Ch 15 Flashcards
3 special characteristics of corporate form that affect accounting
1 influence of state corporate law
2 use of capital stock or share system
3 development of variety of ownership interests
3 primary forms of business organization
1 proprietorship
2 partnership
3 corporation
Articles of incorporation
Anyone wishes to establish corporation sends articles of
Incorporation to state in which incorporation is desired
Corporate charter
Recognizes company as legal entity subject to state law
State issues corporate charter
How many state can a corporation incorporate in?
Only 1
It is the company’s advantage to incorporate in a state whose laws favor the…
Example?
Corporate form of business organization
Ex. Delaware has favorable tax and regulatory environment
How can a company restrict certain rights and privileges when it issues stock?
Through a special contract
In the absence of restrictive provisions, what 4 rights does each share of stock provide to share proportionately in?
1 profits and losses
2 management (right to vote for directors)
3 corporate assets upon liquidation
4 preemptive right
Preemptive right, define
What is it referred to as?
Share proportionately in any new issues of stock of same class
Referred to as stock right or warrant
What does the preemptive right protect?
Protects existing shareholder from involuntary dilution of
Ownership interest
Registrars and transfer agents
Specialize in providing services for recording and transferring
Stock
Common stock
Class of stock represents ownership interest
Residual corporate interest that bears ultimate risks of loss
And receives benefits of success
Who generally controls the management of the corporation?
Common stockholders
Preferred stock
Special class of stock where certain common stock rights are Sacrificed in return for other special rights and privileges
3 other names for owners equity?
1 stockholders’ equity
2 shareholders’ equity
3 corporate capital
What 3 categories normally appear as part of stockholders’ equity?
1 capital stock
2 additional paid in capital
3 retained earnings
What do capital stock and additional paid in capital constitute?
Contributed (paid-in) capital
Retained earnings
Earned capital of the company
Contributed (paid-in) capital
Total amount of capital stock
Amount provided by stockholders to corporation for use in
business
What 2 items does contributed capital include?
1 par value of all outstanding stock
2 premiums less discounts on issuance
Earned capital
Capital that develops from profitable operations
Consists of all undistributed income that remains invested in
The company
Residual interest
Owners’ or Stockholders’ interest in a company
What does stockholders’ (owners’) equity represent?
Cumulative net contributions by stockholders + retained earnings
3 steps companies follow when they issue stock?
1 state must authorize stock in certificate of incorporation or
Charter
2 corp. offers shares for sale, entering into contracts to sell stock
3 after receiving amounts for stock, corp issues shares
Par value of stock, relationship with fair value?
Par value of stock has no relationship to its fair value
What do low par values help companies avoid?
The contingent liability associated with stock sold below par
Accounting for par value of preferred stock and common stock
Company credits these accounts when it originally issues shares
No additional entries made unless issues additional shares or
Retires them
Paid in capital in excess of par account
Indicates any excess over par value paid in by stockholders
In return for shares issued to them
What claim does an individual stockholder have on excess paid in capital?
Individual stockholder has no greater claim on excess paid in than all other holders of the same class of shares
No-par stock
Many states permit issuance of capital stock without par value
2 reasons of issuance of no par stock
1 avoids contingent liability if issued par value at discount
2 the questionable treatment of using par value for fair value
Never arises
2 Major disadvantages of no par stock?
1 Some states levy high taxes on these issues
2 Less flexibility for paying dividend, because no par stock may
Be considered legal capital
True no par stock should be carried in amounts at issue price without any…
Additional paid in capital or discount reported
Stated value of no par stock (required by some states)
Minimum value below which company can’t issue stock
Lump sum sales
How to allocate proceeds among several classes of securities
Sold at once
2 methods that companies can use in allocation of lump sum sales?
1 proportional method
2 incremental method
Proportional method 1) when does it occur? How is it allocated?
1 if fair value or other sound basis for determining relative value Is available for each class of security
2 company allocates lump sum received among securities on proportional basis
Incremental method 1) when does it occur? How is it allocated?
1 instances where company can’t determine fair value
2 company uses fair value of securities as basis for classes it
Knows and allocates remainder of lump sum where it doesn’t
Know FMV
Stock issued in noncash transactions
Issuance of shares for property or services
General rule for stock issued in noncash transactions
Companies should record stock issued for services or property
Other than cash at either FMV of stock issued or FMV of noncash
Consideration received
Whichever is more apparent
If treasury shares are used to acquire property or services, the cost of the treasury shares should…
Not be considered the decisive factor in establishing FMV
of the property or services
FMV of treasury stock should be used to value property or
services
Watered stock
Overvaluation of stockholders’ equity resulting from inflated
asset values
Results from Intentional overvaluation of property or services
received
Secret reserves
Corporation undervalues the recorded assets
As result of issuance of stock for property or services
5 common costs of issuing stock
1 underwriting costs 2 accounting and legal fees 3 printing costs 4 taxes 5 reduction of amounts paid in
What kind of costs are stock issuance costs?
Cost of financing
5 reasons corporations repurchase shares
1 tax efficient distributions of excess cash to shareholders
2 increase EPS and return on equity
3 provide stock for employee stock compensation contracts
Or meet potential merger needs
4 thwart takeover attempts or reduce # of stockholders
5 stabilize the stock price
Make a market in the stock
Stabilize the stock price
Leverage buyout (LBO)
Company borrows money to finance stock repurchases
Treasury stock
Reacquired shares that aren’t retired
Is treasury stock an asset?
No, incorrect to imply that corp can own part of itself
When a corporation buys back some of its own outstanding stock, it has not acquired an asset, it has…
Reduced net assets
Treasury stock is essentially the same as…
Unissued capital stock
2 accounting methods for handling treasury stock accounts
1 cost method
2 par (stated) value method
Cost method
Results in debiting Treasury Stock account for reacquisition Cost
And in reporting this account as deduction from paid-in
Capital and retained earnings on balance sheet
Par (stated) value method
Records all transactions in treasury shares at their par value
And reports the treasury stock as deduction from capital
Stock only
Outstanding stock
Number of shares of issued stock that stockholders own
Sale of treasury stock above cost
When selling price of shares of treasury stock exceeds its cost,
Company credits difference to Paid-in Capital from Treasury Stock
When corporation sells treasury stock below its cost it…
Debits excess cost over selling price to Paid-in Capital from
Treasury Stock
Retiring of treasury shares
Corp debits paid in capital accounts applicable to retired shares
Instead of cash (as with sale of treasury stock)
Approved by board of directors
5 features most often associated with preferred stock issues?
1 preference as to dividends 2 preference to assets in event of liquidation 3 convertible into common stock 4 callable at option of the corporation 5 non voting
Companies usually issue preferred stock with a par value, expressing the dividend preference as…
A percentage of the par value
Preferred stock: preference of dividends
Corporation must pay stated dividend rate or amount applicable
To preferred stock before paying any dividends on the common
Stock
Cumulative preferred stock
Requires that if corp fails to pay dividend in any year, it must
Make it up in later year before paying any dividends to common
Stockholders
Dividend in arrears
If directors fail to declare dividend at normal date for dividend
Action
Dividend is said to be passed, not disclosed in liabilities section
But in notes of financial statements
Holders of Participating preferred stock
Share ratably with common stockholders in any profit distributions
Beyond the prescribed rate
Convertible preferred stock
Allows stockholders , at their option, to exchange preferred shares
For common stock at predetermined ratio
Callable preferred stock
Permits corporation at its option to call or redeem the outstanding
Preferred shares at specified future dates
And at stipulated prices
Redeemable preferred stock
More like debt than equity instrument
Has mandatory redemption period or redemption feature that
Issuer cannot control
5 reasons why few companies pay dividends in amounts equal to their legally available retained earnings
1 maintain agreements with bond covenants/specific creditors
2 meet state corp. requirements
3 retain assets to finance growth or expansion
4 smooth out dividend payments year to year
5 build up buffer against possible losses or errors in calculation
State corporation requirements for dividends
Earnings equivalent to cost of treasury shares purchased be
Restricted against dividend declarations
Protects against loss for creditors
Before declaring a dividend management must consider…
The availability of funds to pay the dividend
4 forms of dividend distributions
1 cash dividends
2 property dividends
3 liquidating dividends
4 stock dividends
Which dividends reduce total stock holders equity in the corporation?
All dividends except stock dividends reduce total stockholders
Equity in the corporation
Liquidating dividend
Dividend not based on retained earnings
Why is there time between the date of declaration and date of payment for cash dividends to stock holders?
Gives time for company to prepare current list of stockholders
that receive the dividends
What is a declared dividend classified as?
Liability
Does a company declare and pay dividends on treasury stock?
No
Property dividends AKA dividends in kind
Dividends payable in assets of corp other than cash
When declaring a property dividend the corporation should…
Restate at fair value the property it will distribute, recognizing
Any gain or loss as difference between property’s FMV and
Basis at date of declaration
Any dividend not based on earnings reduces corporate…
Paid in capital to extent it is a liquidating dividend
Stock dividend
Company distributes no assets
Issuance by corp of its own stock to shareholders on pro rata
Basis, without receiving any consideration
When the stock dividend is less than 20-25% of common shares outstanding at time of dividend declaration, what is the company required to transfer?
Company required to transfer FMV of stock issued from retained
Earnings
Small (ordinary) stock dividends
Stock dividends of less than 20-25%
Stock dividend entries merely reflect a reclassification of…
Stockholders’ equity
Many state do not permit the issuance of stock dividends for…
Treasury shares
Stock split
Split in shares to achieve lower stock price
Ex. 2 for one split, splits par value in half on stockholders equity
And doubles the number of shares issued of common stock
Stock split vs. stock dividend
Both increase number of shares outstanding
Stock splits decrease par value of share, stock dividends increase
Par value of outstanding shares
Large stock dividend AKA Split up effected in form of dividend AKA stock split
Stock dividend of more than 20-25% of shares previously
Outstanding
In a split up effected in the form of a dividend the company transfers from retained earnings to capital stock…
The par value of stock issued
Restrictions of retained earnings, how are they disclosed?
Best disclosed by note
Basic format for presentation of statement of stockholders equity, 4 things
1 balance at beginning of period
2 additions
3 deductions
4 balance at end of period
What 3 ratios of stockholders’ equity do analysts use to evaluate company’s profitability and Longterm solvency?
1 return on common stock equity
2 payout ratio
3 book value per share
Return on common stock equity AKA return on equity (ROE)
Measures profitability from shareholders viewpoint
Shows how many dollars of net income the company earned for
Each dollar invested by the owners
Return on common stock equity equation
Return on common stock equity =
(Net income - preferred dividends)/(avg. common stockholders’ equ.)
Note: amount of common stock equity = total stockholders equity less par value of preferred stock
Trading on the equity
Practice of using borrowed money or issuing preferred stock
In hopes of obtaining higher rate of return on money used
Payout ratio equation
Payout ratio = cash dividends/net income
Book value per share of stock
Amount each share would receive if company were liquidated
On basis of amounts reported on balance sheet
Book value per share equation
Book value per share =
common stockholders’ equity)/(outstanding shares
