CORPORATIONS: CORPORATIONS: ORGANIZATION AND SHARE ORGANIZATION AND SHARE

CAPITAL TRANSACTIONSCAPITAL TRANSACTIONS

CHAPTERCHAPTER

1414

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 and privately-held corporations.

CHARACTERISTICSCHARACTERISTICS

Separate legal existence Limited liability of shareholders Transferable ownership rights Ability to acquire capital Continuous life Corporation management Government regulations Additional taxes

ILLUSTRATIONILLUSTRATION 14-114-1ADVANTAGES AND DISADVANTAGES ADVANTAGES AND DISADVANTAGES

OF A CORPORATION OF A CORPORATION

Advantages Disadvantages

Corporate management - professional managers

Separate legal existence

Limited liability of shareholders

Deferred or reduced income taxesTransferable 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

ORGANIZATION COSTSORGANIZATION COSTS

Costs incurred in forming a corporation are called organization costs.

These costs include fees to underwriters, legal fees, incorporation fees, and promotional 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-common shares

Ownership rights specified in articles of incorporation or by-laws– Voting…owners

SHARE TERMINOLOGYSHARE TERMINOLOGY

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

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? What value should be assigned to the

shares?

SHARE ISSUE CONSIDERATIONSHARE ISSUE CONSIDERATION

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

Account Titles and Explanation Debit CreditCash Common Shares

To record issue of 1,000 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 capital.

1,000 1,000

CORPORATE CAPITALCORPORATE CAPITAL

Shareholders’ equity (owner’s equity) The shareholders’ equity section of a

corporation’s balance sheet consists of: – Contributed capital

• Share capital• Additional contributed capital

– Retained earnings

ILLUSTRATIONILLUSTRATION 14-6 14-6SHAREHOLDERS’ EQUITY SECTIONSHAREHOLDERS’ 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

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

Account Titles and Explanation Debit Credit

Cash Common Shares

Contributed Capital in Excess of Stated ValueTo record issue of 1,000 shares.

5,000 1,000 4,000

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.

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

OF STATED VALUEOF 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

$ 2,0004,0006,000

27,000$33,000

ISSUING COMMON SHARES FOR ISSUING COMMON SHARES FOR SERVICES OR NON-CASH ASSETSSERVICES 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.

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.

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 SHARESREACQUISITION OF SHARES

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

– Increase EPS

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

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 SHARESPREFERRED SHARES

Liquidation preferenceCumulative (dividends in arrears)Convertible (book value)Redeemable/callable (company option)Retractable (shareholder option)

PREFERRED SHARE PREFERRED SHARE PREFERENCESPREFERENCES

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 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, 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 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 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 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.

REMINDER-REMINDER-STATEMENT PRESENTATION OF STATEMENT PRESENTATION OF

SHAREHOLDERS’ EQUITYSHAREHOLDERS’ EQUITY

REMINDER-REMINDER-STATEMENT PRESENTATION OF STATEMENT PRESENTATION OF

SHAREHOLDERS’ EQUITYSHAREHOLDERS’ 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

ILLUSTRATIONILLUSTRATION 14-10 14-10SHAREHOLDERS’ EQUITY SHAREHOLDERS’ EQUITY

PRESENTATIONPRESENTATION

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 issuedCommon shares, $5 stated value, unlimited shares

authorized, 400,000 shares issuedTotal share capital

Additional contributed capital Contributed capital in excess of stated value - common shares Total contributed capital Retained earnings Total 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.

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

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.

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

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 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.