Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 1 of 13

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1 Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 1 of 13

2 Introduction A corporation is a legal entity created by law that is separate from its owners. One creates a corporation by obtaining a charter from a state government. Corporations enjoy most of the same rights and privileges available to individuals. Owners of corporations are called stockholders or shareholders. Two types of corporations exist: Privately held or closely held and publicly held. Privately held corporations do not offer their stock for sale to the general public and usually have few stockholders. A publicly held corporation offers its stock for sale to the general public and can have thousands of stockholders. The latter s stock is usually traded on an organized stock market. Characteristics of a Corporation Corporations represent an important type of organization. Their unique characteristics offer advantages and disadvantages. Advantages of Corporate Characteristics Separate legal entity: A corporation conducts its affairs with the same rights, duties, and responsibilities as those of an individual. It performs actions through its officers and managers. Limited liability of stockholders: Stockholders are not liable for corporate acts or debts. Transferable ownership rights: The transfer of rights from one stockholder to another stockholder has no effect on the corporation or its operations except when this causes a change in the directors or who controls and manages the corporation. Continuous life: A corporation can live forever. Its life is not connected to the physical life of its owners. Ease of capital accumulation: Buying stock stands as attractive for investors because stockholders are not liable for the corporation s acts or debts, the stock can be easily transferred, and the corporation s life is unlimited. Disadvantages of Corporate Characteristics A corporation is a legal entity created by law that is separate from its owners. Government regulation: A corporation must meet the requirements of a state s incorporation laws, which subject the corporation to state regulation and control. Sole proprietors and partnerships avoid many of these regulations. Corporate taxation: Corporations are subject to the same property and payroll taxes as individuals. In addition, the corporate federal and state income tax together can total 40% or more of the entity s pre-tax income. Moreover, corporate income is usually taxed a second time as part of a stockholder s income when stockholders receive cash distributed as a dividend. This is called double taxation. Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 2 of 13

3 Stock, Classes of Stock, and Records for Issuing Stock When investors buy stock, they acquire all specific rights the corporation s charter grants to the stockholder for that type stock. They also acquire general rights granted to stockholders by the laws of the state in which the company is incorporated. When a corporation has only one class of stock, it is identified as common stock. State laws vary, but common stockholders usually have the general right to: Vote at stockholders meetings Sell or dispose of their stock Receive the same dividend, if any, on each common share of the corporation Share in any assets remaining after creditors are paid when, and if, the corporation is liquidated Receive timely financial reports Investors who buy a corporation s stock sometimes receive a stock certificate as proof of ownership. A certificate can be issued for any number of shares. A stock certificate shows the company name, stockholder s name, number of shares, and other crucial information. Issuance of stock certificates has become less common. Instead, many stockholders maintain accounts with a corporation or a stockbroker and never receive an actual certificate. If a corporation trades its stock on a major stock exchange, the corporation must have a registrar and a transfer agent. A registrar keeps stockholder records and prepares an official list of stockholders for stockholder meetings and dividend payments. A transfer agent assists with purchases and sales of shares by receiving and issuing stock certificates as necessary. When investors buy stock, they acquire all specific rights the corporation s charter grants to the stockholder for that type stock. Capital stock is a general term that refers to any shares issued to obtain capital. Authorized stock refers to the number of shares that a corporation's charter allows it to sell. The number of authorized shares usually exceeds the number of shares issued. Outstanding stock refers to issued stock held by stockholders. A corporation discloses the number of shares authorized in the equity section of their balance sheet. A corporation can sell its stock directly or indirectly. To sell directly, it advertises its stock issue directly to prospective buyers, usually through a direct purchase program. While online brokerage firms seem to lower their fees every day, buying stock directly from a company can result in lower cost to the potential investors. To sell indirectly, a corporation pays a brokerage house to issue its stock. Market value per share refers to the price that stock is bought and sold for on the open market. Expected future earnings, dividends, growth, and other company and economic factors influence the market value of stock. Traded stock market values can be found daily in newspapers like the Wall Street Journal or online. Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 3 of 13

4 When all authorized shares share the same rights and characteristics, the stock is called common stock. A corporation can sometimes issue more than one class of stock, including preferred stock and different classes of common stock. Common stock usually entitles one to one vote for every share that one owns; however, this is not always the case. Some companies have different classes of common stock that vary based on the number of votes attached to them. So, for example, one share of Class A stock in a certain company might give one 10 votes per share, while one share of Class B stock in the same company might only give one, one vote per share. And sometimes, a certain class of common stock will have no voting rights attached to it at all. Par value refers to an arbitrary dollar amount assigned per share by the corporation in its charter. No restrictions exist on the assigned par value. In many states, the par value of a stock establishes minimum legal capital, which refers to the least amount that the buyers of stock must contribute to the corporation or be subject to pay at a future date. Minimum legal capital is intended to protect a corporation's creditors. No-par value stock refers to stock that is not assigned a value per share by the corporate charter. Its advantage is that it can be issued at any price without the possibility of a minimum legal capital deficiency. Stated value stock is no-par stock to which the directors assign a stated value per share. Stated value per share becomes the minimum legal capital per share in this case. A corporation s equity is referred to as stockholder s equity. Stockholder s equity consists of paid-in capital and retained earnings. Paid-in capital is the total amount of cash and other assets the corporation receives from stockholders in exchange for common stock. Retained earnings refers to the cumulative net income (and loss) retained by a corporation. Accounting for the issuance of common stock affects only paid-in capital accounts; no retained earnings accounts are affected. The Issuance of Stock at a Premium and Stock without Par Value Par value stock can be issued at par, at a premium (above par), or at a discount (below par). In each case, stock can be exchanged for either cash or non-cash assets. Issuing par value stock. When common stock is issued at par value, it is important to record amounts for both the asset received and the par value stock issued. To illustrate, the entry to record Dillon s issuance of 30,000 shares of $10 par value stock for $300,000 cash on June 5, 2008, follows: June 5 Cash 300,000 Common Stock, $10 Par Value 300,000 Issued 30,000 shares of $10 par value common stock at par Below is shown the stockholder s equity section of Dillon s Balance Sheet at year end 2008 (its first year of operations) after income of $65,000 and no dividend payments. Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 4 of 13

5 Stockholder s Equity Common Stock: $10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding $300,000 Retained earnings Total stockholder s equity $365,000 65,000 Issuing Par Value Stock at a Premium. A premium on stock occurs when a corporation sells its stock for more than par (or stated) value. To illustrate, if Dillon issues its $10 par value common stock at $12 per share, its stock is sold at a $2 per share premium. The premium, known as paid-in capital in excess of par, is reported as part of equity; it is not revenue and is not listed on the income statement. The entry to record Dillon s issuance of 30,000 shares of $10 par value stock for $12 per share on June 5, 2008, follows: June 5 Cash 360,000 Common Stock: $10 Par Value 300,000 Paid-in Capital in Excess of Par Value, Common Stock 60,000 Sold and issued 30,000 shares of $10 par value common Stock at $12 per share The paid-in capital in excess of par value account is added to the par value of the stock in the equity section of the balance sheet. Stockholder s Equity Common Stock: $10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding $300,000 Paid-in capital in excess of par value, common stock 60,000 Retained earnings 65,000 Total stockholder s equity $425,000 Issuing Par Value Stock at a Discount. A discount on stock occurs when a corporation sells its stock for less than par (or stated) value. Most states prohibit the issuance of stock at a discount. In states that allow stock to be issued at a discount, its buyers usually become contingently liable to creditors for the discount. If a stock is issued at a discount, the amount by which issue price is less than par is debited to a Discount on Common Stock account, a contra to the common stock account, and its balance is subtracted from the par value of stock in the equity section of the balance sheet. This discount is not an expense and does not appear on the income statement. Issuing No-Par Value Stock. When no-par stock is issued and is not assigned a stated value, the amount the corporation receives becomes legal capital and is recorded as Common Stock. This means that the entire proceeds are credited to a no-par stock account. A discount on stock occurs when a corporation sells its stock for less than par (or stated) value. Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 5 of 13

6 To illustrate, a corporation records its October 20 issuance of 1000 shares of no-par stock for $40 cash per share as follows: Oct. 20 Cash 40,000 Common Stock, No-Par Value 40,000 Issued 1000 shares of no-par value common stock at $40 per share Issuing Stated Value Stock. When no-par stock is issued and assigned a stated value, its stated value becomes legal capital and is credited to a stated value stock account. Assuming that stated value stock is issued at an amount in excess of stated value (the usual case), the excess is credited to Paid-in Capital in Excess of Stated Value, Common Stock, which is reported in the stockholder s equity section. To illustrate, a corporation that issues 1,000 shares of no-par common stock with a stated value of $40 per share in return for $50 cash per share records as follows: Oct. 20 Cash 50,000 Common Stock, $40 stated value 40,000 Paid-in Capital in Excess of Stated Value, Common Stock Issuing Stock for Non-Cash Assets. A corporation can receive assets other than cash in exchange for its stock. It can also assume liabilities on the assets received such as a mortgage on property received. The corporation records the assets received at their market values as of the date of the transaction. The stock given in exchange is recorded at its par (or stated) value with any excess recorded in the Paid-in Capital in Excess of Par (or Stated) Value account. If no-par stock is issued, the stock is recorded at the assets market value. To illustrate, the entry to record receipt of land valued at $105,000 in return for issuance of 4,000 shares of $20 par value common stock on June 10 is as follows: June 10 Land 105,000 Common Stock, $20 Par Value 80,000 Paid-In Capital in Excess of Par Value, Common Stock 25,000 Exchanged 4000 shares of $20 par value common stock for land. A corporation sometimes gives shares of its stock to promoters in exchange for their services in organizing the corporation, which the corporation records as Organization Expenses. The entry to record receipt of services valued at $12,000 in organizing the corporation in return for 600 shares of $15 par value common stock on June 5 is as follows: June 5 Organization Expense 12,000 Common Stock, $15 Par Value 9,000 Paid-in Capital in Excess of Par Value, Common Stock 3,000 Gave promoters 600 shares of $15 par value common stock in exchange for their services. Accounting Entries for Cash Dividends and Stock Dividends Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 6 of 13

7 The decision to pay cash dividends rests with a corporation s board of directors and involves more than evaluating the amounts of retained earnings and cash. The directors, for instance, may decide to keep the cash to invest in the corporation s growth, to meet emergencies, to take advantage of unexpected opportunities, or to pay off debt. Alternatively, many corporations pay cash dividends to their stockholders at regular dates. This cash flow provides a return to investors and almost always affects the stock s market value. This information indicates that stock returns are positively associated with cash flow and may act as a signal for positive future earnings. Dividend payments involve three important dates: declaration, record, and payment. Date of declaration refers to the date the directors vote to declare and pay a dividend. This creates a legal liability of the corporation to its stockholders. Date of record refers to the future date specified by the directors for identifying those stockholders listed in the corporation s records to receive dividends. The date of record usually follows the date of declaration by at least two weeks. Persons who own stock on the date of record receive dividends. Date of payment refers to the date when the corporation makes payment; it follows the date of record by enough time to allow the corporation to arrange checks, money transfers, or other means to pay dividends. To illustrate, the entry to record a January 9 declaration of a $1 per share cash dividend by the directors of Zeb, Inc. with 5,000 outstanding shares is: Date of Declaration Jan. 9 Retained Earnings 5,000 Common Dividend Payable 5,000 Declared a $1 per common share cash dividend Common Dividend Payable is a current liability. The date of record for the Zeb, Inc. dividend is January 22. No formal journal entry is needed on the date of record. The February 1 date of payment requires an entry to record both the settlement of the liability and the reduction of cash as follows: Date of Payment Feb. 1 Common Dividend Payable 5,000 Cash 5,000 Paid $1 per common share cash dividend A stock dividend, declared by a corporation s directors, refers to a distribution of additional shares of the corporation s own stock to its stockholders without the receipt of any payment in return. Stock dividends and cash dividends are different. A stock dividend does not reduce assets or equity but instead transfers a portion of equity from retained earnings to contributed capital. Stock dividends exist for two reasons. First, directors are said to use stock dividends to keep the market price of the stock affordable. For example, if a corporation continues to earn income but does not issue cash dividends, the price of its common stock likely increases. The price of such a stock may become so high that it discourages some investors from buying the stock. Participating in a stock dividend increases the number of outstanding shares and lowers Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 7 of 13

8 the per share stock price for a corporation. A stock dividend also provides evidence of management s confidence that the company is doing well and will continue to do so. A stock dividend affects equity by transferring part of the retained earnings to contributed capital accounts. Accounting for a stock dividend depends on whether it is a small or large stock dividend. A small stock dividend refers to a distribution of 25% or less of previously outstanding shares. It is recorded by capitalizing retained earnings for an amount equal to the market value of the shares to be distributed. A large stock dividend refers to a distribution of more than 25% of previously outstanding shares. A large stock dividend is recorded by capitalizing retained earnings for the minimum amount required by state law governing the corporation. Most states require capitalizing retained earnings equal to the par or stated value of the stock. To illustrate stock dividends, consider the equity section of Quest s balance sheet just before its declaration of a stock dividend on December 31. Stockholder s Equity (before dividend) Common Stock: $10 par value; 15,000 shares authorized; 10,000 shares issued and outstanding $100,000 Paid-in capital in excess of par value, common stock 8,000 Retained earnings 35,000 Total stockholder s equity $143,000 Recording a small stock dividend. Assume that Quest s directors declare a 10% stock dividend on December 31. This stock dividend of 1000 shares, computed as 10% of its 10,000 issued and outstanding shares, is to be distributed on January 20 to the stockholders of record on January 15. Since the market price of Quest s stock on December 31 is $15 per share, this small stock dividend declaration is recorded as follows: Date of Declaration Dec. 31 Retained earnings 15,000 Common Stock Dividend Distributable 10,000 Paid-in Capital in Excess of Par Value, Common Stock 5,000 Declared a 1,000 share (10%) stock dividend The $10,000 credit in the declaration entry equals the par value of the shares and is recorded in common stock dividend distributable. Its balance exists only until issuance of the shares. The $5,000 credit equals the amount by which market value exceeds par value. This amount increases the Paid-in Capital in Excess of Par Value account in anticipation of the issuance of shares. In general, declaration of a stock dividend changes the balance sheet in three ways. First, the amount of equity attributed to common stock increases; for Quest, from $100,000 to $110,000 for 1,000 additional declared shares. Second, paid-in capital in excess of par increases by the excess of market value over par value for the declared shares. Third, retained earnings decreases, reflecting the transfer of amounts to both common stock and contributed capital in excess of par. The stockholder s equity of Quest is shown below after declaration of the 10% stock dividend on December 31. Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 8 of 13

9 Stockholder s Equity (after dividend) Common Stock: $10 par value; 15,000 shares authorized: 10,000 shares issued and outstanding $100,000 Common stock dividend distributable 1,000 shares 10,000 Paid-in capital in excess of par value, common stock 13,000 Retained earnings 20,000 Total stockholder s equity $143,000 No entry is made on the date of record for a stock dividend. On January 20, the date of payment, Quest distributes the new shares to stockholders and records this entry: Date of Payment Jan. 20 Common Stock Dividend Distributable 10,000 Common Stock, $10 Par Value 10,000 To record issuance of common stock dividend The combined effect of these stock dividend entries is to transfer (or capitalize) $15,000 of retained earning to paid-in capital accounts. Recording a large stock dividend. A corporation capitalizes retained earnings equal to the minimum amount required by state law for a large stock dividend. For most states, this amount is the par or stated value of the newly issued shares. To illustrate, suppose Quest s board declares a stock dividend of 30% instead of 10% on December 31. Since this dividend is more than 25%, it is treated as a large stock dividend. Thus, the par value of the 3,000 dividend shares is capitalized at the date of declaration with this entry: Date of Declaration Dec. 31 Retained earnings 30,000 Common Stock Dividend Distributable 30,000 Declared a 3,000 share (30%) stock dividend This transaction decreases retained earnings and increases contributed capital by $30,000. On the date of payment, the company debits Common Stock Dividend Distributable and credits Common Stock for $30,000. The effects of a large stock dividend on the balance sheet accounts are similar to those of a small stock dividend except for the absence of any effect on contributed capital in excess of par. Treasury Stock Corporations acquire shares of their own stock for several reasons: To use their shares to acquire other corporations To purchase shares to avoid a hostile takeover of the company To reissue them to employees as compensation To maintain a strong market for their stock or to show management confidence in the current price Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 9 of 13

10 A corporation s reacquired shares are called treasury stock, which is similar to un-issued stock since neither is an asset, neither receives voting rights, and neither receives cash or stock dividends. However, treasury stock stands as different from un-issued stock in one major way the corporation can resell treasury stock at less than par value without having the buyer incur a liability, provided the stock was originally issued at par value or higher. Purchasing treasury stock reduces the corporation s assets and equity by equal amounts. To illustrate, using the cost method of accounting for treasury stock, below is Sun Corporation s account balances before any treasury stock purchase. (Assume the company has no liabilities.) Sun then purchases 1,000 of its own shares for $11,500 on May 1, which is recorded as follows: May 1 Treasury Stock Common 11,500 Cash 11,500 Purchased 1,000 treasury shares at $11.50 per share. This entry reduces equity through the debit to the Treasury Stock account, which is a contra equity account. Below is the account balance after this transaction: The treasury stock purchases reduce Sun s cash, total assets, and total equity by $11,500 but do not reduce the balance of either the Common Stock or the retained earnings account. The equity reduction is reported by deducting the cost of treasury stock in the equity section. One can reissue treasury stock by selling it at cost, above cost, or below cost. If treasury stock is reissued at cost, the entry appears as the reverse of the one made to record the purchase. For instance, if on May 21, Sun reissues 100 of the treasury shares purchased on May 1 at the same $11.50 per share cost, the entry reads: Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 10 of 13

11 May 21 Cash 1,150 Treasury Stock, Common 1,150 Received $11.50 per share for 100 treasury shares costing $11.50 per share If treasury stock is sold for more than cost, the amount received in excess of cost is credited to the Paid-in Capital, Treasury Stock account. This account is reported as a separate item in the stockholder s equity section. No gain is ever reported from the sale of treasury stock. To illustrate, if Sun receives $12 cash per share for 400 treasury stock costing $11.50 per share on June 3, the entry reads: June 3 Cash 4,800 Treasury Stock, Common 4,600 Paid-in Capital, Treasury Stock 200 Received $12 per share for 400 treasury shares costing $11.50 per share When treasury stock is sold below cost, the entry to record the sale depends on whether the Paid-In Capital, Treasury Stock account includes a credit balance. If it has a zero balance, the excess of cost over the sales price is debited to retained earnings. If the Paid-in Capital, Treasury Stock account has a credit balance, it is debited for the excess of the cost over the selling price but not to exceed the balance in this account. When the credit balance in this paidin capital account is eliminated, any remaining difference between the cost and selling price is debited to retained earnings. To illustrate, if Sun sells its remaining 500 shares of treasury stock at $10 per share on July 10, equity is reduced by $750 (500 shares x $1.50 per share excess of cost over selling price) as shown in this entry: July 10 Cash 5,000 Paid-in Capital, Treasury Stock 200 Retained earnings 550 Treasury Stock, Common 5,750 Received $10 per share for 500 treasury shares costing $11.50 per share This entry eliminates the $200 credit balance in the paid-in capital account created on June 3 and then reduces the retained earnings balance by the remaining $550 excess of cost over selling price. A company never reports a loss (or gain) from the sale of treasury stock. Stock Splits A stock split refers to the distribution of additional shares to stockholders according to their percent ownership. When a stock split occurs, the corporation calls in its outstanding shares and issues more than one new share in exchange for each old share. Splits can occur in any ratio, including two-for-one, three-for-one, or higher. Stock splits reduce the stated value per share. To illustrate, CanTec has 100,000 outstanding shares of $20 par value common stock with a current market value of $88 per share. A two-for-one stock split cuts par value in half, as it replaces 100,000 shares of $20 par value stock with 200,000 shares of $10 par value stock. Market value is reduced from $88 per share to about $44 per share. The split does not affect Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 11 of 13

12 any equity amounts reported on the balance sheet or any individual stockholder s percent ownership. Both the paid in capital and retained earnings accounts are unchanged by a split, and no journal entry is made. The only effect on accounts is a change in the stock account description. CanTec s two-for-one split on its $20 par value stock means that after the split, it changes to common stock, $10 par value. This stock s description on the balance sheet also changes to reflect the additional, authorized, issued, and outstanding shares and the new par value. Glossary Authorized stock: The number of shares that a corporation's charter allows it to sell. The number of authorized shares usually exceeds the number of shares issued. Capital stock: A general term that refers to any shares issued to obtain capital. Common Stock: When a corporation has only one class of stock, and all authorized shares have the same rights and characteristics. Date of declaration: The date the directors vote to declare and pay a dividend. Date of payment: The date when the corporation makes payment; it follows the date of record by enough time to allow the corporation to arrange checks, money transfers, or other means to pay dividends. Date of record: The future date specified by the directors for identifying those stockholders listed in the corporation s records to receive dividends. Large stock dividend: A distribution of more than 25% of previously outstanding shares. Minimum legal capital: The least amount that the buyers of stock must contribute to the corporation or be subject to pay at a future date. No-par value stock: Stock not assigned a value per share by the corporate charter. Outstanding stock: Issued stock held by stockholders. Paid-in capital in excess of par: A premium on stock occurs when a corporation sells its stock for more than par (or stated) value. Paid-in capital: The total amount of cash and other assets the corporation receives from stockholders in exchange for common stock. Par value: An arbitrary dollar amount assigned per share by the corporation in its charter. Registrar: Keeps stockholder records and prepares official list of stockholders for stockholder meetings and dividend payments. Retained earnings: The cumulative net income (and loss) retained by a corporation. Small stock dividend: A distribution of 25% or less of previously outstanding shares. Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 12 of 13

13 Stated value stock: No-par stock to which the directors assign a stated value per share. Stock certificate: Proof of ownership investors who buy a corporation s stock sometimes receive. Stock dividend: Declared by a corporation s directors, a distribution of additional shares of the corporation s own stock to its stockholders without the receipt of any payment in return. Stock split: The distribution of additional shares to stockholders according to their percent ownership. Stockholder s equity: A corporation s equity. Stockholder s equity consists of paid-in capital and retained earnings. Transfer agent: Assists with purchases and sales of shares by receiving and issuing stock certificates as necessary. Treasury stock: A corporation s reacquired shares; similar to un-issued stock since neither is an asset, neither receives voting rights, and neither receives cash or stock dividends. Copyright 2009 The Learning House, Inc.Organizations, Capital Stock Transactions and Dividends Page 13 of 13