St.

Mary’s University, Department of Accounting

PRINCIPLES OF ACCOUNTING II
Chapter 5
ACCOUNTING FOR CORPORATIONS
5.1 Nature of a Corporation
A corporation is a legal entity—an artificial legal “person”— created on the approval of the
appropriate governmental authority. To form a corporation, the incorporators (often at least
three are required) must apply for a charter. The incorporators prepare and file the articles of
incorporation, which delineate the basic structure of the corporation, including the purposes for
which it is formed, the amount of capital stock to be authorized, and the number of shares into
which the stock is to be divided. If the incorporators meet the requirements of the law, the
government issues a charter or certificate of incorporation. After the charter has been granted,
the incorporators (or the subscribers to the corporation’s capital stock) hold an organization
meeting to elect the first board of directors and adopt the bylaws of corporations.

Because assets are essential to corporate operations, the corporation issues certificates of capital
stock to obtain the necessary funds. As owners of the corporation, stockholders, or shareholders,
are entitled to a voice in the control and management of the company. Stockholders with voting
stock may vote at the annual meeting and participate in the election of the board of directors.
The board of directors is responsible for the overall management of the corporation. Normally
the board selects such corporate officers as a president, one or more vice-presidents, a
controller, and a treasurer. The officers implement the policies of the board of directors and
actively manage the day-to-day affairs of the corporation.

Creating a corporation is more costly than organizing a proprietorship or partnership. The

expenditures incurred to organize a corporation are charged to Organization Costs, an intangible
asset account. These costs include attorney’s fees, fees paid to the government, and costs of
promoting the enterprise. Organization costs typically are amortized.

5.2 Characteristics of Corporations

 Separate Legal Entity
A business with a corporate charter is empowered to conduct business affairs apart from its
owners. The corporation, as a legal entity, may acquire assets, incur debt, enter into contracts,
sue, and be sued—all in its own name. The owners, or stockholders, of the corporation receive
stock certificates as evidence of their ownership interests; the stockholders, however, are
separate and distinct from the corporation. This characteristic contrasts with proprietorships and
partnerships, which are accounting entities but not legal entities apart from their owners.
Owners of proprietorships and partnerships can be held responsible separately and collectively
for unsatisfied obligations of the business.

 Limited Liability
The liability of shareholders with respect to company affairs is usually limited to their
investment in the corporation. Because of this limited liability, laws restrict distributions to
shareholders. To protect creditors, the government controls the distribution of contributed capital.

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Distributions of retained earnings (undistributed profits) are not legal unless the board of
directors formally declares a dividend. Because of the legal delineation of owner capital
available for distribution, corporations must maintain careful distinctions in the accounts to
identify the different elements of stockholders’ equity.
 Transferability of Ownership
Shares in a corporation may be routinely transferred without affecting the company’s
operations. The corporation merely notes such transfers of ownership in the stockholder records
(ledger). Although a corporation must have stockholder records to notify shareholders of
meetings and to pay dividends, the price at which shares transfer between owners is not
recognized in the corporation’s accounts.
 Continuity of Existence
Because routine transfers of ownership do not affect the affairs of a corporation the corporation
is said to have continuity of existence. In this respect, a corporation is completely different from
a partnership. In a partnership, any change in ownership technically results in dissolution of the
old partnership and formation of a new one. In a partnership, the individual partners’ capital
accounts indicate their relative interests in the business. The stockholders’ equity section of a
corporate balance sheet does not present individual stockholder accounts. A shareholder,
however, can easily compute his or her interest in the corporation by calculating the proportion
of the total shares outstanding that his or her shares represent.

For example, if only one class of stock is outstanding and it totals 1,000 shares, an individual
owning 200 shares has a 20% interest in the total stockholders’ equity of the corporation, which
includes all contributed capital and retained earnings. The dollar amount of this interest,
however, is a book amount, rarely coinciding with the market value. A stockholder who
liquidates his or her investment would sell it at a price negotiated with a buyer or, if the stock
is traded on a stock exchange, at the exchange’s quoted market price.

 Capital-raising Capability
The limited liability of stockholders and the ease with which shares of stock may be transferred
from one investor to another are attractive features to potential stockholders. These
characteristics enhance the ability of the corporation to raise large amounts of capital by issuing
shares of stock. Because both large and small investors may acquire ownership interests in a
corporation, a wide spectrum of potential investors exists.
 Taxation
As legal entities, corporations are subject to income taxes on their earnings, whether distributed
or not. In addition, shareholders must pay income taxes on earnings received as dividends.
Therefore, corporate income is subject to double taxation.
 Regulation and Supervision
Corporations are subject to greater degrees of regulation and supervision than are
proprietorships and partnerships. The laws limit the powers a corporation may exercise, identify
reports that must be filed, and define the rights and liabilities of stockholders. Furthermore,
corporations whose stock is listed and traded on organized security exchanges are subject to the
various reporting and disclosure requirements of these exchanges.

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5.3 Nature and Types of Stock in a Corporation
The corporate charter may specify a face value, or par value, for each share of a stock of any
class. Par values are typically set at amounts well below the stock’s market value at date of
issue. Par value today, therefore, has no economic significance. However, par value may have
legal implications. In some countries, par value may represent the minimum amount that must
be paid-in per share of stock.
If stock is issued at a discount (that is, at less than par value), the stockholder may have a
liability for the discount if creditors claims remain unsatisfied after the liquidation of the
company. Issuing stock at a discount is a rare event, because boards of directors have generally
established par values below market values at time of issue.

Par value may also be used in some laws to define the legal capital of a corporation. The legal
capital is the minimum amount of contributed capital that must remain in the corporation as a
margin of protection for creditors. A distribution of assets to stockholders would not be allowed
if it reduced stockholders’ equity below the amount of legal capital. Given the role that par
value may play in defining legal capital, accountants carefully segregate and record the par
value of stock transactions in an appropriate capital stock account.

The laws of most countries permit the issuance of stock without a par value—that is, no-par
stock. The company’s board of directors usually sets a stated value for the no-par stock. In such
cases, the stated value will determine the corporation’s legal capital. Again, the stated value
figure is usually set well below market value at time of issue, but in contrast to par value, the
stated value is not printed on the stock certificate. For accounting purposes, stated value
amounts are treated in a fashion similar to par value amounts. In the absence of a stated value,
the entire proceeds from the issuance of no-par stock will likely establish the legal capital of
the corporation.

5.4 Classification of Stock

The amounts and kinds of stock that a corporation may issue are enumerated in the company’s
charter. Providing for several classes of stock permits, the company has to raise capital from
different types of investors. The charter also specifies the corporation’s authorized stock —the
maximum number of shares of each class of stock that may be issued. A corporation that wishes
to issue more shares than its authorized number must first amend its charter. Shares that have
been sold and issued to stockholders constitute the issued stock of the corporation. The
corporation may repurchase some of this stock. Shares actually held by stockholders are called
outstanding stock, whereas those reacquired by the corporation (and not retired) are treasury
stock. The stocks that are issues and held by the corporation are referred to as outstanding stock.

5.4.1Common Stock
When only one class of stock is issued, it is called common stock. Common shareholders
compose the basic ownership class. They have rights to vote, to share in earnings, to participate
in additional issues of stock, and—in the case of liquidation—to share in assets after prior
claims on the corporation have been settled.

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We now consider each of these rights. As the owners of a corporation, the common shareholders
elect the board of directors and vote on other matters requiring the approval of owners. Common
shareholders are entitled to one vote for each share of stock they own. Owners who do not attend
the annual stockholders’ meetings may vote by proxy (this may be the case for most
stockholders in large corporations).A common stockholder has the right to a proportionate share
of the earnings of the corporation that are distributed as dividends. All earnings belong to the
corporation, however, until the board of directors formally declares a dividend.

Each shareholder of a corporation has a preemptive right to maintain his or her proportionate
interest in the corporation. If the company issues additional shares of stock, current owners of
that type of stock receive the first opportunity to acquire, on a pro-rata basis, the new shares. In
certain situations, management may request shareholders to waive their preemptive rights. For
example, the corporation may wish to issue additional stock to acquire another company. Fur-
ther, stockholders of firms incorporated in some states do not receive preemptive rights.

A liquidating corporation converts its assets to a form suitable for distribution, usually cash,
which it then distributes to parties having claims on the corporate assets. Any assets remaining
after all claims have been satisfied belong to the residual ownership interest in the corporation—
the common stockholders. These owners are entitled to the final distribution of the balance of
the assets.

5.4.2 Preferred Stock

Preferred stock is a class of stock with various characteristics that distinguish it from common
stock. Preferred stock has one or more preferences over common stock, usually with reference
to: (1) dividends and
(2) assets when the corporation liquidates.
To determine the features of a particular issue, we must examine the stock contract. The
majority of preferred issues, however, have certain typical features, which we discuss below.

 Dividend Preference
When the board of directors declares a distribution of earnings, preferred stockholders are
entitled to a certain annual amount of dividends before common stockholders receive any
distribution. The amount is usually specified in the preferred stock contract as a percentage of
the par value of the stock or in dollars per share if the stock does not have a par value. Thus, if
the preferred stock has a Br 100 par value and a 6% dividend rate, the preferred shareholders
receive Br 6 per share in dividends. However, the amount is owed to the stockholders only if
declared.

Preferred dividends are usually cumulative—that is, regular dividends to the preferred
stockholders omitted in past years must be paid in addition to the dividend of the current year
before any distribution is made to common shareholders. For example, a dividend may not be
declared in an unprofitable year. If the Br 6 preferred stock dividend mentioned above is one
year in arrears and a dividend is declared in the current year, preferred shareholders would
receive Br 12 per share before common shareholders received anything.

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If a preferred stock is non-cumulative, omitted dividends do not carry forward. Because investors
normally consider the non-cumulative feature unattractive, non-cumulative preferred stock is
rarely issued.

Dividends in arrears (that is, omitted in past years) on cumulative preferred stock are not an
accounting liability and do not appear in the liability section of the balance sheet. They do not
become an obligation of the corporation until the board of directors formally declares such
dividends. Any arrearages are typically disclosed to investors in a footnote to the balance sheet.
 Asset Distribution Preference
Preferred stockholders normally have a preference over common stockholders as to the receipt
of assets when a corporation liquidates. As the corporation goes out of business, the claims of
creditors are settled first. Then, preferred stockholders have the right to receive assets equal to
the par value of their stock or a larger stated liquidation value per share before any assets are
distributed to common stockholders. The preferred stockholders’ preference to assets in
liquidation also includes any dividends in arrears. Preferred stocks may also be classified into
participating and non-participating. Participating preferred stock refers to preferred stock that
has a right to a stated dividend and, after common stock has been paid a dividend, can participate
in any excess dividends. Nonparticipating preferred stock does not have this right.
5.5 Accounting for Corporations
5.5.1 Issuance of Stocks
Capital stock may be issued at par, above par, or below par. Par value is not an indicator of
market value – it is strictly a legal matter. When stock is issued above or below par, the excess
or deficiency is recorded in a Premium Account called Paid-in Capital in Excess of Par, or, if no
balance exists in this account, in a Discount Account. Stock can be issued for cash, plant assets,
legal services, or on account. Treasury stocks are those shares that are re-acquired and held by
the corporation. The number of shares currently owned by stockholders; that is, the number of
shares authorized minus the total number of un-issued shares and minus the number of treasury-
shares.

Illustration 1, assume that the corporate charter of XYZ Company specifies "authorized capital
stock, 100,000 shares, par value Br.1 per share. Further, assume that to date, XYZ Corporation
has sold and issued 30,000 shares of its capital stock.

 The stocks can be summarized as follows:

Authorized shares 100,000
Issued shares 30,000
Un-issued shares 70,000
 If the corporation has repurchased 1,000 shares to date, the authorized shares, treasury
stocks, un-issued stocks, and outstanding stocks will be as follows:
Authorized shares 100,000
Treasury stock (1,000)
Un-issued shares (70,000)
Outstanding shares 29,000 shares
 The stockholders’ equity accounts of a corporation represent the two primary sources of
stockholders' equity:
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1. Contributed capital from the sale of stock, which is the amount invested by stockholders
through the purchase of shares of stock from the corporation. Contributed capital has two
distinct components: (a) Par or Stated Value derived from the sale of capital stock, and
(b) Additional Contributed Capital in excess of par or stated value.
(This is often called Additional Paid-In Capital.)
2. Retained earnings generated by the profit-making activities of the company. This is the
cumulative amount of net income earned since the organization of the corporation less the
cumulative amount of dividends paid by the corporation since organization.
 Most companies generate a significant part of their stockholders' equity from retained
earnings rather than from capital raised through the sale of stock.

5.5.2 Sale and Issuance of Capital Stock

Most sales of stock to the public are cash transactions.
Illustration 2, To illustrate accounting for an initial sale of stock, assume that on January 1,
20x5, M Company sold 100,000 shares of its Br 0.10 par value stock for Br 22 per share.
 The company records the following journal entry:

Date Accounts Debit Credit

20X5, Jan. 1 Cash (100,000x Br 22) 2,200,000
Common stock (100,000 x Br. 0.10) 10,000
Paid In Capital in Excess of Par 2,190,000
 Sale of Stock with No-Par-Value
Some corporations do not specify a par value for their stock. In these cases, depending on
the law, common stock is recorded under one of the following two approaches:
1. Using Stated Value: The corporation must specify in its bylaws a stated value per
share as legal capital. This stated value is used as a substitute for par value, and the
sale of common stock is recorded in a manner similar to the previous journal entry.
Date Accounts Debit Credit
20X5, Jan. 1 Cash (100,000x Br 22) 2,200,000
Common stock (100,000 x Br. 0.10) 10,000
Paid In Capital in excess of Stated Value 2,190,000
2. Recording the whole proceeds as a Legal Capital: The corporation must record the
total proceeds received from each sale of no-par stock as legal capital. In this case,
the total proceeds are recorded in the Common Stock account and there is no account
called Capital in Excess of Par.

Date Accounts Debit Credit

20X5, Jan. 1 Cash (100,000 x Br 22) 2,200,000
Common stock (100,000 x Br 22) 2,200,000

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5.5.3 Capital Stock Sold and Issued for Non-cash Assets and/or Services
One feature common to all start-up companies is a shortage of cash. Because these companies
often cannot afford to pay cash for needed assets and services, they sometimes issue stock to
people who can supply these assets and services. Indeed, many executives will join start-up
companies for very low salaries because they also earn shares of stock.

When a company issues stock to acquire assets or services, the acquired items are recorded at
the market value of the stock issued at the date of the transaction in accordance with the cost
principle. If the market value of the stock issued cannot be determined, the market value of the
consideration received should be used. .

Illustration 3, Assume that during its early years of operations, M Company was unable to pay
cash for needed legal services. The company issued 10,000 shares of stock to a law firm when
the stock was selling for Br 15 per share.
 At that time, the company recorded the following journal entry:

Date Accounts Debit Credit

20X5, Jan. 1 Legal Fees (Expense) 150,000
Common stock (100,000 x Br 0.10) 1,000
Paid-in Capital in Excess of Par 149,000
 Notice that the value of the legal services received is assumed to be the same as the value
of the stock that was issued. This assumption is reasonable because two independent
parties usually keep negotiating a deal until the value of what is given up equals the value
of what is received.

5.5.4 Capital Stock Sold and Issued through Subscription

The stocks could also be issued with the arrangement that the subscribers sign a contract to
effect payment for a specified number of shares in installment and the shares would be issued
to the subscribers upon the final payment.
Illustration 4, Assume that on Feb 1 20x5, M Company signed a stock subscription agreement
to issue 10,000 shares of common stock at Br 10 per share. A Br 20,000 down payment was
collected. The remainder of the subscription price is due in two equal installments on March 1,
20x5 and April 1, 20x5.
 On February 1, 20x5, the transaction will be recorded as follows:
Date Accounts Debit Credit
20X5, Feb. 1 Stock Subscription Receivable 80,000
Cash 20,000
Common Stock Subscribed (10,000x Br. 0.10) 1,000
Paid-in Capital in Excess of Par 99,000

Stock Subscription Receivable Account is a Current Asset Account to be reported on the balance
sheet. The Common Stock Subscribed Account is a Temporary Capital Account to be closed to
the common stock account when the subscriptions are fully collected.

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The temporary capital account is used to show that the subscribers do not have the rights of
shareholders, as they did not finalize the transaction of buying the shares.
 When the first installment is collected on March 1, 20x5, the following entry would be
recorded:

Date Accounts Debit Credit

20X5 Mar.1 Cash [80,000/2] 40,000
Stock Subscriptions Receivable 40,000
On April 1, 20x5, the final installment is collected and the shares are issued to the
subscribers.
 On this date the following entry is prepared:

Date Accounts Debit Credit

20X5, Apr. 1 Cash [80,000/2] 40,000
Stock Subscriptions Receivable 40,000
1 Common Stock Subscribed 1,000
Common Stock 1,000

 The first entry shows collection of the receivables. And the second entry closes the
temporary capital account of- Common Stock Subscribed since all the amounts due from
the subscribers are collected.

5.6 Treasury Stock

Capital stock that is reacquired by a corporation is termed Treasury Stock. Treasury stock has
no voting, dividend, or other stockholder rights. Stock can be reacquired for various reasons,
such as to have shares available for distribution to employees under bonus plans, and to support
the market price of the stock by stimulating trading in it. If treasury stock is resold, no gain or
loss is recognized on the exchange because the corporation’s primary objective is not to make
profit by trading in its own stock. In addition, the treasury stocks are not assets; rather they are
deductions from stockholders equity. The recording of the purchase of treasury stock is based
on the cost of the shares that were purchased.

Illustration 5, Assume that On April 1, 20x5, M Company bought 100,000 shares of its stock
in the open market when it was selling for Br 22 per share.

 Using the cost method, the company records the following journal entry:

Date Accounts Debit Credit

20X5, Apr. 1 Treasury stock (100,000 x Br 22) 2,200,000
Cash 2,200,000

Intuitively, many students expect the Treasury Stock account to be reported as an asset. This is
not the case because a company cannot create an asset by investing in itself.

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The Treasury Stock account is actually a contra equity account, which means that it is reported
as a subtraction from the total stockholders' equity. This makes sense because treasury stock is
stock that is no longer outstanding, and therefore, should not be included as part of stockholders'
equity.
If M Company eventually sells its treasury stock; it will not report an accounting profit or loss
on the transaction even if it sells the stock for more or less than it paid. GAAP do not permit a
corporation to report income or losses from investments in its own stock because transactions
with the owners are not considered to be normal profit- making activities.
Illustration 6, Based on the previous example, assume that on April 15, M Company sold
10,000 shares of treasury stock for Br30 per share. Remember that the company had purchased
the stock for Br22 per share.
 M Company records the following entry:

Date Accounts Debit Credit

20X5, Apr. 15 Cash (10,000 x Br 30) 300,000
Treasury Stock 220,000
Paid in capital from sale of treasury sock 80,000
If treasury stock were sold at a price below its purchase price (i.e., on a ‘loss’), the Paid in
Capital from sale of Treasury Stock account would be debited for the amount of the loss.
Retained Earnings would be debited for some or the entire amount of the ‘losses’ only if there
were an insufficient credit balance in the Paid in Capital from sales of Treasury Stock account.
In some cases a corporation may receive some of its stocks through donation. The Donated
Capital account (or Contributed Capital account) is credited for the market value of the shares
at the date of acquisition.

Illustration 7, For example, assumes that on March 1, 20x5, M Company received 1000 shares
form stockholders in donation. If the market price per share is Br 100, the following entry would
be prepared:

Date Accounts Debit Credit

20X5, Mar. 1 Treasury Stock 100,000
Donated Capital [1,000 x Br 100] 100,000
 Neither the purchase nor sale of treasury stock affects the number of shares of stock that
are issued or un-issued. Treasury stock affects only the number of shares of outstanding
stock; the basic difference between treasury stock and un-issued stock is that treasury
stock has been sold at least once.
Therefore, the stockholders equity section could be presented as follows:
Paid in Capital:
Common Stock Br xxxxx
Capital in Excess of Par xxxxx xxxxx
Donated Capital xxxxx
Retained Earnings xxxxx xxxxx
Less: Treasury Stock xxxxx
Total Stockholders' Equity Br xxxxx
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5.7 Retained Earnings, Dividends and Stock Splits

5.7.1 Restrictions on Retained Earnings
As the result of several types of business transactions, restrictions to retained earnings limit a
company's ability to pay dividends. A typical example occurs when a business borrows money
and banks include a loan covenant that limits the amount a corporation can pay by placing a
restriction on its retained earnings
The full-disclosure principle requires restrictions on retained earnings to be reported in the
financial statements or in a separate note to the financial statements. Users are particularly
interested in information concerning these restrictions because of the impact they have on the
company's dividend policy.
 Most companies report restrictions on retained earnings in a note to financial statements.

Illustration 8, For example as a restrictive covenants of long-term debt agreements, Br 1.2

million restricted as to the payment of dividends and/or common share repurchases.
 This type of note describes other restrictions that were imposed as a result of debt
covenants. These restrictions often include a limit on borrowing and required minimum
balances of cash or working capital. If debt covenants were violated, the creditor can
demand immediate payment of debt. For this reason, users want to review these
restrictions to be sure that companies are not close to violating loan agreements.
 Another alternative is to record a journal entry, which shows the existence of the
restrictions. Under this alternative there are two retained earnings accounts: Appropriated
[Restricted] and Un-appropriated [Un-restricted].

 For example, the following entry could be prepared for the restriction mentioned above:

Date Accounts Debit Credit

20X5, Sept 1 Retained Earnings: Un-appropriated (Unrestricted) 1,200,000
Retained Earnings: Appropriated(Restricted) 1,200,000

When the loan is fully paid, the restriction is no more relevant and another entry is prepared:
Date Accounts Debit Credit
20X5, Dec. 1 Retained Earnings: Appropriated(Restricted) 1,200,000
Retained Earnings: Un-appropriated(Unrestricted) 1,200,000
 If there were restricted retained earnings, the stockholders’ equity section of the balance sheet
would appear as follows:
Paid in Capital:
Common stock Br xxxxx
Capital in excess of par xxxxx xxxxx
Donated Capital xxxxx
Retained earnings: Appropriated xxxxx
Retained earnings: Un-appropriated xxxxx xxxxx
Less: Treasury stock xxxxx
Total stockholders' equity Br xxxxx
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5.8 Dividends
The earnings of a corporation that are not retained in the business for growth and expansion are
distributed to the stockholders by means of dividends. Dividends are paid only when formally
declared by the board of directors of a corporation .
 A cash dividend results in a decrease in assets (cash) and a commensurate decrease in
stockholders' equity (retained earnings).
 In contrast, a stock dividend does not change assets, liabilities, or total stockholder's
equity. A stock dividend results in a transfer of retained earnings to the permanent or
contributed capital of the corporation by the amount of the stock dividend. Therefore, a
stock dividend affects only certain account balances within stockholders' equity.

 Procedures of Divided Payments: (There are three important dates in relation to

dividends)
 Declaration Date this is the date on which the board of directors officially approves the
dividend. As soon as it makes the declaration, it creates a dividend liability, to be
recorded in a journal entry.
 Date of Record This date follows the declaration date. It is the date on which the
corporation prepares the list of current stockholders based on its stockholder records.
The dividend is payable only to those names listed on the record date. No journal entry
is made on this date.
 Date of Payment this is the date on which the cash is disbursed to pay the dividend
liability. It follows the date of record as specified in the dividend announcement.

5.8.1 Cash Dividend

Investors who purchase preferred stock give up certain advantages that are available to investors
in common stock. Generally, preferred stockholders do not have the right to vote at the annual
meeting, nor do they share in increased earnings if the company becomes more profitable. To
compensate these investors, preferred stock offers some advantages not available to common
stockholders. Perhaps, the most important advantage is dividend preference.
You will frequently encounter the following dividend preferences:
1. Current dividend preference.
2. Cumulative dividend preference.

Preferred Stock always carries a current dividend preference. It requires that the current
preferred dividend be paid before any dividends are paid on the common stock. When the
current dividend preference has been met and no other preference is operative, dividends can
be paid to the common stockholders.
Declared Dividends must be allocated between the preferred and common stock. First, the
preferences of the preferred stock must be met, and then the remainder of the total dividend can
be allocated to the common stock.
Cumulative Preferred Stock has a cumulative dividend preference that states if all or a part
of the specified current dividend is not paid in full, the unpaid amount becomes dividends in
arrears.
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The amount of any cumulative preferred dividends in arrears must be paid before any common
dividends can be paid. Of course, if the preferred stock is non-cumulative, dividends never can
be in arrears. Therefore, the preferred stockholders lose permanently any dividends passed (i.e.,
not declared). Because preferred stockholders are not willing to accept this unfavorable feature,
preferred stock is usually cumulative.

Dividends are never an actual liability until the board of directors declares them. Dividends in
arrears are not reported on the balance sheet, but are disclosed in the notes to the statements.
The allocation of dividends between cumulative preferred stock and common stock should be
strict in accordance with the stock contract. But, generally, we follow the steps below:

Step 1: Allocate dividends in arrears to the preferred stock,

Step 2: Allocate current year dividend to the preferred stock,
Step 3: If the preferred stocks are participating, allocate matching dividends to common stock.
This is dividend comparable to the current year dividend of the preferred stock. For example,
if the current year dividend to preferred stock is 5 % of par, the common stock will also be
entitled to 5% of their stock’s par value. If the current year dividend to the preferred stock
is Br 2 per share, the comparable dividend will also be Br 2 per share to the common stock
Step 4: If there is a balance after step 3, it is allocated to both preferred and common stock.
 If the preferred stocks are non-participating, the entire remaining amount after step 2 will be
given to common stock.

Illustration 9, Assume the following:

 Preferred stock outstanding, 6%, par Br 20; 2,000 shares Br 40,000
 Common stock outstanding, par Br. 10; 5,000 shares 50,000
 Assume that the dividends are in arrears for 1 year, &
preferred stocks are cumulative and participating.

 If the amount of cash dividend declared is Br 50,000 it will be allocated as follows:

Preferred Common Total .
Par Value Br 40,000 Br 50,000 Br 90,000
Total Dividend Br 50,000
1. Dividends in arrears [0.06x 40,000] 2,400 (2,400)
Remaining amount 47,600
2. Current year dividend to preferred 2,400 (2,400)
Remaining amount 45,200
3. Matching dividend to common stock [0.06 x 50,000] 3,000 (3,000)
Remaining amount 42,200
4. To both classes of shares:
[42,200/90,000=0.47] [0.47 x 40,000; 0.47 x 50,000] 18,756 23,444 (42,200)
Total 23,556 26,444 50,000

Notice that all the four steps are applied in this example because there were dividends in
arrears and the preferred stocks were cumulative and participating.

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 St. Mary’s University, Department of Accounting
 On the date of declaration of the dividends, say December 31, 20x5, the following entry is
prepared:

Date Accounts Debit Credit

20X5, Dec. 31 Dividends 50,000
Dividend Payable: Preferred 23,556
Dividend Payable: Common 26,444
 The dividends account would be closed as follows:

Date Accounts Debit Credit

20X5, Dec. 31 Retained Earnings 50,000
Dividends 50,000

 If the dividends are paid out on January 1, 20x6, the following entry would be prepared:

Date Accounts Debit Credit

20X6, Jan 1 Dividend Payable: Preferred 23,556
Dividend Payable: Common 26,444
Cash 50,000
 If we assume that the preferred stocks are non-cumulative non-participating, the dividends
would be allocated as follows:
Preferred Common Total .
Par Value Br 40,000 Br 50,000 Br 90,000
Total Dividend Br 50,000
1. Current year dividend to preferred 2,400 (2,400)
Remaining amount 47,600
2. All the remaining amounts to Common Stock _____ 47,600 (47,600)
Total 2,400 47,600 50,000

5.8.2 Stock Dividends

Corporations issue stock dividends instead of cash dividends. A stock dividend is a distribution
of additional shares of a corporation's own capital stock on a pro rata basis to its stockholders
at no cost. Stock dividends usually consist of common stock issued to the holders of common
stock. Pro rata basis means that each stockholder receives additional shares equal to the
percentage of shares already held. A stockholder with 10 percent of the outstanding shares
receives 10 percent of any additional shares issued as a stock dividend.

The value of a stock dividend is the subject of much debate. In reality, a stock dividend has no
economic value, as such. All stockholders receive a pro rata distribution of shares; which means
that each owns exactly the same portion of the company both before and after the stock
dividend. The value of an investment is determined by the percentage of the company that is
owned, not the number of shares that are held. If you get change for a dollar, you do not have
more wealth because you hold four quarters instead of only one dollar. Similarly, if you own
10 percent of a company, you do not have more wealth simply because the company declares a
stock dividend and gives you (and all other stockholders) more shares of stock.

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 St. Mary’s University, Department of Accounting
At this point, you may still wonder why having extra shares of stock does not make an investor
wealthier. The reason is simple: The stock market reacts immediately when a stock dividend is
issued, and the stock price falls proportionally.

If the stock price was Br 60 before a stock dividend, normally (in the absence of events affecting
the company) the price falls to Br 30 if the number of shares is doubled. Thus, an investor could
own 100 shares worth Br 6,000 before the stock dividend (100 x Br 60) and 200 shares worth
Br 6,000 after the stock dividend (200 x Br. 30).

Illustration 9, Assume that M Company, issues a 100 percent stock dividend February 25 20x6
to shareholders of record on February 2. M Company has 1,149,819,000 shares outstanding.
The market value of the shares was Br 0.10.
Date Accounts Debit Credit
20X6, Feb, 6 Retained Earnings (0.10 x 1,149,819,000) 114,981,900
Common Stock 114,981,900
Stock dividends are classified as either large or small. A large stock dividend involves the
distribution of additional shares that are more than 25 percent of the currently outstanding
shares. A small stock dividend involves additional shares that are less than 25 percent of the
outstanding shares. Because the M Company stock dividend was equal to 100 percent of the
outstanding shares, it should be classified as a large dividend.

Notice that this journal entry moves an amount from Retained Earnings to the permanent
contributed capital of the company. The stock dividend did not change total stockholders'
equity-it changed only the balances of some of the accounts that constitute stockholders' equity.
This process of transferring an amount from Retained Earnings to Contributed Capital often is
called capitalizing earnings because it reduces the amount of retained earnings available for
future dividends.

The amount transferred from Retained Earnings to Contributed Capital was based on the par
value of the shares issued as a stock dividend. Par value is used when the stock dividend is
classified as large. In those cases, when a stock dividend is small (i.e., less than 25 percent), the
amount transferred should be the total market value of the shares issued.

5.8.3 Stock Splits

Stock splits occur when management wishes to reduce the market price of stock so that more
investors can afford it. When stock is split, the par or stated value of the stock is reduced as well
as the market value. However, the amounts in the paid-in capital accounts are not affected.
Consequently, no journal entry – other than a memorandum entry – is needed to record the split.
A stock split affects only the par value of the stock and the number of shares outstanding; the
individual equity account balances are not changed.
Stock splits are not dividends. They are similar to a stock dividend, but are quite different in
terms of their impact on the stockholders' equity accounts. In a stock split, the total number of
authorized shares is increased by a specified amount, such as a 2-for-1 split.

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 St. Mary’s University, Department of Accounting
In this instance, each share held is called in, and two new shares are issued in its place.
Typically, a stock split is accomplished by reducing the par or stated value per share of all
authorized shares so that the total par value of all authorized shares is unchanged.

If M Company executes a 2-for-1 stock split, it reduces the par value of its stock from Br 0.10
to Br 0.05 and it doubles the number of shares outstanding. In contrast to a stock dividend, a
stock split does not result in a transfer of retained earnings to contributed capital. No transfer is
needed because the reduction in the par value per share compensates for the increase in the
number of shares. In both a stock dividend and a stock split, the stockholder receives more
shares of stock, but does not disburse any additional assets to acquire the additional shares, A
stock dividend requires a journal entry; a stock split does not require one.
A stock split is disclosed in the notes to the financial statements.

 The comparative effects of a stock dividend versus a stock split may be summarized as follows:
Stockholders' Equity
After a
Before 100% Stock Two-for-One
dividend Stock Split
Contributed capital:
Number of shares outstanding 30,000 60,000 60,000
Par value per share Br 10 Br 10 Br 5
Total par value outstanding 300,000 600,000 300,000
Retained earnings 650,000 350,000 650,000
Total stockholders' equity 950,000 950,000 950,000

5.9 The Statement of Stockholders’ Equity

The statement of stockholders’ equity is prepared periodically to summarize the changes that
have occurred in the stockholders’ equity of the corporation. In some cases, the statement of
retained earnings is prepared instead of the statement of Stockholders’ equity. This represents
a fairly typical statement of changes in retained earnings. Under rare circumstances, you may
see a statement that includes an adjustment to the beginning balance of retained earnings. This
adjustment is called a prior period adjustment, which is a correction of an accounting error that
occurred in the financial statements of a prior period.
5.10 Equity Per-Share
Equity per share (EPS) is the ratio of stockholder's equity to the related number of shares of stock
outstanding. If there is only one class of shares (common stock), equity per share is computed as follows:
EPS= Total Stockholder's Equity
No. of Shares Outstanding
If there are both common and preferred shares, we have to allocate the total equity to preferred and
common stock. The equity to preferred stock is the liquidation value. The liquidation value is the amount
that the preferred stockholders can claim if the corporation is liquidated. The equity to preferred stock
includes the dividends in arrears. If the equity to the preferred stock is determined, the common equity
is computed by deducting equity to preferred stock from the total equity.
Then, EPS would be computed as follows:(If both are there)

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 St. Mary’s University, Department of Accounting
Preferred EPS = Equity Allocated to Preferred Stock .
No. of Outstanding Shares of Preferred Stock

Common EPS = Equity Allocated to Common Stock .

No. of Outstanding Shares of Common Stock

The Retained Earnings account is a stockholders’ equity account with a normal credit balance. As a
result of net losses, however, a debit balance in Retained Earnings may occur. Such a balance is called
a deficit. The deficit reduces the total stockholders’ equity of the corporation.

Illustration 10, Assume that the following balances appear on the balance sheet of ABC Company:
Common stock, Br 10 par Br 600,000
Paid in Capital in excess of par 120,000
Deficit 75, 000

Total stockholders’ equity is Br 645,000 (Br 600,000 + Br 120,000 – Br 75,000) and the number of share
is 60,000 (Br 600,000/Br 10). The business has only common stock and hence, the EPS is:
645,000/60,000 = 10.75

Illustration 11, Assume the following data:

Preferred, 10% stock, Br 50 par Br. 2,500,000
Premium on preferred stock 275,000
Common stock, Br. 25 par 3,750,000
Deficit 1,240,000

Assume also that Preferred stock has prior claim to assets on liquidation to the extent of 110% of par.
 To compute EPS, let us first split the total equity into the two classes of shares:
Total Equity:
Preferred, 10% stock, Br 50 par Br. 2,500,000
Premium on preferred stock 275,000
Common stock, Br. 25 par 3,750,000
Deficit (1,240,000) Br 5,285,000
Less: Equity to preferred stock (110% x 2,500,000) 2,750,000
Equity to Common Stock Br 2,535,000

Therefore,
Preferred EPS = Br 2,750,000 = Br 55.00
2,500,000/Br 50

Common EPS = Br 2,535,000 = Br 16.90

3,750,000/Br 25

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