PRINCIPLES OF ACCOUNTING II

Chapter 6
ACCOUNTING FOR CORPORATIONS
5.1 Nature of a Corporation
A corporation is a legal entity, an artificial legal “person”, created on the approval of the appropriate
governmental authority. To form a corporation, the incorporators (often at least three are required)
must apply for a charter. The incorporators prepare and file the articles of incorporation, which
delineate the basic structure of the corporation, including the purposes for which it is formed, the
amount of capital stock to be authorized, and the number of shares into which the stock is to be
divided. If the incorporators meet the requirements of the law, the government issues a charter or
certificate of incorporation. After the charter has been granted, the incorporators (or the subscribers
to the corporation’s capital stock) hold an organization meeting to elect the first board of directors
and adopt the bylaws of corporations.

Because assets are essential to corporate operations, the corporation issues certificates of capital stock
to obtain the necessary funds. As owners of the corporation, stockholders, or shareholders, are
entitled to a voice in the control and management of the company. Stockholders with voting stock
may vote at the annual meeting and participate in the election of the board of directors. The board of
directors is responsible for the overall management of the corporation. Normally the board selects
such corporate officers as a president, one or more vice-presidents, a controller, and a treasurer. The
officers implement the policies of the board of directors and actively manage the day to day affairs of
the corporation.

Creating a corporation is more costly than organizing a proprietorship or partnership. The

expenditures incurred to organize a corporation are charged to Organization Costs, an intangible
asset account. These costs include attorney’s fees, fees paid to the government, and costs of
promoting the enterprise. Organization costs typically are amortized.
5.2 Characteristics of Corporations
 Separate Legal Entity: A business with a corporate charter is empowered to conduct business
affairs apart from its owners. The corporation, as a legal entity, may acquire assets, incur debt,
enter into contracts, sue, and be sued all in its own name. The owners, or stockholders, of the
corporation receive stock certificates as evidence of their ownership interests; the
stockholders, however, are separate and distinct from the corporation. This characteristic
contrasts with proprietorships and partnerships, which are accounting entities but not legal
entities apart from their owners. Owners of proprietorships and partnerships can be held
responsible separately and collectively for unsatisfied obligations of the business.

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  Limited Liability: The liability of shareholders with respect to company affairs is usually
limited to their investment in the corporation. Because of this limited liability, laws restrict
distributions to shareholders. To protect creditors, the government controls the distribution of
contributed capital. Distributions of retained earnings (undistributed profits) are not legal
unless the board of directors formally declares a dividend. Because of the legal delineation of
owner capital available for distribution, corporations must maintain careful distinctions in
the accounts to identify the different elements of stockholders’ equity.
 Transferability of Ownership: Shares in a corporation may be routinely transferred without
affecting the company’s operations. The corporation merely notes such transfers of ownership
in the stockholder records (ledger). Although a corporation must have stockholder records to
notify shareholders of meetings and to pay dividends, the price at which shares transfer
between owners is not recognized in the corporation’s accounts.
 Continuity of Existence: Because routine transfers of ownership do not affect the affairs of a
corporation the corporation is said to have continuity of existence. In this respect, a
corporation is completely different from a partnership. In a partnership, any change in own -
ership technically results in dissolution of the old partnership and formation of a new one. In
a partnership, the individual partners’ capital accounts indicate their relative interests in the
business. The stockholders’ equity section of a corporate balance sheet does not present
individual stockholder accounts. A shareholder, however, can easily compute his or her
interest in the corporation by calculating the proportion of the total shares outstanding that
his or her shares represent.
For example, if only one class of stock is outstanding and it totals 1,000 shares, an individual owning
200 shares has a 20% interest in the total stockholders’ equity of the corporation, which includes all
contributed capital and retained earnings. The dollar amount of this interest, however, is a book
amount, rarely coinciding with the market value. A stockholder who liquidates his or her investment
would sell it at a price negotiated with a buyer or, if the stock is traded on a stock exchange, at the
exchange’s quoted market price.
 Capital-raising Capability: The limited liability of stockholders and the ease with which
shares of stock may be transferred from one investor to another are attractive features to
potential stockholders. These characteristics enhance the ability of the corporation to raise
large amounts of capital by issuing shares of stock. Because both large and small investors
may acquire ownership interests in a corporation, a wide spectrum of potential investors
exists.
 Taxation: As legal entities, corporations are subject to income taxes on their earn ings, whether
distributed or not. In addition, shareholders must pay income taxes on earnings received as
dividends. Therefore, corporate income is subject to double taxation.

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  Regulation and Supervision: Corporations are subject to greater degrees of regulation and
supervision than are proprietorships and partnerships. The laws limit the powers a
corporation may exercise, identify reports that must be filed, and define the rights and
liabilities of stockholders. Furthermore, corporations whose stock is listed and traded on
organized security exchanges are subject to the various reporting and disclosure
requirements of these exchanges.
5.3 Nature and Types of Stock in a Corporation
The corporate charter may specify a face value, or par value, for each share of a stock of any class.
Par values are typically set at amounts well below the stock’s market value at date of issue. Par value
today, therefore, has no economic significance. However, par value may have legal implications. In
some countries, par value may represent the minimum amount that must be paid-in per share of
stock. If stock is issued at a discount (that is, at less than par value), the stockholder may have a
liability for the discount if creditors’ claims remain unsatisfied after the liquidation of the company.
Issuing stock at a discount is a rare event, because boards of directors have generally established par
values below market values at time of issue.

Par value may also be used in some laws to define the legal capital of a corporation. The legal capital
is the minimum amount of contributed capital that must remain in the corporation as a margin of
protection for creditors. A distribution of assets to stockholders would not be allowed if it reduced
stockholders’ equity below the amount of legal capital. Given the role that par value may play in
defining legal capital, accountants carefully segregate and record the par value of stock transactions
in an appropriate capital stock account.

The laws of most countries permit the issuance of stock without par value that is, no par stock. The
company’s board of directors usually sets a stated value for the no-par stock. In such cases, the stated
value will determine the corporation’s legal capital. Again, the stated value figure is usually set well
below market value at time of issue, but in contrast to par value, the stated value is not printed on the
stock certificate. For accounting purposes, stated value amounts are treated in a fashion similar to
par value amounts. In the absence of a stated value, the entire proceeds from the issuance of no-par
stock will likely establish the legal capital of the corporation.
5.4 Classification of Stock
The amounts and kinds of stock that a corporation may issue are enumerated in the company’s
charter. Providing for several class of stock permits the company to raise capital from different types
of investors. The charter also specifies the corporation’s authorized stock, the maximum number of
shares of each class of stock that may be issued. A corporation that wishes to issue more shares than

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its authorized number must first amend its charter. Shares that have been sold and issued to
stockholders constitute the issued stock of the corporation. The corporation may repurchase some of
this stock. Shares actually held by stockholders are called outstanding stock, whereas those
reacquired by the corporation (and not retired) are treasury stock. The stocks that are issues and held
by the corporation are referred to as outstanding stock.
5.4.1 Common Stock
When only one class of stock is issued, it is called common stock. Common shareholders compose the
basic ownership class. They have rights to vote, to share in earnings, to participate in additional
issues of stock, and in the case of liquidation to share in assets after prior claims on the corporation
have been settled. We now consider each of these rights. As the owners of a corporation, the
common shareholders elect the board of directors and vote on other matters requiring the approval
of owners. Common shareholders are entitled to one vote for each share of stock they own. Owners
who do not attend the annual stockholders’ meetings may vote by proxy (this may be the case for
most stockholders in large corporations). A common stockholder has the right to a proportionate
share of the earnings of the corporation that are distributed as dividends. All earnings belong to the
corporation, however, until the board of directors formally declares a dividend.

Each shareholder of a corporation has a preemptive right to maintain his or her proportionate
interest in the corporation. If the company issues additional shares of stock, current owners of that
type of stock receive the first opportunity to acquire, on a pro-rata basis, the new shares. In certain
situations, management may request shareholders to waive their preemptive rights. For example, the
corporation may wish to issue additional stock to acquire another company. Further, stockholders of
firms incorporated in some states do not receive preemptive rights.

A liquidating corporation converts its assets to a form suitable for distribution, usually cash, which it
then distributes to parties having claims on the corporate assets. Any assets remaining after all claims
have been satisfied belong to the residual ownership interest in the corporation the common
stockholders. These owners are entitled to the final distribution of the balance of the assets.
5.4.2 Preferred Stock
Preferred stock is a class of stock with various characteristics that distinguish it from common stock.
Preferred stock has one or more preferences over common stock, usually with reference to: (1)
Dividends and (2) Assets when the corporation liquidates.
To determine the features of a particular issue, we must examine the stock contract. The majority of
preferred issues, however, have certain typical features, which we discuss below.

 Dividend Preference

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When the board of directors declares a distribution of earnings, preferred stockholders are entitled
to a certain annual amount of dividends before common stockholders receive any distribution. The
amount is usually specified in the preferred stock contract as a percentage of the par value of the
stock or in dollars per share if the stock does not have a par value. Thus, if the preferred stock has a
Br 100 par value and a 6% dividend rate, the preferred shareholders receive Br 6 per share in
dividends. However, the amount is owed to the stockholders only if declared.
Preferred dividends are usually cumulative—that is, regular dividends to the preferred stockholders
omitted in past years must be paid in addition to the dividend of the current year before any
distribution is made to common shareholders. For example, a dividend may not be declared in an
unprofitable year. If the Br 6 preferred stock dividend mentioned above is one year in arrears and a
dividend is declared in the current year, preferred shareholders would receive Br 12 per share
before common shareholders received anything.
If a preferred stock is non-cumulative, omitted dividends do not carry forward. Because investors
normally consider the non-cumulative feature unattractive, non-cumulative preferred stock is rarely
issued.

Dividends in arrears (that is, omitted in past years) on cumulative preferred stock are not an
accounting liability and do not appear in the liability section of the balance sheet. They do not
become an obligation of the corporation until the board of directors formally declares such
dividends. Any arrearages are typically disclosed to investors in a footnote to the balance sheet.
 Asset Distribution Preference
Preferred stockholders normally have a preference over common stockholders as to the receipt of
assets when a corporation liquidates. As the corporation goes out of business, the claims of creditors
are settled first. Then, preferred stockholders have the right to receive assets equal to the par value of
their stock or a larger stated liquidation value per share before any assets are distributed to common
stockholders. The preferred stockholders’ preference to assets in liquidation also includes any
dividends in arrears. Preferred stocks may also be classified into participating and non-participating.
Participating preferred stock refers to preferred stock that has a right to a stated dividend and, after
common stock has been paid a dividend, can participate in any excess dividends. Nonparticipating
preferred stock does not have this right.

5.5 Issuance of Stocks

Capital stock may be issued at par, above par, or below par. Par value is not an indicator of market
value – it is strictly a legal matter. When stock is issued above or below par, the excess or deficiency
is recorded in a Premium Account called Paid-in Capital in Excess of Par, or, if no balance exists in
this account, in a Discount Account. Stock can be issued for cash, plant assets, legal services, or on

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account. Treasury stocks are those shares that are re-acquired and held by the corporation. The
number of shares currently owned by stockholders; that is, the number of shares authorized minus
the total number of un-issued shares and minus the number of treasury-shares.

Illustration 1, assume that the corporate charter of XYZ Company specifies "authorized capital stock,
100,000 shares, par value Br.1 per share. Further, assume that to date, XYZ Corporation has sold and
issued 30,000 shares of its capital stock.

 The stocks can be summarized as follows:

Authorized shares 100,000
Issued shares 30,000
Un-issued shares 70,000
 If the corporation has repurchased 1,000 shares to date, the authorized shares, treasury
stocks, un-issued stocks, and outstanding stocks will be as follows:
Authorized shares 100,000
Treasury stock (1,000)
Un-issued shares (70,000)
Outstanding shares 29,000 shares
 The stockholders’ equity accounts of a corporation represent the two primary sources of
stockholders' equity:
1. Contributed capital from the sale of stock, which is the amount invested by stockholders through
the purchase of shares of stock from the corporation. Contributed capital has two distinct
components: (a) Par or Stated Value derived from the sale of capital stock, and
(b) Additional Contributed Capital in excess of par or stated value.
(This is often called Additional Paid-In Capital.)
2. Retained earnings generated by the profit-making activities of the company. This is the
cumulative amount of net income earned since the organization of the corporation less the
cumulative amount of dividends paid by the corporation since organization.
 Most companies generate a significant part of their stockholders' equity from retained
earnings rather than from capital raised through the sale of stock.
Sale and Issuance of Capital Stock
Most sales of stock to the public are cash transactions.
Illustration 2, To illustrate accounting for an initial sale of stock, assume that on January 1, 20x5, M
Company sold 100,000 shares of its Br 0.10 par value stock for Br 22 per share.

 The company records the following journal entry:

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 Date Accounts Debit Credit
20X5, Jan. 1 Cash (100,000x Br 22) 2,200,000
Common stock (100,000 x Br. 0.10) 10,000
Paid In Capital in Excess of Par 2,190,000

 Sale of Stock with No-Par-Value

Some corporations do not specify a par value for their stock. In these cases, depending on the
law, common stock is recorded under one of the following two approaches:

1. Using Stated Value: The corporation must specify in its bylaws a stated value per share as
legal capital. This stated value is used as a substitute for par value, and the sale of common
stock is recorded in a manner similar to the previous journal entry.

Date Accounts Debit Credit

20X5, Jan. 1 Cash (100,000x Br 22) 2,200,000
Common stock (100,000 x Br. 0.10) 10,000
Paid In Capital in excess of Stated Value 2,190,000
2.
Recording the whole proceeds as a Legal Capital: The corporation must record the total
proceeds received from each sale of no-par stock as legal capital. In this case, the total
proceeds are recorded in the Common Stock account and there is no account called
Capital in Excess of Par.

Date Accounts Debit Credit

20X5, Jan. 1 Cash (100,000 x Br 22) 2,200,000
Common stock (100,000 x Br 22) 2,200,000

5.6 Treasury Stock

Capital stock that is reacquired by a corporation is termed Treasury Stock. Treasury stock has no
voting, dividend, or other stockholder rights. Stock can be reacquired for various reasons, such as to
have shares available for distribution to employees under bonus plans, and to support the market
price of the stock by stimulating trading in it. If treasury stock is resold, no gain or loss is recognized
on the exchange because the corporation’s primary objective is not to make profit by trading in its
own stock. In addition, the treasury stocks are not assets; rather they are deductions from
stockholders equity. The recording of the purchase of treasury stock is based on the cost of the shares
that were purchased.

Illustration 5, Assume that On April 1, 20x5, M Company bought 100,000 shares of its stock in the
open market when it was selling for Br 22 per share.

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  Using the cost method, the company records the following journal entry:

Date Accounts Debit Credit

20X5, Apr. 1 Treasury stock (100,000 x Br 22) 2,200,000
Intuitively,
Cash 2,200,000
many students
expect the Treasury Stock account to be reported as an asset. This is not the case because a company
cannot create an asset by investing in itself. The Treasury Stock account is actually a contra equity
account, which means that it is reported as a subtraction from the total stockholders' equity. This
makes sense because treasury stock is stock that is no longer outstanding, and therefore, should not
be included as part of stockholders' equity.
If M Company eventually sells its treasury stock; it will not report an accounting profit or loss on the
transaction even if it sells the stock for more or less than it paid. GAAP do not permit a corporation to
report income or losses from investments in its own stock because transactions with the owners are
not considered to be normal profit- making activities.

Illustration 6, Based on the previous example, assume that on April 15, M Company sold 10,000
shares of treasury stock for Br30 per share. Remember that the company had purchased the stock for
Br22 per share.
 M Company records the following entry:

Date Accounts Debit Credit

20X5, Apr. 15 Cash (10,000 x Br 30) 300,000
Treasury Stock 220,000
Paid in capital from sale of treasury sock 80,000

If treasury stock were sold at a price below its purchase price (i.e., on a ‘loss’), the Paid in Capital
from sale of Treasury Stock account would be debited for the amount of the loss. Retained Earnings
would be debited for some or the entire amount of the ‘losses’ only if there were an insufficient
credit balance in the Paid in Capital from sales of Treasury Stock account. In some cases a
corporation may receive some of its stocks through donation. The Donated Capital account (or
Contributed Capital account) is credited for the market value of the shares at the date of acquisition.
Illustration 7, For example, assumes that on March 1, 20x5, M Company received 1000 shares form
stockholders in donation. If the market price per share is Br 100, the following entry would be
prepared:

Date Accounts Debit Credit

20X5, Mar. 1 Treasury Stock 100,000
Donated Capital [1,000 x Br 100] 100,000
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  Neither the purchase nor sale of treasury stock affects the number of shares of stock that are
issued or un-issued. Treasury stock affects only the number of shares of outstanding stock; the
basic difference between treasury stock and un-issued stock is that treasury stock has been
sold at least once.
Therefore, the stockholders equity section could be presented as follows:
Paid in Capital:
Common Stock Br xxxxx
Capital in Excess of Par xxxxx xxxxx
Donated Capital xxxxx
Retained Earnings xxxxx xxxxx
Less: Treasury Stock xxxxx
Total Stockholders' Equity Br xxxxx
5.7 Cash Dividend
Investors who purchase preferred stock give up certain advantages that are available to investors in
common stock. Generally, preferred stockholders do not have the right to vote at the annual meeting,
nor do they share in increased earnings if the company becomes more profitable. To compensate
these investors, preferred stock offers some advantages not available to common stockholders.
Perhaps, the most important advantage is dividend preference.
You will frequently encounter the following dividend preferences:
1. Current dividend preference.
2. Cumulative dividend preference.
Preferred Stock always carries a current dividend preference. It requires that the current preferred
dividend be paid before any dividends are paid on the common stock. When the current dividend
preference has been met and no other preference is operative, dividends can be paid to the common
stockholders.
Declared Dividends must be allocated between the preferred and common stock. First, the
preferences of the preferred stock must be met, and then the remainder of the total dividend can be
allocated to the common stock.
Cumulative Preferred Stock has a cumulative dividend preference that states if all or a part of the
specified current dividend is not paid in full, the unpaid amount becomes dividends in arrears. The
amount of any cumulative preferred dividends in arrears must be paid before any common
dividends can be paid. Of course, if the preferred stock is non-cumulative, dividends never can be in
arrears. Therefore, the preferred stockholders lose permanently any dividends passed (i.e., not
declared). Because preferred stockholders are not willing to accept this unfavorable feature,
preferred stock is usually cumulative.

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Dividends are never an actual liability until the board of directors declares them. Dividends in
arrears are not reported on the balance sheet, but are disclosed in the notes to the statements. The
allocation of dividends between cumulative preferred stock and common stock should be strict in
accordance with the stock contract. But, generally, we follow the steps below:
Step 1: Allocate dividends in arrears to the preferred stock,
Step 2: Allocate current year dividend to the preferred stock,
Step 3: If the preferred stocks are participating, allocate matching dividends to common stock.
This is dividend comparable to the current year dividend of the preferred stock. For example, if
the current year dividend to preferred stock is 5 % of par, the common stock will also be entitled
to 5% of their stock’s par value. If the current year dividend to the preferred stock is Br 2 per
share, the comparable dividend will also be Br 2 per share to the common stock
Step 4: If there is a balance after step 3, it is allocated to both preferred and common stock.
 If the preferred stocks are non-participating, the entire remaining amount after step 2 will be
given to common stock.
Illustration 9, Assume the following:
 Preferred stock outstanding, 6%, par Br 20; 2,000 shares Br 40,000
 Common stock outstanding, par Br. 10; 5,000 shares 50,000
 Assume that the dividends are in arrears for 1 year, &
preferred stocks are cumulative and participating.
 If the amount of cash dividend declared is Br 50,000 it will be allocated as follows:
Preferred Common Total .
Par Value Br 40,000 Br 50,000 Br 90,000
Total Dividend Br 50,000
1. Dividends in arrears [0.06x 40,000] 2,400 (2,400)
Remaining amount 47,600
2. Current year dividend to preferred 2,400 (2,400)
Remaining amount 45,200
3. Matching dividend to common stock [0.06 x 50,000] 3,000 (3,000)
Remaining amount 42,200
4. To both classes of shares:
[42,200/90,000=0.47] [0.47 x 40,000; 0.47 x 50,000] 18,756 23,444 (42,200)
Total 23,556 26,444 50,000
Notice that all the four steps are applied in this example because there were dividends in arrears and
the preferred stocks were cumulative and participating.
 On the date of declaration of the dividends, say December 31, 20x5, the following entry
is prepared:

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 Date Accounts Debit Credit
20X5, Dec. 31 Dividends 50,000
Dividend Payable: Preferred 23,556
Dividend Payable: Common 26,444

 The dividends account would be closed as follows:

Date Accounts Debit Credit

20X5, Dec. 31 Retained Earnings 50,000
Dividends 50,000

 If the dividends are paid out on January 1, 20x6, the following entry would be prepared:

Date Accounts Debit Credit

20X6, Jan 1 Dividend Payable: Preferred 23,556
Dividend Payable: Common 26,444
Cash 50,000

 If we assume that the preferred stocks are non-cumulative non-participating, the dividends
would be allocated as follows:
Preferred Common Total .
Par Value Br 40,000 Br 50,000 Br 90,000
Total Dividend Br 50,000
1. Current year dividend to preferred 2,400 (2,400)
Remaining amount 47,600
2. All the remaining amounts to Common Stock ____ 47,600 (47,600)
Total 2,400 47,600 50,000
5.8 The Statement of Stockholders’ Equity
The statement of stockholders’ equity is prepared periodically to summarize the changes that have
occurred in the stockholders’ equity of the corporation. In some cases, the statement of retained
earnings is prepared instead of the statement of Stockholders’ equity. This represents a fairly typical
statement of changes in retained earnings. Under rare circumstances, you may see a statement that
includes an adjustment to the beginning balance of retained earnings. This adjustment is called a
prior period adjustment, which is a correction of an accounting error that occurred in the financial
statements of a prior period.

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5.9 Equity Per-Share
Equity per share (EPS) is the ratio of stockholder's equity to the related number of shares of stock
outstanding. If there is only one class of shares (common stock), equity per share is computed as
follows:
EPS= Total Stockholder's Equity
No. of Shares Outstanding
If there are both common and preferred shares, we have to allocate the total equity to preferred and
common stock. The equity to preferred stock is the liquidation value. The liquidation value is the
amount that the preferred stockholders can claim if the corporation is liquidated. The equity to
preferred stock includes the dividends in arrears. If the equity to the preferred stock is determined,
the common equity is computed by deducting equity to preferred stock from the total equity.
Then, EPS would be computed as follows:(If both are there)

Preferred EPS = Equity Allocated to Preferred Stock .

No. of Outstanding Shares of Preferred Stock

Common EPS = Equity Allocated to Common Stock .

No. of Outstanding Shares of Common Stock
The Retained Earnings account is a stockholders’ equity account with a normal credit balance. As a
result of net losses, however, a debit balance in Retained Earnings may occur. Such a balance is
called a deficit. The deficit reduces the total stockholders’ equity of the corporation.

Illustration 10, Assume that the following balances appear on the balance sheet of ABC Company:

Common stock, Br 10 par Br 600,000

Paid in Capital in excess of par 120,000
Deficit 75, 000

Total stockholders’ equity is Br 645,000 (Br 600,000 + Br 120,000 – Br 75,000) and the number of
share is 60,000 (Br 600,000/Br 10). The business has only common stock and hence, the EPS is:
645,000/60,000 = 10.75

Illustration 11, Assume the following data:

Preferred, 10% stock, Br 50 par Br. 2,500,000
Premium on preferred stock 275,000
Common stock, Br. 25 par 3,750,000

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 Deficit 1,240,000

Assume also that Preferred stock has prior claim to assets on liquidation to the extent of 110% of par.
 To compute EPS, let us first split the total equity into the two classes of shares:
Total Equity:
Preferred, 10% stock, Br 50 par Br. 2,500,000
Premium on preferred stock 275,000
Common stock, Br. 25 par 3,750,000
Deficit (1,240,000) Br 5,285,000
Less: Equity to preferred stock (110% x 2,500,000) 2,750,000
Equity to Common Stock Br 2,535,000
Therefore, Preferred EPS = Br 2,750,000 = Br 55.00
2,500,000/Br 50

Common EPS = Br 2,535,000 = Br 16.90

3,750,000/Br 25

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