Financial Accounting Lesson 10 Stockholders Equity Ben TrnkaBoz

Financial Accounting Lesson 10: Stockholders’ Equity Ben Trnka/Boz Bostrom www. benandboz. com

Let’s start with an example!

A more detailed look at Balance Sheet components

Some Key Statistics – from Yahoo Finance

Overview Understand purpose of share issuances, dividends, splits and buybacks Understand how to account for common share issuances and dividends Understand how to account for preferred share issuances and dividends Understand how to account for stock splits and stock repurchases (share buybacks)

Issuing Equity vs. Debt – Company’s Perspective Advantages Less risky and keeps cash flows higher, no requirement to pay dividends With debt, interest/principal required to be repaid May attract more investors Disadvantages Control/vote is given up Issuances can be costly Equity investors want higher returns than lenders Share of “residual profits” given up

Investing in Equity vs. Debt – Investor’s perspective Advantages Ability to vote / possibly appoint and influence management Ability to participate in dividends and residual earnings / high returns Disadvantages Dividends payments are not legally required If company goes bankrupt, shareholders get nothing If only own a small share of the company, can’t make management decisions

Relevant Definitions Authorized Shares Number Issued Shares Number of shares the corporation has issued Less: Treasury Shares Number of shares the corporation may legally issue of issued shares the corporation has repurchased Equals: Outstanding Shares Number of shares the corporation has issued that remain available on the market (i. e. not repurchased)

Common Stock Issuances The first time a company issues shares to the public, it is called an IPO (Initial Public Offering) If the company again issues shares to the public, it is called a Seasoned Offering After shares are issued, they are traded in established markets. Share price increases benefit individual investors For example, if a company raises $1, 000 by issuing 100 shares at $10 apiece, and the price quickly jumps to $50 per share, the individual investors will enjoy that $40 gain, not the company

Common Stock Issuances When a company issues shares, the journal entry is: Dr Cr Common Stock Par value Cr Additional Paid in Capital Difference Par value is the amount legally stated in the company’s charter. Shares can’t be issued for less than this amount. If there is no par value, the entire amount is recorded as a credit to Common Stock, and APIC is not used Cash received (less fees)

From Twitter’s 2013 10 -K On November 13, 2013, Twitter sold 80, 500, 000 shares of our common stock at a public offering price of $26. 00 per share for an aggregate offering price of approximately $2. 09 billion. What is the journal entry, assuming a $0. 01 per share par value? Dr Cr Common Stock $805, 000 Cr Additional Paid in Capital $2, 092, 195, 000 Cash $2, 093, 000

Common Stock Dividends Reasons why companies pay dividends: Provide returns to shareholders Best use of cash, other than investing at a low interest rate Increases investor confidence Abbott Labs has increased its dividend for 46 straight years In November of 2017, GE announced it was cutting its dividend in half, and its share price immediately dropped 8% Note: Dividends are generally paid in cash. There are such things as property dividends and stock dividends, but these are quite uncommon Dividends generally reduce the value of the company (as it no longer has the cash) Not a bad thing as the owners have the cash

Journal Entries / 3 M Press Release - Tuesday, November 13, 2018 ST. PAUL, Minn. --(BUSINESS WIRE)-- The 3 M Board of Directors (NYSE: MMM) today declared a dividend on the company’s common stock of $1. 36 per share for the fourth quarter of 2018. The dividend is payable Dec. 12, 2018, to shareholders of record at the close of business on Nov. 23, 2018. Per its Sept 30, 2018 financials, 3 M had 582. 3 M shares outstanding November 13, 2018 (date of declaration) Dr Cr November 23, 2018 (date of record) – no journal entry December 12, 2018 (date of payment) Dr Cr Retained Earnings $791. 93 M Dividends Payable Cash $791. 93 M

Preferred Stock Preferred stock has a fixed return and does not have voting rights Thus, more similar to debt than common equity In the event of bankruptcy, debt is paid first, then preferred stock, then leftovers go to common stock Riskier than debt, so higher returns In January of 2016, GE issued 5. 7 B shares of preferred stock. The stock has $1 par value and a dividend rate of 5%. Record the issuance of the preferred stock. Dr Cr Cash Preferred Stock $5. 7 B

Preferred Stock Dividends In January of 2016, GE issued 5. 7 B shares of preferred stock. The stock has $1 par value and dividend rate of 5%, and dividends are paid twice per year. Record the payment of the fist dividend in July 2016 Dr Cr Retained Earnings Cash $142. 5 M

Cumulative vs. non-Cumulative Preferred Stock Dividends Cumulative Preferred dividends not paid in a given year must be paid before any dividends can be paid to common shareholders Referred to as dividends in arrears Non-Cumulative Preferred dividends not paid in a given year are effectively lost What type of preferred stock do companies normally issue? Cumulative

Preferred Stock Dividends example A company wishes to pay $1, 000 of dividends in 2018. Dividends to preferred shareholders are $100 per year, but were not paid in 2016 or 2017. What amount of dividends will be paid to preferred vs. common shareholders? Consider two scenarios – preferred shares are cumulative and non-cumulative Cumulative 2016 2017 2018 Total Preferred Common Non-Cumulative $100 $300 $0 $0 $100 $700 $900

Stock Splits Historically, most companies would split their stock in order to keep the price low and attractive to more investors Most common split is 2: 1, meaning each shareholder receives 1 additional share for each share they own On March 19, 2018, Aflac had a 2: 1 stock split. Immediately prior, it had about 390 M shares outstanding at a price of $90 per share x 2 /2 Immediately after, it had about 780 M shares outstanding at a price of $45 per share

Fewer companies are now splitting their stock / Priciest stocks in the world in 2018 Alphabet Inc. – $1, 084. 14 Madras Rubber Factory Limited – $1, 109. 73 Markel Corporation – $1, 116. 30 Amazon Inc. – $1, 500. 25 Booking Holdings Inc. – $2, 033. 79 NVR Inc. – $2, 900. 02 Seaboard Corporation – $4, 019. 26 Next Plc – $6, 553. 89 Lindt & Sprüngli AG – $72, 037. 79 Berkshire Hathaway – $303, 100. 00 If Apple had never split its stock, it would be nearly $10, 000 per share currently, instead of about $170 per share

Accounting for stock splits No journal entries are made, but par value and number of shares are adjusted Thus, retained earnings not affected Footnote disclosures required When issuing financial statements after the split, the company will show shares (and earnings per share) as if the split had always happened

Apple – 7: 1 split in June 2014

Treasury Stock / Stock Buybacks When a company generates free cash flows, it has many options: Capital expenditures / Organic growth Acquisitions Dividends Retain and invest cash in government/corporate bonds or share of other companies Share Buybacks Apple has repurchased $150 B worth of shares in the past 5 years

Treasury Stock / Stock Buybacks Many companies choose to repurchase shares as they can make remaining shares more valuable Also, they may want shares on hand to provide employees with stock compensation Example, a company has $100 of assets which generate returns of 15%, and $1, 000 of cash which generates returns of 1%. The company has 10 shares outstanding. $15 operating income + $10 interest income = $25 total income = $2. 50 EPS 10 shares If the company could repurchase 5 of the shares for the $1, 000 cash, its EPS would be as follows: $15 operating income = $3. 00 EPS 5 shares

Accounting for Treasury Stock When Shares are repurchased from the public (Treasury Stock): Dr Cr When Treasury Stock is sold back to the public: Dr Cr Treasury Stock (+SE) Cr Additional paid in capital (if sold back at a higher price than repurchased) Treasury Stock (-SE) Cash

Key Takeaways Companies often issue equity instead of debt The most popular form of equity is common stock, on which companies are not required to pay dividends Preferred stock is a hybrid between debt and equity Companies with excess cash can repurchase previously issued shares for two main reasons: Returns cash to investors Increases EPS for remaining investors Thanks for tuning in!