Question

Lena Kay and Kathy Lauder have a patent on a new line of cosmetics. They need additional capital to market the products, and they plan to incorporate the business. They are considering the capital structure for the corporation. Their primary goal is to raise as much capital as possible without giving up control of the business. Kay and Lauder plan to invest the patent (an intangible asset, which will be transferred to the company’s ownership in lieu of cash) in the company and receive 100,000 shares of the corporation’s common stock. They have been offered \(100,000 for the patent, which provides an indication of the fair market value of the patent. The corporation’s plans for a charter include an authorization to issue 5,000 shares of preferred stock and 500,000 shares of \)1 par common stock. Kay and Lauder are uncertain about the most desirable features for the preferred stock. Prior to incorporating, they are discussing their plans with two investment groups. The corporation can obtain capital from outside investors under either of the following plans:

• Plan 1. Group 1 will invest \(150,000 to acquire 1,500 shares of 6%, \)100 par nonvoting, noncumulative preferred stock.

• Plan 2. Group 2 will invest \(100,000 to acquire 1,000 shares of \)5, no-par preferred stock and \(70,000 to acquire 70,000 shares of common stock. Each preferred share receives 50 votes on matters that come before the common stockholders.

Requirements Assume that the corporation has been chartered (approved) by the state.

1. Journalize the issuance of common stock to Kay and Lauder. Explanations are not required.

2. Journalize the issuance of stock to the outsiders under both plans. Explanations are not required.

3. Net income for the first year is \)180,000, and total dividends are $30,000. Prepare the stockholders’ equity section of the corporation’s balance sheet under both plans at the end of the first year.

4. Recommend one of the plans to Kay and Lauder. Give your reasons

Short answer

1. Patent $100,000 (debited), and Common stock $100,000 (credited)
2. Under plan 1 common stock issued and under plan 2 both common and preferred stock issued.
3. Under plan 1Total Shareholders’ Equity is $400,000 and under plan 2 Total Shareholders’ Equity is $350,000
4. Plan 2 will be recommended.

Step-by-step solution

Journal entry of issuance of common stock

Date	Transactions	Debit	Credit
	Patent	$100,000
	Common stock		$100,000

Journal entry of issuance of stock

Under Plan 1-

Date	Transactions	Debit	Credit
	Cash	$150,000
	Preferred Stock		$150,000
	To record the issuance of preferred stock

Under Plan 2-

Date	Transactions	Debit	Credit
	Cash	$100,000
	Preferred stock		$30,000
	Common stock		$70,000
	To record the issuance of preferred stock and common stock

Balancxe sheet (Partial)-

Under Plan 1-

Balance sheet (Partial)
Preferred stock	$150,000
Common stock	$100,000
Total paid in capital	$250,000
Retained earnings	$150,000
Total Shareholders’ Equity	$400,000

Under Plan 2-

Balance sheet (Partial)
Preferred stock	$30,000
Common stock	$170,000
Total paid in capital	$200,000
Retained earnings	$150,000
Total Shareholders’ Equity	$350,000

Recommendation-

Plan 2 will be recommended.

An increased total shareholders’ equity showing on a company's balance sheet is usually bad news for stockholders because it shows that the additional stock has been issued, which dilute the value of stockholders’ existing shares.