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Chapter 14 – Corporation Organization & Capital Stock Transactions

1. Corporation (a) Separate legal entity (b) Limited liability exists. This means that the stockholders are only at risk to the extent of the financial investment in the company. The stockholders personal assets are protected. (c) The stock certificates represent the ownership interest of the corporation and are easily transferable by stockholders. Although the stockholders can transfer shares of ownership as they buy and sell stock, the corporation is unaffected by these transactions. The stock is considered issued and outstanding regardless of who owns the shares. (d) Unlike that of a partnership, the business continues regardless of the transfer of ownership by the stockholders. (e) There are increased governmental & regulatory reporting requirements that must be complied with. (f) Income tax is assessed at the entity level. unlike a partnership that is a flow through entity and income and the related tax liability flows through to the individual partners and is paid in the form of individual income tax. (g) Double taxation occurs. Initially the company is taxed when it earns the income and again as personal income to the stockholders when a dividend is received. Remember that a dividend is not an expense of the corporation. It is a redistribution of net income and results in a reduction of equity. Therefore a corporation cannot get a tax deduction for payment of dividends. (h) If a corporation temporarily delays payments of dividends and the result is high levels of retained earnings, an accumulated earnings and profits tax can be assessed. (i) Corporations will usually raise large sums of capital through the issuance of capital stock (either preferred or common). This is an example of equity financing. 2. Equity Financing (a) With equity financing, there is no repayment by the corporation of the amount initially invested by the stockholders. The only situation that would result in a repayment of the amount invested by the stockholders would be if the corporation was terminating its business affairs and issued a liquidating dividend to the stockholders. This is deemed to be a return of principal to the stockholder and is not considered income for tax purposes. (b) This type of financing does not create liabilities on the balance sheet.


(c) There is no obligation to pay dividends to the stockholders since dividends are distributed from net income of the corporation. Therefore the company cannot guarantee that it will generate net income and cannot guarantee the payment of dividends. However it is in the best interests of the company to issue dividends (in some form) as frequently as possible. (d) A corporation cannot be sued by the stockholders for non payment of dividends 3. Debt Financing (a) When a corporation borrows money from the bank, a company, or when the corporation issues long-term bonds these transactions are considered examples of debt financing. (b) The corporation must repay the face amount of the obligation and pay interest at some periodic frequency (monthly, semiannually etc.) over the life of the obligation. (c) The creditors have priority claim against the assets of the company ahead of the stockholders. (d) The creditors can sue the corporation for non-payment of interest and the principal amount of the borrowing. 4. Organizational Structure (a) (b) (c) (d) Stockholders Board of Directors CEO & Officers Employees

Note: The stockholders can elect the Board of Directors. The Board of Directors will establish corporate policy and select the CEO (Chief Executive Officer) and other officers to manage, the daily operations of the corporations. They also decide when and how much of a dividend, if any, will be declared and paid to the stockholders. The officers will select the employees to be hired. 5. The Accounting Equation is revised for the corporate form of organization structure and is expressed as follows: Assets = Liabilities + Stockholders’ Equity 6. Stockholders’ Equity Section – Basic Format Capital Stock (either common or preferred stock) Additional Paid in Capital XXX XXX


Retained Earnings /(Deficit) Total Stockholders’ Equity


Note: The total of the capital stock and additional paid in capital represent the amount invested by the stockholders (owners) of the corporation. The retained earnings represent the cumulative income less any dividends declared since the inception of the business. If the business had operated at a net loss in excess of income the result would be called deficit and reported parenthetically. 7. Par Value (a) Arbitrary value that is assigned to a share of stock when it is authorized in the charter. The par value is printed on each stock certificate along with the number of shares and the name of the stockholder. (b) Does not correlate to a stock’s market value (c) Establishes the MLC (Minimum Legal Capital) of the corporation (d) MLC represents an amount that cannot be used by the corporation and must be reserved for the future payment of the creditors. (e) As a result of the MLC, corporations will establish low par values to minimize the amount that must be retained. (f) The true value of the stock is the market price not the par value. The value in the stock market is affected by certain factors: -Financial condition of the company, earnings record, and dividend payout. -Current and potential investors expectations of corporate performance the value that is set between a willing buyer and seller. 8. Stated Value (a) A value that is assigned to “no par” stock. (b) The stated value becomes the MLC. (c) The Board of Directors can change the value at any time. (d) If there is no stated value, then the entire proceeds received related to the issuance is recorded as capital stock.


9. Common Stockholders Rights (a) A common stockholder can vote at the stockholders meetings (b) Sell or depose of stock (c) They have the first opportunity to purchases additional stock (pre-emptive right). They have the right to keep the same percentage of ownership when the new shares are issued by purchasing additional shares. (d) Receive dividends (e) Share in the remaining assets, after the preferred stockholders in the event of business liquidation. 10. Preferred Stock (a) This type of stock has no voting rights. (b) Has a priority over common stock regarding dividend distribution. (c) In the event of a business liquidation, the net assets (assets remaining after all the liabilities have been paid off) will go to the preferred stockholders first and then to the common stockholders. (d) Dividends are guaranteed, providing that earnings exist. (e) A cumulative feature may exist which means s that any undeclared dividends accumulate each year until they are received. Once a dividend is distributed, it must go to the cumulative preferred stockholders prior to the common stockholders receiving any distributions. (f) Unpaid dividends are called dividends in arrears and the amount must be fully disclosed in a footnote to the financial statements as of the balance sheet date. (g) A participating feature may exist, this means that when preferred stockholders are initially paid dividend, additional dividends can be given beyond the stated percentage amount.

11. Organization Costs (a) For purposes of GAAP, these costs are to be expensed as incurred. This treatment is considered more conservative since at the time that the costs are incurred, it is difficult to associate a time period and to quantify the future benefits that will result.


(b) Examples: accounting fees, legal fees, promoter’s fees, and incorporation fees. (c) For income tax reporting purposes, these costs are capitalized and written off over a period of 5 years. To avoid the timing differences between the tax return and the financial statements, the 5-year period is used for financial statement purposes. 12. Treasury Stock (a) This results when a corporation reacquires its own stock. A corporation may reacquire its own stock for one of the following reasons: to reissue to officers and employees under a bonus or stock compensation plan. if they feel that the current market value is low they will try to increase trading of the Company’s stock to increase the market value. have additional shared available for use in the acquisition of other companies. reduce the number of shared outstanding and thereby increase the earnings per share.

(b) This stock is no longer outstanding and reduces the amount of stockholders’ equity. The stock has not been retired or cancelled. it is still issued but is not outstanding, (c) The purchase of Treasury stock does not reduce the balance of the retained earnings account. (d) The purchase places a restriction on the amount of retained earnings available for dividends. (e) Treasury stock may subsequently be reissued by the corporation above, below or at cost.