The stockholders’ equity section of a balance sheet is equal to the reported assets minus liabilities (i.e., net assets). Basically, it shows the source of an entity’s net assets. Stockholders’ equity consists of two major categories: contributed capital (the amount of the net assets that were put into the business by owners) and retained earnings (the amount of the net assets generated by operations – all net income since operations began minus all dividends).
Businesses also report accumulated other comprehensive income to record gains and losses that are not reported on the entity’s income statement (such as gains and losses in the value of investments in available-for-sale securities). A fourth section within stockholders’ equity (treasury stock) is a negative to indicate that net assets have been used to repurchase shares of the business but those shares have not, as of yet, been retired.
Most companies report a statement of changes in stockholders’ equity within their financial statements which reports the change in each element of stockholders’ equity.
In the incorporation process, a business indicates the number of authorized ownership shares (the total number of shares that it wants to have the right to issue—this is often a huge number so that limitations are unlikely to be encountered in the future). The "shares issued" are the shares that have been provided to outside parties. The "shares outstanding" are the shares that are currently held by outside parties. The difference in issued shares and outstanding shares occurs because of treasury stock—issued shares that have been bought back by the business but not retired.
Ownership shares can be common stock or preferred stock. All companies have common stock while a few also issue preferred stock. The holders of common stock gain the rights specified by the state of incorporation. Those rights normally allow the owners to vote for the members of the board of directors that oversees the running of the company. Those rights also provide that each owner gets to share proportionally in any dividends that are distributed.
In most states, a corporation is required to indicate the par value of its common stock and preferred stock. With common stock, the legal purpose of par value has faded over the years. It basically means that anyone who buys the stock directly from the corporation for less than par value might eventually be held liable for this discount if the company ever goes bankrupt. Today, most corporations set the par value of their common stock at such a low amount (often a penny or a nickel) that no one ever buys the stock from the company for less than that amount.
Assume, for example, that a company issues one share of $1 par value common stock for $35 in cash. The journal entry is as follows. Note that the common stock is recorded at the par value (a traditional approach in accounting) with the excess shown in an account such as “additional paid-in capital” or “contributed capital in excess of par.” Together, these equity accounts indicate the total amount of contributed capital—the amount paid in by owners directly to the company.
Common stock 1
Additional paid-in capital—common stock 34
If stock is issued to pay for an asset or expense, the recording is based on the fair value of the stock. Only if the value of the stock is not known is the value of the asset or expense used. However, assets should never be recorded at a figure that is above its own fair value.
Assume that $1 par value common stock is selling for $35 per share and 1,000 shares are issued for land that has a fair value of $36,000. The recording entry is as follows based on the $35,000 value of the shares issued.
Common stock ($1 par value X 1,000 shares) 1,000
Additional paid-in capital—common stock 34,000
In a few states, no-par stock is allowed. All of the proceeds from the issuance of no-par stock is credited to “common stock.”
Costs of registering and issuing common stock are generally netted against the proceeds so that a smaller amount is reported in the Additional Paid-in Capital account.
The holders of preferred stock have only the rights specified in the stock certificate. In effect, the common shareholders are giving up a preference to these specified rights in exchange for the cash or other assets being put into the business. Most commonly, the holders of preferred stock are given the right to receive a set amount of dividends. The amount of the dividend payout is specified as a dollar amount or as a set percentage of the par value of the preferred stock.
Additional possible features stated in a preferred stock certificate:
1. Participating—preferred stockholders share with common stockholders in any dividend distributions that occur after both preferred and common stockholders receive a specified level of the dividend payment. Thus, preferred stockholders benefit by any exceptional large dividend payments.
2. Cumulative—preferred dividends not paid in a prior year (known as “dividends in arrears”) that must be paid before any distributions can be made to common stockholders. Dividends in arrears are not reported as a liability until declared by the board of directors. However, they should be disclosed.
3. Convertible—preferred stockholders have an option of exchanging their stock for common stock at a specified ratio
4. Callable—the corporation has the option to repurchase the preferred stock at a specified price. In stock transactions, no gain or loss is ever recognized on the income statement. Instead, gains are recorded as increases in additional paid-in capital (or an account with a similar title). Losses are a bit more of a reporting problem. If a comparable additional paid-in capital balance exists, it can be reduced to record any loss from a stock transaction. As an alternative, or if no additional paid-in capital balance exists, retained earnings is reduced. Thus, under certain circumstances, retained earnings can be reduced by a stock transaction but can never be increased.
Mandatorily redeemable preferred stock is classified as a liability on the balance sheet (rather than as stockholders’ equity) because payment must be made in the future.
Treasury Stock Transactions
A firm’s own stock repurchased on the open market is known as treasury stock. Stock is bought back by a business for a number of reasons—the most common is the hope of increasing the stock price on the market. Treasury stock is not an asset, as a firm may not own shares of itself. Instead it is treated as a reduction of stockholders’ equity.
Treasury stock can be retired so that all of the original financial impact is removed. Or, treasury stock can continue to be reported within the financial records. Treasury stock usually remains recorded if the corporation feels that it may eventually reissue those shares. If recorded rather than retired, there are two methods of accounting for treasury stock: cost and par value.
1. Treasury Stock - Cost Method
Under the cost method, as the name implies, treasury stock is debited for the cost of the treasury stock and is reported as a negative balance within stockholders’ equity. If resold, cash collected is debited and the cost of the shares is removed through a credit. The difference is a gain or loss but that is not shown on the income statement. As indicated above, gains are increases to “additional paid-in capital—treasury stock.” Losses should first reduce any “additional paid-in capital—treasury stock” to the extent of any balance that is present. Any remaining loss reduces retained earnings.
2. Treasury Stock - Par Value Method
The par value method is much less widely used than the cost method. Under the par value method, treasury stock is recorded (as a debit) for the par value of the shares reacquired. The amount added to additional paid-in capital when originally issued is also removed. Thus, the original capital is removed when the shares are bought back. Any difference between that original figure and the amount paid to reacquire these shares is an increase in additional paid-in capital if a credit is needed. If a debit is needed (more is paid to buy the shares back than they were issued for), once again additional paid-in capital is reduced if a treasury stock balance exists. Otherwise, the retained earnings balance is reduced. If this treasury stock is ever resold, it is treated as a typical issuance except that treasury stock is credited for par value rather than common stock.
Note that total stockholders’ equity is not affected by the method selected; only the allocation among the equity accounts is different. Stockholders' equity increases by the amount you receive when shares are issued. Stockholders' equity decreases by the amount you pay when shares are reacquired.
Retirement of Stock
Formal retirement of stock is handled in the same way as the par value method of recording treasury stock except that common stock is debited for par value rather than treasury stock when the shares are reacquired. The original amounts recorded in common stock and additional paid-in capital are eliminated.
The difference between that amount and the amount paid to buy back the stock is, once again, either an increase in additional paid-in capital or a decrease in additional paid-in capital and/or retained earnings.
Various Types of Dividends
1. At the date of declaration (the date on which the board of directors makes the decision to pay a dividend), an entry is made to record the dividend liability. Assume for example that a company has 200,000 authorized shares of common stock, 120,000 issued shares, and 110,000 shares outstanding. The difference in issued and outstanding shares is caused by the repurchase of 10,000 shares of treasury stock. On that day, the board of directors declares a $1 per share cash dividend. Dividends are only paid on outstanding shares so the total amount is $110,000. The following liability is recorded immediately at the date of declaration:
Retained earnings (or Dividends paid) 110,000
Cash dividend payable 110,000
2. Those individuals or organizations who own shares of the stock on the date of record will be paid the above declared dividends. No entry is made on the date of record—it simply defines who will receive the dividend distribution. The ex-dividend date indicates that anyone who buys the shares on that date will not be entitled to receive the dividend.
3. On the date of payment (sometimes called the date of distribution), the liability is paid and removed from the accounting records.
Cash Dividends--Owner (Investor)
The investor records the dividend as a receivable until collected as revenue. Although the corporation records the payable on the date of declaration, the investor does not report the receivable until the date of record.
With a property dividend, an asset other than cash (often investments) is given to stockholders as a reward. On the date of declaration, this property is adjusted to fair value and a gain or loss is recorded. The liability is then recorded for the fair value of the property and removed on the date of payment.
Liquidating dividends (a dividend payment made when there is no retained earnings or an insufficient retained earnings balance to cover the dividend) is viewed as a return of capital to the stockholders rather than a sharing of profits. Additional paid-in capital is debited (reduced) rather than retained earnings. The common stock account cannot be decreased because it must be reported at par value (the legal capital which must be maintained in the business).
A stock dividend is one in which additional shares of the stock of the company are issued to stockholders. The total of the company's net assets is not changed and each owner retains the same percentage of ownership. Nothing really changes except the number of outstanding shares.
Hence, the main purpose of a stock dividend is to reduce the price of the stock on the stock market (increasing the number of shares outstanding without changing the company in any way should bring the price down proportionally). Thus, unlike cash and property dividends, stock dividends are not a liability when declared.
--In recording a small stock dividend, the retained earnings balance is reduced by the fair value of the new shares issued while increasing common stock and additional paid-in capital by the same amount. A small stock dividend is one that is less than a 20%-25% increase in the amount of stock outstanding.
--In recording a large stock dividend, the retained earnings balance is reduced by the par value of the new shares issued while increasing common stock by the same amount. A large stock dividend is one that is greater than a 20%-25% increase in the amount of stock outstanding.
--A stock dividend of between 20%-25% can be recorded at par value or fair value.
--Investors who receive stock dividends do not make any entry at all but must reduce the book value per share of the investment.
Stock splits are issued to create large drops in the market price of a company’s stock (whereas a reverse stock split causes an increase in the price of stock). Stock splits change both the number of shares outstanding and the par value per share. Par value is reduced in proportion to the increase in the number of shares.
A company with 100,000 shares outstanding having a par value of $1 each might choose to create a two-for-one stock split so that each old share becomes two new shares. The company would then have 200,000 shares outstanding but with a par value of $.50 each (rather than $1.00). The total par value outstanding does not change and no journal entry is made either by the company issuing the stock split or the investor receiving the additional shares.
Share-based payments are transactions wherein an entity acquires goods or services by issuing new shares. There are two important distinctions for applying the rules for share-based payments:
• Is the share-based payment to nonemployees or employees?
• Is the share-based payment considered equity or a liability?
1 - Share-based payments to nonemployees. Share-based payments to nonemployees for goods and services are measured at the fair value of the shares issued or the fair value of the goods and services received, whichever is more reliable.
2 - Share-based payments to employees.
Noncompensatory. Some share-based payments to employees are noncompensatory in nature so that no recognition is made. This generally happens when stock options are given equally to all employees who can then buy stock at a small discount from its market value (a discount of 5 percent or less) for a short period of time (30 days or less from the time the option price is set as a monetary amount). The only entry recorded is the normal entry for the issuance of stock when any of these options are converted by the employees into shares of stock.
Compensatory. Payments to employees that do not qualify as noncompensatory are viewed as compensatory and must be recorded. Share-based payments to employees are measured using the fair-value method.
A major complication arises when a stock option is issued to employees as compensation because fair value is often difficult to determine with any degree of accuracy. Over time, changes in the value of the stock will cause the immediate value of the stock option to rise and fall quickly. For accounting purposes, fair value of a stock option is measured based on the observable market price of an option with the same or similar terms and conditions. That is often not possible so fair value is then estimated using an option-pricing model such as Black-Scholes.
When compensatory options are given to employees, the fair value is determined on the grant date. That amount is then recognized as expense on a straight-line basis over the service period that the employee must work in order to gain the right to these options (which is usually the vesting period). The fair value is determined on the grant date and then recorded equally over the period of required work by a debit to recognize the expense and a credit to a paid-in capital account.
Stock appreciation rights. Some share-based payments are not satisfied by the issuance of stock options. Instead, the person receives cash (often sometime in the future) based on the rise in stock price over and above a set amount. These are sometimes referred to as stock appreciation rights and recognition of this expense leads to the creation of a liability and not an equity balance as with stock options.
The value of these rights is also determined using an option-pricing model. However, an updated estimation is determined at the end of each new year and the old allocations are adjusted to be in line with the newer estimation. Compensation cost is the change in fair value of the instrument from one period to the next.
Any option-pricing model (such as the Black-Scholes model) can be used for the above reporting if it considers all of the following variables in determining fair value of the option or right.
a. Current price of the underlying stock
b. Exercise price of the option
c. Expected life of the option
d. Expected volatility of the underlying stock
e. Expected dividends on the stock
f. Risk-free interest rate during the expected option term
Accounting Entries for Share-Based Payments to Employees
1. Compensatory stock options
To illustrate the accounting for compensatory stock options, assume ABC Corporation (a public company) establishes an employee stock option plan on January 1, Year One. The plan allows its employees to eventually acquire 10,000 shares of its $1 par value common stock at $52 per share, when the market price is also $52. To earn these options, employees must work for ABC for five years from this grant date. The grant-date fair value of an option with similar terms and conditions (or the fair-value amount determined using an option-pricing model) is $8.62 or $86,200 in total.
The journal entries for this option can be made in several different ways. The easiest method is to divide the $86,200 over 5 years or $17,240 so that the following entry is made at the end of each of the next five years.
Compensation expense 17,240
Additional paid-in capital –
stock options outstanding 17,240
2. Stock appreciation rights
To illustrate the recognition and measurement of stock appreciation rights, assume ABC Corporation (a public company) establishes an employee compensation plan on January 1, Year One. The plan allows its employees to receive 10,000 times the increase in the price of the company’s stock over and above $52 per share (the current price). To earn these options, employees must work for ABC for five years from the grant date. The grant-date fair value of a right is determined to be $8.62 or $86,200 in total (assume an option pricing model were used to make this determination).
By December 31, Year One, the price of the stock had risen to $54 per share but the fair value of a right is $10 each or $100,000 in total.
By December 31, Year Two, the price of the stock had risen to $55 per share but the fair value of a right has grown to $11 each or $110,000 in total.
December 31, Year One. Because the value is going to be recomputed each period, no determination of the value of the right is needed until the end of the first reporting period. On that day, these 10,000 rights are worth $100,000. Because employees must work for a total of five years, the liability to be recognized at the end of this first period is $20,000 (1/5 X $100,000).
Compensation expense 20,000
Stock appreciation rights liability 20,000
December 31, Year Two. The new estimation of the fair value of these rights is $110,000. Now employees have worked two out of a total of five required year so that the liability should be 2/5 X $110,000 or $44,000. The previously recorded liability balance of $20,000 is now raised to this $44,000 figure. It is the $24,000 increase in the liability that determines the amount of expense to be recognized.
Compensation expense 24,000
Stock appreciation rights liability 24,000
The purpose of a quasi reorganization is to allow companies to avoid formal bankruptcy proceedings (and the resulting costs and risks). The procedure is applicable for a situation where a company could manage to stay viable except for overvalued assets and a possible deficit. The overvalued assets result in excessive depreciation charges which create losses or unreasonably low net income figures. The resulting deficit precludes payment of dividends which limits the company’s ability to attract new capital.
The procedure consists of two basic steps.
--All assets and liabilities are adjusted to fair value with the gains and losses (primarily losses) charged to retained earnings (probably a deficit balance).
--Then, the entire deficit in retained earnings is eliminated by a charge against paid-in (or contributed) capital.
The company winds up with all assets and liabilities reported at fair value and with a zero balance in retained earnings. As a result, hopefully, potential investors will be more willing to provide additional capital.
To alert readers of financial statements that a quasi organization has taken place, retained earnings must be dated for ten years. Disclosure similar to “retained earnings since quasi reorganization of June 30, 2011,” is appropriate.
The following ratios use stockholders’ equity components in their calculations:
1. Dividend payout—measures percentage of earnings distributed as dividends and is found by dividing a company's dividends per share by earnings per share.
2. Rate of return on common stockholders’ equity—measures the return (profit) earned on the stockholders’ investment in the firm. Net income available to common stockholders is divided by the common stock share of stockholders’ equity.
3. Debt to equity—shows the portion of an entity’s net assets that came from debt. It is the total amount of reported liabilities divided by the total amount of reported stockholders’ equity.