Stockholders' equity: stock, dividends and treasury stock

Equity is the residual interest in a company's assets after deducting its liabilities. Lessons 1 to 9 dealt with liabilities; this lesson turns to the owners' claim. It looks at how stock is issued and recorded, what happens when a company buys back its own shares as treasury stock, how dividends of cash, property and stock are accounted for, how preferred stock is classified, and how the components of equity are presented. US state corporate law shapes the accounting here more than in most areas, and Canadian practice differs in vocabulary and some mechanics. US companies speak of common stock, additional paid-in capital and stockholders' equity; this page follows that usage.

The corporate form and classes of shares

Most US corporations are incorporated under state law, most commonly Delaware's General Corporation Law. Many states allow stock with a par value, a nominal amount per share set in the articles of incorporation, often $0.01 or $1. Par value has little economic meaning today, but it determines how the proceeds of an issue are split: common stock is credited with par value times the number of shares, and the excess is credited to additional paid-in capital (APIC). No-par stock may be issued with a stated value that works the same way. A corporation may have several classes of stock with different voting, dividend and liquidation rights. Common stock carries the residual interest; preferred stock usually carries a fixed dividend and priority over common.

Shares can also be issued for non-cash consideration, such as property, services or a business. They are recorded at the fair value of what is received or, if that cannot be measured reliably, at the fair value of the shares issued. Shares issued to employees for services are share-based payment, covered in lesson 11. When shares and other securities are sold together for a lump sum, the proceeds are allocated using relative fair values or, when only one fair value is known, the incremental method.

Treasury stock

Companies buy back their own shares to return cash to shareholders, offset dilution from employee options or signal that the shares are undervalued. Repurchased shares that are not retired are treasury stock: issued but not outstanding, without voting or dividend rights. Under the cost method, used by most companies, treasury stock is debited at the price paid and shown as a deduction from total stockholders' equity. When treasury shares are reissued above cost, the excess is credited to APIC from treasury stock transactions; when reissued below cost, the shortfall is debited first to that APIC account and then to retained earnings. No gains or losses are recognized in income. Since 2023 public companies have paid a 1 percent federal excise tax on the net value of shares repurchased, which is recorded in equity as part of the cost.

Dividends

A dividend is a distribution to shareholders. Three dates matter. On the declaration date, the board declares the dividend and it becomes a legal obligation, so a liability is recorded and retained earnings are reduced. On the record date, the company determines who owns shares and will receive the dividend; no entry is made. On the payment date, the dividend is paid and the liability settled. Because declaration creates the liability, dividends declared after the reporting period are not liabilities at year end; they are disclosed.

State law restricts dividends to protect creditors. Delaware, for example, allows dividends out of surplus (net assets in excess of stated capital) or, if there is no surplus, out of net profits for the current or preceding year, and directors who authorize unlawful dividends can be personally liable. Other states follow the Model Business Corporation Act's solvency and balance sheet tests. Loan covenants often add tighter limits.

Dividends need not be in cash. A property dividend distributes non-cash assets, such as shares of another company held as an investment. Under US GAAP the assets are remeasured to fair value at the declaration date, with a gain or loss in income, and the dividend is recorded at fair value.

A liquidating dividend returns contributed capital rather than distributing earnings, and is charged to share capital or APIC.

Stock dividends and stock splits

A stock dividend distributes additional shares to existing shareholders in proportion to their holdings. No assets leave the company and percentage ownership is unchanged. US GAAP distinguishes small stock dividends, less than about 20 to 25 percent of shares outstanding, which are recorded at the fair value of the shares issued (debit retained earnings, credit common stock at par and APIC for the excess), from large stock dividends, which are recorded at par value only, because a large distribution is expected to reduce the share price proportionately, like a split. A stock split increases the number of shares and reduces the par value per share proportionately; no entry is needed. Both are applied retroactively in earnings per share (lesson 11).

Preferred shares: equity or liability?

Preferred shares come in many forms. Cumulative preferred shares carry a right to dividends that accumulate if unpaid (dividends in arrears) and must be paid before any common dividend. Participating preferred shares share in dividends beyond their fixed rate. Convertible preferred shares can be exchanged for common shares. Redeemable or retractable preferred shares can be bought back by the issuer, or must be bought back at the holder's request or on a fixed date.

ASC 480 requires mandatorily redeemable preferred stock, which must be redeemed on a fixed or determinable date, to be classified as a liability, with dividends reported as interest expense. Preferred stock redeemable at the holder's option or on events outside the issuer's control is not a liability under ASC 480, but SEC registrants must present it outside permanent equity as temporary (mezzanine) equity under ASC 480-10-S99. Other preferred stock is equity. IFRS reaches a liability classification more often, because IAS 32 treats any holder redemption right as an obligation.

# Allocating a dividend between cumulative preferred and common shares
pref_shares, pref_par, pref_rate = 50_000, 100, 0.05
years_in_arrears = 2
declared = 900_000
annual_pref = pref_shares * pref_par * pref_rate
pref_owed = annual_pref * (years_in_arrears + 1)
to_pref = min(declared, pref_owed)
to_common = declared - to_pref
print(f"Annual preferred dividend: {annual_pref:,.0f}")
print(f"Arrears ({years_in_arrears} years) plus current year: {pref_owed:,.0f}")
print(f"Paid to preferred: {to_pref:,.0f}; paid to common: {to_common:,.0f}")
common_shares = 2_000_000
print(f"Common dividend per share: {to_common / common_shares:.3f}")
# If only $400,000 were declared:
small = 400_000
print(f"With {small:,} declared: preferred {min(small, pref_owed):,}; common {max(0, small - pref_owed):,}; arrears left {pref_owed - min(small, pref_owed):,.0f}")

Annual preferred dividend: 250,000
Arrears (2 years) plus current year: 750,000
Paid to preferred: 750,000; paid to common: 150,000
Common dividend per share: 0.075
With 400,000 declared: preferred 400,000; common 0; arrears left 350,000

Northlake's 5 percent cumulative preferred shares carry a $250,000 annual dividend. With two years in arrears, the preferred shareholders must receive $750,000 before common shareholders get anything; from a $900,000 declaration, common shareholders receive $150,000, or 7.5 cents a share. Dividends in arrears are not a liability until declared, but they must be disclosed, because they stand ahead of common shareholders. If the board declared only $400,000, all of it would go to the preferred shareholders, and $350,000 of arrears would remain.

Retained earnings, reserves and the statement of changes in equity

Retained earnings are the cumulative net income not distributed as dividends. Accumulated other comprehensive income (AOCI) collects items such as unrealized gains and losses on available-for-sale debt securities, cash flow hedges, foreign currency translation adjustments and pension gains and losses not yet amortized (lesson 9). Retained earnings may be appropriated for specific purposes, such as a reserve required by a bond indenture; an appropriation is only a label within equity. SEC registrants present a statement of stockholders' equity, or disclose the changes in the notes, reconciling each component, including the number of shares, for each period presented.