I've attached the quesiton as a word file, thanks!

JWCL165_c11_506-567.qxd 8/12/09 7:54 AM Page 506 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings Chapter STUDY OBJECTIVES After studying this chapter, you should be able to: 1 Identify the major characteristics of a corporation. 2 Record the issuance of common stock. 3 Explain the accounting for treasury stock. 4 Differentiate preferred stock from common stock. 5 Prepare the entries for cash dividends and stock dividends. 6 Identify the items that are reported in a retained earnings statement. 7 Prepare and analyze a comprehensive The Navigator stockholders' equity section. The Navigator Understand Concepts for Review Read Feature Story Scan Study Objectives Read Preview Read text and answer p. 515 p. 529 p. 517 p. 533 Work Comprehensive Do it! p. 520 p. 536 Do it! p. 523 p. 539 p. 541 Review Summary of Study Objectives Answer Self-Study Questions Complete Assignments Feature Story \"HAVE YOU DRIVEN A FORD LATELY?\" A company that has produced such renowned successes as the Model T and the Mustang, and such a dismal failure as the Edsel, would have some interesting tales to tell. Henry Ford was a defiant visionary from the day 506 JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 507 Ford Motor Company (www.ford.com) was formed in 1903. His goal from day one was to design a car he could mass-produce and sell at a price that was affordable to the masses. In short order he accomplished this goal. By 1920, 60% of all vehicles on U.S. roads were Fords. Henry Ford was intolerant of anything that stood between him and success. In the early years Ford had issued shares to the public in order to finance the company's exponential growth. In 1916 he decided not to pay a dividend in order to increase the funds available to expand the company. The shareholders sued. Henry Ford's reaction was swift and direct: If the shareholders didn't see things his way, he would get rid of them. In 1919 the Ford family purchased 100 percent of the outstanding shares of Ford, eliminating any outside \"interference.\" It was over 35 years before shares were again issued to the public. Ford Motor Company has continued to evolve and grow over the years into one of the largest international corporations. Today there are nearly a billion shares of publicly traded Ford stock outstanding. But some aspects of the company have changed very little. The Ford family still retains a significant stake in Ford Motor Company. In a move Henry Ford might have supported, top management recently decided to centralize decision makingthat is, to have more key decisions made by top management, rather than by division managers. And, reminiscent of Henry Ford's most famous car, the company is attempting to make a \"global car\"a mass-produced car that can be sold around the world with only minor changes. The Navigator Inside Chapter 11... Directors Take on More Accountability How to Read Stock Quotes (p. 511) (p. 515) Why Did Reebok Buy Its Own Stock? What's Happening to Dividends? (p. 522) (p. 529) All About You: Home-Equity Loans (p. 540) 507 JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 508 Preview of Chapter 11 Corporations like Nike 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 number of employees. All of the 500 largest companies in the United States are corporations. In this chapter we will explain the essential features of a corporation and the accounting for a corporation's capital stock transactions, dividends, and retained earnings. The content and organization of Chapter 11 are as follows. Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings Corporate Organization and Stock Transactions Corporate form of organization Common stock issues Treasury stock Preferred stock Dividends Cash dividends Stock dividends Stock splits Retained Earnings Retained earnings restrictions Prior period adjustments Retained earnings statement Statement Presentation and Analysis Presentation Analysis SECTION 1 The Navigator The Corporate Organization and Stock Transactions THE CORPORATE FORM OF ORGANIZATION A LT E R N AT I V E TERMINOLOGY Privately held corporations are also referred to as closely held corporations. 508 In 1819, Chief Justice John Marshall defined a corporation as \"an artificial being, invisible, intangible, and existing only in contemplation of law.\" This definition is the foundation for the prevailing legal interpretation that a corporation is an entity separate and distinct from its owners. A corporation is created by law, and its continued existence depends upon the statutes of the state in which it is incorporated. As a legal entity, a corporation has most of the rights and privileges of a person. The major exceptions relate to privileges that only a living person can exercise, such as the right to vote or to hold public office. A corporation is subject to the same duties and responsibilities as a person. For example, it must abide by the laws, and it must pay taxes. Two common ways to classify corporations are by purpose and by ownership. A corporation may be organized for the purpose of making a profit, or it may be not-for-profit. For-profit corporations include such well-known companies as McDonald's, Ford Motor Company, PepsiCo, and Google. Not-for-profit corporations are organized for charitable, medical, or educational purposes. Examples are the Salvation Army, the American Cancer Society, and the Bill & Melinda Gates Foundation. Classification by ownership distinguishes between publicly held and privately held corporations. A publicly held corporation may have thousands of stockholders. Its stock is regularly traded on a national securities exchange such as the JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 509 The Corporate Form of Organization 509 New York Stock Exchange. Most of the largest U.S. corporations are publicly held. Examples of publicly held corporations are Intel, IBM, Caterpillar Inc., and General Electric. In contrast, a privately held corporation usually has only a few stockholders, and does not offer its stock for sale to the general public. Privately held companies are generally much smaller than publicly held companies, although some notable exceptions exist. Cargill Inc., a private corporation that trades in grain and other commodities, is one of the largest companies in the United States. Characteristics of a Corporation A number of characteristics distinguish corporations from proprietorships and partnerships. We explain the most important of these characteristics below. STUDY OBJECTIVE 1 Identify the major characteristics of a corporation. SEPARATE LEGAL EXISTENCE As an entity separate and distinct from its owners, the corporation acts under its own name rather than in the name of its stockholders. Ford Motor Company may buy, own, and sell property. It may borrow money, and may enter into legally binding contracts in its own name. It may also sue or be sued, and it pays its own taxes. Remember that in a partnership the acts of the owners (partners) bind the partnership. In contrast, the acts of its owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you owned shares of Ford Motor Company stock, you would not have the right to purchase automobile parts for the company unless you were appointed as an agent of the company, such as a purchasing manager. LIMITED LIABILITY OF STOCKHOLDERS Since a corporation is a separate legal entity, creditors have recourse only to corporate assets to satisfy their claims. The liability of stockholders is normally limited to their investment in the corporation. Creditors have no legal claim on the personal assets of the owners unless fraud has occurred. Even in the event of bankruptcy, stockholders' losses are generally limited to their capital investment in the corporation. TRANSFERABLE OWNERSHIP RIGHTS Shares of capital stock give ownership in a corporation. These shares are transferable units. Stockholders may dispose of part or all of their interest in a corporation simply by selling their stock. Remember that the transfer of an ownership interest in a partnership requires the consent of each owner. In contrast, the transfer of stock is entirely at the discretion of the stockholder. It does not require the approval of either the corporation or other stockholders. The transfer of ownership rights between stockholders normally has no effect on the daily operating activities of the corporation. Nor does it affect the corporation's assets, liabilities, and total ownership equity. The transfer of these ownership rights is a transaction between individual owners. After it first issues the capital stock, the company does not participate in such transfers. ABILITY TO ACQUIRE CAPITAL It is relatively easy for a corporation to obtain capital through the issuance of stock. Investors buy stock in a corporation to earn money over time as the share price grows, and because a stockholder has limited liability and shares of stock are readily transferable. Also, individuals can become stockholders by investing relatively small amounts of money. In sum, the ability of a successful corporation to obtain capital is virtually unlimited. WKK Corp. Stockholders Legal existence separate from owners WKK Corp. Stockholders Limited liability of stockholders Transferable ownership rights Ability to acquire capital JWCL165_c11_506-567.qxd 510 8/8/09 7:57 PM Page 510 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings Continuous life 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 company can extend the life through renewal of the charter. Since a corporation is a separate legal entity, its continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer. As a result, a successful enterprise can have a continuous and perpetual life. CORPORATION MANAGEMENT As in Ford Motor Company, stockholders legally own the corporation. But they manage the corporation indirectly through a board of directors they elect. The board, in turn, formulates the operating policies for the company. The board also selects officers, such as a president and one or more vice presidents, to execute policy and to perform daily management functions. Illustration 11-1 presents a typical organization chart showing the delegation of responsibility. The chief executive officer (CEO) has overall responsibility for managing the business. As the organization chart shows, the CEO delegates responsibility to other officers. Illustration 11-1 Corporation organization chart Stockholders Chairman and Board of Directors President and Chief Executive Officer General Counsel and Secretary Vice President Marketing Vice President Finance/Chief Financial Officer Treasurer Vice President Operations Vice President Human Resources Controller 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 ETHICS NOTE returns, and internal reports. The treasurer has custody of the corporation's funds and is responsible for maintaining the company's cash position. Managers who are not ownThe organizational structure of a corporation enables a company to ers are often compensated based on the performance of the firm. hire professional managers to run the business. On the other hand, the They thus may be tempted to separation of ownership and management prevents owners from having exaggerate firm performance by an active role in managing the company, which some owners like to inflating income figures. have. JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 511 The Corporate Form of Organization E T H I C S 511 I N S I G H T Directors Take on More Accountability In the wake of Enron's collapse, the members of Enron's board of directors were questioned 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 management and by Arthur AndersenEnron's longtime auditorsand didn't learn about the company's troublesome accounting until 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 partnerships between Enron and its chief financial officer. Those partnerships kept significant debt off of Enron's books and masked actual company finances.\" Since Enron's demise, passage of the Sarbanes-Oxley Act and proposals by the SEC and the stock exchanges have created a new corporate-governance climate: Stronger boards, with more independent directors, are now in favor. Source: Carol Hymowitz, \"Serving on a Board Now Means Less Talk, More Accountability,\"Wall Street Journal, January 29, 2002. Was Enron's board of directors fulfilling its role in a corporate organization when it waived Enron's ethical code on two occasions? GOVERNMENT REGULATIONS A corporation is subject to numerous state and federal regulations. State laws usually prescribe the requirements for issuing stock, the distributions of earnings permitted to stockholders, and the effects of retiring stock. Federal securities laws govern the sale of capital stock to the general public. Also, most publicly held corporations are required to make extensive disclosure of their financial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports. In addition, when a corporation lists its stock on organized securities exchanges, it must comply with the reporting requirements of these exchanges. Government regulations are designed to protect the owners of the corporation. ADDITIONAL TAXES Neither proprietorships nor partnerships pay income taxes separate from the owner's share of earnings. Sole proprietors and partners report earnings on their personal income tax returns and pay taxes on this amount. Corporations, on the other hand, must pay federal and state income taxes as a separate legal entity. These taxes are substantial. In addition, stockholders must pay taxes on cash dividends (pro rata distributions of net income). Thus, many argue that the government taxes corporate income twice (double taxation)once at the corporate level, and again at the individual level. In summary, we can identify the following advantages and disadvantages of a corporation compared to a proprietorship and a partnership. Advantages Disadvantages Separate legal existence Limited liability of stockholders Transferable ownership rights Ability to acquire capital Continuous life Corporation managementprofessional managers Corporation managementseparation of ownership and management Government regulations Additional taxes State laws SEC laws WKK Corp. Stock Federal exchange regulations requirements Government regulations Additional taxes Illustration 11-2 Advantages and disadvantages of a corporation JWCL165_c11_506-567.qxd 512 8/8/09 7:57 PM Page 512 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings Forming a Corporation A LT E R N AT I V E TERMINOLOGY The charter is often referred to as the articles of incorporation. The initial step in forming a corporation is to file an application with the Secretary of State in the state in which incorporation is desired. The application contains such 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 state approves the application, it grants a charter. The charter may be an approved copy of the application form, or it may be a separate document containing the same basic data. The issuance of the charter creates the corporation. Upon receipt of the charter, the corporation develops its by-laws. The by-laws establish the internal rules and procedures for conducting the affairs of the corporation. They also indicate the powers of the stockholders, directors, and officers of the enterprise.1 Regardless of the number of states in which a corporation has operating divisions, it is incorporated in only one state. It is to the company's advantage to incorporate in a state whose laws are favorable to the corporate form of business organization. General Motors, for example, is incorporated in Delaware, whereas Qualcomm is a New Jersey corporation. Many corporations choose to incorporate in states with rules favorable to existing management. For example, Gulf Oil at one time changed its state of incorporation to Delaware to thwart possible unfriendly takeovers. There, state law allows boards of directors to approve certain defensive tactics against takeovers without a vote by shareholders. Corporations engaged in interstate commerce must also obtain a license from each state in which they do business. The license subjects the corporation's operating activities to the corporation laws of the state. Costs incurred in the formation of a corporation are called organization costs. These costs include legal and state fees, and promotional expenditures involved in the organization of the business. Corporations expense organization costs as incurred. To determine the amount and timing of future benefits is so difficult that it is standard procedure to take a conservative approach of expensing these costs immediately. 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 common stock. Each share of common stock gives the stockholder the ownership rights pictured in Illustration 11-3 (next page). A corporation's articles of incorporation or its bylaws state the ownership rights of a share of stock. Proof of stock ownership is evidenced by a form known as a stock certificate. As Illustration 11-4 (next page) shows, the face of the certificate shows the name of the corporation, the stockholder's name, the class and special features of the stock, the number of shares owned, and the signatures of authorized corporate officials. Prenumbered certificates facilitate accountability. They may be issued for any quantity of shares. 1 Following approval by two-thirds of the stockholders, the by-laws become binding upon all stockholders, directors, and officers. Legally, a corporation is regulated first by the laws of the state, second by its charter, and third by its by-laws. Corporations must take care to ensure that the provisions of the by-laws are not in conflict with either state laws or the charter. JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 513 The Corporate Form of Organization Illustration 11-3 Ownership rights of stockholders Stockholders have the right to: 1. Vote in election of board of directors at annual meeting and vote on actions that require stockholder approval. 2. Share the corporate earnings through receipt of dividends. dividends Before 3. Keep the same percentage ownership when new shares of stock are issued (preemptive right2). 4. Share in assets upon liquidation in proportion to their holdings. This is called a residual claim: owners are paid with assets that remain after all creditors' claims have been paid. After New shares issued 14% GON Corp. 14% Lenders Stockholders Creditors Illustration 11-4 A stock certificate 2 A number of companies have eliminated the preemptive right, because they believe it makes an unnecessary and cumbersome demand on management. For example, by stockholder approval, IBM has dropped its preemptive right for stockholders. 513 JWCL165_c11_506-567.qxd 514 8/8/09 7:57 PM Page 514 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings Stock Issue Considerations In considering the issuance of stock, a corporation must resolve a number of basic questions: How many shares should it authorize for sale? How should it issue the stock? At what price should it issue the shares? What value should the corporation assign to the stock? These questions are addressed in the following sections. AUTHORIZED STOCK The charter indicates the amount of stock that a corporation is authorized to sell. The total amount of authorized stock at the time of incorporation normally anticipates both initial and subsequent capital needs. As a result, the number of shares authorized generally exceeds the number initially sold. If it sells all authorized stock, a corporation must obtain consent of the state to amend its charter before it can issue additional shares. The authorization of capital stock does not result in a formal accounting entry. This event has no immediate effect on either corporate assets or stockholders' equity. However, the number of authorized shares is often reported in the stockholders' equity section. It is then simple to determine the number of unissued shares that the corporation can issue without amending the charter: subtract the total shares issued from the total authorized. For example, if Advanced Micro was authorized to sell 100,000 shares of common stock and issued 80,000 shares, 20,000 shares would remain unissued. XYZ Corp. Really Big Investment Bank, Inc. Indirect issuance ISSUANCE OF STOCK A corporation can issue common stock directly to investors. Or it can issue the stock indirectly through an investment banking firm that specializes in bringing securities to market. Direct issue is typical in closely held companies. Indirect issue is customary for a publicly held corporation. In an indirect issue, the investment banking firm may agree to underwrite the entire stock issue. In this arrangement, the investment banker buys the stock from the corporation at a stipulated price and resells the shares to investors. The corporation thus avoids any risk of being unable to sell the shares.Also, it obtains immediate use of the cash received from the underwriter.The investment banking firm, in turn, assumes the risk of reselling the shares, in return for an underwriting fee.3 For example, Google (the world's number-one Internet search engine) used underwriters when it issued a highly successful initial public offering, raising $1.67 billion. The underwriters charged a 3% underwriting fee (approximately $50 million) on Google's stock offering. How does a corporation set the price for a new issue of stock? Among the factors to be considered are: (1) the company's anticipated future earnings, (2) its expected dividend rate per share, (3) its current financial position, (4) the current state of the economy, and (5) the current state of the securities market. The calculation can be complex and is properly the subject of a finance course. MARKET VALUE OF STOCK The stock of publicly held companies is traded on organized exchanges. The interaction between buyers and sellers determines the prices per share. In general, the prices set by the marketplace tend to follow the trend of a company's earnings and dividends. But, factors beyond a company's control, such as an oil embargo, changes in interest rates, and the outcome of a presidential election, may cause day-to-day fluctuations in market prices. 3 Alternatively, the investment banking firm may agree only to enter into a best-efforts contract with the corporation. In such cases, the banker agrees to sell as many shares as possible at a specified price. The corporation bears the risk of unsold stock. Under a best-efforts arrangement, the banking firm is paid a fee or commission for its services. JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 515 The Corporate Form of Organization 515 The trading of capital stock on securities exchanges involves the transfer of already issued shares from an existing stockholder to another investor.These transactions have no impact on a corporation's stockholders' equity. I N V E S T O R I N S I G H T How to Read Stock Quotes 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 and other financial media report the total volume of stock traded for a given day, the high and low price for the day, the closing market price, and the net change for the day. A recent stock quote for PepsiCo, listed on the NYSE under the ticker symbol PEP, is shown below. Stock Volume High Low Close Net Change PepsiCo 4,305,600 60.30 59.32 60.02 0.41 These numbers indicate that PepsiCo's trading volume was 4,305,600 shares. The high, low, and closing prices for that date were $60.30, $59.32, and $60.02, respectively. The net change for the day was an increase of $0.41 per share. For stocks traded on organized stock exchanges, how are the dollar prices per share established? What factors might influence the price of shares in the marketplace? PAR AND NO-PAR-VALUE STOCKS Par-value stock is capital stock to which the charter has assigned a value per share. Years ago, par value determined the legal capital per share that a company must retain in the business for the protection of corporate creditors; that amount was not available for withdrawal by stockholders. Thus, in the past, most states required the corporation to sell its shares at par or above. However, par value was often immaterial relative to the value of the company's stockeven at the time of issue. Thus, its usefulness as a protective device to creditors was questionable. For example, Kellogg's par value is $0.25 per share, yet a new issue in early 2009 would have sold at a market value in the $38 per share range. Thus, par has no relationship with market value; in the vast majority of cases, it is an immaterial amount.As a consequence, today many states do not require a par value. Instead, they use other means to determine legal capital to protect creditors. No-par-value stock is capital stock to which the charter has not assigned a value. No-par-value stock is quite common today. For example, Nike, Procter & Gamble, and North American Van Lines all have no-par stock. In many states the board of directors assigns a stated value to no-par shares. before you go on... Do it! Indicate whether each of the following statements is true or false. _____ 1. Similar to partners in a partnership, stockholders of a corporation have unlimited liability. _____ 2. It is relatively easy for a corporation to obtain capital through the issuance of stock. _____ 3. The separation of ownership and management is an advantage of the corporate form of business. Corporate Organization JWCL165_c11_506-567.qxd 516 8/8/09 7:57 PM Page 516 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings Action Plan Review the characteristics of a corporation and understand which are advantages and which are disadvantages. Understand that corporations raise capital through the issuance of stock, which can be par or no-par. _____ 4. The journal entry to record the authorization of capital stock includes a credit to the appropriate capital stock account. _____ 5. Most states require a par value per share for capital stock. Solution 1. False. The liability of stockholders is normally limited to their investment in the corporation. 2. True. 3. False. The separation of ownership and management is a disadvantage of the corporate form of business. 4. False. The authorization of capital stock does not result in a formal accounting entry. 5. False. Many states do not require a par value. Related exercise material: BE11-1, E11-1, E11-2, and Do it! 11-1. The Navigator Corporate Capital Owners' equity is identified by various names: stockholders' equity, shareholders' equity, or corporate capital. The stockholders' equity section of a corporation's balance sheet consists of two parts: (1) paid-in (contributed) capital and (2) retained earnings (earned capital). The distinction between paid-in capital and retained earnings is important from both a legal and a financial point of view. Legally, corporations can make distributions of earnings (declare dividends) out of retained earnings in all states. However, in many states they cannot declare dividends out of paid-in capital. Management, stockholders, and others often look to retained earnings for the continued existence and growth of the corporation. PAID-IN CAPITAL Paid-in capital is the total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock. As noted earlier, when a corporation has only one class of stock, it is common stock. A L SE 130,000 Inc 130,000 RE Cash Flows no effect RETAINED EARNINGS Retained earnings is net income that a corporation retains for future use. Net income is recorded in Retained Earnings by a closing entry that debits Income Summary and credits Retained Earnings. For example, assuming that net income for Delta Robotics in its first year of operations is $130,000, the closing entry is: Income Summary Retained Earnings (To close Income Summary and transfer net income to retained earnings) 130,000 130,000 If Delta Robotics has a balance of $800,000 in common stock at the end of its first year, its stockholders' equity section is as follows. Illustration 11-5 Stockholders' equity section DELTA ROBOTICS Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock Retained earnings Total stockholders' equity $800,000 130,000 $930,000 JWCL165_c11_506-567.qxd 8/10/09 11:59 AM Page 517 Accounting for Common Stock Issues 517 Illustration 11-6 compares the owners' equity (stockholders' equity) accounts reported on a balance sheet for a proprietorship and a corporation. Illustration 11-6 Comparison of owners' equity accounts Proprietorship Corporation Able, Capital Common Stock Normal bal. Normal bal. Retained Earnings Normal bal. before you go on... Do it! At the end of its first year of operation, Doral Corporation has $750,000 of common stock and net income of $122,000. Prepare (a) the closing entry for net income and (b) the stockholders' equity section at year-end. Solution (a) Income Summary Retained Earnings (To close Income Summary and transfer net income to retained earnings) (b) Stockholders' equity Paid-in capital Common stock Retained earnings Total stockholders' equity 122,000 122,000 $750,000 122,000 Corporate Capital Action Plan Record net income in Retained Earnings by a closing entry in which Income Summary is debited and Retained Earnings is credited. In the stockholders' equity section, show (1) paid-in capital and (2) retained earnings. $872,000 Related exercise material: Do it! 11-2. The Navigator ACCOUNTING FOR COMMON STOCK ISSUES Let's now look at how to account for issues of common stock. The primary objectives in accounting for the issuance of common stock are: (1) to identify the specific sources of paid-in capital, and (2) to maintain the distinction between paid-in capital and retained earnings. The issuance of common stock affects only paid-in capital accounts. STUDY OBJECTIVE 2 Record the issuance of common stock. 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 company records issuance of common stock for cash, JWCL165_c11_506-567.qxd 518 8/8/09 7:57 PM Page 518 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings it credits to Common Stock the par value of the shares. It records in a separate paid-in capital account the portion of the proceeds that is above or below par value. To illustrate, assume that Hydro-Slide, Inc. issues 1,000 shares of $1 par-value common stock at par for cash. The entry to record this transaction is: A L SE 1,000 1,000 CS Cash Flows 1,000 Cash Common Stock (To record issuance of 1,000 shares of $1 par common stock at par) 1,000 1,000 If Hydro-Slide issues an additional 1,000 shares of the $1 par-value common stock for cash at $5 per share, the entry is: A L SE 5,000 1,000 CS 4,000 CS Cash Flows 5,000 Cash Common Stock Paid-in Capital in Excess of Par Value (To record issuance of 1,000 shares of $1 par common stock) 5,000 1,000 4,000 The total paid-in capital from these two transactions is $6,000, and the legal capital is $2,000. Assuming Hydro-Slide, Inc. has retained earnings of $27,000, Illustration 11-7 shows the company's stockholders' equity section. Illustration 11-7 Stockholders' equity paid-in capital in excess of par value A LT E R N AT I V E TERMINOLOGY Paid-in Capital in Excess of Par is also called Premium on Stock. HYDRO-SLIDE, INC. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock Paid-in capital in excess of par value Total paid-in capital Retained earnings Total stockholders' equity $ 2,000 4,000 6,000 27,000 $33,000 When a corporation issues stock for less than par value, it debits the account Paid-in Capital in Excess of Par Value, if a credit balance exists in this account. If a credit balance does not exist, then the corporation debits to Retained Earnings the amount less than par. This situation occurs only rarely: Most states do not permit the sale of common stock below par value, because stockholders may be held personally liable for the difference between the price paid upon original sale and par value. Issuing No-Par Common Stock for Cash When no-par common stock has a stated value, the entries are similar to those illustrated for par-value stock. The corporation credits the stated value to Common Stock. Also, when the selling price of no-par stock exceeds stated value, the corporation credits the excess to Paid-in Capital in Excess of Stated Value. JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 519 Accounting for Common Stock Issues For example, assume that instead of $1 par-value stock, Hydro-Slide, Inc. has $5 stated value no-par stock and the company issues 5,000 shares at $8 per share for cash. The entry is: Cash Common Stock Paid-in Capital in Excess of Stated Value (To record issue of 5,000 shares of $5 stated value no-par stock) A L SE 40,000 40,000 25,000 CS 15,000 CS 25,000 15,000 Cash Flows 40,000 Hydro-Slide, Inc. reports Paid-in Capital in Excess of Stated Value as part of paidin capital in the stockholders' equity section. What happens when no-par stock does not have a stated value? In that case, the corporation credits the entire proceeds to Common Stock. Thus, if Hydro-Slide does not assign a stated value to its no-par stock, it would record the issuance of the 5,000 shares at $8 per share for cash as follows. A Cash Common Stock (To record issue of 5,000 shares of no-par stock) 519 L SE 40,000 40,000 40,000 CS 40,000 Cash Flows 40,000 Issuing Common Stock for Services or Noncash Assets Corporations also may issue stock for services (compensation to attorneys or consultants) or for noncash assets (land, buildings, and equipment). In such cases, what cost should be recognized in the exchange transaction? To comply with the 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 Company incorporate. They have billed the company $5,000 for their services. They agree to accept 4,000 shares of $1 par value common stock in payment of their bill. At the time of the exchange, there is no established market price for the stock. In this case, the market value of the consideration received, $5,000, is more clearly evident. Accordingly, Jordan Company makes the following entry: A Organization Expense Common Stock Paid-in Capital in Excess of Par Value (To record issuance of 4,000 shares of $1 par value stock to attorneys) L SE 5,000 Exp 4,000 CS 1,000 CS 5,000 4,000 1,000 Cash Flows no effect As explained on page 512, organization costs are expensed as incurred. In contrast, assume that Athletic Research Inc. is an existing publicly held corporation. Its $5 par value stock is actively traded at $8 per share. The company issues 10,000 shares of stock to acquire land recently advertised for sale at $90,000. The most clearly evident value in this noncash transaction is the market price of the consideration given, $80,000. The company records the transaction as follows. Land Common Stock Paid-in Capital in Excess of Par Value (To record issuance of 10,000 shares of $5 par value stock for land) A L SE 80,000 80,000 50,000 CS 30,000 CS 50,000 30,000 Cash Flows no effect JWCL165_c11_506-567.qxd 520 8/8/09 7:57 PM Page 520 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings As illustrated in these examples, the par value of the stock is never a factor in determining the cost of the assets received. This is also true of the stated value of no-par stock. before you go on... Issuance of Stock 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. Do it! Cayman Corporation begins operations on March 1 by issuing 100,000 shares of $10 par value common stock for cash at $12 per share. On March 15 it issues 5,000 shares of common stock to attorneys in settlement of their bill of $50,000 for organization costs. Journalize the issuance of the shares, assuming the stock is not publicly traded. Solution Mar. 1 Mar. 15 Cash Common Stock Paid-in Capital in Excess of Par Value (To record issuance of 100,000 shares at $12 per share) Organization Expense Common Stock (To record issuance of 5,000 shares for attorneys' fees) 1,200,000 1,000,000 200,000 50,000 50,000 Related exercise material: BE11-2, BE11-3, BE11-4, E11-3, E11-4, and Do it! 11-3. The Navigator ACCOUNTING FOR TREASURY STOCK STUDY OBJECTIVE 3 Explain the accounting for treasury stock. HELPFUL HINT Treasury shares do not have dividend rights or voting rights. Treasury stock is a corporation's own stock that it has issued and subsequently reacquired from shareholders, but not retired. A corporation may acquire treasury stock for various reasons: 1. To reissue the shares to officers and employees under bonus and stock compensation plans. 2. To signal to the stock market that management believes the stock is underpriced, in the hope of enhancing its market value. 3. To have additional shares available for use in the acquisition of other companies. 4. To reduce the number of shares outstanding and thereby increase earnings per share. 5. To rid the company of disgruntled investors, perhaps to avoid a takeover, as illustrated in the Ford Motor Company Feature Story. Many corporations have treasury stock. One survey of 600 U.S. companies found that approximately two-thirds have treasury stock.4 For example, ExxonMobil Corp., Microsoft Corp., and Time Warner Inc. purchased a combined $14.37 billion of their shares in the first quarter of a recent year. 4 Accounting Trends & Techniques 2007 (New York: American Institute of Certified Public Accountants). JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 521 Accounting for Treasury Stock 521 Purchase of Treasury Stock Companies generally account for treasury stock by the cost method. This method uses the cost of the shares purchased to value the treasury stock. Under the cost method, the company debits Treasury Stock for the price paid to reacquire the shares. When the company disposes of the shares, it credits to Treasury Stock the same amount it paid to reacquire the shares. To illustrate, assume that on January 1, 2011, the stockholders' equity section of Mead, 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 as follows. Illustration 11-8 Stockholders' equity with no treasury stock MEAD, INC. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock, $5 par value, 100,000 shares issued and outstanding Retained earnings Total stockholders' equity $500,000 200,000 $700,000 On February 1, 2011, Mead acquires 4,000 shares of its stock at $8 per share. The entry is: A Feb. 1 Treasury Stock Cash (To record purchase of 4,000 shares of treasury stock at $8 per share) L SE 32,000 TS 32,000 32,000 32,000 Cash Flows 32,000 Note that Mead debits Treasury Stock for the cost of the shares purchased. Is the original paid-in capital account, Common Stock, affected? No, because the number of issued shares does not change. In the stockholders' equity section of the balance sheet, Mead deducts treasury stock from total paid-in capital and retained earnings. Treasury Stock is a contra stockholders' equity account. Thus, the acquisition of treasury stock reduces stockholders' equity. The stockholders' equity section of Mead, Inc. after purchase of treasury stock is as follows. Illustration 11-9 Stockholders' equity with treasury stock MEAD, INC. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock, $5 par value, 100,000 shares issued and 96,000 shares outstanding Retained earnings Total paid-in capital and retained earnings Less: Treasury stock (4,000 shares) Total stockholders' equity $500,000 200,000 700,000 32,000 $668,000 JWCL165_c11_506-567.qxd 522 8/8/09 7:57 PM Page 522 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings In the balance sheet, Mead discloses both the number of shares issued (100,000) and the number in the treasury (4,000). The difference between The purchase of treasury these two amounts is the number of shares of stock outstanding (96,000). stock reduces the cushion for The term outstanding stock means the number of shares of issued stock creditors and preferred stockthat are being held by stockholders. holders. A restriction for the cost of treasury stock purchased is Some maintain that companies should report treasury stock as an often required. The restriction asset because it can be sold for cash. Under this reasoning, companies is usually applied to retained should also show unissued stock as an asset, clearly an erroneous concluearnings. sion. Rather than being an asset, treasury stock reduces stockholder claims on corporate assets. This effect is correctly shown by reporting treasury stock as a deduction from total paid-in capital and retained earnings. ETHICS NOTE ACCOUNTING ACROSS THE ORGANIZATION Why Did Reebok Buy Its Own Stock? In a bold (and some would say risky) move, Reebok at one time bought back nearly a third of its shares. This repurchase of shares dramatically reduced Reebok's available cash. In fact, the company borrowed significant funds to accomplish the repurchase. In a press release, management stated that it was repurchasing the shares because it believed its stock was severely underpriced. The repurchase of so many shares was meant to signal management's belief in good future earnings. Skeptics, however, suggested that Reebok's management was repurchasing shares to make it less likely that another company would acquire Reebok (in which case Reebok's top managers would likely lose their jobs). By depleting its cash, Reebok became a less likely acquisition target. Acquiring companies like to purchase companies with large cash balances so they can pay off debt used in the acquisition. What signal might a large stock repurchase send to investors regarding management's belief about the company's growth opportunities? Disposal of Treasury Stock HELPFUL HINT Treasury stock transactions are classified as capital stock transactions. As in the case when stock is issued, the income statement is not involved. A L SALE OF TREASURY STOCK ABOVE COST If the selling price of the treasury shares is equal to their cost, the company records the sale of the shares by a debit to Cash and a credit to Treasury Stock. When the selling price of the shares is greater than their cost, the company credits the difference to Paid-in Capital from Treasury Stock. To illustrate, assume that on July 1, Mead sells for $10 per share the 1,000 shares of its treasury stock, previously acquired at $8 per share. The entry is as follows. SE 10,000 July 1 8,000 TS 2,000 TS Cash Flows 10,000 Treasury stock is usually sold or retired. The accounting for its sale differs when treasury stock is sold above cost than when it is sold below cost. Cash Treasury Stock Paid-in Capital from Treasury Stock (To record sale of 1,000 shares of treasury stock above cost) 10,000 8,000 2,000 Mead does not record a $2,000 gain on sale of treasury stock for two reasons: (1) Gains on sales occur when assets are sold, and treasury stock is not an asset. (2) A corporation does not realize a gain or suffer a loss from stock transactions JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 523 Accounting for Treasury Stock 523 with its own stockholders.Thus, companies should not include in net income any paidin capital arising from the sale of treasury stock. Instead, they report Paid-in Capital from Treasury Stock separately on the balance sheet, as a part of paid-in capital. SALE OF TREASURY STOCK BELOW COST When a company sells treasury stock below its cost, it usually debits to Paid-in Capital from Treasury Stock the excess of cost over selling price. Thus, if Mead, Inc. sells an additional 800 shares of treasury stock on October 1 at $7 per share, it makes the following entry. A Oct. 1 Cash Paid-in Capital from Treasury Stock Treasury Stock (To record sale of 800 shares of treasury stock below cost) L SE 5,600 5,600 800 800 TS 6,400 TS 6,400 Cash Flows 5,600 Observe the following from the two sales entries: (1) Mead credits Treasury Stock at cost in each entry. (2) Mead uses Paid-in Capital from Treasury Stock for the difference between cost and the resale price of the shares. (3) The original paid-in capital account, Common Stock, is not affected. The sale of treasury stock increases both total assets and total stockholders' equity. After posting the foregoing entries, the treasury stock accounts will show the following balances on October 1. Treasury Stock Feb. 1 32,000 Oct. 1 Bal. July 1 Oct. 1 Paid-in Capital from Treasury Stock 8,000 6,400 Oct. 1 17,600 800 July 1 2,000 Oct. 1 Bal. Illustration 11-10 Treasury stock accounts 1,200 When a company fully depletes the credit balance in Paid-in Capital from Treasury Stock, it debits to Retained Earnings any additional excess of cost over selling price. To illustrate, assume that Mead, Inc. sells its remaining 2,200 shares at $7 per share on December 1. The excess of cost over selling price is $2,200 [2,200 ($8 $7)]. In this case, Mead debits $1,200 of the excess to Paid-in Capital from Treasury Stock. It debits the remainder to Retained Earnings. The entry is: A Dec. 1 Cash Paid-in Capital from Treasury Stock Retained Earnings Treasury Stock (To record sale of 2,200 shares of treasury stock at $7 per share) L SE 15,400 15,400 1,200 1,000 1,200 TS 1,000 RE 17,600 TS 17,600 Cash Flows 15,400 before you go on... Do it! Santa Anita Inc. purchases 3,000 shares of its $50 par value common stock for $180,000 cash on July 1. It will hold the shares in the treasury until resold. On November 1, the corporation sells 1,000 shares of treasury stock for cash at $70 per share. Journalize the treasury stock transactions. Treasury Stock JWCL165_c11_506-567.qxd 524 8/8/09 7:57 PM Page 524 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings 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 Paidin Capital from Treasury Stock. Solution July 1 Nov. 1 Treasury Stock Cash (To record the purchase of 3,000 shares at $60 per share) Cash Treasury Stock Paid-in Capital from Treasury Stock (To record the sale of 1,000 shares at $70 per share) 180,000 180,000 70,000 60,000 10,000 Related exercise material: BE11-5, E11-5, and Do it! 11-4. The Navigator PREFERRED STOCK To appeal to more investors, a corporation may issue an additional class of stock, called preferred stock. Preferred stock has provisions that give it some preference or priority over common stock. Typically, preferred stockholders have a priority as to (1) distributions of earnings (dividends) and (2) assets in the event of liquidation. However, they generally do not have voting rights. Like common stock, corporations may issue preferred stock for cash or for noncash assets. The entries for these transactions are similar to the entries for common stock. When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates. A company might have the following accounts: Preferred Stock, Common Stock, Paid-in Capital in Excess of Par ValuePreferred Stock, and Paid-in Capital in Excess of Par ValueCommon Stock. For example, if Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share, the entry to record the issuance is: STUDY OBJECTIVE 4 Differentiate preferred stock from common stock. A L SE 120,000 100,000 PS 20,000 PS Cash Flows 120,000 I hope there is some money left when it's my turn. Preferred Common stockholders stockholders Dividend Preference Cash Preferred Stock Paid-in Capital in Excess of Par Value-Preferred Stock (To record the issuance of 10,000 shares of $10 par value preferred stock) 120,000 100,000 20,000 Preferred stock may have either a par value or no-par value. In the stockholders' equity section of the balance sheet, companies list preferred stock first because of its dividend and liquidation preferences over common stock. We discuss various features associated with the issuance of preferred stock on the following pages. Dividend Preferences As noted earlier, preferred stockholders have the right to receive dividends before common stockholders. For example, if the dividend rate on preferred stock is $5 per share, common shareholders will not receive any dividends in the current year until preferred stockholders have received $5 per share. The first claim to dividends does not, however, guarantee the payment of dividends. Dividends depend on many factors, such as adequate retained earnings and availability of cash. If a company does not pay dividends to preferred stockholders, it cannot of course pay dividends to common stockholders. JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 525 Preferred Stock 525 The per share dividend amount is stated as a percentage of the preferred stock's par value or as a specified amount. For example, at one time Crane Company specified a 334% dividend on its $100 par value preferred ($100 334% = $3.75 per share). PepsiCo has a $5.46 series of no-par preferred stock. CUMULATIVE DIVIDEND Preferred stock often contains a cumulative dividend feature. This means that preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders receive dividends. When preferred stock is cumulative, preferred dividends not declared in a given period are called dividends in arrears. To illustrate, assume that Scientific Leasing has 5,000 shares of 7%, $100 par value, cumulative preferred stock outstanding. The annual dividend is $35,000 (5,000 $7 per share), but dividends are two years in arrears. In this case, preferred stockholders are entitled to receive the following dividends in the current year. Dividends in arrears ($35,000 2) Current-year dividends Total preferred dividends Illustration 11-11 Computation of total dividends to preferred stock $ 70,000 35,000 $105,000 The company cannot pay dividends to common stockholders until it pays the entire preferred dividend. In other words, companies cannot pay dividends to common stockholders while any preferred stock is in arrears. Are dividends in arrears considered a liability? Nono payment obligation exists until the board of directors declares a dividend. However, companies should disclose in the notes to the financial statements the amount of dividends in arrears. Doing so enables investors to assess the potential impact of this commitment on the corporation's financial position. Companies that are unable to meet their dividend obligations are not looked upon favorably by the investment community. As a financial officer noted in discussing one company's failure to pay its cumulative preferred dividend for a period of time, \"Not meeting your obligations on something like that is a major black mark on your record.\" The accounting entries for preferred stock dividends are explained later in the chapter. Payment of a Cumulative Dividend Dividend in arrears Current dividend Preferred stockholders Liquidation Preference Most preferred stocks also have a preference on corporate assets if the corporation fails. This feature provides security for the preferred stockholder. The preference to assets may be for the par value of the shares or for a specified liquidating value. For example, Commonwealth Edison issued preferred stock that entitles its holders to receive $31.80 per share, plus accrued and unpaid dividends, in the event of involuntary liquidation. The liquidation preference establishes the respective claims of creditors and preferred stockholders in litigation pertaining to bankruptcy lawsuits. SECTION 2 Dividends A dividend is a corporation's distribution of cash or stock to its stockholders on a pro rata (proportional) basis. Investors are very interested in a company's dividend policies and practices. Dividends can take four forms: cash, property, scrip (a promissory note to pay cash), or stock. Cash STUDY OBJECTIVE 5 Prepare the entries for cash dividends and stock dividends. JWCL165_c11_506-567.qxd 526 8/8/09 7:57 PM Page 526 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings dividends predominate in practice. Also, companies declare stock dividends 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. The financial press generally reports dividends as a dollar amount per share. For example, Boeing Company's dividend rate is $1.45 a share, Hershey Foods Corp.'s is $1.19, and Nike's is $0.94. CASH DIVIDENDS A cash dividend is a pro rata distribution of cash to stockholders. For a corporation to pay a cash dividend, it must have: 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 from only the balance in common stock (legal capital) are illegal. A dividend declared out of paid-in capital is termed a liquidating dividend. Such a dividend reduces or \"liquidates\" the amount originally paid in by stockholders. Statutes vary considerably with respect to cash dividends based on paid-in capital in excess of par or stated value. Many states permit such dividends. 2. Adequate cash. The legality of a dividend and the ability to pay a dividend are two different things. For example, Nike recently had a retained earnings balance of approximately $5 billion, could legally declare a dividend of this amount. But Nike's cash balance is only a little over $2 billion. Before declaring a cash dividend, a company's board of directors must carefully consider both current and future demands on the company's cash resources. In some cases, current liabilities may make a cash dividend inappropriate. In other cases, a major plant expansion program may warrant only a relatively small dividend. 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 distribute in the form of a dividend and the amount to retain in the business. Dividends do not accrue like interest on a note payable, and they are not a liability until declared. The amount and timing of a dividend are important issues.The payment of a large cash dividend could lead to liquidity problems for the company. On the other hand, a small dividend or a missed dividend may cause unhappiness among stockholders. Many stockholders expect to receive a reasonable cash payment from the company 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 weeks between each date. Companies make accounting entries on two of the datesthe 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 dividend commits the corporation to a legal obligation. The obligation is binding and cannot JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 527 Cash Dividends 527 be rescinded.The company makes an entry to recognize the cash dividend (decrease in retained earnings) and the increase in the liability Dividends Payable. To illustrate, assume that on December 1, 2011, the directors of Media General declare a 50 per share cash dividend on 100,000 shares of $10 par value common stock.The dividend is $50,000 (100,000 50).The entry to record the declaration is: A Declaration Date Dec. 1 Cash Dividends Dividends Payable (To record declaration of cash dividend) L SE 50,000 Div 50,000 50,000 50,000 Cash Flows no effect In Chapter 1, we used an account called Dividends to record a cash dividend. Here, we use the more specific title Cash Dividends to differentiate from other types of dividends, such as stock dividends. A company may have separate dividend accounts for each class of stock. Dividends Payable is a current liability: It will normally be paid within the next several months. At the end of the year, the company transfers the balance of the dividends account to Retained Earnings by a closing entry. At the record date, the company determines ownership of the outstanding shares for dividend purposes. The records maintained by the corporation supply this information. In the interval between the declaration date and the record date, the corporation updates its stock ownership records. For Media General, the record date is December 22. No entry is required on this date because the corporation's liability recognized on the declaration date is unchanged. Record Date HELPFUL HINT The purpose of the record date is to identify the persons or entities that will receive the dividend, not to determine the amount of the dividend liability. Dec. 22 No entry necessary On the payment date, the company mails dividend checks to the stockholders and records the payment of the dividend. Assuming that the payment date is January 20 for Media General, the entry on that date is: A Payment Date Jan. 20 Dividends Payable Cash (To record payment of cash dividend) L 50,000 50,000 50,000 Note that payment of the dividend reduces both current assets and current liabilities. It has no effect on stockholders' equity.The cumulative effect of the declaration and payment of a cash dividend is to decrease both stockholders' equity and total assets. Illustration 11-12 (page 528) summarizes the three important dates associated with dividends for Media General. Allocating Cash Dividends between Preferred and Common Stock As explained earlier in the chapter, preferred stock has priority over common stock in regard to dividends. Holders of cumulative preferred stock must be paid any unpaid prior-year dividends before common stockholders receive dividends. To illustrate, assume that at December 31, 2011, IBR Inc. has 1,000 shares of 8%, $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 50,000 Cash Flows 50,000 SE JWCL165_c11_506-567.qxd 528 8/8/09 7:57 PM Page 528 Chapter 11 Corporations: Organization, Stock Transactions, Dividends, and Retained Earnings Illustration 11-12 Key dividend dates December S Declaration date Board authorizes dividends M 1 7 8 14 15 21 22 28 29 Tu 2 9 16 23 30 W 3 10 17 24 31 Th F S 4 5 6 11 12 13 18 19 20 25 26 27 Record date Registered shareholders are eligible for dividend January S M Tu W Th F S 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Payment date The company issues dividend checks $8,000 (1,000 $8). At December 31, 2011, the directors 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 is: A L SE 6,000 Div Dec. 31 6,000 Cash Flows no effect Cash Dividends Dividends Payable (To record $6 per share cash dividend to preferred stockholders) 6,000 6,000 Because of the cumulative feature, dividends of $2 per share are in arrears on preferred stock for 2011. The company must pay these dividends to preferred stockholders before it can pay any future dividends to common stockholders. IBR should disclose dividends in arrears in the financial statements. At December 31, 2012, IBR declares a $50,000 cash dividend. The allocation of the dividend to the two classes of stock is as follows. Illustration 11-13 Allocating dividends to preferred and common stock Total dividend Allocated to preferred stock Dividends in arrears, 2011 (1,000 $2) 2012 dividend (1,000 $8) $50,000 $2,000 8,000 Remainder allocated to common stock 10,000 $40,000 The entry to record the declaration of the dividend is: A L SE 50,000 Div 50,000 Cash Flows no effect Dec. 31 Cash Dividends Dividends Payable (To record declaration of cash dividends of $10,000 to preferred stock and $40,000 to common stock) 50,000 50,000 What if IBR's preferred stock were not cumulative? In that case preferred stockholders would have received only $8,000 in dividends in 2012. Common stockholders would have received $42,000. JWCL165_c11_506-567.qxd 8/8/09 7:57 PM Page 529 Cash Dividends 529 ACCOUNTING ACROSS THE ORGANIZATION What's Happening to Dividends? The decision whether to pay a dividend, and how much to pay, is a very important management decision. In recent years, many companies have substantially increased their dividends, and total dividends paid by U.S. companies hit record levels. One explanation for the increase is that Congress lowered, from 39% to 15%, the tax rate paid by investors on dividends received, making dividends more attractive to investors. Another driving force for the dividend increases was that companies were sitting on record amounts of cash. Because they did not see a lot of profitable investment opportunities, companies decided to return the cash to shareholders. However, due to the prolonged recession, numerous companies cut their dividends in late 2008 and early 2009. Banks in particular reduced their dividends significantly. For example, Wells Fargo cut its dividend by 85%, and U.S. Bancorp cut its by 88%. Source: Alan Levinsohn, \"Divine Dividends,\"Strategic Finance, May 2005, pp. 59-60. What factors must management consider in deciding how large a dividend to pay? before you go on... Do it! MasterMind Corporation has 2,000 shares of 6%, $100 par value preferred stock outstanding at December 31, 2011. At December 31, 2011, the company declared a $60,000 cash dividend. Determine the dividend paid to preferred stockholders and common stockholders under each of the following scenarios. Dividends on Preferred and Common Stock 1. The preferred stock is noncumulative, and the company has not missed any dividends in previous years. 2. The preferred stock is noncumulative, and the company did not pay a dividend in each of the two previous years. 3. The preferred stock is cumulative, and the company did not pay a dividend in each of the two previous years. Solution 1. The