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Financial Accounting

by: Floy Cartwright

Financial Accounting ACCT 201A

Floy Cartwright
Cal State Fullerton
GPA 3.81


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This 32 page Class Notes was uploaded by Floy Cartwright on Wednesday September 30, 2015. The Class Notes belongs to ACCT 201A at California State University - Fullerton taught by Staff in Fall. Since its upload, it has received 13 views. For similar materials see /class/217081/acct-201a-california-state-university-fullerton in Accounting at California State University - Fullerton.

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Date Created: 09/30/15
Primary Forms of Business Organization 0 Sole Proprietorship Owned by one person 1 Advantages Simple to establish Owner controlled Tax advantages 2 Disadvantages Proprietor personally liable Financing may be difficult Transfer of ownership is difficult o Partnership Owned by two or more persons 1 Advantages Simple to establish Shared control Tax advantages Broader skills and resources 2 Disadvantages Partners liable Transfer of ownership is difficult o Corporation Separate Legal Entity owned by stockholders 1 Advantages Easy to transfer ownership Greater capital raising potential Lower legal liability Disadvantages Unfavorable taxation N gt No such thing as dividend expense for a corporation gt Not shown on income statement ID Users and Uses of Accounting Information 0 Users of Financial Info Two Categories 1 Internal Users Users within organization Plan run and organize business They ask these questions Finance quotIs cash sufficient to pay dividends to stockholdersquot Human Resources quotCan we afford to give company39s employees pay raise this yearquot Marketing quotWhat cost for product will maximize company39s net incomequot Management quotWhich product line is most profitable Should any product lines be eliminatedquot There are multiple combinations needed to run several or one aspect of a business 2 External Users Users outside organization Customers labor union tax authorities etc Questions asked Investors quotIs company earning satisfying incomequot Investors quotHow does one company compare in size and profitability with anotherquot Creditors quotWill one company be able to pay its debts as they comequot Ethics in Financial Reporting 0 SarbanesOxley Act SOX of 2002 Requirements Top management is to certify accuracy of financial information Severe penalties for fraudulent financial activity Increased independence of auditors Increased responsibility for board of directors Three Principle Types of Business Activities 0 Financing To start or expand a business 1 Selling shares of stocks to investors the owners need from outside sources Sources 1 Borrowing from creditors Loans Liabilities Liabilities are amounts owed to creditors 1 Notes Payable written 2 Bonds Payable debt securities Includes 2 0 Selling Shares of Stock to Investors Common Stock Total amount paidin by stockholders for the shares they purchase Dividends Payments to stockholders Investing Involves purchases gt Resources Assets gt needed to operate business Types Land Cash Equipment Building Investing in debtequity section of another company Operating Primary activity which organization is in business Revenue Increase in assets resulting from sale of products or service in the normal course of business Expense Cost of assets consumed or service used in process of generating revenues Net Income is result of Revenues gt Expenses Net Loss is result of Revenues lt Expenses Content or Purpose of Each of Financial Statements 0 Financial Statements Balance Sheet presents picture at point in time of what business owns or what it owes shows assets liabilities and equity Income Statement shows how successfully business performed during period of time Retained Earnings Statement indicates how much income was distributed to dividends and how much retained is retained in business Statement of Cash Flows shows sources of cash during periods of time and how cash is used 0 Accounting Information System Keeps track of results of each of these business activities Income Statement 0 Reports success or failure of operations during period of the statement Summarizes all revenue and expenses for period month quarter year If Revenue gt Expense gt Net Income If Revenue lt Expenses gt Net Loss Plant Assets 0 Resources that have physical substance Used in operations of business Not intended for sale to customers 0 Recorded at cost in accordance with the cost principle of accounting Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use 0 Land 0 Cost of Land includes cash purchase price closing costs such as title and attorney fees real estate brokers commissions accrued property taxes and other liens on the land assumed by the purchaser These are all necessary costs incurred in making land ready for its intended use These increase the Land account E Computation of cost of Land If land purchased has building on it and building need removing before construction here are the changes to the Land account M Cash purchase of property 100000 Net removal cost of building 6000 Attorney39s fee 1000 Real estate brokers commission M Cost of Land 115000 Land Improvements 0 Includes Driveways Parking Lots Fences Landscaping Buildings 0 When Building is purchased Costs include Purchase price Closing costs attorney fees title insurances etc Real estate brokers39 commission 0 New building construction Costs include Contract price Payments made by owner for architect fees Building permits Excavation costs 0 Interest costs in the cost of a constructed building is limited to the interest incurred during the construction period Equipment 0 Cost includes purchase price sales tax insurance during transit freight by buyer assembly installingtesting 0 Does not include training costs of production personnel E Motor Vehicle License is not included in costs Advantages of leasing plant assets Reduced risk of obsolescence 0 Little or no down payment 0 Shared tax advantages 0 Assets and liabilities are not reported on financial statements 0 Depreciation 0 Process of allocating to expense the cost of a plant asset over its useful life in a rational and systematic manner 0 Cost allocation provides for the proper matching of expenses with revenues in accordance with the matching principle O O O 0 Process of cost allocation not process of asset valuation Applies to Land improvements Does not apply to Land Buildings Equipment Recognizing depreciation for an asset does not result in the accumulation of cash for replacement of the asset The balance in the Accumulated Depreciation account rep39s the total amount of the assets cost that has been charged to expense to date it is not a cash fund Factors in computing depreciation Cost historical cost of the asset Useful Life estimate of the expected productive life also called service life of the asset Salvage Value an estimate of the asset39s value at the end of its useful 0 O 0 life Depreciation Methods StraightLine Majority use this 0 O O O O O Depreciation is the same for each year of the asset39s useful life Annual depreciation cost of asset salvage valueasset39s useful life measured in years Cost of asset Salvage value Depreciable cost DecliningBalance Called an accelerated depreciation method because its results in more depreciation in the early year39s of an asset39s life than straightline Asset39s periodic depreciation is based on a declining book value Cost Accumulated Depreciation of the asset Managers may choose this method if they think that an asset39s utility will decline quickly Un itsofActivity Useful life is expressed in terms of total units of production or expected use from the asset rather than as a time period When productivity of an asset varies significantly from one period to another this method results in the best matching of expenses with revenues Between the methods periodic depreciation varies but total depreciation is the same Each method is acceptable in accounting because each recognizes the decline in service potential of an asset The graphs are also different Revising Periodic Depreciation O O O O The computation of annual depreciation expense is based on estimates therefore depreciation should be reviewed periodically When a change in an estimate is required change is made to current and future years but not to prior periods gtNo correction of previously recorded depreciation expense and associated accumulated depreciation Rationale for this continual restatement of prior periods would adversely affect the user39s confidence in financial statements Significant changes in estimates must be disclosed in the financial statements Ordinary Repairs 0 Expenditures to maintain the operating efficiency and expected productive life of the asset Usually small in amount and incurred frequently throughout service life Increase Repair or Maintenance Expense and considered revenue expenditures E Motor tuneups oil changes painting of buildings and replacing of wornout gears on factory machinery Additions and improvements 0 O O 0 Costs incurred to increase operating efficiency productive capacity or expected useful life of plant asset Usually material in amount and occur infrequently during period of ownership Increases the company39s investment in productive facilities and are generally debited to the plant asset affected Capital expenditure Impairment O O O 0 Permanent decline in market value of an asset To make sure asset is not overstated on the books it is written down to the new market value during the year in which the decline in value occurs In the past companies have delayed recording losses on their impairments until a year when the impact on the firm39s reported results was minimized To reduce the possibility of earnings management immediate recognition of impairments is now required Disposal of Plant Assets 0 Companies dispose of plant assets that are no longer useful to them Whether a plant asset is sold or retired the company must determine the book value of the plant asset at the time of disposal 0 Book value is the difference between the cost of the plant asset and the accumulated depreciation to date 0 If disposal occurs midyear depreciation for the fraction of the year to the date of disposal must be recorded 0 Book value is eliminated by reducing Accumulated Depreciation for the total depreciation associated with the asset and reducing the asset account for the cost of the asset Sale of an Asset 0 When an asset is sold there may be a Gain or Loss on disposal o In a sale of asset book value of asset is compared with the proceeds from the sale If proceeds gt book value then a gain on disposal occurs If proceeds lt book value then loss on disposal occurs E Gain on Disposal Cost of office furniture Less Accumulated Depreciation 41000 8000 Book value at date of disposal Proceeds from sale Gain on disposal E Loss on Disposal Cost of office furniture Less Accumulated Depreciation 41000 8000 Book value at date of disposal Proceeds from sale 60000 49000 11000 16000 5000 60000 49000 11000 9000 Loss on disposal 2000 Retirement of an asset 0 Recorded by decreasing Accumulated Depreciation for the full amount of depreciation taken over the life of the asset o The asset account is reduced for the original cost of the asset o The loss is equal to the asset39s book value at the time of retirement Return on Assets Ratio 0 Overall measure of profitability The higher the Return on Assets Ratio the higher the more profitable the company 0 Computing by dividing net income by average total assets 0 Reveals the amount of net income generated by each dollar invested 0 Formula Return on Assets Ratio Net IncomeAverage Total Assets Asset Turnover Ratio 0 Indicates how efficiently a company uses its assets High the ratio greater operating efficiency 0 Computed by dividing net sales by average total assets 0 Reveals how many dollars of sales are generated by each dollar invested 0 Formula Asset Turnover Ratio Net SalesAverage Total Assets Return on assets ratio 0 Can be computed from the profit margin ratio and the assets turnover ratio Return on Assets Ratio Profit MarginAsset Turnover gt Net IncomeAverage Total Assets Net IncomeNet Sales multiplied by Net SalesAverage Total Assets Asset Turnover Ratio 0 There are two ways a company can increase its return on assets 1 Increase margin per sale measured by profit margin ratio 2 Increase its volume of sales measured by the assets turnover ratio Intangible Assets 0 Rights privileges and competitive advantages that result from ownership of longlived assets that do not possess physical substance E Microsoft patents McDonald39s franchises iPod trade name and Nike39s trademark quotswooshquot Intangible Assets 0 Recorded at cost Intangible assets with limited lives gt this cost is expensed over the useful life of the asset in a rational and systematic manner 0 Term used to describe allocation of the cost of an intangible asset to expense is amortization o Amortization expense is classified as an operating expense in the income statment Patent 0 Exclusive right issued by US Patent Office enables recipient to manufacture sell or otherwise control an invention for 20 years 0 Initial cost cash or cash equivalent price paid to acquire patent Legal costs of protecting a patent in an infringement suit are added to the Patent account and amortized over remaing life of patent 0 Cost is amortized over 20year life or useful life whichever is shorter Research and Development Costs 0 Not intangible costs 0 These are uncertainties in identifying the extent and timing of future benefit of these expenditures As a result research and development costs are usually recorded as an expense when incurred Copyrights o Granted by federal government giving the owner the exclusive right to reproduce and sell artistic or published work 0 Extend for the life of the creator plus 50 years 0 Generally the useful life is significantly shorter than legal life Trademarks 0 Word phrase jingle or symbol that distinguishes or identifies a particular enterprise or product E Names like Wheaties Trivial Pursuit Sunkist Kleenex CocaCola Big Mac and Jeep create immediate product identification and generally enhance the sale of the product Trademarks o Trademarks are not amortized because they have indefinite life 0 The registration provides 20 years39 protection and may be renewed indefinitely Franchises and Licenses 0 Grant holders rights to sell product or provide services within designated geographic areas 0 Permits enterprise to use public property in performing its service ie radio or TV broadcasting 0 When costs can be indentified with the acquisition of the franchise or license an intangible asset shoul dbe recognized 0 Annual payments made under a franchise agreement should be recorded as operating expenses Goodwill o Rep39s the value of all favorable attributes that relate to a busness enterprise including exceptional management desirable location good customer relations skilled employees etc 0 Recorded only when there is an exchange transaction that involves the purchase of an entire business When entire business is purchased goodwill is the excess of cost over the fair market value of the net assets Assets Liabilites acquired 0 Not amortized because it has an indefinite life Must be written down if its value is determined to have been permanently impaired O Balance Sheet Presentation 0 Plant assets are shown under Property Plant and Equipment 0 Intangibles are shown under Intangible Assets Balance Sheet Disclosure o The balance of major classes of assets ie land buildings equipment and accumulated depreciation by major classes or in total should be disclosed in the balance sheet or in the notes to the financial statements 0 The method of depreciation should be disclosed as well Statement of Cash Flows Presentation 0 Investing activities section indicates Purchases of property plant and equipment Proceeds from disposals of property plant and equipment Liabilities 0 Defined as Creditors39 claims on total assets Existing debts and obligations o Liabilities must be settled or paid at some time in the future by the transfer of assets or services A current liability o from existing current assets or through the creaion of other current liabilities o and within one year or the operating cycle whichever is longer 0 A debt that can reasonably be expected to be paid in the future by the transfer of assets or services Types Notes payable Accounts payable Unearned revenues Accrued liabilities such as taxes salaries and wages and interest Notes Payable o Obligations in the form of written notes 0 Often used instead of accounts payable because they give the lender written documentation of the obligation in case legal remedies are needed 0 Usually require the borrower to pay interest 0 Notes due for payment within 1 year of the balance sheet date are usually classified as current liabilities 0 Frequently issued to meet shortterm financing needs Formula for Computing Interest 0 Face ValueAnnual Interest RateTime in Terms of One Year Interest E 100000 X 12 x 412 4000 0 Interest is recorded periodically Sales Tax Payable Expressed as a stated percentage of the sales price on goods sold to customers by a retailer Retailer collects the tax from the customer when the sale occurs Retailer periodically usually monthly remits the collections to the state39s department of revenue 0 Thus the retailer serves only as a collection agent for the taxing authority When sales taxes are not rung up separately on the cash register they must be extracted form the total receipts To determine the amount of sales gt divide total receipts by 100 plus the sales tax percentage to determine sales then the difference is sales tax 0 OO O E If Cooler Grocery quotrings upquot total receipts which are 10600 and the sales tax percentage is 6 what is sales 10600100 6 10000 gt100 6 can also be written as 106 Unea rn ed Revenues Cur 0 When the advance is received both Cash and a current liability account identifying the sources of the unearned revenue are increased 0 When revenue is earned the unearned revenue acount is decreased and revenue is increased 0 Unearned Revenue is recorded when cash is received rent Maturities of LongTerm Debt 0 The current portion of a longterm debt should be included in Current Liabilities 0 Frequently shown in the current liabilities portion of the balance sheet as longterm debt due within 1 year 0 No adjusting entry is made to recognize the debt 0 At the balance sheet date all obligations due within one year are classified as current and all other obligations are classified as longterm Payroll and Payroll Taxes Payable o The amount of wages and salaries owed to employees wages and salaries payable 0 The withholding taxes federal and state required by law to be withheld from employees39 gross pay 0 Payroll taxes levied upon the employer for the employer39s share of FICA and state and federal unemployment taxes Payroll Deductions o Mandatory withholding taxes reduce employees gross pay and result in liabilities for the employer LongTerm Liabilities o Obligations that are expected to be paid after 1 year 0 Often in the form of bonds or longterm notes 0 Involve agreement between corporation and one individual one company or a financial institution and are insufficient to furnish the funds needed for major projects Types of Bonds 0 Secured have specific assets of the issuer pledged as collateral for the bonds E A mortgage bond is secured by real estate 0 Unsecured issued against the general credit of the borrower are also called debenture bonds 0 Convertible Permit bondholders to convert the bonds into common stock at their option 0 Callable o are subject to call and retirement at a stated dollar amount prior to the maturity at the option of the issuer Issuing Procedures 0 A bond certificate is issued to the investor to provide evidence of the investors39 claim against the company 0 Provides Name of the company that issued the bonds Face value of the bonds 1 amount due at the maturity Maturity date of the bonds 1 date that the final payment is due to the investor from the company Contractual interest rate 1 rate used to determine the amount of cash interest the borrower pays and the investor receives usually the contractual rate is stated as an annual rate interest is paid semiannually WN Determining the Market Value of Bonds 0 The market value present value of a bond is a function of three factors 1 dollar amounts to be received 2 length of time until the amounts is received 3 market rate of interest which is the rate investors demand for loaning funds 0 The process of finding the present value is referred to as discounting the future amounts Computing the Market Price of Bonds E Present value of 100000 received in 5 years 64993 Present value of 9000 received annually for 5 years 35007 Market price of bonds 100000 LongTerm Liabilities o Bonds may be issued at face value below face value discount or above face value premium Bonds prices for both new issues and existing bonds are quoted as a percentage of the face value of the bond which is usually 1000 0 Thus a 1000 bond with a quoted price of 97 sells at a price 97 of the face value or 970 0 Discount or Premium on Bonds 0 The contractual or stated interest rate is the rate applied to the face par to arrive at the amount of interest paid o The market interest rate is the rate investors demand for loaning funds to the corporation 0 Bonds sell at face or par value only when the contractual and market interest rates are the same 0 Bonds may be issued below or above face value If the market effective rate of interest is higher than the contractual stated rate the bonds will sell at less than face value or at a discount If market rate of interest is less than contractual rate on the bonds the bonds will sell above face value or at a premium Interest Rates and Bond Prices E Market Interest Rate gt 8 gt Premium Bond Contractual Interest Rate is 10 gt 10 gt Face Value gt 12 gt Discount Statement Presentation of Discount on Bonds Payable 0 Discount has a debit Balance gt Not an asset 0 Discounts are contra accounts which is deducted from bonds payable in the balance sheet Total Cost of Borrowing Bonds Issued at Discount 0 The difference between the issuance price and face value of the bonds discount is an additional cost of borrowing that should be recorded as bond interest expense over the life of the bonds Amortizing Bond Discount 0 To comply with the matching principle bond discount should be allocated to expense in each accounting period that benefits from the use of cash proceeds o This allocation is referred to as amortizing the discount o Amortization of discount increases the amount of interest expense reported each period Issuing Bonds at a Premium 0 If the contractual interst rate is greater than the market rate bonds sell at a premium or at a price greater than 100 of face value 0 The Premium on bonds payable is added to bonds payable on the balance sheet E Longterm Liabilities 100000 Bonds Payable 2000 Add Premium on bonds payable 102000 The sales of bonds above face value premium causes the cost of borrowing to be less than the bond interest paid because the borrower is not required to pay the bond premium at the maturity date of the bonds Thus the premium is considered to be a reduction in the cost of borrowing that reduces bond interest expense over the life of the bonds 0 O Amortizing Bond Premium 0 Bond Premium is allocated to expense in each period in which the bonds are outstanding o This allocation is referred to as the amortizing the premium 0 Amortization of the premium decreases the amount of interest expense reported each period Redeeming Bonds at Maturity o Regardless of the issue preice of bonds the book value of the bonds at maturity will equal their face value 0 Bonds are retired before maturity to reduce interest cost and remive debt from its balance sheet 0 A company should retire debt early only if it has sufficient cash resources When bonds are retired before maturity it is necessary to 1 eliminate the carrying value of the bonds at the redepmtion date 1 2 3 2 record the cash paid 3 recognize the gain or loss on redemption o The carrying value is the face value of the bonds minus unamortized bond discount or plus unamortized bond premium 0 Loss on Bond Redemption happens if cash paid to redeem bonds is gt carrying value of bonds Balance Sheet Presentation 0 Current maturities of longterm debt should be reported as current liabilities if they are to be paid from current assets Statement of Cash Flows 0 Information regarding cash inflows and outflows during the year that resulted from the principal portion of debt transactions is provided in the Financing Activities section of the statement of cash flows 0 Interest expense is reported in Operating Activities Liquidity 0 Liquidity ratios measure ability of a company to pay its maturing obligations and meet unexpected cash needs 0 One measure is the current ratio Current Ratio Current AssetsCurrent Liabilities Solvency 0 Measure the ability of a company to survive over a long period of time Formulas to measure solvency 1 Debt to Total Assets Ratio Total LiabilitiesTotal Assets 2 Times Interest Earned Ratio Net Income Interest Expense Tax ExpenseInterest Expense Contingent Liabilities o Contingencies are events with uncertain outcomes Unsettled lawsuits Product warranties Environment cleanup obligations OffBalanceSheet Financing 0 O Attempt to borrow funds in such a way that the obligations are not recorded Leasing is a common type of offbalancesheet activity Operating leases with do not require leased assets or future lease payments to be reported on the balance sheet Operating lease obligations for subsequent years must be described in notes to balance sheet The Corporate Form of Organization 0 A corporation is an entity created by law that is separate and distinct form its owners 0 Its continues existence is dependent upon the statues of the state in which it is incorporated 0 Two common bases for classi cation of corporations are l by purpose 2 by ownership Characteristics of a Corporation 0 Distinguish a corporation from a partnership and a proprietorship 0 Characteristics Separate Legal Existence Continuous life Corporation management Additional taxes Government regulations Ability to acquire capital Transferable ownership rights Limited liability of stockholders Characteristics Separate Legal Entity 0 An entity separate and distinct from owners 0 Acts under its own name rather than name of stockholders 0 May buy own and sell property borrow money and enter into legally binding contracts may sue or be sued and pays its own taxes 0 Owners stockholders cannot bind corporation unless owners are agents of a corporation Legal Liability of Stockholders o Creditors have recourse only to corporate assets to satisfy claims 0 Liability of stockholders limited to investment in corporation 0 Creditors of corporation have no legal claim on personal assets of owners unless fraud has occurred Transferable Ownership Rights 0 Ownership eVidence by shares of stock which are transferable units 0 Transfer of ownership rights among stockholders has no effect on operating actiVities of the corporation or on a corporation s assets liabilities and total equity 0 Corporation does not participate in transfer of ownership rights after original sale of capital stock Ability to Acquire Capital 0 Limited liab of stockholders coupled with transferable ownership rights make it easier for corporations to raise capital Continuous Life 0 Life of a corporation stated in charter may be perpetual or limited to speci c number of years 0 If limited period of existence can be extended through renewal of charter o Corporation is separate legal entity thus life not affected by withdrawal death or incapacity of stockholder Corporation Management 0 Stockholders manage corporation indirectly through board of directors which they elect Board of directors formulates operating policies and selects officers to execute policy and to perform daily management functions 0 Stockholders elect a board of directors who then appoint an president Government Regulations 0 Corporations are subject to state and federal regulations 0 State prescribes requirements for issuing stock distributions of ea1nings permitted to stockholders and the effect of retiring stock 0 Federal securities laws govern sale of capital stock to general public disclosure of financial affairs to Securities and Exchange Commission through quarterly and annual reports and the reporting requirements of the various securities markets Additional taxes 0 Corporations must pay federal and state income taxes 0 Stockholders must pay taxes on cash dividends 0 Thus income is taxed quottwicequot once on corporate level and once on individual level 0 With partnerships and proprietorships owner s share of earnings is reports on hisher personal income tax return 0 Advantages and Disadvantages of a Corporation 0 Advantages Separate Legal Existence Limited Liability of Stockholders Transferable ownership rights Ability to acquire capital Continuous life Corporation management professional managers 0 Disadvantages Corporation management separation of ownership and management Goverment regulations Additional taxes Forming a Corporation 0 States grant corporate charters 0 Although a corporation may have operatin divisions in a number of states it will be incorporated in only one state 0 Some states have laws favorable to the corporate form of business organization Ownership Rights of Stockholders 0 Each share of common stock gives the shareholder these rights 1 Vote in the election of board of directors and in actions that require stockholder approval Share in corporate earnings through the receipt of dividends Maintain the same r 39 39p which T 39 shares of stock are issued preemptive right 4 Share in assets upon liquidation residual claim N E Stock Issues Considerations 0 When a corporation wants to issue stock must ask these questions 1 How many shares should be authorized for sale 2 How should the stock be issued 3 What value should be assigned to the stock Authorized Stock 0 Amount of stock a corporation is allowed to sell as indicated by its charter o Authorization of common stock does not result in a formal accounting entry because the event has no immediate effect on either corporate assets or stockholders39 equity 0 Disclosure of the number of shares authorized is required in the stockholders39 equity section of the balance sheet Issuance of Stock 0 New issues of stock may be offered for sale to the public through various organized US securities exchanges 0 Stock may also be traded on the quotoverthecounterquot market Far and noPar Value Stocks Par Value Stock is capital stock that has been assigned a value per share in the corporate charter O 0 Par Value may be any amount selected by the corporation Par Value is usually quite low Years ago the value was used to determine legal capital per share that must be maintained in business for protection It is the amount that is not available for withdrawal by stockholder State value like par value does not indicate or correspond to the market value of the stock noPar Value Stock Capital stock that has not been assigned a value per share in the corporate charter In many states the board of directors is permitted to assign a state value to the nopar shares which then becomes the legal capital per share The stated value of no par stock may be changed at any time by action of the directors Accounting for Common Stock Issues Stockholders39 equity section of a corporation s balance sheet includes 0 amount paid in to the corporation by stockholders in eXhange for shares of ownership Paidin contributed capital land Retained Earnings earned capital ea1ned capital held for future use in the business The distinction between paidin capital and retained earnings is important from a legal and economic point of view Accounting for Common Stock Issues Objectives 0 1 Identify speci c sources of paidin capital 2 Maintain the distinction between paidin capital and retained ea1nings Issuing Par Value Common Stock for Cash When the issuance of common stock for cash is recorded and the issue price is the same as the par value of the stock the par value of the shares is credited to Common Stock and debited to Cash When the issuance of common stock for cash is recorded and par value of the shares is not the same as the cash price the par value is credited to common 0 stock and the portion of the proceeds that is above or below par value is recorded in a separate painincapital account Common Stock Paidin capital in excess of par value Total Paidin Capital Accounting for Treasury Stock 0 Treasury stock is a corporation s own stock that has been issued fully paid for reacquired by the corporation and held in its treasury for future use Treasury Stock 1 2 5 To reissue the shares to employees under stock compensation plans To increase trading of the company39s stock in the securities market Companies expect that buying their own stock will signal that management believes the stock is underpriced which they hope will enhance the market value To have shares available for use in the acquisition of other companies To reduce shares outstanding and thereby increase ea1nings per share Purchase of Treasury Stock 0 O O The purchase of treasury stock is generally acounted for by the cost method With the cost method the Treasury Stock acount is maintained at the cost of the shares purchased Under the cost method Treasury Stock is debited for the price paid for the shares the same amount is credited to Treasury Stock when the shares are disposed of Preferred Stock 0 O O O A corporation may issue a class of stock in addition to common stock Has contractual provisions that give it preference or priority over common stock When a corporation has more than one class of stock each paidin capital account title should identify the stock to Which it relates May have either a par value or nopar value Preferred Stock Priorities 0 O Dividends Assets in the event of liquidation Dividend Preferences 0 The first claim to dividends does not guarantee dividends o Dividends depend on factors such as adequate retained earnings and availability of cash 0 The per share dividend amount is stated as a percentage of the stock or as a speci ed amount Cumulative Dividend 0 Preferred stock contracts often contain a cumulative dividend feature 0 If preferred stock is cumulative preferred stockholders must be paid both current year dividends and any unpaid prioryear dividends before common stockholders receive dividends 0 When preferred stock is cumulative preferred dividends not declared in a given period are called dividends in arrears o Dividends in arrears are not a liability because no obligation exists until the board of directors declares a dividend o The amount of dividends in arrears should be disclosed in the notes to the financial statements Computation of Total Dividends to Preferred Stock 0 Annual Dividend of shares per share E If Company A has 5000 shares of 7 100 par value cumulative preferred stock outstanding thent he annual dividend is what Answer 50007100 35000 Ifdividends were two years in arrears preferred stockholders are entitled to receive the following before any dividends are paid to common stockholders Dividends in arrears 35000 X 2 70000 Currentyear dividends 35 000 Total Preferred Dividends 105000 Liquidation Preference 0 Most preferred stocks have a preference on corporate assets if the corporation fails o The preference to assets may be for the par value of the shares or for a specified liquidating value Dividend 0 Distribution by a corporation to its stockholders on a pro rata basis 0 Pro rata means that if you own 10 of the common shares you Will receive 10 of the dividend o Dividends can take four forms cash property script promissory note to pay cash or stock 0 Cash dividends which predominate in practice and stock dividends which are declared with some frequency are discussed in this chapter Cash Dividend o For corporation to pay a cash dividend it must have Retained Earnings 1 In many states payment of dividends from legal capital is prohibited 2 Payment of dividends from a paidin capital in excess of par is legal in some states 3 Payment of dividends from retained ea1nings is legal in all states 4 Conpanies are frequently constrained by agreements with lenders to pay dividends only from retained ea1nings Adequate cash 1 You have to have enough cash to pay the dividend Declared dividends l The board of directors has full authority to determine the amount of income to be distributed in the form of dividends and the amount to be retained in the business Entries for Cash Dividends 0 Three dates are important in connection with dividends 1 Declaration date 2 Record date 3 Payment date Accounting entries are required on the declaration date and payment date Declaration Date 0 The board of directors authorizes the cash dividends and announces it to stock holders The declaration of a cash dividend commits the corporation to a binding legal obligation that cannot be rescinded An entry is required to recognize the decrease in retained earnings and the increase in the liability Dividends Payable O O Record Date 0 The record date marks the time when ownership of the outstanding shares is determined for dividend purposes 0 The purpose of the record date is to identify the persons for entities that will receive the dividend not to determine the dividend liabilty Payment Date 0 Dividend checks are mailed to the stockholders and the payment of the dividend is recorded 0 Payment of a dividend reduces both current assets and current liabilities but has no effect on stockholders39 equity Stock Dividends 0 Pro rata distribution of the corporation s own stock to stockholders o Is paid in stock 0 Results in a decrease in retained earnings and an increase in paidin capital 0 Does not decrease total stockholders39 equity or total assets 0 Issue stock dividends for following reasons Satisfy stockholders dividend expectations without spending cash To increase the marketability of its stock by increasing the number of shares outstanding and thereby decreasing the market price per share to make it easier for smaller investors to purchase the shares To emphasize that a portion of stockholders39 equity has been permanently reinvested in the business and is therefore unavailable for cash dividends The accounting profession distinguishes between small and large stock dividends 0 Small less than 2025 ofthe corporations issued stock is recorded at the fair market value per share 0 Large greater than 2025 of the corporations issued stock is recorded at par or stated value per share Change composition of equity because portion of RE is transferred to paidin capital Total equity and the par or stated value per share remain the same Stock Splits o Involves the issuance of additional shares to stockholders according to their percentage ownership 0 The number of shares is increased in the same proportion that par or stated value per share is decreased Has no effect on total paidin capital RE an total equity It is not necessary to formally joumalize a stock split 0 O Stock Split Effects 0 Does not have any effect on paidin cap RE and total equity Differences between the effects of stock splits and stock dividends Item Stock Dividend Stock Split Total paidin capital Increase No change Total RE Decrease No change Total par value CS Increase No change Par value per share No change Decrease Retained Earnings RE 0 Net Income that is retained in business 0 Balance in RE is part of stockholders claim on the total assets of the corporation 0 Formula Assets Liabilities Paidin Capital Retained Ea1nings 0 Does not represent a claim on any specific asset RE does not equal Assets RE cannot be associated with the balance of any asset account E 100 in RE does not mean 100 in cash The cash resulting from the excess of revenues over expenses may have been used to purchase other assets buildings equipment etc Stockholders39 Equity with De cit 0 Net losses decrease are debited to RE 0 Net losses do not decrease are not debited to Paidin Capital accounts 0 A debit balance in RE is identi ed as a de cit It is reported as a deduction in the stockholders39 equity section Common Stock RE that is de cit Total Stockholders39 equity Retained Earnings Restrictions 0 Make a portion of the balance currently unavailable for dividends 0 Restrictions result from one or more of legal states may require that corporations restrict RE for the cost of treasury stock purchased 2 contractual long term debt contracts may restrict RE as a condition for a loan 3 voluntary board of directors may voluntarily restrict RE for speci c purposes such as future plant expansion Stockholders39 Equity Presentation and Analysis 0 In the equity section of the balance sheet paidin capital and RE are reported 0 The speci c sources of paidin capital are indenti ed 0 Within paidin capital two classi cations are recognized 1 Capital Stock 2 Additional paidin capital 0 Paidin cap is sometimes called contributed capital Dividend Record 0 The payout ratio measures the percentage of earnings distributed in the form of cash dividends to common stockholders and is computed by dividing total cash dividends to common shareholders by net income 0 Formula Payout ratio Cash Dividend Declared on Common Stock Net Income Return on Common Stockholders Equity 0 O O O A widely used ratio that measures pro tability from the common stockholders view point This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders It is computed by dividing net income available to common stockholders by average common stockholders equity Formula Return on Common Stockholders Equity Net Income Preferred Stock Dividends Average Common Stockholders Equity Debt Versus Equity Decision 0 O Bonds have three primary advantages relative to common stock Stockholders control is not affected Bondholders do not have voting rights so current stockholders retain full control of the company Tax advantages result Bond interest is deductible for taX purposes dividends on stock are not Return on common stockholders equity may be higher Although bond interest expense reduces net income return on common stockholders equity often is higher under bond nancing because no additional shares of common stock are issued One major disadvantage Under debt agreements the company locks in fixed payments that must be made in good times and bad Interest must be paid on a periodic basis and the principal of the bonds must be paid at maturity With common stock financing the company can decide to pay low or no dividends if earnings are low Components of the Return on Common Stockholders Equity RCSE O RCSE is affected by both the Return on Assets Ratio and Leverage Debt to Total Assets Ratio Leverage Company s reliance on debt If a company wants to increase its RCSE it can either increase Return on Assets or its reliance on debt financing Effects on RCSE of Issuing Debt 0 O RCSE varies depending on which plan is chosen In general as long as the Return on Assets rate indicated by the income before interest and taxes exceeds the rate paid on debt a company will increase the RCSE by the use of debt


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