Chapter 6: Shareholder’s Equity: Paid-in Capital

Characteristics of a Corporation and Other Types of Entities

Entities can be organized in different forms. Hence it is important to understand the major characteristics of different types of entities to organize their accounting information systems successfully. Different forms of entities can be classified as sole proprietorships, partnerships, and corporations. In this chapter, you will firstly get general information about different forms of entities. Among these, the corporation which has special characteristics is examined in detail and the advantages and disadvantages of corporations will be discussed. After that, the components of shareholders’ equity are explained. Subsequently, the meaning of common shares, preferred shares, and treasury shares will be explained. You will also learn how to account different types of shares.

An entity can be organized in different forms in accordance with several aims. Thus, entities may be classified in different ways because of the different types of entities. In compliance with accounting perspective, types of entities are based on their ownership, taxation, life, the personal liability of the owners particularly. In accordance with this perspective the followings are examples of the most common types of entities:

• Sole proprietorship
• Partnership
• Corporation

While starting a new entity, the question about the type of the entity should be considered carefully. Hence, the decision about the type of the entity will affect almost all of the processes in an entity. As it is explained above, there are three common types of entities. In the following parts of this chapter, you will find general information about these common types.

The first one is proprietorship which is owned by a single owner. This type of entity is the smallest and simplest one among the different types of entities. The owner of proprietorship is called as proprietor and his or her equity can be seen as only one item in owner’s equity section of the balance sheet.

The expiration of a proprietorship is caused either by the proprietor’s death or his/her choice of ending it. Also, the proprietor is personally liable for the proprietorship’s liabilities. However, the accounting process of the proprietorship is separate from the personal records of the proprietor. Another important characteristic is about taxation. A proprietorship is not a separate taxable entity. The proprietor pays tax on the income of proprietorship.

The second type of entity is a partnership which has at least two or more owners. In a partnership, the owners are called as partners. Partnerships are organized as small or medium size entities.

Similar to proprietorship, the cancellation of the partnership may be caused either by one of the partners’ death or choice of cancelling it and the partners are personally liable for the partnership’s liabilities. Surely, based on the entity concept the accounting process of a partnership is separate from the personal records of the partners. Partnerships are not separate taxable entities.

Being responsible for the partnership’s liability is an important disadvantage for the partners. Especially if the number of the partners are high, it may be riskier. If a partner commits fraud or if there is a black hole because of a failure of one partner in the partnership, the result of these all negative possibilities may affect all of the partners. To eliminate this disadvantage Limited Liability Partnership (LLP) occurs. The owner/owners of the limited liability partnership are called member/ members.4 In a Limited Liability Partnerships, all of the members have limited liability. Thus, a Limited Liability Partnership can protect other members from negative possibilities like unethical behaviors that result from some members.

A corporation is a legal entity which is organized under state law and owned by shareholders. Thus, the owners in a corporation are called shareholders. A person or an organization may own some certificate that represents the ownership in a corporation named shares of a corporation and called shareholders. Generally, corporations are organized as very large entities and sometimes their shares can be purchased on an organized stock exchange market. These are called publicly held corporations. In this case, a corporation may have many shareholders.

As an important characteristic, shareholders are not personally responsible for the corporation’s liabilities. This means that shareholders’ possible loss is limited with their capital investment. Hence, the creditors cannot make any claim on shareholders’ personal assets. This characteristic of corporation is essential for the shareholders because their personal assets are protected and the corporation may raise may raise more capital from shareholders. Also, the government and related regulators design more regulations and try to monitor corporations to protect shareholders’ and creditors’ claims. Another characteristic is the transferability of the shares. This characteristic is essential for shareholders since it is flexible. They can transfer corporation’s shares to another one.

The cancellation of the corporation does not depend on the death of any shareholder or their choices to cancel it. In other words, the corporation is a permanent organization. The transfer of the shares, anyone’s death or withdrawal do not put an end to the corporation. Another distinguishing difference of a corporation is about taxation. Corporations are taxable entities.6 All of the corporations have to pay tax. Besides, when corporations make cash payments to the shareholders, double taxation may occur. The imposed taxation is paid by the corporation and the cash received by the shareholders is reported on the income tax return of the shareholder. This subject is called cash dividend. This term “Cash dividend” is an individual share of the income distributed to the shareholders.

The shareholders have a crucial role in the decisionmaking process of a corporation. Therefore, it is important to understand the requisitions of the shareholders and maintain a healthy relationship with them to achieve the common goal of the corporation. With this perspective, technological issues may become more of an issue in some cases. The box below shows the news about technological issues of the shareholders.

Based on the different characteristics of corporations, the advantages and disadvantages may be summarized as follows:

Advantages

• Corporations are separate legal entities. They are organized independently of their shareholders.
• Shareholders have limited liability in corporations.
• Corporations have continuous lives.
• Transferability of ownership is easy in corporations in comparison to other types of entities.
• Raising more capital can be easy in corporations in comparison to other types of entities.

Disadvantages

• There are greater regulations for corporations in comparison to other types of entities.
• Corporations may be subject to double taxation.

Because of some legal procedures, the start-up costs may be higher in the corporations comparing to the other types of entities.

Shareholders’ equity of corporations is defined with some special terms. In this part of the chapter, special terms for corporations will be introduced. A corporation starts with some legal procedures. Then, the state authorizes the corporation and grants a charter or articles of incorporation. Afterwards, the corporation should prepare some special rules and procedure to operate.

As it is known, owners’ equity means shareholders’ equity in a corporation. The structure of the shareholders’ equity is very important for a corporation. There may be two different sources for a shareholders’ equity: First one is “Paid-in Capital (or contributed capital)” which represents the total amount of contribution to the corporation by shareholders. In other words, it represents the total amount of assets received from shareholders. Thus, it is generated from external parties.

The second source of shareholders’ equity is “Retained Earnings (or earned capital)”. Retained earnings are the amount earned through profitable operations of a corporation that is kept in the corporation. In other words, it is the earned amount which is not distributed to the shareholders as dividends. Thus it is generated internally from the corporation’s operation. It is based on the decision of retaining some amount of net income in a corporation.

Issuance of Shares

Corporations are operating on a large scale, therefore; they almost always have financing requirements. Hence, corporations prefer to raise more capital by issuing their shares. The first time of offering shares to the public is called as initial public offering (IPO).

There are two ways for corporations to offer and sell their shares to the investors. They may sell their shares directly to the shareholders or they may prefer to use the service of underwriter such as investment banking firm that specializes in bringing securities to the attention of an investor.

After selling their issues to the shareholders, corporations receive an amount for shares. The amount that is received from issuing shares is called issue price. Usually, the issue price will be higher than the par value.

As a legal procedure, a corporation should authorize some amount of common share at the charter. But authorized share is presenting just the total amount of shares which is allowed by charter as explained before. There is no effect on any of the financial statement item. Therefore, determining authorized share will not require any journal entry in the accounting process. After determining the number of authorized shares, a corporation will issue some of the shares and record this amount.

In some cases, it may be possible to receive some other type of assets –such as a building, some furniture etc.- and also some service -such as some advisory services- instead of cash while issuing common shares. In this case, to record this transaction, related accounts should be used instead of cash. But at that time, the value should be considered carefully. If a corporation issues shares for any asset other than cash or for some type of services, this transaction should be recognized at market value. This means there may be a possibility to face with an ethical challenge.

Corporations usually set par value low (usually 1 TL) to avoid issuing their stock below par. For this reason, usually, most of the corporations issue common shares above par value. A “premium” is the total amount above par value at which a share is issued (sold). A premium on the issue of stock is not a gain, income, or profit for the corporation because the company is dealing with its own stock.

No-par value share is the capital share that has no par value assigned to it. If there is no par or stated value while issuing common share, total selling price should be debited to the cash or any other asset account and common share should be credited. While issuing no-par common share, there is no premium or discount because there is no par or stated value for shares to compare. It means if a corporation issues no-par common shares, “Paid-in Capital in Excess of Par” and “Discount on Capital Share” accounts are not used.

Stated value share is a share that is assigned to an amount similar to par value as it is explained. There is no par value at first, but the corporation assigns a stated value to the shares issued. After determination of the stated value of the common shares, the recording process of issuance will be similar with common share at par value. In other words, a premium and in some rare cases a discount may occur.

To issue stated value common share at a premium in the same way with issuance par value common share at a premium, the name of the equity account should be changed. In this situation, “Paid-in Capital in Excess of Stated” account should be used to record the transaction.

Differances and Issuance of Preferred Shares

A preferred share is already defined as a type of capital share that provides some advantages to its owner over a common share. Actually, the way of the accounting process in issuing for preferred shares is similar with common share’s accounting process. But different accounts should be used and common share and preferred share part should be presented separately on the balance sheet. Beyond these differences related to recording and reporting procedures, the most important differences between a common and a preferred share are about their reasons. In other words, priorities and privileges which are provided by a preferred share are the most important differences between them. According to the agreements, a preferred share may provide some other priorities and privileges such as convertibility. But the most important priorities of a preferred share are “dividends” and “assets in the event of liquidation”.

The first important advantage of a preferred share is dividend preference. As it is mentioned before, preferred shareholders have the right to share in the distribution of corporation’s income before common shareholders. Declaring and distributing dividends depend on many factors, such as adequate retained earnings and the availability of cash. Therefore, having a dividend preference is an important advantage. Besides a preferred share may sometimes provide a cumulative dividend according to the regulations. This advantage means that preferred shareholders must be paid both current-year dividends and any unpaid prior-year dividends before common shareholders receive dividends.

The second important advantage of a preferred share is liquidation preference. Most preferred shares have a preference on corporations’ assets if the corporation fails. This advantage provides effective security for the shareholders who have preferred shares. 24 Thus, liquidation preference is another important advantage of preferred shares for shareholders.

Accounting processes for issuing of common and preferred shares are similar. The possible situations in issuance are that some preferred share would be the same with common share issuance. But, as it is emphasized above, different accounts should be used and common share and preferred share part should be presented separately on the balance sheet. The reason for these different applications is the different characteristics of preferred and common share that have already been discussed.

With this perspective, for the transactions about the issuance, instead of Common Share account, “Preferred Share” account should be used while recording preferred shares. Besides, if a corporation issues both common and preferred share, the type of the share should be indicated in the recording of premium. Therefore, “Paid-in capital in excess of par- Preferred” account should be used.

Treasury Shares

A corporation may repurchase its own shares in some cases abide by the legal boundaries. These shares are named as Treasury Shares. Treasury share is a corporation’s own share that has been repurchased and is being held for future use.25 In other words, treasury shares are previously issued shares which have been reacquired by the corporation later. The corporation repurchases its own shares from the shareholders. In the future, treasury shares may be resold or held for an indefinite time by the corporation.

There may be several reasons for a corporation to repurchase its own shares, but the main possible reasons may be summarized as follows:

The management of the corporation may want;

• to avoid a takeover and be cautious about outsiders.
• o reissue the shares to employees and reward them.
• to promote the price of the shares by increasing the trading of the shares.
• to resell its own shares with a higher price.
• to reduce the number of outstanding shares for some ratio analysis.

As it is explained, for these possible reasons above, a corporation may reacquire its own shares. Hence, these treasury shares should be recorded separately.

While a corporation has some treasury share transaction, a new account will be required entitled “Treasury Share”. When the treasury shares are resold they may be sold at cost, above or below cost, which may require another new account. You will find some illustrations for these transactions. Treasury Share account is a contra shareholders’ equity account. Hence, it is a debit-balance account. Treasury shares should be reported after retained earnings section of the corporation’s balance sheet to show a decrease in shareholders’ equity because the number of the issued share that could be seen on the paidin the capital section does not change.

After reacquiring the treasury shares, the corporation may resell these shares. If treasury share is resold with the same amount of cost, there won’t be any differences to record. As a second possibility in a sale, treasury share may be resold above cost. In this case, there will be a difference between the cost and the sale price of the treasury share. If the sale price is higher than the cost of treasury share, this positive difference should be recorded in a new shareholders’ equity account named “Paid-in Capital from Treasury Share”. Paid-in Capital from Treasury Share is reported in the Paid-in Capital section of a corporation’s balance sheet.

As another possibility in a sale, treasury share may be resold below cost. In this case, again there will be a difference between the cost and the sale price of treasury share. When the sale price is lower than the cost of treasury share, this negative difference should be recorded “Paid-in Capital from Treasury Share” if Paid-in Capital from Treasury Share account has enough credit balance. But, if Paid-in Capital from Treasury Share account has no or less credit balance than the amount that should be recorded on its debit side -because of the difference about sale-, in this case, the total or remaining amount should be recorded on the debit side of the retained earnings account. Because, as it is emphasized, Paid-in Capital from Treasury Share account is a shareholders’ equity account, in other words, a credit balance account and it is impossible to see a debit balance.