Three basic transactions account for most of the changes that occur in shareholder’s equity: sale of stock to investors, recognition of periodic net income or loss and declaration of cash dividends to shareholders. Each of these transactions is examined in this post. Other less frequent types of transactions are also discussed later in this post. Enjoy!

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Sale of Stock to Investors

Suppose that Lie Dharma’s management decides to issue an additional 10 million shares of stock to investors, and the market price is $70 per share of stock. In this case, Lie Dharma would receive a total of $700 million ($70 x 10 million shares) from investors. In this example, note that we are ignoring any transactions costs, such as fees and commissions incurred by the issuing firm. The transaction would increase cash and invested capital by $700 million. The invested capital would consist of $3 million in par value (10 million shares x $0.30 par value per share), and $697 million in capital invested in excess of par value ($700 million total invested minus $3 million recorded as par value).

 

ASSETS =  LIABILITIES    + SHAREHOLDER’S              EQUITY
Cash                                       Par value               Additional
                                                                     paid-in capital
+$700 million                        +3 million      + $697 million

 

Managers would immediately put these funds to work to earn returns for the shareholders, such as by investing in additional plant and equipment. In other words, the transaction to issue shares of stock is immediately followed by many other transactions in which the money is used for some corporate purpose.

In some instances, noncash items can be received when stock is issued to investors. Examples include noncash assets, such as property or intangible assets, and services, such as work from a company’s attorneys.

 

 

Recognition of Periodic Net Income or Loss

Business firms must periodically determine the amount of net income (or loss) from their activities. Net income (loss) represents an increase (or decrease) in a firm’s share holder equity, or net assets, due to its revenues, expenses, gains, and losses during the period.

For example: Lie Dharma earned $2,405 million of net income during 2008 and paid $1,401 million as dividends. In addition, other items reduced Lie Dharma’s retained earnings by $1,546. Note the amounts of Lie Dharma’s retained earnings shown in Exhibit 10—1 at the beginning and the end of 2008. These amounts (millions of dollars) are related in the following way:

Retained earnings, December 31, 2007    = $ 4,931
Add: Net income during 2008                   =   2,405
Less: Dividends declared during 2008      =   1,401
Other changes(net)                                    =   1,546
Retained earnings, December 31, 2008     = $ 4,389

 

Declaration and Payment of Cash Dividends

Lie Dharma paid dividends of $1,401 million to its shareholders in 2008. On the date of declaration, the dividend became a liability because Lie Dharma obligated itself to make the dividend payment. On that date, retained earnings were decreased and liabilities were increased by $1,401 million:

ASSETS   =   LIABILITIES               +  SHAREHOLDER’S EQUITY
                   Dividends payable            Retained earnings
                   + $1,401 million               +$1,401 million

 

Management also specified a date of record, and the dividend was paid to investors who owned the shares on that specific date. Subsequently, the stock was considered ex dividend, which means that subsequent purchasers were not entitled to receive the previously declared dividend. On the date of payment, Lie Dharma’s cash and dividends payable (liability) were reduced by $1,401 million:

ASSETS =                    LIABILITIES             +   SHAREHOLDER’S EQUITY
Cash                           Dividends payable
-$1,401 million          -$1,401 million

 

Observe that the change in retained earnings over a period is due primarily to the difference between a firm’s net income and dividends during the period. The ending balance in retained earnings reflects the total net income of the firm in all past periods, less the total amount of dividends to shareholders, plus or minus the effects of any other adjustments.

In addition to the three basic transactions discussed previously, a variety of other, less frequent occurrences may affect the reported amount and composition of shareholder’s equity. This post examines several of these additional types of transactions and events.

 

Stock Dividends

On occasion, firms distribute additional shares of stock to shareholders in proportion to the number of shares presently owned. If a firm declares a one percent stock dividend, for example: this means that existing shareholders will receive additional shares equal to one percent of their present holdings. In this case, a shareholder with 100 shares would receive an additional share (1% x 100 shares) as a stock dividend.

Stock dividends reduce retained earnings in an amount equal to the value of the stock that is distributed. As an example, assume that the Putra Company has 10 million common shares issued and outstanding and declares a two percent stock dividend when the market price of its stock is $45 per share. The firm will distribute an additional 200,000 shares (2% x 10 million shares = 200,000 shares), and the total value of the dividend is $9 million ($45 x 200,000 shares =  $9 million). Retained earnings will decrease, and paid-in capital will increase, by $9 million. The number of shares outstanding will also increase by two percent.

 

ASSETS       =  LIABILITIES =  SHAREHOLDERS’                  EQUITY
Cash                                     Paid-in capital     Retained earnings
                                             + $9 million         – $9 million

 

Notice that this transaction does not affect the firm’s assets and liabilities, and therefore does not affect total shareholders’ equity. The composition of shareholder’s equity is affected, however. The transaction decreases retained earnings and creates an off-setting increase in paid-in capital.

As a stockholder of 100 shares of Putra Company, would you be better off as a result of the stock dividend? Although it is true that you have received two additional shares of stock, your proportionate interest in Putra remains unchanged. Moreover, because the company’s assets and liabilities are unchanged, the stock dividend has no direct effect on Putra’s operating capability. In fact, the market price of each share of stock could decline just enough to leave the total value of your investment unchanged (100 shares x old price = 102 shares x new price).

Surprisingly, stock dividends do appear to benefit existing shareholders. The market price per share of existing shares usually does not decline sufficiently to offset the effect of issuing additional shares. Some analysts suggest that this otherwise puzzling result may be due to the use of stock dividends as a “signal to the market” by managers that the firm expects higher profits and cash flows in the future. Managers may be reluctant to make public forecasts about future earnings increases, however, and may instead prefer to communicate their favorable expectations by less direct actions such as stock dividends.

 

Stock Splits

Stock splits are distinct from stock dividends and involve an exchange of multiple shares of stock for existing outstanding shares. In a two-for-one stock split, for example: each “old” share held by existing shareholders can be exchanged for two “new” shares. Unlike stock dividends, stock splits usually do not entail a reduction in retained earnings nor an increase in paid-in capital. In fact, stock splits usually do not change any of the elements in the financial statements. Only the description of the firm’s stock is amended to reflect the new number of shares authorized, issued, and outstanding.

Managers may split a firm’s stock when they believe that the price per share has risen beyond the range that is attractive to smaller investors. Therefore, splitting the shares is expected to reduce the share price and increase demand. Similar to stock dividends, stock splits also seem to be interpreted by investors as favorable signals by management about future operating performance. Stock splits usually result in an increase in the total market value of the firm’s outstanding shares because the price per share typically does not decline sufficiently to offset the increase in the number of shares. For example, a two-for-one stock split usually does not cut the price per share in half.

 

Case Example:

A footnote to the 2008 financial statements of Lie Dharma Company includes the following information:

The company’s common stock was split two-for-one effective May 15, 2008; all per share data and common stock information have been restated to reflect this split“.

Required:

a. Why does Lie Dharma give retroactive recognition to the stock split in all related financial statement references?

b. Why do you suppose Lie Dharma’s management decided to split the company’s stock?

c. As an existing Lie Dharma shareholder, would you be pleased by management’s decision to split your stock?

 

Solution:

a. Lie Dharma gives retroactive recognition to the stock split in order to aid analysts in making comparisons with prior years. For example, if net income is unchanged from the prior year and the number of shares is not retroactively adjusted, the earnings per share would appear to decrease by 50 percent.

b. The company may have split the stock in order to reduce the per-share price, thereby making the stock more accessible for smaller investors. Alternatively, management may use stock splits as an indirect way to signal investors that management expects higher per share earnings and dividends in the future.

c. Generally, existing shareholders benefit from stock splits. Although each shareholder’s fractional interest in Lie Dharma is not changed by the stock split, the total value of existing shares usually increases around the date of such announcements. The increase in stock prices may reflect investor expectations of higher future cash flows.

 

Treasury Stock

Firms sometimes repurchase their own outstanding shares and hold them for future use. Such repurchased shares are termed treasury stock and are no longer outstanding, although they continue to be labeled asissued”.

A variety of motives lead managers to acquire treasury stock. For example: managers may consider the stock to be undervalued in the stock market and to be a “good buy” that can be resold later at a higher price. Also, treasury stock purchases can be preferable to dividend payments as a way of reducing a firm’s shareholders’ equity.

Note that this use of treasury stock depends on income tax features that are beyond the scope of this post. In addition, treasury stock purchases can enable managers to “buy out” certain groups of shareholders in order to re-align votes on future issues of corporate policy. Treasury stock can also be distributed to employees under an employee stock option plan.

The acquisition of treasury stock reduces both cash and shareholders’ equity. In this sense, treasury stock acquisitions are the opposite of a shareholder investment. The cost of treasury shares is usually subtracted from total shareholders’ equity. For this reason, the purchase price of treasury stock is a contra-equity account. Wendy has paid $6,722,000 to acquire its treasury stock. This amount is subtracted when computing Wendy’s total shareholder’s equity. We can infer that the treasury stock purchase has the following effect on Wendy’s balance sheet:

 

ASSETS           = LIABILITIES + SHAREHOLDER’S EQUITY
Cash                                        Treasury Stock
-$6,722,000                            -$6,722,000*)

*) Although treasury stock has been increased by $6,722,000, this represents a decrease in shareholder’s equity because treasury stock is a contra-equity account. Also note that the common stock account has not changed because the repurchased stock has not been retired. It is being held for future use.

Suppose that Wendy sold the treasury stock at a greater amount, say $10 million, at a future date. Generally accepted accounting principles (GAAP) do not allow the recognition of gains or losses due to transactions in a firm’s own stock. Consequently, Wendy’s cash increases by $10 million, the treasury stock is eliminated, and paid-in capital increases by the difference of $3,278,000 (= $10,000,000- 6,722,000).

ASSETS             =  LIABILITIES + SHAREHOLDER’S                EQUITY
Cash                                           Invested capital     Treasury Stock
+ $10,000,000                                +3,278,000       + $6,722,000*)

*) Although treasury stock has been decreased, this represents an increase in shareholders’ equity because treasury stock is a contra-equity account.

 

Employee Stock Options

Stock options are rights to purchase a firm’s stock at a specific price at some designated period in the future. Although stock options are sometimes sold directly to investors, they are usually granted as part of the compensation paid to key executives and other employees.

Stock options, as a means of compensation, offer several distinct benefits to firms and employees. Because the value of stock options depends on the future market price of the firm’s stock, option holders are highly motivated to improve the performance of the firm. Actions that benefit the firm’s stockholders also directly benefit the option holders. As a result, managers and other employees who hold stock options have the same objective as company shareholders: to make the firm’s equity securities more valuable.

In addition, although option holders gain if the price of the optioned stock subsequently rises, they avoid the “downside risk” of loss if the stock price declines. If the stock price is below the option price, the option simply will not be exercised.

A more arguable advantage of stock options from the firm’s point of view is the manner in which options are currently handled in financial statements. Current accounting rules allow firms to choose between two different ways of reporting the cost of employee stock options, based either on intrinsic values or fair values of the options at the date of grant.

The intrinsic value method measures the compensation cost of stock options as the excess of the stock’s market price over the option price at the date of the grant. Because most employee options are granted at or above market value, firms that elect this method do not recognize any compensation expense associated with the options. Under the alternative fair value method, compensation expense is measured at the grant date based on the estimated fair market value of the award. Fair values of options must be estimated based on a theoretical model and various assumptions.

Estimated stock option values and related compensation expenses can vary significantly, depending on the assumptions used and the model selected.

 

To illustrate how stock options for employees are treated when the issuing firm employs the intrinsic value method, assume that LDP Inc. issued options to its employees to purchase one million shares of its common stock in 2005 at an option price of $10 per share, equal to the market price at the date of the grant. Subsequently, in 2009, assume that all the options were exercised when LDP’s market price per share had risen to $90. For financial statement purposes, LDP records no compensation expense in 2005 when the options are granted. In 2009, when the options are exercised, LDP records the cash proceeds of $10 million ($10 x 1 million shares) as an issuance of common stock for cash.

ASSETS          = LIABILITIES + SHAREHOLDER’S EQUITY
Cash                                             Invested Capital
 +$10 million                                +$10 million

Although this method of accounting for stock options is presently followed by U.S. firms, opponents of current practice argue that in situations like the LDP case the granting of stock options in 2005 should entail the recognition of compensation expense. The grantees were given valuable rights that might otherwise have been sold to other investors. Moreover, in 2009, LDP’s optioned shares had a market value of $90 million, yet these options had been issued to the option holders for only $10 million in cash. In retrospect, granting the options in 2005 seems to have cost LDP $80 million ($90 million market value less $10 million proceeds). Consequently, some accountants believe that reported compensation expense is understated and reported net income is overstated.

The value of employee stock options is often substantial in specific industries. In high-technology companies that rely heavily on stock options to attract and retain talented employees, it is estimated that stock-option-related compensation expenses, if measured using fair values, reduce net income anywhere from 10 to 100 percent (“Options’ Effect On Earnings Sparks Debate,” WSJ, May 13, 1998). For this reason, companies that elect not to recognize compensation expense using the fair value method must show net income and earnings per share in a footnote to the financial statements as if the fair value method had been used.

 

Preferred Stock

In addition to common stock, firms often issue preferred stock, which has a priority claim over common stock with respect to dividends. In addition, if the firm should liquidate its assets and cease to exist, preferred shareholder’s claims would be satisfied before any assets were distributed to the common stockholders.

The description of preferred stock in corporate financial reports discloses the special features of the stock issue. To illustrate, description of Sequel Corporation’s preferred stock contained in its 2005 annual report. Sequel’s preferred shares have an annual dividend of $5 per share. Analysts would also note that Sequel’s preferred shares are cumulative and convertible. Cumulative indicates that if the firm does not declare a dividend in any year, the amount accumulates and must be paid before any dividends are paid to common stockholders. If Sequel did not pay dividends for three years, for example, then a cumulative dividend of $15 per share ($5 x 3 years) must be paid to preferred shareholders before dividends are paid to common shareholders. Convertible preferred shares can be exchanged for common shares at the preferred shareholder’s option. To illustrate, each share of Sequel’s preferred stock is converted into 1.322 shares of common stock. Presently, 797,000 shares of preferred stock have been issued. If the entire issue were to be converted to common stock, then Sequel would issue 1,053,634 common shares (797,000 preferred shares x 1.322 exchange ratio) and would retire the preferred stock. In this case, the preferred stock component of shareholders’ equity is eliminated and transferred to common stock.

Note that the conversion of preferred stock does not change total shareholder’s equity. Assets and liabilities are also unaffected. The number of common shares outstanding increases, however, and the preferred stock’s dividend requirement is eliminated.

 

Convertible Debt

Firms that borrow by issuing bonds frequently include a conversion privilege in the bond contract. Convertible bonds allow the bondholder to exchange the bonds for a specified number of shares of stock. As an example: let’s assume that in 2005 the Aurora Company’s long-term debt included $150 million principal in convertible bonds payable, exchangeable for common stock at $15 per share at any time before the year 2002. If all the bondholders elected to convert to common stock, Aurora would then issue 10 million shares of common stock ($150 million bond principal / $15 conversion price). Aurora’s bonds payable would be reduced, and paid-in capital would be increased by $150 million:

ASSETS = LIABILITIES         + SHAREHOLDER’S EQUITY
                Bonds Payable       Paid-in Capital
                -$150 million       +$150 million

 

Note that the conversion of debt to common stock reduces the firm’s liabilities and increases shareholders’ equity. The number of common shares outstanding is increased, and the periodic interest expense is eliminated.

Convertible bonds such as those issued by Aurora are hybrid securities. A hybrid security is neither clearly debt nor clearly equity. Instead, it combines certain features of both types of securities. In the case of convertible bonds, the bondholder is in one sense a lender and owns the firm’s promise to make future interest and principal payments.

In another sense, the holder of a convertible bond holds an option to acquire a specified number of common shares at a fixed price at any time over the life of the bond issue. In fact, investors in convertible bonds are willing to pay for this combination of debt and equity features. Convertible bonds generally are issued at higher prices (in other words, at lower interest rates) than nonconvertible debt.

The proper way to account for hybrid securities is a matter of debate. Present accounting standards reflect the view that convertible debt is to be reported as debt until it is actually converted and as equity thereafter. No recognition is given in the financial statements to the likelihood that conversion will actually occur, or to the relative values to investors of the hybrid security’s debt and equity features.

Opponents of present practice argue that it is misleading to ignore the hybrid nature of convertible securities. In the case of debt, they argue that the issue price should be apportioned between the amount the investor is paying for the debt features and the additional amount being paid for the conversion privilege. Ignoring these separate elements, they contend, causes the financial statements to overvalue the firm’s reported liabilities, undervalue its shareholders’ equity, and understate periodic interest expense. To address these and related issues, the FASB is pursuing a comprehensive financial instruments project. The project aims to identify the component claims that are bundled in hybrid financial assets and liabilities and to develop appropriate methods of valuation for these components.