Various transactions are used in the issuance of capital stock. They are examined later in this post. The capital of the firm is measured by the difference between the assets and liabilities of the firm. This difference or residual interest is known as the owner’s or stock-holder’s equity. It is equal to the cumulative net contribution of stockholders plus the plowed-back profit. The interest in this post is with the publicly traded corporations, owned by stockholders who have limited liability, and governed by the articles of incorporation or corporate charter.
The Nature And Changes In Equity [Brief Overview]
The changes in equity include:
Changes in equity affecting assets and liabilities which
- affects net income through revenues, expenses, gains or losses.
- affects transfers between entity and owners through investment by owners and distributions to owners.
Changes in equity not affecting assets or liabilities such as:
- Issuance of stock dividends and splits.
- Conversion of preferred stocks to common stocks.
Stockholder’s equity is in fact the capital of the firm composed of contributed capital (par value of outstanding capital stock, premium less discounts on issuance, amount paid on subscription agreements, and additional assessments) and earned capital (plowed-back earnings). In most states, the par value or stated value of stock issued constitute the legal capital. Finally, the total corporation of stockholders’ equity is as follows:
- Capital Stock = a designated dollar amount per share established in the articles of incorporation x number of shares outstanding.
- Additional Paid-in-Capital = the excess of the value over the par or stated value of the stock x number of shares outstanding.
Unrealized Capital: increases in stockholders’ equity not related to the issuance of stock or to retained earnings, such as donated capital and revaluation capital (writeup or writedown of assets from cost).
Retained Earnings: income not distributed but reinvested in the firm or plowed back.
It is appropriate to note that Additional Paid-in-Capital is a summary account for the following transactions:
- Discounts on capital stock issued (debit).
- Sale of treasury stock below cost (debit).
- Absorption of a deficit in a recapitalization (quasi-reorganization) (debit).
- Declaration of a liquidating dividend (debit).
- Premium on capital stock issued (credit).
- Sale of treasury stock above cost (credit).
- Additional capital arising in recapitalizations or revisions in the capital structure (quasi-reorganization) (credit).
- Additional assessments on stockholders (credit).
- Conversion of convertible bonds or preferred stock (credit).
- Declaration of a ‘‘small’’ (ordinary) stock dividend (credit).
Other items may be presented as contra or adjunct equity items, generally as adjustments to or below retained earnings. Examples of the items include:
- Foreign currency translation adjustments.
- Unrealized holding gains and losses for available-for-sale securities.
- Excess of additional pension liability over unrecognized prior service cost.
- Guarantees of employee stock option plan (ESOP) debt.
- Unearned or deferred compensation related to employee stock award plans.
Next, let’s go to the most interesting part; How to record issuance of capital stock. As I mentioned on the preface, there are various transactions are used in the issuance of capital stock to be recorded.
Issuance of Capital Stock for Cash
When capital stock with a par value is issued for cash, the differences between the proceeds and the par value of the stock issued are accounted for as an Additional Paid-in-Capital on Common Stock. For example, let’s assume that the Lie Dharma Company issued 1,000 shares of its $20 par common stock for $30 per share. The entry to record the issuance is as follows:
[Debit]. Cash ($30 x 1,000) = 30,000
[Credit]. Common stock ($20 x 1,000) = 20,000
[Credit]. Additional Paid-in-Capital on Common Stock =10,000
The same entry would be used if the stock were no-par stock with a stated value of $20 (the $20 value is a minimum value below which it cannot be issued). If the stock was in fact a no-par stock, with no pershare amount printed in the stock certificate, the entry would be as follows:
[Debit]. Cash ($30 x 1,000) = 30,000
[Credit]. Common Stock–No-Par Value = 30,000
The costs of issuing stock are either treated as a reduction of the amounts paid in (a debit to Paid-in-Capital in Excess Par) or as an organization cost to be capitalized as an intangible asset and amortized over a period not to exceed 40 years.
Issuance of Capital Stock on a Subscription Basis
Capital stock may be issued on a subscription basis, namely, on an installment basis, accounted for by a credit to Common or Preferred Stock Subscribed for the amount of stock the firm is obliged to issue, and a debit to Subscription Receivable for the amount to be collected before the subscribed stock is issued.
To illustrate, let’s assume that the Albertos Company offered stocks on a subscription basis to its employees that allows them to purchase 5,000 shares of $8 per common stock at $20 per share if they put down $5 per share and pay the remaining $15 at the end of the month. The entry at the date of issuance is as follows:
[Debit]. Cash ($5 x 5,000) = $25,000
[Debit]. Subscriptions Receivable: Common Stock ($15 x 5,000) = 75,000
[Credit]. Common Stock Subscribed (5,000 x 8) = $40,000
[Credit]. Additional Paid-in-Capital on Common Stock ($12 x 5,000)= 60,000
Subscriptions Receivable may be reprinted in the current asset section of the balance sheet or as a deduction from stockholder’s equity. The Securities and Exchange Commission (SEC) requires the contra-equity approach, which explains its popularity in practice.
At the end of the month, when the Albertos Company received payment for and issued 4,000 shares, the following entries are made:
[Debit]. Cash ($15 x 4,000) = 60,000
[Credit]. Subscription Receivable = 60,000
[Debit]. Common Stock Subscribed = 32,000
[Credit]. Common stock ($8 x 4,000) = 32,000
Assuming that the subscriber to the remaining 1,000 shares defaulted on the contract, the following entry is made:
[Debit]. Common Stock Subscribed (1,000 x $8) = 8,000
[Debit]. Additional Paid-in-Capital (1,000 x $12) = 12,000
[Credit]. Subscription Receivable (1,000 x $15) = 15,000
[Credit]. Additional Paid-in Capital for Subscription Default (1,000 x $5) = 5,000
Issuance of Capital Stock in a Nonmonetary Exchange
Capital stock may sometimes be issued for services or property other than cash. The general rule is to record the exchange at the fair market value of either the stock or the property of services, depending on whichever is readily determinable and more reliable.
For example, let’s assume that a corporation issued 20,000 shares of $10 par value for a patent when the stock was at $30. The transaction is recorded as follows:
[Debit]. Patent = 600,000
[Credit]. Common Stock (20,000 x $10) = 200,000
[Credit]. Paid-in-Capital in Excess of Par (20,000 x 20) = 400,000
If both the fair market value of the stock and the property of services were not easily determinable or were not reliable, the board of directors is responsible for the determination of the fair market value of the exchange. Two likely situations are: (a) an overvaluation of the property or services received resulting in an overvaluation of stockholder’s equity, a phenomenon referred to as “watered stock“, or (b) an undervaluation of stockholder’s equity, a phenomenon referred to as “secret reserves“.