This course is the fourth course in a five-course Financial Reporting Specialization. This course focuses on the recognition, measurement and subsequent accounting for equity, pensions, share-based compensation and cash flows utilizing the FASB Accounting Standards Codification and other resources.
Introduction to Equity
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Из курса от партнера University of Illinois at Urbana-Champaign
Accounting Analysis II: Accounting for Liabilities and Equity
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Module 3 Equity
In this module, the conversation changes from liabilities to equity. You will learn how to account for the issuance of common stock and basic transactions such as cash dividends, stock dividends, stock splits, and the purchase and reissuance of treasury stock. The module also includes a discussion of preferred stock and accumulated other comprehensive income.
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John HeppClinical Assistant Professor of Accountancy
Department of Accountancy
Hello, welcome to module three.
In this module, we talk about equity.
So, let's talk first about what equity is.
Equity is defined in the conceptual framework as a residual interest.
In other words, if you think of your accounting equation, assets,
equals liability, plus equity,
assets are defined in the conceptual framework.
Liabilities are sort of defined in the conceptual framework and equity is the residual.
It's what's left over.
Well, it is the residual but there can be multiple classes of
stock within equity and they can have different rights.
Some of them, it's referred to as preferred stock.
Probably really shouldn't be an equity but it is by tradition
from some court cases that go back into the 19th century,
it was decided at that time,
that because there was an unconditional obligation
to pay back the shareholders who hold preferred stock,
that it would be classified as equity.
In other words, you would only be paid out of profits from the firm.
Other forms of equity that you can have will be warrants,
stock options, that we'll talk about as we go forward.
But even within the common stock,
which is usually considered to be the ultimate residual,
there may be multiple classes of stock with different rights.
And also, there's a separate accounting for par values.
Par values used to have an important legal war, legal function.
It was the permanent capital of the firm.
It doesn't really have that role anymore and it's often
just a token amount of sometimes a dollar
at initial when the stocks initially issued but it can be a fraction of
a penny today due to multiple stock splits or other actions.
Some stocks don't even have a legal par value.
They have a stated value which is considered to be the same,
more or less, for accounting purposes.
So, let's take a look at an example how you can have multiple classes of common stock.
This is from the 2016 financial statements of Facebook.
They talk about how our certificate of incorporation authorizes
the issuance of Class A common stock and Class B common stock.
Now, an important statistic for a common stock is how
much is authorized and how much is issued.
If you don't have stock authorized,
you can't issue it and the authorization usually
comes from a resolution from the board of directors.
So, we are authorized to issue five million shares of
Class A common stock and 4.1 million shares of Class B common stock,
each with the par value of,
look at how many zeros are in front of that six.
This is what I mean that par value is often a very small fraction of a penny.
So, holders of our Class A common stock,
we're continuing with the Facebook example,
and Class B common stock are entitled to dividends when, as and if,
declared by our board of directors,
subject to the rights of the holders of all classes
of stock outstanding having priority rights to dividends.
That could be your preferred stocks.
So, what is the difference between classes A and Class B?
Well, the holder of each share of Class A common stock is entitled to one vote,
while the holder of Class B common stock is entitled to 10 votes.
Sometimes, this is called a golden share.
It gives the owner of that stock a way disproportionate interest in corporate governance.
Sometimes, you'll have a different class of stock which has an absolute veto.
This happens sometimes with privatization of state-owned entities
particularly in Europe where the government will retain what's called a golden share.
But here in Facebook,
they have two shares of stock.
One of which, allows you to participate in dividends and capital appreciation.
But the other one really gives you voting control.
Now note, the shares of Class B are convertible
into equivalent number of shares of Class A common stock.
Well, why would you want to do that?
Well, it generally converts into shares of Class A upon transfer.
So, in the Class B holders of the stock decide to sell,
the person that buys the stock won't get that 10 to one voting preference.
They'll just have the equivalent of an ordinary class A stock.
So, it's a temporary right that was retained
probably by the initial people who set up the company.
Now, stock issuance costs.
We talked about debt issuance costs.
So, debt issuance costs are considered like a discount on the issuance of debts.
That issuance costs aren't considered to be an expense at all.
And they're usually, they're not deferred like debt acquisition costs.
Instead, they're recognized as a debit to this account APIC,
that stands for additional paid-in capital and
you're going to see that a lot of different types of entries go into APIC.
When a stock is originally issued,
the excess over par goes into additional paid-in capital.
And when we have treasury stock and when we have other stock options issued,
you'll see that this APIC count gets a lot of activity.
So, let's look at an issuance of shares.
So, if Facebook were to issue 10 million shares at
$7 per share with $200,000 of issuance cost,
the entry would look something like this: you would debit cash for the seven million,
the additional paid-in capital for 6.7 million in common stock par for $60,
that's the 0.00006 entry.
And you can see most of this is going to be classified as additional paid-in capital.
By the way, I know a Facebook stock is worth
a lot more than that as we're making this film,
but this is actually the price that some people or
lucky people are able to exercise our options.
So, what are other sources of APIC?
You can have conversion of bonds.
You saw that when we wrote the entry for convertible debt, treasury stock, transactions.
We won't be recognizing gains and losses on treasury transactions.
Any surplus or deficit on a resale of treasury stock will go into APIC.
We'll have share repurchases can effect it,
stock compensation can check it,
and lapses of options or warrants,
and stock issuance costs.
All these things can go into this additional paid-in capital account.
Now, dividends are not usually paid out of APIC.
Dividends are paid out of retained earnings.
Retained earnings is another equity account,
which is the cumulative amount of net income and net loss from prior periods.
Now, this retained earnings as the usual source for dividends,
you don't usually pay dividends out of this additional paid-in capital.
If you do, it would be considered to be a return of capital
both for accounting purposes and for tax purposes.
Stocks can also be issued in return for non-cash consideration such as real estate.
This is very common especially when
a new corporation is being set up that somebody may contribute
a real estate which is appreciated in value and it
will go into the corporation in exchange for stock.
So, the issuance is accounted for at the fair value of the consideration
received or the fair value of the shares issued,
whichever is more readily determinable.
So, if you're a public company, certainly,
the value of the shares is going to be more readily determinable.
With private companies, it's often the other way around.
You'll find that the fair value of the consideration may be more readily determinable.
So, here's an example with Facebook where they're acquiring land worth
eight million dollars with their common stock at a time
if it's trading at $8 or if the land's worth eight million,
the fair value of the land.
We would debit the land for eight million and then credit again
common stock and the additional paid-in capital for the balance of common stock at par.
Now, if the shares of Facebook are actively trading at $9 per share,
then that value would be used.
We would value the land at nine million if
the fair value of the stock is more readily determinable.
Sometimes, shares are issued but the firm that
issues them has an obligation to repurchase those shares.
Those are referred to as mandatorily redeemable shares.
So, if there's an unconditional obligation to buy them back,
either at a specified or determinable date or upon an event that is certain to occur,
these are considered to be debt.
Even though their shares,
they would be considered to be debt.
Now, this is most often seen actually in private companies
where they would sometimes issue shares to employees to
allow them to participate in dividends but upon leaving the firm,
they have to sell them back to the firm.
They're not transferable anywhere
except back to the company and the company must buy them back.
That would be considered to be a mandatorily redeemable share.
However, the fares we did make a carve out
exempting most private companies from applying this rule.
So, it would apply mainly to public companies.
And so, it's not something that you see very often but there are rules out there
that sometimes equity can be classified as debt.
So, if it's mandatorily redeemable,
it'll be classified as a liability unless the redemption
is required to occur only upon the liquidation or terminations of the reporting entity.
Any other condition, you're going to classify that as debt.
And as I said, there's a scope exception for private companies.
So, it does not apply to shares that are issued by non-public entities,
those that aren't registered with the SEC or that are not redeemable on
fixed dates or for amounts that are either fixed or
determinable by reference to an interest rate index,
currency index, or another external index.
So, that's a brief introduction to the subject of equity.
In the subsequent lessons,
we'll go through many of these accounts in more detail. Thank you.
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