Chapter Summary

The primary advantages are no personal liability of stockholders for the debts of the business, the transferability of ownership shares, continuity of existence, ability to hire professional management, and the relative ease of accumulating large amounts of capital. The primary disadvantages are double taxation of earnings and greater governmental regulation.

The stock of publicly owned corporations is available for purchase by the general public, usually on an organized stock exchange. Stock in a closely held corporation, in contrast, is not available to the public.

Publicly owned corporations tend to be so large that individual stockholders seldom control the corporation; in essence, most stockholders in publicly owned companies are investors, rather than owners in the traditional sense. Closely held corporations usually are quite small, and one or two stockholders often do exercise control. Publicly owned corporations are subject to more government regulation than are closely held companies, and they must disclose to the public much information about their business operations.

Stockholders in a corporation normally have the right to elect the board of directors, to share in dividends declared by the directors, and to share in the distribution of assets if the corporation is liquidated.

The directors formulate company policies, review the actions of the corporate officers, and protect the interests of the company's stockholders. Corporate officers are professional managers appointed by the board of directors to manage the business on a daily basis.

When capital stock is issued, appropriate asset accounts are debited for the market value of the goods or services received in exchange for the stock. A capital stock account (which indicates the type of stock issued) is credited for the par value of the issued shares. Any excess of the market value received over the par value of the issued shares is credited to an Additional Paid-in Capital account.

The equity section of a corporate balance sheet shows for each class of capital stock outstanding (1) the total par value (legal capital), and (2) any additional paid-in capital. Together, these amounts represent the corporation's total paid-in capital. In addition, the equity section shows separately any earned capital  - that is, retained earnings.

Common stock represents the residual ownership of a corporation. These shares have voting rights and cannot be called. Also, the common stock dividend is not fixed in dollar amount - thus it may increase or decrease based on the company's performance.

Preferred stock has preference over common stock with respect to dividends and to distributions in the event of liquidation. This preference means that preferred stockholders must be paid in full before any payments are made to holders of common stock. The dividends on preferred stock usually are fixed in amount. In addition, the stock may be callable at the option of the issuing corporation and often has no voting rights. Preferred stocks sometimes have special features, such as being convertible into shares of common stock.

The market price of preferred stock varies inversely with interest rates. As interest rates rise, preferred stock prices decline; as interest rates fall, preferred stock prices rise. If a company's ability to continue the preferred dividend is in doubt, the solvency of the company also affects preferred stock prices.

Interest rates also affect the market price of common stock. However, common stock dividends are not fixed in amount. Both the amount of the dividend and the market value of the stock may fluctuate, based on the prosperity of the company. Therefore, the principal factor in the market price of common stock is investors' expectations as to the future profitability of the company.

Par value has the least significance. It is a legal concept, representing the amount by which stockholders' equity cannot be reduced except by losses. Intended as a buffer for the protection of creditors, it usually is so low as to be of little significance.

Book value per share is the net assets per share of common stock. This value is based on amounts invested by stockholders, plus retained earnings. It often provides insight into the reasonableness of market price.

To investors, market price is by far the most relevant of the three values. This is the price at which they can buy or sell the stock today. Changes in market price directly affect the financial position of the stockholder, but not of the issuing company. Therefore, market values do not appear in the equity section of the issuing company's balance sheet  - but they are readily available in the daily newspaper and on the Internet.

When the market price of a corporation's common stock appreciates in value significantly, it may become too expensive for many investors. When this happens, the corporation may split its stock by increasing the number of its common shares outstanding. The purpose of a stock split is to reduce the market price of the company's common stock, with the intent of making it more affordable to investors. A stock split does not change the balance of any ledger account; consequently, the transaction is recorded merely by a memorandum entry.

Purchases of treasury stock are recorded by debiting a contra-equity account entitled Treasury Stock. No profit or loss is recorded when the treasury shares are reissued at a price above or below cost. Rather, any difference between the reissuance price and the cost of the shares is debited or credited to a paid-in capital account. While treasury stock transactions may affect cash flow, they have no effect on the net income of the corporation.

We will continue our discussion of stockholders' equity issues in Chapter 12. Specifically, we will address those events that affect retained earnings, including stock dividends and special income-related issues.