CHAPTER FIVE: ACCOUNTING FOR CORPORATIONS
5.1 Meaning of a Corporation
A corporation is an artificial being, invisible, intangible and existing only in
contemplation of the law.
It 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. The first is that of natural persons and a
corporation.
A corporation is a separate legal entity endowed with many of its rights and obligations
possessed by a natural person.
5.2 Characteristics of a Corporation
a) Separate legal entity: According to the law a corporate entity may own property in its
own name may enter into contract and is responsible for its own debts.
According to the law a corporation may sue and be sued as if it were a real person.
b) Easily transferable ownership rights: Stockholders may dispose of part or all of their
interest in a corporation simply by selling their stock.
c) Continuous life: The life of a corporation is stated in its charter. The life may be
perpetual, or it may be limited to a specific number of years.
d) Limited liability: This means that creditors usually may not go beyond the assets of the
corporation to satisfy their claims.
e) Separation of ownership from management: Stockholders legally own the
corporation. However, they manage the corporation indirectly through a board of
directors they elect. The board, in turn, formulates the operating policies for the
company. The board also selects officers, such as a president and one or more vice
presidents, to execute policy and to perform daily management functions.
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f) Double taxation: As a separate entity (as an artificial person) a corporation is subject to additional
tax; i.e. corporation paid income tax based on net income and stockholders pay personal income
tax.
5.3 Advantages and Disadvantages of the Corporate form of Business Organizations
5.3.1 Advantages
Continuous existence of the Professional management
entity Easily transferable ownership shares
Limited liability No mutual agency of stock
holders
5.3.2 Disadvantages
Double taxation
Difficulties to control: ownership is usually separated from managements; owners
are unable to exercise active control over management actions.
Greater regulations: corporation comes into existence according to the law of the
state. For example, the withdrawal of funds from a corporation is subjected to
certain limits set by the law.
5.4 Forming a Corporation
Corporations may be classified as
Public: Large profit making corporations whose shares are widely distributed and traded
in a public market
Non-public: Corporations whose shares are owned by a small group
The first step in forming a corporation is to file application/articles of incorporation to the
state.
After the application of incorporation has been approved, the state grants a charter or
articles of incorporation.
These articles of incorporation specify the
Purpose of the business, its location
Names of the organizer
Classes and numbers of shares of capital stock authorized and
Consideration to be paid in by the organizers for their respective shares.
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.
The corporate management and board of directors then prepare a set of bylaws, which are the
rules and procedures for conducting the corporation’s affairs.
5.5 Stockholders’ Equity
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The owners’ equity in a corporation is called :
Stockholders’ equity or
Shareholders’ equity or
Shareholders’ investment or capital.
The two main sources of stockholders’ equity are paid-in capital (or contributed capital) and
retained earnings.
a) Paid-in capital or contributed capital: capital contributed to the corporation
by the stockholders and others.
The main source of paid-in capital is from issuing stock.
b) Retained earnings: net income retained in the business.
A Stockholders’ Equity section of a balance sheet is shown below.
If there is only one class of stock, the account is entitled Common Stock or Capital Stock.
Retained earnings are generated from operations.
Net income increases retained earnings, while dividends decrease retained earnings.
Thus, retained earnings represent a corporation’s accumulated net income that has not been
distributed to stockholders as dividends.
5.6 Rights of Stockholders
The rights to vote
The rights to participate in the earnings of a corporation
The rights to share in the distribution of assets upon liquidation
Pre-emptive rights
5.7 Characteristics of Stock
The total number of shares that may be issued is known as the authorized shares.
The term issued refers to the shares issued to the stockholders.
When the corporation receives cash it is an exchange for stock certificates, which
represents the number of shares issued. The shares subsequently become issued
shares.
Shares that are issued and held by the stockholders are called outstanding shares.
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Sometimes a corporation re-acquires shares from 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.
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.
5.8 Types of Stocks/Shares
A) Common Stock
The basic type of stock issued by every corporation is called common stock.
Common stock possesses the traditional rights of ownership such as:
Voting rights
Participation residual dividends
Residual claim to assets in the event of liquidation.
B) Preferred Stock
When any of these rights is modified, the term preferred stock is used.
Some of the distinctive features for preferred stocks are:
Priority claims on dividends
Cumulative dividend rights
Priority as to assets in the event of liquidation of a corporation and
No voting power.
The dividend rights of preferred stock are stated either as dollars per share or as a
percent of par.
For example, a $50 par value preferred stock with a $4 per share dividend may be
described as either:
The preferred stockholders have a greater chance of receiving regular
dividends than do the common stockholders.
a) Nonparticipating Preferred Stock
A nonparticipating preferred stock is limited to a certain amount.
Example: Assume 1,000 shares of $4 nonparticipating preferred stock and
4,000 shares of common stock and the following. Also assume that the net
income, amount of earnings retained, and the amount of earnings distributed by the board of
directors for the first three years of operations are as follows:
Net Income $20,000 $55,000 $62,000
Amount Retained 10,000 20,000 40,000
Amount 10,000 35,000 22,000
Distributed
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Solution
b) Cumulative Preferred Stock
A right to receive regular dividends that were not declared (paid) in prior years.
Cumulative preferred stock dividends that have not been paid in prior years are said
to be in arrears.
Any preferred dividends in arrears must be paid before any common stock
dividends are paid.
Assume that the preferred stock in the above example is cumulative and that no dividends were
paid in 2005 and 2006. In 2007, the board of directors declares dividends of $22,000.
Stocks according to their nature are classified into :
Par value: stocks with a designated dollar amount per share as stated in the
corporate charter and printed on the stock certificates.
No-par stocks: 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.
5.9 Issuing Stock
Stocks may be issued/sold at par or stated value, or at an amount higher than (at premium) or
lower than (at discount) to par or stated value.
For example, assume that a corporation is authorized to issue10,000 shares of $100 par
preferred stock and 100,000 shares of $20 par common stock. The corporation issued 5,000
shares of preferred stock and 50,000 shares of common stock at par for cash. The corporation’s
entry to record the stock issue is as follows:
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For example, if common stock with a par of $50 is sold for $60 per share, the stock has sold at a
premium of $10.
If stock is issued (sold) for a price that is less than its par, the stock has been sold at a discount.
For example, if common stock with a par of $50 is sold for $45 per share, the stock has sold at a
discount of $5.
Premium on Stock
To illustrate, assume that Cold Company issues 2,000 shares of $50 par preferred stock for cash
at $55. The entry to record this transaction is as follows:
When stock is issued in exchange for assets other than cash, such as :
Land
Buildings the assets acquired are recorded at their fair market value.
Equipment
If this value cannot be determined, the fair market price of the stock issued is used.
To illustrate, assume that a corporation acquired land with a fair market value that cannot be
determined. In exchange, the corporation issued 10,000 shares of its $10 par common stock. If
the stock has a market price of $12 per share, the transaction is recorded as follows:
No-Par Stock
As no-par stock is issued over time, this entry is the same even if the issuing price varies.
To illustrate, assume that on January 9 a corporation issues 10,000 shares of no-par common
stock at $40 a share. On June 27, the corporation issues an additional 1,000 shares at $36. The
entries to record these issuances of the no-par stock are as follows:
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In some states, no-par stock may be assigned a stated value per share.
The stated value is recorded like a par value.
Any excess of the proceeds over the stated value is credited to Paid-in Capital in Excess of
Stated Value.
To illustrate, assume that in the preceding example the no-par common stock is assigned stated
value of $25. The issuance of the stock on January 9 and June 27 is recorded as follows:
5.9.1 Stock Issuance For Subscription
A subscription sale is collected in installments and the stock certificate is issued when the price
is paid in full.
A subscription is a contract to acquire a certain number of shares of stock at a specified price.
A subscriber is a person contracting to acquire the shares.
Reason for this procedure is to:
Attract small investors
Appeal to investors who prefer not to invest cash until the corporation is ready to start
business operations.
Assume that 100,000 shares of Nile corporation common stock, par Br. 10, are subscribed for at
Br. 12 by Ambasel Trading. The total is payable in three equal installments. The following
entries are processed by Nile Corporation.
Solution
Common stock subscription Receivable 1,20
0,00
0
Common stock subscribed 1,000,000
Paid-in-capital in excess of par 200,000
To record receipt of subscription for 100,000 shares
Cash 400,
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000
Common stock subscription receivable 400,000
To record receipt of first payment
Cash 400,.000
Common stock subscription receivable 40
To record receipt of Second payment 0,.
00
0
Cash 400,.000
Common stock subscription receivable 40
To record receipt of final payment 0,.
00
0
Common stock subscribed 1,00
0,00
0
Common stock 1,0
To record issuance of stock 00,
00
0
5.10 Accounting for Treasury Stock
Treasury stock is stock that a corporation has issued and then reacquired.
A corporation may reacquire (purchase) its own stock for a variety of reasons including the
following:
To provide shares for resale to employees
To reissue as bonuses to employees, or
To support the market price of the stock
The cost method is normally used for recording the purchase and resale of treasury stock.
To illustrate, assume that a corporation has the following paid-in capital on January 1:
On February 13, the corporation purchases 1,000 shares of its common stock at $45per share.
The entry to record the purchase of the treasury stock is as follows:
On April 29, the corporation sells 600 shares of the treasury stock for $60. The entry to record
the sale is as follows:
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A sale of treasury stock may result in a decrease in paid-in capital. To the extent that
To illustrate, assume that on October 4, the corporation sells the remaining 400 shares of
treasury stock for $40 per share. The entry to record the sale is as follows:
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