NOTES--Chapter 15 A. The Corporate Form of Organization 1. The primary forms of business organization are: 1. proprietorship, 2. partnership and 3. corporation. 2. State corporate law 3. Capital stock system. Each share represents an ownership right with the following privileges: a. To share proportionately in profits and losses. b. To share proportionately in management (vote for directors). c. To share proportionately in corporate assets upon liquidation. d. To share proportionately in any new issues of stock of the same class (preemptive right). 4. Variety of ownership interests. a. b. c. Common stock. Preferred stock. Different classes of common stock may have differences in voting rights. B. Corporate Capital 1. The stockholders’ interest in a company is a residual interest. Assets less Liabilities equals Stockholders’ Equity 2. The two primary sources of equity are: #15-1 & 15-2 1. Stockholders’ investments - contributed capital, - consisting of capital stock - additional paid-in capital 2. Retained earnings (earned capital). C. Accounting for the Issuance of Stock. 15-3 1. Par value stock. a. The par value is credited to the respective capital stock account. b. The excess of proceeds over par value is credited to paid-in capital in excess of par 2. No-par stock: avoids any contingent liability Sometimes refered to as: stated or minimum value. 3. Lump-sum sales. Either the proportional method or the incremental method can be used to allocate proceeds among the different securities. 4. Noncash stock transactions. When stock is issued for services or property other than cash, the property or services should be recorded at either its fair value or the fair value of the stock issued, whichever is more clearly determinable. 5. Costs of issuing stock. These costs are treated as a reduction of the amounts paid in and debited to Paid-in Capital in Excess of Par. D. Reacquisition of Shares. 15-4 1. Corporations may buy their own stock for a variety of reasons. a. To provide tax-efficient distributions of excess cash to shareholders. b. To increase earnings per share and return on equity. c. To provide stock for employee stock compensation contracts or to meet potential merger needs. d. To thwart takeover attempts or to reduce the number of shareholders. e. To make a market for the stock. 2. Treasury stock is a contra-stockholders’ equity account, not an asset and does not: vote, receive dividends, or have other rights afforded stockholders. 3. A corporation cannot own a part of itself. 4. Treasury stock is most often accounted for using the cost method 15-4. a. The cost method results in debiting the Treasury Stock account for the reacquisition cost and reporting this amount as a deduction from total paid-in capital and retained earnings on the balance sheet. (1) Sale of Treasury Stock above cost. NO GAIN. The difference between the cost and the selling price is credited to Paid-in Capital from Treasury Stock. The company identifies which shares are sold using a FIFO, average cost, or specific identification basis. (2) Sale of Treasury Stock below cost. NO LOSS. The difference is debited to: (a) Paid-in Capital from Treasury Stock until that account is depleted. (b) Any balance is debited to Retained Earnings. (3) Retiring Treasury Stock. Retired treasury shares have the status of authorized and unissued shares. The accounting is similar to the sale of treasury stock except the debits are to the Paid-in Capital accounts applicable to the retired shares. ILLUSTRATION 15-4 TREASURY STOCK TRANSACTIONS—COST METHOD ILLUSTRATION15- E. Preferred Stock. 1. Preference as to dividends. - receive dividends before common stockholders are paid dividends. - dividend is expressed as a percentage of par value or as a specific dollar amount. a. Cumulative preferred stock. Dividends in arrears must be paid before payment of the current year’s dividend to either preferred or common stockholders. Dividends in arrears are not a liability until declared by the Board of Directors. They are disclosed in the footnotes. b. Participating preferred stock. Preferred stockholders share ratably with common stockholders in any dividends beyond the prescribed preference rate. 2. Preference as to assets in the event of liquidation. 3. Convertible into common stock. 4. Callable at the option of the corporation—at set prices. 5. Nonvoting. 6. Redeemable preferred stock. This preference has a mandatory redemption period or redemption feature that the issuer cannot control. a. Because it has characteristics of debt, the FASB requires that it be classified as liabilities and be measured and accounted for similar to liabilities. F. Accounting and Reporting of Preferred Stock. 1. The accounting for preferred stock at issuance is similar to common stock. 2. Convertible preferred stock is reported as part of stockholders’ equity. G. Dividend Policy. 15-5 1. Very few companies pay dividends in amounts equal to their legally available retained earnings. Among the reasons: reinvestment of earnings in assets, the desire to build up a cushion, and the “smoothing out” of dividend payments. 2. Legality of dividends. The legality of a dividend is determined by applicable state laws. 3. Financial condition of the company: Before dividends are declared, the availability of funds to pay the dividend should be considered. 4. The SEC encourages companies to disclose their dividend policy in the annual report. H. Types of Dividends. 1. Cash dividends. Once declared, a dividend (except a stock dividend) is a liability (usually current). Dividends are not declared and paid on treasury stock. 2. Property dividends. These are dividends payable in assets of the corporation other than cash. Just prior to declaration, the fair value principle is used in valuing the assets distributed as dividends. 3. Liquidating dividends. Dividends that are not based on earnings are liquidating dividends. They reduce paid-in capital when declared. I. Stock dividends and stock splits. No assets are distributed and each stockholder retains the same proportionate interest in the corporation. 15-6 1. Small (ordinary) stock dividends. The fair value of the stock issued is used to record the stock dividend by debiting Retained Earnings and crediting Common Stock and Paid-in Capital in Excess of Par. 2. Large stock dividends. If the dividend is more than 20-25% of the outstanding shares, then the par value of the stock issued is used to record the stock dividend by debiting Retained Earnings and crediting Common Stock. 3. Stock splits. No entry is made to recognize a stock split. A memorandum note is made to indicate that the number of shares outstanding and the par value of the shares have changed. J. Disclosure of Restrictions on Retained Earnings. 1. Restrictions are best disclosed by note, and should include the source of the restriction, pertinent provisions, and the amount of retained earnings subject to restriction, or the amount not restricted. K. Presentation and Analysis of Stockholders’ Equity. 1. Presentation. a. On the balance sheet, three categories normally appear. (1) Capital stock. (2) Additional paid-in-capital. (3) Retained earnings or deficit. b. On the statement of stockholders’ equity, the basic format is usually: Beginning balance + Additions – Deductions = Ending balance c. Disclosures related to stockholders’ equity include dividend and liquidation preferences, participation rights, and call and conversion information.