Managerial Accounting is very different from Financial Accounting. There you learned about the overall framework of accounting, and how to prepare financial statements for investors and other people outside the company. Managerial Accounting will focus on preparing financial information for Managers who are inside the company. Their needs are different than the general public's, and Managers are entitled to access information that is confidential.

In this course, and in the legal and business world in general, Managers (or Management) are viewed as a special group of people. We will view them both as a "whole" and as individuals. They are employees of the company, and they are the ones in charge of running a company and making daily, mission-critical decisions that effect the very life of the company. 

Because of their position in a company, Management can either act to benefit the company and it's owners or they can undermine the company. We expect the former, and cringe at the latter. The financial collapse of Enron is a recent example of a group of Managers who put their own personal gain above their obligation to the stockholders and public alike. It was the 7th largest company in the US at the time. Thousands of employees people lost their entire retirement fund, and thousands of other investors lost their entire investment. 

Each week we will learn to use new managerial tools. Each one is a little different, but when you are done you will have many useful tools for business decision-making. After all, a carpenter would use a hammer to drive a nail, and a screwdriver to install a screw. OK, I know a few that would use a hammer to drive a screw but you get the idea! ;-)

Let's put it this way: you can do more with a full box of useful tools. Fair enough? So each week we will learn to use some new ones, or find new and different uses for one's we've learned about earlier.

Chapter 11 is the first of two chapters on stockholders� equity. It deals with topics related to paid-in capital of a corporation.  Issues relating to retained earnings is covered in Chapter 12. The advantages and disadvantages of the corporate form are reviewed in detail, and the distinctions between public and closely held corporations are explained.  An extensive discussion of the formation of a corporation highlights the rights of stockholders and the roles of corporate directors and officers.

The treatment of accounting procedures regarding paid-in capital concentrates on the issuance of capital stock and the stockholders� equity section of the balance sheet.  The concept of par value is explained in detail, as is additional paid-in capital.  The introduction of preferred stock leads to more complex illustrations of the stockholders� equity section.  Preferences with respect to dividends and assets are explained and illustrated.  Call and conversion features of preferred stock are also introduced.  Other topics dealing with capital stock that are covered include issuance for assets other than cash, donated capital, and stock subscriptions.

The calculation of book value per common share is explained and illustrated before attention turns to factors concerning market values.  The significance of market price to the issuing corporation is contrasted to its significance to the investor.  We then explain the roles of interest rates and investor expectations in the determination of market prices.

Since stock splits and treasury stock transactions impact the presentation of paid-in capital on the balance sheet, they are also introduced in this chapter.  Journal entries to record both the purchase and reissuance of treasury shares are provided.  We explain and emphasize that profits and losses on treasury stock transactions are not recognized.

Fiduciary Responsibility

People running a business have a fiduciary responsibility to the owners of the business. That is a legal term that basically means a company's managers must act in a responsible manner with the company's money and business affairs. It also means that Management must keep records and be able to show owners whether the company is profitable (Income Statement), it's financial position (Balance Sheet), how much of the profits have been paid out to owners, and how much more they might be entitled to (Statement of Retained Earnings).

Management is not supposed to treat a company's funds like their (Management's) own. Management is also not supposed to maniuplate funds and resrouces for their own personal benefit or conduct the company's business affairs in such a manner as to defraud the owners. 

We see several recent instances of Management fraud in cases such as the Tyco, Enron and Worldcom bankruptcies. The Securuties and Exchange Commission (SEC) is now enforcing new, tougher laws that carry substantial jail sentences for Managment fraud. Company CEOs, Presidents, Vice-Presidents, CFOs, and other managers involved in fraud may have to pay substantial money damages as well as jail terms under the Sarbanes-Oxley Act. The Sarbanes-Oxley Act adds new provisions to the Securities Act of 1933 and the Securities Exchange Act of 1934. These two Acts embody much of the federal law regulating the sale and issue of all investments (in both public and private transactions) and the activities of stock markets.

Equity versus Debt

Equity is Ownership in a company. 

Debt represents all liabilities, bills and money owed by a company, including bank loans and mortgages.

The Accounting Equation is Assets = Liabilities + Owners' Equity

As we see by this equation, all assets are financed by total equity and debt. 

Banks and other lenders expect the owners to take most of the risk in a business. Banks may be willing to lend a corporation some money, but only after stockholders have put in their share first.

Banks generally lend long-term money for long-term assets. This includes mortgage loans for land, buildings and equipment. The asset is pledged capital against the loan, so the bank can take the property back in the event the loan payments aren't made. This further limits the bank's risk of loss.

But, banks generally don't lend long-term money for short-term needs. Short term needs include daily operating expenses, inventory, payroll, insurance premiums and the like. Loaning long-term money for short-term needs is very risky for a bank. They have no collateral to repossess if the corporation defaults on the loan. 

Short-term money comes from stockholders, who must take the greatest risk.But in exchange for taking the risk, stockholders are also entitled to benefit from the growth and earnings of the company for years to come. Some companies fail and the stockholders lose their entire investment. But other companies are extremely successful and the financial reward to stockholders can be huge.

Creating a corporation and issuing stock

The life of a corporation starts when the Organizers file an application with the Secretary of State, and pay a fee. The application contains the Articles of Incorporation and asks the State to authorize the company to issue stock.

Authorized, Issued, Outstanding and Treasury stock

Authorized - The Secretary of State authorizes a corporation to issue shares of stock. This determines the total number of shares that can be issued, and the par value per share.

Issued - Once a corporation sells a share of stock to a stockholder, that share is issued. A share can be issued only once by the corporation, but it can be traded any number of times among shareholders and investors. Trading is generally done on a public stock market, and transactions go through a stock broker. 

An Initial Public Offering (IPO) is the sale and issue of new stock, usually by a new corporation. After the IPO all future trading will take place on a stock market, with shares being traded amoung investors. After the IPO, the corporation is essentially out of the picture, when it comes to stock market activities. The corporation receives money only in the IPO.

Outstanding - After being authorized and issued, the total number of shares held by stockholders is called outstanding. Dividends are paid on outstanding shares only.

Treasury stock - Sometimes a company buys its own stock back from stockholders. This stock is held in the treasury (along with all the gold and crown jewels :-). No dividends are paid on treasury stock. Treasury stock can be held indefinitely, resold at any time, or retired. Retired stock is permanently removed from future sale and dividends.

A treasury stock journal entry includes a debit to the treasury stock account. It appears as a negative amount in the stockholders' equity section of the balance sheet.

Buying treasury stock reduces the number of shares outstanding. This has several effects. Reducing the number of shares increases Earnings Per Share (EPS). In return the stock's market price generally goes up, or at least holds steady in declining economic times. Since fewer shares are outstanding it also reduces total dividends.

An example: XYZ, Inc plans an IPO. The Secretary of State authorizes them to sell 1,000,000 shares of $1 par common stock. Through a stock market the company offers 750,000 shares for sale to interested investors. They hold back 250,000 shares from issue, because these may be needed later for employee stock option plans. Later that year the corporation decides buy back 50,000 shares that were previously issued.
 

	authorized	issued	treasury	outstanding
Authorized	1,000,000	0	0	0
Sold in IPO	1,000,000	750,000	0	750,000
Bought Treasury	1,000,000	750,000	(50,000)	700,000

 

Common and Preferred Stock

All corporations must have one class of voting common stock. Owners of the voting common stock have the right to elect the board of directors and vote on important matters that affect stockholders. They also have the right to receive unlimited dividends and benefit from unlimited capital growth.

Preferred stock is optional. Preferred stock usually carries certain benefits not available to common stockholders. Preferred stockholders generally receive dividends before common stockholders. In the event the corporation is liquidated, the Preferred stockholders are in line ahead of Common stockholders. Despite the benefits of Preferred stock, there are also limits on dividends and there is little or no capital growth potential for Preferred stock.

We follow the same basic rules to record both Common and Preferred Stock transactions.

Par and No-par stock

Par refers to a set amount of money, which is the underlying amount of Capital attributed to each share of stock. It can be any dollar amount the Corporation chooses. Par and No-Par stock rules vary from state to state. The use of these terms is a matter of law. Some states don't allow No-Par stock.

Par value is often used to assess annual corporate franchise fees. The francise fees allow a corporation to be in good standing and continue to operate legally. 

Corporations often distribute money to Stockholders, in the form of Dividends and other payments. In some states the Par value limits the amount that can be paid out to Stockholders. Those laws ensure that the Corporation does not deplete all it's capital resources. Not all states allow No-Par stock to prevent corporations for depleting their capital by paying excess Dividends. You need to check the laws in your state to know how corporations are organized where you live.

Selling Par Stock

A corporation raises money by selling stock. Corporations must sell at least one class of 
Common stock at the initial capitalization. This creates a group of owners who vote to elect a Board of Directors. The Board then hires a President or CEO, who heads the company and authorizes all further activities of the corporation.

Par stock is recorded at its par value in the stock account. 

Record the Sale of 100 shares of $1 par common stock, at par ($1 per share). Selling price is $1 per share

General Journal

Date	Account	Debit	Credit
	Cash	100
	Common Stock		100
	To record the sale of 100 shares of $1 par common stock at par.

Record the Sale of 100 shares of $1 par common stock, at a premium. Selling price is $5 per share.

General Journal

Date	Account	Debit	Credit
	Cash	500
	Common Stock		100
	Additional Paid-in Capital		400
	To record the sale of 100 shares of $1 par common stock at $5 per share

The Stock account (Common Stock in this case) is always credited for the amount of Par only.Any premium above par is credited to a different account. In this case I used the title Additional Paid-in Capital, but some companies and textbooks use other terms to mean the same thing. 

[Quick check -- what term does your textbook use for Additional Paid-in Capital?]

Selling No-Par Stock

When a company uses No-Par stock, they omit the Additional Paid-in Capital account entirely. 

Record the Sale of 100 shares of No-Par common stock for $5 per share.

General Journal

Date	Account	Debit	Credit
	Cash	500
	Common Stock		500
	To record the sale of 100 shares of no-par common stock at $5 per share.

Although No-Par stock is easier to record, not all states permit this type of stock. All stock transactions should follow one of the formats above, which much match the type of stock being sold. 

In some states a corporation may have par, no-par and preferred stock all at the same time. You need to check with state laws to see what is permitted where you live.

Record the Sale of 10 shares of $100 par, 8% cumulative preferred stock for $105 per share.

General Journal

Date	Account	Debit	Credit
	Cash	1050
	Preferred Stock, $100 par, 8% cumulative		1000
	Additional Paid-in Capital - Preferred		50
	To record the sale of 100 shares of $1 par common stock at $5 per share

Using the Additional Paid-in Capital (APIC) accounts

Some corporations set up a different APIC for each class of stock. Other corporations use only one APIC account for all classes of stock. Which way is correct?

Answer: Both are correct. It's up to the corporation to decide how it wants to recorde these transactions.

Ultimately, all APIC belongs to the Common stockholders. Preferred stockholders are entitled to either the Par value or Call value of their stock, and are not entitled to a return of APIC. 

Call value of Preferred Stock

Some Preferred stock has a Call value. This means the corporation can Call, or buy back, the stock from the Preferred stockholders, at the option of the corporation. The stockholders have no say in this matter. Because they are losing their investment the Call value is usually higher than the Par value, at least by a couple of dollars.

There is usally an Exercise Date on a Preferred stock Call. That date is usually many years in the future, and prevents the corporation from calling the stock before this date. The Exercise Date benefits stockholders -- the corporation must wait until some time after this date before it can call the preferred stock.

When Preferred stock is called, it is usually Retired. Retired stock is no longer available for sale, no dividends will be paid on retired stock, and it has no future effect on stockholders equity.

Investor analysis of financial statements

Example: Analysis of an Equity Section of a Balance Sheet

Stockholders' Equity and Paid in Capital

The post closing year-end balance sheet of Technical Services, Inc. includes the following stockholders� equity section (with certain details omitted):
 

Stockholders� equity:
6% cumulative preferred stock, $100 par value, callable at $102, 100,000 shares authorized	$2,400,000
Common stock, $2 par value, 2,000,000 shares authorized	2,200,000
Additional paid-in capital: Common stock	1,485,000
Donated capital	410,000
Retained earnings, end of year	3,470,000
Total stockholders� equity	$9,965,000

 

Instructions

From this information, compute answers to the following questions:

a. How many shares of preferred stock have been issued?

 

Recorded Par value of all preferred stock outstanding	$2,400,000
Divided by: Par value per share of preferred stock	$100
Number of shares of preferred stock outstanding [2,400,000 / 100]	24,000 shares

[Note: Preferred stock usually has a par value of $100 per share. In this case there is no additional paid-in capital associated with preferred stock.]  

b. What is the total amount of the annual dividends paid to preferred stockholders?

 

Dividend requirement per share of preferred stock ($100 x 6%)	$6 per share
Times: Number of shares of preferred stock outstanding (from part a)	24,000
Annual preferred stock dividend requirement [24,000 * $6]	$144,000

 

c. How many shares of common stock are outstanding?

 

Recorded Par value of all common stock outstanding	$2,200,000
Divided by: Par value per share of common stock	$2
Number of shares of common stock outstanding [2,200,000 / $2]	1,100,000 shares

[Note: this company has no Treasury stock. Treasury shares would be sutracted from total shares, but only when they are present.]  

d. What was the average issuance price per share of common stock?

 

Recorded Par value of all common stock outstanding	$2,200,000
Plus: Additional paid-in capital: Common stock	1,485,000
Total issue price of all common stock	$3,685,000
Divided by Number of shares of common stock outstanding (from part c)	1,100,000
Average issue price per share of common stock [$3,685,000 / 1,100,000]	$3.35 per share

[Note: this company has recorded additional paid-in capital on common stock. At least some of the stockholders paid a price greater than par value for their shares. Since stock prices tend to fluctuate, this would be a typical situation for most corporations.]  

e. What is the amount of legal capital?

 

Par value of preferred stock issued	$2,400,000
Plus: Par value of common stock issued	2,200,000
Total legal capital	$4,600,000

[Note: Legal capital is the total of par value of all shares issued. Legal capital laws and requirements vary from state to state. Check with the Secretary of State to find out the legal capital requirements in your state. ]  

f. What is the total amount of paid-in capital? 

 

Total Stockholders Equity	$9,965,000
Less: Retained earnings	3,470,000
Total paid-in capital	$6,495,000

[Note: Paid-in capital represents all amounts paid by stockholders to the corporation in exchange for stock. Donated Capital is also called Contributed Capital. GAAP requires us to include Donated
Capital in the computation of paid-in capital. See the note below on Donated Capital.]  

g. What is the book value per share of common stock? (Assume there are no dividends in arrears.)

 

Total stockholders' equity	$9,965,000
Less: Call value of Preferred stock [$102 * 24,000 shares]	2,448,000
Total Book Value belonging to common stockholders	$7,517,000
Divided by number of common shares outstanding (from part c)	1,100,000
Book value per share of common stock, rounded to nearest cent	$6.83

[Note: Book Value is an artificial amount. It merely represents the amount of value due to the common stockholders, divided by the number of common shares outstanding. Call price of preferred stock represents the amount that would be paid to buy out preferred stockholders.]  

h. Dividends on common stock 

Assume that retained earnings at the beginning of the year amounted to $745,000 and the net income for the year was $3,600,000. What was the dividend declared during the year on each share of common stock? 
 

Retained earnings, beginning of year	$745,000
Add: Net income for the year	3,600,000
Subtotal	4,345,000
Less: Retained earnings end of year	3,470,000
Total dividends paid during the year	875,000
Less: Dividends on preferred stock (part b)	144,000
Total dividends due common stockholders	$731,000
Divided by: Number of common shares outstanding (part c)	1,100,000
Dividends per share of common stock outstanding, rounded	$ .6645

[Note: This part simply follows the general format of a Retained Earnings statement. Accountants generally carry Dividend and EPS calculations out to 4 decimal places, for greater accuracy. Most publicly traded companies have millions, perhaps even tens-of-millions of shares of common stock. It's easy to see how those 2 extra decimal places can make a big difference in accuracy when you are dealing with many shares of stock. ]
 
   

DONATED CAPITAL is a gift of assets to a company, usually by state or local governments, typically to induce a business to relocate to their jurisdiction. Donated Capital belongs to the Common Stockholders, unless otherwise stated in stockholders' agreements. 

When calculating part g, you will use the CALL price of preferred stock. If there is no call price, then you will use the par value. But when preferred stock has a call price, that is the amount used, because it is the amount that would be paid to preferred stockholders if the corporation were to call and retire the preferred stock. Aside from this one small point, this problem is essentially the same as the example I provided in the Study Guide for this week.
 

Non-Cash Stock Transactions

Stock must be paid for before it can be issued. It is a violation of law to issue or record stock prior to receiving payment from investors. It's easy to value a stock sale for cash, since the cash paid fixes the actual value of the transaction.

Sometimes stock is issued for something other than cash. Land, buildings, equipment, vehicles or other assets can be exchanged for stock. Shares of one company's stock can also be exchanged for shares of another company. Investments of various types (stocks, bonds, etc.) may also be exchanged for shares of stock. In some cases, the value of the property given up can easily be determined, making it easy to place a value on the stock transaction. 

When a non-cash transaction occurs, we have to take a market value approach, and we try to identify the part of the transaction that has the most widely accepted market value. There is a specific heirarchy accountants must use to determine the overall value of such transactions.  We apply the heirarchy in the following order.

1. If the stock being issued is publicly traded, the entire transaction is the market value of the stock given up. We will assign that value to any assets received.

Example: On March 27, 2006 Microsoft Corp. exchanges 100,000 shares of company stock for a piece of undeveloped real estate. What is the value of this transaction?

On March 27, 2006 Microsoft stock sells for $27.25 per share. They give up 100,000 shares, in effect saying "we think the property we are purchasing is worth $2,725,000." 
[$27.25 * 100,000 shares = $2,725,000]

We assign the market price of Microsoft stock to this transaction, because the stock is heavily traded on global stock markets, and the price is fixed by a very large market of investors. If Microsoft feels that the real estate is worth 100,000 shares, who are we to argue? Accountants just have to record the transaction.We don't have to care if company management is making a good deal or not. But we do assume that the transaction is "fair" and "at arms length" and that neither party is under any particular pressure or duress to enter into this fair market value agreement.

On the other side of the coin -- the seller (now stockholder) must also feel that $2,725,000 is a "fair" price for his/her real estate, or he/she would not have accepted Microsoft's offer. Since the 100,000 shares can immediately be sold on open market for $2,725,000, the seller can convert the shares to cash the same day as the transaction. 

Microsoft common stock is $0.00000625 par value per share, so they will record $0.63 in par value, with the remaining recorded as additional paid-in capital, as follows:
[$0.00000625 x 100,000 = $ 0.625, rounded to $ 0.63]

General Journal

Date	Account	Debit	Credit
	Real Estate	2,725,000.00
	Common Stock		.63
	Additional Paid-in Capital		2,724,999.37
	To record the issue of 100,000 shares common stock in exchange for unimproved real estate.

This is a rather unusual example because Microsoft's par value is so low. But this is how it's done, regardless of the dollar amounts involved.

2. If the stock being issued is NOT publicly traded, the entire transaction is the market value of the asset received. We will assign that value to any shares of stock issued.

XYZ Corporation is a small private company. It's stock is not sold on a public stock exchange, and there is no ready market for the company's stock at this time. XYZ Corporation agrees to exchange 10,000 shares of company stock for a piece of unimproved real estate. Two independent, certified and licensed appraisers are hired to provide appraisals of the real estate value. The appraisers agree that the real estate has a fair market value in the range of $100,000 to $110,000 at the time of the transaction. 

Following the accounting rule of conservatism, we apply the lower of the range of values, or $100,000, to this transaction. We follow the conservatism rule to minimize the effect of making an estimate. If the company stock has a par value of $1 we would record the transaction as follows:
 
 

General Journal

Date	Account	Debit	Credit
	Real Estate	100,000
	Common Stock		10,000
	Additional Paid-in Capital		90,000
	To record the issue of 10,000 shares $1 par common stock in exchange for unimproved real estate.

3. In some rare instances neither of the two approaces above will work, and we have to take a slightly different approach. We still need to approximate true market value of the transaction, since that is always considered the fair approach.

Assume ABC Corporation is not publicly traded. They agree to exchange 5,000 shares of company stock for a piece of unimproved real estate. The real estate is in an area that is facing economic downturn in the real estate market, and has been available for sale for many years, with no interested buyers or offers. Appraisers are reluctant to place a market value on the property.

After updating and analyzing the company's books, the accountants determine that ABC Corporation's stock has a Book Value of $2.10 per share. We seldom use book value for any calculation, but this is one rare instance where it is used. We place a value on the transaction of  $10,500  [5000 shares * $2.10]. IF the par value is $1 per share, we record the transaction as follows.
 
 

General Journal

Date	Account	Debit	Credit
	Real Estate	10,500
	Common Stock		5,000
	Additional Paid-in Capital		5,500
	To record the issue of 5,000 shares $1 par common stock in exchange for unimproved real estate.

In this case, the corporation is willing to give a share in the company equal to $10,500 in exchange for the real estate. This represents a future interest in profits and ownership to the person selling the property. The new stockholder believes the value of the land is worth $10,500 since he/she accepts the offer under these terms. Both parties will apply the same value to the transaction.