ACCT652 Accounting. Characteristics of Corporations. Characteristics of Corporations. ACCT652 Week 7. Week 7 Corporations and partnerships.

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1 ACCT652 Accounting Week 7 Corporations and partnerships. Some slides Times Mirror Higher Education Division, Inc. Used by permission Michael D. Kinsman, Ph.D. 1 Characteristics of Corporations A corporation is an entity having legal rights, obligations, and an existence separate from its owners. Corporations can... Enter into contracts. Buy, sell, or hold property. Borrow money. Hire and fire employees. Sue and be sued. 2 Characteristics of Corporations Corporations are separate legal entities. Stockholders are not liable for corporate debts. Ownership rights are easily transferred. Corporations have continuity of life. 3

2 Characteristics of Corporations Stockholders are not agents of the corporation. Ease of capital accumulation. Government regulation. Double Taxation. 4 Par Value and Minimum Legal Capital Par value is an arbitrary amount assigned to each share of stock when it is authorized. Total par value establishes minimum legal capital in many states. Laws require stockholders to invest assets equal in value to minimum legal capital, or be liable to corporate creditors for the deficiency. Par value is not an indication of market value. 5 Stock Premiums and Discounts A premium on stock is the amount in excess of par value paid by purchasers of newly issued stock. Premium is called Contributed Capital in Excess of Par Value or Additional Paid in Capital. Contributed Capital in Excess of Par Value is disclosed along with par value in the Stockholders Equity section of the Balance Sheet as shown on the following screen. 6

3 Premiums on Stock Example of Stockholders Equity on the Balance Sheet Stockholders' Equity Common stock, $10 par value, 25,000 shares authorized, 20,000 shares issued and outstanding $ 200,000 Contributed capital in excess of par value 30,000 Total contributed capital $ 230,000 Retained earnings 82,400 Total stockholders' equity $ 312,400 7 Discounts on Stock A discount on stock is the amount below par value paid by purchasers of newly issued stock. Most states prohibit issuing stock for a discount. Stockholders are contingently liable to corporate creditors for the amount of any discount. 8 Stock Issued for Cash Example Par Value Stock Prepare the journal entry to record an issuance of 10,000 shares of $20 par value stock for $25 per share which occurred on September 1, 20x6. 9

4 Stock Issued for Cash Solution Date Description GENERAL JOURNAL Page 13 Post. Ref. Debit Credit Sept 1 Cash 250,000 Common Stock 200,000 Contributed Capital in Excess of Par Value 50,000 To record issuance of Common Stock for cash. Common Stock = 10,000 shares * $20 per share = $200, No-Par Stock Most states permit the issuance of stock without par value: no-par stock. The advantage of no-par stock is that it may be issued at any price without having a discount liability. 11 No-Par Stock The entire proceeds from the issuance of no-par stock becomes minimum legal capital. In some states the board of directors assigns a stated value to no-par stock. In these states, the total stated value of an issue becomes the minimum legal capital. 12

5 Stock Issued for Cash Solution Date Description GENERAL JOURNAL Page 13 Post. Ref. Debit Credit Sept 1 Cash 250,000 Common Stock 250,000 To record issuance of Common Stock for cash. 13 Sale of Stock Through Subscriptions Buyer (subscriber) agrees to purchase shares at specified price. Subscriber pays for shares in installments. Corporation does not issue shares until the subscriber has paid the entire amount of the subscription. 14 Subscriptions Receivable and Subscribed Stock on the Balance Sheet Subscriptions Receivable is reported as a current or long-term asset depending on when collection is expected. Common Stock Subscribed is reported as a separate item in Stockholders Equity until collection. 15

6 Corporate Dividends A cash dividend is... A distribution of a corporation s earnings to its stockholders. Declared by the corporation s board of directors. Paid quarterly by most large corporations. 16 Corporate Dividends A corporation is not legally committed to pay a dividend until the board of directors declares the dividend. In deciding to declare a dividend, the board of directors considers... The general financial condition of the corporation. The availability of cash to pay the dividend. The economic prospects and future profitability of the corporation. 17 Deficits and Dividends A deficit exists when a corporation has a debit balance in retained earnings. Deficits occur because a company has... Incurred cumulative losses greater than cumulative profits. Paid dividends greater than cumulative profits earned in other years. Most states do not allow a company with a deficit to pay dividends. 18

7 General Rights of Common Stockholders Vote at stockholders meetings. Sell or otherwise dispose of their shares. Buy new shares in proportion to shares already owned (preemptive right). Share according to relative ownership percentage in... Dividends when declared. Assets in event of liquidation. 19 Preferred Stock Preferred stock is a separate class of stock, typically having priority over common shares in... Dividend distributions. Distribution of assets in case of liquidation. Preferred stock usually has a stated dividend rate. Preferred stock normally does not have voting rights. 20 Cumulative and Noncumulative Preferred Stock Noncumulative Undeclared dividends from current and prior years (dividends in arrears) do not have be paid in future years. Cumulative Right to undeclared dividends accumulates. Undeclared dividends must be paid before dividends may be paid on common stock. Preferred dividends in arrears must be disclosed in the financial statements. 21

8 Participating Preferred Stock Most preferred stocks have a fixed dividend rate: A percentage of par value, or A dollar amount per share. Participating preferred stockholders have the right to share with common stockholders in any additional dividends paid in excess of the dividend rate on the preferred stock. 22 How do you divide a dividend? We need, sometimes, to decide how to divide a dividend between common and preferred. It is done as follows: 23 Dividing a dividend ➊ First, to preferred, its arrearage. ➋ Next, to preferred, its normal dividend, which is equal to its par value times its dividend rate. ➌ Next, to common, an amount equal to its par value times the dividend rate on preferred. ➍ Next, to common and preferred, in the ratio of their par values, an amount equal to the par value of each times gueeble. Gueeble is the participating rate on preferred minus the normal dividend rate on preferred. ➎ The rest to common. 24

9 Dividing a dividend If, at any step in the preceding, you run out of money, STOP at that step. You are done. If you run out at step 4, divide what was left after step 3 in the ratio of the par values of preferred and common. 25 Let s try an example A company has 100,000 shares of $20 par 6 percent preferred stock participating to 8 percent. The company has 200,000 shares of $15 par value common stock. The company has two years dividends in arrears. The company declares a $600,000 dividend. Divide it. 26 Dividing a dividend ➊ To preferred its arrears: 2* $20*100,000*.06 = $240,000 To pfd To com. Cum pfd. Cum. com. Cum. Tot Amt. Left Step 1 240, , , ,000 Step 2 240, , ,000 Step 3 240, , ,000 Step 4 240, , ,000 Step 5 240, , ,000 Total 240,000-27

10 Dividing a dividend ➋ To preferred, its normal dividend: $20*100,000*.06 = $120,000. To pfd To com. Cum pfd. Cum. com. Cum. Tot Amt. Left Step 1 240, , , ,000 Step 2 120, , , ,000 Step 3 360, , ,000 Step 4 360, , ,000 Step 5 360, , ,000 Total 360, Dividing a dividend ➌ Next, to common, an amount equal to its par value times the dividend rate on preferred. 200,000 * 15 *.06 = 180,000 To pfd To com. Cum pfd. Cum. com. Cum. Tot Amt. Left Step 1 240, , , ,000 Step 2 120, , , ,000 Step 3 180, , , ,000 60,000 Step 4 360, , ,000 60,000 Step 5 360, , ,000 60,000 Total 360, , Dividing a dividend Next, to common and preferred, in the ratio of their par values, an amount equal to the par value of each times gueeble. Gueeble is the participating rate on preferred minus the normal dividend rate on preferred. Calculate gueeble: 8% - 6% = 2% Preferred: 100,000 * 20 *.02 = $40,000 Common: 200,000 * 15 *.02 = $60,000 To pfd To com. Cum pfd. Cum. com. Cum. Tot Amt. Left Step 1 240, , , ,000 Step 2 120, , , ,000 Step 3 180, , , ,000 60,000 Step 4 40,000 60, , , ,000 40,000 Step 5 400, , ,000 40,000 Total 400, ,000 30

11 OOPS! We went too far we ve distributed more dividends than we have. We have to stop after step 3 and divide the rest in the ratio of par values. 31 Dividing a dividend Next, to common and preferred, in the ratio of their par values, an amount equal to the par value of each times gueeble. Gueeble is the participating rate on preferred minus the normal dividend rate on preferred. Preferred: 100,000 * 20 = 2,000,000 40% Common: 200,000 * 15 = 3,000,000 60% Total: 5,000, % To pfd To com. Cum pfd. Cum. com. Cum. Tot Amt. Left Step 1 240, , , ,000 Step 2 120, , , ,000 Step 3 180, , , ,000 60,000 Step 4 24,000 36, , , ,000 Step 5 384, , ,000 Total 384, , Can we automate that? Could we put together a spreadsheet to do that automatically? Sure. 33

12 Summary of Common and Preferred Stock Characteristics Common Stock Voting privileges Dividend may increase or decrease Preemptive right to buy additional shares Dividends paid after preferred dividends paid Receives distribution after preferred in case of liquidation Preferred Stock Usually non-voting Dividend is usually constant Does not have preemptive right Dividends allocated before common stock dividends Receives distribution before common in case of liquidation 34 Stock Values Callable preferred stock Corporation has the right to retire callable preferred stock by paying a specified amount per share (call price) to shareholders. Market value Price at which investors may buy and sell shares in the market place. 35 Stock Values Book Value Book value per share of stock is the share s portion of the stockholders equity. Book value per share of common = (Total stockholders equity minus the call price of preferred minus preferred dividends in arrears) divided by number of shares of common stock outstanding. 36

13 Corporate Dividends and Other Stock Transactions Retained Earnings The total cumulative amount of the reported net income less any net losses and dividends declared since the company started operating. Stockholders residual interest in the corporation. 37 Stock Dividends Rather than pay cash to shareholders, management may decide to issue additional shares of the company s own stock in the form of a dividend. Why Distribute a Stock Dividend? To keep the market price of the company s stock reasonable. Provide evidence of management s confidence that the company is doing well. Conserve the company s cash. 38 Stock Dividends Effect on Stockholders Equity: Transfers part of Retained Earnings to the contributed capital accounts. This is often described as capitalizing retained earnings. 39

14 Stock Dividends Small Stock Dividend Equal to less than 25% of the previously outstanding shares. Recorded at market value of shares issued. Large Stock Dividend Equal to 25% or more of the previously outstanding shares. Usually recorded at par or stated value of the newly issued shares. 40 Stock Splits The corporation calls in its outstanding shares and issues two or more new shares in exchange for each of the old ones. The corporation reduces the par or stated value per share and increases the number of shares outstanding. 1 Share WestCo, Inc. Common Stock 41 Stock Split Example Assume that WestCo, Inc. declares a two-for-one stock split and has the following stockholders equity before the split: 42

15 Stock Split Example ➊ The 50,000 old $2 par value common shares will be called by WestCo and... ➋ 100,000 new $1 par value common shares will be issued. Stockholder 1 old share 2 new shares WestCo Inc. 43 Stock Split Example After the split the stockholders equity section will look like this: 44 Treasury Stock A corporation may acquire shares of its own stock. These shares are known as treasury shares and may be acquired to... Avoid a hostile takeover. Be reissued to employees as compensation. Help its shareholders get a better price for their shares. Acquired treasury shares are recorded at cost. 45

16 Treasury Stock Treasury stock is not considered an asset of the corporation. It is a reduction in stockholders equity. Cash dividends and stock dividends are not paid on treasury shares. Management must be sure the purchase of treasury shares is in the best interest of all stockholders. 46 Reporting Income and Retained Earnings Information In reporting income and retained earnings, our goal is to provide the user with useful information about past-period events. If a company has only routine revenue and expense transactions, a single-step income statement is adequate to meet our goal. 47 Continuing Operations The Single-Step Income Statement Total revenues Less: Operating expenses Income from operations Other income and expenses Net income 48

17 Extraordinary Items A gain or loss that is... Unusual -- not related to the ordinary activities of the business operations, and Infrequent -- not expected to occur again in the company s operations, or Required by an FASB Statement. 49 Extraordinary Items Gains or losses that are unusual in nature or infrequent in occurrence but not both... Are reported as a normal gain or loss above Income from Continuing Operations. Extraordinary items are reported below Income from Continuing Operations net of applicable income taxes. 50 Extraordinary Items 51

18 Earnings Per Share This is the amount of income earned by each share of a corporation s common stock. It is one of the most widely quoted items in the financial community. The calculation of earnings per share (EPS) can be simple or complicated, depending on a company s situation. 52 Companies with Simple Capital Structures A simple capital structure can include... Common stock Nonconvertible preferred stock. A simple capital structure cannot include... Stock options Convertible preferred stocks or bonds. 53 Companies with Simple Capital Structures EPS = Net income - Preferred dividends Average Outstanding common shares 54

19 Companies with Complex Capital Structures Complex capital structures include... Options or rights to purchase common stock, and/or, Convertible bonds or preferred stock. The company may be required to show two EPS values... Primary earnings per share Fully diluted earnings per share 55 Primary Earnings per Share If it appears probable that convertible securities will be converted into common shares... the security is called a common stock equivalent, and the shares issuable are included in the calculation of primary earnings per share. 56 Partnerships A partnership is an unincorporated business owned by two or more persons. 57

20 Characteristics of Partnerships Limited life Mutual Agency Every partner is a fully authorized agent of the partnership. All partners are exposed to the risk of unwise partnership actions by any one partner. Unlimited liability Creditors can satisfy their claims from personal assets of partners. 58 Limited Partnerships Limited partnerships have two classes of partners: General partners who have unlimited liability. Limited partners whose liability is limited to the amount of their original investment. A limited partnership is managed by the general partners. 59 Limited Liability Partnerships Limited liability partnerships are designed to protect innocent partners from malpractice or negligence of other partners. All partners still have unlimited liability for partnership debts. 60

21 Partnership Accounting Because ownership rights in partnership are divided among the partners, partnership accounting... Uses a capital account for each partner. Uses a withdrawals account for each partner. Allocates net income or losses to the partners according to the provisions of the partnership agreement. 61 Nature of Partnership Earnings Guaranteed payments (Salaries) Amounts paid to partners for services are not deducted as salary expense in determining partnership income, but allocation of partnership earnings may reflect salary allowances. Invested capital Partners do not invest in a partnership to earn interest on capital, but the division of partnership earnings may include a return based on invested capital. 62 Division of Earnings In absence of an agreement stating otherwise, partnership income or loss is shared equally by the partners. 63

22 Division of Earnings Partnership agreements frequently specify one of the following methods to divide partnership earnings: In a fixed ratio. Based on capital invested. Using guaranteed payments (salaries) and interest allowances with any remainder of earnings divided according to a fixed ratio. 64 Salaries and Interest as Aids in Sharing Example: Gray and Green agree on salary allowances of $30,000 and $20,000, respectively. Gray invested $25,000 in the partnership and Green invested $50,000. Each partner receives 10 percent interest on capital invested. Any remaining income after allowances is divided equally. If partnership income is $90,000, how much does each partner receive? 65 Rule: do what the partnership agreement says Very often, people get hung up when they do allocation of partnership income. Follow this rule: Follow the partnership agreement. You have no ability to change it because you don t like what it does. If it needs to be rewritten, the partners will rewrite it. We are allocating income, NOT the cash taken. 66

23 Set up a table To be allocated Gray Green Total 90,000 (50,000) Guar. Pmts. 30,000 20,000 50,000 (7,500) Interest 2,500 5,000 7,500 32,500 Remainder 16,250 16,250 32,500 Total 48,750 41,250 90, Salaries and Interest as Aids in Sharing Example continued: The partnership income was sufficient to cover salary and interest allowances. Now assume that partnership income is only $40,000, but all other information remains the same. How much does each partner receive? 68 Set up a table To be allocated Gray Green Total 40,000 (50,000) Guar. Pmts. 30,000 20,000 50,000 (7,500) Interest 2,500 5,000 7,500 (17,500) Remainder (8,750) (8,750) (17,500) Total 23,750 16,250 40,000 69

24 That completes what we are going to do this evening. See you next week! 70