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Chapter 11

Reporting and Interpreting Stockholders’

Equity
 Advantages of a Corporation
The corporate form of business has a critical advantage over
sole proprietorships and partnerships because they can raise
large amounts of capital from both large and small investors.
• Shares of stock may be purchased in small amounts.
• Ownership interests can be transferred easily through the
sale of shares on established markets such as the New
York Stock Exchange or the NASDAQ Stock Exchange.
• Stock ownership provides investors with limited liability.

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 Ownership of a Corporation
Corporations enjoy a continuous existence separate and
apart from its owners. A corporation can . . .
Own assets
Incur liabilities
Sue others and be sued
Expand and contract in size
Enter into contracts independently of its owners

Corporations are created by application to a state

government (not the federal government). Corporations are
governed by a board of directors elected by the stockholders.

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 Benefits of Stock Ownership
Owners of common stock (known as stockholders or
shareholders) receive a number of benefits:

1. A voice in management.
2. Dividends: Proportional share of the distribution of profits.
3. Residual claim: Proportional share of the distribution of
remaining assets upon the liquidation of the company.

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 Authorized, Issued, and Outstanding
Shares 1

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 Authorized, Issued, and Outstanding
Shares 2

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 Authorized, Issued, and Outstanding Shares 3

A few states do not allow treasury stock. In these states companies must
retire shares that are repurchased. Microsoft is incorporated in one of
those states (Washington State). In fiscal 2020, Microsoft repurchased
and retired 126 million shares of common stock. Since those shares are
not listed as treasury stock, Microsoft’s number of outstanding shares is
equal to its number of issued shares.

Microsoft Corporation
Common Stock Shares June
30, 2020 (in millions)

Authorized shares 24,000

Issued shares 7,571
Less: Treasury shares 0
Outstanding shares 7,571

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 Earnings per Share (EPS)
Key Ratio Analysis
How well is a company
performing?
Earnings per Share = Net Income* ÷ Weighted Average Number of
Common Shares Outstanding
*Any preferred dividends (discussed later in this chapter) should be
subtracted from net income.
Companies are required to report E PS on their income statements.
Comparisons Over Time Comparisons with Competitors
Microsoft
IBM Intel
2018 2019 2020 2020 2020
$2.15 $5.11 $5.82 $6.28 $4.98

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 Common Stock Transactions 1

Common stock is held by investors who are the owners of a

corporation.
Stockholders have the right to:
• Vote.
• Share in profits of the business through dividends.
• Elect the board of directors who hire and monitor the
executives who manage a company’s activities on a day-
to-day basis.

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 Common Stock Transactions 2

Par value is the nominal value per share, established in the

corporate charter.*

Par Value ≠ Market Value

Legal capital is the amount of capital, required by the state,

that must remain invested in the business.

*Some states do not require a par value to be stated in

the charter.

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 Initial Sale of Stock
An initial public offering, or IPO, involves the very first sale of a
company’s stock to the public (i.e., when the company first “goes public”).
Additional sales of new stock to the public are called seasoned
offerings.

Assume Microsoft sold 1 million shares of its $0.00000625 par value

common stock for $220 per share.
The company would record the following journal entry:
Debit Credit
Cash (+A) (1,000,000 × $220) 220,000,000
Common stock (+SE) (1,000,000 × $0.00000625) 6
Additional paid-in capital (+SE) 219,999,994

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 Sale of Stock in Secondary Markets
When a company sells stock to the public, the transaction is between the
issuing corporation and the investor.
Subsequent to the initial sale, investors can sell shares to other investors
without directly affecting the corporation. Stockholders expect to earn
money on their investments through possible dividends and increases in
a company’s stock price.
• The corporation is not a part of the transaction and therefore does not
receive or pay anything.

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 Stock Issued for Employee Compensation

Managers may not act in the owners’ best interest. Compensation

packages can be developed to reward employees for meeting
goals important to stockholders.
Another strategy is to offer employees stock, either directly
through stock awards or indirectly through stock options.
• Stock awards grant shares of stock to employees that vest on
future dates.
• Stock options give employees the right to buy stock in the
future at a fixed price.

Both stock awards and stock options provide incentives for

employees to take actions that increase a company’s stock price
(thereby aligning their interest with the interest of stockholders).

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 Repurchase of Stock
A corporation repurchase its stock from existing stockholders for a number of
reasons.
One common reason is the existence of an employee bonus plan that provides
workers with shares of the company’s stock as part of their compensation.
• Due to SEC regulations, it is less costly to give employees repurchased shares
than to issue new ones.
• Reissuing treasury stock avoids diluting existing shareholders’ investments.

Stock that has been repurchased and is held by the issuing corporation is called
treasury stock.
• Treasury stock is not an asset, rather it is a contra-equity account.
• Treasury stock is shown as a negative number on the balance sheet.

Treasury shares have no voting, dividend, or other stockholder rights while they
are held as treasury stock.

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 Repurchase and Reissuance of Stock 1

IBM reacquired 100,000 shares of its common stock when it was selling
for $140 per share.
Debit Credit
Treasury stock (+XSE, −SE) (100,000 × $140) 14,000,000
Cash (−A) 14,000,000

Treasury Stock is a contra-equity account, not an asset!

IBM reissued 10,000 shares of treasury stock at $150 per share.
Debit Credit
Cash (+A) (10,000 × $150) 1,500,000
Treasury stock (−XSE, +SE) (10,000 × $140) 14,000,000
Additional paid-in capital (+SE) 100,000

When Treasury Stock is reissued, no accounting profit or loss is recorded.

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 Repurchase and Reissuance of Stock 2

IBM reissued 10,000 shares of treasury stock at $130 per

share.
Debit Credit
Cash (+A) (10,000 × $130) 1,300,000
Additional paid-in capital (−SE) 100,000
Treasury stock (−XSE, +SE) (10,000 × $140) 1,400,000

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 Exhibit 11.2: Excerpt from the Consolidated
Balance Sheets for IBM
IBM Corporation
Consolidated Balance Sheets
($ in millions)
December 31, 2020 December 31, 2019
Stockholders' Equity
Common stock and additional paid-in $56,556 $55,895
capital
Retained earnings 1,62,717 1,62,954
Treasury stock, at cost (1,69,339) (1,69,413)
Accumulated other comprehensive loss (29,337) (28,597)
Noncontrolling interest 129 144
Total stockholders' equity $20,727 $20,985

*Amounts may not add due to rounding.

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 Dividends on Common Stock
The return from investing in a company’s common stock can come from
two sources: stock price appreciation and dividends.
Some investors prefer to buy stocks that pay little or no dividends.
• Companies that reinvest the majority of their earnings back into their
operations tend to increase their future earnings potential and their
stock price.
• Wealthy investors in high tax brackets prefer to receive their return in
the form of higher stock prices because capital gains may be taxed at
a lower rate than dividend income
Other investors, such as retired people who need a steady income,
prefer to receive their return in the form of dividends.
• Retirees seek stocks that will pay relatively high dividends, such as
utility stocks.
Analysts compute the dividend yield ratio to evaluate a company’s
dividend policy.
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 Key Dividend Dates 1

The declaration and payment of a dividend involve several key dates.

1. Declaration date. The date on which the board of directors officially approves the
dividend. As soon as the board declares a dividend, a liability is created and must be
recorded.
2. Date of record. The date on which the corporation prepares the list of current
stockholders who will receive the dividend payment. The dividend is payable only to
those names listed on the record date. No journal entry is made on this date.
3. Date of payment. The date on which cash is disbursed to pay the dividend liability.

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 Key Dividend Dates 2

Date of Declaration: Assume Microsoft declared a $3,886 million dividend

on 9/18/2019:
Debit Credit
Retained earnings (−SE) 3,886,000,000
Dividends payable (+L) 3,886,000,000

Date of Record: 11/21/2019, stockholders who own shares on this date

will receive the dividend. (No journal entry)

Date of Payment: 12/12/2019 the liability is paid.

Debit Credit
Dividends payable (−L) 3,886,000,000
Cash (−A) 3,886,000,000

Note: The corporation must have sufficient retained earnings and cash to
cover the amount of the dividend.
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 Nature of Stock Dividends 1

Stock dividends represent a distribution of additional shares of stock to

stockholder on a pro rata basis at no cost to the stockholder.
• Stockholders retain the same percentage ownership after stock dividends are
distributed.
• Therefore, a stock dividend by itself has no economic value!
Stock dividends do not change the stock’s par value or total stockholders’ equity.
The stock market reacts immediately when a stock dividend is issued.
• The stock price falls.
• The lower market price may make the stock more attractive to new investors.

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 Nature of Stock Dividends 2

The entry for a stock dividend is a transfer from the Retained

Earnings account to the Common Stock account (and
Additional Paid-in Capital account for small stock dividends).

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 Stock Dividends
Large Stock Dividend: Assume Microsoft issued 40 million shares of its
$0.00000625 par value stock. On the date of declaration the following
journal entry is made:
Debit Credit
Retained earnings (−SE) ($0.00000625 × 40,000,000) 250
Common stock (+SE) ($0.00000625 × 40,000,000) 250

Small Stock Dividend: Assume Microsoft issued 4 million shares of its

$0.00000625 par value stock when it was trading at $220 per share. On
the date of declaration the following journal entry is made:
Debit Credit
Retained earnings (−SE) ($220 market price × 4,000,000) 880,000,000
Common stock (+SE) ($0.00000625 par value × 4,000,000) 25
Additional paid-in capital (+SE) (remainder) 879,999,975

NOTE: Regardless of whether a stock dividend is classified as large or

small, there is no change in the total amount of stockholders’ equity!
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 Stock Splits
• Stock splits are not dividends. In a stock split, a company gives stockholders a specified
number of additional shares for each share that they currently hold.
• Companies do not make journal entries to record stock splits.
• The company reduces the par value of its stock so that the total dollar amount in the
Common Stock account remains unchanged.
• In both a stock dividend and a stock split, the stockholder receives more shares of stock
without having to invest additional resources to acquire the shares.
• A stock dividend requires a journal entry; a stock split does not but is disclosed in the
notes to the financial statements.

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 Stock Dividend versus Stock Split
• This chart shows the comparative effects of a large stock dividend
versus a stock split.
• Assume that a corporation had 300,000 shares of $1 par value
common stock outstanding before a 100% stock dividend versus a
two-for-one stock split:
Stockholders’ Equity
After a 100% After a 2-for-1
Before Stock Dividend Stock Split
Number of shares outstanding 3,00,000 6,00,000 6,00,000
Par value per share $1.00 $1.00 $0.50
Common stock $ 3,00,000 $ 6,00,000 $ 3,00,000
Retained earnings 6,50,000 3,50,000 6,50,000
Total stockholders' equity $9,50,000 $9,50,000 $9,50,000

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 Preferred Stock Transactions

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 Dividends on Preferred Stock 1

Preferred stock offers a dividend preference over common stock.

Current dividend preference: Requires a company to pay current
dividends to preferred stockholders before paying dividends to common
stockholders. After this is met then dividends can be paid to common
stockholders.

Cumulative dividend preference: Requires any unpaid dividends on

preferred stock to accumulate. This amount, called dividends in arrears,
must be paid before common dividends are paid.
If preferred stock is noncumulative, any dividends not declared in
previous years are permanently lost and will never be paid.
Note: Dividends in arrears are disclosed in the notes to the financial
statements. They are not a liability until the board of directors declares
them.

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 Dividends on Preferred Stock 2

Wally Company has the following stock outstanding:

Wally Company
Preferred stock: 6%, $20 par value, 2,000 shares
outstanding = $40,000
Common stock: $10 par value, 5,000 shares outstanding =
$50,000
Assume a current dividend preference only:

Example Total Dividends 6% Preferred Stock* Common Stock

No. 1 $ 3,000 $2,400 $ 600
No. 2 18,000 2,400 15,600

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 Dividends on Preferred Stock 3

Assume the preferred stock is cumulative and that dividends

have been in arrears for two years:

Example Total Dividends 6% Preferred Stock* Common Stock

No. 1 $ 8,000 $7,200 $ 800
No. 2 30,000 7,200 22,600

*Preferred dividend calculation:

• Current dividend preference: $20 par value × 0.06 × 2,000
shares = $2,400
• Dividends in arrears: $2,400 × 2 years = $4,800
• Total preferred dividend: $2,400 + $4,800 = $7,200

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 Financing Activities
Focus On Cash Flows
Transactions involving stock have a direct impact on the
capital structure of a business. The cash inflows and outflows
associated with these transactions are reported in the
Financing Activities section of the statement of cash flows.
Effect on Cash Flows
Financing activities
Issuance of common or preferred stock +
Common stock repurchased (treasury stock) −
Sale of treasury stock +
Payment of cash dividends −

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