:::: Self Study Notes ::::: February 2011

Monday, February 28, 2011

Issues in accounting for global commerce

Understand that international trade no longer simply means importing and exporting. Companies have added subsidiaries in many countries, formed cooperative alliances, listed shares on multiple stock exchanges around the globe, engaged in global cross-border debt financing, and set up service centers that utilize technology to provide seamless customer support around the world. Companies engaging in global business face some specific reporting challenges. Two of those challenges are (1) how to consolidate global subsidiaries and (2) how to account for global transactions denominated in alternative currencies.

GLOBAL SUBS:

When a parent corporation has a subsidiary outside of its home country, the financial statements of that subsidiary may be prepared in the “local” currency of the country in which it operates. But, the parent’s financials are prepared in the “reporting” currency of the country in which it is domiciled. Thus, to consolidate the parent and sub first requires converting the sub’s financial information into the reporting currency. Facts and circumstances will dictate whether the conversion process occurs by a process known as the functional currency translation approach or an alternative approach known as remeasurement.

GLOBAL TRADING:

Many firms buy goods from foreign suppliers and/or sell goods to foreign customers. The terms of the transaction will stipulate how payment is to occur and the currency for making settlement. If the currency is “foreign,” then some additional thought must be given to the bookkeeping.
Suppose Bentley’s Bike Shop purchases bicycles from GiroCycle of Switzerland. On July 1, 20X6, Bentley purchased bicycles, agreeing to pay 20,000 Swiss francs within 60 days. Bentley is in Cleveland, Ohio, and the U.S. dollar is its primary currency. On July 1, Bentley will record the purchase by debiting Inventory and crediting Accounts Payable. But, what amount should be debited and credited? If 20,000 were used, the accounts would cease to be logical. The total Inventory balance would be illogical since it would include this item, and all other transactions in other currencies. Total Accounts Payable would become unintelligible as well. Therefore, Bentley needs to measure the transaction in dollars. On July 1, assume that the current exchange rate (i.e., the “spot rate”) is 0.90 U.S. dollars to acquire 1 Swiss franc. The correct entry would be:

By the August 29 settlement date, assume that the dollar has weakened and the spot rate is $0.95. Bentley will have to pay $19,000 (20,000 X $0.95) to buy the 20,000 francs needed to settle the obligation. The following entry shows that the difference between the initially recorded payable ($18,000) and the cash settlement amount ($19,000) is to be recorded as a foreign currency transaction loss:

If the exchange rate had gone the other way, a foreign currency transaction gain (credit) would have been needed to balance the payable and required cash disbursement.
It is important to know that foreign currency payables and receivables that exist at the close of an accounting period must also be adjusted to reflect the spot rate on the balance sheet date. Suppose Vigeland Corporation sold goods to a customer in England, agreeing to accept payment of 100,000 British pounds in 90 days. On the date of sale, December 1, 20X1, the spot rate for the pound was $1.75. Vigeland prepared financial statements at its year end on December 31, 20X1, at which time the spot rate for the pound was $1.90. The foreign currency receivable was collected on February 28, 20X2, and Vigeland immediately converted the 100,000 pounds to dollars at the then current exchange rate of $1.70.
The following illustrates Vigeland’s sale, year-end adjustment, and subsequent collection:

Some companies may wish to avoid foreign currency exchange risks like those just illustrated. The simplest way is to convince a trading partner to make or take payment in the home currency. In the alternative, various financial agreements can be structured with banks or others to hedge this risk.

Key assumptions of financial accounting and reporting

Many associate accounting with math in terms of absolute precision. However, accounting is actually more like art and social science and depends on certain fundamental assumptions.

ENTITY:

Accounting information should be presented for specific and distinct reporting units. In other words, the entity assumption requires that separate transactions of owners and others not be commingled with the reporting of economic activity for a particular business. On one hand, an individual may prepare separate financial statements for a business they own even if it is not a separate legal entity. On the other hand, consolidated financial statements may be prepared for a group of entities that are economically commingled but are technically separate legal units.

GOING-CONCERN:

In the absence of contrary evidence, accountants base measurement and reporting on the going-concern assumption. This means that accountants are not constantly assessing the liquidation value of a company in determining what to report, unless of course liquidation looks like a possibility. This allows for allocation of long-term costs and revenues based on a presumption that the business will continue to operate into the future. Accountants are typically conservative (when in doubt, select the lower asset/revenue measurement choice, and the higher liability/expense measurement choice), but not to the point of introducing bias based on an unfounded fear for the future.

PERIODICITY:

Accountants assume they can divide time into specific measurement intervals (i.e., months, quarters, years). This periodicity assumption is necessitated by the regular and continuing information needs of financial statement users. More precision could be achieved if accountants had the luxury of waiting many years to report final results, but users need timely information. For instance, a health club may sell lifetime memberships for a flat fee, not really knowing how long their customers will utilize the club. But, the club cannot wait years and years for their customers to die before reporting any financial results. Instead, methods are employed to attribute portions of revenue to each reporting period. This is justified by the periodicity assumption.

Monetary Unit:

The monetary unit assumption means that accounting measures transactions and events in units of money. This assumption overcomes the problems that would arise by mixing measures in the financial statements (e.g., imagine the confusion of combining acres of land with cash). The monetary unit assumption is core and essential to the double-entry, self-balancing accounting model.

STABLE CURRENCY:

Inflation can wreck havoc on the usefulness of financial data. For example, suppose a power plant that was constructed in 1970 is still in operation. Accounting reports may show a profit by matching currently generated revenues with depreciation of old (“cheap”) construction costs. A different picture might appear if one reconsidered the “value” of the power plant that is being “used up” in generating the current revenue stream. Inflation can distort performance measurement. Accountants have struggled with this issue for many years, and even experimented with supplemental reporting requirements. However, accounting generally operates under the stable currency assumption, going along as though costs and revenues incurred in different time periods need not be adjusted for changes in the value of the monetary unit over time.

The development of generally accepted accounting principles

Generally accepted accounting principles, or GAAP, encompass the rules, practices, and procedures that define the proper execution of accounting. It is important to note that this definition is quite broad, taking in more than just the specific rules issued by standard setters. It encompasses the long-standing methodologies and assumptions that have become engrained within the profession through years of thought and development. Collectively, GAAP form the foundation of accounting by providing comprehensive guidance and a framework for addressing most accounting issues.

THE FASB, IASB, and SEC:

The Financial Accounting Standards Board (FASB) has been the primary USA accounting rule maker since the early 1970’s. Prior to its creation, rules were set by the Accounting Principles Board (APB). The APB was created in 1959 by the American Institute of Certified Public Accountants (AICPA). The AICPA is a large association of professional accountants who seek to advance the practice of accounting. Before 1959, the duty of standard development fell on the shoulders of an AICPA committee known as the Committee on Accounting Procedure (CAP).
The International Accounting Standards Board (IASB) is the global counterpart to the FASB. The standards of the IASB are oftentimes referred to as IFRS (International Financial Reporting Standards). The FASB and IASB are working harmoniously to converge toward a single set of accounting standards. This project is receiving considerable interest from financial institutions, investors, and governmental units around the world. Convergence of accounting standards is seen as an important tool in the facilitation and coordination of international commerce and the global economy.
Stock Art

In a 1930’s-era effort to bring credibility to capital markets, the U.S. Congress created the Securities and Exchange Commission (SEC). The SEC was charged with the administration of laws that regulate the reporting practices of companies with publicly traded stock. Today, U.S. public companies must register and report to the SEC on a continuing basis. Although the SEC has ultimate authority to set accounting rules, it has elected to operate under a tradition of cooperation and largely defers to the private sector for most specific accounting rules.

THE AUDIT FUNCTION:

To provide a measure of integrity, financial reports of public companies are required to be audited by independent CPAs. Auditors evaluate the systems and data that lead to the reported financial statements. The auditor will usually issue an opinion letter on the fairness of the reports. This letter is rather brief and to the point and includes a paragraph similar to the following:

Note that the auditor is expressing an opinion about the conformity of the financial statements with generally accepted accounting principles. Thus, conformity with GAAP is the key to obtaining the desired audit opinion. Being alert to the detection of potential fraud is important, but it is not the primary mission of a financial statement audit.
The U.S. Congress created the Sarbanes-Oxley Act of 2002 (SOX). It imposed stringent financial statement certification requirements on corporate officers, raised the fiduciary duty of corporate boards, imposed systematic ethics awareness, and placed a greater burden on auditors. In addition, Section 404 of the Act requires public companies to implement a robust system of internal control; an independent auditor must issue a separate report on the effectiveness of this control system. The Act also created the Public Company Accounting Oversight Board (PCAOB). The PCAOB is a private-sector, non-profit corporation, charged with overseeing the auditors of public companies.

The objectives and qualities of accounting information

Of what value is accounting? Why is so much time and money spent on the development of accounting information? To fairly answer these questions, one must think broadly. Investors and creditors have limited resources and seek to place those resources where they will generate the best returns. Accounting information is the nexus of this capital allocation decision process. Without good information misallocation of capital would occur and result in inefficient production and shortages.
Most organizations devote a fair amount of time and effort to considering their goals and objectives. The accounting profession is no different. Foremost among the objectives of accounting and reporting is to provide useful information for investors, creditors, analysts, government, and others. Accounting information is general purpose and should be designed to serve the information needs of all types of interested parties. To be useful, information should be helpful in assessing the amounts, timing, and uncertainty of an organization’s cash flows; assist in the study of an enterprise’s resources, claims against those resources, and changes in them; and, be helpful in examining an enterprise’s financial performance. Additionally, accounting should help decision makers monitor and evaluate how well management is fulfilling its stewardship responsibilities. The following qualities help to make accounting useful.

UNDERSTANDABILITY:

One challenge facing the accounting profession is to develop measurement and presentation methods that can capture and report complex business activity in a way that is understandable. Importantly, accounting reports should be comprehensible to those with a reasonable understanding of business and economic activities. It is assumed the users will study information with reasonable diligence, but it is equally presumed that those users do not need to be accounting experts.
Be aware of the growing complaint that accounting has become too complex. Many persons within and outside the profession protest the ever growing number of rules and their level of detail. The debate is generally couched under the heading “principles versus rules.” Advocates of a principles-based approach argue that general concepts should guide the judgment of individual accountants. Others argue that the world is quite complex, and accounting must necessarily be rules-based. They believe that reliance on individual judgment may lead to wide disparities in reports that could render meaningful comparisons impossible.

Earnings per share and other key indicators

How is one to meaningfully compare the net income of a large corporation that has millions of shares outstanding to smaller companies that may have less than even one million shares? The larger company is probably expected to produce a greater amount of income. But, the smaller company might be doing better per unit of ownership. To adjust for differences in size, public companies must supplement their income reports with a number that represents earnings on a per common share basis. Earnings per share, or EPS, is a widely followed performance measure. Corporate communications and news stories will typically focus on EPS, but care should be taken in drawing any definitive conclusions. Nonrecurring transactions and events can positively or negatively impact income. Companies that present an income statement that segregates income from continuing operations from other components of income must also subdivide per share data (e.g., EPS from continuing operations, discontinued operations, etc.).

BASIC EPS:

Basic EPS may be thought of as a fraction with income in the numerator and the number of common shares in the denominator. Expanding this thought, consider that income is for a period of time (e.g., a quarter or year), and during that period of time, the number of shares might have changed because of share issuances or treasury stock transactions. Therefore, a more correct characterization is income divided by the weighted-average number of common shares outstanding.
Further, consider that some companies have both common and preferred shares. Dividends on common and preferred stock are not expenses and do not reduce income. However, preferred dividends do lay claim to a portion of the corporate income stream. Therefore, one more modification is needed to correctly portray the Basic EPS fraction:

Basic EPS = Income Available to Common / Weighted-Average Number of Common Shares Outstanding

The Basic EPS calculation entails a reduction of income by the amount of preferred dividends for the period. To illustrate, assume that Kooyul Corporation began 20X4 with 1,000,000 shares of common stock outstanding. On April 1, 20X4, Kooyul issued 200,000 additional shares of common stock, and 120,000 shares of common stock were reacquired on November 1. Kooyul reported net income of $2,760,000 for the year ending December 31, 20X4. Kooyul also had 50,000 shares of preferred stock on which $500,000 in dividends were rightfully declared and paid during 20X4. Kooyul paid $270,000 in dividends to common shareholders. Therefore, Kooyul’s Basic EPS is $2 per share ($2,260,000/1,130,000), as discussed in the following paragraph.
Income available to Kooyul’s common shareholders is $2,260,000. This amount is calculated as the net income ($2,760,000) minus the preferred dividends ($500,000). Dividends on common stock do not impact the EPS calculation. Weighted-average common shares outstanding during 20X4 are 1,130,000. The following table illustrates this calculation:

DILUTED EPS:

Some companies must report an additional Diluted EPS number. The Diluted EPS is applicable to companies that have complex capital structures. Examples include companies that have issued stock options and warrants that entitle their holders to buy additional shares of common stock from the company, and convertible bonds and preferred stocks that are exchangeable for common shares. These financial instruments represent the possibility that more shares of common stock will be issued and are potentially “dilutive” to existing common shareholders.
Companies with dilutive securities take the potential effect of dilution into consideration in calculating Diluted EPS. These calculations require a series of assumptions about dilutive securities being converted into common stock. The hypothetical calculations are imaginative; even providing guidelines about how assumed money generated from assumed exercises of options and warrants is assumed to be “reinvested.” Diluted EPS provides existing shareholders a measure of how the company’s income is potentially to be shared with other interests.

PRICE/EARNINGS RATIO:

Financial analysts often incorporate reported EPS information into the calculation of the price/earnings ratio (P/E). This is simply the stock price per share divided by the annual EPS:

Price Earnings Ratio = Market Price Per Share / Earnings Per Share

For example, a stock selling at $15 per share with $1 of EPS would have a P/E of 15. Other companies may have a P/E of 5 or 25. Wouldn’t investors always be drawn to companies that have the lowest ratios since they may represent the best earnings generation per dollar of required investment? Perhaps not, as the “E” in P/E is past earnings. New companies may have a bright future, even if current earnings are not great. Other companies may have great current earnings, but no room to grow.
A related ratio is the “PEG” ratio. This is the P/E ratio divided by the company’s “growth” rate. For example, a company with a P/E of 20 that is experiencing average annual increases in income of 20% would have a PEG of 1. If the same company instead had annual earnings increases of 10%, then the PEG would be 2. Lower PEG numbers sometimes help identify more attractive investments.

BOOK VALUE PER SHARE:

Another per share amount that analysts frequently calculate is the book value per share. This refers to the amount of reported stockholders’ equity for each share of common stock. Book value is not the same thing as market value or fair value. Book value is based on reported amounts within the balance sheet. Many items included in the balance sheet are based on historical costs which can be well below fair value. On the other hand, do not automatically conclude that a company is worth more than its book value, as some balance sheets include significant intangibles that cannot be easily converted to value.
For a corporation the has only common stock outstanding, the calculation of book value per share is simple. Total stockholders’ equity is divided by common shares outstanding at the end of the accounting period.
To illustrate, assume that Fuller Corporation has the following stockholders’ equity, which results in a $24 book value per share ($12,000,000/500,000 shares):

A company with preferred stock must allocate total equity between the common and preferred shares. The amount of equity attributable to preferred shares is generally considered to be the call price (i.e., redemption or liquidation price) plus any dividends that are due. The remaining amount of “common” equity (total equity minus equity attributable to preferred stock) is divided by the number of common shares to calculate book value per common share:

Book Value Per Share = "Common" Equity / Common Shares Outstanding

Assume that Muller Corporation has the following stockholders’ equity:

Mike Kreinhop is a financial analyst for an investment fund, and is evaluating the merits of Muller Corporation. Pursuant to this task, he has diligently combed through the notes to the financial statements and found that the preferred dividends were not paid in the current or prior year. He notes that the annual dividend is $600,000 (6% X $10,000,000) and the preferred stock is cumulative in nature. Although Muller has sufficient retained earnings to support a dividend, it is presently cash constrained due to reinvestment of all free cash flow in a new building and expansion of inventory. Kreinhop correctly prepared the following book value per share calculation:

DIVIDEND RATES AND PAYOUT RATIOS:

Many companies do not pay dividends. One explanation is that the company is not making any money. Hopefully, the better explanation is that the company needs the cash it is generating from operations to reinvest in expanding a successful concept. On the other hand, some profitable and mature businesses can easily manage their growth and still have plenty of cash left to pay a reasonable dividend to shareholders. In evaluating the dividends of a company, analysts calculate the dividend rate (also known as yield).

The dividend rate is the annual dividend divided by the stock price:

Dividend Rate = Annual Cash Dividend / Market Price Per Share

If Pustejovsky Company pays dividends of $1 per share each year, and its stock is selling at $20 per share, it is yielding 5% ($1/$20). Analysts may be interested in evaluating whether a company is capable of sustaining its dividends and will compare the dividends to the earnings:

Dividend Payout Ratio = Annual Cash Dividend / Earnings Per Share

If Pustejovsky earned $3 per share, its payout ratio is .333 ($1/$3). On the other hand, if the earnings were only $0.50, giving rise to a dividend payout ratio of 2 ($1/$0.50), one would begin to question the “safety” of the dividend.

Rates of Return:

Some financial statement analysts will compare income to assets, in an attempt to assess how effectively assets are being utilized to generate profits. The specific income measure that is used in the return on assets ratio varies with the analyst, but one calculation is:

Return on Assets Ratio = (Net Income + Interest Expense) / Average Assets

These calculations of “ROA” attempt to focus on income (excluding financing costs) in relation to assets. The point is to demonstrate how much operating income is generated by the deployed assets of the business. This can prove useful in comparing profitability and efficiency for companies in similar industries.
The return on equity ratio evaluates income for the common shareholder in relation to the amount of invested common shareholder equity:

Return on Equity Ratio = (Net Income - Preferred Dividends) / Average Common Equity

“ROE” enables comparison of the effectiveness of capital utilization among firms. What it does not do is evaluate risk. Sometimes, firms with the best ROE also took the greatest gambles. For example, a high ROE firm may rely heavily on debt to finance the business, thereby exposing the business to greater risk of failure when things don’t work out. Analysts may compare ROE to the rate of interest on borrowed funds. This can help them assess how effective the firm is in utilizing borrowed funds (“leverage”).

Special reporting situations

The accounting profession uses an “all inclusive” approach to measuring income. Virtually all transactions, other than shareholder related transactions like issuing stock and paying dividends, are eventually channeled through the income statement. However, there are certain situations where the accounting rules have evolved in sophistication to provide special disclosures. The reason for the added disclosure is to make it easier for users of financial statements to sort out the effects that are related to ongoing operations versus those that are somehow unique. The following discussion will highlight the correct handling of special situations.

CORRECTIONS OF ERRORS:

Errors consist of mathematical mistakes, incorrect reporting, omissions, oversights, and other things that were simply handled wrong in a previous accounting period. Once an error is discovered, it must be corrected.
The temptation is to simply force the books into balance by making a compensating error in the current period. For example, assume that a company failed to depreciate an asset in 20X4, and this fact is discovered in 20X5. Why not just catch up by “double depreciating” the asset in 20X5, and then everything will be fine, right? Wrong! While it is true that accumulated depreciation in the balance sheet would be back on track at the end of 20X5, income for 20X4 and 20X5 would now both be wrong. It is not technically correct to handle errors this way. Instead, USA generally accepted accounting principles dictate that error corrections (if material) must be handled by prior period adjustment. This means that the financial statements of prior periods must be subjected to a restatement to make them correct. In essence, the financial statements of prior periods are redone to reflect the correct amounts. Global GAAP follows a similar approach, but provides an exception for adjustments that are impractical to determine.

The following 20X5 entry reveals the method of adjusting the general ledger for failure to record depreciation in 20X4. The debit to Retained Earnings reflects the expense that would have been recorded and closed to Retained Earnings in the prior year, while the credit to Accumulated Depreciation provides a catch up adjustment to reflect the account’s correct balance.

Importantly, if comparative financial statements (i.e., side-by-side financial statements, for two or more years) are presented for 20X4 and 20X5, depreciation would be reported at the correct amounts in each years’ statements (along with a note indicating that the prior years’ data have been revised for an error correction). If an error related to prior periods for which comparative data are not presented, then the statement of retained earnings would be amended as follows:

Correction On Statement of Retained Earnings

DISCONTINUED OPERATIONS:

A company may decide to exit a unit of operation by sale to some other company, or by outright abandonment. For example, a computer maker may sell its personal computer manufacturing unit to a more efficient competitor, and instead focus on its server and service business. Or, a chemical company may decide to close a unit that has been producing a specialty product that has become an environmental liability.
When an entity disposes of a complete business component, it will invoke the unique reporting rules related to discontinued operations. To trigger these rules requires that the disposed business component have operations that are clearly distinguishable operationally and for reporting purposes. This would typically relate to a separate business segment, unit, subsidiary, or group of assets.
Following is an illustrative income statement for Bail Out Corporation. Bail Out distributes farming implements and sporting goods. During 20X7, Bail Out sold its sporting equipment business and began to focus only on farm implements. In examining this illustration, be aware that revenues and expenses only relate to the continuing farming equipment. All amounts relating to operations of the sporting equipment business, along with the loss on the sale of assets used in that business, are removed from the upper portion of the income statement, and placed in a separate category below income from continuing operations.

If a company disposes of a facility or some other set of assets that is not a business component, then discontinued operations reporting is not invoked. Suppose Sail Out sold its facility in Georgia, but continued to distribute the same products at other locations. This would not constitute a discontinued operation. The income statement might include a separate line item for the gain or loss on the sale of the location, but it would not constitute a discontinued operation:

Look again at Bail Out and note that income taxes were “split” between continuing operations and discontinued operations. This method of showing tax effects for discontinued operations is mandatory, and is called intraperiod tax allocation. Intraperiod tax allocation is applicable to other items reported below continuing operations (and some prior period and selected equity adjustments), but only one income tax number is attributed to income from continuing operations.

EXTRAORDINARY ITEMS:

A business may experience a gain or loss that results from an event that is both unusual in nature and infrequent in occurrence. When these two conditions are both met, the item is deemed to be an extraordinary item. Under US GAAP, it is reported net of tax in a separate category below income from continuing operations:

What type of event is both unusual in nature and infrequent in occurrence? UFO Corporation was hit by a meteorite. It is rare for a meteor to hit a specific business. It is unlikely that UFO would sustain this type of loss again. On the other hand, flood losses for businesses located along a river, earthquakes for businesses in the Pacific Rim, and the like can give rise to losses that are not unusual in nature and/or may be expected to reoccur. Accounting requires professional judgement, and there is sometimes room for debate, and perhaps more than one possible solution. International accounting standards do not provide for a separate extraordinary item category.

OCI:

The Long-term Investments chapter introduced other comprehensive income. OCI arose from changes in the fair value of investments classified as “available for sale.” OCI can also result from certain pension plan accounting adjustments and translation of the financial statements of foreign subsidiaries. Whatever the source of OCI, many companies merely charge or credit OCI directly to equity. However, another option is to position OCI at the bottom of the income statement.
It is highly unlikely that a company would experience all of the previously discussed items within the same year. However, were that the case, its income statement might expand to look something like the following (this illustration includes the less common approach of including OCI in the statement of income, rather than recording OCI directly to equity). Take note that net income or earnings is income from continuing operations plus/minus discontinued operations and extraordinary items.

Comprehensive income is net income plus other comprehensive income.

CHANGES IN ACCOUNTING METHODS:

A company may adopt an alternative accounting principle. Such accounting changes relate to changes from one acceptable method to another. For instance, a company may conclude that it wishes to adopt FIFO instead of average cost. Such changes should only occur for good cause (not just to improve income), and flip-flopping is not permitted. When a change is made, the company must make a retrospective adjustment. This means that the financial statements of prior accounting periods should be reworked as if the new principle had always been used.
Disclosures that must accompany a change in accounting principle are extensive. Notes must indicate why the newly adopted method is preferable. In addition, a substantial presentation is required showing amounts that were previously presented versus the newly derived numbers, with a clear delineation of all changes. And, the cumulative effect of the change that relates to all years prior to the earliest financial data presented must be disclosed.
Do not confuse a change in accounting method with a change in accounting estimate. Changes in estimate are handled prospectively. This type of change was illustrated in the Property, Plant, and Equipment chapter. If a change in principle cannot be separated from a change in estimate, the adjustment would be handled as a change in estimate.

EBIT and EBITDA:

Investors may discuss a company’s “earnings before interest and taxes” (EBIT) and “earnings before interest, taxes, depreciation, and amortization” (EBITDA). These numbers can be calculated from information available in the statements. Some argue that EBIT (pronounced with a long “E” sound and “bit”) and EBITDA (pronounced with a long “E” sound and “bit” and “dah”) are important and relevant to decision making, because they reveal the core performance before considering financing costs and taxes (and noncash charges like depreciation and amortization). These numbers are sometimes used in evaluating the intrinsic value of a firm, in that they reveal how much the business is producing in earnings without regard to how the business is financed and taxed. These numbers should be used with great care, as they can provide an overly simplistic view of business performance.

The statement of stockholders’ equity

Remember that a company must present an income statement, balance sheet, statement of retained earnings, and statement of cash flows. However, it is also necessary to present additional information about changes in other equity accounts. This may be done by notes to the financial statements or other separate schedules. However, most companies will find it preferable to simply combine the required statement of retained earnings and information about changes in other equity accounts into a single statement of stockholders’ equity. Following is an example of such a statement.

Statement of Stockholders' Equity Example

Note that the company had several equity transactions during the year, and the retained earnings column corresponds to a statement of retained earnings. Companies may expand this presentation to include comparative data for multiple years. Under international reporting guidelines, the preceding statement is sometimes replaced by a statement of recognized income and expense that includes additional adjustments for allowed asset revaluations (“surpluses”). This format is usually supplemented by additional explanatory notes about changes in other equity accounts.
To close this chapter, I would encourage you to examine the above statement of stockholders' equity, and be sure you can prepare a journal entry that corresponds to Pepper's share issuance, treasury stock transaction, cash dividend, and stock dividend. You will find it helpful to review the various journal entries illustrated in this chapter as you undertake this effort. If you want to check your solution, just click on the related link.

Stock splits and stock dividends

Stock splits are events that increase the number of shares outstanding and reduce the par or stated value per share. For example, a 2-for-1 stock split would double the number of shares outstanding and halve the par value per share. Existing shareholders would see their shareholdings double in quantity, but there would be no change in the proportional ownership represented by the shares (i.e., a shareholder owning 1,000 shares out of 100,000 would then own 2,000 shares out of 200,000).
Why would a company bother with a stock split? The answer is not in the financial statement impact, but in the financial markets. Since the same company is now represented by more shares, one would expect the market value per share to suffer a corresponding decline. For example, a stock that is subject to a 3-1 split should see its shares initially cut in third. But, holders of the stock will not be disappointed by this share price drop since they will each be receiving proportionately more shares; it is very important to understand that existing shareholders are getting the newly issued shares for no additional investment. The benefit to the shareholders comes about, in theory, because the split creates more attractive opportunities for other future investors to ultimately buy into the larger pool of lower priced shares. Rapidly growing companies often have share splits to keep the per share price from reaching stratospheric levels that could deter some investors. In the final analysis, understand that a stock split is mostly cosmetic as it does not change the underlying economics of the firm.
Importantly, the total par value of shares outstanding is not affected by a stock split (i.e., the number of shares times par value per share does not change). Therefore, no journal entry is needed to account for a stock split. A memorandum notation in the accounting records indicates the decreased par value and increased number of shares. If the initial equity illustration for Embassy Corporation was modified to reflect a four-for-one stock split of the common stock, the revised presentation would appear as follows (the only changes are underlined):

By reviewing the changes, one can see that the par has been reduced from $1.00 to $0.25 per share, and the number of issued shares has quadrupled from 400,000 shares to 1,600,000 (be sure to note that $1.00 X 400,000 = $0.25 X 1,600,000 = $400,000). None of the account balances have changes.
Splits can come in odd proportions: 3 for 2, 5 for 4, 1,000 for 1, and so forth depending on the scenario. A reverse split (1 for 5, etc.) is also possible, and will initially be accompanied by a reduction in the number of issued shares along with a proportionate increase in share price.

STOCK DIVIDENDS:

In contrast to cash dividends discussed earlier in this chapter, stock dividends involve the issuance of additional shares of stock to existing shareholders on a proportional basis. Stock dividends are very similar to stock splits. For example, a shareholder who owns 100 shares of stock will own 125 shares after a 25% stock dividend (essentially the same result as a 5 for 4 stock split). Importantly, all shareholders would have 25% more shares, so the percentage of the total outstanding stock owned by a specific shareholder is not increased.
Although shareholders will perceive very little difference between a stock dividend and stock split, the accounting for stock dividends is unique. Stock dividends require journal entries. Stock dividends are recorded by moving amounts from retained earnings to paid-in capital. The amount to move depends on the size of the distribution. A small stock dividend (generally less than 20-25% of the existing shares outstanding) is accounted for at market price on the date of declaration. A large stock dividend (generally over the 20-25% range) is accounted for at par value.
To illustrate, assume that Childers Corporation had 1,000,000 shares of $1 par value stock outstanding. The market price per share is $20 on the date that a stock dividend is declared and issued:

Small Stock Dividend: Assume Childers Issues a 10% Stock Dividend

Large Stock Dividend: Assume Childers Issues a 40% Stock Dividend

It may seem odd that rules require different treatments for stock splits, small stock dividends, and large stock dividends. There are conceptual underpinnings for these differences, but it is primarily related to bookkeeping. The total par value needs to correspond to the number of shares outstanding. Each transaction rearranges existing equity, but does not change the amount of total equity.

Treasury stock

Treasury stock is the term that is used to describe shares of a company’s own stock that it has reacquired. A company may buy back its own stock for many reasons. A frequently cited reason is a belief by the officers and directors that the market value of the stock is unrealistically low. As such, the decision to buy back stock is seen as a way to support the stock price and utilize corporate funds to maximize the value for shareholders who choose not to sell back stock to the company. Other times, a company may buy back public shares as part of a reorganization that contemplates the company “going private” or delisting from some particular stock exchange. Further, a company might buy back shares, and in turn issue them to employees pursuant to some employee stock award plan.
Whatever the reason for a treasury stock transaction, the company is to account for the shares as a purely equity transaction, and “gains and losses” are ordinarily not reported in income. Procedurally, there are several ways to record the “debits” and “credits” associated with treasury stock, and the specifics can vary globally. The “cost method” is generally acceptable. Under this approach, acquisitions of treasury stock are accounted for by debiting Treasury Stock and crediting Cash for the cost of the shares reacquired:

The effect of treasury stock is very simple: cash goes down and so does total equity by the same amount. This result occurs no matter what the original issue price was for the stock. Accounting rules do not recognize gains or losses when a company issues its own stock, nor do they recognize gains and losses when a company reacquires its own stock. This may seem odd, because it is certainly different than the way one thinks about stock investments. But remember, this is not a stock investment from the company’s perspective. It is instead an expansion or contraction of its own equity.
Treasury Stock is a contra equity item. It is not reported as an asset; rather, it is subtracted from stockholders’ equity. The presence of treasury shares will cause a difference between the number of shares issued and the number of shares outstanding. Following is Embassy Corporation’s equity section, modified (see highlights) to reflect the treasury stock transaction portrayed by the entry.

If treasury shares are reissued, Cash is debited for the amount received and Treasury Stock is credited for the cost of the shares. Any difference may be debited or credited to Paid-in Capital in Excess of Par.

Common and preferred stock

Companies may issue different types of stock. For example, some companies have multiple classes of common stock. A “family business” that has grown very large and become a public company may be accompanied by the creation of Class A stock (held by the family members) and Class B stock (held by the public), where only the Class A stock can vote. This enables raising needed capital but preserves the ability to control and direct the company. While common stock is the most typical, another way to gain access to capital is by issuing preferred stock. The customary features of common and preferred differ, providing some advantages and disadvantages for each. The following tables reveal general features that can be modified on a company by company basis.

Typical common stock features:

Possible Preferred stock features:

A comparative review of the preceding tables reveals a broad range of potential attributes. Every company has different financing and tax considerations and will tailor its package of features to match those issues. For instance, a company can issue preferred that is much like debt (cumulative, mandatory redeemable), because a fixed periodic payment must occur each period with a fixed amount due at maturity. On the other hand, some preferred will behave more like common stock (noncallable, noncumulative, convertible).

WHAT IS PAR?

In the preceding discussion, there were several references to par value. Many states require that stock have a designated par value (or in some cases “stated value”). Thus, par value is said to represent the “legal capital” of the firm. In theory, original purchasers of stock are contingently liable to the company for the difference between the issue price and par value if the stock is issued at less than par. However, as a practical matter, par values on common stock are set well below the issue price, negating any practical effect of this latent provision. It is not unusual to see common stock carry a par value of $1 per share or even $.01 per share. In some respects, then, par value is merely a formality. But, it does impact the accounting records, because separate accounts must be maintained for “par” and paid-in capital in excess of par. Assume that Godkneckt Corporation issues 100,000 shares of $1 par value stock for $10 per share. The entry to record this stock issuance would be:

Paid-In Capital in Excess of Par Journal Entry

Occasionally, a corporation may issue no-par stock, which is recorded by debiting Cash and crediting Common Stock for the issue price. A separate Paid-in Capital in Excess of Par account is not needed.
Sometimes, stock may be issued for land or other tangible assets, in which case the debit in the preceding entry would be to the specific asset account (e.g., Land instead of Cash). When stock is issued for noncash assets, the amount of the entry would be based upon the fair value of the asset (or the fair value of the stock if it can be more clearly determined).

A CLOSER LOOK AT CASH DIVIDENDS:

Begin by assuming that a company has only common shares outstanding. There is no mandatory dividend requirement, and the dividends are a matter of discretion for the board of directors to consider. To pay a dividend the company must have sufficient cash and a positive balance in retained earnings (companies with a “deficit” (negative) Retained Earnings account would not pay a dividend unless it is part of a corporate liquidation action). Many companies pride themselves in having a long-standing history of regular and increasing dividends, a feature that many investors find appealing. Other companies view their objective as one of continual growth via reinvestment of all earnings; their investors seem content relying on the notion that their investment value will gradually increase due to this earnings reinvestment activity. Whatever the case, a company has no obligation to pay a dividend, and there is no “liability” for dividends until such time as they are actually declared. A “declaration” is a formal action by the board of directors to indicate that a dividend will be paid at some stipulated future date. On the date of declaration, the following entry is needed on the corporate accounts:

In observing the preceding entry, it is imperative to note that the declaration on July 1 establishes a liability to the shareholders that is legally enforceable. Therefore, a liability is recorded on the books at the time of declaration. Recall (from earlier chapters) that the Dividends account will directly reduce retained earnings (it is not an expense in calculating income, it is a distribution of income)! When the previously declared dividends are paid, the appropriate entry would entail a debit to Dividends Payable and a credit to Cash.

Dividend Dates:

Some shareholders may sell their stock between the date of declaration and the date of payment. Who is to get the dividend? The former shareholder or the new shareholder? To resolve this question, the board will also set a “date of record;” the dividend will be paid to whomever the owner of record is on the date of record. In the preceding illustration, the date of record might have been set as August 1, for example. To further confuse matters, there may be a slight lag of just a few days between the time a share exchange occurs and the company records are updated. As a result, the date of record is usually slightly preceded by an ex-dividend date.

The practical effect of the ex-dividend date is simple: if a shareholder on the date of declaration continues to hold the stock at least through the ex-dividend date, that shareholder will get the dividend. But, if the shareholder sells the stock before the ex-dividend date, the new shareholder can expect the dividend. In the illustrated timeline, if one were to own stock on the date of declaration, that person must hold the stock at least until the “green period” to be entitled to receive payment.

THE PRESENCE OF PREFERRED STOCK:

Recall that preferred dividends are expected to be paid before common dividends, and those dividends are usually a fixed amount (e.g., a percentage of the preferred’s par value). In addition, recall that cumulative preferred requires that unpaid dividends become “dividends in arrears.” Dividends in arrears must also be paid before any distributions to common can occur. Another illustration will likely provide the answer to questions about how these concepts are to be implemented.
To develop the illustration, begin by looking at the equity section of Embassy Corporation’s balance sheet. Note that this section of the balance sheet is quite extensive. A corporation’s stockholders’ equity (or related footnotes) should include rather detailed descriptions of the type of stock outstanding and its basic features. This will include mention of the number of shares authorized (permitted to be issued), issued (actually issued), and outstanding (issued minus any shares reacquired by the company). In addition, be aware of certain related terminology: legal capital is the total par value ($20,400,000 for Embassy), and total paid-in capital is the legal capital plus amounts paid in excess of par values ($56,400,000 for Embassy).

Note that the par value for each class of stock is the number of shares issued multiplied by the par value per share (e.g., 200,000 shares X $100 per share = $20,000,000). The preferred stock description makes it clear that the $100 par stock is 8% cumulative. This means that each share will receive $8 per year in dividends, and any “missed” dividends become dividends in arrears. If the notes to the financial statements appropriately indicate that Embassy has not managed to pay its dividends for the preceding two years, and Embassy desired to pay $5,000,000 of total dividends during the current year, how much would be available to the common shareholders? The answer is only $200,000 (or $0.50 per share for the 400,000 common shares). The reason is that the preferred stock is to receive annual dividends of $1,600,000 ($8 per share X 200,000 preferred shares), and three years must be paid consisting of the two years in arrears and the current year requirement ($1,600,000 X 3 years = $4,800,000 to preferred, leaving only $200,000 for common).

Characteristics of the corporate form of organization

A corporation is a legal entity having existence separate and distinct from its owners (i.e., stockholders). Corporations are artificial beings existing only in contemplation of law. A corporation is typically created when one or more individuals file “articles of incorporation” with a Secretary of State in a particular jurisdiction. The articles of incorporation generally specify a number of important features about the purpose of the entity and how governance will be structured. After reviewing the articles of incorporation, the Secretary of State will issue a charter (or certificate of incorporation) authorizing the corporate entity. The persons who initiated the filing (the “incorporators”) will then collect the shareholders’ initial investment in exchange for the “stock” of the corporation (the stock is the financial instrument evidencing a person’s ownership interest). Once the initial stock is issued, a shareholders’ meeting will be convened to adopt bylaws and elect a board of directors. These directors appoint the corporate officers who are responsible for commencing the operations of the business. In a small start-up venture, the initial incorporators may become the shareholders, then elect themselves to the board, and finally appoint themselves to become the officers. This leads one to wonder why go to all the trouble of incorporating?

Advantages:

The reasons for incorporating can vary, but there are certain unique advantages to this form of organization that have led to its popularity. One advantage of the corporate form of organization is that it permits otherwise unaffiliated persons to join together in mutual ownership of a business entity. This objective can be accomplished in other ways like a partnership, but the corporate form of organization is arguably one of the better vehicles. Large amounts of venture capital can be drawn together from many individuals and concentrated into one entity under shared ownership. The stock of the corporation provides a clear and unambiguous point of reference to identify who owns the business and in what proportion. Further, the democratic process associated with shareholder voting rights (typically one vote per share of stock) permits shareholder “say so” in selecting the board of directors. In addition to electing the board, shareholders may vote on other matters such as selection of an independent auditor, stock option plans, and corporate mergers. The voting “ballot” is usually referred to as a “proxy.”

Corporate stock has the benefit of transferability of ownership. It is easily transferable from one person to another. Transferability provides liquidity to stockholders as it enables them to quickly enter or exit an ownership position in a corporate entity. As a corporation grows, it may bring in additional shareholders by issuing even more stock. At some point, the entity may become sufficiently large that its shares will become “listed” on a stock exchange. An “IPO” is the initial public offering of the stock of a corporation. Rules require that such IPOs be accompanied by regulatory registrations and filings, and that potential shareholders be furnished with a prospectus detailing corporate information. Publicly traded corporate entities are subject to a number of continuing regulatory registration and reporting requirements that are aimed at ensuring full and fair disclosure.
Another benefit of a corporation is perpetual existence. A corporate entity is typically of unlimited duration enabling it to effectively outlive its shareholders. Changes in stock ownership do not cause operations to cease. What would cause a corporation to cease to exist? At some point, a corporation may be acquired by another and merged in with the successor. Or, a corporation may fail and cease operations. Finally, some businesses may find that liquidating operating assets and distributing residual monies to the creditors and shareholders is a preferable strategy to continued operation.
Not to be overlooked in considering why a corporation is desirable is the feature of limited liability for stockholders. Stockholders normally understand that their investment can be lost if the business fails. However, stockholders are not liable for debts and losses of the company beyond the amount of their investment. There are exceptions to this rule. In some cases, shareholders may be called upon to sign a separate guarantee for corporate debt. And, shareholders in closely held companies can inadvertently be drawn into having to satisfy corporate debts when they commingle their personal finances with those of the company or fail to satisfy the necessary legal procedures to maintain a valid corporate existence.

Disadvantages:

Corporations are not without certain disadvantages. Most corporations are taxable entities, and their income is subject to taxation. This “income tax” is problematic as it oftentimes produces double taxation. This effect occurs when shareholders receive cash dividends that they must include in their own calculation of taxable income. Thus, a dollar earned at the corporate level is reduced by corporate income taxes (at a rate that is likely about 35%); to the extent the remaining after-tax profit is distributed to shareholders as dividends, it is again subject to taxes at the shareholder level (at a rate that will vary in the 15% to 35% range). So, as much as half or more of the profits of a dividend-paying corporation are apt to be shared with governmental entities. Governments are aware that this double-taxation outcome can limit corporate investment and be potentially damaging to an economy. Various measures of relief are sometimes available, depending on the prevailing political climate (including “dividends received deductions” for dividends paid between affiliated companies, lower shareholder tax rates on dividends, and S-Corporation provisions that permit closely held corporations to attribute their income to the shareholders thereby avoiding one level of tax). Some countries adopt “tax holidays” that permit newer companies to be exempt from income taxes, or utilize different approaches to taxing the value additive components of production by an entity.
Another burden on the corporate form of organization is costly regulation. In the USA, larger (usually public) companies are under scrutiny of federal (The Securities and Exchange Commission (SEC) and other public oversight groups) and state regulatory bodies. History shows that the absence or failure of these regulators will quickly foster an environment where rogue business persons will launch all manner of stock fraud schemes. Worse, these frauds quickly corrupt public confidence without which investors become unwilling to join together to invest in new ideas and products. Therefore, it seems almost unavoidable that governmental regulation must be a part of the corporate scene. However, the cost of compliance with such regulation is heavy. Public companies must prepare and file quarterly and annual reports with the SEC, along with a myriad of other documents. And, many of these documents must be certified or subjected to independent audit. Further, requirements are in place that require companies to have strong internal controls and even ethical training.