Accounting: The Language of Business (Part 75)

Benito Mussolini created the word 'fascism.' He defined it as 'the merging of the state and the corporation.' He also said a more accurate word would be 'corporatism.' This was the definition in Webster's up until 1987 when a corporation bought Webster's and changed it to exclude any mention of corporations.

Adam McKay

Corporations: Organization, Capital Stock Transactions, and Dividends (Part C)

by

Charles Lamson

Sources of Paid-In Capital

As was mentioned in the preceding post, the two main sources of stockholders' equity are paid-in capital---or contributed capital---(capital contributed to the corporation by the stockholders and others) and retained earnings. The main source of paid-in capital is from issuing stock. In the following paragraphs, we discuss the characteristics of the various classes of stock.

Stock

The number of shares of stock that a corporation is authorized to issue is stated in its charter. The term issued refers to the shares issued to the stockholders. A corporation may, under circumstances we discuss in a later post, reacquire some of the stock that it has issued. The stock remaining in the hands of stockholders is then called outstanding stock.

Shares of stock are often assigned a monetary amount, called par. Corporations may issue stock certificates to stockholders to document their ownership. Printed on a stock certificate is the par value of the stock, the name of the stockholder, and the number of shares owned. Stock may also be issued without par, in which case it is called no-par stock. Some states require the board of directors to assign a stated value to no-par stock.

Because corporations have limited liability, creditors have no claim against the personal assets of stockholders. However, some state laws require that corporations maintain a minimum stockholder contribution to protect creditors. This minimum amount is called legal capital. The amount of required legal capital varies among the states, but it usually includes the amount of par or stated value of the shares of stock issued. 

The major rights that accompany ownership of a share of stock are as follows:

1. The right to vote in matters concerning the corporation.

2. The right to share in distributions of earnings.

3. The right to share in assets on liquidation.

When only one class of stock is issued, it is called common stock. In this case, each share of common stock has equal rights. To appeal to a broader investment market, a corporation may issue one or more classes of stock with various preference rights. A common example of such a right is the preference to dividends. Such a stock is generally called a preferred stock. 

The dividend rights of preferred stock are usually stated in monetary terms or as a percent of par. For example, $4 preferred stock has a right to an annual $4 per share dividend. If the par value of the preferred stock were $50, the same right to dividends could be stated as 8% ($4 / $50) preferred stock.

The board of directors of a corporation has the sole authority to distribute dividends to the stockholders. When such action is taken, the directors are said to declare a dividend. Since dividends are normally based on earnings, a corporation cannot guarantee dividends even to preferred stockholders. However, because they have first rights to any dividends, the preferred stockholders have a greater chance of receiving regular dividends than do the common stockholders.

Nonparticipating Preferred Stock

Preferred stockholders' dividend rights are usually limited to a certain amount. Such stock is said to be nonparticipating preferred stock. To continue our proceeding example, assume that a corporation has 1,000 shares of $4 nonparticipating preferred stock and 4,000 shares of common stock outstanding. Also assume that the net income, amount of earnings retained, and the amount of earnings distributed by the board of directors for the first three years of operation are as follows:

Exhibit 3 shows the earnings distributed each year to the preferred stock and the common stock. In this example, the preferred stockholders received an annual dividend of $4 per share, compared to the common stockholders' dividends of $1.50, $7.75, and $4.50 per share. You should know that although preferred stockholders have a greater chance of receiving a regular dividend, common stockholders have a greater chance of receiving larger returns than do the preferred stockholders.

EXHIBIT 3 Dividends to Nonparticipating Preferred Stock

Cumulative Preferred Stock

Cumulative preferred stock has a right to receive regular dividends that were not paid (not declared) in prior years before any common stock dividends are paid. Noncumulative preferred stock does not have this right. 

Dividends that have not been declared in prior years are said to be in arrears. Such dividends should be disclosed, normally in a note to the financial statements.

To illustrate how dividends on cumulative preferred stock are calculated, assume that the preferred stock in Exhibit 3 is cumulative, and that no dividends were paid in 2022 and 2023. In 2024, the board of directors declares dividends of $22,000. Exhibit 4 shows how the dividends paid in 2024 are distributed between the preferred and common stockholders.

EXHIBIT 4 Dividends to Cumulative Preferred Stock

Other Preferential Rights

In addition to dividend preference, preferred stock may be given preferences to assets if the corporation goes out of business and is liquidated. However, claims of creditors must be satisfied first. Preferred stockholders are next in line to receive any remaining assets, followed by the common stockholders. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 486-488*

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