What major U.S. corporation got its start 41 years ago with a waffle iron? Hint: It doesn't sell food. Another hint: Swoosh. Another hint: “Just do it.” That's right, Nike. In 1971, Nike co-founder Bill Bowerman put a piece of rubber into a kitchen waffle iron, and the trademark waffle sole was born. It seems fair to say that at Nike, “They don't make 'em like they used to.”
Nike was co-founded by Bowerman and Phil Knight, a member of Bowerman's University of Oregon track team. Each began in the shoe business independently during the early 1960s. Bowerman got his start by making hand-crafted running shoes for his University of Oregon track team. Knight, after completing graduate school, started a small business importing low-cost, high-quality shoes from Japan. In 1964, the two joined forces, each contributing $500, and formed Blue Ribbon Sports, a partnership that marketed Japanese shoes.
It wasn't until 1971 that the company began manufacturing its own line of shoes. With the new shoes came a new corporate name–Nike–the Greek goddess of victory. It is hard to imagine that the company that now boasts a stable full of world-class athletes as promoters at one time had part-time employees selling shoes out of car trunks at track meets. Nike has achieved its success through relentless innovation combined with unbridled promotion.
By 1980, Nike was sufficiently established and issued its first stock to the public. That same year, it created a stock ownership program for its employees, allowing them to share in the company's success. Since then, Nike has enjoyed phenomenal growth, with 2011 sales reaching $20.7 billion and total dividends paid of $569 million.
Nike is not alone in its quest for the top of the sport shoe world. Reebok used to be Nike's arch rival (get it? “arch”), but then Reebok was acquired by the German company adidas. Now adidas pushes Nike every step of the way.
The shoe market is fickle, with new styles becoming popular almost daily and vast international markets still lying untapped. Whether one of these two giants does eventually take control of the pedi-planet remains to be seen. Meanwhile, the shareholders sit anxiously in the stands as this Olympic-size drama unfolds.
Preview of Chapter 13
Corporations like Nike and adidas have substantial resources at their disposal. In fact, the corporation is the dominant form of business organization in the United States in terms of sales, earnings, and number of employees. All of the 500 largest companies in the United States are corporations. In this chapter, we will explain the essential features of a corporation and the accounting for a corporation's capital stock transactions. In Chapter 14, we will look at other issues related to accounting for corporations.
The content and organization of Chapter 13 are as follows.
LEARNING OBJECTIVE 1
Identify the major characteristics of a corporation.
In 1819, Chief Justice John Marshall defined a corporation as “an artificial being, invisible, intangible, and existing only in contemplation of law.” This definition is the foundation for the prevailing legal interpretation that a corporation is an entity separate and distinct from its owners.
A corporation is created by law, and its continued existence depends upon the statutes of the state in which it is incorporated. As a legal entity, a corporation has most of the rights and privileges of a person. The major exceptions relate to privileges that only a living person can exercise, such as the right to vote or to hold public office. A corporation is subject to the same duties and responsibilities as a person. For example, it must abide by the laws, and it must pay taxes.
Two common ways to classify corporations are by purpose and by ownership. A corporation may be organized for the purpose of making a profit, or it may be not-for-profit. For-profit corporations include such well-known companies as McDonald's, Nike, PepsiCo, and Google. Not-for-profit corporations are organized for charitable, medical, or educational purposes. Examples are the Salvation Army and the American Cancer Society.
Classification by ownership differentiates publicly held and privately held corporations. A publicly held corporation may have thousands of stockholders. Its stock is regularly traded on a national securities exchange such as the New York Stock Exchange. Examples are IBM, Caterpillar, and General Electric.
In contrast, a privately held corporation usually has only a few stockholders, and does not offer its stock for sale to the general public. Privately held companies are generally much smaller than publicly held companies, although some notable exceptions exist. Cargill Inc., a private corporation that trades in grain and other commodities, is one of the largest companies in the United States.
Alternative Terminology Privately held corporations are also referred to as closely held corporations.
In 1964, when Nike's founders Phil Knight and Bill Bowerman were just getting started in the running shoe business, they formed their original organization as a partnership. In 1968, they reorganized the company as a corporation. A number of characteristics distinguish corporations from proprietorships and partnerships. We explain the most important of these characteristics below.
As an entity separate and distinct from its owners, the corporation acts under its own name rather than in the name of its stockholders. Nike may buy, own, and sell property. It may borrow money, and may enter into legally binding contracts in its own name. It may also sue or be sued, and it pays its own taxes.
In a partnership, the acts of the owners (partners) bind the partnership. In contrast, the acts of its owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you owned shares of Nike stock, you would not have the right to purchase inventory for the company unless you were designated as an agent of the corporation.
Since a corporation is a separate legal entity, creditors have recourse only to corporate assets to satisfy their claims. The liability of stockholders is normally limited to their investment in the corporation. Creditors have no legal claim on the personal assets of the owners unless fraud has occurred. Even in the event of bankruptcy, stockholders' losses are generally limited to their capital investment in the corporation.
Shares of capital stock give ownership in a corporation. These shares are transferable units. Stockholders may dispose of part or all of their interest in a corporation simply by selling their stock. The transfer of an ownership interest in a partnership requires the consent of each owner. In contrast, the transfer of stock is entirely at the discretion of the stockholder. It does not require the approval of either the corporation or other stockholders.
The transfer of ownership rights between stockholders normally has no effect on the daily operating activities of the corporation. Nor does it affect the corporation's assets, liabilities, and total ownership equity. The transfer of these ownership rights is a transaction between individual owners. The company does not participate in the transfer of these ownership rights after the original sale of the capital stock.
It is relatively easy for a corporation to obtain capital through the issuance of stock. Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable. Also, numerous individuals can become stockholders by investing relatively small amounts of money.
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. If it is limited, the company can extend the life through renewal of the charter. Since a corporation is a separate legal entity, its continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer. As a result, a successful company can have a continuous and perpetual life.
Stockholders legally own the corporation. However, they manage the corporation indirectly through a board of directors they elect. Philip Knight is the chairman of Nike. 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. As a result of the Sarbanes-Oxley Act, the board is now required to monitor management's actions more closely. Many feel that the failures of Enron, WorldCom, and more recently MF Global could have been avoided by more diligent boards.
Illustration 13-1 (page 610) presents a typical organization chart showing the delegation of responsibility.
The chief executive officer (CEO) has overall responsibility for managing the business. As the organization chart shows, the CEO delegates responsibility to other officers. The chief accounting officer is the controller. The controller's responsibilities include (1) maintaining the accounting records, (2) maintaining an adequate system of internal control, and (3) preparing financial statements, tax returns, and internal reports. The treasurer has custody of the corporation's funds and is responsible for maintaining the company's cash position.
The organizational structure of a corporation enables a company to hire professional managers to run the business. On the other hand, the separation of ownership and management often reduces an owner's ability to actively manage the company.
Ethics Note
Managers who are not owners are often compensated based on the performance of the firm. They thus may be tempted to exaggerate firm performance by inflating income figures.
A corporation is subject to numerous state and federal regulations. For example, state laws usually prescribe the requirements for issuing stock, the distributions of earnings permitted to stockholders, and the acceptable methods for buying back and retiring stock. Federal securities laws govern the sale of capital stock to the general public. Also, most publicly held corporations are required to make extensive disclosure of their financial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports. In addition, when a corporation lists its stock on organized securities exchanges, it must comply with the reporting requirements of these exchanges. Government regulations are designed to protect the owners of the corporation.
Owners of proprietorships and partnerships report their share of earnings on their personal income tax returns. The individual owner then pays taxes on this amount. Corporations, on the other hand, must pay federal and state income taxes as a separate legal entity. These taxes can be substantial. They can amount to as much as 40% of taxable income.
In addition, stockholders must pay taxes on cash dividends (pro rata distributions of net income). Thus, many argue that the government taxes corporate income twice (double taxation)—once at the corporate level and again at the individual level.
In summary, Illustration 13-2 shows the advantages and disadvantages of a corporation compared to a proprietorship and a partnership.
A corporation is formed by grant of a state charter. The charter is a document that describes the name and purpose of the corporation, the types and number of shares of stock that are authorized to be issued, the names of the individuals that formed the company, and the number of shares that these individuals agreed to purchase. Regardless of the number of states in which a corporation has operating divisions, it is incorporated in only one state.
Alternative Terminology The charter is often referred to as the articles of incorporation
It is to the company's advantage to incorporate in a state whose laws are favorable to the corporate form of business organization. For example, although General Motors has its headquarters in Michigan, it is incorporated in New Jersey. In fact, more and more corporations have been incorporating in states with rules that favor existing management. For example, Gulf Oil changed its state of incorporation to Delaware to thwart possible unfriendly takeovers. There, certain defensive tactics against takeovers can be approved by the board of directors alone, without a vote by shareholders.
Upon receipt of its charter from the state of incorporation, the corporation establishes by-laws. The by-laws establish the internal rules and procedures for conducting the affairs of the corporation. Corporations engaged in interstate commerce must also obtain a license from each state in which they do business. The license subjects the corporation's operating activities to the general corporation laws of the state.
Costs incurred in the formation of a corporation are called organization costs. These costs include legal and state fees, and promotional expenditures involved in the organization of the business. Corporations expense organization costs as incurred. Determining the amount and timing of future benefits is so difficult that it is standard procedure to take a conservative approach of expensing these costs immediately.
ACCOUNTING ACROSS THE ORGANIZATION
A Thousand Millionaires!
Traveling to space or embarking on an expedition to excavate lost Mayan ruins are normally the stuff of adventure novels. But for employees of Facebook, these and other lavish dreams moved closer to reality when the world's No. 1 online social network went public through an initial public offering (IPO) that may have created at least a thousand millionaires. The IPO was the largest in Internet history, valuing Facebook at over $104 billion.
With all these riches to be had, why did Mark Zuckerberg, the founder of Facebook, delay taking his company public? Consider that the main motivation for issuing shares to the public is to raise money so you can grow your business. However, unlike a manufacturer or even an online retailer, Facebook doesn't need major physical resources, it doesn't have inventory, and it doesn't really need much money for marketing. So in the past, the company hasn't had much need for additional cash beyond what it was already generating on its own. Finally, as head of a closely held, nonpublic company, Zuckerberg was subject to far fewer regulations than a public company.
Source: “Status Update: I'm Rich! Facebook Flotation to Create 1,000 Millionaires Among Company's Rank and File,” Daily Mail Reporter (February 1, 2012).
Why did Mark Zuckerberg, the CEO and founder of Facebook, delay taking his company's shares public through an initial public offering (IPO)? (See page 643.)
When chartered, the corporation may begin selling shares of stock. When a corporation has only one class of stock, it is common stock. Each share of common stock gives the stockholder the ownership rights pictured in Illustration 13-3. The articles of incorporation or the by-laws state the ownership rights of a share of stock.
Proof of stock ownership is evidenced by a form known as a stock certificate. As Illustration 13-4 shows, the face of the certificate shows the name of the corporation, the stockholder's name, the class and special features of the stock, the number of shares owned, and the signatures of authorized corporate officials. Prenumbered certificates facilitate accountability. They may be issued for any quantity of shares.
Although Nike incorporated in 1968, it did not sell stock to the public until 1980. At that time, Nike evidently decided it would benefit from the infusion of cash that a public sale would bring. When a corporation decides to issue stock, it must resolve a number of basic questions: How many shares should it authorize for sale? How should it issue the stock? What value should the corporation assign to the stock? We address these questions in the following sections.
The charter indicates the amount of stock that a corporation is authorized to sell. The total amount of authorized stock at the time of incorporation normally anticipates both initial and subsequent capital needs. As a result, the number of shares authorized generally exceeds the number initially sold. If it sells all authorized stock, a corporation must obtain consent of the state to amend its charter before it can issue additional shares.
The authorization of capital stock does not result in a formal accounting entry. The reason is that the event has no immediate effect on either corporate assets or stockholders’ equity. However, the number of authorized shares is often reported in the stockholders’ equity section. It is then simple to determine the number of unissued shares that the corporation can issue without amending the charter: subtract the total shares issued from the total authorized. For example, if Advanced Micro was authorized to sell 100,000 shares of common stock and issued 80,000 shares, 20,000 shares would remain unissued.
A corporation can issue common stock directly to investors. Alternatively, it can issue the stock indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation.
In an indirect issue, the investment banking firm may agree to underwrite the entire stock issue. In this arrangement, the investment banker buys the stock from the corporation at a stipulated price and resells the shares to investors. The corporation thus avoids any risk of being unable to sell the shares. Also, it obtains immediate use of the cash received from the underwriter. The investment banking firm, in turn, assumes the risk of reselling the shares, in return for an underwriting fee.2
For example, Google (the world's number-one Internet search engine) used underwriters when it issued a highly successful initial public offering, raising $1.67 billion. The underwriters charged a 3% underwriting fee (approximately $50 million) on Google's stock offering.
How does a corporation set the price for a new issue of stock? Among the factors to be considered are (1) the company's anticipated future earnings, (2) its expected dividend rate per share, (3) its current financial position, (4) the current state of the economy, and (5) the current state of the securities market. The calculation can be complex and is properly the subject of a finance course.
The stock of publicly held companies is traded on organized exchanges. The interaction between buyers and sellers determines the prices per share. In general, the prices set by the marketplace tend to follow the trend of a company's earnings and dividends. But, factors beyond a company's control, such as an oil embargo, changes in interest rates, and the outcome of a presidential election, may cause day-to-day fluctuations in market prices.
The trading of capital stock on securities exchanges involves the transfer of already issued shares from an existing stockholder to another investor. These transactions have no impact on a corporation's stockholders’ equity.
INVESTOR INSIGHT
How to Read Stock Quotes
Organized exchanges trade the stock of publicly held companies at dollar prices per share established by the interaction between buyers and sellers. For each listed security, the financial press reports the high and low prices of the stock during the year, the total volume of stock traded on a given day, the high and low prices for the day, and the closing market price, with the net change for the day. Nike is listed on the New York Stock Exchange. Here is a listing for Nike:
These numbers indicate the following. The high and low market prices for the last 52 weeks have been $78.55 and $48.76. The trading volume for the day was 5,375,651 shares. The high, low, and closing prices for that date were $72.44, $69.78, and $70.61, respectively. The net change for the day was a decrease of $1.69 per share.
For stocks traded on organized exchanges, how are the dollar prices per share established? What factors might influence the price of shares in the marketplace? (See page 643.)
Par value stock is capital stock to which the charter has assigned a value per share. Years ago, par value determined the legal capital per share that a company must retain in the business for the protection of corporate creditors. That amount was not available for withdrawal by stockholders. Thus, in the past, most states required the corporation to sell its shares at par or above.
However, par value was often immaterial relative to the value of the company's stock—even at the time of issue. Thus, its usefulness as a protective device to creditors was questionable. For example, Loews Corporation's par value is $0.01 per share, yet a new issue in 2012 would have sold at a market price in the $32 per share range. Thus, par has no relationship with market price. In the vast majority of cases, it is an immaterial amount. As a consequence, today many states do not require a par value. Instead, they use other means to protect creditors.
No-par value stock is capital stock to which the charter has not assigned a value. No-par value stock is fairly common today. For example, Nike and Procter & Gamble both have no-par stock. In many states, the board of directors assigns a stated value to no-par shares.
DO IT!
Corporate Organization
Indicate whether each of the following statements is true or false.
______ 1. Similar to partners in a partnership, stockholders of a corporation have unlimited liability.
______ 2. It is relatively easy for a corporation to obtain capital through the issuance of stock.
______ 3. The separation of ownership and management is an advantage of the corporate form of business.
______ 4. The journal entry to record the authorization of capital stock includes a credit to the appropriate capital stock account.
______ 5. All states require a par value per share for capital stock.
Solution
1. False. The liability of stockholders is normally limited to their investment in the corporation.
2. True.
3. False. The separation of ownership and management is a disadvantage of the corporate form of business.
4. False. The authorization of capital stock does not result in a formal accounting entry.
5. False. Many states do not require a par value.
Action Plan
Review the characteristics of a corporation and understand which are advantages and which are disadvantages.
Understand that corporations raise capital through the issuance of stock, which can be par or no-par.
Related exercise material: BE13-1, E13-1, E13-2, and DO IT! 13-1.
Owners’ equity is identified by various names: stockholders’ equity, shareholders’ equity, or corporate capital. The stockholders’ equity section of a corporation's balance sheet consists of two parts: (1) paid-in (contributed) capital and (2) retained earnings (earned capital).
The distinction between paid-in capital and retained earnings is important from both a legal and a financial point of view. Legally, corporations can make distributions of earnings (declare dividends) out of retained earnings in all states. However, in many states they cannot declare dividends out of paid-in capital. Management, stockholders, and others often look to retained earnings for the continued existence and growth of the corporation.
LEARNING OBJECTIVE 2
Differentiate between paid-in capital and retained earnings.
Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock. As noted earlier, when a corporation has only one class of stock, it is common stock.
Retained earnings is net income that a corporation retains for future use. Net income is recorded in Retained Earnings by a closing entry that debits Income Summary and credits Retained Earnings. For example, assuming that net income for Delta Robotics in its first year of operations is $130,000, the closing entry is:
If Delta Robotics has a balance of $800,000 in common stock at the end of its first year, its stockholders’ equity section is as follows.
Illustration 13-6 compares the owners’ equity (stockholders’ equity) accounts reported on a balance sheet for a proprietorship, a partnership, and a corporation.
PEOPLE, PLANET, AND PROFIT INSIGHT
The Impact of Corporate Social Responsibility
A recent survey conducted by Institutional Shareholder Services, a proxy advisory firm, shows that 83% of investors now believe environmental and social factors can significantly impact shareholder value over the long term. This belief is clearly visible in the rising level of support for shareholder proposals requesting action related to social and environmental issues.
The following table shows that the number of corporate social responsibility (CSR)-related shareholder proposals rose from 150 in 2000 to 191 in 2010. Moreover, those proposals received average voting support of 18.4% of votes cast versus just 7.5% a decade earlier.
Trends in Shareholder Proposals on Corporate Responsibility
Source: Investor Responsibility Research Center, Ernst & Young, Seven Questions CEOs and Boards Should Ask About: “Triple Bottom Line” Reporting.
Why are CSR-related shareholder proposals increasing? (See page 643.)
DO IT!
Corporate Capital
At the end of its first year of operation, Doral Corporation has $750,000 of common stock and net income of $122,000. Prepare (a) the closing entry for net income and (b) the stockholders’ equity section at year-end.
Action Plan
Record net income in Retained Earnings by a closing entry in which Income Summary is debited and Retained Earnings is credited.
In the stockholders’ equity section, show
(1) paid-in capital and
(2) retained earnings.
Solution
Related exercise material: BE13-2 and DO IT! 13-2.
Let's now look at how to account for issues of common stock. The primary objectives in accounting for the issuance of common stock are (1) to identify the specific sources of paid-in capital, and (2) to maintain the distinction between paid-in capital and retained earnings. The issuance of common stock affects only paid-in capital accounts.
LEARNING OBJECTIVE 3
Record the issuance of common stock.
As discussed earlier, par value does not indicate a stock's market price. Therefore, the cash proceeds from issuing par value stock may be equal to, greater than, or less than par value. When the company records issuance of common stock for cash, it credits the par value of the shares to Common Stock. It also records in a separate paid-in capital account the portion of the proceeds that is above or below par value.
To illustrate, assume that Hydro-Slide, Inc. issues 1,000 shares of $1 par value common stock at par for cash. The entry to record this transaction is:
Now assume that Hydro-Slide issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share. The amount received above the par value, in this case $4 ($5 – $1), is credited to Paid-in Capital in Excess of Par—Common Stock. The entry is:
The total paid-in capital from these two transactions is $6,000, and the legal capital is $2,000. Assuming Hydro-Slide, Inc. has retained earnings of $27,000, Illustration 13-7 shows the company's stockholders’ equity section.
Alternative Terminology Paid-in Capital in Excess of Par is also called Premium on Stock.
When a corporation issues stock for less than par value, it debits the account Paid-in Capital in Excess of Par—Common Stock if a credit balance exists in this account. If a credit balance does not exist, then the corporation debits to Retained Earnings the amount less than par. This situation occurs only rarely. Most states do not permit the sale of common stock below par value because stockholders may be held personally liable for the difference between the price paid upon original sale and par value.
When no-par common stock has a stated value, the entries are similar to those illustrated for par value stock. The corporation credits the stated value to Common Stock. Also, when the selling price of no-par stock exceeds stated value, the corporation credits the excess to Paid-in Capital in Excess of Stated Value—Common Stock.
For example, assume that instead of $1 par value stock, Hydro-Slide, Inc. has $5 stated value no-par stock and the company issues 5,000 shares at $8 per share for cash. The entry is:
Hydro-Slide, Inc. reports Paid-in Capital in Excess of Stated Value—Common Stock as part of paid-in capital in the stockholders’ equity section.
What happens when no-par stock does not have a stated value? In that case, the corporation credits the entire proceeds to Common Stock. Thus, if Hydro-Slide does not assign a stated value to its no-par stock, it records the issuance of the 5,000 shares at $8 per share for cash as follows.
Corporations also may issue stock for services (compensation to attorneys or consultants) or for noncash assets (land, buildings, and equipment). In such cases, what cost should be recognized in the exchange transaction? To comply with the historical cost principle, in a noncash transaction cost is the cash equivalent price. Thus, cost is either the fair value of the consideration given up or the fair value of the consideration received, whichever is more clearly determinable.
To illustrate, assume that attorneys have helped Jordan Company incorporate. They have billed the company $5,000 for their services. They agree to accept 4,000 shares of $1 par value common stock in payment of their bill. At the time of the exchange, there is no established market price for the stock. In this case, the fair value of the consideration received, $5,000, is more clearly evident. Accordingly, Jordan Company makes the following entry.
As explained on page 611, organization costs are expensed as incurred.
In contrast, assume that Athletic Research Inc. is an existing publicly held corporation. Its $5 par value stock is actively traded at $8 per share. The company issues 10,000 shares of stock to acquire land recently advertised for sale at $90,000. The most clearly evident value in this noncash transaction is the market price of the consideration given, $80,000. The company records the transaction as follows.
As illustrated in these examples, the par value of the stock is never a factor in determining the cost of the assets received. This is also true of the stated value of no-par stock.
ANATOMY OF A FRAUD
The president, chief operating officer, and chief financial officer of SafeNet, a software encryption company, were each awarded employee stock options by the company's board of directors as part of their compensation package. Stock options enable an employee to buy a company's stock sometime in the future at the price that existed when the stock option was awarded. For example, suppose that you received stock options today, when the stock price of your company was $30. Three years later, if the stock price rose to $100, you could “exercise” your options and buy the stock for $30 per share, thereby making $70 per share. After being awarded their stock options, the three employees changed the award dates in the company's records to dates in the past, when the company's stock was trading at historical lows. For example, using the previous example, they would choose a past date when the stock was selling for $10 per share, rather than the $30 price on the actual award date. In our example, this would increase the profit from exercising the options to $90 per share.
Total take: $1.7 million
THE MISSING CONTROL
Independent internal verification. The company's board of directors should have ensured that the awards were properly administered. For example, the date on the minutes from the board meeting could be compared to the dates that were recorded for the awards. In addition, the dates should again be confirmed upon exercise.
DO IT!
Issuance of Stock
Cayman Corporation begins operations on March 1 by issuing 100,000 shares of $10 par value common stock for cash at $12 per share. On March 15, it issues 5,000 shares of common stock to attorneys in settlement of their bill of $50,000 for organization costs. Journalize the issuance of the shares, assuming the stock is not publicly traded.
Solution
Action Plan
In issuing shares for cash, credit Common Stock for par value per share.
Credit any additional proceeds in excess of par to a separate paid-in capital account.
When stock is issued for services, use the cash equivalent price.
For the cash equivalent price, use either the fair value of what is given up or the fair value of what is received, whichever is more clearly determinable.
Related exercise material: BE13-3, BE13-4, BE13-5, E13-3, E13-4, E13-6, and DO IT! 13-3.
Treasury stock is a corporation's own stock that it has issued and subsequently reacquired from shareholders but not retired. A corporation may acquire treasury stock for various reasons:
LEARNING OBJECTIVE 4
Explain the accounting for treasury stock.
1. To reissue the shares to officers and employees under bonus and stock compensation plans.
2. To increase trading of the company's stock in the securities market. Companies expect that buying their own stock will signal that management believes the stock is underpriced, which they hope will enhance its market price.
3. To have additional shares available for use in the acquisition of other companies.
4. To reduce the number of shares outstanding and thereby increase earnings per share.
Helpful Hint Treasury shares do not have dividend rights or voting rights.
Another infrequent reason for purchasing shares is that management may want to eliminate hostile shareholders by buying them out.
Many corporations have treasury stock. For example, approximately 65% of U.S. companies have treasury stock.3 In a recent year, Nike purchased more than 6 million treasury shares.
Companies generally account for treasury stock by the cost method. This method uses the cost of the shares purchased to value the treasury stock. Under the cost method, the company debits Treasury Stock for the price paid to reacquire the shares. When the company disposes of the shares, it credits to Treasury Stock the same amount it paid to reacquire the shares.
To illustrate, assume that on January 1, 2014, the stockholders’ equity section of Mead, Inc. has 400,000 shares authorized and 100,000 shares of $5 par value common stock outstanding (all issued at par value) and Retained Earnings of $200,000. The stockholders’ equity section before purchase of treasury stock is as follows.
On February 1, 2014, Mead acquires 4,000 shares of its stock at $8 per share. The entry is:
Mead debits Treasury Stock for the cost of the shares purchased ($32,000). Is the original paid-in capital account, Common Stock, affected? No, because the number of issued shares does not change.
In the stockholders’ equity section of the balance sheet, Mead deducts treasury stock from total paid-in capital and retained earnings. Treasury Stock is a contra stockholders’ equity account. Thus, the acquisition of treasury stock reduces stockholders’ equity. The stockholders’ equity section of Mead, Inc. after purchase of treasury stock is as follows.
Mead discloses in the balance sheet both the number of shares issued (100,000) and the number in the treasury (4,000). The difference is the number of shares of stock outstanding (96,000). The term outstanding stock means the number of shares of issued stock that are being held by stockholders.
Some maintain that companies should report treasury stock as an asset because it can be sold for cash. But under this reasoning, companies would also show unissued stock as an asset, which is clearly incorrect. Rather than being an asset, treasury stock reduces stockholder claims on corporate assets. This effect is correctly shown by reporting treasury stock as a deduction from total paid-in capital and retained earnings.
Ethics Note
The purchase of treasury stock reduces the cushion (cash available) for creditors and preferred stockholders.
A restriction for the cost of treasury stock purchased is often required. The restriction is usually applied to retained earnings.
ACCOUNTING ACROSS THE ORGANIZATION
Why Did Reebok Buy Its Own Stock?
In a bold (and some would say risky) move, Reebok at one time bought back nearly a third of its shares. This repurchase of shares dramatically reduced Reebok's available cash. In fact, the company borrowed significant funds to accomplish the repurchase. In a press release, management stated that it was repurchasing the shares because it believed its stock was severely underpriced. The repurchase of so many shares was meant to signal management's belief in good future earnings.
Skeptics, however, suggested that Reebok's management was repurchasing shares to make it less likely that another company would acquire Reebok (in which case Reebok's top managers would likely lose their jobs). By depleting its cash, Reebok became a less attractive acquisition target. Acquiring companies like to purchase companies with large cash balances so they can pay off debt used in the acquisition.
What signal might a large stock repurchase send to investors regarding management's belief about the company's growth opportunities? (See page 644.)
Treasury stock is usually sold or retired. The accounting for its sale differs when treasury stock is sold above cost than when it is sold below cost.
If the selling price of the treasury shares is equal to their cost, the company records the sale of the shares by a debit to Cash and a credit to Treasury Stock. When the selling price of the shares is greater than their cost, the company credits the difference to Paid-in Capital from Treasury Stock.
To illustrate, assume that on July 1, Mead, Inc. sells for $10 per share the 1,000 shares of its treasury stock previously acquired at $8 per share. The entry is as follows.
Helpful Hint Treasury stock transactions are classified as capital stock transactions. As in the case when stock is issued, the income statement is not involved.
Mead does not record a $2,000 gain on sale of treasury stock for two reasons. (1) Gains on sales occur when assets are sold, and treasury stock is not an asset. (2) A corporation does not realize a gain or suffer a loss from stock transactions with its own stockholders. Thus, companies should not include in net income any paid-in capital arising from the sale of treasury stock. Instead, they report Paid-in Capital from Treasury Stock separately on the balance sheet, as a part of paid-in capital.
When a company sells treasury stock below its cost, it usually debits to Paid-in Capital from Treasury Stock the excess of cost over selling price. Thus, if Mead, Inc. sells an additional 800 shares of treasury stock on October 1 at $7 per share, it makes the following entry.
Observe the following from the two sales entries. (1) Mead credits Treasury Stock at cost in each entry. (2) Mead uses Paid-in Capital from Treasury Stock for the difference between cost and the resale price of the shares. (3) The original paid-in capital account, Common Stock, is not affected. The sale of treasury stock increases both total assets and total stockholders’ equity.
After posting the foregoing entries, the treasury stock accounts will show the following balances on October 1.
When a company fully depletes the credit balance in Paid-in Capital from Treasury Stock, it debits to Retained Earnings any additional excess of cost over selling price. To illustrate, assume that Mead, Inc. sells its remaining 2,200 shares at $7 per share on December 1. The excess of cost over selling price is $2,200 [2,200 × ($8 – $7)]. In this case, Mead debits $1,200 of the excess to Paid-in Capital from Treasury Stock. It debits the remainder to Retained Earnings. The entry is:
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Treasury Stock
Santa Anita Inc. purchases 3,000 shares of its $50 par value common stock for $180,000 cash on July 1. It will hold the shares in the treasury until resold. On November 1, the corporation sells 1,000 shares of treasury stock for cash at $70 per share. Journalize the treasury stock transactions.
Action Plan
Record the purchase of treasury stock at cost.
When treasury stock is sold above its cost, credit the excess of the selling price over cost to Paid-in Capital from Treasury Stock.
When treasury stock is sold below its cost, debit the excess of cost over selling price to Paid-in Capital from Treasury Stock.
Solution
Related exercise material: BE13-6, E13-5, E13-7, E13-8, and DO IT! 13-4.
LEARNING OBJECTIVE 5
Differentiate preferred stock from common stock.
To appeal to a larger segment of potential investors, a corporation may issue an additional class of stock, called preferred stock. Preferred stock has contractual provisions that give it some preference or priority over common stock. Typically, preferred stockholders have a priority as to (1) distributions of earnings (dividends) and (2) assets in the event of liquidation. However, they generally do not have voting rights.
Like common stock, corporations may issue preferred stock for cash or for non-cash assets. The entries for these transactions are similar to the entries for common stock. When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates. A company might have the following accounts: Preferred Stock, Common Stock, Paid-in Capital in Excess of Par—Preferred Stock, and Paid-in Capital in Excess of Par—Common Stock.
For example, if Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share, the entry to record the issuance is:
Preferred stock may have either a par value or no-par value. In the stockholders’ equity section of the balance sheet, companies list preferred stock first because of its dividend and liquidation preferences over common stock.
As indicated above, preferred stockholders have the right to receive dividends before common stockholders. For example, if the dividend rate on preferred stock is $5 per share, common shareholders will not receive any dividends in the current year until preferred stockholders have received $5 per share. The first claim to dividends does not, however, guarantee the payment of dividends. Dividends depend on many factors, such as adequate retained earnings and availability of cash. If a company does not pay dividends to preferred stockholders, it cannot of course pay dividends to common stockholders.
For preferred stock, companies state the per share dividend amount as a percentage of the par value or as a specified amount. For example, Earthlink specifies a 3% dividend on its $100 par value preferred. PepsiCo pays $4.56 per share on its no-par value stock.
Preferred stock often contains a cumulative dividend feature. This right means that preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders receive dividends. When preferred stock is cumulative, preferred dividends not declared in a given period are called dividends in arrears.
To illustrate, assume that Scientific Leasing has 5,000 shares of 7%, $100 par value, cumulative preferred stock outstanding. Each $100 share pays a $7 dividend (.07 × $100). The annual dividend is $35,000 (5,000 × $7 per share). If dividends are two years in arrears, preferred stockholders are entitled to receive the following dividends in the current year.
The company cannot pay dividends to common stockholders until it pays the entire preferred dividend. In other words, companies cannot pay dividends to common stockholders while any preferred dividends are in arrears.
Are dividends in arrears considered a liability? No—no payment obligation exists until the board of directors declares a dividend. However, companies should disclose in the notes to the financial statements the amount of dividends in arrears. Doing so enables investors to assess the potential impact of this commitment on the corporation's financial position.
The investment community does not look favorably on companies that are unable to meet their dividend obligations. As a financial officer noted in discussing one company's failure to pay its cumulative preferred dividend for a period of time, “Not meeting your obligations on something like that is a major black mark on your record.” The accounting entries for preferred stock dividends are explained in Chapter 14.
Most preferred stocks also have a preference on corporate assets if the corporation fails. This feature provides security for the preferred stockholder. The preference to assets may be for the par value of the shares or for a specified liquidating value.
For example, Commonwealth Edison's preferred stock entitles its holders to receive $31.80 per share, plus accrued and unpaid dividends, in the event of liquidation. The liquidation preference establishes the respective claims of creditors and preferred stockholders in litigation involving bankruptcy lawsuits.
LEARNING OBJECTIVE 6
Prepare a stockholders’ equity section.
Companies report paid-in capital and retained earnings in the stockholders’ equity section of the balance sheet. They identify the specific sources of paid-in capital, using the following classifications.
1. Capital stock. This category consists of preferred and common stock. Preferred stock appears before common stock because of its preferential rights. Companies report par value, shares authorized, shares issued, and shares outstanding for each class of stock.
2. Additional paid-in capital. This category includes the excess of amounts paid in over par or stated value and paid-in capital from treasury stock.
The stockholders’ equity section of Connally Inc. in Illustration 13-12 includes most of the accounts discussed in this chapter. The disclosures pertaining to Connally's common stock indicate that the company issued 400,000 shares; 100,000 shares are unissued (500,000 authorized less 400,000 issued); and 390,000 shares are outstanding (400,000 issued less 10,000 shares in treasury).
Alternative Terminology Paid-in capital is sometimes called contributed capital.
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Stockholders’ Equity Section
Jennifer Corporation has issued 300,000 shares of $3 par value common stock. It authorized 600,000 shares. The paid-in capital in excess of par on the common stock is $380,000. The corporation has reacquired 15,000 shares at a cost of $50,000 and is currently holding those shares. Treasury stock was reissued in prior years for $72,000 more than its cost.
The corporation also has 4,000 shares issued and outstanding of 8%, $100 par value preferred stock. It authorized 10,000 shares. The paid-in capital in excess of par on the preferred stock is $25,000. Retained earnings is $610,000.
Prepare the stockholders’ equity section of the balance sheet.
Action Plan
Present capital stock first; list preferred stock before common stock.
Present additional paid-in capital after capital stock.
Report retained earnings after capital stock and additional paid-in capital.
Deduct treasury stock from total paid-in capital and retained earnings.
Solution
Related exercise material: BE13-8, E13-9, E13-12, E13-13, E13-14, E13-15, and DO IT! 13-5.
Comprehensive DO IT!
Rolman Corporation is authorized to issue 1,000,000 shares of $5 par value common stock. In its first year, the company has the following stock transactions.
Jan. 10 | Issued 400,000 shares of stock at $8 per share. |
July 1 | Issued 100,000 shares of stock for land. The land had an asking price of $900,000. The stock is currently selling on a national exchange at $8.25 per share. |
Sept. 1 | Purchased 10,000 shares of common stock for the treasury at $9 per share. |
Dec. 1 | Sold 4,000 shares of the treasury stock at $10 per share. |
Instructions
(a) Journalize the transactions.
(b) Prepare the stockholders’ equity section assuming the company had retained earnings of $200,000 at December 31.
Action Plan
When common stock has a par value, credit Common Stock for par value.
Solution to Comprehensive DO IT!
Use fair value in a noncash transaction.
Debit and credit the Treasury Stock account at cost.
Record differences between the cost and selling price of treasury stock in stockholders’ equity accounts, not as gains or losses.
1 Identify the major characteristics of a corporation. The major characteristics of a corporation are separate legal existence, limited liability of stockholders, transferable ownership rights, ability to acquire capital, continuous life, corporation management, government regulations, and additional taxes.
2 Differentiate between paid-in capital and retained earnings. Paid-in capital is the total amount paid in on capital stock. It is often called contributed capital. Retained earnings is net income retained in a corporation. It is often called earned capital.
3 Record the issuance of common stock. When companies record the issuance of common stock for cash, they credit the par value of the shares to Common Stock. They record in a separate paid-in capital account the portion of the proceeds that is above or below par value. When no-par common stock has a stated value, the entries are similar to those for par value stock. When no-par stock does not have a stated value, companies credit the entire proceeds to Common Stock.
4 Explain the accounting for treasury stock. The cost method is generally used in accounting for treasury stock. Under this approach, companies debit Treasury Stock at the price paid to reacquire the shares. They credit the same amount to Treasury Stock when they sell the shares. The difference between the sales price and cost is recorded in stockholders’ equity accounts, not in income statement accounts.
5 Differentiate preferred stock from common stock. Preferred stock has contractual provisions that give it priority over common stock in certain areas. Typically, preferred stockholders have preferences (1) to dividends and (2) to assets in liquidation. They usually do not have voting rights.
6 Prepare a stockholders’ equity section. In the stockholders’ equity section, companies report paid-in capital and retained earnings and identify specific sources of paid-in capital. Within paid-in capital, two classifications are shown: capital stock and additional paid-in capital. If a corporation has treasury stock, it deducts the cost of treasury stock from total paid-in capital and retained earnings to obtain total stockholders’ equity.
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1A number of companies have eliminated the preemptive right because they believe it makes an unnecessary and cumbersome demand on management. For example, by stockholder approval, IBM has dropped its preemptive right for stockholders.
2Alternatively, the investment banking firm may agree only to enter into a best-efforts contract with the corporation. In such cases, the banker agrees to sell as many shares as possible at a specified price. The corporation bears the risk of unsold stock. Under a best-efforts arrangement, the banking firm is paid a fee or commission for its services.
3Accounting Trends & Techniques 2011 (New York: American Institute of Certified Public Accountants).