chapter 7
Current Liabilities
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Learning Goals
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•
Know the classification framework and typical examples of current liabilities.
•
Describe the accounting for accounts and notes payable and other typical current
liabilities.
•
Understand the nature of accruals, deposits, estimates, contingencies, and similar
obligations.
•
Prepare the current liability section of a balance sheet.
•
Understand and apply important concepts in corporate financing.
•
Know the basic principles and duties related to proper accounting for a business payroll.
•
Interpret amounts reported in financial statements that pertain to employee benefits.
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Section 7.1 Accounts and Notes Payable
Chapter Outline
7.1 Accounts and Notes Payable
Accruals
Prepayments, Deposits, and Collections for Others
Estimated Liabilities
Contingencies
Balance Sheet Presentation
Being a Better Borrower
7.2 Concepts in Payroll Accounting
Calculating Gross and Net Pay
Payroll Journal Entry
Additional Entries for Employer Amounts
Accurate Payroll
Pension and Other Postretirement Benefits
C
urrent liabilities are obligations that must be settled within 1 year or the operating
cycle, whichever is longer. Current liabilities are usually satisfied by transferring a
current asset. Accounts payable, salaries payable, utilities payable, taxes payable, and
short-term loans are all examples of such current liabilities. Also included are amounts
related to collections for others, accrued liabilities, warranty obligations, unearned revenue, and the current portion of long-term debt. The formal definition of a current liability is sufficiently broad to capture each of these amounts. In addition, current liabilities
include amounts that will be satisfied by the creation of another liability or provision of a
service. For example, unearned revenue is reported as a current liability. It is transferred
to revenue at the time when goods or services are delivered to the customer.
It may be helpful to review the concept of an operating cycle. The operating cycle is the
length of time it takes to turn credit back into cash. For instance, a business may buy inventory, sell the inventory in exchange for a receivable, and eventually collect the receivable.
The typical time period during which cash is tied up in the inventory and receivables is
the operating cycle. A typical operating cycle might span 45 to 180 days but can be much
longer or shorter depending on the business. A fast-food restaurant may have an operating cycle of a mere few days, whereas a winery’s cycle might span years. The diverse
nature of operating cycles explains why the definition of current is related to the longer of
the operating cycle or one year.
7.1 Accounts and Notes Payable
L
et’s turn attention to a closer look as some specific types of current liabilities.
Accounts payable are amounts due to suppliers for the purchase of goods and services. Such payables may be based on very informal credit terms, but those terms usually
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stipulate the expected date of payment. For credit terms, 30 to 60 days is a common time
length. Accounts payable incurred in the normal course of business ordinarily do not incur
interest charges, although you might find exceptions, especially for delinquent accounts.
Accounts payable are almost always shown as current liabilities on the balance sheet.
When a formal written instrument (agreement) shows purchases on credit, the resulting payable may be reported as a note payable. Specifically, a note payable is a written promise to pay and will ordinarily incur interest over the duration of its outstanding
period. Such notes arise not only with purchases of goods and services on account but
also from bank loans, equipment purchases, and simple cash loans. The party who owes
is referred to as the maker of the note. This person’s signature on the instrument represents
a formal promise to pay the amount of the note, along with any agreed interest levies. If
constructed properly, the note can actually become a negotiable instrument, allowing its
holder (owner) to sell the collection rights to another person. The written note instrument
can be as simple as Exhibit 7.1. A full legal form would typically include specific information about remedies upon default, place of payment, requirements of demand and notice,
and so forth.
Exhibit 7.1: An example of a promissory note
FOR VALUE RECEIVED, the undersigned promises to pay to the order of
the sum of:
with annual interest of 6% on any unpaid balance. This note shall mature
and be payable, along with accrued interest, on:
Issue date
Maker Signature
A closer inspection of the note in Exhibit 7.1 reveals that Hillary Li has agreed to pay Vesta
Energy $5,150 on December 31, 20X7. The principal amount of the note is $5,000 and the
interest is $150. Interest is calculated by multiplying the $5,000 by the interest rates of 6%
and time outstanding of one half of a year: $5,000 6% (142) $150. The interest calculation formula is often simply expressed as
Principal 3 Rate Time
Assuming the note originated with a cash loan, Hillary Li would initially record the borrowing transaction by increasing Cash (debit) and Notes Payable (credit). Had the transaction originated by Hillary buying inventory from Vesta, the debit would reflect Inventory
(instead of Cash). At repayment, Cash is credited, Notes Payable is debited, and the difference is booked as Interest Expense. The following journal entries reveal this approach:
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7-1-X7
Cash
5,000.00
Note Payable
5,000.00
To record cash borrowed via a formal note payable bearing interest at 6% per annum
12-31-X7
Interest Expense
150.00
Note Payable
5,000.00
Cash
5,150.00
To record payment of note and interest
Notes occasionally have terms that extend beyond one year; these notes may be shown as
long-term, rather than current, liabilities. The notes may also have amounts due that span
several time periods. This feature can require the accountant to split the note’s presentation into two balance sheet amounts reflecting both the current and noncurrent portions.
Accruals
The interest on a note is said to accrue. This means that it accumulates gradually with the
passage of time. On any given balance sheet date, a company would need to calculate
the total amount of its accrued obligations and report them in the current liability section. These amounts are called accrued liabilities (also, accrued expenses). For instance, if the
6-month note previously illustrated had originally been issued on October 1, rather than
July 1, then $75 of interest would have accrued by December 31. The company would
need to prepare the following adjusting journal entry on December 31, and the accumulated interest would appear within the current liability section of the balance sheet:
12-31-X7
Interest Expense
75.00
Interest Payable
75.00
To record accrued interest for 3 months:$5,000 6% (3412 months)
Interest is not the only type of obligation that is said to accrue. Salaries, wages, taxes, and
utilities are typical expenses that must be accrued at the end of an accounting period. For
instance, recall from an earlier chapter the following example of an entry that was used to
accrue salaries:
12-31-X6
Salaries Expense
15,000.00
Salaries Payable
15,000.00
To record accrued salaries at end of period
The accounting department within an organization must be very cautious to correctly
identify all such accruals; otherwise, liabilities will be understated and income overstated.
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Prepayments, Deposits, and Collections for Others
A customer sometimes makes an advance payment or deposit. You have probably purchased an airline ticket, ticket to a concert or sporting event, or a magazine subscription.
Ordinarily, the seller collects the sales price well in advance of delivery of the promised
goods and services. When this occurs, the seller cannot recognize revenue at the time of
collection. Remember that revenue is only recognized when earned; the mere collection
of the sales price is not sufficient. Therefore, the initial entry is for the seller to debit Cash
and credit Unearned Revenue.
The Unearned Revenue is reported as a current liability until such time as the goods or
services are delivered, whereupon the seller will debit Unearned Revenue and credit Revenue. If you are examining financial statements, you will often identify a significant amount
related to unearned revenue (often called deferred revenue). So long as you reasonably expect
this revenue to be earned by delivery of future goods and services, you can take some comfort that the business’s liability actually corresponds to a future revenue amount.
Home builders, car dealers, and retailers sometimes collect deposits toward future transactions. These down payments are intended to secure a firm customer commitment prior to
beginning actual construction of a major or customized project. For example, in a layaway
transaction, the retailer agrees to set aside a specific item of inventory in exchange for an
initial deposit. Hopefully, the customer deposits are sufficient to ensure that the customer
will follow through on their promise to accept and pay for the product. Whether these
deposits are refundable or not, they are nonetheless reported as current liabilities. Oftentimes, such amounts are called deferred revenues, deferred liabilities, or just simply deferrals.
Another potentially large current liability relates to collections for third parties. For
instance, businesses are tasked with collecting sales taxes. The seller of taxable goods
must collect sales tax from a customer and then turn the money over to a taxing authority.
Such amounts are appropriately reflected as a current liability until the funds are remitted
to the rightful owner.
Estimated Liabilities
Companies routinely offer prizes, coupons, promotions, warranties, rebates, and other
incentives to induce customers to purchase. Each type of transaction introduces unique
accounting questions. Some are so unique that specific accounting rules have been developed, and the accountant must perform detailed research to identify and apply appropriate principles. The accounting profession, through its primary accounting standard setting body, has developed a research database of pronouncements. If you are curious about
this database, you might check with your library or a practicing accountant and ask if they
have access to the Financial Accounting Standards Board Codification. This tool will let
you enter key-word searches, and you will be amazed at the number of pronouncements
and references you will find related to these types of estimated liabilities.
Despite the deep and specific detail on accounting for estimated liabilities, it is possible to make a broad generalization. A company should report the estimated amount of
future cost associated with those agreements and promises that are probable to occur.
This amount, at least, should be presented as a liability on the corporate balance sheet. To
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illustrate using warranties as the example, when goods are sold, an estimate of the future
amount of warranty costs associated with the sales should be recorded as an expense.
The offsetting credit is to a Warranty Liability account. As warranty work is performed,
the Warranty Liability is reduced, and Cash (or other resources used) is credited. This
approach not only results in a fair presentation of the remaining liability on the balance
sheet but also produces a proper matching of revenues and expenses.
The following entries show how a $40,000 sale of a car—costing the dealer $32,000 and
having future estimated warranty work of $3,000—is to be recorded. Also shown is the
provision of one element of warranty service. Take special note that seller will make a
$5,000 profit consisting of the $40,000 sale and $35,000 of total expenses.
Date of Sale
Cash
40,000.00
Sales
40,000.00
To record sale of new car
Date of Sale
Cost of Goods Sold
32,000.00
Inventory
32,000.00
To record cost of new car sold
Date of Sale
Warranty Expense
3,000.00
Warranty Liability
3,000.00
To record estimated cost of future warranty work to be provided on car
Date of Warranty
Service
Warranty Liability
1,000.00
Cash
1,000.00
To provide a portion of anticipated warranty service
Contingencies
Some business obligations seem to take on a heightened degree of uncertainty. In some
respects, the aforementioned estimated liabilities can be regarded in this fashion because
one does not truly know the eventual outcome. However, there is yet another class of
potential liability in which the amount and timing of a possible obligation is far more
subjective. These uncertain potential obligations are known as contingent liabilities.
Numerous examples include lawsuits, environmental damage, risk of expropriation of
assets by a foreign government, and other firm-specific issues.
Accountants have developed a well-defined framework for the reporting of contingencies. Before diving in, be advised that this framework is not applied to general business
risks, like business fluctuations due to the broader economy, risk of war, risk of weather
damage, and so forth. No one can see the future, and investors are presumed to be mature
enough to know that these risks are intrinsic to the hazards of investing. Thus, accountants do not include financial statement measurements related to general business risks.
The starting point for justifying contingent liabilities is to make a subjective assessment
of the probability of an unfavorable outcome. If an unfavorable outcome is viewed as
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probable, a liability will generally be reported on the balance sheet. The credit to set up the
liability is offset with a debit to a loss or an expense account. The amount to record is the
estimated amount of loss (if the loss cannot be estimated, a robust footnote to the financial
statements will likely explain the obligation and reasons why an estimate is not possible).
For contingencies that are deemed to be reasonably possible (but not quite probable), no
accrual (i.e., recording on the balance sheet) is necessary. However, the accountant is certainly expected to disclose the risk with a footnote, possibly indicating the dollar amount
of potential exposure faced by the company. Finally, if a contingent exposure is viewed
as presenting an immaterial or remote risk, the accountant is permitted to conclude that
no balance sheet accrual or footnote is needed. Maybe you thought accountants only did
bookkeeping; think again. The accountant is engaged in a number of complex activities
related to items like risk assessment!
Balance Sheet Presentation
You may now appreciate how complex the current liabilities section of the balance sheet
can grow. Table 7.1 shows a typical presentation for a variety of obligations. Your review
of this may leave you wondering about the specific order in which current obligations are
to be listed. No one scheme dominates, although it is relatively common to first show the
current portion of Long-Term Debt, followed by Short-Term Notes Payable, Loans Payable, and then Accounts Payable. Accrued and other liabilities are usually listed last.
Table 7.1: The listing of various obligations
Current Liabilities
Note Payable
$100,000
Accounts Payable
125,000
Salaries Payable
80,000
Utilities Payable
20,000
Customer Prepayments
5,000
Warranty Obligation
23,000
Accrual for Pending Litigation
25,000
$378,000
Being a Better Borrower
Accountants learn a lot about business financing and gain some competitive advantages
as a result. The skills you have already learned and few added tips may actually put you
in a position to gain a competitive edge yourself.
Begin by recognizing that some short-term borrowing agreements may stipulate that a
year is only 360 days long. Of course, this is not correct. In years gone by, maybe one could
argue that this assumption made it possible to calculate interest more readily. If you happen to see some very old bank statements, you might get a glimpse into the past when tellers manually calculated and posted interest. Using a 360-day year (30 days each month)
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made these manual calculations simpler. With calculators and computers, it is just as easy
to compute interest for a 360- or 365-day year.
However, some borrowing agreements continue to hold over the 360 day2year provision.
Why? Because it favors the lender! For example, interest on a $10,000, 90-day, 6% loan is
$150, assuming a 360-day year [$10,000 .06 (904360)], but only $147.95 based on the
more correct 365-day year [$100,000 .06 (904365)]. That may not look like much of a
difference to you, but it is to the lender if they make enough loans. Caveat emptor means “let
the buyer beware;” perhaps let the borrower beware is also an appropriate admonition.
Compounding is another concept that you should grasp. The formula for simple interest,
such as used in the preceding paragraph, is
Interest Loan Interest Rate Time
There are more involved formulas for compound interest, which are discussed at length in
a managerial accounting course. Compound interest means that interest is earned on the
interest. A loan agreement will stipulate how often the interest calculation is applied (e.g.,
once per day, once per week, once per month, once per quarter, annually). The calculated
amount of interest is added to the balance of the loan, and it too begins to accrue interest.
The greater the frequency of interest compounding, the greater will be the total amount of
interest incurred. Lenders are usually required to present you with an extensive truth-inlending document that describes the basis on which they will assess interest, but that is no
guarantee that the terms are good! Read the fine print and try to negotiate your best deal.
Buying the use of money (i.e., borrowing) is no different than buying any other asset; you
should negotiate the best possible terms.
Sometimes a lender may try to collect their “interest” up front in the form of points (a
single point is equal to 1% of the loan amount), fees, or discounts. This can take many
forms but is best illustrated with a note payable issued at a discount. Assume Advantage
borrowed $1,000 on January 1, to be repaid on December 31. The stated terms included
“10%” interest, or $100, to be withheld up front from the $1,000 loan.” Following is the
accounting sequence:
1-1-XX
Cash
900.00
Discount on Note Payable
100.00
Note Payable
1,000.00
To record note payable, issued at a discount
12-31-XX
Note Payable
1,000.00
Interest Expense
100.00
Discount on Note Payable
100.00
Cash
1,000.00
To record repayment of note and related interest via discount “amortization”
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Observe that the $100 discount is initially recorded to a special account. This account
is shown on a balance sheet as a contra account to the note payable. Simply, this means
that a balance sheet will show the $1,000 note, less the $100 discount, netting to the $900
amount borrowed. Over time, the discount is amortized via a transfer to Interest Expense.
The above entry did this at maturity, but it could have apportioned ratably over the life of
the loan. At maturity, the “$1,000 loan” is repaid, as shown. It is important to understand
that the loan was only $900, on which $100 of interest was paid. This brings the true rate
of interest to over 11% ($1004$900).
7.2 Concepts in Payroll Accounting
P
ayroll is one of the most significant expenditures that businesses may face. It involves
not only a significant amount of money but also is subject to strict legal and tax implications. Failure to meet payroll funding and accounting expectations is usually fatal for a
business.
The starting point of beginning is distinguishing between an employee and
independent contractor. Payroll accounting principles pertain to employees. An
employee is someone who provides services to a business in exchange for payment, with
the business controlling what, when, and how work will be done. In contrast, an independent contractor performs agreed tasks but generally decides the processes that will achieve
the end result. The distinction is important because tax and record-keeping requirements
differ for employees and independent contractors.
It is common for disputes to arise about the classification of a worker as an employee versus contractor; in particular, tax rules have become increasingly specific about the ways in
which the differentiation occurs. If you are working for someone else or engaging another
to perform a service, you are well advised to research the specific situation carefully to
make the proper distinction between employee and contractor. As you are about to discover, the distinction is very important.
Under U.S. tax law, monies paid to independent contractors do not require that the payer
incur payroll taxes or withhold taxes. The primary requirement is that the payer obtain the
contractor’s tax identification number (usually the Social Security number) and provide
the contractor and Internal Revenue Service (IRS) with an annual report of the amount
paid. This annual report is known as Form 1099. It is a simple matter to prepare and file
this report. The contractor is responsible for paying all income and self-employment taxes
on the amounts received from the payer.
Paying employees becomes far more involved. You may have some work experience, and
if you do, you know that your paycheck is usually reduced by a variety of charges. The
list of potential withholdings is long, including federal income tax, state income tax, FICA
(Social Security taxes and Medicare/Medicaid), insurance, retirement contributions, charitable contributions, special health and child-care deferrals, and other similar items. The
total amount you earned is termed the gross pay. The amount you receive after deducting all these charges is the net pay.
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When you look at your pay stub and see all the withholdings, you may feel like you are
taking two steps forward and one step back. However, don’t blame your employer. The
bulk of these withholdings is mandated by law, and certain of them must be matched by
your employer. This has the effect of increasing the total payroll cost to the employer to an
amount well in excess of your gross pay.
Employers are required to match your FICA payments. Employers additionally pay unemployment taxes that are completely invisible and not borne directly by employees. Some
employers also contribute to health insurance costs and retirement programs. A business
must not only correctly account for the gross pay but also must measure, report, and fund
these additional costs as well.
Calculating Gross and Net Pay
For hourly employees, gross pay is the number of hours worked multiplied by the hourly
rate. For salaried employees, it is usually a flat amount. Gross pay might be increased or
decreased for both hourly and salaried employees based on overtime rules or periods
of compensated/uncompensated leaves. Statutes vary by country and state, and global
employers must be very careful to understand fully the rules that apply in each jurisdiction. Laws tend to punish employers that don’t get it right and typically trigger payments
and penalties due to both employees and governmental agencies.
Once gross pay is determined, all applicable withholdings must be considered. Income tax
is usually the single most significant amount. Employees ultimately bear the tax on income,
but the employer must withhold the money (i.e., it is taken out of the gross pay before disbursing payroll to employees). In other words, employees never touch the funds; if too
much (or not enough) is withheld over the span of a tax year, final adjustment will occur
when employees file their income tax returns for the preceding year.
The employer must periodically remit to the government(s) (based on schedules tied to
the amounts involved) all such income tax withholdings. The amount to withhold is based
on rates set by federal, state (when applicable), and city (when applicable) governments,
as well as employee withholding allowances. Withholding allowances identify the tax status of employees as it relates to the number of exemptions to which they may be entitled
based on marital status and personal dependents. Employers learn about these employee
characteristics by having employees fill out a W-4 form.
The Federal Insurance Contributions Act (FICA) establishes a tax that transfers money
from those currently working to aged retirees, disabled workers, and certain children.
FICA is a blanket act encompassing programs normally called Social Security and Medicare/Medicaid. You are likely aware that that these programs are becoming increasingly
costly and controversial as extended life expectancies, rising health-care costs, and shifting imbalances between retired and working persons is calling into question the financial
solvency and viability of these programs. It is difficult to predict the future state of this
tax. For now, the Social Security tax is levied as a designated percentage of income, up to
a certain maximum level of annual income per employee.
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Despite regular revisions to the Social Security tax rates and income levels, the method
of applying the tax has been relatively stable. For illustrative purposes, let’s assume a 7%
rate on a maximum of $120,000 of income. This simply means that an employee making
$200,000 per year would pay $8,400 in Social Security taxes (remember, this tax is also
matched by the employer, as will be shown shortly). The $8,400 amount is the 7% rate
applied to the $120,000 maximum; anything earned over $120,000 per calendar year is not
assessed by the tax.
Medicare/Medicaid tax is assessed at fixed percentage on total gross pay, no matter the
level. Assuming a 2% rate, the employee grossing $200,000 would pay $4,000 per year.
Like Social Security, the employer also matches this medical benefits tax. Do not confuse Medicare/Medicaid with health insurance; the former benefits retirees using the
government-provided coverage plan, and the latter is for people below the poverty line,
retired or not. Active employees and retirees on a company provided plan may not draw
Medicare/Medicaid.
Once the mandatory withholdings are covered, it is time to consider more discretionary
types of costs. A large cost can arise through company-provided health care for its own
work force and retirees. Usually, employees are asked to participate in the costs of these
plans, especially if spouses and children are included in the coverage group. Such insurance premiums are withheld from gross pay. Similar withholdings arise for employee
contributions to various retirement and other cash savings plans. Some companies will
manage withholdings for employee charitable contributions, tax-advantaged health and
child-care savings programs, and other optional programs in which an employee may
choose to participate. Basically, the employer is collecting money from the employee and
assuming a duty to remit those funds to another party. This is like accounting for customer deposits and other collections for third parties.
Payroll Journal Entry
A company will debit Wage/Salary Expense for the gross pay and credit Cash for the net
pay disbursed to an employee. The differences reflect amounts due to others (e.g., the
government, insurance companies, and charities). Following is a representative monthly
entry for a company’s total payroll:
5-31-XX
Wage/Salary Expense
300,000.00
Federal Income Tax Payable
30,500.00
State Income Tax Payable
12,000.00
Social Security Payable
18,000.00
Medicare/Medicaid Payable
6,000.00
Insurance Payable
18,500.00
Retirement Contribution Payable
15,000.00
Charitable Contribution Payable
2,000.00
Cash
198,000.00
To record payroll for the month of May
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All amounts were assumed in the preceding entry. However, using the earlier tax-rate
assumptions, you can see that Medicare/Medicaid reflected the 2% tax ($300,000 2%
$6,000). Apparently, some employee(s) had already exceeded $120,000 of annual compensation because the Social Security tax was not $21,000 (which would be the case if
all employees were still paying the full 7% on all income). As the company remits the
amounts withheld from employees, Cash will be credited, and the various obligations will
be debited.
Additional Entries for Employer Amounts
The preceding discussion pointed out that employers must match certain taxes like Social
Security and Medicare/Medicaid. Additionally, the employer must pay other taxes such
as unemployment tax (both federal and state levies). Unemployment taxes are levied
and pooled to provide a source of funds to support persons who are temporarily out of
work. Here the tax rate varies significantly based on the history of an employer. Employers who rarely lay off or fire employees receive a much lower rate than those who don’t
maintain a stable work force. Like Social Security, the unemployment tax is levied only on
a base amount of pay; earnings in excess of the base are exempt from the tax. In this text,
assume that the federal unemployment tax (FUT) is 1% on a $15,000 base and the state
unemployment tax (SUT) is 5% on a $15,000 base.
Employers that offer health insurance coverage to employees usually foot a significant
share of the bill. This is an additional cost that increases the overall cost of having an
employee on the payroll. Along with optional health care, some states require employers to maintain workers’ compensation insurance. This insurance provides payments
to workers for work-related injuries. Other employee benefits can be found in the form
of retirement plan contributions, tuition reimbursement programs, training costs, gym
memberships, automobile allowances, and so forth. For some companies, the added cost
of employee support can be as much as 50% of gross pay. Following is a companion entry
to that shown earlier, this time reflecting the employer’s added burden associated with
the May payroll. The amounts are assumed and would normally be based on formulas
that are situational dependent.
5-31-XX
Payroll Tax Expense
31,200.00
Employee Benefits Expense
40,000.00
Social Security Payable
18,000.00
Medicare/Medicaid Payable
6,000.00
FUT Payable
1,200.00
SUT Payable
6,000.00
Insurance Payable
25,000.00
Retirement Contribution Payable
15,000.00
To record employer portion of payroll taxes and benefits
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Accurate Payroll
As you can tell, accuracy is vital in payroll accounting. Payroll requires accurate and timely
reporting and funding of all related obligations. Because of the complexity of payroll law
and the severe penalties for errors, a specialized industry can provide payroll support services. For a fee, these businesses will manage payroll functions efficiently. The employer
provides information about hours worked for each employee and transfers funds to cover
the full cost of payroll and payroll taxes. The payroll service firm then pays employees,
keeps payroll records, reports compliance, processes tax deposits, and generates payroll
tax reports.
Businesses that do not rely on payroll services must establish an accurate payroll system for tracking information about every employee. It is imperative to pay employees
the correct amounts at the agreed time, to make timely payments of withholdings to the
appropriate parties, and to file all necessary tax reports associated with the payroll. For
example, an employer is required to provide each employee with an annual wage and tax
statement known as the W-2 form. This document includes information on gross pay, tax
withholdings, and other related information. Copies of this information must also be furnished to tax authorities, and they reconcile income reported by employees on their own
tax returns to amounts reported as paid by employers.
Remitting tax withholdings to the government is simple and can be done at most commercial banks. There is also an online system that is easy to use. It is very important for
you to know that the employer’s obligation to protect withheld taxes and make timely
remittances to the government is taken seriously. Employers who fail to do so are subject
to harsh penalties, and employees who are aware of misapplication of such funds can
expect serious legal problems. You should never be party to such an activity.
Pension and Other Postretirement Benefits
Another potentially costly payroll component relates to a company’s retirement savings
programs for the benefit of employees. Broadly speaking, these pension plans involve
current “set asides” of money into trust, with a goal of current investment and future
distributions to retirees. To the extent the company’s trust fund is deemed inadequate to
cover anticipated obligations under a pension, a company will disclose underfunded pension obligations as balance sheet liabilities. On a related note, some companies provide
postretirement health care, life insurance, and related benefits. These costs can be substantial, and accountants have developed elaborate models for estimating these costs. A
company is to report the value of the accumulated obligation as a liability on the balance
sheet. This can be one of the most significant liabilities faced by many companies.
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Concept Check
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge
of the issues by selecting the best answer. (The answers appear on p. 236.)
1. Which of the following comments is false?
a. Current liabilities include prepayments (advances) by customers.
b. Current liabilities will be settled within 1 year or the operating cycle, whichever
is longer.
c. Current liabilities must be settled by using cash.
d. Current liabilities arise from past transactions and events.
2. The Discount on Notes Payable account
a. usually has a credit balance.
b. is associated with a note payable when interest is included in the obligation’s
face value.
c. represents future interest revenue on the note payable.
d. is used for notes payable when interest is not included in the obligation’s face
value.
3.
A balance in the Estimated Liability for Warranties account at year-end indicates
a. that the accounting records have not been closed.
b. that the accounting records have not been adjusted.
c. the amount incurred during the year to service outstanding warranty agreements.
d. future amounts expected to be incurred when outstanding warranty agreements
are honored.
4. Assume that Robert Conrad, a technical engineer, worked 45 hours last week. He is
paid $28 per hour, with hours in excess of 40 being compensated at one and onehalf times the regular rate. Income tax withholdings amounted to $270; his medical
insurance deduction was $30. The Social Security tax rate is 6% on the first $55,000
earned per employee, and Medicare is 1.5% on the first $130,000. Cumulative gross
pay before considering the preceding data totaled $54,202. What is Conrad’s takehome pay?
a. $930.25
b. $962.17
c. $982.12
d. Some amount other than those listed
5.
Social Security and Medicare taxes are levied on
a. employees only.
b. employers only.
c. both employees and employers.
d. either the employee or the employer, depending on the number of withholding
allowances claimed by the employee.
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Key Terms
Key Terms
accounts payable The amounts due to
suppliers for the purchase of goods and
services.
contingent liabilities A class of a potential liability in which the amount and
timing of a possible obligation is very
subjective.
employee As opposed to an independent
contractor, a person who provides services
to a business in exchange for payment,
with the business controlling what, when,
and how work will be done.
Federal Insurance Contributions Act
(FICA) A tax that transfers money from
those currently working to aged retirees,
disabled workers, and certain children.
FICA See Federal Insurance Contributions
Act.
Form 1099 An annual report provided to
an independent contractor and the IRS,
showing money paid.
gross pay The total amount of wages that
an employee earns.
income tax A federal and sometimes state
and local tax on earned wages.
independent contractor Someone who
performs agreed-on tasks but generally
decides about the processes that will
achieve the end result.
net pay The amount that an employee
receives after deducting charges such as
federal and state taxes, FICA, insurance,
retirement contributions, charitable contributions, special health and child-care
deferrals, and other similar items.
note payable A written promise to pay for
purchases bought on credit and usually
incurs interest during the payment period.
pension A plan that involves current “set
asides” of money into trust, with a goal
of current investment and future distributions to retirees.
unemployment tax A tax levied and
pooled to provide a source of funds to
support persons who are temporarily out
of work.
workers’ compensation insurance Insurance that provides payments to workers
for work-related injuries.
W-2 form An annual wage and tax
statement—which includes information
on gross pay, tax withholding, and other
related information—that an employer
provides to an employee and the IRS.
W-4 form A form stating the tax-withholding status—marital and number of
dependents—of an employee.
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CHAPTER 7
Exercises
Critical Thinking Questions
1. Is a commitment for future goods and services entered in the accounting records as
a liability? Explain.
2. Define the term current liability and present six examples.
3. Present three different situations where a business collects monies from customers
and employees and reports such amounts as current liabilities.
4. Briefly discuss the correct treatment of vacation pay in the accounting records.
5. What does the Discount on Notes Payable account represent?
6. Does discount amortization increase or decrease a company’s reported interest
expense for the year?
7. What guidelines must be met for a contingent liability to be recorded in the accounts?
8. Why is a warranty considered a contingent liability?
9. Are internal control procedures important in the area of payroll? Why?
10. What is the purpose of requiring businesses to withhold income taxes (federal,
state, and local) from employee wages? How are these withholdings treated in the
accounting records of the employer?
11. Which payroll taxes are incurred by an employer? How are these taxes treated in
the accounting records?
Exercises
1. Prepayments
by customers. Greenland Enterprises began a new magazine in
the fourth quarter of 20X2. Annual subscriptions, which cost $18 each, were sold
as follows:
Number of Subscriptions Sold
October
400
November
700
December
1,000
If subscriptions begin (and magazines are sent) in the month of sale:
a. name the necessary journal entry to record the magazine subscriptions sold during the fourth quarter.
b. determine how much subscription revenue Greenland earned by the end of 20X2.
c. compute Greenland’s liability to subscribers at the end of 20X2.
2. Accrued
liability: current portion of long-term debt. On July 1, 20X1, Hall Company borrowed $225,000 via a long-term loan. Terms of the loan require that Hall
pay interest and $75,000 of principal on July 1, 20X2, 20X3, and 20X4. The unpaid
balance of the loan accrues interest at the rate of 10% per year. Hall has a December
31 year-end.
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Exercises
a. Compute Hall’s accrued interest as of December 31, 20X1.
b. Present the appropriate balance sheet disclosure for the accrued interest and the
current and long-term portion of the outstanding debt as of December 31, 20X1.
c. Repeat parts (a) and (b) using a date of December 31, 20X2, rather than December
31, 20X1. Assume that Hall is in compliance with the terms of the loan agreement.
3. Notes
payable. Sentry Security Systems purchased $72,000 of office equipment on
April 1, 20X3, by signing a 3-year, 12% note payable to Sharp Inc. One third of the
principal, along with interest on the outstanding balance, is payable each April 1
until maturity. (The first payment is due in 20X4.)
a. Fill in the following table to reflect Sentry’s liabilities, assuming a March 31 yearend.
20X4
20X5
20X6
Current Liabilities
Current portion of longterm debt
Interest payable
Long-Term Liabilities
Long-term debt
b. Assuming that interest is properly recorded at the end of each year, present the
proper journal entry to record the last payment on April 1, 20X6.
4. Payroll
accounting. Assume that the following tax rates and payroll information
pertain to Brookhaven Publishing:
Social Security taxes: 6% on the first $55,000 earned
Medicare taxes: 1.5% on the first $130,000 earned
Federal income taxes withheld from wages: $7,500
State income taxes: 5% of gross earnings
Insurance withholdings: 1% of gross earnings
State unemployment taxes: 5.4% on the first $7,000 earned
Federal unemployment taxes: 0.8% on the first $7,000 earned
The company incurred a salary expense of $50,000 during February. All employees
had earned less than $5,000 by month-end.
a. Prepare the necessary entry to record Brookhaven’s February payroll that will be
paid on March 1.
b. Prepare the journal entry to record Brookhaven’s payroll tax expense.
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Problems
5. Payroll
accounting. The following payroll information relates to Viking Company
for the month of July:
Total (gross) employee earnings
Earnings in excess of Social Security base earnings
Earnings in excess of Medicare base earnings
Earnings in excess of unemployment base earnings
Federal income taxes withheld
State income taxes withheld
Employee deductions for medical insurance
$150,000
18,000
2,000
94,000
14,500
3,000
2,200
The Social Security tax rate is 6% on the first $55,000 earned per employee; Medicare is 1.5% on the first $130,000 earned. The state and federal unemployment tax
rates are 5.4% and 0.8%, respectively, on the first $7,000 earned per employee.
a. Compute the employees’ total take-home pay.
b. Compute Viking’s total payroll-related expenses.
c. Assuming a stable work force, is total take-home pay likely to increase, decrease,
or remain the same in September? Briefly explain.
Problems
1. Current
liabilities: recognition and valuation. The seven transactions and events
that follow relate to the 20X2 operations of Blue Giant Products.
n February 1, the company signed a 1-year contract with the food processors
• O
union, agreeing to a 6% wage increase for all employees. The cost of the wage
increase is estimated to be $100,000 per month.
• A customer slipped on a soft drink that he had spilled while walking through a
Blue Giant store. The customer injured his back and has filed a $50,000 damage
suit against the company. Blue Giant attorneys feel the suit is uncalled for and
without merit.
• Blue Giant purchased merchandise on October 15 for $4,000; terms 5/15, n/60.
The company overlooked the discount and intends to pay the supplier in January 20X3.
• Equipment that cost $12,000 was acquired on November 1 by issuing a 3-month,
10%, $12,000 note payable.
• Office furniture that cost $4,000 was purchased on December 1, with Blue Giant signing a $4,240, 12-month note payable. Interest is included in the note’s face value.
• The company operates in a state that has a 6% sales tax. Sales of merchandise on
account during December amounted to $300,000.
• On the last day of 20X2, Blue Giant borrowed $1 million from Monticello Bank.
The loan’s principal is due in 10 equal annual installments of $100,000 each, with
each installment payable on December 31. The loan has a 9% interest rate.
Instructions
a. Indicate which of the seven transactions and events would appear in the Current
Liability section of the firm’s December 31, 20X2, balance sheet.
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Problems
b. Show how the items in part (a) would be disclosed. Use proper dollar amounts.
c. Indicate how the transactions and events that are not current liabilities would be
handled for accounting purposes.
2.
Current liabilities: entries and disclosure. A review of selected financial activities
of Visconti’s during 20XX disclosed the following:
12/1:
2/10:
12/22:
12/26:
12/31:
12/31:
12/31:
Borrowed $20,000 from the First City Bank by signing a 3- month, 15%
note payable. Interest and principal are due at maturity.
Established a warranty liability for the XY-80, a new product. Sales are
expected to total 1,000 units during the month. Past experience with
similar products indicates that 2% of the units will require repair, with
warranty costs averaging $27 per unit.
Purchased $16,000 of merchandise on account from Oregon Company,
terms 2/10, n/30.
Borrowed $5,000 from First City Bank; signed a $5,120 note payable due
in 60 days.
Repaired six XY-80s during the month at a total cost of $162.
Accrued 3 days of salaries at a total cost of $1,400.
Accrued vacation pay amounting to 6% of December’s $36,000 total wage
and salary expense.
Instructions
a. Prepare journal entries to record the preceding transactions and events.
b. Determine accrued interest as of December 31, 20XX, and prepare the necessary
adjusting entry or entries.
c. Prepare the current liability section of Visconti’s December 31, 20XX balance sheet.
3.
Notes payable. Red Bank Enterprises was involved in the following transactions
during the fiscal year ending October 31:
8/2:
8/20:
9/10:
9/11:
10/10:
10/11:
10/31:
Borrowed $75,000 from the Bank of Kingsville by signing a 120-day note
for $79,000.
Issued a $40,000 note to Harris Motors for the purchase of a $40,000 delivery truck. The note is due in 180 days and carries a 12% interest rate.
Purchased merchandise from Pans Enterprises in the amount of $15,000.
Issued a 30-day, 12% note in settlement of the balance owed.
Issued a $60,000 note to Datatex Equipment in settlement of an overdue
account payable of the same amount. The note is due in 30 days and carries a 14% interest rate.
The note to Paris Enterprises was paid in full.
The note to Datatex Equipment was due today, but insufficient funds
were available for payment. Management authorized the issuance of
a new 20-day, 18% note for $60,700, the maturity value of the original
obligation.
The new note to Datatex Equipment was paid in full.
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Problems
Instructions
a. Prepare journal entries to record the transactions.
b. Prepare adjusting entries on October 31 to record accrued interest.
c. Prepare the Current Liability section of Red Bank’s balance sheet as of October
31. Assume that the Accounts Payable account totals $203,600 on this date.
4.
Payroll journal entries. The following tax rates and payroll information pertain to
the Syracuse operations of IMS Company for November:
Social Security taxes: 6% on the first $55,000 earned
Medicare taxes: 1.5% on the first $130,000 earned
Federal income taxes withheld from wages: $4,400
State income taxes: 6% of gross earnings
Insurance withholdings: 1% of gross earnings
Pension contributions: 2.5% of gross earnings
State unemployment taxes: 5.4% on the first $7,000 earned
Federal unemployment taxes: 0.8% on the first $7,000 earned
Sales staff salaries amounted to $26,000, $3,000 of which is over the unemployment
earnings base but subject to all other appropriate taxes. The company’s branch
manager, Tracy Smith, earned her regular salary of $9,000 during the month.
Instructions
a. Prepare the journal entry to record the November payroll. Smith’s salary is classified as an administrative expense by the company.
b. IMS matches employees’ insurance and pension contributions. Prepare a journal
entry to record the firm’s payroll taxes and other related payroll costs. Assume
that these amounts will be remitted to the proper authorities in December.
c. The owner of IMS asked the firm’s accountant to reclassify all personnel as independent contractors. The accountant explained that such a reclassification would
not be appropriate because, by law, the personnel were considered employees.
Briefly comment on the probable reasoning behind the owner’s request.
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chapter 8
Corporate and Partnership Equity
© Corbis/SuperStock
Learning Goals
waL80144_08_c08_175-196.indd 1
•
Recite the advantages and disadvantages of alternative entity forms.
•
Account for the formation of a sole proprietorship or partnership.
•
Understand concepts related to distributing partnership income.
•
Know the principles related to accounting for the admission/withdrawal of a partner.
•
Account for special corporate equity transactions, including issuance of par value
stock, dividends, treasury stock transactions, and stock splits.
•
Understand and apply principles for reporting of special events that require modification of the income statement.
8/29/12 2:44 PM
CHAPTER 8
Chapter Outline
Chapter Outline
8.1 The Corporation
8.2 The Partnership
8.3 The Sole Proprietorship
8.4 Accounting for Sole Proprietorships and Partnerships
Basic Accounting Considerations
Initial Investments
Income Sharing
New Partners
8.5 Corporate Equity Transactions
Par Value
Cash Dividends
Treasury Stock
Stock Splits and Stock Dividends
Income Reporting
8.6 Corrections of Errors and Changes in an Accounting Method
T
hus far, the examples in this book have relied on an assumption that a corporation
is conducting business. However, not all businesses are structured as corporations.
There is no such requirement; there are indeed many alternatives. Corporations may be
the most familiar because it is usually the entity form that is used to structure larger organizations, the type in which you can easily buy and sell units of ownership (i.e., stock) and
the type in which megabusinesses offers products you routinely buy. However, there are
many alternative ways that a business can be organized.
Broadly speaking, business activity can be conducted through a corporation, partnership,
or sole proprietorship. Within these three broad groupings, there are many subdivisions
such as LLCs (limited liability corporations), LLPs (limited liability partnerships), and
others. You may hear of other terms, such as S corporations (also called Sub-Chapter S
corporations). The finer distinctions are important for legal and tax reasons but don’t significantly alter the accounting principles. Therefore, we focus our analysis of entity differentiation on the broader hierarchy related to corporations, partnerships, and sole proprietorships. At the outset, you should note that our differentiation relates primarily to issues
pertaining to accounting for topics related to owner’s equity. The fundamental accounting
for assets, liabilities, revenues, and expenses is rarely impacted by the choice of entity.
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CHAPTER 8
Section 8.1 The Corporation
8.1 The Corporation
B
ecause we have been using the corporation for our examples, let’s begin by thinking
deeper about its advantages and disadvantages. A corporation is a legal entity having
existence separate and distinct from its stockholders. Corporations exist only in the legal
sense and cannot exist unless specific actions are taken.
However, one does not have to form a corporation to conduct business. Business can also
be conducted via a sole proprietorship or partnership. As you read on, you will quickly find
that one should only use the sole proprietorship or partnership by design, not by accident.
Why would you want to consider forming your business as a corporation? For starters, it
permits otherwise unaffiliated persons to join together in mutual ownership of a business.
Funds can be accumulated and concentrated into one organization. Significant pooling of
resources can occur that might not otherwise be possible. A corporate strategy often might
entail a large amount of risk with highly uncertain outcomes. Probably you are willing
to risk a small amount of your wealth on speculative investments with the potential for
a high payoff, but you are unlikely to bet everything you have. This is often the dilemma
faced by new businesses.
Some ventures are so large that shared ownership is essentially required. Therefore, the
stock of the corporation provides a perfect vehicle for mutual ownership of a business.
Each shareholder can invest at a level that matches his or her wealth and risk tolerance
attributes. An important aspect of the corporate form of organization is that shareholders
are usually only at risk for the amount they invest in the company’s stock. Creditors cannot pursue shareholders for additional claims beyond the shareholder investments.
Most corporations allow shareholders to vote in proportion to their shares, with one vote
per share. This democratic process allows shareholders to participate in corporate governance based on the level of their investment. Shareholders vote on matters set forth in the
bylaws. The voting is usually conducted on a ballot that is termed the proxy.
Another advantage of the corporate form of organization is the relative ease with which
shares of stock can be transferred to another. Stockholders can normally sell their shares to
others or buy more shares without direct involvement by the corporation. Transferability
of ownership makes stock a relatively liquid asset to its holder. Further, companies can
often access additional capital by issuing more shares to current and new shareholders.
In some cases, a company may go public, meaning that it lists it shares on one of the
popular stock exchanges, such as the New York Stock Exchange (NYSE) or the National
Association of Securities Dealers Automated Quotation (NASDAQ) system. An
initial public offering (IPO) of shares is an exciting (and costly) decision, and is sometimes accompanied by so-called road shows and various other promotions designed to market the offering. Road shows are company-sponsored events where corporate executives
present their business case in the hopes of developing interests among potential investors.
A corporation is presumed to have a perpetual existence. Changes in stock ownership
do not cause operations to cease. The death of a shareholder does not bring about a need
to dissolve the company. Instead, the beneficiaries of the estate of the deceased become
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Section 8.1 The Corporation
new owners. A corporation will continue to exist and operate until it is merged in with
another, fails, or a corporate action is undertaken to liquidate the company. When the latter happens, all bills must be paid, and common shareholders are entitled to final distributions of any residual funds in proportion to shares held.
Perhaps one of the most significant advantages of a corporation, especially when compared to partnerships and sole proprietorships, is the feature of limited liability. The
liability of stockholders is normally limited to the amount of their investment. Stockholders are not personally liable for debts and losses of the company, except to the extent of
their investment, or any additional guarantee of corporate debt. However, you should
be aware that a corporate entity is not a perfect shield against all liability. If affairs of the
shareholders are comingled with the corporation or there is malfeasance by shareholders/
officers, a lawsuit may be filed by damaged parties against the shareholder or officer. It is
not always possible to avoid these types of claims, but taking care to meet good legal and
accounting practices is a good start. This underscores the need for you to be well versed
in proper accounting procedures and internal controls in managing your own businesses
and investments.
The preceding advantages may lead you to believe that the corporation is an ideal legal
structure for a business. However, there are some big disadvantages. Corporations are
frequently taxable entities—that is, their income is taxed. This is a big problem because it
can result in double taxation on income. The company pays tax on its income, and then
shareholders again may pay tax on this same income when it is distributed to them in the
form of taxable dividends. Thus, it is not uncommon for over half of a corporation’s earnings to be taxed away prior to being available to shareholders for their own use.
To illustrate this effect, assume that Mega Corporation earned $100,000,000 before tax.
Assuming a 35% tax rate, the remaining income after tax would be $65,000,000. If that
entire amount was distributed to shareholders in a taxable transaction and assuming
shareholders were subject to an average 40% tax rate, then an additional $26,000,000 of
tax would be paid ($65,000,000 3 40%). Of the $100,000,000 in pretax income, shareholders would only realize $39,000,000 ($100,000,000 2 $35,000,000 2 $26,000,000).
There are planning vehicles to limit the double-taxation impacts, and various tax rules
are occasionally adjusted to provide some relief, but this disadvantage cannot be wholly
avoided. A good tax accountant should be consulted in finding the right corporate strategy, lest the effects can mitigate much of the profit motive associated with the initial business objective.
Corporations also suffer under the weight and cost of added regulatory oversight, especially when the stock is publicly traded. Agencies such as the Securities and Exchange
Commission (SEC) impose stringent reporting guidelines, including mandatory and
expensive audits. Additional rules require companies to have strong internal controls and
ethical training. The financial statements must also be certified by senior officers who
do so under the risk of prosecution for perjury. To be sure, if you were an officer being
required to sign such documents, you would undoubtedly expend ample funds to ensure
that the statements were reliable. Suffice it to say, the cumulative cost of meeting regulatory stipulations is high.
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Section 8.2 The Partnership
8.2 The Partnership
A
partnership is another form of business organization that brings together multiple
parties. The specific definition of a partnership is an association of two or more persons to carry on a business for profit as co-owners. However, in some ways, this also
seems to describe a corporation. What is it that uniquely pertains to a partnership and sets
it apart from a corporation?
For starters, a partnership is not a separate legal entity. It is an association of persons. Partnerships are formed quite easily, without the necessity of any specific legal action. Indeed,
by default, the mere joining together of persons for a profit-oriented business purpose is a
partnership, unless some alternative action is undertaken to set up a corporation (or other
entity type, such as a joint-venture agreement). This feature does not preclude formalizing a partnership agreement via a written document. As you will soon see, preparation of
such documentation, though not a legal requirement, is a good practice. Without such an
agreement, the partnership’s governance, profit sharing, and the like will be established
by standard practices set forth in statute and case law history. The results at times can be
surprising. Thus, it is highly recommended that partnerships agreements be reduced to a
written agreement. This written agreement is sometimes termed the articles of partnership,
but it is generally not necessary to notify regulatory authorities about the terms or existence of the partnership (except as it relates to tax-reporting issues).
You need to recognize the significant attributes of a partnership. First is the principle of
mutual agency. This means that any individual partner has a right to commit or obligate
the entire partnership. It is not possible for one partner to disavow the actions of another
partner that were taken on behalf of the partnership. This can be a scary proposition.
When you enter a partnership, you are bound to honor every contract or debt it undertakes, whether you were consulted or agree.
As an extension of the concept of mutual agency, you also need to know that all property and income of a partnership is held under co-ownership unless there is a specific
agreement calling for an alternative outcome. Technically, the partners own everything
in equal proportion and are each entitled to an equal share of income and distributions
from the partnership. This feature should not be overlooked. When one or more partners
contribute tangible assets to the partnership, they forgo their specific interest in the assets
in exchange for a mutual interest in the business. They are not entitled to a return of those
specific assets if the partnership liquidates. Instead, they are only entitled to a monetary
distribution equivalent of their measured share of total capital.
As the partnership generates profits, each partner accrues an equal share of benefit,
regardless of their capital contribution and work effort. This is huge. Rarely will all partners contribute equal amounts of capital and effort. Thus, a written partnership agreement that modifies this standard provision is paramount to maintenance of equitable outcomes. Written agreements typically include specific provisions related to how income is
to be shared, how distributions will occur, and so forth. But without such an agreement,
the one-for-all, all-for-one rule of co-ownership is generally deemed to be the appropriate
outcome. Perhaps you can begin to see why a partnership, despite its ease of formation,
has certain disadvantages. There are, however, additional problems to consider.
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Section 8.2 The Partnership
Unlike a corporation, a partnership has a limited life. In other words, the partnership
passes with the death of a partner, and the partnership is legally dissolved. A new one may
be immediately formed; written agreements usually make provisions for the dissolution
and reformation upon the death of a partner. At other times, where a deceased partner
was crucial to business operations, the dissolution may also trigger a cessation of business
operations and formal liquidation of the entity. Clearly, this complicating feature is yet
another limitation on the desirability of doing business as a partnership.
In the strictest technical sense, the concept of partnership dissolution occurs each time
a new partner joins (or a prior partner leaves) the partnership. This does not mean that
operations cease; it simply means that a new partnership is formed. Dissolutions may be
relatively invisible from the perspective of clients and suppliers to a partnership, but it
does trigger unique internal accounting aspects to which you will soon be exposed.
Perhaps some of the unique partnership attributes are sufficient to give you pause as it
relates to being involved in a partnership. If not, perhaps the next aspect will. Partners
in a partnership have personal unlimited liability for the debts, claims, and obligations
of the partnership. Each partner is individually liable; one cannot simply resign from the
partnership in an effort to escape his or her share of responsibility. This characteristic is
directly attributable to the fact that a partnership is not a separate legal entity. Unlimited
liability makes a partner’s personal assets at risk to seizure for satisfaction of obligations
of the partnership.
Historically, unlimited liability has been a severe limitation to the partnership form of organization and has posed vexing problems for medical practices, law firms, and accounting
groups. Many professional service firms have not been able to organize as corporations
because of licensing issues that attach to individuals and not businesses (e.g., only an individual, not a business, can get a CPA designation). Thus, professional service firms traditionally formed up as partnerships. But, the increase in litigation exposure has caused
many to back away from consideration of alignment in a partnership. To remedy this
problem, many states now also recognize limited liability partnerships (LLP). This form of
entity provides that only firm assets may be used to satisfy claims against an LLP. Therefore, the personal assets of individual partners are afforded some degree of protection.
At this juncture you may be wondering why anyone would wish to join a partnership.
Despite its shortcomings, the partnership form of organization does have some compelling advantages. Recall that the business is easily formed. Indeed, if more than one person is involved in a business for profit, the partnership is deemed to be the default form
of organization. The ease of formation is a double-edged sword. Although it is a simple
process, it also opens up the partners to the challenges already identified. Basically, one
should make business choices by reason, not default. This underscores why understanding the strengths and weaknesses of the partnership form of organizations is so important.
Partnerships also benefit from their intrinsic agility. Because partners can act on behalf of
the partnership, they can behave with operating flexibility and streamlined decision processes. This can enable rapid action in response to new business opportunities.
In closing, one should not overlook one of the most compelling benefits of a partnership. Partnerships are not subject to tax on their income. Instead, each partner’s share of
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Section 8.3 The Sole Proprietorship
the income, whether distributed or not, is taxed to the partners. This avoids the doubletaxation problem that is associated with most corporate entities, as illustrated earlier.
Legally avoiding taxes is a huge business advantage, and can trump the other concerns
that persons may have about forming a partnership. As an important point of information, do not confuse the lack of being taxable with the lack of filing a tax return. A partnership must calculate and report its income to the government and partners, but this is an
informational process intended to alert interested parties about the amount of income that
partners are expected to pay tax on.
8.3 The Sole Proprietorship
I
n simple terms, you can think of a sole proprietorship as a one-person partnership. It is
not a partnership, but the legal and technical requirements operate in much the same
way. No specific legal action is necessary to start the business, although there are a number
of good practices. For instance, if an individual began doing business under an “assumed
name” such as Jan’s All Seasons Lodge, she would likely want to file an assumed-named
certificate, register an appropriate Internet site, notify licensing and tax agencies, and so
forth. However, she does not need specific authorization to create an entity. Indeed, she is
the entity. When doing business under an assumed name, procurement of the assumedname certification is a very good business practice. This provides protection against other
persons “copying” your business identity and is often required to conduct banking and
other similar transactions. In many states, obtaining an assumed-name certificate is easily done through a county clerk’s office, takes only a few minutes, and requires paying a
small fee.
Sole proprietors are obviously responsible for their debts. If the business fails, the business owner cannot just apologize and tell creditors the business no longer exists. Governance issues are nonexistent, for perhaps rather obvious reasons. There are no partners or
shareholders; thus, sole proprietors answer only to themselves.
Sole proprietorships do not file separate tax returns. Owners will prepare a schedule
detailing the business income and include this schedule with their tax return. You probably work in a job where you receive salary and wages, and you likely understand how
these amounts are reported in your own tax return. In similar fashion, a sole proprietorship’s income is captured as a taxable component in an individual’s income tax return. The
business income of a sole proprietorship is subject to not only income tax but also many of
the payroll taxes discussed in Chapter 7. Social Security and Medicare taxes are twice the
amount imposed directly on employees because the sole proprietor must assume obligation for both the employee and employer components of the tax.
Despite the merging of personal and business income for tax purposes, there is still a full
expectation that a sole proprietorship will maintain appropriate business records. Only
certain expenses that are ordinary and necessary for the conduct of the business can be
deducted from the business’s revenues. You cannot subtract your personal living costs
from business income in determining how much taxable income you have derived from
your business. Thus, appropriate segregation of personal and business affairs is a must,
and good business accounting practices are to be followed for a sole proprietorship.
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Table 8.1 highlights the key features of various forms of business organization. The features and observations are broad generalizations but provide a frame of reference to consider when selecting an entity structure.
Table 8.1: Features of various business organizations
Sole Proprietorship
Partnership
Corporation
Ease of formation
Yes
Yes
No
Multiple owners
No
Yes
Yes
Transferability
Not easily done
Not easily done
Easily done
Double taxation
No
No
Yes
Liability protection
No
No
Yes
Separate tax return
No
Yes
Yes
Operating agility
High
Medium
Depends on number
of stockholders
Perpetual life
No
No
Yes
Degree of regulation
Low
Medium
High
8.4 Accounting for Sole Proprietorships and Partnerships
Y
ou have discovered that sole proprietorships and partnerships are easily formed
and by similar actions. Remember, you can think of a sole proprietorship like a onemember partnership. Thus, the basic accounting for formation and most subsequent
actions is handled in a virtually identical fashion. A key distinction is that a partnership
has multiple capital accounts (one for each partner) representing a subdivision of total
equity. This division is unnecessary with a sole proprietorship. Another unique facet is
that unique accounting issues can arise when partners join/leave a partnership, and no
equivalent counterpart issue exists for a sole proprietorship. Otherwise, it is safe to say
that if you understand partnership accounting, you also understand accounting for a sole
proprietorship. The following discussion focuses on the more complex partnership issues,
with additional notes on modifications that are necessary for a sole proprietorship.
Basic Accounting Considerations
Recall that the choice of the entity rarely impacts the accounting for assets, liabilities,
revenues, and expenses. Our focus is on key differences in equity accounting. You know
that a corporation’s equity is subdivided into contributed capital (capital stock-related
accounts) and retained earnings (the lifetime result of income less dividends). Partnerships and sole proprietorships divide equity in an entirely different fashion. They report a
capital account for each owner. Each capital account reflects the net balance of the owner’s
investments and share of net income, reduced for withdrawals. Consider the three equity
sections for a corporation, partnership, and sole proprietorship, respectively in Table 8.2.
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Section 8.4 Accounting for Sole Proprietorships and Partnerships
Table 8.2: Equity sections for a corporation, partnership, and sole proprietorship
Stockholders’ Equity
Capital Stock
$ 100,000
Retained Earnings
900,000
Total Stockholders’ Equity
$1,000,000
Partnership’s Equity
Owner Capital, Partner A
$ 400,000
Owner Capital, Partner B
300,000
Owner Capital, Partner C
300,000
Total Partners’ Equity
$1,000,000
Sole proprietorship’s Equity
Owner’s Capital
$1,000,000
Initial Investments
A partnership’s or sole proprietorship’s initial activity usually begins when an owner
transfers personal assets (e.g., cash or tangible assets) to the business. The following journal entry shows the recording of unequal cash investments by three separate partners:
1-1-X6
Cash
25,000.00
Owner Capital, Anson
12,000.00
Owner Capital, Ortiz
8,000.00
Owner Capital, Payne
5,000.00
To record initial capital investments by Anson, Ortiz, and Payne
In the event of liquidation, each partner’s final cash settlement will be for the balance of
his or her capital account (after bringing all accounts and activities current). This explains
the justification for correctly recording each partner’s capital contribution at the correct
amount. To do otherwise would set in motion a capital account that is forever out of sync
with contributions. Importantly, the capital account proportion does not necessarily correspond to the income share; Anson, Ortiz, and Payne may have agreed to share profits
and losses equally (or in any other proportion) despite their unequal capital investments.
Assume the preceding scenario is modified slightly such that Anson invested land rather
than cash. Assume that the land originally cost Anson $4,000, but the partners all agreed it
was worth $12,000 on the day Anson contributed it to the partnership. Under the revised
scenario, the following entry is appropriate:
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1-1-X6
Cash
13,000.00
Land
12,000.00
Owner Capital, Anson
12,000.00
Owner Capital, Ortiz
8,000.00
Owner Capital, Payne
5,000.00
To record initial capital investments by Anson, Ortiz, and Payne
By reviewing this entry you can clearly see that the $4,000 land cost has become irrelevant,
reflecting the general rule that each partner’s contribution should be measured on the
partnership books at its fair value on the date of contribution. Failure to follow this general rule will inadvertently result in an eventual nonreciprocal transfer of wealth between
the partners.
If Anson’s land was subject to a $3,000 note payable and the partnership assumed the
obligation to make payments, Anson’s Capital account would be reduced, and the partnership accounts would take on the debt, as follows:
1-1-X6
Cash
13,000.00
Land
12,000.00
Note Payable
3,000.00
Owner Capital, Anson
9,000.00
Owner Capital, Ortiz
8,000.00
Owner Capital, Payne
5,000.00
To record initial capital investments by Anson, Ortiz, and Payne
Income Sharing
Earlier, it was noted that in the absence of a specific profit-and-loss sharing agreement,
income is simply shared equally between the partners. This approach would be fair and
logical if all partners contributed equal amounts of capital and time, but such is rarely the
case. Partnership agreements usually stipulate a model for splitting income. The models
can be become complex but tend to reflect provisions designed to compensate parties for
invested capital, time, and other variables that are seen as driving results.
To begin, recognize that partnership income is defined as the excess of revenues over
expenses, excluding those expenses related to the income-sharing agreement. In other
words, the profit-sharing agreement may designate that each partner is entitled to interest
equal to 5% of their invested capital and salary based on hours dedicated to the business.
Although interest and salaries are usually regarded as expenses in calculating income,
such is not the case when the interest and salary clauses are defined pursuant to a model
for sharing income. The interest and salary provisions are just mathematical tools for equitable distribution of income.
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Partnership agreements need to be sufficiently specific to address what happens in the
event that profits exceed the contemplated interest and salary provisions or if the firm
experiences a loss. There are numerous scenarios and no standard outcome—thus the
necessity for a carefully designed agreement.
To illustrate, assume that Anson, Ortiz, and Payne agreed that their partnership profits
would be shared as follows:
1. Each partner receives an interest provision equal to 10% of invested capital.
2. Anson will receive an annual salary share of $25,000, and Payne will receive
$40,000. Ortiz is not active in the business and does not receive a salary.
3. Remaining profits are to be shared on a 4:4:2 ratio.
If the firm’s first-year income totaled $100,000, before salary and interest, then it would be
shared among the partners as Table 8.3 shows.
Table 8.3: Income sharing in the Anson, Ortiz, and Payne partnership
Interest (10%)
Salary
Subtotal
Residual (4:4:2)
Total
Anson
$ 900
Ortiz
$ 800
Payne
$ 500
Total
$ 2,200
25,000
0
40,000
65,000
800
$40,500
$ 67,200
13,120
13,120
6,560
32,800
$39,020
$13,920
$47,060
$100,000
$25,900
$
The amount of income attributed to each partner does not necessarily equate to a withdrawal. Instead, it reflects the amount that should be credited to the partner’s capital
account, as per the following entry that closes the 20X6 Income Summary account:
12-31-X6
Income Summary
100,000.00
Owner Capital, Anson
39,020.00
Owner Capital, Ortiz
13,920.00
Owner Capital, Payne
47,060.00
To close Income Summary to capital accounts of Anson, Ortiz, and Payne
This entry should appear at least reasonably familiar to you. In this entry, the Income
Summary reflects the net summation of all revenues and expenses. It is otherwise very
similar to the closing entry that was introduced in Chapter 3, except that the credits are
to individual partner capital accounts rather than Retained Earnings. If any partner withdraws cash from the business corresponding to all or part of her or his income share, the
following entry would be needed:
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12-31-X6
Owner Capital, Payne
10,000.00
Cash
10,000.00
Payne elected to withdraw $10,000 from the partnership
As an alternative, some partnerships may debit individual Drawing accounts for each
partner, but they are eventually closed against the partner’s capital account. Thus, the
net effect is as shown. The primary advantage of using separate Drawing accounts is that
it shows an accumulated amount of total withdrawals for a period. That information is
sometimes needed to monitor compliance with partnership agreement provisions and
tax-reporting issues.
New Partners
From time to time, a new person may join the partnership. If the business is prosperous, it is reasonable to expect that the new partner will be required to buy his or her
interest. There are exceptions, such as when the new partner is bringing an extraordinary
reputation (e.g., perhaps you have seen a car dealership sporting the name of a famous
sports figure), in which case he or she might be admitted into the partnership without any
investment. However, when the new partner is buying his or her way into the business,
the payment can flow to an existing partner or the partnership itself. The accounting treatment varies based on the nature of the purchase.
When an entering partner purchases his or her interest from another partner, the assets
and liabilities of the firm remain constant. A journal entry is only needed to reduce the
selling partner’s Capital account and increases the new partner’s Capital account.
1-1-X7
Owner Capital, Payne
21,030.00
Owner Capital, Zhu
21,030.00
Payne sold half of her interest to a new partner Zhu, for an undisclosed amount
There are several points to note about this entry. First, Payne sold one half of her interest.
Thus, one half of her capital account must be transferred to the new partner, Zhu. Payne’s
total Capital account before the transfer was $42,060 ($5,000 initial investment 1 $47,060 of
income 2 $10,000 of withdrawals). It does not matter how much Zhu paid for the one-half
interest (i.e., it could have been more or less than $21,030) because the money did not flow
to the partnership. Payne might have a personal gain or loss, based on the sale price, but
that fact does not bear on the partnership accounts. Finally, this transaction likely required
approval from the other partners. Because partnerships are based on a theory of mutual
agency, each partner normally preserves a right of input on the admission of a new member.
If Zhu had instead invested directly in the partnership, the accounting can become more
involved. A number of scenarios and the accounting go well beyond the scope of this text.
However, to illustrate one case, assume that Zhu purchased a 20% stake by transferring
$100,000 cash directly into the firm. The partnership’s cash account must be increased by
$100,000, as will the total equity. However Zhu’s share of total equity is only 20%. After
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considering Zhu’s injection, the firm’s total equity is $212,000 ($22,000 original capital
$100,000 of income 2 $10,000 of withdrawals $100,000 new investment), and Zhu’s
share is $42,400 ($212,000 3 20%). What becomes of the difference between Zhu’s $100,000
injection and $42,400 capital share? This $57,600 amount is said to be a bonus to existing
partners. It reflects the value they have added to the partnership share that is now transferred to Zhu. Assuming that the partnership agreement stipulated that bonuses were to
be shared in a 4:4:2 ratio, the following entry would be needed to record Zhu’s admission:
1-1-X7
Cash
100,000.00
Owner Capital, Anson
23,040.00
Owner Capital, Ortiz
23,040.00
Owner Capital, Payne
11,520.00
Owner Capital, Zhu
42,400.00
To record admission of Zhu, with a bonus to existing partners
Although not illustrated here, similar issues arise when an existing partner leaves the
partnership. The existing partners or the partnership itself might buy out the leaving partner. The amount paid could reflect a price that is different from the reported amount of
equity, and a transfer between capital accounts might be needed to maintain appropriately measured equity values.
8.5 Corporate Equity Transactions
T
o this point, we have assumed a fairly simple corporate structure. The equity section
has consisted of capital stock and retained earnings. However, corporate entities may
not be so simple. For starters, companies may have more than one type of stock.
The unique attributes for each type of stock are customized to meet the capital needs of
the company while trying to appeal to a spectrum of investor demands. Many companies will have only common stock, but other companies expand their equity financing to
include other types such as preferred stock. Expanded forms of equity and debt financing
will be covered in ACC 206. For now, be aware that alternative types of stock may have
different features pertaining to voting rights, dividends, and liquidation preferences.
For example, each share of common stock usually has one vote that can be cast toward
the election of a board of directors. Preferred stock usually lacks voting rights. Preferred
stock usually gets a fixed amount of dividend each period but does not get to participate
in excess profits that might be earned. In the event of liquidation, it is customary that preferred shares receive back a liquidation value prior to any amounts being paid to common
stock. The common stock is the residual interest, standing to receive the highest returns
from significant business success or to sustain the most loss from business failure.
Even the accounting for common stock can introduce general issues beyond those previously discussed. The next few paragraphs covers additional accounting aspects related to
common stock. These topics include par value, dividends, treasury stock, stock splits, and
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stock dividends. Even if you do not intend to be an accountant, this information should
prove interesting and informative; you are likely to invest in stocks occasionally, and this
knowledge will be help you understand more about your investments.
Par Value
Recall that states authorize the creation of corporations. Within enabling statutes is often a
provision requiring newly formed corporations to designate a par value per share (or an
alternative called stated value). Par value sets the legal capital of the firm, which is intended
to represent the minimum amount of initial capital that investors are theoretically obliged
to invest. Par value is usually set at a nominal amount (e.g., $.01 per share), and the actual
issue price is typically well above par. Thus, par value is really just a legal formality in
most cases. However, it does impact required reporting. The generally accepted accounting principles (GAAP) require companies to detail the legal capital of the firm, separate
and apart from amounts of investments exceeding par. This fact requires accountants to
expand the journal entry that is required when stock is issued. Assume that Spice Corporation issued 1,000,000 shares of $1 par value stock for $5 per share. The entry to record
this stock issuance would be:
5-15-X1
Cash
5,000,000.00
Common Stock
1,000,000.00
Paid-in Capital in Excess of Par
4,000,000.00
To issue 1,000,000 shares of $1 par value stock for $5 per share
In reviewing the preceding entry, specifically note the new account, Paid-in-Capital in
Excess of Par. This effectively separates invested capital into two components, both of
which must be prominently displayed within stockholders’ equity.
Cash Dividends
Dividends are distributions to shareholders. Dividends are usually in form of direct
cash payments and are intended to encourage and reward shareholders. They generally
reflect profitable operations over time and reflect a return on the shareholder’s investment. Dividends on common stock are not mandatory. Shareholders benefit from dividends, but they can also benefit when the corporation instead decides to reinvest in new
opportunities. Thus, even profitable companies may decide that dividends are not the
best use of resources.
When a board of directors does decide to pay a dividend, several events transpire. The
first event is a declaration of the dividend. The declaration states the intent to pay a dividend and sets forth a legal duty to pay. The following entry is usually recorded at the time
of dividend declaration:
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8-10-X2
Dividends
500,000.00
Dividends Payable
500,000.00
To record declaration of $0.50 per share dividend on 1,000,000 outstanding shares of
common stock
The declaration statement also needs to set forth other important information. Specifically,
shareholders need to know the date of record and date of payment. The date of payment
is self-explanatory. The following entry would occur on the date of payment:
10-10-X2
Dividends Payable
500,000.00
Cash
500,000.00
To record payment of previously declared dividends
The date of record precedes the payment date and establishes a cutoff point for determining
which shareholders are to receive the dividend on the payment date. As a practical matter,
the record date is preceded by a few days by an ex-dividend date. A stock is said to trade
ex-dividend when the stock’s seller retains the right to previously declared dividends. In
other words, the stock is trading without a right to the dividend. This time lag allows for
shareholder records to be updated. Very simply, stockholders on the ex-dividend date will
receive the dividends; if some of those holders subsequently sell their shares before the
dividend payment date, they will nonetheless be entitled to the dividend payment.
Treasury Stock
When a company’s stock price is viewed as being too low and a company has sufficient
cash, the board of directors may authorize that the company itself to reacquire some of
the previously issued shares. This effort is seen as supporting the stock price and enhancing value for shareholders who choose not to sell their stock back to the company. Such
reacquired shares are termed treasury stock. Other reasons for buying back stock are to
lessen the risk of takeover by another (returning cash to shareholders via stock buyback
can reduce the attractiveness of a company to others) or to obtain shares that are needed
for stock compensation awards to employees.
Accounting rules for treasury stock treat the transactions as purely equity in nature. Gains
and losses are not recorded when a company issues stock, nor are they recorded for treasury stock transactions. Thus, one acceptable journal entry to record the purchase of treasury stock is as follows:
7-7-X7
Treasury Stock
300,000.00
Cash
300,000.00
To record purchase of 10,000 treasury shares at $30 per share
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Under the approach shown, the Treasury Stock account reflects the cost of all shares
reacquired. It is reported as a Contra Equity account and results in a difference in the
reported number of shares issued versus those outstanding (i.e., issued minus shares held
in treasury). If treasury shares are subsequently reissued, Cash would be increased for the
amount received, and Treasury Stock would be reduced for the cost of the shares; any difference may be debited or credited to Paid-in Capital in Excess of Par.
Stock Splits and Stock Dividends
Another unique set of corporate transactions relates to stock splits and stock dividends.
These events result in a change in the shares outstanding, without any resource inflow to
the company or change in total stockholders’ equity. For instance, a company may arrange
for a 3:1 stock split. This triples the number of shares outstanding (and reduces the pershare par value into a third of the prior amount). Shareholders will hold three times as
many shares but experience no increase in their proportional ownership (a shareholder
owning 100 shares out of a total of 100,000 would become the owner of 300 shares out of
a total of 300,000). The market value per share would likely be reduced to about one third
of the value prior to the split. Of course, stock splits can come in any ratio (2:1, 4:3, etc.).
Indeed, companies may also engage in a reverse split (2:3, 1:5, etc.). These reverse splits
reduce the number of shares and increase the market value per share.
The reasons typically cited for stock splits are to impact the market price per share and
change the number of shares outstanding. A company may do a reverse split to reduce
the number of shares and increase the value per share. Some stock exchanges require that
stocks trade above $1 per share, and the reverse split is a tool to accomplish this purpose.
Conversely, stocks that have appreciated significantly (into the hundreds of dollars per
share) may be seen as too pricey by some investors. The stock split will reduce share price
to what may seem to be a more attractive price point and increase the shares outstanding,
thereby opening up investment to a broader group of shareholders. In the final analysis,
a stock split is mostly cosmetic because it does not change the underlying economics of
the firm.
The accounting for a stock split is easy. Because the total par value of all shares outstanding is not affected by a stock split (i.e., number of shares times par value per share is the
same amount before and after the split), no journal entry is needed. Recall that total equity
is not changed, and no specific account balance total within equity is changed. Thus, all
that is necessary is a notation of the new par value and number of shares.
As a practical matter, stock dividends are much like stock splits but are carried out in a
different legal form and require a unique entry. A stock dividend results in an increase in
shares outstanding via an issuance of more shares to existing shareholders. For instance, a
10% stock dividend would result in the issuance of 10 additional shares to a shareholder
holding 100 shares. All shareholders would have 10% more shares, so the percentage of
the total outstanding stock owned by a specific shareholder is not increased. The difference between a stock split and stock dividend is that a stock dividend does not result in a
change in per-share par value. Instead, the Retained Earnings account is reduced for the
fair value of the additional shares issued. The offset is reflected as an increase in Common
stock and Paid-in Capital in Excess of Par. Consider the following entry:
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10-15-X5
Retained Earnings
1,500,000.00
Common Stock
100,000.00
Paid-in Capital in Excess of Par
1,400,000.00
To record issuance of 10% stock dividend, assuming 1,000,000 shares of $1 par value
stock previously outstanding and having a market value of $15 per share (1,000,000
10% $15 $1,500,000)
The above entry must be modified for large stock dividends, generally regarded as those
above 20 to 25%. Instead, only the par value of the newly issued shares is capitalized (i.e.,
debit Retained Earnings for par of new shares and credit only Common Stock). To illustrate, assume that a company issues a 40% stock dividend:
10-15-X5
Retained Earnings
400,000.00
Common Stock
400,000.00
To record issuance of 40% stock dividend, assuming 1,000,000 shares of $1 par value
stock previously outstanding and having a market value of $15 per share
In the above entry, 400,000 new shares of $1 par value stock are issued (1,000,000 3 40%).
The journal entry reflects that the Retained Earnings account is reduced only by the par
of the newly issued shares. The market value is ignored for large stock dividends. The
accounting rule differentiating between treatment of small and large stock dividends is
ostensibly based on the logic that a large stock dividend will cause a material decline in
per-share stock price, thus rendering the market value unreliable as a basis for recording
the journal entry.
Income Reporting
Within the exception of certain equity-related transactions (such as dividends, treasury
stock transactions, etc.), virtually all transactions that result in a change in equity are channeled through the income statement. However, accountants sometimes wish to call special
attention to special or nonrecurring items. For example, a business may experience a gain
or loss that results from an event that is both unusual in nature and infrequent in occurrence (e.g., an earthquake in a region regarded as having stable geology). Such events are
said to be extraordinary items. When both conditions are met (unusual in nature and
infrequent in occurrence), the item is separately reported, including its tax consequences,
following income from continuing operations. Exhibit 8.1 is a presentation of an income
statement including an extraordinary item.
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Exhibit 8.1: A
n income statement that includes an
extraordinary item
Braxton Corporation
Income Statement
For the Year Ending December 31, 20X2
Sales
Cost of goods sold
Gross profit
Operating expenses
$ 36,300,000
9,900,000
$ 26,400,000
Salaries
Rent
Other operating expenses
Income from continuing operations before income taxes
Income taxes
Income from continuing operations
Extraordinary item
$ 1,905,000
405,000
900,000
Uninsured loss from earthquake at corporate office
Income tax benefit from loss
Extraordinary loss net of tax
Net Income
$ 1,800,000
93,143
3,210,000
$ 23,190,000
1,200,000
$ 21,990,000
1,706,857
$ 20,283,143
Another situation in which the income statement is modified is for discontinued operations. The presentation would appear virtually identical to that shown for Braxton Corporation, except that the extraordinary item section would instead reflect the gain or loss
(net of tax) on disposal of the line of business. Reporting of a discontinued segment is
triggered when a separate major line of business is sold or abandoned. The income reporting model is intended to segregate discontinued operations from continuing operations.
Thus, the discontinued operations section would reflect the results of operating the discontinued segment as well as any gain or loss on its sale. Exhibit 8.2 is an example of the
reporting of a discontinued operation by Saxton Corporation. Saxton was engaged in food
and clothing businesses, and recently exited the clothing business.
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Section 8.6 Corrections of Errors and Changes in an Accounting Method
Exhibit 8.2: A
n income statement that includes
discontinued operations
Saxton Corporation
Income Statement
For the Year Ending December 31, 20X7
$ 24,200,000
6,600,000
$17,600,000
Sales
Cost of goods sold
Gross profit
Operating expenses
Salaries
Rent
Other operating expenses
Income from continuing operations before income taxes
Income taxes
Income from continuing operations
Discontinued operations
$ 1,270,000
270,000
600,000
Loss fr...
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