Lecture #9: Organization and Operation of Corporations

Advantages of the Corporate Form.

1. Corporations are separate legal entities.

A corporation, through its agents, may conduct its affairs with the same rights, duties, and responsibilities as a person.

2. Stockholders are not liable for a corporation’s debts.

If a corporation bankrupts, the creditors cannot collect from the stockholders. This is one important advantage of a corporation.

3. Ownership rights of corporations are easily transferred.

A shareholder can sell his stock to another person (i.e. transferring ownership). This has no effect on the daily operations of a corporation.

4. Corporations have continuity of life.

A successful corporation can in theory live forever.

5. Stockholders do not have a mutual agency relationship.

Under a partnership, one partner can bind the company to contracts, even without the other partners permission or knowledge. You have to be careful who you partners are. Under a corporation, a stockholder cannot bind the corporation to contracts. You do not have to worry about the character of the stockholders.

6. Ease of capital assembly.

A corporation is more attractive to investors than in investing in a partnership. This is because:

• Stockholders are not liable for the corporation’s actions and debts.
• Stockholders do not have a mutual agency relationship.
• The stock is easily transferred and sold.

→ Therefore, corporations can raise a substantial amount of capital compared to other forms of business.

Disadvantages of the Corporate Form

1. Governmental regulation.

State laws usually regulate the corporations more than proprietorships and partnerships. Also corporations usually have to file many governmental reports.

2. Taxation.

As business units, corporations are subject to the same taxes as proprietorships and partnerships. However the tax does not end here. If a corporation pays dividends to the stockholders, this is income to these people. These stockholders have to pay personal income taxes on dividends. Therefore, the corporate income is taxed twice, where the other business forms, they are only taxed once.

Organizing a Corporation

• A corporation is created by securing a charter from the state government. The requirements for a charter vary among the states. Usually the charter application must be signed by three or more subscribers to the prospective corporation’s stock. Once the corporation complies with the law and pays all fees, the charter is issued and the corporation is formed.
• The costs of organizing a corporation, such as legal fees, promoters’ fees, and amounts paid to secure a charter, are called organization costs. On the corporation’s books, these costs are debited to an asset account called Organization Costs. This is an intangible asset that benefits the corporation throughout its life. This asset should be amortized over the estimated life of the corporation.
• The difference between depreciation and amortization is that depreciation you use a contra-account, because this is a tangible asset. Amortization directly credits the asset account to reduce its value, because the asset is intangible.

Management of a Corporation

The ultimate control of a corporation rests with its stockholders. The stockholders exercise this control by electing the board of directors. This vote is done at the stockholders’ meeting, where each stockholder usually has one vote for each share of stock owned. Normally, a corporation’s stockholders meet once each year to elect directors and vote on any other business matters, which according to the corporation’s bylaws, must by approved by the stockholders.

If a group of stockholders own 50% plus one share of a corporation’s stock, they can elect the board and control the corporation. Many stockholders do not attend the meeting, so a smaller percentage is frequently able to dominate the election of board members. A corporation’s board of directors is responsible and has final authority for the direction of corporate affairs. An individual director has no power to transact corporate business, only the board as a whole.

Usually the board limits its actions to establishing policy. Day-to-day direction of corporate business is delegated to executive officers who are appointed by the board to manage the business. Traditionally the chief executive officer (CEO) of the corporation is the president. In recent years, many corporations have a slightly different structure in which the board of directors chairperson assumes the position of chief executive officer. When this is done, the president usually is designated the chief operating officer (COO).

Stock Certificates and the Transfer of Stock

When a person invests in a corporation by buying its stock, the person receives a stock certificate as proof of the shares purchased. Large corporations commonly use preprinted certificates, each of which represents 100 shares, plus blank certificates that may be made out for any number of shares.

When a stockholder sells shares of a corporation, the seller completes and signs the transfer endorsement on the back of the certificate and sends it to the corporation’s transfer agent. The old certificate is canceled and retained, and a new certificate is issued to the new stockholder.

If a corporation’s stock is traded on a major stock exchange, the corporation must have a registrar and a transfer agent. The registrar keeps the stockholder records and prepares official lists of stockholders for stockholders’ meetings and for payment of dividends. Usually registrars and transfer agents are large banks.

When a stockholder wants to sell shares of stock, the owner usually requests a stockbroker to act on the owner’s behalf and sell the shares. Then the owner completes the transfer endorsement on the back of the stock certificates and gives the certificates to the stockbroker who sends it to the corporation’s transfer agent. The transfer agent cancels the old certificates and issues one or more new certificates and sends them to the registrar. The registrar enters the transfer in the stockholder records and sends the new certificate to the proper owners.

Authorization and Issuance of Stock

When a corporation is organized, it is authorized in its charter to issue a certain amount of stock. If all of the authorized shares have the same rights and characteristics, the stock is called common stock. Usually a corporation will secure an authorization to issue more stock than it plans to sell at the time of its organization. Therefore the corporation can sell stock in the future to finance future expansion of the business without having to change its charter, so it can sell more stock. The corporation can sell stock for cash. The journal entry is:

A corporation may accept assets other than cash in exchange for its stock. The corporation can also simultaneously accept some liabilities.

A corporation also may issue shares of its stock to its promoters in exchange for their services in organizing the corporation.

Par Value and Minimum Legal Capital

Many stocks have a par value. This is an arbitrary amount that is assigned to the stock when it is authorized. A corporation may choose any par value. When a corporation issues par value stock, the par value is printed on each certificate. The par value of a corporation’s stock establishes a minimum legal capital for the corporation. For example, if a corporation issues 1,000 shares of $100 par value stock, the minimum legal capital of the corporation is $100,000.

The minimum legal capital is intended to protect the creditors of a corporation. Creditors are only willing to make loans to a corporation if the corporation has enough assets to ensure that the creditors will be repaid. Some of these assets are represented by the minimum legal capital.

The stockholders must provide it with a fund of assets equal to its minimum legal capital. If the corporation bankrupts, then the creditors get paid first, then the remaining assets are returned to the stockholders. Most often, the par value of a stock is set at a nominal amount that is substantially less than the price at which the stock is offered to investors.

Stock Premiums and Discounts.

1. Premium on stock.

When a corporation sells and issues stock at a price above the stock’s par value, the difference between the issue price and the par value is called a premium on stock. If a corporation sells and issues 10,000 shares of its $10 par value common stock for cash at $25 per share, you record the stock issue as follows:

The premium is not revenue to the corporation, so it does not appear on the income statement. It is a part of investment by the stockholders, who paid more than par value for their stock.

2. Discounts on stock.

If stock is issued at a price below par value, the difference between par and the issue price is called a discount on stock. Most states prohibit issuing stock at a discount because the stockholders would be investing less than minimum legal capital. Where stock can be issued at a discount, purchasers of the stock usually become contingently liable to the issuing corporation’s creditors for the amount of the discount. As a result, corporations usually set the par value of their stock at a low amount, so stock discounts cannot occur.

No-Par Stock

At one time, all stocks were required to have a par value. Today, nearly all states permit the issuance of stocks that do not have a par value. The primary advantage of issuing no-par stock is that it may be issued at any price without having a discount. In some states, the entire proceeds from the sale of no-par stock become minimum legal capital. For example, if a corporation issues 1,000 shares of no-par stock at $42 per share, the transaction is recorded as follows:

Sale of Stock through Subscriptions

This is different from selling stock for cash and immediately issue the stock to the buyer. To get the corporation started on a sound footing, the organizers may sell stock to investors who agree to contribute some cash now and also agree to make additional purchases of stock in the future. This is called selling of stock through subscriptions.

The investor signs a subscription list and agrees to buy a certain number of the shares at a specified price. The agreement also states when payments are to be made. When the subscription is accepted by the corporation, it becomes a contract and the corporation acquires an asset.

For example, on May 6, Northgate Corporation accepted subscriptions to 5,000 shares of its $10 par value common stock at $12 per share. The subscription contracts called for a 10% down payment to accompany the subscriptions and the balance in two equal installments due in three months and six months. You record the subscriptions as follows:

Later, the subscriptions receivable will be converted into cash when the subscribers pay for their stock. When payment is completed, the subscribed stock will be issued and will become outstanding stock. For example, let the people pay for their subscribed stock:

The stock usually is not issued until the subscriptions are paid in full. If dividends are declared before subscribed stock has been issued, the dividends go only to outstanding shares, and not to the subscribed shares. For example, the journal entry that shows how the stock is issued, when the subscriptions are paid is:

Sometimes a subscriber fails to pay. If this happens, the subscription contract must be canceled. Also any payment by the subscriber must be returned to him. Remember that subscribed stock is an asset. Subscriptions receivable is reported on the balance sheet as a current asset or as a long-term asset, depending when collection is expected.

Rights of Common Stockholders

When a stockholder purchases common stock, he usually has the following rights.

• The right to note at the stockholders’ meetings.
• The right to sell or otherwise dispose of their stock.
• The right of first opportunity to purchase any additional shares of common stock issued by the corporation. For example, a stockholder who owns one fourth of a corporation’s common stock has the first opportunity to buy one fourth of any new common stock issued. This enables the stockholder to maintain a one-fourth interest.
• The right to share with other common stockholders in any dividends distributed to common stockholders, so that each common share receives the same amount.
• The right to share in any assets that remain after creditors are paid if the corporation is liquidated.

Preferred Stock

A corporation may issue more than one kind or class of stock. It two classes are issued, one is usually called preferred stock and the other is common stock. Preferred stock generally has a par value like common stock, and could be sold at a price that is greater than par. For example, if 1,000 shares of $100 par, preferred stock are issued for $120,000 cash, the entry to record the issue is:

The name preferred comes from the fact that preferred shares have a higher priority than common stock. The preferred shareholders receive their dividends before common stock shareholders. If the corporation is liquidated, then the creditors get their assets first to satisfy debts. Then the preferred stockholders get their share of the corporation’s assets that remain. Then finally, the remaining assets go to the common stock shareholders; Usually the preferred stock shareholder does not have the right to vote at stockholders’ meetings.

1. Preferred Dividends.

The amount of dividends that the preferred stockholders must receive usually is expressed as a percentage that is applied to the par value. For example, a 9%, $100 par value, preferred stock must be paid $9 per share. The preferred stockholders must receive their dividends before the common stockholders. A preference to dividends does not grant an absolute right to dividends. If the board of directors does not declare a dividend, then neither the preferred nor the common stockholders receive a dividend.

2. Cumulative and Noncumulative Preferred Stock.

• Cumulative Preferred Stock - Any undeclared dividends accumulate each year until paid. This does not guarantee payment. For example, for two years, the board of directors did not declare dividends for any type of stock. The third year, the board declares dividends. The cumulative preferred stockholders must receive three years of dividends before the common stockholders can receive a dividend.
• Noncumulative Preferred Stock - The right to receive dividends is forfeited in any year that dividends are not declared. Using the previous example, the noncumulative preferred stockholders will only receive dividends for the third year. They have no right to the dividends of the two years, when no dividends were declared.

3. Disclosure of Dividends in Arrears in the Financial Statements.

A liability for a dividend does not come into existence until the dividend is declared by the board of directors. If a preferred dividend date passes and the corporation’s board fails to declare the dividend on its cumulative preferred stock, the dividend in arrears is not a liability. However, when you prepare the financial statements, the full-disclosure principle requires that you report the amount that preferred dividends are in arrears on the balance sheet as a footnote. Investors have the right to this knowledge.

Why Preferred Stock is Issued

1. Suppose that the organizers of a business have $100,000 to invest, but wish to organize a corporation that requires $200,000 capital. If they sell and issue $200,000 of common stock, they will have to share control with other stockholders. If they issue $100,000 of common stock to themselves and can sell to outsiders $100,000 of 8% cumulative preferred stock that has no voting rights, they will retain control of the corporation.

2. Also suppose the organizers expect their new corporation to earn an annual after-tax return of $24,000. If they sell and issue $200,000 of common stock, this will mean a 12% return. However if they sell and issue $100,000 of each kind of stock, retaining the common for themselves, they can increase their own return to 16% as follows:

An Example of Stockholders’ Equity

Note - Nonparticipating: It is when a preferred stockholder can receive a dividend that is higher than 7%