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FINANCING DECISIONS Creditors and Investors. REPORTING LIABILITIES. Short-term liabilities Long-term Bonds Payable Issuance Accounting for premium or discount Other liabilities Long-term Leases Contingencies Pensions & Postretirement Benefits Income taxes. Definition of a Lease.

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FINANCING DECISIONS Creditors and Investors

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Financing decisions creditors and investors

FINANCING DECISIONS Creditors and Investors

Reporting liabilities


  • Short-term liabilities

  • Long-term Bonds Payable

    • Issuance

    • Accounting for premium or discount

  • Other liabilities

    • Long-term Leases

    • Contingencies

    • Pensions & Postretirement Benefits

    • Income taxes

Definition of a lease

Definition of a Lease

  • A lease is a contractual agreement between the lessor (owner of the property) and the lessee (user of the property), giving the lessee the right to use the lessor’s property for a specific period in exchange for stipulated cash payments

Diamond Chapter 13

Economic advantages of leasing

For the Lessee:

No (or low) down payment

Avoid risks associated with ownership

Technological obsolescence

Physical deterioration

Changing economic conditions


For the Lessor:

Increased sales

Ongoing business relationship with the lessee

Residual value retained

Economic Advantages of Leasing

Diamond Chapter 13

Lease types

Lease Types

  • Capital leases are accounted for as if the lease agreement transfers ownership of the asset to the lessee

    • The lease is equivalent to a financed purchase

    • An asset and liability must be recorded on lessee’s books

  • Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease

    • Lease payments are recorded as rent expense by the lessee and rent revenue to the lessor

Diamond Chapter 13

Lease classification criteria

Lease Classification Criteria

A lease is classified as a capital lease if any one of the following criteria are met:

  • The lease transfers ownership of the property to the lessee by the end of the lease term

  • The lease contains a bargain purchase option

  • The lease term is equal to 75% or more of the estimated economic life of the leased property

  • The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the property

Diamond Chapter 13

Accounting for leases

Accounting for Leases


On January 1, 2006, Scully Corporation (lessee) enters into a lease with Porter Company (lessor) to lease a piece of equipment for five equal annual year-end installments of $13,870

  • Accounting treatments compared

    • operating lease

    • capital lease

  • For illustration purposes only

  • Classification is not elective

  • Terms of the lease dictate classification

Diamond Chapter 13

Accounting for operating lease

Accounting for Operating Lease

  • Lessee

    • Nothing is recorded on January 1, 2006

    • Each December 31, record rent expense

    • No asset; no liability


    • Continues to carry as an asset

    • Continues depreciation

Diamond Chapter 13

Lessee accounting for capital leases

Lessee Accountingfor Capital Leases

  • Records the equipment as an asset and records an associated liability

    • The asset and liability are recorded at the present value of the lease payments using an appropriate rate of interest

  • Makes annual payments that are divided between interest and principal

  • Depreciates the asset over a 5-year period

Diamond Chapter 13

Lessee accounting for capital leases1

Lessee Accountingfor Capital Leases

  • The interest amount for each year is based on 12% of the balance of the liability at the beginning of the year

  • Annual depreciation is $10,000 ($50,000 ÷ 5 years)

Diamond Chapter 13

Stockholders equity


  • Contributed capital

    • Par value issues

    • Common vs. Preferred stock

  • Retained earnings

    • Cash dividends

    • Stock dividends

  • Other issues

    • Stock splits

    • Treasury stock

Corporations an overview

Corporations: An Overview

  • Fewer in number than sole proprietorships and partnerships, yet ...

  • Generate greatest dollar volume of sales revenues

  • Largest in terms of total assets and owners’ equity



Characteristics of a corporation

Characteristics of a Corporation

  • Separate legal entity

  • Continuous life/transferability of ownership

  • Lack of mutual agency

  • Stockholder limited liability

  • Separation of ownership and management

  • Subject to double-taxation

  • Regulated by government

Stockholders rights





Stockholders generally have rights to:

  • Vote on important matters

  • Receive dividends

  • Share in net assets upon liquidation

  • Maintain proportionate ownership interest in corporation

Paid in capital and retained earnings

Paid-in Capital and Retained Earnings

Owners’ Equity is comprised of 2 elements

Paid in capital and retained earnings1

Paid-in Capital and Retained Earnings

Paid-in Capital (Contributed Capital)

  • Total amount investors have contributed to corporation


Paid in capital and retained earnings2

Paid-in Capital and Retained Earnings

Retained Earnings

  • Corporation’s accumulated earnings and losses since its first day of operations

  • Earnings not distributed back to stockholders in the form of dividends


Classes of stock


Generally fewer rights of stock ownership

Less risky than common stock

First to receive corporate dividends

Second claim against net assets in event of liquidation


4 rights of stock ownership

More risk than preferred stock

Dividends not guaranteed

Residual claims on net assets upon liquidation

Classes of Stock

Par value

Par Value

  • Par value - minimum legal capital of the corporation below which Stockholders’ Equity cannot fall

  • Par value is randomly chosen

  • Generally very low in amount - $.01, $.10, or $1.00

Treasury stock

Treasury Stock

  • Shares of its own stock which the corporation has reacquired from investors

  • Similar to unissued stock

  • No dividends paid on treasury stock

  • Company does not “own” itself

  • Treasury Stock is a contra-equity account

Treasury stock1


1.Use shares for employee compensation

  • Stock option/bonus plans

    2.Reduce number of shares outstanding

  • Might create increase in market price of shares

    3.Wait until market price of stock rises

  • Subsequently re-issue shares to increase total owners’ equity

    4.Withdraw shares from secondary market as defense against corporate takeover

Purchase of treasury stock

Purchase of Treasury Stock

  • Reacquiring shares does not reduce total number of shares issued

  • It does reduce total number of shares outstanding

  • Also reduces total stockholders’ equity

Ethical issues and treasury stock transactions

Ethical Issues and Treasury Stock Transactions

Would it be ethical for a corporation to reacquire its common stock in the week prior to announcing record-breaking financial operating results for the accounting period?

Sale of treasury stock

Sale of Treasury Stock

  • No gain or loss is recognized when corporation re-issues (sells) treasury stock to investors

  • Sale might be made at price above or below that paid by corporation to reacquire its stock

Retained earnings

Retained Earnings

  • Retained earnings represents investors’ claims against assets acquired through reinvestment of net income

  • Balance in Retained Earnings account is NOT the same as cash

Retained earnings1

Retained Earnings

  • Rather, retained earnings is a claim against all assets of the company

  • Cash

  • Inventory

  • Plant assets, etc.



  • Distribution, to stockholders, of assets acquired through profitable operations

  • Board of Directors declares dividends

    • Retained Earnings balance must be sufficient to support the declaration

  • But to pay cash dividends...

    • Cash balance must be adequate

Dividend dates

Dividend Dates

  • Declaration date

  • Date of record

  • Date of Distribution

Dividends on cumulative and noncumulative preferred stock


Similar in character to common stock; no claim to previous years’ unpaid dividends


Previous years’ dividends owed on preferred stock which haven’t been paid must be paid before common stockholders can receive any dividends

Dividends on Cumulative and Noncumulative Preferred Stock

Stock dividends

Stock Dividends

  • Shares of corporate stock given in lieu of cash dividends

  • Shareholders receive shares in proportion to their current level of stock ownership

  • Distribution doesn’t increase or decrease total stockholders’ equity

  • Nor does it affect total corporation assets

Financing decisions creditors and investors

Why issue stock dividends?

Stock dividends1

Stock Dividends

  • Allow corporation to retain cash for re-investment in operations or acquire long-term assets (PP&E) to be used for business activities

  • Stockholders still receive some form of “distribution” from corporation

Stock splits

Stock Splits

  • Increase in number of shares authorized, issued, and outstanding

  • Corresponding proportional decrease in stock’s par value

  • Stimulates more active trading of stocks with very high market prices

Similarities and differences between stock dividends and stock splits


Increase # shares owned and outstanding

Doesn’t change total equity or stockholders’ investments

Decreases par value of stock

Doesn’t shift amounts from one account to another


Increase # shares owned and outstanding

Doesn’t change total equity or stockholders’ investments

Leaves par value unchanged

Shifts amounts from retained earnings to paid-in capital

Similarities and Differences Between Stock Dividends and Stock Splits

Financing decisions creditors and investors




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