Accounting for the Corporation

Chapter 10
Chapter Outline
 Applications to people within and outside the
firm
 Characteristics of the corporate form of
business
 Common stock
 Preferred stock
 Stock dividends and stock splits
 Stock option
 Treasury stock
 There are more than 9 million
corporations operating in the U.S. today.

About 15,000 of these are publicly traded on

the stock market.
Publicly traded corporations must meet the
reporting requirements of the Securities and
Exchange Commission (SEC).
 APPLICATIONS TO PEOPLE
WITHIN AND OUTSIDE THE FIRM
 Internal users: Managers use financial
reports to make decisions about when to
issue stock, whether to purchase treasury
stock, when dividends should be declared,
and other equity-related issues.
 External users: Investors, analysts, and
government agencies do not have first-hand
access to the details of a company’s
operations, therefore, they depend on the
corporation’s financial reports.
 Characteristics of the Corporate
Form of Business

Why does a business choose to incorporate?

Because of these

advantages…
1. Ease of raising capital

 Corporations can raise large amounts of

capital more easily than sole proprietorships
or partnerships.
 This is because shares of ownership are
purchased by investors.
2. Unique legal entity

 A corporation is a unique legal entity. It is

separate from its owners (stockholders).
 In many respects, a corporation has legal
rights just like a person. For example, a
corporation can purchase, own, and sell
property. It can make legal contracts, sue,
and can be sued.
3. Limited liability
 If a corporation fails to pay its debts, the
stockholders are not held responsible.
 Stockholders have limited liability.
 Limited liability means that stockholders have no
personal liability for corporate liabilities.
 If a corporation goes out of business, the
stock becomes worthless and stockholders
only lose their investment.
4. Ease of ownership transfer

 A corporation can exist forever, even though

its ownership may change.
 Stockholders of major corporations buy and
sell ownership through corporate stock on a
daily basis.
5. Separation of
management and ownership

 The owners of a corporation are the

stockholders.
 The management of a corporation consists
of people who have been hired because
they are qualified to lead and direct the day-
to-day operations.
Some businesses are deterred from
incorporation because of these

disadvantages…
 Regulation (domestic)
 The government carefully regulates corporations.
 U.S. publicly traded corporations must have their
financial statements audited annually by a CPA firm
and filed with the SEC.
 Section 404 of the Sarbanes-Oxley Act requires
corporations to prepare a yearly internal control report.
 Section 404 requires a publicly traded corporation to
disclose its code of ethics for its senior financial
officers.
Regulation (international commerce)
 The Foreign Corrupt Practices Act (FCPA)
prohibits any U.S. public company from
bribing a foreign official in an effort to obtain
business.
 The FCPA requires public companies to
maintain a system of internal accounting
control.
Taxation
 Corporations pay federal and state income
taxes on their earnings.
 When stockholders who receive cash
dividends from a corporation pay personal
income tax on the dividends.
 This is double taxation – those earnings are taxed
first at the corporate level and then a second time
at the individual level.
 Corporations also pay a franchise tax to the
state in which they are incorporated.
Creation & Management
of a Corporation
1. Acquire a charter from a state.
2. The incorporators sign the charter, file
documents with the Secretary of the State,
and establish a set of bylaws to govern the
corporation.
3. The stockholders of the corporation elect a
board of directors.
4. The board constructs corporate policies and
elects a chairperson and officers.
Creation & Management
of a Corporation
 The chairperson of the board, also called
CEO, is usually the highest authority in a
corporation.
 The president, also called COO, is
responsible for daily operations.
 The vice president of finance, also called the
chief financial officer (CFO), typically has two
subordinates: the treasurer and the controller.
A corporate organization chart follows.
 Corporate Organization Chart
Stockholders
Exhibit 10.1
Board of Directors

Chairperson of the Board

(Chief Executive Officer)

President
(Chief Operating Officer)

Vice President Vice President Vice President Vice President

Marketing Production Finance (CFO) Human Resources

Controller Treasurer
(Chief Accountant)
COMMON STOCK
 Corporations can issue two types of stock:
 common stock
 preferred stock

 Common stock is the basic type of stock and

carries voting rights for the stockholder.
 When the word “stock” is used, it is assumed to
be “common stock,” unless another type of
stock is specified.
Rights of stockholders
Common stockholders typically have 4 rights:
1. Vote - one vote for each share of stock.
2. Receive dividends - distributed proportionately to
the number of shares of stock.
3. Liquidation allocation - If the corporation goes out
of business, stockholders are entitled to a
proportionate share of any assets left over after
debt is paid off.
4. Preemption – the right to maintain a proportionate
share of ownership.
Par value
 In the corporate charter, stock is designated
as either par value stock or no-par stock.
 A stock’s par value is an arbitrary amount
determined by the incorporators.
 In many states, a corporation must maintain a
minimum amount of stockholders’ equity,
called legal capital.
 For par value stock, legal capital equals par value
times the number of shares issued.
 The lower the par value, the lower the amount of
legal capital required.
Issuing common stock
 When a corporation is formed, the
incorporators authorize the number of shares
that can be issued.
 Stockholders can vote to authorize additional
shares.
 A corporation may choose to issue only part
of its authorized shares.
 A corporation can buy back its issued stock.
Common stock at par

If stock sells for exactly its par value, the entry

to record the issuance of 10,000 shares is
(assume $10 par value):

Cash (10,000 x $10) 100,000

Common Stock
100,000
 Common stock above par
 Stocks usually sells at a price above par, since
par values are normally set very low.
 If the stock sells for $12 per share instead of the
$10 par value, the entry is:
Cash (10,000 x $12) 120,000
Common Stock (10,000 x $10) 100,000
Additional Paid-In Capital – Common 20,000
(10,000 x $2)
 Common stock above par

Note: The entries just shown are for the issuance

of new stock from the corporation to
stockholders.
Once stock is initially sold, the stock can then be
traded (bought and sold) many times among
investors. These trades do not affect the
accounting records of the corporation.
 Common stock exchanged for
noncash assets
 When a corporation receives noncash assets (such as
land) in exchange for stock, the general rule is to record
the assets at the fair market value of the stock. If the fair
market value of the stock cannot be determined, the fair
market value of the assets can be used.
 Example entry to issue 50,000 shares of $1 par value
common stock in exchange for land:
Land 480,000
Common Stock (50,000 x $1) 50,000
Additional Paid-In Capital – Common 430,000
(480,000 – 50,000)
No-par common stock

 When no-par common stock is issued, the full

amount received is assigned to the common
stock account and there is no additional paid-
in capital.
 The entry for the previous transaction would
be:
Land 480,000
Common Stock 480,000
 Cash dividends to common
stockholders
 A investor can benefit in two ways from buying stock:
 The price of the stock increases, making the
investment is more valuable.
 The stockholder (investor) receives dividends.
 A cash dividend is a distribution of a corporation’s
earnings to stockholders in the form of cash.
 Instead of paying a cash dividend, the board may
decide to reinvest retained earnings in company
operations.
 Cash dividends to common
stockholders
 If the board of directors wants to pay a cash
dividend, two things must be present:
1. Sufficient retained earnings to declare the
dividend.
2. Cash available to pay the dividend.
 Cash dividends to common
stockholders
 There are 3 key dates related to dividends:
 Declaration date – when the board declares

its intent to pay a dividend.

 Date of record - whoever owns the stock on
the date of record will receive the dividend.
 Payment date - the dividend is actually paid.
 Cash dividends to common
stockholders
 The declaration of a cash dividend
establishes a liability for the corporation.
 For example:

Entry on Declaration date:

Retained Earnings 100,000
Dividends Payable 100,000
Entry on Payment date:
Dividends Payable 100,000
Cash 100,000
PREFERRED STOCK
 Preferred stock has preference over common
stock in terms of dividends and the
distribution of assets.
 Preferred stockholders receive dividends
before common stockholders and have
priority in receiving assets in the event of
corporate liquidation.
 Accounting for preferred stock is similar to
common stock.
 Issuing preferred stock
 Example:
10,000 shares of $50 par value preferred stock is
issued for $60 per share:
Cash 600,000
Preferred Stock 500,000
Additional Paid-In Capital – Preferred 100,000
 If the company assigns a dividend to the preferred
stock, payment of this dividend takes precedence over
any dividend payments to common stockholders.
 Cash dividends to
preferred stockholders
 Preferred dividends can be designated in two
ways:
 as a percentage of the par value
 as a dollar amount per share
 Shareholders of cumulative preferred stock
are entitled to receive all dividends in arrears
before any dividends are paid to common
stock shareholders.
 Preferred stock is considered cumulative unless it
is specifically designated as non-cumulative.
 Cash dividends to
preferred stockholders
Example:
Zany passed the 2008, 2009, and 2010 preferred dividends
of $100,000 in each year. Zany declares a $600,000
cash dividend in 2011. Zany must pay the cumulative
preferred dividends first.
Entry on declaration date:
Retained Earnings 600,000
Dividends Payable, Preferred 400,000
Dividends Payable, Common 200,000
Preferred = $100,000 x 4 = $400,000
Common = $600,000 - $400,000 = $200,000
 STOCK DIVIDENDS AND
STOCK SPLITS
Instead of distributing cash to stockholders,
corporations may issue additional shares of
stock to stockholders. This is done through:
 stock dividends

 stock splits

In both cases, the corporation retains its cash for

use in business operations, while providing
stockholders with additional shares of stock.
Stock dividends
 A stock dividend is a proportional distribution
of stock from the corporation to its
stockholders.
 Total stockholders’ equity is unchanged by a
stock dividend.
 On the declaration date, the amount of the stock
dividend is transferred from retained earnings to
the contributed capital section.
Stock dividends
 A stock dividend that is 25% or less of the
outstanding stock is a “small” dividend.
 A small stock dividend is accounted for at
market value of the shares issued.
 A stock dividend larger than 25% is “large.”
 A large stock dividend is accounted for at
par value of the shares issued.
Stock dividends (small)

Example entry of a small stock dividend:

5% stock dividend on 1 million shares of $1 par value
common stock. Stock price on the distribution date
is $50 per share.
Retained Earnings 2,500,000
Common Stock 50,000
Additional Paid-In Capital – Common 2,450,000
Retained Earnings = 1,000,000 x .05 x $50 (market value)
Common Stock = 1,000,000 x .05 x $1
Additional Paid-In Capital = $2,500,000 - $50,000
Stock dividends (large)

Example entry of a large stock dividend:

50% stock dividend on 100,000 shares of $10 par
value common stock. Stock price on the distribution
date is $30 per share.
Retained Earnings 500,000
Common Stock 500,000
Retained Earnings = 100,000 x .50 x $10 (par value)
Common Stock = 100,000 x .50 x $10
Stock split
 A stock split lowers the market price of a
company’s stock by increasing the number of
shares outstanding.
 For example, in a 2-for-1 split, two new
shares are exchanged for each original share
 The par value of each new share is half the value
of the original share.
 A company may want a lower stock price in
order to attract new investors.
 Stock split
Example: A company wants to decrease its stock price
from $100 to $25, so it declares a 4 for 1 stock split on
10,000 shares outstanding of $10 par common stock.

Before 4-for-1 Stock Split

Common stock, $10 par value,
10,000 shares outstanding $ 100,000
Additional paid-in capital 800,000
Retained Earnings 400,000
Total Stockholders’ Equity $ 1,300,000

After 4-for-1 Stock Split

Common stock, $2.50 par value,
40,000 shares outstanding $ 100,000
Additional paid-in capital 800,000
Retained Earnings 400,000 Exhibit 10.3
Total Stockholders’ Equity $ 1,300,000
 STOCK OPTION
 Under a stock option plan, employees can
purchase their company’s stock.
 Publicly traded corporations often encourage
their employees to participate in the growth of
the company by buying stock.
 For stock option plans that are available to all
employees, the stock is usually sold for its
market price on the date of purchase.
 Stock option
 For stock option plans that are limited to
management, stock may be bought at a fixed
price during a specific time period.
 Managers receive a financial benefit if the stock
price rises above the fixed price.
 This financial benefit is effectively extra
compensation.
 TREASURY STOCK
 Treasury stock is a corporation’s own stock,
which was issued and later reacquired.
 Reasons why a corporation buys back its stock:
 To profit by reselling the stock at a higher price.
 To increase market stock price.
 Shares are needed for company stock option plan.
 To prevent a hostile takeover by another entity.
Purchasing treasury stock
Example: A company buys back 20,000 shares
of $1 par value common stock at the market
price of $45 per share.
Treasury Stock (20,000 x $45) 90,000
Cash 90,000
When a company buys its own stock, both assets and
equity are decreased (as shown next on the
stockholders’ equity section of the company’s balance
sheet.)
 Purchasing treasury stock
Exhibit 10.5
Before Purchase of Treasury Stock:
Common stock, $1 par value $ 20,000
Additional paid-in capital 400,000
Retained earnings 120,000
Total stockholders’ equity $ 540,000

After Purchase of Treasury Stock:

Common stock, $1 par value $ 20,000
Additional paid-in capital 400,000
Retained earnings 120,000
Less: Treasury stock (90,000)
Total stockholders’ equity $ 450,000
 Reissuing treasury stock
Example continued:
The company sells 2,000 shares of its treasury stock at
the market price of $60 (they paid $45 per share).
Cash 120,000
Treasury Stock 90,000
Additional Paid-In Capital 30,000
The Treasury Stock account is credited for the original
amount paid. Stockholders’ equity increases, as
shown on the next slide.
 Reissuing treasury stock
Exhibit 10.6
Before Sale of Treasury Stock:
Common stock, $1 par value $ 20,000
Additional paid-in capital 400,000
Retained earnings 120,000
Less: Treasury stock (90,000)
Total stockholders’ equity $ 450,000

After Sale of Treasury Stock:

Common stock, $1 par value $ 20,000
Additional paid-in capital 430,000
Retained earnings 120,000
Total stockholders’ equity $ 570,000
 Retirement of Stock

 After buying back its own stock, a company

may decide to retire the stock.
 The stock certificates are cancelled and taken
out of circulation.
 Retirement of Stock
Example continued: Instead of reissuing 2,000 shares of
treasury stock, the stock is retired. Assume the $1 par
value common stock originally sold for $21 a share. The
entry to retire the stock:
Common Stock (2,000 x $1 par) 2,000
Additional Paid-In Capital (2,000 x $20) 40,000
Retained Earnings ($90,000 - $42,000) 48,000
Treasury Stock 90,000
The net effect includes a decrease in Common Stock from
$20,000 to $18,000, as shown on the next slide.
 Retirement of Stock
Exhibit 10.7
Before Retirement of Treasury Stock:
Common stock, $1 par value $ 20,000
Additional paid-in capital 400,000
Retained earnings 120,000
Less: Treasury stock (90,000)
Total stockholders’ equity $ 450,000

After Retirement of Treasury Stock:

Common stock, $1 par value $ 18,000
Additional paid-in capital 360,000
Retained earnings 72,000
Total stockholders’ equity $ 450,000