Prepared by: Carole Bowman, Sheridan College Accounting Principles Second Canadian Edition Weygandt · Kieso · Kimmel · Trenholm Prepared by: Carole Bowman, Sheridan College

CORPORATIONS: ORGANIZATION AND SHARE CAPITAL TRANSACTIONS CHAPTER 14 CORPORATIONS: ORGANIZATION AND SHARE CAPITAL TRANSACTIONS

CORPORATE FORM OF ORGANIZATION A corporation is a legal entity created by law that is separate and distinct from its owners As a legal entity, may enter into contracts, responsible for its own debts, and pays income taxes on its earnings. A corporation may sue and be sued as if it were a person.

CLASSIFICATION OF CORPORATIONS A corporation’s purpose may be to earn a profit to be non-profit. Classification by ownership distinguishes between publicly-held corporations and privately-held corporations.

CHARACTERISTICS OF A CORPORATION Separate legal existence May act like a person, sue and be sued Enter into contracts Continuous life Ability to acquire capital (e.g. $ and property) Corporation management Government regulations Additional taxes Limited liability of shareholders Transferable ownership rights

ADVANTAGES AND DISADVANTAGES OF A CORPORATION Advantages Disadvantages Corporate management - professional managers Separate legal existence Limited liability of shareholders Deferred or reduced income taxes Transferable ownership rights Ease of acquiring capital Continuous life Corporation management - ownership separated from management Increased costs and complexity to adhere to government regulation Potential for additional income taxes More complex to set up

FORMATION OF A CORPORATION Need a Certificate of Incorporation (Federal or Provincial) or a corporate charter. Articles of incorporation application must be completed and submitted to the government to obtain a certificate of incorporation. Once the certificate or charter is obtained, shareholders in the new corporation hold a meeting to elect Directors and pass By-laws as a guide to the company's affairs.

ORGANIZATION COSTS Costs incurred in forming a corporation are called organization costs. Include: Incorporation fees (Federal or Provincial) Legal fees Underwriter fees Promotional expenditures Organization costs are normally expensed in the year the organization cost is incurred. However, may be capitalized as "Other Assets” and amortized over a maximum of 40 years

CORPORATE CAPITAL Shareholders’ equity (owner’s equity) The shareholders’ equity section of a corporation’s balance sheet consists of: Contributed capital Capital stock Amount invested by the owners of the business When owners invest cash or other assets in the business, the corporation issues capital stock as evidence of the investors' ownership equity Additional contributed capital Retained earnings From profitable operations

CLOSING ENTRIES For a net income Income Summary xx Retained Earnings xx To close the Income Summary account by transferring the year's net income into the Retained Earnings account. For a net loss To close the Income Summary account to transferring the year's net loss into the Retained Earnings account.

SHAREHOLDERS’ EQUITY SECTION Contributed capital Common shares, 100,000 no par value shares authorized, 50,000 issued Retained earnings Total shareholders’ equity $800,000 130,000 $930,000

DIVIDENDS If a corporation has sufficient cash, a distribution of income or earnings may be made to shareholders. This distribution of earnings is termed "Dividends" and decrease both total assets and total shareholder's equity

CASH DIVIDENDS Dividends are only paid through action by the Board of Directors. Once a dividend is declared the following transactions occur. Declaration date: Retained Earnings xx Dividends Payable xx To record declaration by the board of directors of a cash dividend of $1 per share on the 100,000 shares of capital stock outstanding. Date dividend actually paid: Cash xx To record payment of dividend declared on "Date".

SHAREHOLDER RIGHTS To raise capital, the corporation Sells shares Issues debt securities (to be discussed later) If it only has one class of shares: common shares Ownership rights are specified in articles of incorporation or by-laws Voting…owners

SHARE ISSUE CONSIDERATION How many shares should be authorized for sale? How should the shares be issued? At what price should the shares be issued? What value should be assigned to the shares?

SHARE TERMINOLOGY Authorized shares – maximum amount of shares a corporation is allowed to sell as authorized by the corporate charter Issued shares – number of shares sold

Must retain legal capital. relationship to market value once issued. NO PAR SHARE VALUES No assigned legal capital value Legal capital equals issue price (proceeds) Must retain legal capital. No-par value has NO relationship to market value once issued.

ISSUING NO PAR VALUE COMMON SHARES FOR CASH Shares are most commonly issued for cash. When no par value common shares are issued, the entire proceeds from the issue becomes legal capital. Account Titles and Explanation Debit Credit Cash 600,000 600,000 Common Shares To record issue of 60,000 shares @ $10/share.

SHAREHOLDERS’ EQUITY - CONTRIBUTED CAPITAL AT NO-PAR VALUATION Capital Stock, no-par value, authorized, an unlimited number of shares, issued and outstanding, 60,000 shares Retained earnings Total shareholders’ equity $ 600,000 280,000 $880,000

ISSUING CAPITAL STOCK – The role of an Underwriter When a large amount of capital stock is to be issued, most corporations use the services of an investment dealer (i.e. underwriter). The underwriter guarantees the issuing corporation a specific price for the stock and makes a profit by selling the shares to the investing public at a slightly higher price.

SETTING THE ASKING PRICE The price that a corporation will ask for a new issue of capital stock is based on Expected future earnings and dividends The financial strength of the company The current state of the investment markets If a corporation asks too much, it will not find an underwriter or other buyers willing to purchase the shares.

STATED AND PAR SHARE VALUES Stated value – assigned value to no-par value shares Par value – arbitrary amount assigned by a corporation as its legal capital value per share. E.g. $1, $2, $5 per share – any amount Seldom Used Must retain legal capital. Stated and par values have NO relationship to market value.

ISSUING STATED VALUE COMMON SHARES FOR CASH When common shares have a stated value, the stated value is credited to Common Shares. When the selling price exceeds the stated value, the excess is credited to Contributed Capital in Excess of Stated Value. Account Titles and Explanation Debit Credit Cash 5,000 1,000 4,000 Common Shares Contributed Capital in Excess of Stated Value To record issue of 1,000 shares.

SHAREHOLDERS’ EQUITY - CONTRIBUTED CAPITAL IN EXCESS OF STATED VALUE Common shares, 10,000 shares of $1 stated value authorized, 2,000 shares issued Contributed capital in excess of stated value Total contributed capital Retained earnings Total shareholders’ equity $ 2,000 4,000 6,000 27,000 $33,000

RELATIONSHIP OF PAR, NO PAR AND STATED VALUE SHARES TO LEGAL CAPITAL

COMMON STOCK RIGHTS Common stock is the basic, residual element of ownership in a corporation. To vote at any meeting of shareholders of the corporation. To receive any dividend declared by the corporation To receive the remaining property of the corporation on dissolution.

PREFERRED STOCK Preferred shares have priority over common shares with regards to: 1. Dividends and 2. Assets in the event of liquidation Preferred shareholders usually do not have voting rights Preferred shares are shown first in the share capital section of shareholders' equity

PREFERRED SHARE PREFERENCES Liquidation preference Cumulative (dividends in arrears) Convertible (book value) Redeemable/callable (company option) Retractable (shareholder option)

DIVIDEND PREFERENCES CUMULATIVE DIVIDEND A cumulative dividend requires that preferred shareholders be paid both current and prior year dividends before common shareholders receive any dividends. Preferred dividends not declared in a given period are called dividends in arrears. Dividends in arrears are not considered a liability, but the amount of the dividends in arrears should be disclosed in the notes to the financial statements.

CONVERTIBLE PREFERRED SHARES Convertible preferred shares allow the exchange of preferred shares into common shares at a specified ratio. This kind of share is purchased by investors who want the greater security of a preferred share, but who also desire the added option of conversion. In recording the conversion, the book value of the preferred shares is used. The conversion of preferred shares does not result in either gain or loss to the corporation. The market value of the shares is not considered.

REDEEMABLE PREFERRED Redeemable (callable) preferred shares grant the issuing corporation the right to purchase the shares from shareholders at specified future dates and prices. This call feature allows some flexibility to a corporation by enabling it to eliminate this type of equity when it is advantageous to do so. While convertible shares are for the benefit of the shareholder, redeemable shares are for the benefit of the corporation.

RETRACTABLE PREFERRED Retractable preferred shares are similar to redeemable preferred shares except that the shareholder can redeem shares at their option instead of the corporation’s. Retractable preferred shares and debt have many similarities. Both offer a rate of return to the investor, and with the redemption of the shares they both offer a repayment of the principal investment. Retractable preferred shares are presented in the liability section of the balance sheet rather than in the equity section because it has more of the features of debt than equity.

REMINDER- STATEMENT PRESENTATION OF SHAREHOLDERS’ EQUITY In the shareholders’ equity section of the balance sheet, contributed capital and retained earnings are reported and the specific sources of contributed capital are identified. Within contributed capital, two classifications are recognized: 1. Share capital 2. Additional contributed capital

SHAREHOLDERS’ EQUITY PRESENTATION ZABOSCHUK INC. Partial Balance Sheet Shareholders’ equity Contributed capital Share capital $9 preferred shares, no-par value, cumulative, 10,000 shares authorized, 6,000 shares issued Common shares, $5 stated value, unlimited shares authorized, 400,000 shares issued Total share capital Additional contributed capital Contributed capital in excess of stated value - common shares Total contributed capital Retained earnings Total shareholders’ equity $ 770,000 2,000,000 2,770,000 860,000 3,630,000 1,058,000 $4,688,000

STOCK MARKET PRICE Shares of publicly held companies are traded on organized exchanges at dollar prices per share established by the interaction between buyers and sellers Investors’ expectations as to the profitability of future operations greatly affect the market value of common shares. Bear Market = stock prices are falling Bull Market = stock prices are rising

STOCK MARKET PRICE Once shares are issued they belong to the shareholders, not to the corporation. Therefore, changes in the market price of the shares do not affect the financial statements of the corporation, and these changes are not recorded in the corporation’s accounting records. The contributed capital shown in the corporate balance sheet represents the amount received when the stock was issued, not the current market value of shares.

ISSUING COMMON SHARES FOR SERVICES OR NON-CASH ASSETS Shares may be issued for services, such as compensation to lawyers, or for non-cash assets, such as land. When common shares are issued for services or non-cash assets, cost is either the fair market value of the consideration given up or the consideration received, whichever is more clearly determinable.

SUBSCRIPTIONS TO CAPITAL STOCK Small, newly formed corporations sometimes offer investors an opportunity to subscribe to shares of the company’s capital stock. Under a subscription plan, the investors agree to purchase specified numbers of shares at a stated price at a future date, often by making a series of installment payments. The stock is issued after the entire subscription price has been collected.

DONATED CAPITAL On occasion, a corporation my receive assets as a gift. (e.g. land given by the city to build a factory) Both total assets and total shareholders’ equity increase by the market value of the assets received. DR Asset CR Donated capital No income is recognized when a gift is received.

REACQUIRED SHARES Reacquired shares are a corporation’s own shares that have been issued, fully paid for, and then reacquired by the corporation. Reacquired shares are generally retired and cancelled. In certain restricted circumstances, these shares are not retired, but are held as treasury shares for later reissue.

REACQUISITION OF SHARES Why would a company choose to reacquire its shares? Reduce quantity/raise share price Increase EPS (earnings per share) If authorized share limit is reached, may need additional shares for use in bonus or compensation plans or acquisitions

Total Shareholders’ Equity Number of Common Shares BOOK VALUE PER SHARE Book value per share represents the equity a common shareholder has in the net assets of the corporation from owning one share. The formula for calculating book value per share when a corporation has only one class of shares is:  = Total Shareholders’ Equity Number of Common Shares Book Value per Share

CALCULATION OF BOOK VALUE WITH PREFERRED SHARES When a company has both preferred and common shares, the calculation of book value is more complex. Steps required are: 1. Calculate the preferred shareholders’ equity (the sum of redemption price of preferred shares plus any cumulative dividends in arrears). 2. Determine the common shareholders’ equity (total shareholders’ equity less preferred shareholders’ equity). 3. Divide common shareholders’ equity by the number of common shares to determine book value per share.

BOOK VALUE VS. MARKET VALUE Book value per share seldom equals market value. Book value is based on historical costs; market value reflects the subjective judgement of thousands of shareholders and prospective investors about the company’s potential for future earnings and dividends. Market value per share may exceed book value per share, but that fact does not necessarily mean that the shares are overpriced.

Average Shareholders Equity RETURN ON EQUITY Return on equity (or return on investment) is considered to be the most important measure of a firm’s profitability and efficiency. Evaluates how many dollars were earned for each dollar invested by the owners.  = Net Income Average Shareholders Equity Return on Equity

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