Layes inc. issues 8,000 shares of $100 par value preferred stock for cash at $106 per share.

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11

Reporting and Analyzing Stockholders' Equity

 CHAPTER PREVIEW 

Corporations like Facebook and Google have substantial resources at their disposal. In fact, the corporation is the dominant form of business organization in the United States in terms of sales, earnings, and number of employees. All of the 500 largest U.S. companies are corporations. In this chapter, we look at the essential features of a corporation and explain the accounting for a corporation's capital stock transactions.

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Oh Well, I Guess I'll Get Rich

Suppose you started one of the fastest-growing companies in the history of business. Now suppose that by “going public”—issuing stock of your company to outside investors who are foaming at the mouth for the chance to buy its shares—you would instantly become one of the richest people in the world. Would you hesitate?

That is exactly what Mark Zuckerberg, the founder of Facebook, did. Many people who start high-tech companies go public as soon as possible to cash in on their riches. But Zuckerberg was reluctant to do so. To understand why, you need to understand the advantages and disadvantages of being a public company.

The main motivation for issuing shares to the public is to raise money so you can grow your business. However, unlike a manufacturer or even an online retailer, Facebook doesn't need major physical resources, it doesn't have inventory, and it doesn't really need much money for marketing. But why not go public anyway, so the company would have some extra cash on hand—and so you personally get rich? As head of a closely held, nonpublic company, Zuckerberg was subject to far fewer regulations than a public company. Prior to going public, Zuckerberg could basically run the company however he wanted to.

For example, early in 2012, Facebook shocked the investment community by purchasing the photo- sharing service Instagram. The purchase was startling both for its speed (over a weekend) and price ($1 billion). Zuckerberg basically didn't seek anyone's approval. He thought it was a good idea, so he just did it. The structured decision-making process of a public company would make it very dif�icult for a public company to move that fast.

Speed is useful, but it is likely that Facebook will make even bigger acquisitions in the future. To survive among the likes of Microsoft, Google, and Apple, it needs lots of cash. To raise that amount of money, the company really needed to go public. So in 2012, Mark Zuckerberg reluctantly made Facebook a public company, thus becoming one of the richest people in the world.

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LEARNING OBJECTIVE 1

Discuss the major characteristics of a corporation. 

A corporation is created by law. As a legal entity, a corporation has most of the rights and privileges of a person. The major exceptions relate to privileges that can be exercised only by a living person, such as the right to vote or to hold public of�ice. Similarly, a corporation is subject to the same duties and responsibilities as a person. For example, it must abide by the law and it must pay taxes.

We can classify corporations in a variety of ways. Two common classi�ications are by purpose and by ownership. A corporation may be organized for the purpose of making a pro�it (such as Facebook or General Motors), or it may be a nonpro�it charitable, medical, or educational corporation (such as the Salvation Army or the American Cancer Society).

Classi�ication by ownership differentiates publicly held and privately held corporations. A publicly held corporation may have thousands of stockholders, and its stock is traded on a national securities market such as the New York Stock Exchange. Examples are IBM, Caterpillar, and General Electric. In contrast, a privately held corporation, often referred to as a closely held corporation, usually has only a few stockholders and does not offer its stock for sale to the general public. Privately held companies are generally much smaller than publicly held companies although some notable exceptions exist. Before going public, Facebook was one example. Also, Cargill Inc., a private corporation that trades in grain and other commodities, is one of the largest companies in the United States. This chapter deals primarily with issues related to publicly held companies.

DECISION TOOLS

Understanding the costs and bene�its of different types of business organizations helps managers determine if incorporating is in the best interest of the company.

CHARACTERISTICS OF A CORPORATION Many businesses start as partnerships or sole proprietorships but eventually convert to the corporate form. For example, Nike's founders formed their original organization as a partnership. In 1968, they reorganized the company as a corporation. A number of characteristics distinguish a corporation from sole proprietorships and partnerships. The most important of these characteristics are explained below.

Separate Legal Existence

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As an entity separate and distinct from its owners, the corporation acts under its own name rather than in the name of its stockholders. Facebook, for example, buys, owns, and sells property; borrows money; and enters into legally binding contracts in its own name. It may also sue or be sued. It pays taxes as a separate entity.

In a partnership, the acts of the owners (partners) bind the partnership. In contrast, the acts of corporate owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you own shares of Facebook stock, you do not have the right to purchase inventory for the company unless you are also designated as an agent of the corporation.

Limited Liability of Stockholders

Since a corporation is a separate legal entity, creditors ordinarily have recourse only to corporate assets to satisfy their claims. The liability of stockholders is normally limited to their investment in the corporation. Creditors have no legal claim on the personal assets of the stockholders unless fraud has occurred. Thus, even in the event of bankruptcy of the corporation, stockholders' losses are generally limited to the amount of capital they have invested in the corporation.

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Transferable Ownership Rights

Ownership of a corporation is held in shares of capital stock, which are transferable units. Stockholders may dispose of part or all of their interest in a corporation simply by selling their stock. The transfer of an ownership interest in a partnership requires the consent of each partner. In contrast, the transfer of stock is entirely at the discretion of the stockholder. It does not require the approval of either the corporation or other stockholders.

The transfer of ownership rights among stockholders normally has no effect on the operating activities of the corporation. Nor does it affect the corporation's assets, liabilities, and total stockholders' equity. The transfer of ownership rights is a transaction between individual owners. The company does not participate in the transfer of these ownership rights after the original sale of the capital stock.

Ability to Acquire Capital

It is relatively easy for a corporation to obtain capital through the issuance of stock. Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable. Also, numerous individuals can become stockholders by investing small amounts of money.

Continuous Life

The life of a corporation is stated in its charter. The life may be perpetual or it may be limited to a speci�ic number of years. If it is limited, the company extends the period of existence through renewal of the charter. Since a corporation is a separate legal entity, its continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or of�icer. As a result, a successful corporation can have a continuous and perpetual life.

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Corporation Management

Although stockholders legally own the corporation, they manage it indirectly through a board of directors they elect. Mark Zuckerberg is the chairman of Facebook's board of directors. The board, in turn, formulates the operating policies for the company. The board also selects of�icers, such as a president and one or more vice presidents, to execute policy and to perform daily management functions. As a result of the Sarbanes-Oxley Act, the board is required to monitor management's actions closely. Many feel that the failures at Enron, WorldCom, and more recently MF Global could have been avoided by more diligent boards.

Illustration 11-1 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11lo1#c11-�ig-0001) presents a typical organization chart showing the delegation of responsibility.

ILLUSTRATION 11-1 Corporation organization chart

The chief executive of�icer (CEO) has overall responsibility for managing the business. As the organization chart shows, the CEO delegates responsibility to other of�icers. The chief accounting of�icer is the controller. The controller (1) maintains the accounting records, (2) ensures an adequate system of internal control, and (3) prepares �inancial statements, tax returns, and internal reports. The treasurer has custody of the corporation's funds and oversees the company's cash position.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch11lo1#c11-fig-0001

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The organizational structure of a corporation enables a company to hire professional managers to run the business. On the other hand, the separation of ownership and management often reduces an owner's ability to actively manage the company.

ETHICS NOTE

Managers who are not owners are often compensated based on the performance of the company. They thus may be tempted to exaggerate company performance by in�lating income �igures.

Government Regulations

A corporation is subject to numerous state and federal regulations. For example, state laws usually prescribe the requirements for issuing stock, the distributions of earnings permitted to stockholders, and acceptable methods for buying back and retiring stock. Federal securities laws govern the sale of capital stock to the general public. Also, publicly held corporations must disclose their �inancial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports (Forms 10Q and 10K). The Sarbanes-Oxley Act increased the company's responsibility for the accuracy of these reports. In addition, when a corporate stock is listed and traded on organized securities exchanges, the corporation must comply with the reporting requirements of these exchanges.

PEOPLE, PLANET, AND PROFIT INSIGHT The Impact of Corporate Social Responsibility

A survey conducted by Institutional Shareholder Services, a proxy advisory �irm, shows that 83% of investors now believe environmental and social factors can signi�icantly impact shareholder value over the long term. This belief is clearly visible in the rising level of support for shareholder proposals requesting action related to social and environmental issues.

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The following table shows that the number of corporate social responsibility (CSR) related shareholder proposals rose from 150 in 2000 to 191 in 2010. Moreover, those proposals received average voting support of 18.4% of votes cast versus just 7.5% a decade earlier.

Trends in Shareholder Proposals on Corporate Responsibility 2000 2005 2010 Number of proposals voted 150 155 191 Average voting support 7.5% 9.9% 18.4% Percent proposals receiving >10% support 16.7% 31.2% 52.1%

Source: Investor Responsibility Research Center, Ernst & Young, Seven Questions CEOs and Boards Should Ask About: “Triple Bottom Line” Reporting.

Why are CSR-related shareholder proposals increasing? (Go to WileyPLUS for this answer and additional questions.)

Additional Taxes

Owners of proprietorships and partnerships report their share of earnings on their personal income tax returns. The individual owner then pays taxes on this amount. Corporations, on the other hand, must pay federal and state income taxes as a separate legal entity. These taxes can be substantial. They can amount to as much as 40% of taxable income.

In addition, stockholders are required to pay taxes on cash dividends. Thus, many argue that corporate income is taxed twice (double taxation)—once at the corporate level and again at the individual level.

Illustration 11-2 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11lo1#c11-�ig-0002) shows the advantages and disadvantages of a corporation compared to a sole proprietorship and partnership.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch11lo1#c11-fig-0002

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ILLUSTRATION 11-2 Advantages and disadvantages of a corporation

Other Forms of Business Organization

A variety of “hybrid” organizational forms—forms that combine different attributes of partnerships and corporations—now exist. For example, one type of corporate form, called an S corporation, allows for legal treatment as a corporation but tax treatment as a partnership—that is, no double taxation. Because of changes to the S corporation's rules, more small- and medium-sized businesses now may choose S corporation treatment. One of the primary criteria is that the company cannot have more than 100 shareholders. Other forms of organization include limited partnerships, limited liability partnerships (LLPs), and limited liability companies (LLCs).

FORMING A CORPORATION A corporation is formed by grant of a state charter. The charter is a document that describes the name and purpose of the corporation, the types and number of shares of stock that are authorized to be issued, the names of the individuals that formed the company, and the number of shares that these individuals agreed to purchase. Regardless of the number of states in which a corporation has operating divisions, it is incorporated in only one state. It is to the company's advantage to incorporate in a state whose laws are favorable to the corporate form of business organization. For example, although Facebook has its headquarters in California, it is incorporated in Delaware. In fact, more and more corporations have been incorporating in states with rules that favor existing management. For example, Gulf Oil changed its state of incorporation to Delaware to thwart possible unfriendly takeovers. There, certain defensive tactics against takeovers can be approved by the board of directors alone, without a vote by shareholders.

Upon receipt of its charter from the state of incorporation, the corporation establishes by-laws. The by- laws establish the internal rules and procedures for conducting the affairs of the corporation. Corporations engaged in interstate commerce must also obtain a license from each state in which they do business. The license subjects the corporation's operating activities to the general corporation laws of the state.

STOCKHOLDER RIGHTS When chartered, the corporation begins selling shares of stock. When a corporation has only one class of stock, it is identi�ied as common stock. Each share of common stock gives the stockholder the ownership rights pictured in Illustration 11-3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11lo1#c11-�ig-0003) (page 542). The articles of incorporation or the by-laws state the ownership rights of a share of stock.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch11lo1#c11-fig-0003

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Proof of stock ownership is evidenced by a printed or engraved form known as a stock certi�icate. As shown in Illustration 11-4 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11lo1#c11-�ig-0004) (page 542), the face of the certi�icate shows the name of the corporation, the stockholder's name, the class and special features of the stock, the number of shares owned, and the signatures of authorized corporate of�icials. Certi�icates are prenumbered to ensure proper control over their use; they may be issued for any quantity of shares.

ILLUSTRATION 11-3 Ownership rights of stockholders

ILLUSTRATION 11-4 A stock certi�icate

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STOCK ISSUE CONSIDERATIONS Although Facebook incorporated in 2004, it did not sell stock to the public until 2012. At that time, Facebook evidently decided it would bene�it from the infusion of cash that a public sale of its shares would bring. When a corporation decides to issue stock, it must resolve a number of basic questions: How many shares should it authorize for sale? How should it issue the stock? What value should it assign to the stock? We address these questions in the following sections.

Authorized Stock

Authorized stock is the amount of stock that a corporation is authorized to sell as indicated in its charter. If the corporation has sold all of its authorized stock, then it must obtain permission from the state to change its charter before it can issue additional shares.

The authorization of common stock does not result in a formal accounting entry. The reason is that the event has no immediate effect on either corporate assets or stockholders' equity. However, the corporation discloses in the stockholders' equity section of the balance sheet the number of shares authorized. Facebook, for example, has approximately 9 billion authorized shares.

Issuance of Stock

A corporation can issue common stock directly to investors. Alternatively, it can issue common stock indirectly through an investment banking �irm that specializes in bringing securities to the attention of prospective investors. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation.

New issues of stock may be offered for sale to the public through various organized U.S. or foreign securities exchanges. Five of the largest exchanges by value of shares traded are the New York Stock Exchange, Nasdaq stock market, London Stock Exchange, Tokyo Stock Exchange, and Euronext.

ANATOMY OF A FRAUD

The president, chief operating of�icer, and chief �inancial of�icer of SafeNet, a software encryption company, were each awarded employee stock options by the company's board of directors as part of their compensation package. Stock options enable an employee to buy a company's stock sometime in the future at the price that existed when the stock option was awarded. For example, suppose that you received stock options today, when the stock price of your company was $30. Three years later, if the stock price rose to $100, you could “exercise” your options and buy the stock for $30 per share, thereby making $70 per share. After being awarded their stock options, the three employees changed the award dates in the company's records to dates in the past, when the company's stock was trading at historical lows. For example, using the previous example, they would choose a past date when the stock was selling for $10 per share, rather than the $30 price on the actual award date. In our example, this would increase the pro�it from exercising the options to $90 per share.

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Total take: $1.7 million

THE MISSING CONTROL

Independent internal veri�ication. The company's board of directors should have ensured that the awards were properly administered. For example, the date on the minutes from the board meeting should be compared to the dates that were recorded for the awards. In addition, the dates should again be con�irmed upon exercise.

INTERNATIONAL NOTE U.S. and U.K. corporations raise most of their capital through millions of outside shareholders and bondholders. In contrast, companies in Germany, France, and Japan acquire �inancing mostly from large banks or other �inancial institutions. Consequently, in the latter environment, shareholders are somewhat less important.

Par and No-Par Value Stocks

Par value stock is capital stock that has been assigned a value per share in the corporate charter. Years ago, par value determined the legal capital that must be retained in the business for the protection of corporate creditors. That amount is not available for withdrawal by stockholders. Thus, in the past, most states required the corporation to sell its shares at par or above.

However, the usefulness of par value as a device to protect creditors was limited because par value was often immaterial relative to the value of the company's stock in the securities markets—even at the time of issue. For example, Facebook's par value is $0.000006 per share, yet its market price recently was $84. Thus, par has no relationship with market price. In the vast majority of cases, it is an immaterial amount. As a consequence, today many states do not require a par value. Instead, they use other means to protect creditors.

No-par value stock is capital stock that has not been assigned a value in the corporate charter. No-par value stock is fairly common today. For example, Nike and Procter & Gamble both have no-par stock. In many states, the board of directors assigns a stated value to the no-par shares.

CORPORATE CAPITAL Owners' equity is identi�ied by various names: stockholders' equity, shareholders' equity, or corporate capital. The stockholders' equity section of a corporation's balance sheet consists of two parts: (1) paid-in (contributed) capital and (2) retained earnings (earned capital).

The distinction between paid-in capital and retained earnings is important from both a legal and a �inancial point of view. Legally, corporations can make distributions of earnings (declare dividends) out of

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retained earnings in all states. However, in many states they cannot declare dividends out of paid-in capital. Management, stockholders, and others often look to retained earnings for the continued existence and growth of the corporation.

Paid-in Capital

Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock. As noted earlier, when a corporation has only one class of stock, it is common stock.

Retained Earnings

Retained earnings is net income that a corporation retains in the business. Net income is recorded in Retained Earnings by a closing entry that debits Income Summary and credits Retained Earnings. Similarly, the Retained Earnings account is reduced by dividends (both cash dividends and stock dividends) by a closing entry that debits Retained Earnings and credits Dividends.

DO IT! 1

Corporate Organization

Indicate whether each of the following statements is true or false. If false, indicate how to correct the statement.

______ 1. Similar to partners in a partnership, stockholders of a corporation have unlimited liability.

______ 2. It is relatively easy for a corporation to obtain capital through the issuance of stock.

______ 3. The separation of ownership and management is an advantage of the corporate form of business.

______ 4. The journal entry to record the authorization of capital stock includes a credit to the appropriate capital stock account.

______ 5. All states require a par value per share for capital stock.

Action Plan ✓ Review the characteristics of a corporation and understand

which are advantages and which are disadvantages.

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✓ Understand that corporations raise capital through the issuance of stock, which can be par or no-par.

SOLUTION

1. False. The liability of stockholders is normally limited to their investment in the corporation.

2. True.

3. False. The separation of ownership and management is a disadvantage of the corporate form of business.

4. False. The authorization of capital stock does not result in a formal accounting entry.

5. False. Many states do not require a par value.

Related exercise material: BE11-1 and DO IT! 11-1.

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LEARNING OBJECTIVE 2

Explain how to account for the issuance of common and preferred stock, and the purchase of treasury stock. 

ACCOUNTING FOR COMMON STOCK Let's now look at how to account for new issues of common stock. The primary objectives in accounting for the issuance of common stock are (1) to identify the speci�ic sources of paid-in capital and (2) to maintain the distinction between paid-in capital and retained earnings. As shown below, the issuance of common stock affects only paid-in capital accounts.

▼ HELPFUL HINT

Stock is sometimes issued in exchange for services (payment to attorneys or consultants, for example) or for noncash assets (land or buildings). The value recorded for the shares issued is determined by either the market price of the shares or the value of the good or service received, depending upon which amount the company can more readily determine.

Issuing Par Value Common Stock for Cash

As discussed earlier, par value does not indicate a stock's market price. The cash proceeds from issuing par value stock may be equal to, greater than, or less than par value. When a company records the issuance of common stock for cash, it credits the par value of the shares to Common Stock and records in a separate paid-in capital account the portion of the proceeds that is above or below par value.

To illustrate, assume that Hydro-Slide, Inc. issues 1,000 shares of $1 par value common stock at par for cash. The entry to record this transaction is as follows.

Now assume Hydro-Slide, Inc. issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share. The amount received above the par value, in this case $4 ($5−$1), would be credited to Paid-in Capital in Excess of Par Value. The entry is as follows.

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The total paid-in capital from these two transactions is $6,000. If Hydro-Slide, Inc. has retained earnings of $27,000, the stockholders' equity section of the balance sheet is as shown in Illustration 11-5 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11lo2#c11-�ig-0005) .

ILLUSTRATION 11-5 Stockholders' equity—paid-in capital in excess of par value

Some companies issue no-par stock with a stated value. For accounting purposes, companies treat the stated value in the same way as the par value. For example, if in our Hydro-Slide example the stock was no-par stock with a stated value of $1, the entries would be the same as those presented for the par stock except the term “Par Value” would be replaced with “Stated Value.” If a company issues no-par stock that does not have a stated value, then it credits to the Common Stock account the full amount received. In such a case, there is no need for the Paid-in Capital in Excess of Stated Value account.

ACCOUNTING FOR PREFERRED STOCK To appeal to a larger segment of potential investors, a corporation may issue an additional class of stock, called preferred stock. Preferred stock has contractual provisions that give it preference or priority over common stock in certain areas. Typically, preferred stockholders have a priority in relation to (1) dividends and (2) assets in the event of liquidation. However, they sometimes do not have voting rights. Facebook had 543 million preferred shares held by investors at the end of 2011, prior to going public. Approximately 6% of U.S. companies have one or more classes of preferred stock.

Like common stock, companies issue preferred stock for cash or for noncash consideration. The entries for these transactions are similar to the entries for common stock. When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates (e.g., Preferred Stock, Common Stock, Paid-in Capital in Excess of Par Value—Preferred Stock, and Paid-in Capital in Excess of Par Value—Common Stock).

Assume that Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. The entry to record the issuance is as follows.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch11lo2#c11-fig-0005

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Preferred stock has either a par value or no-par value. In the stockholders' equity section of the balance sheet, companies show preferred stock �irst because of its dividend and liquidation preferences over common stock.

INVESTOR INSIGHT  

Facebook

How to Read Stock Quotes

Organized exchanges trade the stock of publicly held companies at dollar prices per share established by the interaction between buyers and sellers. For each listed security, the �inancial press reports the high and low prices of the stock during the year, the total volume of stock traded on a given day, the high and low prices for the day, and the closing market price, with the net change for the day. Facebook is listed on the Nasdaq exchange. Here is a recent listing for Facebook:

These numbers indicate the following. The high and low market prices for the last 52 weeks have been $86.07 and $54.66. The trading volume for the day was 54,156,600 shares. The high, low, and closing prices for that date were $85.59, $83.11, and $84.63, respectively. The net change for the day was a decrease of $0.629 per share.

For stocks traded on organized exchanges, how are the dollar prices per share established? What factors might in�luence the price of shares in the marketplace? (Go to WileyPLUS for this answer and additional questions.)

DO IT! 2a

Issuance of Stock

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Cayman Corporation begins operations on March 1 by issuing 100,000 shares of $1 par value common stock for cash at $12 per share. On March 28, Cayman issues 1,500 shares of $10 par value preferred stock for cash at $30 per share. Journalize the issuance of the common and preferred shares.

Action Plan ✓ In issuing shares for cash, credit Common Stock for par value

per share.

✓ Credit any additional proceeds in excess of par to a separate paid-in capital account.

✓ For the cash equivalent price, use either the fair value of what is given up or the fair value of what is received, whichever is more clearly determinable.

Related exercise material: BE11-2, BE11-3, BE11-4, DO IT! 11-2a, E11-2, and E11-5.

TREASURY STOCK Treasury stock is a corporation's own stock that has been reacquired by the corporation and is being held for future use. A corporation may acquire treasury stock for various reasons:

1. To reissue the shares to of�icers and employees under bonus and stock compensation plans.

2. To increase trading of the company's stock in the securities market. Companies expect that buying their own stock will signal that management believes the stock is underpriced, which they hope will enhance its market price.

3. To have additional shares available for use in acquiring other companies.

4. To reduce the number of shares outstanding and thereby increase earnings per share.

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A less frequent reason for purchasing treasury shares is to eliminate hostile shareholders by buying them out.

Many corporations have treasury stock. For example, in the United States approximately 65% of companies have treasury stock. During one quarter, companies in the Standard & Poor's 500-stock index spent a record of about $118 billion to buy treasury stock. In a recent year, Nike purchased more than 6 million treasury shares. At one point, stock repurchases were so substantial that a study by two Federal Reserve economists suggested that a sharp reduction in corporate purchases of treasury shares might result in a sharp drop in the value of the U.S. stock market.

Purchase of Treasury Stock

The purchase of treasury stock is generally accounted for by the cost method. This method derives its name from the fact that the Treasury Stock account is maintained at the cost of shares purchased. Under the cost method, companies increase (debit) Treasury Stock by the price paid to reacquire the shares. Treasury Stock decreases by the same amount when the company later sells the shares.

To illustrate, assume that on January 1, 2017, the stockholders' equity section for Mead, Inc. has 100,000 shares of $5 par value common stock outstanding (all issued at par value) and retained earnings of $200,000. Illustration 11-6 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11lo2#c11-�ig-0006) shows the stockholders' equity section of the balance sheet before purchase of treasury stock.

ILLUSTRATION 11-6 Stockholders' equity with no treasury stock

On February 1, 2017, Mead acquires 4,000 shares of its stock at $8 per share. The entry is as follows.

The Treasury Stock account would increase by the cost of the shares purchased ($32,000). The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change.

Companies show treasury stock as a deduction from total paid-in capital and retained earnings in the stockholders' equity section of the balance sheet. Illustration 11-7

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch11lo2#c11-fig-0006

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch11lo2#c11-fig-0007

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(http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch11lo2#c11-�ig-0007) shows this presentation for Mead, Inc. Thus, the acquisition of treasury stock reduces stockholders' equity.

ILLUSTRATION 11-7 Stockholders' equity with treasury stock

Company balance sheets disclose both the number of shares issued (100,000) and the number in the treasury (4,000). The difference is the number of shares of stock outstanding (96,000). The term outstanding stock means the number of shares of issued stock that are being held by stockholders.

In a bold (and some would say risky) move, Reebok at one time bought back nearly a third of its shares. This repurchase of shares dramatically reduced Reebok's available cash. In fact, the company borrowed signi�icant funds to accomplish the repurchase. In a press release, management stated that it was repurchasing the shares because it believed that the stock was severely underpriced. The repurchase of so many shares was meant to signal management's belief in good future earnings.

Skeptics, however, suggested that Reebok's management repurchased the shares to make it less likely that the company would be acquired by another company (in which case Reebok's top managers would likely lose their jobs). Acquiring companies like to purchase companies with large cash reserves so they can pay off debt used in the acquisition. By depleting its cash through the purchase of treasury shares, Reebok became a less likely acquisition target.

DO IT! 2b

Treasury Stock

Santa Anita Inc. purchases 3,000 shares of its $50 par value common stock for $180,000 cash on July 1. It expects to hold the shares in the treasury until resold. Journalize the treasury stock transaction.

Action Plan ✓ Record the purchase of treasury stock at cost.

https://content.ashford.edu/books/Kimmel.2745.17.1/sections/ch11lo2#c11-fig-0007

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✓ Report treasury stock as a deduction from stockholders' equity (contra account) at the bottom of the stockholders' equity section.

Related exercise material: DO IT! 11-2b, E11-2, and E11-5.

▼ HELPFUL HINT

Treasury Stock is a contra stockholders' equity account.

ETHICS NOTE

The purchase of treasury stock reduces the cushion for creditors. To protect creditors, many states require that a portion of retained earnings equal to the cost of the treasury stock purchased be restricted from being paid as dividends.

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LEARNING OBJECTIVE 3

Explain how to account for cash dividends and describe the effect of stock dividends and stock splits. 

As noted earlier, a dividend is a distribution by a corporation to its stockholders on a pro rata (proportional to ownership) basis. Pro rata means that if you own, say, 10% of the common shares, you will receive 10% of the dividend. Dividends can take four forms: cash, property, scrip (promissory note to pay cash), or stock. Cash dividends predominate in practice, although companies also declare stock dividends with some frequency.

Investors are very interested in a company's dividend practices. In the �inancial press, dividends are generally reported quarterly as a dollar amount per share. (Sometimes they are reported on an annual basis.) For example, the recent quarterly dividend rate was 24 cents per share for Nike, 22 cents per share for GE, and 25 cents per share for ConAgra Foods. Facebook does not pay dividends.

CASH DIVIDENDS A cash dividend is a pro rata (proportional to ownership) distribution of cash to stockholders. Cash dividends are not paid on treasury shares. For a corporation to pay a cash dividend, it must have the following:

1. Retained earnings. Payment of dividends from retained earnings is legal in all states. In addition, loan agreements frequently constrain companies to pay dividends only from retained earnings. Many states prohibit payment of dividends from legal capital. However, payment of dividends from paid-in capital in excess of par value is legal in some states.

2. Adequate cash. Recently, Facebook had a balance in retained earnings of $6,099 million but a cash balance of only $4,315 million. If it had wanted to pay a dividend equal to its retained earnings, Facebook would have had to raise $1,784 million more in cash. It would have been unlikely to do this because it would not be able to pay this much in dividends in future years. In addition, such a dividend would completely deplete Facebook's balance in retained earnings, so it would not be able to pay a dividend in the next year unless it had positive net income.

3. Declared dividends. The board of directors has full authority to determine the amount of income to distribute in the form of dividends. Dividends are not a liability until they are declared.

The amount and timing of a dividend are important issues for management to consider. The payment of a large cash dividend could lead to liquidity problems for the company. Conversely, a small dividend or a missed dividend may cause unhappiness among stockholders who expect to receive a reasonable cash payment from the company on a periodic basis. Many companies declare and pay cash dividends quarterly. On the other hand, a number of high-growth companies pay no dividends, preferring to conserve cash to �inance future capital expenditures.

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Investors monitor a company's dividend practices. For example, regular dividend boosts in the face of irregular earnings can be a warning signal. Companies with high dividends and rising debt may be borrowing money to pay shareholders. On the other hand, low dividends may not be a negative sign because it may mean the company is reinvesting in itself, which may result in high returns through increases in the stock price. Presumably, investors seeking regular dividends buy stock in companies that pay periodic dividends, and those seeking growth in the stock price (capital gains) buy stock in companies that retain their earnings rather than pay dividends.

Entries for Cash Dividends

Three dates are important in connection with dividends: (1) the declaration date, (2) the record date, and (3) the payment date. Companies make accounting entries on the declaration date and the payment date.

On the declaration date, the board of directors formally authorizes the cash dividend and announces it to stockholders. The declaration of a cash dividend commits the corporation to a binding legal obligation. Thus, the company must make an entry to recognize the increase in Cash Dividends and the increase in the liability Dividends Payable.

To illustrate, assume that on December 1, 2017, the directors of Media General declare a $0.50 per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is $50,000 (100,000×$0.50). The entry to record the declaration is as follows.

In Chapter 3 (http://content.thuzelearning.com/books/Kimmel.2745.17.1/sections/ch03#ch03) , we used an account called Dividends to record a cash dividend. Here, we use the more speci�ic title Cash Dividends to differentiate from other types of dividends, such as stock dividends. (For homework problems, you should use the Cash Dividends account for recording dividend declarations). Dividends Payable is a current liability. It will normally be paid within the next several months.