This lesson is studied in the Classical Liberal Arts Academy’s HUM-431 Economics course.
The Corporation’s Property Account
The corporation is a “legal person” or an “artificial person,” as distinguished from individuals or “natural persons.” Like natural persons, the corporation has assets and liabilities and a property account. The best way to learn about the corporation is to study its property account, which business men call the balance sheet, or statement of assets and liabilities. In Chapter XII is described the organization of a corporation by shareholders taking so many shares at $100 each. The property account of this corporation just after its organization would read like this:
STATEMENT OF EAGLE MERCANTILE CORPORATION,
JANUARY 1, 1922
- Assets
- Cash…………………….. $50,000
- Liabilities
- Capital stock…….. $50,000
Capital Stock
The corporation owns the cash which the organizers paid in; hence, that is the asset of the corporation. The corporation does not have any debts, and if this account were like those studied in Chapter V, “Balance, $50,000,” would be written on the liability side.
In corporation accounts, however, it is necessary to recognize the rights of the shareholders on account of what they have invested in the corporation. They are the real owners of the corporation. But since the corporation is regarded as a person owning the assets, it must put in its statement the rights of the shareholders against it as a liability. This is the meaning of the item, capital stock. Since the capital stock belongs to the shareholders, they are often called stockholders and their shares are called shares of stock or simply stock.
Suppose that the corporation buys land and a store building for $20,000 and spends $25,000 for a stock of goods. Its balance sheet would read:
STATEMENT OF EAGLE MERCANTILE CORPORATION,
JANUARY 1, 1922
- Assets
- Real estate………….. $20,000
- Merchandise………….. 25,000
- Cash………………… 5,000
- Total: $50,000
- Liabilities
- Capital stock…….. $50,000
- Total: $50,000
The term real estate means land and buildings and permanent structures or improvements on the land.
Bonds and Notes
When a corporation borrows money, it issues bonds and notes as the corporation’s promise to pay money. Bonds are generally promises to pay a long time in the future, often as long as twenty or thirty years or even longer. Notes are usually for shorter periods, a few months, or at most four or five years.
Suppose, after January 1, 1922, the Eagle Mercantile Corporation should borrow $20,000 by means of bonds and $5,000 by notes and should spend $15,000 of the borrowed money for additions to its building and keep the remaining $10,000 in cash. Then the statement would read:
STATEMENT OF EAGLE MERCANTILE CORPORATION,
JANUARY 10, 1922
- Assets
- Real estate………….. $35,000
- Merchandise………….. 25,000
- Cash………………… 15,000
- Total: $75,000
- Liabilities
- Bonds…………….. $20,000
- Notes…………….. 5,000
- Capital stock…….. 50,000
Total: $75,000
Now that the corporation has incurred debts to outsiders, it has two kinds of liabilities: (1) the rights of outsiders (bonds and notes), and (2) the rights of the shareholders (capital stock).
Surplus and Undivided Profits
Suppose that the land rises in value so that the real estate is worth $45,000, and that the merchandise sold at a profit so that the corporation has merchandise worth $34,150 and $20,525 in cash. The statement might then read:
STATEMENT OF EAGLE MERCANTILE CORPORATION,
DECEMBER 31, 1922
- Assets
- Real estate………….. $45,000
- Merchandise………….. 34,150
- Cash………………… 20,525
- Total: $99,675
- Liabilities
- Bonds…………….. $20,000
- Notes…………….. 5,000
- Capital stock…….. 50,000
- Surplus…………… 10,000
- Undivided profits….. 4,675
- Total: $99,675
There are here some new terms to be explained. When a corporation prospers and its assets increase in value, the gain belongs, of course, to the shareholders. To find the total rights of the shareholders, therefore, the rights of outsiders are deducted from the total assets. Thus, from the total assets, $99,675, is deducted the sum of bonds and notes, $25,000; this leaves a difference of $74,675, the amount of the shareholders’ property rights in the corporation’s assets. This is more than the original capital stock of $50,000, because of the gain in the value of the assets. This gain is represented by the two terms, surplus and undivided profits. The shareholders’ rights are thus divided into three parts, (1) capital stock, (2) surplus, and (3) undivided profits.
It is not possible to draw exact and invariable lines separating the meanings of these three terms. As a general rule, the capital stock represents the original and permanent investment of the shareholders in the corporation. Surplus and undivided profits signify the growth in the value of the corporation’s assets. Surplus is that portion of the increase which the directors intend to leave more or less permanently in the business, while undivided profits are probably soon to be given as dividends to the shareholders.
Definitions
We have, then, the following definitions which will be used in this book and which are generally followed by business men:
The capital of a corporation represents the property rights of the shareholders in the assets of the corporation.
The capital may be divided into two or three of the following parts:
- The capital stock represents ordinarily the original and permanent investment of the shareholders in the corporation.
- The surplus represents an increase in the capital which it is intended to leave more or less permanently in the business.
- The undivided profits represent an increase in the capital which is intended to distribute to the shareholders.
Other Meanings of the Terms
It will be noted that this idea of capital is different from that used in Chapter XI. We must also be reminded that in ordinary language these terms are not always used exactly as they have been defined. For example, the word “capital” is sometimes used to stand for “capital stock”; when it is so used, people often use the words “capital surplus” and undivided profits. On the other hand, the terms “capital stock” and “stock” are often used to mean “capital”; that is, the total right of the shareholders in the corporation. Again, the word “capital” is sometimes used for the total “assets” of a corporation or business.
Net Worth
The capital (capital stock and surplus and undivided profits), being found by subtracting the corporation’s outside debts from its assets, is the real balancing item, or net worth, of the corporation.
Par Value of Capital
We must now study the meaning of par value and book value of capital. The par value of a share of capital is the value printed on the stock certificate. It represents (generally, though not always) the amount of money that was originally paid in for one share.
Book Value
The book value of a share of capital is the value as shown by the corporation’s statement. It may be the same as the par value, or it may be more or less.
Market Value
But what if the assets are not entered in the statement at their real values? This actually happens more often than one would suppose. Suppose that, after February 1, 1923, the land belonging to the Eagle Mercantile Corporation increases in value and by April becomes worth $35,000, whereas the other items of assets and liabilities have not changed. If the corporation’s statement still lists the land at $25,000, then it will appear that the capital is still worth $35,525 and that each share is still worth $71.05. In reality, they are worth more than the statement indicates. If the statement were a true one, the land would be listed at $35,000, the total assets would be $70,525, and the capital would be $45,525, or $91.05 per share.
The facts would be known, and people would be willing to pay $91.05 for a share of the stock, regardless of what the book value shows. The price at which a share of capital will sell on the market is its market value. This is the actual value of the share, since it is the amount for which it will be exchanged.
Market Value and Book Value
The market value is often different from the book value. In the example just studied it was greater than the book value, for the reason that some of the assets were not correctly entered. This is sometimes the practice of “conservative” business men. They want to be sure that the statement will never show them better off than they really are; they want to be “on the safe side.” They would rather understate their assets than exaggerate them.
Stock Watering
On the other hand the opposite practice is sometimes adopted. Assets are deliberately put down at more than they are worth. Suppose that a group organize a corporation and put in $50,000 of money, and that $40,000 was used to purchase certain land, believed to contain oil. The directors, wishing to make a good showing, immediately decide to list the land in the corporation’s statement at $60,000.
This is not a true statement. The land is really worth only $40,000. The real value of the capital is only $50,000, though the statement shows a book value of $70,000. People who are buying and selling this stock will be likely to know something about the real value of the land, and the market value is likely to be much closer to the real value than to the exaggerated statement. This practice is called “stock watering.”
Insolvency
When a business is unsuccessful and its assets decline in value, the loss falls upon the owners. Debts to outsiders must be paid, as long as there are any assets left in the business. But suppose the assets decline so greatly that they become less than the debts to outsiders. In this case we say that the business is insolvent, meaning that its assets are less than its liabilities to others than the owners.
Liability
When an individual business man “fails” in his business, any property that he owns may be taken to pay his debts. In the same way, when a partnership fails, all the property of each partner may be taken, if necessary, to pay the debts of the partnership. In this case, therefore, individuals and partnerships have unlimited liability.
Corporations, on the other hand, usually have limited liability, meaning that the amount that the shareholders can be required to pay the debts is limited.
Dividends
The profits which the shareholders receive from a corporation are called dividends. They are generally stated as a certain percentage of the capital stock.
Stock Dividends
The stock dividend is a distribution of additional shares instead of cash.
Effect on Corporation Statement
No change has been made in the assets, so that side of the statement remains as it was. On the liability side, capital stock has been increased from $50,000 to $60,000. The surplus is reduced from $20,000 to $10,000. None of the other items is changed.
Advantages of the Corporation
As a form of business organization, the corporation has many advantages:
- Limited liability is one of the most important.
- Another is perpetual life.
- A third advantage is that it can unite the capital of a great many people.
As a result of these advantages, the greater part of modern business is now conducted by corporations.
