Chapter 9

Sources of Capital:
Owners’ Equity

McGraw-Hill/Irwin Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

 Principal Legal Forms of
Business

• Sole proprietorship. 80% of businesses,

but only 10% of total
• Partnership. business revenue

• Corporation. Only 20% of businesses, but

90% of total business revenue

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 Sole Proprietorship

 Simple, inexpensive to setup.

 Owned by an individual.
 Not legally separate from the owner.
 Difficult to raise large amounts of capital.
 Owner is personally responsible for
entity’s debts.

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 Partnership

 Same features as sole proprietorship

except owned by two or more
partners.
 Limited partnerships.
 Managed by general partner who has
unlimited liability.
 Other partners have limited liability.

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 Corporation

 Artificial legal entity (therefore, taxed).

 Perpetual existence.
 Legal liability on corporation, not
shareholders.
 Empowered by state.
 Easiest form to raise capital.

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 Disadvantages of Corporation over
Sole Proprietorship or Partnership
• Incorporation costs.
• Activities limited to those granted in charter.
• Additional regulations and requirements.
• Must get permission from each state in which
it operates.
• Double taxation (i.e., corporation is taxed and
dividends are taxable income to shareholders).

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 Public vs. Private
Corporations
 Public corporation:
 Shares traded.
 Regulated by Securities and Exchange
Commission (SEC).
 Private corporation:
 Not publicly traded.
 Usually tightly held (e.g., few individuals,
family owned).
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 Proprietorship Equity

 Capital account.
 Drawing account (optional).
 Withdrawals → salary vs. return of profit.

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 Partnership Equity

 Separate capital account for each

partner.
 Partnership agreement defines split of
profits among partners.
 May indicate salaries, share of residual
profits, % of interest on capital, etc.
 If not indicated, divided equally.

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 Ownership in a Corporation
 Stock certificate.
 Evidence of ownership.
 Corporate charter.
 Filed with state.
 Indicates classes of stock and maximum
number of shares allowed to issue.
 Owners’ equity.
 Also called shareholders’ equity or
stockholders’ equity.
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 Preferred Stock

 Pays stated dividend on face (par) value.

 Dividend is not tax deductible (as is
interest expense paid to creditors).
 In event of liquidation, are after creditors
but before common shareholders.

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 Features of Preferred Stock
 Cumulative preferred.
 Current and past dividends (i.e., in arrears) must
be paid before common dividends can be paid.
 Convertible preferred.
 Convertible into a specified number of common
shares.
 Redeemable preferred.
 May be redeemed by investor on or after a
certain date (price usually higher than par value).
 Must be shown under liabilities on balance sheet.
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 Common Stock

 Residual interest in net assets after

creditors and preferred shareholders.
 Par or stated value usually a nominal
amount (basically meaningless today).
 Book value of common stock.
 Total common shareholders’ equity.
 Paid-in capital.
 Retained earnings.
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 Shareholders’ Equity
 Paid-in capital.
 Common stock (at par or stated value).
 Additional paid-in capital (i.e., proceeds
above par value).
 Retained Earnings.
 Cumulative net income earned since
inception of company (less cumulative total
dividends paid).
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 Issuing Stock
 Issuance costs.
 E.g., investment banker, legal, auditing,
printing.
 Reduces Additional paid-in capital amount.
 Sales after issuance.
• No effect on company accounts.
• Corporation notes change of owners.

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 Treasury Stock
• Corporation’s own issued stock that has been
reacquired.
• Reasons to reacquire own stock:
– Needed for acquisitions, bonus plans, exercise of
warrants, conversion of bonds/preferred stock.
– Limited investment opportunities.
– Increase earnings per share (which can increase
market price of stock).
– Prevent hostile takeover.
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 Accounting for Treasury Stock
 Cost method (simpler method):
 Debit “Treasury Stock” at acquisition.
 Not an asset.
 No voting, no dividends, no shareholder rights.
 Shown as a reduction of shareholders’ equity.
 If reissued above cost, increase paid-in
capital from treasury stock.
 If reissued below cost, decrease paid-in
capital from treasury stock (if has balance) or
retained earnings.
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 Appropriation of Retained
Earnings
 Indicates retained earnings restricted for a
specific purpose (thus, not available for
dividends).
 Has no effect on financial position of
corporation.
 Does not reduce total retained earnings.
 Has no affect on cash.
 The retained earnings account balance is
unrelated to the cash account balance.
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 Cash Dividends
• Declaration date.
• Declared by board of directors.
• Create liability (i.e., Dividends Payable).
 Date of record.
 No entry.
 Determine who is entitled to dividend.
 Payment date.
• Pay out cash, eliminate liability.
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 Stock Split
 Each shareholder receives a multiple of
shares previously held (e.g., two-for-one
split).
 No change in total shareholders’ equity
(only proportional adjustment to par value).
 No change in a shareholder’s proportional
interest in corporation.
 Why done? Reduce stock price to make it
more appealing to investors.
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 Stock Dividends
 Every shareholder receives a percentage of
additional shares (e.g., 10% stock dividend).
 Increases number of shares outstanding, but
not proportional interest in corporation.
 Recorded at market value of shares
distributed.
 If the stock dividend is greater than 20-25%, is
basically treated as a stock split.

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 Spin-offs

• Company owns shares of another

company (usually a subsidiary) that it
distributes to shareholders.
• Accounting is similar to a cash dividend
except reduction is to the Investments
asset account (instead of Cash).

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 Warrants

• The right to purchase shares of common

stock at a stated price within a given
time period.
• Negotiable (can be bought and sold).

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 Stock Options

• Same as a warrant, but not negotiable.

• GAAP requires fair value based method.
– Expense fair value of options over their
vesting period.
• Once vested, option can be exercised
even if employee leaves the company.

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 Employee Stock Ownership
Plan (ESOP)
• A program of setting aside stock for
benefit of employees as a group.
• Contributions to plan are tax deductible
to corporation.
• Plan is a separate entity (thus, assets do
not appear on balance sheet, but are
disclosed in notes).
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 Earnings Per Share (EPS)

 Shown on income statement.

 FASB and IASB requires reporting of:
 Basic earnings per share (EPS), and
 Diluted earnings per share (EPS).

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 Basic EPS
Net income available to
common shareholders
Basic EPS =
Weighted average number of
common shares outstanding

 Numerator:
 Net income – preferred dividends.
 Denominator:
 Treasury stock is not considered outstanding.

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 Diluted EPS
 Basic EPS adjusted for potential dilution.
 Effects of convertible securities, stock options, stock
warrants.
 Convertible securities: if-converted method.
 Assume convertible securities were converted to
common stock at beginning of year.
 Stock options/warrants: treasury stock method.
 Assumes options/warrants are exercised and cash
received is used to purchase its stock at the average
stock price during the period.
 Net result with number of shares from exercise of
options/warrants.
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 Equity in Nonprofit
Organizations
• Capital contributions:
• Endowment.
• Contributions whose principal is to be kept intact.
• Earnings on principal are available to finance current
operations.
• Contributed plant.
• Contributed assets (e.g., buildings) or funds to acquire
assets.
• Operating contributions are revenue, not
contributed capital.
• Operating equity, rather than retained
earnings.
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