Chapter 13 Corporations: Organization and Share Capital Transactions

Agenda Learning goals Vocabulary Lesson 1: The Corporate form of organization Characteristics of a corporation Forming a Corporation Ownership rights of shareholders Shares Issue Considerations

Learning goals Identify and discuss the major characteristics of a corporation Record common shares transactions Record preferred shares transactions Prepare the shareholders’ equity of the balance sheet and calculate return on equity.

Vocabulary Authorized shares Noncumulative Common shares Organization costs Comprehensive income Preferred shares Contributed capital Privately held corporation Convertible preferred shares Publicly held corporation Corporation Redeemable (callable) preferred shares Cumulative dividend Retained earnings Dividends in arrears Retractable preferred shares Financial instrument Initial public offering (IPO) Return on equity Share capital Issuing shares Legal capital No par value shares

The Corporate Form of Organization The corporation: is a legal entity that is separate form its owners, who are known as shareholders. As a legal entity, a corporation has most of the rights and privileges of a person. Obligation to respect laws and pay income tax It can not vote or hold public office. Corporation can be for profit and not for profit

Classification by Ownership Publicly held corporation: The shares are traded on organized securities markets, such as Toronto Stock Exchange. Available for anyone in the general public to buy or sell. Privately held corporation: Shares are owned by a few private shareholders. The share are not traded on stock exchanges and are not available to the general public.

Characteristics of a Corporation Separate legal existence from its owners Limited liability of shareholders to the amount of their investment Transferable ownership rights by buying and selling shares Ability to acquire capital by issuing shares Continuous and indefinite life Corporation management Shareholders manage through an elected board of directors Board of directors selects corporation management Government regulations Canada Business Corporation Act regulates what corporation can or can not do Income tax Taxed as a separate entity

Advantages and Disadvantage of a Corporation Disadvantages Corporate management – professional managers Separate legal existence Limited liability to shareholders Potential for deferred or reduced income tax (shareholder do not pay tax on income earned until it is distributed to them) Transferable ownership rights Ability to acquire capital Continuous life Corporate management – ownership separated from management Increased cost and complexity to follow government regulations Potential for additional income tax

Forming a Corporation Can incorporate federally or provincially Done by filing articles of incorporation Provide information such as : Name and purpose of company Amounts and kinds of share capital Names and addresses of incorporators Location of corporation’s head office By-laws: internal rules and policies Organization costs: Costs of forming a corporation (legal fees, accounting fees and regulation) Normally expensed

Ownership Rights of Shareholders Ownership rights are in the form of shares Can be divided into different classes As stated in the articles of incorporation Each class has rights and privileges Usually referred to as common and preferred shares Shareholders have rights: To vote on certain matters To dividends: the distribution of income To remaining assets in a liquidation

Share Issue Considerations Authorized share capital Number of shares company is allowed to sell Many companies have unlimited number of shares Issued shares Authorized shares that have been sold Issued directly to investors or through an investment dealer First public sale is called an initial public offering (IPO)

Share Issue Considerations 2 Market value of shares Once issued, shares trade on a secondary market Prices determined by buyers and sellers and other external factors Legal capital Is the amounts contributed to the corporations by shareholders in exchange for shares of ownership it is considered legal capital and can not be distributed to shareholders Retained earnings are earned capital and can be distributed as dividends

Practice questions Self study questions: 1+2 Question 3,5,6 BE 13-1 & 2 E13-1 P13-1A

Agenda Common Shares Preferred shares Issuing shares for cash Reacquisition of shares Preferred shares What are they Dividend preference Convertible preferred Redeemable and retractable preferred Liquidation Preference

Common Shares: Issuing Shares Shares are usually issued for cash: Dr. Cash Cr. Common shares Shares can be issued in exchange for services (compensation for lawyers or consultants or noncash assets (land, building and equipment) Recorded at market value of shares given up: Dr. Service or asset (amount = mkt value of shares) Cr. Common shares If market value of shares not determinable, use value of services or noncash assets

Common Shares: Issuing Shares Assume that they lawyer who helped Hydroslide incorporated billed the company $5,000 for her services. On January 18, she agreed to accept 4,000 common shares in payment for her bill. At the time of the exchange, the market price for the shares is $1 Jan 18 legal Fees Expense 4,000 Common Shares 4,000 To record issue of 4,000 common shares for legal service

Common Shares: Issuing Shares For noncash transactions the cost is the cash equivalent price. This means that when there is an issue of shares in exchange for services or noncash assets, the cash equivalent price is the market value of the common shares given up

Common Shares: Issuing Shares When common shares do not have a ready market value (meaning they can not be bought or sold easily) or their market cannot be determined. In these cases, the market value of the consideration that is received would instead be used to determine the cash equivalent price.

Common Shares: Issuing Shares Newly incorporated company issued 10,000 shares on October 1 to acquire land with an appraised value of $80,000. At the time of the acquisition the company's shares do not have a reliable market value because they are not actively traded yet. In this case, the land would be recorded at the market value of the consideration received $80,000 Oct 1 Land 80,000 Common shares 80,000 To record issue of 10,000 common shares for land

Common Shares: Reacquisition of Shares Companies can reacquire their shares to: Increase trading on securities markets to increase market value Increase earnings per share by reducing shares Buyout hostile shareholders Have shares available for compensation or other uses (employee and managers) Comply with share ownership restrictions (limits of foreign ownership) Reacquired shares are retired and cancelled

Common Shares: Reacquisition of Shares 2 Steps to record a reacquisition: Remove cost of shares from share capital account Based on average cost per share (must be calculated) Record cash paid for the shares Record the gain or loss on reacquisition Price paid to acquire the shares – original cost

Reacquisition of Shares: Below Average Cost Average cost of shares: Balance in Common Shares Account Number of Common Shares Issued If shares reacquired at a price < average cost: =

Reacquisition of Shares: Above Average Cost If shares reacquired at a price > average cost: Additional cost of shares is first debited to contributed capital from previous reacquisitions (only when there is a balance the account otherwise: Remaining difference is debited to retained earnings:

Checking for Understanding Victoria Corporation begins operations on March 1 by issuing 100,000 common shares for cash at $12 per share. On March 15, it issues 5,000 common shares to its lawyers in settlement of their bill for $65,000. The shares continue to trade at $12 per share on march 15. On June 1, Victoria repurchased 10,000 of it’s shares at $10 per share. Record the share transactions. (page 677)

Preferred Shares and Dividends Priority over common shares for dividends and assets in the event of liquidation of the company. Generally do not have voting rights Entries to record issue and reacquisition of preferred shares similar to entries for common shares Transactions for each class of share is recorded in a separate account

Dividend Preference Preferred shareholders have a right to dividends before common shareholders Cumulative preferred shares have a right to current year’s dividends and any prior years’ dividends owing before dividends are paid on common shares Any unpaid dividends (in arrears) are not considered a liability

Dividend Preference Staudinger Corporation has 10,000 $3-cumulative preferred shares. The $3 is the per share dividend amount, which is usually expressed as an annual amount, similar to interest rates. So, Staudinger’s annual total dividend is $30,000 (10,000 * $3 per share)$90 Dividends in arrears ($30,000 * 2) $60,000 Current year dividends $30,000 Total preferred dividends $90,000

Convertible Preferred Shares Provide option to exchange preferred shares to common shares at a specified ratio Conversion is recorded by transferring cost from Preferred Shares to Common Shares account

Convertible Preferred Shares Ross Industries Inc. issues 1,000 convertible preferred shares at $100 per share. One preferred she is convertible into 10 common shares. The current market price of the common shares is $9 per share. If the market price of the convertible preferred shares is $101 and common shares is $12 on June 10. The convertible preferred shareholder will choose to convert their shares.

Redeemable and Retractable Preferred Shares Corporation (redeemable) give the issuing corporation the right to purchase the shares at specified future dates and prices shareholder (retractable) gives the shareholder the option to sell the shares back to the corporation at a future date and price

Redeemable and Retractable Preferred Shares Redeemable and retractable preferred shares are similar in some ways to debt. Considered a financial instrument (contract between two or more parties that establishes financial rights or obligation) Usually reported in the liabilities section of the balance sheet

Checking for understanding Turin Corporation issued 50,000 preferred shares on February 22 for $20,000 each. Each share was convertible into 10 common shares. ON April 12, another 30,000 preferred shares were issued for $30 each. On June 5, when the price of the common share was $4 and the price of the preferred shares was $35, shareholder converted 20,000 of the preferred share into common. Record the 3 transactions in a journal (page 681)

Practice Self study questions: 3-7 Questions 11+13+14 BE13-39 E13-46

Shareholders’ Equity on the Balance Sheet Contributed Capital Share capital: preferred and common shares Preferred shares are listed first Additional contributed capital: amounts contributed from acquiring and retiring shares

Agenda Statement presentation and analysis Presentation of shareholder’s equity Analysis of the statement

Shareholders’ Equity on the Balance Sheet Retained Earnings Cumulative net income (loss) since incorporation Annual net income is added; dividends are deducted (similar to drawings by the owner in a proprietorship)

Shareholders’ Equity on the Balance Sheet Closing journal entries Dec. 31 Service Revenue 500,000 Income Summary To close revenue to income summary 290,000 Operating expenses To close operating expenses to income summary 210,000 Retained earnings To close income summary (500,000-290,000) to retained earnings

Shareholders’ Equity on the Balance Sheet Dec. 31 Retained Earnings 80,000 Dividends To close dividends to retained earnings.

Shareholders’ Equity on the Balance Sheet Accumulated Other Comprehensive Income Certain gains and losses that bypass net income but affect shareholder’s equity. Recorded directly to shareholders’ equity Things like: unrealized gain or loss on available for share securities. Gain/loss of cash flow hedge Gain/loss from foreign currency translation Gain/loss on defined benefit pension plan

Sample Shareholders’ Equity Section

Average Shareholders’ Equity Return on Equity Also called return on investment Considered to be the most important measure of a firm’s profitability It evaluates how many dollars are earned for each dollar invested by shareholders Average Shareholders’ Equity ÷ = Net income Return on Equity

Check for understanding Look on page 684-685 and the demonstration problem

Practice Self study question 8 BE13-1013 E 13-711