Equity Financing Debt Financing  Loans, repay with interest Liable for amount of loan Relationship ends with repayment Equity Financing  No responsibility to repay Investor takes risk Investor rewarded by company’s future 2 categories of EQUITY Contributed Capital:  The amount of money that the owners have contributed through the purchase of stock  (Capital Stock) Retained Earnings:  The net income earned by the company not paid out as dividends Two types of Capital Stock NOTE: The accounting is identicalPreferred Stock Has Dividend Preference IF a dividend is paid, then the preferredstock holders must be paid in full before the common stockholders can receive a dividendThe preferred stock dividend is a set fixed percentage Preferred stockholders typically do not have voting rightsCommon Stock Has Voting Rights Election of board of directors Vote on significant activities of management  Dividend rates are determined by the board of directors based on the corporation’s profitability  Receive dividends after preferred stockholders Most preferred stock is cumulative Preferred stockholders must be paid both current and prior years unpaid dividends before common stockholders can receive any dividends These prior years are called: Dividends in Arrears- Not liability- Must be disclosed in the notes to the Financial Statements Par Value: a monetary amount assigned to each class of stock  Used for accounting purposes only Has no relationship to market value Accounting Rule: When stock is sold to owners (stockholders), the stock account is only recorded at its par value The excess of the selling price of the stock over the par value is recorded in the equity account called: Paid in equity account Each class of stock has 3 types of Shares Authorized Shares: - The total number of shares of stock that the company is allowed to sell to the public Issued Shares: - The total number of shares that have been sold to the public Outstanding Shares: - The total number of shares actually in hands (owned) of stockholders KEY POINT: Difference between issued and outstanding: Stock that has been reacquired is called Treasury StockTreasury Stock: Corporation’s own stock that had been issued but was subsequently reacquired Account Characteristics of Treasury Stock  Results in a decrease to total stockholders’ equity on the balance sheet Classified as a contra equity account Normal balance is a debit Other Information Considered issued stock but not outstanding stock Does not have voting rights Cannot receive dividends Recorded at its reacquisition cost (buy back cost) NOT recorded at par value No gains or losses are ever recognized from these equity transactions Never affect income statementWhy?o Reduce shares outstanding and thus increase the market value per shareo Because the market price is lowo To remove shares from the market to avoid a hostile takeovero To use in employee stock option programso To give cash back to shareholderso To increase the reported earnings per share Journal Entries for shares that were reacquired and are re-issued Re-issue price > Reacquisition cost  Record excess in Equity Account Paid in Capital – Treasury Always remove the treasury stock fromthe balance sheet at its reacquisition cost Re-issue price < Reacquisition cost  Reduce Paid in capital Treasury until it is at zero If there is extra, then reduce Retained earnings Reviewed Terms: Retained Earnings : Net Income earned by the company not paid out as dividends Dividends : Distribution to the owners (stockholders) of a corporation  Cash Dividends : Cash distribution of earnings to stockholdersCash Dividends Dividends must be declared by board of directors before they can be paid Once a dividend is declared, the liability is created BUT The corporation is not legally required to declare (and subsequently pay) dividends Dividends are not considered expense Thus, do not impact net income Contra-Equity, reduces retained earnings  Normal balance of dividend is a debit Require sufficient cash and retained earnings to cover dividend Important Dates for Dividends: 1. Date of Declaration Board of directors formally announces that to pay a dividend2. Date of Record Date which ha stockholder must own the stock in order to receive the declared dividend 3. Date of Payment The date on which a corporation pays dividends to its stockholders Preferred Stock Dividend = par value x % Total Preferred Stock dividend = par value x % x # shares outstandingNOTE: Dividends are only paid on outstanding shares Thus, no dividends are paid on treasury stockImportant Equity Ratios Return on Equity Measures the amount of profit earned per dollar of invested capital Net Income / Average Equity Overall Company performance Higher is better Earnings per share (EPS) The amount of Net Income that is associated with each share of common stock (Net Income—Preferred stock Dividends) / # of Common shares Outstanding Higher is better How much of the company’s income belongs to an investor PE ratio (Price Earnings) Shows relationship between the market value of a company and that company’s current earnings Measures investors’ expectations regarding the growth potential and earnings stability of a company Market Price per share / Earnings per share Higher is betterFinancial Statement Effects from Equity TransactionsIncomeStatementBalance Sheet Statement of Cash FlowsIssuance of EquityNONE - Increase Assets (Cash)- Increase Equity (Common Stock & Paid in Capital)- Financing InflowBuying Shares BackNONE - Decease Assets (Cash)- Decrease Equity (Treasury Stock = contra-equity)- Financing