Intermediate

Financial
Accounting
LECTURE 02 – INTRODUCTION TO CORPORATIONS
Corporations
 The corporate form is the organization of choice for many businesses —large and small.
 The owners of a corporation are called stockholders/shareholders.
 A corporation is a form of business organization that is recognized under the law as a
separate legal entity, with rights and responsibilities apart from those of its owners.
 The assets of a corporation belong to the corporation itself, not to the stockholders.
 The corporation is responsible for its own debts and must pay income taxes on its
earnings.
 As a separate legal entity, a corporation has status in court; it may enter into contracts,
and it may sue and be sued as if it were a person.
Advantages and Disadvantages
Advantages Disadvantages
 Stockholders are not personally  Heavy taxation. Corporate earnings
liable for the debts of a are subject to double taxation.
corporation.
 Greater regulation.
 Transferability of ownership.
 Professional management.  Cost of formation.
 Continuity of existence.  Separation of ownership and
management.
Public Limited and Private
Limited
 Corporations whose shares are traded in organized securities exchanges by
general public are called public limited corporations.
 If you purchase the stock of such a corporation, you become a stockholder with a
direct ownership interest—that is, you are a stockholder.
 If you invest in a mutual fund or you are covered by a pension plan, you have an
indirect financial interest in the stocks of many publicly owned corporations,
because these mutual funds and pension funds heavily invest in publicly owned
corporations.
 On the other hand, corporations whose shares are not traded in organized
securities exchanges are known as closely held. Such corporations are owned by
an individual, or a family or by a small group of people.
Publicly Owned Corporations
Face Strict Rules
Publicly owned corporations are subject to more regulation than those that are
closely held.
 Prepare and issue quarterly and annual financial statements in conformity with
generally accepted accounting principles.
 Have their annual financial statements audited by an independent firm of certified
public accountants.
 Comply with federal securities laws, which include both criminal penalties and
civil liability for deliberately or carelessly distributing misleading information to
the public.
 Submit much of their financial information to the Securities and Exchange
Commission for review.
Formation of a Corporation
The first step in forming a corporation is to obtain a corporate charter from the
country/province/state of incorporation.
To obtain this charter, the organizers of the corporation submit an application
called the articles of incorporation.
Once the charter is obtained, the stockholders in the new corporation hold a
meeting to elect a board of directors and to pass bylaws that will govern the
corporation’s activities.
The directors in turn hold a meeting at which the top corporate officers and
managers are appointed.
Organization Costs
 Forming a corporation is more costly than starting a sole proprietorship.
 The costs may include, for example, attorneys’ fees, incorporation fees paid to
the state, and other outlays necessary to bring the corporation into existence.
 Conceptually, organization costs are an intangible asset that will benefit the
corporation over its entire life.
 As a practical matter, however, most corporations expense those costs
immediately, even though they are often spread over a five-year period for
income tax purposes.
 Thus you will seldom see organization costs in the balance sheet of a publicly
owned corporation. They have long since been recognized as an expense.
Rights of Stockholders
 A corporation is owned collectively by its stockholders.
 Each stockholder’s ownership interest is determined by the number of shares
that he or she owns.
 The owners of capital stock in a corporation usually enjoys following basic
rights:
 To vote for directors and on certain other key issues.
 To participate in any dividends declared by the board of directors.
 To share in the distribution of assets if the corporation is liquidated.
Paid-In Capital of a Corporation
Stockholders’ equity of a corporation is normally increased in one of two ways:
1. from contributions by investors in exchange for capital stock—called Paid-in
Capital or Contributed Capital
2. from the retention of profits earned by the corporation over time—called
Retained Earnings.
Authorization and Issuance of
Capital Stock
 Authorized Capital – Number of shares a corporation is allowed to issue in
article of incorporation.
 Outstanding Shares – Shares that have been issued and are in the hands of
stockholders. These outstanding shares represent 100 percent of the
stockholders’ investment in the corporation.
 When a large amount of stock is to be issued, most corporations use the
services of an investment banking firm, frequently referred to as an underwriter.
 The use of an underwriter assures the corporation that the entire stock issue
will be sold without delay and that the entire amount of funds to be raised will
be available on a specific date.
Price of New Stock Issuance
The price that a corporation will seek for a new issue of stock is based on such
factors as
1. expected future earnings and dividends,
2. the financial strength of the company, and
3. the current state of the investment markets.
Par Value
 Par value (or stated value or face value) represents the legal capital per share
—the amount below which stockholders’ equity cannot be reduced.
 Par value may be regarded as a minimum cushion of equity capital existing
for the protection of creditors.
 In Pakistan par value of stocks is usually Rs.10/-, but it can be Rs.100/- or any
other number.
 The par value of the stock is not an indication of its market value.
 Laws require corporations to show separately in the stockholders’ equity
section of the balance sheet the par value of shares issued.
Issuance of Par Value Stock
Authorized Capital 50,000 shares of $2 par value.
1st Issue 10,000 shares @ $10 per share.
Cash 100,000
Capital Stock ($2 * 10,000) 20,000
Additional Paid-In Capital ($8 * 10,000) 80,000
Issued 10,000 shares of $2 par value stock at a price of $10 a share.

The additional paid-in capital does not represent a profit to the corporation. It is
part of the invested capital, and is added to the capital stock in the balance sheet
to show the total paid in capital.
Stockholder’s Equity

Capital stock, $2 par value; authorized, 50,000 shares; issued and

outstanding, 10,000 shares $20,000
Additional paid-in capital 80,000
Total paid-in capital $100,000
Retained earnings 150,000
Total stockholders’ equity $250,000
Issuance of Par Value Stock
If stock is issued by a corporation for less than par, the account Discount on Capital
Stock should be debited for the difference between the issuance price and the par
value. A discount on capital stock reduces, rather than increases, the amount of
stockholders’ equity in the balance sheet.
In some cases, stock is issued in exchange for assets other than cash. When this
occurs, the appropriate asset account is debited and the stock accounts are credited
as if the stock had been sold for cash.
No-Par Stock Some states allow corporations to issue stock without designating a par
or stated value. When this “no-par” stock is issued, the entire issue price is credited to
the Capital Stock account and is viewed as legal capital not subject to withdrawal.
Issuance of Stock with Discount
Cash 15,000
Discount on Capital Stock 5,000
Capital Stock 20,000
Issued 10,000 shares of $2 par value stock at a price of $1.5 a share.

Capital stock, $2 par value; authorized, 50,000 shares; issued and

outstanding, 10,000 shares $20,000
Less: Discount on Capital Stock 5,000
Total paid-in capital $15,000
Retained earnings 135,000
Total stockholders’ equity $150,000
Common Stock and Preferred
Stock
 The basic type of capital stock issued by every corporation often is called
Common Stock.
 Common stock possesses the traditional rights of ownership—voting rights,
participation in dividends, and a residual claim to assets in the event of
liquidation.
 When the rights of stockholders are modified, the term Preferred Stock is
normally used to describe the resulting type of capital stock.
 A few corporations issue two or more classes of preferred stock, with each
class having distinctive features designed to appeal to a particular type of
investor.
Issuance of Par Value Stock
Authorized Capital:
 9% cumulative preferred stock, $100 par value, authorized 100,000 shares.
 Common stock, $5 par value, authorized 3 million shares.

Outstanding Capital:
 Issued and outstanding 50,000 preferred stock @110 per share
 Issued and outstanding 2 million common stock @ $15 per share
Cash 35,500,000
Capital Preferred Stock 5,000,000
Capital Common Stock 10,000,000
Additional Paid-In Capital (Preferred Stock) 500,000
Additional Paid-In Capital (Preferred Stock) 20,000,000
Issued 9%, 50,000 cumulative preferred stock $100 par value @$110 per share and 2m common
stock $5par value @ $15 per share.
Stockholders’ Equity with
Preferred Stock
9% cumulative preferred stock, $100 par value, authorized 100,000 shares,
issued and outstanding 50,000 shares, sold at $110 per share $5,000,000
Common stock, $5 par value, authorized 3 million shares, issued and outstanding
2 million shares 10,000,000
Additional paid-in capital:
Preferred stock 500,000
Common stock 20,000,000
Total paid-in capital $35,500,000
Retained earnings 14,000,000
Total stockholders’ equity $49,500,000
Characteristics of Preferred
Stock
 Preference over common stock as to dividends.
 Cumulative dividend rights.
 Preference over common stock as to assets in event of the liquidation of the
company.
 Callable at the option of the corporation.
 No voting power.
 Conversion of preferred stock into common stock at the option of the holder.
Stock Preferred as to Dividends
 Preferred stock is said to have dividend preference because preferred stock investors are
entitled to receive a specified amount each year before any dividend is paid to common stock
investors.
 Some preferred stocks, however, state the specified dividend as a percentage of par value.
 The holders of preferred stock have no guarantee that they will always receive the indicated
dividend.
 A corporation is obligated to pay dividends to stockholders only when cash is available and the
board of directors declares a dividend.
 Dividends must be paid on preferred stock before anything is paid to the common stockholders,
but if the corporation is not prospering, it may decide not to pay any dividends at all.
 For a corporation to pay dividends, profits must be earned and cash must be available.
Cumulative Preferred Stock
 If all or any part of the regular dividend on the preferred stock is omitted in a
given year, the amount omitted is said to be in arrears and must be paid in a
subsequent year before any dividend can be paid on the common stock.
 In the case of noncumulative preferred stock, the unpaid dividend does not
carry forward to future years and has no effect on the company’s ability to
pay dividends on common stock in the future.
 In the case of cumulative preferred stock, however, any unpaid dividend on
preferred stock carries forward and must be paid before dividends can be
paid on common stock.
Example of Cumulative Dividend
A company was incorporated on 1st Jan 2009 with 10,000 shares of $8 preferred stock and
50,000 shares of common stock.
If preferred stock is non-cumulative, the $8 per share dividend does not carry forward if it is not
paid each year. On the other hand, if the preferred stock is cumulative, the $8 per share
dividend carries forward to future years if it is not paid and the accumulated amount must be
paid before any dividend can be paid on common stock.
2009 2010 2011
If preferred stock is noncumulative
Dividend paid $80,000 $20,000
Dividend in arrears NA
If preferred stock is cumulative
Dividend paid $80,000 $20,000
Dividend in arrears $60,000 $80,000
Dividends in Arrears
In 2012, we shall assume that the company earned large profits, has available cash, and wished to pay
dividends on both the preferred and common stocks.
Before paying a dividend on the common, the corporation must pay the $140,000 in arrears on the
cumulative preferred stock plus the regular $8 per share applicable to the current year. The preferred
stockholders would, therefore, receive a total of $220,000 in dividends in 2012 ($22 per share); the
board of directors would then be free to declare dividends on the common stock.
So dividend payments to preferred stock holders in 2012 will be as follows:
Arrears 2010 $60,000
Arrears 2011 $80,000
Dividend 2012 $80,000
Total Payout $220,000
Other Features of Preferred
Stock
 Corporations sometimes offer a conversion privilege that entitles the preferred
stockholders to exchange their shares for common stock at a stipulated ratio.
 If the corporation prospers, its common stock will probably rise in market value,
and dividends on the common stock will probably increase.
 The investor who buys a convertible preferred stock rather than common stock
has greater assurance of regular dividends.
 In addition, through the conversion privilege, the investor is assured of an
opportunity to share in any substantial increase in value of the company’s
common stock.
Primary Elements of
Stockholders’ Equity
Corporation’s Capital
Classified by Source

Preferred Stock Common Stock

Retained Earnings
Par Value Par Value
Accumulated earnings
Additional paid-in Additional paid-in
of previous years
capital capital
Book Value per Share of
Common Stock
 Book value per share is the amount of net assets represented by each share of stock.
 The term net assets means total assets minus total liabilities; in other words, net assets
are equal to total stockholders’ equity.
 Thus, in a corporation that has issued common stock only, the book value per share is
computed by dividing total stockholders’ equity by the number of shares outstanding.
Stockholders’ Equity
Common stock, $1 par value (4,000 shares issued and outstanding) $4,000
Additional paid-in capital 40,000
Retained earnings 76,000
Total stockholders’ equity $120,000
Book value per share = ($120,000 / 4,000) $30
Book Value When a Company
Has Both Preferred and Common
Stock
 Book value is usually computed only for common stock.
 If a company has both preferred and common stock outstanding, the computation of book
value per share of common stock requires two steps:
 First, the amount assigned to preferred stock and any dividends in arrears are deducted from total
stockholders’ equity.
 Second, the remaining amount of stockholders’ equity is divided by the number of common shares
outstanding to determine book value per common share.
 This procedure reflects the fact that the common stockholders are the residual owners of the
corporate entity.
Stockholders’ Equity
Stockholders’ equity of Hart Company at December 31 is as follows:
8% preferred cumulative stock, $100 par value,
10,000 shares authorized, issued, and outstanding $1,000,000
Common stock, $10 stated value, authorized 100,000
shares, issued and outstanding 50,000 shares 500,000
Additional paid-in capital: common stock 750,000
Total paid-in capital $2,250,000
Retained earnings 130,000
Total stockholders’ equity $2,380,000
Calculation of Book Value
Because of a weak cash position, Hart Company has paid no dividends during the current year.
As of December 31, dividends in arrears on the cumulative preferred stock total $80,000. All
the equity belongs to the common stockholders, except the $1,000,000 applicable to the
preferred stock and the $80,000 of dividends in arrears on preferred stock. The calculation of
book value per share of common stock is as follows:
Total stockholders’ equity $2,380,000
Less: Equity of preferred stockholders:
Par value of preferred stock $1,000,000
Dividends in arrears 80,000 1,080,000
Equity of common stockholders $1,300,000
Number of common shares outstanding 50,000
Book value per share of common stock ($1,300,000/50,000) $26