Ifr 2 Chapter 18

Front 1

In the absence of restrictive provisions, each share carries the following rights:

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1. To share proportionately in profits and losses
2. To share proportionately in management
3. To share proportionately in corporate assets upon liquidation
4. To share proportionately in any new issues of stock of the same class (known as preemptive rights); lasts a short period of time

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Common stock

Back 2

bears the ultimate risk of loss and receives the benefits of success

Front 3

Preferred stock

Back 3

in return for any special preferences (dividends), the preferred stock always sacrifices some of the inherent rights of common stock ownership

Front 4

Key components of corporate capital

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capital stock
APIC
retained earnings

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Capital stock =

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shares issued * par or stated value (AKA common or preferred stock)

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APIC =

Back 6

issue price less capital stock

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Retained earnings

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all undistributed income of the firm (a cumulative account)

Front 8

Issuing par value (stated value) stock

Back 8

credit these accounts for the number of shares issued * par value
credit APIC for any excess received over the par value

Front 9

Reasons for issuing no par stock

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1. Avoids the contingent liability that might occur if the company issued par value stock at a discount
2. Eliminates confusion over the relationship or lack of relationship between par value and market value

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Disadvantages of issuing no par stock

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1. Some states levy a high tax on these issues
2. In some states the total issues price is deemed by legal capital (has to be set aside for creditors)

Front 11

Issuing no par stock

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credit the exact amount received to common or preferred stock
any excess received goes into APIC

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Stated value stock

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minimum value below which a company cannot issue stock

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Two methods of issuing stock with other securities (lump-sum sale)

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1. Proportional method – allocate the lump sum received among the classes of securities on a proportional bases based on their FMVs
2. Incremental method – use the FMV of securities as a basis for those that it knows, and allocate the remainder to the classes it does not know

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When to use the proportional method of issuing stock with other securities

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Use if the FMV or relative value is available for each class of security

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When to use the incremental method of issuing stock with other securities

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Use if we cannot determine the FMV of all classes of securities

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What do you record stock issued for services or property at if there is determinable information?

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Either the FMV of the stock issued or the FMV of the noncash consideration, whichever is more clearly determinable

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What do you record stock issued for services or property at if there isn't determinable information?

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Employ an appropriate valuation technique
1. Market transactions involving comparable assets
2. Discounted expected future cash flows

Front 18

Classification of treasury stock

Back 18

a reduction to SE

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Reasons for stock buy-backs

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1. To make a market for the stock
2. To increase earnings per share and ROCE (this increases stock value)
3. To provide tax efficient distributions of excess cash to shareholders (rather than dividends)
Taxed as capital gain rather than ordinary income)
4. To provide stock for employee stock compensation plans
5. To meet potential acquisition needs
6. To thwart takeover attempts (green mail)

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Two methods for the purchase of treasury stock:

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1. Cost method – debit treasury stock for what was paid
Treasury stock is a deduction from paid-in capital and retained earnings
2. Par or stated value method – all transactions are reported at par/stated value
Treasury stock is a deduction from paid-in capital

Front 21

Journal entry for the sale of treasury stock above cost

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DR cash
CR treasury stock for the acquisition price
CR APIC treasury stock for the difference

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Why is no gain recognized for the sale of treasury stock above cost?

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1. Gains occur when selling long-lived assets and investments, not contra stockholders’ equity accounts
2. Gains and losses should not be recognized from stock transactions with one’s own stockholders

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Journal entry for the sale of treasury stock below cost

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Debit the excess of cost over selling price to APIC – treasury stock
If you run out of APIC – treasury stock, DR excess to retained earnings

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Status of retired shares

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authorized and unissued

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Results of retiring treasury stock

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cancellation of treasury stock and reduction in the number of shares issued

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Accounting effects of retiring treasury stocks (US GAAP)

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US GAAP – charge the excess of the cost of treasury stock over par value to retained earnings
Allocate the difference between paid-in capital and retained earnings
Charge the entire amount to paid-in capital

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Account effects of retiring treasury stock (IFRS)

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IFRS – the excess may have to be charged to paid-in capital depending on the original transaction related to the issuance of the stock

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Why choose preferred stock?

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1. High debt-to-equity ratio
2. Dividends received deduction allows private placement at a lower than market dividend rate

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Cumulative preferred stock

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requires that if a corporation fails to pay a dividend in any year, it must make it up in a later year before paying any dividends to common stockholders
Any unpaid dividends on cumulative preferred stock constitutes dividends in arrears and must be disclosed in the footnotes

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Participating preferred stock

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(rare) shares ratably with common stock any profit distributions beyond the prescribed rate

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Convertible preferred stock

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allows stockholders to exchange preferred shares for common shares at a predetermine ratio

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Callable preferred stock

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permits the corporation to call or redeem the outstanding preferred shares at specified future dates and at stipulated prices
When a corporation redeems preferred stock, it must first pay any dividends in arrears
The call price is usually slightly above the original issue price

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Redeemable preferred stock

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has a mandatory redemption period or a redemption feature that the issuer cannot control

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FASB requirements for classification of redeemable preferred stock

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debt-like securities like this must be classified as liabilities and be measured and accounted for similar to liabilities

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Accounting for and reporting preferred stock conversion

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There is no gain or loss
Use the book value method:
DR preferred
DR APIC – preferred for original price
CR common
CR APIC – common to balance

Front 36

Dividend policy

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1. Must consider the liquidity of the firm
2. A company should not pay dividends unless both the present and future financial position warrant the distribution
3. The SEC encourages companies to disclose their dividend policy in their annual report

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All dividends except for X reduce total stockholders' equity

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Stock dividends

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Cash dividends

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Date of declaration: incur liability and reduce RE
Date of record: no journal entry
Date of payment: reduce liability and reduce cash
Do not declare or pay cash dividends on treasury stock

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Property dividends

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Usually in the form of securities of other companies held as an investment
Restate to fair value the property it will distribute recognizing any gain or loss on the date of declaration
Record the declared dividend as a DR to RE and a credit to property dividend payable

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Liquidating dividends

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Dividends based on other than retained earnings
Are a return of the stockholders’ investment rather than profits
Any dividends not based on earnings reduces paid-in-capital

Front 41

Liquidating dividends journal entry

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DR APIC
CR cash

Front 42

Stock dividends

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The issuance by a corporation of its own stock to its stockholders on a pro rata basis, without receiving any consideration

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Small stock dividends (definition and what to record it as)

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less than 25%, recorded at FMV

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Large stock dividends (definition and what to record it as)

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more than 25%, recorded at par or stated value

Front 45

Alternate ways to record a stock split instead of a memorandum

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APIC – common
Common stock
RE
Common stock

Front 46

Stock split

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(stockholders like this more) increases the number of shares authorized, issued, and outstanding and decreases the par value; does not reduce retained earnings

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Stock dividend

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increases the number of shares outstanding, increases the common stock account, but does NOT reduce the par value; this reduces retained earnings

Front 48

Stockholders' equity statement

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1. Balance at the beginning
2. Additions
3. Subtractions
4. Balance at the end
5. Must disclose the changes in the separate accounts comprising stockholders’ equity

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Why split stocks?

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To reduce the market price

Front 50

Analysis of stockholders' equity

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1. Profitability and long-term solvency
2. Rate of return on common stockholders’ equity (ROCE or ROE)
3. Financial leverage (trading on equity)
4. Payout ratio

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ROCE =

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Net income – preferred stock dividends / Average common stockholders’ equity

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ROCE does what?

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Measures profitability from the viewpoint of the common stockholder
How much was earned for each dollar invested by the common stockholder?

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Financial leverage =

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average total assets / average common SE
The bigger, the more debt is being used to finance assets

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When financial leverage works

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If you earn an ROA% above the after-tax cost of borrowing %, then ROCE > ROA and financial leverage works

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Payout ratio

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cash dividends to common shareholders / net income – preferred dividends