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Stockholders' Equity

About Managerial Accounting

Managerial Accounting is very different from Financial Accounting. In Financial Accounting you learned about the overall framework of accounting, and how to prepare financial statements for investors and other people outside the company. Managerial Accounting will focus on preparing financial information for Managers who are inside the company. Their needs are different than the general public's, and Managers are entitled to access information that is confidential.

In Managerial Accounting, and in the legal and business world in general, Managers (or Management) are viewed as a special group of people. We will view them both as a "whole" and as individuals. They are employees of the company, and they are the ones in charge of running a company and making daily, mission-critical decisions that effect the very life of the company.

Because of their position in a company, Management can either act to benefit the company and it's owners or they can undermine the company. We expect the former, and cringe at the latter. The financial collapse of Enron is a recent example of a group of Managers who put their own personal gain above their obligation to the stockholders and public alike. It was the 7th largest company in the US at the time. Thousands of employees people lost their entire retirement fund, and thousands of other investors lost their entire investment.

This lesson is the first of two lessons on stockholders? equity. It deals with topics related to paid-in capital of a corporation. Issues relating to retained earnings is covered in the next lesson. The advantages and disadvantages of the corporate form are reviewed in detail, and the distinctions between public and closely held corporations are explained. An extensive discussion of the formation of a corporation highlights the rights of stockholders and the roles of corporate directors and officers.

The treatment of accounting procedures regarding paid-in capital concentrates on the issuance of capital stock and the stockholders? equity section of the balance sheet. The concept of par value is explained in detail, as is additional paid-in capital. The introduction of preferred stock leads to more complex illustrations of the stockholders? equity section. Preferences with respect to dividends and assets are explained and illustrated. Call and conversion features of preferred stock are also introduced. Other topics dealing with capital stock that are covered include issuance for assets other than cash, donated capital, and stock subscriptions.

The calculation of book value per common share is explained and illustrated before attention turns to factors concerning market values. The significance of market price to the issuing corporation is contrasted to its significance to the investor. We then explain the roles of interest rates and investor expectations in the determination of market prices.

Since stock splits and treasury stock transactions impact the presentation of paid-in capital on the balance sheet, they are also introduced in this chapter. Journal entries to record both the purchase and reissuance of treasury shares are provided. We explain and emphasize that profits and losses on treasury stock transactions are not recognized.

Fiduciary Responsibility

People running a business have a fiduciary responsibility to the owners of the business. That is a legal term that basically means a company's managers must act in a responsible manner with the company's money and business affairs. It also means that Management must keep records and be able to show owners whether the company is profitable (Income Statement), it's financial position (Balance Sheet), how much of the profits have been paid out to owners, and how much more they might be entitled to (Statement of Retained Earnings).

Management is not supposed to treat a company's funds like their (Management's) own. Management is also not supposed to maniuplate funds and resources for their own personal benefit or conduct the company's business affairs in such a manner as to defraud the owners.

We see several recent instances of Management fraud in cases such as the Tyco, Enron and Worldcom bankruptcies. The Securities and Exchange Commission (SEC) is now enforcing new, tougher laws that carry substantial jail sentences for Managment fraud. Company CEOs, Presidents, Vice-Presidents, CFOs, and other managers involved in fraud may have to pay substantial money damages as well as jail terms under the Sarbanes-Oxley Act. The Sarbanes-Oxley Act adds new provisions to the Securities Act of 1933 and the Securities Exchange Act of 1934. These two Acts embody much of the federal law regulating the sale and issue of all investments (in both public and private transactions) and the activities of stock markets.

Equity Versus Debt

Equity is Ownership in a company.

Debt represents all liabilities, bills and money owed by a company, including bank loans and mortgages.

The Accounting Equation is Assets = Liabilities + Owners' Equity

As we see by this equation, all assets are financed by total equity and debt.

Banks and other lenders expect the owners to take most of the risk in a business. Banks may be willing to lend a corporation some money, but only after stockholders have put in their share first.

Banks generally lend long-term money for long-term assets. This includes mortgage loans for land, buildings and equipment. The asset is pledged capital against the loan, so the bank can take the property back in the event the loan payments aren't made. This further limits the bank's risk of loss.

But, banks generally don't lend long-term money for short-term needs. Short term needs include daily operating expenses, inventory, payroll, insurance premiums and the like. Loaning long-term money for short-term needs is very risky for a bank. They have no collateral to repossess if the corporation defaults on the loan.

Short-term money comes from stockholders, who must take the greatest risk. But in exchange for taking the risk, stockholders are also entitled to benefit from the growth and earnings of the company for years to come. Some companies fail and the stockholders lose their entire investment. But other companies are extremely successful and the financial reward to stockholders can be huge.

Creating a Corporation and Issuing Stock

The life of a corporation starts when the Organizers file an application with the Secretary of State, and pay a fee. The application contains the Articles of Incorporation and asks the State to authorize the company to issue stock.

Authorized, Issued, Outstanding and Treasury stock


Authorized - The Secretary of State authorizes a corporation to issue shares of stock. This determines the total number of shares that can be issued, and the par value per share.

Issued - Once a corporation sells a share of stock to a stockholder, that share is issued. A share can be issued only once by the corporation, but it can be traded any number of times among shareholders and investors. Trading is generally done on a public stock market, and transactions go through a stock broker.

An Initial Public Offering (IPO) is the sale and issue of new stock, usually by a new corporation. After the IPO all future trading will take place on a stock market, with shares being traded among investors. After the IPO, the corporation is essentially out of the picture, when it comes to stock market activities. The corporation receives money only in the IPO.

Outstanding - After being authorized and issued, the total number of shares held by stockholders is called outstanding. Dividends are paid on outstanding shares only.

Treasury Stock

Sometimes a company buys its own stock back from stockholders. This stock is said to be held in the company's treasury. No dividends are paid on treasury stock. Treasury stock can be held indefinitely, resold at any time, or retired. Retired stock is permanently removed from future sale and dividends.

A treasury stock journal entry includes a debit to the treasury stock account. It appears as a negative amount in the stockholders' equity section of the balance sheet.

Buying treasury stock reduces the number of shares outstanding. This has several effects. Reducing the number of shares increases Earnings Per Share (EPS). In return the stock's market price generally goes up, or at least holds steady in declining economic times. Since fewer shares are outstanding it also reduces total dividends.

An example: XYZ, Inc plans an IPO. The Secretary of State authorizes them to sell 1,000,000 shares of $1 par common stock. Through a stock market the company offers 750,000 shares for sale to interested investors. They hold back 250,000 shares from issue, because these may be needed later for employee stock option plans. Later that year the corporation decides buy back 50,000 shares that were previously issued.

 
authorized
issued
treasury
outstanding
Authorized
1,000,000
0
0
0
Sold in IPO
1,000,000
750,000
0
750,000
Bought Treasury
1,000,000
750,000
(50,000)
700,000

Common and Preferred Stock

All corporations must have one class of voting common stock. Owners of the voting common stock have the right to elect the board of directors and vote on important matters that affect stockholders. They also have the right to receive unlimited dividends and benefit from unlimited capital growth.

Preferred stock is optional. Preferred stock usually carries certain benefits not available to common stockholders. Preferred stockholders generally receive dividends before common stockholders. In the event the corporation is liquidated, the Preferred stockholders are in line ahead of Common stockholders. Despite the benefits of Preferred stock, there are also limits on dividends and there is little or no capital growth potential for Preferred stock.

We follow the same basic rules to record both Common and Preferred Stock transactions.

Par and No-par Stock

Par refers to a set amount of money, which is the underlying amount of Capital attributed to each share of stock. It can be any dollar amount the Corporation chooses. Par and No-Par stock rules vary from state to state. The use of these terms is a matter of law. Some states don't allow No-Par stock.

Par value is often used to assess annual corporate franchise fees. The franchise fees allow a corporation to be in good standing and continue to operate legally.

Corporations often distribute money to Stockholders, in the form of Dividends and other payments. In some states the Par value limits the amount that can be paid out to Stockholders. Those laws ensure that the Corporation does not deplete all it's capital resources. Not all states allow No-Par stock to prevent corporations for depleting their capital by paying excess Dividends. You need to check the laws in your state to know how corporations are organized where you live.

Selling Par Stock

A corporation raises money by selling stock. Corporations must sell at least one class of Common stock at the initial capitalization. This creates a group of owners who vote to elect a Board of Directors. The Board then hires a President or CEO, who heads the company and authorizes all further activities of the corporation.

Par stock is recorded at its par value in the stock account.

Record the Sale of 100 shares of $1 par common stock, at par ($1 per share). Selling price is $1 per share.

General Journal

Date
Account
Debit
Credit
   Cash
100 
 
      Common Stock  
100 
   To record the sale of 100 shares of $1 par common stock at par.    

Record the Sale of 100 shares of $1 par common stock, at a premium. Selling price is $5 per share.

General Journal

Date
Account
Debit
Credit
   Cash
500 
 
      Common Stock  
100 
      Additional Paid-in Capital  
400
   To record the sale of 100 shares of $1 par common stock at $5 per share    

The Stock account (Common Stock in this case) is always credited for the amount of Par only.Any premium above par is credited to a different account. In this case I used the title Additional Paid-in Capital, but some companies and textbooks use other terms to mean the same thing.

Selling No-Par Stock

When a company uses No-Par stock, they omit the Additional Paid-in Capital account entirely.

Record the Sale of 100 shares of No-Par common stock for $5 per share.

General Journal

Date
Account
Debit
Credit
   Cash
500 
 
      Common Stock  
500 
   To record the sale of 100 shares of no-par common stock at $5 per share.    

Although No-Par stock is easier to record, not all states permit this type of stock. All stock transactions should follow one of the formats above, which much match the type of stock being sold.

In some states a corporation may have par, no-par and preferred stock all at the same time. You need to check with state laws to see what is permitted where you live.

Record the Sale of 10 shares of $100 par, 8% cumulative preferred stock for $105 per share.

General Journal

Date
Account
Debit
Credit
   Cash
1050 
 
      Preferred Stock, $100 par, 8% cumulative  
1000 
      Additional Paid-in Capital - Preferred  
50
   To record the sale of 100 shares of $1 par common stock at $5 per share    

Using the Additional Paid-in Capital (APIC) Accounts

Some corporations set up a different APIC for each class of stock. Other corporations use only one APIC account for all classes of stock. Which way is correct?

Answer: Both are correct. It's up to the corporation to decide how it wants to record these transactions.

Ultimately, all APIC belongs to the Common stockholders. Preferred stockholders are entitled to either the Par value or Call value of their stock, and are not entitled to a return of APIC.

Call Value of Preferred Stock

Some Preferred stock has a Call value. This means the corporation can Call, or buy back, the stock from the Preferred stockholders, at the option of the corporation. The stockholders have no say in this matter. Because they are losing their investment the Call value is usually higher than the Par value, at least by a couple of dollars.

There is usually an Exercise Date on a Preferred stock Call. That date is usually many years in the future, and prevents the corporation from calling the stock before this date. The Exercise Date benefits stockholders -- the corporation must wait until some time after this date before it can call the preferred stock.

When Preferred stock is called, it is usually Retired. Retired stock is no longer available for sale, no dividends will be paid on retired stock, and it has no future effect on stockholders equity.

The next lesson will explain how investors analyze these financial statements. Read on for more information!

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