c

 



 


We also have  , , and  for the topic

 
.

If you were to reduce a corporation's entire balance sheet into its most skeletal form, you would
end up with the following accounting equation:



 


 


As you can see, stockholders' equity is one of the three main components of a corporation's
balance sheet. If you rearrange the equation, you will see that stockholders' equity is the
difference between the asset amounts and the liability amounts:

Assets ± Liabilities = Stockholders' Equity

Stockholders' equity is to a corporation what owner's equity is to a sole proprietorship. Owners

of a corporation are called stockholders (or shareholders), because they own (or hold) shares of
the company's stock. Stock certificates are paper evidence of ownership in a corporation.

U. S. corporations are organized in, and are regulated by, one of the fifty states. Because laws
differ somewhat from state to state, accounting for corporations also differs somewhat from state
to state. (If you need to determine the specific rules for a corporation in a specific state, you
should seek the guidance of a professional who is knowledgeable with the laws of that state.) For
our purposes, we will focus on the structure and concepts that are fundamental to most U.S
corporations.

The concepts and vocabulary we will introduce in this topic (such as dividends, earnings per
share, and book value) are important not only to accountants, but to investors, business owners,
business students, and others.
2
c
 

ãost of the world's largest companies do business as p

 . Companies such as Wal-
ãart, Exxon ãobil, General ãotors, Ford ãotor, and General Electric²each with sales in
excess of $150 billion annually²are corporations. As opposed to a sole proprietorship or a
partnership, a corporation is a business that is recognized by law as a separate legal entity with
its own powers, responsibilities, and liabilities. Before the owners/managers of a business choose
to p

 their business (become corporations), however, they should examine the
advantages and disadvantages of doing so.

 
! 

A corporation has several advantages over the sole proprietorship and the partnership form of
business. The four major advantages are: (1) limited liability, (2) ease in transferring ownership,
(3) continuity, and (4) ease in raising money.

1.V "

 for the owners. Generally, the owners of a corporation can lose no more
than the amount they have invested in that corporation. On the other hand, with a sole
proprietorship or partnership, an owner could lose not only her or his investment, but
could also lose other personal assets as well. In other words, the corporate form of
business "shields" the owners from most creditors. This occurs because corporations are
considered to be legal entities, separate and distinct from their owners. (Due to their legal
entity status, a corporation can sue others, can be sued, and must pay income taxes on its
taxable income.)
2.V      
  
 
. If the stock is 
 ,
investors can sell their ownership interest in a corporation in a matter of minutes simply
by giving instructions to their stockbroker. If the stock is not publicly traded, the stock
certificate can be transferred to another owner by signing a transfer statement.
3.V 
 
. When a stockholder sells shares of stock, the transaction is between the
seller and the buyer of the stock. Unless the corporation is the buyer or the seller, the
corporation is not involved in the transaction. This means that even if a corporation's
stock is the most actively traded stock of the day, the corporation itself will not skip a
beat in its day-to-day operations. When notified by a stockbroker of a transfer between
stockholders, the corporation merely changes in its records the name of the owner of the
shares.
4.V    !" . Because of limited liability and the ease of buying/selling shares,
it is easy to understand why investors are more attracted to investing in corporations
rather than in sole proprietorships or partnerships. This investor attraction allows
corporations to raise the capital needed to manage and expand their operations.
ü 
! 

Some view the legal complexity of starting and running a corporation to be a disadvantage. To
incorporate, an application must be filed with and approved by one of the fifty states, and once
approved, the corporation must comply with that state's regulations. In contrast, a sole
proprietorship can be started in minutes, sometimes with nothing more than a tax identification
number from the state. ãany of the legal requirements imposed on a corporation do not apply to
sole proprietorships.

Another disadvantage associated with corporations is the possibility of "double taxation" on the
dividends it pays. Some argue that a regular corporation's net income is first taxed on the
p

   income tax return. Then, if the corporation distributes some of the net income to
the stockholders as a dividend, the dividend will be taxed again on the  p
  
 personal
income tax returns. (To gain more insight into this and to minimize or to avoid this potential
problem, you should discuss various forms of business structures with tax and legal
professionals.)

Ñ   

The owners of corporations are referred to as 


  or   , because they hold
the shares of stock, which serve as the evidence of their ownership. (The term  p
  
 and

  
 are used interchangeably. However, we will use the term stockholders.)

Because it would be impossible for 30,000 stockholders to sit around a boardroom table and give
meaningful input to the direction of their company, the stockholders elect a board of directors as
their representatives in the corporation's affairs. The # 
 formulates the
corporation's policies and appoints officers of the corporation to carry out those policies. The
board of directors also declares the amount and timing of dividend distribution, if any, to the
stockholders.

The ##  of a corporation are appointed by the corporation's board of directors to carry out
(or execute) the policies established by the board of directors. The officers include the president,
chief executive officer (CEO), chief operating officer (COO), chief financial officer (CFO), vice
presidents, treasurer, secretary, and controller.

"" 


If a corporation has issued only one type, or class, of stock it will be "" 

. ("Preferred
stock" is discussed later.) While "common" sounds rather ordinary, it is the common
stockholders who elect the board of directors, vote on whether to have a merger with another
company, and get huge returns on their investment if the corporation becomes successful.

When an investor gives a corporation money in return for part ownership, the corporation issues
a certificate of ownership interest to the stockholder. This certificate is known as a 


 
#
, 


, or 

. (Today the larger corporations will handle the shares or
stock electronically.)

Stock is the evidence of an 
 interest, it is not a loan to the corporation; stock does not
p   or 
. A stockholder owns the stock until he/she decides to sell it. If stockholders
want to sell their stock, they must find a buyer usually through the services of a stockbroker.
Nowhere on the stock certificate is it indicated what the stock is worth (or what price was paid to
acquire it). In a market of buyers and sellers, the current value of any stock fluctuates moment-
by-moment.

A corporation's accounting records are involved in stock transactions only when the corporation
is the issuer, seller, or buyer of its own stock. For example, if 500,000 shares of Apple Computer
stock are traded on the stock exchange today, and if none of those shares is issued, sold, or
repurchased by Apple Computer, then Apple Computer's accounting records are not affected.
The corporation will go about its routine business operations without even noticing that there
were some changes in its ownership.

 

Some investors may have large ownership interests in a given corporation, while other investors
own a very small part. To keep track of each investor's ownership interest, corporations use a
unit of measurement referred to as a "share" (or "share of stock"). The number of shares that an
investor owns is printed on the investor's stock certificate. This information is also noted in the
corporate secretary's record, a record which is not connected to the corporation's accounting
records.
The ratio of investors to stock owned is different for every corporation and it may change many
times per day depending on who is selling or buying stock. If an investor owns 1,000 shares and
the corporation has issued a total of 100,000 shares outstanding, the investor is said to have a 1%
ownership interest in the corporation. The other owners have the combined remaining 99%
ownership interest.


  

When a business applies for incorporation to a secretary of state, its approved application will
specify the classes (or types) of stock, the par value of the stock, and the number of shares it is
authorized to issue. (Shares are often issued in exchange for cash. However, shares of stock can
be issued in exchange for services or plant assets.) When its articles of incorporation are
prepared, a business will often request authorization to issue a larger number of shares than what
is immediately needed. By planning ahead this way, the business avoids the inconvenience of
having to go back to the state if and when more shares are needed to raise more capital.

To illustrate, assume that the organizers of a new corporation need to issue 1,000 shares of
common stock to get their corporation up and running. They keep in mind, however, that in one
year they will need to issue additional shares to fund a planned factory expansion. Five years
from now they foresee buying out another company and realize they will need to issue more
shares at that time for the acquisition. As a result, they decide that their articles of incorporation
should 
 100,000 shares of common stock, even though only 1,000 shares will be issued
at the time that the corporation is formed.

c  

When a corporation sells some of its authorized shares, the shares are described as "issued." The
number of issued shares is often considerably less than the number of 
 shares.

Corporations issue (or sell) shares of stock to obtain cash from investors, to acquire another
company (the new shares are given to the owners of the other company in exchange for their
ownership interest), to acquire certain assets or services, and as an incentive/reward for key
officers of the corporation.

The "par value" of a share of stock is sometimes defined as the legal capital of a corporation. The
par value of common stock is usually a very small insignificant amount that was required by
state laws many years ago. Because of those existing laws whenever a share of stock is issued,
the par value is recorded in a separate stockholders' equity account in the general ledger. Any
proceeds that exceed the par value are credited to another stockholders' equity account. This
required accounting (discussed later) means that you can determine the number of issued shares
by dividing the balance in the par value account by the par value per share.

¢

  ! 

If a share of stock has been issued and has not been reacquired by the corporation, it is said to be
"outstanding." For example, if a corporation initially sells 2,000 shares of its stock to investors,
and if the corporation did not
p
 any of this stock, this corporation is said to have 2,000
shares of stock outstanding. The number of outstanding shares is always less than or equal to the
number of issued shares. The number of issued shares is always less than (or equal to) the
authorized number of shares.

Here is a mathematical presentation:

Number of 

  ! shares ” number of   shares ” number of 
  shares
When a corporation reacquires shares of its own stock and does not retire them, the corporation
is said to have "treasury stock." (Treasury stock will be discussed later.) The number of
outstanding shares is equal to the number of issued shares minus the number of treasury shares.
Number of 

  ! shares = number of   shares ± number of
  shares

Here are the terms in descending order (largest to smallest) based on hypothetical amounts:

AUTHORIZED 100,000 shares

ISSUED 1,000 shares *
OUTSTANDING 900 shares *

* The difference between the ISSUED shares and the OUTSTANDING shares is the number of
shares of TREASURY STOCK (100 shares in this example).


 !$


 


A corporation's balance sheet reports its assets, liabilities, and stockholders' equity. Stockholders'
equity is the difference (or residual) of assets minus liabilities.


 

%
 

Because of the cost principle (and other accounting principles), assets are generally reported on
the balance sheet at cost (or lower) amounts. As a result, it would be incorrect to assume that the
total amount of stockholders' equity is equal to the current value, or worth, of the corporation.
(For a more thorough discussion of the balance sheet, see & 
 #'   
.)

Because of legal requirements, the  p

  
 equity section of a corporation's balance sheet is
more expansive than the 
 equity section of a sole proprietorship's balance sheet. (For
example, state laws require that corporations keep separate in their records the amounts received
through investors from the amounts 
 through business activity.) State laws may also
require that the par value be reported in a separate account.

Below are the items that a corporation is required to report on its balance sheet in the
stockholder's equity section. We will discuss them in the order they would appear on a balance
sheet:

1.V Paid-in Capital (also referred to as Contributed Capital)

2.V Retained Earnings
3.V Treasury Stock
4.V Accumulated Other Comprehensive Income
-V
( 




>.V

7.V 



is a term that encompasses both common stock and preferred stock. "Paid-
in" capital (or "contributed" capital) is that section of stockholders' equity that reports the
amount a corporation received when it issued its shares of stock.
8.V
9.V State laws often require that a corporation is to record and report separately the par
amount of issued shares from the amount received that was greater than the par amount.
The par amount is credited to Common Stock. The actual amount received for the stock
minus the par value is credited to Paid-in Capital in Excess of Par Value.
10.V
[Link] illustrate, let's assume that a corporation's common stock has a par value of $0.10 per
share. On ãarch 10, 2009, one share of stock is issued for $13.00. (The $13 amount is
the #"

  based on supply and demand for the stock.) The accountant makes
a journal entry to record the issuance of one share of stock along with the corporation's
receipt of the money (note that the "Common Stock" account reflects the par value of
$0.10 per share):
12.V
13.V
ü

)" ü 
 

*+,-.,,/  +0 ,,

"" 

, +,

( 
 & #

+. /,
1
14.V

[Link] some states require a par value for common stock, other states do not. If there is no
par value, some states require a "stated value." If this is the case, the entry will be the
same as the above except that the term "stated" will be used in place of the term "par":
1>.V
ü

)" ü 
 

*+,-.,,/  +0 ,,

"" 

, +,

( 
 & #


+. /,
1
17.V

[Link] a state does not require a par value or a stated value, the entire proceeds will be
credited to the Common Stock account:
19.V
ü

)" ü 
 

*+,-.,,/  +0 ,,

"" 

+0 ,,
20.V

[Link] speaking, the par value of common stock is minimal and has no economic
significance. However, if a state law requires a par (or stated) value, the accountant is
required to record the par (or stated) value of the common stock in the account Common
Stock.
22.V
.0 V
   !
[Link] the life of a corporation it has two choices of what to do with its net income: (1) pay
it out as dividends to its stockholders, or (2) keep it and use it for business activities. The
amount it keeps is the balance in a stockholders' equity account called 
 
  !. This general ledger account is a   or  "
account with a normal
credit balance.
25.V
2>.VThe term retained earnings refers to a corporation's cumulative net income (from the date
of incorporation to the current balance sheet date) minus the cumulative amount of
dividends declared. An established corporation that has been profitable for many years
 will often have a very large credit balance in its Retained Earnings account, frequently
exceeding the paid-in capital from investors. If, on the other hand, a corporation has
experienced significant net losses since it was formed, it could have negative retained
earnings (reported as a debit balance instead of the normal credit balance in its Retained
Earnings account). When this is the case, the account is described as "Deficit" or
"Accumulated Deficit" on the corporation's balance sheet.
27.V
[Link]'s important to understand that a large credit balance in retained earnings does not
necessarily mean a corporation has a large cash balance. To determine the amount of
cash, one must look at the Cash account in the current asset section of the balance sheet.
(For example, a public utility may have a huge retained earnings balance, but it has
reinvested those earnings in a new, expensive power plant. Hence, it has relatively little
cash in relationship to its retained earnings balance.)
29.V
[Link]'s look at the stockholders' equity section of a balance sheet. We'll assume that a
corporation only issues common stock. The stock has a par value of $0.10 per share.
There are 10,000 authorized shares, and of those, 2,000 shares have been issued for
$50,000. At the balance sheet date, the corporation had cumulative net income after
income taxes of $40,000 and had paid cumulative dividends of $12,000, resulting in
retained earnings of $28,000.
31.V


 

Paid-in Capital
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued and
outstanding $ 200
Paid-in capital in excess of par - common 49,800
Total Paid-in Capital 50,000
Retained Earnings 28,000
Total Stockholders' Equity $78,000

2 



A corporation may choose to reacquire some of its outstanding stock from its shareholders when
it has a large amount of idle cash and, in the opinion of its directors, the market price of its stock
is too low. If a corporation reacquires a p amount of its own stock, the corporation's
  !  may increase because there are fewer shares outstanding.

If a corporation reacquires some of its stock and does not

 those shares, the shares are
called treasury stock. Treasury stock reflects the difference between the number of shares 
and the number of shares  . When a corporation holds treasury stock, a debit balance
exists in the general ledger account Treasury Stock (a contra stockholders' equity account). There
are two methods of recording treasury stock: (1) the cost method, and (2) the par value method.
(We will illustrate the cost method. The par value method is illustrated in intermediate
accounting textbooks.)

Under the cost method, the cost of the shares acquired is debited to the account Treasury Stock.
For example, if a corporation acquires 100 shares of its stock at $20 each, the following entry is
made:

2 

.-,,,
 .-,,,

Stockholders' equity will be reported as follows:


 

Paid-in Capital
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued, 1,900 shares
outstanding $ 200
Paid-in capital in excess of par - common 49,800
Total Paid-in Capital 50,000
Retained Earnings 28,000
$
Subtotal
78,000
Less: Treasury Stock, at cost (100 shares at $20) ± 2,000
Total Stockholders' Equity $7>,000

If the corporation were to sell some of its treasury stock, the cash received is debited to Cash, the
p  of the shares sold is credited to the stockholders' equity account Treasury Stock, and the
difference goes to another stockholders' equity account. Note that the difference does   go to
an income statement account, 
      " 

"
 ! 
 #! 
  
 


 
 . (This, of course, is reasonable since the corporation
operates with total "insider" information.)
If the corporation sells 30 of the 100 shares of its treasury stock for $29 per share, the entry will
be:

 (30 shares at $29 selling price) 34,

2 

(30 at $20 cost) 5,,

( 
#"2 

.4,

Recall that the corporation's cost to purchase those shares at an earlier date was $20 per share.
The $20 per share times 30 shares equals the $>00 that was credited above to Treasury Stock.
This leaves a debit balance in the account Treasury Stock of $1,400 (70 shares at $20 each).

The difference of $9 per share ($29 of proceeds minus the $20 cost) times 30 shares was credited
to another stockholders equity account, Paid-in Capital from Treasury Stock. Although the
corporation is better off by $9 per share, the corporation cannot report this "gain" on its income
statement. Instead the $270 goes directly to stockholders' equity in the paid-in capital section as
shown below.


 

Paid-in Capital
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued, 1,930 shares
outstanding $ 200
Paid-in capital in excess of par - common 49,800
Paid-in Capital from Treasury Stock 270
Total Paid-in Capital 50,270
Retained Earnings 28,000
Subtotal $78,270
Less: Treasury Stock, at cost (70 shares at $20) ± 1,400
Total Stockholders' Equity $7>,870

If the corporation sells any of its treasury stock for less than its cost, the cash received is debited
to Cash, the cost of the shares sold is credited to Treasury Stock, and the difference ("loss") is
debited to Paid-in Capital from Treasury Stock (so long as the balance in that account will not
become a debit balance). If the "loss" is larger than the credit balance, part of the "loss" is
recorded in Paid-in Capital from Treasury Stock (up to the amount of the credit balance) and the
remainder is debited to Retained Earnings. To illustrate this rule, let's look at several transactions
where treasury stock is sold for less than cost.
We will continue with our example from above. Recall that the cost of the corporation's treasury
stock is $20 per share. The corporation now sells 25 shares of treasury stock for $1> per share
and receives cash of $400. As mentioned previously, the $4 "loss" per share ($1> proceeds minus
the $20 cost) cannot appear on the income statement. Instead the "loss" goes directly to the
account Paid-in Capital from Treasury Stock (if the account's credit balance is greater than the
"loss" amount). Since the $270 credit balance in Paid-in Capital from Treasury Stock is greater
than the $100 debit, the entire $100 is debited to that account:

 (25 shares at $1> selling price) 6,,

( 
#"2 

("loss") +,,
2 

(25 at $20 cost) -,,

After making this entry, the stockholders' equity section of the balance sheet appears as follows:


 

Paid-in Capital
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued, 1,955 shares
outstanding $ 200
Paid-in capital in excess of par - common 49,800
Paid-in Capital from Treasury Stock 170
Total Paid-in Capital 50,170
Retained Earnings 28,000
Subtotal $78,170
Less: Treasury Stock, at cost (45 shares at $20) ± 900
Total Stockholders' Equity $77,270

After the 25 shares of treasury stock are sold, the balance in Treasury Stock becomes a debit of
$900 (45 shares at their cost of $20 per share). The Paid-in Capital from Treasury Stock now
shows a credit balance of $170.

Now let's illustrate what happens when the next sale of treasury stock results in a "loss" and it
exceeds the credit balance in Paid-in Capital from Treasury Stock. Let's assume that the
remaining 45 shares of treasury stock are sold by the corporation for $12 per share and the
proceeds total $540. Since the cost of those treasury shares was $900 (45 shares at a cost of $20
each) there will be a "loss" of $3>0. This $3>0 is too large to be absorbed by the $170 credit
balance in Paid-in Capital from Treasury Stock. As a result, the first $170 of the "loss" goes to
Paid-in Capital from Treasury Stock and the remaining $190 ($3>0 minus $170) is debited to
Retained Earnings as shown in the following journal entry.

 (45 shares at $12 selling price) -6,

( 
#"2 

("loss") +4,

   ! ("loss" too big for PIC TS) +/,
2 

(45 at $20 cost) /,,

Again, no income statement account was involved with the sale of treasury stock, even though
the shares were sold for less than their cost. The difference between the cost of the shares sold
and their proceeds was debited to stockholders' equity accounts. The debit was applied to Paid-in
Capital from Treasury Stock for as much as that account's credit balance. Any "loss" greater than
the credit balance was debited to Retained Earnings. The stockholders' equity section of the
balance sheet now appears as follows.


 

Paid-in Capital
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued and
outstanding $ 200
Paid-in capital in excess of par - common 49,800
Total Paid-in Capital 50,000
Retained Earnings 27,810
$
Total Stockholders' Equity
77,810

"
¢
 "   c " 

"

 "    " refers to income not reported as net income on a
corporation's income statement. These items involve things such as foreign currency
transactions, hedges, pension liabilities, and unrealized gains and losses on certain investments.
Because these items are not common to most corporations, we will not discuss this topic in
depth. You can learn more about this topic in an intermediate accounting textbook and/or by
reading the Statement of Financial Accounting Standards No. 130, ´
 

p  at  $ ' ! under the "Standards" tab.
Below is an example of the reporting of Accumulated Other Comprehensive Income of $8,000.
Notice that it is reported separately from retained earnings and separately from paid-in capital.


 

Paid-in Capital
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued and
outstanding $ 200
Paid-in capital in excess of par - common 49,800
Total Paid-in Capital 50,000
Retained Earnings 27,810
"
¢
 "   c " 3-,,,
Total Stockholders' Equity $85,810

ü   "" 




Cash dividends (usually referred to as "dividends") are a distribution of the corporation's net
income. Dividends are analogous to draws/withdrawals by the owner of a sole proprietorship. As
such, dividends are not expenses and do not appear on the corporation's income statement.

Corporations routinely need cash in order to replace inventory and other assets whose
replacement costs have increased or to expand capacity. As a result, corporations rarely
distribute all of their net income to stockholders. Young, growing corporations may pay no
dividends at all, while more mature corporations may distribute a significant percentage of their
profits to stockholders as dividends.

Before dividends can be distributed, the corporation's board of directors must p
 a dividend.
The date the board declares the dividend is known as the  
 
and it is on this date
that the liability for the dividend is created. Legally, corporations must have a credit balance in
Retained Earnings in order to declare a dividend. Practically, a corporation must also have a cash
balance large enough to pay the dividend and still meet upcoming needs, such as asset growth
and payments on existing liabilities.

Let's look at an example: On ãarch 15 a board of directors approves a motion directing the
corporation to pay its regular quarterly dividend of $0.40 per share on ãay 1 to stockholders of
record on April 15. The following entry is made on the declaration date of ãarch 15 assuming
that 2,000 shares of common stock are outstanding:


   ! (2,000 X $0.40) 3,,

ü  
 3,,

If the corporation wants to keep a general ledger record of the current year dividends, it could
use a temporary, contra retained earnings account, Dividends Declared. At the end of the year,
the balance in Dividends Declared will be closed to Retained Earnings. If such an account is
used, the entry on the declaration date is:

ü  ü   3,,
ü  
 3,,

It is important to note that there is no entry to record the liability for dividends until the board
declares them. Also, there is no entry on the record date (April 15 in this case). The  

merely determines the names of the stockholders that will receive the dividends. Dividends are
only paid on 

  !  of stock; no dividends are paid on the
 

.

On ãay 1, when the dividends are paid, the following journal entry is made.

ü  
 3,,
 3,,

 #  



When it comes to dividends and liquidation, the owners of preferred stock have preferential
treatment over the owners of common stock. Preferred stockholders receive their dividends
before the common stockholders receive theirs. In other words, if the corporation does not
declare and pay the dividends to preferred stock, there cannot be a dividend on the common
stock. In return for these preferences, the preferred stockholders usually give up the right to share
in the corporation's earnings that are in excess of their dividends.
To illustrate how preferred stock works, let's assume a corporation has issued preferred stock
with a stated annual dividend of $9 per year. The holders of these preferred shares must receive
the $9 per share dividend each year 
 the common stockholders can receive a penny in
dividends. But the preferred shareholders will get no more than the $9 dividend, even if the
corporation's net income increases a hundredfold. (Participating preferred stock is an exception
and will be discussed later.) In times of inflation, owning preferred stock with a fixed dividend
and no maturity or redemption date makes preferred shares less attractive than its name implies.

1 #
 #  


The dividend on preferred stock is usually stated as a percentage of par value. Hence, the par
value of preferred stock has some economic significance. For example, if a corporation issues
9% preferred stock with a par value of $100, the preferred stockholder will receive a dividend of
$9 (9% times $100) per share per year. If the corporation issues 10% preferred stock having a par
value of $25, the stock will pay a dividend of $2.50 (10% times $25) per year. In each of these
examples the par value is meaningful because it is a factor in determining the dividend amounts.

If the dividend percentage on the preferred stock is close to the rate demanded by the financial
markets, the preferred stock will sell at a price that is close to its par value. In other words, a 9%
preferred stock with a par value of $50 being issued or traded in a market demanding 9% would
sell for $50. On the other hand, if the market demands 8.9% and the stock is a 9% preferred stock
with a par value of $50, then the stock will sell for slightly more than $50 as investors see an
advantage in these shares.

c !
 #  


To comply with state regulations, the par value of preferred stock is recorded in its own paid-in
capital account Preferred Stock. If the corporation receives more than the par amount, the
amount greater than par will be recorded in another account such as Paid-in Capital in Excess of
Par - Preferred Stock. For example, if one share of 9% preferred stock having a par value of $100
is sold for $101, the following entry will be made.
  +,+

 #  

7+,,
 +,,

( 
 & #
(
 #  
+



$ 
 ¢##   
 #  


Corporations are able to offer a variety of features in their preferred stock, with the goal of
making the stock more attractive to potential investors. All of the characteristics of each
preferred stock issue are contained in a document called an  
 .

1.V ) 

 !  


 !

Generally speaking, preferred stockholders only receive their stated dividends and
nothing more. If a preferred stock is described as 10% preferred stock with a par value of
$100, then its dividend will be $10 per year (whether the corporation's earnings were $10
million or $10 billion). Preferred stock that earns no more than its stated dividend is the
norm; it is known as  

 ! preferred stock.

Occasionally a corporation issues 

 ! preferred stock. Participating preferred

stock allows for dividends greater than the stated dividend. Since this feature is unusual,
it is prudent to assume that all preferred stock is nonparticipating unless it is clearly
stated otherwise.

2.V "
   ) "


If a preferred stock is designated as "
 , its holders must receive any past
dividends that had been omitted on the preferred stock and its current year dividend,
before common stockholders are paid any dividends. (A corporation might omit its
dividends because it is suffering operating losses and has little cash available.) If a
corporation omits a dividend on its cumulative preferred stock, the past, omitted
dividends are said to be "in arrears" and this must be disclosed in the notes to the
financial statements.

If a preferred stock is  "
 , its dividends will not be in arrears if a corporation
omits dividends. That is, the corporation need not make up any omitted dividends on
noncumulative preferred stock before declaring dividends. However, the noncumulative
 preferred stock must be given its current year dividend before the common stock can get
a dividend.

3.V 

If a corporation has 10% preferred stock outstanding and market rates decline to 8%, it
makes sense that the corporation would like to eliminate the 10% preferred stock and
replace it with 8% preferred stock. On the other hand, the holders of the 10% preferred
stock bought it with the assumption of getting the 10% indefinitely. Anticipating such a
situation, the preferred stock will usually have a stipulation that the corporation can "call
in" (retire) the preferred stock at a certain price. This price is referred to as the 
and it might be 110% of the par amount (par plus one year's dividend).

4.V  


Occasionally, a corporation's preferred stock states that it can be exchanged for a stated
number of shares of the corporation's common stock. If that is the case, the preferred
stock is said to be  
  #  . For example, a corporation might issue shares
of 8% convertible preferred stock which can be converted at any time into three shares of
common stock. The preferred stockholder receives the usual preferences, but in addition
has the potential to share in the success of the corporation. If the common stock is selling
for $20 per share at the time the preferred shares are issued, the preferred stock is more
valuable because of its dividend. However, if the company's success increases the value
of the common stock to $40 per share, the convertibility feature is more valuable since
the preferred stock is now worth $120 per share. (The preferred stock can be exchanged
for 3 shares of common stock worth $40 each). The preferred stockholder could sell the
preferred stock at the market price of $120 per share, or, could have the corporation issue
three shares of common stock in exchange for each share of preferred stock.

5.V " 
 #$ 
 

The strength of the corporation, coupled with the status of key financial markets, all
influence the features that are offered with a given preferred stock. If a corporation is not
attractive to potential investors, the preferred stock might need both the cumulative and
the fully participating features in order to sell. On the other hand, a successful blue chip
corporation might easily sell its preferred stock as noncumulative and nonparticipating. If
a corporation wants to conserve its cash, it may offer a convertibility feature in order to
have a lower dividend rate.





 

 
   !


)
c " 

The closing entries of a corporation include closing the income summary account to the Retained
Earnings account. If the corporation was profitable in the accounting period, the Retained
Earnings account will be credited; if the corporation suffered a net loss, Retained Earnings will
be debited.

ü  

When dividends are declared by a corporation's board of directors, a journal entry is made on the
declaration date to debit 
   ! and credit the current liability ü  
 .
As stated earlier, it is the p
  of cash dividends that reduces Retained Earnings.


  

 #
   !

A board of directors can vote to appropriate, or restrict, some of the corporation's retained
earnings. An appropriation (or restriction) will result in two retained earnings accounts instead of
one: (1) 
   ! (or 8 

   !) and (2) 


   !.

The subdividing of retained earnings is a way of disclosing the appropriation on the face of the
balance sheet. (An appropriation might occur when a corporation is expanding its factory and its
cash must be preserved.) By displaying the appropriated retained earnings account on the balance
sheet, the corporation is communicating a certain situation and is potentially limiting itself from
declaring dividends by having reduced the balance in its regular (the unappropriated) retained
earnings. (Legally, dividends can be declared only if there is a credit balance in Retained
Earnings.)

To record an appropriation of retained earnings, the account Retained Earnings is debited

(causing this account to decrease), and Appropriated Retained Earnings is credited (causing this
account to increase).
An alternative to having Appropriated Retained Earnings appearing on the balance sheet is to
disclose the specific situation in the notes to the financial statements. The board of directors can
simply not declare dividends or dividend increases.


9
"


If an 


is made on a previously issued income statement (as opposed to a change in estimate),
a corporation must restate its beginning retained earnings balance. If the error  
 the
corporation's net income, the beginning retained earnings balance must be increased (a credit to
Retained Earnings). If the error had 
 the corporation's net income, the beginning
retained earnings balance must be decreased (a debit to Retained Earnings). The adjustment to
the beginning balance is shown on the current retained earnings statement as follows:

Beginning retained earnings balance, as previously

XXX
reported
9
"
: 
 #    ;
Beginning retained earnings balance restated XXX

'
1 

The term "book value" is used in a number of ways: book value of an asset, book value of bonds
payable, book value of a corporation, and the book value per share of stock. We will focus on the
last two.

'
1 #
 


The book value of an entire corporation is the total of the stockholders' equity section as shown
on the balance sheet. In other words, the book value of a corporation is the balance sheet assets
minus the liabilities.

Since the balance sheet amounts reflect the cost and matching principles, a corporation's book
value is not the same amount as its market . For example, the most successful brand names
of a consumer products company may have been developed in-house, meaning they would not be
included in the company's assets since they were not purchased. Other long-term assets may have
actually appreciated in value at the same time the accountant has been properly depreciating
them; as a result, they are listed on the balance sheet at a small fraction of their fair market value.

As these examples suggest, a corporation could have a market value far greater than its book
value. In contrast, a corporation that has recently purchased many assets, but is unable to operate
profitably, may have a market value that is less than its book value. Although we can calculate a
corporation's book value from its stockholders' equity, we cannot calculate a corporation's
market value from its balance sheet. We must look to appraisers, financial analysts, and/or the
stock market to help determine an approximation of a corporation's fair market value.

'
1 :"" 

¢ 

Let's use the following stockholders' equity information to calculate (1) the book value of a
corporation, and (2) the book value per share of common stock:


 

Paid-in Capital
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued and
outstanding $ 200
Paid-in capital in excess of par - common 49,800
Total Paid-in Capital 50,000
Retained Earnings 28,000
$
Total Stockholders' Equity
78,000

1.V The 

  #
 having only one class of stock±common stock±is equal
to the total amount of stockholders equity: $78,000.
2.V If common stock is the only class of stock issued by the corporation, the 
   
 #"" 

is $39. It is calculated as follows:

Total stockholders' equity of $78,000 divided by the 2,000 shares of common stock that
are outstanding: $78,000/2,000 shares = 70/ ,,  #"" 


'
1 :
 #  

 "" 


When a corporation has both common stock and preferred stock, the corporation's stockholders'
equity must be divided between the preferred stock and the common stock. To arrive at the total
book value of the common stock, compute the total book value of the preferred stock, and then
subtract that amount from the total stockholders' equity.

 #  

'
1

The book value of one share of preferred stock is its  plus any     . If
a 10% "
 preferred stock having a par value of $100 has a call price of $110, and the
corporation owes a total of two years of dividends, the book value of this preferred stock is $130
per share. If the corporation has 9%  "
 preferred stock having a par value of $50, a
call price of $54, and the corporation owes a total of three years of dividends, its book value is
$54 per share (call price of $54 and no dividends in arrears since the stock is noncumulative).

The total book value of the preferred stock is the book value per share times the total number of
shares outstanding. If the book value per share of preferred is $130 and there are 1,000 shares of
the preferred stock outstanding, then the total book value of the preferred stock is $130,000.

Let's compute the total book value of preferred stock by using the following information:


 

Paid-in Capital
$
9% Preferred stock, $100 par, 300 shares authorized and issued
30,000
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued and
outstanding 200
Paid-in capital in excess of par - common 49,800
Total Paid-in Capital 80,000
Retained Earnings 28,000
Total Stockholders' Equity $108,000

The call price of the preferred stock is $109. It is "
  #   and three years of
dividends are owed.

The 
    #
  #  

equals the call price of $109 plus three years
of dividends at $9 each, or 7+05 ($109 + $27 = $13>).
The


  ##
  #  

equals the book value per share of preferred
stock times the number of shares of preferred stock outstanding, or $40,800 ($13> X 300 =
76,-3,,).

"" 

'
1

When a corporation has both common stock and preferred stock, the book value of the preferred
stock is subtracted from the corporation's total stockholders' equity to arrive at the total book
value of the common stock. Using the information above, we have:

Corporation's total stockholders' equity $ 108,000

Less: Preferred stock's total book value ± 40,800
Common stock's total book value $ >7,200
Number of shares of common stock outstanding 2,000 shares
"" 


    700 5,

  !
  

Earnings per share is not part of stockholders' equity. Nonetheless, we are including an
introduction to the topic here because the calculation for earnings per share involves the stock of
a corporation.

  !  must appear on the face of the income statement if the corporation's stock is
publicly traded. The earnings per share calculation is the after-tax net income (earnings)
available for the common stockholders divided by the weighted-average number of common
shares outstanding during that period.

  !  #"" 


Let's assume that a corporation has the following stockholders' equity at December 31:





 

Paid-in Capital
9% Preferred stock, $100 par, 300 shares authorized and issued $ 30,000
Common stock, $0.10 par, 10,000 shares authorized, 2,000 shares issued and
outstanding 200
Paid-in capital in excess of par - common 49,800
Total Paid-in Capital 80,000
Retained Earnings 28,000
Total Stockholders' Equity $108,000

Additional information:

1.V The corporation's accounting year is the calendar year.

2.V The corporation's net income after taxes is $10,000.
3.V The number of shares of common stock outstanding was >00 shares for the first four
months of the year. On ãay 1 the corporation issued an additional 900 shares. On
October 1 it issued an additional 500 shares.
4.V The shares of preferred stock were outstanding for the entire year.

The earnings (net income after income taxes) available for the common stockholders is:

Corporation's net income after income taxes $ 10,000

Less: Preferred dividend requirement* ± 2,700
  !  #"" 

74-0,,

*The preferred dividend requirement is the annual dividend of $9 per share (9% times $100 par
value) times the 300 shares of preferred stock outstanding.

2 !
( ! )" #  #"" 


Since the earnings occurred throughout the entire year, we need to divide them by the number of
shares that were outstanding throughout the entire year. During the first four months only >00
shares were outstanding, during the next five months 1,500 shares were outstanding, and for the
final three months of the year 2,000 shares of common stock were outstanding. This situation
requires that we come up with an average number of shares of common stock for the year.

 #""  *
 ) #*
 2 !
 ! ) #

¢

  ! ¢

  ! ü  +. ""   
>00 Jan, Feb, ãar, Apr 4/12 200
ãay, Jun, Jul,
1,500 5/12 >25
Aug, Sep
2,000 Oct, Nov, Dec 3/12 500
+-0.-

As the calculation shows, the weighted-average number of shares of common stock for the year
was 1,325.

It's a good idea to test this answer to be sure it's reasonable. During five of the months (ãay -
Sep.) the number of shares of common stock outstanding was 1,500 shares. During the remainder
of the year, there were more months with less than 1,500 shares outstanding. Thus, the figure of
1,325 looks reasonable.

  !   #"" 


After recognizing the preferred stockholders' required dividend, there was $7,300 ($10,000
minus $2,700) of   !  #
 "" 

 . The $7,300 was earned
throughout the year, so we need to divide that amount by the weighted-average number of shares
of common stock outstanding throughout the year:

The   !  (EPS) of common stock = earnings available for common stock  
by the weighted-average number of common shares outstanding:

EPS = $7,300 ÷ 1,325 shares of common stock

EPS = 7- -+ per share of common stock

¢
 


c #¢
 2 
If a corporation has a limited amount of cash, but needs an asset or some services, the
corporation might issue some new stock in exchange for the items needed. When stock is issued
for noncash items, the items and the stock must be recorded on the books at the fair market value
at the time of the exchange. Since both the stock given up and the asset or services received may
have market values, accountants record the fair market value of the one that is more clearly
determinable (more objective and verifiable).

For example, if a corporation exchanges 1,000 of its (
  shares of common stock
for 40 acres of land, the fair market value of the stock is likely to be more clear and objective.
(The stock might trade daily while similar parcels of land in the area may sell once every few
years.) In other situations, the common stock might rarely trade while the value of the received
service is well-established.

To illustrate, let's assume that 1,000 shares of common stock are exchanged for a parcel of land.
The stock is publicly traded and recent trades have been at $35 per share. The par value is $0.50
per share. The land's fair market value is not as clear since there has not been a comparable sale
during the past four years.

The entry made to record the exchange will show the land at the fair market value of the
common stock, since the stock's fair market value is more clear and objective than someone's
estimate of the current value of the land:

  (1,000 shares X $35) 0--,,,

"" 

(1,000 shares X $0.50 Par) -,,

( 
 & #
("" 

06--,,

ü##    
 !#


 
1 

ü  

Stock Split Stock Dividend

No transfer from retained Transfer of market value or par value from
earnings to paid-in capital. retained earnings to paid-in capital.
Par value per share is changed. Par value per share is not changed.
Total par value is unchanged. Total par value is increased.