Chapter 9: Types of Business Organizations

1. 1 Chapter 9: Types of Business Organizations 1. Types of Organizations Corporation - Stockholders’ Equity: 2. Preferred stock 3. Common stock 4. Accounting for preferred and common 5. Treasury stock 6. Retained earnings -prior period adjustment -cash dividends -stock dividends (and stock splits) -appropriations 7. Statement of stockholders’ equity

2. 2 1. Types of Organizations Proprietorship single owner. ownership activity through “Capital” and “Withdrawal” accounts. Partnership multiple owners. ownership activity through multiple “Capital” and “Withdrawal” accounts (for each partner). Corporation multiple owners. ownership activity through “Common/Preferred Stock”, “Retained Earnings” and “Dividend” accounts. Balance of Chapter 9 deals with corporations.

3. 3 2. Preferred Stock Advantages Preference over common in liquidation Stated dividend Variety of features regarding dividends: cumulative dividends, when declared, paid for “missed” years. Preference over common in dividend payout Disadvantages Subordinate to debt in liquidation Stated dividend can be skipped No voting rights (versus common) Debt or equity? components of both usually (but not always) classified with equity

4. 4 3. Common Stock Advantages Voting rights: election of board of directors vote on significant activities of management Rights to residual profits (after preferred) Disadvantages Last in liquidation No guaranteed return

5. 5 4. Accounting for Common Stock  (CS) and Preferred Stock (PS) Par value - initially established to create a “minimum legal capital”. Ex: Texas requires a minimum legal capital of $1,000 for new corporations, so issue: 1,000 shares at $1par, or 100 shares at $10 par, or other combination. . . Par value is not market value. Credit CS or PS for par value. Excess over par credited to “Additional Paid-in Capital” (APIC). Some newer stock issues (for common stock) are “no par” stock.

6. 6 4. Journal Entries Issue PS at greater than par value: Cash xx mkt. value Preferred Stock xx total par APIC - PS xx excess(plug) Issue CS at greater than par value: Cash xx mkt. value Common Stock xx total par APIC - CS xx excess(plug) Note: most states do not allow companies to issue at less than par value.

7. 7 4. Journal Entries -continued Issue no par common stock: Cash xx mkt. value Common Stock xx mkt. value Note: many companies have newer stock issues that are no par, but most companies still have older stock issues which contain a par value and APIC. Additionally, common stock can be issued for non-cash assets. If the stock is publicly traded, the market price per share should be used to value the transaction. If there is no market price per share, the fair value of the asset received in the exchange should be used to value the transaction. Now work Ex. 9-49.

8. 8 5. Treasury Stock Created when a company buys back shares of its own common stock. Reasons for buyback: reissue to employees for compensation. hold in treasury (or retire) to increase market price and earnings per share. reduce total dividend payouts while maintaining per share payouts. thwart takeover attempts by reducing proportion of shares available for purchase.

9. 9 5. Treasury Stock - continued The debit balance account called “Treasury Stock” is reported in stockholders’ equity as a contra equity (reduces SE). Note: not an asset. The stock remains issued, but is no longer outstanding. does not have voting rights. cannot receive cash dividends. May be reissued (to the market or to employees) or retired. No gains or losses are ever recognized from these equity transactions.

10. 10 5.Treasury Stock(TS)-Journal Entries There are two techniques for recording TS transactions (Par Value method and Cost method). We will use only the Cost method. This technique establishes a “cost” for TS equal to the amount paid to acquire the TS. Par value is not used for TS transactions. To record purchase of TS from market: TS xx “cost” Cash xx market (cost equals the cash paid)

11. 11 5.Treasury Stock(TS)- Journal Entries To reissue TS to market at greater than cost: Cash xx market APIC - TS xx over cost TS xx cost To reissue TS to market at less than cost: Cash xx market APIC - TS xx if available Retained Earnings xx if needed* TS xx cost *debit RE if no APIC-TS available to absorb the remaining debit difference.

12. 12 Sample Co. Stockholders’ Equity Common stock, $1 par value, 500,000 shares authorized, 80,000 shares issued, and 75,000 shares outstanding $ 80,000 Common stock dividends distributable 2,000 Preferred stock, $100 par value, 1,000 shares authorized, 100 shares issued and outstanding 10,000 Paid in capital on common $ 20,000 Paid in capital on preferred 3,000 Paid in capital on treasury stock 2,000 25,000 Retained earnings: Unappropriated $18,000 Appropriated 2,000 20,000 Less: Treasury stock, 5,000 shares (at cost) (6,000) Total Stockholders’ Equity $131,000 Now work Ex. 9-39.

13. 13 5. TS Example from Sample Co. Look at the information for Sample Co. on the previous slide. Note that Sample Company has 5,000 shares of TS at a total cost of $6,000, or a cost of $1.20 per share. The journal entry to record that purchase would have been: TS 6,000 Cash 6,000 Note that Sample Company also has APIC - TS of $2,000 in the balance sheet. This must be from previous TS transactions, where the TS was purchased, then reissued for more than original cost. All that remains of those transactions is the APIC-TS.

14. 14 5. TS - Example Problem Tiger Corporation has 100,000 shares of $1 par value stock authorized, issued and outstanding at January 1, 2002. The stock had been issued at an average market price of $5 per share, and there have been no treasury stock transactions to this point. Assume that, in February of 2002, Tiger Corp. repurchases 10,000 shares of its own stock at $7 per share. In July of 2002, Tiger Corp. reissues 2,000 shares of the treasury stock for $8 per share. In December of 2002, Tiger Corp. reissues the remaining 8,000 shares for $6 per share. Prepare the journal entries for 2002 regarding the treasury stock.

15. 15 5. TS Example -Journal Entries Feb: repurchase 10,000 sh. @ $7 = $70,000. TS 70,000 Cash 70,000 July: reissue 2,000 sh @ $ 8 = $16,000 (cost = 2,000 @ $7 = 14,000) Cash 16,000 TS 14,000 APIC - TS 2,000

16. 16 5. TS Example -Journal Entries Dec: reissue 8,000 sh. @ $ 6 = $48,000 (cost = 8,000 sh.@ $7 = 56,000) Cash 48,000 APIC-TS (1) 2,000 RE (2) 6,000 TS 56,000 Now we need to debit one or more accounts to compensate for the difference. (1) debit APIC-TS (but lower limit is to -0-). (2) debit RE if necessary for any remaining balance. (This is only necessary when we are decreasing equity.) Now work Ex. 9-40.

17. 17 6. Retained Earnings We will be expanding the basic retained earnings formula in this chapter. Now, the Statement of Retained Earnings will include the following: RE, beginning (unadjusted) xx Add/Subtract: Prior period adjustment xx RE, beginning (restated) xx Add: net income xx Less dividends: Cash dividends-common xx Cash dividends - preferred xx Stock dividends xx Property dividends xx Less: Adjustment for TS transactions xx Appropriation of RE xx RE, ending xx

18. 18 6. RE - Prior Period Adjustment Prior Period Adjustment is used when the company finds an Income Statement error from a prior year. The error needs to be adjusted to beginning retained earnings, since the error was closed to retained earnings in a prior year. The error can either increase or decrease retained earnings, depending on the type of error (omitted expenses would decrease RE in the adjustment).

19. 19 6. RE - Cash Dividends As cash dividends are declared: Dividends (RE) - common xx Dividends (RE)- preferred xx Dividends Payable xx As cash dividends are paid: Dividends Payable xx Cash xx

20. 20 6. RE - Cash Dividends Note that stated dividends to preferred shareholders must be paid before any dividends can be paid to common shareholders (including dividends in arrears if cumulative). Preferred dividends may be cumulative, which means that, if no dividend is declared in the current year, they must be “caught up” (based on stated dividend rate) for the preferred shareholders in a future year before common shareholders get any dividends. However, cumulative preferred dividends in arrears are not recognized as a liability until a dividend is finally declared by the board of directors. A company might go for a number of years without declaring a dividend, and there is no liability until a dividend is actually declared.

21. 21 6. RE - Property Dividends Property dividends are distribution of non-cash property by a company to its shareholders. The most common type of property dividend is a “spin-off” where the shares of stock of a subsidiary are distributed to the shareholders of the parent company. As property dividends are declared: Property Dividends (RE) xx Property Div. Payable xx As property dividends are distributed: Property Div. Payable xx Investment xx

22. 22 6. RE - Stock Dividends Stock dividends are distribution of additional shares of a company’s own stock to its shareholders. Note that the distribution of additional shares does not result in any value being given to the shareholders. Example: 4 shareholders, each having 10 shares of common stock. Each owner has 25% of total (10/40). If I give each shareholder 1 additional share of stock, each shareholder still owns 25% of the same company (11/44). Nothing has changed, except the number of the pieces of paper.

23. 23 6. RE - Stock Dividends Large stock dividends (greater than 25% of the outstanding common shares) are recorded at total par value. As stock dividends are declared: Stock Dividends (RE) xx par Stock Div. Distributable xx par As stock dividends are distributed: Stock Div. Distributable xx par Common Stock xx par Note that Stock Dividends Distributable is not a liability, it is another equity account (see Sample Company) which indicates that there are additional shares of stock that will be issued but are not currently outstanding.

24. 24 6. RE - Stock Dividends Analyze the effect of the transactions on the balance sheet: As stock dividends are declared: Stock Dividends (RE) xx - SE Stock Div. Distributable xx +SE As stock dividends are distributed: Stock Div. Distributable xx - SE Common Stock xx +SE Note that the total effect on stockholders’ equity is zero. However, retained earnings decreases and common stock increases by the par value of the stock dividend.

25. 25 6. RE - Stock Dividends Small stock dividends (less than 25% of the outstanding common shares) are recorded at market value. Omit the coverage of small stock dividends, as they are seldom used in practice anymore. The only significant function of large stock dividends in practice today is to achieve the market price per share effect of a stock split Stock splits are discussed in the next slide.

26. 26 Stock Splits Stock splits are commonly declared by a company to reduce its market price per share. This makes the stock more accessible to small investors. The process for stock splits is that the “old” stock certificates are turned in, and “new” stock certificates with a new description are issued to the same shareholders. The total par value of the new shares is equal to the total par value of the old shares, but the number of shares (and par value per share changes.

27. 27 Example of Stock Split IZM Company has 100,000 shares of $2 par value stock authorized, 10,000 shares issued and outstanding. Before the stock split, the stockholders’ equity section of the balance sheet shows: Common stock, $2 par, 100,000 shares authorized, 10,000 shares issued and outstanding $ 20,000 Retained earnings 80,000 Total stockholders’ equity $100,000 The market price of the outstanding shares is $50 per share before the split is distributed.

28. 28 Example of Stock Split If IZM declared a 2 for 1 stock split, the old shares would be turned in and new shares would be issued. The total SE is still $100,000, but the description of the common stock has changed: Common stock, $1 par value, 200,000 shares authorized, 20,000 shares issued and outstanding $ 20,000 Retained earnings 80,000 Total stockholders’ equity $100,000 The market price per outstanding share would now be $25 per share. Note: No journal entry is necessary.

29. 29 6. Stock Dividends vs Stock Splits Going back to the original IZM information. Assume instead that IZM declared a 100% stock dividend. First, prepare the JEs to record the declaration and distribution of the stock dividend for new shares (10,000 shares x 100% = 10,000 new shares x $2 per share = $20,000): Stock Dividends (RE) 20,000 Stock Div. Distributable 20,000 Stock Div. Distributable 20,000 Common Stock 20,000

30. 30 6. Stock Dividends vs Stock Splits Note the new description for the stock dividend: Common stock, $2 par value, 100,000 shares authorized, 20,000 shares issued and outstanding The total value in SE is still $100,000, but the individual accounts have changed: Common Stock $40,000 Retained Earnings 60,000 Note that the total market price per share would change to $25 per share. Thus, a 2 for 1 stock split and a 100% stock dividend have the same effect on: total stockholders’ equity and market price per share

31. 31 6. Stock Dividends vs Stock Splits However, a stock dividend requires a journal entry, which changes the components of SE (RE and CS). A stock split changes the description of the shares, including the par value per share. Most companies use a stock split to change the market price per share, but some companies use the large stock dividend to achieve the same result.

32. 32 6. Stock Dividends vs Stock Splits To summarize the effects on IZM Company: 100% Stock 2 for 1 After: Dividend Stock Split Total sh. outstanding 20,000 sh. 20,000 sh. Par value per share $2 $1 Market price per share $25 $25 Total stockholders’ eq: $100,000 $100,000 General ledger results: CS account $ 40,000 $ 20,000 RE account $ 60,000 $ 80,000 Reminder: CS was $20,000 and RE was $80,000 before the split or dividend. Since the stock dividend required journal entries, the amounts for CS and RE changed. Since the stock split does not require a journal entry, the amounts for CS and RE do not change. Now work Ex. 9-54.

33. 33 6. RE - Appropriations Companies may choose to “restrict” a portion of their RE for dividend payout. Reasons for this restriction may include activities such as plans for corporate expansion or plans for the retirement of debt. The restriction does not create a cash balance for these plans. It simply indicates intentions. The restriction, or appropriation may be indicated through disclosure, or through a reclassification of retained earnings.

34. 34 6. RE - Appropriations If reclassification is used, the following journal entry is necessary: RE xx RE-Appropriated xx This entry will create “two” retained earnings in the SE section of the balance sheet. (See Slide 12 for an example.) The debit side of the entry reduces “unappropriated” or “unrestricted” RE in the Statement of RE, and the credit side creates a new RE account. Note that the JE does not change total SE, or even change total RE.

35. 35 7. Statement of Stockholders’ Equity To this point, we have discussed the Statement of Retained Earnings as the link between the balance sheet and the income statement. Another statement, the Statement of Stockholders’ Equity, has gained popularity in recent years. This statement includes the change in retained earnings, but also shows the change during the year in all of the SE accounts. Now work comprehensive Ex. 9-51.

36. Ex. 9-49 a. Exchange price? FMV of land = $1,500 Land 1,500 FMV CS 1,250 ($25 x 50) APIC-CS 250 excess b. Exchange price? Not book value. Use FMV of similar land = $11,000. Land 11,000 FMV CS 11,000 (no par) ------------------------------------------------------------------- What if market price per share (in b) was $60 per share? Use market price (most objective measure) to determine FMV: $60 x 200 shares = $12,000. Land 12,000 mkt value of stock CS 12,000 mkt value of stock

37. Ex. 9-39 a.PS outstanding = $500,000/$100 = 5,000 shares b. CS outstanding = $400,000/$10 = 40,000 shares (but check for treasury stock - none here) c. Avg issue price [(par + APIC)/shares]: PS = ($500,000 + 25,000)/5,000 = $105 per sh. CS = ($400,000 + 200,000)/40,000 = $15 per sh. d.Total contributed capital = 500,000+400,000+200,000+25,000 = $1,125,000

38. Ex. 9-40 (TS journal entries) 2/1 Purch. 800 x $25 per share cost = $20,000 TS 20,000 Cash 20,000 6/15 Reissued 500 @ $29 = $14,500 cash Cash 14,500 TS 12,500 (500 x $25) APIC - TS 2,000 excess 7/15 Reissued 300 @ $24 = 7,200 cash Cash 7,200 TS 7,500 (300 x $25)

39. Ex. 9-54 (b,c) Note: omit part (a). Small stock dividends are not covered in this course. Shares outstanding? 800,000/10 = 80,000 shares

40. Ex. 9-54 Shares outstanding? 800,000/10 = 80,000 shares b. 40% (large) stock dividend = 80,000 sh. x .40 = 32,000 new shares At declaration: (capitalize par value of $10 x 32,000 = $320,000) Retained Earnings 320,000 (par) C.S. Dividend Distributable 320,000 (par) At distribution: C.S. Div. Distributable 320,000 (par) CS 320,000 (par)

41. Ex. 9-54 Shares outstanding? 800,000/10 = 80,000 shares c. 100% stock split - journal entry? NONE Description of stock will change (new certificates issued): Common Stock, $5 par, 160,000 shares issued and outstanding $800,000 (Note: no effect on Retained Earnings.)

42. Ex. 9-51 (+, -, 0, ?) BV/shares = Journal entry CS RE SE BV per share a. RE xx Div. Pay. xx b. TS xx APIC xx c. TS xx Cash xx d. RE xx CS xx e. RE xx Cash xx f. RE xx RE-Approp xx g. Cash xx TS xx APIC-TS xx