Accounting for Corporations Chapter 13 Accounting for Corporations Chapter 13: Accounting for Corporations

Characteristics of Corporations Advantages Separate legal entity Limited liability of stockholders Transferable ownership rights Continuous life Lack of mutual agency for stockholders Ease of capital accumulation Disadvantages Governmental regulation Corporate taxation The corporate form of organization has several advantages: It is a separate legal entity that can enter into contracts and sue and be sued. Stockholders’ losses are limited to the amount invested in the corporation. Ownership rights are transferable. The corporation continues in existence even when ownership changes. Stockholders are not agents of the corporation and can not enter into contracts on the corporation’s behalf. Capital needs can be met by selling more ownership in the corporation. Two disadvantages include extra governmental regulations imposed on corporations and corporate taxation of earnings. Corporations pay taxes on their earnings and if they distribute a dividend to stockholders, the stockholders pay taxes on the dividends received. This is sometimes referred to as double taxation.

Corporate Organization and Management Stockholders usually meet once a year Ultimate control Selected by a vote of the stockholders Overall responsibility for managing the company At their annual meeting, stockholders elect the board of directors and vote on important management issues facing the company. The board of directors has the ultimate responsibility for managing the company. The executive management team manages the day-to-day decisions for the corporation.

Rights of Stockholders Vote at stockholders’ meetings Sell stock Purchase additional shares of stock Receive dividends, if any Share equally in any assets remaining after creditors are paid in a liquidation In addition to voting on important issues at annual meetings, stockholders have the right to buy and sells shares of stock, to receive dividends when declared by the board of directors, and in the event of liquidation, they share equally in any remaining assets after creditors are paid.

Basics of Capital Stock  Par value is an arbitrary amount assigned to each share of stock when it is authorized. Market price is the amount that each share of stock will sell for in the market. Classes of Stock Par Value No-Par Value Stated Value Par value is an arbitrary amount assigned to each share of stock in the corporate charter. Par value is typically a nominal amount, and is not related in any manner to market value which is the selling price of a share of stock. In addition to par value stock, some states permit no-par, stated value common stock, or no par value common stock.

Cash Dividends P 2 Regular cash dividends provide a return to investors and almost always affect the stock’s market value. Stockholders Dividends Corporation Stockholders receive a return on their investment in two ways: one is through increases in the market value of the stock and one is through cash dividends. To pay a cash dividend, a corporation must have two things:  Sufficient retained earnings to absorb the dividend without creating a deficit; and  Enough cash to pay the dividend. To pay a cash dividend, the corporation must have: A sufficient balance in retained earnings; and The cash necessary to pay the dividend.

Accounting for Cash Dividends P 2 Accounting for Cash Dividends Three important dates Dividends There are three important dates to remember when discussing dividends:  The date of declaration is the date the directors declare the dividend. At this time, a liability is created and must be recorded.  The date of record is important because you must own the stock on this date to receive the dividend. No entry is required in the accounting records. The date of payment is the date the corporation pays the dividend to the stockholders who owned the stock on the record date. Date of Declaration Date of Record Date of Payment Record liability for dividend. No entry required. Record payment of cash to stockholders.

Stock Dividends Why a stock dividend? Small Stock Dividend P 2 A distribution of a corporation’s own shares to its stockholders without receiving any payment in return. Why a stock dividend? Can be used to keep the market price on the stock affordable. Can provide evidence of management’s confidence that the company is doing well. Small Stock Dividend Distribution is £ 25% of the previously outstanding shares. Large Stock Dividend Distribution is > 25% of the previously outstanding shares. Sometimes corporations will distribute additional shares of stock as a dividend. Reasons for doing this include keeping the market price affordable by increasing the number of shares outstanding and providing evidence of management’s confidence in the company. A stock dividend can be classified as small or large. A small stock dividend is a distribution of stock that is less than or equal to 25 percent of the outstanding shares. A large stock dividend is a distribution of stock that is greater than 25 percent of the outstanding shares. Let’s look at the entries to record small and large stock dividends. HotAir, Inc. Common Stock 100 shares $1 par

Stock Splits P 2 A distribution of additional shares of stock to stockholders according to their percent ownership. $10 par value Old Shares Common Stock 100 shares A stock split is the distribution of additional shares of stock to stockholders according to their percent ownership. When a stock split occurs, the corporation calls in the outstanding shares and issues new shares of stock. In the process of a stock split, the par value of the stock changes. After the split, the number of shares doubled and the par value was cut in half. There is no change in total par value. The old shares had a total par value of $1,000 (100 shares times $10 per hare par value). The new shares have a total par value of $1,000 (200 shares times $5 par value per share). Notice that an accounting entry is not required, and that Retained Earnings is not reduced. In many respects, a 100 percent stock dividend and a two-for-one stock split result in similar impacts in the market price of the share outstanding. The stock split usually requires more administrative tasks to call in and reissue stock certificates. However, sometimes corporations do not reissue certificates in a stock split, saving some of the administrative costs. $5 par value New Shares Common Stock 200 shares

Usually has a stated dividend rate Normally has no voting rights Preferred Stock C 2 A separate class of stock, typically having priority over common shares in . . . Dividend distributions Distribution of assets in case of liquidation Usually has a stated dividend rate Normally has no voting rights Preferred stock is a separate class of stock that typically has priority over common stock in dividend distributions and distribution of assets in a liquidation. Preferred stock usually has a stated dividend that is expressed as a percentage of its par value. It normally does not have voting rights.

Preferred Stock vs. Noncumulative Cumulative Dividends in arrears must be paid before dividends may be paid on common stock. (Normal case) Undeclared dividends from current and prior years do not have to be paid in future years. Consider the following Stockholders’ Equity section of the Balance Sheet. The Board of Directors did not declare or pay dividends in 2010. In 2011, the Board declared and paid cash dividends of $42,000. Cumulative preferred stockholders have the right to be paid both the current and all prior periods’ unpaid dividends before any dividends are paid to common stockholders. When the preferred stock is cumulative and the directors do not declare a dividend to preferred stockholders, the unpaid dividend is called a dividend in arrears and must be disclosed in the financial statements. Most preferred stock is cumulative. Noncumulative preferred stock has no rights to prior periods’ dividends if they were not declared in those prior periods. Let’s look at an example. This company has both common stock and preferred stock. The directors did not declare a dividend in 2010. In 2011, the directors declared and paid cash dividends of $42,000. Let’s see how this dividend is distributed if the preferred stock is cumulative and if it is noncumulative.

Preferred Stock C2 If the preferred stock is noncumulative, the preferred stockholders have no rights to the missed dividends of the year 2010. However, they get first distribution of the dividends declared in 2011. The dividend for the preferred stock in 2011 is calculated as follows: $100 par value times 9% times 1,000 shares. Since $42,000 in dividends were declared, preferred stockholders would receive the first $9,000, and the remaining $33,000 would be divided evenly among the common stockholders. If the preferred stock is cumulative, the preferred stockholders have rights to the missed dividends of 2010 in addition to the dividends in 2011. The preferred stockholders first get a distribution of $9,000 for the missed dividends of 2010. Then they get another $9,000 for the dividend in 2011. Since $42,000 in dividends were declared, preferred stockholders would receive the first $18,000, and the remaining $24,000 would be divided evenly among the common stockholders.

Preferred Stock vs. Nonparticipating Participating Dividends may exceed a stated amount once common stockholders receive a dividend equal to the preferred stated rate. Dividends are limited to a maximum amount each year. The maximum is usually the stated dividend rate. (Normal case) Reasons for Issuing Preferred Stock To raise capital without sacrificing control To boost the return earned by common stockholders through financial leverage To appeal to investors who may believe the common stock is too risky or that the expected return on common stock is too low An additional preference for preferred stock is participation in dividends if they are declared above certain limits. This participation feature does not apply until common stockholders receive dividends equal to the preferred stock’s dividend percent. This is not a common preference seen in practice. Corporations may issue preferred stock to be able to raise needed capital without sacrificing control since preferred stock has no voting rights. Issuing preferred stock is a way to boost return to common stockholders. It is also a way to increase ownership in the company if the common stock is perceived as too risky or has a lower than expected return.

Treasury Stock P 3 Treasury stock represents shares of a company’s own stock that has been acquired. Corporations might acquire its own stock to: Use their shares to buy other companies. Avoid a hostile takeover. Reissue to employees as compensation. Support the market price. Corporations might acquire their own stock to: Use their shares to buy other companies. Avoid a hostile takeover. Reissue to employees as compensation. Support the market price. As this graph indicates, the majority of corporations have some treasury stock.

Statement of Retained Earnings C 3 Retained earnings is the total cumulative amount of reported net income less any net losses and dividends declared since the company started operating. Legal Restriction Most states restrict the amount of treasury stock purchases to the amount of retained earnings. Contractual Restriction Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings. Restricted Retained Earnings The Statement of Retained Earnings is a summary of the activity that occurred in Retained Earnings during the period. It begins with the balance at the beginning of the period. If a company has net income, it is added to the beginning retained earnings balance. If a company has a net loss, it would be subtracted. Any dividends declared are subtracted to arrive at the ending Retained Earnings balance. Retained earnings can have legal or contractual restrictions. In most states, the corporate charter will not allow a company to purchase treasury stock in excess of the balance in retained earnings. Some loan agreements place restrictions on how much dividends can be based on the balance in retained earnings. Restrictions on retained earnings are generally disclosed in the notes to the financial statements.

Options are given to key employees to motivate them to: Stock Options C 3 The right to purchase common stock at a fixed price over a specified period of time. As the stock’s price rises above the fixed option price, the value of the option increases. Market price of stock $75 per share. Option purchase price $30 per share. Stock options give the owner the right to purchase common stock at a fixed price over a specified period of time. As the stock’s price rises above the fixed option price, the value of the option increases. Corporations give stock options to motivate employees to focus on the company’s stock performance, to take a long-run perspective, and to remain with the company. Options are given to key employees to motivate them to: focus on company performance, take a long-run perspective, and remain with the company.

Earnings Per Share A 1 Earnings per share is one of the most widely cited accounting statistics. Basic earnings per share = Net income - Preferred dividends Weighted-average common shares outstanding Earnings per share is one of the most widely cited accounting statistics. It is calculated as net income minus preferred dividends divided by the weighted-average common shares outstanding.

End of Chapter 13 End of Chapter 13.