Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings

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. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

Disadvantages of a Corporation 1. Government regulations. 2. Corporation taxes (double taxation). 3. Separation of ownership and control: principal & agent conflicts. Stockholders' Equity

The Stockholders’ Equity Section of a Balance Sheet Preferred stock, 7%, $100 par, 5,000 shares authorized, 700 shares issued $ 70,000 Paid-in capital in excess of par -- preferred 7,000 Common stock, $10 par, 20,000 shares authorized, 6,500 shares issued 65,000 Paid-in capital in excess of par -- common 70,000 Retained earnings 95,000 Treasury stock -- common, 500 shares at cost (12,000) Total Stockholders’ Equity $295,000 _________ Stockholders' Equity 9

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. Stockholders' Equity

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. Stockholders' Equity

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

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

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

Terminology Related to Stockholders’ Equity of a Corporation (contd.) 9. No-Par Stock: capital stock without a par value. Many states allow the board of directors to establish a stated value, as the legal capital. Since the concept of par value and legal capital has been eliminated by Model Business Corporation Act, the no-par-value stock has gained its popularity. Stockholders' Equity

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

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

2. Accounting for Issuance of Stock a. Stock issued for cash b. Stock issued for services or noncash assets. Stockholders' Equity

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 Stockholders' Equity

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 Excess of par -- Preferred Stock 20,000 Stockholders' Equity

Stock Issued for Cash (contd.) 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 Stockholders' Equity

Stock Issued for Cash (contd.) 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 Stock 5,000 Stockholders' Equity

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. Stockholders' Equity

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 Capital in excess of par -- C.S. 10,000 Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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) Stockholders' Equity

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=$2,000 Dividends 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. Stockholders' Equity

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. Stockholders' Equity

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 Stockholders' Equity

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. Stockholders' Equity

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 50,000 Additional Paid-in Capital on P.S 10,000 Common Stock 40,000 Additional Paid-in capital -- Common Stock 20,000 Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

Accounting for Treasury Stock (T.S.) –the Cost 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 Stockholders' Equity

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. 9,000 Additional Paid-in Capital from T.S. 1,200 Stockholders' Equity

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 Stock 3,000 Stockholders' Equity

Accounting Methods for Treasury Stock (T.S.) (contd.) 5. Reissuance of another 100 shares of T.S. at $8 per share Cash 800 Additional Paid-in Capital fm T.S. 200 Retained Earning 500 Treasury Stock 1,500 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. Stockholders' Equity

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) Stockholders' Equity

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. 12,000 Total Contributed Capital 72,000 Retained Earnings (see Note) 39,500 Total Contributed Capital and Retained Earnings 111,500 Less: 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. Stockholders' Equity 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 200 Retained Earnings 300 Treasury Stock 1,500 *[12,000  (100 6,000)] = $200 Original additional Paid-in Capital on common stock for 6,000 shares. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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 , Stockholders' Equity

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. Stockholders' Equity

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 Stockholders' Equity

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

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). Stockholders' Equity

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: Stockholders' Equity

Example (contd.) 11/3/x2 (the date of declaration) Retained Earnings 30,000 Dividends Payable: Common 20,000 Dividends Payable: Preferred 10,000 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/x2 Dividends Payable: Common stock 20,000 Dividends Payable: Preferred stock 10,000 Cash 30,000 Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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: Stockholders' Equity

Example 1 (contd.) Date of Declaration: Retained Earnings 46,000 C.S. To be Distributed ** 20,000 Additional 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. Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

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 Stockholders' Equity

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. Stockholders' Equity

Similarities and Differences Between Stock Dividends and Stock Splits (Skip) 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. 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. Stockholders' Equity

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. Stockholders' Equity

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) Stockholders' Equity

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 Stockholders' Equity

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. Stockholders' Equity

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. Stockholders' Equity

Different Values of Stock (contd.) 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. Stockholders' Equity

Different Values of Stock (contd.) 4.Book value (BV): the amount of stockholders’ equity for per share of stock. For preferred stock: redemption value per share plus dividends in arrears. For common stock: (Total stockholders’ equity - BV of prefer. stock) Total common stock shares outstanding Stockholders' Equity

Decision Making Ratio = Rate of Return on stockholders’ equity: Rate of return on 1 common stockholders’ equity Net Income - Preferred dividends Average common stockholders’ equity = Average Common stockholders’ equity = Average of (total stockholders’ equity - preferred stockholders’ equity) 1. Measuring the earning power of common stockholders’ equity. Stockholders' Equity