Organization and Operation of Corporations Module 9

SAP 2007 / SAP University Alliances Introductory Accounting Learning Objectives Identify characteristics of corporations and their organization.Describe and contrast the specialized components of corporate financial statements. Record the issuance of common and preferred shares and describe their presentation in shareholders’ equity on the balance sheet. Describe and account for cash dividends.Distribute dividends between common and preferred shares.Record closing entries for a corporationCompute book value and explain its use in analysisRun an SAP demonstration.Practise entering purchases and payments in SAP.

SAP 2007 / SAP University Alliances Introductory Accounting Characteristics of Corporations Separate legal entityLimited liability of shareholdersOwnership rights are transferableContinuous lifeShareholders are not corporate agentsEase of capital accumulationGovernment regulationCorporate taxation

SAP 2007 / SAP University Alliances Introductory Accounting Organizing a Corporation The company: obtains a certificate of incorporation from the federal or provincial government, sells shares to its subscribers, elects a board of directors, and establishes a set of bylaws regarding the internal activities of the corporation.

SAP 2007 / SAP University Alliances Introductory Accounting Organization Costs Costs include legal fees, promoters’ fees and amounts paid to obtain a charter. These costs are treated as an intangible asset and are amortized. The amortization period is often short since these fees are small in amount.

SAP 2007 / SAP University Alliances Introductory Accounting Example: A corporation pays $15,000 in organization costs. The entry to record this would be: Organization Costs 15,000 Cash 15,000 Organization Costs

SAP 2007 / SAP University Alliances Introductory Accounting Shareholders Board of Directors President, Vice-President, and Other Officers Employees of the Corporation Corporate Authority Structure

SAP 2007 / SAP University Alliances Introductory Accounting 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 Shareholders

The statements are identical except for the $12 of income tax expense. Corporation Single Proprietorship SAP 2007 / SAP University Alliances Introductory Accounting

ABC Corporation Statement of Retained Earnings For Year Ended December 31, 2005 Retained Earnings, January 1 $0 Add: Net Income 48 Total $48 Less: Dividends 40 Retained Earnings, December 31 $8 Joe’s Statement of Owner’s Equity For Year Ended December 31, 2005 I. Dell, Capital, January 1 $0 Add: Owner Investment 500 Net Income 60 Net Income 60 Total $560 Less: Withdrawals 40 Joe’s, Capital, December 31 $520 Retained earnings represents the earnings that have been kept (retained) by the corporation for the purpose of reinvestment. SAP 2007 / SAP University Alliances Introductory Accounting

ABC Corporation Partial Balance Sheet December 31, 2005 Shareholders’ Equity Share Capital$500 Retained Earnings 8 Total Shareholders’ Equity$508 Joe’s Partial Balance Sheet December 31, 2005 Owner’s Equity Joe’s, Capital $520 The balance sheets for the corporation and single proprietorships are identical except for the equity section.

ABC Corporation Partial Balance Sheet December 31, 2005 Shareholders’ Equity Share Capital$500 Retained Earnings 8 Total Shareholders’ Equity$508 Joe’s Partial Balance Sheet December 31, 2005 Owner’s Equity Joe’s, Capital $520 Shareholders’ equity and Owner’s equity include the same transactions in total: net income (losses), distributions of income, and owner investments. SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting Reporting Income Information Income statements are used to evaluate past performance and predict future performance. Certain activities that are not part of a company’s normal, continuing activities are reported separately. Separating these other activities makes the income statement more useful to users.

Continuing operations Discontinued operations Extraordinary items Earnings per share

Continuing operations Shows the revenues, expenses, and income generated by the company’s day-to-day operating activities.

Discontinued operations Shows: 1.The income from operating the discontinued segment prior to its disposal, and 2.The gain or loss from selling or closing down a segment.

Extraordinary items Shows items that meet the following criteria: 1.They are not expected to occur frequently over several years, 2.They do not typify the normal activities of the entity, and 3.They do not depend primarily on the decisions or determinations by management or owners.

Earnings per share Shows the amount of income earned by a company’s outstanding common shares.

SAP 2007 / SAP University Alliances Introductory Accounting Issuing Share Capital Companies obtain capital, or money, by issuing shares.This is referred to as equity financing. Shares may be sold directly to investors or may be sold through a brokerage house. If a company only has one class of shares, they are known as common shares. The CBCA requires all shares to be no par value.

SAP 2007 / SAP University Alliances Introductory Accounting Example: ABC Ltd. issued 30,000 common shares for $300,000 cash. The entry to record this would be: Cash 300,000 Common Shares 300,000 Issuing Share Capital

Example: Shareholders’ equity of ABC Ltd. after the first year of operating. Assume net income of $65,000 and no dividend payments. Shareholders’ Equity Common Shares, unlimited shares authorized, 30,000 shares issued and outstanding $300,000 Retained earnings 65,000 Total shareholders’ equity $365,000 Shareholder’s Equity SAP 2007 / SAP University Alliances Introductory Accounting

Shareholders’ Equity Common Shares, unlimited shares authorized, 30,000 shares issued and outstanding $300,000 Retained earnings 65,000 Total shareholders’ equity $365,000 Identifies how many shares the corporation is allowed to sell. Shareholder’s Equity SAP 2007 / SAP University Alliances Introductory Accounting

Shareholders’ Equity Common Shares, unlimited shares authorized, 30,000 shares issued and outstanding $300,000 Retained earnings 65,000 Total shareholders’ equity $365,000 Identifies how many shares have been sold or given out. Shareholder’s Equity SAP 2007 / SAP University Alliances Introductory Accounting

Shareholders’ Equity Common Shares, unlimited shares authorized, 30,000 shares issued and outstanding $300,000 Retained earnings 65,000 Total shareholders’ equity $365,000 Defines how many shares are held by shareholders. Shareholder’s Equity SAP 2007 / SAP University Alliances Introductory Accounting

Shareholders’ Equity Common Shares, unlimited shares authorized, 30,000 shares issued and outstanding $300,000 Retained earnings 65,000 Total shareholders’ equity $365,000 Discloses dollars invested by shareholders in exchange for shares. Shareholder’s Equity SAP 2007 / SAP University Alliances Introductory Accounting

Shareholders’ Equity Common Shares, unlimited shares authorized, 30,000 shares issued and outstanding $300,000 Retained earnings 65,000 Total shareholders’ equity $365,000 This reflects accumulated profits/losses less dividends. Shareholder’s Equity SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting Preferred Shares Shares that give their owners a priority status over common shareholders including: Payment of dividends, and Distribution of assets on liquidation. Do not usually have the right to vote. Are listed before common shares in the shareholders’ equity section.

SAP 2007 / SAP University Alliances Introductory Accounting Issuing Preferred Shares for Cash Example: ABC Ltd. issued 5,000 preferred shares with a dividend preference of $3 per share for a total of $125,000 cash. The entry to record this would be: Cash 125,000 Preferred Shares 125,000

Shareholders’ Equity — After Issue of Preferred Shares Shareholders’ Equity Contributed Capital: Preferred shares, $3, unlimited shares authorized, 5,000 shares issued and outstanding $125,000 Common Shares, unlimited shares authorized, 30,000 shares issued and outstanding $405,000 Total contributed capital $530,000 Retained earnings 303,000 Total shareholders’ equity $365,000 Represents the dividend preference. Preferred shareholders are entitled to dividends at the rate of $3 per preferred share when declared. SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting Preferred Shares Reasons for issuing preferred shares include: No sacrifice of control, Potential to increase return to common shareholders, Appeal to potential investors, and Market price of common shares may be too low.

SAP 2007 / SAP University Alliances Introductory Accounting Dividends Are a distribution of earnings to shareholdersReduce retained earningsAre decided by the board of directorsMay be in cash or shares

SAP 2007 / SAP University Alliances Introductory Accounting Important dates: 1. Date of declaration 2. Date of record 3. Date of payment The date the directors vote to pay a dividend. This creates a legal liability for the corporation. Dividends

SAP 2007 / SAP University Alliances Introductory Accounting Important dates: 1. Date of declaration 2. Date of record 3. Date of payment The future date specified by the directors for identifying those shareholders listed in the corporation’s records to receive dividends. Dividends

SAP 2007 / SAP University Alliances Introductory Accounting Important dates: 1. Date of declaration 2. Date of record 3. Date of payment The date the shareholders receive payment. Dividends

SAP 2007 / SAP University Alliances Introductory Accounting Example: On October 5, the board of directors of a company with 5,000 common shares outstanding declared a $1 per share dividend payable December 1 to the shareholders of record on November 1. On October 5, the date of declaration, the entry would be either: Cash Dividends 5,000 Common Dividends Payable 5,000 or Retained Earnings 5,000 Common Dividends Payable 5,000 Cash Dividends

SAP 2007 / SAP University Alliances Introductory Accounting No entry is required on November 1, the date of record. Cash Dividends

SAP 2007 / SAP University Alliances Introductory Accounting On December 1, the date of payment, the entry would be: Common Dividends Payable 5,000 Cash 5,000 Cash Dividends

SAP 2007 / SAP University Alliances Introductory Accounting On December 31, the corporation’s year end, the closing entry would be: Retained Earnings 5,000 Cash Dividends 5,000 No closing entry would be necessary if the retained earnings account was debited on the date of declaration. Cash Dividends

SAP 2007 / SAP University Alliances Introductory Accounting A corporation with a debit balance in retained earnings is said to have a deficit. Deficits reduce total shareholders’ equity. Corporations are not allowed to pay cash dividends when there is a deficit. Deficits and Cash Dividends

SAP 2007 / SAP University Alliances Introductory Accounting Preferred Shares Common shares cannot receive dividends unless preferred share dividends are paid first. Preferred dividends are not guaranteed. The board of directors must declare a dividend before shareholders are entitled to a dividend. Preferred shares may be either cumulative or non- cumulative.

SAP 2007 / SAP University Alliances Introductory Accounting Cumulative Undeclared dividends accumulate until they are paid. Common shareholders cannot receive dividends until all cumulative dividends are paid. Non-Cumulative Have no right to prior periods’ unpaid dividends if they were not declared. Preferred Shares

SAP 2007 / SAP University Alliances Introductory Accounting Financial Disclosure of Dividends A liability for a dividend does not exist until the directors declare a dividend. Dividends in arrears on cumulative preferred shares must be disclosed in the corporation’s financial statements.

SAP 2007 / SAP University Alliances Introductory Accounting Non-participating Have dividends limited to a maximum amount each year. Non-Participating Have a feature that allows preferred shareholders to share with common shareholders in any dividends paid in excess of the percent stated on the preferred shares. Preferred Shares

SAP 2007 / SAP University Alliances Introductory Accounting Convertible Gives holders the option of exchanging their preferred shares into common shares at a specified rate. Callable The issuing corporation, at its option, may retire by paying a specified amount (the call price) to the preferred shareholders plus any dividends in arrears. Preferred Shares

SAP 2007 / SAP University Alliances Introductory Accounting Closing Entries Income summary is closed to retained earnings. The cash dividends declared account is closed to retained earnings (assuming dividends were not debited to retained earnings when declared).

SAP 2007 / SAP University Alliances Introductory Accounting Book Value Often used in the financial analysis of a company. Other uses include share valuations, merger negotiations, and loan contracts Uses the book value of assets and liabilities, not the market value.

SAP 2007 / SAP University Alliances Introductory Accounting Book Value Per Common Share Shareholders’ Equity Applicable to Common Shares Number of Common Shares Outstanding = When only common shares are outstanding: Book Value per Share

SAP 2007 / SAP University Alliances Introductory Accounting = When both common and preferred shares are outstanding: Number of Common Shares Outstanding Total Shareholders’ Equity Equity Applicable to Preferred Shares* *Preferred share’s call price plus any cumulative dividends in arrears _ Book Value Per Common Share Book Value per Share