1. Identify and Discuss the Major Characteristics of a Corporation

2. Record the Issuance of Common Stock

3. Explain the Accounting for Purchase of Treasury Stock

4. Differentiate Preferred Stock from Common Stock

5. Prepare the Entries for Cash Dividends and Stock Dividends

6. Identify the Items that Affect Retained Earnings

7. Prepare a Comprehensive Stockholders’ Equity Section

8. Evaluate a Corporation’s Dividend and Earnings Performance from a Stockholder’s Perspective

1. Identify and Discuss the Major Characteristics of a Corporation

• Corporation 
• Legal entity
• Created by law 
• Most of the rights and privileges of a person
• Classified by purpose and by ownership
• Purpose - profit or not for profit
• Ownership - publicly held or privately held
• Publicly held corporation - traded on organized stock exchange and may have thousands of stockholders.
• Privately held corporation - not traded on organized exchange and may have only a few stockholders.

• Characteristics distinguishing corporations from proprietorships and partnerships.

• Separate legal existence
• An entity separate and distinct from owners.
• Acts under its own name rather than name of stockholders.
• May buy, own, and sell property; borrow money; and enter into legally binding contracts; may sue or be sued; and pays its own taxes.
• Owners (stockholders) cannot bind corporation unless owners are agents of the corporation.
• Limited liability of stockholders
• Creditors have recourse only to corporate assets to satisfy claims.
• Liability of stockholders limited to investment in corporation.
• Creditors have no legal claim on personal assets of owners unless fraud has occurred.

• Transferable ownership rights
• Ownership evidenced by shares of stock, which are transferable units.
• Transfer of ownership rights among stockholders has no effect on operating activities of the corporation or on a corporation's assets, liabilities and total stockholders’ equity.
• Corporation does not participate in transfer of ownership rights after original sale of capital stock.

• Ability to acquire capital
• Limited liability of stockholders coupled with transferable ownership rights make it easy for corporations to raise capital.
•  Continuous life
• Life of corporation stated in charter - may be perpetual or limited to specific number of years.
• If limited, period of existence can be extended through renewal of charter.
• Corporation is separate legal entity, thus life not affected by withdrawal, death, or incapacity of stockholder.
• Corporation management
• Stockholders manage corporation indirectly through board of directors, which they elect.
• Board of directors formulates operating policies and selects officers to execute policy and to perform daily management functions.
• Government Regulations
• Corporation subjects to state and federal regulations.
• State prescribes requirements for issuing stock, distributions of earnings permitted to stockholders, and the effects of retiring stock.
• Federal securities laws govern sale of capital stock to general public; disclosure of financial affairs to Securities and Exchange Commission through quarterly and annual reports; and the reporting requirements of the various securities markets.
• Additional Taxes
• Corporations, as separate legal entities, must pay federal and state income taxes.
• Stockholders must pay taxes on cash dividends.  Thus, it may be argued that corporate income is taxed twice—once at the corporate level and again at the individual level.
• With proprietorships and partnerships, the owner’s share of earnings is reported on his or her personal income tax return.r

2. Record the Issuance of Common Stock

• Forming a corporation
• States grant corporate charters.
• Although a corporation may have operating divisions in a number of states, it will be incorporated in only one state.
• Some states have laws favorable to the corporate form of business organization.  (i.e., In the state of Delaware defense tactics against takeovers can be approved by the board of directors without a vote by shareholders.)
• The corporation establishes by-laws for conducting its affairs upon receipt of its charter from the state of incorporation.
• A corporation must obtain a license—subjecting the corporation’s operating activities to the general corporation laws of the state— from each state in which it does business. 

• Stockholder rights
• Once it is chartered, the corporation sells ownership rights in the form of shares of stock.
• When a corporation has only one class of stock it is common stock.
• Ownership rights are specified in the articles of incorporation or in the by-laws.
• Proof of stock ownership is evidenced by a printed or engraved form known as a stock certificate.
• The stock certificate shows the name of the corporation, the stockholder’s name, the class and special features of the stock, the number of shares owned, and the signatures of duly authorized corporate officials.
• Stock certificates are pre numbered to facilitate accountability.

• Stock issue considerations
• When a corporation decides to issue stock it must answer the following questions: How many shares should be authorized for sale?  How should the stock be issued?  At what price should the shares be issued?  What value should be assigned to the stock? 

• Authorized stock 
• The amount of stock a corporation is authorized to sell is indicated the corporate charter.
• If all authorized stock is sold, a corporation must obtain consent of the state to amend its charter before issuing additional shares.
• The authorization of common stock does not result in a formal accounting entry because the event has no immediate effect on either corporate assets or stockholders’ equity. 
• Disclosure of the number of shares authorized is required in the stockholders’ equity section of the balance sheet.

• Issuance of stock
• A corporation has the option of issuing common stock directly to investors or indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors.
• Direct issue is typical in closely held companies.
• Indirect issue is customary for publicly held companies.
• New issues of stock may be offered for sale to the public through various organized U.S. securities exchanges: the New York Stock Exchange, the American Stock Exchange, and 13 regional exchanges. 
• Stock may also be traded on the “over-the-counter (OTC) market.
• In setting the price for a new issue of stock, the following factors must be considered: (1) the company’s anticipated future earnings, (2) its expected dividend rate per share, (3) its current financial position, (4) the current state of the economy, and (5) the current state of the securities market.

• Par and no-par value stocks
• Par value stock is capital stock that has been assigned a value per share in the corporate charter.
• The par value may be any amount selected by the corporation. 
• Par value is usually quite low because states often levy a tax on the corporation based on its par value.
• Par value represents the legal capital per share that must be retained in the business for the protection of corporate creditors.  It is the amount that is not available for withdrawal by stockholders.
• No-par value stock is capital stock that has not been assigned a value per share in the corporate charter.
• In many states the board of directors is permitted to assign a stated value to the no-par shares, which then becomes the legal capital per share. 
• The stated value of no-par stock may be changed at any time by action of the directors. 
• Stated value, like par value, does not indicate or correspond to the market value of the stock.
• When there is no assigned stated value, the entire proceeds received upon issuance of the stock is considered to be legal capital.
• The legal capital per share always establishes the credit to the Common Stock account.
• The relationship of par and no-par value to legal capital is summarized as follows:

•  Accounting for common stock issues
• The stockholders’ equity section of a corporation’s balance sheet includes: 

 
1. paid-in  (contributed) capital and 
2. retained earnings (earned capital).

 
• The distinction between paid-in capital and retained earnings is important from a legal and an economic point of view.
• Paid-in capital is the amount paid in to the corporation by stockholders in exchange for shares of ownership.
• Retained earnings is earned capital held for future use in the business.
• The primary objectives in accounting for the issuance of common stock are to 
• (1) identify the specific sources of paid-in capital and (2) maintain the distinction between paid-in capital and retained earnings. 
• The issue of common stock affects only paid-in capital accounts.
• When the issuance of common stock for cash is recorded, the par value of the shares is credited to Common Stock, and the portion of the proceeds that is above or below par value is recorded in a separate paid-in capital account.
• Assume Hydro-Slide, Inc., issues 1,000 shares of $1 par value of common stock at par for cash.  The entry to record the transaction is:

 

	Dr.	Cr.
Cash	1,000
Common Stock		1,000
(To record issuance of 1,000 shares of $1 par common stock at par)


 
 
• If Hydro-Slide, Inc., issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share, the entry is:

 

	Dr.	Cr.
Cash	5,000
Common stock		1,000
Paid-in capital in excess of par		4,000
(To record issuance of 1,000 shares of $1 par common stock at $5 per share)

 The total paid-in capital from these two transactions is $6,000, and the legal capital is $2,000. 
 
• Assuming Hydro-Slide, Inc., has retained earnings of $27,000, the stockholders’ equity section of the balance sheet would be:

HYDRO-SLIDE, INC. Balance Sheet (partial) Stockholders’ equity

Paid-in capital: Common stock Paid-in capital in excess of par value  Total paid-in capital      Retained earnings Total stockholders’ equity

$  2,000   4,000 $  6,000 27,000 $33,000

•  If, in the previous example, the stock had been no-par stock with a stated value of $5, the entries would be the same as those for the par stock.
• If the company issues no-par stock that does not have a stated value, the full amount received is credited to the Common Stock Account and there is no need for the Paid-in Capital in Excess of Par Value account.

3. Explain the Accounting for Purchase of Treasury Stock

• Accounting for Treasury Stock

• Treasury stock is a corporation’s own stock that has been issued, fully paid for, reacquired by the corporation and held in its treasury for future use. 
• A corporation may acquire treasury stock to meet the following objectives:
1. Reissue the shares to officers and employees under bonus and stock compensation plans
2. Increase trading of the company’s stock in the securities market in the hopes of enhancing its market value
3. Have additional shares available for use in the acquisition of other companies
4. Reduce the number of shares outstanding and thereby increase earnings per share.
• Treasury stock may be purchased if management is trying to eliminate hostile shareholders by buying them out.

•  Purchase of treasury stock
• The purchase of treasury stock is generally accounted for by the cost method.
• With the cost method the Treasury Stock is maintained at the cost of the shares purchased.
• Under the cost method Treasury Stock is increased (debited) by the price paid to reacquire the shares; Treasury Stock decreases by the same amount when the shares are later sold.
• To illustrate, assume on January 1, 2001, the stockholders’ equity section for Mead, Inc., has 100,000 shares of $5 par value common stock outstanding (all issued at par value) and Retained Earnings of $200,000. 
• The stockholders’ equity section of the balance sheet before purchase of treasury stock is shown as follows:

 

MEAD, INC. Balance Sheet (partial)

Stockholders’ equity:   Paid-in capital     Common stock, $5 par value, 100,000        shares  issued and outstanding      Retained earnings  Total stockholders’ equity

$500,000 200,000 $700,000


 
• On February 1, 2001, Mead acquires 4,000 shares of its stock at $8 per share.  The entry is:

	Dr.	Cr.
Treasury Stock	32,000
Cash		32,000
(To record purchase of 4,000 shares of treasury stock at $8 per share)

The Treasury Stock account would increase by the cost of the shares purchased - $32,000.

The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change.

Treasury stock is deducted from total paid-in capital and retained earnings in the stockholders’ equity section of the balance sheet as follows:

• Both the number of shares issued (100,000) and the number in the treasury (4,000) are disclosed. The difference is the number of shares of stock outstanding (96,000).
• Outstanding stock means the number of shares of issued stock that are being held by stockholders.
• Treasury stock is not an asset, rather it reduces stockholder claims on corporate assets.

4. Differentiate Preferred Stock from Common Stock

• A corporation may issue a class of stock in addition to common stock, called preferred stock.
• Preferred stock has contractual provisions that give it preference or priority over common stock. 
• Preferred stockholders have a priority in relation to:
1.  dividends and 
2. assets in the event of liquidation

• Preferred stockholders do not have voting rights.
• When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates. 
• For example, assume Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share.  The entry to record the issuance is:

 

	Dr.	Cr.
Cash	120,000
Preferred stock		100,000
Paid-in capital in excess of par-Preferred stock		20,000
(To record issuance of 10,000 shares of preffered stock at $12 per share))

• Preferred stock may have either a par value or no-par value.

• Dividend preferences
• Preferred stockholders have the right to share in the distribution of corporate income before common stockholders.
• If the dividend rate of preferred stock is $5 per share, common shareholders will not receive any dividends in the current year until preferred stockholders have received $5 per share.
• The first claim to dividends does not guarantee dividends. 
• Dividends depend on factors such as adequate retained earnings and availability of cash.
• The per share dividend amount is stated as a percentage of the stock or as a specified amount.  K-Mart pays a 7 3/4% dividend on $50 par value preferred ($50 X 7 3/4% = $3.875), where as Nike pays $.10 per share dividend on its $1 par preferred stock.

• Cumulative dividend - Preferred stock contracts often contain a cumulative dividend  feature.
• If preferred stock is cumulative, preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders receive dividends.
• When preferred stock is cumulative, preferred dividends not declared in a given period are called dividends in arrears.
• To illustrate dividends in arrears, assume that Scientific-Leasing has 5,000 shares of 7%, $100 par value cumulative preferred stock outstanding.  The annual dividend is $35,000 (5,000 x $7 per share).  If dividends are 2 years in arrears, preferred stockholders are entitled to receive dividends of $105,000 shown below before any distribution may be made to common stockholders.

Dividends in arrears ($35,000 x 2 years)  Current-year dividends Total preferred dividends

$   70,000 35,000 $ 105,000

• Dividends in arrears are not a liability because no obligation exists until the board of directors declares a dividend.
• The amount of dividends in arrears should be disclosed in the notes to the financial statements.
• Liquidation preference
• Most preferred stocks have a preference on corporate assets if the corporation fails.
• The preference to assets may be for the par value of the shares or for a specified liquidating value.

5.  Prepare the Entries for Cash Dividends and Stock Dividends

• A dividend is a distribution by a corporation to its stockholders on a pro rata basis. 
• Pro rata means that if you own 10% of the common shares, you will receive 10% of the dividend. 
• Dividends can take four forms: cash, property, script (promissory note to pay cash), or stock.
• Cash dividends, which predominate in practice, and stock dividends, which are declared with some frequency are discussed in this chapter.
• Dividends are generally reported quarterly as a dollar amount per share, although sometimes they are reported on an annual basis.
• A cash dividend is a pro rata distribution of cash to stockholders.
• For a corporation to pay a cash dividend, it must have the following:

• Retained earnings. 
• In many states, payment of dividends from legal capital is illegal.
• Payment of dividends from paid-in capital in excess of par is legal in some states.
• Payment of dividends from retained earnings is legal in all states.
• Companies are frequently constrained by agreements with lenders to pay dividends only from retained earnings.
• Adequate cash.
• In addition to retained earnings, a corporation must have adequate cash to pay a dividend.
• Declared dividends.
• The board of directors has full authority to determine the amount of income to be distributed in the form of dividends and the amount to be retained in the business.

• Entries for Cash dividends - Three dates are important in connection with dividends:
• (1) The declaration date--The declaration date is the date the board of directors formally declares the cash dividend and announces it to stockholders. 
• The declaration of a cash dividend commits the corporation to a binding legal obligation that cannot be rescinded.
• An entry is required to recognize the decrease in retained earnings and the increase in the liability Dividends Payable.
• Assume that on December 1, 2001, the directors of Media General declare a $.50 per share cash dividend on 100,000 shares of $10 par value common stock.  The dividend is $50,000 (100,000 x $.50), and the entry to record the declaration is:

Declaration Date	Dr.	Cr.
Retained earnings (or cash dividends declared)	50,000
Dividends Payable		50,000
(To record declaration of cash dividend)

• (2) The record date
• The record date marks the time when ownership of the outstanding shares is determined for dividend purposes.
• The purpose the record date is to identify the persons or entities that will receive the dividend, not to determine the dividend liability.

Record Date: No entry necessary

• (3) The payment date
• On the payment date, dividend checks are mailed to the stockholders and the payment of the dividend is recorded.
• If January 20 is the payment date for Media General, the entry on that date is: 

 

Payment Date	Dr.	Cr.
Dividends Payable	50,000
Cash		50,000
(To record payment of cash dividend)

 
• A stock dividend is a pro rata distribution of the corporation’s own stock to stockholders.
• A stock dividend is paid in stock.
• A stock dividend results in a decrease in retained earnings and an increase in paid-in capital.
• A stock dividend does not decrease total stockholders’ equity or total assets.
• Stock dividends are often issued by companies that do not have adequate cash to issue a cash dividend.
• To illustrate a stock dividend, assume that you have a 2% ownership interest in Cetus Inc., owning 20 of its 1,000 shares of common stock.  In a 10% stock dividend, 100 shares (1,000 x 10%) of stock would be issued.  You would receive two shares (2% x 100), but your ownership interest would remain at 2% (22 divided by 1,100).  You now own more shares of stock, but your ownership interest has not changed.

 
• Corporations issue stock dividends for the following reasons:
• To satisfy stockholders’ dividend expectations without spending too much cash.
• To increase the marketability of its stock by increasing the number of shares outstanding and thereby decreasing the market price per share.  Decreasing the market price of the stock makes it easier for smaller investors to purchase the shares.
• To emphasize that a portion of stockholders’ equity has been permanently reinvested in the business and therefore is unavailable for cash dividends.

•  A small stock dividend (less than 20%-25% of the corporation’s issued stock) is recorded at the fair market value per share.
• A large stock dividend (greater than 20%-25% of the corporation’s issued stock) is recorded at par or stated value per share.
• Assume Medland Corporation has a balance of $300,000 in retained earnings and declares a 10% stock dividend on its 50,000 shares of $10 par value common stock.  The current fair market value of the stock is $15 per share.  The number of shares to be issued is 5,000 (50,000 x 10%).  Retained Earnings will be decreased by $75,000 (5,000 x $15).  The entry to record the transaction would be:
 

	Dr.	Cr.
Retained earnings (or stock dividends declared)	75,000
Common stock dividend distributable		50,000
Paid-in capital in excess of par		25,000
(To record declaration of 10% stock dividend)

• The Common Stock Dividends Distributable is an entity account; it is not a  liability account because assets will not be used to pay the dividend. 
• If a balance sheet is paid before the dividend shares are issues, the distributable account is reported in paid-in capital as an addition to common stock issued as shown:

MEDLAND CORPORATION Balance Sheet (partial)

Paid-in capital     Common stock      Common stock dividends distributable Total stockholders’ equity

$500,000  50,000  $550,000

 
•  When the dividend shares are issued, Common Stock Dividends Distributable is decreased and Common Stock is increased as follows:

	Dr.	Cr.
Common stock dividend distributable	50,000
Common stock		50,000
(To record issuance of 5,000 shares in a stock dividend)


 
 
 
• Although total stockholders’ equity remains the same, a stock dividend changes the composition of stockholders’ equity because a portion of retained earnings is transferred to paid-in capital.

 
• The effects of Medland’s stock dividend are shown as follows:

• A stock split is very much like a stock dividend in that it involves the issuance of additional shares of stock to stockholders according to their percentage ownership.
• However, a stock split results in a reduction in the par or stated value per share.
• The purpose of stock split is to increase the marketability of the stock by lowering its market value per share, making it easier for the corporation to issue additional shares of stock.
• In a stock split, the number shares is increased in the same proportion that the par or stated value per share is decreased.  (i.e., in a 2-for-1 split, one share of $10 par value stock is exchanged for two shares of $5 par value stock.)
• A stock split does not have any effect on total paid-in capital, retained earnings, and total stockholders’ equity.
• With a stock split the number of shares outstanding increases.
• Assume that instead of issuing a 10% stock dividend Medland splits its 50,000 shares of common stock on a 2-for-1 basis.  The effects of Medland’s stock dividend are shown as follows:
 

	Before		After
Stockholders’ equity	Stock Split		Stock Split
Paid-in capital:
Common stock	$500,000		$500,000
Paid-in capital in excess of par value	----		----
Total paid-in capital	500,000		500,000
Retained earnings	300,000		300,000
Total stockholders’ equity	$800,000		$800,000
Outstanding shares	50,000		100,000

• Because a stock split does not affect the balances in stockholders’ equity accounts, it is not necessary to journalize a stock split.

• Differences between the effects of stock splits and stock dividends are shown:

Item

Stock Split

Stock Dividend

Total paid-in capital Total retained earnings Total par value (common stock) Par value per share

No change  No change No change  Decrease

Increase Decrease Increase No change

 
6. Identify the Items that Affect Retained Earnings

• Retained earnings is net income that is retained in the business.
• The balance in retained earnings is part of the stockholders’ claim on the total assets of the corporation.
• Retained earnings does not represent a claim on any specific asset.
• The amount of retained earnings cannot be associated with the balance of any asset account.  For example, a $100,000 balance in retained earnings does not mean that there should be $100,000 in cash.
• The cash resulting from the excess of revenues over expenses may have been used to purchase other assets—buildings, equipment, etc.
• Net losses decrease (are debited to) retained earnings. 
• Net losses do not decrease (are not debited to) paid-in capital accounts.
• A debit balance in retained earnings is identified as a deficit and is reported as a deduction in the stockholders’ equity section of the balance sheet as shown below:

 

AMAZON.COM Balance Sheet (partial) (in thousands)

Stockholders’ equity
Paid-in capital:
Common stock		$    1,593
Paid-in capital in excess of par value		299,212
Total paid-in capital		$300,805
Accumulated deficit		(162,060)
Total stockholders’ equity		$138,745

• Although the balance in retained earnings is generally available for dividend declarations, there may be retained earnings restrictions that make a portion of the balance currently unavailable for dividends.
• Restrictions may result from one or more of the following causes: legal, contractual, or voluntary.
• Retained earnings restrictions are generally disclosed in the notes to the financial statements.

 
7. Prepare a Comprehensive Stockholders’ Equity Section

• In the stockholders’ equity section of the balance sheet, paid-in capital and retained earnings are reported, and the specific sources of paid-in capital are identified.
• Within paid-in capital, two classifications are recognized:
• Capital stock - consists of preferred and common stock.
• Preferred stock is shown before common because of its preferential rights.
• Information about the par value, shares authorized, shares issued, and shares outstanding is reported for each class of stock.
• Additional paid-in capital - includes the excess of amounts paid in over par or stated value and paid-in capital from treasury stock.
• Sub-classifications within the stockholders equity sections are seldom presented in published annual reports.
• Individual sources of additional paid-in capital are often combined and reported as a single amount as shown in the following illustration:

8. Evaluate a Corporation’s Dividend and Earnings Performance from a Stockholder’s Perspective

• One way that companies reward stock investors for their investment is to pay them dividends.  The payout ratio and dividend yield are measures of a corporations dividend performance.

• The payout ratio measures the percentage of earnings distributed in the form of cash dividends to common stockholders and is computed by dividing total cash dividends to common shareholders by net income.

• The payout ratios for Nike in 2004 and 2003 are shown in Illustration 11-18 in the textbook

• Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business.  Thus, a low payout ratio is not necessarily bad news

• However, low dividend payments, or a cut in dividend payments, might signal that a company has liquidity or solvency problems and is trying to free up cash by not payment dividends.  Thus, investors and analysts should investigate the reason for low dividend payments.

• Earnings performance - The return on common stockholders' equity is a widely used ratio that measures profitability from the common stockholders’ viewpoint.