TEST 4: Chap. 11 Questions

Why might a company repurchase its own stock?

A company will repurchase its own stock for a number of reasons. Some of the most common reasons include: (1) to reduce the number of shares outstanding and thus increase the earnings per share, (2) to accumulate stock to use for employee bonus plans, (3) to accumulate stock to be used in a merger or acquisition, (4) to avoid a hostile takeover, and (5) to keep the stock price high with active trading.

What is the difference between a stock dividend and a stock split?

A stock dividend can be declared to give the shareholders some reward when the corporation does not have sufficient cash to distribute. The stock dividend will give each shareholder additional shares in proportion to their stock ownership. After the stock dividend, each shareholder owns exactly the same proportion of the corporation as he owned before the dividend. The effect on the accounting equation is to transfer the amount of the stock dividend from retained earnings to contributed capital. A stock split is a method used to lower the market price of a share of stock. A stock split replaces old shares with a proportionate number of new shares. For instance, in a three-for-one stock split, a shareholder that owns one share of stock would now own three shares; in addition, the par value is proportionately reduced.

What is the importance of the declaration date, record date, and payment date in conjunction with corporate dividends?

The date is the date the dividend is officially declared by the corporation's board of directors. The declaration of the dividend creates a legal liability to pay the dividend. The record date is the date that establishes the ownership of the stock by specific shareholders to whom the dividends will be paid. Payment date is the date the dividend checks are actually written and mailed to the shareholders.

What is meant by the phrase separate legal entity? To which type of business organization does it apply?

The phrase means that the business organization operates separately from its owners. The corporation is referred to as a "separate legal entity" and conducts business with the same rights and responsibilities as a person.

What is no-part stock? How is it recorded in the accounting records?

No-par stock is stock for which a par value has not been established by the corporation. No-par stock may have a stated value. If so, issuance of the stock is recorded exactly the same way as par value stock. If the stock has neither a par nor stated value, the entire issuance amount is assigned to the capital stock account

If Best Co. issued 10,000 shares of $20 par value common stock for $30 per share, what amount is added to the Common Stock account? What amount of cash is received?

The amount added to the common stock account is equal to par value times the number of shares issued or $200,000 (10,000 x $20). The amount of cash received is $300,000 (10,000 x $30).

What is the primary reason that a company would declare a stock split?

The primary reason for declaring a stock split is to reduce the market value of stock by increasing the number of shares outstanding on the market. This makes the stock more affordable and may, therefore, increase demand for the stock.

What effect does the purchase of treasury stock have on the equity of a company?

The purchase of treasury stock decreases total equity by increasing the treasury stock account which is a contra-equity account.

What are the three major forms of business organizations? Describe each.

The sole proprietorship is a business owned by one individual. The partnership is a business that is owned by two or more persons with the intent to make a profit. The corporation is a legal entity that is organized according to the laws of the state in which it is formed. The business organization is separate from its owners.

How are sole proprietorship's formed?

When an individual decides to engage in some activity that provides goods or services, with the intent of making a profit.

Why would a company choose to distribute a stock dividend instead of a cash dividend?

A stock dividend is declared either to compensate shareholders when cash is not available or to lower the market price of a share of stock.

What is a widely held corporation? What is a closely held corporation?

A widely held corporation is one in which the stock is held by a large number of investors. A closely held corporation is one in which ownership is concentrated in the hands of a few people.

What is the difference between contributed capital and retained earnings for a corporation?

Contributed capital is the capital that is acquired by the corporation from owners of the corporation. For example, the sale of stock to an investor is a type of contributed capital. Retained earnings is the capital of a corporation that has been generated through the earnings process of a corporation and kept in the corporation (i.e., not distributed to owners)

What is meant by equity financing? What is meant by debt financing?

Equity financing refers to capital acquired from owners; usually the term refers to issuance of stock. Debt financing refers to borrowing in the form of notes and bonds payable.

Discuss the purpose of a partnership agreement. Is such an agreement necessary for partnership formation?

A legal agreement that defines the responsibilities of each partner and specifies the division of profits and losses. In order to form a partnership, there must be some type of agreement. It can simply be the agreement between parties to perform certain duties or make certain contributions of resources or services. While a written agreement is not required for legal purposes, a written document reduces the chance for of misunderstanding.

Assume that Best Co. has issued and outstanding 1,000 shares of $100 par value, 10 percent, cumulative preferred stock. What is the dividend per share? If the preferred dividend is two years in arrears, what total amount of dividends must be paid before the common shareholders can receive any dividends?

Dividend per share: $100 par x 10% = $10 per share. The total dividends per year are $10,000 (1,000 shares x $10). The total dividend to be paid to preferred shareholders is $30,000, the current year's dividend plus that of the past two years.

What is the largest source of financing for most U.S. business?

Equity financing (i.e., capital acquired from owners) is the largest source of financing for most U.S. businesses.

What are some reasons that a corporation might not pay dividends?

In deciding whether to declare dividends, the board of directors must consider whether the corporation has sufficient cash to cover operating requirements and meet emergencies. The board may also wish to retain earnings in order to pay dividends in years when cash flows are low. In addition, the board may restrict dividends in order to finance future expansion of the business.

When a company appropriates retained earnings, does the company set aside cash for a specific use? Explain.

When retained earnings are appropriated, an equal amount of cash is not necessarily set aside. However, retained earnings that are appropriated are not available to be paid out as dividends.

What is the function of the stock certificate?

The certificates are issued as evidence of ownership in a corporation and represents a certain proportionate share of the business ownership.

What is a limited liability company? Discuss its advantages and disadvantages.

A relatively new organizational form in the United States and operates similar to a partnership in that income is taxed at the owner level. That is, the limited liability company does not pay tax, but the owners must pay tax on company profits. It is similar to a corporation in the sense that the owners have limited personal liability similar to a corporation. The personal assets of the owners are protected from business creditors.

What is the purpose of the articles of incorporation? What information do they provide?

The articles constitute a legal document that is filed with the appropriate state agency requesting the official formation of a corporation. The articles of incorporation generally set forth the name of the corporation, the proposed date of incorporation, the purpose for which the corporation is formed, the expected life of the corporation, provisions for the capital stock of the corporation, and the names and addresses of the members of the board of directors

What are the advantages and disadvantages of the corporate form of business organization?

Advantages: 1. Limited liability. Owners are not held personally responsible for the actions of the corporation. Generally, the maximum amount an owner can lose is limited to his/her amount of the investment. 2. Continuity of existence. Corporations do not cease to exist when an owner dies, disposes of his interest, retires, etc. 3. Free transferability of ownership interest. An owner can readily sell or transfer an interest to another party without interfering in the corporation's business. 4. Ease of raising capital. It is generally easier to attract many small investors rather than one or two investors willing to invest large sums of money or assets in a business. Disadvantages: 1. Regulation. Corporations are subject to considerably more regulation, both state and federal, than are sole proprietorship's and partnerships. Corporations are required to file separate income tax returns and public corporations are required to comply with SEC regulations. 2. Double taxation. The most important disadvantage of the corporation is double taxation. Since a corporation is a separate legal entity, it must file and pay tax on corporate profits. When these profits are distributed to the owners (shareholders), these distributions are not deductible for the corporation and are taxable income to the shareholders.

Why is it easier for a corporation to raise large amounts of capital than it is for a partnership?

Because corporations can be owned by millions of individuals, they are able to pool the resources of many individuals which permits access to billions of dollars of capital. Proprietorship's and partnerships are bound by the financial condition of a few, private investors.

What prompted Congress to pass the Securities Act of 1933 and the Securities Exchange Act of 1934? What is the purpose of these laws?

Congress passed the Securities and Exchange Acts of 1933 and 1934 following the stock market crash of 1929 and the subsequent economic depression. These acts were passed to regulate the issuance of stock and govern exchanges of publicly traded stock. A part of this regulation extends to the formulation of certain accounting policies for companies listed on the stock exchanges (publicly traded stock).

What is the difference between par value stock and stated value stock?

Par value and stated value are similar in meaning in the sense that they are arbitrary values assigned to stock. Par value is assigned in the charter at the time of incorporation. Stated value is determined by the board of directors after incorporation.

What is the meaning of each of the following terms with respect to the corporate form of organization? a. Legal capital b. Par value of stock c. Stated value of stock d. Market value of stock e. Book value of stock f. Authorized shares of stock g. Issued stock h. Outstanding stock i. Treasury stock j. Common stock k. Preferred stock l. Dividends

a. Legal capital: Par value multiplied by the number of shares issued. This represents the minimum amount of assets that should be maintained as a protection for creditors. b. Par value of stock: An arbitrary value that is assigned to a share of stock usually at the time of incorporation. Par value, historically, has represented the maximum liability of the investor. c. Stated value of stock: An arbitrary value that is assigned to a share of stock by the board of directors. It has little relevance to investors or creditors. d. Market value of stock: The price that must be paid to purchase a share of stock. e. Book value of stock: The amount of equity of one share of stock, i.e., (assets liabilities) divided by the number of shares of stock outstanding. f. Authorized shares of stock: The number of shares that a corporation has been authorized by the state to issue. g. Issued stock: Stock that has been sold to shareholders. h. Outstanding stock: Issued stock that is owned by outside parties, i.e., stock that has been issued and not repurchased by the corporation. i. Treasury stock: Previously issued stock that has been repurchased by the corporation. j. Common stock: A class of stock that possesses certain rights usually not given to other classes of stock. These rights include the right to share in the distribution of profits, the right to share in the distribution of corporate assets upon liquidation, the right to vote on certain matters that affect the corporate charter, and the right to participate in the selection of directors for the corporation. k. Preferred stock: A class of stock that is given preferential treatment over common shareholders in some matters, usually in the distribution of earnings. However, certain other shareholder rights may not be present; for instance, voting rights. l. Dividends: Distributions of corporate profits to shareholders.

What is the difference between cumulative preferred stock and noncumulative preferred stock?

Cumulative preferred stock is a class of preferred stock for which the stipulated dividend, if not paid, accumulates from one year to the next. If a corporation does not pay dividends one year, the unpaid dividend amount is carried forward and when dividends are paid in later years, any unpaid portion of past dividends (called dividends in arrears) is paid first, before any dividends may be paid on common stock. Noncumulative preferred stock is a class of preferred stock whose unpaid dividend is not carried forward to future years. If dividends are not declared in one year, they are lost.

Assume that Day Company repurchase 1,00 of it's own shares for $30 per share and sold the shares two weeks later for $35 per share. What is the amount of gain on the sale? How is it reported on the balance sheet? What type of account is treasury stock?

Even though the stock was purchased for $30 per share and resold for $35 per share, there is no gain on the sale. The difference in the purchase and sales price is additional contributed capital because it is from capital invested by stockholders. It is recorded on the balance sheet in the stockholders' equity section as paid-in capital. Treasury Stock is a contra equity account.

What are the similarities and differences in the equity structure of a sole proprietorship, a partnership, and a corporation?

For both sole proprietorship's and partnerships, contributed capital and retained earnings are combined in one capital account for financial statement reporting. Capital acquisitions are additions to the capital account of the owners or partners; earnings of the business are additions (losses are reductions) to the capital accounts; and distributions to owners (withdrawals) are reductions from the capital account. Corporations maintain separate accounts for contributed capital and retained earnings.

If Best co. had 10,000 shares of $20 par vale common stock outstanding and declared a 5-for-1 stock split, how many shares would then be outstanding and what would be their par value after the split?

In a stock split, the number of shares is increased according to the amount of the split and the par is reduced proportionately. In a five-for-one split, the new number of shares would be five times the old: 10,000 x 5 = 50,000. The par amount would be reduced to one-fifth of the original amount: $20 ÷ 5 = $4.

How does the term double taxation apply to corporations? Give an example of double taxation.

The term applies to a corporation means that earnings are taxed both at the corporate level and the shareholder level when earnings are distributed in the form of dividends. For example, assume a corporation had taxable income of $100,000 and distributed $50,000 of the earnings to the shareholders as dividends. The corporation would pay tax on $100,000 at corporate income tax rates, and the shareholders would pay tax on $50,000 at their individual income tax rates. Consequently, $50,000 of the income from the corporation would be taxed twice.