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Accounting Principles II: Corporations
Complete Study Guide
Characteristics of a Corporation
A corporation is a legal entity, meaning it is a separate entity from its owners who are called stockholders. A corporation is treated as a “person” with most of the rights and obligations of a real person. A corporation is not allowed to hold public office or vote, but it does pay income taxes. It may be established as a profit making or nonprofit organization and may be publicly or privately held. The stock of a public company is traded on a stock exchange. There may be thousands, even millions, of stockholders in a public company. Stock of a privately held company is not traded on an exchange and there are usually only a small number of stockholders. To be recognized as a corporation, a business must file an application that includes the corporation's articles of incorporation (charter) with the State, pay an incorporation fee, and be approved by the State. Once the approval is received, the corporation must develop its bylaws. Organization costs , including legal fees, underwriters' fees for stock and bond issues, and incorporation fees, are recorded as an intangible asset and amortized over a period of time not to exceed 40 years. Ownership in a corporation is represented by stock certificates , which is why the owners are called stockholders. Stockholders have the right to: vote for the members of the Board of Directors and any other items requiring stockholders action; receive dividends when authorized by the Board of Directors; have first right of refusal when additional shares are issued, thereby allowing the stockholder to maintain the same ownership percentage of the company before and after the new shares are issued (called a pre ‐ emptive right ); and share in assets up to their investment, if the company is liquidated. In some states, stockholders are called shareholders. A number of characteristics distinguish a corporation from a sole proprietor or partnership. Unlimited life As a corporation is owned by stockholders and managed by employees, the sale of stock, death of a stockholder, or inability of an employee to function does not impact the continuous life of the corporation. Its charter may limit the corporation's life although the corporation may continue if the charter is extended. Limited liability
The liability of stockholders is limited to the amount each has invested in the corporation. Personal assets of stockholders are not available to creditors or lenders seeking payment of amounts owed by the corporation. Creditors are limited to corporate assets for satisfaction of their claims. Separate legal entity The corporation is considered a separate legal entity, conducting business in its own name. Therefore, corporations may own property, enter into binding contracts, borrow money, sue and be sued, and pay taxes. Stockholders are agents for the corporation only if they are also employees or designated as agents. Relative ease of transferring ownership rights A person who buys stock in a corporation is called a stockholder and receives a stock certificate indicating the number of shares of the company she/he has purchased. Particularly in a public company, the stock can be easily transferred in part or total at the discretion of the stockholder. The stockholder wishing to transfer (sell) stock does not require the approval of the other stockholders to sell the stock. Similarly, a person or an entity wishing to purchase stock in a corporation does not require the approval of the corporation or its existing stockholders before purchasing the stock. Once a public corporation sells its initial offering of stock, it is not part of any subsequent transfers except as a record keeper of share ownership. Privately held companies may have some restrictions on the transfer of stock. Professional management Investors in a corporation need not actively manage the business, as most corporations hire professional managers to operate the business. The investors vote on the Board of Directors who are responsible for hiring management. Ease of capital acquisition A corporation can obtain capital by selling stock or bonds. This gives a corporation a larger pool of resources because it is not limited to the resources of a small number of individuals. The limited liability and ease of transferring ownership rights makes it easier for a corporation to acquire capital by selling stock, and the size of the corporation allows it to issue bonds based on its name. Government regulations The sale of stock results in government regulation to protect stockholders, the owners of the corporation. State laws usually include the requirements for issuing stock and distributions to stockholders. The federal securities laws also govern the sale of stock. Publicly held companies with stock traded on exchanges are required to file their
investment of the preferred stockholders was returned to them. It may have a par value or be no‐par value stock that may or may not have a stated value. Preferred stock. Preferred stock is a class of stock that normally has the right to receive dividends, and in the case of liquidation of the corporation, a return of investment before the common stockholders. Preferred stock usually does not include a voting right. Dividends. A dividend is a distribution by a corporation to its owners in the form of cash, assets, or the company's stock. Stockholders do not have withdrawal accounts like sole proprietors or partners because the only way they can get money from the corporation is if the Board of Directors authorizes a dividend. Stockholders' equity. In a corporation's balance sheet, the owners' equity section is called stockholders' equity. It includes the contributed capital accounts and retained earnings. Retained earnings. The amount of net income a corporation has earned since it began in business that has not been distributed as dividends to its stockholders. Net income increases retained earnings. Dividends, net losses, and some treasury stock transactions decrease retained earnings. Net income, and dividends, if they are recorded in a separate account, are transferred to retained earnings during the closing entry process.
Accounting for Stock Transactions
This section demonstrates how to account for stock transactions. Stock issued for cash Corporations may issue stock for cash. Common stock. When a company such as Big City Dwellers issues 5,000 shares of its $1 par value common stock at par for cash, that means the company will receive $5, (5,000 shares × $1 per share). The sale of the stock is recorded by increasing (debiting) cash and increasing (crediting) common stock by $5,000.
If the Big City Dwellers sold their $1 par value stock for $5 per share, they would receive $25,000 (5,000 shares × $5 per share) and would record the difference between the $5,000 par value of the stock (5,000 shares × $1 par value per share) and the cash received as additional paid‐in‐capital in excess of par value (often called additional paid‐ in‐capital). When no‐par value stock is issued and the Board of Directors establishes a stated value for legal purposes, the stated value is treated like the par value when recording the stock transaction. If the Board of Directors has not specified a stated value, the entire amount received when the shares are sold is recorded in the common stock account. If
entry to record the transaction increases (debits) organization costs for $50,000, increases (credits) common stock for $5,000 (10,000 shares × $0.50 par value), and increases (credits) additional paid‐in‐capital for $45,000 (the difference). Organization costs is an intangible asset, included on the balance sheet and amortized over some period not to exceed 40 years. If The J Trio, Inc., an established corporation , issues 10,000 shares of its $1 par value common stock in exchange for land to be used as a plant site, the market value of the stock on the date it is issued is used to value the transaction. The fair market value of the land cannot be objectively determined as it relies on an individual's opinion and therefore, the more objective stock price is used in valuing the land. The stock transactions discussed here all relate to the initial sale or issuance of stock by The J Trio, Inc. Subsequent transactions between stockholders are not accounted for by The J Trio, Inc. and have no effect on the value of stockholders' equity on the balance sheet. Stockholders' equity is affected only if the corporation issues additional stock or buys back its own stock. Treasury stock is the corporation's issued stock that has been bought back from the stockholders. As a corporation cannot be its own shareholder, any shares purchased by the corporation are not considered assets of the corporation. Assuming the corporation plans to re‐issue the shares in the future, the shares are held in treasury and reported
as a reduction in stockholders' equity in the balance sheet. Shares of treasury stock do not have the right to vote, receive dividends, or receive a liquidation value. Companies purchase treasury stock if shares are needed for employee compensation plans or to acquire another company, and to reduce the number of outstanding shares because the stock is considered a good buy. Purchasing treasury stock may stimulate trading, and without changing net income, will increase earnings per share. The cost method of accounting for treasury stock records the amount paid to repurchase stock as an increase (debit) to treasury stock and a decrease (credit) to cash. The treasury stock account is a contra account to the other stockholders' equity accounts and therefore, has a debit balance. No distinction is made between the par or stated value of the stock and the premium paid by the company. To illustrate, assume The Soccer Trio Corporation repurchases 15,000 shares of its $1 par value common stock for $25 per share. To record this transaction, treasury stock is increased (debited) by $375,000 (15,000 shares × $25 per share) and cash is decreased (credited) by a corresponding amount. The entry looks like the following: In the balance sheet, treasury stock is reported as a contra account after retained earnings in the stockholders' equity section. This means the amount reported as treasury stock is subtracted from the other stockholders' equity amounts. Treasury shares are included in the number reported for shares issued but are subtracted from issued shares to determine the number of outstanding shares. When treasury stock is sold, the accounts used to record the sale depend on whether the treasury stock was sold above or below the cost paid to purchase it. If the treasury stock is sold above its cost, the sale increases (debits) cash for the proceeds received, decreases (credits) treasury stock for the cost paid when the treasury stock was
If the Board of Directors decides to retire the treasury stock at the time it is repurchased, it is cancelled and no longer considered issued. When this occurs, the common stock and additional paid‐in‐capital accounts are decreased (debited) for the amounts recorded in these accounts when the stock was originally issued and cash is decreased (credited) for the amount paid to repurchase the stock. If the repurchase price is more than the original issue price, the difference is a decrease (debit) to the additional paid‐ in‐capital—treasury stock account until its balance reaches zero. Once the balance in the additional paid‐in‐capital—treasury stock account reaches zero, or if there is no such account, the difference is a decrease (debit) to retained earnings. If the repurchase price is less than the original selling price, the difference increases (is credited to) the additional paid‐in‐capital account.
Dividends
The Board of Directors must authorize all dividends. A dividend may distribute cash, assets, or the corporation's own stock to its stockholders. Distribution of assets, also called property dividends, will not be discussed here. Before authorizing a dividend, a company must have sufficient retained earnings and cash (cash dividend) or sufficient authorized stock (stock dividend). Three dates are relevant when accounting for dividends:
Date of declaration. Date of record. Date of payment or distribution. The date of declaration is the date the Board of Directors formally authorizes for the payment of a cash dividend or issuance of shares of stock. This date establishes the liability of the company. On this date, the value of the dividend to be paid or distributed is deducted from retained earnings. The date of record does not require a formal accounting entry. It establishes who will receive the dividend. The date of payment or distribution is when the dividend is given to the stockholders of record. If a company has both preferred and common stockholders, the preferred stockholders receive a preference if any dividend is declared. Having the preference does not guarantee preferred stockholders a dividend, it just puts them first in line if a dividend is paid. Preferred stock usually specifies a dividend percentage or a flat dollar amount. For example, preferred stock with a $100 par value has a 5% or $5 dividend rate. Five percent is the $5 dividend divided by the $100 par value. This means all preferred stockholders will receive a $5 per share dividend before any dividend is paid to common stockholders. Some shares of preferred stock have special dividend features such as cumulative dividend or participating dividend. A cumulative dividend means if dividends are declared, preferred stockholders will receive their current‐year dividend plus any dividends not paid in prior years before the common stockholders receive a dividend. Owning a share of preferred stock that includes a cumulative dividend still does not guarantee the preferred stockholder a dividend because the company is not liable to pay dividends until they are declared. Having cumulative preferred stock simply reinforces the preference preferred stockholders receive when a dividend is declared. If a company has issued cumulative preferred stock and does not declare a dividend, the company has dividends in arrears. Although not a liability, the amount of any dividends in arrears must be disclosed in the financial statements. The participating dividend feature provides the opportunity for the preferred stockholders to receive dividends above the stated rate. It occurs only after the common stockholders have received the same rate of return on their shares as the preferred stockholders. For example, say the preferred dividend rate is 5% and the preferred stock has a participating feature. This means that the preferred stockholders will receive a larger dividend if the authorized dividend exceeds the total of the 5% dividend for the preferred stockholder and a 5% dividend to the common stockholders. Cash dividends
Once declared and paid, a cash dividend decreases total stockholders' equity and decreases total assets. Dividends are not reported on the income statement. They would be found in a statement of retained earnings or statement of stockholders' equity once declared and in a statement of cash flows when paid. Stock dividends Stock dividends are used when a company needs to maintain its cash in the business but wants to provide a dividend to its stockholders. The size of a stock dividend determines how it is valued. A small size dividend (less than 20–25% of outstanding shares) is usually valued at the market value of the stock. A large size dividend (more than 20–25% of outstanding shares) is usually valued at par or stated value. Assume the Board of Directors of Grandma's Girls authorizes a 10% stock dividend on May 20th, distributable on July 17th to stockholders of record on June 9th when the stock is selling for $20 per share. Before the dividend, the company's balance sheet had the following stockholders' equity section: Common Stock, $3 par value, 1,500,000 shares authorized, 500,000 shares issued and outstanding
The $1,000,000 value of the dividend is determined by multiplying the 50,000 shares to be issued (10% × 500,000 outstanding shares) by $20 (market value of stock). The entry to record the declaration of the dividend decreases (debits) retained earnings for the $1,000,000 market value of the shares to be issued, increases (credits) common stock dividend distributable for the $150,000 par value of the shares to be issued($3 × 50,000), and increases (credits) additional paid‐in‐capital for the difference between the par (or stated value) and the market value of $850,000 ($50,000 × ($20 – $3)).
equity.
The Balance Sheet: Stockholders' Equity
Preferred stock, common stock, additional paid‐in‐capital, retained earnings, and treasury stock are all reported on the balance sheet in the stockholders' equity section. Information regarding the par value, authorized shares, issued shares, and outstanding shares must be disclosed for each type of stock. If a company has preferred stock, it is listed first in the stockholders' equity section due to its preference in dividends and during liquidation.
Book value measures the value of one share of common stock based on amounts used in financial reporting. To calculate book value, divide total common stockholders' equity by the average number of common shares outstanding. If preferred stock exists, the preferred stockholders' equity is deducted from total stockholders' equity to determine the total common stockholders' equity. The preferred stockholders' equity is the call price for the preferred stock plus any cumulative dividends in arrears. The par value is used if the preferred stock does not have a call price. Using Grandpa's Hook Rug, Inc. balance sheet information, the book value is:
Some companies report additional items after income tax expense on their income statements. These items represent special items outside of normal business operations. They are shown separately to ensure users can identify what income from continuing business results will be. If any special items are included on the income statement, the income tax expense or savings related to each item is net against the special item to report it after taxes. These additional special items may be one of three types: discontinued operations, extraordinary items, and changes in accounting principles. Discontinued operations occur when a significant segment of a business has been identified for disposal. Once so identified, any gain or loss from operations of the segment while it is being disposed of and any gain or loss on the sale of the assets of the segment, are reported separately from the remaining, continuing operations. Extraordinary items are events that occur infrequently and are unusual. They can include acts of God as long as they rarely occur in the area where the business operates. Events that would not be extraordinary as they occur regularly, although not yearly, are a severe freeze effecting crops in Florida or an earthquake in southern California. A change in accounting principle occurs when a company changes from one acceptable principle to another. The new principle is used to calculate the current year's amounts in the financial statements. The effect of the change on any prior years' amounts is shown separately in the income statement, net of taxes. A partial income statement for a corporation with these items follows:
Earnings per share Corporations are also required to report earnings per share on the income statement. Earnings per share represents the amount of earnings related to one share of common stock. There are two types of earnings per share, basic earnings per share
