Redemption and Reduction of Capital Stock
The redemption and reduction of capital stock presents a problem of surplus adjustment requiring careful treatment. If a corporation has accumulated no surplus of any sort and redemption of the stock is at par, no difficulty is met in making the entry. If, however, a surplus has been accumulated and redemption is either above or below par, care must be exercised to record the transaction properly. Redemption at a stated price is sometimes one feature of a preferred stock issue. Again the stock may be bought in the open market for the purpose of cancellation. Reduction of capital, except when made a condition of the original issue, cannot usually be accomplished without the consent of at least a majority of the shareholders and authorization from the state. For the sake of simplicity, assume just one class of stock and a surplus in which each share has an equal interest. If redemption is at par, the surplus is evidently not affected but each share of stock remaining outstanding has a larger share in the surplus and so acquires a higher book value.
Redemption of a stock at its book value is accomplished by charging capital stock for its par value and surplus for its pro rata share in the surplus, the offsetting credit to both these being to cash. The value of the remaining shares of stock has not been affected in the least. If redemption is at any other figure than book value, not only is surplus affected, being increased if the redemption price is below par and decreased if above par, but also the value of the remaining shares. In the case of different classes of stocks, a careful determination of their respectively equitable shares in surplus would have to be made before the effect on the remaining shares could be calculated.
In passing from the question of stock values, it should be pointed out that an undervaluation of stock when issued for property, though seldom seen in practice, has the refreshing effect of creating a secret reserve. That is, property values are carried on the books below their actual values and a secret reserve is thereby created. A further discussion of secret reserves will follow in a later chapter.
Dividend Stock
Stock is sometimes issued for dividend purposes. In such cases, it is always issued as of par value. If profits have been earned or a surplus accumulated out of which a dividend may be declared, that dividend may be paid in any way the corporation sees fit. Payment may be made in cash, scrip, or in the shares of the company. If the corporation has neither unissued stock nor stock in the treasury, permission to increase its capitalization must be secured before a stock dividend can be paid. Some corporations, notably financial institutions, often make it a matter of policy to accumulate a large surplus and then distribute it by means of a stock dividend. Declaration of the dividend is made and recorded as usual. Record of the payment in stock is made as a debit to Dividends account and a credit to Capital Stock.
The effect of a stock dividend is twofold. From the point of view of the management of the surplus it has the effect of a permanent investment of the surplus in the business. Thus it places the accumulated profits beyond the control of any future board of directors. If left in surplus, a cash dividend might have been declared and the asset dissipated to that extent. The stock dividend, however, keeps the profits invested in the business in such a way as not hereafter to be available for dividends. From the point of view of the stockholder, upon the declaration of a stock dividend his equity, his proprietorship in the business, is not in the least affected excepting that it is divided into more parts; he has more shares to represent it than he had before. Before he possessed as a community right a pro rata share in the surplus. Now the ownership of that share has become personal, individual. Each share of ownership thus has a smaller book value but each stockholder’s equity is the same as before.
Stock Issued as a Bonus
The manner of recording stock issued as a bonus with bonds or for any other purpose has been illustrated in an earlier chapter. Here, attention is called to the effect of such an issue in states where stock cannot be sold below par. There is no legal bar to the sale of bonds below par. If, then, the price received for the bond carrying a bonus of stock is at least equal to the par value of the bonus stock, there is nothing extra legal in the transaction. However, record must be made of the issue of the stock at par, the discount or bonus being carried as applying to the bond.
The valuation of stock issued in effecting combinations or for labor or services follows along the same general principles as of that issued for property, and the same general considerations are pertinent.