Corporations: Paid-in Capital, Retained Earnings, Dividends, and Treasury Stock

Read this chapter, which outlines the different sources of paid-in capital and how they are presented on the balance sheet. This chapter also covers treasury stock, dividends, stock splits, and price-per-share and price-per-earnings ratios.

Treasury stock

Treasury stock is the corporation's own capital stock that it has issued and then reacquired; this stock has not been canceled and is legally available for reissuance. Because it has been issued, we cannot classify treasury stock as unissued stock.

Recall that when a corporation has additional authorized shares of stock that are to be issued after the date of original issue, in most states the preemptive right requires offering these additional shares first to existing stockholders on a pro rata basis. However, firms may reissue treasury stock without violating the preemptive right provisions of state laws; that is, treasury stock does not have to be offered to current stockholders on a pro rata basis.

Larkin Corporation
Statement of stockholders' equity
For the Year ended 2010 December 31

$50 par, value,
6% preferred stock
$20 par value
Common stock
Paid-In capital
In excess of par value
Treasury Stock
Balance, 2010 January 1 $250,000 $300,000 $200,000 $500,000 $(42,000)
Issuance of 10,000 shares of common stock 200,000 100,000
5% stock dividend on common stock, 1,250 shares 25,000 27,500 (52,500)
Purchase of 1,200 shares of treasury stock (48,000)
Net income 185,000
Cash dividends:
Preferred stock (15,000)
Common stock (25,000)
Balance, 2010 December 31 $250,000 $525,000 $327,500 $592,500 $(90,000)

Exhibit 26: Statement of stockholders' equity

A corporation may reacquire its own capital stock as treasury stock to: (1) cancel and retire the stock; (2) reissue the stock later at a higher price; (3) reduce the shares outstanding and thereby increase earnings per share; or (4) issue the stock to employees. If the intent of reacquisition is cancellation and retirement, the treasury shares exist only until they are retired and canceled by a formal reduction of corporate capital.

For dividend or voting purposes, most state laws consider treasury stock as issued but not outstanding, since the shares are no longer in the possession of stockholders. Also, accountants do not consider treasury shares outstanding in calculating earnings per share. However, they generally consider treasury shares outstanding for purposes of determining legal capital, which includes outstanding shares plus treasury shares.

In states that consider treasury stock as part of legal capital, the cost of treasury stock may not exceed the retained earnings at the date the shares are reacquired. This regulation protects creditors by preventing the corporation in financial difficulty from using funds to purchase its own stock instead of paying its debts. Thus, if a corporation is subject to such a law (as is assumed in this text), the retained earnings available for dividends must exceed the cost of the treasury shares on hand.

When firms reacquire treasury stock, they record the stock at cost as a debit in a stockholders' equity account called Treasury Stock.  They credit reissuances to the Treasury Stock account at the cost of acquisition. Thus, the Treasury Stock account is debited at cost when shares are acquired and credited at cost when these shares are sold. Any excess of the reissue price over cost represents additional paid-in capital and is credited to Paid-In Capital – Common (Preferred) Treasury Stock Transactions.

To illustrate, assume that on 2010 February 18, the Hillside Corporation reacquired 100 shares of its outstanding common stock for USD 55 each. (The company's stockholders' equity consisted solely of common stock and retained earnings.) On 2010 April 18, the company reissued 30 shares for USD 58 each. The entries to record these events are:

2010 Feb. 18 Treasury stock – Common (100 shares x $55) (-SE) 5,500
Cash (-A)
Acquired 100 shares of treasury stock at $55.
Apr. 18 Cash (30 shares x $58) (+A) 1,740
Treasury stock – Common (30 shares x $55) (+SE) 1650
Paid-In Capital – Common treasury stock transactions (+SE) 90
Reissued 30 shares of treasury stock at $58; cost is $55 per share.

When the reissue price of subsequent shares is less than the acquisition price, firms debit the difference between cost and reissue price to Paid-In Capital – Common Treasury Stock Transactions. This account, however, never develops a debit balance. By definition, no paid-in capital account can have a debit balance. If Hillside reissued an additional 20 shares at USD 52 per share on 2010 June 12, the entry would be:

June 12 Cash (20 shares x $52) (+A) 1,040
Paid-In Capital – Common treasury stock transactions (-SE) 60
Treasury stock – Common (20 shares x $55) (+SE) 1,100
Reissued 20 shares of treasury stock at $52; cost is $55 per share.

At this point, the credit balance in the Paid-In Capital – Common Treasury Stock Transactions account would be USD 30. If the remaining 50 shares are reissued on 2010 July 16, for USD 53 per share, the entry would be:

July 16 Cash (50 shares x $53) (+A) 2,650
Paid-In Capital – Common treasury stock transactions (-SE) 30
Treasury stock – Common (50 shares x $55) (+SE) 70
Reissued 50 shares of treasury stock at $53; cost is $55 per share.

Notice that Hillside has exhausted the Paid-In Capital –Common Treasury Stock Transactions account credit balance. If more than USD 30 is debited to that account, it would develop a debit balance. Thus, the remaining USD 70 of the excess of cost over reissue price is a special distribution to the stockholders involved and is debited to the Retained Earnings account.

Sometimes stockholders donate stock to a corporation. Since donated treasury shares have no cost to the corporation, accountants make only a memo entry when the shares are received. The only formal entry required is to debit Cash and credit the Paid-In Capital – Donations account when the stock is reissued. For example, if donated treasury stock is sold for USD 5,000, the entry would be:

Cash (+A) 5,000
Paid-In capital – Donations (+SE) 5,000
To record the sale of donated treasury stock.
Reissued 20 shares of treasury stock at $52; cost is $55 per share.

When treasury stock is held on a balance sheet date, it customarily appears at cost, as a deduction from the sum of total paid-in capital and retained earnings, as follows:

Hypothetical Corporation
Partial balance sheet 2010 December 31

Stockholder's equity:
Paid-In capital:
Preferred stock -8%, $100 par value; 2,000 shares authorized, issued, and outstanding $200,000
Common stock-$10 par value; authorized, 100,000 shares; issued, 80,000 shares of which 1,000 are held in the treasury $800,000
Stock dividend distributable on common stock on 2011 January 15, 7,900 shares 79,000 879,000
Paid-in capital-
From common stock issuances $40,000
From stock dividends 60,000
From treasury stock transactions 30,000
From donations 50,000
Total paid-in capital $1,259,000
Retained earnings:
Per loan agreement $250,000
Unappropriated (restricted to the extent of $20,000, the cost of treasury shares held) $150,000
Total retained earnings 400,000
Total paid-in capital and retained earnings $1,659,000
Less: Treasury stock, common, 1,000 shares at cost 20,000
Total stockholders' equity $1,639,000

Exhibit 27: Stockholders' equity section of the balance sheet

Stockholders' equity:
Paid-in capital:
Common stock-$10 par value; authorized and issued, 20,000 shares, of which 2,000 shares are in the treasury $200,000
Retained earnings (including $22,000 restricted by acquisition of treasury stock) 80,000
Total paid-in capital and retained earnings $280,000
Less: Treasury stock at cost, 2,000 shares 22,000
Total stockholders' equity $258,000

An accounting perspective:

Business insight

General Mills is a leading producer of ready-to-eat cereals, desserts and baking mixes, snack products, and dinner and side dish mixes. Popular brand names include Hamburger Helper, Betty Crocker, and Yoplait. For 2001 and 2000, General Mills reported common stock in the treasury (treasury stock) of 123,100,000 and 122,900,000 shares, respectively. General Mills deducted the cost of these shares in the stockholders' equity section of the balance sheet.

To summarize much of what we have discussed in Chapters 12 and 13, we present the stockholders' equity section of the balance sheet in Exhibit 27. This partial balance sheet shows: (1) the amount of capital assigned to shares outstanding; (2) the capital contributed for outstanding shares in addition to that assigned to the shares; (3) other forms of paid-in capital; and (4) retained earnings, appropriated and unappropriated.

Anson Company Income Statement
For the Year Ended
2010 December 31

Net sales $41,000,000
Other revenues 2,250,000
Total revenue $43,250,000
Cost of goods sold $22,000,000
Administrative, selling, and general expenses 12,000,000 34,000,000
Income before federal income taxes $9,250,000
Deduct: Federal income taxes (40%) 3,700,000
Income from continuing operations $5,550,000
Discounted operations:
Loss from operations of discontinued Cosmetics
Division (net of 40% tax effect of $800,000) $(1,200,000)
Loss on disposal of Cosmetics Division (net of 40% tax effect of $200,000) (300,000) (1,500,000)
Income before extraordinary item and the cumulative effect of a change in accounting principle $4,050,000
Extraordinary item:
Gain on sale of subsidiary over book value $40,000
Less: Tax effect (40%) 16,000 24,000
Income after extraordinary item $4,074,000
Net income $4,074,000
Earnings per share of common stock:
Income from continuing operations $ 5,550
Discontinued operations (1.500)
Extraordinary item 0.024
Net income $4.074

Exhibit 28: Income statement