Objective 11.1: Explain the role of stock in financing a corporation.

Corporate Ownership

• The major advantage of the corporate form of business is the ease of raising capital as both large and small investors can participate in corporate ownership.

• Advantages include:

  • It is simple to become an owner of a corporation:

    • You just have to buy a share of the company’s stock.

  • You can easily transfer ownership:

    • Sell the stock to someone else.

  • A corporation provides limited liability.

    • A shareholder is not responsible for a company’s debt.

    • It the company goes bankrupt, you lose the amount you paid for the initial stock, but you are not liable for company’s liabilities.

• Because a corporation is a separate legal entity, it can:

  • Own assets

  • Incur liabilities

  • Sue and can be sued

  • Enter into contracts

• Corporations are regulated by law.

• You must submit an application to the state government to create a corporation. When a corporation is approved, the state issues the articles of incorporation which holds information about the corporation.

• Stockholder benefits include:

  • Voting rights - being able to vote on important issues at annual meetings.

  • Dividends - Stockholders have the right to receive dividends when declared by the board of directors.

  • Residual claims (liquidation rights) - If the corporation goes bankrupt, stockholders share in any remaining assets after creditors are paid.

  • Preemptive rights - Existing stockholders have the first chance to purchase newly issued stock before it is issued to the public.

Equity vs Debt Financing

• Equity financing is issuing new stock to investors.

  • Advantages:

    • Equity does not have to be repaid, but debt does.

    • Dividends are optional, but there is interest on debt.

• Debt financing is borrowing money from lenders.

  • Advantages:

    • Interest on debt is tax deductible.

    • Debt does not change shareholder control.

Objective 11.2: Explain and analyze common stock transaction.

Stockholders’ Equity

• The four elements of stockholders’ equity:

  • Contributed Capital

  • Retained Earnings

  • Treasury Stock

  • Accumulated Other Comprehensive Income or Loss

• Contributed Capital (Common Stock and APIC)

  • The company receives capital from investors when they sell stock to them.

  • APIC is Additional Paid in Capital, which is the amount collected over par.

• Retained Earnings

  • It is earned capital.

  • Cumulative net income means less cumulative dividends.

• Treasury Stock

  • Shares that were issued, but the company decided they wanted to buy them back.

  • This is a contra accounts that has a normal DEBIT balance and reduces Stockholders’ Equity.

  • It is a permanent account.

  • A contra account that is “stuck like glue” to Common Stock and APIC.

• Accumulated Other Comprehensive Income or Loss

  • Recorded unrealized gains and losses that cause temporary changes in the value of assets and liabilities of the company.

  • The may involve pensions, foreign currencies, and financial investments.

  • It holds everything else (what we can’t squeeze into Common Stock because it can only hold par value).

Authorization, Issuance, and Repurchase of Stock

• A corporation can only issue a certain number of shares, which are known as authorized shares.

• Issued shares are permanently for the stockholder unless:

  • They sell them to another company

  • The corporation buys them back (treasury stock)

• Unissued shares are shares that haven’t been traded.

• Outstanding shares are owned by stockholders. They are the only shares that can’t get dividends.

Stock Authorization

• Par value is assigned to each share of stock that is authorized.

• It is not the same at market price, which is the value of what shares can sell for to the public.

• It is always a small number, like $0.01 per share.

• Some states require par value.

• No-Par value stock does not have a determined price.

• No PAR = No APIC

Stock Issuance

• The first time a corporation’s stock is available to the public is called an initial public offering (IPO).

• When new stock is issued to the public, this is called seasoned new issue.

• Issuing stock at par value, always the same journal entry:

  • Debit cash

  • Credit Common Stock (shares x par value amount)

  • Credit Additional Paid In Capital (cash - common stock)

• Example: A company issued 100,000 shares of $0.01 par value common stock for $30 per share.

  • Step 1: Calculate cash received.

    • Shares x Price per share

    • 100,000 x $30

    • Cash = 3,000,000

  • Step 2: Calculate Common Stock.

    • Shares x Par value

    • 100,000 x $0.01

    • Common Stock = $1,000

  • Step 3: Calculate Additional Paid-In Capital (APIC).

    • Cash - Common stock

    • 3,000,000 - $1,000

    • APIC = 2,999,000

  • Step 4: Make the journal entry.

Stock Exchanged Between Investors

• A transaction between two investors does not involve the corporation, so the corporation does not need to record anything.

• The corporation still has the same amount of shares issued to shareholders.

Stock Used to Compensate Employees

• Employees pay packages may include exclusive stock options for a “discount” price compared to what the market price is.

• Employees are later able to buy stock and the value will be higher.

• They can also sell their stock at a higher price.

Repurchase of Stock

• Treasury stock is the repurchase of issued stock.

• The purpose of repurchases can be:

  • Making a company believe the stock is worth getting.

  • Buy back the shares just to reissue them at a higher price to other companies.

  • Buy back shares to reissue them to employees.

  • Reduce the number of outstanding shares to increase per-share measures of earnings.

• When it is bought back, it is recorded at cost.

• It has no voting or dividend rights.

  • Cash dividends paid is reduced when Treasury Stock is purchased.

  • Stock transactions are only on the balance sheet.

• Journal entry for reacquiring stock:

  • Debit Treasury Stock

  • Credit Cash

• Example for reacquiring stock: A company reacquires 20,000 shares of its common stock at $20 per share.

  • Step 1: Calculate cash paid.

    • 20,000 x $20

    • $400,000 is paid.

  • Step 2: Make the journal entry.

• Journal entry for reissued stock:

  • Debit Cash (shares x new price of share)

  • Credit Treasury Stock (shares x initial price of stock)

  • Credit Additional Paid-In Capital (shares x (new price - old price))

• Example for reissuing stock: A company reissues 10,000 shares of Treasury Stock at $35 per share.

  • Step 1: Calculate cash received.

    • Shares x New cost per share

    • 10,000 x $25

    • Cash = $250,000

  • Step 2: Calculate Treasury Stock that will be issued.

    • Shares x Initial price of stock (from reacquiring example)

    • 10,000 x $20

    • Treasury Stock = $200,000

  • Step 3: Calculate APIC.

    • (Shares x (new price - old price))

    • (10,000 x ($25 - $20))

    • 10,000 x $5

    • APIC = $50,000

  • Step 4: Make the journal entry.

• Stock transactions NEVER generates gains or losses.

Objective 11.3: Explain and analyze cash dividends, stock dividends, and stock split transactions.

Cash Dividends on Common Stock

• If investors get common stock then they will get a return on their investment.

• Returns on Common Stock investments can come in two forms:

  • Dividends

  • Increases in stock price

• Growth investment is buying stock that pay a small amount of dividends or no dividends at all.

• Income investments are from common stock that do pay dividends.

• Before a dividend is declared, a company must have:

  • Enough retained earnings

  • Enough cash

• Dividends are…..

  • Declared by a board of directors.

  • Not legally required.

  • Liabilities once declared

• Dividends are not an expense.

Dividend Dates

• The declaration date is the day when the Board of Directors decide to issue a cash dividend. This is the day the liability is established. Journal entry:

  • Debit Dividends

  • Credit Dividends Payable

• The date of record is an administrative responsibility.

  • No journal entry

• The date of payment reduces the liability and cash. Journal entry:

  • Debit Dividends Payable

  • Credit Cash

• The year end is when the temporary accounts are closed to Retained Earnings. Journal entry:

  • Debit Retained Earnings

  • Credit Dividends

• Example:

  • Declaration Date: A company declares a cash dividends of $115,000,000 during its 2021 fiscal year.

• Date of record: NO JOURNAL ENTRY

• Date of payment: The previously declared dividend is paid off by the company.

• Year end: The company’s temporary accounts are closed into Retained Earnings at the end of their accounting period.

The Common Stock Triangle 🔽

• Authorized shares are the max amount of shares that can be issued.

• Issued shares are given to shareholders.

• Outstanding shares are what has not been issued.

  

• Equation to calculate outstanding shares:

  • Issued - Treasury shares = Outstanding Shares

• Example:

Objective 11.4: Describe the characteristics of preferred stock and analyze transactions affecting preferred stock.

Preferred Stock

• Preferred stock is given to a special group of investors.

• Preferred stock has different features such as:

  • It has different voting rights (none or a lot).

  • Dividends may be paid at a fixed rate.

  • It has priority over normal common stock.

• Preferred Stock Issuance increases cash and stockholders’ equity.

Preferred Stock Redemption

• Preferred stock that was issued can be bought back.

• This redemption means the preferred stock is retired, which results in the issuance being reversed.

Preferred Stock Dividends

• Preferred stock gives two dividends preferences:

  • Current dividend preference

  • Cumulative dividend preference

• A current dividend preference states that preferred dividends must be paid before paying dividends to stockholders.

• A cumulative dividend preference states if a current dividends is not paid, the unpaid amount has to be paid before other common dividends.

• Dividends in arrears regard cumulative preferred stock that has not been paid yet. They are not on the balance sheet.

Retained Earnings

• Retained Earnings are the collective earnings of a company.

• Net income increases Retained Earnings.

• Net loss decreases Retained Earnings.

• Giving cash or dividends to stockholders also decreases Retained Earnings.

• The negative balance of Retained Earnings is called accumulated deficit.

Statement of Stockholders’ Equity

• The statement of stockholders’ equity shows each stockholders’ equity account so we can track increases and decreases for each account.

• Examples of what may be included:

  • Issued shares

  • Treasury stock

  • Net income

  • Cash dividends

  • Stock dividends

  • Common stock

  • APIC

  • Retained Earnings

Objective 11.5: Analyze the earnings per share (EPS), return on equity (ROE), and price/earnings (P/E) ratios.

Earnings Per Share (EPS)

• Earnings per share provides information on the profit earned from common stock that is outstanding.

• Recent earning ratios can look into how dividends and stock prices may be in the future.

• Using EPS, you can compare the financial ratio to other years.

• You can not compare companies using this ratio.

• The higher that ratio, the better.

• Equation to calculate earnings per share:

  • (Net Income - Preferred Dividends)/ Average number of Common Shares Outstanding

• Example: A company’s income for 2022 was $160,100,000. It has $0 of preferred dividends. The average number of its outstanding shares was 50,400,000.

Return on Equity (ROE)

• Return on Equity reports a company’s return to stockholders.

• The ratio can be compared across companies.

• The higher the ratio, the better.

• Equation to calculate return on equity:

  • (Net Income - Preferred Dividends)/ Average Common Stockholders’ Equity

• Example: A company’s income for 2022 was $160,100,000. It has $0 of preferred dividends. The average common stockholders equity was $315,600,000.

Price/Earnings (P/E) Ratio

• The Price/Earnings ratio is a measure of the value that investors place on a company’s common stock.

• The current stock price comes from the stock exchange.

• With this ratio, you need to calculate EPS before calculating P/E.

• Equation to calculate the price/earning ratio:

  • Current Stock Price (per share)/ Earning Per Share (annual)

• Example: A company’s stock price was $38.44 when the company reported its 2022 EPS of $3.07.