There is a lot of important terminology when referring to stock and stock transactions. Therefore, I felt that it needed its own post. Here is a breakdown of the important terms you should know in regards to stock.
Common stock is the most basic form of capital that a corporation can have. All corporations will have common stock. One unit of stock is called a share. Common shareholders have certain rights of ownership.
- Voting rights – Common shareholders have the right to vote at annual meetings, either in person or by proxy, on matters such as electing the board of directors, mergers, and liquidation.
- Dividend rights – A dividend is a payment of company profits to the shareholders. Companies are not required to pay dividends but only shareholders can receive dividends. According to a 2013 New York Times article, 54% of companies worth more than $100 million pay dividends.
- Liquidation rights – When a company liquidates, common shareholders have the right to any remaining assets after all debts are paid. Typically, a company liquidates because of poor performance or bankruptcy and the shareholders rarely recover any of their investment in those cases. While the right exists, it is not a very useful one.
- Preemptive rights – If a company issues new shares, those additional shares dilute or lessen the percentage of ownership of the current shareholders. Preemptive rights give the current shareholders the right to purchase enough shares to maintain their current percentage of ownership. For example, if a company plans to issue 100,000 new shares of stock and Bob owns 5% of the current shares of stock, the company must offer 5% of the new shares to Bob before offering them on the open market. Bob must have the cash to purchase the additional shares.
Preferred stock is often called a hybrid investment because it has some characteristics of stock and some characteristics of bonds. Like common shareholders, preferred shareholders have liquidation and dividend rights. Preferred shareholders actually have preferential rights over common shareholders. That means that preferred shareholders would be paid before common shareholders in both circumstances.
Unlike common shareholders, preferred shareholders typically do not get voting rights.
Preferred stock is similar to bonds because it offers a fixed dividend rate. For example, a $1000 preferred share might have a face rate of 7%. That means that for each share owned, the shareholder would get a dividend of $70. This rate is fixed as long as the preferred share is in circulation. Preferred stock can also be called, meaning that after a certain period of time, the company has the right to redeem the preferred shares. Preferred stock can be convertible, which means that the shares can be converted to common stock.
Less than 10% of companies have preferred stock. Click here for a list of companies that have preferred shares.
Treasury stock is stock that has been repurchased by the company. Treasury stock is a contra-equity account and therefore, has a debit balance. Shares of common stock lose all of the rights the shares would traditionally have once they have been repurchased by the company. Treasury shares can serve a number of purposes. Companies will repurchase shares to use for stock options, bonuses, or employee programs (retirement matching or employee stock purchase plans). Companies will also repurchase shares to help strengthen the remaining shares on the market.
Number of Shares Authorized
Authorized shares are the total number of shares the company is allowed to sell. The number of shares authorized is designated in the corporate charter (organizational document). Companies must be sure to authorize enough shares to allow for growth in the company because in most states, it is rather difficult to change the corporate charter.
Number of Shares Issued
Issued shares are the shares the company has elected to sell. This number cannot be greater than the number of shares authorized.
Number of Shares Outstanding
Outstanding shares are the shares that have been issued that are currently not owned by the company as treasury stock. These shares are the shares that are owned by the general public. Outstanding shares include all parties that are not the company, including current and former employees. Only company owned shares are excluded from this total.
When you see the term stockholders’ equity, you should instantly think of a corporation. That is because corporations are the only type of entity that have stockholders. Partnerships have partners. Sole proprietorships have a proprietor. Corporations have shareholders.
A corporation is an entity structure that offers a number of characteristics that make it unique. Some of these characteristics are advantages and some are disadvantages. The important characteristics of a corporation are:
When you create a corporation, it is like giving birth to a child. The corporation is a being separate from the owner. It has many of the rights and privileges that a person would have, things like free speech and the ability to establish credit. It is because of this principle that a number of the other characteristics exist.
Unlimited Life and Continuous Existence
Because a corporation is an entity separate from the owner, even if shareholder were to pass away, the corporation still exists. A corporation can continue to exist until it is dissolved, either because the owners agree to do so or because it is forced into bankruptcy and forcibly dissolved.
Easy Transfer of Ownership
If you watch the stock market, you know how easy it is to buy and sell stock. Every time a stock transaction takes place, partial ownership of the company changes hands. Due to the fact that a corporation is a separate entity from its owners, owners can easily dispose of their ownership stake by simply selling their stock. As long as there is a willing buyer, ownership transfers can take place.
Limited Liability for Shareholders
A corporation can establish credit and enter into business transactions with third-parties. Shareholders are not liable for the actions of the corporation unless a shareholder personally guarantees a debt (which is often required when small corporations are establishing credit). Therefore, shareholders have limited liability against personal losses.
If a corporation gets sued, the shareholders cannot be sued with it. If a corporation goes bankrupt, the shareholders cannot be held liable for the debt (unless personally guaranteed). A shareholder’s liability is limited to the amount of the investment made by the shareholder. For example, if you invest $10,000 in a corporation and that corporation does bankrupt, you will most likely lose your $10,000 investment because the stock will become worthless. You cannot lose more than the investment in the company.
Separation of Ownership and Management
Corporations allow for the separation of ownership and management. That means that owners do not need to be managers and managers do not need to be owners. It is often the case that someone is both, like the case of Mark Zuckerberg at Facebook. In most small corporations, the owners typically manage the company but it is not necessary that owners run the company or are even involved in the day-to-day operations of the company.
In some cases, this is considered an advantage, but if you are a shareholder/manager, you could also lose control of the company you started.
Corporate Taxation and Double Taxation
Unlike sole proprietorships and partnerships, corporations pay taxes at the entity level. According to KPMG (one of the Big 4 Accounting Firms), the U.S. corporate tax rate is approximately 40%. This applies to the profit that the corporation makes. If the company decides to pay out dividends to its shareholders, those dividends are also taxed. The tax on the dividends is collected from the shareholders. The maximum dividend tax rate is 23.9%.
Imagine a corporation has a profit of $1 million and decides to pay out all of the after-tax profit to the shareholders. How much money would the shareholders have after taxes?
One million dollars of corporate profit could be taxed as high as 54.34% leaving $456,600 to the shareholders after all taxes are paid. This is certainly a disadvantage for U.S. corporations.
It is important to be aware of the characteristics of corporations in order to decide how to form a new business venture. It is also important to know these characteristics when working with corporations.
What is a warranty?
Most of the products we purchase come with some type of warranty. A warranty is guarantee that the manufacturer of the product will repair or replace the product for a certain period of time. In 2013, I bought my husband a Weber Smokey Mountain Cooker, because he likes to smoke meat and I like to eat smoked meat. It works out well for everyone! This product came with a 10-year limited warranty. That means that if something breaks because of a defect (not normal wear and tear or abuse), the company will replace the part that broke. This was not something that we purchased in addition to the product. It came with the product as part of the purchase.
Do not confuse standard warranties with extended warranties that consumers purchase for an additional fee.
Why must companies record a liability?
When a company provides a warranty with its product, the company has an obligation to repair or replace the product if it is defective. That obligation generates a liability at the time the product is sold because the company has a liability that starts when the product is sold.
When must the company record the warranty expense?
The matching principle states that a company must match revenue with expenses. If Weber sells a smoker in 2013 but expenses a warranty claim in 2020 (remember it is a 10-year warranty), the company is violating the matching principle. The warranty expense occurs because the sale took place. The expense is a cost of the sale and therefore should be matched with the revenue generated by that sale.
How does the company record an expense for a repair that has not happened yet?
It might seem a little strange to ask a company to record an expense when it hasn’t occurred yet but we have done this many times in accounting. Accounting requires the use of many estimates. Warranties are no exception. Remember when we recorded Bad Debt Expense under the allowance method and had to estimate the expense at the time of the sale? Warranty expense is very similar. We must estimate the expense based on previous company history and record the journal entry.
In order for a company to estimate the warranty expense and liability, we need to know three things:
- How many units of the product were sold during the period of time we need to record?
- What percentage of the products sold will need repairs or replacement based on previous experience?
- What is the average cost of the repair or replacement under warranty?
All of this information is readily available to managers and accounts within the company. To calculate the warranty expense, first figure out how many products will need repair or replacement:
Total number of units sold X Percentage of units that are defective
Next, calculate the cost of repair or replacement for those units:
Units needing repair or replacement X cost per unit to repair or replace
Let’s look at an example to see how a company would estimate and record warranty expense.
Hydration-on-the-Go makes stylish water bottles. Each water bottle includes a one-year warranty against manufacturing defects. Based on five years worth of data, the company estimates that 3% of the water bottles sold will be returned because of a defect. When this occurs the company replaces the water bottle. Each water bottle costs $4 to produce.
In 2013, the company sold 250,000 water bottles. Record the amount of warranty expense that the company should record for 2013.
To record the warranty expense, we need to know three things: units sold, percentage that will be replaced within the warranty period, and the cost of replacement.
First calculate the number of units the company believes will need to be replaced under warranty.
250,000 water bottles sold x 3% defect rate = 750 water bottles potentially defective
Next, calculate the cost of replacing those potentially defective water bottles.
750 water bottles potentially defective x $4 replacement cost = $3000 estimated warranty liability
That is all there is to it. Recording the expense and the liability as an adjusting journal entry.
Recording customer warranty claims
When a customer requests a repair or replacement under warranty, the customer files a claim. The company must record this claim. Every time the company fulfills a claim, a portion of the warranty liability is also fulfilled. In other words, every time a claim is fulfilled, the company must decrease the amount of the liability by the cost of fulfilling the claim.
There are a number of ways that the company can fulfill a claim. It can replace the item with an item from inventory, therefore decreasing inventory. The company could repair the product using parts from inventory and outside labor (which would require cash) or inside labor (wages payable). Always record the replacement or repair at cost, not at the retail value of the item or parts.
On February 1, Hydration-on-the-Go received 14 water bottles in the mail that had been returned by customers to be replaced under warranty. Each water bottle costs $4 to produce and sells for $9. Record the entry for fulfillment of the warranty claims.
The problem is asking us to record the warranty claim. When the company fulfills a warranty claim, we need to debit the estimated warranty liability. This is because part of the warranty obligation is being fulfilled. The amount of liability is decreasing.
Now to determine the account to credit. Ask yourself how how the liability is being fulfilled. How is the company fulfilling the liability in this case? The company is replacing the water bottle. Water bottles are the product that the company sells. They are inventory. Therefore, we will reduce inventory by the amount that the bottles cost. When we use inventory to fulfill the warranty liability, the value of inventory falls.
How much should we record as the cost of the water bottles? If we are removing them from inventory, we should remove them at cost. Therefore, use $4 per water bottle.
14 water bottles x $4 per water bottle = $56 cost of inventory
We have all the information we need to record the journal entry.
In the previous post, we defined and calculated gross pay, payroll taxes, and net pay. In this post, we will discuss how to record the paycheck and the employer taxes.
You might be wondering why this is in the liabilities section of the course. So far we have discussed wage and salaries expense and payroll tax expense. How are liabilities involved?
Once you write the check for $371.28 and you have withheld taxes, those taxes that you have withheld from the check are due to the government. Those taxes represent a liability to the company because the company has an obligation to pay those taxes on behalf of the employee. Also once the employee is paid, the employer has the obligation to pay the employer portion of the taxes. Because of these obligations, this is why you typically see these topics covered in the liabilities section of your accounting textbook.
Let’s look at what we calculated in the previous post. We calculated the net pay that an employee would receive:
We also calculated the amount of taxes that the employer would need to pay.
Now that we have those figures, we need to record this as journal entries. We are going to record this in two pieces. First, record the paycheck then record the employer taxes.
To record the entry for the paycheck, we need to consider a few things:
- The wage expense
- The cash paid to the employee
- The taxes that will be paid later to the various government agencies
The wage expense is the total cost of labor incurred by the company. Wage expense is typically the gross wages paid to the employee. In this case, $480.
Although the wage expense is $480, how much did the employee actually receive? The net pay is $371.28. That is the amount of cash paid to the employee and the amount that the company’s cash will decrease by.
The difference between the gross pay and the net pay is the taxes that were withheld from the employee’s pay. This amount will be recorded as various liabilities.
Here is the journal entry to record the payment of the paycheck:
Notice the Wage Expense is debited for the gross pay. We have credited a liability account for each of the tax amounts. Sometimes you will see all the taxes lumped together into one account called Payroll Taxes Payable. We have also credited Cash for the amount of the net pay.
The entry to record the employer portion of the taxes is similar to the entry above except no cash is paid at the time the entry is recorded. We must record the liabilities that will be paid and the company expense.
The total amount of company expense is $58.80 because the is the total amount of tax that the company incurred. Use the same payable accounts for Social Security and Medicare. We also added two new payable accounts for the two different unemployment taxes.
When working on payroll problems, first calculate the amount of the payroll and employer expenses. This will make doing the journal entries so much easier. It might seem like more work but it will save you time and confusion in the long run because everything is laid out for you.
Payroll is one of the most complicated areas of accounting because of all the rules and regulations surrounding payroll. Not only do we need to calculate taxes, but we also need to subtract things like retirement benefits, health insurance contributions and other employee contributions. This post will cover the basics of payroll and payroll taxes.
What are wages and salaries?
Wages and salaries are the compensation paid to employees for the work they do for a company. Wages are calculated based on an hourly rate and the number of hours an employee works. Salaries are a fixed amount paid to employees no matter how many hours are worked. Salaries are based on an annual or monthly rate. Other items that are considered part of wages and salaries are commission paid to sales people, bonuses paid to employees, holiday pay, and vacation pay. The total compensation paid to employees based on work performed is considered to be the total wage and salary expense for the company. This is also called Gross Payroll.
What taxes are withheld from employee compensation?
Once gross payroll has been calculated, we can start looking at deductions. Taxes generally make up the largest portion of employee deductions. These taxes include social security and medicare taxes, withholding for federal income taxes and withholding for state income taxes. We will look at each of these taxes individually to insure that you understand each of these taxes and how the tax is calculated.
Social Security and Medicare Tax
The Social Security Act was signed into law on August 14, 1935 to provide benefits to retirees, widows, and surviving children. Medicare was later added in 1965 as a health insurance program for retirees over the age of 65. Social Security and Medicare taxes are often referred to FICA tax because of Federal Insurance Contributions Act of 1935 which allowed for the collection of the taxes to pay for these programs.
Social Security and Medicare taxes are paid by employees and matched by their employers.
The current Social Security tax rate is 6.2% and is collected on all wages until an employee earns up to the Social Security wage base limit. For 2014, that amount is $117,000. For 2015, the wage base limit is $118,500. Once an employee makes more than the wage base, no additional tax is collected. The employer is also responsible for matching 6.2% of an employee’s pay up to the wage base limit. The total percentage paid by the employee and the employer is 12.4%
The current Medicare tax rate is 1.45% and is collected on all wages. There is no wage base limit for Medicare. The employer is also responsible for matching the Medicare tax at 1.45%. The total percentage paid by the employee and the employer is 2.9%.
Federal Withholding is the amount that an employer withholds from an employee’s pay that goes toward the employee’s federal income tax liability. Each year, when the employee files his or her federal tax return (typically a 1040, 1040A, or 1040EZ), the form will compare how much the employee must pay in tax with the amount that the employee had withheld from his or her paychecks. If too much tax was withheld, the employee will receive a refund. If too little tax was withheld, the employee will owe money.
When a company hires an employee, the employee is required to fill out an IRS Form W-4. On this form, the employee indicates his or her filing status and the number of allowances the employee is claiming. The employer then uses the withholding tables from IRS Publication 15 (also called Circular E) to determine how much to withhold from an employee’s paycheck. The tables are based on the frequency of pay (weekly, biweekly, monthly) and if the employee is married or single.
It is the employee’s responsibility to properly fill out the form based on the employee’s circumstances. The employer can only withhold based on the W-4 provided.
Currently, there are seven states that do not have an income tax. They are:
- South Dakota
Two additional states do not have an income tax on wages and salaries:
- New Hampshire
If you live on any of the states not listed above, your wages are subject to state withholding for income taxes. The procedure is similar to Federal Withholding. The employee fills out a state form and the employer uses that form to calculate the tax based on state withholding requirements.
Employers are responsible for paying state and federal unemployment taxes for their employees. This is not a tax that is withheld from an employee’s pay. It is an employer expense.
Unemployment taxes pay for benefits paid to people who have been laid off from their job.
Unemployment tax rates and wage base limitations vary state. Most states charge a higher rate to employers that lay off more workers. Typically, the wage base is very low. The majority of states have a wage base that is less than $15,000, with 19 states having a wage base below $10,000. That means unemployment taxes are no longer charged to an employer once that employer pays an employee more than the wage base. Washington had the highest wage base for 2014 at $41,300.
The federal unemployment tax rate is 6% with an $7,000 wage base. Most employers get a credit of up to 5.4% for taxes paid to their state unemployment fund. That means that most employers pay 0.6% (less than 1%) on the first $7,000 of wages paid to each employee.
Basic paycheck and expense calculations
Our ultimate goal is to calculate the employee’s gross pay and the amount of taxes that must be withheld from the employee, as well as the employer tax expense. Net pay is the amount of the check written to the employee after taxes and other deductions are subtracted from gross pay. This is also called take-home pay. Let’s see what a basic paycheck calculation would look like for a company.
Jeff’s Geek-O-Rama has one employee. As of January 14, the first biweekly pay date of the year, the employee had worked 48 hours and is paid at a rate of $10 per hour. According to the employee’s state and federal forms, the company will withhold 10% in federal withholding taxes and 5% in state withholding taxes. The state unemployment rate is 4% on the first $10,000 of wages paid to each employee and the federal unemployment rate is 0.6% on the first $7,000 of wages paid to each employee.
Calculate the gross pay and net pay for the January 14 paycheck. Also calculate the company’s tax expense for this paycheck.
There is a lot of information in this short little problem and it can seem really overwhelming. Let’s start with what the question wants us to do.
- Calculate the gross pay
- Calculate the net pay
- Calculate the company’s tax expense
Now we can tackle each of these one at a time. It is really important to learn the terminology so you can calculate the correct figures.
Gross pay is the amount of wages the employee earned. This is based off the number of hours the employee worked and how much the employee is paid each hour. In this case, the employee worked 48 hours over a two-week period. We know this because we are told the employee is paid biweekly (every two weeks). The employee is paid $10 per hour.
48 hours worked x $10 per hour = $480.00 gross pay
Net pay is the amount the employee takes home after all the taxes are deducted. First, determine which taxes should be withheld from the employee.
- Social Security
- Federal Withholding
- State Withholding
We need to calculate each of these taxes.
Social Security is 6.2% of the gross pay. Multiply the gross pay by 6.2% or 0.062.
$480.00 x 0.062 = $29.76 Social Security tax
Medicare is 1.45% of the gross pay. Multiply the gross pay by 1.45% or 0.0145.
$480.00 x 0.0145 = $6.96 Medicare tax
According to the problem, federal withholding is 10% of gross pay. Multiply gross pay by 10% or 0.1.
$480.00 x 0.1 = $48.00 federal withholding tax
According to the problem, state withholding is 5% of gross pay. Multiply gross pay by 5% or 0.05.
$480.00 x 0.05 = $24.00 state withholding
All the taxes that will be withheld from the employee’s pay have been calculated. For net pay, subtract all the taxes from the gross pay.
Of the $480.00 the employee earned, the employee will take home $371.28. The rest of the money, $108.72 will be paid to the federal and state governments on the employee’s behalf.
The last portion of the problem asks us to calculate the employer taxes. First, list the taxes that the employer must pay.
- Social Security
- Federal Unemployment
- State Unemployment
We need to calculate each of these taxes.
Social Security is 6.2% of the gross pay. Remember that the employee pays this but the employer does as well. Multiply the gross pay by 6.2% or 0.062.
$480.00 x 0.062 = $29.76 Social Security tax
Medicare is 1.45% of the gross pay. This is another tax that is paid by both the employee and the employer. Multiply the gross pay by 1.45% or 0.0145.
$480.00 x 0.0145 = $6.96 Medicare tax
According to the problem, federal unemployment is 0.6% of the first $7,000 of wages paid to each employee. Since this is the first payroll of the year, the employee has only earned $480.00 and is well below the $10,000 threshold. Multiply the gross pay by 0.6% or 0.006. Remember, this is less than 1% so it is 0.006.
$480.00 x 0.006 = $2.88 federal unemployment tax
According to the problem, state unemployment is 4% of the first $10,000 of wages paid to the employee. Since this is the first payroll of the year, the employee has only earned $480.00 and is well below the $10,000 threshold. Multiply the gross pay by 4% or 0.04.
$480.00 x 0.04 = $19.20 state unemployment tax
Add up all the employer taxes to calculate the total employer tax.
This is an expense to the employer on top of the wages paid to the employee. Therefore, the total cost of the employee to the employer is $480.00 in wages plus $58.80 in taxes.
In the next post, we will discuss how to record the journal entries for this payroll transaction.