Ch 15.1 (Corporate Capital)

Question 1

Special Characteristics of the corporate form that affect accounting include

Answer 1

1. Influence of state corporate law.
2. Use of the capital stock or share system.
3. Development of a variety of ownership interests.

Question 2

State Corporate Law

Answer 2

Articles of Incorporation.

Incorporated only in one state so choose wisely (most corporations in Delaware).

Model Business Corporate Act - business incorporation act.

Question 3

Capital Stock or Share System

Answer 3

The number of shares possessed determines each owner’s interest.

Question 4

Rights for shares (in the absence of restrictive provisions)

Answer 4

1. To share proportionately in profits and losses.
2. To share proportionately in management (the right to vote for directors).
3. To share proportionately in corporate assets upon liquidation.
4. To share proportionately in any new issues of stock of the same class—called the preemptive right.2

Question 5

Preemptive Right

Answer 5

Protects an existing stockholder from involuntary dilution of ownership interest.

Question 6

Individuals owning shares and transferring them

Answer 6

May sell them to others at any time and at any price without obtaining the consent of the company or other stockholders.

Question 7

Registrars and Transfer agents

Answer 7

Corporations often use registrars and transfer agents who specialize in providing services for recording and transferring stock.

Question 8

Common Stock

Answer 8

In every corporation, one class of stock must represent the basic ownership interest.

The residual corporate interest that bears the ultimate risks of loss and receives the benefits of success. Common stockholders are not guaranteed dividends or assets upon dissolution. But common stockholders generally control the management of the corporation and tend to profit most if the company is successful.

Question 9

Preferred Stock

Answer 9

In return for any special preference, the preferred stockholder always sacrifices some of the inherent rights of common stock ownership.

A common type of preference is to give the preferred stockholders a priority claim on earnings (In return for this preference, the preferred stockholders may sacrifice their right to a voice in management or their right to share in profits beyond the stated rate).

Question 10

Components of Stockholders’ Equity (four categories that normally appear as part of stockholders’ equity)

Answer 10

1. Capital stock.
2. Additional paid-in capital.
3. Retained earnings.
4. Accumulated other comprehensive income.

Question 11

Contributed (Paid-In) Capital

Answer 11

The total amount paid in on capital stock—the amount provided by stockholders to the corporation for use in the business. Contributed capital includes items such as the par value of all outstanding stock and premiums less discounts on issuance.

Capital stock and additional paid-in capital, constitute contributed (paid-in) capital.

Question 12

Earned Capital

Answer 12

The capital that develops from profitable operations. It consists of all undistributed income that remains invested in the company.

Question 13

Retained Earnings

Answer 13

Represents the earned capital of the company.

Question 14

Accumulated other comprehensive income

Answer 14

reflects the aggregate amount of the other comprehensive income items. It includes such items as unrealized gains and losses on available-for-sale debt investments and unrealized gains and losses on certain derivative transactions.

Question 15

Stockholders’ (Owners) Equity

Answer 15

Represents the cumulative net contributions by stockholders plus retained earnings.

As a residual interest, stockholders’ equity has no existence apart from the assets and liabilities.

Not a claim to specific assets but a claim against a portion of the total assets. Its amount is not specified or fixed; it depends on the company’s profitability.

Question 16

Procedure for issuing stock

Answer 16

State must authorize the stock, generally in a certificate of incorporation or charter.

The corporation offers shares for sale, entering into contracts to sell stock.

After receiving amounts for the stock, the corporation issues shares.

Question 17

Par Value Stock

Answer 17

Low par values help companies avoid the contingent liability associated with stock sold below par.

Preferred or Common Stock (reflect the par value of the corporation’s issued shares.)

Paid-in Capital in Excess of Par (Additional Paid-in Capital) is any excess over par value paid in by stockholders in return for the shares issued to them.

Question 18

No-Par Stock (Advantages and Disadvantages)

Answer 18

No-par stock avoids the contingent liability that might occur if the corporation issued par value stock at a discount.

If shares have no-par value, the questionable treatment of using par value as a basis for fair value never arises.

A major disadvantage of no-par stock is that some states levy a high tax on these issues.

in some states the total issue price for no-par stock may be considered legal capital, which could reduce the flexibility in paying dividends.

True no-par stock should be carried in the accounts at issue price without any additional paid-in capital or discount reported. But some states require that no-par stock have a stated value.

Question 19

Stock Issued with Other Securities (Lump-Sum Sales)

Answer 19

Generally, corporations sell classes of stock separately from one another to track the proceeds relative to each class, as well as relative to each lot.

Occasionally, a corporation issues two or more classes of securities for a single payment or lump sum.

Question 20

Lump Sum Sales

Answer 20

Companies use one of two methods of allocation: (1) the proportional method and (2) the incremental method.

Question 21

Proportional Method

Answer 21

If the fair value or other sound basis for determining relative value is available for each class of security, the company allocates the lump sum received among the classes of securities on a proportional basis.

Question 22

Incremental Method

Answer 22

In instances where a company cannot determine the fair value of all classes of securities, it may use the incremental method. It uses the fair value of the securities as a basis for those classes that it knows, and allocates the remainder of the lump sum to the class for which it does not know the fair value.

If a company cannot determine fair value for any of the classes of stock involved in a lump-sum exchange, it may need to use other approaches.

Question 23

Stock Issued in Noncash Transactions

Answer 23

Accounting for the issuance of shares of stock for property or services involves an issue of valuation.

Companies should record stock issued for services or property other than cash at either the fair value of the stock issued or the fair value of the noncash consideration received, whichever is more clearly determinable.

Question 24

Watered Stock

Answer 24

In corporate law, the board of directors has the power to set the value of noncash transactions. However, boards sometimes abuse this power. The issuance of stock for property or services has resulted in cases of overstated corporate capital through intentional overvaluation of the property or services received.

Question 25

Secret Reserves

Answer 25

As a result of the issuance of stock for property or services, a corporation undervalues the recorded assets.

An example of a liability overstatement is an excessive provision for estimated product warranties that ultimately results in an understatement of owners’ equity, thereby creating a secret reserve.

Question 26

Costs of Issuing Stock

Answer 26

When a company issues common stock, it should report direct costs incurred to sell stock, such as underwriting costs, accounting and legal fees, printing costs, and taxes, as a reduction of the amounts paid in.

The company debits issue costs to Paid-in Capital in Excess of Par—Common Stock because they are unrelated to corporate operations. In effect, issue costs are a cost of financing.

Question 27

Preferred Stock

Answer 27

1. Preference as to dividends.
2. Preference as to assets in the event of liquidation.
3. Convertible into common stock.
4. Callable at the option of the corporation.
5. Nonvoting.

A company often issues preferred stock (instead of debt) because of a high debt-to-equity ratio.

Question 28

Cumulative Preferred Stock

Answer 28

If a corporation fails to pay a dividend in any year, it must make it up in a later year before paying any dividends to common stockholders.

Question 29

Dividend in Arrears

Answer 29

If the directors fail to declare a dividend at the normal date for dividend action, the dividend is said to have been “passed.”

Any passed dividend on cumulative preferred stock constitutes a dividend in arrears.

Question 30

Participating Preferred Stock

Answer 30

Share ratably with the common stockholders in any profit distributions beyond the prescribed rate.

For example, 5 percent preferred stock, if fully participating, will receive not only its 5 percent return, but also dividends at the same rates as those paid to common stockholders if paying amounts in excess of 5 percent of par or stated value to common stockholders.

Question 31

Convertible Preferred Stock

Answer 31

Allows stockholders, at their option, to exchange preferred shares for common stock at a predetermined ratio. The convertible preferred stockholder not only enjoys a preferred claim on dividends but also has the option of converting into a common stockholder with unlimited participation in earnings.

Question 32

Callable Preferred Stock

Answer 32

Permits the corporation at its option to call or redeem the outstanding preferred shares at specified future dates and at stipulated prices. Many preferred issues are callable.

When a corporation redeems preferred stock, it must pay any dividends in arrears.

Holders of the shares need to return their shares on a certain day in exchange for payment of their capital, outstanding dividends and a premium, as the case may be.

Question 33

Redeemable Preferred Stock

Answer 33

Has a mandatory redemption period or a redemption feature that the issuer cannot control.

The FASB now requires debt-like securities, such as redeemable preferred stock, to be classified as liabilities and be measured and accounted for similar to liabilities.

Question 34

Preferred Stock

Answer 34

Convertible bonds are recorded as liability on the date of issuance.

When exercising the conversion option on convertible preferred stock the company employs the book value method: debit Preferred Stock, along with any related Paid-in Capital in Excess of Par—Preferred Stock, and credit Common Stock and Paid-in Capital in Excess of Par—Common Stock.

Preferred stock generally has no maturity date. Therefore, no legal obligation exists to pay the preferred stockholder.

Question 35

Common Stock

Answer 35

There can be different classes of common stock such as class A, class B, and Class C.