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Understanding Accounting for Stock Transactions

written by: ciel s cantoria•edited by: Linda Richter•updated: 3/16/2015

Accounting for stock transactions may seem complex but once the learner fully understands the structure of the stockholder's equity accounts, accounting entries will be repetitious in nature. The difficulty in handling stock transactions is not in the accounting process but in its trading.

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    A Brief Overview of the Corporation as a Separate & Legal Entity

    Accounting for stock transactions commences once a state’s approving body has authorized the number of stocks to be sold and the par value per share. This means that the corporation’s capital account has been established and will be presented in the Balance Sheet as the Stockholder’s Equity.

    A corporation is a separate legal entity and has the capability to enter into legal transactions. It may borrow, lend, be bound by a contract, be held responsible for any wrongdoing, be sued or file its own lawsuit, pay taxes, and be expected to comply with all laws and regulations of the state and the federal government.

    Every stockholder is a co-owner of all its assets and will be liable for all its obligations, in proportion to the number of shares owned. However, only those who have been designated, elected, or authorized by the Board of Directors in accordance with its by-laws shall have the capacity to represent the corporation in any of its legal transactions.

    450px-American stock exchange NYC 

    Ownership of the shares of stock are easily transferable; hence selling, conferring, bestowing, or transferring ownership of shares to another person or entity does not require the approval of other shareholders. This is particularly true in public companies of which shares of stock are publicly sold or traded at stock market trading floors.

    In case new shares are approved, thereby increasing the capital of the company, the current stockholders will have the preemptive right to purchase the newly approved shares of stock. That way, they can maintain the proportion of their ownership in the company.

    Based on these premises, examples of stock transactions are provided in the following sections to show the accounting entries taken up for each type of stock deal.

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    Accounting for Stock Transactions Upon Approval of the Corporation as a Legal Entity

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    The value of each share is called par value, although the company may sell stocks considered as no par value. However, the laws governing the issuance of no par value stocks differ from state to state; hence it would be best to check the rules regarding no par value stock issuance in each state before the corporation deals in this type of stock transaction. Nevertheless, the fact of common stocks sold at no par value does not recognize the difference between the stated value of the stock as against the par value of common stocks.

    The initial sale of the company’s stock is formally referred to as the Initial Public Offering (IPO) and all future trading of the public corporation’s capital stocks will take place at the stock market. All shares of stock issued and paid-up will then be described as outstanding.

    (1) Accounting entry to record the initial sale of stock at par value, e.g. 50,000 shares at $1 par value:

    Dr. Cash ___________ $50,000

    Cr. Common Stock ___________ $50,000

    (2) Selling the shares of stock at a price higher than the par value, the price will be referred to as the stated value of the capital stock.

    Example: 2,000 shares of common stock @ $1 par value were sold at a stated value of $5 per share.

    The accounting entry will first take into account the value of the common stocks as if sold at par and then recognize the difference as additional paid-in capital:

    Dr. Cash ___________ $10,000

    Cr. Common Stock (2,000 shares @ $1 par value)­___________ $2,000

    Cr. Additional Paid-in Capital – Common Stocks ___________$8,000

    (3) Selling the common stocks at no par value, this particular transaction will be merely recorded as:

    Dr. Cash ___________ $10,000

    Cr. Common Stock (2,000 shares @ $ 5 par value) ___________ $10,000

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    Accounting for the Issuance of Preferred Stocks

    Accounting entries in the sale of Preferred Stocks will have relatively the same mechanics as that of common stocks. The differences between these two types of stocks lie mainly in the order of distribution of dividends and investment recovery in case of dissolution.

    By the latter, it means that upon satisfaction of all corporate obligations due to its creditors and bondholders, the holders of preferred shares will have first priority over the remaining value of the company’s assets. After this, the common stockholders can then recover their investments without consideration as to how much can be recovered.

    (1) The accounting entry to recognize the sale of preferred stocks at par value: Given: Sale of 5,000 preferred stocks at $50 par value

    Dr. Cash ___________ $250,000

    Cr. Preferred Stock (5,000 @ $50 par value) ___________ $250,000

    (2) Selling of preferred stocks above par value: Given: Sale of 100 preferred stocks @ $50 par value issued at stated value of $100 per share;

    Dr. Cash ___________ $10,000

    Cr. Preferred Stock (100 shares @ $ 50 par value) ___________ $5,000

    Cr. Additional Paid-in Capital Preferred Stocks ___________ $5,000

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    Accounting for the Issuance of Redeemable Preferred Stocks & Stock Buyback Options

    The Concept of Redeemable Preferred Stocks

    The redemption of Redeemable Preferred Stocks is a special transaction and is different from recognizing the buyback of common stocks. The selling of the preferred shares could be under a stock buyback option wherein the company will buy back the preferred shares at a specified period of time and at a certain price referred to as call back price. The call back price is usually higher than the par value of the preferred shares.

    The specific date on which the redemption takes place is usually several years after the issuance of the preferred shares, and it is formally referred to as the exercise date. Once the preferred shares have been called back by the company on its exercise date, shares recalled or bought back will be retired from the company’s books and will no longer qualify as a stock commodity eligible for further trading.

    The accounting entries to buy back common stocks or redeem preferred stocks will first have to recognize the repurchase / redemption by using the Treasury stocks account. This is to provide an accounting trail that indicates the nature of the transaction as a call back deal.

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    Sample Computation of Total Payout for the Redeemable Preferred Stock on Exercise Date

    Given: Preferred stocks totaling 100 shares with par value of $50 were issued at a stated value of $100 per share; 8% cumulative for 2 years compounded quarterly; with buyback option at $102 per share.

    The company will buy back the share at a total price of $11,032, computed as follows:

    1st year = Interest: $5,000 x 8% = $400; fair value of the 100 shares = $5,400

    2nd year = Interest: $5,400 x 8% = $432;

    Total interest due on Exercise Date = $832

    Buyback amount = 100 preferred stocks @ $102 per share = $10,200

    Total Cash Payout = $11,032

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    Continuation of Accounting for the Redemption of Redeemable Preferred Stocks

    1st Accounting Entry: reversal of the original entry will not be debited against the preferred stock account. Instead the Treasury stock contra-account will be used to reduce the total preferred stock issued and outstanding presented in the stockholders’ equity.

    As a note, the $200 amount debited to the retained earnings account technically represents dividends earned by the 100 shares; hence it is not considered as a loss on the transaction.

    Dr. Treasury Stocks (100 Preferred Stocks @ $50 par value redeemed at $102)___________ $5,000

    Dr. Additional Paid-In Capital - Preferred Stocks ___________ $5,000

    Dr. Retained Earnings ___________ $200

    Cr. Cash ___________ $10,200

    Based on our previous examples, the total preferred shares issued will be presented in the stockholders' equity as:

    Preferred Stocks (5,100 Preferred Stocks @ $50 par value) ___________ $255,000

    Treasury Stocks (100 Preferred Stocks @ $50 par value redeemed at $102/ 8% cumulative) $5,000

    Preferred Stocks Issued and Outstanding - $250,000

    For common stocks that are likewise repurchased, similar entries and accounting treatment will be made but using the appropriate accounts for common stocks and additional paid-in capital for common stocks.

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    2nd Accounting Entry: to record the cumulative interest earned by the preferred stock for the two-year call back period.

    This is assuming that on the first year, the $400 interest earned by the redeemable preferred stock was accrued and recognized in the books of accounts. Therefore the second accounting entry on the exercise date would be to recognize the interest or premium paid on the redeemed preferred stocks:

    Dr. Premiums Payable on Redeemable Preferred Stock ___________ $400

    Dr. Premiums Paid on Redeemed Preferred Stock ­___________ $432

    Cr. Cash ___________ $832

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    3rd Accounting Entry: to retire the redeemed preferred stock from the company’s books of accounts:

    Dr. Preferred Stock (100 @ $50 par value) ___________ $5,000

    Cr. Treasury Stocks (100 Preferred Stocks @ $50 par value redeemed at $102) ___________ $5,000

    This entry will now zero-out the Treasury stock account for this particular transaction and the stockholder’s equity will present the preferred stocks at its actual issued and outstanding value at $250,000.

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    Accounting for Declaration and Payment of Cash Dividends

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    Declaration of Cash Dividend – Dividends paid in cash will not affect the balance of the outstanding common or preferred stocks. Instead, the following accounting entries will be taken up:

    Dr. Dividend Expenses___________ $xyz

    Cr. Dividends Payable ___________$xyz

    Payment of Dividends to Stockholders

    Dr. Dividends Payable ___________ $xyz

    Cr. Cash ___________ $xyz

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    Accounting for Stock Dividends

    If the Board of Directors will declare dividends to be paid out in the form of additional shares of the company's common stocks, the following accounting entries will be taken up in the books of the company:

    Stock dividends issued at par value

    Dr. Retained Earnings ___________ $xyz

    Cr. Common Stocks ___________ $xyz

    Stock dividends issued above par value

    Dr. Retained Earnings ___________ $xyz

    Cr. Common Stocks ___________ $xyz

    Cr. Additional Paid-in Capital – Common Stocks ___________$xyz

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    The Statement of Stockholders' Equity

    As a note, if the company’s stockholders’ equity is comprised of both common and preferred shares of stocks, proper accounting for stock transactions requires the presentation of a separate statement of stockholders’ equity in order to present fully the important information regarding the changes that affected the stockholders’ equity accounts during the year.