1 Identify the major characteristics of a corporation



LECTURE NOTES—Accounting for Corporations: Stockholders’ Equity

Introduction—Chapter Study Objectives:

1. Identify the major characteristics of a corporation.

2. Differentiate between paid-in capital and retained earnings.

3. Record the issuance of common stock.

4. Explain the accounting for treasury stock.

5. Differentiate preferred stock from common stock.

6. Prepare a stockholders’ equity section.

7. Compute book value per share.

8. Prepare the entries for cash dividends and stock dividends.

9. Identify the items that are reported in a retained earnings statement.

10. Prepare and analyze a comprehensive stockholders’ equity section.

11. Describe the form and content of corporation income statements.

12. Compute earnings per share

I. The Corporate Form of Organization: the equity section for corporations have 2 sections in Stockholders’ Equity s: (1) Capital Stock showing the amount and types of capital stock that has been issued and (2) Retained Earnings which represents the net income retained in the corporation and not paid out to stockholders in the form of dividends. The account “Dividends” that are amount paid out to stockholders has a normal debit balance and “Owners’ Equity” or Stockholders’ Equity made up of Capital Stock and Retained Earnings have normal credit balances.

A. A corporation is an entity created by law that is separate and distinct from its owners.

B. Its continued existence is dependent upon the statutes of the state in which it is incorporated.

C. Two common bases for classification of corporations are:

1. by purpose

2. by ownership

D. Classifications of Corporations

1. A corporation’s purpose may be to earn a profit, or it may be organized as nonprofit.

2. Classification by ownership distinguishes between publicly-held corporations and privately held corporations.

a) Publicly-held corporations may have thousands of stockholders, and its stock is regularly traded on a national securities exchange.

b) Privately-held corporations, often referred to as closely held corporations, usually have only a few stockholders, and does not offer its stock for sale to the general public.

II. Characteristics of a Corporation

A. The corporation has separate legal existence from its owners.

B. The stockholders have limited liability.

C. Ownership is held in shares of capital stock, which are transferable units.

D. The corporation has the ability to acquire capital through the issuance of stock.

E. The corporation can have a continuous life.

F. The corporate management is at the discretion of the board of directors who are elected by the stockholders.

G. The corporation is subject to numerous government regulations.

H. The corporation must pay an income tax on its earnings, and the stockholders are required to pay taxes on the dividends they receive: the result is double taxation.

I. Advantages and disadvantages of a corporation—note how you need to weigh the advantages and disadvantages:

1. Advantages:

a) Separate legal existence

b) Limited liability of stockholders

c) Transferable ownership rights

d) Ability to acquire capital

e) Continuous life

f) Corporation management—professional managers

2. Disadvantages:

a) Corporations management—separation of ownership and management

b) Government regulations

c) Additional taxes

III. Forming a Corporation

A. Initial Steps:

1. Filing an application with the Secretary of State in the state in which incorporation is desired

2. Receiving a charter (articles of incorporation) which creates the corporation

3. Developing by-laws, which establish the internal rules and procedures for conducting the affairs of the corporation and indicate the powers of parties involved.

B. Organization Costs

1. Costs incurred in forming a corporation are called organization costs.

2. These costs include legal fees and state fees, and promotional expenditures.

3. Organization costs are expensed as incurred since it is so difficult to determine the amount and timing of future benefits.

IV. Ownership Rights of Stockholders

A. Each share of common stock gives the stockholder the following ownership rights:

1. Vote in the election of board of directors and in actions that require stockholder approval.

2. Share in corporate earnings through the receipt of dividends.

3. Maintain the same percentage ownership when additional shares of common stock are issued (preemptive right).

4. Share in assets upon liquidation (residual claim).

V. Stock Issue Considerations Issuance of Stock—STOCK ISSUE TERMS:

A. Authorized Stock:

1. Authorized stock is the amount of stock a corporation is allowed to sell as indicated by its charter or anticipated number of shares to meet the needs of the company and included in the corporate charter.

2. The authorization of capital stock does not result in a formal accounting entry. This event has no immediate effect on either corporate assets or stockholders’ equity.

B. Issuance of Stock:

1. A corporation can issue common stock directly to investors or indirectly through an investment banking firm (brokerage house).

a. Direct issue is typical in closely held companies.

b. Indirect issue is customary for a publicly held corporation.

❖ In an indirect issue, the investment banking firm may agree to underwrite the entire stock issue.

C. Stock market price information

1. The stock of publicly held companies is traded on organized exchanges. Dollar prices per share are established by the interaction between buyers and sellers.

2. The prices set by the marketplace generally follow the trend of a company’s earnings and dividends.

D. Stock Issue Considerations Par and No-Par Value Stocks

1. Par value stock is capital stock that has been assigned a value per share in the corporate charter.

❖ It represents the legal capital per share that must be retained in the business for the protection of corporate creditors. This is only a dollar amount (not necessarily the amount of cash in the cash account) that the creditors have claim to the assets of the corporation.

2. No-par stock is capital stock that has not been assigned a value in the corporate charter.

a. In many states the board of directors can assign a stated value to the shares which then becomes the legal capital per share.

b. When there is no assigned stated value, the entire proceeds are considered to be legal capital.

3. RELATIONSHIP OF PAR AND NO-PAR VALUE STOCK TO LEGAL CAPITAL:

Stock Legal Capital per Share

Par value Par value

No-par value with stated value Stated value

No-par value without stated value Entire Proceeds

VI. Corporate Capital

A. Owner’s equity in a corporation is identified as stockholders’ equity, share-holders’ equity, or corporate capital.

B. The stockholders’ equity section of a corporation’s balance sheet consists of:

1. Paid-in (contributed) capital - the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock.

2. Retained earnings - net income that is retained in a corporation.

C. Retained Earnings is net income retained in a corporation and is recorded in Retained Earnings by a closing entry in which Income Summary is debited and Retained Earnings is credited. Closing Process for a Corporation where revenues (R) are first closed into Income Summary; expenses (E) are secondly closed into Income Summary; and the last step would be the closing of net income or net loss shown in the Income Summary (I) account into Retained Earnings if there has not been any dividends paid out to stockholders. If dividends have been paid out to stockholder, then there is the 4th step to close Dividends (D) into Retained Earnings. Below is the example to close Income Summary that has a NET INCOME (entry would be reversed for a Net Loss):

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- |Closing Entries | | | |

|Dec. |31 |Income Summary | |130,000 | |

| | |Retained Earnings | | |130,000 |

| | | | | | |

D. Stockholders’ equity section of a balance sheet:

|DELTA ROBOTICS |

|Balance Sheet (Partial) |

|Date |

|Stockholders’ equity: | | |

| Paid-in-capital:: | | |

|Common stock |$800,000 | |

|Retained Earnings |130,000 | |

|Total stockholders’ equity | |$930,000 |

E. The Accounting Equation for a Corporation defining the two sections of the Stockholders’ Equity:

1. Paid-in Capital—capital that has been contributed by the stockholders through the purchase of a company’s stock which is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock.

2. Earned Capital—earnings that have been retained or plowed back into the corporation which comes from the net income of the corporation that is retained (Retained Earnings) and not paid out to the stockholders in the form of dividends.

F. Expanded Accounting Equation:

1. Under the Owner’s Equity for a Corporation:

a. Common Stock represents the Paid-in Capital because if a corporation has only one class of stock, it is identified as common stock.

b. Retained Earnings showing that under this section which would be the net income retained in the business are the sections:

1) Revenues and Expenses which would provide the net income or the net loss of the corporation. Profit or Loss Distribution for a Corporation showing how net income increases Retained Earnings and how net loss decreases Retained Earnings.

2) Dividends which is a distribution to the stockholders on a pro rata (proportional) basis. Therefore after dividends are paid out to the stockholders (if any is paid out) the remaining amount of net income is retained in the company which is the balance in the Retained Earnings account.

G. Compare the FINANCIAL STATEMENTS FOR A SOLE PROPIETOPRSHIP with those for a CORPORATION:

1. For the sole proprietorship, the owner’s equity is the Owners, Capital account which represents the net income or net loss of the company less any drawings paid out to the owner.

2. For the corporation, the stockholders’ equity must disclose:

a) Capital stock which would represent the sources of paid-in capital (the classes or types of paid-in capital will be covered in the next sections).

b) Retained earnings

VII. Accounting for Common Stock Issues

A. The primary objectives in accounting for the issuance of common stock are:

3. to identify the specific sources of paid- in capital and

4. to maintain the distinction between paid-in capital and retained earnings.

B. The issuance of common stock affects only paid-in capital accounts:

ISSUANCE OF STOCK example where Boomer Corporation issues 2,000 shares of common stock at $10 per share under 4 situations: (1) Stock at $4 par value; (2) Stock at no par value where the entire proceeds is legal capital; (3) Stock has $4 stated value; and (4) Stock has no stated value where the entire proceeds is legal capital and Note: The amount credited to the Common Stock account becomes legal capital for the protection of the corporation’s creditors:

1. ISSUING PAR VALUE COMMON STOCK FOR CASH where par value does NOT represent the stock’s market value but is defined as capital stock that has been assigned value per share in the corporate or the legal amount assigned to each share of stock in the corporate charter Since par value does not indicate the stock’s market value, the cash proceeds from issuing par value stock may be equal to, greater than, or less than par value as follows:

a) Illustration of issuing common stock at par for cash:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Cash | |1,000 | |

| | |Common Stock | | |1,000 |

| | |(record issuance of 1000 shs.@ $1 par) | | | |

b) Illustration of issuing common stock above par for cash where an account called, “Paid-in Capital in Excess of Par Value” will show the amount above legal capital where the “Common Stock” account will only show the legal capital (creditors claim) or par value:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Cash | |5,000 | |

| | |Common Stock | | |1,000 |

| | |Paid-in Capital in Excess of Par Value | | |4,000 |

| | |(record issuance of 1000 shs.@ $5/sh.) | | | |

The total paid-in capital of the above two transactions is $6,000, and the legal capital is $2,000.

c) Issuing common stock below par for cash would result is debit to Paid-in Capital in Excess of Par Value and a credit to cash. But this situation rarely occurs as the sale of common stock below par value is not permitted in most states, because stockholders may be held personally liable for the difference between the price paid upon original sale and par value.

d). Stockholders’ equity -paid-in-capital in excess of par value:

|HYDRO-SLIDE, INC. |

|Balance Sheet (Partial) |

|Date |

|Stockholders’ equity: | | |

| Paid-in-capital:: | | |

|Common stock |$2,000 | |

|Paid-in capital in excess of par value |4,000 | |

|Total paid-in capital |6,000 | |

|Retained Earnings |27,000 | |

|Total stockholders’ equity | |$33,000 |

| | | |

2. ISSUING NO-PAR COMMON STOCK FOR CASH

a) When no par stock has a stated value as in the following example with $5 stated value and note the word “stated” must be used in the account showing the excess above the legal capital in place of the word, “par”:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Cash | |40,000 | |

| | |Common Stock | | |25,000 |

| | |Paid-in Capital in Excess of Stated Value | | |15,000 |

| | |(record issuance of 5000 shs.of $5/sh. Stated value) | | | |

b) When no par stock does not have a stated value and this case the entire proceeds from the issue becomes legal capital:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Cash | |40,000 | |

| | |Common Stock | | |40,000 |

| | |(record issuance of 5000 shs.of no-par stock) | | | |

2. ISSUING COMMON STOCK FOR SERVICES OR NONCASH ASSETS:

Stock may be issued for services, such as compensation to attorneys or consultants, or for noncash assets, where to comply with the cost principle, in a noncash transaction; cost is the cash equivalent price. Since organization costs are expenses when incurred, the following entry would the issuance of 4,000 shares of $1 par value common stock to the attorneys who billed the company $5,000 for their services to organize the corporation:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Organization Expense | |5,000 | |

| | |Common Stock | | |4,000 |

| | |Paid-in Capital in Excess of Par Value | | |1,000 |

| | |(record issuance of 4000 shs.of $1/sh.to attorneys) | | | |

When common stock is issued for services or non-cash assets, such as land, cost is either the fair market value (FMV) of the consideration given up, or the consideration received, whichever is more clearly determinable. The par value is never a factor in determining the cost of the assets received. With the following example, the land was advertised for $90,000 but that is NOT a FMV as only advertised for that amount but the current market price of the stock IS CLEARLY DETERMINABLE as stock is selling for that amount where $5 par stock is actively trading for $8 per share and the company issued 10,000 shares to acquire the land:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Land (10,000 x $8) | |80,000 | |

| | |Common Stock (10,000 x $5) | | |50,000 |

| | |Paid-in Capital in Excess of Par Value | | |30,000 |

| | |(record issuance of 10,000 shs.of $5/sh.for land) | | | |

VIII. Accounting for Treasury Stock

A. Treasury stock is a corporation's own stock that has been issued, fully paid for, and reacquired but not retired. A corporation may acquire treasury stock in order:

1. To reissue the shares to officers or employees

2. To increase trading thereby enhancing market value

3. To have additional shares available for use in acquisitions of other companies

4. To reduce the number of shares outstanding and thereby increase earnings per share

5. To rid the company of disgruntled investors, perhaps to avoid a takeover.

B. PURCHASE OF TREASURY STOCK—Treasury stock is generally accounted for by the cost method—uses the cost of the shares purchased to value the treasury stock (Par value is NOT a consideration when acquiring treasury stock).

The entry to show Mead, Inc. acquiring 4,000 shares at $8 per share:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Feb. |1 |Treasury Stock (4,000 x $8) | |32,000 | |

| | |Cash | | |32,000 |

| | |(record purchase of 4,000 shs. of treasury stock for $8/sh.) | | | |

C. Stockholders’ equity with treasury stock AFTER the purchase of treasury stock. NOTE (1) the disclosures (par value, shares issued, and shares outstanding—the number of shares of issued stock that are still held by stockholders—out in the hands of stockholders) that are required under the paid-in capital section for the Common Stock and (2) that the acquisition of treasury stock reduces stockholders’ equity and is shown as the last item under the stockholders’ equity section just above, “Total stockholders’ equity”:

|MEAD, INC. |

|Balance Sheet (Partial) |

|Date |

|Stockholders’ equity: | | |

| Paid-in-capital:: | | |

|Common stock, $5 par value, 100,000 shares | | |

| issued and 96,000 shares outstanding |$500,000 | |

|Retained Earnings |200,000 | |

| Total paid-in capital and retained earnings | |700,000 |

|Less: Treasury stock (4,000 shares) | |32,000 |

|Total stockholders’ equity | |$668,000 |

| | | |

D. DISPOSAL OF TREASURY STOCK—TREASURY STOCK TRANSACTIONS:

When the Treasury Stock is resold and the selling price of the shares is greater than cost (Resold above cost), the difference is credited to Paid-in Capital from Treasury Stock.

Boomer Corporation sells 25 shares of its treasury stick for $18 per share which was acquired for $15 per share:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Cash (25 shares x $18/share) | |450 | |

| | |Treasury Stock (25 shares x $15/share) | | |375 |

| | |Paid-in Capital from Treasury Stock | | |75 |

| | |(record sale of 25 shares of treasury stock at $18/sh. above | | | |

| | |cost of $15/sh.) | | | |

The entry for Mead, Inc. for the sell of treasury stock previously acquired for $8 per share and is sold for $10 per share:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|July. |1 |Cash (1,000 shares x $10/share) | |10,000 | |

| | |Treasury Stock (1,000 x $8/share) | | |8,000 |

| | |Paid-in Capital from Treasury Stock | | |2,000 |

| | |(record sale of 1,000 shares of treasury stock at $10/sh. above | | | |

| | |cost of $8/sh.) | | | |

NOTE: the $2,000 credit in the entry would not be considered a gain on sale of treasury stock for two reasons: (1) gains on sales occur when assets are sold and treasury stock is not an asset; and (2) a corporation does not realize a gain or suffer a loss from stock transactions with its own stockholders. Paid-in Capital from Treasury Stock will be shown as a separate line item under the Paid-in Capital section of the stockholders’ equity section of the Balance Sheet as it is an increase to the corporation’s paid-in capital.

When the selling price is less than cost (Resold below cost), the excess of cost over selling price is usually debited to Paid-in Capital from Treasury Stock.

Refer to the entry for Boomer Corporation where Boomer Corporation sells 25 shares of its treasury stock for $14 per share which was acquired for $15 per share. Since Paid-in Capital From Treasury Stock exists and there is a sufficient amount for this entry ($75 from above entry), the entry is recorded as:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Cash (25 shares x $14/share) | |350 | |

| | |Paid-in Capital from Treasury Stock | |25 | |

| | |Treasury Stock (25 shares x $15/share) | | |375 |

| | |(record sale of 25 shares of treasury stock at $14/sh. below | | | |

| | |cost of $15/sh.) | | | |

Refer to the entry for Mead, Inc. for the sell of treasury stock previously acquired for $8 per share and is sold for $7 per share and there is a sufficient amount for this entry ($2,000 from above entry), the entry is recorded as:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Oct. |1 |Cash (800 shares x $7/share) | |5,600 | |

| | |Paid-in Capital from Treasury Stock | |800 | |

| | |Treasury Stock (800 x $8/share) | | |6,400 |

| | |(record sale of 800 shares of treasury stock at $7/sh. below | | | |

| | |cost of $7/sh.) | | | |

When there is no remaining balance (Does Not Exist) in Paid-in Capital from Treasury Stock or not enough for the entry, the remainder is debited to Retained Earnings. The entry for Mead, Inc. for the sell of the remaining treasury stock previously acquired for $8 per share and is sold for $7 per share and there is not sufficient amount for this entry (only $1,200 remaining ($2,000 original entry - $800 used) from the above 2 entries), the entry is recorded as

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Dec. |1 |Cash (2,200 shares x $7/share) | |15,400 | |

| | |Paid-in Capital from Treasury Stock | |1,200 | |

| | |Retained Earnings | |1,000 | |

| | |Treasury Stock (2,200 x $8/share) | | |17,600 |

| | |(record sale of 800 shares of treasury stock at $7/sh. below | | | |

| | |cost of $7/sh.) | | | |

IX. Preferred Stock

A. Preferred stock has contractual provisions that give it priority over common stock in certain areas: distribution of earnings assets in the event of liquidation.

B. Preferred stockholders usually do not have voting rights.

C. Preferred stock may have either a par value or no-par value. Like common stock, preferred stock may be issued for cash or for noncash assets. The entries are similar as with the issuance of common stock. Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share recorded as follows where PS is Preferred Stock after the Paid in Capital in Excess of Par Value as when a corporation has more than one class of stock, the different paid-in capital in excess accounts must be distinguished from one another:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Cash (10,000 x $12) | |120,000 | |

| | |Preferred Stock (par or legal capital $10.sh.) | | |100,000 |

| | |Paid-in Capital in Excess of Par Value-PS | | |20,000 |

| | |(record issuance of 10,000 shs.of $10 par valued preferred stock) | | | |

A. Preferred stock is shown first in the stockholders' equity section and should be identified separately from other stock and paid in capitals. See page 14 of handouts, chapter 13, of the handout packet—STATEMENT PRESENTATION OF STOCKHOLDERS’ EQUITY showing that preferred stock is shown first (with the proper disclosures) in the stockholders’ equity as well as first in the Additional paid-in capital section.

B. DIVIDEND PREFERENCES—preferred stockholders have the right to share in the distribution of corporate income BEFORE common stockholders

Cumulative Dividend—A cumulative dividend provides that preferred stockholders must be paid both current and prior year dividends before common stockholders receive any dividends.

Preferred dividends not declared in a given period are called dividends in arrears.

Dividends in arrears are not considered a liability, but the amount of the dividends in arrears should be disclosed in the notes to the financial statements.

C. CONVERTIBLE PREFERRED STOCK

Convertible preferred stock provides for the exchange of preferred stock into common stock at a specified ratio.

Convertible stock is purchased by investors who want the greater security of a preferred stock, but who also want to be able to capture the market value of the stock if it increases significantly.

In recording the conversion, the amount paid-in on the preferred stock is transferred to appropriate common stock accounts (Common Stock and Paid-in Capital in Excess of Par Value).

Convertible Preferred Stock example—assume that the 1,000 shares of Ross Industries $100 par preferred are issued at $105 and are converted into 10,000 shares of common stock ($5 par) when the market values per share of the two classes of stock are $101 and $12, respectively. Note that the preferred accounts are debited to reduce them to zero. The common stock is credited for the par value and the remainder will be credited to the Paid-in Capital in Excess of Par—Common Stock (to balance the entry) and the market values of the shares at the time of the conversion are NOT considered. The entry is recorded as follows:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mo. |Day |Preferred Stock (1,000 x $100) | |100,000 | |

| | |Paid-in Capital in Excess of Par Value-PS | |5,000 | |

| | |Common Stock (par $5 x 10,000 shs..) | | |50,000 |

| | |Paid-in Capital in Excess of Par Value-CS | | |55,000 |

| | |(record conversion of 1,000 shs.of $10 par valued preferred stock) | | | |

D. CALLABLE PREFERRED STOCK

Callable preferred stock grants the issuing corporation the right to purchase the stock from stockholders at specified future dates and prices.

This call feature enables a corporation to eliminate the preferred stock when it is advantageous to do so.

The call (or redemption) price is frequently above the par or stated value of the shares.

While convertible stock is for the benefit of the stockholder, callable stock is for the benefit of the corporation.

X. Stockholders’ Equity Presentation and Analysis

A. PRESENTATION—In the stockholders’ equity section of the balance sheet, paid-in capital and retained earnings are reported. The specific sources of paid-in capital (sometimes called contributed capital) are identified and the two classifications are recognized:

Capital stock—STATEMENT PRESENTATION OF STOCKHOLDERS’ EQUITY noting that this category consists of:

Preferred stock first (because of its preferential rights) where par value, shares authorized, shares issued, and shares outstanding are disclosed.

Common stock is second where par value, shares authorized, shares issued, and shares outstanding are disclosed.

Additional paid-in capital which includes:

In excess of par—preferred stock

In excess of par—common stock

From treasury stock if applicable

B. ANALYSIS—BOOK VALUE PER SHARE:

Book value per share represents the equity a common stockholder has in the net assets of the corporation from owning one share of stock.

The formula for computing book value per share when a corporation has only one class of stock is:

|Total Stockholder’s Equity |÷ |No. of Common Shares Outstanding |= |Book Value per Share |

Computation of preferred stock equity

When a company has both preferred and common stock, the computation of book value is a bit more complex. Steps required are:

1) Compute the preferred stock equity (the sum of call price of preferred stock plus any cumulative dividends in arrears). If the preferred stock does not have a call price, the par value of the stock is used

2) Determine the common stock equity. Subtract the preferred stock equity from total stockholders’ equity

3) Divide common stock equity by shares of common stock outstanding.

C. Book Value versus Market Value

1. Book value per share may not equal market value.

2. Book value is based on recorded costs. Market value reflects the subjective judgments of thousands of stockholders and prospective investors about the company’s potential for future earnings and dividends.

3. Market value per share may exceed book value per share, but that fact does not necessarily mean that the stock is overpriced.

4. Book and market values compared with some companies have large differences between book value and market range. The correlation between book value and the annual range of a company’s market value per share is often remote.

5. Book value per share is useful in determining the trend of a stockholder’s per share equity in a corporation. It is also significant in many contracts and in court cases where the rights of individual parties are based on cost information.

LECTURE NOTES—Accounting for Corporations: Income Reporting

I. DIVIDENDS

❖ A dividend is a distribution by a corporation to its stockholders on a pro rata (proportional) basis.

❖ Dividends may be in the form of cash, property, scrip (promissory note to pay cash), or stock.

❖ Dividends may be expressed in one of two ways:

• 1) as a percentage of the par or stated value of the stock or

• 2) as a dollar amount per share.

A. Cash Dividends—REQUIREMENTS FOR CASH DIVIDENDS:

1. A cash dividend is a pro rata distribution of cash to stockholders. For a corporation to pay a cash dividend it must have:

a) retained earnings,

b) adequate cash, and

c) a declaration of dividends

2. Entries for Cash Dividends—Three dates are important in connection with dividends:

a) Declaration date—board of directors formally declares a cash dividend and a liability is recorded. The declaration of a cash dividend commits the corporation to a legal obligation that must be recorded. The account credited, Dividends Payable, is a current liability as it will normally be paid within the next several months. The account debited can be Retained Earnings or Dividends if a separate general ledger account is set up. The entry to record a 50¢ per share cash dividend on 100,000 (.50 x 100,000) shares of $10 par value common stock is recorded as follows:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Dec. |1 |Retained Earnings | |50,000 | |

| | |Dividends Payable | | |50,000 |

| | |(To record declaration of cash dividend). | | | |

b) Record date— marks the time when ownership of outstanding shares is determined from the records maintained by the corporation. No entry is required on this date because the corporation’s liability is unchanged.

c) Payment date—the date dividend checks are mailed to the stockholders and the payment of the dividend is recorded. Assuming the payment date is January 20, the following entry is recorded:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Jan. |20 |Dividends Payable | |50,000 | |

| | |Cash | | |50,000 |

| | |(To record payment of a cash dividend). | | | |

3. Allocating Cash Dividends between Preferred and Common Stock

a) Cash dividends must be paid first to preferred stockholders before any common stockholders are paid.

b) When preferred stock is cumulative, any dividends in arrears must be paid to preferred stockholders before allocating any dividends to common stockholders. The allocation of the dividend to the two classes of stock as follows:

|Total Dividend | |$50,000 |

|Allocated to preferred stock: | | |

|Dividends in arrears, 2008 (1,000 x $2/share dividend) |$2,000 | |

|2009 dividend (1,000 x $8) |8,000 |10,000 |

|Remained allocated to common stock | |$40,000 |

To record the declaration the entry would be:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Dec. |31 |Retained Earnings | |50,000 | |

| | |Dividends Payable | | |50,000 |

| | |(To record declaration of cash dividends of $10,000 to preferred| | | |

| | |stock and $40,000 to common stock). | | | |

c) When preferred stock is not cumulative, only the current year’s dividend must be paid to preferred stockholders before paying any dividends to common stockholders. The difference would be in the explanation as follows:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Dec. |31 |Retained Earnings | |50,000 | |

| | |Dividends Payable | | |50,000 |

| | |(To record declaration of cash dividends of $8,000 to preferred | | | |

| | |stock and $42,000 to common stock). | | | |

B. Stock Dividends—reasons for stock dividends, summary of stock dividends and how to account for small and large stock dividends.

1. A stock dividend is a pro rata distribution to stockholders of the corporation’s own stock and results in a decrease in retained earnings and an increase in paid-in capital.

2. At a minimum, the par or stated value must be assigned to the dividend shares; in most cases, however, fair market value is used.

3. A stock dividend does NOT decrease total assets or total stockholders’ equity.

4. Purposes and Benefits of a Stock Dividend: Corporations issue stock dividends generally for one or more of the following reasons:

a) 1) To satisfy stockholders’ dividend expectations without spending cash.

b) 2) To increase the marketability of stock by increasing the number of shares.

c) 3) To emphasize that a portion of stockholders’ equity has been permanently reinvested in the business and unavailable for cash dividends.

5. Stock Dividends Distinguished

a) The accounting profession distinguishes between a SMALL stock (less than 20-25% of the corporation’s issued stock) and a LARGE stock dividend (greater than 20-25%).

b) Directors should assign fair market value to SMALL stock dividends based on the assumption that a small stock dividend will have little effect on the market price of the shares previously outstanding.

c) Par or stated value per share is normally assigned to a LARGE stock dividend.

6. Entries for Stock Dividends:

a) Small Stock Dividends: Assume that Medland Corporation has a balance of $300,000 in retained earnings and declares a 10% stock dividend on its 50,000 shares of $10 par value common stock. The current FMV of its stock is $15 per share and the number of shares to be issued is 5,000 (10% of 50,000). The amount debited to Retained Earnings is $75,000 (5,000 x $15). NOTE: Retained Earnings is debited for the FMV (5,000 x $15) of the stock issued because this is a SMALL stock dividend. Common Stock Dividends Distributable is credited for the par value of the dividend shares (5,000 x $10), and the excess is credited to Paid-in Capital (5,000 x $5). The first entry below shows the declaration and the second entry shows the entry when dividends are issued:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mon. |X |Retained Earnings (5,000 x $15 FMV) | |75,000 | |

| | |Common Stock Dividends Distributable | | |50,000 |

| | |Paid-in Capital in Excess of Par Value | | |25,000 |

| | |(To record declaration of 10% stock dividend). | | | |

| | | | | | |

| |X |Common Stock Dividends Distributable | |50,000 | |

| | |Common Stock | | |50,000 |

| | |(To record issuance of 5,000 shares in a stock dividend). | | | |

b) Illust.—Statement presentation of common stock dividends distributable:

|MEDLAND CORPORATION |

|Balance Sheet (Partial) |

|Date |

|Stockholders’ equity: | | |

| Paid-in-capital:: | | |

|Common stock |$500,000 | |

|Common stock dividends distributable |50,000 |$550,000 |

|Additional paid-in capital: | | |

|Paid-in capital in excess of par value | |25,000 |

|Total paid-in capital | |575,000 |

|Retained Earnings | |225,000 |

|Total stockholders’ equity | |$800,000 |

| | | |

7. Stock Dividend Effects—stock dividends change the composition of stockholders’ equity because a portion of retained earnings is transferred to paid-in capital. However, total stockholders’ equity and the par or stated value per share remains the same:

|Stockholders’ equity |Before Divided |After Dividend |

|Paid-in capital: | | |

|Common stock, $10 par (5,000 x $10) |$500,000 |$550,000 |

|Paid-in capital in excess of par value (5,000 x $5) |-------- |25,000 |

|Total paid-in capital |500,000 |575,000 |

|Retained earnings ($75,000 transferred to Paid-in capital) |300,000 |225,000 |

|Total stockholders’ equity |$800,000 |$800,000 |

|Outstanding shares |50,000 |55,000 |

|Book value per share |$16.00 |$14.55 |

NOTE: Because outstanding shares increased, book value per share decreased.

C. Stock Splits—EFFECT OF A STOCK SPLIT ON STOCKHOLDERS’ EQUITY:

A. A stock split involves the issuance of additional shares to stockholders according to their percentage ownership.

B. In a stock split, the number of shares is increased in the same proportion that par or stated value per share is decreased.

C. A stock split has no effect on total paid-in capital, retained earnings, and total stockholders’ equity.

D. It is not necessary to formally journalize a stock split.

E. The Stockholders’ Equity BEFORE a 2 for 1 Stock Split and AFTER a 2 for 1 Stock Split that both Paid-in capital and Retained earnings remain the same but the Par value per share decreases with a Stock:

| |Before Stock | |After Stock |

| |Split | |Split |

|Stockholders’ equity | | | |

| | |Effect | |

|Paid-in capital: | | | |

|Common stock, $10 par (5,000 x $10) |$500,000 |Same |$500,000 |

|Paid-in capital in excess of par value |-0- | |-0- |

|Total paid-in capital |500,000 | |500,000 |

|Retained earnings |300,000 |Same |300,000 |

|Total stockholders’ equity |$800,000 | |$800,000 |

|Outstanding shares (Increased—doubled) |50,000 |Inc. |100,000 |

|Book value per share (Decreased—half as much) |$16.00 |Dec. |$8.00 |

F. Differences between the effects:

|Item |Stock Split |Stock Dividend |

|Total paid-in capital |No change |Increase |

|Total retained earnings |No change |Decrease |

|Total par value (common stock) |No change |Increase |

|Par value per share |Decrease |No change |

II. RETAINED EARNINGS

A. Introduction

1. Retained earnings is net income that is retained in the business.

2. The balance in retained earnings is part of the stockholders’ claim on the total assets of the corporation.

3. A net loss is recorded in Retained Earnings by a closing entry in which Retained Earnings is debited and Income Summary is credited. A debit balance in Retained Earnings is identified as a deficit and must be labeled as such under the stockholders’ equity section of the balance sheet as the words, “Retained earnings,” can mislead users of the financial statements that the company does have retained earnings when it DOES NOT and would be shown as follows:

|MEDLAND CORPORATION |

|Balance Sheet (Partial) |

|Date |

|Stockholders’ equity: | | |

| Paid-in-capital:: | | |

|Common stock | |$800,000 |

|Deficit | |(50,000) |

|Total stockholders’ equity | |$750,000 |

B. RETAINED EARNINGS (RE) RESTRICTIONS:

1. In some cases there may be retained earnings restrictions. These make a portion of the balance currently unavailable for dividends.

2. Restrictions result from one or more of the following causes:

a) Legal - states may require that corporations restrict RE for the cost of treasury stock purchased.

b) Contractual - long term debt contracts may restrict RE as a condition for a loan.

c) Voluntary - the board of directors may voluntarily restrict RE for specific purposes such as future plant expansion.

3. The balance in retained earnings is generally available for dividend declarations. Some companies state this fact.

4. Examples of disclosures concerning unrestricted and restricted retained earnings:

a) An example showing the disclosure of unrestricted retained earnings was shown in the notes to its financial statements of Lockheed Martin Corporation.

b) Disclosure of restriction on Tektronix Inc.’s Notes to the Financial Statements stated the restriction on the payments of dividends was due to loan (debt) agreements.

C. PRIOR PERIOD ADJUSTMENTS:

1. A prior period adjustment is the correction of a material error in reporting net income in previously issued financial statements. The correction is:

a) Made directly to Retained Earnings.

b) Reported in the current year’s retained earnings statement as an adjustment of the beginning balance of Retained Earnings.

c) To illustrate the entry for a prior period adjustment when a material error is discovered that understated depreciation expense in a prior period by $300,000, the following entry would be made noting that since Depreciation Expense has been closed into Income Summary which in turn is closed into Retained Earnings that the debit, therefore, is to Retained Earnings to decrease Retained Earnings and the credit is to the permanent account that was understated by $300,000—Accumulated Depreciation to increase that account to the correct balance:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- | | | | |

|Mon. |X |Retained Earnings | |300,000 | |

| | |Accumulated Depreciation | | |300,000 |

| | |(To adjust the understatement of depreciation in a prior | | | |

| | |period). | | | |

2. Statement presentation of prior period adjustments for a correction for overstatement of net income in prior period (depreciation error) is as follows:

|GENERAL MICROWAVE |

|Retained Earnings Statement (Partial) |

|For the Year Ended (Date) |

|Balance, January 1, as reported | |$800,000 |

|Correction of overstatement of net income in prior | | |

|period (depreciation error) | |(300,000) |

|Balance, January 1, as adjusted | |$500,000 |

D. RETAINED EARNINGS STATEMENT:

1. The retained earnings statement shows the changes in retained earnings during the year prepared from the Retained Earnings account.

2. Transactions and events that affect retained earnings are tabulated in account form—Debits and Credits to Retained Earnings as follows with a Retained Earning T-account:

|Retained Earnings |

|Debits (Decreases) |Credits (Increases) |

|1. Net loss |1. Net income |

|2. Prior period adjustments for overstatement of net income |2. Prior period adjustments for understatement of net income |

|3. Cash dividends and stock dividends | |

|4. Some disposals of treasury stock | |

E. STATEMENT PRESENTATION AND ANALYSIS:

1. Presentation: Comprehensive stockholders’ equity section noting the following:

a) In the stockholders’ equity section of a balance sheet, Common Stock Dividends Distributable is shown under capital stock in paid-in-capital.

b) Retained earnings restrictions are disclosed in the notes to the financial statements.

2. Analysis

a) Profitability from the viewpoint of the common stockholder can be measured by the return on stockholders’ equity. This ratio shows how many dollars of net income were earned for every dollar invested by the stockholders.

b) It is computed as follows:

|Net Income – Preferred Dividends |÷ |“Average” Common Stockholders’ Equity |= |Return on Common Stockholders’ |

| | |[(beg. of yr. + end of year ÷ 2) – Par value | |Equity |

| | |Preferred Stock] | | |

For Kellogg Company’s which does not have preferred stock and therefore the center portion of the formula is just calculating the “average” stockholders’ equity:

|Net Income – Preferred Dividends |÷ |“Average” Common Stockholders’ Equity |= |Return on Common Stockholders’ |

| | |(beg. of yr. + end of year ÷ 2) | |Equity |

|($890.6 - $0) |÷ |($1,443.2+ $2,257.2 ÷ 2) |= |48.1% |

III. CORPORATION INCOME STATEMENTS with income taxes:

A. Introduction

1. Income statements for corporations are the same as the statements for proprietorships or partnerships except for one thing: the reporting of income taxes.

2. For income tax purposes, corporations are a separate legal entity. As a result, income tax expense is reported in a separate section of the corporation income statement before net income.

3. Income statement with income taxes showing the Income tax expense after the Income before income taxes line item.

4. Income tax expense and the related liability for income taxes payable are recorded as part of the adjusting process where the adjusting for Leads, Inc. would be entered as followed:

|General Journal |Page 1 |

|Date |Account Title |P.R |Debit |Credit |

|20-- |Adjusting Entry | | | |

|Dec. |31 |Income Tax Expense | |46,800 | |

| | |Income taxes Payable | | |46,800 |

IV. EARNINGS PER SHARE (EPS)

A. Earnings per share (EPS) indicate the net income earned by each share of outstanding common stock.

B. Most companies are required to report earnings per share on the income statement.

C. EARNINGS PER SHARE CALCULATION:

|Net Income – Preferred Dividends |÷ |“Weighted” Average of Common Shares Outstanding |= |Earnings per Share |

D. To illustrate, assume Rally Inc. reports net income of $211,000 on its 102,500 weighted average common shares (calculation of weighted average is covered in advanced accounting courses dealing with days during the year with the number of shares outstanding) and that during the year it also declares a $6,000 dividend on its preferred stock is calculated as follows:

|Net Income – Preferred Dividends |÷ |“Weighted” Average of Common Shares Outstanding |= |Earnings per Share |

|$211,000 - $6,000 |÷ |102,500 |= |$2.00 |

E. Basic earnings per share disclosure which is simply reported below the net income on the income statement.

F. Additional earnings per share disclosures are required when the income statement contains any irregular (non-recurring) items; EPS should be disclosed for each component. Assuming that Arco Energy had 100,000 shares of common stock outstanding during the year, the additional EPS disclosures on the income statement would be shown as follows noting that the dollar amount in parenthesis are coming from the main part of the income statement:

|ARCO ENERGY INC. |

|Income Statement (partial) |

|For the Year Ended December 31, 20-- |

|Net income |$284,200 |

|Earnings per share: | |

|Income from continuing operations ($560,000 ÷ 100,000) |$5.60 |

|Loss from discontinued operations ($210,000 ÷ 100,000) |(2.10) |

|Income before extraordinary item and cumulative | |

|Effect of change in accounting principle ($350,000 ÷ 100,000) |3.50 |

|Extraordinary loss ($49,000 ÷ 100,000) |(.49) |

|Cumulative effect of change in accounting principle ($16,800÷100,000) |(.17) |

|Net income |$2.84 |

V. Price/Earnings Ratio (P/E) is the ratio of the market price of a share of common stock to the company’s earnings per share (market price per share / earnings per share). It measures the value that the stock market places on $1 of a company’s earnings. A higher price/earnings ratio signifies a higher return on investment and is most useful when comparing one company to another.

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