Problem 3 - Accounting

Question

On July 7, Sloth Inc., a marble contractor, issued for cash 40,000 shares of \(\$ 25\) par common stock at \(\$ 40\), and on October 20 , it issued for cash 15,000 shares of \(\$ 100\) par preferred stock at \(\$ 120\). a. Journalize the entries for July 7 and October 20 . b. What is the total amount invested (total paid-in capital) by all stockholders as of October 20?

Step-by-Step Solution

Answer

Total paid-in capital is $3,400,000.

Step 1: Journalizing the July 7 Common Stock Issuance

For the issue of 40,000 shares of common stock on July 7, Sloth Inc. sold each share for \(40, above the par value of \)25. First, calculate the total cash received: \(40,000 \times 40 = 1,600,000\). Next, calculate the par value of the stocks issued: \(40,000 \times 25 = 1,000,000\). Finally, compute the additional paid-in capital (excess) by subtracting the par value from the cash: \(1,600,000 - 1,000,000 = 600,000\). The journal entry is: Debit Cash: \(1,600,000 Credit Common Stock (at par value): \)1,000,000 Credit Additional Paid-In Capital: $600,000.

Step 2: Journalizing the October 20 Preferred Stock Issuance

For the issue of 15,000 shares of preferred stock on October 20, the shares were sold at \(120, above the par value of \)100. First, calculate the total cash received: \(15,000 \times 120 = 1,800,000\). Then determine the par value: \(15,000 \times 100 = 1,500,000\). Compute the additional paid-in capital: \(1,800,000 - 1,500,000 = 300,000\). The journal entry is: Debit Cash: \(1,800,000 Credit Preferred Stock (at par value): \)1,500,000 Credit Additional Paid-In Capital: $300,000.

Step 3: Calculating Total Paid-in Capital as of October 20

To find the total amount invested by all stockholders (total paid-in capital), sum the cash received from both the common and preferred stock issuances. From Step 1, the common stock issuance provided \(1,600,000 and from Step 2, the preferred stock issuance provided \)1,800,000. Adding these gives a total: \(1,600,000 + 1,800,000 = 3,400,000\).

Key Concepts

Journal Entries

Journal entries are essential tools in accounting that help document financial transactions in the company's books. Each entry comprises at least two accounts – one that receives a debit and another that receives a credit. These entries ensure that the accounting equation, Assets = Liabilities + Equity, stays balanced.

When Sloth Inc. issued its stocks, it recorded the transactions through journal entries. For the issuance of common stock on July 7, there was an increase in cash, a debit of $1,600,000. This amount represents the cash received by selling the stock. A credit entry was made to common stock for $1,000,000 to reflect the par value. The difference, an additional $600,000, went into an account called 'Additional Paid-In Capital'.

Similarly, for the preferred stock issuance on October 20, the cash account was debited $1,800,000. This reflects cash inflow from selling preferred shares. A credit of $1,500,000 to preferred stock showed the par value, while the additional paid-in capital credited $300,000 to represent the excess over par value.

Paid-in Capital

Paid-in capital, often seen as 'contributed capital,' is the total amount of cash or other assets a company receives from shareholders in exchange for its stock. It consists of funds above the par value of the stock issued and is an essential part of a company's equity structure.

In the case of Sloth Inc., the additional paid-in capital was generated from the premium received above the par value of both common and preferred shares. For the common stock issued on July 7, the additional paid-in capital was $600,000. For the preferred stock issued on October 20, it was $300,000. Combined, these transactions created $900,000 in extra value for the company's paid-in capital account.

The concept of paid-in capital highlights how firms can acquire more cash by issuing stock at prices exceeding their par value, thus bolstering their financial framework.

Common Stock

Common stock represents ownership in a company and entitles the holder to voting rights. It's a fundamental piece of a corporation's equity structure, allowing investors to share in the company's profits through dividends and capital gains.

For Sloth Inc., the issuance of 40,000 shares of common stock at $40 per share provided significant cash inflow. However, the par value assigned to the common stock was $25 per share. This par value is the nominal value stated in the corporate charter, which primarily serves a legal purpose, having little to do with the market value.

When Sloth Inc. issued its common stock for more than the par value, the difference went into the additional paid-in capital account, emphasizing the liquidity and value the stock brings to the company.

Preferred Stock

Preferred stock is a type of equity security often considered more stable and less volatile than common stock. It gives holders preferential treatment in dividends and during liquidation of assets, but usually without voting rights.

In the case of Sloth Inc., they were able to issue 15,000 shares of preferred stock at $120 while the par value was set at $100. This helped Sloth Inc. raise $1,800,000 in cash, strengthening its financial position. The par value of $1,500,000 was recorded as preferred stock, and the surplus $300,000 was noted as additional paid-in capital.

Preferred stock is beneficial in attracting investors seeking consistent dividends, while also providing the company with a means to enhance its equity without diluting voting control.