Nearly all large businesses-and many small ones-are organized as corporations. There are many more sole proprietorships than corporations; but in dollar volume of business activity, corporations hold an impressive lead. Because of the dominant role of the corporation in our economy, it is important for everyone interested in business, economics. or politics to have an understanding of corporations and ,their accounting policies
What Is’ a Corporation?
A corporation is a legal entity, having an existence’ separate and distinct from that of its owners. The owners of a corporation are called stockholders (or shareholders), .and their ownership is evidenced by transferable shares of capital stock.
A corporation is more difficult and costly to form than other types of organizations, The corporation must obtain a charter from the state in which it is formed. and it must .receive authorization from that state to issue shares of capital stock. The formation of a corporaries usually requires the services of an attorney.
As a separatelegal entity, a corporation may own property in its own name. The assets of a corporation belong to the corporation itself, not to the stockholders. A corporation has legal status in court-it may sue and be sued as if it were a person. As a legal entity. a corporation may enter into contracts, is responsible for its own debts, and pays income laxesbn its earnings
The transferability of corporate ownership, together with professional management, , gives corporations a greater continuity of existence than other forms of organization. Individual stock holders may sell; give, or bequeath their shares to someone -else without disrupting business operations. Thus a corporation may continue its business operations indefinitely, without regard to changes in ownership.
The following table contrasts the corporate form of business with a sole proprietorship and a general partnership
Income Taxes In Unprofitable Periods
What happens to income taxes expense when , losses are incurred? In these situations, the company may recognize a negative amount. of income taxes ‘expense. The adjusting entry to record income taxes in an unprofitable accounting period consists of a debit to Income Taxes Payable and a credit to Income Taxes Expense.
“Negative” income taxes expense means that the company expects to recover from the government some of the income taxes recognized as expense in earlier profitable periods.” A credit balance in the Income Taxes Expense account is offset against the amount of the before-tax loss, as shown on the following page
In most cases, income before taxes provides a reasonable approximation of taxable income, but differences’ in the determination of income before income taxes and taxable income do exist. We will discuss significant differences between these subtotals at. various points throughout this textbook. K-raxrefunds are limited, to taxes paid in recent years. In this introductory discussion, we assume the company has paid sufficient taxes in prior periods to permit full recovery of any negative tax expense relating to’ a loss in the current period
We have seen that- income taxes expense the amount of before-tax profits .. Notice now that income tax .benefits-representing tax refunds-reduce the amount of . a pretax loss. Thus income taxes reduce the amounts of both profits and losses. If the Income Taxes Payable account has a debit balance at year-end, h is reclassified in the balance shee; ·as an asset .called “Income Tax Refund Receivable
Salaries Paid to Owners
We have made the point that unincorporated businesses record payments to their owners as drawings, not as salaries. expense. But the owners of a corporation cannot .make withdrawals of corporate assets. Also, many of a corporation’s employees-perhaps thou- sands-may also be stockholders. Therefore, corporations make no distinction between ’employees who are stockholders and those who are not. All salaries paid to employees (including employee/stockholders) are recognized by the corporation as salaries expense.
Owners’ Equity In a Corporate Balance Sheet
In every form of business organization, there are two basic sources of-owners’ equity: (1) investment by the owners and. (2) earnings from profitable operations. State lawsrequire corporations to distinguish in their balance sheets between the amounts of equity arising from each source.
Accounting for Dividends
The owners of a corporation may not withdraw profits from the business at will. Instead distributions of cash or other assets to the stockholders must be, formally authorized=- or declared-by the company’s board of directors. These formal distributions are termed
dividends. By law, dividends must be distributed to all stockholders in proportion to the number of shares owned
A dividend is officially declared by the board of directors on one .date, and then is paid (distributed) in the near future. To illustrate, assume that on December I, the directors of Mary’s Cab Co. declare a regular quarterly dividend of 50 cents per shan: on the ]·0,000 shares of outstanding capital stock. The board’s resolution specifies that the dividend will be paid on December 15 to. stockholders of record’ on December 10.
Two entries are required: one on December I to record ‘the declaration of the dividend. and the other on December 15 to record paymen
.Notice that at the declaration date December I, there is no reduction in assets. But the stockholders’ right to receive the dividend ‘is recognized as a liability. This liability is discharged on the payment date, December 15, when the dividend checks are actually mailed to stockholders. No entry. is required on the date of record, December 19. , At the end of the period, the Dividends account is closed into the Retained Earnings . account, much as an owner’s drawing account is closed into that owner’s’ capital account
Evaluating the Financial Statements of a Corporation
The Adequacy of Net Income
In some respects, the financial statements of a corporation are easier to evaluate than those of an unincorporated business. For example, the income of an unincorporated business represents compensation to the owners for three distinct factors:
I. Services rendered to the business.
2. Capital invested in the business.
3. The risks of ownership, which often include unlimited personal liability
Remember also that stockholders do not report their respective shares of the corporate net income in their personal income tax returns. However, they must pay personal income taxes on the amount of any dividends received.
When extending credit to an ‘unincorporated business, creditors . often look to the solvency of the individual owners, rather than that of the business entity. This is because the owners often are personally liable for the business debts. But in lending funds to a corporation. creditors generally may look only to the business entity
for repayment. Therefore, the financial strength of the business organization becomes much more important when the business is organized as a corporation
Small Corporations and Loan Guarantees
Small, closely held corporations often do not have sufficient financial resources to qualify for the credit they need. In such cases,
creditors may require one or more of the company’s stockholders to personally guaran- . tee (or co-sign) specific’ debts of the business entity. By co-signing debts of the corporation, the individual stockholders do become personally liable for the debts if the corporation fails to make payment.
Small, closely held corporations often do not have sufficient financial resources to qualify for the credit they need. In such cases,
creditors may require one or more of the company’s stockholders to personally guarantee (or co-sign) specific’ debts of the business entity. By co-signing debts of the corporation, the individual stockholders do become personally liable for the debts if the corporation fails to make payment.
The entry to establish a new set of records for the business as a corporation, based on the values of the assets received and the liabilities assumed, is as follows:
A publicly owned corporation receives cash only when it first sells shares of stock to the investment public (called an “initial public offering,” or IPO). Future trading of these securities takes place between individual investors and has no direct impact on the company’s cash flows. Yet publicly
Why is this? There are several reasons. First, corporations monitor closely the current market value of their securities because current stock performance directly influences the ability to raise equity capital in the future (through new public offerings). Second, poor stock performance often signals that a company is experiencing financi~1 difficulty. This, in turn, often makes it d,fflcult for the company to obtain credit and may even make potential customers reluctant to buy the goods or services it sells. Finally, a growing number of corporations include stock options in their executive compensation plans. If the market price of the company’s stock falls below a certain value,these options become worthless. When this happens, key execuives often lose motivation to stay with the company and l)’lClkethe decision to take their “intellectual capital” elsewhere
PARTNERSHIP ACCOUNTING-A CLOSER LOOK
There are a number of unique aspect” of partnership accounting. Tnthis section, we will describe opening the accounts of a new partnership, additional investments and withdrawals by owners, allocating partnership net income among the partners, and closing the accounts at year-end
Opening the Accounts of a New Partnership
When a: partner contributes assets other than cash, a question always arises as to the value of such assets. The valuations assigned to non cash assets should be their fair market values at the date of transfer to the partnership. The valuations assigned must be agreed to by all partners
To illustrate the opening entries for a newly formed partnership, assume that on January I, 2001, Joan Blair and Richard Cross; who operate competing retail stores, decide to form a partnership by consolidating their two businesses. A capital account will be opened for each partner and credited with the agreed valuation of the net assets (total assets less total liabilities) that the partner contributes. The journal entries to open the accounts of the partnership of Blair and Cross are as follows
1. A fixed ratio. The fixed ratio method has already been illustrated in the example of the Blair and Cross partnership, in which profits were shared equally, that is, 50% and 50%. Partners may agree upon any fixed ratio such as 60% and 40%, or 70% and 30%.
2. Salary allowances to the partners, with remaining net income or loss divided in a fixed ratio.
3. Interest allowances on partners’ capital balances, with remaining net income”or loss divided in a fixed ratio.
4. Salary allowances to the partners, interest allowances on partners’ capital balances, and remaining net income or loss divided in a fixed ratio
All these methods of sharing partnership net income are intended to recognize differences in the personal services rendered by partners and in the amounts of capital invested in the firm.
In the illustrations that follow, it is assumed that beginning balances in the partners’ capital accounts were Brooke Adams, $160,000, and Ben Barnes, $40,000. At year-end, the Income Summary account showed a credit balance of $96,000, representing the net income for “the year.
Salaries to Partners, with Remainder in a Fixed Ratio
Because partners often contribute different amounts of personal services, partnership agreements often provide for partners’ salaries as a factor in the division of profits
The division of the $96,000 in partnership net income between Adams and Barnes is illustrated in the schedule sh~n below. “Thefirst step is to allocate to each partner his or her agreed-upon salary allowance. This step allocates $72,000 of the partnership net
income. The remaining $24,000 is then divided in the agreed-upon fixed ratio (50-50 in this example).
Under this agreement, Adams’s share of the $96,000 profit amounts to $24,000 and Barnes’s share amounts to $72,000, The entry to close the Income Summary account would be:
The salary allowances used in dividing partnership net income are sometimes misinterpreted, even by the partners. These salary allowances are merely an agreed-upon device for dividing net income; they are not expenses of the business and are not recorded
ill any ledger account. A partner is considered an owner of the business, not an employee. Therefore, the services that a partner renders to the firm are assumed to be rendered in anticipation of earning a share of the profits-not a salary.
The amount of cash or other assets that a partner withdraws from the partnership may be greater than or less than the partner’s salary allowance. Even if a partner decides to withdraw an amount of cash equal to his or her “salary allowance:’ the withdrawal should be recorded by debiting the partner’s drawing account, not by debiting an expense account, Let us repeat the main point: “salary allowances;’ to partners should not be recorded. as expenses of the business;’
Interest Allownees on Partners’ Capital, with Remainder In a Fixed Ratio
shall assume a business situation in which the partnerssp end very little time in the business and net income depends primarily on the amount of money invested. The profitsharing plan then might emphasize invested capital as a basis for the first step in allow eating income.
For example, assume that Adams and Barnes agree that both partners are to be·allowed interest at ]5% on their beginning capital balances, with any remaining profit or lass to be divided equally. Net income to be divided is $96,000, and the beginning capital balances are Adams, $160,000, and Barnes, $40,000
The entry to close the Income Summary account in this example would be