Characteristics of a Corporation Chapter 11 A corporation is a business organization authorized by the state to conduct business; it is considered a separate legal entity from its owners. It is the dominant form of American business because it makes possible the accumulation of large quantities of capital. Corporations have the following characteristics that distinguish them from partnerships: Separate Legal Existence. A corporation is a separate entity from its shareholders. A partnership is often treated by the law as a group of individuals acting together rather than one entity. Limited Liability of Stockholders. Because the corporation is a separate legal entity, the owners are not usually liable for the corporation s debt. Thus, a shareholder s liability for a corporate debt is limited to the shareholder s investment in the corporation. Sometimes creditors can pierce the corporate veil, but if corporate formalities are followed this is not usually possible. In the case of a partnership, the law views the partnership s actions as that of its owners, and therefore, the partners have unlimited liability. Creditors may seize all of the partners wealth (including assets not connected with the partnership) in order to satisfy a partnership debt. Transferable Ownership Rights. In a partnership a partner may not transfer his or her interest to another without the permission of all of the other partners, but in a corporation, a shareholder may transfer his or her shares to anyone he or she wishes. Ability To Acquire Capital. American capital markets (e.g., stock exchanges) are geared to raise capital for corporations rather than partnerships. Thus, it is much easier for corporations to raise capital than it is for partnerships. This is more of an advantage of a corporation over a partnership than a characteristic. Continuous Life. In a partnership, if a partner dies, the partnership dies, and a new partnership must be formed. On the other hand, a corporation s existence is not affected by the death of one or all of its shareholders. Corporation Management. In a partnership, any partner may bind the partnership in agreements. This is called mutual agency. Any partner is an agent of all of the other partners. On the other hand, a shareholder has no authority to execute a contract on behalf of his or her corporation. In a partnership, all the partners must vote on any decision. On the other hand, the shareholders do not participate in the management of a corporation s
affairs. In a corporation the board of directors runs the business through its officers. This is called centralized management. Your book also list two more characteristics of corporations. These are not really characteristics but disadvantages of a corporation compared with a partnership: Government Regulations. Because a corporation is a separate legal entity, corporations have more governmental filings than do partnerships Additional Taxes. Because a corporation is a separate legal entity, corporations have to pay income taxes, and shareholders pay taxes on any dividends received from corporations. This is called double taxation. On the other hand, because partnerships are treated (for the most part) as a group of individuals conducting business together, each partner pays tax on his or her share of partnership income. Later, if a partner receives a distribution from the partnership, the distribution is not taxed a second time. Forming A Corporation In California, you form a corporation by filing its articles of incorporation with the Secretary of State. After it is approved, the organizers select the board of directors, who then adopt the by-laws, which are thge rules and procedures for conducting the corporation's affairs. The articles contains such information as (i) the name of the corporation; (ii) the purpose of the corporation; and (iii) the types and number of stock that the corporation is authorized to sell. Organization Costs (Not In Book) The costs of forming a corporation (such as attorneys'fees and incorporation fees) are debited to an intangible asset account called Organization Costs. Because the corporation has an indefinite life, no amortization is required. These costs typically are amortized (straight-line amortization) over the first five years of the corporation's life. This matches the tax treatment of these costs. Fee for services rendered in corporate organization: D. Organization Costs $5,000 Cr. Cash $5,000 Amortization of Organization Costs: D. Amortization Expense $5,000 Cr. Organization Costs $5,000
Stockholder Rights There may be different classes of stock. Every corporation must have a class of stock referred to as common stock. Common stockholders elect members of the Board of Directors, which (i) elects the officers of the corporation, and (ii) oversees the operations of the corporation. Common stockholders are the residual owners of the corporation. They are entitled to all of the assets of the corporation after all of the claims against the corporation are satisfied. Ownership in a corporation is evidenced by a document called a stock certificate, which the shareholder receives when he or she purchases shares in the corporation. The stock certificate states how many shares of stock is owned by the shareholder. If the stockholder wishes to sell his shares, he or she endorses the stock certificate and sends it to the corporation's secretary or its transfer agent. The secretary or transfer agent is responsible for transferring the corporation's stock, maintaining stockholders' records, and preparing a list of stockholders for stockholders'meetings and for the payment of dividends. Issuance of Stock A corporation may sell stock directly to its shareholders. This is called a direct issue. This is typical for small corporations (e.g., you form a corporation and purchase all of the shares of stock). In the case of large offerings of stock to the public, an indirect issue is typically used. In an indirect issue, the corporation retains investment bankers to sell the corporation s stock to the investment banker s clients. Par and On-Par Value Stocks Par value is an arbitrary amount assigned to each share of stock that constitutes the legal value of a share of stock. The common stock is not supposed to be sold initially by the corporation for less than the par value. Thus, creditors and other shareholders know that the stock must be issued for a price above the par value. Also, the par value cannot be returned to the shareholders at a later date. Dividends can only be paid out of earnings, not par value. (Some states allow earnings to be paid out of paid-in capital in excess of par value.) Par value is stated in the articles of incorporation. Sometimes, corporations simulate par value on their own. This is called stated value. The corporation commits itself not to issue the stock less than the stated value. Stated value is handled in a manner similar to par value. Legal capital equals the number of shares issued times the par value; it is the minimum amount that can be reported as contributed capital. When only one type of stock is issued, it is called common stock. A second type of stock, called preferred stock, also can be issued. Preferred Stock also may have a par or stated value.
In California (and other states), stocks do not need to have a par or stated value. They are referred to a no-par stock. Your book notes that no-par stock is common today. Nike and Proctor & Gamble are no-par stocks. Accounting For Common Stock Issues A corporation's balance sheet contains assets, liabilities, and a stockholders'equity section. Stockholders'equity is made up of contributed capital, which is also called "paid-in capital"(the stockholders'investment) and retained earnings (earnings that have remained in the business). When par value stock is issued, the Capital Stock account is credited for the legal capital (par value), and any excess is recorded as Paid-In Capital in Excess of Par Value. Issue par value common stock for par value: D. Cash $1,000 Cr. Common Stock $1,000 Issue par value common stock for amount in excess of par value: D. Cash $5,000 Cr. Common Stock $1,000 Paid-in Capital in Excess of Par Value 4,000 No-par stock is stock for which par value has not been established; it may be issued with or without a stated value. D. Cash $5,000 Cr. Common Stock $5,000 Stated value (which is established by the board of directors) constitutes the legal capital for a share of no-par stock. The total stated value is recorded in the Common Stock account. Any amount received in excess of the stated value is recorded as Paid-in Capital in Excess of Stated Value. Issue stated value common stock for stated value: D. Cash $1,000 Cr. Common Stock $1,000
Issue stated value common stock for amount in excess of stated value: D. Cash $5,000 Cr. Common Stock $1,000 Paid-in Capital in Excess of Stated Value 4,000 Other Stock Issuance Topics (Not In Book) In the stockholders'equity section of the balance sheet, the entire amount received from the shareholders is labeled Total Contributed Capital. On rare occasions, stock is issued at a discount (less than par value), creating a contingent liability (for the amount of the discount) for those stockholders if the corporation cannot pay its debts. When stock is issued in exchange for assets or for services rendered, the stock should be recorded at the fair market value of the assets or services, unless the fair market value of the stock is more easily determined. Issued par value common stock with a market value in excess of par value for a parcel of land: D. Land $5,000 Cr. Common Stock $1,000 Paid-in Capital in Excess of Par Value 4,000 Sometimes a corporation receives gifts or donations from civic groups and/or governments. For example, if you agree to open up a plant in our state or community, we will give you this land and/or facility. States and Communities do this to lure businesses away from other locations. This is called Donated Capital: D. Land $5,000 Cr. Donated Capital $5,000 Accounting For Treasury Stock As noted above, the articles of incorporation indicate the number of shares of stock that a corporation is authorized to issue. This is called authorized stock. Issued stock is the number of shares transferred to stockholders. Stock not sold is unissued. Stock that has been issued to stockholders and has not been bought back by the corporation is called outstanding stock. Treasury stock consists of shares bought back and held. In the equity section of a balance sheet, you will find information regarding the number of shares authorized, issued and outstanding.
Treasury stock is purchased: to distribute to officers and employees through stock option plans; to maintain a favorable market for the company's stock, to use in purchasing other companies, to increase earnings per share, and to prevent a hostile takeover of the company. Purchase of Treasury Stock Treasury stock can be held indefinitely, reissued, or canceled, and it has no rights until it is reissued. Treasury stock appears on the balance sheet as the last item in the stockholders'equity section, as a deduction. Treasury Stock is a contra-equity account. Under the cost method, when treasury stock is purchased, Treasury Stock, Common is debited for the purchase cost. D. Treasury Stock, Common $32,000 Cr. Cash $32,000 Reissue of Treasury Stock (Not In Book) The Treasury Stock may be reissued at cost, above cost, or below cost. When cash received from reissuance exceeds the cost, the difference is credited to Paid-in Capital, Treasury Stock (and Retained Earnings if needed). Reissued shares of treasury stock at cost: D. Cash $32,000 Cr. Treasury Stock, Common $32,000 Sale of one-half of shares of treasury stock at above cost: D. Cash $18,000 Cr. Treasury Stock, Common $16,000 Paid-in Capital, Treasury Stock 2,000 Sale of shares of treasury stock at below cost: D. Cash $13,000 Paid-in Capital, Treasury Stock 2,000 Retained Earnings 1,000 Cr. Treasury Stock, Common $16,000 In no instance should a gain or loss account be established.
When stock is retired, all of the contributed capital associated with the retired shares must be removed from the accounts. Preferred Stock In addition to common stock, a company can also issue preferred stock, which is used to attract investors by giving them certain preferences over common stockholders. Holders of preferred stock are given preference over common shareholders when dividends (and liquidating dividends) are declared. Each share of preferred stock entitles its owner to a dollar amount or percentage of par value each year, before common stockholders receive anything. Once preferred stockholders have received the annual dividends to which they are entitled, however, common stockholders may receive dividends. A dividend does not have to be paid at all because it is not debt. With noncumulative preferred stock, if no dividend is paid in one year, then the preferred stockholders are never entitled to receive that dividend in future years. With cumulative preferred stock, all current dividends plus any missed dividends from prior years (dividends in arrears) must be paid prior to any dividends being paid to common shareholders. Dividends in arrears should be disclosed either in the balance sheet or as a footnote. The journal entries related to preferred stock are similar to those of common stock except that preferred stock is used rather than common stock. For example, if you issue par value preferred stock for amount in excess of par value: D. Cash $5,000 Cr. Preferred Stock $1,000 Paid-in Capital in Excess of Par Value 4,000 Additional Preferred Stock Discussion (Not In Book) An owner of convertible preferred stock has the option to exchange each share of preferred stock for a set number of shares of common stock. Some preferred stock is callable, meaning that the corporation has the right to buy it back for cancellation at a specified call or redemption price. If the preferred stock is convertible, then holders of convertible preferred stock can choose instead to convert it to common stock. Sometimes preferred stock is participating, which means that after they receive all of their dividends and liquidation preferences, then they may receive additional funds. Thus they "participate" in the upside if there are sufficient profits. This is rarely used. Most preferred stock is non-participating.
Preferred stockholders do not usually have the right to vote for directors of a corporation. Very often, however, preferred shareholders will be given the right to vote for directors if the preferred stock is cumulative and preferred dividends have been in arrears for a specified number of years. Cash Dividends A dividend is a distribution of assets by a corporation to its stockholders, normally in cash. Dividends usually are stated as a specified dollar amount per share of stock and are declared by the board of directors. Dividends are declared on the date of declaration, specifying that the owners of the stock on the date of record will receive the dividends on the date of payment. A liquidating dividend is the return of contributed capital to the stockholders. The corporation pays out more than the retained earnings. It normally is paid when a company is going out of business or reducing operations. When cash dividends are declared, the Dividends Declared account is debited and Dividends Payable is credited; when they are paid, Dividends Payable is debited and Cash is credited. Declaration of a cash dividend to common stockholders: D. Dividends Declared $50,000 Cr. Dividends Payable $50,000 Your book also notes that Retained Earnings may be debited instead of Dividends Declared. Payment of cash dividends declared above D. Dividends Payable $50,000 Cr. Cash $50,000 No journal entry is made on the date of record. After the date of record, stock is sold exdividend (without dividend rights). The temporary account, Dividends Declared, will be closed out to Retained Earnings at the end of the year. D. Retained Earnings $50,000 Cr. Dividends Declared $50,000
Stock Dividends A stock dividend is a pro rata distribution of shares of stock to a corporation's stockholders. A Stock dividends: conserves cash; tends to lower the stock's market price; and allows for a nontaxable distribution of additional stock to a corporation's present shareholders. When stock dividends are declared, the general journal entry treats it as if the corporation declared a cash dividend, and then the stockholders turned around and bought stock. The result of a stock dividend is the transfer of a portion of retained earnings to contributed capital. Imagine these two hypothetical transactions: Declare Cash Dividends: D. Dividends Declared $5,000 Cr. Cash $5,000 Stockholders use money to buy stock: D. Cash $5,000 Cr. Common Stock $5,000 If you net these two transactions, you get: D. Stock Dividends $5,000 Cr. Common Stock $5,000 If the stock dividend is less than 20%-25%, it is a small stock dividend. The dividend is assumed to have little impact on the value of the stock, so we value the stock dividend at the current market value of the stock. If that results in a value greater than par value, then the additional amount is credited to Paid In Capital In Excess of Par: D. Stock Dividends Declared $5,000 Cr. Common Stock Distributable $1,000 Paid-in Capital in Excess of Par Value 4,000
If the stock dividend is more than 20%-25%, it is a large stock dividend. The dividend is assumed to affect the value of the stock, so we just use the par value of the stock: D. Stock Dividends Declared $1,000 Cr. Common Stock Distributable $1,000 Stock Dividends is closed out to Retained Earnings. A stock dividend does not affect total shareholder equity, but it does transfer amounts from Retained Earnings to Contributed Capital. D. Retained Earnings $5,000 Cr. Stock Dividends Declared $5,000 When the stock is actually distributed: D. Common Stock Distributable $5,000 Cr. Common Stock $5,000 Stock Splits A stock split is an increase in the number of shares of stock outstanding, with a corresponding decrease in the par or stated value of the stock. For example, a 3 for 1 split on 40,000 shares of $30 par value stock results in the distribution of 80,000 additional shares (that is, a former owner of one share now owns three shares) and the reduction of par value to $10. The amount for each component of stockholders'equity is not affected. A memorandum entry should be made for a stock split, disclosing the decrease in par or stated value as well as the increase in shares of stock outstanding. The purpose of a stock split is to improve the stock's marketability by decreasing the stock's market price. In the above example, if the stock were selling for $180 per share, a 3 for 1 split probably would cause the market price to decline to approximately $60 per share. Retained Earnings As we have mentioned before, a corporation s equity is divided into two parts: (i) the portion contributed by its shareholders and others (Paid-In or Contributed Capital); and (ii) the portion generated by the corporation through its operations (Retained Earnings). A corporation s net income increases its Retained Earnings. A corporate loss or the payment of dividends reduces a corporation s Retained Earnings. Retained Earnings normally has a credit balance. A debit balance in the Retained Earnings is called a deficit.
Retained Earnings Restrictions Retained earnings can be divided into unrestricted and restricted retained earnings. What we have dealt with so far has been unrestricted retained earnings. Unrestricted retained earnings indicate the amount (if available) that can be distributed to stockholders as dividends. Restricted retained earnings cannot be used to pay dividends. Restriction on retained earnings indicates the amount that is to be retained in the business for other purposes. Retained earnings may be restricted for contractual, legal, or voluntary reasons -- by the board of directors only. State law may require restrictions on retained earnings when treasury stock is acquired. Companies might also do this because loan arrangement require it, or because it wants readers to know that it will not be paying dividends because of some policy (e.g., expansion). Retained Earnings is not a cash account. The restriction of Retained Earnings is just a transfer from one account to another, to give notice of the intention not to pay dividends. No money is transferred anywhere. Restrictions on retained earnings are disclosed in the retained earnings portion of the balance sheet or as notes to the financial statements. A restriction on retained earnings will not change total retained earnings. Presentation of Stockholders Equity in Balance Sheet (Not In Book) When reporting stockholder's equity on a Balance Sheet, the preferred stock is listed first because it has preference on distributions over the common stock. The common stock appears next. Donated capital appears last. The following gives you an idea of how all of the different equity accounts are represented on the Balance Sheet. Stockholders'Equity Contributed Capital Preferred stock Common stock Preferred stock subscribed Common stock subscribed Common stock distributable Paid-in capital in excess of par value Total contributed capital Retained Earnings Total contributed capital and retained earnings Less treasury stock Total stockholders'equity
Statement of Retained Earnings (Not In Book) Any changes in the retained earnings of a company is shown in its Statement of Retained Earnings. Statement of Retained Earnings January 1, 2004 $43,933 Net Income 14,500 Subtotal $58,433 Less Dividends -20,000 Retained Earnings, December 31, 2004 $38,433 When a corporation wishes to restrict the payment of dividends out of certain Retained Earnings, it moves that amount out of unrestricted Retained Earnings, into Restricted Retained Earnings: D. Retained Earnings $50,000 Cr. Restricted Retained Earnings $50,000 Prior Period Errors (Not In Book) When you find that you made a mistake in a prior financial statement, you have to correct it. The income effect of the mistake doesn't belong in the current income statement, and you don't change the old income statement. Instead, you calculate what the retained earnings would have been after correcting the mistake and you fix them with an adjustment to the beginning balance of the Retained Earnings Statement. Statement of Stockholders Equity (Not In Book) When an item of shareholders 'equity changes (other than retained earnings), then you use a Statement of Stockholder's Equity. Here every item in the shareholder equity section of the balance sheet gets a column and you show the beginning balance, and how it changed during the year, and its ending balance: Common Stock PIC, in excess of par Retained Earnings Total Balance, January1, 2004 $1,000,000 $500,000 $300,000 $1,800,000 Net Income 80,000 80,000 Dividends (30,000) (30,000) Issue Additional Common Stock 300,000 300,000 600,000 ------------- ------------- ------------- ------------- Balance, December 31, 2004 $1,300,000 $800,000 $350,000 $2,450,000
Financial Statement Analysis For shareholders who are interested in the corporation s ability to pay dividends and its history of paying dividends, two ratios are important: (i) the dividend payout ratio, and (ii) the dividend yield. Dividend Payout Ratio The dividend payout ratio measures the percentage of a corporation s earnings that it pays out to its common shareholders: Dividend Yield Total Cash Dividends Paid To Common Shareholders ---------------------------------------------------------------------------- Net Income Financial analysts use dividend yield to describe a company's dividend policies in terms similar to interest received. Return on Equity Dividend Per Share of Common Stock -------------------------------------------------------- Market Price Per Share of Common Stock When measuring corporate profitability, a popular ratio is the Return on Common Stockholders Equity. This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders. Net Income Preferred Dividends ----------------------------------------------- Average Stockholders Equity