CHAPTER 13 CORPORATIONS: ORGANIZATION, STOCK TRANSACTIONS, AND DIVIDENDS EYE OPENERS 1. Each stockholder’s liability for corporation debts is limited to the amount invested in the corporation. A corporation is responsible for its own obligations; therefore, its creditors may not look beyond the assets of the corporation for satisfaction of their claims. 2. The large investments needed by large businesses are usually obtainable only through pooling of resources of many people. The corporation also has the advantages over proprietorships and partnerships of transferable shares of ownership, and thus the continuity of existence, and limited liability of its owners (stockholders). 3. No. Common stock with a higher par is not necessarily a better investment than com-mon stock with a lower par because par is an amount assigned to the shares. 4. The broker is not correct. Corporations are not legally liable to pay dividends until the dividends are declared. If the company that issued the preferred stock has operating losses, it could omit dividends, first, on its common stock and, later, on its preferred stock. 5. Factors influencing the market price of a corporation’s stock include the following: a. Financial condition, earnings record, and dividend record of the corporation. b. Its potential earning power. c. General business and economic conditions and prospects. 6. No. Premium on stock is additional paid-in capital. 7. a. Sufficient retained earnings, sufficient cash, and formal action by the board of directors. b. February 16, declaration date; March 18, record date; and April 17, payment date. 8. The company may not have had enough cash on hand to pay a dividend on the com-mon stock, or resources may be needed for plant expansion, replacement of facilities, payment of liabilities, etc. 705 705
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CHAPTER 13CORPORATIONS: ORGANIZATION, STOCK
TRANSACTIONS, AND DIVIDENDS
EYE OPENERS
1. Each stockholder’s liability for corporation debts is limited to the amount invested in the corporation. A corporation is responsible for its own obligations; therefore, its creditors may not look beyond the assets of the cor-poration for satisfaction of their claims.
2. The large investments needed by large busi-nesses are usually obtainable only through pooling of resources of many people. The corporation also has the advantages over proprietorships and partnerships of transfer-able shares of ownership, and thus the con-tinuity of existence, and limited liability of its owners (stockholders).
3. No. Common stock with a higher par is not necessarily a better investment than com-mon stock with a lower par because par is an amount assigned to the shares.
4. The broker is not correct. Corporations are not legally liable to pay dividends until the dividends are declared. If the company that issued the preferred stock has operating losses, it could omit dividends, first, on its common stock and, later, on its preferred stock.
5. Factors influencing the market price of a corporation’s stock include the following:a. Financial condition, earnings record, and
dividend record of the corporation.b. Its potential earning power.c. General business and economic condi-
tions and prospects.6. No. Premium on stock is additional paid-in
capital.7. a. Sufficient retained earnings, sufficient
cash, and formal action by the board of directors.
b. February 16, declaration date; March 18, record date; and April 17, payment date.
8. The company may not have had enough cash on hand to pay a dividend on the com-mon stock, or resources may be needed for plant expansion, replacement of facilities, payment of liabilities, etc.
9. a. No change.b. Total equity is the same.
10. a. Current liabilityb. Stockholders’ equity
11. a. Unissued stock has never been issued, but treasury stock has been issued as fully paid and has subsequently been reacquired.
b. As a deduction from the total of other stockholders’ equity accounts.
12. a. It has no effect on revenue or expense.b. It reduces stockholders’ equity by
$450,000.13. a. It has no effect on revenue.
b. It increases stockholders’ equity by $615,000.
14. The primary advantage of the combined in-come and retained earnings statement is that it emphasizes net income as the con-necting link between the income statement and the retained earnings portion of stock-holders’ equity.
15. The three classifications of restrictions on retained earnings are legal, contractual, and discretionary. Appropriations are normally reported in the notes to the financial state-ments.
16. Such prior period adjustments should be re-ported as an adjustment to the beginning balance of retained earnings.
17. The statement of stockholders’ equity is nor-mally prepared when there are significant changes in stock and other paid-in capital accounts.
18. The primary purpose of a stock split is to bring about a reduction in the market price per share and thus to encourage more in-vestors to buy the company’s shares.
Oct. 30 Cash...................................................................... 225,000Preferred Stock............................................... 187,500Paid-In Capital in Excess of Par.................... 37,500*
*(7,500 shares × $5)
PE 13–2B
Feb. 13 Cash...................................................................... 10,500,000Common Stock............................................... 9,375,000Paid-In Capital in Excess of Stated Value.... 1,125,000*
Nov. 23 Cash...................................................................... 560,000Preferred Stock............................................... 480,000Paid-In Capital in Excess of Par.................... 80,000*
Nov. 15 Cash (6,800 × $12)............................................... 81,600Treasury Stock (6,800 × $9)........................... 61,200Paid-In Capital from Sale of Treasury Stock [6,800 × ($12 – $9)].............. 20,400
Dec. 22 Cash (3,200 × $7)................................................. 22,400Paid-In Capital from Sale of Treasury Stock [3,200 × ($9 – $7)]...................... 6,400
Mar. 15 Cash (4,500 × $34)............................................... 153,000Treasury Stock (4,500 × $30)......................... 135,000Paid-In Capital from Sale of Treasury Stock [4,500 × ($34 – $30)]............ 18,000
June 2 Cash (3,000 × $28)............................................... 84,000Paid-In Capital from Sale of Treasury Stock [3,000 × ($30 – $28)].................. 6,000
Dividend for common share(a. – b.)............................................. $ — $ — $ 22,000 $ 75,000Common shares outstanding........ ÷ 25,000 ÷ 25,000 Common dividend per share......... $ 0.88 $ 3.00
Ex. 13–3
a. Feb. 10 Cash............................................................... 1,360,000Common Stock........................................ 400,000Paid-In Capital in Excess of Par—Common Stock........................................ 960,000
May 9 Cash............................................................... 700,000Preferred Stock........................................ 500,000Paid-In Capital in Excess of Par—Preferred Stock........................................ 200,000
b. $2,060,000 ($1,360,000 + $700,000)
Ex. 13–4
a. June 4 Cash............................................................... 3,000,000Common Stock........................................ 750,000Paid-In Capital in Excess ofStated Value............................................. 2,250,000
Oct. 9 Cash............................................................... 2,000,000Preferred Stock........................................ 1,875,000Paid-In Capital in Excess of Par—Preferred Stock........................................ 125,000
b. $5,000,000 ($3,000,000 + $2,000,000)
Ex. 13–5
Jan. 30 Land....................................................................... 270,000Common Stock................................................ 180,000Paid-In Capital in Excess of Par..................... 90,000
Ex. 13–6
a. Cash................................................................................. 400,000Common Stock (10,000 × $40)................................. 400,000
b. Organizational Expenses............................................... 30,000Common Stock (750 × $40)...................................... 30,000
c. Land................................................................................. 125,000Building........................................................................... 600,000
Preferred Stock................................................................ 250,000Paid-In Capital in Excess of Par—Preferred Stock....... 75,000
Cash....................................................................................... 475,000Common Stock................................................................ 300,000Paid-In Capital in Excess of Par—Common Stock....... 175,000
Mar. 6 Land....................................................................... 50,000Buildings................................................................ 275,000Equipment............................................................. 60,000
Common Stock (18,000 × $15)........................ 270,000Paid-In Capital in Excess of Par—Common Stock................................................ 115,000
Apr. 30 Cash....................................................................... 1,200,000Preferred Stock (20,000 × $50)....................... 1,000,000Paid-In Capital in Excess of Par—Preferred Stock................................................ 200,000
Ex. 13–9
May 3 Cash Dividends..................................................... 69,500Cash Dividends Payable................................. 69,500
June 17 No entry required.
Aug. 1 Cash Dividends Payable...................................... 69,500Cash.................................................................. 69,500
Ex. 13–10
a. (1) Stock Dividends........................................................ 250,000*Stock Dividends Distributable (2,000 × $100)... 200,000Paid-In Capital in Excess of Par—Common Stock.................................................... 50,000
a. Mar. 4 Treasury Stock.............................................. 450,000Cash.......................................................... 450,000
Aug. 7 Cash............................................................... 350,000Treasury Stock (3,500 × $90).................. 315,000Paid-In Capital from Sale ofTreasury Stock......................................... 35,000
Nov. 29 Cash............................................................... 132,000Paid-In Capital from Sale ofTreasury Stock.............................................. 3,000
c. Beaverhead Creek may have purchased the stock to support the market price of the stock, to provide shares for resale to employees, or for reissuance to employees as a bonus according to stock purchase agreements.
Ex. 13–12
a. Aug. 30 Treasury Stock (17,500 × $42)..................... 735,000Cash.......................................................... 735,000
Oct. 31 Cash (14,000 × $45)....................................... 630,000Treasury Stock (14,000 × $42)................ 588,000Paid-In Capital from Saleof Treasury Stock.................................... 42,000
Nov. 10 Cash (2,000 × $48)......................................... 96,000Treasury Stock (2,000 × $42).................. 84,000Paid-In Capital from Saleof Treasury Stock.................................... 12,000
b. $54,000 ($42,000 + $12,000) credit
c. $63,000 (1,500 × $42) debit
d. The balance in the treasury stock account is reported as a deduction from the total of the paid-in capital and retained earnings.
Ex. 13–13
a. July 15 Treasury Stock (24,000 × $60)..................... 1,440,000Cash.......................................................... 1,440,000
Aug. 10 Cash (19,000 × $63)....................................... 1,197,000Treasury Stock (19,000 × $60)................ 1,140,000Paid-In Capital from Sale ofTreasury Stock......................................... 57,000
Dec. 18 Cash (5,000 × $56)......................................... 280,000Paid-In Capital from Sale ofTreasury Stock.............................................. 20,000
d. Sweet Water Inc. may have purchased the stock to support the market price of the stock, to provide shares for resale to employees, or for reissuance to employees as a bonus according to stock purchase agreements.
Excess of issue price over par....... 120,000 520,000From sale of treasury stock............ 30,000
Total paid-in capital................... $2,140,000Retained earnings................................. 3,900,000
Total.................................................. $6,040,000Deduct treasury common stock
(5,000 shares at cost)...................... 55,000 Total stockholders’ equity................... $5,985,000
Ex. 13–17
BANCROFT CORPORATIONRetained Earnings Statement
For the Year Ended January 31, 2010
Retained earnings, February 1, 2009................................ $ 3,175,500Net income.......................................................................... $415,000Less dividends declared.................................................... 215,500 Increase in retained earnings............................................ 199,500 Retained earnings, January 31, 2010............................... $ 3,375,000
Ex. 13–18
1. Retained earnings is not part of paid-in capital.
2. The cost of treasury stock should be deducted from the total stockholders’ equity.
3. Dividends payable should be included as part of current liabilities and not as part of stockholders’ equity.
4. Common stock should be included as part of paid-in capital.
5. The amount of shares of common stock issued of 180,000 times the par value per share of $75 should be extended as $13,500,000, not $14,040,000. The dif-ference, $540,000, probably represents paid-in capital in excess of par.
6. Organizing costs should be expensed when incurred and not included as a part of stockholders’ equity.
One possible corrected Stockholders’ Equity section of the balance sheet is as follows:
Earnings per share............................... $3.22 $2.79 $2.70As a percent of 2005 (base year)......... 119% 103% 100%
Net income............................................. $10,340 $8,684 $6,923As a percent of 2005 (base year)......... 149% 125% 100%
The earnings per share growth was much less than the net income growth. Earn-ings per share increased 119% from 2005 to 2007, while net income grew 149% over the same period. The major reason for this difference is due to the increase in common shares outstanding. During this period the common shares increased by 126% (3,159/2,515), thus depressing the earnings per share growth. This sig-nificant increase in the common shares outstanding was due to the purchase of Gillette.
Ex. 13–25
a.
OfficeMax:
Earnings per Share =
Earnings per Share =
Earnings per Share = $1.20 per share
Staples:
Earnings per Share =
Earnings per Share =
Earnings per Share = $1.35 per share
b. Staples’ net income is over 10 times greater than OfficeMax’s. This is because Staples is a much larger business than OfficeMax. As a result, Staples also has nearly 10 times greater shares outstanding as well. The earnings per share for both firms can be used to compare their relative earnings. Staples has a better earnings per share ($1.35) than does OfficeMax ($1.20).
PROBLEMS
Prob. 13–1A
1.
Total Preferred Dividends Common Dividends Year Dividends Total Per Share Total Per Share
21 Cash....................................................................... 1,267,500Preferred Stock (15,000 × $80)....................... 1,200,000Paid-In Capital in Excess of Par—Preferred Stock................................................ 67,500
Common Stock (17,500 × $100)...................... 1,750,000Paid-In Capital in Excess of Par—Common Stock................................................ 262,500
Prob. 13–3A
a. Treasury Stock................................................................ 540,000Cash........................................................................... 540,000
($540,000/60,000 shares) = $9 per share.
b. Cash................................................................................. 462,000Treasury Stock (42,000 × $9).................................... 378,000Paid-In Capital from Sale of Treasury Stock.......... 84,000
c. Cash (7,500 × $38).......................................................... 285,000Preferred Stock (7,500 × $25)................................... 187,500Paid-In Capital in Excess of Par—PreferredStock (7,500 × $13).................................................... 97,500
d. Cash (120,000 × $15)...................................................... 1,800,000Common Stock (120,000 × $5)................................. 600,000Paid-In Capital in Excess of Par—CommonStock.......................................................................... 1,200,000
e. Cash................................................................................. 110,500Paid-In Capital from Sale of Treasury Stock................ 6,500
Mar. 9 Cash....................................................................... 1,350,000Treasury Stock................................................. 1,000,000Paid-In Capital from Sale of Treasury Stock. 350,000
Apr. 3 Cash....................................................................... 1,700,000Common Stock (50,000 × $20)........................ 1,000,000Paid-In Capital in Excess of Stated Value..... 700,000
July 30 Stock Dividends.................................................... 162,000*Stock Dividends Distributable (4,500 × $20) 90,000Paid-In Capital in Excess of Stated Value..... 72,000
*(175,000 + 50,000) × 2% × $36
Aug. 30 Stock Dividends Distributable............................. 90,000Common Stock................................................ 90,000
July 9 Treasury Stock (75,000 × $26).............................. 1,950,000Cash.................................................................. 1,950,000
Aug. 29 Cash (40,000 × $32)............................................... 1,280,000Treasury Stock (40,000 × $26)........................ 1,040,000Paid-In Capital from Sale of TreasuryStock (40,000 × $6).......................................... 240,000
*$13,500 = (2005 dividends in arrears of $2,500) +
(2006 dividends in arrears of $1,000) +
(2007 current dividend of $10,000)
2. Average annual dividend for preferred: $1.00 per share ($6.00/6)
Average annual dividend for common: $0.35 per share ($2.10/6)
3. a. 2.5% ($1.00/$40)
b. 7.0% ($0.35/$5)
Prob. 13–2B
June 9 Building.................................................................. 1,680,000Land....................................................................... 420,000
Common Stock (65,000 × $30)........................ 1,950,000Paid-In Capital in Excess of Par—Common Stock................................................ 150,000
13 Cash....................................................................... 840,000Preferred Stock (21,000 × $25)....................... 525,000Paid-In Capital in Excess of Par—Preferred Stock................................................ 315,000
a. Cash (17,500 × $81)........................................................ 1,417,500Common Stock (17,500 × $75)................................. 1,312,500Paid-In Capital in Excess of Par—CommonStock (17,500 × $6).................................................... 105,000
b. Cash (8,000 × $63).......................................................... 504,000Preferred Stock (8,000 × $50)................................... 400,000Paid-In Capital in Excess of Par—PreferredStock (8,000 × $13).................................................... 104,000
c. Treasury Stock................................................................ 390,000*Cash........................................................................... 390,000
*($390,000/5,000 shares) = $78 per share
d. Cash................................................................................. 240,000Treasury Stock (3,000 × $78).................................... 234,000Paid-In Capital from Sale of Treasury Stock.......... 6,000
e. Cash................................................................................. 75,000Paid-In Capital from Sale of Treasury Stock................ 3,000
Feb. 9 Cash....................................................................... 600,000Common Stock (50,000 × $8).......................... 400,000Paid-In Capital in Excess of Stated Value..... 200,000
May 21 Cash....................................................................... 300,000Treasury Stock (30,000 × $8).......................... 240,000Paid-In Capital from Sale of Treasury Stock. 60,000
July 1 Stock Dividends.................................................... 234,000*Stock Dividends Distributable (18,000 × $8). 144,000Paid-In Capital in Excess of Stated Value..... 90,000
*(400,000 + 50,000) × 4% × $13
Aug. 15 Stock Dividends Distributable............................. 144,000Common Stock................................................ 144,000
May 1 Cash Dividends........................................................ 122,600*Cash Dividends Payable.................................... 122,600
*(25,000 × $0.80) + [(600,000 – 30,000) × $0.18]
June 1 Cash Dividends Payable......................................... 122,600Cash..................................................................... 122,600
Aug. 5 Cash (22,000 × $34)................................................. 748,000Treasury Stock (22,000 × $27)........................... 594,000Paid-In Capital from Sale of TreasuryStock (22,000 × $7)............................................. 154,000
At the time of this decision, the WorldCom board had come under intense scru-tiny. This was the largest loan by a company to its CEO in history. The SEC be-gan an investigation into this loan, and Bernie Ebbers was eventually terminated as the CEO, with this loan being cited as part of the reason. The board indicated that the decision to lend Ebbers this money was to keep him from selling his stock and depressing the share price. Thus, it claimed that it was actually help-ing shareholders by keeping these shares from being sold. However, this argu-ment wasn’t well received, given that the share price dropped from around $15 per share at the time of the loan to about $2.50 per share when Ebbers was termi-nated. In addition, critics were scornful of the low “sweetheart” interest rate given to Ebbers for this loan. In addition, many critics viewed the loan as risky, given that it was not supported by any personal assets. WorldCom has since en-tered bankruptcy proceedings, Ebbers has gone to prison, and the Ebbers loan went uncollected.
Some press comments:
1. When he borrowed money personally, he used his WorldCom stock as collat-eral. As these loans came due, he was unwilling to sell at “depressed prices” of $10 to $15 (it’s now around $2.50). So WorldCom lent him the money to consolidate his loans, to the tune of $366 million. How a board of directors, representing you and me at the table, allowed this to happen is beyond com-prehension. They should resign with Bernie. (Source: Andy Kessler, “Bernie Bites the Dust,” The Wall Street Journal, May 1, 2002, p. A18.)
2. It was astonishing to read the other day that the board of directors of the United States’ second-largest telecommunications company claims to have had its shareholders’ interests in mind when it agreed to grant more than $430 million in low-interest loans to the company’s CEO, mainly to meet mar-gin calls on his stock.
Yet that’s the level to which fiduciary responsibility seems to have sunk on the board of Clinton, Mississippi-based WorldCom, the deeply troubled tele-com giant, as it sought to bail Bernard Ebbers out of the folly of speculating in shares of WorldCom itself. Sadly, WorldCom is hardly alone.
“The very essence of why Mr. Ebbers was granted a loan was to protect shareholder value,” said a WorldCom spokesman in mid-March, just as the U.S. Securities & Exchange Commission was unfurling a probe of the loan and 23 other matters related to WorldCom’s finances.
Activity 13–1 Concluded
Yes, folks, you read that right. On March 14, 2002, a spokesman for a publicly traded, $20 billion company actually stood up and declared that of all the uses to which the company could have put almost half-a-billion dollars, the best one by far—at least from the point of view of the shareholders—was to spend it on some sort of stock-parking scheme in order to keep the CEO out of bankruptcy court. (Source: Christopher Byron, “Bernie’s Bad Idea,” Red Herring, April 16, 2002.)
Note to Instructors: Bernie Ebbers is currently serving a 25-year prison sentence for conspiracy, securities fraud, and making false statements to securities regu-lators.
Activity 13–2
Jas and Nadine are behaving in a professional manner as long as full and com-plete information is provided to potential investors in accordance with federal regulations for the sale of securities to the public. If such information is pro-vided, the marketplace will determine the fair value of the company’s stock.
Activity 13–3
1. This case involves a transaction in which a security has been issued that has characteristics of both stock and debt. The primary argument for classifying the issuance of the common stock as debt is that the investors have a legal right to an amount equal to the purchase price (face value) of the security. This is similar to a note payable or a bond payable. The additional $50 pay-ment could be argued to be equivalent to an interest payment, whose pay-ment has been deferred until a later date.
Arguments against classifying the security as debt include the fact that the investors will not receive fixed “annual” interest payments. In fact, if Bio-sciences Unlimited Inc. does not generate any net sales, the investors do not have a right to receive any payments. One could argue that the payments of 2% of net sales are, in substance, a method of redeeming the stock. As indi -cated in the case, the stockholders must surrender their stock for $100 after the $10 million payment has been made. Overall, the arguments would seem to favor classifying the security as common stock.
Activity 13–3 Concluded
2. In practice, the $10 million stock issuance would probably be classified as common stock. However, full disclosure should be made of the 2% of net sales and $100 payment obligations in the notes to the financial statements. In addition, as Biosciences Unlimited Inc. generates net sales, a current lia-bility should be recorded for the payment to stockholders. Such payments would be classified as dividend payments rather than as interest payments. Emma Cavins should also investigate whether such payments might violate any loan agreements with the banks. Banks often restrict dividend payments in loan agreements. If such an agreement has been violated, Biosciences Un-limited Inc. should notify the bank immediately and request a waiver of the vi-olation.
Activity 13–4
a. 500 shares × ($1.24 ÷ 4) = $155
b. 1.75% = ($32.5815 – $32.02)/$32.02
c. 1.49% ($32.02 – $31.55)/$31.55
d. 500 shares × $32.5815 = $16,290.75 plus brokerage commission
The $16,290.75 paid for 500 shares of GE common stock goes to the seller of the common stock (another shareholder). The brokerage commission goes to the broker who facilitated the trade.
Note to Instructors: You may wish to leave the answer as given, or go into greater detail about the NYSE specialist system. Namely, the specialist both buys and sells the GE common stock and acts as an intermediary between individual buyers and sellers. The specialist makes money on the bid/ask price spreads between buyers and sellers. The specialist creates an orderly market by matching supply and demand.
Activity 13–5
1. Before a cash dividend is declared, there must be sufficient retained earn-ings and cash. On December 31, 2010, the retained earnings balance of $1,798,800 is available for use in declaring a dividend. This balance is suffi-cient for the payment of the normal quarterly cash dividend of $0.40 per share, which would amount to $24,000 ($0.40 × 60,000).
Rainbow Designs Inc.’s cash balance at December 31, 2010, is $96,000, of which $60,000 is committed as the compensating balance under the loan agreement. This leaves only $36,000 to pay the dividend of $24,000 and to fi -nance normal operations in the future. Unless the cash balance can be ex-pected to increase significantly in early 2011, it is questionable whether suffi -cient cash will be available to pay a cash dividend and to provide for future cash needs.
Other factors that should be considered include the company’s working capi-tal (current assets – current liabilities) position and the loan provision per-taining to the current ratio, resources needed for plant expansion or replace-ment of facilities, future business prospects of the company, and forecasts for the industry and the economy in general. The working capital is $1,210,800 ($1,510,800 – $300,000) on December 31, 2010. The current ratio is therefore 5:1 ($1,510,800/$300,000) on December 31, 2010. However, after de-ducting the $900,000 committed to store modernization and product-line ex-pansion, the ratio drops to 2:1 ($610,800/$300,000). If the cash dividend were declared and paid and the other current assets and current liabilities remain unchanged, the current ratio would drop to 1.956:1 ($586,800/$300,000), and this would violate the loan agreement. Further, working capital commitments for 2011 and any additional funds that might be required, such as funds for the replacement of fixed assets, would suggest that the declaration of a cash dividend for the fourth quarter of 2010 might not be wise.
Activity 13–5 Concluded
2. Given the cash and working capital position of Rainbow Designs Inc. on De-cember 31, 2010, a stock dividend might be an appropriate alternative to a cash dividend.
a. From the point of view of a stockholder, the declaration of a stock divi-dend would continue the dividend declaration trend of Rainbow Designs Inc. In addition, although the amount of the stockholders’ equity and proportional interest in the corporation would remain unchanged, the stockholders might benefit from an increase in the fair market value of their total holdings of Rainbow Designs Inc. stock after distribution of the dividend.
b. From the point of view of the board of directors, a stock dividend would continue the dividend trend, while the cash and working capital position of the company would not be jeopardized. Many corporations use stock dividends as a way to “plow back” retained earnings for use in acquiring new facilities or for expanding their operations. Rainbow Designs Inc. has sufficient unissued common stock to declare a stock dividend with-out changing the amount authorized.
Activity 13–6
Note to Instructors: The purpose of this activity is to familiarize students with sources of information about corporations and how that information is useful in evaluating the corporation’s activities.