Chapter 12 – Shareholders’ Equity:

Capital Contributions,
Distributions, and Earnings

FINANCIAL ACCOUNTING
AN INTRODUCTION TO CONCEPTS,
METHODS, AND USES
12th Edition
Clyde P. Stickney and Roman L. Weil
 Learning Objectives
1. Understand the different priority claims of
common and preferred shareholders on the
assets of a firm and the disclosure of those
claims in the shareholders’ equity section of
the balance sheet.
2. Understand the concepts underlying and apply
the accounting procedures for, the issuance of
capital stock, particularly with respect to
capital stock issued under various option
arrangements.
3. Understand the concepts underlying, and
apply the accounting procedures for, cash,
property, and stock dividends.
 Learning Objectives
4. Understand the concepts underlying, and
apply the accounting procedures for, the
acquisition and reissue of treasury stock.
5. Understand why the format for reporting
income matters and master the concept that
different kinds of income require different
formats.
6. Understand the distinction between earnings
and comprehensive income.
7. Develop the skills to interpret disclosures
about changes in shareholders’ equity
accounts.
 Chapter Outline
1.
1. Capital Contributions
2.
2. Issuing Capital Stock
3.
3. Corporate Distributions
4.
4. Reporting Earnings Transactions
5.
5. Earnings and Book Value per Share
6.
6. An International Perspective
7.
7. Disclosure of Changes in Shareholders’ Equity
Chapter Summary
8.
8. Appendix 12.1: Effects on the Statement of Cash
Flows of Transactions Involving Shareholders’ Equity
 Define These Terms
Capital Contributions:
Firms issue common or preferred stock to obtain funds
to finance various operating and investing activities.

Earnings Transactions:
Firms use assets financed by creditors and owners to
generate earnings.

Distributions:
Firms distribute assets to shareholders either in the
form of a dividend or the repurchase of common or
preferred stock.
 Review of Important Concepts
1. Shareholders’ equity is a residual interest,
representing the shareholders’ claims on
the assets of a firm in excess of the
claims of creditors.
2. All firms issue common stock. Firms may
also issue preferred stock which has a
senior but limited claim on assets.
3. Common and preferred stock usually have
a par or a stated value.
 Review of Important Concepts
4. Firms accumulate information about
revenues and expenses to support the
income statement. Revenues and
expenses are closed to retained earnings
at the end of the accounting period.
5. Firms may distribute assets to
shareholders as a dividend which reduces
retained earnings and assets.
6. Retained earnings is the accumulation of
earnings reduced by dividends.
 Capital Contributions
 The Corporate form:
1. Limits the liability of owner
2. Allows for raising funds by issuing shares
3. Makes transfer of ownership easy in
secondary markets
 Financing a corporation:
a. Preferred stock
b. Common stock
 Preferred Shareholders’ Equity
 Preferred shareholders generally have a
claim on assets that is superior or senior to
any claim by common shareholders.
 Their claims are often limited so that
preferred shareholders look more like
creditors than owners.
 Some preferred is convertible into common
shares.
 Firms do not have to issue preferred stock
and many firms have not.
 Common Shareholders’ Equity
 All corporations have common stock; they
need not have preferred stock.
 Common shareholders are the residual
interest owners; that is, they own everything
that is left after all other obligations have
been fulfilled.
 Balance sheet disclosure includes:
1. Capital contributions
2. Earnings and dividends
3. Accumulated other comprehensive income
4. Treasury share transactions
 Issuing Capital Stock
1. Issue for Cash.
2. Issue for non-cash Assets.
3. Issue under Option Arrangements.
4. Employee Stock Option Plans.
5. Stock Rights.
6. Stock Warrants.
7. Convertible Bonds or Preferred Stock.
Capital Contributions -- Issue for Cash
 A firm needing financing may issue new shares of
stock. In return for the shares, the firm gets cash.
 This is not disadvantageous to previous owners of
shares because even though ownership goes up, the
total assets go up.
 For historical and legal reasons, the increase in equity
is separated into an increase in common stock at par
and the remainder, an increase in additional paid-in
capital.

Cash 100,000
Common stock ($10 par) 10,000
Additional P.I.C. 90,000
 Capital Contributions
-- Issue for Non-Cash Assets
 A firm may find it desirable to trade stock for
an asset other than cash.
 In this case, the question is what is the value
of the transactions?
 We look first to a reliable market based value
of the asset and record that stock and the
asset at this price. If the value of the asset is
hard to measure, we may take the market
value of the stock instead.
Capital Contributions -- Issued Under
Options Arrangements
 Firms sometimes give stock at reduced
prices or free in exchange for goods or
services or as compensation.
 Top management is often compensated
in stock or stock options so that they
will have strong incentives to make
decisions which will increase the price
of shares.
 Employee Stock Option Plans
 A stock option is a contract that allows the holder to buy
a stated number of shares of stock for a fixed price,
called the exercise price. If the market price is above
the exercise price, then the option have value.
Otherwise, the holder will just ignore the option and it
has no value.
 On the grant date, the firm transfers options to an
employee, for free or a reduced price.
 The employee typically cannot sell the stock
immediately but must wait until the vesting date.
 When the employee does buy shares of stock using the
option (to get the lower price), this is called exercising
the option.
Employee Stock Option Plans (cont.)
 How do you value an option? If the price of the stock
falls, it is valueless. If the price goes up, then the
amount of increase is the value.
 One cannot know the ultimate value until the exercise
date.
 Two GAAP methods:
– Market Value Method.
– APB Opinion 25 Method.
 Firms have argued (under APB 25) that if the exercise
price is above the current stock price, then the option
has no value and requires no recording.
 Define Stock Rights.
 Like stock options, stock rights give the holder
the right to acquire shares at a specified price.
– Stock Options are generally granted to employees
and cannot be transfer until vested.
– Stock Rights are generally granted to current
shareholders who can trade them in secondary
public markets.
 GAAP ignore any value inherent in the stock
right on the date of the grant and make no
entry when granted. Of course, the exercise of
a stock right is recorded like the sale of shares.
 Why issue stock warrants?
 Firmsissue stock warrants to the
investing public for cash.
 Whensold, the warrants are recorded in
a manner similar to a liability.
 When warrant holders exercise their
rights, the firm records the transaction
like the sale of stock except that the
warrant account created when granted
is reduced.
 Convertible Security
 A convertible security may be exchanged at
the holders option for another security.
 For example, a convertible bond may be
exchangeable for a share of common stock.
 This feature allows the holder to choose the
option that has the greater benefit and is a
desirable feature.
 Convertible securities are recorded as regular
securities until they are converted.
 Corporate Distributions
 A dividend is the distribution of assets to the
owners.
 The amount of any dividend may be limited
by statue or by contract.
 Three forms of dividends:
– Cash dividends.
– Stock dividends.
– Stock splits.
 A company may repurchase its own stock as
treasury stock.
 Restrictions on Dividends
1. Legal limits on dividends -- statutory
some states limit the payment of dividends: they
are not allowed if retained earnings were to be
forced to below zero.
2. Legal limits on dividends -- contractual
contracts with debtors or others may further
restrict the payment of dividends.
3. Dividends and corporate financial policy
4. Accounting for dividends
a. cash dividends c. stock dividends
b. property dividends d. stock splits
 How to Record Cash Dividends
a. Cash dividends -- dividends paid in cash
– When dividends are declared, they give rise to a liability
and a reduction in retained earnings Dividends of $150,00
are declared. Please Record.

Retained earnings 150,000

Dividends payable 150,000
– When the cash is sent out, the liability is
fulfilled

Dividends payable 150,000

Cash 150,000
How to Record Non-Cash Dividends
b. Property dividends -- dividends paid in assets other
than cash. A non-cash dividend of $150,00 is
declared. Please record.
– The accounting is similar to cash dividends except when
the dividend is paid, the credit is to the asset rather than
to cash.

Dividends payable 150,000

Asset 150,000
 Dividends in Stock
c. Stock dividends
 Technically this is a dividend paid in new shares of
stock and not general dividends.
 However the term is often used to refer to all kinds
of dividends including cash dividends in the sense of
“dividends on stock” rather than “dividends paid in
stock.”
 Retained earnings are reduced (debited) and
common stock and a.p.i.c. are increased (credited).
 The effect of this is to move equity from retained
earnings to common stock and a.p.i.c.
 Stock Splits
d. Stock splits or split-ups
 Theoretically this is just a large stock dividend.
 It has long been debated whether there is any
difference between a stock dividend and a stock split
other than the size.
 GAAP does consider the two different and requires a
different accounting treatment for stock splits.
 Specifically, no journal entry is required for a stock
split.
 Many believe that a stock split will result in an
increase in the market price of the shares. Empirical
evidence seems to support this, but a causal
relationship has not been established.
 Stock Repurchase
 Treasury shares are common shares that have
been repurchased by the firm.
 Treasury shares are not assets or
investments.
 Instead, they are a reversal of the issuance of
common shares.
 Recall that when stock was issued, the firm
received cash and issued stock:

Cash 100,000
Common stock ($10 par) 10,000
Additional P.I.C. 90,000
 Treasury Shares
 The purchase of treasury shares is the reverse of the
issuance; the firm gives up cash and gets back the shares:

Treasury shares (cost) 110,000

Cash 110,000
 Treasury shares are recorded at cost and kept in a
separate account so that the firm can more easily resell
them, if they desire.
 Treasury shares are a contra account to the shareholders’
equity section.
 Treasury shares do not receive cash dividends or vote.
They may split or receive dividends in stock.
 Treasury Shares (Cont.)
 If treasury shares are later resold, there is no
gain or loss on the sale.
 Rather any difference increases or decreases
the additional paid in capital account.

Cash 14,000
Treasury shares (cost) 11,000
Additional p.i.c. from
sale of treasury shares 3,000
 Reporting Earnings Transactions

 The term Earnings has no precise definition.

It is used to refer to profits in a general
sense but not a technical sense. It is often
used as a broader view of profit which might
include changes in economic wealth not
captured by net income.
 NetIncome is a measure of earnings using
accrual accounting methods as defined by
GAAP.
 Reporting Earnings Transactions

 Earningsand net income are gauges of

the operating activities of the firm.
 We assume that investors desire earnings
information so that they can forecast
future cash flows as input to their
investment decision.
Reporting Earnings Transactions

 Reporting earnings transactions

– Recurring/nonrecurring and central/peripheral
– Measurement of earnings effect
– Classification in the income statement
– Unrealized gains and losses from changes in
market values…
– An international perspective
 Comprehensive income
 Recurring/Nonrecurring
and Central/Peripheral
 Recurring/nonrecurring refers whether
earnings can be expected to repeat in the
future.
 Central/peripheral refers to how closely
earnings are related to the core activities of
the firm. The firm may be more efficient in
core activities than in peripheral activities.
Sometimes the term core competencies is
used.
 Measurement of Earnings Effect
 Revenues and expenses result from recurring primary
activities of the firm.
 Gains and losses result from either peripheral or
nonrecurring activities.
 Revenue and gains result in increases in shareholders’
equity.
 Expenses and losses result in decreases in shareholders’
equity.
 Revenues and expenses are gross concepts in that
nothing is subtracted.
 Gains and losses are net concepts in that a cost basis is
subtracted from an inflow in defining the gain or loss.
 Discuss Classification
 Earnings from continuing operations are revenues, gains,
expenses and losses from activities of the firm that can
be expected to continue in the near future.
 Earnings, gains and losses from discontinued operations
are separate reports of activities that will be
discontinued in the near future.
 Extraordinary gains and losses are gains and losses from
events which are both
– Unusual in nature, and
– Infrequent in occurrence.
 Adjustments for changes in Accounting Principles are
disclosures of the effects of a change in the use of
accounting rules.
Unrealized Gains and Losses from
Changes in Market Values
 The FASB has increasingly required firms
to report certain assets and liabilities at
their current market values:
– Inventories at lower of cost or market
– Plant assets and intangibles at current
market value when asset impairment has
occurred
– Financial instruments including derivatives at
market value
– Marketable equity securities at market value
Unrealized Gains and Losses from
Changes in Market Values (Cont.)
 When an asset (or liability) account is changed to
market value, double entry accounting systems require
an offset.
 The offset is generally to an unrealized gain or loss.
 Unrealized means that the gain or loss was not the
result of an economic transaction, but rather a market
adjustment.

Marketable securities nnn

Unrealized gain (or loss) nnn
 What is the nature of the unrealized gain or loss
account?
Unrealized Gains and Losses from
Changes in Market Values (Cont.)
 The unrealized gain or loss account is part of
earnings because it changes the wealth of the
firm.
 It may or may not be part of net income
depending of the accounting rules.
 Unrealized gains or losses may be closed at the
end of the accounting period and appear on the
income statement.
 Or they may bypass the income statement and
appear on the balance sheet.
 Earnings Per Share
 Publicly traded firms must show earnings-per-
share data in the body of the income
statement.
 Earnings per common share is net earnings
divided by the average number of
outstanding common shares.
 Firms that report more than one of the four
categories of earnings must disclose earnings
per common share for each category.
 Earnings Per Share

 Securities(such as preferred shares) that

are convertible into common shares
complicate the meaning of this number.
This is an advanced accounting topic.
Disclosure of Changes in Shareholders’
Equity
 Annual reports must explain the changes in all
shareholders’ equity accounts.
 For retained earnings, this means that a
reconciliation must be presented. This
reconciliation may be in the income statement,
the balance sheet or as a separate statement.
 Also, this means that other comprehensive
income accounts must also be reconciled.
An International Perspective – Capital
Contributions
 Accounting for shareholders’ equity is
similar the world over.
 Foreign financial statements often use
the term reserve in the equity section to
show a restriction on equity.
 U.S. GAAP discourages the use the the
word reserve because it may seem to
some that there is a cash or asset fund
available -- there is not.
 An International Perspective --
Earnings
 Almost all industrial countries require income
statements.
 The format and classification of earnings items on those
income statements vary.
 Revenue and expense recognition rules may vary in
detail but most countries require a form of accrual
accounting rather than cash basis.
 The nature of what can by-pass the income statements
may vary.
 A few countries require inflation adjustments to items
on the income statement.
 Chapter Summary
 This chapter has presented issues in
accounting for earnings and its effect on
shareholders equity.
 Careful distinctions were made between
results of operations and other changes in
the firms’ wealth.
 These distinctions are presented as separate
parts of the income statement.
 The shareholders’ equity section is likewise
divided into different sections reflections
distinctions among sources of capital.
 Appendix 12.1: Effects on Cash Flows
of Transactions Involving Shareholders’
Equity
 Capital contributions (including cash received
from the issuance of stock options or warrants
and treasury stock transactions) are a source of
cash in the financing section.
 The conversion of convertible securities into
common stock is a financing activity but is not
reported unless it does not involves cash.
 Dividends are use of cash in the financing
section.
 Rapid Review – Yes No
1. Claims against assets after settling all
liabilities can be called residual interest.

2. A stock option allows the holder to

buy a stated number of shares of stock
for the market price.

3. Treasury shares are common shares

that have been repurchased by the firm.