Stockholders Equity

Question 1

Equity Capital

Answer 1

Ownership dilution
Buy-backs vs. Dividends
Impact on EPS

Question 2

Debt Financing

Answer 2

No ownership dilution
Net Income Impacts
Leverage and Credit Risk

Question 3

3 primary forms of business organization

Answer 3

Proprietorship
Partnership
Corporation

Question 4

Special characteristics of the corporate form

Answer 4

Influence state of corporate law
Use of capital stock or share system
Development of a variety of ownership interests

Question 5

Corporate form of organization

Answer 5

Corporation must submit articles of incorporation to the state in which incorporation is desired

State issues charter

Advantage to incorporate in a state that favors corporate organization (Delaware)

Accounting for SE follows the rules of each state

Question 6

Two primary sources of equity

Answer 6

Contributed Capital (Common stock, Preferred Stock, APIC)

Retained Earnings (Less: Treasury Stock)

Question 7

Fundamental Accounting Equation (broken down SE)

Answer 7

A = L + SE
A = L + Contributed Capital + Retained Earnings
A = L + Contributed Capital + Net Income - Dividends
A = L + Contributed Capital + Rev - Exp - Dividends

Question 8

Capital Stock (Share System Privileges)

Answer 8

To share proportionately in profits and losses
To vote for directors
To share proportionately assets upon liquidation
Preemptive right to subscribe to new share

Question 9

Common Stock

Answer 9

Claim on firm’s assets after the stated obligations (bear risk, but share in success)

Voting and Dividend rights attached

Question 10

Preferred Stock

Answer 10

Entitled to a fixed rate of dividend that is senior
Dividends can be cumulative (paid before common stock)
Usually do not have voting rights
Convertible to common stock (optional)

Question 11

Authorized shares

Answer 11

Number of shares that can be issued as stated in company’s articles of incorporation

Question 12

Issued shares

Answer 12

Number of authorized shares that a company has distributed to shareholders

Question 13

Outstanding shares

Answer 13

Number of issued shares still owned by shareholders

shares issued - treasury stock

Question 14

APIC

Answer 14

Amount of par value received by company upon share issuance in excess of par value

Question 15

Par value

Answer 15

Maximum responsibility of shareholders in the event of insolvency (ceremonial/irrelevant)

Legal capital per share must be retained in the business

No relation to issue price (very low)

Question 16

Accounting for market prices

Answer 16

Only changes in issued share capital, not the ownership f this share capital relevant

Accounts only reflect the money originally paid to purchase the share (not market value)

Share capital figure in accounts will change if:

• new shares are issued
• the company repurchases its own shares

Question 17

Advantages of “No-Par Value” Stock

Answer 17

Avoids contingent liability

Avoids confusion over recording par value vs. market value

Question 18

Disadvantages of “No-Par Value” Stock

Answer 18

Some states levy high tax on these issues

The total issue price for no-par stock may be considered legal capital, reduces flexibility of paying dividends

Some states require “stated-value” per share… which is basically like par value anyway

Question 19

Issuing multiple classes of stock

Answer 19

Proportional method: market value of all securities are known

Incremental method: market value of at least one, but not all securities are known.

Question 20

Stock issued in non-cash transaction

Answer 20

Companies should record at fair value of the stock issued OR fair value of the non cash consideration received (whichever is more determinable)

Question 21

Hidden risks of non-cash transaction

Answer 21

Watered stock: overvaluation of assets

Secret reserves: undervaluation of assets

Question 22

Direct costs incurred to sell stock

Answer 22

Underwriting costs
Accounting and legal fees
Printing costs
Taxes

Should be reported as reduction of APIC

Question 23

Motives to stock buybacks

Answer 23

Signal undervaluation (improve market efficiency)

Less stocks –> higher EPS

Efficient return of cash in the absence of investment opportunities

To re-issue shares to directors/employees under bonus and stock compensation plans, and/or use in future acquisitions

“Gear up” balance sheet (increase leverage) to make an unattractive takeover target

Clean-up share register/manage costs

Question 24

Two forms of buyback

Answer 24

Cost method (widely/preferred)
Par (Stated) value method

Question 25

Treasury shares

Answer 25

Stocks that company buys back

Question 26

Treasury Stock account

Answer 26

Contra-equity account that reduces shareholders equity for buybacks

Question 27

Accounting for share buy-backs

Answer 27

After eliminating Paid-in Capital from Treasury Stock, we debit any excess of cost over selling price to RE Treasury stock transaction can never increase RE, but it can reduce Transactions in treasury stock will never increase or decrease current year earnings

Question 28

Dividend Policy

Answer 28

Covered by state specific laws and tax laws Generally paid out of RE Don't need profits in the current year Cannot be paid out of legal capital (par value) Company should not pay dividends unless both the present and future financial position warrant the distribution

Question 29

Why don't companies pay dividends in amounts equal to their legally available retained earnings?

Answer 29

``` Maintain agreements with creditors Meet state incorporation requirements To finance growth or expansion To smooth out dividend payments To build up cushion against possible losses ```

Question 30

SEC and dividends

Answer 30

SEC encourages companies to disclose their dividend policy in their annual report, especially if: - have earnings but - do not expect to pay dividends in the foreseeable future

Question 31

Types of stock of dividends

Answer 31

Cash dividends Property dividends Liquidating dividends Stock dividends All dividends (except stock) dividends, reduce total stockholders' equity

Question 32

Stock Dividends

Answer 32

Pro rata basis | Used when management wishes to "capitalize" part of the earnings

Question 33

Small Stock Dividends

Answer 33

If stock dividend is less than 20-25 percent of the common shares outstanding, company transfers fair market value from RE (small stock dividend)

Question 34

Large Stock Dividends

Answer 34

Accounting based on par value of the stock issued When declared, transfer amount equal to par value of stock issued from RE to contributed capital

Question 35

Stock Splits

Answer 35

Issue additional shares of stock to shareholders based on number of shares currently owned No effect on total paid-in capital, RE, or total SE Number of shares increase as par/stated value per shares decrease

Question 36

Preferred Stock

Answer 36

Unlike common stock, preferred stock can have the following features: - fixed dividend - preference as to dividends (may be cumulative) - preference as to assets in the event of liquidation - absence of voting rights - participating (dividends) - convertible to common stock - callable (mandatory buy-backs) - redeemable (debt-like securities)

Question 37

Presentation of SE

Answer 37

Analysts use SE ratios to evaluate a company's profitability and long-term solvency

Question 38

3 SE Ratios

Answer 38

Rate of return on common stock equity Payout ratio Book value per share