Corporations and Stocks

Corporations

A corporation is a legal entity, separate from the individuals who create, own and operate it. The owners of the corporation are those that own shares of the corporation’s stock. These are the stockholders, or shareholders, for the corporation. Corporations whose stocks are bought and sold (traded) in public markets are called public corporations. Those that do not are called nonpublic or private corporations.

The first step in forming a corporation is to file an application of incorporation with the state. State incorporation laws differ, and businesses often organize in states with the more favorable laws. Delaware has very favorable laws for corporations, and thus, over half of the largest corporations have incorporated in Delaware.

After the application has been approved, the state grants a charter or articles of incorporation. These articles formally create the corporation. The management and board of directors then prepare a set of bylaws, which are rules and procedures for conducting the corporations business.

Costs may be incurred in organizing a corporation. These costs include legal fees, taxes, incorporation fees, license fees and promotional costs. Such costs are debited to an expense account entitled Organizational Expenses.

Stock

As discussed in previous articles, the two main sources of stockholders’ equity are retained earnings and contributed capital, also known as paid-in capital. The main source of paid-in capital is from issuing stock.

Within the company’s charter is stated the number of shares that a corporation is authorized to issue. A company doesn’t issue all of it’s stock at one time. The total amount of shares a company is authorized, minus the shares issued, leaves the outstanding stock. This is stock that is still withheld by the company.

There are two main classes of stock. The first is called common stock. With common stock, each share has equal rights. The second is called preferred stock. Owners of preferred stock receive preference to dividends and other monetary issues. In other words, those with preferred stock get paid first, and sometimes more.

Issuing Stock

A separate account is used for recording the amount of each class of stock issued. Shares of stock are often assigned a value called par. Stock is often issued at a price other than its par. This is because the par value of a stock is its legal capital. The price at which stock can be sold depends on a variety of factors including the financial condition of the corporation, investor expectations, and general business and economic conditions.

When a stock is issued at a price over its par, the stock is sold at premium. When it is issued at a price under its par, it is sold at discount. Some states do not allow for stock to be issued at a discount. Others will allow it only under unusual circumstances. Thus, we will only be looking at stocks sold at premium.

Premium Stock

When stock is issued at a premium, cash (or other assets received) are debited for the amount received. Common Stock (or Preferred Stock, depending on which is sold) is then credited for the par amount (par value times number of shares issued). The excess of the amount paid over par is classified as Pain-In Capital in Excess of Par.

If a company has par value of $1 per share, and issues 100,000 shares at $1.50, then the transaction would be recorded as:

Cash150,000 ($1.50 times 100,000)
     Common Stock     100,000 ($1 times 100,000)
     Pain-in Capital in Excess of Par     50,000 (($1.50 minus $1) times 100,000)

No-Par Stock

No-par stock is stock that does not have an assigned par value. When stock is issued with no-par, the entire proceeds are credited to the stock account. In the above example where there is no par, the transaction would be recorded as:

Cash150,000
     Common Stock     150,000

Dividends

There are two types of dividends that we will look at. The first is cash dividends. The second is stock dividends. For either type, there are three dates that are important. The first is the date of declaration. This is when the board of directors declares that a dividend will be paid out. At this point, the company incurs the liability of paying the dividend at a future date, stated during the declaration. The second date is the date of record. This means that anybody that is a shareholder at the close of business on the day of record will be paid the dividend. The third date is the payment date. The payment date is the date that the dividend is actually paid. The liability is then cleared by the payment of the dividend.

Cash Dividends

A cash dividend requires three items in order to be declared. These are:

1. Sufficient retained earnings
2. Sufficient cash
3. Formal action by the board of directors

We discussed the action by the board of directors above, declaring the dividend. Let’s look at a working example.

Driden Enterprises has 100,000 shares of outstanding stock. The company’s board of directors decides on June 15th to issue a cash dividend of $0.25 with a date of record being August 15th, and payment date being September 1st.

On June 15th, after declaring the dividend, Driden Enterprises would record the following transaction:

Cash Dividends25,000
     Cash Dividends Payable     25,000

There is no entry required for the date of record. On September 1st, the payment date, the following transaction would be recorded:

Cash Dividends Payable   25,000
     Cash     25,000

Stock Dividends

Sometimes a company will issue additional shares of stock rather than a cash dividend. The effect of a stock dividend is to transfer retained earnings to a paid-in capital. For public companies, the amount transferred is usually the fair value (market price) of the shares issued. For example, Driden Enterprises decides on the June 15th meeting to issue 0.05 shares for each share a stockholder owns instead of 25 cents per share Another way to say this is the company is issuing 5% stock dividend. The following data has to be taken into account:

Common stock with $1 par, 2,000,000 shares issued$2,000,000.00
Paid-In Capital in Excess of Par (shares were sold at $1.50)  $1,000,000.00
Retained Earnings$ 25,000.00
Market price on June 15th$35/share

The entry to record the declaration on June 15th would be:

Stock Dividends (2,000,000 shares X .05 X 35/share)3,500,000
     Stock Dividends Distributable ($1 par X 100,000 shares)     100,000
     Paid-In Capital in Excess of Par-
Common Stock
     3,400,000

The $3,500,000 is closed to Retained Earnings on June 30th, at the end of the accounting period. On September 1st, when the dividend is paid out, the number of shares outstanding is increased by the following entry:

Stock Dividend Distributable  100,000
     Common Stock     100,000

A stock dividend does not change the assets, liabilities or total stockholders’ equity.

Treasury Stock

A company may buy its own stock to provide shares for resale to employees, reissuing as a bonus, or for supporting the market price of the stock. Stock that a company issues, and then reacquires, is called Treasury Stock.

The most common way of accounting for treasury stock is the cost method. With this method, the paid-in capital is reduced by debiting treasury stock for the price paid for it. The par value and price at which the stock was originally issued are ignored. A company cannot earn dividends on treasury stock.

When the stock is resold, treasury stock is credited for its cost, and any difference between the cost and the selling price is debited or credited to Paid-In Capital From the Sale of Treasury Stock.

Stock Splits

Sometimes a stock will be valued so high that investors do not want to buy. Sometimes a corporation may wish to reduce the par value of their common stock and issue a proportionate number of additional shares of the stock. When either of these occur, the company performs a stock split.

To illustrate, Driden Enterprises has 10,000 shares at $100 par. The current market price is $150 per share. The board of directors decides to perform a 5-for-1 stock split. That means every 1 share of stock will become 5 shares. In doing so, the par is reduced by 1/5th to $20 ($100 divided by 5). The market price is reduced by 1/5th to $30 ($150 divided by 5). However, the number of shares is increased to 50,000 (10,000 times 5). The end result is the same monetary values for the shares, but with more shares available. See the comparison chart below

OriginalAmountSplit
Par 10,000 @ $1001,000,000   50,000 @ $20
Market 10,000 @ $150  1,500,000   50,000 @ $30

Since a stock split changes only the par value and the number of shares outstanding, it is not recorded by a journal entry. Although the accounts are not affected, details of the stock splits are generally disclosed in the notes to the financial statements.