Corporations

 

www.fasb.org --   In the publications section of this website, actual accounting pronouncements ( Statement of Financial Accounting Concepts, FASB Statements and FASB Interpretations) are available for reading and printing. 

 

Corporation—Business recognized as legally separate from its owners

  • Advantages of the corporate form include limited liability for owners (liability is limited to business assets), ease of capital generation, ease of ownership transfers, lack of mutual agency (one shareholder’s actions cannot bind the corporation), and continuous existence
  • Disadvantages of the corporate form include double taxation (Corporations pay taxes on net income.  Shareholders pay taxes again when they receive dividends), and increased regulation.

 

Public Corporations—Corporations offering stock to the public for investment purposes; public corporations are regulated by the SEC.  These corporations make quarterly and annual information filings (including annual audited financial statements) with the SEC for public disclosure purposes.  Audited financial statements and other SEC filings are usually available at each company’s website in “Investor Information.”

 

 

CPA Audit Letter—Letter written by an independent* auditor of annual financial statements stating that an audit has been performed according to professional standards and the financial statements fairly present or do not fairly present the financial position (balance sheet) and result of operations (income statement) of the company in accordance with generally accepted accounting principles.

 

            *Independent auditor—does not own stock in the corporation being audited

            and passes other tests of independence

 

Investment in a Public Corporation—People invest in corporations to gain returns through subsequent stock price increases or receipt of dividend payments.  Stock prices adjust continuously reacting to industry news, accounting announcements, and market conditions.  Due to stock market volatility, people must carefully consider all factors including risk when investing funds.

 

Small Business Corporations—some small business owners choose to operate their businesses as a corporations instead of other entity forms to limit their personal liabilities.  Those corporations that meet the criteria of being an “S Corporation” for tax purposes usually avoid the “double taxation” consequences regular corporations have by making an S election for tax purposes.

 

Stock or Share—Unit of ownership in a corporation

 

 

 

Par value—an amount printed in the articles of corporation (incorporation documents filed with the state).  Many states do not allow companies to sell stock beneath par value.

 

Stated value—an amount determined by the board of directors.  For corporations that issue no par stock with a stated value, the stated value is used in journal entries in the same manner par value would be.

 

Authorized shares—the maximum number of shares a corporation is able to issue.  This figure is printed in the articles of incorporation.  (Articles may later be amended)

 

Issued shares—shares sold or issued to the public

 

JOURNAL ENTRIES FOR STOCK ISSUANCES ILLUSTRATION:

The Knot.com (KNOT) has 100,000,000 shares of its $.01 par value common stock authorized.  At the end of last year, there were 18,373,327 shares issued (10K, 2004).  Make journal entries to show how the company would have recorded the following transactions in each of the years. (Actual prices and actual dates are used here.  The share numbers below are false and used for illustration purposes alone.)

  1. On October 15, 1999,  200,000 shares of the $.01 par value common stock are issued for $8.50 cash per share.
  2. On October 15, 2001,  300,000 shares of the $.01 par value common stock are issued for $.30 cash per share.
  3. On October 15, 2004, 100,000 shares of the $.01 par value common stock are issued for $3.85 cash per share.

 

a.  Cash ($8.50 x 200,000 shares)

1,700,000

 

          Common Stock ($.01 x 200,000 shares)

 

2,000

          Paid in capital in excess of par value

 

1,698,000

To record the issuance

 

 

 

 

 

b.  Cash ($.30 x 300,000 shares)

90,000

 

          Common Stock ($.01 x 300,000 shares)

 

3,000

          Paid in capital in excess of par value

 

87,000

To record the issuance

 

 

 

 

 

c.  Cash ($3.85 x 100,000 shares)

385,000

 

          Common Stock ($.01 x 100,000 shares)

 

1,000

          Paid in capital in excess of par value

 

384,000

To record the issuance

 

 

 

STOCK ISSUED IN EXCHANGE OF SERVICES AND PROPERTY

If the stock has a market value, credit the common stock and paid in capital accounts for the amount of this known value.  If there is not a market for the stock, credit the common stock and paid in capital accounts for the value of the asset or services received in the exchange.

 

Retained earnings—Account absorbing the closing of temporary accounts each year; back years earnings reduced for past dividends declared and appropriations

 

Appropriated (or Restricted) Retained Earnings—Retained earnings not available for dividend declaration

 

Dividend Declaration—the board of directors has the power to declare a dividend.  Dividends declared (cash, property and stock) reduce retained earnings.  The amount in the retained earnings account generally would be a limit on how much dividends the board can declare.

 

Date of Record—Stockholders on this date are entitled to the dividend declared. 

 

JOURNAL ENTRIES FOR DIVIDENDS

a.  The board of directors declares a $10,000 cash dividend

 

 

Dividends declared

10,000

 

          Dividends payable

 

10,000

b.  The date of declaration—no journal entry

 

 

 

 

 

c.  The date of dividend payment

 

 

Dividends payable

10,000

 

          Cash

 

10,000

 

 

PREFERRED STOCK—Category of stock that usually has attractive investment features

  • Preference to dividends—preferred stockholders are paid dividends before common stockholders are

Cumulative Preferred—in years where the board of directors does not declare a dividend, the dividend will accumulate.  This accumulated dividend is called dividends in arrears.  Dividends in arrears will be paid when the board does declare a dividend.

Non-cumulative Preferred—there is no accumulation feature

  • Preference to assets in liquidation
  • Convertible Preferred Stock--preferred stock that is convertible into the common stock

 

Preferred stockholders do not have the voting rights common stockholders have.

 

Callable Preferred Stock—Stock that may be redeemed or retired at the option of the corporation for a price stated in the preferred stock contract (Needles, 2005 edition, page 552)

 

PRIORITY OF DIVIDENDS EXAMPLE:  Acme has 100,000 shares of $5, 2 percent cumulative preferred outstanding; 200,000 shares of $4, 3 percent cumulative preferred outstanding; and 50,000 $10 par value common stock outstanding.  In 2001, there were no dividends in arrears.  In 2002 and 2003, the board of directors did not declare a dividend.  In 2004, the board declared a $45,000 dividend.  How much will each class be entitled to?

 

ANSWER:

 

Distribution

$5, 2% cumulative preferred

100,000 x $5 x .02 =

2002 arrears $10,000

2003 arrears $10,000

2004 current $10,000

Total            $30,000

$4, 3% non-cumulative preferred

200,000 x $4 x .03 +

Total             $6,000

Common Stockholders

 

Remainder     $9,000

 

 

Treasury Stock—A negative equity account having a debit balance; the account shows the cost paid by corporations for repurchasing its own stock.  Traditional treasury stock transactions presented in introductory accounting textbooks include journal entries for buying treasury stock, selling treasury stock and retiring treasury stock.  “Treasury stock” is not an asset.  It should be shown as a subtraction in the stockholders’ equity section

                                         

More Paid in Capital Accounts—Gains and losses are not recorded in transactions between the business and its owners.  So “dividends” are not presented as an expense on the income statement; and treasury stock transactions will not result in the recording of revenue or expense accounts.  (Statement of Financial Accounting Concepts No. 5—earnings should include changes in equity from “non-owner sources,” page 18, paragraph 30)  Instead, paid in capital accounts are created when (1) treasury stock is sold for more than it costs, or (2) treasury stock is retired and the repurchase price is less than the initial issuance price.

          Paid in capital, treasury stock

          Paid in capital, retirement of stock

 

 

Example Stockholders’ Equity Section

 

Common Stock, $5 par  

$500,000

Paid in Capital in Excess of Par, Common Stock

$300,000

Preferred Stock, 3%, $4 par

$200,000

Paid in Capital in Excess of Par, Preferred Stock

$800,000

Less Treasury Stock (5,000 shares purchased for $3 per share)

-150,000

Paid in Capital, Treasury Stock

$3,000

Paid in Capital, Retirement of Stock

$10,000

Appropriated Retained Earnings

$100,000

Retained Earnings

$2,000,000

Total Stockholders’ Equity

$3,763,000

 

Non-Operating Items (presented in the lower portion of the income statement) (Statement of Accounting Standards Number 130 Reporting Comprehensive Income)

Each category should be shown net of related taxes

  • Discontinued Operations—Section reports (1)  income or loss from operating a defined business segment being closed and (2) disposal gains and losses.
  • Extraordinary Gains and Losses—Category reports items that are unusual in nature and infrequent in occurrence (APB Opinion 30).

              Hurricane losses experienced by a business in Michigan would

be classified as extraordinary.  Hurricane losses in Florida would not  be classified as extraordinary.

  • Cumulative Effect of Change in Accounting Principle—This section reports the difference on net income reported in prior years if the new principle had been applied instead of the one used.  Changes in accounting principles affect net income, but the cumulative effect is reported separately in this non-operating category for analysis purposes.

 

 

Quality of Earnings—Analysts look at components of the multiple step income in assessing performance instead of looking at just bottom line net income

  • Did top line sales increase each year?
  • Did a change in accounting principle affect net income to make the corporation’s net income look better than if there had been no change?
  • Was net income lower in the current year because of disposal of a business segment?

 

Basic Earnings per Common Share—net income applicable to common stock divided by weighted average common shares outstanding (FASB Statement 128 Earnings Per Share)

 

Example:  Net income is  $595,000 in the current year.  The preferred dividend for this year is $40,000.  On 1/1/xx, 50,000 common shares were outstanding.  On, 7/1/xx, 80,000 more common shares were issued.  On 12/1/xx, 120,000 more common shares were issued.  Compute basic earnings per share.

 

 

$595,000- $40,000

= $5.55 basic earnings per share

 

50,000 + 40,000 + 10,000 common shares

 

 

 

 

 

Corporations having complex capital (stock options, convertible bonds and convertible preferred) structures report two earnings per share figures:  basic and diluted.

Diluted Earnings per share—A more complex computation studied in intermediate level accounting courses (not here).  The diluted earnings per share figure shows how low earnings per share would be assuming the exercise and conversion of all potentially dilutive securities

 

Diluted EPS =  ( Net income – nonconvertible preferred dividend + interest on assumed converted bonds)

(Weighted avg common shares + Shares from assumed exercise of stock option + shares from assumed conversion of convertible preferred stock + shares from assumed conversion of convertible bonds)

 

Prior Period Adjustment—Entry made to retained earnings to correct errors discovered in a prior period.  Since the revenue and expenses accounts in the prior year have already been closed to retained earnings, retained earnings should bear the adjustment.  A change in accounting principle is NOT an error.  Changes in accounting principle affect current net income. (Statement of Financial Accounting Standards Number 16 Prior Period Adjustments)

 

DIFFERENCE BETWEEN STOCK SPLITS AND STOCK DIVIDENDS

Stock Split—Usually performed to make the stock more affordable.  No journal entries are required.  Only a memorandum entry is made to note that par value has changed and outstanding shares have changed.

Stock Dividend—Journal entries will be prepared which have the effect of reducing retained earnings for the fair market value of stock on the declaration date of stock being issued in the dividend; like other dividends, it is a return on investment

 

 

PROBLEM ONE  STOCK ISSUANCES AND LIMITED TREASURY STOCK TRANSACTIONS  Snelling Company has 10,000,000 $1 par value common stock authorized.  Make journal entries to record the following transactions.

  1. It issues 3,000 shares of its $1 par value common stock for $6 cash per share.
  2. It issues 4,000 shares of its $1 par value common stock for $12 cash per share.
  3. It issues 500 shares of its $1 par value common stock in exchange for accounting services associated with formation of the corporation.  The stock does not have a public market value; but the fair market value of the services received is $3,000.
  4. The company repurchases 200 shares of its common stock to be held in treasury for $3 per share or $600 total.
  5. The company resells the shares in “d” for $4 per share or $800 cash.

 

PROBLEM TWO  STOCK ISSUANCES AND LIMITED TREASURY STOCK TRANSACTIONS  Mars Company has 40,000,000 $2 par value common stock authorized.  Make journal entries to record the following transactions.

  1. It issues 1,000 shares of its $2 par value common stock for $6 cash per share.
  2. It issues 1,500 shares of its $2 par value common stock for $15 cash per share.
  3. It issues 300 shares of its $2 par value common stock in exchange for accounting services associated with formation of the corporation.  The stock does not have a public market value; but the fair market value of the services received is $7,500.
  4. The company repurchases 100 shares of its common stock to be held in treasury for $5 per share or $500 total.
  5. The company resells the shares in “d” for $8 per share or $800 cash.

 

PROBLEM THREE CASH DIVIDEND JOURNAL ENTRIES  Make journal entries for each of the following transactions.  If no journal entry is required, state that none is required.

  1. The board of directors declares a $20,000 cash dividend to be paid on date “c” to stockholders on record date “b.”
  2. Date of record
  3. The company distributes the cash dividend

 

PROBLEM FOUR CASH DIVIDEND JOURNAL ENTRIES  Make journal entries for each of the following transactions.  If no journal entry is required, state that none is required.

  1. The board of directors declares a $100,000 cash dividend to be paid on date “c” to stockholders on record date “b.”
  2. Date of record
  3. The company distributes the cash dividend

 

PROBLEM FIVE  DIVIDEND PRIORITY In 2001, there were no dividends in arrears.  The board of directors did not declare a dividend in 2003.  In 2004, the board declared an $82,000cash dividend.  How much will each class of stock be entitled to?

 

100,000 shares

$4 par value, 3% Cumulative Preferred

200,000 shares

$2 par value, 2% Non-cumulative Preferred

50,000 shares  

$1 par value, Common Stock

 

PROBLEM SIX  DIVIDEND PRIORITY In 2002, there were no dividends in arrears.  The board of directors did not declare a dividend in 2002 and 2003.  In 2004, the board declared an $80,000 cash dividend.  How much will each class of stock be entitled to?

 

50,000 shares

$4 par value, 3% Cumulative Preferred

300,000 shares

$2 par value, 2% Non-cumulative Preferred

25,000 shares  

$1 par value, Common Stock

 

 

PROBLEM SEVEN  BASIC EPS  Net income for the current period is $363,000.  The preferred dividend for the current period is $30,000.  On 1/1/xx, 200,000 common shares were outstanding.  On 3/1/xx, 100,000 more common shares were issued.  On 11/1/xx, 100,000 additional common shares were issued.  Compute basic earnings per common share.

 

PROBLEM EIGHT  BASIC EPS  Net income for the current period is $1,210,000.  The preferred dividend for the current period is $100,000.  On 1/1/xx, 275,000 common shares were outstanding.  On 4/1/xx, 300,000 more common shares were issued Compute basic earnings per common share.

 

PROBLEM NINE  DIFFERENCE BETWEEN STOCK DIVIDEND AND STOCK SPLIT

The stockholders’ equity section of the balance sheet is listed below.

How if at all will the accounts be affected for the following?

  1. A 2 for 1 stock split is declared
  2. A 10% stock dividend is declared when the fair market value of the stock is $7 per share

 

Common Stock ($10 par value, 20,000 issued)

$200,000

Paid in capital in excess of par value, Common Stock

$513,000

Retained earnings

$700,000

Total Stockholders’ Equity

$1,413,000

 

PROBLEM TEN  DIFFERENCE BETWEEN STOCK DIVIDEND AND STOCK SPLIT

The stockholders’ equity section of the balance sheet is listed below.

How if at all will the accounts be affected for the following?

  1. A 2 for 1 stock split is declared
  2. A 10% stock dividend is declared when the fair market value of the stock is $7 per share

Common Stock ($5 par value, 40,000 issued)

$200,000

Paid in capital in excess of par value, Common Stock

$613,000

Retained earnings

$800,000

Total Stockholders’ Equity

$1,613,000