Section 3.) Stock Dividends and Splits
When a company has had success in its operations, a common result is that they issue a dividend to the investors as one of the returns on that investor’s investment. In some cases, this takes the form of a cash dividend where the investor gets a certain dollar amount per share. In other cases, this takes the place of a stock dividend where an existing shareholder gets additional “free” shares of stock based on their current percentage of ownership in the company.
The important thing to note is that in both cases, the cash or stock dividend ends up reducing retained earnings (with a debit.) The credit for a cash dividend would go to cash. The credit for a stock dividend would go to the common stock account.
However, it is important to note that the total equity doesn’t change with a stock dividend. Instead, one element of equity decreases (retained earnings) and the other increases (common stock.) Since more shares are being issued without a corresponding cash increase for the company, the value per share will decrease. This is similar to the impact of a stock split. The main difference is that the stock dividend requires a journal entry, whereas a stock split does not.
Journal Entry for Stock Dividend:
When calculating the value for the stock dividend entry, you must first determine the number of shares that are to be issued. This requires taking the stock dividend percentage multiplied by the current number of shares “outstanding.” This outstanding number of shares reflects those that have been issued and have NOT been bought back by the company as treasury stock (discussed later.) For example, if the company issued 100,000 shares of stock, but bought back 20,000 shares as treasury stock, then only 80,000 would be eligible for the stock dividend. If the stock dividend was 10%, that would result in 8,000 new shares (80,000 outstanding shares* 10%.) If the par value of the shares was $50, that stock dividend would be recorded at a value of $400,000.
Remember the general rule that dividends of any kind (cash or stock) can NEVER be paid to treasury stock owned by the company.
Purpose of Stock Dividends and Splits
Generally speaking, both investors and companies prefer a higher stock market price. From an investor perspective, it means their investment is worth more. From a corporate perspective, it means that the strategies they have implemented have been successful.
That being said, there are drawbacks to a higher stock value. As an investor that is looking to purchase a new share of stock, a higher value may also mean a higher risk that the value will drop, and they will lose their investment. A large part of investing in the stock market is simply psychology.
Generally speaking, when a share of stock gets to certain plateaus ($50, $100, $200, etc.) investors start to become wary that it is overvalued and due for a correction. Of course, this doesn’t happen all of the time to every stock, but it is not all that rare either. As the value gets higher and higher, there is more of a concern that demand for the stock will decrease. For this reason, although a high stock price is generally something companies (and investors) look forward to, there is also a concern about that increasing value.
From a corporate perspective, companies may also be concerned with the higher price because it limits the number of investors that can even afford to purchase their stock. Most brokers do not allow for the purchase of partial shares (known as fractional shares), although some do. As such, if a stock price is very high, only a relative few investors can afford it. This can be both good and bad from a company’s perspective. On the plus side, having just a few large investors generally means that there will not be as much volatility. Several smaller investors tend to lead to more volatility as they act more on the basis of psychology than the fundamentals of the market. From the negative perspective, these larger investors tend to be more likely to exercise the power that they get from ownership. As such, they can place more demands on the officers and management of the company.
For all of these reasons, there may be situations where a company wants to reduce the value of their stock on the open market. Of course, they want to do so in such a way as not to hurt the overall value of the stock or harm any existing investor. A company has no way of directly impacting the total value of their stock on the stock market, however they do have ways of reallocating that value to more or fewer shares. The is the concept behind a stock split. The principal reason for a company having a common stock dividend or stock split is to decrease the market value per share of common stock.
A stock split is a situation where the company increases the number of shares outstanding, at the same decreasing the value per share proportionately. In the simplest example, the number of stock shares doubled while the value per share is decreased by half. Again, this means that the same total value exists for each investor and in total. However, it had the effect of reducing the per share price.
A reverse stock split can be completed when the company desires to decrease the number of shares and increase the value per share.
More complicated stock splits such as a 3 for 2 would require you to divide the existing share number by 2 and then multiply by 3. Another way is to simply multiply the existing share count by 3/2 (i.e., 1.5)
No journal entries are needed for either type of stock split. Instead, the par value and number of shares simply need to be updated on the balance sheet and statement of stockholder’s equity.
Stock Options:
In some companies, one of the main components of the employee and manager compensation plan is the stock option. This is a situation that gives the recipient the right to purchase shares of stock in the future at a set price (known as the exercise price.) Of course, on the date that the option was granted, the stock price is much lower than the exercise price. The goal is to create an incentive for the employees to do their very best at work to contribute to the success of the company, which should translate into an increased stock price by the time they sell.
Generally speaking, an option has a specific vesting period built in, which means that it cannot be exercised until a certain period of time passes. In many cases this is years. The goal is to persuade the employee to work for the company long term.
Until the current stock price increases above the exercise price, the option is considered to be “under water.” This is a situation where the option holder would not want to exercise the stock price. Who would want to purchase a share of stock for $55 when the current price is $45?
If the stock never increases above that exercise price by the time the option expires, it would not be considered to have any value.
There are a variety of tax issues that come into play with stock options, however these are beyond the scope of these basic financial courses.
Below is a YouTube video that will help to clarify the topics discussed above.
Cash Dividend
Section 4.) Treasury Stock
When a company decides to buy shares of another company’s stock it holds those as an investment (an asset). However, in some cases a company may also decide to buy back shares of its own stock from the open market for one reason or another. In these cases, it cannot treat this as an asset. Instead, it can do one of two things with it:
1.) Retire the shares of stock (de-issuing them.) Note that this will put it back in the “authorized” bucket of stock shares so that it can reissue it again in the future if it wants.
2.) It may decide to hold the shares of stock in the corporation’s treasury (referred to as treasury stock.)
If the company holds the stock as treasury stock, this is considered a reduction in owner’s equity. As such, treasury stock is thought of as a “contra owner’s equity” account. This is shown in the statement of Changes in Stockholder’s Equity below.
There are a few important things to remember with shares that are being held as treasury stock:
1.) It is not an asset
2.) Treasury stock is not eligible for any dividends that may be paid.
3.) No gains or losses can be reported on any treasury stock sales.
We will discuss these issues later.
Why would a company want to buy back treasury stock? There are several reasons:
1.) It is one way of paying money back to its investors. It gives them more opportunities to sell their shares, and it reduces the number of outstanding shares in the market, which, if demand stays the same tends to increase the price. The remaining owners now own a larger share of the company, although the value of the company has now dropped due to the payout in cash.
2.) They may be buying back the shares because the company believes the market is undervaluing them. The fact that the company is willing to sacrifice their cash to buy the shares back may signal to investors that management knows something good is on the horizon.
3.) They may be buying back the shares of stock to keep a controlling interest and prevent hostile takeovers.
4.) They may be buying back shares of stock for future issuance as stock dividends, stock options, or some other form of compensation.
When a company decides to buy back shares of stock, it has to pay the going price for those shares just like any other investor would. There is an exception with something known as callable preferred stock, but this will be discussed in a later module.
If the company buys back 10,000 shares of stock at $10 per share, the transaction will look like this:
When the company eventually sells the treasury shares back, it has to keep track of the price it originally purchased the shares for. Using the cost method of recording treasury stock, any excess sales price above the original cost will be recorded in an account called “Additional Paid in Capital Treasury Stock.” This is not considered a gain like it would be if a company sold shares it was holding as an investment in another company above cost. Furthermore, it does not increase retained earnings. Instead, it directly increases a different classification of equity (additional paid in capital, sometimes referred to additional paid in capital-treasury stock.)
This “Additional Paid In Capital Treasury Stock” is also used as a “fund” to account for situations where the treasury stock was sold back at a price lower than the original cost. In situations where these shares are continuously sold at prices below cost, you may run out of that “Additional Paid in Capital” account, in which case you would have to begin debiting Retained Earnings directly for the difference.
Let’s take a look at each of the examples for the above treasury stock situation.
Example 1: Out of the 10,000 shares it originally purchased at $10 per share, it is now selling 3,000 shares at $14 per share (i.e., $4 above cost.)
-Note that the cash account must be debited for the full resale price (3,000 shares * $14).
-The Treasury Stock account can only be credited for the 3,000 shares multiplied by the original $10 cost
-The excess $4 per share goes into the “Additional Paid in Capital-Treasury Stock” account.
Example 2: Out of the remaining 7,000 shares it originally purchased at $10 per share, it is now selling 3,000 more shares at $8 per share (i.e., $2 below cost.)
-Note that the cash account must be debited for the full resale price (3,000 shares * $8)
-The Treasury Stock account can only be credited for the 3,000 shares multiplied by the original $10 cost
-The deficit of $2 per share must come out of the “Additional Paid in Capital-Treasury Stock” account. This reduces the account with a debit, using up some of the excess amount we recorded earlier.
Example 3: Out of the remaining 4,000 shares it originally purchased at $10 per share, it is now selling 4,000 more shares at $6 per share (i.e., $4 below cost.)
-Note that the cash account must be debited for the full resale price (4,000 shares * $6)
-The Treasury Stock account can only be credited for the 4,000 shares multiplied by the original $10 cost. This will bring it to zero.
-The deficit of $4 per share must first come out of the “Additional Paid in Capital-Treasury Stock” account. This reduces the account with a debit, using up some of the excess amount we recorded earlier. Note that we only have $6,000 left in the APIC account from earlier (the original $12,000 we set up less the $6,000 we used.) We have a total deficit of $16,000 (Cost of $40,000 less resale price of $24,000.) Since we don’t have enough APIC, we will have to directly debit Retained Earnings for the remaining difference.
Remember the general rule that dividends of any kind (cash or stock) can NEVER be paid to treasury stock owned by the company.
Below are YouTube videos that will help to clarify the topics discussed above.
Equity and Treasury Stock
https://youtu.be/CT6EjIyHucE
Section 1.) Stock Overview and Issuance (Common and Preferred Stock)
In previous modules, we covered assets and liabilities, both current and long-term. The final element of the basic accounting equation, (Assets = Liabilities + Equity), is Equity. Equity represents the residual share of the assets that revert back to the owners/stockholders when the company liquidates. This is sometimes referred to as “net assets” because it is the amount of assets left over after paying off the liabilities owed to the creditors. Liabilities come before equity in the accounting equation because they are the first to be paid off.
Liabilities and Equity are similar in that they are two different ways that a company can finance its operations. With liabilities, the company is borrowing money from non-owners, and in return they are required to pay back the principal and a specified amount of interest. With equity, the company is sharing the ownership of the company with new owners who are contributing money in exchange for a share of future profits and asset distributions.
For this module, we generally focus on an actual corporation that issued stock on a public stock exchange. As you may recall, the owner’s equity section can be expanded into its components. This module discusses all of these components. Owner’s Equity can be broken into the following components: Note that there are a few ways to visualize this as there are so many sections and subsections of owner’s equity. Some of these may be categorized in different ways.
1. Paid in Capital - (including the common and preferred classes of stock)
· This may include value recorded at par value (if one has been stated) and any “additional paid in capital” representing sales of stock at a price in excess of par value. More detail on this later
2. Retained Earnings - This is the net income that has accumulated from day one of the company minus any amounts paid out to investors in the form of dividends. Recall from earlier modules that when we closed our income and expenses, they were closed out to retained earnings. Another way of thinking about this is that it is the total amount of net income that has been reinvested in the company (as opposed to being distributed out to their stockholders in the form of a dividend.) Retained earnings is increased by net income, decreased by net loss, and decreased by dividends.
3. Dividends – These represent the portion of earnings that were paid out to the owners (rather than retained) in a given period. As you may also recall from the closing process discussion, the dividend balance for a given period was also closed out to retained earnings, because it reduces it.
· Dividends may be in the form of cash dividends or stock dividends (discussed later.)
4. Accumulated Other Comprehensive Income – Up to this point we have not mentioned this item, however it is a relatively new component of the owner’s equity. This represents any type of income/loss that is not allowed by GAAP to be reported in our normal section of the income statement. Since all income/loss has a final effect on owner’s equity, these special types of “other comprehensive income” will be reported directly to the owner’s equity section.
5. Treasury Stock – This represents stock that the company has repurchased from the open market and is holding it as an offset to the paid in capital amount. This does NOT represent an asset (investment) of the company.
Paid in Capital (aka contributed capital)
This represents amounts paid into the company by owners. For example, when a company issues shares of stock to obtain financing to run the business the investors pay the issue price, and this becomes contributed capital. It is important to note that once shares of stock are issued and become public, any increases in decreases in the value on the stock market DO NOT have any effect on the paid in capital of the company. This is a completely external transaction. Nevertheless, a company will generally try what little they can to manage the market price of their stock with any resource they have because this will affect how easily they will be able to obtain financing in the future.
Note that some stock is issued at a specific par (or stated) value, which doesn’t necessarily mean that is the price is issued at. The original purpose of these par values was to protect the creditors by stating that all amounts up to the par value must remain available to protect the claims of the creditors. In other words, a company cannot decide to pay out dividends in excess of retained earnings and retained earnings.
Additional Paid In Capital- This arises when a par or stated value is issued and the issue price of the stock is in excess of this par or stated value.
Common Stock- All corporations must have this class of stock. This class receives voting rights and shares in on profits of the company.
Preferred Stock- This class of stock is optional. The “preference” comes from the fact that the preferred stockholders receive their dividends before the common stockholders. There is generally a set percentage of par value assigned to dividends (or a set $ amount if there is no par value.)
Even though there is a set amount of dividends to be paid to preferred stockholders, this does not necessarily mean that the preferred stockholders are definitely going to get that dividend in a specific year. In some years a company may not choose to or be able to pay a dividend. What “preferred” means is that, if a dividend is paid to anyone, it will go to preferred stockholders first. In some cases, even if dividends are skipped for a given year, the preferred stockholders will be paid for the last year in the next year that there are dividends. This is called a “cumulative dividend.”
In some cases, this may result in the common shareholders not getting anything. However, in some cases total dividends issued will be so high that even after preferred stockholders get their share, there is a lot more to go to common shareholders. If preferred shares also have a “participating” dividend option, this means that they get paid their share first, then common stockholders get their share up to that amount, and then both classes of stock share in any additional dividends equally.
There are two other options that can come into play with preferred stock.
1. Callable preferred stock is that which can be bought back by the company at any given time at a set price.
2. Convertible stock is that which can be converted to common stock at the option of the investor.
The best way to think of shares is that they represent a percentage of ownership in the company. If there are 100 shares outstanding, then each share represents 1% of the ownership. If there are 200 shares outstanding then each share represents .5%, etc.
There are a few important numbers when reviewing the stock of a company.
# Of shares authorized- This tells how much the company is currently authorized (by its corporate charter to issue. Remember that issuing shares is a way that a corporation can obtain financing to run their business.
# Of shares issued- This is the number of shares (out of the number authorized) that a company has already issued in return for cash investments.
# Of shares outstanding- This is the number of shares (out of the number issued) that are still out in the open market. This is # issued less # of shares held as treasury stock.
Below are YouTube videos that will help to clarify the topics discussed above. This includes one that matches our Excel assignment.
Equity and Issuance of Stock
Equity and Retained Earnings
Stock Entry Exercise (This one will help with this week’s assignment)
Section 2.) Cash Dividends
As an investor, there is an expectation that you will eventually receive some sort of return on your investment. The long-term return will come from holding the stock as the value rises and then selling it at a later time. However, many companies also pay out dividends to their investments for more of a short-term return.
As discussed in earlier modules, when a company has net income (revenues that exceed expenses), this flows into retained earnings. The company can choose what they want to do with the retained earnings. Although many companies do pay dividends, there are several that do not. In those cases, an investor only gets a return by the eventual increase in the stock’s value.
Below are some very well-known examples of large companies that do not currently pay a dividend:
- Berkshire Hathaway (Warren Buffett’s company)
- Amazon
- Apple (This is an example of a company that currently pays dividends but had a history of not paying dividends (or very small ones) even though they had plenty of cash to do so.
One may question why such large companies do not pay dividends and further why investors don’t demand it. The reason has nothing to do with an inability to pay a dividend, but rather the fact that the company can use the money to grow and increase the value of the stock over the long term.
Consider what a company can do with the net income and cash that they get from their operations.
They could certainly pay it out to the investors in the form of a dividend, but then if they needed money to expand, they would have to turn around and borrow money and pay interest. In many cases, it is easier and cheaper to finance themselves internally (through using their retained earnings.) In other words, they can distribute the earnings, or they can retain them. Sometimes retaining those earnings for future growth benefits the investors far more than paying them a dividend would.
Recall that dividends are NOT an expense, but instead directly reduce retained earnings, thereby reducing overall capital. As such, they have a normal debit balance (opposite of equity overall.)
Below is an example of the Statement of Retained Earnings, which shows how the declaration of dividends reduces equity.
When dealing with dividends there are three important dates to know about for accounting purposes:
1.) The Date of Declaration - This is the date that the Board of Directors declares that they will be paying a dividend at some point in the future. Up until this date there are no guarantees that a dividend will be paid at all. This is unlike a bond where the corresponding interest is a contractual obligation. This is even true with the preferred dividends that we will discuss later. No stockholder is ever guaranteed a dividend until it has been declared.
That being said, many companies that do pay dividends strive to keep a trend of dividend payments up as in those cases the stock’s value may in part be determined based on the dividend payment history. For those stocks where dividends are expected a failure to declare one in a particular year may signal a failure to investors and the stock may lose value as a result.
For example, let’s say that on January 1 a company declares a dividend of $1 per share (for 100,000 shares) to stockholders of record on February 1 to be paid on March 1.
The journal entry for the dividend declaration would look like this:
Notably, this increases dividends (which in turn reduces dividends) and increases a liability account known as dividends payable.
Note that companies also have the option of just debiting retained earnings directly (instead of using a dividends account). This option will directly reduce retained earnings, instead of doing it indirectly.
2.) The Date of Record – This is the date on which the current stockholders are locked in for the future dividend that will be paid. Keep in mind that stock shares trade continuously around the world, and the owner of a share on one day may be different from the owner of the share the next day. As such, it is important to set one date to identify who is the owner that will eventually receive the dividend when it is paid.
No journal entry is needed for this date.
3.) The Date of Payment – This is the date that payment is actually made to whoever was locked in as the owner on the date of record.
The journal entry would look like this:
In order for a company to pay an ordinary dividend they must have sufficient cash (to pay it) and sufficient retained earnings (since that is the account that dividends come out of). There are other types of dividends known as capital or liquidating dividends, which are essentially a return of the owner’s initial investment. These types of dividends do not have to follow that same rule; however, they are outside of the scope of this course.
Preferred Dividends
A preferred stockholder gets their dividends before any common shareholder does. This is one of the benefits of preferred stock. The drawback is generally that they may not be able to share in the excess of any unusually large dividends. Instead, they are generally guaranteed their stated dividend rate, much like a bondholder is guaranteed their stated interest rate. In fact, the calculation of the preferred dividend is very similar to the calculation of the bond interest. You take the par value of the preferred stock multiplied by the dividend rate to get the per share dividend amount. Then, take that per share amount multiplied by the number of preferred shares outstanding.
For example, if a company had 50,000 shares of $100 par value preferred stock (with a 10% dividend rate) issued and outstanding (i.e., no treasury stock.) then the cash dividend would be 50,000 shares x 10% x $100 par value = $500,000.
Note in the above example there was no treasury stock, so the number of shares issued equaled the number of shares outstanding. There is a general rule that dividends of any kind (cash or stock) can NEVER be paid to treasury stock owned by the company. Treasury stock will be discussed in a later section, but it reflects stock that has been bought back from the open market by the company. The company cannot pay themselves a dividend. As such, if there were treasury stock in the above example, that number of shares would have to be subtracted out before calculating the dividend.
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