Principal Legal Forms of Business

2. Principal Legal Forms of Business • Sole proprietorship. • Partnership. • Corporation. 80% of businesses, but only 10% of total business revenue Only 20% of businesses, but 90% of total business revenue

3. Sole Proprietorship • Simple, inexpensive to setup. • Owned by an individual. • Not legally separate from the owner. • Difficult to raise large amounts of capital. • Owner is personally responsible for entity’s debts.

4. Partnership • Same features as sole proprietorship except owned by two or more partners. • Limited partnerships. • Managed by general partner who has unlimited liability. • Other partners have limited liability.

5. Corporation • Artificial legal entity (therefore, taxed). • Perpetual existence. • Legal liability on corporation, not shareholders. • Empowered by state. • Easiest form to raise capital.

6. Disadvantages of Corporation over Sole Proprietorship or Partnership • Incorporation costs. • Activities limited to those granted in charter. • Additional regulations and requirements. • Must get permission from each state in which it operates. • Double taxation (i.e., corporation is taxed and dividends are taxable income to shareholders).

7. Public vs. Private Corporations • Public corporation: • Shares traded. • Regulated by Securities and Exchange Commission (SEC). • Private corporation: • Not publicly traded. • Usually tightly held (e.g., few individuals, family owned).

8. Proprietorship Equity • Capital account. • Drawing account (optional). • Withdrawals → salary vs. return of profit.

9. Partnership Equity • Separate capital account for each partner. • Partnership agreement defines split of profits among partners. • May indicate salaries, share of residual profits, % of interest on capital, etc. • If not indicated, divided equally.

10. Ownership in a Corporation • Stock certificate. • Evidence of ownership. • Corporate charter. • Filed with state. • Indicates classes of stock and maximum number of shares allowed to issue. • Owners’ equity. • Also called shareholders’ equity or stockholders’ equity.

11. Preferred Stock • Pays stated dividend on face (par) value. • Dividend is not tax deductible (as is interest expense paid to creditors). • In event of liquidation, are after creditors but before common shareholders.

12. Features of Preferred Stock • Cumulative preferred. • Current and past dividends (i.e., in arrears) must be paid before common dividends can be paid. • Convertible preferred. • Convertible into a specified number of common shares. • Redeemable preferred. • May be redeemed by investor on or after a certain date (price usually higher than par value). • Must be shown under liabilities on balance sheet.

13. Common Stock • Residual interest in net assets after creditors and preferred shareholders. • Par or stated value usually a nominal amount (basically meaningless today). • Book value of common stock. • Total common shareholders’ equity. • Paid-in capital. • Retained earnings.

14. Shareholders’ Equity • Paid-in capital. • Common stock (at par or stated value). • Additional paid-in capital (i.e., proceeds above par value). • Retained Earnings. • Cumulative net income earned since inception of company (less cumulative total dividends paid).

15. Issuing Stock • Issuance costs. • E.g., investment banker, legal, auditing, printing. • Reduces Additional paid-in capital amount. • Sales after issuance. • No effect on company accounts. • Corporation notes change of owners.

16. Treasury Stock • Corporation’s own issued stock that has been reacquired. • Reasons to reacquire own stock: • Needed for acquisitions, bonus plans, exercise of warrants, conversion of bonds/preferred stock. • Limited investment opportunities. • Increase earnings per share (which can increase market price of stock). • Prevent hostile takeover.

17. Accounting for Treasury Stock • Cost method (simpler method): • Debit “Treasury Stock” at acquisition. • Not an asset. • No voting, no dividends, no shareholder rights. • Shown as a reduction of shareholders’ equity. • If reissued above cost, increase paid-in capital from treasury stock. • If reissued below cost, decrease paid-in capital from treasury stock (if has balance) or retained earnings.

18. Appropriation of Retained Earnings • Indicates retained earnings restricted for a specific purpose (thus, not available for dividends). • Has no effect on financial position of corporation. • Does not reduce total retained earnings. • Has no affect on cash. • The retained earnings account balance is unrelated to the cash account balance.

19. Cash Dividends • Declaration date. • Declared by board of directors. • Create liability (i.e., Dividends Payable). • Date of record. • No entry. • Determine who is entitled to dividend. • Payment date. • Pay out cash, eliminate liability.

20. Stock Split • Each shareholder receives a multiple of shares previously held (e.g., two-for-one split). • No change in total shareholders’ equity (only proportional adjustment to par value). • No change in a shareholder’s proportional interest in corporation. • Why done? Reduce stock price to make it more appealing to investors.

21. Stock Dividends • Every shareholder receives a percentage of additional shares (e.g., 10% stock dividend). • Increases number of shares outstanding, but not proportional interest in corporation. • Recorded at market value of shares distributed. • If the stock dividend is greater than 20-25%, is basically treated as a stock split.

22. Spin-offs • Company owns shares of another company (usually a subsidiary) that it distributes to shareholders. • Accounting is similar to a cash dividend except reduction is to the Investments asset account (instead of Cash).

23. Warrants • The right to purchase shares of common stock at a stated price within a given time period. • Negotiable (can be bought and sold).

24. Stock Options • Same as a warrant, but not negotiable. • GAAP requires fair value based method. • Expense fair value of options over their vesting period. • Once vested, option can be exercised even if employee leaves the company.

25. Employee Stock Ownership Plan (ESOP) • A program of setting aside stock for benefit of employees as a group. • Contributions to plan are tax deductible to corporation. • Plan is a separate entity (thus, assets do not appear on balance sheet, but are disclosed in notes).

26. Earnings Per Share (EPS) • Shown on income statement. • FASB and IASB requires reporting of: • Basic earnings per share (EPS), and • Diluted earnings per share (EPS).

27. Basic EPS Net income available to common shareholders • Numerator: • Net income – preferred dividends. • Denominator: • Treasury stock is not considered outstanding. Basic EPS = Weighted average number of common shares outstanding

28. Diluted EPS • Basic EPS adjusted for potential dilution. • Effects of convertible securities, stock options, stock warrants. • Convertible securities: if-converted method. • Assume convertible securities were converted to common stock at beginning of year. • Stock options/warrants: treasury stock method. • Assumes options/warrants are exercised and cash received is used to purchase its stock at the average stock price during the period. • Net result with number of shares from exercise of options/warrants.

29. Equity in Nonprofit Organizations • Capital contributions: • Endowment. • Contributions whose principal is to be kept intact. • Earnings on principal are available to finance current operations. • Contributed plant. • Contributed assets (e.g., buildings) or funds to acquire assets. • Operating contributions are revenue, not contributed capital. • Operating equity, rather than retained earnings.