Chapter 20 Corporate Organization and Capital Stock Forms of Business Organization Sole proprietorship Partnership Copyright © Houghton Mifflin Company. All rights reserved. Corporation • Fewest in number • Account for more business transactions than the other two types combined 20 | 2 What Is a Corporation? • “An artificial being, invisible, intangible, and existing only in contemplation of the law.” —Chief Justice John Marshall, 1818 – A separate legal entity – A continuous existence apart from that of its owners (stockholders) – It may (among other things): • Own property • Enter into contracts • Sue or be sued in the court system Copyright © Houghton Mifflin Company. All rights reserved. 20 | 3 Corporations • Issue stock to stockholders • Carry out business activities for the purpose of making profits • Distribute profits to owners © Royalty Free PhotoDisc Blue/ Getty Images Copyright © Houghton Mifflin Company. All rights reserved. 20 | 4 Advantages of the Corporate Form 1. Limited liability – The corporation is responsible for its own debt. – The stockholder can lose only up to the amount of his or her investment. 2. Ease of raising capital – A corporation can issue stock to raise capital. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 5 Advantages of the Corporate Form (cont’d) 3. Ease of transferring ownership rights – Ownership rights in a corporation are represented by shares of stock. – Stock can readily be transferred from one person to another without the permission of other stockholders. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 6 Advantages of the Corporate Form (cont’d) 4. Continuous existence – The length of life of a corporation is stipulated in its charter. • When the charter expires, it may be renewed. – The death, incapacity, or withdrawal of an owner does not affect the life of the corporation. 5. No mutual agency – Stockholders who are not officers do not have the power to bind the corporation to contracts. – Owners need not participate in management. – The corporation is free to employ the managerial talent it believes can best accomplish its objectives. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 7 Disadvantages of the Corporate Form 1. Additional taxation – Taxation of corporate income at two separate points is called double taxation. • First, the net income of the corporation is taxed because the corporation is a separate entity. • When the net income is distributed as dividends to stockholders, it becomes part of the personal income of the individual stockholder and is taxed a second time. – The corporation must pay charter fees (fees paid for the corporation’s right to exist). Copyright © Houghton Mifflin Company. All rights reserved. 20 | 8 Disadvantages of the Corporate Form (cont’d) 2. Government regulation – States often regulate: • The amount of net income that a corporation may retain • The extent to which it may buy back its own stock • The amount of real estate it may own 3. Lack of control by owners – Corporate ownership is separated from the control of operations. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 9 Formation of a Corporation 1. A person or persons applies for a charter. 2. The appropriate state official issues the charter. Charter Written permit, issued by a state government, for a corporation to exist State-approved articles of incorporation Copyright © Houghton Mifflin Company. All rights reserved. 20 | 10 Articles of Incorporation • Include the following information: – – – – Name and legal address of the corporation Nature of the business to be conducted Amount and description of capital stock to be issued Name(s) and address(es) of first governing body of the corporation • Must be accompanied by a charter fee, which is based on the dollar amount of the maximum stock investment as specified in the charter, called authorized capital Copyright © Houghton Mifflin Company. All rights reserved. 20 | 11 Some Definitions Authorized Capital – The maximum number of shares that may be issued for each class of stock (common and preferred) as set out in the charter Copyright © Houghton Mifflin Company. All rights reserved. Capital Stock – General term referring to shares of ownership in a corporation 20 | 12 Some Definitions (cont’d) Closely Held Corporation – A corporation having a relatively small group of owners – Stockholders may also be directors and officers Copyright © Houghton Mifflin Company. All rights reserved. Public Corporation – A corporation having a large group of owners with shares traded on a stock exchange or in overthe-counter markets 20 | 13 What Are Organization Costs? • Organization costs, debited as they are incurred to Organization Expense, include: – – – – – Fees paid to the state Attorneys’ fees Promotional costs Travel outlays Costs of printing stock certificates • Organization Expense appears on the income statement as an Operating Expense. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 14 Stock Certificates • Consecutively numbered documents giving evidence of ownership in shares of stock • Issued only when the stockholder has paid for the shares in full • May have stubs and be bound into a stock certificate book • Stubs list: – Name of the owner – Number of shares issued – Date of issuance Copyright © Houghton Mifflin Company. All rights reserved. 20 | 15 Transfer of Stock Ownership 1. Stockholder surrenders certificate. 2. Corporation cancels certificate and matching stub. 3. Corporation issues one or more stock certificates to the new owner(s). Copyright © Houghton Mifflin Company. All rights reserved. 20 | 16 Maintaining Up-to-Date Records • Corporation uses this information for: – Notifying stockholders of annual meetings – Preparing financial reports – Paying dividends © Royalty Free C Squared Studios/ Getty Images Copyright © Houghton Mifflin Company. All rights reserved. 20 | 17 Structure of a Corporation Copyright © Houghton Mifflin Company. All rights reserved. 20 | 18 Dividends • Distributions of earnings of a corporation, in the form of either cash or additional shares of stock • Sources of dividends: – Current year’s net income – Retained earnings of prior years Copyright © Houghton Mifflin Company. All rights reserved. 20 | 19 Preemptive Right • A stockholder’s right to maintain the same proportionate ownership in a corporation in the future as he or she does originally, through the privilege of subscribing to a new issue of stock in the same proportion as her or his present ownership • Example: Corporation's New Issue of Stock: 1,000 Present amt. of stock outstanding = 10,000 Ruth Allen’s proportional share (2,000/10,000) = 1/5 Number of shares Ruth Allen owns Right to subscribe to before the new issue = 2,000 (1/5 x 1,000) = 200 Copyright © Houghton Mifflin Company. All rights reserved. 20 | 20 Stockholders’ Equity • Stockholders’ equity is the owners’ equity in a corporation. – Also referred to as capital • Assets – Liabilities = Stockholders’ Equity • For a corporation, Capital Stock accounts replace Owner’s Capital accounts in a sole proprietorship. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 21 Retained Earnings Account • A stockholders’ equity account representing capital generated by the corporation’s earnings that remain in the firm • The amount by which net income exceeds dividends paid over the life of the corporation Copyright © Houghton Mifflin Company. All rights reserved. 20 | 22 Stockholders’ Equity Accounts Copyright © Houghton Mifflin Company. All rights reserved. 20 | 23 Capital Stock Issued Stock – Stock issued by a corporation – Stock actually in the possession of stockholders (issued stock less the number of shares reacquired by the company) – Outstanding Stock = Issued Stock – Treasury Stock Outstanding Stock Treasury Stock – A corporation’s own stock, which it has issued and which was at one time outstanding, that the firm reacquires – Treasury Stock = Issued Stock – Outstanding Stock Copyright © Houghton Mifflin Company. All rights reserved. 20 | 24 Why Reacquire Treasury Stock? Corporation may want to: 1. Reissue shares to officers/employees under bonus and stock option compensation plans 2. Rid the company of disgruntled investors 3. Increase trading of company’s stock in the securities market to enhance its market value Copyright © Houghton Mifflin Company. All rights reserved. 20 | 25 Par-Value Stock Versus No-Par Stock • Par-value stock – Par-value stock is stock for which a uniform face value is printed on the stock certificates. – The face value indicates the amount per share to be entered in the Capital Stock account. – Preferred stock generally has a par value. – Common stock may not always have a par value. • No-par stock – No-par stock has no value printed on the stock certificates. – A stated value indicates the amount per share to be entered in the Capital Stock account. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 26 Stated Value • The amount per share of no-par stock that is recorded in the corporation’s stock accounts • An amount designated by law as not subject to withdrawal by stockholders – The minimum stated value varies from state to state. – In some states, the board of directors may choose a stated value that is higher than the minimum required by state law. • Stock will not be issued at an amount below stated value, since the stated value may be changed during a meeting of the board of directors. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 27 Legal Capital • Minimum capital stock investment that a corporation must maintain • Capital that is not subject to withdrawal by stockholders except in liquidation – Protects part of the corporate assets for the creditors • Usually equals total par or stated value Copyright © Houghton Mifflin Company. All rights reserved. 20 | 28 Copyright © Houghton Mifflin Company. All rights reserved. 20 | 29 Common Stock • Stock whose owners are paid dividends only after owners of preferred stock have been paid (residual share) – Although the preferred stockholders are paid first, the potential upside of common stock is that dividends may be greater than preferred stock dividends, which are set at a uniform rate. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 30 Rights of Common Stockholders • • • • Elect board of directors Receive dividends Preemptive right Share in distribution of assets if corporation is liquidated Copyright © Houghton Mifflin Company. All rights reserved. 20 | 31 What Is Preferred Stock? • Preferred stock is stock whose holders are paid dividends at a uniform rate before any dividends are paid to holders of common stock. – Dividends, if declared, consist of an established percentage of par value per share of preferred stock. • The holder of preferred stock also has preference in the distribution of assets in the event of a liquidation. – Holders of preferred stock are paid off before holders of common stock. • In most circumstances, holders of preferred stock do not have voting privileges. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 32 Four Types of Preferred Stock 1. 2. 3. 4. 1 2 3 4 Cumulative preferred stock Noncumulative preferred stock Participating preferred stock Nonparticipating preferred stock Possibilities for Preferred Stock Noncumulative preferred and nonparticipating preferred Participating preferred Cumulative preferred Cumulative preferred and participating preferred Copyright © Houghton Mifflin Company. All rights reserved. 20 | 33 Cumulative Preferred Stock • Preferred stock whose holders must be paid accumulated dividends, or dividends in arrears, before any dividends can be paid to holders of common stock – If the corporation does not pay dividends to the cumulative preferred stockholders, it is obligated to pay them at a later date (before the common stockholders are paid). • Dividends in arrears, or “passed” dividends – Dividends that the firm has failed to pay in prior years to the cumulative preferred stockholders • Most common type of preferred stock Copyright © Houghton Mifflin Company. All rights reserved. 20 | 34 Noncumulative Preferred Stock • Noncumulative preferred stock is preferred stock in which dividends in arrears do not accumulate. • Once dividends are passed, they are gone forever. • Preferred stock is assumed to be noncumulative (and nonparticipating) unless otherwise stated. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 35 Participating Preferred Stock • Preferred stock whose holders share in any extra dividends distributed by the corporation after the regular dividend has been paid to holders of preferred stock and a stipulated dividend has been paid to holders of common stock • Provides for the possibility of dividends (depending on profits and a declaration by the board) above and beyond the uniform rate Copyright © Houghton Mifflin Company. All rights reserved. 20 | 36 Nonparticipating Preferred Stock • Nonparticipating preferred stock is stock in which the dividends are limited to the regular rate. • Preferred stock is assumed to be noncumulative and nonparticipating unless otherwise stated. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 37 Issuing Stock at Par for Cash: An Example • The Rocky Mountain Corporation is organized on July 16 with authorized capital of 4,000 shares of $100-par preferred 8 percent stock and 20,000 shares of $50-par common stock. • On August 1, the company issues 2,000 shares of preferred 8 percent stock at par and 10,000 shares of common stock at par. Copyright © Houghton Mifflin Company. All rights reserved. Authorized Common Stock Number of Shares 20,000 Par Value $50.00 Authorized Preferred Stock Number of Shares 4,000 Par Value $100.00 Uniform Dividend Rate 8% Stock Issuance Date Common Stock Preferred Stock August 1 10,000 2,000 20 | 38 Journal Entry and T Accounts for Transaction Copyright © Houghton Mifflin Company. All rights reserved. 20 | 39 Controlling Accounts and Subsidiary Ledgers Controlling Accounts Subsidiary Ledger • Capital stock accounts • Known as the – Preferred 8 Percent stockholders’ ledger Stock – Common Stock Copyright © Houghton Mifflin Company. All rights reserved. – Stock certificate book or supplementary record showing name and address of each stockholder and number of shares owned 20 | 40 Issuing Stock at Par for Noncash Assets: An Example • On August 1, Rocky Mountain Corporation receives equipment, a building, and land in exchange for 5,420 shares of common stock. Authorized Common Stock Number of Shares 20,000 Par Value $50.00 Authorized Preferred Stock Number of Shares 4,000 Par Value $100.00 Uniform Dividend Rate 8% Stock Issuance Date Common Stock Preferred Stock August 1 5,420 0 Assets should be recorded at their fair market values so that there is a realistic base on which to calculate future depreciation. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 41 Journal Entry with Assets Recorded at Fair Market Value Copyright © Houghton Mifflin Company. All rights reserved. 20 | 42 Issuing Stock at Par for Organization Costs: An Example • On August 1, Rocky Mountain Corporation issues 100 common stock shares to its organizers in exchange for their services in organizing the corporation. • In this case, the fair market value of the service recorded (Organization Expense) is not determinable. • Therefore, the current market price of the stock on the date the service was acquired is used as the amount at which to record the expense and the stock. Copyright © Houghton Mifflin Company. All rights reserved. Authorized Common Stock Number of Shares 20,000 Par Value $50.00 Authorized Preferred Stock Number of Shares 4,000 Par Value $100.00 Uniform Dividend Rate 8% Stock Issuance Date Common Stock Preferred Stock August 1 100 0 20 | 43 Journal Entry for the Transaction Copyright © Houghton Mifflin Company. All rights reserved. 20 | 44 Factors That Influence the Issue Price of Stock 1. The earnings record, financial position, and dividend record of the corporation 2. The potential for growth in earnings of the corporation 3. The supply and demand for money for investment purposes in the money market as a whole 4. General business conditions and prospects for the future Copyright © Houghton Mifflin Company. All rights reserved. 20 | 45 Premiums and Discounts • Premium – The amount by which the issuing price of a stock exceeds the par value • Discount – The amount by which the issuing price of a stock falls below the par value Copyright © Houghton Mifflin Company. All rights reserved. 20 | 46 Issuing Stock at a Premium • When stock is issued for more than its par value, the accountant must credit a premium account. • When stock is issued for less than its par value, the accountant must debit a discount account. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 47 Premium on Stock • For par stock, the accountant records: – Debit to Cash or other noncash asset – Credit to the stock account for the par value – Credit to Paid-in Capital in Excess of Par Value for the difference between the amount received and the par value • Treated as an addition to stockholders’ equity Copyright © Houghton Mifflin Company. All rights reserved. 20 | 48 Issuing Stock at a Premium: An Example McKay Corporation issues 900 shares of $100-par cumulative preferred 9 percent stock at $103 on July 1. Preferred Stock Number of Shares Issued 900 Par Value $100.00 Uniform Dividend Rate 9% Cumulative Yes Issue Price on July 1 $103.00 Calculations for a Premium Cash = Number of Shares Issued x Issue Price on July 1 900 x $103.00 = $92,700.00 Preferred 9% Stock = Number of Shares Issued x Par Value 900 x $100.00 = $90,000.00 Premium on Preferred 9% Stock = Number of Shares Issued x Issue Price - Par 900 x $3.00 = $2,700.00 Copyright © Houghton Mifflin Company. All rights reserved. 20 | 49 Journal Entry and T Accounts for the Transaction Copyright © Houghton Mifflin Company. All rights reserved. 20 | 50 Review T Accounts Copyright © Houghton Mifflin Company. All rights reserved. 20 | 51 Premium on Stock • For no-par stock with a stated value, the accountant records: – Debit to Cash or other noncash asset – Credit to the stock account for the stated value amount – Credit to Paid-in Capital in Excess of Stated Value for the difference between the amount received and the stated value • Treated as an addition to stockholders’ equity Copyright © Houghton Mifflin Company. All rights reserved. 20 | 52 Paid-in Capital • Paid-in Capital is a caption on the balance sheet listed immediately under Stockholders’ Equity. • The Paid-in Capital section includes the Stock accounts and their related Premium or Discount accounts. – For each account, the accountant records all the relevant details, including: • • • • Par value Number of shares authorized Number of shares issued Whether or not the stock is cumulative or participating (not whether it is noncumulative or nonparticipating) Copyright © Houghton Mifflin Company. All rights reserved. 20 | 53 Paid-in Capital • Paid-in Capital is a caption on the balance sheet listed immediately under Stockholders’ Equity. • The Paid-in Capital section includes the Stock accounts and their related Premium or Discount accounts. – For each account, the accountant records all the relevant details, including: • • • • Par value Number of shares authorized Number of shares issued Whether or not the stock is cumulative or participating (not whether it is noncumulative or nonparticipating) Copyright © Houghton Mifflin Company. All rights reserved. 20 | 54 Stockholders’ Equity on the Balance Sheet Copyright © Houghton Mifflin Company. All rights reserved. 20 | 55 No-Par Stock and Stated Value • Advantages of no-par stock: – May be issued without a discount contingent liability – Prevents any misconception on the part of naïve investors as to the value of the stock • The stated value may be changed during a meeting of the board of directors (the value must be higher than the legal minimum required by the state). • No-par stock will not be issued at an amount below the stated value. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 56 Journalize Entries for the Issuance of No-Par Stock • When no-par stock with a stated value is issued, all the proceeds are credited to the stock account. • The entry credits a Paid-in Capital in Excess of Stated Value account for amounts higher than the stated value. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 57 Issuing Stock with Stated Value • Total Security Corporation chooses a stated value of $50 per share for its common stock. • On June 20, Total Security Corporation issues 1,400 shares at $56 per share, receiving cash. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 58 Stock Subscriptions • Sale of stock directly to investors on a subscription contract (installment) basis – The investor enters into a contract with the corporation, promising to pay at a later date for a specified number of shares at an agreed upon price. – The corporation agrees to issue the shares when the investor has paid for them in full. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 59 Recording Sale of Stock on the Subscription Basis • Debit Subscriptions Receivable (a current asset): – Number of Shares × Subscription Price • Credit Stock Subscribed (a Paid-in Capital account): – Number of Shares × Par or Stated Value • For a difference between the subscription price and par or stated value: – For par stock, credit Paid-in Capital in Excess of Par Value account. – For stated value stock, credit Paid-in Capital in Excess of Stated Value for a premium (no discounts allowed). Copyright © Houghton Mifflin Company. All rights reserved. 20 | 60 Recording Receipt of Payments for the Sale of Stock on the Subscription Basis • Debit Cash. • Credit Subscriptions Receivable. • When the subscription is paid in full and the stock is issued: – Debit a Stock Subscribed account. – Credit a Stock account. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 61 Subscription Transactions: No-Par Stock, Mariposa, Inc. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 62 T Accounts for Mariposa, Inc. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 63 Ledger Accounts for Common Stock and Common Stock Subscribed Be sure to list the number of shares in the item column! Copyright © Houghton Mifflin Company. All rights reserved. 20 | 64 Controlling Accounts and Subsidiary Ledgers for Subscribed Stock • Investors finish paying for subscriptions at different times. • Stock is issued when the subscriber has paid in full. • Corporation must maintain an account for each individual subscriber. • Subsidiary ledger is known as the Stock Subscribers’ Ledger. – A record showing the name and address of each stockholder and the number of shares owned Copyright © Houghton Mifflin Company. All rights reserved. 20 | 65 Relationship Between Controlling Accounts and Subsidiary Ledgers Copyright © Houghton Mifflin Company. All rights reserved. 20 | 66 A Corporate Balance Sheet • Refer to Figure 6 on page 770 in your textbook for an example of the classified balance sheet for a corporation. • Note that the credit balance in Retained Earnings represents a surplus. • If the Retained Earnings account were a debit, this would represent a deficit. Copyright © Houghton Mifflin Company. All rights reserved. 20 | 67 Accounts and the Fundamental Accounting Equation Copyright © Houghton Mifflin Company. All rights reserved. 20 | 68