Dr. M. D. Chase Long Beach State University Intermediate Accountng-44A Corporations: Stockholder's Equity/Dividends Page 1 CORPORATIONS: STOCKHOLDERS' EQUITY and DIVIDENDS I. Types of Business Organizations: Proprietorship: A proprietorship is a business operated one owner, the proprietor. The proprietor may have any number of employees, but is the only individual responsible for the operation of the business. A proprietorship is an accounting entity but it is not an entity for legal or tax purposes. 1. Principal advantages: a. ease of formation b. flexibility due to freedom from outside constraints 2. Principal disadvantages: a. unlimited liability of the proprietor because the proprietorship is not a legal entity; Partnerships: Same as proprietorship except two or more owners Corporation: Corporations differ from proprietorships and partnerships in that they are legal and taxable entities in addition to being an accounting entity. They are characterized by stock, which represents ownership shares. Individuals purchase stock to own part of the corporation. 1. Principle advantages: a. separation of ownership (stockholders) from management usually insures a more professional management team; b. ability to raise capital through the sale of common stock c. owners (stockholders) liability is limited to the amount of their investment (purchase price of their stock) 2. Principle disadvantages: a. Strict regulations must be adhered to on formation to protect creditors, owners and other outsiders result in high initial costs; b. Because the corporation is a legal and taxable entity in addition to being an accounting entity, income is taxed at the corporate level and taxed again at the ownership level when dividends are declared. II. Corporations: A. Public Corporations: Government owned corporations to meet a social need. Examples include the FDIC (Federal Deposit Insurance Corporation), FSLIC (Federal Savings and Loan Insurance Corporation) among others. B. Mutual Corporations: Cooperatives formed to benefit specific consumer groups. There are many insurance companies and savings and loans operated as mutual corporations. C. Private Corporations: 1. Publicly held corporations: This is the type of "corporation" most commonly thought of when we think of the corporate form of business. The stock is actively traded on organized stock exchanges and changes hands on a regular basis. There is a ready "market" for such stock as a result of being traded on the stock market. The discussion about corporations above and to follow refers to publicly held corporations. 2. Closely held corporations: a. Professional Corporations: Limited stock ownership to members of legally recognized professions and shares are not actively traded on organized exchanges. b. Subchapter S Corporations: Small business corporations allowed under Subchapter S of the Internal Revenue Code to prevent double taxation of owners while still allowing other benefits that accrue to legal entities (corporations) such as certain types of health plans, retirement benefits, ownership of assets etc. Ownership is limited to 35 individuals (70 if spouses are owners) and shares are not traded on organized exchanges. III. The Nature of Stockholders' Equity A. "Equity" means ownership interest. Therefore stockholders' equity represents that part of the corporation "owned" by the stockholders (in concept). This ownership is "in concept" because stockholder equity represents the book value of the stockholders ownership interest, which usually bears little if any relationship to the fair market value of the corporation. This concept will be illustrated in the following discussion and examples. Dr. M. D. Chase Long Beach State University Intermediate Accountng-44A Corporations: Stockholder's Equity/Dividends Page 2 B. The terminology of Stockholders Equity. 1. Par Value: An arbitrary value assigned to each share of stock issued by a corporation. This value is determined by the issuing corporation and is imprinted on each stock certificate issued. The number of shares issued multiplied by the par value per share becomes the legal capital of the corporation. The par value of the stock has absolutely no effect on the market value of the stock. Note: The value of capital stock on the balance sheet is always equal to the number of shares issued and outstanding multiplied by the par or stated value of the common stock. 2. No Par Stock: If allowed by the State in which the corporation is chartered stock may be issued without a par value. In this case no value is imprinted on the stock certificates issued. All no par stock must have a "stated value" in lieu of par value. In the case of no par stock, the legal capital is the number of shares issued multiplied by the stated value of the stock. If no stated value exists, legal capital is the total amount received. 3. Legal Capital: Legal capital is the number of shares issued and outstanding multiplied by the par or stated value of the stock. Because assets must equal labilities plus owners equity, Legal capital provides protection for the creditors by guaranteeing that the corporation maintain a certain amount of assets on the books. Further, legal capital may have the effect of restricting the amount of cash dividends that can be distributed to stockholders because cash is an asset and the payment of dividends would reduce the asset side of the equation. Dividends can generally only be distributed to the extent that a company has retained earnings. Legal Capital The concept of Legal Capital is illustrated below: Assume that 100,000 shares of $10 par value stock is issued at par and that the corporation has $50,000 in liabilities: Assets = Labilities + Stockholders Equity $ 1,050,000* $ 50,000 $ 1,000,000 (100,000 x $10) * We can compute the value of assets by definition Note that because the equation must by definition be "in balance", the asset side of the equation must always be maintained at a certain minimum. By definition, this provides protection to creditors. If not for the concept of legal capital (a result of the stock market crash of 1929) the stock holders equity portion of the equation could be reduced an thereby put creditors at much greater risk. To illustrate, assume that the par value of the stock is $1. Note the effect on assets. Assets = Labilities + Stockholders Equity $ 150,000* $ 50,000 $ 100,000 (100,000 x $1) Obviously, the lower the par or stated value, the less protection is provided to creditors in the form of mandatory assets that must be maintained. It should be noted that the value of assets is historical cost, and may bear little or no relationship to the actual fair market value of the assets. 4. Classes of Stock: a. Common Stock: CS has the following rights: 1. Voting rights: The right to vote for the Board of Directors and on other important issues. A stockholder has one vote for each share of common stock owned. 2. Dividend rights: The right to receive dividends (distribution of earnings from retained earnings) WHEN DECLARED by the Board of Directors. Dr. M. D. Chase Long Beach State University Intermediate Accountng-44A Corporations: Stockholder's Equity/Dividends Page 3 3. Liquidation Rights: A right to share in the distribution of assets upon liquidation of the corporation. Liquidation rights are residual. This means that when the corporation is liquidated, the common stockholders receive their share of the liquidating proceeds only after the preferred stockholders liquidation rights are satisfied (preferred stockholder receive par value of the preferred stock). 4. Preemptive Right: The right to maintain a proportionate share of ownership in the corporation. b. Preferred Stock: PS has the following rights: 1. No voting rights. 2. Preference rights to dividends. Preferred stockholders' dividends must be paid before common stock dividends are paid. Dividends are fixed but are still only paid if declared by the Board of Directors. 3. Preference of liquidation distribution. Preferred stockholders get residual distribution before common stockholders. 4. No preemptive rights. 5. Preferred Stock "Sweeteners": In order to make preferred stock more attractive and thereby reduce the stated interest rate that will be paid to preferred stockholders, some corporations add characteristics to the preferred stock to make it more attractive. These enticing characteristics are commonly referred to as "sweeteners". a. Cumulative Preferred: Dividends not paid in one year accumulate and must be paid in succeeding years. The unpaid dividends are generally referred to as DIVIDENDS IN ARREARS. The total amount of dividends in arrears plus the current year's dividends must be paid to the preferred stockholders before common stockholders have rights to dividend payments declared by the Board of Directors in the current year. Note: Dividends in arrears are not liabilities but they should be disclosed as footnotes to the financial statements. b. Participating Preferred: When the board of directors declares a dividend large enough exceed the amount due to preferred stockholders (par value of the preferred stock multiplied by the stated dividend rate) and the same rate applied to the common stock (par value of the common stock multiplied by the preferred stated dividend rate), the participation feature entitles preferred stockholders to participate in the excess dividends ratably (based on relative par values) with the common stockholders. Participating preferred stock may be either fully or partially participating. Fully participating