The amount of issued stock is based on a company’s authorized shares, or the maximum number of shares authorized for issue to shareholders.
Differentiate between common and preferred stock
- Issued shares are the sum of outstanding shares and treasury stock, or stock reacquired by the company. Most public companies issue two major types of shares: common and preferred.
- Common shareholders may possess “voting” shares and have the ability to influence company decisions through their vote. Owning common stock tends to be riskier than owning preferred stock.
- Preferred stock is considered a hybrid financial instrument because the shares have properties of both equity and debt.
- When reporting common or preferred stock in stockholder ‘s equity, the value of shares is divided between the stock’s par, or stated, value, and the amount in excess of par is recorded to additional paid in capital.
- creditor: A person to whom a debt is owed.
- capital: Money and wealth. The means to acquire goods and services, especially in a non-barter system.
- authorized stock: shares created by the company
- liquidation: The selling of the assets of a business as part of the process of dissolving it.
Issuing Company Stock
The process of issuing stock– or shares– of a publicly traded company involves several steps. The amount of issued stock is dependent on the authorized capital of a company, or the maximum number of shares authorized by a company’s corporate documents to issue to shareholders. A portion of authorized capital tends to remain unissued, but the number can be changed by shareholder approval. When shares are issued, they are transferred to a subscriber, an action referred to as an allotment. After the allotment, a subscriber becomes a shareholder. Issued shares are the sum of outstanding shares and treasury stock, or stock reacquired by the company. Most public companies issue two major types of shares: common and preferred.
Shares of common stock are primarily issued in the United States. Common shareholders may possess “voting” shares and have the ability to influence company decisions through their vote. Owning common stock tends to be riskier than owning preferred stock; yet over time, common shares on average perform better than preferred shares or bonds. The greater amount of risk is due to the fact that shares receive dividends only after preferred shareholders are paid and, in the event of a business liquidation, common stock shareholders are paid last, after creditors and preferred shareholders.
Preferred stock is considered a hybrid financial instrument because the shares have properties of both equity and debt. Preferred shares tend to pay dividends to shareholders, which can accumulate from one period to the next, and have priority over common shareholders when dividends are paid or assets liquidated. Similar to bonds, preferred shares are rated by credit-rating companies and are also callable by the company. Some other features associated with preferred stock include convertibility to common stock, non-voting rights, and the potential of shares to be either cumulative or non-cumulative of company dividends.
Stock Issuance and Stockholder’s Equity
Both common and preferred stock issued are reported in the stockholder’s equity section of the balance sheet. Each share type is reported at market value at the time the shares are purchased by investors, which is also the point in time when shares become outstanding. This value is divided between the stock’s par, or stated value and additional paid in capital.
Employee Stock Compensation
An employee stock option (ESO) is a call (buy) option on a firm’s common stock, granted to an employee as part of his compensation.
Explain how employee stock options work and how a company would record their issue
- Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stock ‘s market price rises higher than the option’s exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price.
- An ESO has features that are unlike exchange -traded options, such as a non-standardized exercise price and quantity of shares, a vesting period for the employee, and the required realization of performance goals.
- An option’s fair value at the grant date should be estimated using an option pricing model, such as the Black–Scholes model or a binomial model. A periodic compensation expense is reported on the income statement and also in additional paid in capital account in the stockholder ‘s equity section.
- exercise price: The fixed price at which the owner of an option can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity.
- remuneration: A payment for work done; wages, salary, emolument.
- vesting period: A period of time an investor or other person holding a right to something must wait until they are capable of fully exercising their rights and until those rights may not be taken away.
Definition of Employee Stock Options
An employee stock option (ESO) is a call (buy) option on the common stock of a company, granted by the company to an employee as part of the employee’s remuneration package. The objective is to give employees an incentive to behave in ways that will boost the company’s stock price. ESOs are mostly offered to management as part of their executive compensation package. They may also be offered to non-executive level staff, especially by businesses that are not yet profitable and have few other means of compensation. Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stock’s market price rises higher than the option’s exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price.
Features of ESOs
ESOs have several different features that distinguish them from exchange-traded call options:
- There is no standardized exercise price and it is usually the current price of the company stock at the time of issue. Sometimes a formula is used, such as the average price for the next 60 days after the grant date. An employee may have stock options that can be exercised at different times of the year and for different exercise prices.
- The quantity of shares offered by ESOs is also non-standardized and can vary.
- A vesting period usually needs to be met before options can be sold or transferred (e.g., 20% of the options vest each year for five years).
- Performance or profit goals may need to be met before an employee exercises her options.
- Expiration date is usually a maximum of 10 years from date of issue.
- ESOs are generally not transferable and must either be exercised or allowed to expire worthless on expiration day. This should encourage the holder to sell her options early if it is profitable to do so, since there’s substantial risk that ESOs, almost 50%, reach their expiration date with a worthless value.
- Since ESOs are considered a private contract between an employer and his employee, issues such as corporate credit risk, the arrangement of the clearing, and settlement of the transactions should be addressed. An employee may have limited recourse if the company can’t deliver the stock upon the exercise of the option.
- ESOs tend to have tax advantages not available to their exchange-traded counterparts.
Accounting and Valuation of ESOs
Employee stock options have to be expensed under US GAAP in the US. As of 2006, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agree that an option’s fair value at the grant date should be estimated using an option pricing model. The majority of public and private companies apply the Black–Scholes model. However, through September 2006, over 350 companies have publicly disclosed the use of a binomial model in Securities and Exchange Commission (SEC) filings. Three criteria must be met when selecting a valuation model:
- The model is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R;
- is based on established financial economic theory and generally applied in the field;
- and reflects all substantive characteristics of the instrument (i.e. assumptions on volatility, interest rate, dividend yield, etc.).
A periodic compensation expense is recorded for the value of the option divided by the employee’s vesting period. The compensation expense is debited and reported on the income statement. It is also credited to an additional paid-in capital account in the equity section of the balance sheet.
A stock repurchase is the reacquisition by a company of its own stock for the purpose of retirement or re-issuance.
Explain why a company would repurchase their stock and how they would record it on their financial statements
- Shares kept for the purpose of re-issuance are referred to as treasury stock.
- Buying back shares reduces the number of shares a company has outstanding without altering earnings. This can improve a company’s price/earnings ratio and earnings per share.
- In an inefficient market that has underpriced a company’s stock, a repurchase of shares can benefit current shareholders by providing support to the stock price. If the stock is overpriced, the opposite is true.
- On the balance sheet, treasury stock is listed under shareholders’ equity as a negative number. The accounts may be called “Treasury stock” or “equity reduction”.
- treasury stock: A treasury or “reacquired” stock is one which is bought back by the issuing company, reducing the amount of outstanding stock on the open market (“open market” including insiders’ holdings).
- price earnings ratio: The market price of that share divided by the annual earnings per share.
- Earnings Per Share: The amount of earnings per each outstanding share of a company’s stock.
Reasons to Repurchase Stock
The reasons to repurchase stock can vary from company to company. Reasons can include: (1) to cancel and retire the stock; (2) to reissue the stock later at a higher price; (3) to reduce the number of shares outstanding and increase earnings per share (EPS); or (4) to issue the stock to employees. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance. If the intent of stock reacquisition is cancellation and retirement, the treasury shares exist only until they are retired and cancelled by a formal reduction of corporate capital. For accounting purposes, treasury shares are included in calculations to determine legal capital, but are excluded from calculations for EPS amounts.
Benefits to Repurchasing Stock
Stock repurchases are often used as a tax-efficient method to put cash into shareholders’ hands, rather than paying dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Another motive for stock repurchase is to protect the company against a takeover threat.
In an efficient market, the net effect of a stock repurchase does not change the value of each share. For example, if the market fairly prices a company’s shares at $50 a share, and the company buys back 100 shares for $5,000, it now has $5,000 less cash but there are also 100 fewer shares outstanding. So, the net effect of the repurchase would be zero. Buying back shares can improve a company’s price earnings ratio due to the reduced number of shares (and unchanged earnings). It can improve EPS due to the fewer number of shares outstanding as well as unchanged earnings. In an inefficient market that has underpriced a company’s stock, a repurchase of shares can benefit current shareholders by providing support to the stock price. If the stock is overpriced, the opposite is true.
Accounting for Repurchased Shares
On the balance sheet, treasury stock is listed under shareholders’ equity as a negative number. The accounts may be called “Treasury stock” or “equity reduction”.
One way of accounting for treasury stock is with the cost method. In this method, the paid-in capital account is reduced in the balance sheet when the treasury stock is bought. When the treasury stock is sold back on the open market, the paid-in capital is either debited or credited if it is sold for more or less than the initial cost respectively.
Another common way for accounting for treasury stock is the par value method. In the par value method, when the stock is purchased back from the market, the books will reflect the action as a retirement of the shares. Therefore, common stock is debited and treasury stock is credited. However, when the treasury stock is resold back to the market, the entry in the books will be the same as the cost method.
In either method, any transaction involving treasury stock cannot increase the amount of retained earnings. If the treasury stock is sold for more than cost, then the paid-in capital treasury stock is the account that is increased, not retained earnings. In auditing financial statements, it is a common practice to check for this error to detect possible attempts to “cook the books. ”
Consider a company that repurchases 15,000 shares of its $1 par value stock for $25 per share. In this transaction:
- Treasury stock is debited $375,000
- Cash is credited $375,000
The firm then resells 7,500 shares of treasury stock for $28. In this transaction:
- Cash is debited $210,000
- Treasure Stock is credited $187,500
- Additional Paid-In Capital is credited $22,500
If the remaining 7,500 shares of stock are resold for less than the original $25 purchase price, and if the adjustment to treasury stock minus the proceeds from the sale is more than the balance of additional paid-in capital, an adjustment to retained earnings must be made. Consider the shares are sold for $21. The accounting for the transaction would be:
- Cash is debited $157,500
- Additional Paid-In Capital is debited $22,500
- Retained Earnings debited $7,500
- Treasury Stock is credited $187,500
Treasury stock is a company’s issued and reacquired capital stock; the stock has not been retired and is legally available for reissuance.
Distinguish between the cost method and the par value method of recording treasury stock
- Treasury stock can be accounted for using the cost or par value methods.
- Using the cost method, a treasury stock account is debited in the equity section of the balance sheet for the stock purchase price and cash is credited.
- When using the par value method, the company’s reacquisition of its own stock is treated as a retirement of the shares reacquired; treasury stock is debited for the par value of the stock and paid-in capital is debited or credited by the difference between the par value and repurchase price.
- preemptive right: The right of shareholders to maintain a constant percentage of a company’s shares by receiving a proportionate fraction of any new shares issued, thus preempting any dilution
- paid-in capital: refers to capital contributed to a corporation by investors through purchase of stock from the corporation (primary market) (not through purchase of stock in the open market from other stockholders (secondary market)
Definition of Treasury Stock
Treasury stock is the corporation ‘s own capital stock it has issued and then reacquired. Because this stock has not been canceled, it is legally available for reissuance and cannot be classified as unissued stock. 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. Treasury stock can be accounted for using the cost or par value methods.
Using the cost method, a treasury stock account is increased (debited) in the equity section of the balance sheet for the stock purchase price and cash is reduced (credited). The treasury stock amount is subtracted from the other stockholders’ equity amount, therefore it is considered a contra account. When the treasury stock is sold back on the open market, the treasury stock account is reduced (credited) for the original cost and the difference between original cost and sales price is debited or credited to a treasury stock paid in capital account, which is also disclosed in the equity section of the balance sheet. Cash is debited for the proceeds of the sale.
Par Value Method
When using the par value method, the company’s reacquisition of its own stock is treated as a retirement of the shares reacquired. On the purchase date, treasury stock is increased (debited) for the par value of stock reacquired and paid in capital is reduced (debited) or increased (credited) by the amount of the purchase price in excess of par. Cash is also credited for the purchase price. When the stock is resold, treasury stock is credited for the par value of the stock sold. Differences between the sales price and repurchase price are debited or credited to paid in capital, along with a debit to cash for proceeds from the sale.