The advantages and disadvantages of alternative entity forms

chapter 8

Corporate and Partnership Equity

Learning Goals

• Recite the advantages and disadvantages of alternative entity forms.

• Account for the formation of a sole proprietorship or partnership.

• Understand concepts related to distributing partnership income.

• Know the principles related to accounting for the admission/withdrawal of a partner.

• Account for special corporate equity transactions, including issuance of par value stock, dividends, treasury stock transactions, and stock splits.

• Understand and apply principles for reporting of special events that require modifica- tion of the income statement.

© Corbis/SuperStock

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176

CHAPTER 8Chapter Outline

Chapter Outline 8.1 The Corporation 8.2 The Partnership 8.3 The Sole Proprietorship 8.4 Accounting for Sole Proprietorships and Partnerships

Basic Accounting Considerations Initial Investments Income Sharing New Partners

8.5 Corporate Equity Transactions Par Value Cash Dividends Treasury Stock Stock Splits and Stock Dividends Income Reporting

8.6 Corrections of Errors and Changes in an Accounting Method

Thus far, the examples in this book have relied on an assumption that a corporation is conducting business. However, not all businesses are structured as corporations. There is no such requirement; there are indeed many alternatives. Corporations may be the most familiar because it is usually the entity form that is used to structure larger orga- nizations, the type in which you can easily buy and sell units of ownership (i.e., stock) and the type in which megabusinesses offers products you routinely buy. However, there are many alternative ways that a business can be organized.

Broadly speaking, business activity can be conducted through a corporation, partnership, or sole proprietorship. Within these three broad groupings, there are many subdivisions such as LLCs (limited liability corporations), LLPs (limited liability partnerships), and others. You may hear of other terms, such as S corporations (also called Sub-Chapter S corporations). The finer distinctions are important for legal and tax reasons but don’t sig- nificantly alter the accounting principles. Therefore, we focus our analysis of entity differ- entiation on the broader hierarchy related to corporations, partnerships, and sole propri- etorships. At the outset, you should note that our differentiation relates primarily to issues pertaining to accounting for topics related to owner’s equity. The fundamental accounting for assets, liabilities, revenues, and expenses is rarely impacted by the choice of entity.

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177

CHAPTER 8Section 8.1 The Corporation

8.1 The Corporation

Because we have been using the corporation for our examples, let’s begin by thinking deeper about its advantages and disadvantages. A corporation is a legal entity having existence separate and distinct from its stockholders. Corporations exist only in the legal sense and cannot exist unless specific actions are taken.

However, one does not have to form a corporation to conduct business. Business can also be conducted via a sole proprietorship or partnership. As you read on, you will quickly find that one should only use the sole proprietorship or partnership by design, not by accident.

Why would you want to consider forming your business as a corporation? For starters, it permits otherwise unaffiliated persons to join together in mutual ownership of a business. Funds can be accumulated and concentrated into one organization. Significant pooling of resources can occur that might not otherwise be possible. A corporate strategy often might entail a large amount of risk with highly uncertain outcomes. Probably you are willing to risk a small amount of your wealth on speculative investments with the potential for a high payoff, but you are unlikely to bet everything you have. This is often the dilemma faced by new businesses.

Some ventures are so large that shared ownership is essentially required. Therefore, the stock of the corporation provides a perfect vehicle for mutual ownership of a business. Each shareholder can invest at a level that matches his or her wealth and risk tolerance attributes. An important aspect of the corporate form of organization is that shareholders are usually only at risk for the amount they invest in the company’s stock. Creditors can- not pursue shareholders for additional claims beyond the shareholder investments.

Most corporations allow shareholders to vote in proportion to their shares, with one vote per share. This democratic process allows shareholders to participate in corporate gover- nance based on the level of their investment. Shareholders vote on matters set forth in the bylaws. The voting is usually conducted on a ballot that is termed the proxy.

Another advantage of the corporate form of organization is the relative ease with which shares of stock can be transferred to another. Stockholders can normally sell their shares to others or buy more shares without direct involvement by the corporation. Transferability of ownership makes stock a relatively liquid asset to its holder. Further, companies can often access additional capital by issuing more shares to current and new shareholders.

In some cases, a company may go public, meaning that it lists it shares on one of the popular stock exchanges, such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotation (NASDAQ) system. An initial public offering (IPO) of shares is an exciting (and costly) decision, and is some- times accompanied by so-called road shows and various other promotions designed to mar- ket the offering. Road shows are company-sponsored events where corporate executives present their business case in the hopes of developing interests among potential investors.

A corporation is presumed to have a perpetual existence. Changes in stock ownership do not cause operations to cease. The death of a shareholder does not bring about a need to dissolve the company. Instead, the beneficiaries of the estate of the deceased become

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CHAPTER 8Section 8.1 The Corporation

new owners. A corporation will continue to exist and operate until it is merged in with another, fails, or a corporate action is undertaken to liquidate the company. When the lat- ter happens, all bills must be paid, and common shareholders are entitled to final distribu- tions of any residual funds in proportion to shares held.

Perhaps one of the most significant advantages of a corporation, especially when com- pared to partnerships and sole proprietorships, is the feature of limited liability. The liability of stockholders is normally limited to the amount of their investment. Stockhold- ers are not personally liable for debts and losses of the company, except to the extent of their investment, or any additional guarantee of corporate debt. However, you should be aware that a corporate entity is not a perfect shield against all liability. If affairs of the shareholders are comingled with the corporation or there is malfeasance by shareholders/ officers, a lawsuit may be filed by damaged parties against the shareholder or officer. It is not always possible to avoid these types of claims, but taking care to meet good legal and accounting practices is a good start. This underscores the need for you to be well versed in proper accounting procedures and internal controls in managing your own businesses and investments.

The preceding advantages may lead you to believe that the corporation is an ideal legal structure for a business. However, there are some big disadvantages. Corporations are frequently taxable entities—that is, their income is taxed. This is a big problem because it can result in double taxation on income. The company pays tax on its income, and then shareholders again may pay tax on this same income when it is distributed to them in the form of taxable dividends. Thus, it is not uncommon for over half of a corporation’s earn- ings to be taxed away prior to being available to shareholders for their own use.

To illustrate this effect, assume that Mega Corporation earned $100,000,000 before tax. Assuming a 35% tax rate, the remaining income after tax would be $65,000,000. If that entire amount was distributed to shareholders in a taxable transaction and assuming shareholders were subject to an average 40% tax rate, then an additional $26,000,000 of tax would be paid ($65,000,000 3 40%). Of the $100,000,000 in pretax income, sharehold- ers would only realize $39,000,000 ($100,000,000 2 $35,000,000 2 $26,000,000).

There are planning vehicles to limit the double-taxation impacts, and various tax rules are occasionally adjusted to provide some relief, but this disadvantage cannot be wholly avoided. A good tax accountant should be consulted in finding the right corporate strat- egy, lest the effects can mitigate much of the profit motive associated with the initial busi- ness objective.

Corporations also suffer under the weight and cost of added regulatory oversight, espe- cially when the stock is publicly traded. Agencies such as the Securities and Exchange Commission (SEC) impose stringent reporting guidelines, including mandatory and expensive audits. Additional rules require companies to have strong internal controls and ethical training. The financial statements must also be certified by senior officers who do so under the risk of prosecution for perjury. To be sure, if you were an officer being required to sign such documents, you would undoubtedly expend ample funds to ensure that the statements were reliable. Suffice it to say, the cumulative cost of meeting regula- tory stipulations is high.

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179

CHAPTER 8Section 8.2 The Partnership

8.2 The Partnership

A partnership is another form of business organization that brings together multiple parties. The specific definition of a partnership is an association of two or more per- sons to carry on a business for profit as co-owners. However, in some ways, this also seems to describe a corporation. What is it that uniquely pertains to a partnership and sets it apart from a corporation?

For starters, a partnership is not a separate legal entity. It is an association of persons. Part- nerships are formed quite easily, without the necessity of any specific legal action. Indeed, by default, the mere joining together of persons for a profit-oriented business purpose is a partnership, unless some alternative action is undertaken to set up a corporation (or other entity type, such as a joint-venture agreement). This feature does not preclude formaliz- ing a partnership agreement via a written document. As you will soon see, preparation of such documentation, though not a legal requirement, is a good practice. Without such an agreement, the partnership’s governance, profit sharing, and the like will be established by standard practices set forth in statute and case law history. The results at times can be surprising. Thus, it is highly recommended that partnerships agreements be reduced to a written agreement. This written agreement is sometimes termed the articles of partnership, but it is generally not necessary to notify regulatory authorities about the terms or exis- tence of the partnership (except as it relates to tax-reporting issues).

You need to recognize the significant attributes of a partnership. First is the principle of mutual agency. This means that any individual partner has a right to commit or obligate the entire partnership. It is not possible for one partner to disavow the actions of another partner that were taken on behalf of the partnership. This can be a scary proposition. When you enter a partnership, you are bound to honor every contract or debt it under- takes, whether you were consulted or agree.

As an extension of the concept of mutual agency, you also need to know that all prop- erty and income of a partnership is held under co-ownership unless there is a specific agreement calling for an alternative outcome. Technically, the partners own everything in equal proportion and are each entitled to an equal share of income and distributions from the partnership. This feature should not be overlooked. When one or more partners contribute tangible assets to the partnership, they forgo their specific interest in the assets in exchange for a mutual interest in the business. They are not entitled to a return of those specific assets if the partnership liquidates. Instead, they are only entitled to a monetary distribution equivalent of their measured share of total capital.

As the partnership generates profits, each partner accrues an equal share of benefit, regardless of their capital contribution and work effort. This is huge. Rarely will all part- ners contribute equal amounts of capital and effort. Thus, a written partnership agree- ment that modifies this standard provision is paramount to maintenance of equitable out- comes. Written agreements typically include specific provisions related to how income is to be shared, how distributions will occur, and so forth. But without such an agreement, the one-for-all, all-for-one rule of co-ownership is generally deemed to be the appropriate outcome. Perhaps you can begin to see why a partnership, despite its ease of formation, has certain disadvantages. There are, however, additional problems to consider.

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CHAPTER 8Section 8.2 The Partnership

Unlike a corporation, a partnership has a limited life. In other words, the partnership passes with the death of a partner, and the partnership is legally dissolved. A new one may be immediately formed; written agreements usually make provisions for the dissolution and reformation upon the death of a partner. At other times, where a deceased partner was crucial to business operations, the dissolution may also trigger a cessation of business operations and formal liquidation of the entity. Clearly, this complicating feature is yet another limitation on the desirability of doing business as a partnership.

In the strictest technical sense, the concept of partnership dissolution occurs each time a new partner joins (or a prior partner leaves) the partnership. This does not mean that operations cease; it simply means that a new partnership is formed. Dissolutions may be relatively invisible from the perspective of clients and suppliers to a partnership, but it does trigger unique internal accounting aspects to which you will soon be exposed.

Perhaps some of the unique partnership attributes are sufficient to give you pause as it relates to being involved in a partnership. If not, perhaps the next aspect will. Partners in a partnership have personal unlimited liability for the debts, claims, and obligations of the partnership. Each partner is individually liable; one cannot simply resign from the partnership in an effort to escape his or her share of responsibility. This characteristic is directly attributable to the fact that a partnership is not a separate legal entity. Unlimited liability makes a partner’s personal assets at risk to seizure for satisfaction of obligations of the partnership.

Historically, unlimited liability has been a severe limitation to the partnership form of orga- nization and has posed vexing problems for medical practices, law firms, and accounting groups. Many professional service firms have not been able to organize as corporations because of licensing issues that attach to individuals and not businesses (e.g., only an indi- vidual, not a business, can get a CPA designation). Thus, professional service firms tra- ditionally formed up as partnerships. But, the increase in litigation exposure has caused many to back away from consideration of alignment in a partnership. To remedy this problem, many states now also recognize limited liability partnerships (LLP). This form of entity provides that only firm assets may be used to satisfy claims against an LLP. There- fore, the personal assets of individual partners are afforded some degree of protection.

At this juncture you may be wondering why anyone would wish to join a partnership. Despite its shortcomings, the partnership form of organization does have some compel- ling advantages. Recall that the business is easily formed. Indeed, if more than one per- son is involved in a business for profit, the partnership is deemed to be the default form of organization. The ease of formation is a double-edged sword. Although it is a simple process, it also opens up the partners to the challenges already identified. Basically, one should make business choices by reason, not default. This underscores why understand- ing the strengths and weaknesses of the partnership form of organizations is so important.

Partnerships also benefit from their intrinsic agility. Because partners can act on behalf of the partnership, they can behave with operating flexibility and streamlined decision pro- cesses. This can enable rapid action in response to new business opportunities.

In closing, one should not overlook one of the most compelling benefits of a partner- ship. Partnerships are not subject to tax on their income. Instead, each partner’s share of

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CHAPTER 8Section 8.3 The Sole Proprietorship

the income, whether distributed or not, is taxed to the partners. This avoids the double- taxation problem that is associated with most corporate entities, as illustrated earlier. Legally avoiding taxes is a huge business advantage, and can trump the other concerns that persons may have about forming a partnership. As an important point of informa- tion, do not confuse the lack of being taxable with the lack of filing a tax return. A partner- ship must calculate and report its income to the government and partners, but this is an informational process intended to alert interested parties about the amount of income that partners are expected to pay tax on.

8.3 The Sole Proprietorship

In simple terms, you can think of a sole proprietorship as a one-person partnership. It is not a partnership, but the legal and technical requirements operate in much the same way. No specific legal action is necessary to start the business, although there are a number of good practices. For instance, if an individual began doing business under an “assumed name” such as Jan’s All Seasons Lodge, she would likely want to file an assumed-named certificate, register an appropriate Internet site, notify licensing and tax agencies, and so forth. However, she does not need specific authorization to create an entity. Indeed, she is the entity. When doing business under an assumed name, procurement of the assumed- name certification is a very good business practice. This provides protection against other persons “copying” your business identity and is often required to conduct banking and other similar transactions. In many states, obtaining an assumed-name certificate is eas- ily done through a county clerk’s office, takes only a few minutes, and requires paying a small fee.

Sole proprietors are obviously responsible for their debts. If the business fails, the busi- ness owner cannot just apologize and tell creditors the business no longer exists. Gover- nance issues are nonexistent, for perhaps rather obvious reasons. There are no partners or shareholders; thus, sole proprietors answer only to themselves.

Sole proprietorships do not file separate tax returns. Owners will prepare a schedule detailing the business income and include this schedule with their tax return. You prob- ably work in a job where you receive salary and wages, and you likely understand how these amounts are reported in your own tax return. In similar fashion, a sole proprietor- ship’s income is captured as a taxable component in an individual’s income tax return. The business income of a sole proprietorship is subject to not only income tax but also many of the payroll taxes discussed in Chapter 7. Social Security and Medicare taxes are twice the amount imposed directly on employees because the sole proprietor must assume obliga- tion for both the employee and employer components of the tax.

Despite the merging of personal and business income for tax purposes, there is still a full expectation that a sole proprietorship will maintain appropriate business records. Only certain expenses that are ordinary and necessary for the conduct of the business can be deducted from the business’s revenues. You cannot subtract your personal living costs from business income in determining how much taxable income you have derived from your business. Thus, appropriate segregation of personal and business affairs is a must, and good business accounting practices are to be followed for a sole proprietorship.

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CHAPTER 8Section 8.4 Accounting for Sole Proprietorships and Partnerships

Table 8.1 highlights the key features of various forms of business organization. The fea- tures and observations are broad generalizations but provide a frame of reference to con- sider when selecting an entity structure.

Table 8.1: Features of various business organizations

Sole Proprietorship Partnership Corporation

Ease of formation Yes Yes No

Multiple owners No Yes Yes

Transferability Not easily done Not easily done Easily done

Double taxation No No Yes

Liability protection No No Yes

Separate tax return No Yes Yes

Operating agility High Medium Depends on number of stockholders

Perpetual life No No Yes

Degree of regulation Low Medium High

8.4 Accounting for Sole Proprietorships and Partnerships

You have discovered that sole proprietorships and partnerships are easily formed and by similar actions. Remember, you can think of a sole proprietorship like a one- member partnership. Thus, the basic accounting for formation and most subsequent actions is handled in a virtually identical fashion. A key distinction is that a partnership has multiple capital accounts (one for each partner) representing a subdivision of total equity. This division is unnecessary with a sole proprietorship. Another unique facet is that unique accounting issues can arise when partners join/leave a partnership, and no equivalent counterpart issue exists for a sole proprietorship. Otherwise, it is safe to say that if you understand partnership accounting, you also understand accounting for a sole proprietorship. The following discussion focuses on the more complex partnership issues, with additional notes on modifications that are necessary for a sole proprietorship.

Basic Accounting Considerations Recall that the choice of the entity rarely impacts the accounting for assets, liabilities, revenues, and expenses. Our focus is on key differences in equity accounting. You know that a corporation’s equity is subdivided into contributed capital (capital stock-related accounts) and retained earnings (the lifetime result of income less dividends). Partner- ships and sole proprietorships divide equity in an entirely different fashion. They report a capital account for each owner. Each capital account reflects the net balance of the owner’s investments and share of net income, reduced for withdrawals. Consider the three equity sections for a corporation, partnership, and sole proprietorship, respectively in Table 8.2.

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Table 8.2: Equity sections for a corporation, partnership, and sole proprietorship

Stockholders’ Equity

Capital Stock $ 100,000

Retained Earnings 900,000

Total Stockholders’ Equity $1,000,000

Partnership’s Equity

Owner Capital, Partner A $ 400,000

Owner Capital, Partner B 300,000

Owner Capital, Partner C 300,000

Total Partners’ Equity $1,000,000

Sole proprietorship’s Equity

Owner’s Capital $1,000,000

Initial Investments

A partnership’s or sole proprietorship’s initial activity usually begins when an owner transfers personal assets (e.g., cash or tangible assets) to the business. The following jour- nal entry shows the recording of unequal cash investments by three separate partners:

1-1-X6 Cash 25,000.00

Owner Capital, Anson 12,000.00

Owner Capital, Ortiz 8,000.00

Owner Capital, Payne 5,000.00

To record initial capital investments by Anson, Ortiz, and Payne

In the event of liquidation, each partner’s final cash settlement will be for the balance of his or her capital account (after bringing all accounts and activities current). This explains the justification for correctly recording each partner’s capital contribution at the correct amount. To do otherwise would set in motion a capital account that is forever out of sync with contributions. Importantly, the capital account proportion does not necessarily cor- respond to the income share; Anson, Ortiz, and Payne may have agreed to share profits and losses equally (or in any other proportion) despite their unequal capital investments.

Assume the preceding scenario is modified slightly such that Anson invested land rather than cash. Assume that the land originally cost Anson $4,000, but the partners all agreed it was worth $12,000 on the day Anson contributed it to the partnership. Under the revised scenario, the following entry is appropriate:

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1-1-X6 Cash 13,000.00

Land 12,000.00

Owner Capital, Anson 12,000.00

Owner Capital, Ortiz 8,000.00

Owner Capital, Payne 5,000.00

To record initial capital investments by Anson, Ortiz, and Payne

By reviewing this entry you can clearly see that the $4,000 land cost has become irrelevant, reflecting the general rule that each partner’s contribution should be measured on the partnership books at its fair value on the date of contribution. Failure to follow this gen- eral rule will inadvertently result in an eventual nonreciprocal transfer of wealth between the partners.

If Anson’s land was subject to a $3,000 note payable and the partnership assumed the obligation to make payments, Anson’s Capital account would be reduced, and the part- nership accounts would take on the debt, as follows:

1-1-X6 Cash 13,000.00

Land 12,000.00

Note Payable 3,000.00

Owner Capital, Anson 9,000.00

Owner Capital, Ortiz 8,000.00

Owner Capital, Payne 5,000.00

To record initial capital investments by Anson, Ortiz, and Payne

Income Sharing

Earlier, it was noted that in the absence of a specific profit-and-loss sharing agreement, income is simply shared equally between the partners. This approach would be fair and logical if all partners contributed equal amounts of capital and time, but such is rarely the case. Partnership agreements usually stipulate a model for splitting income. The models can be become complex but tend to reflect provisions designed to compensate parties for invested capital, time, and other variables that are seen as driving results.

To begin, recognize that partnership income is defined as the excess of revenues over expenses, excluding those expenses related to the income-sharing agreement. In other words, the profit-sharing agreement may designate that each partner is entitled to interest equal to 5% of their invested capital and salary based on hours dedicated to the business. Although interest and salaries are usually regarded as expenses in calculating income, such is not the case when the interest and salary clauses are defined pursuant to a model for sharing income. The interest and salary provisions are just mathematical tools for equi- table distribution of income.

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Partnership agreements need to be sufficiently specific to address what happens in the event that profits exceed the contemplated interest and salary provisions or if the firm experiences a loss. There are numerous scenarios and no standard outcome—thus the necessity for a carefully designed agreement.

To illustrate, assume that Anson, Ortiz, and Payne agreed that their partnership profits would be shared as follows:

1. Each partner receives an interest provision equal to 10% of invested capital. 2. Anson will receive an annual salary share of $25,000, and Payne will receive

$40,000. Ortiz is not active in the business and does not receive a salary. 3. Remaining profits are to be shared on a 4:4:2 ratio.

If the firm’s first-year income totaled $100,000, before salary and interest, then it would be shared among the partners as Table 8.3 shows.

Table 8.3: Income sharing in the Anson, Ortiz, and Payne partnership Anson Ortiz Payne Total

Interest (10%) $ 900 $ 800 $ 500 $ 2,200

Salary 25,000 0 40,000 65,000

Subtotal $25,900 $ 800 $40,500 $ 67,200

Residual (4:4:2) 13,120 13,120 6,560 32,800

Total $39,020 $13,920 $47,060 $100,000

The amount of income attributed to each partner does not necessarily equate to a with- drawal. Instead, it reflects the amount that should be credited to the partner’s capital account, as per the following entry that closes the 20X6 Income Summary account:

12-31-X6 Income Summary 100,000.00

Owner Capital, Anson 39,020.00

Owner Capital, Ortiz 13,920.00

Owner Capital, Payne 47,060.00

To close Income Summary to capital accounts of Anson, Ortiz, and Payne

This entry should appear at least reasonably familiar to you. In this entry, the Income Summary reflects the net summation of all revenues and expenses. It is otherwise very similar to the closing entry that was introduced in Chapter 3, except that the credits are to individual partner capital accounts rather than Retained Earnings. If any partner with- draws cash from the business corresponding to all or part of her or his income share, the following entry would be needed:

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12-31-X6 Owner Capital, Payne 10,000.00

Cash 10,000.00

Payne elected to withdraw $10,000 from the partnership

As an alternative, some partnerships may debit individual Drawing accounts for each partner, but they are eventually closed against the partner’s capital account. Thus, the net effect is as shown. The primary advantage of using separate Drawing accounts is that it shows an accumulated amount of total withdrawals for a period. That information is sometimes needed to monitor compliance with partnership agreement provisions and tax-reporting issues.

New Partners

From time to time, a new person may join the partnership. If the business is prosper- ous, it is reasonable to expect that the new partner will be required to buy his or her interest. There are exceptions, such as when the new partner is bringing an extraordinary reputation (e.g., perhaps you have seen a car dealership sporting the name of a famous sports figure), in which case he or she might be admitted into the partnership without any investment. However, when the new partner is buying his or her way into the business, the payment can flow to an existing partner or the partnership itself. The accounting treat- ment varies based on the nature of the purchase.

When an entering partner purchases his or her interest from another partner, the assets and liabilities of the firm remain constant. A journal entry is only needed to reduce the selling partner’s Capital account and increases the new partner’s Capital account.

1-1-X7 Owner Capital, Payne 21,030.00

Owner Capital, Zhu 21,030.00

Payne sold half of her interest to a new partner Zhu, for an undisclosed amount

There are several points to note about this entry. First, Payne sold one half of her interest. Thus, one half of her capital account must be transferred to the new partner, Zhu. Payne’s total Capital account before the transfer was $42,060 ($5,000 initial investment 1 $47,060 of income 2 $10,000 of withdrawals). It does not matter how much Zhu paid for the one-half interest (i.e., it could have been more or less than $21,030) because the money did not flow to the partnership. Payne might have a personal gain or loss, based on the sale price, but that fact does not bear on the partnership accounts. Finally, this transaction likely required approval from the other partners. Because partnerships are based on a theory of mutual agency, each partner normally preserves a right of input on the admission of a new member.

If Zhu had instead invested directly in the partnership, the accounting can become more involved. A number of scenarios and the accounting go well beyond the scope of this text. However, to illustrate one case, assume that Zhu purchased a 20% stake by transferring $100,000 cash directly into the firm. The partnership’s cash account must be increased by $100,000, as will the total equity. However Zhu’s share of total equity is only 20%. After

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considering Zhu’s injection, the firm’s total equity is $212,000 ($22,000 original capital 1 $100,000 of income 2 $10,000 of withdrawals 1 $100,000 new investment), and Zhu’s share is $42,400 ($212,000 3 20%). What becomes of the difference between Zhu’s $100,000 injection and $42,400 capital share? This $57,600 amount is said to be a bonus to existing partners. It reflects the value they have added to the partnership share that is now trans- ferred to Zhu. Assuming that the partnership agreement stipulated that bonuses were to be shared in a 4:4:2 ratio, the following entry would be needed to record Zhu’s admission:

1-1-X7 Cash 100,000.00

Owner Capital, Anson 23,040.00

Owner Capital, Ortiz 23,040.00

Owner Capital, Payne 11,520.00

Owner Capital, Zhu 42,400.00

To record admission of Zhu, with a bonus to existing partners

Although not illustrated here, similar issues arise when an existing partner leaves the partnership. The existing partners or the partnership itself might buy out the leaving part- ner. The amount paid could reflect a price that is different from the reported amount of equity, and a transfer between capital accounts might be needed to maintain appropri- ately measured equity values.

8.5 Corporate Equity Transactions

To this point, we have assumed a fairly simple corporate structure. The equity sectionhas consisted of capital stock and retained earnings. However, corporate entities may not be so simple. For starters, companies may have more than one type of stock.

The unique attributes for each type of stock are customized to meet the capital needs of the company while trying to appeal to a spectrum of investor demands. Many compa- nies will have only common stock, but other companies expand their equity financing to include other types such as preferred stock. Expanded forms of equity and debt financing will be covered in ACC 206. For now, be aware that alternative types of stock may have different features pertaining to voting rights, dividends, and liquidation preferences.

For example, each share of common stock usually has one vote that can be cast toward the election of a board of directors. Preferred stock usually lacks voting rights. Preferred stock usually gets a fixed amount of dividend each period but does not get to participate in excess profits that might be earned. In the event of liquidation, it is customary that pre- ferred shares receive back a liquidation value prior to any amounts being paid to common stock. The common stock is the residual interest, standing to receive the highest returns from significant business success or to sustain the most loss from business failure.

Even the accounting for common stock can introduce general issues beyond those previ- ously discussed. The next few paragraphs covers additional accounting aspects related to common stock. These topics include par value, dividends, treasury stock, stock splits, and

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stock dividends. Even if you do not intend to be an accountant, this information should prove interesting and informative; you are likely to invest in stocks occasionally, and this knowledge will be help you understand more about your investments.

Par Value

Recall that states authorize the creation of corporations. Within enabling statutes is often a provision requiring newly formed corporations to designate a par value per share (or an alternative called stated value). Par value sets the legal capital of the firm, which is intended to represent the minimum amount of initial capital that investors are theoretically obliged to invest. Par value is usually set at a nominal amount (e.g., $.01 per share), and the actual issue price is typically well above par. Thus, par value is really just a legal formality in most cases. However, it does impact required reporting. The generally accepted account- ing principles (GAAP) require companies to detail the legal capital of the firm, separate and apart from amounts of investments exceeding par. This fact requires accountants to expand the journal entry that is required when stock is issued. Assume that Spice Corpo- ration issued 1,000,000 shares of $1 par value stock for $5 per share. The entry to record this stock issuance would be:

5-15-X1 Cash 5,000,000.00

Common Stock 1,000,000.00

Paid-in Capital in Excess of Par 4,000,000.00

To issue 1,000,000 shares of $1 par value stock for $5 per share

In reviewing the preceding entry, specifically note the new account, Paid-in-Capital in Excess of Par. This effectively separates invested capital into two components, both of which must be prominently displayed within stockholders’ equity.

Cash Dividends

Dividends are distributions to shareholders. Dividends are usually in form of direct cash payments and are intended to encourage and reward shareholders. They generally reflect profitable operations over time and reflect a return on the shareholder’s invest- ment. Dividends on common stock are not mandatory. Shareholders benefit from divi- dends, but they can also benefit when the corporation instead decides to reinvest in new opportunities. Thus, even profitable companies may decide that dividends are not the best use of resources.

When a board of directors does decide to pay a dividend, several events transpire. The first event is a declaration of the dividend. The declaration states the intent to pay a divi- dend and sets forth a legal duty to pay. The following entry is usually recorded at the time of dividend declaration:

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8-10-X2 Dividends 500,000.00

Dividends Payable 500,000.00

To record declaration of $0.50 per share dividend on 1,000,000 outstanding shares of common stock

The declaration statement also needs to set forth other important information. Specifically, shareholders need to know the date of record and date of payment. The date of payment is self-explanatory. The following entry would occur on the date of payment:

10-10-X2 Dividends Payable 500,000.00

Cash 500,000.00

To record payment of previously declared dividends

The date of record precedes the payment date and establishes a cutoff point for determining which shareholders are to receive the dividend on the payment date. As a practical matter, the record date is preceded by a few days by an ex-dividend date. A stock is said to trade ex-dividend when the stock’s seller retains the right to previously declared dividends. In other words, the stock is trading without a right to the dividend. This time lag allows for shareholder records to be updated. Very simply, stockholders on the ex-dividend date will receive the dividends; if some of those holders subsequently sell their shares before the dividend payment date, they will nonetheless be entitled to the dividend payment.

Treasury Stock

When a company’s stock price is viewed as being too low and a company has sufficient cash, the board of directors may authorize that the company itself to reacquire some of the previously issued shares. This effort is seen as supporting the stock price and enhanc- ing value for shareholders who choose not to sell their stock back to the company. Such reacquired shares are termed treasury stock. Other reasons for buying back stock are to lessen the risk of takeover by another (returning cash to shareholders via stock buyback can reduce the attractiveness of a company to others) or to obtain shares that are needed for stock compensation awards to employees.

Accounting rules for treasury stock treat the transactions as purely equity in nature. Gains and losses are not recorded when a company issues stock, nor are they recorded for trea- sury stock transactions. Thus, one acceptable journal entry to record the purchase of trea- sury stock is as follows:

7-7-X7 Treasury Stock 300,000.00

Cash 300,000.00

To record purchase of 10,000 treasury shares at $30 per share

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Under the approach shown, the Treasury Stock account reflects the cost of all shares reacquired. It is reported as a Contra Equity account and results in a difference in the reported number of shares issued versus those outstanding (i.e., issued minus shares held in treasury). If treasury shares are subsequently reissued, Cash would be increased for the amount received, and Treasury Stock would be reduced for the cost of the shares; any dif- ference may be debited or credited to Paid-in Capital in Excess of Par.

Stock Splits and Stock Dividends

Another unique set of corporate transactions relates to stock splits and stock dividends. These events result in a change in the shares outstanding, without any resource inflow to the company or change in total stockholders’ equity. For instance, a company may arrange for a 3:1 stock split. This triples the number of shares outstanding (and reduces the per- share par value into a third of the prior amount). Shareholders will hold three times as many shares but experience no increase in their proportional ownership (a shareholder owning 100 shares out of a total of 100,000 would become the owner of 300 shares out of a total of 300,000). The market value per share would likely be reduced to about one third of the value prior to the split. Of course, stock splits can come in any ratio (2:1, 4:3, etc.). Indeed, companies may also engage in a reverse split (2:3, 1:5, etc.). These reverse splits reduce the number of shares and increase the market value per share.

The reasons typically cited for stock splits are to impact the market price per share and change the number of shares outstanding. A company may do a reverse split to reduce the number of shares and increase the value per share. Some stock exchanges require that stocks trade above $1 per share, and the reverse split is a tool to accomplish this purpose. Conversely, stocks that have appreciated significantly (into the hundreds of dollars per share) may be seen as too pricey by some investors. The stock split will reduce share price to what may seem to be a more attractive price point and increase the shares outstanding, thereby opening up investment to a broader group of shareholders. In the final analysis, a stock split is mostly cosmetic because it does not change the underlying economics of the firm.

The accounting for a stock split is easy. Because the total par value of all shares outstand- ing is not affected by a stock split (i.e., number of shares times par value per share is the same amount before and after the split), no journal entry is needed. Recall that total equity is not changed, and no specific account balance total within equity is changed. Thus, all that is necessary is a notation of the new par value and number of shares.

As a practical matter, stock dividends are much like stock splits but are carried out in a different legal form and require a unique entry. A stock dividend results in an increase in shares outstanding via an issuance of more shares to existing shareholders. For instance, a 10% stock dividend would result in the issuance of 10 additional shares to a shareholder holding 100 shares. All shareholders would have 10% more shares, so the percentage of the total outstanding stock owned by a specific shareholder is not increased. The differ- ence between a stock split and stock dividend is that a stock dividend does not result in a change in per-share par value. Instead, the Retained Earnings account is reduced for the fair value of the additional shares issued. The offset is reflected as an increase in Common stock and Paid-in Capital in Excess of Par. Consider the following entry:

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10-15-X5 Retained Earnings 1,500,000.00

Common Stock 100,000.00

Paid-in Capital in Excess of Par 1,400,000.00

To record issuance of 10% stock dividend, assuming 1,000,000 shares of $1 par value stock previously outstanding and having a market value of $15 per share (1,000,000 3 10% 3 $15  $1,500,000)

The above entry must be modified for large stock dividends, generally regarded as those above 20 to 25%. Instead, only the par value of the newly issued shares is capitalized (i.e., debit Retained Earnings for par of new shares and credit only Common Stock). To illus- trate, assume that a company issues a 40% stock dividend:

10-15-X5 Retained Earnings 400,000.00

Common Stock 400,000.00

To record issuance of 40% stock dividend, assuming 1,000,000 shares of $1 par value stock previously outstanding and having a market value of $15 per share

In the above entry, 400,000 new shares of $1 par value stock are issued (1,000,000 3 40%). The journal entry reflects that the Retained Earnings account is reduced only by the par of the newly issued shares. The market value is ignored for large stock dividends. The accounting rule differentiating between treatment of small and large stock dividends is ostensibly based on the logic that a large stock dividend will cause a material decline in per-share stock price, thus rendering the market value unreliable as a basis for recording the journal entry.

Income Reporting

Within the exception of certain equity-related transactions (such as dividends, treasury stock transactions, etc.), virtually all transactions that result in a change in equity are chan- neled through the income statement. However, accountants sometimes wish to call special attention to special or nonrecurring items. For example, a business may experience a gain or loss that results from an event that is both unusual in nature and infrequent in occur- rence (e.g., an earthquake in a region regarded as having stable geology). Such events are said to be extraordinary items. When both conditions are met (unusual in nature and infrequent in occurrence), the item is separately reported, including its tax consequences, following income from continuing operations. Exhibit 8.1 is a presentation of an income statement including an extraordinary item.

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Exhibit 8.1: An income statement that includes an extraordinary item

Another situation in which the income statement is modified is for discontinued opera- tions. The presentation would appear virtually identical to that shown for Braxton Cor- poration, except that the extraordinary item section would instead reflect the gain or loss (net of tax) on disposal of the line of business. Reporting of a discontinued segment is triggered when a separate major line of business is sold or abandoned. The income report- ing model is intended to segregate discontinued operations from continuing operations. Thus, the discontinued operations section would reflect the results of operating the dis- continued segment as well as any gain or loss on its sale. Exhibit 8.2 is an example of the reporting of a discontinued operation by Saxton Corporation. Saxton was engaged in food and clothing businesses, and recently exited the clothing business.

Sales

Cost of goods sold

Gross profit

Operating expenses

Income from continuing operations before income taxes

Income taxes

Income from continuing operations

Extraordinary item

Net Income

Salaries

Rent

Other operating expenses

Uninsured loss from earthquake at corporate office

Income tax benefit from loss

Extraordinary loss net of tax

$ 36,300,000

9,900,000

$ 26,400,000

3,210,000

$ 23,190,000

1,200,000

$ 21,990,000

1,706,857 $ 20,283,143

$ 1,905,000

405,000

900,000

$ 1,800,000 93,143

Braxton Corporation Income Statement

For the Year Ending December 31, 20X2

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Exhibit 8.2: An income statement that includes discontinued operations

Although beyond the scope of this text, you should be aware that accountants sometimes calculate special adjustments for (1) translating foreign currency based financial state-ments of foreign subsidiaries, (2) certain pension plan calculations, and (3) changes in market value of selected longer-term investments. These unique accounting adjustments (sometimes referred to as elements of other comprehensive income, or OCI) are not reported as part of income from continuing operations but are afforded full disclosure in an expanded statement of comprehensive income. If you go on to study advanced accounting or rou-tinely look at the financial statements of large corporate entities, you are apt to see a com-prehensive income statement including these unique elements.

8.6 Corrections of Errors and Changes in an Accounting Method

Mathematical mistakes, incorrect reporting, omissions, and the like are regarded as accounting errors. Accountants are obligated to correct errors. If the error is material, all prior periods effected must be corrected and represented using the corrected approach. This is termed a prior period adjustment. It is of course possible that the error will reach back many years; usually it is sufficient to just report corrected statements for the prior 2- or 3-year period and roll the remaining effects into a revision of the opening Retained Earnings of the earliest period presented. In addition to correcting financial reports, it is also necessary to update the ledger account. This typically entails a change to one or more Asset or Liability accounts, with an offsetting balance impact to Retained Earnings.

Another change to previously presented reports can be triggered by a change in accoun- ting method. In other words, a company adopts an alternative accounting principle, such

Sales

Cost of goods sold

Gross profit

Operating expenses

Income from continuing operations before income taxes

Income taxes

Income from continuing operations

Discontinued operations

Net Income

Salaries

Rent

Other operating expenses

Loss from operation of clothing unit, including loss on disposal

Income tax benefit from loss on disposal of business unit

Loss on discontinued operations

$ 24,200,000 6,600,000

$17,600,000

2,140,000

$ 15,460,000

800,000

$ 14,660,000

13,522,095 $ 13,720,000

$ 1,270,000

270,000

600,000

$ 1,200,000

62,095

Saxton Corporation Income Statement

For the Year Ending December 31, 20X7

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CHAPTER 8Concept Check

as changing from one acceptable inventory method to another. GAAP requires that such changes be made by retrospective adjustment. As a practical manner, this requires the financial information of prior periods to be redone “as though” the newer method has always been in use. Additionally, disclosures must indicate why the newly adopted method is preferable and call attention to differences in reported amounts because of the change.

A change in accounting method should not be confused with a change in accounting estimate. An example of a change in estimate was discussed in Chapter 6. There, it was shown that changes in estimate are handled prospectively by adjusting only the current and future periods.

Concept Check

The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 236.)

1. Which of the following statements is false? a. All corporations issue preferred stock. b. Stockholders have limited liability. c. Corporate earnings are subject to double taxation. d. Corporations face heavier governmental regulation than sole proprietorships.

2. Which of the following rights do not apply to common stockholders? a. The right to share in dividends if declared by the board of directors b. The preemptive right c. The right to vote on changes in a corporation’s bylaws d. The right to receive dividends that are in arrears

3. Fenton Corporation is authorized to issue 10/000 shares of $5 par value common stock. If 60% of these shares are issued at $20, what amount should be credited to the Common Stock account?

a. $30,000 b. $50,000 c. $90,000 d. $120,000

4. Bright Eyes Inc. has 100,000 shares outstanding of $5 par value common stock and 10,000 shares of $100 par value preferred stock. The preferred stock is cumulative and has a price of $115 per share. If there are no dividends in arrears and total stock- holders’ equity amounts to $4,000,000, what is the book value per share of the com- mon stock?

a. $2.85 b. $5.00 c. $28.50 d. $30.00

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change in accounting method Adopting an alternative but still acceptable method of accounting.

dissolution The breakup of a partnership.

extraordinary item An event causing a gain or a loss that are both unusual in nature and infrequent in occurrence.

initial public offering (IPO) A privately held company’s offering of the first sales of its stock to the public.

IPO See initial public offering.

limited liability A principle of corpora- tions stating that stockholders can only lose the amount of their investment to creditors.

limited life The nature of partnership in that partnership passes with the death of a partner.

liquidation The formal termination of an entity.

mutual agency In a partnership, the indi- vidual partner’s right to commit or obli- gate the entire partnership.

par value Sets the legal capital of the firm, which is intended to represent the mini- mum amount of initial capital that inves- tors are theoretically obliged to invest.

perpetual existence A characteristic of a corporation, meaning that it will continue to exist and operate until it is merged with another, fails, or a corporate action is undertaken to liquidate the company.

prior period adjustment The correction of an accounting error in all periods affected.

retrospective adjustment The require- ment that when a company changes from one acceptable accounting method to another, it must redo financial informa- tion of prior periods as though the newer method had always been in use.

treasury stock The shares reacquired by the issuing company when the stock price is viewed as being too low.

unlimited liability In partnerships, a partner has liability for debts, claims, and obligations of the partnership even after he or she resigns from the partnership.

Critical Thinking Questions

Key Terms

Critical Thinking Questions

1. What is a corporation? Discuss the advantages of the corporate form of organization. 2. Briefly explain the disadvantages of the corporate form of organization. 3. Discuss the meaning of legal capital. 4. Why is stock rarely issued below par value? 5. Do changes in a stock’s market value influence a company’s financial position?

Briefly discuss.

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Exercise

Stockholders’ equity concepts. Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why.

a. Corporations are subject to double taxation. Thus, a 40% tax rate on income be- comes an effective tax rate of 80% to the corporation.

b. Common stockholders are likely to be rewarded with increases in the market value of their shares as a corporation becomes more profitable.

c. Par value virtually always coincides with a stock’s original issue price. d. Par value stock is generally worth more than no-par stock.

Problem

Issuance of stock: organization costs. Snowbound Corporation was incorporated in July. The firm’s charter authorized the sale of 200,000 shares of $10 par-value common stock. The following transactions occurred during the year:

7/1: Sold 45,000 shares of common stock to investors for $18 per share. Cash was collected and the shares were issued.

7/7: Issued 600 shares to Sharon Dale, attorney-at-law, for services rendered during the corporation’s organizational phase. Dale charged $12,600 for her work.

8/11: Sold 20,000 shares to investors for $22 per share. Cash was collected and the shares were issued.

12/14: Issued 30,000 shares to the MJB Company for land valued at $900,000.

Instructions Prepare journal entries to record each transaction.