Accounting
Principles
Second Canadian Edition
Weygandt · Kieso · Kimmel · Trenholm
Prepared by:
Carole Bowman, Sheridan College
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
Corporate management professional managers
Separate legal existence
Limited liability of
shareholders
Deferred or reduced income
taxes
Transferable ownership rights
Disadvantages
Corporation management ownership separated from
management
Increased costs and complexity
to adhere to government
regulation
Ease of acquiring capital
Potential for additional income
taxes
Continuous life
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
Retained Earnings
xx
xx
To close the Income Summary account by transferring the
year's net income into the Retained Earnings account.

For a net loss
Retained Earnings
xx
Income Summary
xx
To close the Income Summary account to transferring the
year's net loss into the Retained Earnings account.
SHAREHOLDERS’ EQUITY SECTION
Shareholders’ equity
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:
Dividends Payable
xx
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
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
Cash
Common Shares
To record issue of 60,000 shares @ $10/share.
Debit
600,000
600,000
Credit
SHAREHOLDERS’ EQUITY CONTRIBUTED CAPITAL AT NO-PAR
VALUATION
Shareholders’ equity
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

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
Cash
Common Shares
Contributed Capital in Excess of Stated Value
To record issue of 1,000 shares.
Debit
Credit
5,000
1,000
4,000
SHAREHOLDERS’ EQUITY CONTRIBUTED CAPITAL IN EXCESS
OF STATED VALUE
Shareholders’ equity
Contributed capital
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
Shares
Legal Capital per Share
Par value
No par value
Par value
Entire proceeds
Stated value
Stated value
COMMON STOCK RIGHTS
Common stock is the basic, residual element of
ownership in a corporation.
1. To vote at any meeting of shareholders of the
corporation.
2. To receive any dividend declared by the
corporation
3. 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.
REMINDERSTATEMENT 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
$ 770,000
Common shares, $5 stated value, unlimited shares
authorized, 400,000 shares issued
2,000,000
Total share capital
2,770,000
Additional contributed capital
Contributed capital in excess of stated value - common shares
860,000
Total contributed capital
3,630,000
Retained earnings
1,058,000
Total shareholders’ equity
$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
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.
– Indicates the net assets represented by each share of
common stock

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
IMPORTANCE OF BOOK VALUE


Used in judging the reasonableness of the market price
of a stock. (This must be used with caution as current
earnings, dividends per, share, prospects for future
earnings, and current investment market conditions are
usually more important factors affecting the market
price than book value.)
The concept of book value is sometimes important in
contracts. For example, the majority shareholders might
obtain an option to purchase shares of the minority
shareholders at book value at a specified future date.
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.
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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