Ch. 12: Contributed Capital 1
Chapter 12
Contributed Capital
In this chapter you will learn how contributed capital affects businesses, how it is controlled, accounted for, and reported in financial statements.
What Is Contributed Capital?
Chapters 10 and 11 examined current and long-term liabilities, which together represent one major source of resources for companies. Liabilities are the dollar amounts of borrowed resources. A second source of resources is owners. When corporations obtain resources through owners' investments, the resources are called assets and the source of resources is called contributed capital. Thus, a corporation's contributed capital represents the dollar amount of resources invested by its owners. In prior chapters, the source of owner-invested resources was called common stock. In the remainder of this text, the source of owner-invested resources will be called contributed capital to reflect the fact that there are different types of corporate owners and there are several accounts in which their investments are reported. The third major source of resources is operations, that is, management's generation of resources through the operation of the company. The source of management generated resources is called net income, which is eventually reported as part of retained earnings. This chapter examines contributed capital while retained earnings is examined in Chapter 13.
In terms of the accounting equation, because owners have rights to amounts they invested and to resources generated by management (net income), contributed capital and retained earnings are both reported as parts of stockholders' equity, as shown below. The numbers in parentheses refer to the chapters in which the items are discussed.
AssetsCurrent Assets
Cash and Cash Equivalents (6)
Accounts Receivable (7)
Allowance for Uncollible Accounts (7)
Merchandise
Inventory(8)
Property, Plant, & Equipment
Land (9)
Buildings (9)
Accumulated Depreciation, Buildings (9)
Equipment (9)
Accumulated Depreciation, Equipment (9)
Autos & Trucks (9)
Accumulated Depreciation, Autos & Trucks (9) / = / Liabilities
Current Liabilities
Notes Payable (10)
Accounts Payable (10)
Taxes Payable (10)
Current Portion of Long-term Debt (10)
Long-term Liabilities
Bonds Payable (11)
Deferred Taxes (11)
Obligations Under Capital Leases (11) / + / Stockholders' Equity
Contributed
Capital (12)
Retained Earnings (13)
Revenues
Sales (7)
Sales Returns & Allowances (7)
Cost of Goods Sold (8)
Operating Expenses
Uncollectible Accounts Expense (7)
Depreciation
Expense (9) & (11)
Salary & Wages
Expense (10)
Payroll Taxes
Expense (10)
Bank Service Expense (6)
Other Revenues & Expenses
Interest Revenue (6)
Interest
Expense (6) & (11)
Gain or Loss on Disposal of Property, Plant, & Equipment (9)
Gain or Loss on Early
Retirement of Bonds (11)
Income Taxes
Expense (10)
The dollar amount of contributed capital differs from company to company. For example, AT&T, the largest telecommunications services company in the United States, reported contributed capital of $98 billion on December 31, 2009. This $98 billion was approximately 37% of AT&T’s December 31, 2009 total assets. Nippon Telegraph and Telephone, the largest telecommunications services company outside of the United States, reported contributed capital of 3,776 billion yen on December 31, 2009. The 3,776 billion yen was approximately 20% of Nippon Telegraph and Telephone’s December 31, 2009 total assets. One year earlier, on December 31, 2008, AT&t’s contributed capital was also $98 billion or again approximately 37% of AT&T’s total assets.
The Nature of Contributed Capital
While the dollar amounts of resources invested by owners are reported as assets, the sources of such resources are reported in contributed capital accounts, the major ones of which will be examined in detail in this chapter. Specifically, the following accounts will be examined: common stock, additional paid-in capital, preferred stock, dividends, and treasury stock.
Proprietorships, Partnerships, and Corporations
In order to understand contributed capital, it is necessary to understand the corporate form of business. In general, there are three basic forms of business: proprietorships, partnerships, and corporations.
Proprietorships A proprietorship is a company owned by one person, who is usually very actively involved in its operation. For example, many of the coffee shops and pizza restaurants near your campus are probably proprietorships operated by their owners. From an accounting standpoint, the resources, sources of resources, and results of operations of a proprietorship are kept separate from the personal life of its owner. From a legal and tax standpoint, however, the business is viewed as the responsibility of its owner. The owner is held personally responsible for any debts the company cannot pay. This legal requirement means the owner of a proprietorship has unlimited liability for the obligations of the business. If something disastrous happens, the owner could possibly lose the original dollar amount invested in the business and, if necessary, part or all other resources the owner possesses. For example, if someone injured in a coffee shop that is a proprietorship is awarded a $5,000,000 court settlement, the owner of the coffee shop would be personally responsible for the amount of the $5,000,000 that could not be paid by the coffee shop. Thus, even if the owner had only invested $10,000 in the coffee shop, the owner could end up losing much more than the $10,000 investment.
In addition to being responsible for the company's obligations, the owner of a proprietorship has the sole right to the company's net income as well as its resources when the company stops operating. In fact, this right to net income often makes people establish proprietorships. For tax purposes, the company's income is included as part of the income on which the owner is taxed. The proprietorship company is not responsible for income taxes. For example, if a pizza restaurant that is a proprietorship reported income of $8,000, the $8,000 would be reported as part of the owner's income on the owner's income taxes return. The pizza restaurant would not pay any income taxes on the $8,000 income.
Partnerships A partnership is a company owned by two or more persons, who are also usually actively involved in its operation. For example, many accounting firms, law firms, and medical practices are partnerships. Partnerships are often formed because of the different talents possessed by the partners. For example, one law partner might be a skilled corporate lawyer, while others could be skilled in personal injury law or law research. Still other partners could possess the resources necessary to start the company operating. Similar to proprietorships, the owners of partnerships have unlimited liability for the obligations of the company and have a right to the company's income as well as its resources when it stops operating. The income of the partnership is not taxed to the partnership but is included as part of the taxable income of the partners. Because of the various types of involvement of the owners, partnerships should have written agreements detailing the responsibilities of the partners and how the partnership's income will be distributed among them.
Corporations A corporation is a company whose legal existence is separate from its owners' existence. Many companies with which you are familiar are corporations, including AT&T and Nippon Telegraph and Telephone. The primary right of corporations is the right to enter into contracts. For example, corporations may purchase assets, hire employees, sell products, and borrow money. In effect, corporations have the right to conduct business under their own responsibility. Unlike proprietorships and partnerships, in which the owners are ultimately responsible for the debts of the companies, corporations are responsible for their own debts. Owners of corporations are responsible only for the dollar amounts they invest. In other words, owners of corporations are said to have limited liability. The fact that corporation owners have limited liability is one of the major reasons people are willing to invest in corporations. As a result, many corporations have been able to obtain large amounts of resources from owners. Remember, for example, as shown earlier, AT&T obtained approximately $98 billion from its owners.
Another important reason corporations are so popular in business is that it is often easy for owners to change the amounts they invest in them. As examined later in this chapter, shares of stock represent an owner's financial interest in a corporation. To change owners, it is simply necessary for owners to sell some or all of their shares to other investors who want them. Since there are many stockbrokers who can make such stock sales possible, it is often quite easy for corporate owners to change. This ease of changing ownership makes the financial commitment and the length of the commitment depend primarily on the investors. It is possible, of course, investors will not be able to sell their stock shares at prices high enough to recover the amounts they originally invested in the corporation. This is one of the risks of investing in corporations.
In exchange for rights accompanying separate legal existence, corporations have increased responsibilities, two important ones of which relate to regulation and taxes. Corporations are regulated by the states in which they are formed (incorporated) as well as the states and countries in which they operate. This means corporations must be familiar with the legal requirements of various states and countries and must comply with these requirements. Furthermore, corporations must fulfill the regulations and reporting requirements of the Securities and Exchange Commission (SEC) and the stock exchanges on which the corporations' shares of stock are traded. These requirements can be very expensive to meet. For example, one SEC requirement that affects corporations and has been instrumental in the growth of the accounting profession is the requirement that corporations submit audited financial statements to the SEC. Audited financial statements are those that have been examined by Certified Public Accountants. Due to the size of many corporations, the accounting fees for auditing their financial statements can be quite large, even in excess of several million dollars a year.
As explained in previous chapters, corporations pay income taxes. In 2010, in the United States, the effective income tax rate for corporations with taxable income of $18,333,333 or more is 35%. For example, a corporation with taxable income of $200,000,000 would have been responsible for income taxes of $70,000,000 ($200,000,000 x .35). Additionally, if the corporation's $130,000,000 net income ($200,000,000 income before taxes - $70,000,000 income taxes expense) were distributed in the form of dividends, owners would have been responsible for income taxes on the portion of the $130,000,000 they received. In total, assuming owners' effective federal income taxes rate was 30%, owners would have paid $39,000,000 ($130,000,000 x .30) of income taxes on dividends. Thus, the total income taxes on the corporation's income before taxes would have been $109,000,000 ($70,000,000 taxed to the corporation + $39,000,000 taxed to owners). The fact that both the corporation and its owners pay income taxes on corporate income is sometimes referred to as double taxation of corporations. Whatever it is called, corporations and owners paying taxes on corporate income are evidence that the right to operate as a corporation can be expensive.
Corporate Structure
A corporation is created through the legal process of filing articles of incorporation in a state in which the company's owners want it to be incorporated. Quite often, a company will be incorporated in the state in which its founders live. However, because of favorable treatment in Delaware, many U.S. corporations were incorporated there even though they conduct all or the vast majority of their business elsewhere. AT&T, for example, is incorporated in Delaware, has its principal executive offices in Texas, provides landline services in 22 states, and provides wireless services throughout the US. Recently, due to favorable treatment, many new companies are incorporating in Nevada. Regardless of the state of incorporation, once the articles of incorporation are properly filed and approved by the state, they are often referred to as the corporation's charter and the company has the right to conduct business.
There are several important groups involved in the operation of corporations, three of which will be briefly discussed in the following paragraphs, namely, owners, board of directors, and managers.
Owners As stated earlier, ownership interests in corporations are represented by shares of stock. Although there can be many different types of stock, the primary owners of corporations are those who own shares of common stock. Thus, corporate owners are often referred to as common stockholders. An owner's percentage ownership of a corporation is a function of the number of shares of common stock owned. For example, if a person owns 2,000 shares of common stock of a corporation in which the total number of common shares owned by all owners is 100,000, the owner of the 2,000 shares owns 2% of the corporation (2,000 / 100,000).
By owning common stock, stockholders can have many rights, as specified in the corporation's charter. One right usually given to common stockholders is the right to elect the corporation's board of directors, which in turn usually has a significant influence over the operation of the corporation, as discussed below. The number of votes a stockholder has is based on the number of shares of common stock owned. A stockholder who owns 10,000 shares has the right to 10,000 votes.
A second right of common stockholders is the right to the corporation's income. Remember, as mentioned numerous times in previous chapters, owners have a right to company income. Corporate income is distributed to owners through dividends. For example, if a corporation declares a $.50 per share dividend on common stock, a stockholder with 2,000 shares of the corporation's common stock would receive a dividend of $1,000 ($.50 x 2,000 shares).
A third right of common stockholders is the right to the corporation's resources (assets) if the company goes out of business. The common stockholders would receive the corporation's remaining assets once all its obligations are paid. Similar to the right to vote and the right to receive corporate income through dividends, a common stockholder's right to corporate resources is based on the number of common shares owned by the stockholder. For example, consider what would happen if the Lawrence Corporation, whose simplified balance sheet is presented below, stopped doing business on December 31.
Total assets / $80,000,000Total liabilities / $60,000,000
Total stockholders' equity / $20,000,000
In general, when a company goes out of business, it (1) sells its assets, (2) eliminates its liabilities by paying its creditors, and (3) distributes any remaining assets to owners. If the Lawrence Company first sells its $80,000,000 of assets for $75,000,000 cash and uses $60,000,000 of this cash to pay its creditors in full, there would be $15,000,000 left to be distributed to owners ($75,000,000 - $60,000,000). The $15,000,000 cash would be distributed to owners based on the number of shares of common stock they own. For example, if all stockholders combined own a total of 5,000,000 shares of common stock, stockholders would receive $3 for each share of common stock they own ($15,000,000 / 5,000,000 shares). Thus, a stockholder who owns 2,000 shares of the Lawrence Company's common stock would receive $6,000 ($3 x 2,000 shares).
Of the common stockholders' three rights described above, the right to income through dividends is by far the most important to most stockholders. Due to the large number of investors who own common shares of corporations, most investors do not own enough shares of any individual company's common stock to make the right to vote for directors very important to the individual owner. For example, on December 31, 2009, there were 5.9 billion shares of AT&T’s common stock in the possession of its owners. A stockholder who owned 20,000 shares of AT&T's common stock would own .0003% of AT&T (20,000 / 5,900,000,000). Such a small ownership interest in AT&T would give a stockholder very little influence over the company. However, if enough stockholders become organized and vote the same way, they can have a significant influence on a corporation by electing board of directors members whose interests in the corporation are similar to those of the stockholders. Similar to the right to vote for directors, although common stockholders do have a right to resources when a corporation ceases to exist, this right is not very important to most stockholders. Most stockholders do not invest in corporations they expect to go out of business!
Board of Directors A corporation's board of directors is a group of individuals elected by common stockholders to represent them in making some important decisions regarding the corporation. Corporations hold annual meetings to elect boards of directors, as well as to conduct other business. Common stockholders elect directors by voting based on the number of shares owned. A board of directors is necessary simply because there are often too many individual stockholders for efficient decision-making. For example, on December 31, 2009, Wal-Mart had over 300,000 common stockholders. Such a large group would find it virtually impossible to make decisions. One of the more important decisions made by a board of directors is the dollar amount of dividends to be distributed to owners. While management is responsible for the company's generation of income through operations, the board of directors is responsible for determining the amount of income to be distributed to owners through dividends. Other important activities in which the board of directors is involved are determining the long-term goals and objectives of the corporation, selecting the corporation's major managers (often called executives) and the dollar amounts of their salaries, and determining terms for bonds and stock issues.
Managers Managers are responsible for operating corporations. For example, managers hire and evaluate performance of employees (including other managers), oversee purchase and sale of products, arrange for company loans, buy and sell property, plant, and equipment, and approve major advertising campaigns. In short, management is responsible for generating resources through operation of the company.
One way to view the relationship between owners, the board of directors, and managers is presented in Exhibit 12-1, which shows each group's major responsibilities.
Exhibit 12-1Corporate Structure and Major Responsibilities
Common Stockholders
(Responsible for electing board of directors)
Board of Directors
(Responsible for dividends and hiring major managers)
Managers
(Responsible for day-to-day activities to generate
resources through business operations: net income)
Common Stock
Common stockholders are the primary owners of corporations. They invest resources in corporations and receive rights to vote for the boards of directors. They receive dividends declared by the boards of directors and paid by the corporations. They receive corporate resources when the corporations go out of business. Even more importantly for most common stockholders, they have the right to sell their shares of common stock at any time and at any price for which they can find a buyer. From the viewpoint of corporations, owners are one major source of resources. Remember, there are three major sources of resources for corporations: borrowing (creditors), owners (stockholders), and management (net income).