CORPORATIONS: ORGANIZATION AND SHARE CAPITAL TRANSACTIONS UNIT 11 CORPORATIONS: ORGANIZATION AND SHARE CAPITAL TRANSACTIONS

CORPORATE FORM OF ORGANIZATION A corporation is a legal entity created by law that is separate and distinct from its owners

CLASSIFICATION OF CORPORATIONS A corporation’s purpose may be to earn a profit, or it may be organized as non-profit. Classification by ownership distinguishes between publicly-held corporations and privately-held corporations.

CHARACTERISTICS Separate legal existence Limited liability of shareholders Transferable ownership rights Ability to acquire capital Continuous life Corporation management Government regulations Additional taxes

ILLUSTRATION 14-1 ADVANTAGES AND DISADVANTAGES OF A CORPORATION Advantages Disadvantages Corporate management - professional managers Separate legal existence Limited liability of shareholders Deferred or reduced income taxes Transferable ownership rights Ability to acquire capital Continuous life Corporation management - ownership separated from management Increased costs and complexity to adhere to government regulation Potential for additional income taxes

ORGANIZATION COSTS Costs incurred in forming a corporation are called organization costs. These costs include fees to underwriters, legal fees, incorporation fees, and promotional expenditures. Organization costs are normally expensed in the year the organization cost is incurred.

Forming a Corporation File an application with the provincial or federal authorities. Issuance of shares. A corporation has the choice of issuing common shares directly to investors or indirectly through an investment dealer (brokerage house). A first-time issue is known as an initial public offering (IPO). Types of Shares. Shares of a company are divided into different classes, such as Class A, Class B, and so on. The different classes are often identified by the generic terms common shares and preferred shares. Market value of shares. The market price per share is established by the interaction between buyers and sellers. Generally, the price follows earnings trends.

COMMON SHAREHOLDER RIGHTS VOTING:Each share entitles the owner to one vote in the election of the board of directors and in corporate actions that require shareholder approval. DIVIDENDS:Through the receipt of dividends a shareholder receives a portion of the profits. PREEMPTIVE RIGHTS: In many companies and jurisdictions, common shareholders are granted the first right to purchase any additional shares in proportion to their present holdings. RESIDUAL CLAIM: Common shareholders have a claim on corporate assets in proportion to their holdings if the corporation is terminated.

SHARE TERMINOLOGY Authorized shares – maximum amount of shares a corporation is allowed to sell as authorized by corporate charter Issued shares – number of shares sold (issued = sold)

STATED AND PAR SHARE VALUES Stated value – assigned value to no-par value shares Par value – assigned legal capital value Seldom Used Must retain legal capital. Stated and par values have NO relationship to market value

Must retain legal capital. relationship to market value once issued. NO PAR SHARE VALUES No assigned legal capital value Legal capital equals issue price (proceeds) Must retain legal capital. No-par value has NO relationship to market value once issued.

ISSUING NO PAR VALUE COMMON SHARES FOR CASH Shares are most commonly issued for cash. When no par value common shares are issued, the entire proceeds from the issue becomes legal capital. Account Titles and Explanation Debit Credit Cash 1,000 1,000 Common Shares To record issue of 1,000 shares.

CORPORATE CAPITAL Shareholders’ equity (owner’s equity) The shareholders’ equity section of a corporation’s balance sheet consists of: Contributed capital Share capital Additional contributed capital Retained earnings The cumulative net income (loss) that has been retained (not issued to shareholders)

ILLUSTRATION 14-6 SHAREHOLDERS’ EQUITY SECTION Contributed capital Common shares, 100,000 no par value shares authorized, 50,000 issued Retained earnings Total shareholders’ equity $800,000 130,000 $930,000

ISSUING STATED VALUE COMMON SHARES FOR CASH Sated value shares cannot be sold for less than the stated value. When common shares have a stated value, the stated value is credited to Common Shares. When the selling price exceeds the stated value, the excess is credited to Contributed Capital in Excess of Stated Value. Account Titles and Explanation Debit Credit Cash 5,000 1,000 4,000 Common Shares Contributed Capital in Excess of Stated Value To record issue of 1,000 shares.

SHAREHOLDERS’ EQUITY - CONTRIBUTED CAPITAL IN EXCESS OF STATED VALUE Common shares, 10,000 shares of $1 stated value authorized, 2,000 shares issued Contributed capital in excess of stated value Total contributed capital Retained earnings Total shareholders’ equity $ 2,000 4,000 6,000 27,000 $33,000

EXAMPLE

ISSUING COMMON SHARES FOR SERVICES OR ASSETS Shares may be issued for services, such as compensation to lawyers, or for non-cash assets, such as land. When common shares are issued for services or non-cash assets, cost is either the fair market value of the consideration given up or the consideration received, whichever is more clearly determinable.

ISSUING COMMON SHARES FOR SERVICES OR ASSETS EXAMPLE Panjer Corporation purchased land with a sale value of $100,000 in exchange for 20,000 shares. The shares active trading price is $4.00 per share. Land $80,000 Common Shares (20,000 x 4.00) $80,000 To record issue of 20,000 no par value shares for land Note that the value of the shares is recorded not the sale value of the land. If there was no market price for the shares the land value would be recorded.

REACQUIRED SHARES Reacquired shares are a corporation’s own shares that have been issued, fully paid for, and then reacquired by the corporation. Reacquired shares are generally retired and cancelled. In certain restricted circumstances, these shares are not retired, but are held as treasury shares for later reissue.

REACQUISITION OF SHARES Why would a company choose to reacquire its shares? Reduce quantity/raise share price Increase EPS If authorized share limit reached, may need additional shares for use in bonus or compensation plans or acquisitions

PREFERRED SHARES Preferred shares have priority over common shares with regards to: 1. Dividends and 2. Assets in the event of liquidation Preferred shareholders usually do not have voting rights Preferred shares are shown first in the share capital section of shareholders' equity

PREFERRED SHARE PREFERENCES Liquidation preference Cumulative (dividends in arrears) Convertible (book value) Redeemable/callable (company option) Retractable (shareholder option)

DIVIDEND PREFERENCES CUMULATIVE DIVIDEND A cumulative dividend requires that preferred shareholders be paid both current and prior year dividends before common shareholders receive any dividends. Preferred dividends not declared in a given period are called dividends in arrears. Dividends in arrears are not considered a liability, but the amount of the dividends in arrears should be disclosed in the notes to the financial statements.

CONVERTIBLE PREFERRED SHARES Convertible preferred shares allow the exchange of preferred shares into common shares at a specified ratio. This kind of share is purchased by investors who want the greater security of a preferred share, but who also desire the added option of conversion. In recording the conversion, the book value of the preferred shares is used. The conversion of preferred shares does not result in either gain or loss to the corporation. The market value of the shares is not considered.

REDEEMABLE PREFERRED Redeemable (callable) preferred shares grant the issuing corporation the right to purchase the shares from shareholders at specified future dates and prices. This call feature allows some flexibility to a corporation by enabling it to eliminate this type of equity when it is advantageous to do so. While convertible shares are for the benefit of the shareholder, redeemable shares are for the benefit of the corporation.

RETRACTABLE PREFERRED Retractable preferred shares are similar to redeemable preferred shares except that the shareholder can redeem shares at their option instead of the corporation’s. Retractable preferred shares and debt have many similarities. Both offer a rate of return to the investor, and with the redemption of the shares they both offer a repayment of the principal investment. Retractable preferred shares are presented in the liability section of the balance sheet rather than in the equity section because it has more of the features of debt than equity.

REMINDER- STATEMENT PRESENTATION OF SHAREHOLDERS’ EQUITY In the shareholders’ equity section of the balance sheet, contributed capital and retained earnings are reported and the specific sources of contributed capital are identified. Within contributed capital, two classifications are recognized: 1. Share capital 2. Additional contributed capital

ILLUSTRATION 14-10 SHAREHOLDERS’ EQUITY PRESENTATION ZABOSCHUK INC. Partial Balance Sheet Shareholders’ equity Contributed capital Share capital Preferred shares, $9, no-par value, cumulative, 10,000 shares authorized, 6,000 shares issued Common shares, $5 stated value, unlimited shares authorized, 400,000 shares issued Total share capital Additional contributed capital Contributed capital in excess of stated value - common shares Total contributed capital Retained earnings Total shareholders’ equity $ 770,000 2,000,000 2,770,000 860,000 3,630,000 1,058,000 $4,688,000

Average Shareholders Equity RETURN ON EQUITY Return on equity (or return on investment) is considered to be the most important measure of a firm’s profitability and efficiency. Evaluates how many dollars were earned for each dollar invested by the owners.  = Net Income Average Shareholders Equity Return on Equity

Total Shareholders’ Equity Number of Common Shares BOOK VALUE PER SHARE Book value per share represents the equity a common shareholder has in the net assets of the corporation from owning one share. The formula for calculating book value per share when a corporation has only one class of shares is:  = Total Shareholders’ Equity Number of Common Shares Book Value per Share

CALCULATION OF BOOK VALUE WITH PREFERRED SHARES When a company has both preferred and common shares, the calculation of book value is more complex. Steps required are: 1. Calculate the preferred shareholders’ equity (the sum of redemption price of preferred shares plus any cumulative dividends in arrears). 2. Determine the common shareholders’ equity (total shareholders’ equity less preferred shareholders’ equity). 3. Divide common shareholders’ equity by the number of common shares to determine book value per share.

BOOK VALUE VS. MARKET VALUE Book value per share seldom equals market value. Book value is based on historical costs; market value reflects the subjective judgement of thousands of shareholders and prospective investors about the company’s potential for future earnings and dividends. Market value per share may exceed book value per share, but that fact does not necessarily mean that the shares are overpriced.