14

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SOLE
PROPRIETORSHIPS,
PARTNERSHIPS, AND
CORPORATIONS

THE NAVIGATOR ✓
• Understand Concepts for Review ❑
• Read Feature Story ❑
• Scan Study Objectives ❑
• Read Preview ❑
• Read text and answer Before You Go On
p. 426 ❑ p. 429 ❑ p. 432 ❑ p. 436 ❑
p. 444–445 ❑ p. 448 ❑

• Work Demonstration Problem ❑

• Review Summary of Study Objectives ❑
• Complete Assignments ❑

C ONCEPTS FOR REVIEW

Before studying this chapter, you should know or, if necessary, review:
a. The content of the stockholders’ equity section of a balance sheet.
(Ch. 5, pp. 157–158)
b. How to prepare closing entries for a corporation. (Ch. 5, pp. 144–148)
c. The difference between paid-in capital and retained earnings. (Ch. 1,
p. 12)
✓ THE
NAVIGATOR
4
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F E A T U R E S T O R Y
As a corpora-
“Two All Beef Patties, tion, McDon-
ald’s went to
Special Sauce, Wall Street in
Lettuce, Cheese, 1965, selling
stocks in round
Pickles, Onions on a lots of 100
shares at
Sesame Seed Bun” $2,250, or
Many people know this saying too $22.50 per share.
well and can even say it with a If one calculates all
rhythm. It all started with a true the stock splits and divi-
salesman, Raymond Albert Kroc. dends, the 100 shares in
Ray Kroc’s entrepreneurial zeal, 1965 had grown to 74,360
combined with an almost evangeli- shares in 1998, with a value of over
cal ability to motivate nearly every- $2.8 million. In 1985, McDonald’s most widely recognized trademark in
one he touched, enabled him to was added to one of the 30 compa- the world. Ray’s company changed
build the largest and most successful nies whose share prices make up the the dining lifestyle of an entire society
restaurant franchise company in the formula to derive the Dow Jones In- in less than one generation. Conse-
world. Ray didn’t promise fran- dustrial Average. Ray’s operating quently, 96 percent of all Americans
chisees success. Instead, he offered credo of “Quality, Service, Cleanli- have eaten at a McDonald’s restau-
the opportunity to achieve it. Ray’s ness and Value” became the mantra rant on at least one occasion, and an
fair and balanced franchise partner- for all McDonald’s owners and estab- average McDonald’s restaurant brings
ship is said to be his greatest lished a permanent benchmark for in $1.6 million in sales per year in
legacy. To underscore his own com- the entire foodservice and food pro- the United States. To improve sales in
mitment to “taking the hamburger cessing industries and, by extension, the international units, McDonald’s
business more seriously than anyone all service industry components. His has ongoing initiatives to include
else,” he established Hamburger exacting mandates for uniformity and more local flavor in its menu options.
University. By so doing, he confirmed product consistency made it possible
SOURCES: www.
his willingness to invest in the train- for a customer to get a Big Mac and
mcdonalds.com/
ing and education of McDonald’s french fries in Houston, Texas, or
Moscow, Russia. In fact, the Golden
corporate/info/history
and www.hrm.uh.edu/ ✓ THE
people and thereby accentuated his NAVIGATOR
?PageID=191
franchising commitment. Arches are said to be the second

After studying this chapter, you should be able to

S T U D Y O B J E C T I V E S

1. Identify the major characteristics of a sole proprietorship.

2. Identify the major characteristics of a partnership.
3. Explain the accounting entries for the formation of a partnership.
4. Identify the bases for dividing net income or net loss.
5. Identify the major characteristics of a corporation.
6. Record the issuance of common stock. ✓ THE
NAVIGATOR
7. Explain the accounting for treasury stock.
Continued

411
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P R E V
P R I EI W
E V E WOO
F FC C
H H
A A
P TP ET R
E R1 1
4
At some time in your hospitality career, you might want to open your own restaurant, build your own
bed-and-breakfast, or purchase a franchise hotel. How should you structure or organize your business?
Small businesses mostly start as sole proprietorships. Some business people get together with friends
or business partners and pull resources together to form a partnership. In contrast, corporations like
Hilton, Disney, and Marriott have substantial resources. In fact, the corporation is the dominant form
of business organization in the United States in terms of dollar volume of sales and earnings and num-
ber of employees. All of the 500 largest companies in the United States are corporations. In this chap-
ter we will explain the essential features of a proprietorship, a partnership, and a corporation and will
look at the accounting for both forms of business organizations.
The content and organization of Chapter 14 are as follows:

SOLE PROPRIETORSHIPS, PARTNERSHIPS, AND CORPORATIONS

Corporate
Sole Organization and Corporate Corporate Retained
Proprietorships Partnerships Stock Transactions Dividends Earnings

Characteristics Characteristics Characteristics Cash dividends Retained earnings

Formation Formation of a Stock dividends restrictions
Dividing net income corporation Stock splits Prior period
and net loss Corporate capital adjustments
Financial statements Common stock issues Retained earnings
statement
Treasury stock
Preferred stock

✓ THE
NAVIGATOR

8.
S T U D Y O B J E C T I V E S
Differentiate preferred stock from common stock.
( C O N T I N U E D )

9. Prepare the entries for cash dividends and stock dividends.

10. Identify the items that are reported in a retained earnings statement.

SO L E PROPRIETORSHIPS
The simplest form of business organization is sole proprietorship. For entrepre-
STUDY OBJECTIVE 1 neurs in the hospitality business who want to own their own business, this is the
Identify the major easiest way to begin. A sole proprietorship is formed by a single individual and
characteristics of a sole owned by this same person. This individual will register as “doing business as” with
proprietorship. the proper authority and can begin. Thus one of characteristics of a sole propri-
etorship is the ease of formation. In addition, since it is owned by one person, the
decision-making process is less complex, affording the business with flexibility.
Moreover, when profits are reaped, the single owner will retain all the money.
However, a sole proprietorship also has some risky characteristics. Since it is owned
by one person, should there be a loss in the business, this one person will have to ab-

412
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Partnerships 413

sorb all the loss. Legally, there is also unlimited liability. Thus the creditors can seize
the owner’s personal belongings to pay the bills.Another negative characteristic is that
it is often difficult to raise funds through one person’s collateral. Therefore, many hos-
pitality businesses are formed as partnerships or, more often, corporations.

PA R T N E R S H I P S
The Uniform Partnership Act provides the basic rules for the formation and op-
eration of partnerships in more than 90 percent of the states. This act defines a
STUDY OBJECTIVE 2
partnership as “an association of two or more persons to carry on as co-owners of Identify the major
a business for profit.” The partnership form of business organization is not re- characteristics of a
stricted to any particular type of business, but it is most often used in relatively partnership.
small companies and in professional fields, as mentioned earlier.
Illustration 14-1 shows principal characteristics of the partnership form of busi-
ness organization.

Illustration 14-1
Partnership characteristics
Association of Individuals

Partnership
Co-ownership of Property Form of Mutual Agency
Business
Organization

Unlimited Liability Limited Life

ASSOCIATION OF INDIVIDUALS
A partnership is a voluntary association of two or more individuals based on a legally
binding contract, which may be written, oral, or implied. Under the Uniform Part-
nership Act, a partnership is considered a legal entity for certain purposes. For
instance, property (land, buildings, equipment) can be owned in the name of the
partnership, and the firm can sue or be sued. A partnership also represents an
accounting entity for financial reporting purposes. Thus the purely personal assets,
liabilities, and personal transactions of the partners are excluded from the account-
ing records of the partnership, just as they are in a proprietorship. In addition, the
net income of a partnership is not taxed as a separate entity. However, a partner-
ship is required to file an information tax return showing partnership net income
and each partner’s share of the net income. Each partner’s share is taxable, regard-
less of the amount of net income withdrawn from the business during the year.

MUTUAL AGENCY
Each partner acts on behalf of the partnership when engaging in partnership busi-
ness. The act of any partner is binding on all other partners, even when partners act
beyond the scope of their authority, as long as the act appears to be appropriate for
the partnership. For example, a partner of a catering company who purchases a
delivery truck creates a binding contract in the name of the partnership, even if the
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414 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

partnership agreement denies this authority. In contrast, if a partner in a catering

company purchased a snowmobile for the partnership, such an act would not be bind-
ing on the partnership because it is clearly outside the scope of partnership business.

LIMITED LIFE
A partnership does not have unlimited life. Its continuance as a going concern rests
in the partnership contract. As long as existing partners are willing to be bound by
the contract, the maximum life of a partnership is equal to the life of any one of
its partners. A partnership may be ended voluntarily at any time through the ac-
ceptance of a new partner into the firm or the withdrawal of a partner. A partner-
ship may be ended involuntarily by the death or incapacity of a partner. In short,
any change in the number of partners, regardless of the cause, effects the dissolu-
tion of the partnership. Thus the life of a partnership is unpredictable.

UNLIMITED LIABILITY
Each partner is personally and individually liable for all partnership liabilities. Cred-
itors’ claims attach first to partnership assets and then to the personal resources of
any partner, irrespective of that partner’s capital equity in the company. To illus-
trate, assume that (1) the Rowe-Sanchez partnership is terminated when the claims
of company creditors exceed partnership assets by $30,000 and (2) L. Rowe’s
personal assets total $40,000 but B. Sanchez has no personal assets. Creditors can
collect their total claims from Rowe regardless of Rowe’s capital balance in the
firm, even though Sanchez and Rowe may be equal partners. Rowe, in turn, has a
legal claim on Sanchez, but this would be worthless under the conditions described.
Some states allow limited partnerships, in which the liability of a partner is limited
to the partner’s capital equity. However, there must always be at least one partner
with unlimited liability, often referred to as the general partner.

CO-OWNERSHIP OF PROPERTY
Partnership assets are co-owned by the partners. Once assets have been invested
in the partnership, they are owned jointly by all the partners. Moreover, if the part-
nership is terminated, the assets do not legally revert to the original contributor.
Each partner has a claim on total assets equal to the balance in his or her respec-
tive capital account, but this claim does not attach to specific assets that an indi-
vidual partner may have contributed to the firm.
Similarly, if a partner invests a $100,000 building in the partnership, and the
building is sold later at a gain of $20,000, that partner does not personally receive
the entire gain. Partnership net income (or net loss) is also co-owned; if the part-
nership agreement does not specify to the contrary, all net income or net loss is
shared equally by the partners. As you will see later, however, the partnership
agreement may provide for unequal sharing of net income or net loss.

ADVANTAGES AND DISADVANTAGES OF A PARTNERSHIP

What are the major advantages and disadvantages of a partnership? One major
advantage is that the skills and resources of two or more individuals can be combined.
For example, a large public accounting firm such as PricewaterhouseCoopers must have
combined expertise in auditing, taxation, and management consulting, not to mention
specialists within each of these areas. In addition, a partnership does not have to con-
tend with the “red tape” that a corporation must face; that is, a partnership is easily
formed and is relatively free from governmental regulations and restrictions. Decisions
can be made quickly on substantive matters affecting the firm, whereas in a corpora-
tion, formal meetings with the board of directors are often needed.
On the other hand, the major disadvantages of a partnership are mutual agency,
limited life, and unlimited liability. Unlimited liability is particularly troublesome
to many individuals, because they may lose not only their initial investment but
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Partnerships 415

also their personal assets, if they are needed to pay partnership creditors. As a re-
sult, it is often difficult to obtain large amounts of investment capital in a partner-
ship. That is one reason why the largest business enterprises in the United States
are corporations, not partnerships.
The advantages and disadvantages of the partnership form of business organ-
ization are summarized in Illustration 14-2.

Illustration 14-2
Advantages Diasadvantages
Advantages and
Combining skills and resources of two or more individuals Mutual agency disadvantages of a
Ease of formation Limited life partnership
Freedom from government regulations and restrictions Unlimited liability
Ease of decision making

THE PARTNERSHIP AGREEMENT

A partnership is created by a contract expressing the voluntary agreement of two
or more individuals. The written partnership agreement, often referred to as the
partnership agreement or articles of co-partnership, contains such basic informa-
tion as the name and principal location of the firm, the purpose of the business,
and date of inception. In addition, different relationships that will exist among the
partners, such as the following, should be specified:
• Names and capital contributions of partners
• Rights and duties of partners
• Basis for sharing net income or net loss
• Provision for withdrawals of income
• Procedures for submitting disputes to arbitration
• Procedures for the withdrawal or addition of a partner
• Rights and duties of surviving partners in the event of a partner’s death
The importance of a written contract cannot be overemphasized. The agree-
ment should be drawn with care and should attempt to anticipate all possible sit-
uations, contingencies, and disagreements. The help of a lawyer is highly desirable
in preparing the agreement. A poorly drawn contract may create friction among
the partners and eventually cause the termination of the partnership.

FORMATION OF A PARTNERSHIP
Each partner’s initial investment in a partnership should be recorded at the fair
market value of the assets at the date of their transfer to the partnership. The val-
ues assigned must be agreed to by all of the partners.
STUDY OBJECTIVE 3
To illustrate, assume that A. Rolfe and T. Shea combine their proprietorships Explain the accounting
to start a partnership named U.S. Pizza. Rolfe and Shea invest in the partnership entries for the formation of
as shown in Illustration 14-3. a partnership.

Illustration 14-3
Book Value Market Value
A. Rolfe T. Shea A. Rolfe T. Shea Book and market value
of assets invested
Cash $ 8,000 $ 9,000 $ 8,000 $ 9,000
Equipment 5,000 4,000
Accumulated depreciation (2,000)
Accounts receivable 4,000 4,000
Allowance for doubtful
accounts (700) (1,000)
$11,000 $12,300 $12,000 $12,000
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416 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

The entries to record the investments are

Investment of A. Rolfe
Cash 8,000
Equipment 4,000
A. Rolfe, Capital 12,000
(To record investment of Rolfe)
Investment of T. Shea
Cash 9,000
Accounts Receivable 4,000
Allowance for Doubtful Accounts 1,000
T. Shea, Capital 12,000
(To record investment of Shea)

Note that neither the original cost of the equipment ($5,000) nor its book value
($5,000  $2,000) is recorded by the partnership. The equipment has not been used
by the partnership, so there can be no accumulated depreciation. In contrast, the
gross claims on customers ($4,000) are carried forward to the partnership, and the
allowance for doubtful accounts is adjusted to $1,000 to arrive at a cash (net) re-
alizable value of $3,000. A partnership may start with an Allowance for Doubtful
Accounts account because this balance pertains to existing accounts receivable
that are expected to be uncollectible in the future. In addition, this procedure main-
tains the control and the subsidiary relationship between accounts receivable and
the customers’ ledger.
After the partnership has been formed, the accounting for its transactions is
similar to accounting for transactions of any other type of business organization.
For example, all transactions with outside parties, such as the purchase or sale of
merchandise inventory and the payment or receipt of cash, should be recorded in
the same manner for a partnership as for a proprietorship.

DIVISION OF NET INCOME OR NET LOSS

Partnership net income or net loss is shared equally unless the partnership con-
STUDY OBJECTIVE 4 tract specifically indicates the manner in which net income and net loss are to be
Identify the bases for divided. The same basis of division usually applies to both net income and net loss.
dividing net income or As a result, it is customary to refer to the basis as the income ratio, the income
net loss. and loss ratio, or the profit and loss ratio. Because of its wide acceptance, we will
use the term income ratio to identify the basis for dividing both net income and
net loss. A partner’s share of net income or net loss is recognized in the accounts
through closing entries.

Closing Entries
You may recall from Chapter 5 that four closing entries are needed during the
closing process. The first two entries close revenues and expenses to Income Sum-
mary; the latter two entries transfer the balance in Income Summary to the part-
ners’ capital accounts and close their drawing accounts to their capital accounts.
To refresh your memory concerning the closing entries for a partnership, as-
sume that L. Arbor and D. Barnett share net income and net loss equally. After
closing all revenue and expense accounts, there is a credit balance in Income Sum-
mary of $32,000, which is the net income for the period. The entry to close this
balance to the respective capital accounts is as follows:
Income Summary 32,000
L. Arbor, Capital 16,000
D. Barnett, Capital 16,000
(To close net income to partners’ capitals)
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Partnerships 417

If Arbor and Barnett have balances in their drawing accounts of $8,000 and
$6,000, respectively, the entry to close these accounts looks like this:

L. Arbor, Capital 8,000

D. Barnett, Capital 6,000
L. Arbor, Drawing 8,000
D. Barnett, Drawing 6,000
(To close partners’ drawings)

Assuming the beginning capital balance is $47,000 for Arbor and $36,000 for
Barnett, the following capital and drawing accounts (Illustration 14-4) will appear
in the general ledger.

Illustration 14-4
L. Arbor, Capital D. Barnett, Capital
Ledger balances after
Drawing 8,000 Beg. Bal. 47,000 Drawing 6,000 Beg. Bal. 36,000
closing
Net income 16,000 Net income 16,000
End Bal. 55,000 End Bal. 46,000

L. Arbor, Drawing D. Barnett, Drawing

End Bal. 8,000 To Capital 8,000 End Bal. 6,000 To Capital 6,000

The capital accounts indicate each partner’s “permanent” investment, whereas

the partners’ drawing accounts are temporary owners’ equity accounts. Nor-
mally, the capital accounts will have credit balances, whereas the drawing
accounts will have debit balances. The drawing account is commonly debited in
situations where cash or other assets are withdrawn by the partner for personal
use. For example, the partnership contract may permit each partner to withdraw
cash monthly for personal living expenses.

Income Ratios
As indicated earlier, the partnership agreement should specify the basis for shar-
ing net income or net loss. The following are typical of the ratios that may be used:
• A fixed ratio, expressed as a proportion (6:4), a percentage (70 percent and
30 percent), or a fraction (2/3 and 1/3)
• A ratio based either on capital balances at the beginning of the year or on av-
erage capital balances during the year
• Salaries to partners and the remainder on a fixed ratio
• Interest on partners’ capitals and the remainder on a fixed ratio
• Salaries to partners, interest on partners’ capitals, and the remainder on a fixed
ratio
The objective is to reach agreement on a basis that will equitably reflect the dif-
ferences among partners in terms of their capital investment and service to the
partnership.
A fixed ratio is easy to apply, and it may be an equitable basis in some cir-
cumstances. Assume, for example, that Hughes and Lane are partners. Each con-
tributes the same amount of capital; but Hughes expects to work full-time in the
partnership, and Lane expects to work only half-time. Accordingly, the partners
agree to a fixed ratio of 2/3 to Hughes and 1/3 to Lane.
A ratio based on capital balances may be appropriate when the funds invested
in the partnership are considered the critical factor. This might be true when the
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418 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

partners expect to give equal service to the partnership. Capital balances may also
be equitable when a manager is hired to run the business and the partners do not
plan to take an active role in daily operations.
The three remaining ratios give specific recognition to differences that may ex-
ist among partners by providing salary allowances for time worked and interest
allowances for capital invested. Then, any remaining net income or net loss is allo-
cated on a fixed ratio. Some caution needs to be exercised in working with these
types of income ratios. These ratios pertain exclusively to the computations that
are required in dividing net income or net loss. Salaries to partners and interest on
partners’ capitals are not expenses of the partnership. Therefore, these items do
not enter into the matching of expenses with revenues and the determination of
net income or net loss. For a partnership, as well as for other entities, salaries ex-
pense pertains to the cost of services performed by employees, and interest expense
relates to the cost of borrowing money from creditors. Partners in their ownership
capacity are not considered either employees or creditors. When the income ratio
includes a salary allowance for partners, some partnership agreements permit the
partner to make monthly withdrawals of cash based on their “salary.” In such cases,
the withdrawals are debited to the partner’s drawing account.

Salaries, Interest, and Remainder on a Fixed Ratio

Under this income ratio the provisions for salaries and interest must be applied
before the remainder is allocated on the specified fixed ratio. This is true even if
the provisions exceed net income or if the partnership has suffered a net loss for
the year. Detailed information concerning the division of net income or net loss
should be shown at the bottom of the income statement.
To illustrate this income ratio, we will assume that Sara King and Ray Lee are co-
partners in Kingslee Pizza. The partnership agreement provides for (1) salary al-
lowances of $8,400 to King and $6,000 to Lee, (2) interest allowances of 10 percent
on capital balances at the beginning of the year, and (3) the remainder equally. Cap-
ital balances on January 1 were King, $28,000, and Lee, $24,000. In 2008, partnership
net income was $22,000. The division of net income is as shown in Illustration 14-5.

Illustration 14-5
KINGSLEE PIZZA
Income statement with Income Statement
division of net income
For the Year Ended December 31, 2008
Sales $200,000
Net income $ 22,000
Division of Net Income
Sara Ray
King Lee Total
Salary allowance $ 8,400 $6,000 $14,400
Interest allowance
Sara King ($28,000  10%) 2,800
Ray Lee ($24,000  10%) 2,400
Total interest 5,200
Total salaries and interest 11,200 8,400 19,600
Remaining income, $2,400
Sara King ($2,400  50%) 1,200
Ray Lee ($2,400  50%) 1,200
Total remainder 2,400
Total division $12,400 $9,600 $22,000
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Partnerships 419

The entry to record the division of net income looks like this:

Dec. 31 Income Summary 22,000

Sara King, Capital 12,400
Ray Lee, Capital 9,600
(To close net income to partners’ capitals)

To illustrate a situation in which the salary and interest allowances exceed net
income, we will assume that net income in Kingslee Pizza was only $18,000. In this
case, the allowances will create a deficiency of $1,600 ($19,600  $18,000). Since
the computations of the salary and interest allowances are the same as those shown
in Illustration 14-5, we will begin the division of net income with total salaries and
interest as shown in Illustration 14-6.

Illustration 14-6
Sara Ray
King Lee Total Division of net income—
income deficiency
Total salaries and interest $11,200 $8,400 $19,600
Remaining deficiency ($1,600)
Sara King ($1,600  50%) (800)
Ray Lee ($1,600  50%) (800)
Total remainder (1,600)
Total division $10,400 $7,600 $18,000

PARTNERSHIP FINANCIAL STATEMENTS

The financial statements of a partnership are similar to those of a proprietorship. The
differences are generally related to the fact that a number of owners are involved in
a partnership. In a balance sheet, for instance, each partner’s capital balance is re-
ported. The income statement for a partnership is identical to the income statement
for a proprietorship, except for the division of net income, as shown earlier.
The owner’s equity statement for a partnership is called partners’ capital state-
ment. Its function is to explain the changes in each partner’s capital account and
in total partnership capital during the year. As in a proprietorship, changes in cap-
ital may result from three causes: (1) additional capital investment, (2) drawings,
and (3) net income or net loss.
The partners’ capital statement for Kingslee Pizza shown in Illustration 14-7
is based on the division of $22,000 of net income. The statement includes assumed
data for the additional investment and for drawings.

Illustration 14-7
KINGSLEE PIZZA
Partners’ Capital Statement Partners’ capital statement
For the Year Ended December 31, 2008
Sara Ray
King Lee Total
Capital, January 1 $28,000 $24,000 $52,000
Add: Additional investment 2,000 2,000
Net income 12,400 9,600 22,000
42,400 33,600 76,000
Less: Drawings 7,000 5,000 12,000
Capital, December 31 $35,400 $28,600 $64,000

The capital statement is prepared from the income statement and the partners’
capital and drawing accounts.
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420 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

TH EC O R P O R AT E F O R M O F O R G A N I Z AT I O N
AND STOCK TRANSACTIONS
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 en-
tity separate and distinct from its owners.
A corporation is created by law, and its continued existence depends on 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 priv-
ileges 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.
Corporations may be classified in a variety of ways. Two common bases are
by purpose and by ownership. A corporation may be organized for the purpose
of making a profit, or it may be nonprofit. Corporations for profit include such
well-known companies as McDonald’s, Darden, Landry’s, Hilton, Starwood, and
Marriott. Nonprofit corporations are organized for charitable, medical, or educa-
tional purposes. Examples are the Salvation Army, the American Cancer Society,
the Hilton Foundation, and the Forte Foundation.
Classification by ownership distinguishes between publicly held and privately
held corporations. A publicly held corporation may have thousands of stockhold-
ers. Its stock is regularly traded on a national securities exchange, such as the New
York Stock Exchange. Most of the largest U.S. corporations are publicly held. Ex-
amples of publicly held hospitality corporations are Starwood, Hilton, Marriott,
Disney, Darden, and Landry’s. In contrast, a privately held corporation, often re-
ferred to as a closely 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 ex-
ceptions exist. Hyatt Hotels is one of the most well-known hotel companies in the
United States that is privately held.

CHARACTERISTICS OF A CORPORATION
STUDY OBJECTIVE 5 A number of characteristics distinguish a corporation from proprietorships and
partnerships. The most important of these characteristics are explained here.
Identify the major
characteristics of a Separate Legal Existence
corporation.
As an entity separate and distinct from its owners, the corporation acts under its
own name rather than in the name of its stockholders. Disney may buy, own, and
WKK sell property. It may borrow money and may enter into legally binding contracts
Hotel in its own name. It also may sue or be sued, and it pays its own taxes.
In contrast to a partnership, in which acts of the owners (partners) bind the
partnership, the acts of its owners (stockholders) do not bind the corporation un-
less such owners are duly appointed agents of the corporation. For example, if you
owned shares of Disney stock, you would not have the right to purchase a theme
park for the company unless you were appointed as an agent of the corporation.
Stockholders
Legal existence separate Limited Liability of Stockholders
from owners
Since a corporation is a separate legal entity, creditors have recourse only to corpo-
rate 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 as-
sets of the owners unless fraud has occurred. Even in the event of bankruptcy, stock-
holders’ losses are generally limited to their capital investment in the corporation.
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The Corporate Form of Organization and Stock Transactions 421

Transferable Ownership Rights

Ownership of a corporation is held in shares of capital stock. These are transfer- WKK
Hotel
able units. Stockholders may dispose of part or all of their interest in a corpora-
tion simply by selling their stock. The transfer of an ownership interest in a part-
nership 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 Stockholders
on the operating activities of the corporation. Nor does it affect the corporation’s Limited liability
of stockholders
assets, liabilities, and total ownership equity. The transfer of these ownership rights
is a transaction between individual owners. The enterprise does not participate in
such transfers after it issues the capital stock.

Ability to Acquire Capital

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 Transferable
has limited liability and shares of stock are readily transferable. Also, numerous in- ownership rights
dividuals can become stockholders by investing small amounts of money. In sum,
the ability of a successful corporation to obtain capital is virtually unlimited.

Continuous Life
The life of a corporation is stated in its charter. The life may be perpetual, or it
may be limited to a specific number of years. If it is limited, the life can be ex-
Ability to acquire capital
tended through renewal of the charter. Since a corporation is a separate legal en-
tity, 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 en-
terprise can have a continuous and perpetual life.

Corporation Management
As in Marriott, stockholders legally own the corporation. But they manage the
corporation indirectly through a board of directors they elect. The board, in turn, Continuous life
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 per-
form daily management functions.
A typical organization chart showing the delegation of responsibility is shown
in Illustration 14-8 on page 422.
The president is the chief executive officer. This individual has direct responsi-
bility for managing the business. As the organization chart shows, the president del-
egates 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 cor-
poration’s funds and is responsible for maintaining the company’s cash position.
On one hand, the organizational structure of a corporation enables a company
to hire professional managers to run the business. On the other hand, the separa-
tion of ownership and management prevents owners from having an active role State laws SEC laws
in managing the company, which some owners like to have.
WKK
Government Regulations Hotel

A corporation is subject to numerous state and federal regulations. State laws usu- Stock
exchange Federal
ally prescribe the requirements for issuing stock, the distributions of earnings per- requirements regulations
mitted to stockholders, and the effects of retiring stock. Federal securities laws
Goverment regulations
govern the sale of capital stock to the general public. Also, most publicly held
15339_Weygandt_Ch14.qxp 12/13/07 11:40 PM Page 422

422 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

Illustration 14-8
Corporation organization
chart Stockholders

Board of
Directors

ETHICS NOTE
Managers who are not owners
are often compensated based on
President
the performance of the firm.
They thus may be tempted to
exaggerate firm performance by
inflating income figures.

Corporate Vice President Vice President Vice President Vice President

Secretary Marketing Finance Production Personnel

Treasurer Controller

ACCOUNTING IN ACTION ^ Business Insight

When a group of investors in a company is unhappy with a company’s perform-
ance, it sometimes tries to elect new members to the board of directors at the
company’s annual stockholder meeting. This is referred to as a proxy fight.
Usually these efforts fail because it has been very expensive to get in contact
with all of the company’s shareholders to try to convince them to vote for your group of
nominees.
But the Internet has changed that, says James Heard, chief executive of Proxy
Monitor, a New York firm that consults institutional shareholders on how to vote on cor-
porate governance issues. “Increasingly the Internet is being used as a tool of communi-
cation among shareholders to pressure managements,” he said. One recent case involved
an effort by a shareholder at Luby’s to get four new people elected to that company’s
board of directors. That shareholder attracted considerable support from other Luby’s
shareholders by posting messages on a Yahoo! message board.

SOURCE: Aaron Elstein, “Online Grousing Over Luby’s Escalates to Proxy

Solicitation,” Wall Street Journal, October 25, 2000.

corporations are required to make extensive disclosure of their financial affairs to

the Securities and Exchange Commission (SEC) through quarterly and annual re-
ports. In addition, when a corporate stock is traded on organized securities ex-
changes, the corporation must comply with the reporting requirements of these
exchanges. Government regulations are designed to protect the owners of the cor-
poration. Such protection is needed because most stockholders do not participate
in the day-to-day management of the company.
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The Corporate Form of Organization and Stock Transactions 423

ACCOUNTING IN ACTION Ethics Perspective

In the wake of Enron’s collapse, the members of Enron’s board of directors have been ques-
tioned and scrutinized to determine what they knew and when they knew it. A Wall Street
Journal story reported that Enron’s board contends it was “kept in the dark” by manage-
ment and by Arthur Andersen—Enron’s longtime auditors—and didn’t learn about the com-
pany’s troublesome accounting untill October 2001. But the Wall Street Journal reported that
according to outside attorneys, “directors on at least two occasions waived Enron’s ethical
code of conduct to approve partnership between Enron and its chief financial officer. Those
partnership kept significant debt off of Enron’s books and masked actual company finances.”
Was Enron’s board of directors fulfilling its role in a corporate organization when it
waived Enron’s ethical code on two occasions?
SOURCE: Carol Hymowitz, “Serving on a Board Now Means Less Talk, More Account-
ability,” Wall Street Journal Online, January 29, 2002.

Additional Taxes
Neither proprietorships nor partnerships pay income taxes. The owner’s share of
earnings from these organizations is reported on his or her personal income tax re-
turn. Taxes are then paid by the individual on this amount. Corporations, on the
other hand, must pay federal and state income taxes as a separate legal entity. These
taxes are substantial: They can amount to more than 40 percent of taxable income.
In addition, stockholders are required to pay taxes on cash dividends (pro rata
distributions of net income). Thus, many argue that corporate income is taxed twice Additional taxes
(double taxation), once at the corporate level and again at the individual level.
From the foregoing, we can identify the following advantages and disadvantages
of a corporation compared to proprietorship or partnership (Illustration 14-9).

Illustration 14-9
Advantages Diasadvantages
Advantages and
Separate legal existence Corporation management—separation of disadvantages of a
Limited liability of stockholders ownership and management corporation
Transferable ownership rights Government regulations
Ability to acquire capital Additional taxes
Continuous life
Corporation management—professional
managers

S-Corporation
As you can see, while the characteristics of a regular corporation provide more
liability protection for the investors, it is not practical for small, individual entre-
preneurs to really take advantage of forming a corporation. In order to encourage
business development, the government does allow a category of corporation
known as the sub-chapter S corporation under the Internal Revenue Services
Code, more widely known as S-corp, for smaller investors. The one characteristic
of an S-corp that is similar to that of a regular corporation is limited liability. How-
ever, there is no double-taxation. The earnings or losses are passed directly to the
owners and are taxed at the owners’ individual tax rates.
If an S-corp has these good characteristics, why do all corporations not become
S-corp? As I mentioned, the aim of the government is to encourage small businesses
to still form as businesses but not to bear some of the disadvantages of a sole propri-
etorship. To become an S-corp, a corporation must have fewer than thirty-five share-
holders, be a domestic corporation, and have only one class of stocks. These are all set
up to provide protection and encouragement for domestic small businesses.
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424 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

FORMING A CORPORATION
ALTERNATIVE TERMINOLOGY The initial step in forming a corporation is to file an application with the secretary
The charter is often referred of state in the state in which incorporation is desired. The application contains such
to as the articles of
incorporation. information as (1) the name and purpose of the proposed corporation; (2) amounts,
kinds, and number of shares of capital stock to be authorized; (3) the names of the
incorporators; and (4) the shares of stock to which each has subscribed.
After the application is approved, a charter is granted. The charter may be an
approved copy of the application form, or it may be a separate document contain-
ing the same basic data. The issuance of the charter creates the corporation. Upon
receipt of the charter, the corporation develops its bylaws. The bylaws establish the
INTERNATIONAL NOTE internal rules and procedures for conducting the affairs of the corporation. They also
U.S. corporations are identified indicate the powers of the stockholders, directors, and officers of the enterprise.1
by Inc., which stands for Incor- Regardless of the number of states in which a corporation has operating divi-
porated. In Italy, the letters used
sions, it is incorporated in only one state. It is to the company’s advantage to in-
are SpA (Societa per Azioni); in
Sweden, AB (Aktiebolag); in corporate in a state whose laws are favorable to the corporate form of business
France, SA (Sociedad Anonima); organization.
and in the Netherlands, NV
Corporations engaged in interstate commerce must also obtain a license from
(Naamloze Vennootschap).
In the United Kingdom, public each state in which they do business. The license subjects the corporation’s oper-
limited corporations are identi- ating activities to the corporation laws of the state.
fied by PLC, and private corpo-
Costs incurred in the formation of a corporation are called organization costs.
rations are denoted by
Ltd.(Limited). The parallel des- These costs include legal and state fees and promotional expenditures involved in
ignations in Germany are AG the organization of the business. Organization costs are expensed as incurred. To
for public corporations and
determine the amount and the timing of future benefits is so difficult that a con-
GmbH for private corporations.
servative approach of expensing these costs immediately is followed.

ACCOUNTING IN ACTION Business Insight

It is not necessary for a corporation to have an office in the state in which
it incorporates. In fact, more than 50 percent of the Fortune 500 corpora-
tions are incorporated in Delaware.A primary reason is the Delaware courts’
long-standing “business judgment rule.” The rule provides that as long as di-
rectors exercise “due care” in the interests of stockholders, their actions will not be
second-guessed by the courts. The rule has enabled directors to reject hostile takeover
offers and to spurn takeovers simply because they did not want to sell the company.
However, new interpretations are emerging. In a recent case, the state court ruled for
a company that made a hostile takeover bid. On appeal, the Delaware Supreme Court
ruled for the directors but gave the following guideline to the state courts: “Was the
board’s response reasonable in the light of the threat posed?”

CORPORATE CAPITAL
Owners’ equity in a corporation is identified as stockholders’ equity, sharehold-
ers’ equity, or corporate capital. The stockholders’ equity section of a corpora-
tion’s balance sheet consists of (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, dis-
tributions of earnings (dividends) can be declared out of retained earnings in all
states, but in many states dividends cannot be declared out of paid-in capital.

1
Following approval by two-thirds of the stockholders, the bylaws become binding on all stockhold-
ers, directors, and officers. Legally, a corporation is regulated first by the laws of the state, second
by its charter, and third by its bylaws. Care must be exercised to ensure that the provisions of the
bylaws are not in conflict with either state laws or the charter.
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The Corporate Form of Organization and Stock Transactions 425

Financially, management, stockholders, and others look to earnings for the contin-
ued existence and growth of the corporation.

Ownership Rights of Stockholders

When chartered, the corporation may begin selling ownership rights in the form
of shares of stock. When a corporation has only one class of stock, it is identified
as common stock. Each share of common stock gives the stockholder the owner-
ship rights pictured in Illustration 14-10. The ownership rights of a share of stock
are stated in the articles of incorporation or in the bylaws.

Illustration 14-10

Stockholders have the right to: Ownership rights of

stockholders
1. Vote in the election of board
of directors at the annual
meeting and on actions
that require stockholder
approval.

2. Share the corporate dividends

earnings through receipt
of dividends.

Before After
3. Keep same
percentage ownership New shares issued
when new shares of
stock are issued 14% 14%
(preemptive right2).

4. Share in assets upon

liquidation, in proportion Lenders Stockholders
to their holdings; GON Corp.
called a residual claim
because owners are paid
with assets remaining
after all claims have Creditors
been paid.

ACCOUNTING IN ACTION International Insight

In Japan, stockholders are considered to be far less important to a corporation
than employees, customers, and suppliers. There, stockholders are rarely asked
to vote on an issue, and the notion of bending corporate policy to favor stock-
holders borders on the heretical. This attitude toward stockholders appears to
be slowly changing, however, as influential Japanese are advocating listening to investors,
raising the extremely low dividends paid by Japanese corporations, and improving disclo-
sure of financial information.

2
Several companies have eliminated the preemptive right because they believe that it makes an un-
necessary and cumbersome demand on management. For example, by stockholder approval, IBM
has dropped its preemptive right for stockholders.
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426 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

Proof of stock ownership is evidenced by a form known as a stock certificate.

As shown in Illustration 14-11, 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 duly authorized corporate of-
ficials. Certificates are prenumbered to facilitate accountability. They may be is-
sued for any quantity of shares.

llustration 14-11
A stock certificate

B E F O R E Y O U G O O N . . .
▼

REVIEW IT
1. What are the advantages and disadvantages of a corporation compared to a propri-
etorship and a partnership?
2. Identify the principal steps in forming a corporation.
3. What rights are inherent in owning a share of stock in a
corporation? ✓ THE
NAVIGATOR

Stock Issue Considerations

INTERNATIONAL NOTE In considering the issuance of stock, a corporation must resolve a number of ba-
U.S. and U.K. corporations raise sic questions: How many shares should be authorized for sale? How should the
most of their capital through stock be issued? At what price should the shares be issued? What value should be
millions of outside shareholders assigned to the stock? These questions are answered in the following sections.
and bondholders. In contrast,
companies in Germany, France,
and Japan acquire financing A U T H O R I Z E D S T O C K . The amount of stock that a corporation is authorized to
from large banks or other insti- sell is indicated in its charter. The total amount of authorized stock at the time of
tutions. In the latter environ-
ment, shareholders are less im- incorporation normally anticipates both initial and subsequent capital needs. As a
portant, and external reporting result, the number of shares authorized generally exceeds the number initially sold.
and auditing receive less If all authorized stock is sold, a corporation must obtain consent of the state to
emphasis.
amend its charter before it can issue additional shares.
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The Corporate Form of Organization and Stock Transactions 427

The authorization of capital stock does not result in a formal accounting entry.
This event has no immediate effect on either corporate assets or stockholders’ equity.
But disclosure of the number of authorized shares is often reported in the stockhold-
ers’ equity section. It is then simple to determine the number of unissued shares that
can be issued without amending the charter: Subtract the total shares issued from the
total authorized. For example, if Micro Hotel was authorized to sell 100,000 shares of
XYZ
common stock and issued 80,000 shares, 20,000 shares would remain unissued. Restaurant

I S S U A N C E O F S T O C K . A corporation can issue common stock directly to in-

vestors. Or it can issue the stock indirectly through an investment banking firm
(brokerage house) that specializes in bringing securities to the attention of
prospective investors. Direct issue is typical in closely held companies. Indirect is-
sue 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 cor-
poration 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 bank-
ing firm, in turn, assumes the risk of reselling the shares in return for an under-
writing fee.3 For example, Bahama Resorts used an underwriter to help it issue
common stock to the public. The underwriter charged a 6.6 percent underwriting
fee on Bahama’s approximately $20 million public 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 cal- Indirect Issuance
culation can be complex and is properly the subject of a finance course.

M A R K E T VA L U E O F S T O C K . The stock of publicly held companies is traded on

organized exchanges. The dollar prices per share are established by the interaction
between buyers and sellers. In general, the prices set by the marketplace tend to

ACCOUNTING IN ACTION Business Insight

The volume of trading on national and international exchanges is heavy. Shares
in excess of a billion are often traded daily on the New York Stock Exchange
(NYSE) alone. For each listed stock, the Wall Street Journal Online reports the
total volume of stock traded for a given day, the high and the low prices for the
day (now in decimals), the closing market price, and the net change for the day. A recent
listing for PepsiCo is shown.

Stock Volume High Low Close Net Change

PepsiCo 2,942,400 48.88 47.31 47.50 0.10

These numbers indicate that PepsiCo’s trading volume was 2,942,400 shares. The
high, low, and closing prices for that date were $48.88, $47.31, and $47.50, respectively.
The net change for the day was a decrease of $0.10 per share.
For stock traded on organized stock exchanges, how are the dollar prices per share
established? What factors might influence the price of shares in the marketplace?

3
Alternatively, the investment banking firm may agree only to enter into a best efforts contract
with the corporation. In such a case, the banker agrees to sell as many shares as possible at a speci-
fied price. The corporation bears the risk of unsold stock. Under a best efforts arrangement, the
banking firm is paid a fee or a commission for its services.
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428 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

follow the trend of a company’s earnings and dividends. But factors beyond a com-
pany’s control, such as international turmoil, changes in interest rates, and the out-
come 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 trans-
actions have no impact on a corporation’s stockholders’ equity.

TECHNOLOGY IN ACTION
Giant, publicly held corporations could not exist without the organized stock
markets, and the stock markets could not exist without massive computeriza-
tion. Not too many years ago, the NYSE “ticker” would run behind, or trad-
ing would even be halted, when sales exceeded 30 million shares or so. Now, with sales
sometimes in excess of 800 million shares, the NYSE and its companion exchanges
throughout the country operate efficiently with computer technology. Technology has also
made possible extended trading hours. An investor in New York can trade electronically
at 3:30 A.M., which is the time in New York when the London Stock Exchange opens at
8:30 A.M. Some predict that twenty-four-hour trading is not far off.

P A R A N D N O - P A R VA L U E S T O C K S . Par value stock is capital stock that has

been assigned a value per share in the corporate charter. The par value may be
any amount selected by the corporation. Generally, the par value is quite low be-
cause states often levy a tax on the corporation based on par value. For example,
Starwood has a par of $0.01. Hilton’s common stock carries a par value of $2.50
per share, whereas its preferred stock has a par value of $1.00 per share.
Par value does not indicate the worth or the market value of the stock. Dis-
ney, like Starwood, also carries stocks with a par value $0.01; but its recent mar-
ket price was $18.18 per share. Par value has legal significance. It represents the
legal capital per share that must be retained in the business for the protection of
corporate creditors. That amount is not available for withdrawal by stockholders.
Thus most states require the corporation to sell its shares at par or above.
No-par value stock is capital stock that has not been assigned a value in the
corporate charter. It is often issued because some confusion still exists concerning
par value and fair market value. If shares are not assigned a par value, the ques-
tionable use of par value as a basis for fair market value never arises. The major
disadvantage of no-par value stock is that some states levy a high tax on such shares.
No-par value stock is quite common today. For example, Marriott’s preferred
stock has no par value. In many states the board of directors is permitted to as-
sign a stated value to the no-par shares. This value becomes the legal capital per
share. The stated value of no-par stock may be changed at any time by action of
the directors. Stated value, like par value, does not indicate the market value of
the stock. When there is no assigned stated value, the entire proceeds received on
issuance of the stock is considered to be legal capital.
The relationship of par and no-par value to legal capital is shown in Illustra-
tion 14-12.

Illustration 14-12
Stock Legal Capital per Share
Relationship of par and
no-par value stock to legal Par value ⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯→ Par value
capital No-par value with stated value ⎯⎯→ Stated value
No-par value without stated value ⎯→ Entire proceeds
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The Corporate Form of Organization and Stock Transactions 429

▼ B E F O R E Y O U G O O N . . .

REVIEW IT
1. Of what significance to a corporation is the amount of authorized stock?
2. What alternative approaches may a corporation use in issuing stock?
3. Distinguish between par value and fair market value.

DO IT
▼

At the end of its first year of operation, Doral Restaurants, Inc., has $750,000 of common
stock and net income of $122,000. Prepare (a) the closing entry for net income (as shown
in Illustration 5-7, page 147) and (b) the stockholders’ equity section at year-end (as shown
in Illustration 5-25, page 159).

ACTION PLAN
• Record net income in Retained Earnings by a closing entry in which Income Sum-
mary is debited and Retained Earnings is credited.
• In the stockholders’ equity section, show (1) paid-in capital and (2) retained earn-
ings.
SOLUTION
(a) Income Summary 122,000
Retained Earnings 122,000
(To close income summary and transfer net
income to retained earnings)
(b) Stockholders’ equity
Paid-in capital
Common stock $750,000
Retained earnings 122,000
Total stockholders’ equity $872,000

✓ THE
NAVIGATOR

ACCOUNTING FOR COMMON STOCK ISSUES

Let’s now look at how to account for issues of common stock. The primary objec-
tives in accounting for the issuance of common stock are (1) to identify the spe-
STUDY OBJECTIVE 6
cific sources of paid-in capital and (2) to maintain the distinction between paid- Record the issuance of
in capital and retained earnings. The issuance of common stock affects only paid-in common stock.
capital accounts.

Issuing Par Value Common Stock for Cash

As discussed earlier, par value does not indicate a stock’s market value. Therefore,
the cash proceeds from issuing par value stock may be equal to, greater than, or
less than par value. When the issuance of common stock for cash is recorded, the
par value of the shares is credited to Common Stock. The portion of the proceeds
that is above or below par value is recorded in a separate paid-in capital account.
To illustrate, assume that Hydro-Slide Theme Park issues 1,000 shares of $1
par value common stock at par for cash. The entry to record this transaction is

Cash 1,000
A = L + SE
Common Stock 1,000 1,000 1,000
(To record issuance of 1,000 shares of $1 par common
stock at par)
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430 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

ALTERNATIVE TERMINOLOGY If Hydro-Slide issues an additional 1,000 shares of the $1 par value common
Paid-in Capital in Excess of stock for cash at $5 per share, the entry is
Par is also called Premium on
Stock.

Cash 5,000
A = L + SE Common Stock 1,000
5,000 1,000
Paid-in Capital in Excess of Par Value 4,000
4,000
(To record issuance of 1,000 shares of common stock in
excess of par)

The total paid-in capital from these two transactions is $6,000, and the legal
capital is $2,000. If Hydro-Slide has retained earnings of $27,000, the stockholders’
equity section is as shown in Illustration 14-13.

Illustration 14-13
HYDRO-SLIDE THEME PARK
Stockholders’ equity— Balance Sheet (partial)
paid-in capital in excess of
par value Stockholders’ equity
Paid-in-capital
Common stock $ 2,000
Paid-in capital in excess of par value 4,000
Total paid-in capital 6,000
Retained earnings 27,000
Total stockholders’ equity $33,000

When stock is issued for less than par value, the account Paid-in Capital in Ex-
cess of Par Value is debited, if a credit balance exists in this account. If a credit
balance does not exist, then the amount less than par is debited to Retained Earn-
ings. This situation occurs only rarely: The sale of common stock below par value
is not permitted in most states because stockholders may be held personally liable
for the difference between the price paid upon original sale and par value.

Issuing No-Par Common Stock for Cash

When no-par common stock has a stated value, the entries are similar to those il-
lustrated for par value stock. The stated value represents legal capital. Therefore,
it is credited to Common Stock. Also, when the selling price of no-par stock ex-
ceeds stated value, the excess is credited to Paid-in Capital in Excess of Stated
Value. For example, assume that instead of $1 par value stock, Hydro-Slide Theme
Park has $5 stated value no-par stock and the company issues 5,000 shares at $8
per share for cash. The entry looks like this:

Cash 40,000
A = L + SE
40,000 25,000
Common Stock 25,000
15,000 Paid-in Capital in Excess of Stated Value 15,000
(To record issue of 5,000 shares of $5 stated value
no-par stock)

Paid-in Capital in Excess of Stated Value is reported as part of paid-in capital in

the stockholders’ equity section.
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The Corporate Form of Organization and Stock Transactions 431

What happens when no-par stock does not have a stated value? In that case,
the entire proceeds from the issue become legal capital and are credited to
Common Stock. Thus, if Hydro-Slide does not assign a stated value to its no-
par stock, the issuance of the 5,000 shares at $8 per share for cash is recorded
as follows:

Cash 40,000
A = L + SE
Common Stock 40,000 40,000 40,000
(To record issue of 5,000 shares of no-par stock)

The amount of legal capital for Hydro-Slide stock with a $5 stated value is $25,000.
Without a stated value, it is $40,000.

Issuing Common Stock for Ser vices or Noncash Assets

Stock also may be issued 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 cost
principle, in a noncash transaction, cost is the cash equivalent price. Thus cost is
either the fair market value of the consideration given up or the fair market value
of the consideration received, whichever is more clearly determinable.
To illustrate, assume that attorneys have helped Jordan Sports Spa incorpo-
rate. 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 market value of the consideration received, $5,000, is more clearly evident. Ac-
cordingly, the entry is

Organization Expense 5,000

A = L + SE
Common Stock 4,000 5,000
Paid-in Capital in Excess of Par Value 1,000 4,000
(To record issuance of 4,000 shares of $1 par value 1,000
stock to attorneys)

As explained on page 424, organization costs are expensed as incurred.

In contrast, assume that Athletic Rock Climbing Camp is an existing pub-
licly 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 transaction is recorded
as follows:

Land 80,000
A = L + SE
Common Stock 50,000 80,000 50,000
Paid-in Capital in Excess of Par Value 30,000 30,000
(To record issuance of 10,000 shares of $5 par value
stock for land)

As illustrated in these examples, the par value of the stock is never a factor in de-
termining the cost of the assets received. This is also true of the stated value of
no-par stock.
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432 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

B E F O R E Y O U G O O N . . .

▼
REVIEW IT
1. Explain the accounting for par and no-par common stock issued for cash.
2. Explain the accounting for the issuance of stock for services or noncash assets.

▼
DO IT
Cayman Resorts 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.

ACTION PLAN
• In issuing shares for cash, credit Common Stock for par value per share.
• Credit any additional proceeds in excess of par value 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 market value of what is given up or
the fair market value of what is received, whichever is more clearly determinable.
SOLUTION
Mar. 1 Cash 1,200,000
Common Stock 1,000,000
Paid-in Capital in Excess of Par Value 200,000
(To record issuance of 100,000 shares at $12
per share)

Mar. 15 Organization Expense 50,000

Common Stock 50,000
(To record issuance of 5,000 shares
for attorneys’ fees)

✓ THE
NAVIGATOR

AC C O U N T I N G FOR TREASURY STOCK

Treasury stock is a corporation’s own stock that has been issued, fully paid for,
STUDY OBJECTIVE 7 and reacquired by the corporation but not retired. A corporation may acquire
Explain the accounting for treasury stock for various reasons:
treasury stock.
1. To reissue the shares to officers and employees under bonus and stock com-
pensation plans.
2. To increase trading of the company’s stock in the securities market in the hopes
HELPFUL HINT of enhancing its market value.
Treasury stock is so named be-
cause the company often holds
3. To have additional shares available for use in the acquisition of other companies.
the shares in its treasury for 4. To reduce the number of shares outstanding and thereby increase earnings per
safekeeping.
share.
5. To rid the company of disgruntled investors, perhaps to avoid a takeover.
Many corporations have treasury stock. One survey of 600 companies in the
HELPFUL HINT United States found that 66 percent have treasury stock.4 Specifically, The Coca-
Treasury shares do not have Cola Company reported as of December 31, 2005, $19,644 million; and Marriott
dividend rights or voting rights.
reported $2,667 million in treasury stock.

4
Accounting Trends & Techniques 2000 (New York: American Institute of Certified Public
Accountants).
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Accounting for Treasury Stock 433

ACCOUNTING IN ACTION Business Insight

Why would a company use its own cash or, worse yet, borrow money to buy back
its own shares? Wouldn’t a company want the public to buy its shares so that it
could raise funds for future projects? Stock repurchase is a really interesting
phenomenon. In 2000, more than a dozen lodging companies initiated repurchase
programs. These include Cendant Corporation, Choice Hotels International, Marriott
International, Park Place Entertainment, and Sun International, among others. Some com-
panies believe their stocks are undervalued, and therefore, a stock repurchase program can
maximize their returns. Such is the case with John Q. Hammons Hotels; it realized a 63 per-
cent gain on its repurchase move.
Restaurants also use this tactic. Landry’s repurchased its own shares in 1999, 2000,
and 2001, totaling more than $89 million. In 2002, Starbucks Corporation also announced
the repurchase of 3.5 million of its common stock at a value of more than $50 million. Its
board also has approved up to a 10-million-share repurchase. In 2005, Royal Caribbean
Cruises, Ltd., announced a $250 million stock repurchase plan. Morgans Hotel Group is one
of the latest hotel groups that made known its $50 stock repurchase plan to the public in
December 2006.

SOURCES: M. Whitford, “Stock Buybacks Spur Demand,” Hotel and Motel Management
215(16) (2000): 44.
“Starbucks Perks Up Stock Buyback Plan,” Nation’s Restaurant News 36(26) (2002): 12.
“Morgans Hotel Group Announces $50 Million Stock Repurchase Program,”
http://biz.yahoo.com bw /061207/20061207005841.html?.v=1
“Royal Carribbean in Stock Repurchase,” www.bizjournals.com/pacific/stories/2005/09/
26/daily1.html.

Purchase of Treasur y Stock

Treasury stock is generally accounted for by the cost method. This method uses the
cost of the shares purchased to value the treasury stock. Under the cost method,
Treasury Stock is debited for the price paid to reacquire the shares.
The same amount is credited to Treasury Stock when the shares are disposed
of. To illustrate, assume that on January 1, 2008, the stockholders’ equity section of
Mead Foods, Inc., has 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 shown in Illustration 14-14.

Illustration 14-14
MEAD FOODS, INC.
Balance Sheet (partial) Stockholders’ equity with no
treasury stock
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares
issued and outstanding $500,000
Retained earnings 200,000
Total stockholders’ equity $700,000

On February 1, 2008, Mead acquires 4,000 shares of its stock at $8 per share:

Feb. 1 Treasury Stock 32,000

A = L + SE
Cash 32,000 32,000 32,000
(To record purchase of 4,000 shares
of treasury stock at $8 per share)
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434 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

Note that Treasury Stock is debited for the cost of the shares purchased. Is the
original paid-in capital account, Common Stock, affected? No, because the num-
ber of issued shares does not change. In the stockholders’ equity section of the
balance sheet, treasury stock is deducted from total paid-in capital and retained
earnings. Treasury Stock is a contra stockholders’ equity account.
The stockholders’ equity section of Mead Foods after purchase of treasury
stock is shown in Illustration 14-15.

Illustration 14-15
MEAD FOODS, INC.
Stockholders’ equity with Balance Sheet (partial)
treasury stock
Stockholders’ equity
Paid-in capital
Common stock, $5 par value, 100,000 shares issued
and 96,000 shares outstanding $500,000
Retained earnings 200,000
Total paid-in capital and retained earnings 700,000
Less: Treasury stock (4,000 shares) 32,000
Total stockholders’ equity $668,000

Thus the acquisition of treasury stock reduces stockholders’ equity.

In the balance sheet, both the number of shares issued (100,000) and the num-
ber in the treasury (4,000) are disclosed. The difference between these two amounts
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 treasury stock should be reported as an asset because it
can be sold for cash. Under this reasoning, unissued stock also should be shown
as an asset, clearly an erroneous conclusion. 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.

Disposal of Treasur y Stock

Treasury stock is usually sold or retired. The accounting for its sale is different
when treasury stock is sold above cost than when it is sold below cost.
HELPFUL HINT
Treasury stock transactions are
classified as capital stock trans- S A L E O F T R E A S U R Y S T O C K A B O V E C O S T. If the selling price of the treasury
actions. As in the case when shares is equal to cost, the sale of the shares is recorded by a debit to Cash and a
stock is issued, the income
statement is not involved.
credit to Treasury Stock. When the selling price of the shares is greater than cost,
the difference is credited to Paid-in Capital from Treasury Stock.
To illustrate, assume that 1,000 shares of treasury stock of Mead Foods, Inc.,
previously acquired at $8 per share, are sold at $10 per share on July 1. The entry
is as follows:

July 1 Cash 10,000

A = L + SE
10,000 8,000
Treasury Stock 8,000
2,000 Paid-in Capital from Treasury Stock 2,000
(To record sale of 1,000 shares of treasury
stock above cost)
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Accounting for Treasury Stock 435

The $2,000 credit in the entry would not be considered a 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 paid-in capital arising from the
sale of treasury stock should not be included in the measurement of net income.
Paid-in Capital from Treasury Stock is listed separately on the balance sheet as a
part of paid-in capital.

S A L E O F T R E A S U R Y S T O C K B E L O W C O S T. When treasury stock is sold be-

low its cost, the excess of cost over selling price is usually debited to Paid-in Cap-
ital from Treasury Stock. Thus, if Mead Foods, Inc., sells an additional 800 shares
of treasury stock on October 1 at $7 per share, the entry is as follows:

Oct. 1 Cash 5,600

A = L + SE
Paid-in Capital from Treasury Stock 800 5,600 800
Treasury Stock 6,400 6,400
(To record sale of 800 shares of treasury
stock below cost)

Observe the following from the two sales entries: (1) Treasury Stock is credited
at cost in each entry. (2) Paid-in Capital from Treasury Stock is used for the differ-
ence between cost and the resale price of the shares. (3) The original paid-in capi-
tal 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 (Illustration 14-16).

Illustration 14-16
Treasury Stock Paid-in Capital from Treasury Stock
Treasury stock accounts
Feb. 1 32,000 July 1 8,000 Oct. 1 800 July 1 2,000
Oct. 1 6,400
Oct. 1 Bal. 1,200
Oct. 1 Bal. 17,600

When the credit balance in Paid-in Capital from Treasury Stock is elimi-
nated, any additional excess of cost over selling price is debited to Retained
Earnings. To illustrate, assume that Mead Foods, 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, $1,200 of the excess is debited to Paid-in
Capital from Treasury Stock. The remainder is debited to Retained Earnings. The
entry follows:

Dec. 1 Cash 15,400

A = L + SE
Paid-in Capital from Treasury Stock 1,200 15,400 1,200
Retained Earnings 1,000 1,000
Treasury Stock 17,600 17,600
(To record sale of 2,200 shares of treasury
stock at $7 per share)
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436 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

B E F O R E Y O U G O O N . . .

▼
REVIEW IT
1. What is treasury stock, and why do companies acquire it?
2. How is treasury stock recorded?
3. Where is treasury stock reported in the financial statements? Does a company record
gains and losses on treasury stock transactions? Explain.

▼ DO IT
Santa Anita Resorts, Inc., purchases 3,000 shares of its $60 par value common stock
for $180,000 cash on July 1. The shares are to be held 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
July 1 Treasury Stock 180,000
Cash 180,000
(To record the purchase of 3,000 shares at
$60 per share)

Nov. 1 Cash 70,000

Treasury Stock 60,000
Paid-in Capital from Treasury Stock 10,000
(To record the sale of 1,000 shares at $70
per share)
✓ THE
NAVIGATOR

PREFERRED STOCK
To appeal to more potential investors, a corporation may issue an additional class
STUDY OBJECTIVE 8 of stock, called preferred stock. Preferred stock has contractual provisions that give
it a preference or priority over common stock in certain areas. Typically, preferred
Differentiate preferred
stock from common stock.
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, preferred stock may be issued for cash or for noncash as-
sets. 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. For example, a company might
have the following accounts: Preferred Stock, Common Stock, Paid-in Capital in
Excess of Par Value—Preferred Stock, and Paid-in Capital in Excess of Par Value—
Common Stock. Assume that Stine Hotel Corporation issues 10,000 shares of $10
par value preferred stock for $12 cash per share. The entry to record the issuance
follows:

Cash 120,000
A = L + SE
120,000 100,000
Preferred Stock 100,000
20,000 Paid-in Capital in Excess of Par Value—Preferred Stock 20,000
(To record the issuance of 10,000 shares of $10 par
value preferred stock)
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Accounting for Treasury Stock 437

Preferred stock may have either a par value or a no-par value. In the stock-
holders’ equity section of the balance sheet, preferred stock is shown first because
of its dividend and liquidation preferences over common stock.
Various features associated with the issuance of preferred stock, including div-
idend preferences, liquidation preferences, convertibility, and callability, are dis-
cussed on the following pages.

Dividend Preferences
As noted earlier, preferred stockholders have the right to share in the distribution I hope there
of corporate income before common stockholders. For example, if the dividend is some money
rate on preferred stock is $5 per share, common shareholders will not receive any left when it’s
my turn.
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.
The per share dividend amount is stated as a percentage of the preferred
stock’s par value or as a specified amount. For example, Crane Resorts specifies Preferred Common
a 3 3/4 percent dividend on its $100 par value preferred ($100  3 3/4%  $3.75 per stockholders stockholders
share). Dividend Preference

Cumulative Dividend
Preferred stock often contains a cumulative dividend feature. This means that pre-
ferred stockholders must be paid both current-year dividends and any unpaid
prior-year dividends before common stockholders receive dividends. When pre- HELPFUL HINT
ferred stock is cumulative, preferred dividends not declared in a given period are The cumulative dividend fea-
ture is often critical in investors’
called dividends in arrears. acceptance of a preferred stock
To illustrate, assume that Sun Resorts and Spas has 5,000 shares of 7 percent, issue. Investors are much less
$100 par value, cumulative preferred stock outstanding. The annual dividend is interested in a noncumulative
$35,000 (5,000  $7 per share), but dividends are two years in arrears. In this case, preferred stock because a
dividend passed in any year is
preferred stockholders are entitled to receive the dividends shown in Illustration lost forever.
14-17 in the current year.

Illustration 14-17
Dividends in arrears ($35,000  2) $ 70,000
Current-year dividends 35,000 Computation of total
dividends to preferred stock
Total preferred dividends $105,000

No distribution can be made to common stockholders until this entire preferred

Payment of a
dividend is paid. In other words, dividends cannot be paid to common stockhold- Cumulative Dividend
ers while any preferred stock is in arrears.
Dividends in arrears are not considered a liability. No payment obligation ex- Dividend Current
ists until a dividend is declared by the board of directors. However, the amount in dividend
arrears
of dividends in arrears should be disclosed in the notes to the financial statements.
Doing so enables investors to assess the potential impact of this commitment on
the corporation’s financial position.
Companies that are unable to meet their dividend obligations are not looked
upon favorably by the investment community. As a financial officer noted in dis-
Preferred
cussing one company’s failure to pay its cumulative preferred dividend for a pe- stockholders
riod 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 the following section.
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438 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

DI V I D E N D S
A dividend is a distribution by a corporation to its stockholders on a pro rata
STUDY OBJECTIVE 9 (proportional) basis. Potential buyers and sellers of stock are very interested in a
Prepare the entries for company’s dividend policies and practices. Dividends can take four forms: (1) cash,
cash dividends and stock (2) property, (3) scrip (a promissory note to pay cash), or (4) stock. Cash dividends
dividends. predominate in practice, and stock dividends are declared with some frequency.
These two forms of dividends will be the focus of discussion in this chapter.
Dividends may be expressed in two ways: (1) as a percentage of the par or
stated value of the stock or (2) as a dollar amount per share. In the financial press,
dividends are generally reported quarterly as a dollar amount per share.

CASH DIVIDENDS
A cash dividend is a pro rata distribution of cash to stockholders. For a corpora-
tion to pay a cash dividend, it must have three things:
1. Retained earnings. The legality of a cash dividend depends on the laws of the
state in which the company is incorporated. Payment of cash dividends from
retained earnings is legal in all states. In general, cash dividend distributions
based only on common stock (legal capital) are illegal. Statutes vary consid-
erably with respect to cash dividends based on paid-in capital in excess of par
or stated value. Many states permit such dividends. A dividend declared out
of paid-in capital is termed a liquidating dividend. The amount originally paid
in by stockholders is being reduced, or “liquidated,” by such a dividend.
2. Adequate cash. The legality of a dividend and the ability to pay a dividend
are two different things. For example, Best Hotels, with retained earnings of
$3 million, could legally declare a dividend of $3 million. But Best’s cash bal-
ance is only $250,000. In order to pay a $3 million dividend, Best would need
to raise additional cash through the sale of other assets or through additional
financing.
Before declaring a cash dividend, a company’s board of directors must
carefully consider both current and future demands on the company’s cash re-
sources. In some cases, current liabilities may make a cash dividend inappro-
priate. In other cases, a major plant expansion program may warrant only a
relatively small dividend. Sysco declared an $8.17 per share dividend per quar-
ter in 2006. For the same period, Hilton declared a $0.04 per share dividend,
whereas Marriott paid $0.05 to $0.06 per share.
3. A declaration of dividends. A company does not pay dividends unless its board
of directors decides to do so, at which point the board “declares” the dividend.
The board of directors has full authority to determine the amount of income
to be distributed in the form of a dividend and the amount to be retained in
the business. Dividends do not accrue like interest on a note payable, and they
are not a liability until declared.
The amount and the timing of a dividend are important issues. The payment of
a large cash dividend could lead to liquidity problems for the enterprise. On the other
hand, a small dividend or a missed dividend may cause unhappiness among stock-
holders. Many of them expect to receive a reasonable cash payment from the com-
pany on a periodic basis. Many companies declare and pay cash dividends quarterly.

Entries for Cash Dividends

Three dates are important in connection with dividends: (1) the declaration date,
(2) the record date, and (3) the payment date. Normally, there are two to four
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Dividends 439

ACCOUNTING IN ACTION Business Insight

To pay, or not to pay, that seems to be the question. As stock prices fall and the
market becomes more volatile, investors become more interested in dividends.
And what they found was not too pleasing. One article noted, “According to
Standard and Poor’s, only 72 percent of companies in its S&P 500 index paid a
dividend last year [2001], down from 94 percent in 1980.” However, as a result of new
tax regulations reducing the tax on dividends to only 15 percent, many corporate boards
increased their dividend in 2003.
What factors must a board of directors consider before declaring a cash dividend?

SOURCE: “Dividends’ End: Should Technology Companies Pay Divdends?” The Econ-
omist, January 12, 2002, p. 68.

weeks between each date. Accounting entries are required on two of the dates—
the declaration date and the payment date.
On the declaration date, the board of directors formally declares (authorizes)
the cash dividend and announces it to stockholders. Declaration of a cash divi-
dend commits the corporation to a legal obligation. The obligation is binding and HELPFUL HINT
cannot be rescinded. An entry is required to recognize the decrease in retained What is the effect of the decla-
ration of a cash dividend on
earnings and the increase in the liability Dividends Payable. To illustrate, assume (1) total stockholders’ equity,
that on December 1, 2008, the directors of Heavenly Resorts declare a 50 cents (2) total liabilities, (3) total
per share cash dividend on 100,000 shares of $10 par value common stock. The assets? Answer: (1) decrease,
(2) increase, (3) no effect.
dividend is $50,000 (100,000  50 cents). The entry to record the declaration is

Declaration Date
A = L + SE
Dec. 1 Retained Earnings 50,000 50,000 50,000
Dividends Payable 50,000
(To record declaration of cash dividend)

Dividends Payable is a current liability: It will normally be paid within the next
several weeks.
Instead of debiting Retained Earnings, the account Dividends may be debited.
This account provides additional information in the ledger. Also, a company may
have separate dividend accounts for each class of stock. When a dividend account
is used, its balance is transferred to Retained Earnings at the end of the year by
a closing entry. Whichever account is used for the dividend declaration, the effect
is the same: Retained earnings is decreased and a current liability is increased. For
homework problems, you should use the Retained Earnings account for record- HELPFUL HINT
Between the declaration date
ing dividend declarations. and the record date, the number
At the record date, ownership of the outstanding shares is determined for of shares outstanding should re-
dividend purposes. The records maintained by the corporation supply this infor- main the same. The purpose of
the record date is to identify the
mation. In the interval between the declaration date and the record date, the persons or entities that will re-
corporation updates its stock ownership records. For Heavenly Resorts, the record ceive the dividend, not to deter-
date is December 22. No entry is required on this date because the corporation’s mine the amount of the divi-
dend liability.
liability recognized on the declaration date is unchanged.

Record Date A = L + SE
Dec. 22 50,000 50,000
No entry necessary
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440 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

On the payment date, dividend checks are mailed to the stockholders, and the
payment of the dividend is recorded. Assuming that the payment date is January
20 for Heavenly Resorts, the entry on that date would be:

Payment Date
Jan. 20 Dividends Payable 50,000
Cash 50,000
(To record payment of cash dividend)

Note that payment of the dividend reduces both current assets and current liabil-
ities. It has no effect on stockholders’ equity. The cumulative effect of the decla-
ration and payment of a cash dividend is to decrease both stockholders’ equity
and total assets. Illustration 14-18 summarizes the three important dates associ-
ated with dividends.

Illustration 14-18
Key dividend dates
December January
S M Tu W Th F S S M Tu W Th F S
Declaration
1 2 3 4 5 6 1 2 3
date
Board 7 8 9 10 11 12 13 4 5 6 7 8 9 10
authorizes 14 15 16 17 18 19 20 11 12 13 14 15 16 17
dividends
21 22 23 24 25 26 27 18 19 20 21 22 23 24
28 29 30 31 25 26 27 28 29 30 31

Record date Payment date

Registered shareholders Dividend checks
are eligible for dividend are issued

Allocating Cash Dividends between Preferred

and Common Stock
As explained earlier in this chapter, preferred stock has priority over common
stock in regard to dividends. Preferred stockholders must be paid any unpaid prior-
year dividends before common stockholders receive dividends.
To illustrate, assume that at December 31, 2008, IBR Hotels Inc. has 1,000
shares of 8 percent, $100 par value cumulative preferred stock. It also has 50,000
shares of $10 par value common stock outstanding. The dividend per share for
preferred stock is $8 ($100 par value  8%). The required annual dividend for
preferred stock is therefore $8,000 (1,000  $8). At December 31, 2008, the direc-
tors declare a $6,000 cash dividend. In this case, the entire dividend amount goes
to preferred stockholders because of their dividend preference.The entry to record
the declaration of the dividend looks like this:

Dec. 31 Retained Earnings 6,000

A = L + SE
6,000 6,000
Dividends Payable 6,000
(To record $6 per share cash dividend
to preferred stockholders)

Because of the cumulative feature, dividends of $2 per share are in arrears on

preferred stock for 2008. These dividends must be paid to preferred stockholders
15339_Weygandt_Ch14.qxp 12/13/07 11:40 PM Page 441

Dividends 441

before any future dividends can be paid to common stockholders. Dividends in ar-
rears should be disclosed in the financial statements.
On December 31, 2008, IBR declares a $50,000 cash dividend. Illustration 14-19
shows the allocation of the dividend to the two classes of stock.

Illustration 14-19
Total dividend $50,000
Allocated to preferred stock Allocating dividends to
Dividends in arrears, 2004 (1,000 ⴛ $2) $2,000 preferred and common
2005 dividend (1,000 ⴛ $8) 8,000 10,000 stock
Remainder allocated to common stock $40,000

The entry to record the declaration of the dividend looks like this:

Dec. 31 Retained Earnings 50,000

A = L + SE
Dividends Payable 50,000 50,000 50,000
(To record declaration of cash dividends
of $10,000 to preferred stock and $40,000
to common stock)

What if IBR’s preferred stock were not cumulative? In that case, preferred
stockholders would have received only $8,000 in dividends in 2008. Common stock-
holders would have received $42,000.

STOCK DIVIDENDS
A stock dividend is a pro rata distribution to stockholders of the corporation’s
own stock. Whereas a cash dividend is paid in cash, a stock dividend is paid in
stock. A stock dividend results in a decrease in retained earnings and an increase
in paid-in capital. Unlike a cash dividend, a stock dividend does not decrease to-
tal stockholders’ equity or total assets.
To illustrate, assume that you have a 2 percent ownership interest in Cetus
Restaurant, Inc.; you own twenty of its 1,000 shares of common stock. If Cetus de-
clares a 10 percent stock dividend, it would issue 100 shares (1,000  10%) of
stock. You would receive two shares (2%  100). Would your ownership interest
change? No, it would remain at 2 percent (22  1,100). You now own more shares
of stock, but your ownership interest has not changed. Illustration 14-20 shows the
effect of a stock dividend for stockholders.

Illustration 14-20
Before stock dividend After stock dividend “I owned 40 Effect of stock dividend for
shares before and I own
Hotel Hotel stockholders
120 shares now, but I still
own only 1⁄4 of the
company!”

10 10 10 10 10 10
shares shares
10 10 10 10
10 10
shares shares 10 10 10 10

Number of shares owned increases, but

percentage of company owned remains the same.
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442 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

From the company’s point of view, no cash has been disbursed, and no liabil-
ities have been assumed by the corporation. What are the purposes and benefits
of a stock dividend? Corporations issue stock dividends generally for one or more
of the following reasons:
1. To satisfy stockholders’ dividend expectations without spending cash.
2. To increase the marketability of the corporation’s stock. When the number of
shares outstanding increases, the market price per share decreases. Decreas-
ing the market price of the stock makes it easier for smaller investors to pur-
chase the shares.
3. To emphasize that a portion of stockholders’ equity has been permanently
reinvested in the business (and is unavailable for cash dividends).
The size of the stock dividend and the value to be assigned to each dividend
share are determined by the board of directors when the dividend is declared. The
per share amount must be at least equal to the par or stated value in order to meet
legal requirements.
The accounting profession distinguishes between a small stock dividend (less
than 20 to 25 percent of the corporation’s issued stock) and a large stock divi-
dend (greater than 20 to 25 percent). For small stock dividends, it recommends
that the directors assign the fair market value per share. This treatment is based
on the assumption that a small stock dividend will have little effect on the mar-
ket price of the outstanding shares. Many stockholders consider small stock div-
idends to be distributions of earnings equal to the fair market value of the shares
distributed. The amount to be assigned for a large stock dividend is not specified
by the accounting profession. Par or stated value per share is normally assigned.
Small stock dividends predominate in practice. Thus we will illustrate only the
entries for small stock dividends.

ENTRIES FOR STOCK DIVIDENDS

To illustrate the accounting for small stock dividends, assume that Medland
Restaurants Corporation has a balance of $300,000 in retained earnings. It declares
a 10 percent stock dividend on its 50,000 shares of $10 par value common stock.
The current fair market value of its stock is $15 per share. The number of shares
to be issued is 5,000 (10%  50,000). Therefore, the total amount to be debited
to Retained Earnings is $75,000 (5,000  $15). The entry to record the declara-
tion of the stock dividend is as follows:

Retained Earnings 75,000

A = L + SE
75,000 Common Stock Dividends Distributable 50,000
50,000 Paid-in Capital in Excess of Par Value 25,000
25,000 (To record declaration of 10% stock dividend)

Note that Retained Earnings is debited for the fair market value of the stock is-
sued ($15  5,000). Common Stock Dividends Distributable is credited for the
par value of the dividend shares ($10  5,000), and the excess over par ($5 
5,000) is credited to Paid-in Capital in Excess of Par Value.
Common Stock Dividends Distributable is a stockholders’ equity account. It
is not a liability because assets will not be used to pay the dividend. If a balance
sheet is prepared before the dividend shares are issued, the distributable account
is reported under Paid-in capital, as an addition to common stock issued. This is
shown in Illustration 14-21.
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Dividends 443

Illustration 14-21
Paid-in capital
Common stock $500,000 Statement presentation of
Common stock dividends distributable 50,000 $550,000 common stock dividends
distributable

When the dividend shares are issued, Common Stock Dividends Distributable
is debited, and Common Stock is credited as follows:

Common Stock Dividends Distributable 50,000

A = L + SE
Common Stock 50,000 50,000
(To record issuance of 5,000 shares in a stock dividend) 50,000

EFFECTS OF STOCK DIVIDENDS

How do stock dividends affect stockholders’ equity? They change the composi-
tion of stockholders’ equity because a portion of retained earnings is transferred
to paid-in capital. However, total stockholders’ equity remains the same. Stock
dividends also have no effect on the par or stated value per share. But the num-
ber of shares outstanding increases. These effects are shown for Medland Corpo-
ration in Illustration 14-22.

Illustration 14-22
Before After
Dividend Dividend Stock dividend effects

Stockholders’ equity
Paid-in capital
Common stock, $10 par $ 500,000 $ 550,000
Paid-in capital in excess of par value –0– 25,000
Total paid-in capital 500,000 575,000
Retained earnings 300,000 225,000
Total stockholders’ equity $ 800,000 $ 800,000
Outstanding shares 50,000 55,000

In this example, total paid-in capital is increased by $75,000, and retained earn-
ings is decreased by the same amount. Note also that total stockholders’ equity
remains unchanged at $800,000.

STOCK SPLITS
A stock split, like a stock dividend, involves the issuance of additional shares to
stockholders according to their percentage ownership. A stock split results in a re-
duction in the par or stated value per share. The purpose of a stock split is to in-
crease the marketability of the stock by lowering its market value per share. A
lower market value also makes it easier for the corporation to issue additional
stock.
The effect of a split on market value is generally inversely proportional to the HELPFUL HINT
size of the split. For example, after a two-for-one stock split, the market value of A stock split changes the par
a stock will fall. The lower market value stimulates market activity. value per share but does not
In a stock split, the number of shares is increased in the same proportion that affect any balances in stock-
holders’ equity.
par or stated value per share is decreased. For example, in a two-for-one split, one
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444 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

share of $10 par value stock is exchanged for two shares of $5 par value stock. A
stock split does not have any effect on total paid-in capital, retained earnings, or
total stockholders’ equity. But the number of shares outstanding increases. These
effects are shown in Illustration 14-23 for Medland Restaurants, assuming that it
splits its 50,000 shares of common stock on a two-for-one basis.

Illustration 14-23
Before After
Stock split effects Stock Split Stock Split
Stockholders’ equity
Paid-in capital
Common stock $500,000 $500,000
Paid-in capital in excess of par value –0– –0–
Total paid-in capital 500,000 500,000
Retained earnings 300,000 300,000
Total stockholders’ equity $ 800,000 $ 800,000
Outstanding shares 50,000 100,000

SYSCO Corporation is well known for splitting its stocks. In the past twenty-five
years, it has had eight splits. The earlier splits were three-for-two and the latter
were two-for-one. If you owned two shares of SYSCO in 1979, you will have 288
shares today! A stock split does not affect the balances in any stockholders’ eq-
uity accounts. Therefore, it is not necessary to journalize a stock split. However, a
memorandum entry explaining the effect of the split is typically made.
The significant differences between stock splits and stock dividends are shown
in Illustration 14-24.

Illustration 14-24
Item Stock Split Stock Dividend
Differences between the
effects of stock splits and Total paid-in capital No change Increase
stock dividends Total retained earnings No change Decrease
Total par value (common stock) No change Increase
Par value per share Decrease No change

ACCOUNTING IN ACTION Business Insight

A handful of U.S. companies have no intention of keeping their stock trading
in a range accessible to mere mortals. These companies never split their stock,
no matter how high their stock price gets. The king is investment company
Berkshire Hathaway’s Class A stock, which sells for a pricey $110,100—per
share! The company’s Class B stock is a relative bargain at roughly $3,663 per share.
Another “premium” stocks is Mechanics Bank of Richmond, California, at $19,500.

B E F O R E Y O U G O O N . . .
▼

REVIEW IT
1. What entries are made for cash dividends on (a) the declaration date, (b) the record
date, and (c) the payment date?
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Retained Earnings 445

2. Distinguish between a small and a large stock dividend, and indicate the basis for
valuing each kind of dividend.
3. Contrast the effects of a small stock dividend and a two-for-one stock split on (a) stock-
holders’ equity and (b) outstanding shares.
▼

DO IT
Sing Resort Company has had five years of record earnings. Owing to this success, the mar-
ket price of its 500,000 shares of $2 par value common stock has tripled from $15 per share
to $45. During this period, paid-in capital remained the same at $2 million. Retained earn-
ings increased from $1.5 million to $10 million. President Jan Ellis is considering either (1)
a 10 percent stock dividend or (2) a two-for-one stock split. She asks you to show the be-
fore-and-after effects of each option on (a) retained earnings and (b) total stockholders’
equity and the total shares outstanding.

ACTION PLAN
• Calculate the stock dividend’s effect on retained earnings by multiplying the number
of new shares times the market price of the stock (or par value for a large stock div-
idend).
• Recall that a stock dividend increases the number of shares without affecting total
equity.
• Recall that a stock split only increases the number of shares outstanding and
decreases the par value per share.
SOLUTION
(a) (1) The stock dividend amount is $2,250,000 [(500,000  10%)  $45]. The new bal-
ance in retained earnings is $7,750,000 ($10,000,000  $2,250,000).
(2) The retained earnings balance after the stock split would be the same as it was
before the split: $10 million.
(b) The effects on total stockholders’ equity and total shares outstanding are

Original After After

Balances Dividend Split
Paid-in capital $ 2,000,000 $ 4,250,000 $ 2,000,000
Retained earnings 10,000,000 7,750,000 10,000,000
Total stockholders’ equity $12,000,000 $12,000,000 $12,000,000
Shares outstanding 500,000 550,000 1,000,000

✓ THE
NAVIGATOR

RE TA I N E D EARNINGS
Retained earnings is net income that is retained in the business. The balance in
retained earnings is part of the stockholders’ claim on the total assets of the cor-
STUDY OBJECTIVE 10
poration. It does not, though, represent a claim on any specific asset; nor can the Identify the items that are
amount of retained earnings be associated with the balance of any asset account. reported in a retained
For example, a $100,000 balance in retained earnings does not mean that there earnings statement.
should be $100,000 in cash. The reason is that the cash resulting from the excess
of revenues over expenses may have been used to purchase buildings, equipment,
and other assets. To illustrate that retained earnings and cash may be quite differ-
ent, Illustration 14-25 shows recent amounts of retained earnings and cash in se-
lected companies.
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446 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

Illustration 14-25
(in millions)
Retained earnings and cash
balances Retained
Company Earnings Cash
Walt Disney Co. $17,990 $1,819
Landry’s 198 43
McDonald’s 23,516 4,260
Hilton 1,125 1,336

Remember that when a company has net profit, the net income that is retained
in the business is recorded in retained earnings by means of a closing entry. This
HELPFUL HINT
Remember that Retained Earn-
entry debits Income Summary and credits Retained Earnings.
ings is a stockholders’ equity ac- However, when expenses exceed revenues, a net loss results. A net loss is
count, whose normal balance is debited to Retained Earnings in a closing entry. This is done even if it results
a credit.
in a debit balance in Retained Earnings. Net losses are not debited to paid-in
capital accounts. To do so would destroy the distinction between paid-in and
earned capital. A debit balance in Retained Earnings is identified as a deficit.
It is reported as a deduction in the stockholders’ equity section, as shown in
Illustration 14-26.

Illustration 14-26
Balance Sheet (partial)
Stockholders’ equity with
deficit Stockholders’ equity
Paid-in capital
Common stock $800,000
Retained earnings (deficit) (50,000)
Total stockholders’ equity $750,000

RETAINED EARNINGS RESTRICTIONS

The balance in retained earnings is generally available for dividend declarations.
Some companies state this fact.
In some cases, there may be retained earnings restrictions. These make a por-
tion of the retained earnings balance currently unavailable for dividends. Re-
strictions result from one or more of the following causes: legal, contractual, or
voluntary.
1. Legal restrictions. Many states require a corporation to restrict retained earn-
ings for the cost of treasury stock purchased. The restriction keeps intact the
corporation’s legal capital that is being temporarily held as treasury stock.
When the treasury stock is sold, the restriction is lifted.
2. Contractual restrictions. Long-term debt contracts may restrict retained earn-
ings as a condition for the loan. The restriction limits the use of corporate as-
sets for payment of dividends. Thus, it increases the likelihood that the corpo-
ration will be able to meet required loan payments.
3. Voluntary restrictions. The board of directors may voluntarily create retained
earnings restrictions for specific purposes. For example, the board may author-
ize a restriction for future plant expansion. By reducing the amount of retained
earnings available for dividends, more cash may be available for the planned
expansion.
Retained earnings restrictions are generally disclosed in the notes to the finan-
cial statements.
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Retained Earnings 447

PRIOR PERIOD ADJUSTMENTS

Suppose that a corporation’s books have been closed and the financial statements
have been issued. The corporation then discovers that a material error has been
made in reporting net income of a prior year. How should this situation be recorded
in the accounts and reported in the financial statements?
The correction of an error in previously issued financial statements is known
as a prior period adjustment. The correction is made directly to Retained Earn-
ings because the effect of the error is now in this account: The net income for the
prior period has been recorded in retained earnings through the journalizing and
posting of closing entries.
To illustrate, assume that General Microtels discovers in 2008 that it under-
stated depreciation expense in 2005 by $300,000 due to computational errors.These
errors overstated both net income for 2005 and the current balance in retained
earnings. The entry for the prior period adjustment, assuming all tax effects are
ignored, is as follows:

Retained Earnings 300,000

A = L + SE
Accumulated Depreciation 300,000 300,000 300,000
(To adjust for understatement of depreciation in a
prior period)

A debit to an income statement account in 2008 would be incorrect because the

error pertains to a prior year.
Prior period adjustments are reported in the retained earnings statement.5
They are added (or deducted, as the case may be) from the beginning retained
earnings balance. This results in an adjusted beginning balance. Assuming General
Microtels has a beginning balance of $800,000 in retained earnings, the prior pe-
riod adjustment is reported in Illustration 14-27.

Illustration 14-27
GENERAL MICROTELS
Retained Earnings Statement (partial) Statement presentation of
prior period adjustments
Balance, January 1, as reported $800,000
Correction for overstatement of net income
in prior period (depreciation error) (300,000)
Balance, January 1, as adjusted $500,000

Again, reporting the correction in the current year’s income statement would be
incorrect because it applies to a prior year’s income statement.

RETAINED EARNINGS STATEMENT

The retained earnings statement shows the changes in retained earnings during
the year. The statement is prepared from the Retained Earnings account. Trans-
actions and events that affect retained earnings are tabulated in account form as
shown in Illustration 14-28 on page 448.

5
A complete retained earnings statement is shown in Illustration 14-29 (p. 448).
15339_Weygandt_Ch14.qxp 12/13/07 11:40 PM Page 448

448 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

Illustration 14-28
Retained Earnings
Debits and credits to
retained earnings 1. Net loss 1. Net income
2. Prior period adjustments for 2. Prior period adjustments for
overstatement of net income understatement of net income
3. Cash dividends and stock dividends
4. Some disposals of treasury stock

As indicated, net income increases retained earnings, and a net loss decreases re-
tained earnings. Prior period adjustments may either increase or decrease retained
earnings. Both cash dividends and stock dividends decrease retained earnings. The
circumstances under which treasury stock transactions decrease retained earnings
were explained earlier, on pages 433-435.
Illustration 14-29 shows a complete retained earnings statement for Graber
Hotels, Inc., based on assumed data.

Illustration 14-29
GRABER HOTELS, INC.
Retained earnings statement Retained Earnings Statement
For the Year Ended December 31, 2008
Balance, January 1, as reported $1,050,000
Correction for understatement of net income
in prior period (inventory error) 50,000
Balance, January 1, as adjusted 1,100,000
Add: Net income 360,000
1,460,000
Less: Cash dividends $100,000
Stock dividends 200,000 300,000
Balance, December 31 $1,160,000

B E F O R E Y O U G O O N . . .
▼

REVIEW IT
1. How are retained earnings restrictions generally reported?
2. What is a prior period adjustment, and how is it reported?
3. What are the principal sources of debits and credits to Retained Earnings?

DO IT
▼

Vega Casino Corporation has retained earnings of $5,130,000 on January 1, 2008. During
the year, Vega earns $2 million of net income. It declares and pays a $250,000 cash divi-
dend. In 2008, Vega records an adjustment of $180,000 owing to the understatement of
2007 depreciation expense from a mathematical error. Prepare a retained earnings state-
ment for 2008.

ACTION PLAN
• Recall that a retained earnings statement begins with retained earnings, as reported
at the end of the previous year.
• Add or subtract any prior period adjustments to arrive at the adjusted beginning
figure.
• Add net income and subtract dividends declared to arrive at the ending balance in
retained earnings.
15339_Weygandt_Ch14.qxp 12/13/07 11:40 PM Page 449

Retained Earnings 449

SOLUTION

VEGA CASINO CORPORATION

Retained Earnings Statement
For the Year Ended December 31, 2008
Balance, January 1, as reported $5,130,000
Correction for overstatement of net income
in prior period (depreciation error) (180,000)
Balance, January 1, as adjusted 4,950,000
Add: Net income 2,000,000
6,950,000
Less: Cash dividends 250,000
Balance, December 31 $6,700,000

✓
THE
NAVIGATOR

D E M O N S T R AT I O N P R O B L E M
The Rolman Hotel Corporation is authorized to issue 1 million shares of $5 par value common
stock. In its first year, 2008, 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, 2008.

S O L U T I O N T O D E M O N S T R AT I O N P R O B L E M

(a) Jan. 10 Cash 3,200,000

Common Stock 2,000,000
Paid-in Capital in Excess of Par Value 1,200,000 ACTION PLAN
(To record issuance of 400,000 shares of $5 • When common stock has
par value stock) a par value, credit Com-
mon Stock for par value.
July 1 Land 825,000 • Use fair market value in a
Common Stock 500,000 noncash transaction.
Paid-in Capital in Excess of Par Value 325,000 • Debit and credit the
(To record issuance of 100,000 shares of $5 Treasury Stock account at
par value stock for land) cost.
• Record differences
Sept. 1 Treasury Stock 90,000 between the cost and the
Cash 90,000 selling price of treasury
(To record purchase of 10,000 shares of stock in stockholders’
treasury stock at cost) equity accounts, not as
gains or losses.
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450 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

Dec. 1 Cash 40,000

Treasury Stock 36,000
Paid-in Capital from Treasury Stock 4,000
(To record sale of 4,000 shares of treasury
stock above cost)

(b) ROLMAN HOTEL CORPORATION

Balance Sheet (partial)
December 31, 2008
Stockholders’ equity
Paid-in capital
Capital stock
Common stock, $5 par value, 1,000,000 shares
authorized, 500,000 shares issued, 494,000
shares outstanding $2,500,000
Additional paid-in capital
In excess of par value $1,525,000
From treasury stock 4,000
Total additional paid-in capital 1,529,000
Total paid-in capital 4,029,000
Retained earnings 200,000
Total paid-in capital and retained earnings 4,229,000
✓ THE
Less: Treasury stock (6,000 shares) (54,000)
NAVIGATOR Total stockholders’ equity $4,175,000

SU M M A R Y OF STUDY OBJECTIVES
1. Identify the major characteristics of a sole proprietorship. The 6. Record the issuance of common stock. When the issuance
major characteristics of a sole proprietorship are easy formation, of common stock for cash is recorded, the par value of the
no dilution of profits, limited life, and unlimited liability. shares is credited to Common Stock; the portion of the pro-
2. Identify the major characteristics of a partnership. The ma- ceeds that is above or below par value is recorded in a sepa-
jor characteristics of a partnership are association of individ- rate paid-in capital account. When no-par common stock has
uals, mutual agency, limited life, unlimited liability, and co- a stated value, the entries are similar to those for par value
ownership of property. stock. When no-par does not have a stated value, the entire
3. Explain the accounting entries for the formation of a proceeds from the issue become legal capital and are credited
partnership. Each partner’s initial investment in a partner- to Common Stock.
ship should be recorded at the fair market value of the as- 7. Explain the accounting for treasury stock. The cost
sets at the date of their transfer to the partnership. The val- method is generally used in accounting for treasury stock.
ues assigned must be agreed to by all of the partners. Cash, Under this approach, Treasury Stock is debited at the price
Equipment, or other asset accounts are debited. The same paid to reacquire the shares. The same amount is credited
amount is credited under the partner’s name in the capital to Treasury Stock when the shares are sold. The difference
account. between the sales price and the cost is recorded in stock-
4. Identify the bases for dividing net income or net loss. Part- holders’ equity accounts, not in income statement
nership net income or loss is shared equally unless the part- accounts.
nership contract specifically indicates the manner in which 8. Differentiate preferred stock from common stock. Pre-
net income and net loss are to be divided. The same basis of ferred stock has contractual provisions that give it priority
division usually applies to both net income and net loss. over common stock in certain areas. Typically, preferred
5. Identify the major characteristics of a corporation. The ma- stockholders have a preference as to (1) dividends and (2)
jor characteristics of a corporation are separate legal existence, assets in the event of liquidation. They usually do not have
limited liability of stockholders, transferable ownership rights, voting rights.
ability to acquire capital, continuous life, corporation manage- 9. Prepare the entries for cash dividends and stock dividends.
ment, government regulations, and additional taxes. Entries for both cash and stock dividends are required at the
15339_Weygandt_Ch14.qxp 12/13/07 11:40 PM Page 451

Glossary 451

declaration date and at the payment date. At the declaration 10. Identify the items that are reported in a retained earnings
date, the entries are: Cash dividend—debit Retained Earnings statement. Each of the individual debits and credits to retained
and credit Dividends Payable; small stock dividend—debit earnings should be reported in the retained earnings statement.
Retained Earnings, credit Paid-in Capital in Excess of Par (or Additions consist of net income and prior period adjustments
Stated) Value, and credit Common Stock Dividends Distrib- to correct understatements of prior years’ net income. Deduc-
utable. At the payment date, the entries for cash and stock div- tions consist of net loss, adjustments to cor-
idends, respectively, are: debit Dividends Payable and credit rect overstatements of prior years’ net in- ✓THE
Cash; and debit Common Stock Dividends Distributable and come, cash and stock dividends, and some NAVIGATOR
credit Common Stock. disposals of treasury stock.

GL O S S A R Y
Articles of co-partnership A document detailing the organi- Partnership An asssociation of two or more persons to carry
zation of the partnership and including information such as on as co-owners of a business for profit (p. 413).
name and principal location of the firm, the purpose of the Partners’ capital statement The owners’ equity statement for
business, and the date of inception (p. 415). a partnership (p. 419).
Authorized stock The amount of stock that a corporation is Par value stock Capital stock that has been assigned a value
authorized to sell as indicated in its charter (p. 426). per share in the corporate charter (p. 428).
Bylaws The internal rules and procedures for conducting the Payment date The date dividend checks are mailed to stock-
affairs of a corporation (p. 424). holders (p. 440).
Cash dividend A pro rata distribution of cash to stockhold- Preferred stock Capital stock that has contractual preferences
ers (p. 438). over common stock in certain areas (p. 436).
Charter A document that creates a corporation (p. 424). Prior period adjustment The correction of an error in previ-
Corporate capital The owners’ equity in a corporation. Also ously issued financial statements (p. 447).
called stockholders’ equity or shareholders’ equity (p. 424). Privately held corporation A corporation that has only a few
Corporation A business organized as a legal entity separate stockholders and whose stock is not available for sale to the
and distinct from its owners under state corporation law general public (p. 420).
(p. 420). Publicly held corporation A corporation that may have thou-
Cumulative dividend A feature of preferred stock entitling sands of stockholders and whose stock is regularly traded on
the stockholder to receive current and unpaid prior year div- a national securities market (p. 420).
idends before common stockholders receive any dividends Record date The date when ownership of outstanding shares
(p. 437). is determined for dividend purposes (p. 439).
Declaration date The date the board of directors formally de- Retained earnings Net income that is retained in the business
clares the dividend and announces it to stockholders (p. 439). (p. 445).
Deficit A debit balance in retained earnings (p. 446). Retained earnings restrictions Circumstances that make a
Dividend A distribution by a corporation to its stockholders portion of retained earnings currently unavailable for divi-
on a pro rata (equal) basis (p. 438). dends (p. 446).
General partner This partner’s liability is not limited to his or Retained earnings statement A financial statement that shows
her capital equity in the business.There must always be at least the changes in retained earnings during the year (p. 447).
one partner with unlimited liability in a partnership (p. 414). Sole proprietorship A business owned by one individual
Income ratio The basis for dividing both net income and net (p. 412).
loss in a partnership (p. 416). Stated value The amount per share assigned by the board of
Legal capital The amount per share of stock that must be re- directors to no-par stock that becomes legal capital per share
tained in the business for the protection of corporate credi- (p. 428).
tors (p. 428). Stock dividend A pro rata distribution of the corporation’s
Limited partnership This partner’s liability is limited to his or own stock to stockholders (p. 441).
her capital equity in the business (p. 414). Stock split The issuance of additional shares of stock to stock-
Liquidating dividend A dividend declared out of paid-in cap- holders accompanied by a reduction in the par or stated
ital (p. 438). value per share (p. 443).
No-par value stock Capital stock that has not been assigned Stockholders’ equity account A statement that shows the
a value in the corporate charter (p. 428). changes in each stockholders’ equity account and in total
Organization costs Costs incurred in the formation of a cor- stockholders’ equity during the year (p. 442).
poration (p. 424). Treasury stock A corporation’s own stock that has been is-
Outstanding stock Capital stock that has been issued and is sued, fully paid for, and reacquired by the corporation but
being held by stockholders (p. 434). not retired (p. 432)
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452 CHAPTER 14 Sole Proprietorships, Partnerships, and Corporations

EX E R C I S E S
Prepare entries for the 14-1 Lori and Timothy combined their savings to open the Tres Leche Bakery. Lori invested
formation of a partnership. $10,000 in cash, whereas Timothy put in $7,500 in cash and some kitchen equipment with a book
(SO 3) value at $8,000, accumulated depreciation at $2,000, and a market value at $5,000. Provide the
journal entries to record these investments.
Prepare entries for the 14-2 Chris and Carl have been partners for more than five years in their catering business,
formation of a partnership. where Chris put in 40 percent of the equity and Carl put in the other 60 percent. With the growth
(SO 3) of the business, Chris and Carl decide to part ways and each open up a new catering company.
If the total amount in the Income Summary is $80,000, prepare the entries needed for Chris
and Carl to close the Income Summary amount and also their capital accounts.
Journalize the division of 14-3 After Carl starts his own catering company, he realizes that there is a lot of demand for
income of a partnership. desserts from his clients. Therefore, he negotiates with another friend, Mike, who is a pastry chef
(SO 4) at a five-star hotel, to become a partner with him in this new venture. On January 1, 2008, 5-
Star Gourmet Desserts started with $30,000 from Carl and $40,000 from Mike. The net income
of the first year was $12,000. If the income is divided according to their capital, how should the
income be divided?
Journalize the division of 14-4 Referring back to 14-3, please prepare the partner’s capital statement for the year ended
income of a partnership. December 31, 2008, for 5-Star Gourmet Desserts if Mike withdraws $1,000 from the partnership.
(SO 4)
14-5 During the first year of operations, Benji’s Health Club had the following transactions
Journalize issuance of
common stock.
pertaining to its common stock:
(SO 6) Jan. 8 Issued 50,000 shares for cash at $10 per share.
Aug. 1 Issued 25,000 shares for cash at $12 per share.
Instructions
(a) Journalize the transactions, assuming that the common stock has a par value of $1 per share.
(b) Journalize the transactions, assuming that the common stock is no-par with a stated value
of $0.50 per share.
Prepare entries for issuance of 14-6 Cocoa Beach Hotels and Resorts had the following transactions during the current period:
common stock and purchase
Feb. 22 Issued 10,000 shares of $1 par value common stock to attorneys in payment
of treasurt stock.
of a bill for $30,000 for services rendered in helping the company to incorpo-
(SO 6, 7, 8)
rate.
Mar. 23 Issued 80,000 shares of $1 par value common stock for cash of $400,000.
July 15 Issued 2,000 shares of $100 par value preferred stock for cash at $125 per share.
Dec. 1 Purchased 3,000 shares of treasury stock for $90,000.
Instructions
Please prepare the necessary journal entries for these transactions.
Journalize cash dividends; 14-7 On June 1, Meyers Hotel Corporation had 80,000 shares of no-par common stock issued
indicate statement presentation. and outstanding. The stock has a stated value of $10 per share. During the year, the following
(SO 9) occurred:
Jul. 1 Issued 10,000 additional shares of common stock.
Aug. 1 Declared a cash dividend of $1.50 per share to stockholders of record on Au-
gust 30.
Oct. 1 Paid the $1.50 per share cash dividend.
Nov. 3 Issued 2,500 additional shares of common stock.
Dec. 3 Declared a cash dividend on outstanding shares of $1.60 per share to stock-
holders of record on December 31.
Instructions
(a) Prepare the entries, if any, on each of the three dividend dates.
(b) How are dividends and dividends payable reported in the financial statements prepared
at December 31?
15339_Weygandt_Ch14.qxp 12/13/07 11:40 PM Page 453

Exercises 453

14-8 On March 1, 2008, Peluso Hotels had retained earnings of $690,000. During the year, Prepare a retained earnings
Peluso had the following selected transactions: statement.
(SO 10)
1. Declared cash dividends $155,000.
2. Corrected understatement of 2007 net income because of inventory valuation error of
$35,000.
3. Earned net income $411,500.
4. Declared stock dividends $50,000.

Instructions
Prepare a retained earnings statement for the year.
14-9 A June 1999 issue of Money magazine included an article by David Futrelle entilted
“Stock Splits: How the Dumb Get Rich.”
Instructions
Read the article and answer the following questions:
(a) What is a stock split?
(b) How do anxious traders and investors obtain timely information about stock splits?
(c) What are the statistics relative to market-price reactions for stocks of companies that
have split their stocks?
(d) Is there a downside to buying the stock of companies that announce stock splits?

EXPLORING THE WEB

14-11 SEC filings of publicly traded companies are available to view online.
Address: http://biz.yahoo.com/i/
Steps
1. Pick a company, and type in the company’s name.
2. Choose Quote.
Instructions
Answer the following questions.
(a) What company did you select?
(b) What is its stock symbol?
(c) What was the stock’s trading range today?
(d) What was the stock’s trading range for the year?

✓
■
■ Remember to go back to the Navigator box on the chapter-opening page and
check off your completed work.