Corporations Paidin Capital and the Balance Sheet Chapter

Learning Objectives 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 2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Learning Objectives 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 12 A) 3 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

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

Advantages and Disadvantages of Corporations 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 5 DISADVANTAGES 1. Ownership and management separated. 2. Double taxation 3. Government regulation is expensive 4. Start-up costs are higher Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Corporate Organization 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.

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

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? Stockholders have limited liability. 8 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2 Describe the two sources of stockholders’ equity and the classes of stock 9

Stockholders’ Equity Basics Paid-in capital (Contributed capital) Retained earnings Amounts received from stockholders Common stock is main source Externally generated Resulting from transactions with outsiders 10 Earned by profitable operations Internally generated Results from internal corporate decisions to retain net income for use in the company Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Classes of Stock 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 11 Preferred stock Certain advantages over common stock Receive dividends before common Fixed dividend amount Upon liquidation, receive assets before common Also have basic rights of common stockholders unless withheld Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Par, Stated and No-par Par value No-par Arbitrary amount assigned to a share of stock Set when the corporate charter is filed Usually set low as to avoid legal difficulties 12 No arbitrary amount assigned Could have a stated value Stated value treated as par Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

3 Journalize the issuance of stock and prepare the stockholders’ equity section of a

Accounting for the Issuance of Stock 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 Wall Street Journal Tombstone—an advertisement for initial sale of a stock 14 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Tombstone Ad 15 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Accounting for the Issuance of Stock Issuing common stock at par Issuing common stock above par Amount received above par is called a premium Not a gain; called additional paid-in capital Another account is created for the premium amount 16 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Stockholders’ Equity Presentation Total Paid-in capital is the sum of Common stock plus Paid-in capital in excess of par The balance of the Common stock account is calculated 17 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Accounting for Stock Issuances No-par stock No Paid-in capital in excess of par account needed Full amount received is credited to Common stock Balance sheet shows only the Common stock account 18 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Accounting for Stock Issuances Stated value stock Similar to accounting for par value stock Amount above stated value is credited to Paid-in capital in excess of stated value Issuing stock for assets other than cash Asset is debited for its fair value Building is debited instead of cash 19 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Accounting for Stock Issuances Issuing preferred stock Similar to issuing common stock, except Preferred stock is credited at par value Preferred stock usually is not issued above par 20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Stockholders’ Equity on the Balance Sheet Equity accounts are listed in the following order on the balance sheet: Preferred stock , Common stock, Retained earnings 21 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

S 12 -5: ISSUING STOCK AND INTERPRETING STOCKHOLDERS’ EQUITY 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.

S 12 -5: ISSUING STOCK AND INTERPRETING STOCKHOLDERS’ EQUITY Common stock, $ 2. 00 par value Authorized: 6, 000 shares Issued: 4, 000 shares Paid-in capital in excess of par Retained earnings DATE Dec 31 Cash 23 Journal Entry ACCOUNTS $ 8, 000 4, 000 26, 500 DEBIT CREDIT 12, 000 Common stock 8, 000 Paid in capital in excess of par 4, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

E 12 -15: ISSUING STOCK 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? 24 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. DATE May 19 Cash Journal Entry ACCOUNTS CREDIT 19, 000 Common stock 2, 000 Paid in capital in excess of par 25 DEBIT 17, 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. DATE Jun 3 Cash Journal Entry ACCOUNTS CREDIT 15, 000 Preferred stock 26 DEBIT 15, 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. DATE Jun 11 Journal Entry ACCOUNTS Equipment CREDIT 78, 000 Common stock 3, 000 Paid in capital in excess of par 27 DEBIT 75, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2. How much paid-in capital did these transactions generate for Susie Systems? $112, 000

4 Illustrate Retained earnings transactions 29 Copyright © 2012 Pearson Education, Inc. Publishing as

Retained Earnings Closing entries Step 1 – Close Revenues Step 2 – Close Expenses

Retained Earnings Closing entries Step 3 – Close Income summary 31 Copyright © 2012

Deficit Balance A loss causes Retained earnings to decrease A debit balance in Retained

Deficit Balance on Balance Sheet A deficit is reported as a negative amount 33

The data for Amanda’s Tax Service, Inc. , for the year ended August 31, 2012, follow: Cost of goods sold $ 62, 000 Dividends 14, 000 Interest revenue 1, 800 Sales revenue Operating expenses Retained earnings $ 125, 000 44, 000 24, 000 Journalize the required closing entries for the year. Step 1 Journal Entry ACCOUNTS DATE Aug 31 Sales revenue Interest revenue Income summary 34 DEBIT CREDIT 125, 000 1, 800 126, 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: Cost of goods sold $ 62, 000 Sales revenue Dividends Operating expenses 44, 000 Retained earnings 24, 000 14, 000 Interest revenue 1, 800 $ 125, 000 Journalize the required closing entries for the year. Step 2 DATE Journal Entry ACCOUNTS Aug 31 Income summary 35 DEBIT CREDIT 106, 000 Cost of goods sold 62, 000 Operating expenses 44, 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: Cost of goods sold $ 62, 000 Sales revenue $ 125, 000 Dividends 14, 000 Interest revenue 1, 800 Operating expenses 44, 000 Retained earnings 24, 000 Journalize the required closing entries for the year. Step 3 DATE Journal Entry ACCOUNTS Aug 31 Income summary Retained earnings 36 DEBIT CREDIT 20, 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: Cost of goods sold $ 62, 000 Dividends 14, 000 Interest revenue 1, 800 Sales revenue Operating expenses Retained earnings $ 125, 000 44, 000 24, 000 Journalize the required closing entries for the year. Step 4 DATE Journal Entry ACCOUNTS Aug 31 Retained earnings Dividends 37 DEBIT CREDIT 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: Cost of goods sold $ 62, 000 Dividends 14, 000 Interest revenue 1, 800 Sales revenue Operating expenses Retained earnings $ 125, 000 44, 000 2. What is the balance in Retained earnings after the closing entries are posted? 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 38 $30, 800 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

5 Account for cash dividends 39 Copyright © 2012 Pearson Education, Inc. Publishing as

Accounting for Cash Dividends Sometimes a state prohibits using Paid-in capital for dividends Legal capital is the portion of equity unavailable for dividends Dividends are declared before paying Three dates: Declaration date–Board declares a dividend and creates a liability Date of record–determines which stockholders receives dividends Payment date–pay dividends and remove liability 40 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Declaring and Paying Dividends Preferred dividends expressed as either: A percent of par value 2, 000 shares of $100 par 8% preferred = $16, 000 dividend Or a flat dollar amount per share 2, 000 shares of no-par $3 preferred = $6, 000 dividend Common dividends are expressed as a dollar amount per share 41 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Declaring and Paying Dividends Declaration date Date of Record (no entry) Payment date 42

Dividing Dividends Between Preferred and Common Preferred stockholders receive dividends before common Common stockholders receive dividends if total declared is large enough to cover preferred 43 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Cumulative and Noncumulative Preferred Stock Cumulative preferred stock Accumulates dividends each year until the dividends are paid Dividends in arrears—dividends passed or not paid Noncumulative preferred stock Dividends not paid do not accumulated from one year to the next Dividend in arrears are paid first, then current dividends paid 44 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Cumulative and Noncumulative Preferred Stock A company declares $50, 000 for dividends In arrears, 1 year at $6, 000 Preferred gets $6, 000 in arrears + $6, 000 current Common receives the remainder Journal entry 45 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Frenchvanilla Company earned Net income of $75, 000 during the year ended December 31, 2012. 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, 2013. Journalize for Frenchvanilla: a. Declaring the cash dividends on December 15, 2012. DATE Journal Entry ACCOUNTS Dec 31 Retained earnings Dividends Payable 46 DEBIT CREDIT 33, 250 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

(Continued) Journalize for Frenchvanilla: b. Paying the cash dividends on January 4, 2013. Journal Entry ACCOUNTS DATE Jan 4 Dividends payable Cash 47 DEBIT CREDIT 33, 250 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

6 Use different stock values in decision making 48 Copyright © 2012 Pearson Education,

Different Values of Stock 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 49 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Book Value of Preferred Stock 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. 50 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Book Value per Share Book value of preferred stock: Liquidation price or Preferred stock account A Dividends in arrears on any outstanding preferred shares B Total book value attributed to preferred stock A+B Number of outstanding preferred shares C Book value per share of preferred stock (A+B)/C Book value of common stock: Total stockholders’ equity D Less: book value attributed to preferred A+B Total book value attributed to common stock D-(A+B) Number of outstanding common shares E Book value per share of common stock D(A+B)/E 51 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Bronze Tint Trust has the following stockholders’ equity: 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—common 400, 000 Total paid-in capital Retained earnings Total stockholders’ equity $685, 000 255, 000 $ 940, 000 Bronze Tint has not declared preferred dividends for five years (including the current year). 52 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Compute the book value per share of Bronze Tint’s preferred and common stock. Preferred stock Par value of Preferred stock Cumulative dividends Total book value attributed to preferred stock $45, 000 11, 250 56, 250 Number of outstanding preferred shares 4, 500 Book value per share of preferred stock $12. 50 53 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Compute the book value per share of Bronze Tint’s preferred and common stock. Common stock Total stockholders’ Equity Less: Preferred equity Common equity $940, 000 (56, 250) $883, 750 Number of outstanding preferred shares 1, 200, 000 Book value per share of preferred stock * $0. 74 (*$ 0. 73645833 rounded) 54 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

7 Evaluate return on assets and return on stockholders’ equity 55 Copyright © 2012

Rate of Return on Total Assets Measures a company’s success in using assets Most

Rate of Return on Common Stockholders’ Equity Relationship between net income available and their average common equity invested Net income – Preferred dividends Average common stockholders’ equity Companies strive for return on equity of 15% or higher 57 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Godhi’s 2012 financial statements reported the following items—with 2011 figures given for comparison: 58

Compute Godhi’s rate of return on total assets and rate of return on common stockholders’ equity for 2012. Do these rates of return look high or low? Rate of return on total assets = Net income + Interest expense Average total assets $3, 890 + 210 / $31, 550 = 13% (0. 12995) Rate of return on common Net income – Preferred dividends = stockholders’ equity Average common stockholders’ equity $3, 890 + 0 / $15, 519 = 25. 1% (0. 250660) These rates of return look: High 59 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

8 Account for the income tax of a corporation 60 Copyright © 2012 Pearson

Income Taxes 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 61 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Differences Between Income Statement and the Tax Return Example Income before income tax of $33, 000, 000 X 40% = $13, 200, 000 taxes Taxable income of $20, 000, 000 X 40% = $8, 000 IRS taxes Difference is $5, 200, 000 $13, 200, 000 - $8, 000 Deferred until taxable income catches up 62 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 12 Summary 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. 63 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 12 Summary 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. 64 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 12 Summary 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. 65 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 12 Summary 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. 66 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 12 Summary 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. 67 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

68 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. 69 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.