Stockholders' Equity: Classes of Capital Stock

The corporation

Advantages of the corporate form of business

Corporations have many advantages over single proprietorships and partnerships. The major advantages a corporation has over a single proprietorship are the same advantages a partnership has over a single proprietorship. Although corporations have more owners than partnerships, both have a broader base for investment, risk, responsibilities, and talent than do single proprietorships. Since corporations are more comparable to partnerships than to single proprietorships, the following discussion of advantages contrasts the partnership with the corporation.

  • Easy transfer of ownership. In a partnership, a partner cannot transfer ownership in the business to another person if the other partners do not want the new person involved in the partnership. In a publicly held (owned by many stockholders) corporation, shares of stock are traded on a stock exchange between unknown parties; one owner usually cannot dictate to whom another owner can or cannot sell shares.
  • Limited liability. Each partner in a partnership is personally responsible for all the debts of the business. In a corporation, the stockholders are not personally responsible for its debts; the maximum amount a stockholder can lose is the amount of his or her investment. However, when a small, closely held corporation (owned by only a few stockholders) borrows money, banks and lending institutions often require an officer of the small corporation to sign the loan agreement. Then, the officer has to repay the loan if the corporation does not.
  • Continuous existence of the entity. In a partnership, many circumstances, such as the death of a partner, can terminate the business entity. These same circumstances have no effect on a corporation because it is a legal entity, separate and distinct from its owners.
  • Easy capital generation. The easy transfer of ownership and the limited liability of stockholders are attractive features to potential investors. Thus, it is relatively easy for a corporation to raise capital by issuing shares of stock to many investors. Corporations with thousands of stockholders are not uncommon.
  • Professional management. Generally, the partners in a partnership are also the managers of that business, regardless of whether they have the necessary expertise to manage a business. In a publicly held corporation, most of the owners (stockholders) do not participate in the day-to-day operations and management of the entity. They hire professionals to run the business on a daily basis.
  • Separation of owners and entity. Since the corporation is a separate legal entity, the owners do not have the power to bind the corporation to business contracts. This feature eliminates the potential problem of mutual agency that exists between partners in a partnership. In a corporation, one stockholder cannot jeopardize other stockholders through poor decision making.

The corporate form of business has the following disadvantages:

  • Double taxation. Because a corporation is a separate legal entity, its net income is subject to double taxation. The corporation pays a tax on its income, and stockholders pay a tax on corporate income received as dividends.
  • Government regulation. Because corporations are created by law, they are subject to greater regulation and control than single proprietorships and partnerships.
  • Entrenched, inefficient management. A corporation may be burdened with an inefficient management that remains in control by using corporate funds to solicit the needed stockholder votes to back its positions. Stockholders scattered across the country, who individually own only small portions of a corporation's stock, find it difficult to organize and oppose existing management.
  • Limited ability to raise creditor capital. The limited liability of stockholders makes a corporation an attractive means for accumulating stockholder capital. At the same time, this limited liability feature restrains the amount of creditor capital a corporation can amass because creditors cannot look to stockholders to pay the debts of a corporation. Thus, beyond a certain point, creditors do not lend some corporations money without the personal guarantee of a stockholder or officer of the corporation to repay the loan if the corporation does not.

Corporations are chartered by the state. Each state has a corporation act that permits the formation of corporations by qualified persons. Incorporators are persons seeking to bring a corporation into existence. Most state corporation laws require a minimum of three incorporators, each of whom must be of legal age, and a majority of whom must be citizens of the United States.

The laws of each state view a corporation organized in that state as a domestic corporation and a corporation organized in any other state as a foreign corporation. If a corporation intends to conduct business solely within one state, it normally seeks incorporation in that state because most state laws are not as severe for domestic corporations as for foreign corporations. Corporations conducting interstate business usually incorporate in the state that has laws most advantageous to the corporation being formed. Important considerations in choosing a state are the powers granted to the corporation, the taxes levied, the defenses permitted against hostile takeover attempts by others, and the reports required by the state.

Once incorporators agree on the state in which to incorporate, they apply for a corporate charter. A corporate charter is a contract between the state and the incorporators, and their successors, granting the corporation its legal existence. The application for the corporation's charter is called the articles of incorporation.

After supplying the information requested in the incorporation application form, incorporators file the articles with the proper office in the state of incorporation. Each state requires different information in the articles of incorporation, but most states ask for the following:

  • Name of corporation.
  • Location of principal offices.
  • Purposes of business.
  • Number of shares of stock authorized, class or classes of shares, and voting and dividend rights of each class of shares.
  • Value of assets paid in by the incorporators (the stockholders who organize the corporation).
  • Limitations on authority of the management and owners of the corporation. On approving the articles, the state office (frequently the secretary of state's office) grants the charter and creates the corporation.

As soon as the corporation obtains the charter, it is authorized to operate its business. The incorporators call the first meeting of the stockholders. Two of the purposes of this meeting are to elect a board of directors and to adopt the bylaws of the corporation.

The bylaws are a set of rules or regulations adopted by the board of directors of a corporation to govern the conduct of corporate affairs. The bylaws must be in agreement with the laws of the state and the policies and purposes in the corporate charter. The bylaws contain, along with other information, provisions for: (1) the place, date, and manner of calling the annual stockholders' meeting; (2) the number of directors and the method for electing them; (3) the duties and powers of the directors; and (4) the method for selecting officers of the corporation.

Organization costs are the costs of organizing a corporation, such as state incorporation fees and legal fees applicable to incorporation. The firm debits these costs to an account called Organization Costs. The Organization Costs account is an asset because the costs yield benefits over the life of the corporation; if the fees had not been paid, no corporate entity would exist. Since the account is classified on the balance sheet as an intangible asset, it is amortized over its finite useful life. Most organizations write off these costs fairly rapidly because they are small in amount.

As an illustration, assume that De-Leed Corporation pays state incorporation fees of USD 10,000 and attorney's fees of USD 5,000 for services rendered related to the acquisition of a charter with the state. The entry to record these costs is:

Organization Costs (+A) 15,000
Cash (-A) 15,000
To record costs incurred in organizing corporation.

Assuming the corporation amortizes the organization costs over a 10-year period, this entry records amortization at the end of the year:

Amortization Expense – Organization Costs (- SE) 1,500
Organization Costs (-A) 1,500
To record organization costs amortization expense.
(15,000/10 years = $1,500).

Management of the corporation is through the delegation of authority from the stockholders to the directors to the officers, as shown in the organization chart in Exhibit 19. The stockholders elect the board of directors. The board of directors formulates the broad policies of the company and selects the principal officers, who execute the policies.

Stockholders Stockholders do not have the right to participate actively in the management of the business unless they serve as directors and/or officers. However, stockholders do have certain basic rights, including the right to (1) dispose of their shares, (2) buy additional newly issued shares in a proportion equal to the percentage of shares they already own (called the preemptive right), (3) share in dividends when declared, (4) share in assets in case of liquidation, and (5) participate in management indirectly by voting at the stockholders' meeting.

The preemptive right allows stockholders to maintain their percentage of ownership in a corporation when additional shares are issued. For example, assume Joe Thornton owns 10 percent of the outstanding shares of Corporation X. When Corporation X decides to issue 1,000 additional shares of stock, Joe Thornton has the right to buy 100 (10 percent) of the new shares. Should he decide to do so, he maintains his 10 percent interest in the corporation. If he does not wish to exercise his preemptive right, the corporation may sell the shares to others.

Normally, companies hold stockholders' meetings annually. At the annual stockholders' meeting, stockholders indirectly share in management by voting on such issues as changing the charter, increasing the number of authorized shares of stock to be issued, approving pension plans, selecting the independent auditor, and other related matters.

At stockholders' meetings, each stockholder is entitled to one vote for each share of voting stock held. Stockholders who do not personally attend the stockholders' meeting may vote by proxy. A proxy is a legal document signed by a stockholder, giving a designated person the authority to vote the stockholder's shares at a stockholders' meeting.

Board of directors Elected by the stockholders, the board of directors is primarily responsible for formulating policies for the corporation. The board appoints administrative officers and delegates to them the execution of the policies established by the board. The board's more specific duties include: (1) authorizing contracts, (2) declaring dividends, (3) establishing executive salaries, and (4) granting authorization to borrow money. The decisions of the board are recorded in the minutes of its meetings. The minutes are an important source of information to an independent auditor, since they may serve as notice to record transactions (such as a dividend declaration) or to identify certain future transactions (such as a large loan).

Corporate officers A corporation's bylaws usually specify the titles and duties of the officers of a corporation. The number of officers and their exact titles vary from corporation to corporation, but most have a president, several vice presidents, a secretary, a treasurer, and a controller.

The president is the chief executive officer (CEO) of the corporation. He or she is empowered by the bylaws to hire all necessary employees except those appointed by the board of directors.

Most corporations have more than one vice president. Each vice president is responsible for one particular corporate operation, such as sales, engineering, or production. The corporate secretary maintains the official records of the company and records the proceedings of meetings of stockholders and directors. The treasurer is accountable for corporate funds and may supervise the accounting function within the company. A controller carries out the accounting function. The controller usually reports to the treasurer of the corporation.