Investments by Shareholders: Common Equity Issuance
The general principle of accounting for common equity issues is to record the equity claim on the balance sheet at the fair value of what the corporation initially receives from the investor. If the issuing firm cannot reliably measure fair value of what it receives, it uses the fair value of the equity issued to record the transaction. As long as the fair value of one side of the exchange is determinable, the fair value of the other side of the transaction is implied under the assumption that unrelated parties exchange equal fair values in arm’s-length transactions.
Most commonly, an equity investor transfers cash to the corporation to secure an equity interest. However, the investor could transfer assets (such as property) to or perform services for the corporation in return for an equity interest. Instead of issuing common stock to the investor, the corporation could issue other types of equity interests: preferred stock, options to purchase common stock, or stock rights.3 In any event, the fair-value rule applies. The fair value received is split between two contributed capital accounts: common stock (par value) and additional paid-in capital (amount of fair value received that exceeds par value). Additional paid-in capital is generally referred to as share premium in many non-U.S. jurisdictions. The partition of proceeds into the par and additional paid-in capital accounts is not significant from an analysis viewpoint because par value is declared by the board of directors and has no economic meaning. In fact, some firms issue ‘‘no par’’ common stock.
Common shareholders’ equity is the residual interest in the corporation, which equals the assets remaining after all liabilities are paid. Because common shareholders bear both residual upside and downside risk, they generally have control, as evidenced by the right to vote. However, contractual relationships between the firm and other parties can limit common shareholder control. For example, effective control can be obtained through contracts to acquire all of a firm’s output or to use all of a firm’s productive capacity or through rights to obtain control of productive capacity through purchase at a later date
Corporations sometimes also issue preferred stock. Issuing preferred stock involves a trade-off between maintaining corporate control (preferred stock does not have voting rights) and creating a class of shareholders with preference above common equity shareholders in all asset distributions, including dividends. Accounting for the initial issue of preferred stock is no different than accounting for the issue of common stock. The fairvalue rule applies when a firm issues preferred stock. Preferred stock (at par) is normally reported before common stock in the shareholders’ equity section because preferred shareholders have priority over common shareholders in corporate liquidations. In addition to the preference in dividends and distribution, preferred stock dividends may accumulate if not declared and paid (the cumulative right). These dividends in arrears must be declared and paid before common stock dividends are declared and paid and must be disclosed in the notes to the financial statements. Preferred stock may be convertible into common shares (a positive feature for investors) or callable at scheduled dates or at the firm’s discretion (a negative feature for investors). The call options that can exist on preferred stock raise the larger issue (discussed in a later section) of whether certain types of preferred stock should be designated as debt rather than equity. To illustrate basic shareholders’ equity accounting, assume that a company raises capital through the following series of equity issues:
1. Issues 100,000 shares of $1 par value common stock for $5 per share.
2. Receives land in exchange for 28,000 shares of $1 par common stock. The equity investor purchased the land for $85,000. Similar land has recently sold for $150,000.
3. Issues 5,000 shares of $10 par value preferred stock for $75,000. Exhibit 7.1 summarizes the financial statement effects of the transactions. (Let APIC ¼ additional paid-in capital.) Dollar amounts indicate the effects of each transaction on the
The general principle of accounting for common equity issues is to record the equity claim on the balance sheet at the fair value of what the corporation initially receives from the investor. If the issuing firm cannot reliably measure fair value of what it receives, it uses the fair value of the equity issued to record the transaction. As long as the fair value of one side of the exchange is determinable, the fair value of the other side of the transaction is implied under the assumption that unrelated parties exchange equal fair values in arm’s-length transactions.
Most commonly, an equity investor transfers cash to the corporation to secure an equity interest. However, the investor could transfer assets (such as property) to or perform services for the corporation in return for an equity interest. Instead of issuing common stock to the investor, the corporation could issue other types of equity interests: preferred stock, options to purchase common stock, or stock rights.3 In any event, the fair-value rule applies. The fair value received is split between two contributed capital accounts: common stock (par value) and additional paid-in capital (amount of fair value received that exceeds par value). Additional paid-in capital is generally referred to as share premium in many non-U.S. jurisdictions. The partition of proceeds into the par and additional paid-in capital accounts is not significant from an analysis viewpoint because par value is declared by the board of directors and has no economic meaning. In fact, some firms issue ‘‘no par’’ common stock.
Common shareholders’ equity is the residual interest in the corporation, which equals the assets remaining after all liabilities are paid. Because common shareholders bear both residual upside and downside risk, they generally have control, as evidenced by the right to vote. However, contractual relationships between the firm and other parties can limit common shareholder control. For example, effective control can be obtained through contracts to acquire all of a firm’s output or to use all of a firm’s productive capacity or through rights to obtain control of productive capacity through purchase at a later date
Corporations sometimes also issue preferred stock. Issuing preferred stock involves a trade-off between maintaining corporate control (preferred stock does not have voting rights) and creating a class of shareholders with preference above common equity shareholders in all asset distributions, including dividends. Accounting for the initial issue of preferred stock is no different than accounting for the issue of common stock. The fairvalue rule applies when a firm issues preferred stock. Preferred stock (at par) is normally reported before common stock in the shareholders’ equity section because preferred shareholders have priority over common shareholders in corporate liquidations. In addition to the preference in dividends and distribution, preferred stock dividends may accumulate if not declared and paid (the cumulative right). These dividends in arrears must be declared and paid before common stock dividends are declared and paid and must be disclosed in the notes to the financial statements. Preferred stock may be convertible into common shares (a positive feature for investors) or callable at scheduled dates or at the firm’s discretion (a negative feature for investors). The call options that can exist on preferred stock raise the larger issue (discussed in a later section) of whether certain types of preferred stock should be designated as debt rather than equity. To illustrate basic shareholders’ equity accounting, assume that a company raises capital through the following series of equity issues:
1. Issues 100,000 shares of $1 par value common stock for $5 per share.
2. Receives land in exchange for 28,000 shares of $1 par common stock. The equity investor purchased the land for $85,000. Similar land has recently sold for $150,000.
3. Issues 5,000 shares of $10 par value preferred stock for $75,000. Exhibit 7.1 summarizes the financial statement effects of the transactions. (Let APIC ¼ additional paid-in capital.) Dollar amounts indicate the effects of each transaction on the
financial statement elements (that is, on assets, liabilities, or a subelement of shareholders’ equity: contributed capital ¼ CC, accumulated other comprehensive income ¼ AOCI, orretained earnings ¼ RE). The applicable journal entry follows each financial statement effecttemplate entry and shows the effects of each transaction on specific accounts.Shareholders’ equity is increased by the fair value of the asset (cash) contributed tothe corporation in Transaction 1. In Transaction 2, the fair value of the land contributedto the company is a readily determinable $150,000 (cash price of similar land), and this amount becomes the basis for measurement of the transaction. However, often fair values of non-cash asset (for example, land) are harder to obtain and may require the corporation to rely on an estimate of the fair value of common shares issued (for example, share price in an active market if available). Note that contributed capital is dividedinto par value and additional paid-in capital amounts when preferred or common shares are issued.
Cash flow effects of these financing activities are reported in the financing section of the statement of cash flows as sources of cash. The issue of stock for land is reported in a separate schedule of ‘‘significant investing and financing activities that do not affect cash’’ that accompanies the statement of cash flows.
Refer to PepsiCo’s consolidated balance sheet (Appendix A). In the shareholders’ equity section, PepsiCo discloses that it has issued 1,866 million shares of common stock (out of 3,600 million shares authorized for issue by the board of directors) and repurchased 322 million shares that it holds in the treasury, a net of 1,544 million shares outstanding, with a par value of 1 2/3¢ per share. (1,544 million 3 1 2/3¢ per share is approximately equal to $26 million.) The December 29, 2012, balance in capital in excess of par (that is, additional paid-in capital) implies that issue prices over time for common stock and possibly options and warrants (discussed later) have exceeded par value by $4,178 million. PepsiCo reports $41 in preferred stock, but does not use a separate additional paid-in capital account because the preferred stock has no par value. PepsiCo reports in Note 12 that the preferred stock was issued for an employee stock ownership program established by its Quaker subsidiary. Each of the 186,533 shares outstanding as of December 29, 2012, is convertible into 4.9625 shares of PepsiCo common stock at the option of the holder. PepsiCo also may call the preferred shares at $78 per share plus accrued and unpaid dividends.
Cash flow effects of these financing activities are reported in the financing section of the statement of cash flows as sources of cash. The issue of stock for land is reported in a separate schedule of ‘‘significant investing and financing activities that do not affect cash’’ that accompanies the statement of cash flows.
Refer to PepsiCo’s consolidated balance sheet (Appendix A). In the shareholders’ equity section, PepsiCo discloses that it has issued 1,866 million shares of common stock (out of 3,600 million shares authorized for issue by the board of directors) and repurchased 322 million shares that it holds in the treasury, a net of 1,544 million shares outstanding, with a par value of 1 2/3¢ per share. (1,544 million 3 1 2/3¢ per share is approximately equal to $26 million.) The December 29, 2012, balance in capital in excess of par (that is, additional paid-in capital) implies that issue prices over time for common stock and possibly options and warrants (discussed later) have exceeded par value by $4,178 million. PepsiCo reports $41 in preferred stock, but does not use a separate additional paid-in capital account because the preferred stock has no par value. PepsiCo reports in Note 12 that the preferred stock was issued for an employee stock ownership program established by its Quaker subsidiary. Each of the 186,533 shares outstanding as of December 29, 2012, is convertible into 4.9625 shares of PepsiCo common stock at the option of the holder. PepsiCo also may call the preferred shares at $78 per share plus accrued and unpaid dividends.
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