Lesson 13--Basic Accounting for Corporations

Corporations: Organization and Capital Stock Transactions

Chapter 13 introduces the corporate form of organization. Unlike a proprietorship or partnership, a corporation is an entity separate from its owners. The chapter describes some of the characteristics of a corporation, along with the fundamental structure of the Stockholders' Equity section. It is the Stockholders’ Equity section that provides much of the contrast between corporations and other types of organizations.

Learning Objectives

The topics addressed in Chapter 13 could be outlined as follows:

  1. The Nature of a Corporation

  2. Sources of Stockholders' Equity

  3. Issuing Stock--Common and Preferred

  4. Cash and Stock Dividends

  5. Treasury Stock

  6. Reporting Stockholders' Equity

  7. Stock Splits

  8. Earnings Per Share (EPS)

Definitions and Characteristics of a Corporation

The following list summarizes the most important characteristics of corporations:

  1. A corporation has a separate legal existence from that of its owners. A corporation is chartered in a state, and each state has its own rules as to incorporation requirements. A corporation is an income-taxable entity, which means that "Income Tax Expense" will show up on the Income Statement for a corporation. The organization types you have studied in the past (proprietorship and partnership) are not income-tax paying entities--the income tax is paid by the proprietor or individual partner.

  2. Stockholders have limited liability. Unlike a proprietorship or partnership, wherein personal assets of the owners are at risk if the company fails, such is not the case for a corporation's stockholders. A stockholder risks only the dollar amount invested in the corporation. Example: you invest $10,000 in shares of the Boeing Company. If the Boeing Company should fail as a business, you could lose your $10,000. But that would be the extent of your loss. Contrast this liability with that of a proprietor--whose risk extends to personal assets such as a home or automobile, to satisfy the debts of the proprietorship. The limited liability feature allows a corporation to amass large amounts of cash, and, allows stockholders to limit risk on their investments.

  3. Ownership rights (shares) are easily transferred. The various stock exchanges in the United States are well organized and regulated, allowing buyers and sellers to trade shares safely and fairly. For example, the Boeing Company is traded on the New York Stock Exchange. A person wishing to invest in the Boeing Company would purchase shares from a brokerage (such as Charles Schwab or Fidelity Investments), who would acquire the shares from the exchange on the buyer's behalf. Similarly, when the investor wishes to sell the shares, the broker would handle that transaction by selling the shares on the exchange.

  4. A corporation has continuous life, and in most cases, perpetual life. The death of an owner (stockholder) does not require legal proceedings to keep the corporation going.

  5. Stockholders can exert influence on the corporation through its Board of Directors. Each year, stockholders are given the opportunity to vote (usually one vote per share) on the recommended slate of Directors, and other matters of a general nature.

  6. A corporation is subject to many regulations. The Securities Exchange Commission requires extensive disclosures (through the financial statements and other documents) for any corporation listed on an exchange.

  7. A corporation's income is said to be "taxed twice." The net income earned by the corporation is taxed, and the tax is reported on the income statement. If the corporation pays a dividend, the dividend income earned by stockholders is taxed again. This "double taxation" has always been a controversial issue, but there is little to be done about it, since taxes are based on law, rather than accounting principles.

The process by which a corporation is chartered is described in your text. There are often significant legal costs associated with incorporation, which are treated as an expense called Organization Expense. If you are curious about the incorporation process, remember that corporations are formed at the state level, so you can find information at each state's Secretary of State web site. If you use a search engine with the phrase "washington secretary of state", you should be able to view further information on the incorporation process as it exists in this state.

One other item to note--a business is not required to incorporate in the state in which the company originated. For example, in theory it would be possible for a company in Washington state to incorporate in a different state. Some states have less stringent rules for corporations than others, making them more attractive for incorporation. It is even possible to incorporate over the internet. One should seek competent legal advice to determine if incorporating in a different state is advisable.

Structure of the Stockholders' Equity Section

You will recall the structure of the Owner's Equity Section for a proprietorship, and the Partners' Equity Section for a partnership. In either of those cases, the Capital account is used for both owner investments and as a destination for the net income for each period. In other words, the owner's capital account increase if the owner invests, and if the company makes a net income. A major difference in the case of a corporation is that owner investments and profits are kept separate from one another. Example:

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The Paid-In Capital represents money invested by stockholders. In the example above, perhaps investors purchased 100,000 shares of $10 par value stock from the corporation, resulting in the Paid in Capital figure of $1,000,000. The corporation is authorized by the state to issue some maximum number of shares to the public. Let's assume that the corporation was authorized by the state of Washington to issue 500,000 shares of $10 par stock. They issued only 100,000 at the outset, which means that there are extra shares that could be issued at a later time, if the corporation needed cash. These 100,000 issued shares are considered "outstanding shares," meaning that the shares are in the hands of investors.

The Retained Earnings results from Net Income being closed from the Income Summary account. As stated above, the investments by stockholders and the income earned by the corporation are kept in separate accounts. Suppose that in the first year of operation, this corporation had $1,040,000 of revenues and $700,000 of expenses. In the closing process (described in chapter 4 of your textbook), we close revenues and expenses to income summary. In this case, the revenues will go to the credit side of Income Summary, and the expenses to the debit side of Income Summary. The final closing entry will be a debit to Income Summary for $340,000 and a credit to Retained Earnings for $340,000.

It is possible (and some would say probable) that in the first few years, a corporation might make a net loss rather than a net income. In such a case, the expenses are greater than the revenues, resulting in a debit balance in Retained Earnings. This situation is called a deficit. The management of the corporation must insure that there is adequate cash to continue the business until the earnings turn positive.

The Total Stockholders’ Equity ($1,340,000 in this case) is added to the Liabilities and must match the Total Assets figure. So, the balance sheet equation for corporations is: Assets = Liabilities + Stockholders’ Equity. In the example above, the assets might be $1,440,000, and the liabilities $100,000. With stockholders' equity of $1,340,000 the balance sheet would balance.

There are two classes of stock described in your text--common stock and preferred stock. Every corporation has common stock. Some businesses will issue a preferred stock as well. Most of the discussion in this chapter is about common stock, which comes with four typical rights.

Rights of Common Stockholders

A person who buys one or more shares of common stock usually has four rights:

  1. The right to vote. Each share of common stock held by a shareholder allows that shareholder one vote when the Board of Directors is elected. This election is usually once per year. There may be additional items put up for vote, such as whether to issue more shares of stock, or which CPA firm should be hired to perform the corporation’s audit. Typically, each share gets one vote. So if you own 100 shares, you get 100 votes.

  2. The right to share in earnings of the corporation. If the company's Board of Directors declares a dividend, each shareholder earns a sum of money for each share owned. Keep in mind that the dividend must be declared, in order for the stockholder to get paid. The Board is under no obligation to authorize a dividend, and in fact, there is a modern trend (particularly among high-tech firms) to refrain from paying dividends.

  3. The pre-emptive right. The preemptive right is the right to maintain one's percentage share in the total ownership if new shares are issued by the corporation. If stockholder A holds 10% of the outstanding shares of the corporation, and the corporation is planning to issue 1,000,000 new shares, then stockholder A must be given the opportunity to purchase 100,000 of them (10%) to maintain his/her ownership percentage. If this right did not exist, a company's management might decide to issue shares only to those who agree with management's point of view. Such a situation might allow a certain bloc of shareholders to control the corporation through the voting right.

  4. The right to a share of the company upon liquidation. Although this is a legitimate right, keep in mind that a company going out of business would likely have to pay creditors first, and there would probably be very little left for common stockholders to collect.

Preferred Stock

Some corporations issue Preferred Stock in addition to Common Stock. Preferred Stock shares usually receive a dividend of fixed amount. For example, a share of $100 par 8% Preferred would earn exactly $8.00 per year (8% of par). In good times and bad, this stock would earn $8.00 per share. Preferred Stock attracts the more conservative investors who want some assurance of a dividend each year. Like Common dividends, Preferred dividends must be declared by the Board of Directors; there is no guarantee that preferred dividends will be paid.

Investing in Stock--the Profit Objective

An investor invests in stock in order to make a profit. There are two basic ways to make money on stock investments. First, you might make a capital gain on stock, if you purchase it at one price, and then sell it at a higher price. Example: Donna purchases 100 shares of Boeing Company stock at $100 per share. Her cost of the shares (ignoring brokerage fees) is $10,000. Donna holds the stock for three years, during which time the Boeing Company makes a healthy profit. Let's say that the price of a share of Boeing rises to $125 per share. Donna could sell her 100 shares for a total of $12,500 and make a $2,500 capital gain.

The prices of thousands of companies are printed in the newspaper daily, and depending on the company, there may be minor or major fluctuation in a company's stock price. A smart investor will invest in companies that are leaders in their industries, have a long record of profit and strong cash flow, and who hire competent, ethical management. Additionally, the basic economic aspects of population growth, industry trends, and technological developments must be thoughtfully considered. It is to your advantage to learn more about the stock market, as many retirement plans today (401K plans) allow you to direct your contributions (as well as contributions from your employer) into equity securities.

If the stock pays a dividend, Donna could earn money in that way as well. Let's say that Boeing pays a $4 dividend per share each year. Her 100 shares would generate income for Donna of $400 in year 1, year 2 and year 3.

If you think about the relative risk of purchasing common stock versus purchasing preferred stock, you would probably conclude that common stock is a more risky investment than preferred. A common stock is subject to more fluctuation in the share price, than preferred stock. This means that your return is more variable for a common stock--you can make a lot or lose a lot. With preferred stock's fixed return, there is virtually no variability in the dividend, and the share price stays pretty constant as well.

Here's a generalization about stock investing: a younger person might favor common stock investments as the basis for a retirement plan. Why? Because a company might lose money for a few years, but end up doing well in the future. Because a younger person doesn't need the money (in theory!) until retirement, the stock has time to thrive. On the other hand, an investor who is investing for retirement starting at the age of fifty has only about 10-15 years to achieve growth--and had better make good stock picks, or stay with conservative investments that are sure to generate a return.

Stock Issuance

At the time a corporation is formed, the state will authorize the number of shares of stock that the corporation can issue. The corporation will normally not issue all of the shares authorized; rather, it will issue an amount necessary for current needs, and save the rest for the future -- when, it is hoped, the market value of the shares will be higher.

An arrangement will be made with a number of brokerage firms to distribute the stock. If the stock is readily marketable, the brokerage firms may underwrite the issue, meaning that they will purchase the shares outright, and then attempt to make a profit by issuing the shares to the public.

When shares of stock are to be issued, each share is given a nominal value, called the par value, which represents the legal capital per share. Usually, the par value is set at a very low amount, such as $.10 (ten cents) per share. When a share is issued by the corporation, it must be sold for at least the legal capital amount, to assure creditors of a minimum capitalization for the firm. Note: your text also discusses the term "stated value", which serves the same purpose as par value. The market, at large, will determine how much the shares actually will sell for, because investors decide to purchase shares based upon their collective expectations as to the company's future profitability. Thus, there is no connection between the par or stated value and the amount the shares actually sell for.  But, the issuing company will try to issue shares at a time when investors are optimistic to the company's prospects.

A Corporate General Ledger

The T-account diagram below shows the new accounts for this chapter. In the following discussion, refer to this chart.  I have left out all of the liabilities for now, because we want to focus on how the corporation acquires assets, and how the stockholders’ equity accounts operate.  Also keep in mind the rules for debits and credits for assets and equities.  Assets increase with debits and decrease with credits.  In the Stockholders' Equity, an increase is recorded with a credit; decreases are recorded as debits.

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Issuing Common Stock:  Journal Entry

When Common Stock is issued, it will usually have a par or stated value. The stock can be issued at par value or an amount above par. State law usually prohibits sale of stock below its par value. The par value gets credited to the Common Stock account; amounts above par (premiums are credited) to the Paid In Capital in Excess of Par on Common Stock account.

Example: a corporation issues 10,000 shares of $1.00 par Common for $1.50 per share. The journal entry would be:

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At this point, the Stockholders' Equity section would consist of $15,000, of which $10,000 is considered the legal capital. If there had been a stated value of $1.00 instead of a par value of $1.00, the accounting would be almost identical. The title of the Paid in Capital in Excess account would be Paid in Capital in Excess of Stated Value. Corporations are required to keep the legal capital for the protection of its creditors; that is, the corporation is not allowed to pay out the legal capital as a dividend.

Issuance of Preferred Stock

The issuance of Preferred Stock is quite similar--there is a Preferred Stock account and a Paid in Capital in Excess of Par account for preferred stock. Example: 20,000 shares of a company's $3.00 par value Preferred Stock are sold for $5.00 per share. The entry would be:

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Preferred stockholders have ownership in the company, similar to Common stockholders, but typically have no voting rights. A feature of preferred stock is that the dividend is fixed. It will not change. For example a corporation might issue a $100 par 8% preferred stock. The annual dividend would be .08*$100=$8.00, and would never change.

Special rights attached to the Preferred may exist, such as the "cumulative" right, or the "convertible" right. These special features are described below.

Preferred stock possesses the following potential characteristics:

  1. It is "preferred" as to dividends -- receiving a dividend before common stockholders get theirs. Keep in mind though, that all dividends for either class of stock must be declared by the Board of Directors -- who may decide not to declare any dividends at all.

  2. There is a preference upon liquidation. If the company liquidates, the rights of preferred stockholders take precedence over those of the common stockholders, meaning that if there are assets left, the preferred stockholders would receive those assets prior to common stockholders.

  3. The dividends for preferred stockholders may be cumulative, meaning that any undeclared dividends become dividends in arrears, and accumulate over time. For example, if the company annually pays an $8 dividend per share to the preferred stockholder, but runs into a cash shortage--missing the dividend this year, the dividend will accumulate. So, maybe next year, when times are good, the company makes up the dividend by paying $16 to each share of preferred stock. This will only happen if the preferred stock certificate is labeled "cumulative". By the way, a missed dividend is called a "dividend in arrears," but is not considered a liability. This is because the dividend is not owed until the Board of Directors declares it. A note should be written in the annual report, however, so that potential investors in the preferred stock are aware that an arrearage exists.

  4. Preferred stock may be convertible to common stock, according to specified terms.   An investor might purchase of shares of preferred stock in order to receive the fixed dividend.  Later, as the company becomes more profitable, the investor might choose to convert the preferred shares to common stock in order to receive a potentially higher dividend, as well as a higher capital gain as the common stock's price rises.

  5. Preferred stock may be callable at the company's option, and at a certain price. Corporations sometimes resent having shares of preferred stock outstanding, because of the requirement to pay a dividend. The stock certificate may state that the preferred shares are callable at a certain price--which gives the corporation a way to free itself of paying the dividend. However, the call price may be set somewhat higher than the current market price--giving the stockholder a windfall when the call is made.

In the case of issuance of either Common or Preferred shares, the company issuing the stock gets its money only once. A company issues shares and receives cash. The original purchaser may choose to sell the stock to another investor, but the company does not benefit from that sale. From the company's standpoint, it is just a change in the roster of stockholders. It is important, therefore, that a company issue its shares at time when the market is willing to pay a good price for the shares.

Issuance of Stock for Noncash Assets

It is possible that a corporation may issue shares of stock for assets other than cash. For example, a corporation may issue 5,000 shares of $100 par preferred stock in exchange for a building. Assume that the building has a fair market value of $600,000. The transaction would be recorded as follows:
Building 600,000  
......Common Stock (5,000*$100)   500,000
......Paid in Capital in Excess of Par   100,000

It is also possible that a mature corporation might acquire a building through issuance of stock. If the Boeing Company, for example, issued shares to acquire a building, it might be preferable to use the fair market value of the shares issued, rather than the fair market value of the building, as the basis for recording the transaction amounts. A company's shares, traded daily on a stock exchange, would have a value that is "more clearly determinable" than a building that is rarely bought or sold.

Cash Dividends

Periodically, a corporation will distribute some of its earnings in the form of dividends. A dividend provides the stockholder with a return on the stock investment, similar to the interest one receives on a bank savings account. One item to keep in mind, however, is that, while interest is an obligation of a company owing money, cash dividends do not become a liability until they are declared. In fact, many companies do not, as a practice declare dividends. Stockholders of such companies must be satisfied that the capital appreciation of the stock (increase of the share price on the market) is sufficient to continue holding the stock.

There are 3 requirements necessary to paying a cash dividend: the corporation must have some retained earnings, sufficient cash to pay the dividend, and a declaration by the board of directors. But how do Retained Earnings come into being? Consider the following general ledger accounts:

1. The company has revenues of $100,000 and Expenses of $75,000 for the period. Retained Earnings will be increased by the following closing entry:

2. The Company's Board of Directors declares a $10,000 cash dividend, payable to stockholders, determined at a publicized date.

Note: some accountants use a separate Dividends account, (analogous to the Drawings account for a proprietorship), and later close the Dividends account to Retained Earnings.

3. When the dividend is actually paid out in cash, the following entry is made:

Three Dividend Dates

A cash dividend involves three dates. These are:

  1. The dividend declaration date (see transaction 2 above).

  2. The date of record (a publicized date at which ownership of all shares is determined).

  3. Payment date (transaction 3 above).

Keep in mind that preferred stock shares may exist, and in such a case, the dividend of the preferred stockholders must be paid first, before the common stockholders receive their dividend-- which may limit or eliminate the dividend available for the common stockholders. As the phrase suggests, preferred stock has certain preferences. The basic preferences are that preferred stockholders get their dividend first, and would stand ahead of common stockholders in the event of company liquidation.

Preferred stockholders usually receive a dividend which is fixed in amount. For example, a 6% preferred stock issue with a $100 par value would receive a fixed amount of $6.00 per share per year, but only if a dividend is declared. Note: in the balance sheet, this Preferred Stock would be called "6% Preferred Stock", or "$6.00 Preferred Stock." This can be confusing, because it is easy to confuse the dividend amount with the par value.

Stock Dividend Example

Medland Corporation declares a 10% stock dividend on its 50,000 shares of $10 par value common stock. The current fair market value of each share is $15.00. A total of 5000 shares will be issued -- 10% of 50,000 shares.  But the critical question is, should Retained Earnings be debited for the par value of the shares to be distributed, or the market value?  The rule is:  if the stock dividend is small (less than about 20%-25%), Retained Earnings is debited for the fair market value of the shares to be distributed:

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Later, when the stock is actually issued, the following entry is made:

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These two entries could be combined into one entry, by debiting Retained Earnings, crediting Common Stock, and crediting Paid in Capital in Excess of Par.

The treatment above is appropriate for small stock dividends (those less than 20-25% of the total shares issued). Notice that there are no assets or liabilities involved in a stock dividend. The effect, therefore, is to convert an amount of Retained Earnings to Paid in Capital. Thus, the number of shares outstanding increases, and the book value per share would decrease. The use of market value for the stock dividend is appropriate if the distribution of shares will not drive the market price down appreciably.  A main reason for issuing stock dividends is to maintain investor sentiment toward the company's stock without using cash. On the other hand, the number of common shares outstanding will increase, which may have an undesirable effect on the company's Earnings Per Share (EPS).

Stock Split

Sometimes a company will declare a stock split. A split reduces the par or stated value of the stock and increases the number of shares outstanding proportionally. Example: a company's $10.00 par stock is split 2 for 1 when there are 1000 shares of stock outstanding. After the split, there will be 2000 shares outstanding, with a par value of $5.00. Total Paid in Capital, Retained Earnings, and Total Stockholders' Equity remain the same. No assets or liabilities are affected. A memo entry would be sufficient in the journal to note the stock split.  Note that no Stockholders' Equity accounts change in dollar amount. The par per share is halved, and the number of shares is doubled. The Common Stock had a balance of $10,000 before the split (1000 shares * $10), and will have the same balance after the split (2000 shares * $5).

Why would a company execute a stock split? The usual reason is that the company's shares are trading at a high market value, which may reduce the volume of shares traded. For example, a computer software company issues shares of stock at $15 per share. The company experiences rapid growth and finds that its volume of shares traded among investors is 100,000 shares per day. As the company continues to be successful, the price of the stock rises to $60 a share, and later, rises to $70 per share. The company discovers that as the price goes higher, the volume of shares traded is reduced--perhaps to 40,000 shares traded per day. To keep the shares actively trading, the company executes a 2 for 1 stock split. This doubles the number of shares outstanding, and the price per share should fall to about $35 per share. The volume of shares rises, as stockholders can get a good quantity of shares for their investment.

Treasury Stock

Treasury Stock is common stock that a company has issued to the public, but for some reason, has decided to buy it back. Why would a company buy back its own stock? Here are some possibilities:

  1. To have shares on hand to distribute to employees under stock option plans;

  2. To reduce the number of shares in the market, and perhaps cause the price to go up, or improve the Earnings Per Share;

  3. To use up idle cash, while increasing trading in the company's stock.

The acquisition of Treasury Stock reduces Stockholders' Equity and reduces assets. Example: Lodi Company acquires 100 shares of its $1.00 par stock for $20 per share.

Picture of TS

As shown in this entry, Treasury Stock is debited for the cost of the shares purchased. The debit entry is consistent with a reduction of Stockholders' Equity, and on the Balance Sheet, any Treasury Stock is deducted from Stockholders' Equity. Furthermore, Treasury Stock is not considered to be "outstanding" stock, so no dividend is paid on it.

If Treasury Stock is acquired at one price (such as $20 per share shown above), and later sold again for $23, you would use the account Paid In Capital from Treasury Stock for the amount above $20 per share. Example: Lodi Company sells the 100 shares of Treasury Stock acquired above for $23 per share.

Another TS picture

This transaction works out well for the company, but the $300 benefit is not considered a revenue or a gain. A company cannot legitimately consider trades in its own stock to be income. As an example, if the Boeing Company buys and sells its own stock, it is true that the stockholders' equity goes up and it is beneficial for the company. However, the Boeing Company doesn't record this as net income, because net income is earned by selling airplanes. The paid in capital from this transaction simply adds to the Stockholders' Equity in the corporation.

Retained Earnings Restrictions

Frequently, companies will segregate a portion of Retained Earnings, so that the segregated amount cannot be distributed in the form of dividends. Such restrictions are disclosed in the notes to the financial statements. Keep in mind that a restriction of Retained Earnings is not a cash transaction. Nevertheless, a creditor company may insist that Retained Earnings be restricted so that cash cannot be reduced through a dividend.

Prior Period Adjustments

Sometimes there are material errors that occur in one period, but are not discovered until a later period. For example, the inventory may have been seriously understated in 1992, but this error was only discovered in 1994. Should the income statements for 1992 and 1993 be corrected and sent out to stockholders? Normally, this is not done. Rather, a correction, called a Prior Period Adjustment, is made to the beginning Retained Earnings balance of the current period.

Corporate Income Statements -- Reporting of Income Tax Expense

About thirty years ago, there was a revolution in the construction of an income statement. Many accounting professionals were concerned that the idea of "net income" was not consistent with the idea of "predictable net income next year." If you were to monitor the net income of a company over a five year period, and the net income was rising by about 5% per year, this might cause you to predict that the net income was likely to increase by 5% next year. Would this be a safe assumption? Probably not, because economic factors change over time.

Additionally, companies often face one-time events that are out of the ordinary, and won't likely happen next year or any other year. The profession came to the conclusion that these one-time events should be flagged as such and segregated in the income statement. Examples of these one-time events, each one reported net of the applicable income tax, are:

1. Income or Loss from Discontinued Operations

2. Income or Loss from Extraordinary Items (unusual and infrequent events like natural disasters)

3. Effects of Accounting Changes such as changing from FIFO to LIFO inventory systems

More importantly, the income measure that represents regular income from our principle activity is called "Income from Continuing Operations" and is reported net of tax. This is the figure you might use if you were looking for a multi-year trend, because it is free of unusual, one-time events.

As mentioned in other chapters, the net income earned by a proprietor or a partner flows through to the individual and is reported on an individual 1040 tax form. However, a corporation is taxable for income tax purposes. Thus, income tax expense is a line item on a corporate income statement. Note that, for a corporation, net income is considered an after-tax amount.

Earnings Per Share

Earnings per Share, abbreviated EPS, is an important figure used by investors in deciding whether to buy stock in a certain company. In its simplest form, the EPS can be calculated by dividing net income by number of common shares outstanding.

The Earnings per Share calculation can be complicated, however, by a number of items. For example, if a stock is actively traded, how does one calculate the number of shares outstanding, particularly for a company whose shares are traded daily? The fairest way to do so is by weighting the share totals by the amount of time each total has existed. This calculation is not demonstrated in your text and you are not responsible for knowing it.

A second complication is that preferred dividends, if declared, are not available to common stockholders. Therefore, the amount of preferred dividends is subtracted from the net income for the period. The calculation of EPS is as follows:

EPS = (Net Income - Preferred Stock Dividends) / Number of Common Shares Outstanding

The earnings per share is an important calculation that investors pay attention to. Often, the EPS is compared to the price of the stock. For example, if Johnson Company's stock is selling on the market for $20 and the most recent EPS is $1, the potential investor might ask, "should I invest $20 in a share of stock that generates $1 of income?" The correct answer to this question will depend on the future expectations of the company, market conditions, interest rates, and other criteria. If you look in the newspaper at the stock report, you will find a ratio called the PE ratio, which is the price of the stock divided by the EPS. In the Johnson Company example, the PE ratio would be 20/1=20 and we would say that "Johnson's stock is trading at 20 times earnings." The PE ratio is a measure of how expensive the stock is. The higher the PE, the more expensive.

The EPS is reported on the income statement just below the net income figure.

Balance Sheet Presentation of Stockholders' Equity

The journal entries for stock issuance, closing of net income to retained earnings, and paying out dividends lead us to the construction of a stockholders' equity section of the balance sheet. Although the stockholders' equity section seems complicated, you can break it down into several basic parts.

The structure of the Stockholders' Equity section may be thought of as follows:

Total Stockholders' Equity = Paid In Capital + Retained Earnings

Paid In Capital = Paid In Capital from Preferred Stock + Paid In Capital from Common Stock + Paid In Capital in Excess of Par

The Paid In Capital in Excess of Par can be from Common or Preferred Stock, or from miscellaneous sources, such as Treasury Stock transactions. Note that Preferred Stock is listed before Common Stock. Why? Because it is preferred.

Market Value Per Share

Earlier, the topic of par value per share was discussed. The par value per share represents the legal minimum at which the shares can be issued. So, of the par value is $1.00 per share, the corporation must receive at least $1.00 per share when the share is originally issued to the public. After issuance, the market price of the share may go up or down, as the company continues to operate. If the company is successful, investors will bid the price upward; conversely, if the company does not perform well, the price may fall--even below the original par value. The stipulation is that the par value must be received at the original issuance. Subsequently, as investors buy and sell shares, the market price can fall below the original par value.

As mentioned earlier, the prices for most large corporations are published daily in some newspapers. However, you can also log in to various free internet services (yahoo finance and msn money are two examples) and get a current quote of the market price, volume of shares traded, price to earnings ratio, and even the company's latest financial statements.

Book Value Per Share

In various financial publications, you will see references to the term Book Value per Share. The Book Value per Share represents the net assets of the company reflected in one common share. Generally, the formula for computing this figure is as follows:

Book Value per Share = Total Stockholders' Equity / Number of Common Shares

The computation is simple if there is only one class of stock. However, if there are preferred shares outstanding, the Stockholders' Equity must be reduced by whatever costs would be incurred to liquidate the Preferred stockholders. These costs would consist of 1) the cost for a company to call in the Preferred shares, at some cost per share and 2) the payment of any preferred dividends in arrears. The formula shown above is thus modified to:

BV per Share = (Total Stockholders' Equity - Call Price of Pfd - Dividends in Arrears)/Number of Common Shares

The calculation is used in determining how the market price of a share of stock compares to its book value. Keep in mind however, that the book value is based on cost information, not market value information. The assets are recorded at cost, and are normally not written up or down with market fluctuations. Thus, Book Value per Share may be of limited value as a measuring tool.