1. College Accounting, by Heintz and Parry Chapter 21: Corporations: Organization and Capital Stock

2. When Nick entered the store Friday, he looked puzzled. “Eddie, you got some ‘splainin’ to do,” he said in his best Ricky Ricardo accent. “Rick Swagger talked to his lawyer, and he says he won’t invest in the business unless we become a corporation. He mentioned some mumbo-jumbo about ‘limited liability.’ Eddie, a corporation can have as many liabilities as any other business, can’t it?” “Sure. That’s not what ‘limited liability’ means. A sole proprietorship or a partnership has ‘unlimited liability’ because the owner or owners can legally be forced to pay business liabilities with personal assets. However, a corporation’s liabilities are limited by the amount of capital the business has.” “So Rick is afraid that somebody will slip on some ice in front of our store, sue us for millions, and he’ll be broke.” “Exactly.” Question: What are some other pros and cons of incorporating a business?

3. Answer: In addition to limited liability, some other pros of being a corporation are: 1) ease of ownership transfer--one owner can sell some or all of their stock to someone else without disbanding the business. Stock can also be passed on to heirs if an owner dies, giving the corporation unlimited life. 2) ease of raising capital--a corporation can sell just enough stock to raise the desired amount of capital. 3) no mutual agency--owners normally do not have the right to enter the business into binding contracts. Cons include: 1) double taxation--the corporation pays income tax, and then any dividends become taxable income for the owners 2) government regulations and reporting requirements can be a burden

4. “Is it expensive to incorporate?” “Probably not in your case. Besides, incorporation fees and attorneys’ fees can be put into an intangible asset account called organization costs and amortized over time (generally five years). If the organization costs were $6,000, the amortization entry for each of the 5 years would look like this ($6,000/5 years = $1200):” Date Description P. R. Debit Credit 2002 Dec. 31 Amortization of Organization Costs 1200.00 Organization Costs 1200.00

5. Nick was determined to understand how it would work. “So we just print some stock and Rick and I buy it all, right?” “It could work that way. However, you could also bring in extra capital without giving up control of the company.” “How would we do that?” “By selling preferred stock. It is a form of stock that represents ownership of company assets, but usually doesn’t include any voting rights.” “You’ve got to be kidding, Eddie. Why would anyone buy ownership shares if they had no voice in running the company?” “There are other ways that preferred stockholders are treated better than common stockholders (ones who can vote). Question: What are some advantages that preferred stockholders have over common stockholders?

6. Answer: ”Advantages given to preferred stockholders include the following: 1) preferred stock has a dividend (dollar amount or percentage rate) printed on it, and this dividend must be paid before common stockholders receive any dividend. 2) if the preferred stock is cumulative (rather than noncumulative), any unpaid dividends from prior years must also be paid before common stockholders can receive a dividend. 3) in the case of liquidation, preferred stockholders receive the book value of their stock before common stockholders. “To explain how the cumulative feature works, let’s make up an example. ”

7. “Assume this: a new company pays no dividends in 2001. In 2002, $50,000 is available for dividends. Stock issued and outstanding (still in stockholders’ hands) consists of: Cumulative preferred stock, 5,000 shares, $30 par value (the value stated on the shares), $3 dividend (or a 10% dividend) Common Stock, $5 par value, 10,000 shares Preferred dividends would include Year 1’s unpaid dividend: (Year 1 dividend + Year 2 dividend) X outstanding shares ( $3 + $3 ) X 5,000 = $30,000 Dividends available for common stockholders would be: Total available - preferred dividends $50,000 - $30,000 = $20,000 Dividends per share of common stock would be: Dividends available $20,000 Common shares outstanding = 10,000 = $2 per share Question: How would common dividends be different if the preferred stock were noncumulative?

8. Answer: ”The stock issued and outstanding would be: Cumulative preferred stock, 5,000 shares, $30 par value (the value stated on the shares), $3 dividend (or a 10% dividend) Common Stock, $5 par value, 10,000 shares Preferred dividends would not include 2001’s unpaid dividend: Year 2 dividend X outstanding shares $3 X 5,000 = $15,000 Dividends available for common stockholders would be: Total available - preferred dividends $50,000 - $15,000 = $35,000 Dividends per share of common stock would be: Dividends available $35,000 Common shares outstanding = 10,000 = $3.50 per share.”

9. “Okay, I guess that preferred stock is an option down the road, but tell me how this common stock would work. Would we still have our own capital accounts? Would we be able to divide income the same way?” “Whoa, one at a time. No, you wouldn’t have capital accounts. There would be a common stock account instead. For example, let’s say you print up 5,000 shares of common stock and put a par value of $50 on each certificate. If you and Rick bought all of the certificates for exactly $50, the entry would look like this.” Date Description P. R. Debit Credit 2001 Aug. 5 Cash (5,000 shares X $50) 250,000.00 Common Stock 250,000.00

10. “Of course, there is no law forcing you to sell common stock at par value, and you probably wouldn’t if you sold more shares later. Let’s say that one of Rick’s bandmates wants to buy into the company a year from now. At that point, a fair price for the stock might be $55. If you print up 1,000 new shares and sell them to him at that price, the entry would involve an account called Paid-in Capital in Excess of Par-Common Stock, because entries to the ‘Common Stock’ account should always be at par value.” Date Description P. R. Debit Credit 2002 Aug. 5 Cash (1,000 shares X $55) 55,000.00 Common Stock 50,000.00 Paid-in Capital in Excess of Par- Common Stock 5,000.00

11. “Some companies use a stated value instead of a par value. The only impact on the entry is a change in wording.” Date Description P. R. Debit Credit 2002 Aug. 5 Cash (1,000 shares X $55) 55,000.00 Common Stock 50,000.00 Paid-in Capital in Excess of Stated Value--Common Stock 5,000.00

12. “Some companies use no-par stock instead of assigning a par value. If that is the case, the full selling price would go into the common stock account.” Date Description P. R. Debit Credit 2002 Aug. 5 Cash (1,000 shares X $55) 55,000.00 Common Stock 55,000.00

13. “Sometimes, a company may give stock in trade for another valuable asset. Let’s say, for example, that when you attempt to buy a new location for a store, the owner of the land and building wants 2,000 shares of $50 par value stock instead of cash. If your stock were listed on a stock exchange and traded regularly, you would probably use the last trading price to value this transaction. However, in a case like this, where two people hold the stock and the value of the company is hard to determine, an appraisal of the land and building could be used to place a fair value on the transaction. If the property were valued at $120,000 ($30,000 for the land, $90,000 for the building), the entry would look like this.” Date Description P. R. Debit Credit 2002 Aug. 5 Land 30,000.00 Building 90,000.00 Common Stock 100,000.00 Pd.-in Cap. In Excess of Par-C.S. 20,000.00

14. Nick had one of his usual interesting “what-if” questions. “Suppose this other guy tries to start telling us how to run the business and is generally a pest. How would we get rid of him?” “You or Rick could buy his shares from him, or the company could buy back the shares. When a company buys its own stock, it is called treasury stock. Treasury stock will have a debit balance, but it is not an asset; it is a contra stockholders’ equity account on the balance sheet. If you were to buy his 2,000 shares at $65 apiece just to be rid of him, this would be your entry.” Date Description P. R. Debit Credit 2003 June 30 Common Treasury Stock 130,000.00 Cash 130,000.00

15. “If you subsequently sell your treasury stock for more than your purchase price, the difference (after you debited cash and credited your treasury stock account for your purchase price) would go into an account called ‘Paid-in capital from sale of treasury stock.’ This account would be listed on your balance sheet with your ‘Paid-in capital in excess of par’ accounts. For example if you were to sell the 2,000 shares of treasury stock at $70 apiece, this would be your entry.” Date Description P. R. Debit Credit 2003 July 30 Cash 140,000.00 Common Treasury Stock 130,000.00 Paid-in Capital from Sale of Treasury Stock 10,000.00

16. “If you subsequently sell your treasury stock for less than your purchase price, the difference (after you debited cash and credited your treasury stock account for your purchase price) can only be debited to ‘Paid-in capital from sale of treasury stock’ to the extent that a credit balance already exists in that account. Otherwise, the debit goes to retained earnings. In our example if you were to sell the 2,000 shares of treasury stock at $58 apiece, this would be your entry.” Date Description P. R. Debit Credit 2002 July 30 Cash 116,000.00 Retained Earnings 14,000.00 Common Treasury Stock 130,000.00

17. “For a corporation, a typical ‘Stockholders’ Equity’ section (which replaces the owners’ equity section) would look something like this: Paid-in Capital: Preferred Stock, 8%, $100 par (2,000 shares authorized, 1,000 shares issued) $100,000 Common Stock, $10 par (30,000 shares authorized, 20,000 issued) 200,000 Additional Paid-In Capital: Paid-in Capital in Excess of Par-Common Stock 130,000 Total Paid-In Capital $430,000 Retained Earnings 50,000 $480,000 Less Treasury Stock (1,000 shares at cost) 14,000 Total Stockholders’ Equity $466,000