ACCOUNTING PRINCIPLES Third Canadian Edition Prepared by: Keri Norrie, Camosun College

CORPORATIONS: ORGANIZATION AND SHARE CAPITAL TRANSACTIONS CHAPTER 13

Separate and distinct legal entitySeparate and distinct legal entity Owners known as shareholdersOwners known as shareholders PurposePurpose –Profit –Not-for-profit Classification by ownershipClassification by ownership –Publicly held –Privately held CORPORATE FORM OF ORGANIZATION

ADVANTAGES AND DISADVANTAGES OF A CORPORATION (ILLUSTRATION 13-1) Advantages Disadvantages Corporate management – professional managers Separate legal existence Limited liability of shareholders Potential for deferred or reduced income taxes Transferable ownership rights Ability to acquire capital Continuous life Corporation management – ownership separated from management Increased costs and complexity to adhere to government regulation Potential for additional income taxes

Articles of incorporationArticles of incorporation By-lawsBy-laws Organization costs normally expensedOrganization costs normally expensed FORMING A CORPORATION

A CORPORATION’S ACCOUNTING EQUATION Retained Earnings RevenuesExpenses Share Capital (investments by shareholders) Assets = Liabilities + Shareholders’ Equity The accounting equation is the same as it is for other organizations except different terminology is used in the shareholders’ equity component. Dividends (withdrawals by shareholders) -

OWNERSHIP RIGHTS OF SHAREHOLDERS In return for contributions to the corporation, shareholders receive shares of ownership, either common shares or preferred shares Voting rights Voting rights Share the corporate income by receiving dividends Share the corporate income by receiving dividends Upon liquidation of the corporation, common shareholders have residual claim to assets after creditors and preferred shareholders have been paid Common Shares Preference over common shares for the distribution of earnings by dividends Preference over common shares for the distribution of earnings by dividends Upon liquidation of the corporation, preferred shares have priority over common shares Usually non-voting Upon liquidation of the corporation, preferred shares have priority over common shares Usually non-voting in the claim to the assets in the claim to the assets Preferred Shares

Authorized shares — maximum amount of shares a corporation is allowed to sell, as authorized by its articles of incorporationAuthorized shares — maximum amount of shares a corporation is allowed to sell, as authorized by its articles of incorporation –It does not result in an accounting entry Issued (or “sold”) shares — number of shares given to a shareholder in exchange for a contributionIssued (or “sold”) shares — number of shares given to a shareholder in exchange for a contribution –When the corporation receives the contribution, its assets increase, as does shareholders’ equity (share capital, either common shares or preferred shares) –If the shareholder subsequently sells the shares to another investor, it is a personal transaction that does not affect the corporation. Corporate records would only be changed for the name of the new shareholder SHARETERMINOLOGY SHARE TERMINOLOGY

Account Titles and Explanation Debit Credit Cash Common Shares To record issue of 1,000 shares. ISSUING COMMON SHARES FOR CASH Assume that a corporation issues 1,000 common shares for $1 per share.The effect on the corporation’s accounting equation and the resulting journal entry would be: Assume that a corporation issues 1,000 common shares for $1 per share. The effect on the corporation’s accounting equation and the resulting journal entry would be: 1,000 1,000 Assets = Liabilities + Shareholders’ Equity $1,000

ISSUING COMMON SHARES FOR SERVICES OR NON-CASH ASSETS Measure value as: #1Fair market value of consideration given up, or if that is not determinable #2Fair market value of consideration received

ISSUING COMMON SHARES FOR SERVICES OR NON-CASH ASSETS Assume that lawyers bill a corporation $5,000 in legal services. Rather than being paid in cash, the lawyers accept 4,000 common shares that have a fair market value of $1 per share The shares and legal expense would be recorded at $4,000 = fair market value of the consideration given up by the corporation. This is the cost to the corporation of receiving the legal services. Account Titles and Explanations DebitCredit Legal Fees Expense 4,000 Common Shares 4,000 To record issue of 4,000 shares

SHAREHOLDERS’ EQUITY OVERVIEW - Dividends Expenses + Revenue Share Capital - + Investments (contributions) received in exchange for shares. Similar to sole proprietorships and partnerships, these three components are closed into a permanent equity account. For corporations, this permanent account is called Retained Earnings. Common Shares Preferred Shares For sole proprietorships and partnerships, the four components of equity were recorded to one permanent equity account. For corporations, the investment component is kept separate from the other three components. A corporation may also receive contributions for which shares are not given. These contributions are typically called contributed capital.

SHAREHOLDERS’ EQUITY OVERVIEW Shareholders’ equity Share capital Common shares, 100,000 no par value shares authorized, 50,000 issued Retained earnings Total shareholders’ equity $800, ,000 $930,000 Share capital is the legal capital that must be held in the businessShare capital is the legal capital that must be held in the business Retained earnings can be distributed to shareholders as dividends (similar to owner’s drawings) or retained in the company for operating requirementsRetained earnings can be distributed to shareholders as dividends (similar to owner’s drawings) or retained in the company for operating requirements

A corporation may choose to reacquire its shares from shareholders:A corporation may choose to reacquire its shares from shareholders: –to reduce quantity/raise share price –to increase EPS –if the authorized share limit has been reached Reacquired shares are generally retired and cancelledReacquired shares are generally retired and cancelled In certain restricted circumstances, these shares are not retired, but are held as treasury shares for later reissueIn certain restricted circumstances, these shares are not retired, but are held as treasury shares for later reissue REACQUISITION OF SHARES

To illustrate, assume a corporation has 40,000 common shares issued and a common shares account of $100,000. Average cost = $2.50 ($100,000 ÷ 40,000). Assumption #1: The corporation paid $50,000 to reacquire 20,000 common shares. Common shares will be reduced by the average cost of the shares = 20,000 shares x $2.50 = $50,000.Common shares will be reduced by the average cost of the shares = 20,000 shares x $2.50 = $50,000. Account Titles and Explanations DebitCredit Common Shares 50,000 Cash 50,000 To record reacquisition of 20,000 shares

REACQUISITION OF SHARES Below Cost Assumption #2: The corporation paid $30,000 to reacquire 20,000 of the common shares with an average cost of $50,000. The corporation paid $30,000 to reacquire $50,000 of common shares, meaning it still has $20,000 of the original contributions from the shareholders.The corporation paid $30,000 to reacquire $50,000 of common shares, meaning it still has $20,000 of the original contributions from the shareholders. Since half of the common shares no longer exist, the common share account should be reduced by ½ x $100,000 = $50,000 or 20,000 x $2.50 average cost.Since half of the common shares no longer exist, the common share account should be reduced by ½ x $100,000 = $50,000 or 20,000 x $2.50 average cost. Assets = Liabilities + Shareholders’ Equity Cash $30,000 Common Shares $50,000 Difference of $20,000

REACQUISITION OF SHARES Below Cost While the $20,000 difference is conceptually similar to gains, a company cannot record a gain or a loss from share transactions with their own shareholdersWhile the $20,000 difference is conceptually similar to gains, a company cannot record a gain or a loss from share transactions with their own shareholders The $20,000 is recorded as contributed capital, which is reported as part of shareholders’ equity along with share capital, to indicate the total capital contributed by the shareholdersThe $20,000 is recorded as contributed capital, which is reported as part of shareholders’ equity along with share capital, to indicate the total capital contributed by the shareholders Account Titles and Explanations DebitCredit Common Shares 50,000 Cash 30,000 Contributed Capital – Reacquisition of Shares Contributed Capital – Reacquisition of Shares20,000 To record reacquisition of 20,000 shares

REACQUISITION OF SHARES Above Cost The $5,000 net difference is recorded: #1to contributed capital if a sufficient balance exists in the Contributed Capital account from previous reacquisitions of these class of shares. #2to the Retained Earnings account if there is no credit balance remaining in the Contributed Capital account. Assuming that there is no existing balance in contributed capital, the journal entry would be as follows: Assuming that there is no existing balance in contributed capital, the journal entry would be as follows: Assumption #3: The corporation paid $55,000 to reacquire 20,000 of the common shares with an average cost of $50,000. Account Titles and Explanations DebitCredit Common Shares 50,000 Retained Earnings 5,000 Cash 55,000 To record reacquisition of 20,000 shares

Stock compensation plans (stock options)Stock compensation plans (stock options) Until 2004, corporations did not need to record the value of stock options as an expense, but rather, they could disclose them only in the notes to the financial statementsUntil 2004, corporations did not need to record the value of stock options as an expense, but rather, they could disclose them only in the notes to the financial statements Effective January 1, 2004, Canadian public companies are required to record stock-based compensation as an expense in their financial statementsEffective January 1, 2004, Canadian public companies are required to record stock-based compensation as an expense in their financial statements STOCK COMPENSATION PLANS

Preference over common shares for dividends and assets in the event of liquidationPreference over common shares for dividends and assets in the event of liquidation Entries to record the issue and the reacquisition of preferred shares similar to the entries discussed already for common sharesEntries to record the issue and the reacquisition of preferred shares similar to the entries discussed already for common shares PREFERRED SHARES

Cumulative dividendCumulative dividend – If cumulative, preferred shares are paid both current year’s dividends and any prior years’ dividends in arrears before common shareholders receive dividends PREFERRED SHARES Typical Features ConvertibleConvertible – Provides the option to exchange preferred shares for common shares – To record the conversion, the cost of the preferred shares are transferred to the common shares account

Redeemable and RetractableRedeemable and Retractable – Either the corporation (redeemable) or the shareholder (retractable) can redeem the shares at specified future dates and prices – Offers a repayment of the principal investment similar to debt – Usually reported in the liabilities section of the balance sheet, given its similarity to debt PREFERRED SHARES Typical Features

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 identifiedIn 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:Within contributed capital, two classifications are recognized: 1.Share capital 2.Additional contributed capital

CLOSING ENTRIES FOR CORPORATIONS 1 (INDIVIDUAL) EXPENSES Normal Dr. Balance Normal Cr. Balance Cr. to close Dr. to close Dr. ExpensesCr. Revenues Dr. to close Cr. Balance = Net Income Debit each revenue account for its balance, and credit the income summary account for total revenues. 2. Debit the income summary account for total expenses, and credit each expense account for its balance. 3. Credit the Retained Earnings account for the amount of net income. Dividends RETAINED EARNINGS Dividends Opening balance Net Income 4. Debit Retained Earnings for the amount of dividends declared. 4 Ending balance

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, no par value, unlimited shares authorized, 400,000 shares issued Total share capital Additional contributed capital Contributed capital – reacquired common shares Total contributed capital Retained earnings Total shareholders’ equity $ 770,000 2,800,000 3,570,000 60,000 3,630,000 1,058,000 $4,688,000

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

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