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14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock

  • The process of forming a corporation involves several steps, which result in a legal entity that can issue stock, enter into contracts, buy and sell assets, and borrow funds.
  • The corporate form has several advantages, which include the ability to function as a separate legal entity, limited liability, transferable ownership, continuing existence, and ease of raising capital.
  • The disadvantages of operating as a corporation include the costs of organization, regulation, and potential double taxation.
  • There are a number of considerations when choosing whether to finance with debt or equity as a means to raise capital, including dilution of ownership, the repayment obligation, the cash obligation, budgeting reliability, cost savings, and the risk assessment by creditors.
  • The Securities and Exchange Commission regulates large and small public corporations.
  • There are key differences between public corporations that experience an IPO and private corporations.
  • A corporation’s shares continue to be bought and sold by the public in the secondary market after an IPO.
  • The process of marketing a company’s stock involves several steps.
  • Capital stock consists of two classes of stock—common and preferred, each providing the company with the ability to attract capital from investors.
  • Shares of stock are categorized as authorized, issued, and outstanding.
  • Shares of stock are measured based on their market or par value. Some stock is no-par, which carries a stated value.
  • A company’s primary class of stock issued is common stock, and each share represents a partial claim to ownership or a share of the company’s business. Common shareholders have four rights: right to vote, the right to share in corporate net income through dividends, the right to share in any distribution of assets upon liquidation, and a preemptive right.
  • Preferred stock, by definition, has preferred characteristics, which are more advantageous to shareholders over common stock characteristics. These include dividend preferences such as cumulative and participating and a preference for asset distribution upon liquidation. These shares can also be callable or convertible.

14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock

  • The initial issuance of common stock reflects the sale of the first stock by a corporation.
  • Common stock issued at par value for cash creates an additional paid-in capital account for the excess of the issue price over the par value.
  • Stock issued in exchange for property or services is recorded at the fair market value of the stock or the asset or services received, whichever is more clearly determinable.
  • Stock with a stated value is treated as if the stated value is a par value. The entire issue price of no-par stock with no stated value is credited to the capital stock account.
  • Preferred stock issued at par or stated value creates an additional paid-in capital account for the excess of the issue price over the par value.
  • A corporation reports a stock’s par or stated value, the number of shares authorized, issued, and outstanding, and if preferred, the dividend rate on the face of the balance sheet.
  • Treasury stock is a corporation’s stock that the corporation purchased back. A company may buy back its stock for strategic purposes against competitors, to create demand, or to use for employee stock option plans.
  • The acquisition of treasury stock creates a contra equity account, Treasury Stock, reported in the stockholders’ equity section of the balance sheet.
  • When a corporation reissues its treasury stock at an amount above the cost, it generates a credit to the Additional Paid-in Capital from Treasury stock account.
  • When a corporation reissues its treasury stock at an amount below cost, the Additional Paid-in Capital from Treasury stock account is reduced first, then any excess is debited to Retained Earnings.

14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits

  • Dividends are a distribution of corporate earnings, though some companies reinvest earnings rather than declare dividends.
  • There are three dividend dates: date of declaration, date of record, and date of payment.
  • Cash dividends are accounted for as a reduction of retained earnings and create a liability when declared.
  • When dividends are declared and a company has only common stock issued, the reduction of retained earnings is the amount per share times the number of outstanding shares.
  • A property dividend occurs when a company declares and distributes assets other than cash. They are recorded at the fair market value of the asset being distributed.
  • A stock dividend is a distribution of shares of stock to existing shareholders in lieu of a cash dividend.
  • A small stock dividend occurs when a stock dividend distribution is less than 25% of the total outstanding shares based on the outstanding shares prior to the dividend distribution. The entry requires a decrease to Retained Earnings for the market value of the shares to be distributed.
  • A large stock dividend involves a distribution of stock to existing shareholders that is larger than 25% of the total outstanding shares just before the distribution. The journal entry requires a decrease to Retained Earnings and a credit to Stock Dividends Distributable for the par or stated value of the shares to be distributed.
  • Some corporations employ stock splits to keep their stock price competitive in the market. A traditional stock split occurs when a company’s board of directors issues new shares to existing shareholders in place of the old shares by increasing the number of shares and reducing the par value of each share.

14.4 Compare and Contrast Owners’ Equity versus Retained Earnings

  • Owner’s equity reflects an owner’s investment value in a company.
  • The three forms of business utilize different accounts and transactions relative to owners’ equity.
  • Retained earnings is the primary component of a company’s earned capital. It generally consists of the cumulative net income minus any cumulative losses less dividends declared. A statement of retained earnings shows the changes in the retained earnings account during the period.
  • Restricted retained earnings is the portion of a company’s earnings that has been designated for a particular purpose due to legal or contractual obligations.
  • A company’s board of directors may designate a portion of a company’s retained earnings for a particular purpose such as future expansion, special projects, or as part of a company’s risk management plan. The amount designated is classified as appropriated retained earnings.
  • The statement of stockholders’ equity provides the changes between the beginning and ending balances of each of the stockholders’ equity accounts, including retained earnings.
  • Prior period adjustments are corrections of errors that occurred on previous periods’ financial statements. They are reported on a company’s statement of retained earnings as an adjustment to the beginning balance.

14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance

  • Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock.
  • EPS is calculated by dividing the profit earned for common shareholders by the weighted average common shares of stock outstanding.
  • Because EPS is a key profitability measure that both current and potential common stockholders monitor, it is important to understand how to interpret it.
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