EN.662.611 Chap.7 Shareholders' Equity and Dividends
Shareholders' Equity and Dividends
Why most large businesses are corporations
The Week 6 equity lecture compares legal forms. Sole proprietorships and partnerships are easy to form and lightly regulated, but their owners face unlimited liability.
A corporation is a separate legal entity with an unlimited life, limited liability for its investors, liquidity through trading in its shares, and the ability to raise large sums through an initial public offering.
Its disadvantage is double taxation: income is taxed at the corporate level and dividends are taxed again as investor income.
Contributed and earned capital
Contributed capital is what the company received when it first issued stock in the primary market: common stock, additional paid-in capital and preferred stock, with treasury stock deducted as a contra-equity account. Earned capital is retained earnings.
When shares carry a par value, par goes to common or preferred stock and the excess to additional paid-in capital; with no par, the whole amount goes to the stock account.
Later trading between investors in the secondary market does not touch the company's cash.
Splits, buybacks and share counts
A stock split issues new shares in proportion to existing holdings, so equity and each holder's total value are unchanged, while the lower price makes the stock more affordable.
A buyback creates treasury stock, which can support the share price, avoids committing to an ongoing dividend and can be reissued for stock awards or options.
Authorized shares are the charter maximum, issued shares are those sold in the primary market, and outstanding shares are issued shares less treasury stock.
Preferred stock and dividends
Preferred stock is a hybrid: its dividend is fixed, it has no vote and no maturity, and it ranks after creditors but before common shareholders.
Cumulative preferred must receive any dividends in arrears before common shareholders are paid. A dividend becomes a liability on the declaration date, needs no entry on the record date and is settled on the payment date.
The dividend payout ratio compares cash dividends with net income and tends to be higher in mature companies.
Classes of common stock
Some companies issue voting and non-voting classes of common stock. The accounting treatment is the same, but the market values them differently: voting shares tend to trade higher, while non-voting shares are often used for later issues and for incentive compensation plans.
Reading the equity note of an annual report tells you how many shares of each class are authorized, issued and outstanding, which is the starting point for any per-share figure.
What this chapter covers
- 01
Sole proprietorship, partnership and corporation
- 02
Contributed versus earned capital
- 03
Par value and additional paid-in capital
- 04
Stock splits
- 05
Treasury stock and share counts
- 06
Preferred and cumulative preferred stock
- 07
Dividend dates and payout ratio
Worked example · free
Record a share issue with par value
- 1Cash received: 500,000 times $15 is $7,500,000, debited to Cash.
- 1Common Stock is credited at par: 500,000 times $2 is $1,000,000.
- 1Additional paid-in capital takes the rest: $6,500,000.
- 1With no par, Common Stock is credited with the whole $7,500,000.
Key terms
- Additional Paid-In Capital
- The amount received for shares above their par value, part of contributed capital.
- Treasury Stock
- A company's own shares bought back and held, deducted from equity as a contra-equity account.
- Cumulative Preferred Stock
- Preferred stock whose unpaid dividends accumulate and must be paid before any common dividend.
- Stock Split
- An issue of new shares to existing holders in proportion to their holdings, leaving total equity unchanged.
- Dividend Payout Ratio
- Cash dividends divided by net income, the share of profit paid out to shareholders.
Shareholders' Equity and Dividends FAQ
Why does a buyback not count as an expense?
Buying back shares is a transaction with owners, not a cost of running the business. It reduces equity through the treasury stock account and never passes through the income statement.
What makes preferred stock less risky than common stock?
Its dividend is fixed and it ranks ahead of common stock for dividends and in liquidation. Creditors still come first, so preferred stock remains riskier than the company's debt.
Which shares receive a declared dividend?
Outstanding shares: those issued less any held in treasury. Treasury shares receive nothing, and authorized shares that were never issued do not count at all.
Exam move
Write the equity section of one invented company after an issue, a buyback and a split, updating issued and outstanding shares at each step. Then work a cumulative preferred dividend with two years in arrears.
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