Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Sources of Capital: Owners’ Equity 9.

Chapter

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Sources of Capital:Owners’ Equity

9

9-2

Principal Legal Forms of Business

• Sole proprietorship.

• Partnership.

• Corporation.

9-3

Legal Forms of Business: Sole Proprietorship

Owned by an individual. Not legally separate from the owner. Cannot issue stock.

9-4

Legal Forms of Business:Partnership

Same features as sole proprietorship except owned by 2 or more partners.

Limited partnerships. Managed by general partner who has

unlimited liability. Other partners have limited liability.

9-5

Legal Forms of Business: Corporation

Separate (artificial) legal entity. Perpetual existence. Taxed.

Double taxation: corporation is taxed and dividends are taxable income to shareholders.

Legal liability Accrues to corporation itself; not to owners.

Empowered by state.

9-6

Disadvantages of Corporation over Sole Proprietorship or Partnership

• Costs to incorporate.

• Activities limited to those granted in charter.

• Additional regulations and requirements.

• Must get permission from each state in which it operates.

• Double taxation.

9-7

Public vs. Private Corporations

Public corporation: Shares traded. Subject to jurisdiction of SEC.

Private corporation: Not publicly traded. Not subject to SEC.

9-8

Proprietorship Equity

Capital account. Drawing account (optional). Retained earnings (optional).

9-9

Partnership Equity

Separate capital account for each partner. Partnership agreement defines split of

profits among partners. Otherwise, divided equally.

9-10

Ownership in a Corporation

Evidenced by stock certificate. Corporate charter (filed with state).

Indicates maximum number of shares allowed to issue.

Owners’ equity called: Shareholders’ or stockholders’ equity.

9-11

Preferred Stock

Usually issued with a face or par value. In case of liquidation, entitled to receive

par value after liabilities settled and before common shareholders receive anything.

Pays stated dividend. Dividend is not tax deductible as is interest

expense paid to debt holders.

9-12

Types of Preferred Stock

Cumulative preferred: dividends in arrears and current year’s dividends must be paid before common dividends can be paid.

Convertible preferred: convertible into a specified number of shares of common.

Redeemable preferred: may be redeemed by investor on or after a certain date at a certain price (usually higher than par value). SEC requires that it be shown on the BS between

Liabilities and Owners’ Equity.

9-13

Common Stock (1 of 2)

Residual interest in net assets after all creditors and preferred shareholders.

Par or stated value usually a nominal (small, meaningless) amount.

Book value of common stock = total common shareholders’ equity.

Common shareholders’ equity = Paid in capital + retained earnings.

9-14

Common Stock (2 of 2)

Paid in capital = Common stock at par (or stated value) + capital contributed in excess of par (also called “Additional paid in capital” or “Other paid in capital”)

Issuance cost. Investment banker, legal, auditing, printing;

subtracted from Additional paid in capital (shown net on the balance sheet).

9-15

Shareholder Sells Stock to Another Party

• No affect on company accounts.

• Company notes change of owners and address of owners.

9-16

Treasury Stock

• Corporation’s own stock that has been issued and reacquired.

• Reasons to reacquire own stock:– Limited investment opportunities.

– Believe stock price is low.

– To increase stock price.

– To increase EPS.

– Needed for acquisition.

– To issue stock bonus to employees.

– To prevent hostile takeover.

9-17

Accounting for Treasury Stock

Cost method (simpler method): At acquisition, dr. Treasury stock (a contra

account within shareholders’ equity) and cr. cash.

If reissued above cost, credit a paid in capital account.

If reissued below cost, dr. the same paid in capital account or retained earnings.

9-18

Retained Earnings

Cumulative net income earned since inception of company less cumulative total dividends paid.

9-19

Appropriation of RE (Reserves)

Indicates retained earnings that are not available for dividends. For example, restricting dividends due to needs for

planned future plant expansion.

Not a reduction of RE. Just designating a portion of RE to be restricted

for a specific purpose.

Appropriating RE does not mean that cash is set aside cash. That is a separate decision.

9-20

Cash Dividends

• At declaration (vote of the BOD): dr. RE, cr. Dividends Payable.

At date of record, figure out who is entitled to the dividend, no entry.

At payment, dr. Dividends payable, cr. Cash.

9-21

Stock Dividends

Increases every shareholders’ interest by the same proportion of shares, say 5%.

Recorded at market value of the shares distributed. (dr. RE, cr. Common stock at Par, Additional paid in capital.)

If the stock dividend is greater than 20-25%, it is basically treated as a stock split.

9-22

Stock Split

Each shareholder receives a multiple of shares previously held.

(As in a stock dividend,) no change in total shareholders’ equity.

No change to dollar amounts of account balances. Par value per share is changed.

9-23

Spin-offs

• Company owns shares of another company that it distributes to shareholders.

• Accounting is similar to a cash dividend except credit is to the asset account, Investments (instead of Cash).

9-24

Warrants

• The right to purchase shares of common stock at a stated price within a given time period.

• Negotiable (can be bought and sold).

9-25

Stock Options

• Same as a warrant but not negotiable.

• GAAP requires Fair value based method:– Expenses fair value of options over their

vesting period.– Vesting means option can be exercised even

if employee leaves the company.

9-26

Employee Stock Ownership Plan (ESOP)

• A program of setting aside stock for benefit of employees as a group.

• Contributions to plan are tax deductible.

• Separate entity whose assets do not appear on balance sheet, but are disclosed in notes.

9-27

Earnings per share (EPS)

GAAP requires reporting of: Basic earnings per share and Diluted EPS.

9-28

Basic EPS

(net income available to common shareholders) / (weighted average # of common shares outstanding) Net income available to common

shareholders = Net income – preferred dividends

Treasury stock is not considered outstanding.

9-29

Diluted EPS

Basic EPS adjusted for potential dilution Dilution from: stock options, warrants, convertible securities.

If converted method: Assumes convertible security has been converted.

Treasury stock method: Assumes options or warrants are exercised and cash received

by corporation is used to purchase its stock at the average price of stock during the period.

Net of number of common shares issued when options or warrants are assumed exercised less assumed number of shares purchased is added to denominator of basic EPS calculation.

9-30

Equity in Nonprofit Organizations

• Capital contributions usually in form of endowment or contributed plant.– Endowment = contributions whose principal is

to be kept intact; earning on principal are available to finance current operations.

– Contributed plant = contributed buildings, other assets, or funds to acquire assets.

• Operating contributions are revenue not contributed capital.

Chapter

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

End of Chapter 9

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