11–1 Copyright © Cengage Learning. All rights reserved. Chapter 11 Management Issues Related to Contributed Capital.

11–1Copyright © Cengage Learning. All rights reserved.

Chapter 11Management Issues Related to

Contributed Capital


What is Contributed Capital?

Investments by stockholders, called contributed capital, is one of the major means of financing for a

corporation


What Is a Corporation?

An entity having separate legal rights, privileges, and liabilities distinct from

those of its owners.

The result of a body of persons who have requested and been granted a charter by

the state, recognizing the entity.


Corporate Form of Business

Separation of ownership and control

Limited liability

Double taxation

More government regulation

DisadvantagesAdvantages

Centralized authority

Professional management

Continuous existence

Lack of mutual agency

Ease of transferring stock

Ease of raising capital

Separate legal entity

Limited liability


Using Equity Financing

A stock certificate is issued to the owner Stockholder can transfer ownership at will Independent registrars and transfer agents are

often used to keep track of stockholders’ records

Stock Certificate Shows units of ownership in a

corporation


Par Value

Usually bears little or no relationship to the market value or book value of shares

Constitutes the legal capital of the corporationLegal capital

– The number of shares issued times the par value– The minimum amount that can be reported as

contributed capital

An arbitrary amount assigned to each share of stock


Initial Public Offering (IPO)

May be used to act as intermediary between the corporation and investing public for an IPO

Guarantees the sale of the stock for a fee

The initial offering of capital stock

Underwriter

The corporation records the net proceeds of the offering


Costs to Start a Corporation?

Start-up and Organization

Costs

Start-up and Organization

Costs

State incorporation fees Attorneys’ fees Cost of printing stock

certificates Accountants’ fees related to

registering the firm’s stock

A corporation’s life normally is not known,

so these costs are expensed as incurred.


Dividends

Distribution among stockholders of the assetsthat a corporation’s earnings have generated

Stockholders receive these assets,

usually cash, in proportion to the number of shares

they own

Board of directors has sole authority to declare dividends

Decision to declare dividends affected by cash flows, pending lawsuits, economic situation, or debt levels.


Dividend Dates

Date of Declaration

Board of directors formally declares that the corporation is going to pay a

dividend


Dividend Dates

Date of Declaration

Date of Record


dividend

Persons who own the stock on the record

date will receive the dividend


Dividend Dates

Date of Declaration

Date of Record

Payment Date


dividend

Persons who own the stock on the record

date will receive the dividend

Date on which the dividend is

paid to the stockholders of

record


Evaluating Dividend Policies

Dividends Yield Ratio

Shareper PriceMarket

Shareper Dividends Yield Dividends

%4.1$27.87

$0.40 Microsoft

Tells investors how much they can expect to receive in dividends expressed as a percentage of the

market price per share


Return on Equity

Most important ratio associated with stockholders’ equity Compensation of top executives often tied to return on

equity

Net IncomeAverage Stockholders’ Equity

$4,203,720($22,689,679 + $17,039,840) / 2

= 21.2%

=

=

Return on Equity

Google


Price/Earnings (P/E) Ratio

A measure of investors’ confidence in a company’s future

Shareper Earnings

Shareper PriceMarket Ratio (P/E) Earnings Price

times16$1.74

$27.87 Microsoft

Because the market price is 16 times earnings, investors are paying a good price in relation to earnings. They do so in the expectation that

this software company will continue to be successful

Hwk E 3, Example Review problem pg 592-594


Stock Option Plans

Give employees the right to purchase stock in the future at a fixed price

A means of both motivating and compensating employees

On date of grant:

estimate fair value of options

Amount in excess of exercise price is

recorded as compensation

expense over the grant period


Stockholders’ Equity

Contributed capital

Stockholders’ investments

Retained earnings Earnings since corporation’s inception, less any losses, dividends, or transfers to contributed capital

Treasury stock Shares of its own stock that the corporation has bought back on the open market

Three basic components:


Contributed Capital

Common Stock Preferred Stock

Basic form of stock that a corporation issues

Also called residual equity, which means that if the corporation is liquidated, the claims of all creditors and usually those of preferred stockholders rank ahead of the claims of common stockholders

Gives owners preference over common stockholders, usually in terms of receiving dividends and in terms of claims to assets if the corporation is liquidated

Hwk E 5

11–19Copyright © Cengage Learning. All rights reserved. 11-19

Relationship of Shares


Authorized, Issued, and Outstanding Shares

Contributed capitalPreferred stock, $50 par value, 1,000 shares authorized, issued, and outstanding

$50,000

Common stock, $5 par value, 30,000 shares authorized, 20,000 shares issued, 18,000 shares outstanding

$100,000

Additional paid-in capital 50,000 150,000

Total contributed capital $200,000

Stockholders’ Equity

Outstanding shares: Shares issued and still in

circulation (unlike treasury stock)

Issued shares: Sold or

transferred to stockholders

Authorized shares: Maximum number that the corporation’s

charter allows it to issue


What Are the Characteristics of Preferred Stock?

One or more of the following:Preference as to dividends ConvertibilityRights to assets on liquidationCallable option


Dividend Preference

Preferred stockholders must ordinarily receive a certain amount of dividends before common stockholders receive anythingNo guarantee of ever receiving dividendsConsequences of not declaring an annual dividend depends

on whether the preferred stock is cumulative or noncumulative

CumulativeDividend amount per share accumulates from year to year; Company must pay the whole amount before it pays any dividends on common stock

NoncumulativeCompany is under no obligation to make up the missed dividend in future years


A corporation has 20,000 shares of $100 par, 5 percent cumulative preferred stock, its first year of operations outstanding. If the corporation pays no dividends in 2011, its first year of operations, preferred dividends in arrears at the end of the year would amount to $100,000.

(20,000 shares × $100 × .05)

Dividends in Arrears

Dividends not paid to cumulative preferred stock in the year they are due

If the corporation’s board declares dividends in 2012, the corporation must pay preferred stockholders the dividends in arrears plus their current year’s dividends before paying any dividends to common stockholders.


January 1, 2011: A corporation issued 20,000 shares of $10 par, 6 percent cumulative preferred stock and 100,000 shares common stock. The board of directors declared a $6,000 dividend to preferred stockholders after the first year of operations.

2011 dividends due preferred stockholders ($200,000 x .06) $12,000 Less 2011 dividends declared to preferred stockholders 6,000 2011 preferred stock dividends in arrears $6,000

Dividends in Arrears Illustrated

In 2012, the board of directors declared a $24,000 dividend to be distributed to preferred and common stockholders.

How much of the $24,000 can be given to common stockholders and how much belongs to preferred stockholders?


Dividends in Arrears Illustrated (cont’d)

2012 declaration of dividends $24,000 Less 2011 preferred stock dividends in arrears 6,000 Available for 2012 dividends $ 18,000 Less 2012 dividends due preferred stockholders ($200,000 x .06)

12,000

Remainder available to common stockholders $ 6,000

Record the journal entry for the declaration of the dividend:

Dec. 31 Dividends 24,000 Dividends Payable 24,000 Declared a $18,000 cash dividend to preferred

stockholders and a $6,000 cash dividend to common stockholders

Hwk E 9-10; Example SE 6 & 7


Convertible Preferred Stock

Stockholder’s may exchange their shares of preferred stock for shares of common stock at a ratio stated in the company’s preferred stock contract


A company issued 1,000 shares of 8 percent, $100 par value convertible preferred stock for $100 per share. Each share can be converted into 5 shares of the company’s common stock at any time.

The market value of the common stock is now $15 per share and, in the past, the owner of common stock could expect dividends of $1 per share per year. Per Share

Stock Market Value Dividends Common $15 $1 Preferred if converted to common

75

(5 shares x $15)

5

( 5 shares x $1)

Convertible preferred 100 8

At this point, the preferred stockholder receives more in dividends by keeping the preferred shares and is more likely to receive dividends than the common stockholders.

Convertible Preferred Stock Illustrated


A few years later, the dividends paid to common stockholders increase to $3 per share and market value is $30 per share.

Per Share Stock Market Value Dividends

Common $30 $ 3 Preferred if converted to common

150

(5 shares x $30)

15

( 5 shares x $3)

Convertible Preferred 100 8

At this point, the market value of each share of convertible preferred stock is equivalent to $150 and converting to common would increase dividend payments from $8 per share to the equivalent of $15.

Convertible Preferred Stock Illustrated (cont’d)


Callable Preferred Stock

Can be redeemed or retired at the option of the issuing corporation at a price stated in the preferred stock contract

The call price is usually higher than the par value of the stock

Reasons to call stock– A desire to pay lower dividends– Because the corporation has enough profits to

retire preferred stock


Issuance of Common Stock -Par Value

Nocek Corporation is authorized to issue 10,000 shares of $10 par value common stock. The company issues 5,000 shares at $12 per share

on January 1, 2010.

Jan. 1 Cash 60,000 Common Stock 50,000 Additional Paid-in Capital 10,000 Issued 5,000 shares of $10 par value

common stock for $12 per share

Par value is the amount per share that is recorded in a corporation’s capital stock accounts


Par Value Stock (continued)

Balance Sheet Presentation

Stockholders’ Equity Section

Contributed capital Common stock, $10 par value, 10,000 shares authorized, 5,000 shares issued and outstanding $50,000 Additional paid-in capital 10,000 Total contributed capital $60,000 Retained earnings — Total stockholders’ equity $60,000


Jan. 1 Cash 75,000 Common Stock 50,000 Additional Paid-in Capital 25,000 Issued 5,000 shares of no-par value

common stock with $10 stated value for $15 per share

No-Par Stock

Nocek Corporation is authorized to issue 20,000 shares of no-par common stock. Suppose the company issues 5,000 shares at $15 per share on January 1, 2010.

Jan. 1 Cash 75,000 Common Stock 75,000 Issued 5,000 shares of no-par

common stock for $15 per share

Assume Nocek’s board puts a $10 stated

value on its no-par stock. It issues 5,000 shares at $15 per share on January 1, 2010.

Stated value of stock can be any value set by the board unless the state specifies a minimum

amount.

Hwk E11; Example SE8


Issuance of Stock for Noncash Assets

Record the transaction at the fair market value of what the corporation is giving up (stock)

If fair market value of the stock cannot be determined, use the fair market value of the assets or services received

Board of directors has the right to determine the fair value of the property

Companies may issue stock for services or assets like buildings or land


When Nocek Corporation was formed on January 1, 2010, its attorney agreed to accept 200 shares of its $10 par value common stock for services rendered.

At the time the stock was issued, its market value could not be determined. For similar services, the attorney would have billed $3,000.

Jan. 1 Start-up and Organization Expense 3,000 Common Stock 2,000 Additional Paid-in Capital 1,000 Issued 200 shares of $10 par

common stock for attorney’s services

Issuance of Stock for Noncash Assets

Hwk E12; Example SE9


Treasury Stock

Why do more than 67 percent of large companies repurchase their own stock?

Use the stock for employee stock option plans Want to maintain a favorable market for their

stock Want to increase earnings per share or stock price

per share Want to have additional shares of stock available

for purchasing other companies Attempt to prevent hostile takeovers


On Sept. 15, Amber Corporation purchases 2,000 shares of its common stock on the market for $50 per share.

When treasury stock is purchased, it is usually recorded at cost:

Sept. 15 Treasury Stock, Common 100,000 Cash 100,000 Acquired 2,000 shares of the

company’s common stock for $50 per share

Purchase of Treasury Stock Illustrated


Balance Sheet Presentation

Stockholders’ Equity SectionContributed capital Common stock, $5 par value, 200,000 shares authorized, 60,000 shares issued, 58,000 shares

outstanding

$300,000 Additional paid-in capital 60,000 Total contributed capital $360,000 Retained earnings 1,800,000 Total contributed capital and retained earnings $2,160,000 Less treasury stock, common (1,000 shares at cost) 100,000 Total stockholders’ equity $2,060,000

Notice that the number of shares issued, and therefore legal capital, has not changed even though the number of shares outstanding has decreased.

Purchase of Treasury Stock Illustrated (cont’d)


Sale of Treasury Stock

At cost Above cost

Debit Cash

Credit Treasury Stock, Common

Debit Cash for proceeds Credit Treasury Stock, Common for cost

Credit Paid-in Capital, Treasury Stock for amount over cost


Dec. 15: Amber Corporation sells 1,200 shares of its treasury stock for $42 per share. (Cost was $50 per share.)

Dec. 15 Cash 50,400 Paid-in Capital, Treasury Stock 9,600 Retained Earnings 1,600 Treasury Stock, Common 60,000 Sold 1,200 shares of the treasury stock

for $42 per share; cost was $50 per share

When treasury shares are sold below cost, the difference is deducted from Paid-in Capital, Treasury Stock

If the Paid-in Capital, Treasury Stock account cannot absorb the full amount of the difference, or doesn’t exist, Retained Earnings absorbs the remainder.

Sale of Treasury Stock Below Cost


Retirement of Treasury Stock

Treasury stock is retired when the company determines that it will not reissue stock it has purchased

If acquisition price < original contributed capitalCredit Paid-In Capital, Retirement of Stock

If acquisition price > original contributed capitalDebit Retained Earnings

Hwk E13-14; Example SE10-11

11–1 Copyright © Cengage Learning. All rights reserved. Chapter 11 Management Issues Related to Contributed Capital.

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