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Chapter 11

Chapter 11. Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings. Objectives of The Chapter. 1. Basic characteristics of a corporation. 2. Accounting for issuance of common stock and preferred stock. 3. Accounting for treasury stock.

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Chapter 11

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  1. Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings

  2. Objectives of The Chapter • 1. Basic characteristics of a corporation. • 2. Accounting for issuance of common stock and preferred stock. • 3. Accounting for treasury stock. • 4. Retained earning and dividends. Stockholders' Equity

  3. I. Corporations: An Overview • A form of business entity formed under state law. • It is established as a legal entity separated from its owners. • It has all rights as a person has except for voting and holding public offices. • The owners of corporations have limited liabilities. Stockholders' Equity

  4. Procedures of Forming a Corporation • 1. Incorporators apply for a charter by submitting articles of incorporation to state officials. • 2. If the application is approved, the state will issue a charter. • The corporation is formed upon the issuance of the charter. • A charter is a document to give legal status and other rights to a corporation. Stockholders' Equity

  5. Procedures of Forming a Corporation (contd.) • 3. A stockholders’ meeting would be held at which the initial issuance of capital stock is made to the incorporators and by-laws are developed. • A board of directors is elected. • 4. Ready for operations. • 5. Issuance of stock to public to raise more capital (IPO). • Note: Regardless of the number of states in which a corporation operating, it is incorporated in one state. Stockholders' Equity

  6. Organization of a Corporation • a. Stockholders (owners) • b. Board of directors; a chairperson is elected among board of directors. • The board • decides major operation principles. • arranges major loans, authorize contracts. • appoints officers such as CEO,COO,President, vice president. • c. Management (i.e., CEO,COO,etc.): • Responsible for day-to-day operations and the preparations of the financial statements. Stockholders' Equity

  7. Advantages of a Corporation • 1. Separated legal entity. • 2. Stockholders have limited liability. • 3. Continuous existence. • 4. Ease of transfer of ownership. • 5. Ease of capital generation. • 6. Centralized authority and responsibility -- to the president, not to numerous owners. • 7. Professional management. Stockholders' Equity

  8. Disadvantages of a Corporation • 1. Government regulations. • 2. Corporation taxes (double taxation). • 3. Separation of ownership and control: principal & agent conflicts. Stockholders' Equity

  9. The Stockholders’ Equity Section of a Balance Sheet The Stockholders’ Equity Section of a Balance Sheet • Preferred stock, 7%, $100 par, 5,000 shares authorized, • 700 shares issued $ 70,000 • Paid-in capital in excess of par -- preferred 7,000 • Common stock, $10 par, 20,000 shares authorized, • 6,500 shares issued 65,000 • Paid-in capital in excess of par -- common 70,000 • Retained earnings 95,000 • Treasury stock -- common, 500 shares at cost (12,000) • Total Stockholders’ Equity $295,000 • _________ Stockholders' Equity 9

  10. Terminology Related to Stockholders’ Equity of a Corporation • 1. Contributed Capital: the portion of stockholders’ equity contributed by investors through the issuance of stock. • 2. Legal Capital (eliminated by Model Business Corporation Act) : the amount of contributed capital not available for dividends. Stockholders' Equity

  11. Terminology Related to Stockholders’ Equity of a Corporation (contd.) • 3. Outstanding Stock: issued stock held by investors. • 4. Treasury Stock: issued stock repurchased by the corporation and held by the corporation, not retired. • 5. Authorized Capital: The number of shares of stock that the corporation may issue as stated in its corporate charter. Stockholders' Equity

  12. Terminology Related to Stockholders’ Equity of a Corporation (contd.) • 6. Common Stock: A class of stock with rights to share proportionately in: • (a) profits and losses; • (b) management (i.e., voting in corporate matters, one share one vote); • (c) corporate assets in liquidation; • (d) any new issues of stock of the same class (to maintain one’s proportionate ownership in corporation). • Note: companies can have more than one class of stock with different rights. Stockholders' Equity

  13. Terminology Related to Stockholders’ Equity of a Corporation (contd.) • 7. Preferred Stock: A class of stock with some rights such as: • (a) Dividends (with a higher priority than that of common stock); • (b) Sharing assets in liquidation (with higher priority than that of common stock). Stockholders' Equity

  14. Terminology Related to Stockholders’ Equity of a Corporation (contd.) • 8. Par Value Stock: Capital Stock with a nominal dollar amount printed on the stock certificate. In the past, most states designate the par value of all issued stock as the legal capital. Stockholders' Equity

  15. Terminology Related to Stockholders’ Equity of a Corporation (contd.) • 9. No-Par Stock: capital stock without a par value. Many states allow the board of directors to establish a stated value, as the legal capital. • Since the concept of par value and legal capital has been eliminated by Model Business Corporation Act, the no-par-value stock has gained its popularity. Stockholders' Equity

  16. Terminology Related to Stockholders’ Equity of a Corporation (contd.) • Examples of companies with no-par-value stock: Nike, Procter & Gamble and North American Van Lines (source: Financial Accounting by Weygadt, etc.). • However, there are companies which issued par value stock prior to the changes in the state law and continued to issue previously authorized par value shares. Stockholders' Equity

  17. Terminology Related to Stockholders’ Equity of a Corporation (contd.) • 10. Stated Value: a nominal value assigned to no-par stock by board of directors. • 11. Additional Paid-in Capital (or Paid-in Capital in Excess of Par Value or Premium on Capital Stock): the excess of the issuance price over the par value or the stated value. Stockholders' Equity

  18. 2. Accounting for Issuance of Stock • a. Stock issued for cash • b. Stock issued for services or noncash assets. Stockholders' Equity

  19. Stock Issued for Cash –common stock with par value • Example 1: (See p539 of textbook for an example of a stock certificate) • Issued 1,000 shares of $10 par common stock for $50 per share. • Journal Entry • Cash 50,000 • Common Stock 10,000 • Paid-in Capital in Excess • of Par--Common Stock 40,000 Stockholders' Equity

  20. Stock Issued for Cash (contd.) • Example 2: (Preferred Stock with Par) • Issued 1,000 shares of $10 par preferred stock for $30 per share. • Journal Entry • Cash 30,000 • Preferred Stock 10,000 • Paid-in Capital in Excess • of par -- Preferred Stock 20,000 Stockholders' Equity

  21. Stock Issued for Cash (contd.) • Example 3 (Common stock with stated value • set by the board of directors) • Issued 1,000 shares of no-par common stock with a stated value $1 per share. Shares are issued at $5 per share. • Journal Entry • Cash 5,000 • Common Stock 1,000 • Paid-in Capital in Excess • of Stated Value 4,000 Stockholders' Equity

  22. Stock Issued for Cash (contd.) • Example 4 (No-par common stock • without stated value) • Issued 1,000 shares of no-par and no stated value common stock for $5 per share. • Journal Entry • Cash 5,000 • common Stock 5,000 Stockholders' Equity

  23. Stock Issued for services or noncash assets • Principle: Stock issued for service or property should be recorded either at the fair value of the stock or at the fair value of the property, whichever is more clearly determinable (reliable). • In most cases, if stock is traded frequently, the fair value of stock is used. • Otherwise, use the market value of the property. Stockholders' Equity

  24. Stock Issued for Noncash Proposition (contd.) • Example: issued 1,000 shares of $5 par C.S. for building. The market value of the stock is $15 per share and is traded frequently. • Journal Entry: • Building 15,000 • C.S. 5,000 • Additional paid-in Capital • in excess of par -- C.S. 10,000 Stockholders' Equity

  25. Preferred Stock Characteristics • 1. Preference as to dividends: holders have a preference to dividends. • 2. The annual dividends are expressed as percentage of the par value. • If no-par preferred stock is issued, the dividend is expressed as a dollar amount per share. Stockholders' Equity

  26. Preferred Stock Characteristics (contd.) • 3. A preference to dividends does not guarantee a preferred dividend payment. • Dividend payment is at the discretion of the board of directors. • 4. If dividends are “passed” (not declared or amounts declared less than the stated dividends) in a year, a holder of non cumulative preferred stockholder will never be paid those dividends. Stockholders' Equity

  27. Cumulative Preferred Stock • However, the amount of passed dividends becomes “dividends in arrears” for a cumulative preferred stock. • Dividends in arrears accumulate from period to period. • Dividends in arrear have the highest priority to be paid in the future if dividends were declared in the future. Stockholders' Equity

  28. Dividends Allocation: Examples • Year 1: Case I: • Dividends declared = $10,000 • Com. STK shares outstanding: 10,000, @$5 • Preferred STK outstanding : 5,000, @$10, dividend is 6% of the par value • Dividends for P.S. = 6% *10*5,000= $3,000. • Dividends for C.S. = ($10,000-3,000)=$7,000. • Or $0.7 per share ($7,000/10,000 shares) Stockholders' Equity

  29. Dividends Allocation: (contd.) • Case II: Same information as in Case I except that dividends declared = $1,000. • Dividends for P.S. = $1,000. Div. Passed=$2,000 • Dividends for C.S. = $0 • If this is a cumulative P.S. the dividends in arrears equal $2,000 ($3,000-1,000). • If this is a non-cumulative P.S., the $2,000 will never been paid. Stockholders' Equity

  30. Dividends Allocation (contd.) • Case III: • Same information as in Case I except that dividends declared = $500. • Dividends for P.S. = $500. • Dividends for C.S. = $0 • If this is a cumulative P.S. the dividends in arrears equal $2,500 ($3,000-500). • If this is a non-cumulative P.S., the $2,500 will never been paid. Stockholders' Equity

  31. Dividends Allocation (Contd.) • Year 2: Continued from Case II of year 1, assuming a cumulative preferred stock and the dividends declared = $8,000. • Dividends for P.S. => $2,000 (div. In arrears) • $3,000 (div. Of year 2) $ 5,000 • Dividends for C.S. => $8,000- $2,000-3,000 = $3,000 Stockholders' Equity

  32. Convertible Preferred Stock (skip) • Convertible preferred stock allows stockholders, at their option, under specified conditions to convert the shares of preferred stock into another security of the corporation. Stockholders' Equity

  33. Accounting for Conversion of Preferred to Common Stock (skip) • Book value method is used. • Example: A corporation issued 500 shares of $100 par convertible preferred stock at $120 per share. If each preferred share is converted into 4 shares of $20 par common stock, the following entry will be recorded: • Preferred Stock 50,000 • Additional Paid-in Capital on P.S 10,000 • Common Stock 40,000 • Additional Paid-in capital • -- Common Stock 20,000 Stockholders' Equity

  34. 3. Treasury Stock • Treasury stock is issued stock that has been purchased back (reacquired) by the issuing corporation. • Treasury stock carries no voting or preemptive rights, no right to dividends, and no right at liquidation. • However, it does participate in stock split. Stockholders' Equity

  35. Treasury Stock (contd.) • Reasons of acquiring treasury stock: • 1. To use for stock option, bonus and employee purchase plans; • 2. To use in the conversion of convertible preferred stock or bonds; • 3. To use excess cash and help maintain the market price of its stock; to increase EPS; • 4. To use in the acquisition of other companies; • 5. To use for stock dividend; • 6. To reduce the number of shares held by outside shareholders and thereby reduce the likelihood of being acquired by another company. Stockholders' Equity

  36. Accounting for Treasury Stock (T.S.) –the Cost Method • Cost Method: • T.S. is recorded at cost paid for transactions: • 1. Issuance of 6,000 shares of $10 par common stock for $12 per share • Cash 72,000 • C.S., $10 par 60,000 • Additional Paid-in Capital • on C.S. 12,000 Stockholders' Equity

  37. Accounting Methods for Treasury Stock (T.S.) (contd.) • 2. Reacquisition of 1,000 shares of C.S. • at $15 per share: • Treasury Stock 15,000 • Cash 15,000 • 3. Reissuance of 600 shares of T.S. • at $17 per share: • Cash 10,200 • T.S. 9,000 • Additional Paid-in Capital • from T.S. 1,200 Stockholders' Equity

  38. Accounting Methods for Treasury Stock (T.S.) (contd.) • 4. Reissuance of another 200 shares of T.S. • at $10 per share • Cash 2,000 • Additional Paid-in Capital • from T.S. 1,000 • Treasury Stock 3,000 Stockholders' Equity

  39. Accounting Methods for Treasury Stock (T.S.) (contd.) • 5. Reissuance of another 100 shares of T.S. • at $8 per share • Cash 800 • Additional Paid-in Capital fm T.S. 200 • Retained Earning 500 • Treasury Stock 1,500 • Note: neither the purchase nor the sale of treasury stock results in a gain or a loss. Sale of T.S. above cost results in an increase in the paid-in capital while sale of T.S. below the cost results in a decrease of paid-in capital or retained earnings. Stockholders' Equity

  40. Balance Sheet Presentation of Treasury Stock • The stockholders’ equity section is prepared after transactions 1-5 as follows: • (Assume retained earnings is $40,000 prior to recording any treasury stock transactions) Stockholders' Equity

  41. Balance Sheet Presentation of Treasury Stock (contd) Balance Sheet Presentation of Treasury Stock (contd) • Cost Method: • Contributed Capital: • Common stock, $10 par (20,000 shares authorized, • 6,000 shares issued, of which • 100 are being held as Treasury Stock) $ 60,000 • Additional paid-in capital on C.S. 12,000 • Total Contributed Capital 72,000 • Retained Earnings (see Note) 39,500 • Total Contributed Capital and Retained Earnings 111,500 • Less: Treasury Stock (100 shares at cost) (1,500) • Total Stockholders’ Equity $110,000 • _________ • Note: Retained Earnings are restricted regarding dividends in the amount of $1,300, the cost of treasury stock. Stockholders' Equity 41

  42. Retirement of Stock • Continuing the treasury stock example: • 6. Retirement of the last 100 shares of T.S. • Common Stock, $10 par 1,000 • *Additional Paid-in • on Common Stock 200 • Retained Earnings 300 • Treasury Stock 1,500 • *[12,000  (100 6,000)] = $200 • Original additional Paid-in Capital on common stock for 6,000 shares. Stockholders' Equity

  43. 4. Retained Earnings and Dividends • The major components of stockholders’ equity are contributed capital and the retained earnings. • Factors that affect retained earnings besides net income (or net loss) include (1) dividends, (2) prior period adjustments, (3) appropriations (voluntary restrictions), and (4) quasi-reorganizations. Stockholders' Equity

  44. Dividends • While the net income increases the retained earnings, the distribution of dividends reduces the retained earnings. • In order to declare dividends, a company must meet legal requirements and must have assets available for distribution. Stockholders' Equity

  45. Dividends (Contd.) • Most companies regard the unrestricted retained earnings as the limit for dividends distribution. • Restrictions of retained earnings include: • 1) Legal restrictions: Many states require corporations to restrict the cost of treasury stock from dividends distribution. • 2)Contractual restrictions: A long-term bond contract may limit the use of assets for payment of dividends , Stockholders' Equity

  46. Dividends (Contd.) • 3)Voluntary restrictions: Appropriation of retained earnings for specific purposes. • The board of directors is responsible for the establishment of dividend policy and the determination of the amount, timing and types of dividends to be declared. Stockholders' Equity

  47. Dividends (contd.) • A few types of dividends may be considered: • (1) cash, (2) property, (3) scrip, (4) stock, and (5) liquidating dividends. • Cash, property and scrip dividends decrease retained earnings (R/E) (and stockholders’ equity); stock dividends decrease R/E and increase contributed capital by the same amount; liquidating dividends decrease con Stockholders' Equity

  48. Cash Dividends • Cash dividend is the most common type of dividend which is the distribution of cash by the corporation to its stockholders. Stockholders' Equity

  49. Cash Dividends • Four dates are relevant to the cash dividends: • (1) the date of declaration, • (2) the ex-dividend date (a few days before the record date), • (3) the date of record (a few weeks after declaration date), and • (4) the date of payment (2-4 weeks after the date of record). Stockholders' Equity

  50. Example • On Nov. 3, 20x2, the board of directors declares preferred dividends totaling $10,000 and common dividends totally $20,000. These dividends are payable on 12/15/x2 to stockholders of record on 11/24/x2. The ex-dividend date is 11/21/x2. The journal entries to record the dividends are: Stockholders' Equity

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