Relation between the Corporation and Its Owners.—It should be noted that the owners of a corporation are on a somewhat different basis in their relationships and activities to the business than are the owners of a partnership or single proprietorship business. The legal theory that the corporation is an entity, a person, separate and apart from its owners, necessitates a change in the status of accounts with owners as compared with similar accounts in the other types of organization. A charge against a stockholder as a customer of the corporation is on the same basis as a charge against any other customer. A stockholder may become a creditor of the corporation in exactly the same way as any other person. In a partnership, on the other hand, charges against a partner and credits to his account are looked upon as charges against and credits to his proprietary interest in the event of liquidation of the firm. This is not true in the case of a corporation, stockholders in such dealings being considered “outside” parties.

Current Record on Corporation Books.—After the corporation has been organized and the opening entries made on its books, the record of current transactions proceeds on practically the same basis as in all other types of business organization. Sales, purchases, cash receipts and disbursements, notes receivable and payable, and all the transactions arising out of them, are recorded currently in the same types of books and in the same manner as the similar transactions of a single proprietorship or a partnership.

While the record of current transactions is practically the same for all types of business organizations, there are some kinds of current transactions of a corporation which differ somewhat from those of the other types. They arise out of the nature of the corporation and are recorded under account titles peculiar to the corporate form. Some of these transactions and other accounting records will be discussed briefly.

Treasury Stock.—In some classes of enterprise and also under some methods of organizing and financing the corporation, no provision is made for the securing of a fund of working capital, all of the original capital being tied up in fixed assets—as a mine or some other plant. A similar condition is sometimes encountered even after a corporation has been operating for a number of years. Lack of business judgment and financial foresight sometimes brings about a condition in which the company has allowed an undue proportion of its current assets, and therefore its working capital, to become tied up in plant extensions.

In both such cases a frequent method of raising working capital is for the stockholders to donate to the corporation a pro rata portion of their holdings of stock to enable it to secure the needed working capital by selling the stock. When such stock comes back into the company’s treasury, it is termed “treasury stock.” Having once been issued and presumably fully paid for, it has this characteristic which does not attach to the original shares before their issue, viz., that it can be sold at a discount without the purchasers being liable to creditors, in case of bankruptcy, for the amount of the discount. Par-value stock which is originally sold at a discount or which is being sold on the instalment plan and has not therefore been paid for in full is subject to levy for the unpaid amount in the event of bankruptcy of the corporation. Thus, the man who buys a $100 share of original stock for $90, is subject to a $10 levy in the event that the assets of the corporation are not sufficient to pay its debts.

Accordingly, in financing highly speculative ventures such as mining, oil, and other similar companies, it is customary to issue the entire capital stock of the company to the owner or owners of the mining or oil property taken over by the corporation as the basis for its operations. Inasmuch as the value of the properties taken over is not determinable, it is usually impossible to show that the stock issued for them does not represent their true value. Accordingly, such stock is legally fully paid stock and not subject to the liability for additional assessment which attaches to stock sold at a discount. Working capital is provided through the donation of a portion of the capital stock to the treasury of the corporation, which is then in a position to sell to others the stock now fully paid and non-assessable. It is easier to find purchasers for this stock because it can be sold at whatever discount is necessary to dispose of it and carries with it no liability for future assessment.

Treasury stock may arise also through repurchase by the company. It may sometimes be desirable for a company to buy back some of its own stock. This is not allowed in all states but where allowed such stock repurchased becomes treasury stock.

The student should distinguish carefully between treasury stock and unissued stock.

Accounting for Treasury Stock.—The record of treasury stock transactions is not complicated. They are discussed under three heads as follows:

1. Record at Time of Acquisition. Only the acquisition through donation will be explained here. Acquisition through purchase usually involves an adjustment of purchase price to par value and the vexed problem of valuation. This problem will be found discussed on page 18, Volume II.

Assume that a company has issued all its capital stock, $1,000,000 in amount, for the acquisition of a mining property, and that the shareholders donate to the treasury $400,000 of the stock to provide working capital. This stock donation will be recorded on the books as follows:

Like any other gift, this gift of stock in theory creates additional capital and must therefore be recorded in a proprietorship account. The title “Donated Surplus” is used to indicate the source of this additional capital. Capital arising from this source should never be recorded in the general Surplus account, largely because of its problematical value but also because of the information which it gives concerning the financing of the company by making a separate record.

2. Record at Time of Sale. Assume that $250,000 of the treasury stock is sold at 50. Inasmuch as the stock was brought on the books at par, the portion sold must be taken off at the same figure. The 50% discount, instead of being recorded in a Capital Stock Discount account, will be recorded as a charge against the Donated Surplus, thus adjusting a portion of this donated surplus, recorded originally at par value, to its realizable value. The following entry records the sale and adjustment:

The student should understand that the customary procedure of opening the subscription books, making the entries with subscribers for treasury stock subscriptions, payment in cash or by instalments, and finally, the issue of the stock, may be the procedure followed in the sale of treasury stock just as in the sale of other stock. The net result will, however, be as shown by the above entry.

3. Record of Treasury Stock on the Balance Sheet. On the balance sheet treasury stock is treated in the same way as unissued stock, namely, as a deduction item in the net worth section of the balance sheet. Using the above figures for illustration, the net worth section will appear as follows:

Bonds Payable.—Generally, when a corporation borrows money on long-term notes secured by a portion of its fixed assets, chiefly its holdings of real estate, the notes (usually of uniform amounts so as to make them more marketable) are called “bonds.” Thus, such notes or bonds are frequently in $100, $500, and $1,000 denominations, making it possible for one of limited means to take advantage of the mortgage offered as security for the loan. Bond issues are floated in pretty much the same way as capital stock issues, being offered for subscription at a price depending both on the interest rate which the bonds bear and the prevailing interest rate at the time of their offering. Thus, if the bonds bear 5% interest and the market rate for bonds of the same general character is 6%, an investor will naturally not be willing to pay par for them and the company will therefore have to sell them at such a discount as will put the yield to the investor approximately on a 6% basis. The company, by receiving for its bonds an amount less than par value but by being required to pay interest on the par amount, is thus paying higher than the nominal or agreed rate.

There is thus a very definite relationship between the bond discount and the interest rate which the bonds bear.

The accounting record of bond transactions is very similar to that of other liability transactions, and is shown under three heads as follows:

1. Sale of Bonds Payable. Assume that a $100,000 issue of bonds bearing 5% interest, payable semiannually, and maturing in 20 years, is sold at 90. The record will be:

Bonds payable are always set up at par, since that represents the liability which must be met at maturity of the issue.

2. Bond Interest Payment. At the close of the first six months, 2½% interest, or $2,500, will be paid to the holders of the bonds. Since the corporation will have to redeem its bonds at par, it has been deprived of the use of $10,000, represented by bond discount, because the issue was brought out at 5%. The $10,000 discount is therefore in the nature of a lump sum interest cost incurred in advance—prepaid—and must be spread equitably over the life of the bonds. Accordingly, at each of the 40 interest payments during the life of the issue, a pro rata share of this prepaid interest should be taken into account as bond interest. The distribution of bond discount over the interest payments made during the life of a bond issue is termed “amortization” of the discount. Scientifically, amortization is worked out on a compound interest basis, discussion and explanation of which are found on page 269, Volume II. Here, all we are concerned with is the principle involved and for the sake of simplicity the amortization is prorated evenly over the 40 interest periods, resulting in an additional interest charge of $250 each period. The record is therefore:

3. Cancellation or the Bonds at Maturity. When the bonds come due and are paid, the record is the same as the cancellation of any other liability, viz.,

Bond Premium.—Bonds are also often sold at a premium. As with discount, the premium is intimately related to the interest rate which the bonds bear. At the time of the sale of bonds, the premium is brought on the books as a credit, which together with the par value at which the bonds are booked, offsets the cash received from their sale. At the regular interest periods the premium is amortized over the life of the bonds and so results in a lessening of the periodic bond interest charge. The student should set up the entries to record the sale of bonds at a premium and the interest payment for such bonds.

Sinking Fund.—The sinking fund is a fund of liquid assets created by periodic sums, usually of equal amounts, set aside during the life of a bond issue or other liability to provide ready funds for the cancellation of the liability at maturity. This method is very commonly followed in public finance and is not infrequent in private corporations. It is not purposed here to explain the methods of determining what periodic sum is necessary to be set aside so that these principal sums and their interest accumulations will provide sufficient funds for the cancellation of the liability at maturity. Nor will the complicated problem of sinking fund investments in the hands of a trustee, and the expense and income arising out of it, be discussed here. These and related problems are covered fully in Chapter XXV, Volume II. Only the creation of the fund and its final disposition are treated here, under two heads as follows:

1. Creation of the Fund. Assume that $1,000 cash is set aside at the end of each six months to provide for the retirement of the bonds at maturity. The entry for this, every six months, will be:

2. Cancellation of the Bond Liability. The student will understand that the cash set aside periodically for the sinking fund will be invested in securities in order to accumulate an income, which usually accrues to the fund. The securities in the fund must be sold just before the maturity of the bond issue, in order to provide cash. It will be assumed that in this instance the securities in the fund have been sold, that the cash in the sinking fund at the time of maturity is $101,500, and that the bond issue to be retired is $100,000. The entries will be:

Entry (b) returns to the general cash the unused cash in the sinking fund. In case of a deficiency in the sinking fund it will be necessary, of course, to draw on the general cash for the amount of the deficiency.

Sinking Fund Reserve.—It is often the policy of a corporation, which has to provide for the redemption of a bond issue, to reserve from the yearly profits a sum equal to the periodic payment into the sinking fund and the accumulations of the fund during that period. Such a policy prevents the distribution by dividends of all the current profits to stockholders, and insures that the increase in the assets represented by these profits will be held in the business and so provide each period an increased amount of assets for use in the business and ultimately, by conversion of the assets into cash, for the use of the sinking fund. The entries crediting the sinking fund reserve and showing its disposition at the maturity of the bonds are as follows:

The first entry shows the periodic reservation of profits. The second entry transfers the total profits so reserved during the life of the bonds, back to surplus—capital surplus if it is desired that these profits be made a part of the permanent capital of the corporation, or to general surplus in the event that these profits are to be made available for future dividends.

Closing the Books of the Corporation.—The results of the period’s operations are summarized and the books closed in very much the same way as with the partnership. From what has been said above, it will be understood that there are some types of transactions to be considered at the time of closing the corporation’s books that are not found in the partnership and single proprietorship. These concern largely the bond interest, the sinking fund reserve, and the dividend transactions. Bond interest is an expense. The sinking fund reserve is a reserve of net profits. Two methods are employed in showing the appropriation of net profits. Under the one method the total net profit is transferred to Surplus account, which then shows not only the profit for the current year but also the undistributed balance of previous years. The current appropriations of profits for whatever purpose are then booked as a charge against Surplus. Under the other method the current appropriations of profits are shown as charges against the net balance in the Profit and Loss account. Any unappropriated profit remaining is then transferred to the Surplus account.

Dividends.—A business is being operated always for the benefit of its owners, to whom the profits belong. In the case of a corporation, before the owners may secure any of the profits, a formal declaration of dividends must be made by the board of directors. During the term of its election the board is supreme in its management of the business. It is intimately in touch with the condition of the business. It knows the needs of the corporation and its obligations and must provide for them. If, after considering all the circumstances, it decides that some or all of the profits should be divided among the shareholders rather than be retained in the business for purposes of expansion, it meets in regular session and passes a formal dividend resolution.

Ultimate Control of Stockholders.—Thus it is seen that the board of directors is supreme during the period of its incumbency. Its actions are, however, subject to the review of the stockholders at their periodic meetings, which are usually held annually. If their policies are not favored by the shareholders, a new board, presumably one which will carry out the will of the majority of stockholders, is elected.

Dividends Out of Profits Only.—It is forbidden by law to pay dividends out of the capital of the corporation. Such payments would encroach upon the net assets of the organization and thereby weaken the creditors’ security for the payment of their claims. Dividends need not be paid out of the profits of the current year, provided the undistributed profits of former periods are still available.

Distribution of Profits.—The appropriation of profits in a corporation differs, therefore, from that in a partnership. The entries recording the appropriation of profits cover in the main two kinds: (1) reserves, and (2) dividends. These entries are not necessarily the same for all corporations nor for all periods. No set disposition of profits is prescribed, authority resting with the directors. Their decision, therefore, as recorded in the minutes of their meetings is the basis for this group of entries. Some of the usual entries are illustrated in the following paragraphs.

Reserves and Dividends.—As stated above, the two methods for handling the appropriation of profits are: (1) as a charge against Surplus after the net profit for the current period has been transferred to that account; and (2) as a charge against the current Profit and Loss credit balance and a transfer of the remaining balance, if any, to the Surplus account.

A part of the profits may be retained in the business to provide funds for certain future needs, as for the payment of fixed debts, the extension of fixed plant, etc. Such items are transferred to the credit of properly named reserve accounts. Profits for distribution as dividends are similarly transferred to a Dividends Payable account. The dividend is always based on the amount of outstanding stock, not on the unissued or treasury stock. It is reckoned either as a percentage of the par value of each share, as a 6% dividend, or as a stated amount on each share, as a dividend of $4 or 10 cents per share.

The following illustration will show the necessary entries in accordance with the two methods.

Dividend Liability.—The student should note that the effect of a dividend declaration is to change a portion of the proprietorship into a liability. Surplus is decreased and liabilities are increased. The liability so created ranks with other liabilities, i.e., the assets of the corporation may be used to pay the liability to its stockholders equally with the payment of liabilities to outside creditors. The payment of such dividend is recorded by the cancellation of the dividend liability, as follows:

Where there is more than one class of stock outstanding, it is customary to keep separate dividend accounts with each class.

Other Methods of Adjusting and Closing the Books.—It seems desirable at this point, although the material is applicable to any type of business organization, to discuss other methods of adjusting and closing the books than those heretofore explained. In Chapter XXVIII and previous chapters, the methods of handling deferred expense and income, and of summarizing the merchandising transactions were shown. The method given there of adjusting the ledger because of deferred expenses rested upon a classification of the various expense accounts to be adjusted as temporary proprietorship accounts. The method of adjustment effected a transfer out of the current part of the account, the asset portion of the expense, and carried it over into the next period. The balance remaining in the account after this adjustment shows the expense, that is, the amount of service or use, chargeable to the current period.

Another method of handling such items is based on an asset classification of the accounts recording them. Under this hypothesis such account titles as Postage, Stationery, Wrapping Supplies, and even Insurance (that is, unexpired insurance), are classed as asset accounts. At the close of the period when the adjustments are made, it is necessary to transfer from such asset accounts only the portions used or consumed during the current period. The balances left in the accounts represent the unused assets carried over into the next period. The difference between the two methods is indicated by the two sets of adjusting and closing entries given below.

The Trading or Selling Account.—For the purpose of summarizing the merchandising activities a separate account called Trading or Merchandise Trading is sometimes used to effect the partial summarization heretofore explained as being made in the Purchases and Sales accounts respectively. Where so used the Trading account becomes virtually the old Merchandise account with totals in place of details. The following entries will show its content and the method of handling it.

The Trading account is thus used as a means of separating the net sales into its two elements: (1) income, or gross profits; and (2) decrease of assets, or the cost of goods sold. This method makes the Profit and Loss account a purely summary account of income and expenses. Its chief disadvantage, however, is that a picture of the entire operations for the period is not presented in one account. One seldom finds the Trading account used in actual practice. It does serve, however, as an efficient teaching device to bring out clearly the way in which the merchandise accounts are adjusted and summarized in order to effect a separation of the income and decrease in asset elements.