Hello, I'm Professor Brian Bushee. Welcome back. This video kicks off our look at shareholders equity, which is the last stop on the balance sheet. In this video, we're going to talk about share issuances, the difference between common and preferred stock, and share repurchases. Let's get started. So as we talked about in the first week, shareholders' equity is the residual claim on assets after settling the claims of your creditors. In other words, assets minus liabilities. So this notion that if you measure your assets correctly and your liabilities correctly, shareholders' equity is what's left over, but we saw that it came from two different sources. One was share issuance. So you could have contributed capital where you go out and raise funds through common stock or preferred stock. Then we'll introduce this concept of treasury stock, which are repurchased shares, shares that the company buys back that may be reissued to the public at any point, and then stockholder's equity or shareholder's equity can come due to operations. So we have retained earnings, which we've talked about a lot in the course where we have your beginning retained earnings goes up by net income, goes down when you pay dividends and that gives you the ending retained earnings. So retained earnings is literally net income that you have retained, that you have not paid out as dividends, and then we talked about, briefly, accumulated other comprehensive income. This functions sort of like retained earnings, except for it's items that bypass the income statement. >> I would very much appreciate it if you could elucidate the differences between stockholders' equity, shareholders' equity, owner's equity and just plain equity. I have been avidly watching the videos these past weeks and I have heard mention of each of these terms. >> Good question. The terms stockholder's equity, shareholder's equity, owner's equity just plain equity all mean the same thing. You see stockholder's equity and shareholder's equity most common and I'll tend to use those terms interchangeably both on the slides and when I talk about the slides. So, let's talk about the two types of stock that companies can issue. So, there's preferred stock which is between debt holders and common stocks in claims on assets. So, what that means is if there was a bankruptcy, the company had to liquidate all its assets to give to it's creditors and owners. The debt holders would get first claim on the assets, whatever's leftover. Then the preferred stock holders would come in and then the common stockholders would come in last. Preferred stock doesn't have any voting rights. So they can't vote on the board of directors. But they are entitled to a fixed dividend that has to be paid before any common dividends are paid, and it oftentimes has some kind of feature like like it's callable, or convertible, or redeemable. Callable means that the company could buy it back at the company's option. Convertible means that the holder can convert it into common stock. Redeemable means the holder can make the company buy it back. So this preferred stock is this sort of weird way station kind of instrument, sort of between debt and between equity, that can often times be turned into common equity, or just be taken out by the company if need be. Common stock has all the voting rights, so they get to vote on who the board of directors will be, but they're the last claimant on assets so they have the biggest risk of loss and bankruptcy. But then they often get the biggest return if the company does well. Par value as we've talked about before in the course, that's the stated value on the shares. It's used to compute the balance in common stock and preferred stock. Historically, par value had a meaning, but nowadays, it's somewhat arbitrary. And it's really just there to give accountants an extra thing to teach, and then of course, Additional Paid in Capital or APIC records all of the amounts it received when you issue stock that come in excess of the par value. >> I would prefer preferred stock if it had no par value! But, why else would one prefer Preferred Stock? >> I agree that preferred stock is this weird combination of debt and common stock and I think one of the reasons that investors like preferred stock is that some investors really like dividends. And with preferred stock, you get a guaranteed dividend, or at least guaranteed in that they can't pay common dividends until they pay all the preferred dividends. And in some countries, like the U.S, dividend income is taxed at a lower rate than interest income, like if you bought a bond. Also, preferred stock is like a way to get your feet wet, or dip your toe in the water with a company where because of these call features and redeemable features, you can go into get preferred stock, you take a little bit more risk than a bond, but you have the option, often times, to convert that to common stock if you think the company is doing well. And if you don't think the company's doing well, then you can basically redeem it and get out of the company fairly easily. So it's a way to sort of get into the company's equity without diving in full, taking the full risks of common stock. There's some key terminology that we have to keep track of when we're looking at contributed capital, at common stock and preferred stock. First term is shares authorized. These are the total number of shares that the firm could issue. This is often determined in the corporate charter, or by the board of directors, and it doesn't mean a lot. It just means that the management could go out and issue new shares up to this limit, and then they'd have to go and try to get permission to issue more shares. A more important number is shares issued. These are the number of shares that've been sold to the public at one point or another. And when you look at the balance in common stock par, its based on this amount. So if you took par value times the number of shares issued it should equal to balance in common stock par. Another key term is shares outstanding. These are the number of shares that are currently held by the public. How can that be different than shares issued? Well, it's because companies buy back their stocks in these treasury shares. So shares outstanding equals the shares issued minus the treasury shares. Minus the shares the company has bought back over time. The dividend payments and numbers like earnings per share are based on this amount. So dividends are paid to shares outstanding and when you see earning per share reported, which we'll take about later, that's based on the shares outstanding. >> Seriously? Are you just going to define terms this whole video? I could just read Wikipedia if that is the case. How about adding some value by doing an extended example? >> Good point. Enough definition of terminology. Let's dive in and do an example. So let's start the example. So first of all we've got on January 14th 2012 Stack Inc issued 10,000 shares of no-par preferred stock for proceeds of $7 per share. The preferred stock specifies cumulative $1 annual dividends per share. So let's try to do the journal entry to record issuing the stock and I'll go ahead and throw up the pause sign so you can try to do this one. 'Kay so we're going to have a debit to cash for 70,000. We're showing 10,000 shares $7 per share. That's $70,000 cash we're receiving. We're going to credit preferred stock for 70,000. All of the contributed capital goes into preferred stock because it was no par, so there's nothing that goes into additional paid in capital in this case. But, by assumption when it's no par everything goes into preferred stock. And we also don't do anything with the dividends at this point. We don't do anything until the dividends are declared, which they will be later as we go through the example. >> Zut Alors! I love this preferred stock! But what is this cumulative dividend? >> The cumulative dividend is basically a promise by the company that if they're going to pay any dividends at all, preferred stockholders are definitely going to get their $1 per year. So where this would come into play is let's say a company got into a cash crunch. They couldn't pay dividends so they skip preferred dividends for a year. They owe those preferred dividend shareholders at least $1 per share. Now let's say they couldn't pay the next year. Now they owe those preferred dividend, preferred stockholders $2 of dividends. Before the company could pay any common stock dividends, they have to go back and pay the two dollars of cumulative dividends that they've missed. So what happens is, if a company misses preferred dividends, they add up, they accumulate, and before the company can pay any common dividends, they have to pay all those accumulated dividends on the preferred stock. Now, let's take a look at the example where we're going to raise common stock, which is of course the review of what we did much earlier in the course. So on January 14th 2012, Stack Inc issues 12,000 shares of $1 par value stock for proceeds of $10 per share. So I'll go ahead and throw up the pause sign and you can try to do this. So we're going to debit cash for 120,000. That's the 12,000 shares times the $10 of share that we get as proceeds. Credit common stock for the par value. So that's 12,000 shares, $1 per share par value is $12,000, and then everything else goes into additional paid in capital or APEC, 108,000, that's the additional proceeds beyond the par value. Now one thing that we're going to keep track of with this example is the number of shares issued, and the number of shares outstanding, which are both 12,000 in this case. But we'll need to know these figures later on. Next thing we're going to talk about is share repurchases and this account called Treasury Stock. So companies sometimes repurchase their own shares. These repurchases shares are carried in the Treasury Stock account, which is a contra share holders equity. So, XSE stands for contra shareholders equity. That means it goes up with a debit and down with a credit balance. So just the opposite of the way stockholders' equity normal works. Treasury stock does not have any voting rights or dividends rights. Which makes sense, we wouldn't want the company voting on its own board of directors. And Treasury Stock can be reissued by the firm at any point. Reissued means sold back to the public. The reissued treasury stock will come out of the treasury stock account at its original price. So it you repurchased at $11.00, when we take it out, we're going to bring it out at $11.00, and then APIC or in some cases Retained Earnings is used to balance the journal entry if we resell it for a price that differs from what we bought it. So if we bought it at $11, but then resell it at $13, we need to do something with that extra two dollars. It's going to go into APIC or Retained Earnings because companies cannot book gains or losses trading in their own stock. >> I am a bit flamboozled as to why a company would repurchase its own shares. >> Seriously. Does a company also loan itself money and hire itself to work for itself? >> So there are four big reasons why a company would repurchase its own shares. The first one is they may have excess cash. And instead of paying that cash out at a, as a dividend, which can have some problems that we'll talk about later, they decide to just buy back their shares. Basically give the excess cash to any shareholders that want to get out of their investment or cash out. Second reason is the company may think their stock price is undervalued, and while you could talk to analysts or investors, or go on TV and talk about how your stock is under priced, a way to put your money where your mouth is, a costly signal, would be to go back and buy your shares because you think they're under priced. The third reason, and this is one of the big reasons nowadays, is you buy back shares to sell to employees under employee stock option plans, and we'll talk about that later in the week. And the fourth reason is you may think that you're under leveraged as a company, so you borrow some money, use the proceeds to buy back stock to increase your leverage, increase your debt to equity ratio, which would then increase your ROE. Maybe give you some more returns to leverage. So those are the four big reasons, but the big one I think nowadays is buying back shares to use for employee stock options which, as I mentioned, we'll talk about later in the week. So now let's go back to our example and look at how treasury stock would be purchased. So on March 3, 2012, Stack Inc repurchases 4,000 shares of its common stock at a price of $11 per share. I will throw up the pause sign, and you can give this one a chance. Okay, so we're paying cash, 44,000, so I have a credit to cash, 44,000. That's 4,000 shares times $11 per share. The debit is going to be this account treasury stock which is a contra shareholder's equity which means it's increased with a debit and it goes in at 44,000 which is the 4,000 shares times $11 per share. Now this doesn't effect our number of shares issued which stay at 12,000, but our number of shares outstanding drops to 8,000 by bringing these 4,000 shares into the Treasury. There's now only 8,000 shares that are outstanding among the public. Now, let's sell some of this treasury stock and first what we'll look at what happens when there's a price increase. On April 4th, 2012, Stack Incorporated sold 1,000 shares of its treasury stock at a price of $14 per share. So this one's hard so I'll put out the pause sign if you want to try to do the journal entry. So we want to debit cash for $14,000 because we're receiving $14,000 cash. That's 1,000 shares at $14 per share. We're going to credit treasury stock to reduce the treasury stock for 11,000. Remember, that's the original cost that we bought shares at $11 a piece. So 1,000 shares times $11 gives us the 11,000 that we take out of treasury stock. And then we're going to plug additional Paid in Capital. So additional Paid in Capital is going to increase by 3,000 and it's going to do that simply because we cannot book a gain on this sale because transaction of our own stock. Got to put it somewhere so we put it into additional Paid in Capital. Our shares issued remain at 12,000. Our shares outstanding now increase to 9,000 because we've reissued a thousand shares to the public. The public now holds 9,000. We still have 3,000 shares in treasury. >> Why would the company not be enabled to record a gain in this transaction? They bought low, sold high, and should get credit for a gain. >> No pun intended. Oh, credit for a gain and gain as a credit. Good one. So, there's a couple of reasons why we don't allow companies to book gains or losses on transactions in their own stock in the income statement. First is the stock transactions have nothing to do with operating the company, so what we want on the income statement is revenues and expenses that apply to running the business. Buying and selling your stock doesn't have anything to do with your business. It's not your core operations, and the second reason is that this these stock transactions are easily manipulable by companies so it would be very easy for a company to book a gain trading in its own stock. All the company would have to do is come out with some pessimistic news, some bad forecast, the stock price would go down. The company buys it. Then a month or two later, come out with some good news, a good forecast, stock price goes up. They sell it. If we let them book a gain on that, that's not very high quality earnings because managers have a lot of control over the timing of that gain. So we don't want to have that kind of potential abuse, so any kind of stock transactions where companies have superior information, we keep off of the income statement. Next, let's look at an example of selling treasury stock when the price has gone down relative to when we originally bought it. So, on May 5, 2012, Stack Inc sold 1,000 shares of its treasury stock at a price of only $9 per share. Remember, it originally bought it at $11. So I'll go ahead and put up the pause sign and see if you can do the journal entry here. So in the journal entry, we debit cash for $9,000 because we're receiving $9 per share for a thousand shares so that's $9,000 cash. We credit treasury stock. We remove it from the contra shareholders' equity account at the original cost which was $11 per share, or $11,000. Now we need a plug to a debit, so we debit additional paid in capital. Reduce the, the APIC account by 2,000, that's the plug. We need that because we can't recognize a loss in this case. Now our shares issued again, still 12,000. Our shares outstanding have gone up to 10,000 because we've re-issued another 1,000 shares to the public. We still have 2,000 shares in treasury. One more note, we reduced APIC. If APIC had a zero balance additional paid in capital can't go negative. So if, if APIC had gotten down to zero, then you'd have to switch the debit to retained earnings instead, which is not a problem because retained earnings can have either a debit or a credit balance. >> Seriously? How could a company ever have a balance of zero in APIC? And what if retained earnings was zero? >> Actually, it's becoming more and more commonplace that companies' APIC is going down to zero, and they're having to go to a debit to retained earnings in this kind of journal entry, and again it's because of these employee's stock options, which I'll talk about later in the week. Just as a preview anytime an employee exercises a stock option and we use treasury stock to, to deliver the stock to them, they're playing less cash than what we bought the treasury stock for. And so we get this debit to APIC and so there's companies which have gone through all their APIC. APIC can't go negative so it stops at a zero balance and then we start to debit retained earnings, and for a lot of companies that do a lot of stock options, their return earnings actually go negative, as it can and becomes accumulated deficit. And in this case, the accumulated deficit is not bad news. It's not that their operations have been cumulatively unprofitable. It's actually good news. It means that their stock price has been going up. They've been giving a lot of options. The options have been exercised, and it's just eating into this APIC and retained earnings. So it's a weird feature of this stock based compensation that we're seeing nowadays. But you actually see a lot of these debits to APIC and then debits to retained earnings, and oftentimes negative retained earnings due to these employee stock options. Which I don't know if I mentioned, we'll talk about later in the week. There's one more treasury stock transaction we're going to look at and that's Treasury Stock Retirement. Now, retirement means that we're going to destroy the shares. We're, we're going to permanently retire them so that they can never be reissued and they'll be taken out of shares issued count. So these shares are gone for good. So on May 15th 2012, Stack Inc decided to retire 1,000 shares of its treasury stock. So I'll put up the pause sign, and you can try this journal entry. But this one is pretty challenging. So the journal entry will start with the credit to treasury stock. So we're taking that 1,000 shares of treasury stock, we're taking it out of the account it's original cost, which is again the $11 times 1,000 shares. Since the shares are being retired, being destroyed, we want to get rid of the balance in common stock. So we're going to reduce that by 1,000 shares times the $1.00 par value, and then we'll take the rest of this out of additional paid in capital to plug. So it's the exact opposite of issuing a share where you create common stock and create APIC. When you retire a share, you remove the common stock, you remove the APIC. So now our shared issues balance drops from 12,000 to 11,000, so those shares are gone. Those thousand shares can never be reissued, and if, and what's going to happen is now our balancing common stock par is going to be $11,000, the 11,000 issued times $1.00 par value. Our shares outstanding are not affected because this transaction didn't affect the amount of shares held by the public. So we have 11,000 shares issued, 1,000 shares still left in treasury after we destroyed this 1,000, which means that we still have 10,000 shares outstanding. >> Good bye Common Stock. Good by Par Value. I love this retirement transaction! But why do it? >> Yeah, the, the stock retirement transaction is not that common. Most of the time when companies buy back their own treasury stock, they intend to either reissue it, or they hold on to it so they have the option to reissue it, sell it back to the market, at some point. The only time I've actually seen this retirement transaction practiced is when there's some kind of hostile battle between management and shareholders. Or where management's trying to take over the company. And so they're buying back shares to try to prevent them from falling into the wrong hands or increase their own ownership, and they basically destroy the shares to make it more costly to have them reissued later, but other than these really hostile battles, I haven't seen that many instances where companies retire their stock. But just because it doesn't happen that often in the real world, doesn't mean that I can't show you the journal entry, so at least you know it in case you ever run into it. That's not the most compelling motivation to keep watching these videos, to continue to learn things that don't actually happen in the real world. Well don't worry, in the next video we're going to talk about retained earnings, which will get us into dividends, both cash and stock, stock splits and a little bit of ALCI. So I promise you the stuff in the next video will all be relevant to what happens in the real world, I'll see you then. >> See you next video.
