

11–31Copyright © Cengage Learning. All rights reserved.

A company issued 1,000 shares of 8 percent, $100 par value convertible preferred stock for $100 per share. Each share can be converted into 5 shares of the company’s common stock at any time.

The market value of the common stock is now $15 per share and, in the past, the owner of common stock could expect dividends of $1 per share per year.

Per Share Stock Market Value Dividends

Common $15 $1 Preferred if converted to common

75

(5 shares x $15)

5

( 5 shares x $1)

Convertible preferred 100 8

At this point, the preferred stockholder receives more in dividends by keeping the preferred shares and is more likely to receive dividends than the common stockholders.

Convertible Preferred Stock Illustrated

11–32Copyright © Cengage Learning. All rights reserved.

A few years later, the dividends paid to common stockholders increase to $3 per share and market value is $30 per share.

Per Share Stock Market Value Dividends

Common $30 $ 3 Preferred if converted to common

150

(5 shares x $30)

15

( 5 shares x $3)

Convertible Preferred 100 8

At this point, the market value of each share of convertible preferred stock is equivalent to $150 and converting to common would increase dividend payments from $8 per share to the equivalent of $15.

Convertible Preferred Stock Illustrated (cont’d)

11–33Copyright © Cengage Learning. All rights reserved.

Callable Preferred Stock

redeemed or retired at the option of the corporation at a price stated in the preferred stock contract

call price > par value of the stock

Reasons to call stock

– A desire to pay lower dividends

– Because the corporation has enough profits to retire preferred stock

11–34Copyright © Cengage Learning. All rights reserved.

Stop & Apply

Q. Grant Corporation has 2,000 shares of $100 par value, 6 percent cumulative preferred stock outstanding and 100,000 shares of $1 par value common stock outstanding. No dividend was declared in 20x5. In 20x6, the board declared a dividend of $14,000. What amount will be paid to preferred stockholders in 20x6?

A. 20x6: Preferred dividends in arrears (2,000 shares × $100 × .06) $12,000

Current year to preferred 2,000

Total paid to preferred stockholders $14,000

11–35Copyright © Cengage Learning. All rights reserved.

LO4 Issuance of Common Stock

LO4

Account for the issuance of stock for cash and other assets.

11–36Copyright © Cengage Learning. All rights reserved.

LO4 Issuance of Common Stock with Par Value

Nocek Corporation is authorized to issue 10,000 shares of $10 par value common stock. The company issues 5,000 shares at $12

per share on January 1, 2010.

Jan. 1 Cash 60,000 Common Stock 50,000 Additional Paid-in Capital 10,000 Issued 5,000 shares of $10 par value

common stock for $12 per share

Par value is the amount per share that is recorded in a corporation’s capital stock accounts

11–37Copyright © Cengage Learning. All rights reserved.

Par Value Stock (continued)

Balance Sheet Presentation

Stockholders’ Equity Section

Contributed capital Common stock, $10 par value, 10,000 shares authorized, 5,000 shares issued and outstanding $50,000 Additional paid-in capital 10,000 Total contributed capital what stock sold for $60,000 Retained earnings — Total stockholders’ equity $60,000

11–38Copyright © Cengage Learning. All rights reserved.

Jan. 1 Cash 75,000 Common Stock 50,000 Additional Paid-in Capital 25,000 Issued 5,000 shares of no-par value

common stock with $10 stated value for $15 per share

Stated Value Stock

Assume Nocek’s board puts a $10 stated value on its no-par stock. It issues 5,000 shares at $15 per share on January 1, 2010.

Stated value of stock can be any value set by the board unless the state specifies a minimum amount.

11–39Copyright © Cengage Learning. All rights reserved.

No-Par Stock

Nocek Corporation is authorized to issue 20,000 shares of no-par common stock. Suppose the company issues 5,000 shares at $15 per share on January 1, 2010.

Jan. 1 Cash 75,000 Common Stock 75,000 Issued 5,000 shares of no-par

common stock for $15 per share

11–40Copyright © Cengage Learning. All rights reserved.

Issuance of Stock for Noncash Assets

Record at fair market value of what the corporation is giving up (stock)

or

If fair market value of the stock cannot be determined, use the fair market value of the assets or services received

Companies may issue stock for services or assets like buildings or land

11–41Copyright © Cengage Learning. All rights reserved.

When Nocek Corporation was formed on January 1, 2010, its attorney agreed to accept 200 shares of its $10 par value common stock for services rendered.

At the time the stock was issued, its market value could not be determined. For similar services, the attorney would have billed $3,000.

Jan. 1 Start-up and Organization Expense 3,000 Common Stock (200 x $10 par) 2,000 Additional Paid-in Capital 1,000 Issued 200 shares of $10 par

common stock for attorney’s services

Issuance of Stock for Noncash Assets

11–42Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. What is the difference between stated value and par value?

A. Par value is the amount per share that is recorded in a corporation’s capital stock accounts, and it constitutes a corporation’s legal capital. The stated value can be any value set by the board unless the state specifies a minimum amount, which is sometimes the case. The stated value can be set before or after the shares are issued if the state law is not specific.

11–43Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. If common stock is sold for an amount above par value, in which account is this amount recorded?

A. Additional Paid-in Capital

11–44Copyright © Cengage Learning. All rights reserved.

LO 5 Treasury Stock

more than 67 percent of large companies repurchase their own stock

Use the stock for employee stock option plans Want to maintain a favorable market for their stock

to increase earnings per share or stock price per share

to have additional shares of stock available for purchasing other companies

Attempt to prevent hostile takeovers

11–45Copyright © Cengage Learning. All rights reserved.

On Sept. 15, Amber Corporation purchases 2,000 shares of its common stock on the market for $50 per share.

When treasury stock is purchased, it is usually recorded at cost:

Sept. 15 Treasury Stock, Common 2000 shares x $50 cost 100,000 Cash 100,000 Acquired 2,000 shares of the

company’s common stock for $50 per share

Purchase of Treasury Stock Illustrated

11–46Copyright © Cengage Learning. All rights reserved.

Balance Sheet PresentationStockholders’ Equity SectionContributed capital Common stock, $5 par value, 200,000 shares authorized, 60,000 shares issued, 58,000 shares

outstanding

$300,000 Additional paid-in capital 60,000 Total contributed capital $360,000 Retained earnings 1,800,000 Total contributed capital and retained earnings $2,160,000 Less treasury stock, common (1,000 shares at cost) 100,000 Total stockholders’ equity $2,060,000

Notice that the number of shares issued, and therefore legal capital, has not changed even though the number of shares outstanding has decreased.

Purchase of Treasury Stock

11–47Copyright © Cengage Learning. All rights reserved.

Dec. 15: Amber Corporation sells 1,200 shares of its treasury stock for $52 per share. (Cost was $50 per share.)

Dec. 15 Cash ($52 x 1,200 shares) 62,400 Paid-in Capital, Treasury Stock 2,400 Treasury Stock, Common ($50 cost x 1200 shares) 60,000 Sold 1,200 shares of the treasury stock for

$52 per share; cost was $50 per share

When treasury shares are sold above cost, the difference (gain) is added to Paid-in Capital, Treasury Stock

Sale of Treasury Stock Above Cost

11–48Copyright © Cengage Learning. All rights reserved.

Dec. 15: Amber Corporation sells 1,200 shares of its treasury stock for $42 per share. (Cost was $50 per share.)

Dec. 15 Cash ($42 x 1200 shares) 50,400 Paid-in Capital, Treasury Stock 2,400 Retained Earnings 7,200 Treasury Stock ($50 cost x 1200 shares) 60,000 Sold 1,200 shares of the treasury stock

for $42 per share; cost was $50 per share

When treasury shares are sold below cost, the difference is deducted from Paid-in Capital, Treasury Stock

If the Paid-in Capital, Treasury Stock account cannot absorb the full amount of the difference, or doesn’t exist, Retained Earnings absorbs the remainder.

Sale of Treasury Stock Below Cost

11–49Copyright © Cengage Learning. All rights reserved.

Retirement of Treasury Stock

Treasury stock is retired when the company decides not reissue stock it has purchased

If acquisition price < original issue priceCredit Paid-In Capital, Retirement of Stock

If acquisition price > original issue price Debit Retained Earnings

11–50Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. Does the purchase of treasury stock change the legal capital of a corporation?

A. No, total shares issued has not changed, though the total number of shares outstanding has been decreased.

11–51Copyright © Cengage Learning. All rights reserved.

Stop & Review

Q. What are reasons that a company might buy back its own stock?

A. To use the stock for employee stock option plans, maintain a favorable market for its stock, increase earnings per share, or prevent a hostile takeover

11–52Copyright © Cengage Learning. All rights reserved.

Chapter Review Problem

Required: 1. Record the journal entry for the issuance of common stock in 20x6.2. What amount is paid to common and preferred stockholders in 20x7 for

dividends?

Riddle Corporation is authorized to issue 50,000 shares of $10 par value common stock and 20,000 shares of preferred stock. The

company issues 20,000 shares at $15 per share on January 1, 20x6. Later that year, the company issues 10,000 shares of $10 par value 6 percent cumulative preferred stock. The board declared cash dividends of $14,000 in 20x7.

11–53Copyright © Cengage Learning. All rights reserved.

Chapter Review Problem (Solution)

Jan. 1 Cash 300,000 Common Stock 200,000 Additional Paid-in Capital 100,000 Issued 20,000 shares of $10 par value

common stock for $15 per share

20x7: Preferred dividends in arrears from 20x6 (10,000 shares x $10 x .06) $ 6,000Current year preferred dividends (10,000 shares x $10 x .06) 6,000Total to be distributed to preferred stockholders $12,000Remainder to be distributed to common stockholders 2,000 Total to be distributed $14,000

1.

2.