Organization and Operation of Corporations

CHAPTER 10CHAPTER 10

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1. Identify characteristics of corporations and their organization.

2. Describe and contrast the specialized components of corporate financial statements.

3. Record the issuance of common and preferred shares and describe their presentation in shareholders’ equity on the balance sheet.

Learning ObjectivesLearning Objectives

4. Describe and account for cash dividends.

5. Distribute dividends between common and preferred shares.

6. Record closing entries for a corporation

7. Compute book value and explain its use in analysis (Appendix 15A).

Learning ObjectivesLearning Objectives

Separate legal entitySeparate legal entity Limited liability of shareholdersLimited liability of shareholders Ownership rights are transferableOwnership rights are transferable Continuous lifeContinuous life Shareholders are not corporate agentsShareholders are not corporate agents Ease of capital accumulationEase of capital accumulation Government regulationGovernment regulation Corporate taxationCorporate taxation

Characteristics of CorporationsCharacteristics of Corporations

The company:The company: obtains a certificate of incorporation from obtains a certificate of incorporation from

the federal or provincial government, the federal or provincial government, sells shares to its subscribers, sells shares to its subscribers, elects a board of directors, and elects a board of directors, and establishes a set of bylaws regarding the establishes a set of bylaws regarding the

internal activities of the corporation.internal activities of the corporation.

Organizing a CorporationOrganizing a Corporation

Costs include legal fees, promoters’ Costs include legal fees, promoters’ fees and amounts paid to obtain a fees and amounts paid to obtain a charter.charter.

These costs are treated as an These costs are treated as an intangible asset and are amortized.intangible asset and are amortized.

The amortization period is often short The amortization period is often short since these fees are small in amount. since these fees are small in amount.

Organization CostsOrganization Costs

Example: A corporation pays $15,000 in Example: A corporation pays $15,000 in organization costs. organization costs.

The entry to record this would be:The entry to record this would be:

Organization Costs 15,000Organization Costs 15,000

Cash 15,000Cash 15,000

Organization CostsOrganization Costs

Shareholders

Board of Directors

President, Vice-President, and Other Officers

Employees of the Corporation

Corporate Organization Corporate Organization StructureStructure

According to the Canada Business Corporations Act, shareholders have the right to:

Vote.

Receive dividends that have been declared.

Receive property of the corporation after its closure.

Rights of ShareholdersRights of Shareholders

Corporate Financial StatementsCorporate Financial Statements

Revenues $116Operating expenses 40Income from operations $76Other revenues and expenses Gain on sale of capital assets$7 Interest revenue 3 Loss on sale of capital assets(12)Interest expense (14) (16)Income before tax $60Income tax expense $12

Net Income $48

ABC CorporationIncome Statement

For Year Ended December 31,2011

The statements are identical except for the $12 of income tax expense.

Revenues $116Operating expenses 40Income from operations $76Other revenues and expenses Gain on sale of capital assets $7 Interest revenue 3 Loss on sale of capital assets (12)Interest expense (14) (16)Net Income $60

Dell's ServicingIncome Statement

For Year Ended December 31, 2011

Corporation Single Proprietorship

ABC CorporationABC CorporationStatement of Retained EarningsStatement of Retained Earnings

For Year Ended December 31, 2011For Year Ended December 31, 2011Retained Earnings, January 1Retained Earnings, January 1 $0 $0Add: Net IncomeAdd: Net Income 4848TotalTotal $48 $48Less: DividendsLess: Dividends 4040Retained Earnings, December 31Retained Earnings, December 31 $8$8

Dell’s ServicingDell’s ServicingStatement of Owner’s EquityStatement of Owner’s Equity

For Year Ended December 31, 2011For Year Ended December 31, 2011I. Dell, Capital, January 1I. Dell, Capital, January 1 $0 $0Add: Owner InvestmentAdd: Owner Investment 500 500 Net IncomeNet Income 60 60TotalTotal $560 $560Less: WithdrawalsLess: Withdrawals 4040I. Dell, Capital, December 31 $I. Dell, Capital, December 31 $520520

Retained earnings represents the earnings that have been kept (retained) by the corporation for the purpose of reinvestment.

ABC CorporationABC CorporationPartial Balance SheetPartial Balance SheetDecember 31, 2011December 31, 2011

Shareholders’ EquityShareholders’ Equity

Share CapitalShare Capital $500$500 Retained Earnings Retained Earnings 8 8Total Shareholders’ EquityTotal Shareholders’ Equity $508$508

Dell’s ServicingDell’s ServicingPartial Balance SheetPartial Balance SheetDecember 31, 2011December 31, 2011

Owner’s EquityOwner’s EquityI. Dell, Capital $520I. Dell, Capital $520

The balance sheets for corporations and single proprietorships are identical except for the equity section.

ABC CorporationABC CorporationPartial Balance SheetPartial Balance SheetDecember 31, 2011December 31, 2011

Shareholders’ EquityShareholders’ Equity

Share CapitalShare Capital $500$500 Retained Earnings Retained Earnings 8 8Total Shareholders’ EquityTotal Shareholders’ Equity $508$508

Dell’s ServicingDell’s ServicingPartial Balance SheetPartial Balance SheetDecember 31, 2011December 31, 2011

Owner’s EquityOwner’s EquityI. Dell, Capital $520I. Dell, Capital $520

Shareholders’ equity and Owner’s equity include the same transactions in total: net income (losses), distributions of income, and owner’s investments.

Companies obtain capital, or money, by Companies obtain capital, or money, by issuing shares.issuing shares.

This is referred to as This is referred to as equity financingequity financing.. Shares may be sold directly to investors or Shares may be sold directly to investors or

may be sold through a brokerage house.may be sold through a brokerage house. If a company only has one class of shares, If a company only has one class of shares,

they are known as they are known as common sharescommon shares.. The CBCA requires all shares to be no par The CBCA requires all shares to be no par

value.value.

Issuing Share CapitalIssuing Share Capital

Example: Dillon Snowboards Ltd. issued Example: Dillon Snowboards Ltd. issued 30,000 common shares for $300,000 30,000 common shares for $300,000 cash.cash.

The entry to record this would be:The entry to record this would be:

Cash 300,000Cash 300,000

Common Shares 300,000Common Shares 300,000

Issuing Share CapitalIssuing Share Capital

Example: Shareholders’ equity of Dillon Snowboards Example: Shareholders’ equity of Dillon Snowboards Ltd. after the first year of operating. Assume net Ltd. after the first year of operating. Assume net income of $65,000 and no dividend payments.income of $65,000 and no dividend payments.

Shareholders’ EquityShareholders’ Equity

Common Shares, unlimited shares Common Shares, unlimited shares authorized, 30,000 shares issued and authorized, 30,000 shares issued and outstandingoutstanding $300,000$300,000

Retained earningsRetained earnings 65,00065,000

Total shareholders’ equityTotal shareholders’ equity $365,000$365,000

Shareholders’ EquityShareholders’ Equity

Identifies how many shares the corporation is allowed to sell.

Shareholders’ EquityShareholders’ Equity

Common Shares, Common Shares, unlimited sharesunlimited shares authorizedauthorized, 30,000 shares issued and , 30,000 shares issued and outstandingoutstanding $300,000$300,000

Retained earningsRetained earnings 65,00065,000

Total shareholders’ equityTotal shareholders’ equity $365,000$365,000

Shareholders’ EquityShareholders’ Equity

Identifies how many shares have been sold or given out.

Shareholders’ EquityShareholders’ Equity

Common Shares, unlimited shares Common Shares, unlimited shares authorized, authorized, 30,000 shares issued30,000 shares issued and and outstandingoutstanding $300,000$300,000

Retained earningsRetained earnings 65,00065,000

Total shareholders’ equityTotal shareholders’ equity $365,000$365,000

Shareholders’ EquityShareholders’ Equity

Defines how many shares are held by shareholders.

Shareholders’ EquityShareholders’ Equity

Common Shares, unlimited shares Common Shares, unlimited shares authorized, 30,000 shares issued and authorized, 30,000 shares issued and outstandingoutstanding $300,000$300,000

Retained earningsRetained earnings 65,00065,000

Total shareholders’ equityTotal shareholders’ equity $365,000$365,000

Shareholders’ EquityShareholders’ Equity

Discloses dollars invested by shareholders in exchange for shares.

Shareholders’ EquityShareholders’ Equity

Common Shares, unlimited shares Common Shares, unlimited shares authorized, 30,000 shares issued and authorized, 30,000 shares issued and outstandingoutstanding $300,000$300,000

Retained earningsRetained earnings 65,00065,000

Total shareholders’ equityTotal shareholders’ equity $365,000$365,000

Shareholders’ EquityShareholders’ Equity

This reflects accumulated profits/losses less dividends.

Shareholders’ EquityShareholders’ Equity

Common Shares, unlimited shares Common Shares, unlimited shares authorized, 30,000 shares issued and authorized, 30,000 shares issued and outstandingoutstanding $300,000$300,000

Retained earningsRetained earnings 65,00065,000

Total shareholders’ equityTotal shareholders’ equity $365,000$365,000

Shareholders’ EquityShareholders’ Equity

Mini-QuizMini-Quiz

The category of shareholders' equity The category of shareholders' equity created by a corporation's profitable created by a corporation's profitable activities is called: activities is called:

A.A. Contributed capital.Contributed capital.

B.B. Intangibles.  Intangibles.  

C.C. Retained earnings.  Retained earnings.  

D.D. Paid-in capital.  Paid-in capital.  

E.E. P & L. P & L.

Mini-QuizMini-Quiz

The category of shareholders' equity The category of shareholders' equity created by a corporation's profitable created by a corporation's profitable activities is called: activities is called:

A.A. Contributed capital.Contributed capital.

B.B. Intangibles.  Intangibles.  

C.C. Retained earnings.Retained earnings.    

D.D. Paid-in capital.  Paid-in capital.  

E.E. P & L. P & L.

Shares that give their owners a priority status Shares that give their owners a priority status over common shareholders including: over common shareholders including: Payment of dividends, andPayment of dividends, and Distribution of assets on liquidation.Distribution of assets on liquidation.

Do not usually have the right to vote.Do not usually have the right to vote. Are listed before common shares in the Are listed before common shares in the

shareholders’ equity section.shareholders’ equity section.

Preferred SharesPreferred Shares

Example: Dillon Snowboards Ltd. issued Example: Dillon Snowboards Ltd. issued 5,000 preferred shares with a dividend 5,000 preferred shares with a dividend preference of $3 per share for a total of preference of $3 per share for a total of $125,000 cash.$125,000 cash.

The entry to record this would be:The entry to record this would be:

Cash 125,000Cash 125,000

Preferred Shares 125,000Preferred Shares 125,000

Issuing Preferred Shares for Issuing Preferred Shares for CashCash

$530,000$530,000Total contributed capitalTotal contributed capital

$125,000$125,000

Preferred shares, Preferred shares, $3$3, unlimited shares , unlimited shares authorized, 5,000 shares issued and authorized, 5,000 shares issued and outstandingoutstanding

Shareholders’ EquityShareholders’ Equity

Contributed Capital:Contributed Capital:

$365,000$365,000Total shareholders’ equityTotal shareholders’ equity

303,000303,000Retained earningsRetained earnings

$405,000$405,000

Common Shares, unlimited shares Common Shares, unlimited shares authorized, 30,000 shares issued and authorized, 30,000 shares issued and outstandingoutstandingRepresents the dividend preference. Preferred

shareholders are entitled to dividends at the rate of $3 per preferred share when declared.

Shareholders’ EquityShareholders’ EquityAfter Issue of Preferred SharesAfter Issue of Preferred Shares

Reasons for issuing preferred shares Reasons for issuing preferred shares include:include: No sacrifice of control,No sacrifice of control, Potential to increase return to common Potential to increase return to common

shareholders,shareholders, Appeal to potential investors, andAppeal to potential investors, and Market price of common shares may be too Market price of common shares may be too

low.low.

Preferred SharesPreferred Shares

Are a distribution of earnings to shareholdersAre a distribution of earnings to shareholders Reduce retained earningsReduce retained earnings Are decided by the board of directorsAre decided by the board of directors May be in cash or shares May be in cash or shares

DividendsDividends

Important dates:Important dates:

1.1. Date of declarationDate of declaration

2.2. Date of recordDate of record

3.3. Date of paymentDate of paymentThe date the directors vote to pay a dividend. This creates a legal liability for the corporation.

DividendsDividends

Important dates:Important dates:

1.1. Date of declarationDate of declaration

2.2. Date of recordDate of record

3.3. Date of paymentDate of paymentThe future date specified by the directors for identifying those shareholders listed in the corporation’s records to receive dividends.

DividendsDividends

Important dates:Important dates:

1.1. Date of declarationDate of declaration

2.2. Date of recordDate of record

3.3. Date of paymentDate of payment

The date the shareholders receive payment.

DividendsDividends

Example: On November 9, the board of directors of a Example: On November 9, the board of directors of a company with 5,000 common shares outstanding declared company with 5,000 common shares outstanding declared a $1 per share dividend payable December 1 to the a $1 per share dividend payable December 1 to the shareholders of record on November 22. shareholders of record on November 22.

On November 9, the On November 9, the date of declaration,date of declaration, the entry would the entry would be either:be either:

Cash Dividends 5,000Cash Dividends 5,000

Common Dividends Payable 5,000Common Dividends Payable 5,000oror

Retained Earnings 5,000Retained Earnings 5,000 Common Dividends Payable 5,000Common Dividends Payable 5,000

Cash DividendsCash Dividends

No entry is required on November 22, the No entry is required on November 22, the date of record.date of record.

Cash DividendsCash Dividends

On December 1, the On December 1, the date of paymentdate of payment, the entry , the entry would be:would be:

Common Dividends Payable 5,000Common Dividends Payable 5,000

Cash 5,000Cash 5,000

Cash DividendsCash Dividends

On December 31, the corporation’s year end, the On December 31, the corporation’s year end, the closing entry would be:closing entry would be:

Retained Earnings 5,000Retained Earnings 5,000

Cash Dividends 5,000Cash Dividends 5,000

No closing entry would be necessary if the No closing entry would be necessary if the retained earnings account was debited on the retained earnings account was debited on the date of declaration.date of declaration.

Cash DividendsCash Dividends

A corporation with a debit balance in A corporation with a debit balance in retained earnings is said to have a retained earnings is said to have a deficitdeficit..

Deficits reduce total shareholders’ equity.Deficits reduce total shareholders’ equity. Corporations are not allowed to pay cash Corporations are not allowed to pay cash

dividends when there is a deficit.dividends when there is a deficit.

Deficits and Cash DividendsDeficits and Cash Dividends

Mini-QuizMini-Quiz

The payment of a dividend will reduce the following two accounts:

A) Common shares and cash 

B) Cash and retained earnings 

C) Shareholders' equity and retained earnings 

D) Retained earnings and accounts payable 

E) Shareholders' equity and cash

Mini-QuizMini-Quiz

The payment of a dividend will reduce the following two accounts:

A) Common shares and cash 

B) Cash and retained earnings 

C) Shareholders' equity and retained earnings 

D) Retained earnings and accounts payable 

E) Shareholders' equity and cash

Common shares cannot receive dividends Common shares cannot receive dividends unless preferred share dividends are paid unless preferred share dividends are paid first.first.

Preferred dividends are Preferred dividends are notnot guaranteed. guaranteed. The board of directors must declare a The board of directors must declare a

dividend before shareholders are entitled dividend before shareholders are entitled to a dividend. to a dividend.

Preferred shares may be either cumulative Preferred shares may be either cumulative or non-cumulative.or non-cumulative.

Preferred SharesPreferred Shares

CumulativeCumulative Undeclared dividends accumulate until they are Undeclared dividends accumulate until they are

paid.paid. Common shareholders cannot receive dividends Common shareholders cannot receive dividends

until all cumulative dividends are paid.until all cumulative dividends are paid.

Non-CumulativeNon-Cumulative Have no right to prior periods’ unpaid dividends Have no right to prior periods’ unpaid dividends

if they were not declared.if they were not declared.

Preferred SharesPreferred Shares

A liability for a dividend does not exist until the A liability for a dividend does not exist until the directors declare a dividend.directors declare a dividend.

Dividends in arrears on cumulative preferred Dividends in arrears on cumulative preferred shares must be disclosed in the corporation’s shares must be disclosed in the corporation’s financial statements.financial statements.

Financial Disclosure of Financial Disclosure of DividendsDividends

Non-participatingNon-participating Have dividends limited to a maximum amount Have dividends limited to a maximum amount

each year.each year.

Non-ParticipatingNon-Participating Have a feature that allows preferred shareholders Have a feature that allows preferred shareholders

to share with common shareholders in any to share with common shareholders in any dividends paid in excess of the percent stated on dividends paid in excess of the percent stated on the preferred shares.the preferred shares.

Preferred SharesPreferred Shares

Convertible Convertible Gives holders the option of exchanging their Gives holders the option of exchanging their

preferred shares into common shares at a preferred shares into common shares at a specified rate.specified rate.

CallableCallable The issuing corporation, at its option, may retire The issuing corporation, at its option, may retire

by paying a specified amount (the call price) to by paying a specified amount (the call price) to the preferred shareholders plus any dividends in the preferred shareholders plus any dividends in arrears.arrears.

Preferred SharesPreferred Shares

Income summary is closed to retained Income summary is closed to retained earnings.earnings.

The cash dividends declared account is The cash dividends declared account is closed to retained earnings (assuming closed to retained earnings (assuming dividends were not debited to retained dividends were not debited to retained earnings when declared).earnings when declared).

Closing EntriesClosing Entries

ReviewReview

Discuss the characteristics of corporations.

Corporations are legal entities separate and distinct from their owners. Ownership of corporations is represented by shares. Owners of the shares are called shareholders or stockholders. Shares issued by corporations are easily transferable and shareholders are not personally liable for acts of the corporation. Corporations are regulated by provincial and federal governments and are subject to income tax.

ReviewReview

Describe the components of shareholders' equity.

Shareholders' equity is composed of two parts, contributed capital and retained earnings. Contributed capital consists of funds raised by the issuance of shares, either common or preferred. Retained earnings consists of current and prior periods' earnings not distributed to shareholders.

Often used in the financial analysis of a Often used in the financial analysis of a company.company.

Other uses include share valuations, Other uses include share valuations, merger negotiations, and loan contractsmerger negotiations, and loan contracts

Uses the book value of assets and Uses the book value of assets and liabilities, not the market value.liabilities, not the market value.

Book Value Per ShareBook Value Per ShareAppendix 15AAppendix 15A

Book Value Per Common ShareBook Value Per Common Share

Shareholders’ Equity Applicable to Common Shares

Number of Common Shares Outstanding=

When only common shares are outstanding:

Book Value Per ShareBook Value Per ShareAppendix 15AAppendix 15A

Book Value Per Preferred ShareBook Value Per Preferred Share

Shareholders’ Equity Applicable to Preferred Shares*

Number of Preferred Shares Outstanding=

Book Value Per ShareBook Value Per ShareAppendix 15AAppendix 15A

*Preferred share’s call price plus any cumulative dividends in arrears or paid

in capital from preferred shares plus dividends in arrears.

=

When both common and preferred shares are outstanding:

Number of Common Shares Outstanding

Total Shareholders’ Equity

Equity Applicable to Preferred Shares*

_

Book Value Per Common ShareBook Value Per Common Share

Book Value Per ShareBook Value Per ShareAppendix 15AAppendix 15A

*Preferred share’s call price plus any cumulative dividends in arrears or

paid-in capital from preferred shares plus dividends in arrears.

End of ChapterEnd of Chapter