Chapter 20 Corporations: Formation and Capital Stock Transactions

Question 1

corporation:

Answer 1

In 1818, Chief Justice John Marshall of the U.S. Supreme Court defined the corporation as “an artificial being, invisible, intangible, and existing only in contemplation of the law.” The corporation is a legal entity, completely separate and apart from its owners. It is created by a corporate charter A document issued by a state government that establishes a corporation issued by a state government. Since it is a legal entity, a corporation can enter into contracts, can own property, and has almost all of the rights and privileges of a sole proprietorship or a partnership.

Question 2

Corporations can have few or many owners:

Answer 2

A privately held corporation is one that is owned by one or more persons and whose stock is not traded on an organized stock exchange. A publicly held corporation has many owners and its stock is traded on an organized stock exchange.

Question 3

A shareholder or stockholder:

Answer 3

is a person who owns shares of stock in a corporation and is, thus, one of the owners of the corporation.

Question 4

Mutual Funds:

Answer 4

Mutual funds allow small investors to pool their funds with other small investors. There are many types of mutual funds. Each fund concentrates on a particular type of stock. Index funds invest in the S&P 500. Growth funds invest in companies that are growing quickly. International funds buy stocks from European and Pacific Rim companies. Bond funds invest in the bond market.

Question 5

Subchapter S Corporations:

Answer 5

also known as S corporations, are entities formed as corporations which meet the requirements of Subchapter S of the Internal Revenue Code to be treated essentially as a partnership so the corporation pays no income tax.
The advantage of S corporations is that the owners have limited liability and avoid double taxation.

Question 6

Limited Liability Partnerships The limited liability partnership (LLP):

Answer 6

Limited Liability Partnerships The limited liability partnership (LLP) A partnership that provides limited liability for all partners is a general partnership that provides some limited liability for all partners. LLP partners are responsible and have liability for their own actions and the actions of those under their control or supervision. They are not liable for the actions or malfeasance of another partner. LLPs must have more than one owner, so a sole proprietorship cannot be treated as one. In some states, LLPs are for the service professions only, such as law, accounting, medicine, and engineering.
Except for the limited liability aspect, LLPs generally have the same characteristics, advantages, and disadvantages as any other partnership.

Question 7

Limited Liability Companies:

Answer 7

Limited Liability Companies (LLCs) provide limited liability to the owners, who can elect to have the profits taxed at the LLC level or on their individual income tax returns. The profits and losses can be allocated to the owners other than in proportion to the ownership interests. In most states, one individual can form an LLC. Its ownership interests are not freely transferable; other owners must approve a transfer of ownership interest. When transferring ownership, the existing LLC is terminated and a new one formed. Unlike the limited partners discussed in Chapter 19, LLC owners can take part in policy and operating decisions.

Question 8

controller or chief financial officer:

Answer 8

The top accounting official is called the controller or chief financial officer.

Question 9

Flow of Corporate Authority and Responsibility:
1 Stockholders *Elect directors

2 Directors *Make policies
*Appoint officers

3 Officers *Carry out policies
*Hire managers

4 Managers *Oversee and supervise operations

5 Other employees *Perform assigned tasks

Answer 9

Flow of Corporate Authority and Responsibility:
1 Stockholders *Elect directors

2 Directors *Make policies
*Appoint officers

3 Officers *Carry out policies
*Hire managers

4 Managers *Oversee and supervise operations

5 Other employees *Perform assigned tasks

Question 10

the authorized capital stock:

Answer 10

is the number of shares authorized for issue by the corporate charter. Usually the authorized stock is more than the number of shares the corporation plans to issue in the foreseeable future. This gives the corporation flexibility to issue stock in the future without having to amend the corporate charter.

Question 11

When a corporation issues stock, the stock is sold (transferred to stockholders). Outstanding stock is stock that has been issued and is still in circulation, meaning it is still in the hands of stockholders.

Answer 11

When a corporation issues stock, the stock is sold (transferred to stockholders). Outstanding stock is stock that has been issued and is still in circulation, meaning it is still in the hands of stockholders.

Question 12

Par Value:

Answer 12

is an amount assigned by the corporate charter to each share of stock for accounting purposes. It is usually $100 or less; it can be $25, $5, or even less than $1 per share. Stock can be issued for more than par value. State laws prohibit the issuance of par-value stock for less than the par value.

Question 13

Stated Value:

Answer 13

Stated Value. State laws permit stock to be issued without par value. This type of stock is called no-par-value stock. The value that can be assigned to no-par-value stock by a board of directors for accounting purposes is called the stated value.

Question 14

Market Value:

Answer 14

Market Value. Market value The price per share at which stock is bought and sold is the price per share at which stock is bought and sold. After the corporation issues stock, it can be resold for any price that can be agreed on between the shareholder and purchaser. Usually a stock’s market value has little relation to its par or stated value.

Question 15

Common Stock:

Answer 15

Common Stock If there is only one class of stock, the stock is called common stock The general class of stock issued when no other class of stock is authorized; each share carries the same rights and privileges as every other share. Even if preferred stock is issued, common stock will also be issued.

Question 16

Preemptive right:

Answer 16

the preemptive right -A shareholder’s right to purchase a proportionate amount of any new stock issued at a later date.

Question 17

Preferred stock:

Answer 17

has special claims on the corporate profits or, in case of liquidation, on corporate assets. In receiving special preferences, the owners of preferred stock might lose some of their general rights, such as the right to vote. Unless the charter specifies otherwise, however, preferred stock has voting rights.

Question 18

A Liquidation Value:

Answer 18

(usually par value or an amount higher than par value) is assigned to the preferred stock.

Question 19

Assume that a corporation is going out of business. It has paid all of its liabilities. There remains $1,700,000 to distribute to the shareholders. The company has outstanding 25,000 shares of $50 preferred stock, with a liquidation value of $52 per share, and 50,000 shares of $20 par-value common stock. The preferred stockholders will receive $1,300,000 (25,000 shares × $52 per share). The common stockholders will receive what’s left, $400,000 ($1,700,000 − $1,300,000).

Answer 19

Assume that a corporation is going out of business. It has paid all of its liabilities. There remains $1,700,000 to distribute to the shareholders. The company has outstanding 25,000 shares of $50 preferred stock, with a liquidation value of $52 per share, and 50,000 shares of $20 par-value common stock. The preferred stockholders will receive $1,300,000 (25,000 shares × $52 per share). The common stockholders will receive what’s left, $400,000 ($1,700,000 − $1,300,000).

Question 20

Convertible Preferred Stock:

Answer 20

is preferred stock that conveys the right to convert that stock to common stock after a specified date or during a period of time. The conversion ratio is the number of shares of common stock that will be issued for each share of preferred stock surrendered.

Question 21

Assume that a corporation has outstanding 100,000 shares of 12 percent, $25 par-value preferred stock that can be converted into common stock. (The term “12 percent” refers to the dividend rate and is discussed below.) The conversion ratio is two shares of common stock for each share of preferred stock surrendered. The conversion privilege is exercisable on or after January 1, 2013. A stockholder can convert 400 shares of preferred stock into 800 (400 × 2) shares of common stock.

Answer 21

Assume that a corporation has outstanding 100,000 shares of 12 percent, $25 par-value preferred stock that can be converted into common stock. (The term “12 percent” refers to the dividend rate and is discussed below.) The conversion ratio is two shares of common stock for each share of preferred stock surrendered. The conversion privilege is exercisable on or after January 1, 2013. A stockholder can convert 400 shares of preferred stock into 800 (400 × 2) shares of common stock.

Question 22

Callable preferred stock:

Answer 22

gives the issuing corporation the right to repurchase the preferred shares from the stockholders at a specific price. The call price is usually substantially greater than the original issue price. The rights are effective after some specified date. Callable stock gives the corporation flexibility in controlling its capital structure.

Question 23

The following example illustrates the call feature. Assume a corporation issued 50,000 shares of 10 percent, $40 par-value preferred stock at $40 per share. The corporation has the right to call any part of the preferred stock any time after December 31, 2013, for $53 per share. If the corporation has funds available, or if money can be borrowed at substantially less than 10 percent, the corporation may call the preferred stock and retire it.

Answer 23

The following example illustrates the call feature. Assume a corporation issued 50,000 shares of 10 percent, $40 par-value preferred stock at $40 per share. The corporation has the right to call any part of the preferred stock any time after December 31, 2013, for $53 per share. If the corporation has funds available, or if money can be borrowed at substantially less than 10 percent, the corporation may call the preferred stock and retire it.

Question 24

Dividends:

Answer 24

are distributions of the profits of a corporation to its shareholders. The right to receive a dividend is one of the major incentives for buying stock. The board of directors declares dividends. The board of directors has complete discretion, subject to certain legal restrictions or contractual restrictions, in deciding whether to declare a dividend and the amount of the dividend. The amount of the dividend depends on the corporation’s earnings and on the need to keep profits for use in the business. Dividends are usually paid on a quarterly basis.

Question 25

Preference dividend:

Answer 25

Preferred stock bears a basic or stated dividend rate, called the preference dividend, that must be paid before dividends can be paid on common stock. The dividend rate is expressed in dollars-per-share per year or as a percentage. When the dividend is expressed as a percentage, the dividend amount is par value of the stock multiplied by the percentage. For example, the annual dividend on 8 percent preferred stock with a par value of $50 is $4 per share ($50 × 0.08).

Question 26

cumulative preferred stock:

Answer 26

conveys to its owners the right to receive the preference dividend for the current year and any prior years in which the preference dividend was not paid before common stockholders receive any dividends.

Question 27

noncumulative preferred stock:

Answer 27

conveys to its owners the stated preference dividend for the current year, but stockholders have no rights to dividends for years in which none were declared.

Question 28

nonparticipating preferred stock:

Answer 28

conveys to its owners the right to only the preference dividend amount specified on the stock certificate.

Question 29

participating preferred stock:

Answer 29

conveys the right not only to the preference dividend amount but also to a share of other dividends paid.

Question 30

DIVIDENDS ON COMMON STOCK

Answer 30

DIVIDENDS ON COMMON STOCK

Common stock dividends are paid only after preferred dividend requirements have been met. The fewer the dividend privileges enjoyed by preferred stockholders, the higher the dividends that common stockholders can receive, especially in prosperous years.

The amount of dividends paid each year reflects such factors as the company’s trend of profits and cash flows, tax laws, availability of cash, plans for future expansion, and so on. Typically, a company avoids decreases in dividend payouts because a decrease often leads to loss of investor confidence and reduced prices for the stock.

Question 31

Only Common Stock Issued

Suppose that a corporation has only one class of stock—common stock. Assume that 15,000 shares of $50 par-value common stock are authorized, issued, and outstanding:

Situation 1. The board of directors declared a 5 percent dividend for the year. Total dividends are $37,500 (15,000 shares × $50 par × 0.05). (The dividend is usually announced as $2.50 per share.)

Situation 2. The board of directors decides to pass the dividend (not declare or pay it).

There is no guarantee that the corporation will pay dividends. The uncertainty of dividends is a risk of owning common stock.

Answer 31

Only Common Stock Issued

Suppose that a corporation has only one class of stock—common stock. Assume that 15,000 shares of $50 par-value common stock are authorized, issued, and outstanding:

Situation 1. The board of directors declared a 5 percent dividend for the year. Total dividends are $37,500 (15,000 shares × $50 par × 0.05). (The dividend is usually announced as $2.50 per share.)

Situation 2. The board of directors decides to pass the dividend (not declare or pay it).

There is no guarantee that the corporation will pay dividends. The uncertainty of dividends is a risk of owning common stock.

Question 32

Common and Noncumulative Nonparticipating Preferred Stock Issued

Preferred stock reduces the uncertainty of dividends.

Answer 32

Common and Noncumulative Nonparticipating Preferred Stock Issued

Preferred stock reduces the uncertainty of dividends.

Question 33

Common and Cumulative Nonparticipating Preferred Stock Issued
When business conditions are poor, preferred stockholders have a better chance of receiving a dividend than do common stockholders. In turn, cumulative preferred stockholders have a better chance of receiving a dividend than do noncumulative preferred stockholders. The dividends not paid on cumulative preferred stock are carried forward as a continuing claim into future periods. Cumulative preferred dividends not previously paid are shown on the balance sheet or in the footnotes to the financial statements.

Answer 33

Common and Cumulative Nonparticipating Preferred Stock Issued
When business conditions are poor, preferred stockholders have a better chance of receiving a dividend than do common stockholders. In turn, cumulative preferred stockholders have a better chance of receiving a dividend than do noncumulative preferred stockholders. The dividends not paid on cumulative preferred stock are carried forward as a continuing claim into future periods. Cumulative preferred dividends not previously paid are shown on the balance sheet or in the footnotes to the financial statements.

Question 34

When dividends are paid, they are paid in the following order:

1. To holders of cumulative preferred stock for prior year dividends not paid.
2. To preferred stockholders for the preference dividend for the current year.
3. To common stockholders.

Answer 34

When dividends are paid, they are paid in the following order:

1. To holders of cumulative preferred stock for prior year dividends not paid.
2. To preferred stockholders for the preference dividend for the current year.
3. To common stockholders.

Question 35

Common and Cumulative Participating Preferred Stock Issued
When cumulative participating preferred stock is issued, dividend distributions are allocated to preferred and common stock as follows:

1. Preferred stockholders receive any prior year dividends not paid plus the preference dividend for the current year.
2. A specific rate of dividend is paid to common stockholders, equal to the same percentage rate paid to preferred.
3. The dividends that remain are shared between preferred and common stockholders. The participation terms determine how the dividends are shared. Typically, equal rates are paid on common stock and preferred stock.Since almost all preferred stock is nonparticipating, this textbook provides examples of nonparticipating preferred stock only.

Answer 35

Common and Cumulative Participating Preferred Stock Issued
When cumulative participating preferred stock is issued, dividend distributions are allocated to preferred and common stock as follows:

1. Preferred stockholders receive any prior year dividends not paid plus the preference dividend for the current year.
2. A specific rate of dividend is paid to common stockholders, equal to the same percentage rate paid to preferred.
3. The dividends that remain are shared between preferred and common stockholders. The participation terms determine how the dividends are shared. Typically, equal rates are paid on common stock and preferred stock.Since almost all preferred stock is nonparticipating, this textbook provides examples of nonparticipating preferred stock only.

Question 36

Owner’s Investment:

Answer 36

Common and preferred stock are owners’ (stockholders’) equity accounts. Increases to owners’ equity accounts are recorded as credits.

Question 37

The assets and liability are recorded at fair market value. Accounts Receivable and Allowance for Doubtful Accounts are recorded separately. The $22,500 balance in the Accounts Receivable control account agrees with the total of the accounts receivable subsidiary ledger.

Answer 37

The assets and liability are recorded at fair market value. Accounts Receivable and Allowance for Doubtful Accounts are recorded separately. The $22,500 balance in the Accounts Receivable control account agrees with the total of the accounts receivable subsidiary ledger.

Question 38

Organization costs:

Answer 38

are incurred to provide benefit over the entire life of the corporation because they are necessary in order for the entity to exist and carry on business. For this reason, organization costs in the past have been capitalized and amortized over an arbitrary period. A common amortization period was five years. That practice resulted from federal income tax requirements that the costs be capitalized and subsequently amortized over a period of not less than 60 months. Some corporations, however, simply recorded the costs as an intangible asset and did not amortize the costs for financial accounting purposes.

Question 39

On January 18, Camping Supply Center, Inc., paid $2,000 of organization costs to its attorney. The amount includes legal fees, reimbursement for the charter fee, and the cost of drafting and printing the stock certificates. This reimbursement is recorded by a debit to Organization Expense and a credit to Cash.

Answer 39

On January 18, Camping Supply Center, Inc., paid $2,000 of organization costs to its attorney. The amount includes legal fees, reimbursement for the charter fee, and the cost of drafting and printing the stock certificates. This reimbursement is recorded by a debit to Organization Expense and a credit to Cash.

Question 40

Premium:

Answer 40

The amount received by a corporation that is in excess of the par value is called a premium. A premium on preferred stock is credited to an account called Paid-in Capital in Excess of Par Value—Preferred Stock.

Question 41

In the Stockholders’ Equity section of the balance sheet shown below, the amount of the new account, Paid-in Capital in Excess of Par Value—Preferred Stock, is added to the par value of the shares issued to show the total paid in by that class of stockholder. (The account title might also be Premium on Preferred Stock or a similar name.)

Answer 41

In the Stockholders’ Equity section of the balance sheet shown below, the amount of the new account, Paid-in Capital in Excess of Par Value—Preferred Stock, is added to the par value of the shares issued to show the total paid in by that class of stockholder. (The account title might also be Premium on Preferred Stock or a similar name.)

Question 42

In Excess of Par:
The amount credited to the Paid-In Capital in Excess of Par Value account is the price paid by the stockholder minus the par value of the stock multiplied by the number of shares issued.

Answer 42

In Excess of Par:
The amount credited to the Paid-In Capital in Excess of Par Value account is the price paid by the stockholder minus the par value of the stock multiplied by the number of shares issued.

Question 43

No-par-value Stock:

Answer 43

is not assigned a par value in the corporate charter. No-par-value stock has theoretical advantages over par-value stock:

1. No-par-value stock can be issued at any price. Par-value stock cannot be issued for less than its par value.
    2. If there is no par value, investors cannot confuse par value and market value.

Question 44

If no-par-value stock does not have a stated value, the proceeds from the issue of shares are credited to the Common Stock account.

Answer 44

If no-par-value stock does not have a stated value, the proceeds from the issue of shares are credited to the Common Stock account.

Question 45

No-Par-Value Stock with Stated Value: Most no-par-value stock is assigned a stated value by the board of directors. The stated value is treated like par value. If no-par-value common stock with a stated value is issued at a price higher than the stated value, the stated value is credited to the Common Stock account. Any excess received over stated value is treated as a premium and credited to Paid-in Capital in Excess of Stated Value.

Answer 45

No-Par-Value Stock with Stated Value: Most no-par-value stock is assigned a stated value by the board of directors. The stated value is treated like par value. If no-par-value common stock with a stated value is issued at a price higher than the stated value, the stated value is credited to the Common Stock account. Any excess received over stated value is treated as a premium and credited to Paid-in Capital in Excess of Stated Value.

Question 46

The credit to the Paid-in Capital in Excess of Stated Value account is $2,400 [($26 price − $25 stated value) × 2,400 shares]. On the balance sheet, the premium is shown as an addition to the stated value to show the total paid by common stockholders.

Answer 46

The credit to the Paid-in Capital in Excess of Stated Value account is $2,400 [($26 price − $25 stated value) × 2,400 shares]. On the balance sheet, the premium is shown as an addition to the stated value to show the total paid by common stockholders.

Question 47

A separate Subscriptions Receivable account is used for each class of stock. There are also separate Stock Subscribed accounts. When the subscriptions are paid in full, the stock is issued. Until then, the Stock Subscribed accounts appear in the Stockholders’ Equity section of the balance sheet as additions to the class of stock issued.

Answer 47

A separate Subscriptions Receivable account is used for each class of stock. There are also separate Stock Subscribed accounts. When the subscriptions are paid in full, the stock is issued. Until then, the Stock Subscribed accounts appear in the Stockholders’ Equity section of the balance sheet as additions to the class of stock issued.

Question 48

Stock Subscriptions:
Subscriptions receivable accounts are presented in the asset section. Stock subscribed accounts are presented in the Stockholders’ Equity section of the balance sheet.

Answer 48

Stock Subscriptions:
Subscriptions receivable accounts are presented in the asset section. Stock subscribed accounts are presented in the Stockholders’ Equity section of the balance sheet.

Question 49

Patel paid his preferred stock subscription in two monthly installments of $21,000 each. The company debits each payment to Cash and credits Subscriptions Receivable—Preferred.

Answer 49

Patel paid his preferred stock subscription in two monthly installments of $21,000 each. The company debits each payment to Cash and credits Subscriptions Receivable—Preferred.

Question 50

This stock subscription transaction resulted in a $42,000 increase in Cash, a $40,000 increase in Preferred Stock, and a $2,000 increase in Paid-in Capital in Excess of Par Value—Preferred Stock.

Answer 50

This stock subscription transaction resulted in a $42,000 increase in Cash, a $40,000 increase in Preferred Stock, and a $2,000 increase in Paid-in Capital in Excess of Par Value—Preferred Stock.

Question 51

Minute Book:

Answer 51

keeps accurate and complete records of all meetings of stockholders and directors. The minute book formally reports actions taken, directives issued, directors elected, officers elected, and other matters.

Question 52

Stock Certificate:

Answer 52

stock certificate: The form by which capital stock is issued; the certificate indicates the name of the corporation, the name of the stockholder to whom the certificate was issued, the class of stock, and the number of shares. 
Certificates are valid when they are properly signed by corporate officers and have the corporate seal affixed to them.

Question 53

Capital Stock Ledger:

Answer 53

It is essential for corporations to keep accurate records of the shares of stock issued and the names and addresses of the stockholders. This information is needed to mail dividend checks and official notices about stockholders’ meetings and votes.

Question 54

capital stock ledger:

Answer 54

To keep the required information, corporations set up a capital stock ledger, A subsidiary ledger that contains a record of each stockholder’s purchases, transfers, and current balance of shares owned; also called stockholders’ ledger. There is a sheet for each stockholder with the following information:

stockholder’s name and address,

dates of transactions affecting stock holdings,

certificate numbers,

number of shares for each transaction.

Question 55

Stock Certificate:

Answer 55

After the corporation issues stock, new stockholders purchase shares from existing stockholders. The process is as follows:
The buyer pays the seller.
The seller surrenders the stock certificate to the corporation.
The corporation issues a new certificate to the buyer.

Question 56

capital stock transfer journal:

Answer 56

is a record of stock transfers used for posting to the stockholders’ ledger. There is a capital stock transfer journal for each class of stock issued by the corporation.

Question 57

Records of Stock Subscriptions:

Answer 57

The corporation tracks stock subscriptions using the subscription book and the subscribers’ ledger. The subscription book, A list of the stock subscriptions received:

is a listing of the stock subscriptions received,

shows the names and addresses of the subscribers,

shows the number of shares subscribed,

contains the amounts and times of payment.

A subscription book can contain the actual stock subscription contracts.

Question 58

subscribers’ ledger:

Answer 58

contains an account receivable for each stock subscriber. The account is debited for the total subscription and credited when the subscriber makes payments. The subscribers’ ledger is a subsidiary ledger. The balances of the individual subscriber accounts must agree with the Subscriptions Receivable control account in the general ledger.

Question 59

Subsidiary Ledgers

The total of the individual accounts must agree with the control account in the general ledger.

Answer 59

Subsidiary Ledgers

The total of the individual accounts must agree with the control account in the general ledger.

Question 60

transfer agent:

Answer 60

A person or institution that handles all stock transfers and transfer records for a corporation.

Question 61

An assignment form on the certificate indicates to whom a new certificate should be issued. The agent:

Subsidiary Ledgers
The total of the individual accounts must agree with the control account in the general ledger.

cancels the old certificates,

issues the new ones,

makes the necessary entries in the capital stock ledger,

prepares lists of stockholders who should receive dividend payments and notices.

The agent might also prepare and mail the dividend checks.

Answer 61

An assignment form on the certificate indicates to whom a new certificate should be issued. The agent:

Subsidiary Ledgers
The total of the individual accounts must agree with the control account in the general ledger.

cancels the old certificates,

issues the new ones,

makes the necessary entries in the capital stock ledger,

prepares lists of stockholders who should receive dividend payments and notices.

The agent might also prepare and mail the dividend checks.

Question 62

the registrar:

Answer 62

accounts for all the stock issued by the corporation and makes sure that the corporation does not issue more shares than are authorized. The registrar receives from the transfer agent all the canceled certificates and all the new certificates issued. The registrar must countersign the new certificates before they are valid.