ACCT 100 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained...

ACCT 100

Chapter 11

Corporations: Organization, Stock Transactions, Dividends, and

Retained Earnings

Stockholders' Equity 2

Objectives of The Chapter

1. Basic characteristics of a corporation.

2. Accounting for issuance of common stock and preferred stock.

3. Accounting for treasury stock.

4. Retained earning and dividends.


I. Corporations: An Overview

A form of business entity formed under state law.

It is established as a legal entity separated from its owners.

It has all rights as a person has except for voting and holding public offices.

The owners of corporations have limited liabilities.


Procedures of Forming a Corporation

1. Incorporators apply for a charter by submitting articles of incorporation to state officials.

2. If the application is approved, the state will issue a charter.

The corporation is formed upon the issuance of the charter.

A charter is a document to give legal status and other rights to a corporation.


Procedures of Forming a Corporation (contd.)3. A stockholders’ meeting would be held

at which the initial issuance of capital stock is made to the incorporators and by-laws are developed.

A board of directors is elected.4. Ready for operations.5. Issuance of stock to public to raise more

capital (IPO).Note: Regardless of the number of states in which a

corporation operating, it is incorporated in one state.


Organization of a Corporation

a. Stockholders (owners)b. Board of directors; a chairperson is elected among

board of directors. The board

decides major operation principles. arranges major loans, authorize contracts. appoints officers such as CEO,COO,President, vice

president.c. Management (i.e., CEO,COO,etc.):

Responsible for day-to-day operations and the preparations of the financial statements.


Advantages of a Corporation

1. Separated legal entity.

2. Stockholders have limited liability.

3. Continuous existence.

4. Ease of transfer of ownership.

5. Ease of capital generation.

6. Centralized authority and responsibility -- to the president, not to numerous owners.

7. Professional management.


Disadvantages of a Corporation

1. Government regulations.

2. Corporation taxes (double taxation).

3. Separation of ownership and control: principal & agent conflicts.


The Stockholders’ Equity Section of a Balance Sheet

The Stockholders’ Equity Section of a Balance Sheet

Preferred stock, 7%, $100 par, 5,000 shares authorized,

700 shares issued

$ 70,000Paid-in capital in excess of par -- preferred 7,000Common stock, $10 par, 20,000 shares authorized,

6,500 shares issued

65,000Paid-in capital in excess of par -- common 70,000Retained earnings 95,000Treasury stock -- common, 500 shares at cost (12,000)Total Stockholders’ Equity $295,000_________

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Terminology Related to Stockholders’ Equity of a Corporation

1. Contributed Capital: the portion of stockholders’ equity contributed by investors through the issuance of stock.

2. Legal Capital (eliminated by Model Business Corporation Act) : the amount of contributed capital not available for dividends.


Terminology Related to Stockholders’ Equity of a Corporation (contd.)

3. Outstanding Stock: issued stock held by investors.

4. Treasury Stock: issued stock repurchased by the corporation and held by the corporation, not retired.

5. Authorized Capital: The number of shares of stock that the corporation may issue as stated in its corporate charter.



6. Common Stock: A class of stock with rights to share proportionately in:

(a) profits and losses;

(b) management (i.e., voting in corporate matters, one share one vote);

(c) corporate assets in liquidation;(d) any new issues of stock of the same

class (to maintain one’s proportionate ownership in corporation).

Note: companies can have more than one class of stock with different rights.



7. Preferred Stock: A class of stock with some rights such as:

(a) Dividends (with a higher priority than that of common stock);

(b) Sharing assets in liquidation (with higher priority than that of common stock).



8. Par Value Stock: Capital Stock with a nominal dollar amount printed on the stock certificate. In the past, most states designate the par value of all issued stock as the legal capital.


Examples of companies with no-par-value stock: Nike, Procter & Gamble and North American Van Lines (source: Financial Accounting by Weygadt, etc.).

However, there are companies which issued par value stock prior to the changes in the state law and continued to issue previously authorized par value shares.




10. Stated Value: a nominal value assigned to no-par stock by board of directors.

11. Additional Paid-in Capital (or Paid-in Capital in Excess of Par Value or Premium on Capital Stock): the excess of the issuance price over the par value or the stated value.


2. Accounting for Issuance of Stock

a. Stock issued for cash

b. Stock issued for services or noncash assets.


Stock Issued for Cash –common stock with par value Example 1: (See p539 of textbook for an

example of a stock certificate)

Issued 1,000 shares of $10 par common stock for $50 per share.

Journal Entry

Cash 50,000

Common Stock 10,000

Paid-in Capital in Excess of Par--Common Stock 40,000


Stock Issued for Cash (contd.)

Example 2: (Preferred Stock with Par)

Issued 1,000 shares of $10 par preferred stock for $30 per share.

Journal Entry

Cash 30,000

Preferred Stock 10,000

Paid-in Capital in Excessof par -- Preferred Stock 20,000



Example 3 (Common stock with stated value set by the board of directors)

Issued 1,000 shares of no-par common stock with a stated value $1 per share. Shares are issued at $5 per share.

Journal Entry

Cash 5,000

Common Stock 1,000

Paid-in Capital in Excess of Stated Value 4,000



Example 4 (No-par common stock without stated value)

Issued 1,000 shares of no-par and no stated value common stock for $5 per share.

Journal Entry

Cash 5,000

common Stock5,000


Stock Issued for services or noncash assets

Principle: Stock issued for service or property should be recorded either at the fair value of the stock or at the fair value of the property, whichever is more clearly determinable (reliable).

In most cases, if stock is traded frequently, the fair value of stock is used.

Otherwise, use the market value of the property.


Stock Issued for Noncash Proposition (contd.)

Example: issued 1,000 shares of $5 par C.S. for building. The market value of the stock is $15 per share and is traded frequently.

Journal Entry:

Building 15,000

C.S. 5,000

Additional paid-in Capitalin excess of par -- C.S.10,000


Preferred Stock Characteristics

1. Preference as to dividends: holders have a preference to dividends.

2. The annual dividends are expressed as percentage of the par value.

If no-par preferred stock is issued, the dividend is expressed as a dollar amount per share.


Preferred Stock Characteristics (contd.)

3. A preference to dividends does not guarantee a preferred dividend payment.

Dividend payment is at the discretion of the board of directors.

4. If dividends are “passed” (not declared or amounts declared less than the stated dividends) in a year, a holder of non cumulative preferred stockholder will never be paid those dividends.


Cumulative Preferred Stock

However, the amount of passed dividends becomes “dividends in arrears” for a cumulative preferred stock.

Dividends in arrears accumulate from period to period.

Dividends in arrear have the highest priority to be paid in the future if dividends were declared in the future.


Dividends Allocation: Examples

Year 1: Case I:

Dividends declared = $10,000

Com. STK shares outstanding: 10,000, @$5

Preferred STK outstanding : 5,000, @$10, dividend is 6% of the par value

Dividends for P.S. = 6% *10*5,000= $3,000.

Dividends for C.S. = ($10,000-3,000)=$7,000.

Or $0.7 per share ($7,000/10,000 shares)


Dividends Allocation: (contd.)

Case II: Same information as in Case I except that dividends declared = $1,000.Dividends for P.S. = $1,000. Div. Passed=$2,000Dividends for C.S. = $0

If this is a cumulative P.S. the dividends in arrears equal $2,000 ($3,000-1,000).

If this is a non-cumulative P.S., the $2,000 will never been paid.


Dividends Allocation (contd.)

Case III:

Same information as in Case I except that dividends declared = $500.Dividends for P.S. = $500. Dividends for C.S. = $0

If this is a cumulative P.S. the dividends in arrears equal $2,500 ($3,000-500).

If this is a non-cumulative P.S., the $2,500 will never been paid.


Dividends Allocation (Contd.)

Year 2: Continued from Case II of year 1, assuming a cumulative preferred stock and the dividends declared = $8,000.

Dividends for P.S. => $2,000 (div. In arrears)

$3,000 (div. Of year 2) $ 5,000

Dividends for C.S. => $8,000- $2,000-3,000 = $3,000


Convertible Preferred Stock (skip)

Convertible preferred stock allows stockholders, at their option, under specified conditions to convert the shares of preferred stock into another security of the corporation.


Accounting for Conversion of Preferred to Common Stock (skip)Book value method is used.Example: A corporation issued 500 shares of $100

par convertible preferred stock at $120 per share. If each preferred share is converted into 4 shares of $20 par common stock, the following entry will be recorded:

Preferred Stock 50,000Additional Paid-in Capital on P.S 10,000

Common Stock 40,000Additional Paid-in capital -- Common Stock 20,000


3. Treasury Stock

Treasury stock is issued stock that has been purchased back (reacquired) by the issuing corporation.

Treasury stock carries no voting or preemptive rights, no right to dividends, and no right at liquidation.

However, it does participate in stock split.


Treasury Stock (contd.)

Reasons of acquiring treasury stock:1. To use for stock option, bonus and employee

purchase plans;2. To use in the conversion of convertible preferred

stock or bonds;3. To use excess cash and help maintain the market

price of its stock; to increase EPS;4. To use in the acquisition of other companies;5. To use for stock dividend;6. To reduce the number of shares held by outside

shareholders and thereby reduce the likelihood of being acquired by another company.


Accounting for Treasury Stock (T.S.) –the Cost MethodCost Method:

T.S. is recorded at cost paid for transactions:

1. Issuance of 6,000 shares of $10 par common stock for $12 per share

Cash 72,000

C.S., $10 par 60,000

Additional Paid-in Capital on C.S.

12,000


Accounting Methods for Treasury Stock (T.S.) (contd.)2. Reacquisition of 1,000 shares of C.S.

at $15 per share:Treasury Stock 15,000

Cash 15,000

3. Reissuance of 600 shares of T.S. at $17 per share:Cash 10,200

T.S. 9,000Additional Paid-in Capital from T.S. 1,200


Accounting Methods for Treasury Stock (T.S.) (contd.)4. Reissuance of another 200 shares of T.S.

at $10 per share

Cash 2,000

Additional Paid-in Capital from T.S. 1,000

Treasury Stock3,000


Accounting Methods for Treasury Stock (T.S.) (contd.)5. Reissuance of another 100 shares of T.S.

at $8 per share

Cash 800Additional Paid-in Capital fm T.S. 200Retained Earning 500

Treasury Stock1,500

Note: neither the purchase nor the sale of treasury stock results in a gain or a loss. Sale of T.S. above cost results in an increase in the paid-in capital while sale of T.S. below the cost results in a decrease of paid-in capital or retained earnings.


Balance Sheet Presentation of Treasury Stock The stockholders’ equity section is

prepared after transactions 1-5 as follows:

(Assume retained earnings is $40,000 prior to recording any treasury stock transactions)


Balance Sheet Presentation of Treasury Stock (contd)

Balance Sheet Presentation of Treasury Stock (contd)

Cost Method:Contributed Capital: Common stock, $10 par (20,000 shares authorized,

6,000 shares issued, of which 100 are being held as Treasury Stock)

$ 60,000 Additional paid-in capital on C.S.

12,000Total Contributed Capital

72,000Retained Earnings (see Note)

39,500Total Contributed Capital and Retained Earnings

111,500Less: Treasury Stock (100 shares at cost)

(1,500)Total Stockholders’ Equity

$110,000 _________

Note: Retained Earnings are restricted regarding dividends in the amount of $1,300, the cost of treasury stock.

41


Retirement of Stock

Continuing the treasury stock example:

6. Retirement of the last 100 shares of T.S.Common Stock, $10 par 1,000*Additional Paid-in on Common Stock 200Retained Earnings 300

Treasury Stock 1,500

*[12,000 (100 6,000)] = $200

Original additional Paid-in Capital on common stock for 6,000 shares.


4. Retained Earnings and Dividends

The major components of stockholders’ equity are contributed capital and the retained earnings.

Factors that affect retained earnings besides net income (or net loss) include (1) dividends, (2) prior period adjustments, (3) appropriations (voluntary restrictions), and (4) quasi-reorganizations.


Dividends

While the net income increases the retained earnings, the distribution of dividends reduces the retained earnings.

In order to declare dividends, a company must meet legal requirements and must have assets available for distribution.

Dividends (Contd.)

Most companies regard the unrestricted retained earnings as the limit for dividends distribution.Restrictions of retained earnings include:1) Legal restrictions: Many states require corporations to restrict the cost of treasury stock from dividends distribution.2)Contractual restrictions: A long-term bond contract may limit the use of assets for payment of dividends ,


Dividends (Contd.)

3)Voluntary restrictions: Appropriation of retained earnings for specific purposes.

The board of directors is responsible for the establishment of dividend policy and the determination of the amount, timing and types of dividends to be declared.



Dividends (contd.)

A few types of dividends may be considered:

(1) cash, (2) property, (3) scrip, (4) stock, and (5) liquidating dividends.

Cash, property and scrip dividends decrease retained earnings (R/E) (and stockholders’ equity); stock dividends decrease R/E and increase contributed capital by the same amount; liquidating dividends decrease con


Cash Dividends

Cash dividend is the most common type of dividend which is the distribution of cash by the corporation to its stockholders.


Cash Dividends

Four dates are relevant to the cash dividends:

(1) the date of declaration, (2) the ex-dividend date (a few days before the record date),

(3) the date of record (a few weeks after declaration date), and

(4) the date of payment (2-4 weeks after the date of record).


Example

On Nov. 3, 20x2, the board of directors declares preferred dividends totaling $10,000 and common dividends totally $20,000. These dividends are payable on 12/15/x2 to stockholders of record on 11/24/x2. The ex-dividend date is 11/21/x2. The journal entries to record the dividends are:


Example (contd.)

11/3/x2 (the date of declaration)Retained Earnings 30,000

Dividends Payable: Common20,000

Dividends Payable: Preferred10,000

11/24/x2 (the date of record)Memo: the company will pay dividends on 12/15/x2 to

preferred and common stockholders of record as of today, the date of record.

12/15/x2Dividends Payable: Common stock 20,000Dividends Payable: Preferred stock 10,000

Cash30,000


Stock Dividends

A stock dividend is a proportional distribution of additional shares of a corporations’ own stock to its shareholders.

When a stock dividend is distributed, no corporate assets are distributed.

Each stockholder maintains the same percentage of ownership as before the stock dividend.


Stock Dividends (contd.)

Small stock dividend is accounted for by transferring an amount equals to the fair market value of the additional shares issued from retained earnings to contributed capital.

Reasons of declaring a stock dividend: to continue dividend but to conserve cash.


Stock Dividends (contd.)

A small stock dividend is less than 20% or 25% of outstanding shares.

For a large stock dividend, the accounting treatment is only to capitalize the par value of the stock.


Example 1: Small Stock Dividend

A Corporation with 20,000 shares outstanding declares and issues a 10% stock dividend. On the date of declaration, the stock sells for $23 per share with a par value of $10. The 2,000 share stock dividend is recorded at the fair market value of $46,000 as follows:


Example 1 (contd.)Date of Declaration:Retained Earnings 46,000

C.S. To be Distributed ** 20,000Additional Paid-in Capital from Common Stock Dividend 26,000

Date of Issuance:C.S. To be Distributed 20,000

C.S., $10 par 20,000* There is no change in the stockholders’ equity before and after

the stock dividend.** This account is Not a liability, but a temporary stockholders’

equity item representing the legal capital related to the stock to be issued. This account is reported as a component of contributed capital.


Example 2: Large Stock Dividend

Assume that a corporation with 20,000 share outstanding declares a 40% stock dividend when the stock is selling for $23 per share with a par value of $10 per share.


Example 2 (contd.)

Date of Declaration:Paid in Capital 80,000

C.S to be Distributed ($10 20,000 40%) 80,000

Date of Issuance:C.S to be Distributed 80,000

C.S, $10 par 80,000

* The stockholders’ equity remains the same before and after the stock dividend.


Stock Splits Reasons:

(1) To increase the marketability of stock by decreasing the market value and par value per share

(2) To increase the numbers of shares outstanding

Example: a 2 for 1 proportionate stock split Shares Par Market Outstanding value Price Before Split 1,000 $50 $120 After Split a b c


Accounting for Stock Splits (proportionate stock splits)No entry for proportionate stock splits. A memo is required.The memo indicates the increase of shares outstanding and the reduction of par value proportionately.Stock splits will not affect total paid-in capital, retained earnings or total stockholders’ equity.


Similarities and Differences Between Stock Dividends and Stock Splits (Skip)

Similarities:

1. Both increase the number of shares issued and outstanding. Both also increase proportionately the number of shares of stock owned per stockholder.

2. Both do not change the total cost of stock owned or the total stockholders’ equity.


Stock Dividends and Stock Splits (contd.) (Skip)

Differences: Stock dividend shifts an amount from

retained earnings to contributed capital with the par value per share unchanged. A stock split does not change any account balance but change the par value per share. A stock split also increases the number of shares of stock authorized, issued and outstanding.

Accounting for Prior Years’ Errors

The correction of an error in a previously issued financial statement is referred to as a prior period adjustment.

The correction is made to the retained earnings as an adjustment to the beginning balance of current year’s retained earnings.


Prior Period Adjustment- An Example

• Failure to record depreciation expense of $5,000 in 20x7. This error was discovered in 20x8.

• 20x8• Retained Earnings 5,000• Accumulated Depre. 5,000• (To adjust for understated depreciation

In 20x7)


Prior Period Adjustment- An Example (contd.)Presentation: (assuming a beginning balance

of $30,000 in retained earnings)

Statement of Retained Earnings (partial)

For the Year Ended 12/31/20x8

Retained Earnings, 1/1/2008 $30,000

Prior Period Adjustment (5,000)

Adjusted retained earnings, 1/1/2008 $25,000



Different Values of Stock

1. Market value: the price of a stock for which a person can buy or sell a share of the stock in the stock market.

2. (Skip) Redemption value: applies only to callable preferred stock.

Different Values of Stock (contd.)

(skip) A corporation can redeem (pay to retire) a callable preferred stock at a predetermined price during a predetermined period (i.e., after 1/1/2008).

(skip)This predetermined price is the redemption value of the callable preferred stock.




3. (skip) Liquidation value: applies only to preferred stock.

(skip)This is the amount the corporation agrees to pay the preferred stockholders per share if the corporation liquidates.

(skip)Dividends in arrears are added to liquidation value.


Decision Making Ratio

Rate of Return on stockholders’ equity:

Rate of return on 1 common

stockholders’ equity

Net Income - Preferred dividendsAverage common stockholders’

equity

Average Common stockholders’ equity = Average of (total stockholders’ equity - preferred stockholders’ equity)

1. Measuring the earning power of common stockholders’ equity.

=

ACCT 100 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained...

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