Lesson 23 - Corporations

CORPORATIONS

Three major types of business entities are sole proprietorships, partnerships, and corporations. Most of today's business activities are done through the corporate form of organizations. Many advantages and legal privileges cause the corporations, as legal creatures, become dominant in the business and economy.

Advantages and Disadvantages

The corporate form of business has both advantages and disadvantages when compared with sole proprietorships and partnerships. The primary advantages are: 1) limited liability, 2) possibility of accumulating large amounts of funds, 3) access to the stock exchanges, 4) ease of continuity, transfer, expansion, and contraction of ownerships interests. The primary disadvantages include 1) double taxation, and 2) lack of control.

Definition

Corporation is an entity whose ownership is evidenced by shares of capital stock. Corporations may be closely held or publicly owned. The owners' equity of a corporation is usually called stockholders' equity and is divided into three major sections: 1) contributed capital, 2) earned capital, and 3) unrealized capital.

Common and Preferred Stock

The gathering of capital needed to operate the corporation begins with the sale of common stock, which is the primary class of shares and has the voting right. Preferred stock is a second class of equity capital that may be issued to raise capital and it confers privileges or specifies differences, when compared with ordinary shares. These preferences and differences may involve in one or more of the followings: 1) voting, 2) dividends (cumulative or noncumulative, nonparticipating and partially or fully participating) 3) assets in liquidation, 4) convertibility to other securities, 5) call feature, and 6) redemption.

Issuance of Stock

Capital stock, both common and preferred, may be sold for cash, on a subscription basis, or in exchange for services or noncash assets. It may also be sold or issued in lump sum. When capital stock is issued and exchanged for assets other than cash, the assets acquired should be recorded at fair market value or at the fair market price of the stock issued whichever is more objectively determinable.

In all cases of issuing stock, the capital stock account is credited equal to total par value of stock issued and the difference is recorded in an additional paid-in capital or stock premium account. When nopar stock is issued and a stated or assigned value is determined by the board of directors, the capital stock account is credited equal to the total stated value and again the difference is recorded in an additional paid-in capital account. If there is no stated or assigned value for the stock issued, the total amount is credited in capital stock account.

Organization Costs

Establishing a business in the form of corporation often requires usage of huge amounts of expense. Expenditures incurred in organizing a corporation are charged to an expense account titled Organization Costs. The reason for expensing organization costs is that the determination of the amount and timing of future benefits is so difficult that a conservative approach is required.

Issuance Costs

In addition to organization costs, corporations often incur large expenditures with major issues of capital stock. These expenditures include registration fees, underwriter commissions, attorney and accountant fees, printing, clerical, and promotional costs. These expenditures may be accounted for by an offset method. In fact, issuance costs are costs of financing and should reduce the proceeds received from the sale of stock.

Number of Shares

The number of shares of stock that can be issued legally, as specified in the charter of the corporation, is called authorized capital stock.

Issued stock is the number of shares of authorized capital stock that have been issued to date. The difference between authorized and issued shares is called unissued stock. Outstanding shares are those stocks that have been issued and are currently owned by stockholders.

Treasury stocks are those shares that are reacquired by the issuing corporation. Unissued shares set aside to meet subscription contracts are called subscribed stock.

Dividends

Distribution of earned capital by a corporation to its stockholders is called dividends. Dividends may be paid in cash, in the form of new stock of the company (stock dividend), out of treasury stock, or in other property (property dividend). Three dates are important in the accounting for dividends: declaration date, record date, and the payment date. Only for declaration and payment dates a journal entry is required. The record date refers to the date at which the name of eligible stockholders to receive dividends is determined.

If a dividend is paid out of paid-in capital, it is called a liquidating dividend. Dividends paid in an installment basis are called scrip dividend. Dividends on cumulative preferred stock do not become a liability of the corporation until the board of directors takes formal action. However, dividends in arrears at a balance sheet date should be disclosed by a footnote, a parenthetical notation, or a segregation of retained earnings.

Appropriation of Retained Earnings

The amount of a corporation's retained earnings may be limited by action of the board of directors or by law or contract. The amount restricted, called an appropriation or a reserve, is not directly related to any certain group of assets, and its existence does not imply that an equivalent amount of cash is set aside in a special fund. However, the appropriation may be accompanied by a segregation of cash, in which case the appropriation is said to be funded.

Stock Split

For some companies, the market value of outstanding stock is likely to increase in the exchange. The higher the market price of a stock, the less likely be purchased by the investors. To encourage more investors to enter the market for the company's share, a corporation may decide to split its outstanding stock. A stock split is a change in the number of shares outstanding accompanied by an offsetting change in the par or stated value per share. Because only the number and the par amount of shares change in an offsetting way, there are no changes in the balances of the accounts of the company and no entry is required. When a corporation increases the par or assigned value of its stock and reduces the number of shares outstanding proportionately, a reverse stock split has occurred.

Treasury Stock

For the purpose of controlling stock prices in the exchanges, a corporation may decide to repurchase its outstanding stock. Treasury stock is a corporation's own outstanding stock that has been issued and reacquired by the issuing corporation, and has not been resold or formally retired. They may be resold latter and reclassified as outstanding. Two methods are used to account for treasury stock transactions: a) cost method, one-transaction concept, and b) par value method or dual-transaction concept.

Convertible Debts

If debt securities can be converted into other corporate equity securities during specified period of time after issuance, they are called convertible debts. Convertible bonds, for example, combine the benefits of a bond with the privilege of exchanging if for stock at the holder's option. Investors who desire the advantage of a bond holding, guaranteed interest, plus the added option of conversion if the value of the stock appreciates significantly, purchase convertible bonds.

Accounting for convertible debt involves issues at the time of issuance, conversion, and retirement. Recording convertible bond at the time of issuance follows the methods used in an ordinary bond issue. To record the conversion of bond at the time of conversion, two possible methods of determining the issue price of the stock could be used: the market price of the stock or bond, and the book value of the bonds. At the time of retirement there is a difference between the carrying value of the bond and the cash paid to retire them. If a debt feature for bonds is presumed, the difference should be carried to income. If the bond considered as equity, it should be carried to paid-in capital. Since the method for recording convertible bonds follows the rules for recording straight debt issues, it must be reported currently in income or loss.

Earnings per Common Share

Earnings per share (EPS) amounts must be published in the income statements of corporations whose stock is publicly traded on the stock exchanges. Corporations that have convertible securities and stock options are required to issue additional shares of common stock upon demand of these security holders. These companies must report a primary earning per share and a fully diluted earning per share.

Quasi-Reorganization

A corporation that consistently suffers net losses accumulates negative retained earnings or a deficit. In this case, no dividends may be declared and the company may have finally turned the corner. To permit the corporation to proceed with its plans might well be to the advantage of all interests in the enterprise. A procedure provided for in some state laws eliminates an accumulated deficit and permits the company to proceed on much the same basis as if it had been legally reorganized, without the difficulty and expenses generally connected with a legal reorganization. This procedure is known as quasi reorganization.

Quasi reorganization involves restating the assets to fair values and liabilities to present values with the net amount of these adjustments added to or deducted from the deficit. The balance in the retained earnings (deficit or credit) is then closed to other capital accounts, usually paid-in capital, so that the company has a fresh start with a zero balance in retained earnings.

Stock Warrants

Warrants are certificates entitling the holder to acquire shares of stock at a certain price within a stated period. This option is similar to the conversion privilege because warrants, if exercised, become common stock and usually have a dilutive effect as with the convertible debts.

However, a substantial difference is that the holder has to pay a certain amount to obtain the shares.

The issuance of warrants or options to buy additional shares normally arises under three situations: as an attachment to other securities to be more attractive, as an evidence of preemptive right to purchase common stock in the issuance of additional common stock, and as compensation to executives and employees.

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