Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 12 1

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Review the characteristics of a corporation Describe the two sources of stockholders’ equity and the classes of stock Journalize the issuance of stock and prepare the stockholders’ equity section of a corporation balance sheet Illustrate Retained earnings transactions Account for cash dividends

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 3 Use different stock values in decision making Evaluate return on assets and return on stockholders’ equity Account for the income tax of a corporation Compare issuing bonds to issuing stocks (Appendix 12A)

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4 Review the characteristics of a corporation 1 1

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. ADVANTAGES 1.Corporations can raise more money 2.Corporations have continuous life 3.Ownership transfer is easy 4.No mutual agency 5.Stockholders have limited liability DISADVANTAGES 1.Ownership and management separated. 2.Double taxation 3.Government regulation is expensive 4.Start-up costs are higher 5

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Authorization–State’s permission to operate Authorized stock–How many shares of a class of stock a corporation may issue Capital stock–Represents ownership of the corporation's capital Stock certificate–Paper evidencing ownership in a corporation Company name Stockholder name Number of shares owned Outstanding stock–Stock held by stockholders 6

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 7

Due to the recent beef recalls, Southern Steakhouse is considering incorporating. Bill, the owner, wants to protect his personal assets in the event the restaurant is sued. Which advantage of incorporating is most applicable? 8 Stockholders have limited liability.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Describe the two sources of stockholders’ equity and the classes of stock 9 2 2

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Two ways to increase stockholders’ equity

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Paid-in capital (Contributed capital) Amounts received from stockholders Common stock is main source Externally generated Resulting from transactions with outsiders Retained earnings Earned by profitable operations Internally generated Results from internal corporate decisions to retain net income for use in the company 12

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Common stock Four basic rights Vote—voting on corporate matters Dividends—receive a proportionate part of dividend declared Liquidation—receive a proportionate part of assets remaining Preemption—maintain their proportionate ownership Preferred stock Certain advantages over common stock Receive dividends before common Fixed dividend amount still optional Upon liquidation, receive assets before common Normally no voting rights 13

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Common stock can be issued in three forms: No-Par Common Stock Par Value Common Stock Stated Value Common Stock Common Stock entry limited to par value. The rest is handled sort of like a bond premium at issue. Common Stock entry limited to par value. The rest is handled sort of like a bond premium at issue. All proceeds credited to Common Stock

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Pure Borrowing Pure Ownership Corporate bonds Preferred, Cumulative Stock Preferred, Non- Cumulative Stock Capital Stock Risk and expected reward increase

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Par value Arbitrary amount assigned to a share of stock Set when the corporate charter is filed Usually set low as to avoid legal difficulties No-par No arbitrary amount assigned Could have a stated value Stated value treated as par 16

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Journalize the issuance of stock and prepare the stockholders’ equity section of a corporation balance sheet

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Sell directly to stockholders Use an underwriter/brokerage firm Buys unsold stock Issue price–price received for issuing stock Usually exceeds par value Stock exchange– here public company stock is traded NYSE–New York Stock Exchange 18

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 19

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Journalizing issue of one million shares of common stock issued for $20 per share. Demo: Issuing no-par common stock Demo: Issuing the same stock if it was $1 par value common stock sold for $20 per share 20

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Stockholders’ Equity Presentation The balance of the Common stock account is calculated 21

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Issuing stock for assets other than cash Asset is debited for its fair value or value of asset may be determined by stock value if appropriate Building is debited instead of cash Par rules still followed 22

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Issuing preferred stock Similar to issuing common stock, except Preferred stock is credited at par value Preferred stock sticks pretty close to par value. The dividend is fixed, so the pricing calculation is very similar to bonds. Demo: Journalize the above issue if sold for $55 per share. 23

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Equity accounts are listed in order from debt-like toward pure ownership on the balance sheet: Preferred stock, Common stock, Retained earnings 24

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Who issued preferred, no-par common, par value common? What else can we tell from their equity history? DENN AMZN DIS XOM 25

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Scifilink.com issued stock beginning in 2012 and reported the following on its balance sheet at December 31, 2012: Common stock, $ 2.00 par value Authorized: 6,000 shares Issued: 4,000 shares $ 8,000 Paid-in capital in excess of par 4,000 Retained earnings 26,500 Requirement: Journalize the company’s issuance of the stock for cash. 22

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 27 Journal Entry DATE ACCOUNTS DEBITCREDIT Dec 31 Cash12,000 Common stock8,000 Paid in capital in excess of par4,000 Common stock, $ 2.00 par value Authorized: 6,000 shares Issued: 4,000 shares $ 8,000 Paid-in capital in excess of par 4,000 Retained earnings 26,500

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Susie Systems completed the following stock issuance transactions: May 19 Issued 2,000 shares of $1 par common stock for cash of $9.50 per share. June 3 Sold 300 shares of $3, no-par preferred stock for $15,000 cash. June 11 Received equipment with market value of $78,000. Issued 3,000 shares of the $1 par common stock in exchange. Requirements: 1. Journalize the transactions. Explanations are not required. 2. How much paid-in capital did these transactions generate for Susie Systems? 28

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Susie Systems completed the following stock issuance transactions: May 19 Issued 2,000 shares of $1 par common stock for cash of $9.50 per share. 29 Journal Entry DATE ACCOUNTS DEBITCREDIT May 19 Cash19,000 Common stock2,000 Paid in capital in excess of par17,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Susie Systems completed the following stock issuance transactions: June 3 Sold 300 shares of $3, no-par preferred stock for $15,000 cash. 30 Journal Entry DATE ACCOUNTS DEBITCREDIT Jun 3 Cash15,000 Preferred stock15,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Susie Systems completed the following stock issuance transactions: June 11 Received equipment with market value of $78,000. Issued 3,000 shares of the $1 par common stock in exchange. 31 Journal Entry DATE ACCOUNTS DEBITCREDIT Jun 11 Equipment78,000 Common stock3,000 Paid in capital in excess of par75,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall How much paid-in capital did these transactions generate for Susie Systems? $112,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Review retained earnings transactions

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Closing entries Step 1 – Close Revenues Step 2 – Close Expenses 34

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Closing entries Step 3 – Close Income summary 35

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A loss causes Retained earnings to decrease A debit balance in Retained earnings is a deficit 36

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A deficit is reported as a negative amount What does this say about the business? 37

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The data for Amanda’s Tax Service, Inc., for the year ended August 31, 2012, follow: Journalize the required closing entries for the year. Step 1 38 Cost of goods sold$ 62,000Sales revenue$ 125,000 Dividends14,000Operating expenses44,000 Interest revenue1,800Retained earnings24,000 Journal Entry DATEACCOUNTSDEBITCREDIT Aug 31 Sales revenue125,000 Interest revenue1,800 Income summary126,800

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The data for Amanda’s Tax Service, Inc., for the year ended August 31, 2012, follow: Journalize the required closing entries for the year. Step 2 39 Cost of goods sold$ 62,000Sales revenue$ 125,000 Dividends14,000Operating expenses44,000 Interest revenue1,800Retained earnings24,000 Journal Entry DATEACCOUNTSDEBITCREDIT Aug 31 Income summary106,000 Cost of goods sold62,000 Operating expenses44,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The data for Amanda’s Tax Service, Inc., for the year ended August 31, 2012, follow: Journalize the required closing entries for the year. Step 3 40 Cost of goods sold$ 62,000Sales revenue$ 125,000 Dividends14,000Operating expenses44,000 Interest revenue1,800Retained earnings24,000 Journal Entry DATEACCOUNTSDEBITCREDIT Aug 31 Income summary20,800 Retained earnings20,800

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The data for Amanda’s Tax Service, Inc., for the year ended August 31, 2012, follow: Journalize the required closing entries for the year. Step 4 41 Cost of goods sold$ 62,000Sales revenue$ 125,000 Dividends14,000Operating expenses44,000 Interest revenue1,800Retained earnings24,000 Journal Entry DATEACCOUNTSDEBITCREDIT Aug 31Retained earnings 14,000 Dividends 14,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The data for Amanda’s Tax Service, Inc., for the year ended August 31, 2012, follow: 2. What is the balance in Retained earnings after the closing entries are posted? 42 Cost of goods sold$ 62,000Sales revenue$ 125,000 Dividends14,000Operating expenses44,000 Interest revenue1,800Retained earnings24,000 Beginning Retained Earnings, Sep 1, 2011$24,000 Plus: Net income 20,800 44,800 Minus: Dividends 14,000 Ending Retained Earnings, Sep 1, 2011$30,800

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Account for cash dividends

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Dividends are optional up until the point the dividend is declared. Then it becomes a legal obligation to pay the declared amount on the promised date Three dates: Declaration date–Board declares a dividend and creates a liability Date of record–determines which stockholders receive dividends (note ex-dividend date) Payment date–pay dividends and remove liability 44

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Name that Date! Bonus Trivia: Name that journal entry! Name that Date! Bonus Trivia: Name that journal entry! Declaration Date Ex-Dividend Date Date of Record Date of Payment

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. $100,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Preferred dividends expressed as either: A percent of par value Or a flat dollar amount per share Common dividends are expressed as a dollar amount per share 47 2,000 shares of $50 par 6% preferred = $6,000 dividend 2,000 shares of no-par $3 preferred = $6,000 dividend

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Example: Declaration date of $6,000 preferred stock cash dividend Date of Record (no entry) Payment date 48

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Preferred stockholders receive dividends before common Common stockholders receive any dividend above the capped preferred dividend, if any Demo information: 2,000 shares of 6%, $50 par value preferred stock is outstanding 20,000 shares of common stock in outstanding Case A: $5,000 dividend declared Case B: $50,000 dividend declared Don’t erase board too soon 49

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Preferred stockholders receive dividends before common Common stockholders receive dividends if total declared is large enough to cover preferred 50

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Cumulative preferred stock Accumulates dividends each year until the dividends are paid Dividends in arrears—dividends passed or unpaid Noncumulative preferred stock Dividends not declared in any year will never be paid. 51

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. A company declares $50,000 for dividends 1 year at dividends in arrears stands at $6,000 Preferred gets $6,000 in arrears + $6,000 current Common receives the remainder Journal entry 52

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Frenchvanilla Company earned Net income of $75,000 during the year ended December 31, On December 15, Frenchvanilla declared the annual cash dividend on its 5% preferred stock (par value, $115,000) and a $0.50 per share cash dividend on its common stock (55,000 shares). Frenchvanilla then paid the dividends on January 4, Journalize for Frenchvanilla: a. Declaring the cash dividends on December 15, Journal Entry DATEACCOUNTSDEBITCREDIT Dec 15Retained earnings (or Dividends) 33,250 Dividends Payable 33,250

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. (Continued) Journalize for Frenchvanilla: b. Paying the cash dividends on January 4, Journal Entry DATEACCOUNTSDEBITCREDIT Jan 4Dividends payable 33,250 Cash 33,250

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use different stock values in decision making

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Market value Price at which a person can buy or sell a share Most important to shareholders Liquidation value Amount guaranteed to preferred if company liquidates Book value Amount of equity per share of stock If preferred stock exists, subtract preferred equity from total equity to compute book value of common shares 56

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Book value attributed to preferred stock + any preferred dividends that are in arrears Book value attributed to preferred stock is either the number of outstanding preferred shares times liquidation value per share, OR the book value of preferred equity (the Preferred stock account balance) Plus any dividends that are in arrears, if the preferred stock is cumulative. 57

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Book value of preferred stock: Liquidation price or Preferred stock accountA Dividends in arrears on any outstanding preferred sharesB Total book value attributed to preferred stockA+B Number of outstanding preferred sharesC Book value per share of preferred stock(A+B)/C 58 Book value of common stock: Total stockholders’ equityD Less: book value attributed to preferredA+B Total book value attributed to common stockD-(A+B) Number of outstanding common sharesE Book value per share of common stockD- (A+B)/E

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Bronze Tint Trust has the following stockholders’ equity: Bronze Tint has not declared preferred dividends for five years (including the current year). 59 Paid-in capital: Preferred stock, 5%, $10 par, 6,000 shares authorized, 4,500 shares issued $ 45,000 Common stock, $0.20 par, 1,200,000 shares authorized and issued 240,000 Paid-in capital in excess of par—common400,000 Total paid-in capital$685,000 Retained earnings255,000 Total stockholders’ equity$ 940,000

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Compute the book value per share of Bronze Tint’s preferred and common stock. 60 Preferred stock Par value of Preferred stock$45,000 Cumulative dividends11,250 Total book value attributed to preferred stock 56,250 Number of outstanding preferred shares 4,500 Book value per share of preferred stock $12.50

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Compute the book value per share of Bronze Tint’s preferred and common stock. (*$ rounded) 61 Common stock Total stockholders’ Equity$940,000 Less: Preferred equity(56,250) Common equity $883,750 Number of outstanding preferred shares 1,200,000 Book value per share of preferred stock * $0.74

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Evaluate return on assets and return on stockholders’ equity

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Measures a company’s success in using assets Most industries consider a 10% return good 63

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Relationship between net income available and their average common equity invested Companies strive for return on equity of 15% or higher 64 Net income – Preferred dividends Average common stockholders’ equity

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Godhi’s 2012 financial statements reported the following items—with 2011 figures given for comparison: 65

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Compute Godhi’s rate of return on total assets and rate of return on common stockholders’ equity for Do these rates of return look high or low? 66 Rate of return on total assets = Net income + Interest expense Average total assets Rate of return on common stockholders’ equity = Net income – Preferred dividends Average common stockholders’ equity $3, / $31,550 = 13% ( ) $3, / $15,519 = 25.1% ( ) These rates of return look:High

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Account for the income tax of a corporation

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Federal tax rate of 35% when combined with State taxes can increase total taxes to 40% Corporations measure two income tax amounts Income tax expense–income statement based Income tax payable–IRS taxable income based Income tax expense Income before tax on the income statement x Income tax rate Income tax payable Taxable income from the IRS filed tax return x Income tax rate Major difference–depreciation methods differ 68

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Example Income before income tax of $33,000,000 $33,000,000 X 40% = $13,200,000 taxes Taxable income of $20,000,000 $20,000,000 X 40% = $8,000,000 IRS taxes Difference is $5,200,000 $13,200,000 - $8,000,000 Deferred until taxable income catches up 69

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Corporations have advantages and disadvantages A corporation’s bylaws state how many shares it is authorized to issue. Shares may be issued electronically or traditionally, on paper. Stock types include common and preferred, par or no-par. Attributes such as voting rights, dividends proportionate to ownership percentage, liquidation preferences, and the right to maintain the same percentage of ownership (preemption) may apply. All these factors, as well as others, affect the risk inherent in the stock. 70

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Companies may issue their stock in exchange for cash or other assets. The issuance entry always involves a credit to the stock account, whether common or preferred. The amount credited to the stock account depends on whether the stock is par value stock or no par value stock. If the stock has a par value, the number of shares issued multiplied by the par value is recorded in the stock account. The premium received, if any, is credited to Paid-in capital in excess of par. If the stock has no par, then the total amount received goes to the stock account. Stockholders’ equity always lists paid-in capital first and within that listing, preferred stock amounts are listed before common stock amounts. 71

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The steps of the closing process are the same as those you learned in Chapter 4. Net income increases Retained earnings. Net loss decreases Retained earnings. Once dividends are declared, they are an obligation (liability) of the corporation. Preferred dividends are fixed and based on a stated percentage of par value or a flat dollar amount. Preferred dividends, if cumulative, must be paid in full before any dividends can be paid to common shareholders. 72

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Market value is the value for which a person can buy or sell a stock on the open market. Liquidation value is the value a preferred shareholder will receive if the corporation goes out of business. Book value per share is the net equity divided between the outstanding preferred and common shares. Return on assets and return on equity ratios are both measures of how a company is performing. Return on assets measures earnings based on average total assets employed. Return on equity measures earnings for the common stockholders based on average common equity invested. 73

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Income tax payable is based on the tax return filed with the IRS. Income tax expense is based on earnings reported on the income statement. Because of different choices a company can make for its tax return versus its GAAP-based financial statements, these earnings numbers are usually different. The difference between Income tax expense and Income tax payable is either a deferred tax asset or liability. 74

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 76