Needles Powers Crosson Principles of Accounting 12e Accounting for Corporations 13 C H A P T E R © human/iStockphoto

NeedlesPowersCrosson

Principles of Accounting

12e

Accounting for Corporations13C H A P T E R

© human/iStockphoto

LEARNING OBJECTIVES

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LO1: Define the corporate form of business and its characteristics.

LO2: Identify the components of stockholders’ equity and their characteristics.

LO3: Account for the issuance of stock for cash and other assets.

LO4: Account for treasury stock. LO5: Account for cash dividends. LO6: Account for stock dividends and stock splits. LO7: Describe the statement of stockholders’

equity, and compute book value per share. LO8: Calculate dividend yield and return on

equity, and define stock options.

SECTION 1: CONCEPTS


Separate entity: a business that is treated as distinct from its creditors, customers, and owners

Concepts Underlying the Corporate Form of Business (slide 1 of 3)

A corporation is a separate entity chartered by the state and legally separate from its owners, or stockholders.– Contributed capital refers to stockholders’

investments in a corporation. A unit of ownership in a corporation is called a share of

stock.

– To form a corporation, most states require incorporators to sign an application and file it with the proper state official. This application contains the articles of incorporation, which form the company charter. The articles of incorporation state the maximum

number of shares that a corporation is authorized to issue.



– To invest in a corporation, a stockholder transfers cash or other resources to the corporation. In return, the stockholder receives shares of stock representing a proportionate share of ownership.

– Stockholders elect a board of directors, which sets corporate policies and chooses the corporation’s officers, who in turn carry out the corporate policies in their management of the business, as shown below.



– Besides deciding on major business policies, a corporation’s board of directors: authorizes contracts. sets executive salaries. arranges major loans with banks. declares dividends, which are distributions,

among the stockholders, of the assets that a corporation’s earnings have generated.

– Management of a corporation, which consists of the operating officers, carries out corporate policies, runs day-to-day operations, and reports the financial results of its administration to the board of directors and the stockholders.


Advantages of Incorporation

Separate legal entity Limited liability: Creditors can satisfy their claims

only against the assets of the corporation, not against the personal property of the corporation’s owners.

Ease of capital generation Ease of transfer of ownership Lack of mutual agency: The corporation is not

bound by any contracts that individual stockholders may enter into.

Continuous existence Centralized authority and responsibility Professional management


Disadvantages of Incorporation

Government regulation: Corporations must file many reports with the state in which they are chartered, and publicly held corporations must also file reports with the SEC and with their stock exchanges.

Double taxation: A corporation’s earnings are subject to federal and state income taxes. If any of the corporations’ earnings are paid out as dividends, the earnings are taxed again as income to stockholders.

Limited liability: This may restrict the ability of a small corporation to borrow money.

Separation of ownership and control: Management may make decisions that are not good for the corporation.


Equity Financing(slide 1 of 2)

Equity financing is accomplished by issuing stock to investors in exchange for assets.– Once the stock has been issued to them,

stockholders can transfer their ownership at will. Large corporations often appoint independent

registrars and transfer agents (usually banks and trust companies) to help perform the transfer duties.

– Two important terms in equity financing are: Par value—an arbitrary amount assigned to each

share of stock. It must be recorded in the capital stock accounts.

Legal capital—the number of shares issued multiplied by the par value. It is the minimum amount that a corporation can report as contributed capital.


Equity Financing(slide 2 of 2)

– To help with its initial public offering (IPO), a corporation often uses an underwriter—an intermediary between the corporation and the investing public. The corporation records the amount of the net

proceeds of the offering in its Capital Stock and Additional Paid-in Capital accounts. The net proceeds are what the public paid less the underwriter’s fees, legal expenses, and other direct costs of the offering.

The costs of forming a corporation are called start-up and organization costs. These costs include state incorporation fees, attorneys’ and accountants’ fees, the cost of printing stock certificates, and other expenditures necessary to form the corporation.


Advantages and Disadvantages of Equity Financing

Advantages– Decreased

financial risk Issuing common

stock is less risky than financing with long-term debt.

– Increased cash for operations

– Better debt to equity ratio

Disadvantages– Increased tax

liability Whereas the

interest on debt is tax-deductible, the dividends paid on stock are not.

– Decreased stockholder control When a corporation

issues more stock, it dilutes its ownership.



SECTION 2: ACCOUNTING APPLICATIONS

Prepare the statement of stockholders’ equity

Record the issuance of stock for cash and other assets

Record the purchase, sale, and retirement of treasury stock

Account for cash dividends Account for stock dividends and stock

splits


Components of Stockholders’ Equity

In a corporation’s balance sheet, the owners’ claims to the business are called stockholders’ equity.– As shown on the next slide, this section of a

corporate balance sheet usually has at least three components: Contributed capital—the stockholders’ investments in

the corporation Retained earnings—the earnings of the corporation

since its inception, less any losses, dividends, or transfers to contributed capital. These are reinvested in the business.

Treasury stock—shares of the corporation’s own stock that it has bought back on the open market


Stockholders’ Equity Section of a Balance Sheet


Types of Stock

A corporation can issue two types of stock:– Common stock—the basic form of stock

Shares of common stock carry voting rights and usually provide their owners with the means of controlling the corporation.

Common stock is also called residual equity because the claims of all creditors and usually those of preferred stockholders rank ahead of the claims of common stockholders.

– Preferred stock—stock that gives its owners preference over common stockholders in terms of receiving dividends and in terms of claims to assets if the corporation is liquidated.


Types of Shares

Authorized shares are the maximum number of shares that a corporation’s charter allows it to issue.

Issued shares are those that a corporation sells or otherwise transfers to stockholders.

Outstanding shares are shares that a corporation has issued and that are still in circulation. A corporation may have more shares issued than are currently outstanding if it has bought back treasury shares.


Preference as to Dividends

Preferred stockholders ordinarily must receive a certain amount of dividends before common stockholders receive anything.– If the stock is noncumulative preferred stock

and the board of directors fails to declare a dividend in any year, the company is under no obligation to make up the missed dividend in future years.

– If the stock is cumulative preferred stock, the dividend amount per share accumulates from year to year if unpaid, and the company must pay the whole amount before it pays any dividends on common stock.


Dividends in Arrears

Dividends not paid in the year they are due are called dividends in arrears.


Dividend Distribution


Convertible and Callable Preferred Stock(slide 1 of 2)

Owners of convertible preferred stock can exchange their shares of preferred stock for shares of common stock at a ratio stated in the preferred stock contract.

– If the market value of the common stock increases, the conversion feature allows these stockholders to share in the increase by converting their stock to common stock.

Most preferred stock is callable preferred stock—that is, the issuing corporation can redeem it at a price stated in the preferred stock contract.


Convertible and Callable Preferred Stock(slide 2 of 2)

– The call price, or redemption price, of callable preferred stock is usually higher than the stock’s par value.

– If the preferred stock is convertible, the stockholder can either surrender the stock or convert it to common stock.

– When preferred stock is called and surrendered, the stockholder is entitled to: The par value of the stock The call premium Any dividends in arrears The current period’s dividend prorated by the

proportion of the year to the call date



Issuance of Common Stock

A share of capital stock may be par or no-par.– The value of par stock is stated in the corporate charter

and on each stock certificate. A corporation cannot declare a dividend that would cause

stockholders’ equity to fall below the legal capital. Thus, par value is a minimum cushion of capital that protects a corporation’s creditors.

When a corporation issues par value stock, the appropriate Capital Stock account is credited for the par value regardless of whether the proceeds are more or less than the par value.

– No-par stock does not have a par value. Most states require that all or part of the proceeds from a

corporation’s issuance of no-par stock be designated as legal capital, which cannot be used unless the corporation is liquidated.


Issuing Stock Above Par Value(slide 1 of 2)


Issuing Stock Above Par Value(slide 2 of 2)


Issuing No-Par Stock with No Stated Value(slide 1 of 2)


State laws often require corporations to place a stated value on each share of stock they issue. The stated value can be any value set by the board unless the state specifies a minimum. In some states, however, this is not required.

Issuing No-Par Stock with No Stated Value(slide 2 of 2)


Issuing No-Par Stock with a Stated Value(slide 1 of 2)


Issuing No-Par Stock with a Stated Value(slide 2 of 2)


Issuance of Stock for Noncash Assets

A corporation may issue stock in return for assets or services other than cash.– These transactions usually involve an

exchange of stock for land or buildings or for the services of attorneys and others who help organize the corporation.

– Generally, this kind of transaction is recorded at the fair market value of the stock given up.

– If the stock’s fair market value cannot be determined, the fair market value of the assets or services received can be used.


Issuing Stock for Noncash Assets When No Market Value for the Stock Exists (slide 1 of 2)


Issuing Stock for Noncash Assets When No Market Value for the Stock Exists (slide 2 of 2)


Issuing Stock for Noncash Assets When Market Value for the Stock Exists (slide 1 of 2)


Issuing Stock for Noncash Assets When Market Value for the Stock Exists (slide 2 of 2)



Accounting for Treasury Stock

Treasury stock is stock that the issuing company has reacquired, usually by purchasing shares on the open market.– A company may want to buy back its own stock

for any of the following reasons: To distribute to employees through stock option plans. To maintain a favorable market for its stock. To increase its earnings per share or stock price per

share. To have additional shares of stock available for

purchasing other companies. To prevent a hostile takeover.


Purchase of Treasury Stock(slide 1 of 2)


Purchase of Treasury Stock(slide 2 of 2)


Sale of Treasury Shares at Cost(slide 1 of 2)


Sale of Treasury Shares at Cost(slide 2 of 2)


Sale of Treasury Shares Above Cost(slide 1 of 2)


Sale of Treasury Shares Above Cost(slide 2 of 2)


Sale of Treasury Shares Below Cost(slide 1 of 2)


Sale of Treasury Shares Below Cost(slide 2 of 2)


Retiring Treasury Stock(slide 1 of 2)


If a company decides not to reissue treasury stock, it can retire the stock.

Retiring Treasury Stock(slide 2 of 2)



Accounting for Cash Dividends

Although a corporation may have sufficient cash and retained earnings to pay a dividend, its board of directors may not do so for several reasons:– The corporation may need the cash for expansion.– It may want to improve its overall financial position by

liquidating debt.– It may be facing major uncertainties, such as a pending

lawsuit, strike, or a projected decline in the economy.

If a corporation declares a dividend that exceeds retained earnings, this is called a liquidating dividend. A corporation usually pays a liquidating dividend only when it is going out of business or reducing its operations.


Dividend Dates

Three important dates are associated with dividends:- Declaration date—the date on which the board of directors

formally declares that the corporation is going to pay a dividend

Because the legal obligation to pay the dividend arises at this time, a liability for Dividends Payable is recorded.

- Record date—the date on which ownership of stock is determined

- Persons who own stock on the record date will receive the dividend.- Between the record date and the date of payment, the stock is said

to be ex-dividend.- If the owner on the date of record sells the shares of stock before

the date of payment, the right to the dividend remains with that person.

- Payment date—the date on which the dividend is paid to the stockholders of record


Dividend Transactions: Declaration Date


Dividend Transactions: Record Date


Dividend Transactions: Payment Date



Stock Dividends

A stock dividend is a proportional distribution of shares among a corporation’s stockholders.– Unlike a cash dividend, a stock dividend has no effect on

assets or liabilities, nor does it affect total stockholders’ equity. It transfers an amount from retained earnings to contributed capital.

– A board of directors may declare a stock dividend for the following reasons:

To give stockholders some evidence of the company’s success without affecting working capital.

To reduce the stock’s market price by increasing the number of shares outstanding (a goal more often met by a stock split).

To make a nontaxable distribution to stockholders. To increase the company’s permanent capital by transferring

an amount from retained earnings to contributed capital.


Stock Dividend Transactions


To illustrate accounting for stock dividends, we will use Wing Corporation. Stockholders’ equity in Wing is as follows:

Declaration Date(slide 1 of 2)


Declaration Date(slide 2 of 2)


Record Date and Payment Date


Effect of a Stock Dividend on Stockholders’ Equity

If financial statements are prepared between the declaration date and the date of distribution, Common Stock Distributable should be reported as part of contributed capital, as shown below.

– Note that after the distribution, total stockholders’ equity remains the same, as does proportionate ownership in the corporation of any individual stockholder.


Stock Splits

A stock split occurs when a corporation increases the number of shares of stock issued and outstanding and reduces the par or stated value proportionally.– A company may plan a stock split for the

following reasons: To lower its stock’s market price per share and,

thereby, increase the demand and volume of trading for its stock at this lower price.

To signal to the market its success in achieving its operating goals.


Stock Split(slide 1 of 2)


Stock Split(slide 2 of 2)



Statement of Stockholders’ Equity


The statement of stockholders’ equity summarizes changes in the components of the stockholders’ equity section of the balance sheet, as shown below.

Stockholders’ Equity Section of a Balance Sheet


Book Value per Share

The book value of stock represents a company’s total assets less its liabilities (in other words, its net assets).

The book value per share is the equity of the owner of one share of stock in the net assets of the company.– If a company has only common stock

outstanding, book value per share is calculated as follows:

Stockholders’ Equity ÷ Common Shares Outstanding = Book Value per Share


Book Value for Common and Preferred Stock

If a company has both preferred and common stock, the preferred stock’s call value and any dividends in arrears are subtracted from stockholders’ equity to determine the equity pertaining to common stock. – If Snow has no dividends in arrears and its preferred

stock is callable at $105, the equity pertaining to its common stock would be calculated as follows:

- If Snow has 82,600 shares of common stock outstanding, its book values per share would be computed as follows:


Book Value for Dividends in Arrears

Assume the same facts except that Snow’s preferred stock is 8 percent cumulative and that one year of dividends is in arrears. The stockholders’ equity would be allocated as follows:

The book values per share would then be as follows:


Stockholders’ Equity on the Balance Sheet



SECTION 3: BUSINESS APPLICATIONS

Evaluate dividend policies– Dividend yield

Evaluate profitability– Return on equity

Evaluate investors’ confidence in a company’s future– Price/earnings ratio

Evaluate stock options


Dividend Yield

Dividend yield is computed by dividing the dividends per share by the market price per share.– Investors use the dividend yield ratio to

evaluate the amount of dividends they receive.

– Microsoft’s dividend yield in 2011 is computed below.


Return on Equity

Return on equity is the ratio of net income to average total stockholders’ equity.– It is the most important ratio associated with stockholders’ equity

and is a common measure of management’s performance.– As a company sells more shares of stock,

– Management can reduce stockholders’ equity, thereby increasing return on equity, by buying back the company’s shares on the open market. The cost of treasury stock has the following effect:

– Microsoft’s return on equity in 2011 is computed on the next slide.


Return on Equity


Price Earnings Ratio

The price/earnings (P/E) ratio is a measure of investors’ confidence in a company’s future. – It is calculated by dividing the market price per

share by the earnings per share.– Microsoft’s P/E ratio for 2011 is calculated below.


Cash Flow Information and Stock Options as Compensation

The best source of information concerning cash flows related to stock transactions and dividends is the financing activities section of the statement of cash flows.

Stock option plans give employees the right to purchase stock in the future at a fixed price.– Because the market value of a company’s stock is tied to a

company’s performance, these plans are a means of both motivating and compensating employees.

– As the market value of the stock goes up, the difference between the option price and the market price grows, which increases the amount of compensation.

– Another key benefit is that compensation expense is tax-deductible.



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Needles Powers Crosson Principles of Accounting 12e Accounting for Corporations 13 C H A P T E R © human/iStockphoto