Financial AccountingDave Ludwick, P.Eng, MBA, PMP, PhD

Chapter 15Organization of Corporations

In this chapter…Balance Sheet

Current Assets

Cash 10000

Current Liabilities

Accounts Payable

Chapter

5000

Accounts Receivable 20000 Wages Payable 25000

Notes Receivable 15000 Utilities Payable 2000

Marketable Securities 25000 Long-Term Debt

Inventory 120000 Notes Payable 20000

Capital Assets Bonds Payable 600000

Equipment 250000 Owner’s Equity

Buildings 500000 Common Stock 15, 16 300000

Goodwill 60000 Retained Earnings

48000

Total Assets 1000000 Total Liabilities + OE 1000000

Corporations• Corporations are entities that are created by law and are

separate from its owners

• Owners are called shareholders. A unit of ownership is called a share

• Corporations can be publicly traded or privately held

Some Characteristics• Separate legal entity

• Limited Liability of shareholders

• Ownership rights are transferable (stock trading)

• Continuous life beyond that of the owners

• Lack of mutual agency (owners may not be corporate agents)

• Easy to raise capital (through share sales)

Organizing a Corporation• Incorporation – the creation of a corporation under federal

or provincial law.– Creates a corporate charter which authorizes the number and type

of shares to be issued

– Describes the structure of the Board of Directors who are responsible for running the corporation

– Exhibit 15.2 shows the corporate authority structure

• Organization costs – the legal fees, promoters’ fees and amounts paid to register and obtain a charter.– Promoters promote the shares of the new company to interested

investors

– These are considered an intangible asset but are usually small and so are amortized over a short period

Definitions of Stocks• Authorized stock – The total number of shares that can be

issued by the company

• Issued stock – Total number of stocks sold by a company from its authorized amount

• Initial Public Offering (IPO) – the initial sale and issue of new stock, usually by a new corporation.

• Outstanding stock - The total number of shares held by stockholders. Dividends are paid on outstanding shares only.

• Treasury stock - Sometimes a company buys its own stock back from stockholders. This stock is held in the treasury.– Treasury stock is often used for employee stock plans

– No dividends are paid on treasury stock.

– Treasury stock can be held indefinitely, resold at any time, or retired.

Role of the Shareholders• Shareholders have the ultimate control over the company

through the election of the Board of Directors. They have one vote per share (usually) at the Annual General Meeting

• The Board of Directors takes a broad role, usually limited to:– Establishing broad corporate policy– Hiring external auditors– Hiring corporate officers and electing a CEO/President

• Shareholder(s) having 50% or more voting shares can elect the Board and control the company– In most situations though, few shareholders actually vote, so a

controlling interest can actually be achieved with less than 50% ownership

Corporate Financial Statements• Required by GAAP, there are 4 corporate financial

statements:– Income Statement

– Statement of Retained Earnings

– Balance Sheet

– Statement of Changes in Financial Position (Cash Flow Statement)

• Key notes:– A corporation is taxed like an individual, so there is typically a tax

expense line in the income statement to reflect this

– Retained Earnings is the income, to date, that has been kept (retained) in the corporation for reinvestment

Issuing Shares• Shares can be sold directly or indirectly

– Directly selling shares involves advertising the company to prospective shareholders directly and is usually done for a closely held/privately held corporation

– Indirectly selling shares involves paying a brokerage house to issue its shares. Underwriting means the brokerage buys the shares from the corporation and resells them for profit to investors. Usually this method is used for widely held corporations

• Selling on the Open Market– Shares can be bought and sold between shareholders in the open

market (some times called the secondary market)

– Buying and selling between shareholders does not affect the corporation’s equity accounts

Issuing Shares for Cash• When common stock is being issued, the company is

distributing rights of ownership in exchange for cash– It then uses this cash to invest in R&D, pay bills, etc

• Common shares is an equity account.

• You can also issue stock for other kinds of assets

Date Account Titles and explanation PR Debit Credit

Dec 31 Cash 300000

Common Shares 300000

Date Account Titles and explanation PR Debit Credit

Dec 31 Insert any asset here 300000

Common Shares 300000

Types of Shares• Common shares are the most commonly issued. Typically

– They have one vote per share at the company’s annual general meeting

– They hold the last claim on assets in the event of insolvency

– They generally don’t receive dividends

• Preferred shares are common shares that are more “senior” to common shares– They hold a more senior claim on assets in the event of insolvency

– They sometimes get a dividend

– They usually don’t have a vote at the AGM

• Exhibits 15.8 and 15.9 give you a good idea of how the two types of shares are shown on the Shareholder’s Equity report and the Balance Sheet

Issuing Shares and Debt• One of the key managerial tasks of corporate managers is

to decide on how to raise funds using the instruments of common shares, preferred shares and debt.

• Common shares have the lowest claim on assets and don’t expect a dividend, but have ownership control (the vote)

• Preferred shares have a more senior claim on assets, no vote, but can receive a dividend.

• Debt has the highest claim on assets, have no vote and don’t receive a dividend, but debt payments are a contractual obligation and can’t be missed.

• Using Preferred Shares or Debt to raise capital are examples of financial leverage

Financial Leverage• Leverage is when you use the money from someone else to

grow the company, or achieve its goals

• Common share holders (the true owners of the corporation) can leverage cash generated from the sale of Preferred Shares or Debt to grow the company

• As long as the net income generated is greater than the dividends paid to preferred shareholders or the interest paid to debt holders, then there is a net increase to the common shareholder and leverage has taken place.– They have leveraged money from preferred shareholders and debt

holders to improve the value of the corporation to the common shareholder

Special Features of Preferred Shares• Preferred shares usually pay a dividend in exchange for the

fact that they do not have a voting right• This is called a Dividend Preference: A dividend could

not be paid to common shareholders until the dividend is paid to the preferred shareholders

• Cumulative Preferred Shares have a right to be paid both current and all prior periods’ undeclared dividends. This is a feature to preferred shares, but it must be a stated feature (not all preferred shares carry this feature)

• Participating Preferred Shares have a feature in which preferred shareholders share with common shareholders in any dividends paid in excess of the dollar amount specified for the preferred shares

Special Features of Preferred Shares• Convertible Preferred Shares give holders the option of

exchanging their preferred shares for common shares. – Usually there is a specified time period in which this can be done

and there is a specified exchange rate for the shares.

– This gives preferred shareholders the advantage of the dividend, but when the company value goes up they can convert to common shares.

– Note that the convertible feature will cause the value of the preferred shares themselves to go up since they are connected to the common shares.

• Callable Shares give the issuing company the right to buy the shares back from owners at a defined date and for defined price

Cash Dividends• Dividends are distributions of earnings. They are paid out

of the company’s net income after all expenses and taxes

• Dividends are basically distributions of Retained Earnings

• Dividends can be paid in the form of cash or more stock

• Company’s generally can (or only will) pay dividends if– The company has enough Retained Earnings

– The company has enough Cash to meet debt, grow the company or cover emergencies

• In the end, issuing dividends is a corporate decision, not an obligation

Paying Dividends• When the Directors decide to pay dividends, the following

journal entry is entered to reserve cash for the dividends

• When the dividend is paid,

Date Account Titles and explanation PR Debit Credit

Dec 31 Cash Dividends 100000

Cash 100000

Dec 31 Cash Dividends 100000

Dividends Payable 100000

Date Account Titles and explanation PR Debit Credit

Jan 16 Dividends Payable 100000

Cash Dividends 100000