Chapter 12: Contributed Capital

In this chapter you will learn how contributed capital affects businesses, how it is controlled, accounted for, and reported in financial statements.
 

What is contributed capital?

Contributed capital is a source of resources. It is the dollar amount of resources invested in corporations by their owners. Many large merchandising corporations that operated for many years obtained less than 10% of their resources from owners. Such companies obtained approximately two-thirds of their resources through borrowing (liabilities) and approximately one-fourth of their resources through management's efforts (net income).

In terms of the accounting equation, contributed capital is part of stockholders' equity, as shown below. The numbers in parentheses refer to the chapters in which the accounts are discussed.
 

Resources

=

Sources of Resources

Assets

=

Liabilities

+

Stockholders' Equity

Current Assets
  Cash and cash equivalents (6)
  Accounts receivable (7)
  Allowance for uncollectible 
accounts (7)
  Merchandise inventory (8)
Property, plant, & equipment
  Land (9)
  Buildings (9)
  Accumulated depreciation, 
buildings (9)
  Equipment (9)
  Accumulated depreciation, 
equipment (9)
  Autos & trucks (9)
  Accumulated depreciation, 
autos & trucks (9)

 

 Current Liabilities
  Notes payable (10)
  Accounts payable (10)
  Taxes payable (10)
  Current portion of long-term debt (10)
Long-term Liabilities
  Bonds payable (11)
  Deferred taxes payable (11)
  Obligations under capital leases (11)

 

Contributed Capital (12)
Revenues
  Sales (7)
  Sales returns and 
allowances (7)
Cost of goods sold (8)
Operating Expenses
  Bank service expense (6)
  Uncollectible accounts expense (7)
  Depreciation expense (9)
  Salaries & wages 
expense (10)
  Payroll taxes expense (10)
Other Revenues & Expenses
  Interest revenue (6)
  Interest expense (6) & (11)
  Gain or loss on disposal 
of property, plant, and equipment (9)
Extraordinary Items
  Gains or losses on early retirement of debt
Income taxes expense (10)


 

The nature of contributed capital

Contributed capital includes several accounts summarizing the dollar amounts invested by owners of corporations. The contributed capital accounts relate to the specific types of owners who invested resources in the corporations. The three most common contributed capital accounts are preferred stock, common stock, and additional paid-in capital. To aid understanding the information contained in contributed capital accounts, the following sections briefly present the major characteristics of the corporations.
 

Proprietorships, partnerships, and corporations

Most companies discussed in this course are corporations. The advantages of corporate form have made corporations the business form of choice for the largest companies in the world. While most large companies are corporations, many smaller companies are proprietorships or partnerships.

Proprietorships A proprietorship is a business owned by one person, who is usually also the most important worker in the business. Two important advantages of a proprietorship are its ease of formation and control. Since only one person owns the business, as long as that person is satisfied, the company may exist. The most important disadvantage of a proprietorship is the owner's unlimited legal liability. An owner of a proprietorship is legally, personally liable for the debts of the company. If the company cannot pay its debts, the owner becomes responsible for such payments. As a result, the owner of a proprietorship can potentially lose much more than originally invested in the business. From an income tax standpoint, a proprietorship is not taxed but, rather, the owner is taxed on the company's income.

Partnerships A partnership is a business owned by more than one person, some of whom are often important workers in the business. Partnerships are easily formed and enable companies to relatively easily combine the talents of various people. As was the case with proprietorships, the most important disadvantage of partnerships is the unlimited legal liability of owners. Owners of a partnership are legally, personally liable for the debts of the company. Owners of a partnership can potentially lose much more than originally invested in the business. From an income tax standpoint, a partnership is not taxed but, rather, the owners are taxed on their share of the company's income.

Corporations A corporation is a business whose legal existence is separate from its owners. Because it is a separate, legal entity, a corporation can enter into contracts and conduct business under its own responsibility. For example, a corporation can buy and sell merchandise, employ workers, and borrow resources. Unlike proprietorships and partnerships, owners of corporations have limited legal liability. Owners of corporations are legally liable only for the resources they invest. As a result, owners of a corporation can potentially lose only the amount invested in the business. This limited liability of owners has resulted in many people investing in corporations and corporations being able to obtain large dollar amounts of resources from all owners combined. For example, on December 31, 2006, IBM Corporation had over 610,000 owners who, combined, had invested approximately $31 billion in the company. Unlike proprietorships and partnerships, corporations are taxed separately from their owners. Owners are not taxed on corporations' income but are taxed on dividends paid to them by the corporations.
 

Corporate structure

Corporations become legal entities by filing articles of incorporation in a state and receiving state approval. Corporations are not required to conduct all or even the majority of their business in the state in which they are incorporated. Although the incorporation process may vary from state to state, three important groups in all corporations are the owners, board of directors, and management, each of which is briefly discussed below.

Owners The primary owners of corporations are called common stockholders. As evidence of their ownership interests, such owners receive shares of common stock. Each owner's rights in the corporation are a function of the number of shares owned. The specific rights of owners are specified in the corporation's articles of incorporation. The three most important rights are (1) the right to vote for the corporation's board of directors, (2) the right to receive dividends, and (3) the right to receive the corporation's resources (assets) if the company goes out of business.

As discussed in the following section, boards of directors play important roles in corporations. Most often, only common stockholders have rights to vote for members of corporate board of directors. Each common stockholder is allowed one vote for each share of common stock owned. For example, the owner of 500 shares would have 500 votes for the board of directors.

Owners of corporations have rights to the companies' income. Corporate income is distributed to owners through dividends. The amount of dividends a common stockholder receives depends upon the number of common shares owned. For example, the owner of 500 shares would receive dividends of $50 if a corporation distributed a $.10 per share cash dividend ($500 shares x $.10 per share = $50).

If a corporation goes out of business, its owners have rights to any resources (assets) remaining after all liabilities have been paid. The amount of resources an owner receives depends upon the number of common shares owned. For example, the owner of 500 shares would receive $1,000 if a corporation went out of business and distributed resources of $2 per share to owners ($500 shares x $2 per share = $1,000).

For most owners in today's economy, the right to corporate dividends is by far the most important of the three rights discussed above. Most owners do not own enough shares of common stock to significantly affect the election of a board of directors. For example, an owner of 1,000 shares of IBM's common stock on December 31, 2006, would have 1,000 of approximately 1.5 billion votes. Such a small percentage of votes could not realistically affect the board of directors' election. On the other hand, if enough owners banded together it is possible to significantly affect the election process. Similarly, corporate owners do not invest for the purpose of receiving assets when the company goes out of business. Owners want corporations to continue to operate and generate more resources. Remember, owners have rights to resources generated through management activities. Today, an ownership right that is even more important than the right to dividends is the right to sell the shares of stock owned. Corporate owners may sell their shares of stock very easily through the use of the highly organized stock markets in the United States. Most stock owners invest in stock in the hopes the stock price will rise and they can sell the shares at higher prices than they paid for them.
 

Practice Exercise

The Christopher Corporation's articles of incorporation allow the company to issue a total of 10,000,000 shares of $.10 par common stock (authorized shares = 10,000,000).  By December 31, 4,000,000 shares have been issued.

1.  Determine the amount of cash the Christopher Corporation received if it issued the 4,000,000 shares at an average price of $15 per share.

4,000,000 common shares issued x $15 per share = $60,000,000 cash received.

2.  Determine the amount of cash the Christopher Corporation requires in order to pay a $.03 per share cash dividend.

4,000,000 common shares x $.03 cash dividend per share = $120,000 cash required.  Note that cash dividends only go to owners of stock.  Dividends are not paid on the 6,000,000 common shares that were authorized but not issued.

3. Determine the amount of cash dividends you would receive if you owned 800 shares of Christopher Corporation common stock.

800 common shares owned x $.03 cash dividend per share = $24 cash received.

4.  Determine the number of votes for the Christopher Corporation's board of directors you would have if you owned 800 common shares.

800 common shares x 1 vote per share = 800 votes.

5.  Assume the Christopher Corporation went out of business and had $10,000,000 remaining after paying all its debts.  Determine the amount of cash you would receive from the Christopher Corporation's liquidation if you owned 800 common shares.

$10,000,000 cash available / 4,000,000 common shares = $2.50 per share.  Since you own 800 common shares, you would receive $2,000 (800 shares x $2.50 = $2,000).  Note that upon liquidation, resources only go to owners of stock.  Resources are not paid on the 6,000,000 common shares that were authorized but not issued.
 

Board of directors As mentioned above, a corporation's board of directors is elected by owners. Because corporations can have hundreds of thousands of owners, the directors are elected to represent owners and make major decisions regarding the corporation. Some of the more important decisions made by the board of directors concern dividends, long-term borrowings, issuing stock, and hiring major executives.

Managers The day-to-day operations of corporations are the responsibility of managers. Managers make many decisions regarding such things as products to buy and sell, prices to charge customers, assets to buy, and services to use. The actual decisions made by managers depend upon the business elements they are managing. For example, an engineering manager might be concerned about the operation efficiency of equipment used by the company. The most important goal for managers is to generate income and, thus, increase the corporation's resources through operations.

The relationship among owners, boards of directors and managers can be seen below. The major responsibilities of each group are also shown.
 

Owners: Common Stockholders
(Responsible for electing the board of directors)

 

Board of Directors: Represent Owners
(Responsible for dividends and hiring major managers)

 

Managers
(Responsible for day-to-day operations
and generating net income)

 

 

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