Chapter 11: Contributed Capital 1

Chapter 11: Contributed Capital 1

CHAPTER 11

Contributed Capital

reviewing the chapter

Objective 1: Identify and explain the management issues related to contributed capital.

1.A corporation is a business unit chartered by the state and legally separate from its owners—the stockholders. The management of contributed capital (stockholders’ investments) is critical to the financing of a corporation. Specifically, management must fully understand (a) the advantages and disadvantages of incorporation, (b) the issues involved in equity financing, (c) the business’s dividend policies, (d) the use of return on equity to evaluate performance, and (d) the company’s stock option plans. These topics will be addressed in the paragraphs to follow.

2.Because of the ease with which a corporation can raise large amounts of capital, it is the dominant form of business in the United States. The corporation has several advantages over the sole proprietorship and partnership. In addition to its ability to raise large amounts of capital, it is a separate legal entity, offers its owners limited liability, lacks the mutual agency that characterizes a partnership, has a continuous existence, and allows for centralized authority and responsibility, as well as for professional management. It is also easy to transfer ownership in a corporation. However, a corporation has several disadvantages when compared with a sole proprietorship or partnership. It is subject to greater government regulation and to double taxation (i.e., the corporation’s income is subject to income taxes, and its stockholders are taxed on any dividends), and the owners’ limited liability can limit the amount a small corporation can borrow. Moreover, separation of ownership and control may allow management to make harmful decisions.

3.Ownership in a corporation is evidenced by a document called a stock certificate, which shows the number of shares the stockholder owns. A stockholder sells stock by endorsing the stock certificate and sending it to the corporation’s secretary. The secretary—or in many instances, an independent registrar or transfer agent—is responsible not only for transferring the stock, but also for maintaining stockholders’ records, preparing a list of stockholders for stockholders’ meetings, and paying dividends. Par value is an arbitrary amount assigned to each share of stock, and it constitutes a corporation’s legal capital. Legal capital equals the number of shares issued times the par value; it is the minimum amount that can be reported as contributed capital. Par value bears little if any relationship to the market value or book value of the shares.

4.Corporations often hire an underwriter, an intermediary between the corporation and the investing public, to help in their initial public offering (IPO) of capital stock. A corporation in this instance is said to be “going public.” The underwriter guarantees the sale of the stock and charges a fee for this service.

5.The costs of forming a corporation are called start-up and organization costs. Incurred before a corporation starts operations, they include state incorporation fees, attorneys’ fees, accountants’ fees, and the cost of printing stock certificates. Such costs are expensed when incurred.

6.Equity financing, or financing a business by issuing common stock, has the following advantages: (a) The risk of default is lower than when financing with bonds, (b) Earnings can be plowed back into operations by withholding dividend payments, and (c) The debt to equity ratio will be improved.

7.Equity financing, on the other hand, has the following disadvantages: (a) Unlike interest on bonds, dividends paid on stock are not tax-deductible to the issuing corporation, and (b) When a corporation issues more stock, the current stockholders must, therefore, yield some control to the new stockholders.

8.A dividend is a distribution of assets to stockholders, based on past earnings. Although a board of directors has the sole authority to declare dividends, senior managers, who usually serve on the board, influence dividend policies. A liquidating dividend is a dividend that exceeds retained earnings. It represents a return of contributed capital to the stockholders and is usually issued when a corporation is going out of business or reducing its operations.

9.A corporation’s board of directors decides on the timing of dividend payments, which may be quarterly, semiannually, annually, or at other times. In addition, most states do not allow a corporation to declare a dividend that exceeds its retained earnings. The declarationdate is the date on which the board formally declares a dividend, specifying that the owners of the stock on the recorddate will receive their dividends on the date of payment. Between the record date and the date of payment, the stock is said to be ex-dividend (without dividend rights). The liability for payment of cash dividends arises on the date of declaration. The declaration is recorded with a debit to Dividends and a credit to Dividends Payable. No journal entry is made on the record date. On the date of payment, Dividends Payable is debited, and Cash is credited. The Dividends account is closed to Retained Earnings at the end of the accounting period.

10.Investors evaluate the amount of the dividends they receive by looking at the dividends yield, which is calculated as follows:

Dividends per Share
Market Price per Share

Expressed as a percentage, the dividends yield measures the return, in terms of dividends, per share of stock.

11.Among the factors that affect a company’s decision to pay dividends are the level of profitable operations, the dividend policy that prevails among other companies in the same industry, the expected volatility of earnings, and the actual amount of cash available for dividend payments.

12.Management’s decisions about a variety of matters, including the issuance of stock, affect return on equity. Return on equity is therefore commonly used as a measure of management’s performance. Expressed as a percentage, it is calculated as follows:

Net Income
Average Stockholders’ Equity

One way to increase return on equity (other than increasing net income) is to reduce average stockholders’ equity. This can be accomplished by buying back some of the company’s stock on the open market. These shares are then described as treasury stock.

13.The price/earnings (P/E) ratio, on the other hand, measures investors’ confidence in a company’s future. The P/E ratio is calculated as follows:

Market Price per Share
Earnings per Share

A P/E ratio of 15 times, for example, means that investors are confident enough in a company to pay $15 per share for every dollar of earnings accruing to one share.

14.A stock option plan allows a corporation’s employees to purchase a certain quantity of the corporation’s stock at a certain price over a certain period of time. Sometimes, stock options are offered only to management personnel. On the date on which the options are granted, their fair value must first be estimated. Then, the amount by which the fair value exceeds the option price must be recorded as compensation expense (a tax-deductible expense) over the grant period. If the market price of the stock increases above the fixed option price during the option period, the employee can purchase the stock and then sell it for a gain.

Objective 2: Identify the components of stockholders’ equity.

15.On a corporation’s balance sheet, the owners’ claims to the business are called stockholders’ equity. The stockholders’ equity section is divided into at least three parts: contributed capital (the stockholders’ investments in the corporation), retained earnings (earnings that have remained in the business), and treasury stock (issued stock that has been bought back by the issuing corporation).

16.If a corporation issues only one type of stock, it is called common stock. A second type of stock, called preferred stock, can also be issued. Because common stockholders’ claims to corporate assets rank behind the claims of creditors and preferred stockholders in the case of liquidation, common stock is considered a corporation’s residual equity.

17.Authorized shares are the maximum number of shares that a corporation’s state charter allows it to issue. Issued shares consist of stock that a corporation has sold or otherwise transferred to stockholders. Outstanding shares consist of issued stock that is still in circulation.

Objective 3: Identify the characteristics of preferred stock.

18.Each share of preferred stock entitles its owner to a dividend each year. Although holders of preferred stock usually lack the voting rights that common stockholders enjoy, they have preference over common stockholders in terms of the receipt of dividends; that is, when a board of directors declares dividends, holders of preferred stock must receive a certain amount of dividends before common stockholders receive anything. The amount they receive is a specific dollar amount or a percentage of the par value of the preferred shares.

19.If a board of directors fails to declare an annual dividend to preferred stockholders, the consequences vary according to the terms under which the shares were issued. If the stock is cumulative preferred stock, the unpaid amount is carried over to the next year. Unpaid back dividends are called dividends in arrears. They become a liability only when the board declares a dividend, and they should then be disclosed in the financial statements or in a note to the financial statements. If the stock is noncumulative preferred stock, the corporation is under no obligation to make up the missed dividends.

20.In addition to having preference over common stockholders in terms of receipt of dividends, holders of preferred stock have preference in terms of assets when a corporation is liquidated. In this case, preferred stockholders must receive the par value of their shares or a larger stated liquidation per share before common stockholders receive any share of the corporation’s assets.

21.An owner of convertible preferred stock has the option of exchanging each share of preferred stock for a specified number of shares of common stock. However, once the stockholder has converted to common, he or she cannot convert back to preferred.

22.Most preferred stock is callable preferred stock, which means that the corporation has the right to buy the stock back at a specified price (called the call price, or redemption price), which is usually higher than the par value of the stock. If the stock is nonconvertible, the holder must surrender it to the corporation when asked to do so. If it is convertible preferred stock, the holder has the option of converting it to common stock. When preferred stock is called and surrendered, the stockholder is entitled to (a) the par value of the stock, (b) the call premium, (c) any dividends in arrears, and (d) a prorated portion of the current period’s dividend.

Objective 4: Account for the issuance of stock for cash and other assets.

23.Capital stock may or may not have a par value, depending on the specifications in the corporate charter. When par value stock is issued, the Capital Stock account (that is, Common Stock or Preferred Stock) is credited for the legal capital (par value), and any excess is recorded as Additional Paid-in Capital. The entire amount is labeled total contributed capital in the stockholders’ equity section of the balance sheet. On the rare occasions that stock is issued at a discount (less than par value), Discount on Capital Stock is debited.

24.No-par stock is stock for which a par value has not been established. It can be issued with or without a stated value. The stated value can be any value assigned by the board of directors unless state law specifies a minimum amount. The total stated value is recorded in the Capital Stock account. Any amount received in excess of the stated value is part of the corporation’s contributed capital; it is recorded as Additional Paid-in Capital. When a corporation issues no-par stock without a stated value, the entire amount received is credited to Capital Stock. Unless state law specifies a different amount, that amount is designated as legal capital, which can be withdrawn only if the corporation is being liquidated.

25.Stock is sometimes issued in exchange for noncash assets or for services received. This kind of transaction should be recorded at the fair market value of the stock. If the stock’s fair market value cannot be determined, the fair market value of the assets or services received should be used.

Objective 5: Account for treasury stock.

26.Treasury stock is stock that the issuing corporation has reacquired (i.e., the stock is issued but is no longer outstanding). Companies may purchase their own stock for several reasons: to distribute it to employees through stock option plans, to maintain a favorable market for the stock, to increase earnings per share, to use in purchasing other companies, or to prevent a hostile takeover by another company. Treasury stock can be held indefinitely, reissued, or retired. It has no rights until it is reissued. It appears as the last item in the stockholders’ equity section of the balance sheet as a deduction from the total of contributed capital and retained earnings.

27.When treasury stock is acquired, its account is debited for the purchase cost, and Cash is credited. The par value, stated value, or original issue price of the stock is disregarded.

28.Treasury stock may be reissued at the purchase cost, above that cost, or below it. When cash received from a reissue exceeds the purchase cost, the difference is credited to Paid-in Capital, Treasury Stock. When cash received is less than the purchase cost, the difference is debited to Paid-in Capital, Treasury Stock. If Paid-In Capital, Treasury Stock does not exist or if the balance in that account is insufficient to cover the difference, Retained Earnings should be debited. In no case should a gain or loss on the reissuance of treasury stock be recorded.

29.When treasury stock is retired (stockholder approval is required), all the contributed capital associated with the retired shares must be removed from the accounts. If less was paid to acquire the stock than was contributed originally, the difference is credited to Paid-in Capital, Retirement of Stock. If more was paid, the difference is debited to Retained Earnings.

Summary of Journal Entries Introduced in Chapter 11

A. / (LO 1) / Dividends / XX (amount declared)
Dividends Payable / XX (amount to be paid)
Declared cash dividend to common stockholders
B. / (LO 1) / Dividends Payable / XX (amount paid)
Cash / XX (amount paid)
Paid cash dividends declared in Entry A
C. / (LO 4) / Cash / XX (amount invested)
Common Stock / XX (legal capital amount)
Additional Paid-in Capital / XX (excess of par value)
Issued par value common stock for amount in excess of par value
D. / (LO 4) / Cash / XX (amount invested)
Common Stock / XX (legal capital amount)
Issued no-par common stock (no stated value
established)
E. / (LO 4) / Cash / XX (amount invested)
Common Stock / XX (legal capital amount)
Additional Paid-in Capital / XX (excess of stated value)
Issued no-par common stock with stated value
for amount in excess of stated value
F. / (LO 4) / Start-up and Organization Expense / XX (fair market value of services)
Common Stock / XX (par value)
Additional Paid-in Capital / XX (excess of par value)
Issued par value common stock for incorporation services
G. / (LO 4) / Land / XX (fair market value of stock)
Common Stock / XX (par value)
Additional Paid-in Capital / XX (excess of par value)
Issued par value common stock with a market
value in excess of par value for a piece of land
H. / (LO 5) / Treasury Stock, Common / XX (cost)
Cash / XX (amount paid)
Acquired shares of the company’s common stock
I. / (LO 5) / Cash / XX (amount received)
Treasury Stock, Common / XX (cost)
Reissued shares of treasury stock at cost
J. / (LO 5) / Cash / XX (amount received)
Treasury Stock, Common / XX (cost)
Paid-in Capital, Treasury Stock / XX (“gain”)
Sold shares of treasury stock at amount above cost
K. / (LO 5) / Cash / XX (amount received)
Paid-in Capital, Treasury Stock / XX (“loss”)
Retained Earnings (only if needed) / XX (“loss”)
Treasury Stock, Common / XX (cost)
Sold shares of treasury stock at amount below cost
L. / (LO 5) / Common Stock / XX (par value)
Additional Paid-in Capital / XX (excess of par value)
Retained Earnings (only if needed) / XX (premium paid)
Treasury Stock, Common / XX (cost)
Retired treasury stock; cost exceeded original
investment amount
M. / (LO 5) / If the treasury stock in Entry L were retired for an
amount less than the original investment, then instead of
Retained Earnings being debited for the excess paid,
Paid-in Capital, Retirement of Stock would be credited
for the difference.