Chapter Fourteen: Corporate Equity Accounting

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Building PictureA corporation is a legal entity having existence separate and distinct from its owners (i.e., stockholders). Corporations are artificial beings existing only in contemplation of law. A corporation is typically created when one or more individuals file “articles of incorporation” with a Secretary of State in a particular jurisdiction. The articles of incorporation generally specify a number of important features about the purpose of the entity and how governance will be structured.

After reviewing the articles of incorporation, the Secretary of State will issue a charter (or certificate of incorporation) authorizing the corporate entity. The persons who initiated the filing (the “incorporators”) will then collect the shareholders’ initial investment in exchange for the “stock” of the corporation (the stock is the financial instrument evidencing a person’s ownership interest). Once the initial stock is issued, a shareholders’ meeting will be convened to adopt bylaws and elect a board of directors. These directors appoint the corporate officers who are responsible for commencing the operations of the business. In a small start-up venture, the initial incorporators may become the shareholders, then elect themselves to the board, and finally appoint themselves to become the officers. This leads one to wonder why go to all the trouble of incorporating?

Advantages

The reasons for incorporating can vary, but there are certain unique advantages to this form of organization that have led to its popularity. One advantage of the corporate form of organization is that it permits otherwise unaffiliated persons to join together in mutual ownership of a business entity. This objective can be accomplished in other ways (like a partnership), but the corporate form of organization is arguably one of the better vehicles. Large amounts of venture capital can be drawn together from many individuals and concentrated into one entity under shared ownership. The stock of the corporation provides a clear and unambiguous point of reference to identify who owns the business and in what proportion. Further, the democratic process associated with shareholder voting rights (typically one vote per share of stock) permits shareholder “say so” in selecting the board of directors. In addition to electing the board, shareholders may vote on other matters such as selection of an independent auditor, stock option plans, and corporate mergers. The voting “ballot” is usually referred to as a “proxy.”

Corporate stock has the benefit of transferability of ownership. It is easily transferable from one person to another. Transferability provides liquidity to stockholders as it enables them to quickly enter or exit an ownership position in a corporate entity. As a corporation grows, it may bring in additional shareholders by issuing even more stock. At some point, the entity may become sufficiently large that its shares will become “listed” on a stock exchange.

An “IPO” is the initial public offering of the stock of a corporation. Rules require that such IPOs be accompanied by regulatory registrations and filings, and that potential shareholders be furnished with a prospectus detailing corporate information. Publicly traded corporate entities are subject to a number of continuing regulatory registration and reporting requirements that are aimed at ensuring full and fair disclosure.

Another benefit of a corporation is perpetual existence. A corporate entity is typically of unlimited duration enabling it to effectively outlive its shareholders. Changes in stock ownership do not cause operations to cease. What would cause a corporation to cease to exist? At some point, a corporation may be acquired by another and merged in with the successor. Or, a corporation may fail and cease operations. Finally, some businesses may find that liquidating operating assets and distributing residual monies to the creditors and shareholders is a preferable strategy to continued operation.

Not to be overlooked in considering why a corporation is desirable is the feature of limited liability for stockholders, who normally understand that their investment can be lost if the business fails. However, stockholders are not liable for debts and losses of the company beyond the amount of their investment. There are exceptions to this rule. In some cases, shareholders may be called upon to sign a separate guarantee for corporate debt. And, shareholders in closely held companies can inadvertently be drawn into having to satisfy corporate debts when they commingle their personal finances with those of the company or fail to satisfy the necessary legal procedures to maintain a valid corporate existence.

disadvantages

Corporations are not without certain disadvantages. Most corporations are taxable entities, and their income is subject to taxation. This “income tax” is problematic as it oftentimes produces double taxation. This effect occurs when shareholders receive cash dividends that they must include in their own calculation of taxable income. Thus, a dollar earned at the corporate level is reduced by corporate income taxes (at a rate that is likely about 35%); to the extent the remaining after-tax profit is distributed to shareholders as dividends, it is again subject to taxes at the shareholder level (at a rate that will vary in the 15% to 35% range). So, as much as half or more of the profits of a dividend-paying corporation are apt to be shared with governmental entities.

Governments are aware that this double-taxation outcome can limit corporate investment and be potentially damaging to an economy. Various measures of relief are sometimes available, depending on the prevailing political climate (including “dividends received deductions” for dividends paid between affiliated companies, lower shareholder tax rates on dividends, and S-Corporation provisions that permit closely held corporations to attribute their income to the shareholders thereby avoiding one level of tax). Some countries adopt “tax holidays” that permit newer companies to be exempt from income taxes, or utilize different approaches to taxing the value additive components of production by an entity.

Another burden on the corporate form of organization is costly regulation. In the U.S., larger (usually public) companies are under scrutiny of federal (The Securities and Exchange Commission (SEC) and other public oversight groups) and state regulatory bodies. History shows that the absence or failure of these regulators will quickly foster an environment where rogue business persons will launch all manner of stock fraud schemes. These frauds can quickly corrupt public confidence without which investors become unwilling to join together to invest in new ideas and products. It seems almost unavoidable that governmental regulation must be a part of the corporate scene. However, the cost of compliance with such regulation is high. Public companies must prepare and file quarterly and annual reports with the SEC, along with a myriad of other documents. Many of these documents must be certified or subjected to independent audit. Further, requirements are in place that require companies to have strong internal controls and even ethical training.

 

Common and Preferred Stock

Companies may issue different types of stock. For example, some companies have multiple classes of common stock. A “family business” that has grown very large and become a public company may be accompanied by the creation of Class A stock (held by the family members) and Class B stock (held by the public), where only the Class A stock can vote. This enables raising needed capital but preserves the ability to control and direct the company. While common stock is the most typical, another way to gain access to capital is by issuing preferred stock. The customary features of common and preferred stock differ, providing some advantages and disadvantages for each. The following tables reveal general features that can be modified on a company by company basis.

typical common stock features

Common Stock Features Chart

Possible Preferred stoCk feAtures

Preferred Stock Features Chart

A comparative review of the preceding tables reveals a broad range of potential attributes. Every company has different financing and tax considerations and will tailor its package of features to match those issues. For instance, a company can issue preferred that is much like debt (cumulative, mandatory redeemable), because a fixed periodic payment must occur each period with a fixed amount due at maturity. On the other hand, some preferred will behave more like common stock (noncallable, noncumulative, convertible).

WHAT IS PAR?

In the preceding discussion, there were several references to par value. Many states require that stock have a designated par value (or in some cases “stated value”). Thus, par value is said to represent the “legal capital” of the firm. In theory, original purchasers of stock are contingently liable to the company for the difference between the issue price and par value if the stock is issued at less than par. However, as a practical matter, par values on common stock are set well below the issue price, negating any practical effect of this latent provision.

It is not unusual to see common stock carry a par value of $1 per share or even $.01 per share. In some respects, then, par value is merely a formality. But, it does impact the accounting records, because separate accounts must be maintained for “par” and paid-in capital in excess of par. Assume that Godkneckt Corporation issues 100,000 shares of $1 par value stock for $10 per share. The entry to record this stock issuance would be:

Paid-In Capital in Excess of Par Journal Entry

Occasionally, a corporation may issue no-par stock, which is recorded by debiting Cash and crediting Common Stock for the issue price. A separate Paid-in Capital in Excess of Par account is not needed.

Sometimes, stock may be issued for land or other tangible assets, in which case the debit in the preceding entry would be to the specific asset account (e.g., Land instead of Cash). When stock is issued for noncash assets, the amount of the entry would be based upon the fair value of the asset (or the fair value of the stock if it can be more clearly determined).

A CLOSER LOOK AT CASH DIVIDENDS

Begin by assuming that a company has only common shares outstanding. There is no mandatory dividend requirement, and the dividends are a matter of discretion for the board of directors to consider. To pay a dividend the company must have sufficient cash and a positive balance in retained earnings (companies with a “deficit” (negative) Retained Earnings account would not pay a dividend unless it is part of a corporate liquidation action). Many companies pride themselves in having a long-standing history of regular and increasing dividends, a feature that many investors find appealing. Other companies view their objective as one of continual growth via reinvestment of all earnings; their investors seem content relying on the notion that their investment value will gradually increase due to this earnings reinvestment activity. Whatever the case, a company has no obligation to pay a dividend, and there is no “liability” for dividends until such time as they are actually declared. A “declaration” is a formal action by the board of directors to indicate that a dividend will be paid at some stipulated future date. On the date of declaration, the following entry is needed on the corporate accounts:

Dividend Journal Entry

dividend dates

In observing the preceding entry, it is imperative to note that the declaration on July 1 establishes a liability to the shareholders that is legally enforceable. Therefore, a liability is recorded on the books at the time of declaration. Recall (from earlier chapters) that the Dividends account will directly reduce retained earnings (it is not an expense in calculating income; it is a distribution of income)! When the previously declared dividends are paid, the appropriate entry would require a debit to Dividends Payable and a credit to Cash.

Some shareholders may sell their stock between the date of declaration and the date of payment. Who is to get the dividend? The former shareholder or the new shareholder? To resolve this question, the board will also set a “date of record;” the dividend will be paid to whomever the owner of record is on the date of record. In the preceding illustration, the date of record might have been set as August 1, for example. To further confuse matters, there may be a slight lag of just a few days between the time a share exchange occurs and the company records are updated. As a result, the date of record is usually slightly preceded by an ex-dividend date.

Ex-Dividend The practical effect of the ex-dividend date is simple: if a shareholder on the date of declaration continues to hold the stock at least through the ex-dividend date, that shareholder will get the dividend. But, if the shareholder sells the stock before the ex-dividend date, the new shareholder can expect the dividend. In the illustrated time line, if one were to own stock on the date of declaration, that person must hold the stock at least until the “green period” to be entitled to receive payment.

 

THE PRESENCE OF PREFERRED STOCK

Recall that preferred dividends are expected to be paid before common dividends, and those dividends are usually a fixed amount (e.g., a percentage of the preferred’s par value). In addition, recall that cumulative preferred requires that unpaid dividends become “dividends in arrears.” Dividends in arrears must also be paid before any distributions to common can occur. The following illustration will provide the answer to questions about how these concepts are to be implemented.

To develop the illustration, begin by looking at the equity section of Embassy Corporation’s balance sheet. Note that this section of the balance sheet is quite extensive. A corporation’s stockholders’ equity (or related footnotes) should include rather detailed descriptions of the type of stock outstanding and its basic features. This will include mention of the number of shares authorized (permitted to be issued), issued (actually issued), and outstanding (issued minus any shares reacquired by the company). In addition, be aware of certain related terminology: legal capital is the total par value ($20,400,000 for Embassy), and total paid-in capital is the legal capital plus amounts paid in excess of par values ($56,400,000 for Embassy).

Preferred Stock On The Balance Sheet

Note that the par value for each class of stock is the number of shares issued multiplied by the par value per share (e.g., 200,000 shares X $100 per share = $20,000,000). The preferred stock description makes it clear that the $100 par stock is 8% cumulative. This means that each share will receive $8 per year in dividends, and any “missed” dividends become dividends in arrears.

If the notes to the financial statements appropriately indicate that Embassy has not managed to pay its dividends for the preceding two years, and Embassy desired to pay $5,000,000 of total dividends during the current year, how much would be available to the common shareholders?

The answer is only $200,000 (or $0.50 per share for the 400,000 common shares). The reason is that the preferred stock is to receive annual dividends of $1,600,000 ($8 per share X 200,000 preferred shares), and three years must be paid consisting of the two years in arrears and the current year requirement ($1,600,000 X 3 years = $4,800,000 to preferred, leaving only $200,000 for common).

 

Treasury Stock

Treasury stock is the term that is used to describe shares of a company’s own stock that it has reacquired. A company may buy back its own stock for many reasons. A frequently cited reason is a belief by the officers and directors that the market value of the stock is unrealistically low. As such, the decision to buy back stock is seen as a way to support the stock price and utilize corporate funds to maximize the value for shareholders who choose not to sell back stock to the company.

Other times, a company may buy back public shares as part of a reorganization that contemplates the company “going private” or delisting from some particular stock exchange. Further, a company might buy back shares and in turn issue them to employees pursuant to an employee stock award plan.

Whatever the reason for a treasury stock transaction, the company is to account for the shares as a purely equity transaction, and “gains and losses” are ordinarily not reported in income. Procedurally, there are several ways to record the “debits” and “credits” associated with treasury stock, and the specifics can vary globally. The “cost method” is generally acceptable. Under this approach, acquisitions of treasury stock are accounted for by debiting Treasury Stock and crediting Cash for the cost of the shares reacquired:

Treasury Stock Journal Entry

The effect of treasury stock is very simple: cash goes down and so does total equity by the same amount. This result occurs no matter what the original issue price was for the stock. Accounting rules do not recognize gains or losses when a company issues its own stock, nor do they recognize gains and losses when a company reacquires its own stock. This may seem odd, because it is certainly different than the way one thinks about stock investments. But remember, this is not a stock investment from the company’s perspective. It is instead an expansion or contraction of its own equity.

Treasury Stock is a contra equity item. It is not reported as an asset; rather, it is subtracted from stockholders’ equity. The presence of treasury shares will cause a difference between the number of shares issued and the number of shares outstanding. Following is Embassy Corporation’s equity section, modified (see highlights) to reflect the treasury stock transaction portrayed by the entry.

Treasury Stock On The Balance Sheet

If treasury shares are reissued, Cash is debited for the amount received and Treasury Stock is credited for the cost of the shares. Any difference may be debited or credited to Paid-in Capital in Excess of Par.

 

Stock Splits and Stock Dividends

Video LectureStock splits are events that increase the number of shares outstanding and reduce the par or stated value per share. For example, a 2-for-1 stock split would double the number of shares outstanding and halve the par value per share. Existing shareholders would see their shareholdings double in quantity, but there would be no change in the proportional ownership represented by the shares (i.e., a shareholder owning 1,000 shares out of 100,000 would then own 2,000 shares out of 200,000).

Why would a company bother with a stock split? The answer is not in the financial statement impact, but in the financial markets. Since the same company is now represented by more shares, one would expect the market value per share to suffer a corresponding decline. For example, a stock that is subject to a 3-1 split should see its shares initially cut in third. But, holders of the stock will not be disappointed by this share price drop since they will each be receiving proportionately more shares; it is very important to understand that existing shareholders are getting the newly issued shares for no additional investment outlay. The benefit to the shareholders comes about, in theory, because the split creates more attractive opportunities for other future investors to ultimately buy into the larger pool of lower priced shares.

Rapidly growing companies often have share splits to keep the per share price from reaching stratospheric levels that could deter some investors. In the final analysis, understand that a stock split is mostly cosmetic as it does not change the underlying economics of the firm.

Importantly, the total par value of shares outstanding is not affected by a stock split (i.e., the number of shares times par value per share does not change). Therefore, no journal entry is needed to account for a stock split. A memorandum notation in the accounting records indicates the decreased par value and increased number of shares. If the initial equity illustration for Embassy Corporation was modified to reflect a four-for-one stock split of the common stock, the revised presentation would appear as follows (the only changes are underlined):

Stock Split on the Balance Sheet

By reviewing the changes, one can see that the par has been reduced from $1.00 to $0.25 per share, and the number of issued shares has quadrupled from 400,000 shares to 1,600,000 (be sure to note that $1.00 X 400,000 = $0.25 X 1,600,000 = $400,000). None of the account balances have changes.

Splits can come in odd proportions: 3 for 2, 5 for 4, 1,000 for 1, and so forth depending on the scenario. A reverse split (1 for 5, etc.) is also possible and will initially be accompanied by a reduction in the number of issued shares along with a proportionate increase in share price.

STOCK DIVIDENDS

In contrast to cash dividends discussed earlier in this chapter, stock dividends involve the issuance of additional shares of stock to existing shareholders on a proportional basis. Stock dividends are very similar to stock splits. For example, a shareholder who owns 100 shares of stock will own 125 shares after a 25% stock dividend (essentially the same result as a 5 for 4 stock split). Importantly, all shareholders would have 25% more shares, so the percentage of the total outstanding stock owned by a specific shareholder is not increased.

Although shareholders will perceive very little difference between a stock dividend and stock split, the accounting for stock dividends is unique. Stock dividends require journal entries. Stock dividends are recorded by moving amounts from retained earnings to paid-in capital. The amount to move depends on the size of the distribution. A small stock dividend (generally less than 20-25% of the existing shares outstanding) is accounted for at market price on the date of declaration. A large stock dividend (generally over the 20-25% range) is accounted for at par value.

To illustrate, assume that Childers Corporation had 1,000,000 shares of $1 par value stock outstanding. The market price per share is $20 on the date that a stock dividend is declared and issued:

Small Stock Dividend: Assume Childers Issues a 10% Stock Dividend

Small Stock Dividend Journal Entry

Large Stock Dividend: Assume Childers Issues a 40% Stock Dividend

Large Stock Dividend Journal Entry

It may seem odd that rules require different treatments for stock splits, small stock dividends, and large stock dividends. There are conceptual underpinnings for these differences, but it is primarily related to bookkeeping. The total par value needs to correspond to the number of shares outstanding. Each transaction rearranges existing equity, but does not change the amount of total equity.

 

Statement of Stockholders’ Equity

Video LectureRemember that a company must present an income statement, balance sheet, statement of retained earnings, and statement of cash flows. However, it is also necessary to present additional information about changes in other equity accounts. This may be done by notes to the financial statements or other separate schedules. However, most companies will find it preferable to simply combine the required statement of retained earnings and information about changes in other equity accounts into a single statement of stockholders’ equity. Following is an example of such a statement.

Statement of Stockholders' Equity Example

Note that the company had several equity transactions during the year, and the retained earnings column corresponds to a statement of retained earnings. Companies may expand this presentation to include comparative data for multiple years. Under international reporting guidelines, the preceding statement is sometimes replaced by a statement of recognized income and expense that includes additional adjustments for allowed asset revaluations (“surpluses”). This format is usually supplemented by additional explanatory notes about changes in other equity accounts.