Chapter 13 Corporations: Organization, Stock Transactions, and Dividends 253
piece of the pie. However, in many cases, the market price of the stock does not decline the full 10
percent. Therefore, the total market value of each shareholder’s stock increases.
DEMONSTRATION PROBLEM—Closing Entries for a Corporation
Assume a corporation had the following account balances at the end of a fiscal year. (For simplicity, all
expenses are assumed to be recorded in one expense account.)
Revenues $200,000
Expenses 150,000
Cash Dividends 12,000
Stock Dividends 8,000
Use these accounts to demonstrate closing entries for a corporation. Remind students that (1) revenues
and expenses are closed to Income Summary, (2) Income Summary is closed to Retained Earnings, and
(3) dividend accounts are closed to Retained Earnings.
Revenues Expenses
Bal. 200,000 Bal. 150,000
Clos. 200,000 Clos. 150,000
Income Summary
Clos. 150,000 Clos. 200,000
Bal. 50,000
Clos. 50,000
Bal. 0
Retained Earnings
Clos. 50,000 * NOTE: The ending balance
Clos. 12,000 of Retained Earnings =
Clos. 8,000 Net Income – Dividends
Bal. 30,000*
Cash Dividends Stock Dividends
Bal. 12,000 Bal. 8,000
Clos. 12,000 Clos. 8,000
254 Chapter 13 Corporations: Organization, Stock Transactions, and Dividends
OBJECTIVE 5
Describe and illustrate the accounting for treasury stock transactions.
SYNOPSIS
Treasury stock is stock the corporation has issued or sold and then repurchased. A business may do this
for a variety of reasons: to provide shares for resale to employees, to reissue as bonuses, or to support the
market price of the stock. The method for recording this purchase is known as the cost method. When
purchased, the stock is debited as cost to Treasury Stock. When the stock is resold, this account is
credited for its cost; any difference between the cost and the selling price is debited or credited to Paid-In
Capital from Sale of Treasury Stock.
Key Terms and Definitions
• Treasury Stock – Stock that a corporation has once issued and then reacquires.
Relevant Example Exercises and Exhibits
• Example Exercise 13-5 Entries for Treasury Stock
SUGGESTED APPROACH
The term “treasury stock” originated because the treasurer’s office of a corporation usually has the
responsibility for purchasing and maintaining custody of such stock. The text presents the cost method of
accounting for treasury stock. The par value method is mentioned only in a footnote. The following
Demonstration Problem presents sample entries that you can review with your class.
You will want to stress that the treasury stock account is a contra equity account, reducing shareholders’
equity for the amount returned to shareholders through the purchase of treasury stock. Many students are
under the false impression that treasury stock is an asset, because it has a debit balance. Point out that a
corporation does not (1) pay dividends on treasury stock, (2) vote treasury stock, or (3) recognize gains or
losses if the treasury stock is reissued. Therefore, a corporation does not purchase its own stock as an
investment, and it is not recorded as an asset.
You should also stress that treasury stock is the only “stock” account that is not recorded at par. The cost
of treasury stock, not the par value, is debited to the account.
Before covering the entries for treasury stock, you may want to discuss the reasons that a corporation
would purchase shares of its own stock (TM 13-7).
Chapter 13 Corporations: Organization, Stock Transactions, and Dividends 255
DEMONSTRATION PROBLEM—Entries for Treasury Stock
Record the following entries for Lawry Corporation:
Lawry purchased 1,000 shares of $5 par value common stock for $10 per share.
Treasury Stock…………………………………….. 10,000
Cash……………………………………….. 10,000
Lawry sold 100 shares of its treasury stock at $12 per share.
Cash……………………………………………….. 1,200
Treasury Stock…………………………….. 1,000
Paid-In Capital from Sale of Treasury Stock 200
Emphasize that paid-in capital from the sale of treasury stock is not reported on the income statement. A
corporation cannot report a gain as the result of buying and selling its own stock. This would encourage
insider trading. Paid-in capital from treasury stock is reported as an increase in stockholders’ equity.
When purchasers of treasury stock pay more than the cost of the stock, they have contributed additional
capital to the corporation.
Lawry sold 100 shares of its treasury stock at $9 per share.
Cash………………………………………………… 900
Paid-In Capital from Sale of Treasury Stock………. 100
Treasury Stock……………………………… 1,000
After demonstrating these entries, ask your students to record the following three transactions in their
notes:
Lawry sold 100 shares of its treasury stock at $14 per share.
Cash……………………………………………….. 1,400
Treasury Stock……………………………. 1,000
Paid-In Capital from Sale of Treasury Stock 400
Lawry sold 100 shares of its treasury stock at $8 per share.
Cash……………………………………………….. 800
Paid-In Capital from Sale of Treasury Stock……… 200
Treasury Stock……………………………. 1,000
Lawry sold 100 shares of its treasury stock at $10 per share.
Cash……………………………………………….. 1,000
Treasury Stock…………………………….. 1,000
256 Chapter 13 Corporations: Organization, Stock Transactions, and Dividends
WRITING EXERCISE—Treasury Stock
Ask your students to respond to the following (TM 13-8):
Name and explain two reasons that a corporation might choose to repurchase its own
stock.
Answers are found on TM 13-7.
OBJECTIVE 6
Describe and illustrate the reporting of stockholders’ equity.
SYNOPSIS
There are two methods to report stockholders equity on the balance sheet. In Method 1, each stock is
reported separately along with its related paid-in capital account. In Method 2, each stock is reported
separately but the paid-in capital account is combined for all classes of stock. In both methods, retained
earnings are presented last followed by the deduction for treasury stock. Relevant rights and privileges of
each class of stock should also be disclosed in the notes to the financial statements. Changes in the
retained earnings may be reported using a separate retained earnings statement, a combined income and
retained earnings statement, or a statement of stockholders’ equity. Appropriations of retained earnings by
the board of directors may restrict its use for the payment of dividends. The three ways retained earnings
may be appropriated are legal, contractual, and discretionary. If any errors are made in the reporting of
retained earnings, it is reported as an adjustment to the beginning balance of retained earnings. If the only
changes to the retained earnings are due to net income or loss, a retained earnings statement is sufficient.
However, when there are also changes to stock and paid-in capital, a statement of stockholders’ equity is
prepared.
Key Terms and Definitions
• Prior Period Adjustments – Corrections of material errors related to a prior period or periods,
excluded from the determination of net income.
• Restrictions – Amounts of retained earnings that have been limited for use as dividends.
• Retained Earnings Statement – A summary of the changes in the retained earnings in a
corporation for a specific period of time, such as a month or a year.
• Statement of Stockholders’ Equity – A summary of the changes in the stockholders’ equity in a
corporation that have occurred during a specific period of time.
Relevant Example Exercises and Exhibits
• Example Exercise 13-6 Reporting Stockholders’ Equity
Chapter 13 Corporations: Organization, Stock Transactions, and Dividends 257
SUGGESTED APPROACH
This objective covers paid-in capital, retained earnings, and treasury stock on the balance sheet. It also
illustrates the retained earnings statement, describes restrictions on retained earnings, and describes prior
period adjustments. Lecture Aids to cover each of these items are discussed below.
LECTURE AID—Paid-In Capital on the Balance Sheet
Paid-in capital and retained earnings are the two major sources of stockholders’ equity; therefore, they are
the two major sections on a corporation’s balance sheet.
You will probably need to remind your students that paid-in capital consists of the following accounts:
Preferred Stock
Paid-In Capital in Excess of Par—Preferred Stock
Common Stock
Paid-In Capital in Excess of Par—Common Stock
Paid-In Capital from Treasury Stock
TM 13-11 lists the stockholders’ equity accounts that are reported in the paid-in capital section of the
balance sheet.
Refer your students to Exhibit 4 in the text to see two examples of how these accounts are reported. Stress
that the second format for Stockholder’s Equity summarizes all of the paid-in capital accounts as one
total, labeled “Additional Paid-In Capital.”
To make sure your students see the “big picture,” remind them that the Stockholders’ Equity section of
the balance sheet consists of the following:
Paid-In Capital
+ Retained Earnings
– Treasury Stock
Total Stockholders’ Equity
Emphasize that treasury stock is deducted because it is a contra-equity account.
DEMONSTRATION PROBLEM—Retained Earnings Statement
Begin by reviewing the concept of retained earnings. Retained earnings are profits that have been kept
(retained) by a corporation. They are profits that have not been returned to shareholders through
dividends. Therefore, retained earnings are increased by a corporation’s net income and reduced by
dividends declared.
Ask your students to compute the retained earnings balance at the end of the year for Parks Corporation,
based on the following data:
258 Chapter 13 Corporations: Organization, Stock Transactions, and Dividends
Retained Earnings, Jan. 1 $ 50,000
Net Income $100,000
Dividends Declared $ 30,000
(Answer: $120,000)
TM 13-12 presents a retained earnings statement for Parks Corporation.
LECTURE AID—Restrictions on Retained Earnings
Many students have the following misconception: Restricting retained earnings sets aside cash for a
specific purpose. You must work to dispel the notion that restricting retained earnings affects a
corporation’s cash.
Use the following story to introduce the concept of restricted retained earnings:
Let’s say that you have decided to treat yourself to a nice lunch off campus today. You have $30 in your
pocket. When you get to the restaurant where you plan to eat, you notice that your car’s gas tank is on
empty. You don’t have any credit cards with you, and you know you will have to purchase at least $10 in
gas. How much can you afford to spend on lunch? Of course, the answer is $20.
In your mind, you have just restricted $10 of your money to purchase gas. As a result, you know that you
have a maximum of $20 to spend on lunch.
A corporation may find itself in a position in which it needs to restrict a portion of its retained earnings.
The Retained Earnings account shows the profits of a corporation less any profits returned to shareholders
in the form of dividends. Under normal conditions, the corporation is free to distribute all of its earnings
to its shareholders if it chooses to do so, just as you are free to spend your entire $30 on lunch. However,
some conditions limit the earnings that may be returned to the shareholders, just as your need for gas
limited what you could spend on lunch.
Restricting retained earnings does not set aside any cash in a special account. For example, assume that a
corporation with a net income of $500,000 must restrict $100,000 of retained earnings due to the terms of
a bank loan. The restriction informs shareholders that $100,000 in profits is needed to repay the bank
loan. However, the corporation must also consciously save $100,000 in cash to make the loan payments.
The fact that you restricted $10 for gas doesn’t do any good if you spend the $10 on dessert.
Remind students that some states require a corporation to restrict retained earnings for an amount equal to
the cost of any treasury stock that has been purchased.
WRITING EXERCISE—Restriction of Retained Earnings
Ask your students to write a response to the following question (TM 13-13):
Chapter 13 Corporations: Organization, Stock Transactions, and Dividends 259
Technograph Corporation discovered that some hazardous material was buried on a parcel of land
currently owned by the corporation. A former owner of the property buried the material. It will cost
Technograph $1 million to remove the material and dispose of it properly.
Would it be appropriate for Technograph’s board of directors to restrict $1 million for cleanup of the
hazardous material? If so, what would the restriction accomplish?
Possible Response: Since it is possible that the EPA would require that such hazardous materials be
cleaned up, the board of directors could restrict retained earnings for the cleanup. This would be
categorized as a “legal” restriction.
DEMONSTRATION PROBLEM—Prior-Period Adjustments
When an error in a prior year’s net income is discovered, it is reported as a prior-period adjustment. Prior-
period adjustments are shown on the retained earnings statement as a correction to the beginning balance
of retained earnings.
The text does not illustrate a retained earnings statement with a prior-period adjustment. The following
example will help you give a brief practical example of this concept:
At the end of 2014, E & M Corporation discovered that several errors were made in the physical
inventory count taken at the end of 2013. As a result, the cost of merchandise sold was understated by
$10,000 in 2013, causing income before taxes to be overstated by the same amount. E & M reported
$100,000 in retained earnings on December 31, 2013.
E & M made $80,000 of net income after taxes in 2014. The company declared $30,000 in dividends. E &
M’s tax rate is 40 percent.
E & M Corporation
Retained Earnings Statement
For the Year Ended December 31, 2014
Retained earnings, January 1, 2014 $100,000
Less prior-period adjustment for 2013 error
in calculating cost of merchandise sold,
net of $4,000 in taxes 6,000
Corrected retained earnings, January 1, 2014 $ 94,000
Net income for 2014 $80,000
Less dividends 30,000
Increase in retained earnings 50,000
Retained earnings, December 31, 2014 $144,000
In practice, only material errors from prior periods are reported as a prior-period adjustment. Errors
arising from the use of estimates are never treated as prior-period adjustments.
260 Chapter 13 Corporations: Organization, Stock Transactions, and Dividends
OBJECTIVE 7
Describe the effect of stock splits on corporate financial statements.
SYNOPSIS
A stock split is the process by which a corporation reduces the pay of stated value of the common stock
and issues a proportionate number of additional shares. Sometimes this is done to make the stock more
appealing in the open market. If the market value of a stock gets too high, a limited number of investors
can afford the stock. A stock split requires no journal entry.
Key Terms and Definitions
• Stock Split – A reduction in the par or stated value of a common stock and the issuance of a
proportionate number of additional shares.
Relevant Example Exercises and Exhibits
• Exhibit 10 – Stock Split: Before and After
SUGGESTED APPROACH
With a stock split, one share of stock is split into two or more shares. When this occurs, the par value of
the stock decreases, and the number of shares increases. The market value of the stock should also fall.
Under this objective, you will need to explain why a corporation would choose to split its stock. Also
illustrate the effect of a stock split on the number of shares and par value.
DEMONSTRATION PROBLEM—Stock Splits
Bravara Corporation has 10,000 shares of $20 par-value common stock selling at $100 per share.
Determine the new number of shares, par value, and market price under each of the following
independent assumptions.
“Theoretical” New
New Par Value
New No. of Shares
Market Price
(Current Par
(Current No. of
(Current Market
Split
Value = $20)
Shares = 10,000)
Price = $100)
2:1
$10
20,000
$50
4:1
$ 5
40,000
$25
10:1
$ 2
100,000
$10
5:2
$ 8
25,000
$40
Chapter 13 Corporations: Organization, Stock Transactions, and Dividends 261
The new market price is what the stock should sell for in theory after the stock split. However, many
factors other than the split may affect the price of the stock. For example, favorable news about the
economy may keep the price of the stock from dropping as low as it should.
Stock splits tend to be very good for shareholders. The split will lower the price, making stock affordable
for more investors. More investors will enter the market, creating demand. Additional demand will begin
to drive the stock price back up, and the shareholders will enjoy the profits resulting from the share
appreciation.
Emphasize that no journal entry is required for a stock split.
INTERNET ACTIVITY—Stock Splits
Since stock splits create excitement in the stock market, many investors track which companies have
announced stock splits. The following Web site provides a “Stock Split Calendar.”
http://investing.money.msn.com/investments/calendar/stock-splits
Have your students visit this site or perform a search on “stock splits” for more information.
WRITING EXERCISE—Stock Splits
Ask your students to answer the following question (TM 13-9):
Why would a company choose to split its stock?
Possible response: Stock splits tend to be very good for shareholders. The split will lower the price,
making stock affordable for more investors. More investors will enter the market, creating demand.
Additional demand will begin to drive the stock price back up, and the shareholders will enjoy the profits
resulting from the share appreciation.
OBJECTIVE 8
Describe and illustrate the use of earnings per share in evaluating a company’s profitability.
SYNOPSIS
The earnings per share ratio is used to evaluate the company’s profitability. Net income alone can be
difficult to compare across different size companies. This ratio is used to determine earnings per common
share sometimes called basic earnings per share. The ratio is calculated as: earnings per share = (net
income – preferred dividends)/average number of common shares outstanding.
262 Chapter 13 Corporations: Organization, Stock Transactions, and Dividends
Key Terms and Definitions
• Earnings per Common Share (EPS) – Net income per share of common stock outstanding
during a period.
Relevant Example Exercises and Exhibits
• Example Exercise 13-8 Earnings per Share
SUGGESTED APPROACH
Explain the significance of earnings per share data and present the formula for basic earnings per share.
LECTURE AID—Earnings per Share
Assume that two couples residing in the same city each have combined incomes of $70,000. Would you
expect both couples to have about the same lifestyle? If you knew that one of those couples had no
children and the other couple had seven children, would you still expect both couples to have the same
lifestyle? In this case, the per-person income of the two families is dramatically different.
Couple A—No Children Couple B—Seven Children
Earnings per Person =
$70,000 $35,000
2
=
Earnings per Person =
$70,000 $7,778
9
=
This same concept can be applied to corporations. Assume that two corporations both made $100,000 of
net income last year. Corporation A has 1,000 shares of stock, and Corporation B has 100,000 shares.
Would you rather have a share of stock in Corporation A or B? Corporation A has more income for each
share of stock.
Corporation A Corporation B
Earnings per Share =
$100,000 $100
1,000
=
Earnings per Share =
The formula for earnings per share is as follows:
Net Income – Preferred Dividends
Earnings per Share = # of Common Shares Outstanding
Remind your students that if a company has no preferred stock, earnings per share is simply:
Net Income
Earnings per Share = # of Common Shares Outstanding
Chapter 13 Corporations: Organization, Stock Transactions, and Dividends 263
Stress that earnings per share does not normally represent the amount that stockholders can expect to
receive in dividends. It would only represent this amount if the corporation paid out all its earnings in
dividends.
GROUP LEARNING ACTIVITY—Earnings per Share
Ask your class to work end of chapter practice exercise 13-8A or 13-8B to calculate and report earnings-
per-share data.
Type Item Description LO(s) Difficulty Time Est BUSPROG AICPA ACBSP – APC Bloom’s EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 3 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 2 3 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 3 4 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 4 4 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 5 4 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 6 5 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 7 5 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 8 6 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
DQ 9 6 Easy 5 min. Analytic Measurement Accounting for Corporations Remembering
PE 6A Reporting stockholders’ equity 6 Easy 5 min. Analytic Measurement Accounting for Corporations Applying x
PE 6B Reporting stockholders’ equity 6 Easy 5 min. Analytic Measurement Accounting for Corporations Applying x
PE 7A Retained earnings statement 6 Easy 5 min. Analytic Measurement Accounting for Corporations Applying x
PE 7B Retained earnings statement 6 Easy 5 min. Analytic Measurement Accounting for Corporations Applying x
PE 8A Earnings per share 8 Easy 5 min. Analytic Measurement Accounting for Corporations Applying x x
PE 8B Earnings per share 8 Easy 5 min. Analytic Measurement Accounting for Corporations Applying x x
EX 1 Dividends per share 3 Easy 10 min. Analytic Measurement Accounting for Corporations Applying x x
EX 2 Dividends per share 3 Easy 10 min. Analytic Measurement Accounting for Corporations Applying
EX 3 Entries for issuing par stock 3 Easy 10 min. Analytic Measurement Accounting for Corporations Applying x
EX 4 Entries for issuing no-par stock 3 Easy 10 min. Analytic Measurement Accounting for Corporations Applying x
EX 5 Issuing stock for assets other than cash 3 Easy 5 min. Analytic Measurement Accounting for Corporations Applying x
EX 22 Selected dividend transactions, stock split 4,7 Moderate 15 min. Analytic Measurement Accounting for Corporations Applying
EX 23 EPS 8 Easy 5 min. Analytic Measurement Accounting for Corporations Applying
EX 24 EPS 8 Easy 10 min. Analytic Measurement Accounting for Corporations Applying x
EX 25 EPS 8 Moderate 10 min. Analytic Measurement Accounting for Corporations Applying x
PR 1A Dividends on preferred and common stock 3 Moderate 1 hour Analytic Measurement Accounting for Corporations Applying x x
PR 2A Stock transactions for corporate expansion 3 Moderate 45 min. Analytic Measurement Accounting for Corporations Applying x
PR 3A Selected stock transactions 3,4,5 Moderate 1 hour Analytic Measurement Accounting for Corporations Applying x x
PR 4A Entries for selected corporate transactions 3,4,5,6 Challenging 1 hour Analytic Measurement Accounting for Corporations Applying x x
PR 5A Entries for selected corporate transactions 3,4,5,7 Moderate 1 hour Analytic Measurement Accounting for Corporations Applying x
PR 1B Dividends on preferred and common stock 3 Moderate 1 hour Analytic Measurement Accounting for Corporations Applying x x
PR 2B Stock transactions for corporate expansion 3 Moderate 45 min. Analytic Measurement Accounting for Corporations Applying x
PR 3B Selected stock transactions 3,4,5 Moderate 1 hour Analytic Measurement Accounting for Corporations Applying x x
PR 4B Entries for selected corporate transactions 3,4,5,6 Challenging 1 hour Analytic Measurement Accounting for Corporations Applying x x
PR 5B Entries for selected corporate transactions 3,4,5,7 Moderate 1 hour Analytic Measurement Accounting for Corporations Applying x
CP 1 Board of directors’ actions 1 Easy 10 min. Ethics Industry Accounting for Corporations Understanding x x
CP 2 Ethics and professional conduct in business 3 Easy 10 min. Ethics Industry Accounting for Corporations Analyzing x x
CP 3 Issuing stock 3 Moderate 20 min. Analytic Measurement Accounting for Corporations Analyzing x
CP 4 Interpret stock exchange listing 1 Moderate 20 min. Analytic Industry Accounting for Corporations Evaluating
CP 5 Dividends 4 Moderate 20 min. Analytic Measurement Accounting for Corporations Analyzing x
CP 6 Profiling a corporation 1 Moderate 30 min. Analytic Industry Accounting for Corporations Analyzing
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