Full file at
Chapter 13
Corporations: Share Capital
and the Balance Sheet
Questions
1.Corporation characteristics:
•a separate legal entity, formed under federal or provincial law
•continuous life and transferability of ownership
•no mutual agency
•limited liability of shareholders
•separation of ownership and management
•corporate earnings subject to a degree of double taxation
•government regulation
•corporations may incur costs unique to corporations.
2.The corporation itself pays income tax, and the shareholder pays personal tax on after-tax dividends received from the corporation. However, a portion of the corporate tax is allowed as a dividend tax credit to the shareholder to eliminate some of the double taxation.
3.The incorporators pay the fees and file the required documents with the incorporating jurisdiction, and approval of articles of incorporation is granted by the federal or a provincial government. The articles of incorporation include authorization for the corporation to issue a certain number of shares. The incorporators agree to a set of bylaws for governing the corporation. The corporation then issues its shares and receives assets. The shareholders elect the board of directors, which appoints the officers. At this point, the corporation begins operations.
4.CharacteristicCorporationPartnership
Legal Entity–a business entity–does not require
formed under federalfederal or provincial
or provincial lawapproval to do business
–corporation a distinct–partnership not
entity; assets anddistinct from partners
liabilities belong towho hold all assets
corporationand liabilities
Continuous Life–sale or transfer of–partnerships
and Transferabilityshares does not affectterminate when
of Ownershipthe continuity of theownership changes
corporation
CharacteristicCorporationPartnership
Mutual Agency–officers commit the–a partner can bind
corporation to contractspartnership by
signing contract
Liability–shareholders have no–partners are personally
personal obligation forliable for all debts of
corporate liabilities; the partnership
however, directors do
Ownership/–corporations are–partners manage
Managementowned by shareholdersthe partnership
who elect a board of
directors
–the board of directors
appoints officers to
manage the business
Taxation–corporate earnings are–partners are taxed
subject to two different on their share of
types of taxation:partnership income
corporate income is
taxed and after-tax
dividends are taxable
to the shareholder
Additional costs–corporations incur costs–partnerships do not incur
unique to corporations,these costs
such as the cost of
directors’ insurance
5.A common shareholder has the right to: (a) vote on matters that come before the shareholders, (b) receive a proportionate part of any dividends declared on that class of shares, (c) receive a proportionate share of corporate assets if the corporation liquidates, (d) sell the shares and (e) a pre-emptive right, the right to maintain one’s proportionate ownership in the corporation. Preferred shares are automatically voting, unless stated otherwise; however, they are typically nonvoting. These rights may be withheld by the corporation only by agreement with the shareholders.
6.Issuance of shares increases the assets of the corporation, which receives assets in exchange for shares issued. Authorization merely gives the corporation permission to issue shares.
7.Issuance of 1,200 shares of $4.50 preferred shares for $100 would increase the contributed capital by $120,000 (1,200 $100). The transaction would not increase retained earnings because a company does not earn a profit by selling its shares to its own shareholders. Saskinc Ltd.’s annual cash dividend payments would increase by $5,400 (1,200 $4.50).
8.Cash3,575
Common shares [(150 $8) + (250 $9.50)]3,575
9.Issuance of 1,500 common shares for land and a building worth $200,000 increases contributed capital by $200,000.
10.Saxon, Capital...... XXX
Cowle, Capital...... XXX
Common Shares...... XXX
11.Intangible assets: Organization Cost
Current liabilities: Dividends Payable
Shareholders’ equity: Preferred Shares, Common Shares, Retained Earnings.
12.Organization Cost is an intangible asset account. It is debited for its cost when acquired, and the cost is usually amortized as expense over a short period of time.
13.Three important dates for dividends are: (a) Declaration date: the board of directors announces the dividend, (b) Date of record: the corporation identifies the people who own the shares on this date so that they can receive the dividend. (c) Payment date: the corporation pays the dividend.
14.(a)Cumulative preferred:$13,125 (2,500 $1.75 3 years)
Common:$11,875 ($25,000 – $13,125)
(b)Noncumulative preferred:$4,375 (2,500 $1.75)
Common:$20,625 ($25,000 –$4,375)
15.A preferred shareholder would rather own cumulative preferred shares because any preferred dividends passed by the corporation must be paid before paying dividends to the common shareholders. The corporation would rather issue noncumulative preferred shares in order to avoid having to pay dividends in arrears to preferred shareholders.
16.Cumulative preferred dividends in arrears are reported in the notes to the financial statements. Dividends become a liability only after the board of directors declares the dividends.
17.The market value of a share is the price at which a person could buy or sell a single share. The book value of a share is the total amount of shareholders’ equity in the company’s books divided by the number of shares issued. Market value is far more important to investors than book value.
18.In a company with both preferred and common shares outstanding, the preferred shareholders have the first claim to shareholders’ equity. The book value of preferred shares is their liquidation value plus any cumulative preferred dividends in arrears if the preferred shares are cumulative. The remaining equity divided by the number of common shares gives the book value for each common share.
19.A healthy company’s return on shareholders’ equity should exceed its return on total assets because of the interest expense component of return on assets. Shareholders demand a higher rate of return than creditors. If return on total assets is higher than return on shareholders’ equity, the company may be over leveraged.
Starters
(5 min.)S 13-1
1.The chairperson of the board of directors is usually the most powerful person in a corporation.
2.The shareholders hold ultimate power in a corporation.
3.The president or Chief Executive Officer (CEO) is in charge of day-to-day operations.
4.The vice-president of accounting and finance is in charge of accounting.
(5 min.)S 13-2
DIFFERENCE:
A proprietorship’s balance sheet reports a single capital account, such as Joe Hopper, Capital. A corporation balance sheet reports shareholders’equity by source. There are two sources: contributed capital and retained earnings.
SIMILARITY:
A proprietorship’s balance sheet and a corporation’s balance sheet both report assets and liabilities in the same way.
(5 min.)S 13-3
JournalACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
a. / Cash (1,000 × $50) / 50,000
Common Shares / 50,000
b. / Cash / 48,000
Preferred Shares / 48,000
(5 min.)S 13-4
JournalACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Cash / 9,200
Common Shares / 9,200
Issued common shares.
(5-10 min.)S 13-5
1.Total contributed capital increased $11,000 ($90,000 $79,000). The increase was due to the sale of common shares in 2010, shown by the increase in the number of shares from 2009 to 2010 and by the increase in the dollar balance of the common shares from 2009 to 2010.
2.KD Corporation had a profit in 2010 because the balance of retained earnings increased from 2009 to 2010 by $2,200 ($49,000 $46,800).
(5 min.)S 13-6
Shareholders’ equity:
Common shares, 40,000 shares issued...... $28,500
Retained earnings...... 8,000
Total shareholders’ equity...... $36,500
(5 min.)S 13-7
a.Accounts payable...... $ 3,000
Unearned revenue...... 2,600
Long-term note payable...... 3,800
Total liabilities...... $ 9,400
b.Total liabilities (from Req. a)...... $ 9,400
Total shareholders’ equity (from Starter 13-6)...... 36,500
Total assets...... $ 45,900
(10 min.)S 13-8
JournalDATE
2009 / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Dec. / 15 / Retained Earnings
(5,000 × $5.00) + (50,000 × $0.60) / 55,000
Dividends Payable — Preferred Shares / 25,000
Dividends Payable — Common Shares / 30,000
Declared a cash dividend.
2010
Jan. / 4 / Dividends Payable — Preferred Shares / 25,000
Dividends Payable — Common Shares / 30,000
Cash / 55,000
Paid the cash dividend.
(5-10 min.)S 13-9
1.The preferred shares are cumulative because they are specifically designated as cumulative.
2.Preferred gets $1,000 (40,000 × $0.025).
Common gets $14,000 ($15,000 – $1,000)
3.Preferred gets:
2008 dividend in arrears (40,000 × $0.025)...... $1,000
2009 dividend in arrears ...... 1,000
2010 current-year dividend...... 1,000
Total...... $3,000
Common gets ($15,000 – $3,000)...... $12,000
(5 min.)S 13-10
Preferred equity:
Book value or liquidating value (40,000 × $0.50)...... $ 20,000
Cumulative dividends (40,000 × $0.025 × 5)...... 5,000
Shareholders’ equity allocated to preferred ...... $ 25,000
Common equity:
Total shareholders’ equity...... $350,000
Less preferred equity...... (25,000)
Common equity...... $325,000
Book value per share ($325,000 ÷ 1,000,000 shares).....$ 0.325
(5 min.)S 13-11
Rate of returnon total
assets / = / Net
income / + / Interest
expense / = / $6,100 + $400
Average total assets / ($49,000 + $44,800) / 2
= / $6,500 / = / 13.9%
$46,900
Rate of return
on common shareholders’ equity / = / Net
income / – / Preferred dividends / = / $6,100 – $ 0
Average common
shareholders’ equity / ($23,600 + $22,800) / 2
= / $6,100 / = / 26.3%
$23,200
These rates of return are quite high.
Exercises
(5-10 min.)E 13-1
Note: Student responses will vary because different people have various reasons for the decisions they make.
Reasons for organizing as a corporation:
1.Ease of raising capital from other investors
2.Limited liability of shareholders for the business’s debts
3.Ease of transferring ownership if a shareholder wants to sell his or her interest in the business
Reasons for not organizing as a corporation:
1.Must pay corporate tax and personal tax on dividends
2.More government regulation of corporations
(5-10 min.)E 13-2
MEMO TO:David Johnston and Lisa Jacobs
SUBJECT:Incorporation of D&L Decor Ltd.
In order to incorporate D&L Decor Ltd., you must obtain and complete the required documents from either the province in which you wish to incorporate or the federal Ministry of Industry. The completed documents must be submitted with the required fee. The documents are called articles of incorporation and include a request for authorization for the corporation to issue shares. When the appropriate jurisdiction authorizes the incorporation, D&L Decor Ltd. will become a legal entity.
As soon as D&L Decor Ltd. is incorporated you will draw up and agree to a set of bylaws by which D&L Decor Ltd. will be governed. All those who purchase common shares in D&L Decor Ltd. will be shareholders of the corporation. The shareholders will elect the board of directors of the corporation. The board of directors sets the policy for D&L Decor Ltd. and appoints the officers of the corporation, including the president, who is the chief executive officer in charge of managing day-to-day operations.
Instructional Note: Student responses may vary considerably.
Req. 1(10-15 min.)E 13-3
General JournalDATE / ACCOUNT TITLES AND EXPLANATION / POST. REF. / DEBIT / CREDIT
Jan. / 19 / Cash / 44,000
Common Shares (4,000 $11.00) / 44,000
Feb. / 3 / Cash / 14,000
Class A Preferred Shares (1,000 shares) / 14,000
11 / Inventory / 27,000
Equipment / 16,500
Common Shares (5,800 shares) / 43,500
15 / Cash / 26,000
Class B Preferred Shares (2,000 $13) / 26,000
Req. 2
Total Contributed Capital:
Preferred:Class A$ 14,000
Class B26,000
Common: ($44,000 + $43,500)87,500
Total contributed capital$127,500
(5-10 min)E 13-4
General JournalDATE / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Cash / 150,000
Common Shares / 150,000
To issue 10,000 common shares at $15.
Case A—Issue shares and buy the assets in separate transactions.(10 min.)E 13-5
General JournalDATE / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Cash / 1,260,000
Common Shares / 1,260,000
Issued shares.
Building / 900,000
Equipment / 360,000
Cash / 1,260,000
Purchased property, plant, and equipment.
Case B—Issue shares to acquire the assets.
General JournalDATE / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Building / 900,000
Equipment / 360,000
Common Shares / 1,260,000
Issued shares to acquire building and
equipment.
The balances in all accounts are the same because, in both cases, the value of the assets received for the common shares issued is $1,260,000:
Building...... $900,000
Equipment...... 360,000
Req. 1(15-20 min.)E 13-6
General JournalDATE
2010 / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Jan. / 4 / Cash / 120,000
Common Shares / 120,000
Issued 5,000 common shares.
13 / Cash / 50,000
Preferred Shares / 50,000
Issued 500 preferred shares for cash.
14 / Land / 120,000
Common Shares / 120,000
Issued 4,000 common shares for land.
Dec. / 31 / Income Summary / 150,000
Retained Earnings / 150,000
Closed net income to Retained Earnings.
Req. 2
Mid-way Consulting Inc.Shareholders’ Equity
December 31, 2010
Contributed capital:
Preferred shares, $4.00, 500,000 shares authorized, 500 shares issued / $50,000
Common shares, 1,000,000 shares authorized, 9,000 shares issued / 240,000
Total contributed capital / 290,000
Retained earnings / 150,000
Total shareholders’ equity / $440,000
(10 min.)E 13-7
Contributed capitalPreferred shares, $1.50:
Issued for cash (2,500 shares $20) / $50,000
Common shares:
Issued for cash (35,000 shares $12.50)$437,500
Issued for organization cost7,500
Issued for patent50,000 / 495,000
Total contributed capital / $545,000
(10-15 min.)E 13-8
General JournalDATE / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
June / 14 / Organization Costs ($2,000 + $500) / 2,500
Cash / 2,500
To pay legal fees and other fees to
incorporate.
14 / Sheila Mason, Capital / 40,000
Tom Neilson, Capital / 30,000
Common Shares (7,000 shares) / 70,000
To incorporate the business, close the
capital accounts of the partnership, and
issue common shares to the incorporators.
Req. 1(10-15 min.)E 13-9
General JournalDATE / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Mar. / 23 / Cash / 120,000
Common Shares / 120,000
Issued 12,000 common shares at $10.00.
Apr. / 12 / Inventory / 40,000
Equipment / 10,000
Common Shares / 50,000
Issued 5,000 common shares to acquire
inventory and equipment.
17 / Cash / 15,000
Preferred Shares, $2.25 / 15,000
Issued 1,500 preferred shares at $10 each.
Req. 2
Lipton Technology Inc.Shareholders’ Equity
Contributed capital
Preferred shares, $2.25, 100,000 shares authorized, 1,500 shares issued / $15,000
Common shares, 250,000 shares authorized, 17,000 shares issued / 170,000*
Total contributed capital / 185,000
Retained earnings / 65,000
Total shareholders’ equity / $250,000
*Computation:
Mar. 23:12,000 shares $10.00=$120,000
Apr. 12:$40,000 + $10,000=50,000
$170,000
(10-15 min.)E 13-10
Sunnee CorporationShareholders’ Equity
June 30, 2010
Contributed capital
Preferred shares, $1.25, 100,000 shares authorized, 10,000 shares issued / $87,500
Common shares, 500,000 shares authorized, 100,000 shares issued / 100,000
Total contributed capital / 187,500
Retained earnings / 90,000
Total shareholders’ equity / $277,500
(10-15 min.) E 13-11
1.1,000 shares $5.00 = $5,000
2.Preferred gets $5,000
Common gets $15,000 ($20,000 – $5,000)
3.Preferred shares are noncumulative because they are not specifically designated as cumulative.
4.Preferred gets:
2010 current-year dividend = $5,000
Common gets $35,000 ($40,000 – $5,000)
(15-20 min)E 13-12
Barclay Marketing Ltd.Dividend Payment Schedule
PREFERRED / COMMON / TOTAL
Total dividend / $31,000
Preferred dividends in arrears for 2009:
(50,000 $0.10) / 5,000
Total preferred dividends in arrears / 5,000
Remainder / 26,000
Dividends for 2010:
Preferred
Total preferred dividends for 2010 / 5,000 / 5,000
Remainder / 21,000
Common / $21,000 / 21,000
Remainder / $0
Totals / $10,000 / $21,000 / $31,000
(10-15 min.)E 13-13
Nature’s Design Technology Inc.Book value per share of preferred and common shares:
Preferred:
Liquidation value (in total) / $15,000
Book value per share ($15,000/300) / $50.00
Common:
Shareholders’ equity allocated to common
($15,000 + $187,500 + $115,000 – $15,000) / $302,500
Book value per share ($302,500/25,000 shares) / $12.10
(10-15 min.)E 13-14
Nature’s Design Technology Inc.Book value per share of preferred and common shares:
Preferred:
Liquidation value / $15,000
Dividends in arrears (300 $7.00 3) / 6,300
Total preferred equity / $21,300
Book value per share ($21,300/300 shares) / $71.00
Common:
Total shareholders’ equity ($15,000 + $187,500 + $115,000) / $317,500
Less: Total preferred equity / 21,300
Total common equity / $296,200
Book value per share ($296,200/25,000 shares) / $11.85
(10-15 min.)E 13-15
Rate ofreturn on
total assets / = / Net income
+ Interest expense / = / $3,250 + $5,200 / = / $8,450
Average total assets / ($105,000 + $95,000)/2 / $100,000
= / 0.0845 100 = 8.45%
Rate of return
on common
shareholders’
equity / = / Net income
– Preferred dividends / = / $3,250 – (200 1.15) / = / $3,020
Average common
shareholders’ equity / ($46,500 + $43,000)/2 / $44,750
= / 0.0675 100 = 6.75%
These profitability measures suggest some weakness because Waldy’s 6.75 percent return on shareholders’ equity is fair but the return on assets exceeds it by 1.7 percent meaning that the company is paying more for its borrowed funds than it is earning.
Req. 1(5-10 min)E 13-16
General JournalDATE
2011 / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Feb. / 1 / Carl Haupt, Capital / 17,227
Common Shares / 17,227
To incorporate the business, close the
capital account of the proprietorship, and issue 20,000 common shares to the incorporator
Req. 2
General JournalDATE
2011 / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Feb. / 1 / Cash / 50,000
Preferred Shares / 50,000
Issued 1,000 preferred shares at $50 each
Req. 3
General JournalDATE
2011 / ACCOUNT TITLES AND EXPLANATIONS / POST. REF. / DEBIT / CREDIT
Feb. / 1 / Organization Costs / 1,500
Cash / 1,500
Legal fees and incorporation fees to organize the corporation
(15-20 min.)E 13-17
Common shares, Dec. 31, 2009 / $300,000Issuance of shares for cash (3,000 shares at $50) / 150,000
Issuance of shares to purchase another company (15,000 shares at $70) / 1,050,000
Common shares, Dec. 31, 2010 / $1,500,000
Retained earnings, Dec. 31, 2009 / $1,538,000
Net income / 1,430,000
Cash dividends / (660,000)
Retained earnings, Dec. 31, 2010 / $2,308,000
Beyond the Numbers
BN 13-1
1.Contributed capital and retained earnings are reported separately as they represent different sources of capital:
Contributed capital represents investments in share capital by shareholders
Retained earnings is capital earned by profitable operations of the corporation
Incorporating acts require corporations to report the sources of their capital.
2.VC Inc. faces the problem of determining the market value of the land it receives. The current market value of the land will determine the recorded value of the land and of the common shares issued.
3.Investors buy common shares in the hope of earning higher returns on their investment than are available on an investment in preferred shares. For a healthy company, the rate of return on common shareholders’ equity is usually higher than the rate of return on preferred shares. Also the market value of common shares in such a company will increase more than its preferred shares’ price.
4.Yes, if book value exceeds market value. No, if market value exceeds book value. The shareholder will accept the offer that maximizes his or her wealth.
5.Convertible preferred shares may be exchanged by preferred shareholders, if they choose, for another specified class of shares in the corporation. An investor would exercise the conversion privilege if the market value of the shares received on conversion exceeded the market value of the preferred shares held.
Ethical Issue
Req. 1
Wertz’s reporting a $50,000 franchise at $375,000 is unethical. The franchise cost $50,000, not $375,000. The three transactions are not independent. Wertz and the corporation are effectively the same entity. The third party serves no purpose other than as an accomplice to increase the value of the franchise fraudulently.
Req. 2
Potential buyers of the individual-language franchises can be harmed. Wertz’s balance sheet overstates his assets. If outsiders believe his balance sheet, they may be induced to pay Wertz more than the individual-language franchises are worth.