UNIT-5

ACCOUNTING FOR CORPORATIONS

Section 1: Nature of Corporations

1.1. Meaning and Characteristics Corporation

A corporation is an artificial being, invisible, intangible and existing only in contemplation of the law. It
is a legal entity having an existence separate and distinct from that of its owners. In the eyes of the law
there are two persons. The first is that of natural persons and a corporation. A corporation is a separate
legal entity endowed with many of its rights and obligations possessed by a natural person.

Among the characteristics of a corporation are:

a. A corporation is a separate legal entity. According to the law a corporate entity may own property
in its own name may enter into contract and is responsible for it own debts.
b. A corporation has a legal status in court. According to the law a corporation may sue and be sued
as if it were a real person.
c. A corporation has its own charter. A corporation is created by obtaining charter from the state in
which the company is to be incorporated.
d. A corporation pays income taxes on its earnings. The income of a corporation is subject to income
taxes, which must be paid by the corporation.

Advantages and Disadvantages of the Corporate form of Business Organizations.

A corporate entity has many advantages not available in other forms of organization. Among the
advantages are the following:

a) Continuous existence of the entity: A corporation has perpetual existence in that its continuous
existence is not dissolved by the death or retirements of any of its members.

b) Limited liability: In a partnership each partner is personally responsible to all the debts of the
business. In a corporation the stockholders are personally responsible for the corporation’s debts.

Since a corporation is a separate legal entity, the creditors of a corporation have a claim against the
assets of the corporation, not the personal property of the owners and the maximum amount a stock
holder can lose is the amount of his/her investment.

c) Professional management: the owners of a corporation (called stock holders or shareholders) own
the corporation but they do not manage it on a daily basis. To administer the affairs of the corporation,
president and other officers are hired for it. Thus, individual stockholder has no rights to participate in
the management’s activity of the corporation unless the stockholder has been hired as a corporate
officer.

d) Easily transferable ownership shares: Ownership of a corporation is evidenced by transferable

shares of stocks. These shares of stocks may be sold by one investor to another without dissolving or
disrupting the business organization.

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e) No mutual agency of stock holders: Since the corporation is considered as a separate legal entity,
the owners do not have the power to bind the corporation to business contracts. This feature eliminates
the potential problem of mutual agency that exists between partners in a partnership.

Some of the disadvantages of the corporation are:

a) Double taxation: corporate earnings are taxed two times. The earnings are taxed first as a
corporate income tax and again as personal income taxes, if the corporation distributes its earnings to
stockholders.
b) Difficulties to control: since ownership is usually separated from managements, owners are
unable to exercise active control over management actions.
c) Greater regulations: since a corporation comes into existence according to the law of the state, the
law may provide for considerable regulation of the corporation’s activities. For example, the
withdrawal of funds from a corporation is subjected to certain limits set by the law.

1.2 Formation of a corporation

Corporations may be classified as public and non-public. Large profit making corporations whose shares
are widely distributed and traded in a public market are often called public corporations. Corporations
whose shares are owned by a small group are often called non-public corporations. Governments have
their own laws that govern the incorporations of a business.

A corporation is created by obtaining a corporate charter. The charter is given from the states in which
the corporation is to be incorporated. To obtain a corporate charter an application called articles of
incorporation are prepared by the organizers called incorporators and submitted to the state
corporation’s commissioner or other designated officials. These articles of incorporation specify the
purpose of the business, its location, the names of the organizers, the classes and numbers of shares of
capital stock authorized, and the consideration to be paid in by the organizers for their respective shares.

The article of incorporation is approved by the state and charter is issued. Once a charter is obtained a
board of directors is elected. The directors in turn hold meetings at which officers of the corporation are
appointed.

Organization Costs

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

Rights of Stockholders

? What rights can owner of a corporation possess?

The stockholders who are the owners of a corporate entity having the following basic rights:

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

section 2: Authorization and Issuance of Stocks.

This Section tries to discuses about the process of forming corporations. Detail coverage of various
classes of stocks and form of issuance of these stocks are also covered. Accounting treatment of
retained earning and calculation of earning per share are discussed in the later part of this Section.

The state officials approve the articles of incorporation, which specify the number of shares a
corporation is authorized to issue. The total number of shares that may be issued is known as the
authorized shares. When the corporation receives cash it is an exchange for stock certificates, which
represents the number of shares issued. The shares subsequently become issued shares. Shares that are
issued and held by the stockholders are called outstanding shares. Sometimes a corporation re-acquires
shares from its own shareholders. These shares are called treasury stocks, which reduce the number of
outstanding shares.

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

2.1. Types of Stocks/Shares

Capital stock consists of transferable units of ownership in corporation. Each unit of ownership is called
a share of stock. Many corporations issue several classes of capital stock, each providing investors with
different rights and opportunities. A corporation may issue two classes of stock namely Common stocks
and preferred stock

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

Stocks according to their nature are classified into par value and no-par stocks.

 Par value stocks are stocks with a designated dollar amount per share as stated in the corporate
charter and printed on the stock certificates. On the other hand, some states allow corporations to issue

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stocks without designating a par value. Such stocks are called no-par stocks. When no par stocks are
issued by a corporation, the entire issuance price is viewed as a legal capital, which is subject to
withdrawal. Sometimes some states authorize the issuance of no-par stock with a stated, or assigned,
value per share that is established permanently by the corporate directors and is in the laws. Most
corporations use a stated value for no par stock.

Accounting for stock issuance

2.2.1 Stock Issued for Cash

When stocks are issued to various investors, a stock certificate specifying the number of shares
represented is prepared for each investor/or stockholder. When par value stock is issued for cash, the
capital stock account is credited with the par value of the shares issued regardless of whether the
issuance price is more or less than par.

If par value stock is issued for more than par value (at premium), “paid in capital in excess of par”
account is credited for the excess of selling price over par. This paid in capital is excess of par does not
represent a profit to the corporation for less than par (at discount), a negative stockholders’ equity
account, “Discount on common (or preferred ) stock”, is debited for the amount of the discount.

For example, assume that 100,000 shares of Br. 2 par value common stock have been authorized and
that 20,000 of these authorized shares are issued at a price of Br. 10 each. The entry would be:

Cash…………………………...200,000

Common stock…………………………..40,0000

Paid in capital in excess of par-c/s………160,000

When a corporation issues no-par stock without a stated value, the entire amount received is credited to
the capital stock account. Assume XYZ Company issued 10, 000 no-par stocks for Br 20 per share. The
entry would be:
Cash…………………..200,000
Common stock………..200,000
(To record the issuance of 10,000 no-par stock)

2.2.2. Stock issuance for subscription

Stock is often sold on a subscription basis. A subscription sale is collected in installments and the
stock certificate is issued when the price is paid in full. A subscription is a contract to acquire a certain
number of shares of stock at a specified price. A subscriber is a person contracting to acquire the shares.
One reason for this procedure is to attract small investors. Another reason is to appeal to investors who
prefer not to invest cash until the corporation is ready to start business operations. A corporation may
also sell its capital stock on credit after incorporation.

When stock is subscribed, the company

 debits “stock subscription receivable” for the subscription price,

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 Credits capital stock subscribed for the par value of the subscribed shares, and
credits “paid in capital in excess of the subscription price over par value”. Later, as cash is collected,
the entry is a debit to “cash” and a credit to “stock subscription receivable”. When the entire
subscription price is collected, the stock certificates are issued for the subscribers. The issuance of stock
is recorded by debiting capital stock subscribed and crediting capital stock.

The following illustration demonstrates the accounting procedures for stock subscriptions.

Assume that 100,000 shares of NILE corporation common stock, par Br. 10, are subscribed for at Br. 12
by Ambasel Trading. The total is payable in three equal installments. The following entries are
processed by NILE Corporation.

Common stock subscription Receivable 1,200,000

Common stock subscribed 1,000,000
Paid-in-capital in excess of par 200,000
To record receipt of subscription for 100,000
shares
Cash 400,000
Common stock subscription receivable 400,000
To record receipt of first payment
Cash 400,.000
Common stock subscription receivable 400,.000
To record receipt of Second payment
Cash 400,.000
Common stock subscription receivable 400,.000
To record receipt of final payment
Common stock subscribed 1,000,000
Common stock 1,000,000

To record issuance of stock

2.2.3-Stock issuance for property or services

Stock may be issued in exchange for non-cash assets or services. In this case, the transaction should be
recorded at either the fair value of the assets or services received or the market value of the shares
issued, whichever can be determined more objectively. The transaction is recorded like a sale for cash
except that the appropriate asset account is debited in the place of cash.

Assume Ato Zerihun gave his land to the corporation in exchange for 1000 shares of Br 10 par value
common stock. The fair market value of the land can not be determined objectively. At the time the
exchange, the stock has an estimated total market value of Br 12,000. The required entry is:
Land………………..12,000
Common stock……………..……10,000

Paid in capital in excess of par…..2,000

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Accounting for Treasury Stocks

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

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

In general, a corporation may reacquire treasury stocks for the following reasons:

a) To eliminate the ownership interest of a particular stockholder

b) To increase earnings per share by reducing the number of shares outstanding.
c) To reduce dividend payment by reducing the number of shares outstanding.
d) To provide shares for reassurance to employees as a bonus.
e) To use the share acquired for stock dividend.
f) To reissue with a higher price.
g) To increase the market price per share

2.5.1. Recording and reporting Treasury stock Transactions

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

To illustrate the cost method, assume that Dabat Corporation had 60,000 share of Br. 10 par common
stock outstanding at the beginning of the current year. The company purchased 1000 shares for cash.
The markets price of stocks was Br. 30/share. The following entry is required involving the
transactions.
Treasury stock (1,000 x 30) 30,000
Cash 30,000
If the company sells 600 shares of the treasury stock for Br. 31 each, the entry would be:
Cash (600 x 31) 18,600
Treasury stock (600 x 30) 18,000
Paid in capital from sale of -Treasury stock 600
Paid in capital from sale of treasury stock is reported in the paid in capital section of the balance sheet.
Treasury stock is deducted from the total of the paid in capital and Retained earnings.

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2.6. Equity per Share

The amount appearing on the balance sheet as total stockholders’ equity can be stated in terms of the
equity per share (book value per share). When there is only one class of stock, the equity per share is
determined by dividing total stockholders’ equity by the number of shares outstanding. For a
corporation with both preferred and common stock, it is necessary first to allocate the total equity
between the two classes.

EXERCISES:

1. Early in the year a group of friends organized a corporation called Abeba S.C. The corporation
was authorized to issue 50,000 of Br. 100 per value, 10% cumulative preferred stock and 400,000 shares
of Br. 2 common stock. The following transactions occurred during the year.

Jan. 6 Issued for cash 20,000 shares of common stock at Br. 14 per share.

The shares were issued to various investors.

Jan. 12 Issued 2,500 shares of preferred stocks for cash of Br. 250,000.

Jan. 14 acquired land as a building site in exchange for 15,000 shares of common stock.

In view of the appraised value of the land, the directors agreed that the common stock was to be valued
for purpose of this transaction at Br. 15 per share.

Nov. 15 The first annual dividend of Br. 10 per share was declared on the preferred stock to be paid on
December 20,

Dec. 20 Paid the cash dividend declared on November 15,

Instructions

Prepare journal entries in general journal form to record the above transactions