UNIT 5: ACCOUNTING FOR CORPORATIONS

5.1 INTRODUCTION
Suppose you are planning to start a new business. Would you choose a sole proprietorship, a
partnership or a corporation? In introduction to accounting and previous unit of principles of
accounting courses you have studied about the first two forms of business organizations. In
this unit corporate form of business organization will be discussed.
5.2 DEFINITION OF CORPORATION
 A Corporation is a legal entity having an existence separate and distinct from that
of its owners.
owners. In the eyes of law a corporation is an ‘artificial
‘artificial person’ having many of
its own rights and responsibilities.
5.3 CHARACTERISTICS OF CORPORATION
Among the characteristics of a corporation are:
a) A corporation is a separate legal entity.
entity. According to the law a corporate entity may
own property in its own name, may enter into contract and responsible for its own
debt.
b) A corporation has a legal status in court.
court. According to the law a corporation may sue
and be sued as if it were a real person.
c) A corporation has its own charter.
charter. A corporation is created by obtaining charter from
the state is which the company is to be incorporated.
d) A corporation pays income taxes on its earnings. The income of a corporation is
subject to income taxes which must be paid by the corporation or double taxation.
taxation.
5.4 ADVANTAGES OF THE CORPORATE FORM OF ORGANIZATION
A corporate entity has many advantages not available is other forms of organization. Among
the advantages are the following:
a) Continuous existence: a Corporation has perpetual existence in that its continuous
existence is not dissolved by the death or retirement of any of its members.
b) No personal liability for owners:
owners: Since a corporation is a separate legal entity,
entity, the
creditors of a corporation have a claim against the assets of the corporation, not the
personal property of the owners.

1|Page
 c) Separation of management from ownership:
ownership: the owners of a corporation (called
stockholders or shareholders) own the corporation but they do not manage it on a daily
basis. To administer the affairs of the corporation, president and other officers are
hired for it.
it. Thus, individual stockholder has no right to participate in the
management activity of the corporation unless the stockholder has been hired as a
corporate officer.
d) Easily transferable ownership shares:
shares: ownership of a corporation is evidenced by
transferable shares of stocks. These shares of stocks may be sold by one investor to
another without dissolving or disrupting the business organization.
5.5 DISADVANTAGES OF CORPORATE FORM OF ORGANIZATION
Some of the disadvantages of the corporation are:
a) Double taxation:
taxation: corporate earnings are taxed two times; first as corporate income
taxes and again as personal income taxes if the corporation distributes its earnings to
stockholders.
b) Difficulties to control:
control: Since ownership is usually separated from management,
owners are unable to exercise active control over management actions.
c) Greater regulation:
regulation: since a corporation comes into existence according to the law of
the state, the law may provide for considerable regulation of the corporation’s
activities. For example, the withdrawal of funds from a corporation is subjects to
certain limits set by law.

5.6 FORMATION OF A CORPORATION

A corporation is created by obtaining a charter. The charter is given from the state in
which the corporation is to be incorporated. To obtain a corporate charter an application
called articles of incorporation are prepared by the organizers called incorporators and
submitted to the state corporation’s commissioner or other designated officials. This articles
of incorporation specify the purpose of the business, its location, the names of the organizers,
the classes and numbers of shares of capital stock authorized, and the consideration to be paid
by the organizers for their respective shares. The articles of incorporation is approved by the
state and a charter is issued, Once a charter is obtained a board of directors is elected.
elected. The
directors, in turn, hold a meeting at which officers of the corporation are appointed.

2|Page
5.7 Organization Costs
In the process of incorporation, the organizers must pay for necessary costs such as payment
of incorporation fee to the state,
state, payment of fees to attorneys for their services in drawing up
the articles of incorporation, payment to promoters and a variety of other outlays necessary to
bring the corporation into existence. These costs are charged to an asset account called
organization costs. In the balance sheet, Organization costs appear under the other asset
caption.

5.8 Rights of Stockholders

The stockholders who are the owners of a corporate entity have the following basic rights:
a) The right to vote:
vote: the common stockholders have the right to elect the board of
directors, and thereby to be represented in the managements of the business.
b) The right to participate in the earnings of a corporation:
corporation: stockholders in a
corporation may not make withdrawal of company assets.
assets. However, the earnings of a
profitable corporation may be distributed to stockholders in the form of cash dividend.
The payment of a dividend always required formal authorization by the board of
directors.
c) The right to share in the distribution of assets upon liquidation:
liquidation: when a
corporation ends its existence, the creditors of the corporation must first be paid in
full; any remaining assets are divided among stockholders in proportion to the number
of shares owned.
d) Preemptive rights:
rights: the current stockholders have the right to purchase the shares of
the corporation on a prorate basis when new stocks are offered for sale. This
preemptive right is designed to provide each stockholder the opportunity to maintain a
proportional ownership in the corporation.

5.9 AUTHORIZATION AND ISSUANCE OF STOCKS

The state officials approve the articles of incorporation, which specify the number of shares a
corporation is authorized to issue. The total number of shares that may be issued is known as
the authorized shares. When the corporation receives cash in exchange for stock certificates,
which represent the number of shares issued, the shares become issued shares. Shares that are
issued and held by the stockholders are called outstanding shares. Sometimes a corporation

3|Page
reacquires shares from its own shareholders. These shares are called treasury stocks which
reduce the number of outstanding shares.

A corporation may choose not to issue immediately all the authorized shares even though it is
customary to have a large number of authorized shares than presently needed. If more capital
is needed, the previously authorized shares will be readily available for issue. A corporation
can apply to the state for permission to increase the number of authorized shares.

5.9.1 Types of Stocks Shares

Many corporations issue several classes of capital stock, each providing investors with
different rights and opportunities. The basic type of stock issued by every corporation is
called common stock. Common stock possesses the traditional rights of ownership such as
voting rights, participation in residual claim to assets in the event of liquidation. When any of
these rights is modified, the term preferred stock is used. Preferred stock specifies different
rights that distinguish it form common stock. Some of the distinctive features for preferred
stocks are priority claims on dividends, cumulative dividend rights, priority as to assets in the
event of liquidation of a corporation and no voting power.

Stocks according to their nature are classified into par value and no par stocks. Stock with a
designated dollar amount per share as stated in the corporate charter and printed on the stock
certificate is called par value stock. On the other hand, some states allow corporations to
issue stocks without designating a par value. Such stock is called no par stock. When no par
stock is issued by a corporation, the entire issuance price is viewed as a legal capital, which is
a not subject to withdrawal. Sometimes some states authorize the issuance of no par stock
with a stated, or assigned, value per share that is established permanently by the corporate
directors and is stated in the bylaws. Most corporations use a stated value for no par stock.

5.9.2 Issuance of Par-Value Stocks

5.9.2.1 Authorization
Authorization of par value stocks, specified in the charter may be recorded as a memo entry in
the general journal and in the ledger accounts. Most states require the total number of shares
authorized be shown on each stock certificate, in addition to the number of shares represented
by that particular stock certificates.

4|Page
5.9.2.2 Par Value Stock Issued for Cash
When stocks are issued to various investors, a stock certificate specifying the number of
shares represented is prepared for each investor/ or stockholder). When par value stock is
issued for cash, the capital stock account is credited with the par value of the shares issued
regardless of whether the issuance price is more or less than par, If par value stock is issued
for more than par value (at premium), paid in capital in excess of par account is credited for
the excess of selling price over par. This paid in capital in excess of par does not represent a
profit to the corporation rather it is part of the invested capital. If par value stock is sold by a
corporation for less than par (at discount), a negative stockholders’ equity accounts, Discount
on common (or preferred) stock, is debited for the amount of the discount.

For example, assume that 50,000 shares of Birr 2 par value common stock have been
authorized and that 10,000 of these authorized shares are issued at a price of Birr 10 each. The
entry would be;

Cash…………………………………..100,000
Common stock……………………………..20,000
Paid – in – capital in excess of par……..80,000

5.10. Par Value Stock Issued on a Subscription Basis

During the start – up of a corporation, prospective investors may sign a contract to purchase a
specified number of shares on credit with payment due at one or more specified future dates.
One reason for this procedure is to attract small investors. Another reason is to appeal to
investors who prefer not to invest cash until the corporation is ready to start business
operation. A corporation may also sell its capital stock on credit after incorporation.

When stock is subscribed above par, the company debits stock subscription receivable for the
subscription price, credits capital stock subscribed for the par value of the subscribed shares,
and credits paid in capital in excess of the subscription price over par value. Later, as cash is
collected, the entry is a debit to cash and a credit to stock subscription receivable. When the
entire subscription price is collected, the stock certificates are issued for the subscribers. The

5|Page
issuance of stock is recorded by debiting capital stock subscribed and crediting capital stock.
The following illustration demonstrates the accounting procedures for stock subscriptions.

Assume that 120,000 shares of RAM corporation common stock, par Birr 10 is subscribed for
at Birr 12 by Misrak Binda. The total is payable in three installments. The following entries
are processed by RAM Corporation.

Common stock subscription Receivable 1,440.000.00

Common stock subscribed 1,200.000.00
Paid-in-capital in excess of par 240,000.00
To record receipt of subscription par 120,000 shares

Cash 480,000.00
Common stock subscription receivable 480,000.00
To record receipt of 1st payment

Cash 480,000.00
Common stock subscription receivable 480,000.00
nd
To record receipt of 2 payment

Cash 480,000.00
Common stock subscription receivable 480,000.00
To record receipt of final payment

Common stock subscribed 1,200,000.00

Common stock 1,200,000.00
To record issuance of stocks

5.10.1 Non Cash Issuance of Capital Stock

Corporation sometimes issue capital stock for non-cash assets such as in exchange for real
state. The current market value of the stock issued or the non-cash consideration received,
whichever is most reliably determinable, is used to record the transaction. If the market
values of either capital stock issued or the non-cash items are not reliable; the values are
established by the corporation board of directors.

6|Page
 5.10.2 Issuance of No-Par Stock
Some states allow corporations to issue stock without designating a par or stated value. When
this no par stock is issued, the entire issuance price is credited to the capital stock account and
is viewed as legal capital not subjects to withdrawal.

5.11 ACCOUNTING FOR RETAINED EARNINGS AND DIVIDENDS

Nature of Retained Earnings
Capital provided to corporation by stockholders in exchange for shares of either preferred or
common stock is called paid-in-capital or contributed capital. The second major type of
stockholders’ equity is a retained earnings. The amount of the retained earnings account at
any balance sheet date represents the accumulated earnings (net income) of the company since
the date of incorporation, less any losses and all dividends distributed to stockholders.

5.11.1 Nature of Dividends

A dividend is a distribution of earnings to stockholders in the form of assets or shares of the
issuing company’s stock. Types of dividends include the following:

a) Cash dividend
-cash disbursed

b) Property dividend
-non cash assets disbursed

c) Stock dividend
-corporation’s own stock disbursed

d) Liquidating dividend
-return of contributed capital

e) Scrip dividend
-creative of a liability by declaring a dividend to be paid at a specific future date

7|Page
5.11.2 Relevant Dividend Dates
Prior to payment, dividends must be declared by the board of directors of the corporation.
The important dividend dated are:

1. Date of declaration:
declaration: on this date, the corporation’s board of directors
formally approves and announces the dividend to be distributed. The declaration is
recorded on this date as a debit to dividends and credits to dividends payable.

2. Date of payments:
payments: this date is determined by the board of directors
and is usually stated in the declaration. At the date of payment the liability recorded at
the date of declaration is debited and the appropriate asset account is credited.

5.12 Dividends and Characteristics of Preferred Stock

A corporation with both preferred stock and common stock may declare dividends on the
common only after it meets the requirements of the stated dividend on the preferred. The
preferred dividend may be stated in monetary terms or as a percent of par.

5.12.1 Participating and Nonparticipating Preferred Stock

A participating preferred stock receives a minimum dividend but also receives higher
dividends when the company pays substantial dividends on common shares. The preferred
stockholders’ right may be to receive dividends only stated amounts. Such stock is said to be
nonparticipating.

To illustrate, assume the following information

-common stock issued 4,000.

-Preferred stock issued 2,000.
-Dividend par share of preferred stock Birr 10.00
-The corporation reported net income of Birr 150,000for the third year and the BOD
declared 60% of the net income as dividend. If the preferred sock issued by the corporation is
participating, the preferred stockholders will receive Birr 30,000 ( Birr 20,000+Birr 10,000),
and the common stockholders will receive Birr 60,000 (Birr 40,000+Birr 20,000).

5.12.2 Cumulative and Non- Cumulative Preferred Stock

8|Page
Cumulative preferred means that if the company fails to pay a preferred dividend, its
obligation accumulates and all omitted dividends must be paid in the future before any
common dividends are paid. The cumulative preferred stockholders would receive all
accumulated unpaid dividends (called dividend in arrears) before the holders of common
shares receive anything. Preferred stock not having this cumulative right is called non-
cumulative.

For example, assume the following information

- Cumulative preferred, 10% of Birr 100 par (10,000 shares issued)
- Common stock of Birr 90 par (40,000 shares issued)
- The board of directors (bod) did not declare dividend in year 2
- Year 3 dividend declared by the bod amounts to Birr 320,000
- Year 1 dividend declared and distributed amounts to birr 200,000
If the preferred stock is cumulative, the preferred stockholders will receive Br.
200,000 (Birr 100,000 + Birr 100,000), and the common stockholders will receive Birr
120,000 (Birr 320,000-Birr 200,000).

5.13 ACCOUNTING FOR TREASURY STOCKS

Treasury stock is a corporation’s own stock (preferred or common) that has been issued and
reacquired by the issuing corporation. A corporation may also accept shares of its own stock
in payment of a debt owed by a stockholder or as a donation from a stockholder.

Treasury stock does not reduce the number of shares issued, but does reduce the number of
outstanding shares. The purchase of treasury stock decreases both assets and stockholders’
equity. Moreover, treasury stock does not carry voting, dividend, preemptive, or liquidation
log rights and is not an asset.

Reasons to acquire Treasury Stocks

In general treasury socks are acquired for the following reasons:
a) to support (increase) the market price of the stock.
b) To increase earnings per share by reducing the number of shares outstanding.
c) To reduce dividend payments by reducing the number of shares outstanding.
d) To provide shares for reissuance to employees as a bonus

9|Page
 e) To use the shares acquired for stock dividend
f) To reissue with a higher price

5.13.1 Recording and Reporting Treasury Stock Transactions

There are several methods of accounting for the purchase and the resale of treasury stock. A
commonly used method is the cost basis. When the stock is purchased by the corporation,
treasury stock account is debited for the price paid for it. The par and the price at which the
stock was originally issued are ignored. When the stock is resold, treasury stock is credited at
the price paid for it, and the difference between the price paid and the selling price is debited
or credited to an account entitled paid in capital from sale of treasury stock.

To illustrate the cost method, assume that Harambe Corporation had 50,000 shares of Birr 10
par common stock outstanding at the beginning of the current year. The company purchased
500 shares for cash and received 500 shares in settlement of a debt from stockholders. The
markets price of stocks was Birr 30 per share. The following entry is required involving the
transactions.

Treasury stock 30,000.00

Cash 15,000.00
Notes Receivable 15,000.00

If the company sells 600 shares of the treasury stock for Birr 31 each, the entry would be:

Cash 18,600.00
Treasury stock 18,000.00
Paid in capital from sale of treasury stock 600.00

Paid in capital from sale of treasury stock is reported in the paid in capital section of the
balance sheet. Treasury stock is deducted from the total of the paid in capital and retained
earnings.

QUITY PER SHARE

The amount appearing on the balance sheets as total stockholders’ equity can be stated in
terms of the equity per share. When there is only one class of stock, the equity per share is

10 | P a g e
determined by dividing total stockholders’ equity by the number of shares outstanding. For a
corporation with both preferred and common stock, it is necessary first to allocate the total
equity between the two classes.
To illustrate, consider the following statement of stock holders’ equity at:
December 31, 19 X 1.

-9% preferred stock, Birr 50 par value , authorized 20,000 share,

issued and outstanding 12,000 shares ……………………………….Birr 600,00.00
-Common stock, no par, stated value Birr.2 per share, authorized
500,000 shares, issued 400,000 shares of which 25,000 shares are
held in the treasury………………………………………………… 800,000.00
- paid in capital in excess of par

-preferred birr 50,000

-common 1,000.000 1,050,000.00
-Retained earnings……………………………………………………….2,000,000.00
earnings……………………………………………………….2,000,000.00
subtotal ………………………………………………….Birr 4,450,000.00
-Less cost of 25,000 shares of common stock
reacquired and held in treasury…………………………………………..250,000.00
treasury…………………………………………..250,000.00
-Total stockholders’ equity………………………………………Birr 4,200,000.00

If the preferred stock is entitled to receive Birr 105 per share upon liquidation and if there is
no preferred dividend in arrears, the computation of earnings per share are as follows:

Preferred Eps = equity allocated to preferred stock

Number of outstanding shares of preferred stock

= 105 X 12,000
12,000

= Birr 105 Share

Common EPS = Equity allocated to common stock

Number of o/s shares of common stack

= 2,940,000
11 | P a g e
 375,000

= Birr 7.84/Share

1.

12 | P a g e