Letting Owners Know Where They
them. Plus, I discuss noncash dividend transactions: stock dividends and stock splits.
Wait, I’m not finished! You also receive a tutorial on retained earnings: the total profit brought in by the business that has not been paid out as divi- dends. Finally, you bring all this information together by walking through the equity section of a sample balance sheet for a corporation.
Distinguishing Different Types of Business Entities
Forming a business can be easy as pie or extremely complicated depending on the type of business entity being created. Likewise, the owners’ equity section of the balance sheet can range from bare-boned to quite elaborate — again depending on the type of business entity.
Following are the ABCs of the three types of business entities and their unique components of equity. First, I give you a brief overview of sole pro- prietorships and partnership, which likely receive only a cursory mention in your financial accounting textbook. Then I launch into a discussion of all you need to know about the type of business entity you most often encounter in your financial accounting course: the corporation.
Sole proprietorship
Like the name implies, a sole proprietorship has one and only one individual owner. This owner can’t collectively own the business with anyone else — even with a spouse or another relative or friend. While there can be only one owner, the sole proprietorship can hire as many employees as it needs.
Forming a sole proprietorship is a snap. Most states don’t require a formal filing for a sole proprietorship. Instead, as soon as the company makes its first sale or incurs its first business expense, it is officially in business as a sole proprietorship.
The sole proprietorship has two unique equity accounts: owner capital and owner draw. The owner capital account shows cash and other contributions (such as equipment) that the owner makes to the business. The owner draw account shows money and other assets the owner takes from the business to convert to personal use.
Figure 9-1 shows the owner’s equity section of the sole proprietorship for Penway Manufacturing owned by Mike Penway. Not too complicated, right?
Figure 9-1:
A statement of owner’s equity for a sole propri-
etorship.
Penway Manufacturing Statement of Owner’s Equity December 31, 2012
Mike Penway, capital January 1, 2012 Year-to-date net income
Mike Penway, draw
Mike Penway, capital December 31, 2012
20,000 15,000 (5,000) 30,000
Partnership
A partnership must have at least two partners holding any percentage of interest in a company. For example, one partner can have 99 percent interest and the other can have 1 percent, or each partner can have 50 percent inter- est. The division doesn’t matter as long as the combined interest adds up to 100 percent. Keep in mind that a partnership is not limited to two partners;
there can be as many partners as the partnership wants to have.
In whichever state the partnership wants to operate, the state statutes spell out how to form and operate the partnership. In many states, the partnership has to prepare a written partnership agreement and file paperwork with the Secretary of State. Most states have provisions for both general partnerships and limited partnerships:
✓ With general partnerships, all partners are personally liable for any legal action taken against the partnership and for any debts the partnership owes.
✓ Many states also allow for limited liability partnerships. If you are a lim- ited partner, your liability for partnership debt is limited to your invest- ment in the partnership. However, as a limited partner, you may not have any say in how the partnership is run.
Partnerships mimic sole proprietorships in that the equity section on the balance sheet has capital and draw accounts. Figure 9-2 shows the partner equity section of the Double-Trouble Partnership, whose partners, Tom and Dottie Double, each own 50 percent of the business.
Figure 9-2:
A statement of partners’
equity.
Double-Trouble Partnership Statement of Partners’ Equity December 31, 2012
Partner capital January 1, 2012 Year-to-date net income Partner draws
Partner capital December 31, 2012
Tom Double, Capital
10,000 12,000 (10,000) 12,000
Dottie Double,
Capital
7,000 12,000 (2,000) 17,000
Total Capital
17,000 24,000 (12,000) 29,000
The amount of draws and income distributions a partner is allowed to take can be different than that person’s partnership interest. So even though you have two equal partners, that doesn’t mean they have to take the same draw amount. Hence the differences in beginning and ending partners’ capital accounts between partners in Figure 9-2.
Corporate
If a business wants to operate as a corporation, it has to prepare and file arti- cles of incorporation, also known as a corporate charter, with the Secretary of State in the state where it wishes to operate. The articles of incorporation cover the basics about the company such as its name and address, the stock it issues (what type and how many shares), and the registered agent, who is the person the Secretary of State contacts with any questions about the corporation.
The type of information a state requires for the incorporation is a matter of state statute and can be found online by doing a search for the specific state’s name and the word statute. (For example, I did a Google search on the phrase “Illinois state statute,” and the correct Web site was number one in my search results.) If you scroll through the various statute titles for any given state, you should find one called “business organizations” or something similar. There is more information about incorporation in Chapter 15.
The balance sheet section called “stockholders’ equity” represents the claim shareholders of the corporation have to the company’s net assets. There are three common components to stockholders’ equity: paid-in capital, treasury stock, and retained earnings. Paid-in capital and treasury stock involve trans- actions dealing with the corporate stock issuances. Retained earnings shows income and dividend transactions. In the sections that follow, I give each of
these components their due, starting with paid-in capital and retained earn- ings and moving on to treasury stock.
Defining Paid-in Capital
Paid-in capital represents money the shareholders in a corporation invest in the business (contributed capital). It consists of purchases for preferred stock, common stock, and additional paid-in capital. (No, you’re not seeing double! Additional paid-in capital is a subset of paid-in capital.) Here is a defi- nition of each:
✓ Preferred stock: Preferred stock represents ownership in the corpo- ration and has traits of both debt and equity. What this means is if a corporation sells its assets and closes its doors, preferred shareholders get back the money they invested in the corporation plus any dividends owed to them (money paid to the shareholders based on their propor- tionate stock ownership) before the common stockholders get their piece of the pie. (For more info on dividends, see the upcoming section called “Paying dividends.”)
✓ Common stock: Common stock represents residual ownership in the corporation. Residual ownership consists of any remaining net assets after preferred stockholders’ claims are paid.
Common stockholders elect the board of directors that oversees the business. The board of directors elects the corporate officers (presi- dent, vice president, secretary, and treasurer) who handle the day-to- day operations of the business. In order to be a real corporation, at least one share of common stock has to be issued. After all, somebody has to be in charge of the corporation!
✓ Additional paid-in capital: This account represents the excess of what shareholders pay to buy the stock over the par value of the stock. Par value is what’s printed on the face of the stock certificate. Wondering how par value is determined? Whoever was in charge of originally form- ing the corporation decided on the amount of par value. Most of the time, par value is an insignificant amount selected at random (although some state statutes may address par value as well).
For example, the par value for ABC’s common stock is $10 per share.
You buy 20 shares for $15 a share. The addition to ABC’s common stock account is $200 (20 shares at $10 par value). Additional paid-in capital is
$100, which is calculated by multiplying those 20 shares by the excess you paid for the stock over its par value (20 shares times $5).
GAAP dictate that you properly describe stock transactions on the balance sheet. To follow are the proper balance sheet descriptions for preferred and common stock:
✓ Preferred: Preferred stock, 5%, $200 par value, cumulative, 30,000 shares authorized, issued, and outstanding.
Because preferred stock has a debt-like characteristic, the amount of return the corporation has to pay is printed on each share. In this description it is 5 percent. The face value per the corporate charter is
$200. The limit for the number of shares the corporation can have out- standing is 30,000. All 30,000 are sold to investors.
✓ Common: Common stock, $5 par value, 500,000 shares authorized, 250,000 shares issued at December 31, 2012.
This means the par value of the stock in the corporate articles of incor- poration is $5 (remember this is usually an arbitrary number), the total number of shares the corporate can have outstanding is 500,000, and as of December 31, 2012, 250,000 shares have been sold to investors.