PROFESSOR’S NOTES – UNIT 17 COB 241 – Section 8 Spring Semester 2020

This unit is primarily terminology, and understanding the composition of the Owner’s Equity portion of the Balance Sheet. The Video lectures, Professor’s Notes, and the List of Terms for Unit 17 are the primary areas in which you should concentrate your attention. FORMS OF BUSINESS OWNERSHIP

As explained in the video from the very first day of class, there are three types of business ownership. Proprietorships

Proprietorships are owned by a single individual. Almost always, that individual is directly involved in the day-to-day running of the business. The finances of the business are kept separate from the individual’s finances (the Entity Principle), but are reported on the individual’s personal Income Tax Return on Schedule C as “Business Income”. The business itself does not pay or file Income Tax on the business’s income. All income from the business “flows through” directly to the owner, and is treated as earned income of the owner. The owner includes the business’s Net Income in the calculation of his own personal taxes. Note that the amount of Distributions the owner takes out of the business does not have any impact on the owner’s taxes. The owner includes the Net Income (not the amount of distributions) in his or her personal income total on his personal tax return. In true proprietorships, the owner, as an individual, is personally responsible and liable for all debts, obligations, and risks of the business. If an activity of the business results in a lawsuit, the owner, as an individual, is responsible. In many cases, his or her personal assets can be confiscated to pay any judgments from the lawsuit, as well as any other debts incurred by the business. For this reason, most proprietorships are tiny businesses, run by the owner, and perhaps a handful of employees, most of whom will be family members or friends of the owner. The main advantage of proprietorships is their simplicity. Almost anyone can start a business with relatively little effort, simply by creating a separate set of books (accounting records), obtaining a local business license, and keeping their business records separate from their

personal financial records. Depending on the nature of the business, they may be subject to some regulation, such as sanitary or safety regulations, or proficiency licensing (barbers, hairstylists, consultants, etc.), but in general, proprietorships are easiest to start and the least restrictive form of business ownership. Partnerships Partnerships are somewhat different from proprietorships, but are still very similar. A partnership is a formal entity, created by a contract between the partners, who agree to share ownership, responsibility, and risk of the business. The contract specifies the actual division of ownership, contribution, involvement, and responsibility of the respective partners. For example, most of the time partners are directly involved in the daily running of the business, such as doctors, dentists, and accountants. But a partnership contract might specify that one or more partners shares ownership and profit, but is aa “silent partner” and is not involved in any way with the daily operations of the business. Because of the nature of contractual agreements, lawyers are usually consulted in the formation of a partnership. Like proprietorships, partners are personally responsible for the financial obligations, debts, judgments, and affairs of the business. And as said aabove, almost always, most partners are directly involved in the day-to-day running of the business. Partnerships must file an informational return with the IRS, but are not taxed as entities themselves and thus pay no taxes on the business’s income. .Like proprietorships, all Net Income from the partnership “flows through” to the owners, and is treated as earned income by the partners as individuals. Note again that partners pay tax on their share of the partnership’s Net Income, regardless of any distributions the partners may or may not have received. And like proprietorships, partners are relatively simple to start. Most states and localities require that partnership agreements be registered with the government, but usually partners have great freedom with respect to how the partnership is organized and operated. Limited Liability Businesses The main disadvantage of partnerships and proprietorships is the risk assumed by the owner. If the business is sued, the owners’ assets may be seized to pay for the remaining judgment once the entity’s assets have been liquidated.

This risk does not exist with corporations. Corporations are entities unto themselves, with all the rights afforded to citizens (except the right to vote, the right to bear arms, and the right against self-incrimination). The owners of a corporation are not personally liable for ANY of the corporation’s debts, liabilities, or obligations. This is called the “protection of the Corporate veil”. Corporate owners are shielded from any liability other than simply losing their investment in the corporation. Such protection was not provided for proprietorships or partnerships until the past couple of decades. In fact, even today, it is possible for a proprietor or partner to invest $10,000 in their business, but end up being liable for hundreds of thousands of dollars of debts incurred by the business, or even millions of dollars of damages caused by the business. To mitigate this risk somewhat, almost all states have passed laws allowing proprietorships and partnerships who meet certain legal requirements to register with the state as “Limited Liability Companies”. This arrangement does not completely free the owners from all risks, but does place limits or caps on the amount of the owner’s personal assets which are at risk due to debts of the business. The requirements and the actual limits of the liability vary quite a bit from state to state. Companies who register as LLCs are required to place certain letters after their business name to inform the public of their limited liability status.

LLC Proprietorships are usually registered as “Single Member Limited Liability Companies”. The owner must register with the state government (usually the state’s “Secretary of State”), meet certain requirements and restrictions on the operations of the business. Registering as an LLC does not alter the tax status of the business. All profits continue to “flow through” directly to the owner, and the business itself does not pay income tax. But unlike plain simple proprietorships, the LLC must file an informational return with the IRS. LLP Almost all states permit partnerships to take advantage of the limited liability arrangement in the same manner as LLC’s. In fact, a few states permit partnerships to register as a “Multi-member Limited Liability Company”, and use the initials LLC. But

most states require businesses with more than one owner to use the term “Limited Liability Partnership”, or LLP. To form an LLP, the partnership must also formally register with the state like an LLC. but almost all states place a few more restrictions and regulations on the LLP, primarily due to the contractual and sharing nature of the partnership form of business ownership. Like an LLC, the profits from a Limited Liability Partnership still flow through to the individual owners. Owners pay personal income tax on the Net Income of the business, regardless of any distribution they do or do not receive from the business. PLLC Some states allow what is called “Professional Limited Liability Companies”. These are restricted to owners engaged in a profession requiring a state professional license to practice. Doctors, Dentists, Accountants, Architects, Engineers, Real Estate Agents, Insurance Agents, Funeral Home Directors, and other state-licensed professionals may form PLLCs in most states. Some states prohibit professionals from forming regular LLCs and the PLLC is the only option in those states. Other states permit professionals to form regular LLCs unless specifically prohibited by state licensing boards. Most PLLC laws do not protect the professional from personal liability for personal malpractice. For example, a doctor’s personal assets are not protected from a lawsuit charging that the doctor personally engaged in malpractice; the doctor cannot claim that the PLLC engaged in the malpractice, not the doctor. But the other owners of the PLLC are not responsible for the malpractice liabilities of an individual owner.

CORPORATIONS Corporations offer protection for their owners, but differ greatly from proprietorships, partnerships, LLCs, LLPs, and PLLCs.in many ways. Thus, the remainder of this unit will concentrate on Corporations. Forming a Corporation Corporations must be registered with the states, and require a “Corporate Charter” from the respective state’s Corporation Commission. Application for this charter must include “Articles of Incorporation”, a Constitution, and/or By-Laws. These documents which define, very

specifically, exactly how ownership and governance of the corporation is to be organized. The Articles of Incorporation must define the selection and operation of a Board of Directors, and must specify the responsibilities of the Officers of the corporation. Because of the additional regulation at the state level, corporations are often subject to much more regulation and paperwork than the other forms of business ownership. Corporations must have a legal agent, usually a licensed lawyer, to ensure that corporate laws are known by the corporate officers and Board. Corporations must also make annual filing with their respective states, as well as the Internal Revenue Service. Ownership “Shares” of Stock Businesses organized as corporations divide their ownership into “shares” of “stock”. A document called a “stock certificate” is issued to each owner, specifying how much of the business he or she owns. This “share” system makes it easy to transfer ownership from one party to another, which is one of the many advantages of the corporate form of business ownership. Whereas a proprietorship and partnership must be dissolved and reformed by new owners, shares in a corporation are merely traded (bought or sold) between the old and new owner. Thus a corporation can easily outlive its owners. Corporations are permitted to have different classes of ownership, and the responsibilities and privileges of each class must be specified. These differences are discussed in the section below titled, “Classes of Stock”. Corporate Taxation The IRS recognizes two types of corporations: “Subchapter S” corporations (known as an “S-Corp”) and “Subchapter C” corporations (sometimes referred to as a “C-Corp). S-corporations must file an informational tax return as a business, separate from the owner’s personal tax return. But S-corporations do not pay taxes as an entity: all of the business Net Income “flows through” to the owners as in the case of a partnership or a proprietorships. By contrast, C-corporations do pay taxes as a corporation, at the national corporate tax rate. They file their own (corporate) income tax return, and pay taxes on their corporate Net Income The owners of a C-corporation do not pay taxes on the corporation’s Net Income, but pay taxes as individuals on the Distributions received from the corporation.

S-corporations are usually restricted to very small businesses, and can not have more than 100 owners, and all owners must be U.S. citizens (individuals), and can have only one class of stock. C-Corporations are under no such restrictions, shareholders can be individuals or other corporations, usually of any nationality/citizenship, and can have different classes of stock, including ownership shares which have no voting rights. Owner’s Involvement in the Business While most S-corporations are run by their owners, practically all C-corporations do not require, and in most cases, even prohibit, the owners from being involved in the day-to-day running of the business. Governance As said above, the owners (stockholders) of most C-Corporations do not participate in the day-to-day running of the business. Stockholders meet at least once a year to elect a Board of Directors. The Board is elected to represent the owners in top-level decision-making for the business. The Board of Directors is a governance body, and does not actually operate the business. The Board, as a body, chooses and hires Executive Management to actually run the business. Executive Management in turn hires other employees, and designates managers who are responsible for the day-to-day decisions and operation of the business. It is important to repeat that shareholders who own a C-corporation rarely have actual involvement in running the business, and indeed are in most cases prohibited from even visiting or touring the business facilities. This is the very reason why corporations are required to maintain accounting records and issue periodic financial statements: so the owners can see what management is doing with the owner’s company. CORPORATE STOCK Public vs. Private Corporations S-Corporations are private businesses, since they are small businesses that are essentially proprietorships or partnerships operating under the corporate form of ownership. C-Corporations can be either public or private corporations.

Private Corporations are those whose stock is not traded on the open market. Shares of ownership can be bought and sold, but only between private individuals, such as family members and close friends of existing shareholders. Shares of a private corporation can not offered for sale to the general public. Private Corporations are sometimes called “Closely-Held Corporations” Private C-Corporations are not subject to regulation by the federal Securities and Exchange Commission rules. They do not have to make their financial statements available to the public, nor are they required to be audited by independent financial auditors, although most private companies do voluntarily undergo financial audits). Private corporations do, however, have to file income tax returns and pay taxes on the corporation’s Net Income. By contrast, Public Corporations (often called “public companies”) are those C-Corporations whose stock can be offered for sale to anyone in the general public. These companies are subject to very stringent rules of the Securities Exchange Acts of 1933 and 1934, as amended. As covered already in this course, public companies must issue annual (and sometimes quarterly) financial reports, must file 10-K reports with the SEC, must be audited at least annually by independent financial auditors who are Certified Public Accountants, must issue an annual report to shareholders and make it available to the general public, must have (and test) a system of Internal Controls, and meet numerous other requirements. Students may wish to review the “Background and Details Relating to Unit 11”, issued previously in this course, for some history behind the SEC and public corporations. Stock in a C-Corporation: Shares A “Share” of stock is a share of ownership in a company. The startup of a private C-Corporation is very complex compared to starting a proprietorship or partnership. However, starting a private C-Corporation is extremely simple compared to starting a public C-Corporation. For this reason, most public companies start out as private corporations. A private corporation is started by first obtaining a corporate charter from the state in which the company plans to be headquartered. The founders of the company draw up articles of incorporation, by-laws, and other documents to obtain a corporate charter.

Shares Authorized Typically, the documents used to start the corporation will define how many “pieces” the ownership will be divided into, and who will own those pieces. This is known as the “number of shares authorized”. For flexibility, most corporations divide their ownership into hundreds or thousands or even millions of pieces, even though there may initially be only two or three owners.

Example One: If four initial investors start a company and equally share ownership, each owner will own one-fourth of the company. But they may draw up the corporate papers which divides company ownership into ten thousand pieces. So this corporation is authorized to issue up to ten thousand “shares” of stock.

Shares Issued Just because a company’s ownership can be divided into, say, ten thousand shares, does not mean that company actually has to “Issue” all 10,000 shares to its original owners.

Example: Let’s say the four initial owners (in the example above) each contributed $10,000 to start the company. Total Equity shown on the company’s books on the first day is $40,000. But the four owners agree to “issue” only eight thousand of the 10,000 shares authorized. In other words, they issue 2.000 shares to each of the four initial investors, in return for that investor’s $10,000 investment in the company.

This way, if a fifth person wishes to join the company later, the new investor can contribute money to the corporation, and the corporation can issue additional shares of stock, up to the maximum of 10,000 shares authorized. The accounting for the initial issuance of stock to the four initial owners is shown below: Example: The four initial owners (in the example above) each contributed $10,000 to start the company. Total Equity shown on the company’s books on the first day is $40,000. But the four owners agree to “issue” only eight thousand of the 10,000 shares authorized. In other words, they issue 2.000 shares to each of the four initial investors, in return for that investor’s $10,000 investment in the company. Journal Entry

DATE or ID √ DEBIT CREDIT

Startup Cash 40,000Date Common Stock, 8000 shares issued 40,000

Posting to the Ledger

Horizontal Model

Additional Investors in a Private C-Corporation If the company had issued all it authorized shares to the initial four investors, the company’s original contributed capital would be limited to $40.000 because the company could not raise additional capital from new investors without significant paperwork and bureaucratic effort with the state. Of course, a fifth investor could acquire ownership in the company by buying some of the shares from one of the four original investors. (In fact, this ease of transfer of ownership is one of the advantages of the corporate form of business ownership.) But the problem here is that all of the new investor’s money would be going to the original investor, not the corporation. The corporation would not receive any money from the new investor! For this reason, most private corporations do not initially issue all of their shares authorized. Book Value Per Share Let’s continue our example further:

40,000 40,000Cash Common Stock

LIABILCash Common Stock Revenue Expense R/E40,000 40,000

ASSETS OWNERS EQUITY

Example: The four original investors contributed $10,000 each to the new corporation. So initially, Total Equity in the company is $40,000. During the first two years of operation, however, the company earns huge amounts of Net Income. By the end of the second year the company has accumulated $28,000 in Retained Earnings. Thus, total Owner’s Equity at the end of the second year is $68,000 (which is composed of the initial $40,000 contribution, plus $28,000 of Retained Earnings).

At the end of the second year, Equity on the corporate Balance Sheet is composed of $40,000 Contributed Capital, plus $28,000 in Retained Earnings, so Total Equity is $68,000. Initially, each investor gave $10,000 in return for 2000 shares of stock, or $5 per share The $68,000 Total Equity divided by 8000 Shares held by those four investors equals $8.50 per share. This figure ($8.50) is known as “Book Value Per Share”. Distributing Profits vs. Retaining the Earnings As we have seen previously in the course, companies can either distribute profits to the owners, or they can retain those earnings in the business. If some or all of the profits are distributed to the owners, the most common way is to give the owners a cash dividend. Money is removed from cash, and at closing is removed from Retained Earnings. This reduces the Total Owner’s Equity and reduces Cash. The profits were distributed to the owners, which was their goal in starting the business in the first place. And they each still own 1/4th of the company. As an alternative, the owners can forego their distribution, and keep all the profits in the company as Retained Earnings. Each of the initial investors still owns 1/4th of the company, and the company has now grown more than it would if the owners had taken their distribution.

Example: the corporation earns $12,000 in Net Income it its first year, and $18,000 in Net Income the second year. The four original owners decided not to distribute any Retained Earnings to themselves. At the beginning of the third year of operation, the corporation has Total Equity of $68,000, composed of the initial $40,000 in Contributed Capital, plus $28,000 in Retained Earnings. Thus, the owners each own 1/4th of a company which started out being worth $40,000 and today is worth $68,000. So each of the initial owners has seen their $10,000 investment turn into $17,000 or a 70% increase, over two years, or a return on investment of 35% per year. By foregoing distributions, the owners left more money in the business, enabling it to grow, and produce even more profit than if it had remained a smaller business.

Par Value Both public and private corporations can specify a “Par Value” for their stock. In some cases, this is the amount per share the original owners contributed to the business. In reality, par value can be set at any price the corporation desires. We said earlier in the course that investors “give” money to the corporation, and this money can never be given back to the investors. But more investors would be willing to buy stock if they knew that at least part of their stock purchase could be returned if the company fell on hard times and failed to earn a profit. To entice more investors to purchase the stock, most (if not all) states permit companies to designate a “par value” of their stock. If an investor contributes more than “par value” for the stock, the company is permitted to return some or all of the excess over par (depending on the state laws) to the investor as distributions, as if it were coming from Retained Earnings.

Example: Continuing our example: At the time the company decides to break its ownership down into a maximum of 10,000 pieces (or shares), the company also designates the Par Value of those shares to be $5.00 per share. The four initial investors start the company by contributing $10,000 each, and receiving 2000 shares of stock in return. Their contribution is placed in “Contributed Capital”, and is reported as “Capital Stock Issued at $5 Par Value”. Four investors, contributing $5 per share, for 2000 shares each, means that the capital contributed (Common Stock at $5.00 par) is $40,000. (4 x 5.00 x 2000 = $40,000)

Additional Paid-In Capital Let’s say that at the beginning of the corporation’s third year, a close friend of one of the original four investors wants to “buy in” to the company. Rather than buying a share from one of the original investors, the corporation needs the money, so the company issues additional stock to the new investor. But since each share is worth $8.50 now, it is expected that a new investor will provide more than the $5.00 par value for each share of stock.

Common Stock at $5 Par Rev Exp R/E

40,00012,00016,000

First Year's Profit Second year's Profit

OWNERS EQUITY

Example: continuing our example: the new investor believes the company will continue to grow, and agrees to give the corporation $9 per share for 500 shares. The original investors agree, so the corporation issues 500 shares of stock, which carries par value of $5 per share, but collects $4500 from the new investor.

The par value of the stock issued is $5.00 per share. The new investor is receiving 500 shares, so the total par value is $2,500. But the investor is paying $9 each for those 500 shares, so the corporation is receiving $4,500 from this investor! The additional $2,000 is called “Additional Paid-In Capital”. It is kept in a separate account from the par value of the stock issued.

Example: continuing our example: the new investor believes the company will continue to grow, and agrees to give the corporation $9 per share for 500 shares. The original investors agree, so the corporation issues 500 shares of stock, which carries par value of $5 per share, but collects $4500 from the new investor.

Journal Entry

Posting to Ledger

Horizontal Model

DATE or ID √ DEBIT CREDIT

Cash 4,500 Common Stock, $5 par, 500 shares issued 2,500 Additional Paid In Capital 2,000

4,500 2,500 2,000Cash Common Stock Paid-In Capital

Additional

LIABIL

CashCommon Stock

at $5 ParAdditional

Paid-In Capital Rev Exp R/E40,000 40,000

XXX XXX XXX 12,000XXX XXX XXX 16,0004,500 2,500 2,000

First Year's Profit Second year's Profit New Investor

ASSETS OWNERS EQUITY

The “Additional Paid-In Capital” is an Equity Account, reported as a line-item entry on the Balance Sheet. EQUITY SECTION OF THE BALANCE SHEET Common Stock, $5 par $42,500 Additional Paid-In Capital $ 3,000 Retained Earnings $28,000 TOTAL OWNER’S EQUITY $73,500 Distribution of Additional Paid-In Capital Why is the “Additional Paid-In Capital” kept separate from the “Common Stock at Par” account? A few states permit the corporation to distribute the Additional Paid-In Capital to owners the same as Retained Earnings. But no state currently permits corporations to distribute the “par value” of common stock to the owners. “Going Public”: The Initial Public Offering (IPO) Often, a small private C-Corporation will start out with only a few owners. As the business progresses, more business opportunities become available to the corporation. But taking advantage of these opportunities might require new warehouses, new factories, bigger truck fleets, etc. The current retained earnings, large as they are, might still be insufficient to accommodate the additional needs. And the original owners might not have the personal financial means to give more money to the business. They might be unable to find friends and relatives and others who can afford to give the company money in return for new stock. The company might be able to borrow money, but the needs might be far more than lenders are willing to loan. If the company is attractive enough, there might be plenty of investors in the open stock market who are willing to contribute capital to the business in return for the possibility for increasing their own wealth. So by going on the open market, the company has access to millions of potential investors, some of whom might be willing to give money to our corporation. Now selling more stock to additional owners means the original owners might lose some control over the company. But usually owners are more interested in increasing their personal wealth than they are in simply having total control over a corporation.

Offering stock to the General Public for the first time is known as the “Initial Public Offering”, or IPO. This process is extremely complicated, requires much work by lawyers, attorneys, agents, stock brokers, stock exchanges, investment bankers, and many others. Our course will not cover the myriad paperwork requirements of “going public”. Suffice it to say that an IPO is a complicated process, but every public corporation in the U.S. went through it at one time. It is also important to note that by going public, the company will be obligated to follow the rules, regulations, and laws governing public corporations. The company must make its audited financial statements available to the Securities and Exchange Commission, the books must be audited by a CPA, an annual report package must be submitted to all stockholders as well as the general public and potential investors and others, and a plethora of other requirements must be met. The purpose of these rules is to prevent shysters from offering stock in fake companies, then taking the money raised by the sale of the worthless stock and fleeing to a country which does not have extradition treaties with the U.S.

New Example: A new corporation is formed. This corporation has common stock, with 800,000 shares authorized, carrying a par value of $10 per share. It takes the company almost a year to comply with all the paperwork and legal requirements to make an Initial Public Offering, but finally, on August 1, the company shares “go public”. The general public has heard about the company and is enthusiastic about buying its stock. On the first day, the company sells 700,000 shares at an average price of $55 per share. This company receives cash of $38,500,000. ($55 per share times 700,000 shares). It sold 700,000 shares at $10 par. $7,000,000 is placed in the “Common Stock at Par” account. The remaining $31,500,000 is placed in the “Additional Paid In Capital” account.

Shares Authorized vs. Shares Issued In the above example, the company sold only 700,000 shares. So this corporation has 800,000 shares authorized, and 700,000 issued.

DATE or ID √ DEBIT CREDIT

IPO Cash 38,500,000 Common Stock, $10 par, 700,000 shares issued 7,000,000 Additional Paid In Capital 31,500,000

TREASURY STOCK Treasury Stock Sometimes, a corporation will want to buy its own stock back off the market. There are several reasons why a corporation will want to buy its own stock. First, many corporations give stock as a reward or bonus (or even part of normal compensation) to its officers, managers, employees or others. The corporation has two options: (1) it can issue new shares, or (2) it can buy back shares of its own stock from current owners. Another reason; If investors think that other investors are avoiding buying a company’s stock, they are less inclined to desire shares in that company. The company’s stock price may fall. This might make the stock attractive to “insiders”, who know that the company is getting ready to report good news. Of course, it is illegal for these insiders to buy the stock personally. But it is perfectly legal for the corporation itself to buy the stock off the market, in the hopes of possibly selling it later at a higher price, and thus increasing the owner’s wealth. Related to this, if a company’s stock is not trading well on the market, the corporation may wish to “simulate demand” by buying its own stock. This makes it seem that someone wants to buy the stock, thus stimulating interest from other investors, and raising demand for the stock. The increased demand for the corporation’s stock, coupled with the fewer shares still left on the market, sometimes will boost the stock price. Sometimes the company will want to remove shares from the market so that each remaining investor will receive a bigger portion of the profits. Regardless of the reason, when a corporation buys its shares on the open market, it must place the cost of those shares in a special account called “Treasury Stock”. The shares are withdrawn from the market, but may be sold by the company later, or awarded to employees, managers, or officers. Shares held in Treasury are still considered “Shares Issued”, since they can be put back on the market at any time. The “Treasury Stock” account is a Contra-Asset account. (Remember: it took cash to buy the shares off the market. This lowers assets. The other side of the double entry is to lower equity, via the “Treasury Stock” Contra-Equity account.)

Example: our corporation decides to give its General Manager one share of stock as a bonus for every thousand dollars in profit the company earns. Rather than issue new stock, the company uses its cash to

purchase stock from one of the shareholders on the market. The market price per share has fallen from $55 per share to $21 per share. The company purchases 1,000 shares to hold in Treasury, paying $21,000 cash.

Treasury stock is a debit balance account. Being part of equity, a debit balance reduces owner’s equity. It is thus a “Contra-Equity account”. The shares are stored in a vault (Treasury) for re-sale when and if the company decides to actually award the bonus or sell the stock.

Notice in the above journal entry: cash (asset) has been reduced by $21,000, and Equity has been reduced $21,000 by the debit balance in the Treasury Stock account. Being a Contra-Equity account, the Treasury Stock account reduces Owner’s Equity on the Balance Sheet. EQUITY SECTION OF THE BALANCE SHEET Common Stock, $5 par $ 7,000,000 Additional Paid-In Capital $31,500,000 Less Treasury Stock $ - 21,000 Retained Earnings $ XXXXXX TOTAL OWNER’S EQUITY OTHER EQUITY TERMS Shares Outstanding The number of shares outstanding is simply the number of shares still left in the market.

Example: our corporation was authorized 800,000 shares. It issued 700,000 shares, and later repurchased 1000 shares on the market for Treasury Stock. Thus, it has:

800,000 shares authorized 700,000 shares issued 699,000 shares outstanding

DATE or ID √ DEBIT CREDIT

Purch of Treasury Stock (1000 shares at $21/share) 21,000Treas Stk Cash 21,000

Earnings Per Share Investors in the market are seeking to increase their wealth. They make buying decisions based on how much profit they can make for a given investment. To compare stocks, many financial advisors look at Earnings Per Share. Earnings Per Share at the end of any period is simply the Net Income of that period, divided by the number of shares outstanding at the end of that period.

Example: our corporation has 800,000 shares authorized, 700,000 shares issued, but only 699,000 shares outstanding. The corporation’s Net Income for this period is $280,000. Thus, $280,000 / 699,000 = $0.40 or 40 cents per share.

Market Price Per Share Once a public company issues stock to a shareholder, that shareholder can sell it to anyone willing to buy, at whatever price the seller and buyer agree on. A company with a good track record of profits is likely under good management, and likely to continue earning profit, and thus saavy investors will want to own that stock. Following the economic law of Supply and Demand, these investors will bid up the price of the stock. Thus, it is not unusual for a reputable company’s stock to sell at many times its par value. Of course, good times must eventually give way to bad times. When a company is performing poorly, supply will outsrip demand, and the market price goes down. The market price per share of any given day is the closing price of the day before (the last trade of the day, before the final bell rings on the stock exchange)/ Market Capitalization “Market Cap” is the market price per share multiplied by the number of shares outstanding. Example: ABC Corporation stock has total equity of $1 million dollars. There are 500,000 shares outstanding. Thus, the Book Value per Share is $2.00. But the stock is selling at $4.50 per share. With 500,000 shares at $4.50 per share, the total “Market Cap” is $2,250,000.

Another way of looking at Market Cap is to see it as the value the market is placing on the company’s “assets minus its liabilities”. CLASSES OF STOCK Common Stock A company can issue different classes of stock, each with different par values, different voting rights, different precedence to liquidation distributions, etc. For example, a company’s Class A Common Stock can have a par value of $100 per share, with full voting rights of 1 vote per share. That same corporation can issue Class B Common Stock, with par value of $5 per share, and with partial voting rights of 1 vote per every five shares owned. The same corporation can issue Class C Common Stock with par value of $1 per share, with no voting rights, and no claim on equity if the company goes bankrupt. The different classes of stock might sell at very different prices on the market. The complexities of these differences, and the reasons for the different Market Prices, are beyond the scope of this class, and are a topic for a finance course. Preferred Stock In addition to Common Stock shares, a company can issue Preferred Stock shares. There can also be different classes of Preferred Stock. Preferred Stock has very different characteristics than Common Stock. Preferred Stock almost always is issued at its par value, although its value on the market can fluctuate greatly once it is issued. Also, preferred stock usually has a “guaranteed” dividend payment, usually a percentage of the par value. For example, a company might issue shares of Preferred Class A stock with a par value of $100 per share, with a guaranteed dividend of 5%. This means that every year the company shows a profit, the holders of Preferred Class A stock will receive a $5 dividend check for every share they own. In this manner, preferred stock is similar to a loan. The preferred shareholders receive their dividends before any of the Common Shareholders receive any dividends. For example, if there are 10,000 shares of preferred stock outstanding with a par value of $100 per share and a dividend rate of 5%, and the company earns $60,000 in Net Income, the preferred shareholders receive their $5 per share dividend (totaling $50,000),

leaving only $10,000 for distribution to the common shareholders, or to be left in Retained Earnings. In this case, it is likely the Board of Directors will not declare a dividend at all for the Common Shareholders. This is why “Preferred Stock” is, well, preferred. Preferred stockholders generally hold precedence over Common shareholders in the distribution of residual value, if the company goes bankrupt. Once the liabilities are all paid off, anything left over in a bankruptcy must go to the preferred shareholders, up to their par value. If anything is left over after paying the preferred shareholders their par value, then the final residual will be distributed to Common Shareholders. Preferred Stock almost always has no voting rights. Preferred Stock usually can be converted into Common Stock. Why would a preferred shareholder give up their guaranteed dividend? Continuing the above example, assume the corporation had 10,000 shares of $100 par, 5% preferred stock, and 10,000 shares of Common Stock outstanding. If the company earns $400,000 in Net Income, and the Board of Directors decides to distribute half of this ($200,000) to the shareholders, the Preferred Shareholders will receive their 5% dividend (5% of $100 par, or $5 per share, times 10,000 shares) a total of $50,000, as above. But the Common Stockholders will receive $150,000, divided between 10,000 shareholders or $15 per share. In this case, the Common Shareholders will receive three times the dividend payment of the Preferred shareholders! To entice the market to purchase preferred stock and thus increase the price per share, companies might issue “Participating” preferred stock, where once the preferred shareholders receive their guaranteed dividend, the remaining dividend funds are split between the preferred and common shareholders, allowing the preferred shareholders to “participate” in the windfall of profits. Another way to entice the market to demand preferred shares is to allow preferred shareholders to “convert” their shares to Common Stock. This is known as “Convertible Preferred Stock”. Yet another way to entice the market to demand preferred stock is to make the preferred stock “cumulative” Preferred Stock. This means that if the company does not make enough money in one year to declare a dividend to the preferred shareholders, once the company begins making money again, the preferred shareholders will receive their “dividends in arrears”, that is, the company will make up any missed dividend payment. So if the company does not make enough money this year to pay the preferred shareholders their $5 per share dividend, then next year, the company will owe them $10 per share.

DIVIDENDS The Board of Directors decides whether or not to distribute dividends to shareholders. Dividends are the “Distributions” to the owners. Typically, most corporations distribute part of their Net Income each year to the owners, and retain part of it in Retained Earnings. However, a few corporations want to maintain a reputation for always paying a dividend, so in years that they earn no Net Income, they will dip into Retained Earnings to fund dividends. Paying Dividends are basically Distributions. Note that Distributions (and hence, dividends) do NOT affect the Income Statement at all. Dividends are paid only on Outstanding Shares, never on Treasury Stock. Dividends can be distributed in the form of cash (a dividend payment), or in stock certificates. When the board decides to pay dividends it “Declares” a dividend to shareholders of record on a certain date, known as the Date of Record. To qualify for a dividend payment, the stockholder must own the stock at the close of business (the stock exchange) on the date of record. On the Declaration Date, the accountants make an entry to debit Dividends (Distributions), and credit a liability called “Dividends Payable”. As said above, dividends can be distributed as cash, or as stock certificates, mainly depending on whether the company believes it can come up with the cash necessary to pay the declared dividend. Cash Dividends Once the Board of Directors had declared a Cash Dividend, the Treasurer of the company must now assemble the cash to pay the shareholders. This takes some time, typically a few weeks, since most corporations do not keep a lot of spare cash sitting idly in the bank. Also, the shareholder relations office must compile the list of owners who owned the stock as of the Date of Record. This also takes several weeks or perhaps even more. Eventually the cash is assembled, the list of owners is completed, and the dividend paid. The date the checks are issued is the Date of Payment for the dividends. When the checks are issued, the accountants debit the payable (thus clearing it), and credit Cash. Sometimes the declaration date is before a period ending date, but the payment does not take place until after the end of that period. In that case, the Balance Sheet on the period closing date will show the Dividends Payable balance as a liability.

Stock Dividends If a company does not have enough cash to pay dividends, but the shareholders still want some distribution of profits, the company can declare a Stock Dividend rather than a Cash Dividend. In this case, the company either issues new stock, or stock from the Treasury stock. The accounting is done exactly the same as a Cash Dividend, with the exception of the Payment entry. Instead of crediting cash, a stock dividend will credit either the Stock at Par value account, or Treasury Stock account, depending on the source of the certificates. If the stock is selling on the market at more than the par value, the Additional Paid-In Capital Account might also be involved. STOCK SPLITS Frequently, a company’s stock will become so popular with the market that the price moves it out of reach of the ordinary investor. Most brokerage houses limit transactions to a minimum trade of 100 shares or more. Once a stock price reaches $500, $1000, or even $10,000 per share, many investors cannot afford to buy 100 shares. To bring the stock price back down to where more investors can buy and sell the stock, the Board of Directors will order a “Stock Split”. A “Two-for-One” stock split means that each current shareholder will receive two new shares for each share they currently own. Since the stock split has absolutely no effect on the accounting records, Total Owner’s Equity remains unchanged. The number of shared issued simply doubles. A stock split can be any multiple. A 3-for-1 stock split is common, as is a 5-for-1 stock split. In the latter case, each current shareholder receives five shares of stock for each one they now own. The par value is divided by five, so a stock previously carrying par value of $10 per share would be replaced by five shares of stock carrying par value of $2 per share. Effectively, this would appear to make the stock worth less in the market, and the price does drop. For example, the day of a 5 for 1 stock split, a stock selling for $500 per share will sell the next morning for $100 per share. But with more shares on the market, and with more investors able to afford the stock, the price usually increases to $103, $105, or even $110 within a few days.