CHAPTER FIVE: CORPORATION ORGANIZATION AND OPERATION

Definition:
 A corporation is a legal entity whose capital is fixed in advance and divided in to
transferable units known as shares and whose liabilities are met only by its own
assets.
 Is an entity recognized by law as possessing an existence separate and distinct
from its owners?
6.1 Accounting for corporations
1. Definitions
 Capital stock:- represents shares(units) of ownership in a company
 Stock certificate: a written document given to stockholders indicating
evidence of ownership in the company
 Authorized capital stock: the number of shares of capital stock that a
corporation is permitted to issue
 Outstanding capital stock: the number of authorized shares of stock that
have been issued and currently held by stockholders
 Par value: an arbitrary monetary amount assigned to each share of a given
class the amount per share that is credited to the capital stock for each
share issued
 Stated value: an arbitrary monetary amount assigned by board of directors
to each shares of a given class of no par value capital stock
2. Organization costs
Definition: are expenditures incurred to form or organize a company before it
begins its operations. These include:-
 Attorney’s fee
 Incorporations fee
 Promoter’s fee
 Accountant’s fee and
 Other related costs necessary for forming the corporations.
 Recording:
Organization costs are debited to an intangible asset account called organization
cost and amortized over a period not exceeding 40 years.
Example: - On March 3, 1999, Belete and Abebe paid the following expenditures to
organize (form) ABC pvt Ltd co.
 Attorney’s fee Br.8,000
 Incorporations fee 5,000
 Stock certificate printing costs 10,000
 Other expenditures 17,000
Required:
Make the entry required to record the above expenditures and amortization expense for
the year ended December 31,1999, assuming that the organization cost is amortized over
five years.
3. Corporate capital
 Stockholders equity:-are owner’s claims against the business; owner’s equity
in a company.
The equity section of the corporate balance sheet is divided in to two parts:

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  Contributed capital:- represents investments made by the stockholder’s in the
corporation.
contributed capital is also known as paid in capital
 Retained earnings:- part of the earnings reinvested in the corporation
Contributed capital and retained earnings are the two principal sources of corporate
capital.
 Dividends: part of profit which is distributed to stockholders
 Stockholder’s right: stockholders are not directly involved in the management
of the business unless they are elected to serve as directors or officers.
The rights enjoyed by the stockholder’s in the company are:
 The right to participate in management indirectly by voting at the
stockholder’s meeting
 The right to receive dividends when declared
 The right to transfer their shares
 The pre-emptive right- the right to buy additional newly shares already
owned
 The right to share assets in liquidation.
Classes of Capital Stock
A corporate form of business may issue two kinds of stock: common stock and
preferred stock.
I. Common stock:- a stock that is issued by any corporation and that provides basic
ownership include:
 The right to vote
 The right to share in profits
 The pre-emptive right
 The right at liquidation to receive a proportionate share of the net assets
remaining.
Common stockholders are the legal owner’s of a corporation and in effect they bear risks
if the corporation is not successful. At the time of liquidation of a corporation the claim
of common stockholders is settled at last after the claims of all others are settled.
II. Preferred stock
 A class of stock having the preferential right over common stock
 The most commonly given preferential right of preferred owners may
relate to dividends, liquidation, convertibility and callable.
 Preferred to attract investors by providing special rights when there is a
need for additional capital.
 Owners of preferred stock give up some of the rights that common
stockholders have in order to obtain special previllages that reduce the risk
ness of their investment.
ACCONTING FOR STOCK ISSUANCE
Issuance of stock refers to the distribution of shares to investors in exchange for cash or
other assets.
 When a stock is issued:
Asset-----------------xxx
Capital stock-------xxx
 Stock issued may have:

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  Par value
 No par value but stated value
 No par value, No stated value
 Stocks may be issued at par or stated value, or at an amount higher or lower
than par or stated value.
 When a stock is issued (sold) for an amount greater than its par or stated
value, the excess amount is called premium and is credited to a capital account
called paid in capital in excess of par.
 Capital stock may be issued (sold) for cash or for non cash assets or through
subscription.
(A) Issuance of capital stock for cash
Example 6.2
Assume that on January 1, 2002 ABC Share Company authorized to issue 30,000
shares of common stock and sold 18,000 shares on February 4, 2002 for Br.50 per
share.
Required: make the necessary journal entries to record issuance of stock if the
shares are from:-
a) Br.40 par common stock
b) No par value but Br.35 stated value common stock
c) No par value, No stated value common stock
(B) Issuance of capital stock for Non cash Assets
 When a stock is issued in exchange for assets or services other than
cash
 The transaction should be recorded at the current market value of the
goods or services received in exchange or at the fair market value of
capital stock issued in exchange which is more objective.
Example 6.3
A) Suppose that when AVC Share Company was formed on March 3, 1999 its
attorney agreed to accept 80 shares of Br.4,500.
Required? Make the necessary journal entry required.
B) On March 10, 2003, ABC share co issued 1,000 shares of Br.60 par value
common stock with fair market value of Br.65 per share in exchange for a land to
be used as a future building site.
Required? Make the necessary journal entry required.
(C) stock sold on subscription basis
 This refers to a situation or an event when an investor agrees to pay the
stock on some future date or in a series of installments.
 When a stock is sold on subscription basis, the full price of the stock is
not received initially.
 A partial payment may be made originally but the stock is not issued
and a stock certificate will not be given until the full subscription price
is received.
 Two accounts are used when a stock is sold on subscription basis:-

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  Common or preferred stock subscribed:-indicates the
corporation’s obligation to issue shares of its stock up on
payment of final subscription balances.
 Subscription receivable:- indicates the amount to be collected
in full before a stock is issued and a stock certificate is given.
Entries
 Receipt of subscription
Stock subscription receivables-----------xx
Capital stock subscribed---------xx
 Collection of stock subscription Receivables
Cash----------------------------------------xx
Stock subscription receivable--------------xx
 Issuance of stock certificate
Capital stock subscribed---------xx
Capital stock--------------------xx
Example 6.4
ABC share co. offers stock on subscription basis to selected individuals giving them the
right to purchase on subscription basis. The following were transactions related to stock
sold on subscription basis during the year 2002.
Jan 1. Received subscription for 3,000 shares of $50 par value common stock at $60 per
share with down payment of 10% of subscription price
March 10. Received 60% of outstanding subscription receivable
April 1. Collected the remaining balance and issued a stock certificate
Required? Prepare entries required for the transactions
DIVIDENDS ON PREFERRED STOCK
 Dividends are distribution of earnings to shareholders
 When dividends are declared by board of directors preferred shareholders shold
be paid for a certain amount they are entitled before any dividends are paid on
common shares
 For par value preferred stock, the dividend is stated as a percentage of the par
value
 For non-par preferred stock, the dividend is stated as a specific dollar amount per
share per year.
Example 6.5
During the year 2002 ABC share co. has outstanding 15,000 shares of $50 par common
stock and 5,000 shares of $100 par 6% preferred stock, ABC co. declared and paid cash
dividends of $150,000.
Required? Determine the total dividends paid to each class of stock.
Classification of preferred stocks
Preferred stock may be:-
I. Preferred as to dividends or
II. Preferred as to assets in the event of liquidation, convertible or non-convertible
and callable
I. Stock preferred as to dividends
 Stock preferred as to dividend may be either:
- commutative or non-commutative or

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 - participating or non-participating
a) Commutative or non-commutative preferred stock.
 Commutative preferred stock: have the right to receive dividends in
arrears and current year dividends before any dividend is paid on common
shares.
 Non-commutative preferred stock: the right to receive dividends is
cancelled or prohibited in any years in which dividends are not declared.
Example 6.6:
During the past three years ABC Share Company has outstanding 100,000 shares of $20
par common stock and 10,000 shares of $100 par 8% preferred stock, the company
declared and paid cash dividends as follows:
2000 0
2001 30,000
2002 105,000
Required: determine the total dividends paid to each classes of stock if preferred shares
are: a) commutative b) non-commutative

b) participating or non-participating preferred stock

 Participating preferred stock: provides the right to receive dividends in
excess of a certain amount after a comparable dividend is paid on common
shares.
 Non-participating preferred stock: preferred stock that is entitled to its
cumulative dividends only, regardless of the size of dividends paid on
common stock.
Example 6.7:
During the year 2002 ABC Share Company has outstanding 12,000 shares of $50 par
common stock and 3,000 shares of $100 par 9% preferred stock. During this year the
company declared and paid cash dividend of $180,000.
Required: determine the total dividends paid to each classes of stock if preferred shares
are: a) non-participating
c) Participating on a share to share basis if dividends declared exceed the regular
preferred dividends and comparable dividends on common shares.
II) Stock preferred as to assets
 This refers to preference in terms of the assets of the corporation in the case of
liquidation.
 If the corporations’ existence is terminated, the preferred stock holders have the
right to receive the par value of their stock or a legal stated liquidation value per
share before the common stock holders receive any share of the company’s asset.
III) Convertible preferred stock
Preferred stocks that can be converted in to common stock of the issuing corporation by
the holders are known as convertible preferred stock.
IV) Callable preferred stock
The corporation can:-
 Inform non-convertible preferred share holders to surrender their stock to the
company, and

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  Inform convertible preferred share holders either to surrender their stock or
convert it to common share.
Treasury stock
Treasury stock is a capital stock that has been issued and latter re-acquired by the issuing
company but that has not subsequently been resold or retired.
A company may purchase its own stock:
 For reselling them to employees.
 For maintaining favorable market price for its shares.
 To avoid (prevent) a hostile take over etc.
I) purchase of treasury stock
 When a treasury stock is purchased, it is recorded at cost of reacquisition.
 The purchase of treasury stock reduces the assets, stock holders equity and
outstanding shares.
 Entry
Treasury stock………………xx
Cash………………………..xx
Example 6.8
On January 1, 2001 ABC Share Company had 100,000 authorized, 80,000 $100 par
issued and outstanding common shares. On January 15,000 shares at $110 per share and
on march 2, 2001 reacquired 1,000 shares of outstanding common stock at $112 per
share.
Required: a) make the entry required to handle the above transaction, and
b) Determine the number of shares outstanding.
II) Sale of treasury stock
 Treasury stock can be sold at cost, above cost or bellow cost of acquisition.
 When treasury stock is sold for an amount greater than their cost, the excess of the
sales price over cost is credited to paid-in capital, treasury stock account.
 When treasury stock is sold bellow their cost the difference is deducted from paid
in capital, treasury stock account.
 When paid in capital in treasury stock does not exist pr its balance is insufficient
to cover the excess of cost over the reissue price, retained earnings absorb the
excess amount.
Example 6.9
ABC Company in example 6.8 above sold:
a) 100 shares of its treasury stock for $112 on April 1, 2001
b) 150 shares of its treasury stock at $130 each on march 5,2001
c) 250 shares of its treasury stock at $102 per share on June 10,2001
d) 200 shares of its treasury stock at $105 each on Dec. 15,2001
Required: record the resale of treasury stock and determine the number of shares
outstanding?
Corporate financial statements
1) Income statement
Income tax: since a corporation is a separate legal entity it is required by
law to pay tax on its earnings.
Earnings per share: when a company net income is expressed in terms of
per share of its outstanding common stock.

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 Formula:
Earning per share (EPS) = net income
Outstanding shares of common stock
Investors need earning per share information to judge a company’s
performance and to compare it with the performance of other companies
for making investment decisions.
The earning per share information is disclosed on the income statement
below the net income.
Example 6.10
Below is the an income statement for ABC share company for the year ended Dec.
31,2002 .
ABC Share Company
Income statement
For the year ended Dec.31, 2002
Net sale……………………………………$4,800,000
Cost of goop sold……………………….….3,300,000
Gross profit…………………………….…..1,500,000
Operating expense…………………….……780,000
Income before tax……………………….….720,000
Required:
a) Assuming a 35% income tax rate, determine and journalize income tax expense
for year ended Dec.31, 2002.
b) Determine earnings per share if there are 60,000 shares of outstanding common
stock.
2) Retained earnings statement
A financial statement that shows changes that occurred in retained earnings during a
specific accounting period due to:
Net income or loss
Dividends declared.

Example 6.11
Use the following data to prepare retained earning statement for ABC Share Company for
the year ended Dec.31, 2002.
Retained earnings beginning………..$270,000
Dividends declared during the year…..22,500
Net income……………………………96,000
Required: prepare statement of retained earnings?
Dividends
Distribution of retained earnings in the form of cash stock or other assets. There
are three dates associated with dividends. These are:
 Date of declaration: the date on which the board of directors formally
declared a dividends going to be paid.
 Date of record: the date on which ownership of the stock of a company
and the right to receive dividend is determined.
 Date of payment: the date on which dividend is paid to the stock holders.

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Example 6.12
In 2002 ABC Share Company has common stock of $10 par 200,000 shares authorized,
130,000 shares issued and 20,000 shares held in treasury and 40,000 shares of $60 par
8% preferred stock. On November 25, 2002, the company declares the regular cash
dividend per share on preferred shares and a $3 per share cash dividend and a 2% stock
dividend on outstanding common shares. The market value of common share is $15 per
share. On Dec.5 the company paid cash dividend and issued a stock dividend.
Required: make the entry to handle the above transactions.
3) Balance sheet
Stock holders equity:
Shows the capital of the company from different sources.
The statement of stock holder’s equity summarizes the changes in the components
of stock holder’s equity section of the balance sheet.
Equity (book value) per share:
Shows the total equity of the company in terms of per share.
Equity per share = total stock holders equity
Outstanding shares
When there are two classes of stock
 1st allocate the total equity between the two classes of stock giving
preferential right for preferred shares.
 2nd determine equity per share for each class of stock.
Example 6.13
Below is give stock holders equity section of the balance sheet of ABC Share Company
as of January 1, 2002.
Stock holder’s equity
Paid in capital:
Preferred stock, $100 par 6%
200 shares outstanding……………………….$20,000
Paid in capital in excess of par…………………5,000 $25,000
Common stock, $5 par 100,000
Shares authorized 10,000 issued………………50,000
Paid in capital in excess of par………………...15,000 65,000
Paid capital from treasury……………………. 8,000
Total paid in capital……………………………………….98,000
Retained earning…………………………………………..95,000
Total stock holders equity and retained earning…………..193,000
Less: treasury stock (1,000 shares at cost)…………..…….15,000
Total stock holder’s equity…………………………………178,000
Suppose that the preferred stock is entitled to receive $105 per share up on liquidation
and a two year dividends are in arrear including the current year.
Required: compute earnings (book value) per share for each classes of stock?