Chapter 10: Stockholders' equity

The last financial chapter looks at the owners' side of the balance sheet of a corporation: stockholders' equity. It covers the features of a corporation, the different classes and values of stock, issuing stock, buying back stock (treasury stock), cash and stock dividends, stock splits, and the ratios investors use most: earnings per share, the price/earnings ratio and the return on equity. The chapter ends with an overview of all ratios of the financial part.

The corporation

A corporation is a business organised under state law as a separate legal entity: it can make contracts, borrow, pay tax and be sued in its own name.

Authorized stock is the maximum number of shares the corporation may issue; issued stock has been issued; outstanding stock is held by stockholders (issued minus treasury stock). Each stockholder has four basic rights: to vote (one vote per share), to receive a proportionate part of any dividend, to a proportionate share of assets at liquidation, and the preemptive right to keep the same ownership percentage when new shares are issued.

Common stock represents basic ownership. Preferred stock gives advantages over common stock: preferred stockholders receive dividends first and are paid before common stockholders at liquidation, but usually have no vote. Stock generally has a par value, an arbitrary legal amount per share unrelated to market value. Stock may also be no-par or have a stated value, which works like a par value.

Stockholders' equity has two sources: paid-in capital (amounts received from stockholders) and retained earnings (profits kept in the business).

Issuing stock

Stock can be sold directly or through an underwriter, and public companies' stock trades on exchanges such as the NYSE or NASDAQ. The par value goes to the stock account; anything received above par goes to paid-in capital in excess of par.

• 15,000 shares of $1 par common stock at par: Dr Cash 15,000, Cr Common stock 15,000.
• 3,000 shares at $5: Dr Cash 15,000, Cr Common stock 3,000, Cr Paid-in capital in excess of par 12,000.
• Furniture worth $18,000 for 5,000 shares: Dr Furniture 18,000, Cr Common stock 5,000, Cr Paid-in capital in excess of par 13,000. Non-cash issues are recorded at the market value of the stock or of the asset, whichever is more clearly determinable.
• 1,000 shares of $50 par, 6% preferred stock at $55: Dr Cash 55,000, Cr Preferred stock 50,000, Cr Paid-in capital in excess of par, preferred 5,000.

Treasury stock

Treasury stock is the company's own stock that it issued earlier and has bought back. Reasons: to buy low and resell high, to support the share price, to avoid a takeover, or to reward employees with shares. Treasury stock is a contra equity account with a normal debit balance, recorded at cost (par value is ignored) and shown after retained earnings as a reduction of equity. Buying treasury stock therefore reduces both assets and equity.

• Purchase of 1,000 shares at $5: Dr Treasury stock 5,000, Cr Cash 5,000.
• Resale of 100 shares at cost ($5): Dr Cash 500, Cr Treasury stock 500.
• Resale of 200 shares at $6: Dr Cash 1,200, Cr Treasury stock 1,000, Cr Paid-in capital from treasury stock transactions 200. A resale above cost is never a gain on the income statement: a company does not earn profit from trading in its own shares.
• Resale of 200 shares at $4.30: the shortfall of $140 is debited to Paid-in capital from treasury stock transactions (balance falls to $60).
• Resale of another 200 shares at $4.50: the shortfall is $100, but only $60 is left in that paid-in capital account, which can never have a debit balance. The remaining $40 is debited to retained earnings.

After these transactions 300 treasury shares remain; with 23,000 shares issued, 22,700 are outstanding. Retiring stock means cancelling the certificates: retired stock cannot be reissued and the stock accounts are debited.

Cash dividends

Three dates matter. On the declaration date the board announces the dividend and a liability arises (Dr Cash dividends, Cr Dividends payable). On the date of record the company determines who receives the dividend: no entry. On the payment date the dividend is paid (Dr Dividends payable, Cr Cash). At the end of the period Cash dividends is closed to retained earnings. A $0.05 dividend on 22,700 outstanding shares is $1,135. Legal capital is the part of equity that cannot be used for dividends.

Preferred dividends are expressed as a percentage of par (6% on $50 par is $3 a share) or as a fixed amount per share. A dividend not paid for a year is in arrears. Holders of cumulative preferred stock must receive all dividends in arrears plus the current year's dividend before common stockholders get anything; holders of noncumulative preferred stock lose a skipped dividend.

Stock dividends and stock splits

A stock dividend distributes the company's own shares to its stockholders. It only shifts amounts between equity accounts: retained earnings decrease, paid-in capital increases, total equity, assets and liabilities do not change. Companies use it to reward stockholders while keeping cash, or to lower the market price per share. A small stock dividend (less than 20 to 25% of the outstanding shares) is recorded at market value; a large one at par value. The dates are declaration, record and distribution.

Example: a 5% stock dividend on 2,000,000 shares ($1 par, market $50) means 100,000 new shares. Retained earnings decrease by 100,000 × 50 = $5,000,000; common stock increases by $100,000 and paid-in capital in excess of par by $4,900,000.

A stock split increases the number of shares and proportionally decreases the par value and market price per share. A 2-for-1 split of 3,150,000 shares of $1 par gives 6,300,000 shares of $0.50 par, and the market price roughly halves. No journal entry is needed, only a memorandum entry.

Earnings per share and related ratios

The corporate income statement ends with earnings per share (EPS), the most widely used business statistic: the net income available for each common share.

The P/E ratio tells how much investors pay for $1 of earnings. Return on equity relates the income for common stockholders to their average investment (total equity minus preferred equity).

Overview: the ratios of the financial part