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CA (170,000)
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Chapter 11

Chapter 11 Notes

Financial Accounting
Course Code
Liang Chen

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Chapter 11 Reporting and Analyzing Shareholders’ Equity Notes
The Corporate Form of Organization
x corporation—organized as separate legal entity, with most of rights and privileges of person; shares are evidence of ownership
x may be classified in variety of ways—two common classifications are by purpose and by ownership; corporation may be
organized for purpose of making profit, or it may be not-for-profit
x public corporation may have thousands of shareholders, and its shares are regularly traded on a securities market, such as TSX
x private corporation (closely held corporation) usually has only a few shareholders, does not offer its shares for sale to general
public; generally much smaller than public companies, although there are some big exceptions
x other more specialized forms of corporations in Canada, such as income trust
x income trust is special or limited purpose company that is set up specifically to invest in income-producing assets; its “trust
unitsare traded on organized securities exchanges; trust pays out most of its earnings to investors, called unitholders
x only significant difference in accounting for income trusts compared to other types of corporations involves their distribution of
earnings and equity structure, else they are accounted for in the same way
Characteristics of a Corporation
Separate Legal Existence
x as entity that is separate and distinct from its owners, corporation acts under its own name rather than in name of its shareholders
x acts of corporation’s owners (shareholders) do not bind corporation unless these owners are also agents of corporation
Limited Liability of Shareholders
x liability of shareholders is limited to their investment in corporation, and ownership is represented by number of shares that
individual shareholder owns, meaning that creditors only have access to corporate assets to satisfy their claims
x in other words, shareholders cannot be made to pay for companys liabilities out of their personal assets
x limited liability is a significant advantage for the corporate form of organization, however, in certain situations, creditors may
demand a personal guarantee from a controlling shareholder
x this has the effect of making the controlling shareholder’s personal assets available, if required, to satisfy the creditor’s claim
which, of course, eliminates or reduces the advantage of limited liability
Transferable Ownership Rights
x ownership of corporation is held in shares of capital, which are transferable units
x shareholders can dispose of part or all of their interest in a corporation simply by selling their shares
x transfer of shares is entirely up to shareholder and does not require approval of either corporation or other shareholders
x in addition, the transfer of ownership rights among shareholders has no effect on the operating activities of the corporation nor
does it affect the corporation’s assets, liabilities, or shareholders’ equity
x transfer of ownership rights is a transaction between individual shareholders and the corporation does not participate in the
transfer of these ownership rights; it is only involved in the original sale of the share capital
Ability to Acquire Capital
x it is fairly easy for corporation to obtain capital by issuing shares
x buying shares in a corporation is often attractive to an investor because a shareholder has limited liability and shares are readily
transferable; also, many individuals can become shareholders because only small amounts of money need to be invested
x ability of successful corporation to obtain capital is almost unlimited—only true for large, publicly traded corporations
x small, or closely held, corporations can have as much difficulty in acquiring capital as do proprietorships or partnerships
Continuous Life
x corporations have an unlimited life—since a corporation is a separate legal entity, its continuance as a going concern is not
affected by the withdrawal, death, or incapacity of a shareholder, employee, or officer
x as a result, a successful corporation can have a continuous and indefinite life
Corporation Management
x shareholders can invest in a corporation without having to manage it personally—although shareholders legally own the
corporation, they manage it indirectly through a board of directors they elect
x the board, in turn, sets the broad strategic objectives for the company, and also selects officers, such as a president and one or
more vice-presidents, to execute policy and to perform daily management functions
Government Regulations
x Canadian companies may be incorporated federally, under the terms of the Canada Business Corporations Act, or provincially,
under the terms of a provincial business corporations act
x federal and provincial laws usually state the requirements for issuing and reacquiring shares and distributing earnings
x similarly, the regulations of provincial securities commissions control the sale of share capital to the general public
x when a corporation’s shares are listed and traded on foreign securities markets, the corporation must also respect the reporting
requirements of these exchanges, which implies that complying with federal, provincial, and securities regulations in multiple
jurisdictions increases the cost and complexity of the corporate form of organization
Income Taxes
x corporations must pay income taxes as separate legal entities (with the exception of real estate income trusts and mutual fund
investment trusts), which can be substantial and can amount to as much as 35% of taxable income
x there are, however, income tax rate reductions available to some corporations—with eligible reductions, or other corporate tax
incentives, corporation’s tax rate may be reduced to between 13 and 20% on certain kinds of active small business income

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x this rate is much lower than the tax rate for the same amount of income earned by an individual
x shareholders of corporation do not pay tax on corporate earnings until earnings are distributed to them as dividends
x many people argue that corporate earnings are taxed twice (double taxation), once at corporate level and again at the individual
level, however, this is not exactly true as individuals receive a dividend tax credit to reduce some of this tax burden
Share Issue Considerations
x after incorporation, a corporation sells ownership rights as shares, which are divided into different classes
x rights and privileges for each class of shares are stated in articles of incorporation, which formconstitution of company
x different classes are usually identified by generic terms of common shares and preferred shares
x when corporation has only one class of shares, that class has rights and privileges of common shares
x each common share gives the shareholder the following ownership rights:
o Vote. Shareholders have the right to vote on certain matters, such as the election of the board of directors and appointment
of external auditors. Each shareholder normally has one vote for each common share owned.
o Dividends. Shareholders share in the distribution of the corporate income through dividends, in proportion to the number of
shares owned.
o Liquidation. Shareholders share in any assets that remain after liquidation, in proportion to the number of shares owned.
This is known as a residual claim because shareholders are paid only if any cash remains after all the assets have been sold
and all liabilities paid.
Authorized Share Capital
x authorized shares—amount of share capital that corporation is authorized to sell; amount may be unlimited or specified
x if number is specified, amount of authorized shares normally anticipates a company’s initial and later capital needs
x the authorization of share capital does not result in a formal accounting entry, because the event has no immediate effect on
either corporate assets or shareholders’ equity; however, the number of shares authorized must be disclosed in the shareholders
equity section of the balance sheet
Issue of Shares
x corporation can issue common shares directly to investors or indirectly though investment dealer (brokerage house) that
specializes in bringing securities to attention of potential investors
x direct issue is typical in closely held companies; indirect issue is customary for publicly held corporation
x initial public offering (IPO)—initial offering of corporation’s shares to public
x whether company issues its shares directly or indirectly, it receives cash (less any financing or issue fees) from sale of IPO shares
x companys assets (cash) increases, and its shareholders’ equity (share capital) also increases
x whereas a journal entry is not made for authorized share capital, an entry is made whenever shares are issued by the company
because the companys financial position changes
x issued shares—portion of authorized shares that has been sold
x once shares have been issued and sold, they then trade on secondary market, that is, investors buy and sell shares from each other
rather than from the company, using a stock exchange such as the Toronto Stock Exchange
x when shares are sold among investors, there is no impact on the company’s financial position
x the company receives no additional assets, and it issues no additional shares; only change in company records is the name of the
shareholder, not the number of shares issued
Fair Value of Shares
x after initial issue of new shares, share price changes according to interaction between buyers and sellers
x in general, price follows trends of company’s earnings and dividends, and factors that are beyond company’s control (such as
embargo on oil, economic recession, changes in interest rates, outcome of election, and war) also influence market prices
x for each listed security, the financial press reports the highest and lowest prices that the share sold at for the year, the annual
dividend rate, the high and low prices for the day, and the net change over the previous day
x the total volume of shares traded on a particular day, the dividend yield, and the price-earnings ratio are also reported
x dividend yield reports rate of return investor earned from dividends, calculated by dividing dividend by share price
x dividend yield and price-earnings ratios are often interpreted together to determine how much investors favour a company
x market capitalization—a measure of the value of a company’s equity; it is calculated by multiplying the number of shares by the
share price at any given date
Legal Capital
x when shares are issued, they form share capital of corporation
x retained earnings can be distributed to shareholders as dividends or retained in the company for operating needs
x on the other hand, share capital is legal capital that cannot be distributed to shareholders; it must remain invested in the company
for the protection of corporate creditors
x legal capital—amount per share that must be retained in the business for the protection of corporate creditors
x no par value shares—share capital that has not been pre-assigned a legal capital value; the total proceeds from the sale of no par
value shares becomes the legal capital
Share Capital
x contributed capital—total amount contributed to shareholders, or reacquired from them, in exchange for shares of ownership; its
consists of share capital and additional contributed capital, if any
x share capital—the amount paid, or contributed, to the corporation by shareholders in exchange for shares of ownership; it can
consist of preferred and common shares
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