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L WRITING ASSIGNMENT
My Contract s Bigger Than Your Contract!
You are an agent for professional athletes. One of your clients is a superstar
in the NBA. Last month you negotiated a new deal for your client that pays
him $22 million per year for each of the next six years. Your client was very
pleased with this $132 million contract, especially because it was a bigger con-
tract than any of the other players on his team received.
This morning, while you were relaxing in your Jacuzzi, you got an angry
cellular call from your client. It seems that one of his teammates just signed a
$150 million deal, paying him $15 million per year for each of the next 10 years.
Your client is outraged because you guaranteed that no one on his team would
be receiving a bigger contract this season. Your client has threatened to ter-
minate his agreement with you and also to spread the word among all his
friends that you are not trustworthy.
Write a one-page memo to your client explaining that the actual value of
his $132 million contract is greater than the $150 million contract signed by his
teammate. Your client has a marketing degree from an ACC school, so he has
had some exposure to the concept of the time value of money.
L




THE DEBATE
Which is the Better Way to Borrow Bank Loan or Bonds?
When a major corporation is seeking to borrow a large sum of money, it can
choose to arrange a loan through a single bank (or group of banks), or it can
issue bonds and essentially borrow the money from the public.
Divide your group into two teams.
One team represents Bank Loans. Prepare a two-minute oral presenta-
tion arguing that the best way for a major corporation to borrow money is
through bank loans negotiated directly with a single bank or group of banks.
The other team represents Bonds. Prepare a two-minute oral presenta-
tion arguing that bonds offer the best way for a major corporation to bor-
row a large sum of money.
L




CUMULATIVE SPREADSHEET PROJECT
This spreadsheet assignment is a continuation of the spreadsheet assignments
given in earlier chapters. If you completed those spreadsheets, you have a head
start on this one.
1. Handyman wishes to prepare a forecasted balance sheet and income state-
ment for 2004. Use the original financial statement numbers for 2003 [given
in part (1) of the Cumulative Spreadsheet Project assignment in Chapter 2]
as the basis for the forecast, along with the following additional informa-
tion:
a. Sales in 2004 are expected to increase by 40% over 2003 sales of $700.
b. Cash will increase at the same rate as sales.
c. The forecasted amount of accounts receivable in 2004 is determined
using the forecasted value for the average collection period. For sim-
plicity, do the computations using the end-of-period accounts receiv-
507
f508 Long-Term Debt Financing
Part 3 CEO Investing and Financing Activities




able balance instead of the average balance. The average collection pe-
riod for 2004 is expected to be 14.08 days.
d. The forecasted amount of inventory in 2004 is determined using the
forecasted value for the number of days sales in inventory (computed
using the end-of-period inventory balance). The number of days sales
in inventory for 2004 is expected to be 107.6 days.
e. The forecasted amount of accounts payable in 2004 is determined us-
ing the forecasted value for the number of days purchases in accounts
payable (computed using the end-of-period accounts payable balance).
The number of days purchases in accounts payable for 2004 is ex-
pected to be 48.34 days.
f. The $160 in operating expenses reported in 2003 breaks down as fol-
lows: $5 depreciation expense, $155 other operating expenses.
g. See item (l) for the assumption concerning the amount of new long-
term debt that will be acquired in 2004.
h. No cash dividends will be paid in 2004.
i. New short-term loans payable will be acquired in an amount sufficient
to make Handyman s current ratio in 2004 exactly equal to 2.0.
j. The forecasted amount of property, plant, and equipment (PP&E) in
2004 is determined using the forecasted value for the fixed asset
turnover ratio. For simplicity, compute the fixed asset turnover ratio us-
ing the end-of-period gross PP&E balance. The fixed asset turnover ra-
tio for 2004 is expected to be 3.518 times.
k. In computing depreciation expense for 2004, use straight-line depreci-
ation and assume a 30-year useful life with no residual value. Gross
PP&E acquired during the year is depreciated for only half the year. In
other words, depreciation expense for 2004 is the sum of two parts: (1)
a full year of depreciation on the beginning balance in PP&E, assum-
ing a 30-year life and no residual value and (2) a half-year of depreci-
ation on any new PP&E acquired during the year, based on the change
in the gross PP&E balance.
Note: These statements were constructed as part of the spreadsheet as-
signment in Chapter 9; you can use that spreadsheet as a starting point if
you have completed that assignment. Clearly state any additional as-
sumptions that you make.
For this exercise, add the following additional assumptions:
l. New long-term debt will be acquired (or repaid) in an amount sufficient
to make Handyman s debt ratio (total liabilities divided by total assets)
in 2004 exactly equal to 0.80.
m. Assume an interest rate on short-term loans payable of 6.0% and on
long-term debt of 8.0%. Only a half year s interest is charged on loans
taken out during the year. For example, if short-term loans payable at
the end of 2004 are $15 and given that short-term loans payable at the
end of 2003 were $10, total short-term interest expense for 2004 would
1
be $0.75 [($10 0.06) ($5 0.06 /2)].
Clearly state any additional assumptions that you make.
2. Repeat (1), with the following changes in assumptions:
a. The debt ratio in 2004 is exactly equal to 0.70.
b. The debt ratio in 2004 is exactly equal to 0.90.
508 f509
Long-Term Debt Financing CEO Chapter 10
Long-Term Debt Financing




3. Prepare a table displaying the forecasted values of long-term debt and paid-
in capital in 2004 under each of the following assumptions about the debt
ratio: 0.70, 0.80, and 0.90. The sum of these two items can be viewed as
the total amount of long-term financing (both debt and equity) received
from outsiders. Comment on why the total of these two items is not the
same under each debt ratio assumption.
L


INTERNET SEARCH
Disney
The history of DISNEY was outlined at the beginning of the chapter. Access
Disney s Web site at http://www.disney.com. Sometimes Web addresses
change, so if this Disney address doesn t work, access the Web site for this
textbook (http://albrecht.swcollege.com) for an updated link to Disney.
Once you ve gained access to Disney s Web site, answer the following ques-
tions:
1. Disney s home page offers a link to a site promoting Disney s current
movies. What movie is currently featured at that site?
2. Use Disney s link to its international operations in France to see if you can
find the Web site for Disneyland Paris. What is the Web address? Is the site
in English or in French?
3. If you wish to enroll in Disney s direct stock purchase plan, meaning that
you will buy ownership shares from Disney itself rather than going through
a stockbroker, what is the minimum amount you must invest?
4. According to Disney s most recent statement of cash flows, how much new
borrowing did Disney do in the most recent year? How much was spent to
repay loans in the most recent year?
Equity Financing

chapter



11
f11
learning objectives After studying this chapter, you should be able to:

income in the equity section
1 Distinguish between debt and 3 Account for the issuance and 7 Explain prior-period
of the balance sheet, and
equity financing, and describe repurchase of common and adjustments and prepare a
prepare a statement of
the advantages and preferred stock. statement of retained
stockholders equity.
disadvantages of organizing a earnings.
4 Understand the factors that
business as a proprietorship affect retained earnings,
8 Understand basic
or a partnership. describe the factors proprietorship and
determining whether a
2 Describe the basic partnership accounting.
company can and should
characteristics of a
pay cash dividends, and
corporation and the nature
6 Account for stock dividends
account for cash dividends.
of common and preferred and distinguish them from
stock. 5 Describe the purpose of stock splits.
reporting comprehensive
510 chapter f11
Equity Financing


In 1882, two young newspaper reporters, Jones is best known because of the Dow
Charles Dow and Edward Jones, teamed Jones Industrial Average that is cited in
up to provide the Wall Street financial the news every day. The Dow is widely
community with handwritten news bul- used to reflect the general health of the
letins. In 1889, when the staff of DOW U.S. economy. So, what is it? Simply put,
JONES & COMPANY had grown to 50, the Dow Jones Industrial Average mea-
they decided to convert the bulletin service sures the average movement of the stock
into a daily newspaper. The first issue of prices of selected U.S. companies. The
The Wall Street Journal appeared on July very first value of the average was 40.94
8, 1889. Clarence Barron, who operated a on May 26, 1896. Charles Dow computed
financial news service in Boston, was the this value by adding the share prices of 12
paper s first out-of-town reporter. Barron important companies chosen by him
purchased Dow Jones & Company in 1902 (GENERAL ELECTRIC was one of them)
for $130,000, and his heirs still hold ma- and then dividing by 12. Thus, the aver-
jority control of the company today. age price per share for these 12 compa-
In the 1940s, The Wall Street Journal nies was $40.94. Since 1928, the average
began publishing more than just business has included 30 companies selected by
the editors of The Wall Street Journal. The
news, expanding its coverage to include
economics, politics, and general news. To- average is no longer computed by simply
day, The Wall Street Journal has a paid cir- averaging share prices, but the underlying
culation of 1.8 million and is read by an es- concept remains the same. Changes in the
timated 4.9 million people every day. Dow companies included in the average are
Jones also publishes The Wall Street Jour- rare. Nevertheless, since 1990, 11 compa-
nal Europe and The Asian Wall Street Jour- nies have been replaced to reflect the de-
nal, and each day it contributes special creasing importance of manufacturing in
business pages to 23 Spanish and Por- the U.S. economy. For example, BETHLE-
tuguese language newspapers in Latin HEM STEEL, which had been in The
American countries. The Wall Street Jour- Dow since 1928, was replaced in March
nal is also a leader in Web-based news, 1997 by WAL-MART. In 1999, the first two
with more than 500,000 paid subscribers NASDAQ companies were added to The
setting the stage
for http://wsj.com as of September 30, D o w MICROSOFT and INTEL. The 30
2000. This is particularly impressive in that companies included in the average as of
the public is accustomed to getting infor- October 16, 2000, are listed in Exhibit 11-1.
mation for free on the Web. The 30 companies in the average are listed
The Wall Street Journal is the flagship every day in The Wall Street Journal, of-
ten on page C3.1
of the company, but the name Dow




DOW JONES & COMPANY is an appropriate symbol of capitalism a corporation that has done
business in and around the spiritual heart of capitalistic finance, the New York Stock Exchange, for
over one hundred years. With the disintegration of the former Soviet Union and the rapid conver-
sion of China into a socialist market economy, it seems that the economic battle of capitalism and
communism has been won by capitalism. As the history of many of the companies profiled in earlier
chapters (MICROSOFT, SEARS, YAHOO!, GENERAL ELECTRIC) illustrates, the true story of
capitalism is not the story of rich capitalists exploiting the masses, but rather the story of unknown
individuals using a free market to find outside investor financing that will turn their ideas into re-
ality. Accounting for investor financing is the topic of this chapter.
This is the second chapter on financing activities. In the previous chapter, financing through bor-
rowing (debt) was discussed. Another way organizations raise money to finance operations is from in-
vestments by owners. In corporations, those investments take the form of stock purchases. In propri-
etorships and partnerships, they take the form of capital investments in the business. Exhibit 11-2
shows the financial statement items that will be covered in this chapter.

1 This description is based on information obtained from Dow Jones & Company History at http://dowjones.com;
Dow Jones & Company, International Directory of Company Histories, vol. 19 (Detroit: St. James Press, 1998), pp.
128 131.
511
f512 Part 3 Equity Financing
Investing and Financing Activities



The 30 Firms Included in the Dow Jones Industrial Average
exhibit 11-1
(as of October 16, 2000)




Aluminum Co.
General Electric Co. McDonald™s Corp.
of America

General Motors Corp. Merck & Co.
American Express Co.

Microsoft
Hewlett-Packard Co.
AT&T Corp.

Minnesota Mining &
CO K E Home Depot
Boeing Co.
Manufacturing Co.

Philip Morris Cos.
Caterpillar, Inc. Honeywell

Procter & Gamble Co.
Citigroup, Inc. Intel

International Business
SBC Communications
Coca-Cola Co. Machines Corp.

International Paper Co.
DuPont Co. United Technologies Corp.

J. P. Morgan & Co.
Eastman Kodak Co. Wal-Mart Stores, Inc.

ExxonMobil Corp. Johnson & Johnson Walt Disney Co.




Financial Statement Items Covered in This Chapter
exhibit 11-2



Statement of
Balance Sheet
Cash Flows
Stockholders™ equity
Financing activities
Contributed capital
Sale of stock
Retained earnings
Purchase of
Treasury stock
treasury stock
Payments of
dividends
512 f513
Equity Financing Chapter 11
Equity Financing


Certain basic characteristics are common to all investor financing, no matter what the form of
business. The first is that owner investments affect the equity accounts of the business. Second, together
with the liabilities, these owners equity accounts show the sources of the cash that was used to buy
the assets. There are three primary ways to bring money into a business: borrowing (debt financing),
selling owners interests (equity financing), and earning profits (also reflected in the equity accounts
through the retained earnings account).
In the first part of this chapter, we illustrate the accounting for equity financing in the context
of corporations. In the expanded material section of the chapter, we show how equity financing is ac-
counted for in proprietorships and partnerships.


1 RAISING EQUITY FINANCING
Distinguish between debt
Most business owners do not have enough excess personal cash to establish and expand their
and equity financing, and
describe the advantages companies. Therefore, they eventually need to look for money from outsiders, either in the form
and disadvantages of
of loans or as funds contributed by investors. The business issues associated with investor fi-
organizing a business as a
nancing are summarized in the time line in Exhibit 11-3.
proprietorship or a
partnership. The factors affecting the choice between borrowing and seeking additional investment funds
are described in this section of the chapter. This section also outlines the advantages and disad-
vantages of organizing a business as a proprietorship or a partnership. The decision to incorporate
and the process that a corporation follows in soliciting investor funds are described in the next sec-
tion. The bulk of the chapter is devoted to the accounting procedures used to give a proper re-
porting of stockholders equity to the investors. Of course, proper financial reporting to current
and potential investors is one of the primary reasons for the existence of financial accounting.

Difference between a Loan and an Investment
Imagine that you own a small business and need $40,000 for expansion. What is the difference
between borrowing the $40,000 and finding a partner who will invest the $40,000? If you bor-
row the money, you must guarantee to repay the $40,000 with interest. If you fail to make these
payments, the lender can haul you into court and use the power of the law to force repayment.
On the other hand, if your company does very well and you generate more than enough cash
to repay the $40,000 plus interest, the lender does not get to share in your success. You owe
the lender $40,000 plus interest and not a penny more. So, a loan is characterized by a fixed,
legal obligation to repay a specified amount, whether the borrowing company performs poorly
or performs well.
If you receive $40,000 in investment funds from a new partner, the partner now shares in
your company s failures and successes. If business is bad and the investor is never able to recover



Time Line of Business Issues Involved with Investor Financing
exhibit 11-3




GENERATE
SOLICIT REPORT
CHOOSE
returns for
investor funds performance
form of
investors to current and
financing
potential investors
513
f514 Part 3 Equity Financing
Investing and Financing Activities


his or her $40,000 investment well, that s the way it goes. The law will not help the in-
fyi
vestor recover the investment because the very nature of an investment is that the investor
The law does not help investors accepts the risk of losing everything. However, in exchange for accepting this risk, the in-
recover lost investment funds vestor also gets to share in the success if the company does well. For example, if you had
unless the investors can show loaned $40,000 to Bill Gates for MICROSOFT s expansion back in 1986, you would
have been repaid the $40,000 plus a little interest. If you had invested that same $40,000
that they were tricked (by false
in Microsoft, however, your investment would have grown in value to $14.4 million by
financial reports, for example)
October 2000. Thus, an investment is characterized by a higher risk of losing your money,
into making the investment.
balanced by the chance of sharing in the wealth if the company does well.

Proprietorships and Partnerships
As explained in Chapter 2, a business can be organized as a proprietorship, a partnership, or a
corporation. These three types of organization are merely different types of legal contracts that
define the rights and responsibilities of the owner or owners of the business. The advantages and
disadvantages of proprietorships and partnerships are discussed below. Corporations are discussed
in the next section.
proprietorship A business A proprietorship is a business owned by one person. A partnership is a business owned
owned by one person.
by two or more persons or entities. In most respects, proprietorships and partnerships are sim-
ilar to each other but very different from corporations. Both a proprietorship and a partnership
partnership An association
are characterized by ease of formation, limited life, and unlimited liability.
of two or more individuals
or organizations to carry on
economic activity.
Proprietorships and partnerships can be formed with few legal for-
EASE OF FORMATION
malities. When a person decides to establish a proprietorship, he or she merely acquires the nec-
essary cash, inventory, equipment, and other assets; obtains a business license; and begins pro-
viding goods or services to customers. The same is true for a partnership, except that because
two or more persons are involved, they must decide together which assets will be acquired and
how business will be conducted.

Because proprietorships and partnerships are not legal entities that are sepa-
LIMITED LIFE
rate and distinct from their owners, they are easily terminated. In the case of a proprietorship,
the owner can decide to dissolve the business at any time. For a partnership, anything that ter-
minates or changes the contract between the partners legally dissolves the partnership. Among
the events that dissolve a partnership are
1. the death or withdrawal of a partner,
2. the bankruptcy of a partner,
3. the admission of a new partner,
4. the retirement of a partner, or
5. the completion of the project for which the partnership was formed.
The occurrence of any of these events does not necessarily mean that a partnership must cease
business; rather, the existing partnership is legally terminated, and another partnership must be
formed.

Proprietorships and partnerships have unlimited liability, which
UNLIMITED LIABILITY
means that the proprietor or partners are personally responsible for all debts of the business. If
a partnership is in poor financial condition, creditors first attempt to satisfy their claims from
the assets of the partnership. After those assets are exhausted, creditors may seek payment from
the personal assets of the partners. In addition, because partners are responsible for one another s
actions (within the scope of the partnership), creditors may seek payment for liabilities created
by a departed or bankrupt partner from the personal assets of the remaining partners. This un-
limited liability feature is probably the single most significant disadvantage of a proprietorship
or partnership. It can deter a wealthy person from joining a partnership for fear of losing per-
sonal assets.
514 f515
Equity Financing Chapter 11
Equity Financing




to summarize
A loan is a fixed, legal obligation to repay a specified amount, whether the bor-
rowing company performs poorly or performs well. With an investment, the
investor risks losing the investment funds if the company performs poorly but
shares in the wealth if the company does well. A proprietorship is a business
owned by one person. A partnership is a business owned by two or more per-
sons. Both types of businesses are easy to start and easy to terminate. A ma-
jor disadvantage of proprietorships and partnerships is the unlimited liability
of the owner or partners.




2 CORPORATIONS AND CORPORATE STOCK
Describe the basic
characteristics of a
Corporations are the dominant form of business enterprise in the United States. Established as
corporation and the nature
separate legal entities, corporations are legally distinct from the persons responsible for their
of common and preferred
stock. creation. In many respects, they are accorded the same rights as individuals; they can conduct
business, be sued, enter into contracts, and own property. Firms are incorporated by the state
corporation A legal entity
in which they are organized and are subject to that state s laws and requirements.
chartered by a state; owner-
ship is represented by
transferable shares of stock. Characteristics of a Corporation
Corporations have several characteristics that distinguish them from proprietorships and part-
nerships. These characteristics are discussed below.

Limited liability means that in the event of corporate bankruptcy, the
LIMITED LIABILITY
limited liability The legal
protection given stockhold- maximum financial loss any stockholder can sustain is his or her investment in the corporation
ers whereby they are re-
(unless fraud can be proved). Because a corporation is a separate legal entity and is responsible
sponsible for the debts and
for its own acts and obligations, creditors usually cannot look beyond the corporation s assets
obligations of a corporation
for satisfaction of their claims. This limited liability feature is probably the main reason for the
only to the extent of their
capital contributions.

Corporations are the domi-
nant form of business in
the United States. As a
corporation, MICROSOFT
is a legal entity, and its
ownership is represented
by transferable shares of
stock.
515
f516 Part 3 Equity Financing
Investing and Financing Activities



business environment essay


1. Issuer conducts bake-off to select underwriter.
Going Public with a Dot.com Company
It used to be that initial public offerings In September 1998, theglobe.com chose BEAR
(IPOs) created millionaires overnight. STEARNS to be the underwriter for its IPO. An un-
Now, with the high values of many high- derwriter guides the company through the IPO
tech start-up companies, IPOs are cre- process.
2. Underwriter benchmarks issuer s financial state-
ating billionaires overnight. For exam-
ments with competitors. Bear Stearns analyzed the-
ple, CORVIS, a provider of all-optical
network switching equipment, went globe.com s financial statements to determine how
public on July 28, 2000. As of that date, the company should be valued in light of the stock
Corvis had not yet reported any revenue prices of other, similar companies that had already
in its history. Nevertheless, favorable expectations gone public.
3. Underwriter sets the preliminary IPO price per
about the company s future potential caused the
share. Based on its analysis of theglobe.com s fi-
shares to trade for $84 per share at the end of the first
day of trading, making the company worth over $20 nancial statements, Bear Stearns determined that
billion on paper. As of the end of the IPO day, founder theglobe.com s shares should be issued at a price
David Huber was personally worth $10 billion. between $11 and $13 per share.
4. Issuer and underwriter hold a roadshow to pro-
The eight steps involved in going public are out-
mote the IPO to large investors. Bear Stearns and
lined below by reference to the IPO of THEGLOBE.COM,
a company that facilitates many online clubs and thus executives from theglobe.com gave a series of pre-
serves as an Internet portal for members of those sentations to large investors to convince them to
clubs. invest in the IPO shares of theglobe.com.




phenomenal growth of the corporate form of business because it protects investors from
fyi
sustaining losses beyond their investments. In most cases of bankruptcy, however, stock-
There are some hybrid organi- holders will lose most of their investment because the claims of creditors must be satisfied
zations that have characteristics before stockholders receive anything.
of both partnerships and corpo-
Shares of stock in a corporation can
EASY TRANSFERABILITY OF OWNERSHIP
rations. For example, several of
be bought, sold, passed from one generation to another, or otherwise transferred without
the large international account-
affecting the legal or economic status of the corporation. In other words, most corpora-
ing firms are organized as lim-
tions have perpetual existence the life of the corporation continues by the transfer of
ited liability partnerships (LLPs).
shares of stock to new owners.
An LLP offers the advantages of
Raising large amounts of cap-
ABILITY TO RAISE LARGE AMOUNTS OF CAPITAL
a partnership structure but also
ital can be easier for a corporation than for a proprietorship or a partnership because a
provides each partner with lim-
corporation can sell shares of its stock. The sale of shares of stock permits many investors,
ited liability for the costs of law-
both large and small, to participate in ownership of the business. Some corporations ac-
suits caused by the actions of
tually have thousands of individual stockholders. In its 1999 annual report, DOW JONES
his or her partners.
& COMPANY reports that it has 15,508 stockholders of record. Because of this wide-
spread ownership, large corporations are said to be publicly owned.
fyi Because corporations are separate legal entities, they are taxed
DOUBLE TAXATION
independently of their owners. This often results in a disadvantage, however, because the
An LLC (limited liability com-
portion of corporate profits that is paid out in dividends is taxed twice. First, the profits
pany) offers the limited liability
are taxed to the corporation; second, the owners, or stockholders, are taxed on their div-
legal protection of a corpora-
idend income.
tion as well as the favorable
Because large corporations may have thou-
CLOSE GOVERNMENT REGULATION
partnership treatment for in-
sands of stockholders, each with only a small ownership interest, the government has as-
come tax purposes.
sumed the task of monitoring certain corporate activities. For example, the government
516 f517
Equity Financing Chapter 11
Equity Financing




5. Underwriter builds a book of tentative orders over the IPO price of $9. This huge first-day price
to see how much interest there is in the IPO. In increase indicates that the founders of
October 1998, a downturn in the market caused theglobe.com could have sold their shares for
some hesitancy among potential investors in more. However, the publicity benefit of having all
theglobe.com s IPO. The price range was lowered of Wall Street clamor to buy shares of
to $8 to $10 per share, and Bear Stearns people theglobe.com stock may more than make up for
called large investors to determine their interest. this cost.
6. Final IPO price is set. The day before the IPO, Bear
Frequently, the initial euphoria surrounding an IPO
Stearns set the final IPO price at $9 per share. This
quickly dissipates and the share price sinks accord-
is the amount (less the Bear Stearns commission)
ingly. For every MICROSOFT, where a share pur-
that the founders of theglobe.com would receive
chased in the IPO for $21 in 1986 was worth $7,560 in
for the shares that they intended to sell as part of
October 2000, there are dozens of less successful IPOs,
the IPO.
such as theglobe.com. As of October 17, 2000, shares
7. IPO shares are issued. On November 13, 1998,
of theglobe.com stock that had traded as high as $97
theglobe.com s shares were issued.
per share on the IPO date were trading for just $1 per
8. Trading begins. As frequently happens with IPO
share.
shares, the price per share skyrocketed during the
first day of trading. During the day on November
13, 1998, shares of theglobe.com stock traded for Source: The IPO Machine: From Start to Finish, The Wall Street
as high as $97 per share, a 928 percent increase Journal, April 14, 1999, p. C1.




requires that all major corporations be audited and that they issue periodic financial statements.
As a result, in certain respects, major corporations often enjoy less freedom than do partnerships
and proprietorships.

Starting a Corporation
Suppose that you want to start a corporation. First, you should study your state s corporate laws
(usually with the aid of an attorney). Then you must apply to the appropriate state official for
a charter. Your application will include the intended name of your corporation, its purpose (that
is, the type of activity it will engage in), the type and amount of stock you plan to have autho-
rized for your corporation, and, in some cases, the names and addresses of the potential stock-
holders. Finally, if the state approves your application, you will be issued a charter (also called
articles of incorporation ), giving legal status to your corporation.
Of course, the primary purpose of forming a corporation is to then sell stock in the cor-
prospectus A report pro-
vided to potential investors poration in order to obtain business financing. If the business you intend to establish will op-
that represents a com- erate across state lines and if you intend to seek investment funds from the general public, then
pany s financial statements
you must register your intended stock issue with the Securities and Exchange Commission in
and explains its business
Washington, D.C. You are required to provide a prospectus to each potential investor; the
plan, sources of financing,
prospectus outlines your business plan, sources of financing, significant risks, and the like. Fi-
and significant risks.
nally, you can sell your shares to the public in what is called an initial public offering (IPO).
stockholders Individuals or
You will receive the proceeds from the IPO, minus the commission charged by the investment
organizations that own a
banker sponsoring the issue.
portion (shares of stock) of
When an investor buys stock in a corporation, he or she receives a stock certificate as evi-
a corporation.
dence of ownership. For convenience, these stock certificates are frequently held by the stock-
board of directors Individu-
broker through whom the investor purchased the shares. The investors in a corporation are called
als elected by the stock-
stockholders, and they govern the corporation through an elected board of directors. In most
holders to govern a corpo-
corporations, the board of directors then chooses a management team to direct the daily affairs
ration.
517
f518 Part 3 Equity Financing
Investing and Financing Activities



business environment essay


Investing in the Stock Market Octo- allow you to buy and sell as many shares as you wish
ber, said Mark Twain, is one of the pe- for less than $10 per trade. For some people, Internet
culiarly dangerous months to speculate stock trading has become the ultimate video game,
in stocks. Others are July, January, Sep- with shooting lasers and fighting ninjas being replaced
tember, April, November, May, March, by stock price charts and the Federal Reserve Board.
June, December, August, and February. This textbook won t make you an expert in picking
Despite Mark Twain s warning, stocks promising stocks. In fact, you should be suspicious of
have always been one of the most pres- any book or investment adviser claiming to have the
tigious and desired investments. These secrets to deciphering the stock market. Here are
days, stock trading is easier than ever. some practical guidelines to help you avoid some of
There are scores of Internet stock trading firms that will the pitfalls when deciding to buy stock:




of the corporation. In smaller companies, the board of directors is usually made up of members
of that management team.
Several types of stock can be authorized by the charter and issued by the corporation. The
most familiar types are common stock and preferred stock, and the major difference between
them concerns the degree to which their holders are allowed to participate in the rights of own-
ership of the corporation.

Common Stock
common stock The most
frequently issued class of Certain basic rights are inherent in the ownership of common stock. These rights are as follows:
stock; usually, it provides a
1. The right to vote in corporate matters such as the election of the board of directors
voting right but is sec-
ondary to preferred stock in or the undertaking of major actions such as the purchase of another company.
dividend and liquidation
2. The preemptive right, which permits existing stockholders to purchase additional shares
rights.
whenever stock is issued by the corporation. This allows common stockholders to main-
tain the same percentage of ownership in the company if they choose to do so.
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3. The right to receive cash dividends if they are paid. As explained later, corporations
Occasionally, a corporation will do not have to pay cash dividends, and the amount received by common stockhold-
have more than one class of ers is sometimes limited.
4. The right to ownership of all corporate assets once obligations to everyone else have
common stock. For example,
been satisfied. This means that once all loans have been repaid and the claims of the
Dow Jones & Company has
preferred stockholders have been met (as discussed below), all the excess assets belong
common stock and Class B
to the common stockholders.
common stock. Each Class B
share gets 10 votes in corporate In essence, the common stockholders of a corporation are the true owners of the busi-
matters, and most of the Class ness. They delegate their decision-making authority to the board of directors, who in turn
B shares are owned by the de- delegate authority for day-to-day operations to managers hired for that purpose. Thus, a
distinguishing characteristic of business ownership as a common stockholder of a corpo-
scendants of Clarence Barron.
ration is a clear separation between owning the business and operating the business.

Preferred Stock
The term preferred stock is somewhat misleading because it gives the impression that pre-
preferred stock A class of
stock that usually provides ferred stock is better than common stock. Preferred stock isn t better; it s different. A good way
dividend and liquidation to think of preferred stock is that preferred stockholders give up some of the ownership rights
preferences over common
of the common stockholders in exchange for some of the protection enjoyed by lenders.
stock.
In most cases, preferred stockholders are not allowed to vote for the corporate board of di-
rectors. In addition, preferred stockholders are usually allowed to receive only a fixed cash div-
idend, meaning that if the company does well, preferred stockholders do not get to share in the
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Equity Financing




1. Do not make hasty, emotional decisions about buy- 5. Don t invest in stocks unless you can afford to lose
ing and selling stocks. the money you invest or at least have no access to
2. Do not fall in love with stocks so that you are no it for a long time.
longer objective in appraising them. 6. Plan to hold your stock investments for a long time.
3. Remember, you will seldom, if ever, buy stocks at Most stock market millionaires were not specula-
their lowest price and sell them at their highest tors, and commissions on frequent sales and pur-
price. chases will eat up your short-term gains.
4. There are stock market fads, so when you buy at
the height of a stock s popularity, you almost al- Source: W. S. Albrecht, Money Wise (Salt Lake City, Utah: Deseret
ways pay too much. Book Company, 1983), pp. 134 139.




success. In exchange for these limitations, in the event that the corporation is liquidated, pre-
ferred stockholders are entitled to receive their cash dividends and have their claims fully paid
before any cash is paid to common stockholders.
Preferred stock may also include other types of privileges, the most common of which is
convertibility. Convertible preferred stock is preferred stock that can be converted to common
convertible preferred stock
Preferred stock that can be stock at a specified conversion rate. For example, the notes to MICROSOFT s 1999 financial
converted to common stock statements (see Appendix A) reveal that the investors who purchased 12.5 million shares of Mi-
at a specified conversion
crosoft convertible preferred stock in December 1996 were able to exchange those preferred
rate.
shares (if they wish) for Microsoft common stock beginning in December 1999. Convertible
preferred stock can be very appealing to investors. They can enjoy the dividend privileges of the
preferred stock while having the option to convert to common stock if the market value of the
common stock increases significantly. By issuing shares of stock with varying rights and privi-
leges, companies can appeal to a wider range of investors.




to summarize
A corporation is a business entity that has a legal existence separate from that
of its owners; it can conduct business, own property, and enter into contracts.
The five major features of a corporation are (1) limited liability for stockhold-
ers, (2) easy transferability of ownership, (3) the ability to raise large amounts
of capital, (4) separate taxation, and (5) for large corporations, closer regula-
tion by government. Common stock confers four basic rights upon its owners:
(1) the right to vote in corporate matters, (2) the right to maintain proportion-
ate ownership, (3) the right to receive cash dividends, and (4) the ownership
of all excess corporate assets upon liquidation of the corporation. Preferred
stock typically carries preferential claims to dividend and liquidation privileges
but has no voting rights.




3 ACCOUNTING FOR STOCK
Account for the issuance
In this section we focus on the accounting for the issuance of stock as well as the accounting
and repurchase of common
and preferred stock. for stock repurchases.
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Investing and Financing Activities



Issuance of Stock
Each share of common stock usually has a par value printed on the face of the stock certificate.
par value A nominal value
assigned to and printed on For example, the common stock of DOW JONES & COMPANY has a $1 par value. This par
the face of each share of a
value has little to do with the market value of the shares. In October 2000, each Dow Jones
corporation s stock.
common share with a $1 par value was selling for about $55 per share. When par-value stock
sells for a price above par, it is said to sell at a premium. In most states it is illegal to issue stock
for a price below par value. If stock were issued at a discount (below par), stockholders could
later be held liable to make up the difference between their investment and the par value
fyi of the shares they purchased. The par value multiplied by the total number of shares out-
standing is usually equal to a company s legal capital, and it represents the amount of
Most companies establish a
the invested funds that cannot be returned to the investors as long as the corporation is
very low par value, such as $0.10
in existence. This legal capital requirement was originally intended to protect a company s
or $1.00 per share. In fact, in
creditors; without it, excessive dividends could be paid, leaving nothing for creditors. The
1998, 40% of the publicly traded
par value really was of more importance a hundred years ago and is something of a his-
companies in the United States
torical oddity today. These days, most states allow the sale of no-par stock.
had par values of exactly $0.01.
When par-value stock is issued by a corporation, usually Cash is debited, and the ap-
propriate stockholders equity accounts are credited. For par-value common stock, the eq-
uity accounts credited are Common Stock, for an amount equal to the par value, and Paid-In
Capital in Excess of Par, Common Stock, for the premium on the common stock.
To illustrate, we will assume that the Boston Lakers Basketball Team (a corporation) issued
1,000 shares of $1 par-value common stock for $50 per share. The entry to record the stock is-
suance is:


Cash (1,000 shares $50) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Common Stock (1,000 shares $1 par value) . . . . . . . . . . . . . . . . . 1,000
Paid-In Capital in Excess of Par,
Common Stock (1,000 shares $49) . . . . . . . . . . . . . . . . . . . . . . . . 49,000
Issued 1,000 shares of $1 par-value common stock at
$50 per share.


A similar entry would be made if the stock being issued were preferred stock. The total par
value of the common and preferred stock, along with the associated amounts of paid-in capital
in excess of par, constitutes a corporation s contributed capital.
contributed capital The por-
tion of owners equity con- This illustration points out two important elements in accounting for the issuance of stock:
tributed by investors (the (1) the equity accounts identify the type of stock being issued (common or preferred), and (2)
owners) in exchange for
the proceeds from the sale of the stock are divided into the portion attributable to its par value
shares of stock.
and the portion paid in excess of par value. These distinctions are important because the own-
ers equity section of the balance sheet should correctly identify the specific sources of capital so
that the respective rights of the various stockholders can be known.
If the stock being issued has no par value, only one credit is included in the entry. To il-
net work lustrate, assume that the Lakers stock does not have a par value and that the corporation issued
1,000 shares for $50 per share. The entry to record this stock issuance would be:
Do you want to try your
hand at buying some
shares of stock? Go to
http://ameritrade.com, the Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Web site for one of the
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
leading Internet stock trad-
ing companies. How much Issued 1,000 shares of no-par stock at $50 per share.
is the commission for exe-
cuting one stock trade?
Although stock is usually issued for cash, other considerations may be involved. To illus-
trate the kinds of entries made when stock is issued for noncash considerations, we will assume
that a prospective stockholder exchanged a piece of land for 5,000 shares of the Boston Lakers
$1 par-value common stock. Assuming the market value of the stock at the date of the exchange
was $40 per share, the entry is:
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Equity Financing



Land (5,000 shares $40) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Common Stock (5,000 shares $1) . . . . . . . . . . . . . . . . . . . . . . . 5,000
Paid-In Capital in Excess of Par,
Common Stock (5,000 shares $39) . . . . . . . . . . . . . . . . . . . . . . 195,000
Issued 5,000 shares of $1 par-value common stock for land
(5,000 shares $40 per share $200,000).



When noncash considerations are received in payment for stock, the assets or services re-
ceived should be recorded at the current market value of the stock issued. If the market value
of the stock cannot be determined, the market value of the assets or services received should be
used as the basis for recording the transaction.

Accounting for Stock Repurchases
Sometimes, when a company has excess cash or needs some of its shares of stock back from in-
vestors, it may purchase some of its own outstanding stock. This repurchased stock is called trea-
treasury stock Issued stock
that has subsequently been sury stock by accountants. There are many reasons for a firm to buy its own stock. Five of the
reacquired by the corpora- most common are that management:
tion.
1. wants the stock for a profit-sharing, bonus, or stock-option plan for employees,
2. feels that the stock is selling for an unusually low price and is a good buy,
3. wants to stimulate trading in the company s stock,
4. wants to remove some shares from the market in order to avoid a hostile takeover, or
5. wants to increase reported earnings per share by reducing the number of shares of stock
outstanding.

Many successful U.S. companies have ongoing stock repurchase plans. For example, MI-
CROSOFT disclosed in its 1999 annual report (Appendix A) that it spent $2.95 billion in 1999
to repurchase 44 million of its own shares. COCA-COLA spent $2.8 billion in the years
1997 1999 repurchasing its own shares. The most aggressive stock buyback program is GEN-
ERAL ELECTRIC s a number of years ago GE announced its intention to spend a total of
$13 billion buying back its own shares. As of the end of 1999, GE had already exceeded this
amount, spending a cumulative total of $22.6 billion on stock repurchases.
When a firm purchases stock of another company, the investment is included as an asset on
the balance sheet. However, a corporation cannot own part of itself, so treasury stock is not con-
sidered an asset. Instead, it is a contra-equity account and is included on the balance sheet as a de-
duction from stockholders equity. Think of it this way: when a corporation is-
For General Electric, the
sues shares, its equity is increased; when the corporation buys those shares back,
total amount invested by stockholders is
its equity is reduced. The reporting of treasury stock is illustrated in the stock-
$11,384 million, which is the sum of com- holders equity section of the balance sheet for General Electric in Exhibit 11-4.
Notice that the $22.567 billion spent by General Electric to buy back its
mon stock at par ($594 million) and paid-in
own shares as of December 31, 1999, is shown as a subtraction from total share
capital in excess of par (other capital of
owners equity. By the way, the other capital included in GE s equity section
$10,790 million). And yet GE has spent
is primarily composed of paid-in capital in excess of par. Also, the unrealized
$22,567 million buying back shares from
gains and currency translation adjustment items are quite interesting and
stockholders. How is this possible?
controversial, as will be explained in a later section.
Treasury stock is usually accounted for on a cost basis; that is, the stock is debited at its
cost (market value) on the date of repurchase. To illustrate, we assume that 100 shares of the
$1 par-value common stock were reacquired by the Boston Lakers for $60 per share. The entry
to record the repurchase is:

Treasury Stock, Common . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Cash (100 shares $60) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Purchased 100 shares of treasury stock at $60 per share.
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Share Owners Equity for General Electric
exhibit 11-4


General Electric Company
December 31, 1999 and 1998
Share Owners Equity
(in millions of U.S. dollars)

1999 1998

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 594 $ 594
Unrealized gains on investment securities net . . . . . . . . . . . . . . 626 2,402
Accumulated currency translation adjustments . . . . . . . . . . . . . . (1,370) (738)
Other capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,790 6,808
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,484 48,553
Less common stock held in treasury . . . . . . . . . . . . . . . . . . . . . . (22,567) (18,739)
Total share owners equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $42,557 $38,880




The effect of this entry is to reduce both total assets (Cash) and total stockholders equity
fyi
by $6,000.
An alternative way to account When treasury stock is reissued, the treasury stock account must be credited for the
for stock repurchases is called original amount paid to reacquire the stock. If the treasury stock s reissuance price is greater
the par-value method. This than its cost, an additional credit must be made to an account called Paid-In Capital,
Treasury Stock. Together, these credits show the net increase in total stockholders equity.
method, though not used as
At the same time, the cash account is increased by the total amount received upon reis-
frequently as the cost method
suance of the treasury stock.
illustrated in this section, is the
To illustrate, we assume that 40 of the 100 shares of the treasury stock that were orig-
method of choice for a number
inally purchased for $60 per share are reissued at $80 per share. The entry to record that
of large U.S. companies includ-
reissuance is:
ing Microsoft, INTEL, and WAL-
MART. The par-value method of
Cash (40 shares $80) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
accounting for stock repur-
Treasury Stock, Common (40 shares $60 cost) . . . . . . . . . . . . 2,400
chases is covered in intermedi-
Paid-In Capital, Treasury Stock [40 ($80 $60)] . . . . . . . . . . . 800
ate accounting courses.
Reissued 40 shares of treasury stock at $80 per share.


The company now has a balance of $3,600 in the treasury stock account (60 shares at $60
caution
per share).
Do not credit a gain when trea- Sometimes the reissuance price of treasury stock is less than its cost. As before, the
sury stock is reissued at a price entry involves a debit to Cash for the amount received and a credit to Treasury Stock for
greater than its cost. Gains are the cost of the stock. However, because an amount less than the repurchase cost has been
received, an additional debit is required. The debit is to Paid-In Capital, Treasury Stock
associated with a company s
if there is a balance in that account from previous transactions, or to Retained Earnings
operations, not with a company
if there is no balance in the paid-in capital, treasury stock account.
buying and selling its own
To illustrate, we will consider two more treasury stock transactions. First, we assume that
shares.
another 30 shares of treasury stock are reissued for $40 per share, $20 less than their cost. Be-
cause Paid-In Capital, Treasury Stock has a balance of $800, the entry to record this transaction is:

Cash (30 shares $40) . . . . . . . . . . . . . ........................ 1,200
Paid-In Capital, Treasury Stock . . . . . . . . ........................ 600
Treasury Stock, Common (30 shares $60 cost). . . . . . . . . . . . . . . . . 1,800
Reissued 30 shares of treasury stock at $40 per share;
original cost was $60 per share.
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Note that after this transaction is recorded, the balance in Paid-In Capital, Treasury Stock is
$200 ($800 $600).
Next, we assume that the company reissues 20 additional shares at $45 per share. The en-
try to record this transaction is:


Cash (20 shares $45) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900
Paid-In Capital, Treasury Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Treasury Stock (20 shares $60 cost). . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Reissued 20 shares of treasury stock at $45 per share;
original cost was $60 per share.



In this transaction, the selling price was $300 less than the cost of the treasury stock. Because
the paid-in capital, treasury stock account had a balance of only $200, Retained Earnings was
debited for the remaining $100.

Balance Sheet Presentation
We have discussed the ways in which stock transactions affect owners equity accounts. We will
now show how these accounts are summarized and presented on the balance sheet. The fol-
lowing data, with the addition of the preferred stock information in (1), summarize the stock
transactions of the Boston Lakers shown earlier:
1. $40 par-value preferred stock: issued 1,000 shares at $45 per share.
2. $1 par-value common stock: issued 1,000 shares at $50 per share.
3. $1 par-value common stock: issued 5,000 shares for land with a fair market value of
$200,000.
4. Treasury stock, common: purchased 100 shares at $60; reissued 40 shares at $80; reissued
30 shares at $40; reissued 20 shares at $45.
With these data, and assuming a Retained Earnings balance of $100,000, the stockholders eq-
uity section would be as shown in Exhibit 11-5.



Stockholders Equity for Boston Lakers
exhibit 11-5


Boston Lakers Basketball Team
Stockholders Equity

Preferred stock ($40 par value, 1,000 shares issued
and outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000
Common stock ($1 par value, 6,000 shares issued,
5,990 shares outstanding)* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Paid-in capital in excess of par, preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . . . . . . . . . . 244,000
Total contributed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $295,000
Retained earnings (to be discussed) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Total contributed capital and retained earnings . . . . . . . . . . . . . . . . . . . . . . . $395,000
Less treasury stock (10 shares of $1 par common at
cost of $60 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600)
Total stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $394,400

*Treasury shares are described as being issued but not outstanding. Thus, 6,000 common shares have
been issued, but only 5,990 are outstanding because 10 are held by the Boston Lakers as treasury shares.
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Investing and Financing Activities




to summarize
When a company issues stock, it debits Cash or a noncash account (Property,
for example) and credits various stockholders equity accounts. Shares typi-
cally are assigned a par value, which is usually small in relation to the market
value of the shares. Amounts received upon issuance of shares are divided into
par value and paid-in capital in excess of par. A company s own stock that is
repurchased is known as treasury stock and is included in the financial state-
ments as a contra-stockholders equity account. Treasury stock is usually ac-
counted for on a cost basis. The stockholders equity section of a balance sheet
contains separate accounts for each type of stock issued, amounts paid in ex-
cess of par values, treasury stock, and retained earnings.




4 RETAINED EARNINGS
Understand the factors that
Common stockholders can invest money in a corporation in two ways. First, as described in the
affect retained earnings,
describe the factors previous section, common stockholders can buy shares of stock. Second, when the corporation
determining whether a
makes money, the common stockholders can allow the corporation to keep those earnings to be
company can and should
reinvested in the business. Retained earnings is the name given to the aggregate amount of cor-
pay cash dividends, and
account for cash dividends. porate earnings that have been reinvested in the business. The retained earnings balance is in-
creased each year by net income and decreased by losses, dividends, and some treasury stock
retained earnings The por-
transactions (as illustrated earlier).
tion of a corporation s own-
Remember, retained earnings is not the same as cash. In fact, a company can have a large
ers equity that has been
earned from profitable op- Retained Earnings balance and be without cash, or it can have a lot of cash and a very small Re-
erations and not distributed
tained Earnings balance. For example, on December 31, 1999, DOW JONES & COMPANY
to stockholders.
had a Cash balance of $86 million but a Retained Earnings balance of $810 million. Although
both Cash and Retained Earnings are usually increased when a company has earnings, they typ-
ically are increased by different amounts. This occurs for two reasons: (1) the company s net in-
dividends Distributions to
come, which increases Retained Earnings, is accrual-based, not cash-based; and (2) cash from
the owners (stockholders)
of a corporation. earnings may be invested in productive assets such as inventories, used to pay off loans, or spent
in any number of ways, many of which do not affect net income or retained earnings. In sum-
cash dividend A cash distri-
mary, cash is an asset; retained earnings is one source of financing (along with borrowing and
bution of earnings to stock-
direct stockholder investment) that a corporation can use to get funds to acquire assets.
holders.

Cash Dividends
fyi
If you had your own business and wanted to withdraw money for personal use, you would
Fortune magazine maintains a
simply withdraw it from the company s checking account or cash register. In a corpora-
list of the top 50 e-companies,
tion, a formal action by the board of directors is required before money can be distrib-
called the Fortune e-50. A ran-
uted to the owners. In addition, such payments must be made on a pro rata basis. That
dom sample of 10 of these
is, each owner must receive a proportionate amount on the basis of ownership percent-
companies indicated that only
age. These pro rata distributions to owners are called dividends. When paid in the form
one of the 10 paid cash divi-
of cash, they are called cash dividends. The amount of dividends an individual stock-
dends to common stockholders
holder receives depends on the number of shares owned and on the per-share amount of
in 1999. Thus, we see that high-
the dividend.
tech, high-growth companies
are not likely to pay cash divi- Note that a company does not
SHOULD A COMPANY PAY CASH DIVIDENDS?
dends. By the way, the only one have to pay cash dividends. Theoretically, a company that does not pay dividends should
be able to reinvest its earnings in assets that will enable it to grow more rapidly than its
of the sampled e-50 companies
dividend-paying competitors. This added growth will presumably be reflected in increases
to pay cash dividends to com-
in the per-share price of the stock. In practice, most public companies pay regular cash
mon stockholders was IBM, not
dividends, but some well-known companies do not. For example, MICROSOFT has never
exactly a young start-up.
paid cash dividends to its common stockholders.
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Equity Financing Chapter 11
Equity Financing


So, should a corporation pay cash dividends or not? Well, the surprising answer is that no
one knows the answer to that question. Ask your finance professor what he or she thinks. Al-
though no one knows the theoretically best dividend policy, three general observations can be
made:
Stable companies pay out a large portion of their income as cash dividends.
Growing companies (such as Microsoft) pay out a small portion of their income as cash
dividends. They keep the funds inside the company for expansion.
Companies are very cautious about raising dividends to a new level because once investors
come to expect a certain level of dividends, they see it as very bad news if the company re-
duces the dividends back to the old level.
Although cash dividends are the most common type of dividend, corpo-
If you were a Microsoft rations can distribute other types of dividends as well. A stock dividend is a dis-
tribution of additional shares of stock to stockholders. Stock dividends will be
shareholder, would you want to receive a
discussed in the expanded material section of this chapter. A property dividend
high level of cash dividends, or would you
is a distribution of corporate assets (for example, the stock of another firm) to
prefer that Bill Gates use your share of the
stockholders. Property dividends are quite rare. In this section, only the ac-
profits for business expansion?
counting for cash dividends will be discussed.

Three important dates are associated with divi-
ACCOUNTING FOR CASH DIVIDENDS
dends: (1) declaration date, (2) date of record, and (3) payment date. The first is when the board
of directors formally declares its intent to pay a dividend. On this declaration date, the com-
declaration date The date
on which a corporation s pany becomes legally obligated to pay the dividend. Assuming that the board of directors votes
board of directors formally on December 15, 2003, to declare an $8,000 dividend, this liability may be recorded as follows:
decides to pay a dividend
to stockholders.
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Dividends Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Declared dividend on December 15, 2003.


At the end of the year, the dividends account is closed to Retained Earnings by the fol-
lowing entry:

Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
To close Dividends to Retained Earnings.


From this entry, you can see that a declaration of dividends reduces Retained Earnings and,
eventually, the amount of cash on hand. Thus, though not considered to be an expense, divi-
dends do reduce the amount a company could otherwise invest in productive assets.
Alternatively, a declaration of dividends can be recorded by debiting Retained Earnings di-
rectly. However, using the dividends account instead of Retained Earnings allows a company to
keep separate records of dividends paid to preferred and common stockholders. Whichever
method is used, the end result is the same: a decrease in Retained Earnings.
The second important dividend date is the date of record. Falling somewhere between the
date of record The date se-
lected by a corporation s declaration date and the payment date, this is the date selected by the board of directors on
board of directors on which which the stockholders of record are identified as those who will receive dividends. Because many
the stockholders of record
corporate stocks are in flux being bought and sold daily it is important that the stockhold-
are identified as those who
ers who will receive the dividends be identified. No journal entry is required on the date of
will receive dividends.
record; the date of record is simply noted in the minutes of the directors meeting and in a let-
ter to stockholders.
dividend payment date The
As you might expect, the third important date is the dividend payment date. This is the
date on which a corpora-
date on which, by order of the board of directors, dividends will be paid. The entry to record
tion pays dividends to its
a dividend payment would typically be:
stockholders.
525
f526 Part 3 Equity Financing
Investing and Financing Activities



Dividends Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Paid dividends declared on December 15, 2003.


The following press release, made by Dow Jones on January 19, 2000 (declaration date),
identifies both the date of record and the dividend payment date:

Dow Jones & Company announced that its Board of Directors voted
today to increase the quarterly dividend on the common stock and Class
B common stock to 25 cents a share from 24 cents a share. The 4.2%
increase, the first for Dow Jones in four years, raises the indicated an-
nual dividend rate to one dollar per share. The first new quarterly div-
idend is payable March 1 to shareholders of record as of February 1.

As mentioned earlier, once a dividend-paying pattern has been established, the ex-
fyi
pectation of dividends is built into the per-share price of the stock. A reduction in the
When Dow Jones announced
dividend usually produces a sharp drop in the price. Similarly, an increased dividend usu-
its dividend increase on Janu-
ally triggers an increase in the stock price. Dividend increases are usually considered to set
ary 19, 2000, its stock price in- a precedent, indicating that future dividends will be at this per-share amount or more.
creased by just 1.9% over the With this in mind, boards of directors are careful about increasing or decreasing dividends.
following two days. This is a
When cash dividends are declared by a corporation that
DIVIDEND PREFERENCES
small price rise and may sug-
has both common and preferred stock outstanding, how the dividends are allocated to the
gest that investors already
two classes of investors depends on the rights of the preferred stockholders. These rights
were aware of the planned div-
are identified when the stock is approved by the state. Two dividend preferences, as they
idend increase.
are called, are (1) current-dividend preference and (2) cumulative-dividend preference.
Current-Dividend Preference Preferred stock has a dividend percentage associated with it
and is typically described as follows: 5% preferred, $40 par-value stock, 1,000 shares out-
standing. The first figure 5% in this example is a percentage of the par value and can be
any amount, depending on the particular stock. So, $2 per share (0.05 $40 par) is the amount
that will be paid in dividends to preferred stockholders each year that dividends are declared.
The fact that preferred stock dividends are fixed at a specific percentage of their par value makes
them somewhat similar to the interest paid to bondholders. The current-dividend preference
current-dividend preference
The right of preferred stock- requires that when dividends are paid, this percentage of the preferred stock s par value be paid
holders to receive current
to preferred stockholders before common stockholders receive any dividends.
dividends before common
To illustrate the payment of different types of dividends, the following data from the Boston
stockholders receive divi-
Lakers Basketball Team will be used throughout this section. (The various combinations of div-
dends.
idend preferences illustrated over the next few pages are summarized in Cases 1 to 4 in Exhibit
11-6.) As a reminder, the outstanding stock includes:
Preferred stock: 5%, $40 par value, 1,000 shares issued and outstanding.
Common stock: $1 par value, 6,000 shares issued, 5,990 shares outstanding.


Dividend Preferences: Summary of Cases 1 to 4
exhibit 11-6


Preferred
Dividend Years in Total Preferred Common
Case Feature Arrears Dividend Dividend Dividend

1 5%, Noncumulative Not applicable $ 1,500 $1,500 $ 0
2 5%, Noncumulative Not applicable 3,000 2,000 1,000
3 5%, Cumulative 2 5,000 5,000 0
4 5%, Cumulative 2 11,000 6,000 5,000
526 f527
Equity Financing Chapter 11
Equity Financing


To begin, note that, as with all preferred stock, the Lakers 5% preferred stock has a
current-dividend preference: Before any dividends can be paid to common stockholders, pre-
ferred stockholders must be paid a total of $2,000 ($40 0.05 1,000 shares). Thus, if only
$1,500 of dividends are declared (Case 1), preferred stockholders will receive the entire dividend
payment. If $3,000 are declared (Case 2), preferred stockholders will receive $2,000 and com-
mon stockholders, $1,000.
Cumulative-Dividend Preference The cumulative-dividend preference can be quite costly
cumulative-dividend prefer-
ence The right of preferred for common stockholders because it requires that preferred stockholders be paid current divi-
stockholders to receive cur-
dends plus all unpaid dividends from past years before common stockholders receive anything.
rent dividends plus all divi-
If dividends have been paid in all previous years, then only the current 5% must be paid to pre-
dends in arrears before
ferred stockholders. But if dividends on preferred stock were not paid in full in prior years, the
common stockholders re-
cumulative deficiency must be paid before common stockholders receive anything.
ceive any dividends.
With respect to the cumulative feature, it is important to repeat that companies are not re-
quired to pay dividends. Any past unpaid dividends are called dividends in arrears. Because
dividends in arrears Missed
dividends for past years they do not have to be paid unless dividends are declared in the future, dividends in arrears do
that preferred stockholders not represent actual liabilities and thus are not recorded in the accounts. Instead, they are re-
have a right to receive un-
ported in the notes to the financial statements.
der the cumulative-dividend
To illustrate the distribution of dividends for cumulative preferred stock, we will assume
preference if and when divi-
that the Boston Lakers Basketball Team has not paid any dividends for the last two years but
dends are declared.
has declared a dividend in the current year. The Lakers must pay $6,000 in dividends to pre-
ferred stockholders before they can give anything to the common stockholders. The calculation
is as follows:

Dividends in arrears, 2 years. . . . . . . . . $4,000
Current dividend preference
($40 0.05 1,000 shares) . . . . . . 2,000
Total . . . . . . . . . . . . . . . . . . . . . . . . . $6,000

Therefore, if the Lakers pay only $5,000 in dividends (Case 3), preferred stockholders will re-
ceive all the dividends, common stockholders will receive nothing, and there will still be divi-
dends in arrears of $1,000 the next year. If $11,000 in dividends are paid (Case 4), preferred
stockholders will receive $6,000, and common stockholders will receive $5,000.
The entries to record the declaration and payment of dividends in Case 4 are:

Date of Declaration


Dividends, Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Dividends, Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Dividends Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Declared dividends on preferred and common stock.


Date of Payment


Dividends Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Paid dividends on preferred and common stock.




Earlier in this section, the ques-
CONSTRAINTS ON PAYMENT OF CASH DIVIDENDS
tion was asked whether a company should pay cash dividends. A related question is: Can the
company legally pay cash dividends? To illustrate, consider the following exaggerated scenario.
Tricky Company obtains a corporate charter, borrows $1 million from Na ve Bank, pays out a
$1 million cash dividend to the stockholders, and all the stockholders disappear to the Bahamas.
Is this a legal possibility? No, it isn t, because the corporate right to declare cash dividends is
527
f528 Part 3 Equity Financing
Investing and Financing Activities


regulated by state law in order to protect creditors. The right to declare cash dividends is often
linked to a company s Retained Earnings balance.
In many states, a company is not allowed to pay cash dividends in an amount that
fyi would cause the retained earnings balance to be negative. Thus, if the retained earnings
balance of the Boston Lakers were $8,500, the $11,000 dividend in Case 4 discussed above
Delaware has a reputation for
could not be paid, even if the Lakers had the available cash to make the payment. The
having the least restrictive div-
incorporation laws in many states are less restrictive and allow the payment of cash divi-
idend laws. This is one reason
dends in excess of the retained earnings balance if, for example, current earnings are strong
many of the major U.S. com-
or the market value of the assets is high.
panies are incorporated in the
Frequently, lenders do not rely on state incorporation laws to protect them from ex-
state of Delaware.
cess cash dividend payments by corporations to which they lend money. Instead, the loan
contract itself includes restrictions on the payment of cash dividends during the period
that the loan is outstanding. In this way, lenders are able to prevent cash that should be used
to repay loans from being paid to stockholders as dividends.

Dividend Payout Ratio
A ratio of interest to stockholders is the dividend payout ratio. This ratio indicates the per-
dividend payout ratio A
measure of the percentage centage of net income paid out during the year in the form of cash dividends and is computed
of earnings paid out in divi- as follows:
dends; computed by divid-
ing cash dividends by net
Cash dividends
income. Dividend payout ratio
Net income


Dividend payout ratio values for Dow Jones, Microsoft, and GENERAL ELECTRIC for
1999 are computed below. The numbers are in millions.


Dow General
Jones Microsoft Electric

Cash dividends $87 $28 $4,786
Net income $272 $7,785 $10,717
Dividend payout ratio 32.0% 0.4% 44.7%


Both Dow Jones and General Electric pay out between 30 and 50% of their annual income as
dividends, a normal level for large U.S. corporations. Microsoft s low dividend payout ratio is
indicative of a rapidly expanding company. In fact, all of the Microsoft cash dividends are pre-
ferred stock dividends; as mentioned earlier, Microsoft has never paid any cash dividends to its
common stockholders.




to summarize
The retained earnings account reflects the total undistributed earnings of a
business since incorporation. It is increased by net income and decreased by
dividends, net losses, and some treasury stock transactions. The important
dates associated with a cash dividend are the date of declaration, the date of
record, and the payment date. Preferred stockholders can be granted a current
and a cumulative preference for dividends over the rights of common stock-
holders. In some states, the payment of cash dividends is limited to an amount
not to exceed the existing Retained Earnings balance. The dividend payout ra-
tio (cash dividends divided by net income) reveals the percentage of net in-
come that is paid out as cash dividends.
528 f529
Equity Financing Chapter 11
Equity Financing



5 OTHER EQUITY ITEMS
Describe the purpose of
In addition to the two major categories of contributed capital and retained earnings, the equity
reporting comprehensive
income in the equity section of a balance sheet often includes a number of miscellaneous items. These items are gains
section of the balance
or losses that bypass the income statement when they are recognized. A further discussion of
sheet, and prepare a
these items is given below.
statement of stockholders
equity.

Equity Items That Bypass the Income Statement
Since 1980, the equity sections of U.S. balance sheets have begun to fill up with a strange col-
lection of items, each the subject of an accounting controversy. Two of these items are sum-
marized below:

Foreign currency translation adjustment. The foreign currency translation adjustment arises
from the change in the equity of foreign subsidiaries (as measured in terms of U.S. dollars)
that occurs as a result of changes in foreign currency exchange rates. For example, if the
Japanese yen weakens relative to the U.S. dollar, the equity of Japanese subsidiaries of U.S.

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