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Chapter18: Shareholders’ Equity

The Corporate Organization

p. 1015

A company may be organized in any of three ways: (1) a sole proprietorship, (2) a partnership, or (3) a corporation. In your introductory accounting course, you studied each form. In this course we focus exclusively on the corporate form of organization.

   Most well-known companies, such as Microsoft, IBM, and General Electric, are corporations. Also, many smaller companies—even one-owner businesses—are corporations. Although fewer in number than proprietorships and partnerships, in terms of business volume, corporations are the predominant form of business organization.

   In most respects, transactions are accounted for in the same way regardless of the form of business organization. Assets and liabilities are unaffected by the way a company is organized. The exception is the method of accounting for capital, the ownership interest in the company. Rather than recording all changes in ownership interests in a single capital account for each owner, as we do for sole proprietorships and partnerships, we use the several capital accounts overviewed in the previous section to record those changes for a corporation. Before discussing how we account for specific ownership changes, let's look at the characteristics of a corporation that make this form of organization distinctive and require special accounting treatment.

Limited Liability

 

A statement of shareholders' equity reports the transactions that cause changes in its shareholders' equity account balances.

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Corporations are the dominant form of business organization.

Accounting for most transactions is the same regardless of the form of business organization.

The owners are not personally liable for debts of a corporation. Unlike a proprietorship or a partnership, a corporation is a separate legal entity, responsible for its own debts. Shareholders' liability is limited to the amounts they invest in the company when they purchase shares (unless the shareholder also is an officer of the corporation). The limited liability of shareholders is perhaps the single most important advantage of corporate organization. In other forms of business, creditors may look to the personal assets of owners for satisfaction of business debt.

 

A corporation is a separate legal entity—separate and distinct from its owners.

Ease of Raising Capital

A corporation is better suited to raising capital than is a proprietorship or a partnership. All companies can raise funds by operating at a profit or by borrowing. However, attracting equity capital is easier for a corporation. Because corporations sell ownership interest in the form of shares of stock, ownership rights are easily transferred. An investor can sell his/her ownership interest at any time and without affecting the corporation or its operations.

 

Ownership interest in a corporation is easily transferred.

   From the viewpoint of a potential investor, another favorable aspect of investing in a corporation is the lack of mutual agency. Individual partners in a partnership have the power to bind the business to a contract. Therefore, an investor in a partnership must be careful regarding the character and business savvy of fellow co-owners. On the other hand, shareholders' participation in the affairs of a corporation is limited to voting at shareholders' meetings (unless the shareholder also is a member of management). Consequently, a shareholder needn't exercise the same degree of care that partners must in selecting co-owners.

 

Shareholders do not have a mutual agency relationship.

   Obviously, then, a corporation offers advantages over the other forms of organization, particularly in its ability to raise investment capital. As you might guess, though, these benefits do not come without a price.

Disadvantages

Paperwork! To protect the rights of those who buy a corporation's stock or who loan money to a corporation, the state in which the company is incorporated and the federal government impose expensive reporting requirements. Primarily the required paperwork is intended to ensure adequate disclosure of information needed by investors and creditors.

 

Corporations are subject to expensive government regulation.

   You read earlier that corporations are separate legal entities. As such, they also are separate taxable entities. Often this causes what is referred to as double taxation. Corporations first pay income taxes on their earnings. Then, when those earnings are distributed as cash dividends, shareholders pay personal income taxes on the previously taxed earnings. Proprietorships and partnerships are not taxed at the business level; each owner's share of profits is taxed only as personal income.

 

Corporations create double taxation.

p. 1016

Types of Corporations

When referring to corporations in this text, we are referring to corporations formed by private individuals for the purpose of generating profits. These corporations raise capital by selling stock. There are, however, other types of corporations.

   Some corporations such as churches, hospitals, universities, and charities do not sell stock and are not organized for profit. Also, some not-for-profit corporations are government-owned—the Federal Deposit Insurance Corporation (FDIC), for instance. Accounting for not-for-profit corporations is discussed elsewhere in the accounting curriculum.

 Not-for-profit corporations may be owned:
1. By the public sector.
2. By a governmental unit.

   Corporations organized for profit may be publicly held or privately (or closely) held. The stock of publicly held corporations is available for purchase by the general public. You can buy shares of General Electric, Ford Motor Company, or Walmart Stores through a stockbroker. These shares are traded on the New York Stock Exchange. Other publicly held stock, like Intel and Microsoft, are available through Nasdaq (National Association of Securities Dealers Automated Quotations).

   On the other hand, shares of privately held companies are owned by only a few individuals (perhaps a family) and are not available to the general public. Corporations whose stock is privately held do not need to register those shares with the Securities and Exchange Commission and are spared the voluminous, annual reporting requirements of the SEC. Of course, new sources of equity financing are limited when shares are privately held, as is the market for selling existing shares.

 Corporations organized for profit may be:
1. Publicly held and traded:
a. On an exchange.
b. Over-the-counter.
2. Privately held.

   Frequently, companies begin as smaller, privately held corporations. Then as success broadens opportunities for expansion, the corporation goes public. For example, in 2008 Visa decided to take public the privately held company. The result was the largest technology initial public offering ever.

Hybrid Organizations

 

Privately held companies’ shares are held by only a few individuals and are not available to the general public.

A corporation can elect to comply with a special set of tax rules and be designated an S corporation characteristics of both regular corporations and partnerships.. S corporations have characteristics of both regular corporations and partnerships. Owners have the limited liability protection of a corporation, but income and expenses are passed through to the owners as in a partnership, avoiding double taxation.

   Two particular business structures have evolved in response to liability issues and tax treatment—limited liability companies and limited liability partnerships.

   A limited liability company owners are not liable for the debts of the business, except to the extent of their investment; all members can be involved with managing the business without losing liability protection; no limitations on the number of owners. offers several advantages. Owners are not liable for the debts of the business, except to the extent of their investment. Unlike a limited partnership, all members of a limited liability company can be involved with managing the business without losing liability protection. Like an S corporation, income and expenses are passed through to the owners as in a partnership, avoiding double taxation, but there are no limitations on the number of owners as in an S corporation.

   A limited liability partnership similar to a limited liability company, except it doesn't offer all the liability protection available in the limited liability company structure. is similar to a limited liability company, except it doesn't offer all the liability protection available in the limited liability company structure. Partners are liable for their own actions but not entirely liable for the actions of other partners.

The Model Business Corporation Act

Corporations are formed in accordance with the corporation laws of individual states. State laws are not uniform, but share many similarities, thanks to the widespread adoption of the Model Business Corporation Act designed to serve as a guide to states in the development of their corporation statutes..5 This act is designed to serve as a guide to states in the development of their corporation statutes. It presently serves as the model for the majority of states.

 

The Model Business Corporation Act serves as the model for the corporation statutes of most states.

   State laws regarding the nature of shares that can be authorized, the issuance and repurchase of those shares, and conditions for distributions to shareholders obviously influence actions of corporations. Naturally, differences among state laws affect how we account for many of the shareholders' equity transactions discussed in this chapter. For that reason, we will focus on the normal case, as described by the Model Business Corporation Act, and note situations where variations in state law might require different accounting. Your goal is not to learn diverse procedures caused by peculiarities of state laws, but to understand the broad concepts of accounting for shareholders' equity that can be applied to any specific circumstance.

 

Variations among state laws influence GAAP pertaining to shareholders' equity transactions.

p. 1017

   The process of incorporating a business is similar in all states. The articles of incorporation statement of the nature of the firm's business activities, the shares to be issued, and the composition of the initial board of directors (sometimes called the corporate charter) describe (a) the nature of the firm's business activities, (b) the shares to be issued, and (c) the composition of the initial board of directors establishes corporate policies and appoints officers who manage the corporation.. The board of directors establishes corporate policies and appoints officers who manage the corporation.

   The number of shares authorized is the maximum number of shares that a corporation is legally permitted to issue, as specified in its articles of incorporation. The number of authorized shares is determined at the company's creation and can only be increased by a vote of the shareholders. At least some of the shares authorized by the articles of incorporation are sold (issued) at the inception of the corporation. Frequently, the initial shareholders include members of the board of directors or officers (who may be one and the same). Ultimately, it is the corporation's shareholders that control the company. Shareholders are the owners of the corporation. By voting their shares, it is they who determine the makeup of the board of directors—who in turn appoint officers, who in turn manage the company.

   Shareholders' investment in a corporation ordinarily is referred to as paid-in capital. In the next section, we examine the methods normally used to maintain records of shareholders' investment and to report such paid-in capital in financial statements.




5Model Business Corporation Act, the American Bar Association, 2009.

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