Unit 9: Accounting For Corporations
Assume that you are planning to start a new business. Would you choose a sole proprietorship, a partnership or a corporation? In principles of accounting 1 and previous chapter of principles of accounting you have studied about the first two forms of business organizations. In this chapter the importance of corporate form of organization will be discussed.
9.2 Definition of Corporation
A corporation is a legal entity having an existence separate and distinct from that of its owners. In the eyes of the law there are two persons and a corporation is an ‘artificial person’ having many of its own rights and responsibilities.
9.3 Characterstics of Corporation
Among the characteristics of a corporation are:
- A corporation is a separate legal entity. According to the law a corporate entity may own property in its own name, may enter into contract and responsible for its own debts.
- A corporation has a legal status in court. According to the law a corporation may sue and be sued as if it were a real person.
- A corporation has its own charter. A corporation is created by obtaining charter from the state in which the company is to be incorporated.
- A corporation pays income taxes on its earnings. The income of a corporation is subject to income taxes, which must be paid by the corporation.
9.4 Advantages of the Corporate Form of Organization
A corporate entity has many advantages not available in other forms of organization. Among the advantages are the following:
- Continuous existence: A corporation has perpetual existence in that its continuous existence is not dissolved by the death on retirements of any of its members.
- No personal liability for owners: Since a corporation is a separate legal entity, the creditors of a corporation have a claim against the assets of the corporation, not the personal property of the owners.
- Separation of managements from ownership: the owners of a corporation (called stock holders or shareholders) own the corporation but they do not manage it on a daily basis. To administer the affairs of the corporation, president and other officers are hired for it. Thus, individual stockholder has no rights to participate in the management's activity of the corporation unless the stockholder has been hired as a corporate officer.
- Easily transferable ownership shares: ownership of a corporation is evidenced by transferable shares of stocks. These shares of stocks may be sold by one investor to another without dissolving or disrupting the business organization.
9.5 Disadvantages of Corporate Form of Organization
Some of the disadvantages of the corporation are:
- Double taxation: corporate earnings are taxed two times. The earnings are taxed first as a corporate income taxes and again as personal income taxes if the corporation. Distributes its earnings to stockholders.
- Difficulties to control: since ownership is usually separated from managements, owners are unable to exercise active control over management actions.
- Greater regulation: since a corporation comes into existence according to the law of the state, the law may provide for considerable regulation of the corporation’s activities. For example, the withdrawal of funds from a corporation is subjects to certain limits sets by law.
9.6 Formation of a Corporation
A corporation is created by obtaining a corporate charter. The charter is given from the states in which the corporation is to be incorporated. To obtain a corporate charter an application called articles of incorporation are prepared by t he organizers called incorporators and submitted to the state corporations commissioner or other designated officials. These articles of incorporation specify the purpose of the business, its location, the names of the organizers, the classes and numbers of shares of capital stock authorized, and the consideration to be paid in by the organizers for their respective shares. The article of incorporation is approved by the state and charter is issued. Once a charter is obtained a board of directors is elected. The directors in turn hold meetings at which officers of the corporation are appointed.
9.6.1 Organization costs
In the process of incorporation, the organizers must pay for necessary costs such as payment of an incorporation fee to the state, payment of fees to attorneys for their services in drawing up the articles of incorporation, payment to promoters and variety of other outlays necessary to bring the corporation into existence. These costs are charged to an asset account called organization costs. In the balance sheets, organization costs appear under the ‘other assets’ caption.
9.6.2 Rights of Stockholders
The stockholders who are the owners of a corporate entity have the following basic rights:
- The rights to votes: the common stockholders have the right to elect the board of directors, and thereby to be represented in the management of the business.
- The rights to participate in the earnings of a corporation: Stockholders in corporations may not make withdrawal of company assets. However, the earnings of a profitable corporation may be distributed to stockholders is the form of cash dividend. The payment of a dividend always requires formal authorization by the board of directors.
- The rights to share in the distribution of assets upon liquid action: when a corporation ends its existence, the creditors of the corporation must first be paid is full; any remaining assets are dividend among stockholders in proportion to the number of shares owned.
- Pre-emptive rights: the current stockholders has the right to purchase the shares of the corporation on a prorate basis when new stocks are offered for sale. This preemptive rights is designed to provide each stockholder the opportunity to maintain a proportional ownership in the corporation.
9.7 authorization and issuance of stocks
The state officials approve the articles of incorporation, which specify the number of shares a corporation is authorized to issue. The total number of shares that may be issued is known as the authorized shares. When the corporation receives cash is exchange for stock certificates, which represents the number of shares issued, the shares become issued shares. Shares that are issued and held by the stockholders are called outstanding shares. Sometimes a corporation requires shares from its own shareholders. These shares are called treasury stocks, which reduce the number of outstanding shares.
A corporation may choose not to issue immediately all the authorized shares even though it is customary to have a large number of authorized shares than presently needed. If more capital is needed, the previously authorized shares will be readily available for issue. A corporation can apply to the state for permission to increase the number of authorized shares.
9.7.1 Types of Stocks/Shares
Many corporations issue several classes of capital stock, each providing investors with different rights and opportunities. The basic types of stock issued by every corporation is called common stock. Common stock possessed the traditional rights of ownership such as voting rights, participation residual dividends, and residual claim to assets in the event of liquidation. When any of these rights is modified, the term preferred stock is used. Preferred stock specifies different rights that distinguish it from common stock. Some of the distinctive features for preferred stocks are priority claims on dividends, cumulative dividend rights, priority as to assets is the event of liquid action of a corporation and no voting power.
Stocks according to their nature are classified into par value and no-par stocks. Par value stocks with a designated dollar amount per share as stated in the corporate charter and printed on the stock certificates. On the other hand, some states allow corporations to issue stocks without designating a par value. Such stocks are called no-par stocks. When no par stocks are issued by a corporation, the entire issuance price is viewed as a legal capital, which is subject to withdrawal. Sometimes some states authorize the issuance of no-par stock with a stated, or assigned, value per share that is established permanently by the corporate directors and is in the laws. Most corporations use a stated value for no par stock.
9.7.2 Issuance of Par-value Stocks
Authorization of par value stocks, specified in the unit may be recorded as a memo entry in the general journal and in the ledger accounts. Most states require the total number of shares authorized be shown on each stock certificate, in addition to the number of shares represented by that particular stock certificates.
22.214.171.124 Par value stock issued for cash
When stocks are issued to various investors, a stock certificate specifying the number of shares represented is prepared for each investor/or stockholder. When par value stock is issued for cash, the capital stock account is credited with the par value of the shares issued regardless of whether the issuance price is more or less than par. If par value stock is issued for more than par value (at premium), paid in capital in excess of par account is credited for the excess of selling price over par. This paid in capital is excess of par does not represent a profit to the corporation rather it is part of the invested capital. If par value stock is sold by corporation for less than par (at discount), a negative stockholders’ equity accounts, Discount on common (or preferred) stock, is debited for the amount of the discount.
For example, assume that 50,000 shares of Br. 2 par value common stock have seen authorized and that 10,000 of these authorized shares are issued at a price of Br. 10 each. The entry would be:
Paid-in-capital is excess of par………………… 80,000
126.96.36.199 Par value stock issued on a subscription basis
During the start-up of a corporation, prospective investors may sign a contract to purchase a specified number of shares on credits with payments due at one or more specified future dates. One reason for this procedure is to attract small investors. Another reason is to appeal to investors who prefer not to invest cash until the corporation is ready to start business operations. A corporation may also sell its capital stock on credit after incorporation.
When stock is subscribed, the company debits stock subscription receivable for the subscription price, credits capital stock subscribed for the par value of the subscribed shares, and credits paid in capital in excess of the subscription price over par value. Later, as cash is collected, the entry is a debit to cash and a credit to stock subscription receivable. When the entire subscription price is collected, the stock certificates are issued for the subscribers. The issuance of stock is recorded by debiting capital stock subscribed and crediting capital stock. The following illustration demonstrates the accounting procedures for stock subscriptions.
Assume that 120,000 shares of RAM corporation common stock, par br. 10, are subscribed for at Br. 12 by Misrak Binda. The total is payable in three installments. The following entries are processed by RAM Corporation.
Common stock subscription Receivable 1,440,000
Common stock subscribed 1,200,000
Paid-in-capital in excess of par 240,000
To record receipt of subscription for 120,000 shares
Common stock subscription receivable 480,000
To record receipt of 1st payment
Common stock subscription Receivable 480,000
To record receipt of final payment
Common stock subscription Receivable 480,000
To record receipt of final payment
Common stock subscribed 1,200,000
Common stock 1,200,000
To record issuance of stock
188.8.131.52 Non Cash Issuance of Capital Stock
Corporations sometimes issue capital stock for non-cash assets such as in exchange for real estate. The current markets value of the stock issued or the non-cash consideration received, whichever is must reliable, determinable, is used to record the transaction. If the market value of either capital stock issued or the no cash items are not reliable, the value are established by the corporation’s board of directors.
184.108.40.206 Issuance of No-par Stock
Some states allow corporations to issue stock without designating a par or stated value. When this no par stock is issued, the entire issuance price is credited to the capital stock account and is viewed as legal capital not subject to withdrawal.
9.8 Accounting for Retained Earnings and Dividends
9.8.1 Nature of Retained Earnings
Capital provided to a corporation by stockholders in exchange for shares of either preferred or common stock is called paid in capital or contributed capital. The second major type of stockholders’ equity is a retained earnings. The amount of the retained earnings account at any balance sheet date represents the accumulated earnings (net income) of the company since the date of incorporation, less any losses and all dividends distributed to stockholders.
9.8.2 Nature of Dividends
A dividend is a distribution of earnings to stockholders is the form of assets or shares of the issuing company’s stock. Type of dividends includes the following.
- Cash dividend
- Property Dividend
Non cash assets disbursed
- Stock Dividend
Corporations own stock disbursed
- Liquidating Dividend
Return of contributed capital
- Scrip Dividend
Creation of a liability by declaring a dividend to be paid at a specific future date.
9.8.3 Relevant dividend dates
Prior to payment, dividends must be declared by the board of directors of the corporation. The important dividend dates are:
- Date of Declaration: on this date, the corporation’s board of directors formally approves and announces the dividend to be distributed. The declaration is recorded on this date as a debit to dividends and a credit to dividends payable.
- Date of payment: this date is determined by the board of directors and is usually stated is declaration. At the date of payment the liability recorded at the date of declaration is debited and the appropriate asset account is credited.
9.8.4 Dividend and Characteristics of preferred stock
A corporation with both preferred stock and common stock may declare dividends on the common only after it meets the requirements of the stated dividend on the preferred. The preferred dividend may be stated in monetary terms or as a percent of par.
220.127.116.11 Participating and non-participating preferred stock
A participating preferred stock receives a minimum dividend but also receives higher dividend when the company pays substantial dividends on common shares. The preferred stockholders’ right may be to receive dividend only a stated amounts. Such stock is said to be nonparticipating.
To illustrated, assume the following information
- Common stock issued 4,000
- Preferred stock issued 2,000
- Dividend per share of preferred stock Br. 10
The corporation reported net income of Br. 150,000 for the third year and the BOD declared both of the net income as dividend. If the preferred stock issued by the corporation is participating, the preferred stockholders will receive. Br. 30,000 (Br. 20,000 + Br. 10,000), and the common stockholders will receive Br. 60,000 (Br. 40,000 + Br. 20,000).
18.104.22.168 Cumulative and Non-cumulative preferred stock
Cumulative preferred means that if the company fails to pay a preferred dividend, its obligation accumulates and all omitted dividends must be paid in the future before any common dividends are paid. The cumulative preferred stockholders would receive all accumulated unpaid dividends (called dividend in arrears) before the holders of common shares receive anything. Preferred stock not having this cumulative rights is called no cumulative.
For example, assume the following information
- Cumulative preferred, 10% of Br. 100 par (10,000 shares issued)
- Common stock of Br. 90 par (40,000 shares issued)
- The Board of Directors (BOD) did not declare dividend in year 2
- Year 3 dividend declared by the BOD amounts to Br. 320,000.
- Year 1 dividend declared and distributed amounts to Br. 200,000.
If the preferred stock is cumulative, the preferred stockholders will receive Br. 200,000 (Br. 100,000 + Br. 100,000), and the common stock holders will receive Br. 120,000 (Br. 320,000 – Br. 200,000).
9.9 Accounting for Treasury stocks
Treasury stock is a corporation’s own stock (preferred or common) that has been issued and required by the issuing corporation. A corporation may also accept shares of its own stock in payment of a debits owed by a stockholder or as a donation from a stockholder.
Treasury stock does not reduce the number of shares issued, but does reduce the number of outstanding shares. The purchase of treasury stock decreases both assets and stockholders’ equity. Moreover, treasury stock does not carry voting, dividend, preemptive, or liquidating rights and is not assets.
9.9.1 Reasons to acquire Treasury Stocks
In general treasury steps are to acquire for the following reasons:
- to support (increase) the markets price of the stock
- to I increase earnings par share by reducing the number of shares outstanding.
- To reduce dividend payment payments by reducing the number of shares outstanding.
- To provide shares for reassurance to employees as a bonus
- To use the share acquired for stock dividend
- To reissue with a higher price
9.9.2 Recording and reporting Treasury stock Transactions
There are several methods of accounting for the purchase and the resale of treasure stock. A commonly used method is the cost basis. When the stock is purchased by the corporation, treasury stock account is debited for the price paid for it. The par and the price at which the stock was originally issued are ignored. When the stock is resold, treasury stock is credited at the price paid for it, and the difference between the price paid and the selling price is debited or credited to an account entitled paid in capital from sale of treasury stock.
To illustrate the cost method, assume that Harambe Corporation had 50,000 shares of Br. 10 par common stock outstanding at the beginning of the current year. The company purchased 500 shares for cash and received 500 shares in settlement of a debt from stockholders. The markets price of stocks was Br. 30/share. The following entry is required involving the transactions.
Treasury stock 30,000
Notes Receivable 15,000
If the company sells 600 shares of the treasury stock for Br. 31 each, the entry would be:
Treasury stock 18,000
Paid in capital from sale of 600
Paid in capital from sale of treasury stock is reported in the paid in capital section of the balance sheet. Treasury stock is deducted from the total of the paid in capital and Retained earnings.
9.10 Equity per share
The amount appearing on the balance sheet as total stockholders’ equity can be stated in terms of the equity per share. When there is only one class of stock, the equity per share is determined by dividing total stockholders’ equity by the number of shares outstanding. For a corporation with both preferred and common stock, it is necessary first to allocate the total equity between the two classes. To illustrate, consider the following statements of stockholders’ equity at December 31, 19x1.
- 9 to preferred stock, Br. 50 par value, authorized 20,000 shares, issued and
Outstanding 12,000 share Br. 600,000
- Common stock, no par, stated value Br. 2 per share,
authorized 500,000 shares, issued 400,000 shares of which 25,000
shares are held is the treasury 800,000
- Paid in capital is excess of per
-Preferred Br. 50,000
-Common 1,000,000 1,050,000
- Retained earnings 2,000,000
Subtotal Br. 4,450,000
- Less cost of 25,000shares of common stock
Reacquired and held in treasury 250,000
- Total stockholders’ equity Br. 4,200,000
If the preferred stock is entitled to receive Br. 105 per share upon liquidation and if there is no preferred dividend in arrears, the computation of earnings per share are as follows:
Preferred EPS = Equity allocated to preferred stock
Number of o/s shares of preferred stock
= 105 X 12,000
= Br. 105/share
Common EPS = Equity allocated to common stock
Number of o/s shares of common stock
= Br. 7.84 /share