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 liabilities 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 a residual but there can be multiple classes of stock within equity, and they can have different rights. Some of them can be, 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 wasn't 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. Also, there's a separate accounting for par values, par value used to have an important legal wall, 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 it's at 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 common stock is how much is authorized and how much is issued? If you don't have stock authorized, you can't issue it. The authorization usually comes from the 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 a 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. In 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 class 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 the 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 this stock won't get that 10 to 1 voting preference, and 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 debt. Stock issuance costs aren't considered to be an expense at all, and they're not differed like debt acquisition costs, instead they're recognized as a debit to this account APIC, that stands for additional paid in capital. You're going to see that a lot of different types of entries go into APIC. When a stock is originally issued, the excess of a par goes into additional paid in capital. When we have treasury stock, and when we have other stock options issued, you'll see that this APIC account gets a lot of activity. So, let's look at the issuance of shares. If Facebook were to issue one million shares at seven dollars per share, but with $200,000 of issuance cost, the entry would look something like this. You would debit cash for the net amount received of $6,800,000 and the additional paid in capital for the same amount minus of course the amount that goes into the common stock at par for $60, that's the 0.000006% entry. So, you don't recognize an expense, instead you reduce the paid in capital for the issuance cost. 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 or losses on treasury transactions. Any surplus or deficit on a week sale of treasury stock will go into APIC. We'll have share repurchases can affect it, stock compensation can check it, and lapses of options the 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 is 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 cooperation has been 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's 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 when if it's trading at eight dollars 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 nine dollars 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 also 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 they're 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 fairs we did make a caveat exempting most private companies from applying this rule, so it would apply mainly to public companies. 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 mandatory redeemable, it'll be classified as a liability unless the redemption is required to occur only upon the liquidation or termination of the reporting entity. Any other condition, you're going to classify that as debt. 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 and fixed dates or for amounts that are either fixed or determinable by reference to an interest rate index, currency index or other 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.
