MODULE 11 ACG REVIEW

Return on common stockholders' equity

(net income - preferred dividends) / average common stockholders' equity

Forming a corporation does not necessarily involve

Incurring debt

Par Value Stock

Stock that has been assigned a value per share in the corporate charter

Legal capital

The amount per share of stock that must be retained in the business for protection of corporate creditors.

Outstanding Shares

The issued shares that remain owned by stockholders. It is the number of issued shares minus the number of treasury shares (i.e., re‐acquired shares)

Authorized shares

The maximum number of shares of each class of stock that a corporation can issue or sell to shareholders. The number of authorized shares is disclosed in the corporate charter

Which of the following is false with regards to corporations?

The shares of stock of privately held corporations are traded on stock exchanges.

Issued Shared

The shares that the corporation has issued to stockholders regardless of whether the shares remain outstanding

A corporation issued 1,000 shares of its $2.00 par value common stock for $10.00 per share and later repurchased 100 of those shares for $15.00 per share. Which of the following will be recorded when the repurchase of the shares is journalized?

Treasury Stock will be debited for $1,500. 100 shares x $15/share = $1,500. Debit the Treasury Stock account to increase it.

Preferred stock: (2)

Preferred stockholders have priority over common stockholders when the company liquidates. a. Corporations can cease to exist by liquidating. b. Liquidating corporations must pay creditors before paying stockholders even if paying creditors leaves nothing of value for stockholders (e.g., insolvency, bankruptcy). c. After a liquidating corporation pays its creditors, it can distribute all remaining assets, if any, to its stockholders. i. Preferred stockholders have liquidation preference over common stockholders; they are paid liquidating distributions before common stockholders are paid liquidating distributions. ii. Liquidating distributions to preferred stockholders is usually either the stock's par value or a specified dollar amount per share. iii. After the preferred stockholders' liquidation rights have been satisfied, the corporation can begin distributing remaining assets, if any, to its common stockholders (i.e., common stockholders are residual owners meaning they get the residual assets after all other claims on assets have been satisfied).

Issuing stock

1. Corporations issue stock to investors who become shareholders and owners of the corporation. a. Issuing stock in exchange for cash &/or other property results in the corporation obtaining equity financing. b. Cash paid to a corporation for its stock is a financing cash inflow. 2. All corporations issue common stock. a. Common stockholders are the residual owners of a corporation meaning when a corporation satisfies claims of others everything remaining can be claimed by common stockholders. Example: A company liquidates it pays creditors and then preferred stockholders and then it pays everything remaining, if anything remains, to common stockholders. b. Some corporations issue more than one class of common stock, and the rights of associated with one class might differ from the others (e.g., one class of common stock might not have voting rights). 3. A few corporations issue preferred stock in addition to issuing common stock. a. Preferred stock is "preferred" in (i) dividends and (ii) liquidation of the corporation meaning they are prioritized or paid before common stockholders. b. Preferred stock rarely gives its owners voting rights. 4. Shares of common stock and preferred stock either (i) have a par value or (ii) they are no‐par value. a. Preferred stock is "preferred" in (i) dividends and (ii) liquidation of the corporation meaning they are prioritized or paid before common stockholders. b. Preferred stock rarely gives its owners voting rights. 4. Shares of common stock and preferred stock either (i) have a par value or (ii) they are no‐par value. a. Par value is a nominal amount assigned by the corporation. i. For common stock, par value is usually a small amount such as $1 per share (or even $0.01 per share or less). ii. For preferred stock, par value is usually large relative to the stock's issue price (e.g., $50 per share, $100 per share). b. Par value is not related to the stock's market value. c. In the past, par value represented legal capital that the corporation could not distribute as dividends. It no longer has the legal capital implications it meaning it has become merely a nominal amount. d. Corporations with no‐par value stock often give their stock a stated value. i. For accounting purposes, stated values are used in the same manner as par values. ii. Par and stated value determine the amount to be recorded in the common stock account (or preferred stock account) rather than paid‐in capital in excess of par (or stated) value.

Preferred stock dividend characteristics:

1. Dividends are voluntary payments made by a corporation to its shareholders; dividends are not expenses. a. A corporation is never required to declare and pay a dividend. b. Once a corporation's board of directors declares a dividend, it records it as a liability. c. Dividends are pro rate or proportional to ownership within a type and class of stock (e.g., all common shares of the same class receive the same dividend per share, and all shares of another class receive the same dividend per share, but differences may exist between classes). 2. If a corporation declares a dividend in the current period, it must pay preferred stockholders their current year's dividend before paying a dividend to common stockholders.

Dividends:

1. Once a corporation's board of directors declares a dividend, it is an obligation of the corporation and it needs to be recorded as an obligation or liability. Debit: Dividends (or Cash dividends) Credit: Dividends payable 2. Dividends will be paid to stockholders of record on a particular date. i. The corporation gathers stock ownership data at the end of that date to determine to whom it pays a dividend. ii. The corporation does not record a journal entry on the date of record. 3. A few days after the date of record, the corporation pays the dividends to its shareholders as of the record date. Debit: Dividends payable Credit: Cash

Forming a corporation:

1. Organizers called incorporators follow certain steps to create a corporation: a. File an application with the Secretary of State in the state chosen by incorporators. b. The state grants the new corporation a charter: i. It is a document that identifies the name of the corporation. ii. It describes the corporation's purpose. iii. It identifies who formed the corporation. iv. It identifies how many shares of stock the people who formed the corporation purchased. v. It identifies how many shares the corporation is authorized to issue or sell. c. Corporation develops by‐laws. i. By‐laws establish rules and procedures for conducting the corporation's affairs. ii. By‐laws of a corporation are similar to a constitution for governing a corporation. 2. Companies generally incorporate in a state where the laws are favorable to the corporate form of business (e.g., Delaware). 3. Corporations that engage in interstate commerce may need a license from each state in which they do business.

Sources of stockholders' equity in the order they appear in the balance sheet:

1. Paid‐in capital a. Preferred stock b. Common stock (i.e., par value or stated value if nonzero; otherwise the entire proceeds) c. Paid‐in capital in excess of par (or stated) value - Preferred stock d. Paid‐in capital in excess of par (or stated) value - Common stock 2. Retained earnings

Descriptions of sources of equity:

1. Paid‐in capital is the amount cash and other assets (e.g., capital investment) paid to the corporation by its investors/owners in exchange for common stock and/or preferred stock representing ownership of the corporation. a. Paid‐in capital represents the amount of equity financing raised by the business entity from selling its own stock. b. Paid‐in capital is not affected by its earnings or operating activities. 2. Retained earnings is net income of a corporation that it has not paid to owners as distributions (e.g., dividends); it includes a company's entire history of net income since its inception minus all of its dividends. a. Retained earnings represents the amount of equity financing created by the company's net income since the company's inception minus its dividend distributions since its inception. b. Retained earnings is affected by a company's revenues and expenses when those accounts are closed at the end of the period. c. Retained earnings is equity a company earns for itself; it is also called earned capital.

Preferred stock:

1. Preferred stockholders have priority over common stockholders when the corporation pays dividends. a. Preferred stock usually identify a specific dividend amount in terms of dollars or a percentage of par value. i. Example of a dividend on preferred stock set in dollars: Preferred stock with a $5 per share dividend. ii. Examples of dividends on preferred stock set as a percentage of par value: o Preferred stock with a $50 par value and a 4% dividend rate must be paid $2 per share before the corporation can pay dividends to common stockholders. o Preferred stock with a $100 par value and a 3% dividend rate must be paid ___$3 per share___ before the corporation can pay dividends to common stockholders.

Retained earnings:

1. Retained earnings is stockholders' equity resulting from net income since the inception of the company minus dividends it has paid since its inception. 2. Retained earnings is stockholders' equity generated by operating a business entity; it is the stockholders' claim on the corporation's total assets. 3. Retained earnings normally has a credit balance, but it can have a debit balance if the company has experienced net losses. a. A debit balance in retained earnings is referred to as a deficit. b. Companies with retained earnings deficits have a high probability of becoming bankrupt. 4. All or part of retained earnings may be restricted meaning that portion of retained earnings cannot be used to pay dividends. 5. Restrictions on retained earnings can result from: a. Legal restrictions. b. Contractual restrictions. c. Voluntary restrictions.

Debt versus equity

1. The decision to issue debt versus equity has several implications on a business entity. 2. Stockholder control is not affected by issuing debt. a. Bondholders do not have voting rights, so current owners (stockholders) retain full control of the company. b. Bondholders are creditors, and creditors have a liquidation preference. When a company liquidates, it must pay creditors before paying shareholders even if nothing is left for shareholders after paying the creditors. 3. Tax savings from debt. a. Interest expense on bond is deductible for tax purposes, but dividends paid to shareholders are not tax deductible. b. Interest must be paid as stated on the bond, but dividends are never required to be declared by a corporation. 4. Return on common stockholders' equity may be higher when debt is issued rather than equity. a. Bond interest expense reduces net income, but the number of common shares is increased when issuing it. Return on common stockholders' equity can be higher with bond financing.

Stockholder rights:

1. The right to vote in the election of the corporation's board of directors and vote on actions that require stockholder approval. Usually only common stockholders vote for the board of directors. 2. The right to share in the corporation's earnings via dividends paid by the corporation. 3. The right to maintain the same percentage ownership of the corporation when it issues new shares of stock. This right is called a preemptive right. 4. The right to share in assets upon liquidation of the corporation in proportion to their relative holdings of stock. This right is called a residual claim.

Reasons corporations purchase their outstanding stock:

1. To reissue the shares to officers and employees as part of bonus plans and stock compensation plans. 2. To increase the trading of the company's stock in the securities market and on stock exchanges. 3. To have additional shares available to offer it for the stock of other corporations in a merger. 4. To increase earnings per share by reducing the number of outstanding shares. 5. To reduce or eliminate the threat of hostile take‐overs by shareholders (e.g., reduce the number of shareholders who could be induced to sell to the party trying to take‐over the corporation).

Presentation of treasury stock:

1. Treasury stock is not outstanding, but it is still considered to be issued. i. Do not reduce common stock or paid‐in capital in excess of par by treasury stock. ii. Report treasury stock as a contra; report it as a reduction in stockholders' equity. 2. Treasury stock is the last item in the stockholders' equity section of the balance sheet.

Treasury stock

1. Treasury stock is stock of a corporation that it has issued and reacquired. 2. Corporations do not retire or cancel its stock when the corporation reacquires or holds it. 3. Treasury stock is reported in the stockholders' equity section of the balance sheet as a contra equity; it is not an asset. 4. Corporations can hold treasury stock indefinitely, and they can reissue treasury stock at any time. 5. Corporations pay dividends on outstanding shares of stock; they do not pay dividends on treasury stock. 6. Treasury shares do not have voting rights, liquidation rights (e.g., residual claims), or preemptive rights, but any such rights are regained once the corporation reissues the treasury shares. 7. When a corporation acquires treasury stock it records it at cost (i.e., historical cost). Debit: Treasury stock Credit: Cash 8. When a corporation reissues treasury stock it records the following: Debit: Cash Credit: Treasury stock Credit: Paid‐in capital - Treasury stock (i.e., to the extent the proceeds from re‐issuing treasury stock exceeds its cost)

The following data is available for a certain corporation at December 31: Common stock, par $2 (authorized 300,000 shares), $250,000 Treasury stock (at cost $10 per share), $1,200 Based on the data, how many shares of common stock are outstanding?

124,880 $250,000/$2 per share = 125,000 shares 1,200/10 =120 125,000 - 120

A corporation reported net income of $360,000 and paid dividends of $125,000 on its common stock and $50,000 on its preferred stock. Common stockholders' equity was $1,600,000 at the start of the year and $2,000,000 at the end of the year. Total assets was $2,200,000 at the start of the year and $2,600,000 at the end of the year. What is the company's return on common stockholder's equity?

17.22% Return on common stockholders' equity = Net income minus preferred stock dividends divided by the average common stockholders' equity Return on common stockholders' equity = (360,000 - 50,000)/(1,600,000 + 2,000,000)/2) = 17.22%.

A corporation has 2,000 shares of cumulative preferred stock with a $100 par value per share and a 5% dividend rate. The dividends are in arrears for two years. If the corporation plans to distribute $55,000 as dividends in the current year, how much will the common stockholders receive?

25,000 Preferred dividend for current year = 2,000 shares x $100/share x 5% = $20,000 Preferred dividends in arrears for two years ($10,000 × 2) = $20,000 Total dividends to preferred stockholders = $30,000 Total dividends available = $55,000 Dividends available to common stockholders = $55,000 - 30,000 = $25,000

Preferred stock dividend characteristics: (2)

3. Corporations sometimes do not pay a dividend (or do not pay one that is large enough to satisfy the preferred stockholders' current period dividend). a. Cumulative preferred stock - Preferred stock dividends not paid accumulate. Corporations must pay previously unpaid preferred dividends before the corporation can pay dividends to common stockholders if the cumulative stock is cumulative. i. Dividends in arrears are cumulative unpaid dividends. They are not a liability because the corporation does not have to declare a dividend. ii. A corporation with dividends in arrears must pay the preferred stockholders all dividends in arrears plus the current period's dividend before paying a dividend to common stockholders. b. Noncumulative preferred stock - Preferred stock dividends not paid do not accumulate. The right to receive a dividend expires to the extent a dividend is not declared during the period. 4. Some corporations issue convertible preferred stock that can be converted into common stock upon request from the stockholders. 5. Some corporations issue callable preferred stock that corporation can call or redeem after a specified period of time and at a specified price. 6. Some corporations issue participating preferred stock that receive dividends larger than their specified amounts if corporate profitability or dividends to common stockholders exceed a specified amount.

A corporation's December 31, 2021 balance sheet showed the following: 8% preferred stock, $20 par value, cumulative, 30,000 shares authorized; 15,000 shares issued $ 300,000 Common stock, $10 par value, 3,000,000 shares authorized; 1,950,000 shares issued, 1,920,000 shares outstanding 19,500,000 Paid-in capital in excess of par value - preferred stock 60,000 Paid-in capital in excess of par value - common stock 27,000,000 Retained earnings 7,650,000 Treasury stock (30,000 shares) 630,000 The corporation declared and paid a $75,000 cash dividend on December 15, 2021. If the company's dividends in arrears prior to that date were $18,000, the corporation's common stockholders would receive

33,000 Dividends to preferred stockholders include dividends in arrears plus the current year's dividend. Dividends in arrears = $18,000. Current year dividend to preferred stockholders = 15,000 x $20 x 8% = $24,000 Total paid to preferred stockholders = $18,000 + 24,000 = $42,000 Total paid to common stockholders = $75,000 - 42,000 = $33,000

If 1,000 shares of $2 par common stock are reacquired by a corporation for $4 a share, by how much will total stockholders' equity change?

4,000 decrease 1,000 shares x $4 per share = $4,000.

Dividends: (2)

4. Stockholders who buy a corporation's stock after the date of record are not paid that dividend even if they buy the shares before the date of payment. They purchased their stock "ex‐dividend." 5. Types most common types of dividends: a. Cash dividends ‐‐ The corporation distributes cash to its shareholders. b. Stock dividends: i. The corporation distributes additional shares of its stock to its shareholders. ii. The corporation reduces its retained earnings and increases its paid‐in capital: o Total equity does not change. o Shareholders maintain the same proportionate ownership as before the dividend (e.g., shareholders who own 5% before the stock dividend continue to own 5% after it). Example: A shareholder, Bob, owns 200 of a corporation's 1,000 shares or 20% of the company. After a 10% stock dividend, the corporation has 1,100 outstanding shares and Bob has 220 shares. Bob still owns 10% of the corporation (i.e., 220/1,100 = 20%).

A corporation reported net income of $250,000 and paid dividends of $10,000 on its common stock and $50,000 on its preferred stock. Common stockholders' equity was $1,200,000 at the start of the year and $1,600,000 at the end of the year. Total assets were $1,900,000 at the start of the year and $2,100,000 at the end of the year. What is the company's payout ratio?

4.00% Payout ratio = Cash dividends declared on common stock divided by net income Payout ratio = 10,000/250,000 = 4.00%.

A corporation's December 31, balance sheet shows the following: 8% preferred stock, $10 par value, cumulative, 40,000 shares authorized; 18,000 shares issued $180,000 Common stock, $1 par value, 4,000,000 shares authorized; 2,700,000 shares issued, 2,460,000 shares outstanding, $2,700,000 Paid-in capital in excess of par value - preferred stock, $180,000 Paid-in capital in excess of par value - common stock, $51,500,000 Retained earnings, $23,000,000 Treasury stock (40,000 shares), $1,050,000 The company's total stockholders' equity is

76,510,000 Total stockholders' equity = Preferred stock + Common stock + Paid-in capital in excess of par (for preferred stock & common stock) + Retained earnings - Treasury stock Total stockholders' equity = $180,000 + 2,700,000 + 180,000 + 51,500,000 + 23,000,000 - 1,050,000 = $76,510,000

Cumulative Dividend

A feature of preferred stock entitling the stockholder to receive current and unpaid prior‐ year dividends before common stockholders receive any dividends.

Where is common stock listed in the stockholders' equity section of the balance sheet?

As part of paid-in capital

Characteristics of corporations

Corporate management: 1. Chief executive officer (i.e., CEO): a. Has responsibility for managing a business entity, including its day‐to‐day operations. b. Communicates with stakeholders, including shareholders, the public, regulators, etc. on behalf of the company. 2. Chief accounting officer (i.e., controller): a. Maintains the business entity's accounting records, including payroll, taxes, and financial reporting. b. Ensures that the business entity uses an adequate system of internal controls. c. Prepares the business entity's financial statements, tax returns, and internal reports. 3. Treasurer: a. Maintains custody of the corporation's funds, including its bank accounts. b. Oversees the company's cash position (i.e., makes sure enough cash is on hand to pay bills as they come due).

A corporation issued 3,000 shares of $10 par value preferred stock at $15 per share. Which of the following will be part of the journal entry to record the corporation's issuance of preferred stock?

Credit to Paid-in Capital in Excess of Par Value—Preferred Stock for $15,000 Debit to Cash = 3,000 x $15 = $45,000 Credit to Preferred Stock = 3,000 x $10 = $30,000 Credit to Paid-in capital in excess of par value = 3,000 x ($15 - $10) = $15,000

Which type of stock can be in arrears?

Cumulative preferred stock

On which dates are entries for cash dividends required?

Declaration date and the payment date

Preferred stock has preference or priority over common stock in

both the claim on dividends and the claim on corporate assets when corporations liquidate.

Payout Ratio

cash dividends declared on common stock/net income

The net effect of declaring and paying a cash dividend on a company's financial statements is to

decrease assets and decrease stockholders' equity.

Placing a restriction on retained earnings will

disclose that a portion of retained earnings is unavailable for dividends.

Which of the following is not considered to be a characteristic of the corporate form of organization?

fewer taxes

Which of the following is a characteristic of partnerships?

limited life

The officer that is generally responsible for maintaining the cash position of the corporation is the

treasurer