Accounting for Corporations - Chapter 13

Accounting for Corporations: Chapter 13 Notes

Learning Objectives

  • C1: Identify characteristics of corporations and their organization.

  • C2: Explain characteristics of, and distribute dividends between, common and preferred stock.

  • C3: Explain the items reported in retained earnings.

  • A1: Analyze earnings per share, price-earnings ratio, and dividend yield.

  • P1: Record the issuance of corporate stock.

  • P2: Record transactions involving cash dividends, stock dividends, and stock splits.

  • P3: Record purchases and sales of treasury stock.

Characteristics of Corporations (Learning Objective C1)

Corporate Organization

  • Privately Held vs. Publicly Held:

    • Privately Held: Ownership is restricted; shares typically are not traded publicly.

    • Publicly Held: Shares are available for purchase on public exchanges.

  • Legal Structure:

    • Separate existence from owners.

    • Created by law, has rights and privileges similar to a person.

Advantages of Corporations

  • Separate Legal Entity: Distinct legal identity separate from owners.

  • Limited Liability: Owners (shareholders) are not personally liable for corporate debts.

  • Transferable Ownership Rights: Easy buying and selling of shares.

  • Continuous Life: Corporation exists regardless of ownership changes.

  • No Mutual Agency for Stockholders: Shareholders cannot bind the corporation to contracts.

  • Easier Capital Accumulation: Ability to raise capital by issuing stock.

Disadvantages of Corporations

  • Governmental Regulation: Subject to strict regulatory requirements.

  • Corporate Taxation: Earnings are taxed at the corporate level, potentially twice on dividends for shareholders.

Rights of Stockholders

  • Voting Rights: Ability to vote at stockholder meetings.

  • Sell or Dispose of Stock: Freedom to sell owned shares.

  • Purchase Additional Shares: Right to buy more shares to maintain ownership proportionality.

  • Receive Dividends: Entitlement to dividends declared by the corporation.

  • Share in Liquidation Assets: Right to any remaining assets after creditor repayment in case of liquidation.

Capital Stock Basics

  • Authorized Stock: Total number of shares allowed by the corporation's charter.

  • Issued Stock: Total shares sold to stockholders.

  • Market Value: Current price of stock in the market.

  • Classes of Stock: Can be 'Common' or 'Preferred'.

    • Common stock represents ownership with normal voting rights.

    • Preferred stock typically provides fixed dividends and has priority over common stock in asset liquidation.

  • Outstanding Stock: Shares issued that are currently held by shareholders.

Par Value and Market Price

  • Par Value: An arbitrary value assigned to shares upon authorization (also known as book value).

  • Market Price: Price at which a stock is currently trading.

Stockholders’ Equity

  • Components:

    • Paid-in Capital: Cash and assets received in exchange for stock.

    • Retained Earnings: Total net income accumulated, minus dividends declared.

Recording Issuance of Corporate Stock (Learning Objective P1)

Issuing Par Value Stock

  • Example: On June 5, Dillon Snowboards, Inc. issued 30,000 shares of $10 par stock for $300,000.

  • At Par: Issuing 30,000 shares at $10 each results in total proceeds of $300,000.

  • At Premium: If sold for $12, record at total proceeds accordingly.

No-Par Value Stock and Stated Value Stock

  • No-Par Value Stock: No par value assigned; sold for whatever market determines (e.g., October 20, 1,000 shares sold for $40 each).

  • Stated Value Stock: Arbitrarily assigned value greater than zero, transactions recorded according to that value.

Issuing Stock for Noncash Assets

  • Stock can be issued in exchange for noncash assets (e.g., land for stock).

  • Example: Issuing stock for land valued at $105,000.

Dividends and Stock Transactions (Learning Objective P2)

Cash Dividends

  • Requirements to Pay Cash Dividends:

    1. Sufficient retained earnings.

    2. Cash available for distribution.

  • Impact on Stock Valuation: Cash dividends can affect market value positively.

Important Dates for Cash Dividends

  • Date of Declaration: Liability is recorded when the dividend is declared.

  • Date of Record: No entry required; identifies shareholders eligible for dividend.

  • Date of Payment: Record payment of cash to stockholders.

Stock Dividends

  • Purpose: Keep market prices affordable and demonstrate management confidence.

  • Categories:

    • Small Stock Dividend (≤ 25% of outstanding shares).

    • Large Stock Dividend (> 25% of outstanding shares).

  • Recording Small Stock Dividend Example: For 10,000 shares declared as 10%, record based on market values.

Recording a Large Stock Dividend

  • Capitalize retained earnings for the minimum amount mandated by law based on par or stated values.

Common vs. Preferred Stock (Learning Objective C2)

Issuance of Preferred Stock

  • Common reasons include raising funds without relinquishing control and appealing to risk-averse investors.

Dividend Preference

  • Cumulative vs. Noncumulative:

    • Cumulative dividends must be paid before any common stock dividends.

    • Noncumulative dividends do not accumulate if unpaid in prior years.

Illustration of Dividend Preference

  • Example scenarios illustrating dividend distribution among preferred and common stocks in various years, detailing preferences in payment.

Treasury Stock Transactions (Learning Objective P3)

Treasury Stock Definition

  • Shares repurchased by the corporation; used for acquisitions, stock compensation, or to stabilize market prices.

Buying and Selling Treasury Stock

  • Impact recorded as a reduction of equity; examples of buying, selling at cost, above cost, or below cost documented with amounts.

Retained Earnings (Learning Objective C3)

Statement of Retained Earnings

  • Definition: Total cumulative net income less net losses and dividends declared.

  • Legal/Contractual Restrictions: Possible limitations on using retained earnings for dividends based on state law or loan agreements.

  • Prior Period Adjustments: Correcting material errors from past financial statements affecting retained earnings.

Statement of Stockholders’ Equity

  • A comprehensive statement detailing stock equity beyond just retained earnings, includes all aspects of shareholder equity.

Financial Ratios (Learning Objective A1)

Earnings Per Share (EPS)

  • Formula: EPS=Net Income−Preferred DividendsWeighted Average Common Shares OutstandingEPS = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Common Shares Outstanding}}

  • Significance: Widely used metric indicating company profitability.

Price-Earnings Ratio (P/E Ratio)

  • Formula: P/ERatio=Market Value (Price) per ShareEarnings per ShareP/E Ratio = \frac{\text{Market Value (Price) per Share}}{\text{Earnings per Share}}

  • Indicates market expectations for company growth and profitability.

Dividend Yield

  • Formula: DividendYield=Annual Cash Dividends per ShareMarket Value per ShareDividend Yield = \frac{\text{Annual Cash Dividends per Share}}{\text{Market Value per Share}}

  • Shows dividend returns relative to stock price.