Financial Accounting II Unit 3 Review: Stock Issuance & Buyback

Key Concepts

• Stockholders' equity represents the residual interest in a company's assets after deducting liabilities
• Consists of contributed capital (amounts received from issuing stock) and retained earnings (cumulative net income less dividends)
• Stock issuance increases contributed capital and total stockholders' equity
• Stock buybacks decrease outstanding shares and total stockholders' equity
• Par value is the nominal or face value assigned to a share of stock
• Additional paid-in capital is the amount received from issuing stock in excess of par value
• Retained earnings are not directly affected by stock issuance or buybacks

Types of Stock

• Common stock represents the residual ownership in a company and typically carries voting rights
  • Dividends on common stock are not guaranteed and are paid at the discretion of the board of directors
• Preferred stock provides a higher claim on assets and earnings compared to common stock
  • Often carries a fixed dividend rate and may have priority over common stockholders in receiving dividends and assets during liquidation
• Treasury stock is previously issued stock that has been repurchased by the company
  • Treated as a contra-equity account and reduces total stockholders' equity
• Callable preferred stock allows the issuer to redeem the shares at a predetermined price after a specified date

Stock Issuance Process

• Board of directors approves the issuance of new shares
• Company determines the number of shares to be issued and the offering price
• Prospectus is prepared, detailing the terms of the offering and the company's financial information
• Investment bank may be engaged to underwrite the offering and assist with pricing and distribution
• Shares are offered to the public through an initial public offering (IPO) or to existing shareholders through a rights offering
• Investors purchase the newly issued shares, and the company receives the proceeds
• Transfer agent records the ownership of the new shares and distributes stock certificates to investors

Accounting for Stock Issuance

• When stock is issued, the company records the par value of the shares in the common stock account
• Any amount received in excess of par value is recorded in the additional paid-in capital account
  • For example, if a company issues 1,000 shares with a par value of $1 at a price of $10 per share, common stock would be credited for $1,000 (1,000 shares ×$1 par value), and additional paid-in capital would be credited for $9,000 (1,000 shares ×$9 excess over par value)
• If stock is issued in exchange for assets or services, the transaction is recorded at the fair value of the shares issued or the fair value of the assets or services received, whichever is more reliably measurable
• Stock issuance costs, such as underwriting fees and legal expenses, are recorded as a reduction of additional paid-in capital
• Preferred stock issuance is accounted for similarly to common stock issuance, with the par value recorded in a separate preferred stock account

Stock Buybacks

• Stock buybacks, also known as share repurchases, occur when a company buys back its own shares from shareholders
• Reasons for stock buybacks include returning excess cash to shareholders, increasing earnings per share, and providing a tax-efficient alternative to dividends
• When shares are repurchased, they are recorded as treasury stock, a contra-equity account that reduces total stockholders' equity
  • For example, if a company repurchases 500 shares at $20 per share, treasury stock would be debited for $10,000 (500 shares × $20 per share), and cash would be credited for $10,000
• Repurchased shares may be retired (cancelled) or held as treasury stock for future reissuance
• Stock buybacks can be executed through open market purchases, tender offers, or privately negotiated transactions

Financial Statement Impact

• Stock issuance increases assets (cash) and stockholders' equity (common stock and additional paid-in capital)
• Stock buybacks decrease assets (cash) and stockholders' equity (treasury stock)
• Earnings per share (EPS) is calculated by dividing net income by the weighted average number of common shares outstanding
  • Stock issuance increases the number of shares outstanding and may dilute EPS if the newly issued shares do not generate a proportionate increase in net income
  • Stock buybacks reduce the number of shares outstanding and may increase EPS if net income remains constant or grows
• Return on equity (ROE) measures a company's profitability relative to stockholders' equity
  • Stock issuance and buybacks can impact ROE by changing the balance of stockholders' equity

Regulatory Considerations

• Public companies must comply with securities laws and regulations when issuing or repurchasing stock
• Securities and Exchange Commission (SEC) requires registration of securities offerings and disclosure of material information to investors
• Sarbanes-Oxley Act of 2002 (SOX) imposes strict financial reporting and internal control requirements on public companies
• Insider trading laws prohibit company insiders from trading on material, non-public information
• Stock buybacks are subject to SEC Rule 10b-18, which provides a safe harbor for companies repurchasing their shares
  • Rule 10b-18 specifies manner, timing, price, and volume conditions that must be met to avoid liability for market manipulation

Real-World Examples

• In 2020, Tesla, Inc. (TSLA) conducted a $5 billion at-the-market stock offering to raise capital for general corporate purposes and to strengthen its balance sheet
• Apple Inc. (AAPL) has an ongoing share repurchase program, buying back $81.7 billion of its common stock in fiscal year 2021 to return cash to shareholders
• Berkshire Hathaway Inc. (BRK.A, BRK.B) has two classes of common stock, with Class A shares carrying more voting rights than Class B shares
• In 2018, General Electric Company (GE) issued $5 billion of perpetual preferred stock with a fixed dividend rate to raise capital and improve its liquidity position
• Many companies, such as Microsoft Corporation (MSFT) and Johnson & Johnson (JNJ), have dividend reinvestment plans (DRIPs) that allow shareholders to reinvest their dividends in additional shares of stock, effectively increasing the number of shares outstanding over time