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Accounting Accounting PrinciplesPrinciplesSecond Canadian EditionSecond Canadian Edition

Weygandt · Kieso · Kimmel · Trenholm

Prepared by: Carole Bowman, Sheridan College

Weygandt Kieso Kimmel Trenholm

CHAPTERCHAPTER

1414

CORPORATIONS: CORPORATIONS: ORGANIZATION AND SHARE ORGANIZATION AND SHARE

CAPITAL TRANSACTIONSCAPITAL TRANSACTIONS

CORPORATE FORM OF CORPORATE FORM OF ORGANIZATIONORGANIZATION

A corporation is a legal entity created by law that is separate and distinct from its owners

CLASSIFICATION OF CLASSIFICATION OF CORPORATIONSCORPORATIONS

A corporation’s purpose may be to earn a profit, or it may be organized as non-profit.

Classification by ownership distinguishes between publicly-held corporations (shares are traded in the stock market) and privately-held corporations (shares are not available on the stock market; thus, they are traded privately).

CHARACTERISTICSCHARACTERISTICS

Separate legal existence (A corporation is an entity in the eyes of the law!)

Limited liability of shareholdersT f bl hi i h Transferable ownership rights

Ability to acquire capital for corporation Continuous life of corporation Corporation management Numerous government regulations Additional taxes (entity tax)

ILLUSTRATIONILLUSTRATION 1414--11ADVANTAGES AND DISADVANTAGES ADVANTAGES AND DISADVANTAGES

OF A CORPORATIONOF A CORPORATION

Advantages Disadvantages

•Corporate management -professional managers•Separate legal existence

•Corporation management -ownership separated from management

•Limited liability of shareholders•Deferred or reduced income taxes (ex. manufacturing deduction, small business deduction)•Transferable ownership rights•Ability to acquire capital•Continuous life

•Increased costs and complexity to adhere to government regulation•Potential for additional income taxes through entity tax. (Corporation is taxed on income as an entity, then shareholders are taxed on dividends as separate entities!)

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ORGANIZATION COSTSORGANIZATION COSTS

Costs incurred in forming a corporation are called organization costs.

These costs include fees to underwriters, legal fees, incorporation fees, and

ti l ditpromotional expenditures.

Organization costs are normally expensed in the year the organization cost is incurred.

SHAREHOLDER RIGHTSSHAREHOLDER RIGHTS

To raise capital, the corporation sells shares.

If only one class of shares exist they are common shares.

Ownership rights specified in articles of incorporation or by-lawsincorporation or by-laws.

Legal Capital: Capital that by law or resolution must remain within a firm and that is restricted for purposes of dividends or other distributions. Legal capital is generally equal to the par or stated value of all outstanding stock. Also called stated capital. (To violate this rule is essentially a Ponzi scheme.)

PonziPonzi SchemeScheme

A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned.

The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

The scheme is named after Charles Ponzi, who became notorious for using the technique in early 1920. He had emigrated from Italy to the United States in 1903. Ponzidid not invent the scheme, but his operation took in so much money that it was the first to become known throughout the United States.

SHARE TERMINOLOGYSHARE TERMINOLOGY

Authorized shares – maximum amount of shares a corporation is allowed to sell as authorized by corporate chartery p

Issued shares – number of shares sold

How many shares should be authorized for sale?

How should the shares be issued? At what price should the shares be issued?

SHARE ISSUE CONSIDERATIONSHARE ISSUE CONSIDERATION

At what price should the shares be issued? What value should be assigned to the

shares?

STOCK MARKET PRICESTOCK 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.interaction between buyers and sellers.

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Par Value: Shares that have a specific value assigned in the corporate charter.

Par value is the legal capital per share that must be kept in the business for protection of corporate creditors.

PAR VALUE SHARESPAR VALUE SHARES

This amount cannot be withdrawn by shareholder.

Par value has no relationship to market value.

Seldom used because: – if market prices rise significantly above par, the low par

value offers little protection to creditors; and

– if market prices fall significantly below par, the corporation can’t raise capital through sale of shares

ISSUING PAR VALUE ISSUING PAR VALUE COMMON SHARES FOR CASHCOMMON SHARES FOR CASH

When common shares have a par value, the par value is credited to the “Common Shares” equity account.

When the selling price exceeds the par value, the excess is credited to the “Contributed Capital in Excess of Par Value” (aka “Paid-in Capital”) equity account. Even though this is capital that is contributed by shareholders, it may be (depending on provincial or state laws) fully or partially available for

Account Titles and Explanation Debit Credit

CashCommon SharesContributed Capital in Excess of Par Value

To record issue of 1,000 shares with $1.00 par value for $5.00 a share.

5,0001,000 4,000

may be, (depending on provincial or state laws) fully or partially, available for paying dividend.

No Par Value: Shares that have no specific value assigned in the corporate charter.

Legal capital equals issue price (proceeds).

Most popular form of shares today (more than 90% of shares in Canadian public companies).

NO PAR VALUE SHARESNO PAR VALUE SHARES ISSUING NO PAR VALUE ISSUING NO PAR VALUE COMMON SHARES FOR CASHCOMMON 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

Account Titles and Explanation Debit CreditCash

Common Shares

To record issue of 1,000 shares at $1/share.

capital.

1,0001,000

NO PAR VALUE SHARES NO PAR VALUE SHARES with with

Stated ValueStated Value

Stated Value No Par Value Shares:

Stated Value: The Board of Directors can assign a value to “no par value” shares.

This “stated” value becomes the legal capital per share.

(State law in the US generally prohibits a corporation from paying dividends or repurchasing shares when doing so would impair its legal capital. Thus, stated value does offer stockholders a measure of protection against loss of value.)

No relationship to market value.

Not highly popular in Canada.

ISSUING ISSUING STATED VALUE STATED VALUE COMMON SHARES FOR CASHCOMMON SHARES FOR CASH

When common shares have a stated value, the stated value is credited to the “Common Shares” equity account.

When the selling price exceeds the stated value, the

Account Titles and Explanation Debit Credit

CashCommon SharesContributed Capital in Excess of Stated Value

To record issue of 1,000 shares with $1.00 stated value for $5.00 a share.

5,0001,000 4,000

g p ,excess is credited to the “Contributed Capital in Excess of Stated Value” equity account.

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In Summary…In Summary…

ILLUSTRATIONILLUSTRATION 1414--55RELATIONSHIP OF PAR, NO PAR AND STATED VALUE SHARES TO RELATIONSHIP OF PAR, NO PAR AND STATED VALUE SHARES TO

LEGAL CAPITALLEGAL CAPITAL

Shares Legal Capital per SharePar value Par value

No par value Entire proceeds

Stated value Stated value

CORPORATE CAPITALCORPORATE CAPITAL

Shareholders’ equity (owner’s equity)

The shareholders’ equity section of a corporation’s balance sheet consists of:corporation s balance sheet consists of: – Contributed capital

• Share capital

• Additional contributed capital

– Retained earnings

ILLUSTRATIONILLUSTRATION 1414--66SHAREHOLDERS’ EQUITY SECTIONSHAREHOLDERS’ EQUITY SECTION

Shareholders’ equity

Contributed capitalCommon shares, 100,000 no par value

shares authorized, 50,000 issued $800,000

Retained earnings

Total shareholders’ equity

130,000

$930,000

SHAREHOLDERS’ EQUITY SHAREHOLDERS’ EQUITY --CONTRIBUTED CAPITAL IN EXCESS CONTRIBUTED CAPITAL IN EXCESS

OF STATED VALUEOF STATED VALUE

Shareholders’ equityContributed capital

Common shares, 10,000 shares of $1 stated value authorized,2 000 shares issued $ 2 0002,000 shares issued

Contributed capital in excess of stated valueTotal contributed capital

Retained earningsTotal shareholders’ equity

$ 2,0004,0006,000

27,000$33,000

ISSUING COMMON SHARES FOR ISSUING COMMON SHARES FOR SERVICES OR NONSERVICES OR NON--CASH ASSETSCASH 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

l f h id i i hvalue of the consideration given up or the consideration received, whichever is more clearly determinable.

REACQUIRED SHARESREACQUIRED SHARESREACQUIRED SHARESREACQUIRED SHARES Reacquired shares are a corporation’s own shares that have been issued, fully

paid for, and then reacquired by the corporation. (A corporation, being a legal person, can buy and own any asset, including stock in other firms or itself!)

In Canada, Reacquired shares are generally retired and cancelled.

– Federally incorporated firms must retire and cancel reacquired shares, effectively returning them to the status of authorized but unissued shares.

Reacquisition and Retirement of Shares:

In certain restricted circumstances, these shares are not retired, but are held as treasury shares for later reissue. “Treasury Shares” are a contra-equity account, meaning that it has a debit balance and is shown as a negative component of stockholders' equity on the balance sheet.

Date Account Title and Explanation Post Ref. Debit Credit

March 1, 2001Common Shares 80,000.00 

Cash 80,000.00 

To record reacquisition and retirement of 20,000 common shares.

Reacquisition and Holding of Shares:

Date Account Title and Explanation Post Ref. Debit Credit

March 1, 2001Treasury Shares ‐ Common 80,000.00 

Cash 80,000.00 

To record reacquisition and holding of 20,000 common shares.

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REACQUISITION OF SHARESREACQUISITION OF SHARES

Why would a company choose to reacquire its shares?– Reduce quantity/raise share priceq y p

– Increase earnings per share (EPS)

– If authorized share limit reached, may need additional shares for use in bonus or compensation plans or acquisitions

REACQUISITION OF SHARESREACQUISITION OF SHARES

Preferred shares have priority over common shares with regards to:

1. Dividends and

2 A i h f li id i

PREFERRED SHARESPREFERRED SHARES

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

Liquidation preference

Cumulative (dividends in arrears)

Convertible (option to exchange for

PREFERRED SHARE PREFERRED SHARE PREFERENCESPREFERENCES

common)

Redeemable/callable (company option to buy back at future for specified price)

Retractable (shareholder option to sell back at future for specified price)

DIVIDEND PREFERENCESDIVIDEND PREFERENCESCUMULATIVE DIVIDENDCUMULATIVE 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 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 CONVERTIBLE PREFERRED SHARESSHARES

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 butwant 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.

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REDEEMABLE PREFERREDREDEEMABLE 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 soit 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 PREFERREDRETRACTABLE 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 similaritiessimilarities.

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.

REMINDERREMINDER--STATEMENT PRESENTATION OF STATEMENT PRESENTATION OF

SHAREHOLDERS’ EQUITYSHAREHOLDERS’ EQUITY

REMINDERREMINDER--STATEMENT PRESENTATION OF STATEMENT PRESENTATION OF

SHAREHOLDERS’ EQUITYSHAREHOLDERS’ EQUITY

In the shareholders’ equity section of the balance sheet, contributed capital and retained earningsare reported and the specific sources of contributed capital are identified.

Within contributed capital, two classifications are recognized:

1. Share capital

2. Additional contributed capital

ILLUSTRATIONILLUSTRATION 1414--1010SHAREHOLDERS’ EQUITY SHAREHOLDERS’ EQUITY

PRESENTATIONPRESENTATION

ZABOSCHUK INC.Partial Balance Sheet

Shareholders’ equityContributed capital

Share capital$9 f d h l$9 preferred shares, no-par value, cumulative, 10,000 shares authorized, 6,000 shares issuedCommon shares, $5 stated value, unlimited shares authorized, 400,000 shares issuedTotal share capital

Additional contributed capitalContributed capital in excess of stated value - common sharesTotal contributed capital

Retained earningsTotal shareholders’ equity

$ 770,000

2,000,0002,770,000

860,0003,630,0001,058,000

$4,688,000

RETURN ON EQUITYRETURN ON EQUITYRETURN ON EQUITYRETURN ON EQUITY

Return on equity (or return on investment) is considered to be the most important measure of a firm’s profitability and efficiency.p y y

Evaluates how many dollars were earned for each dollar invested by the owners.

=Net IncomeAverage

Shareholders Equity

Return on Equity

BOOK VALUE PER SHARE 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

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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

CALCULATION OF BOOK VALUE CALCULATION OF BOOK VALUE WITH PREFERRED SHARESWITH PREFERRED SHARES

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 VALUEBOOK 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 futureinvestors 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.

COPYRIGHTCOPYRIGHT

Copyright © 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.