Question

Because Natalie has been so successful with Cookie Creations and Curtis has been just as successful with his coffee shop, they both conclude that they could benefit from each other’s business expertise. Curtis and Natalie next evaluate the different types of business organization, and because of the advantage of limited personal liability, decide to form a new corporation.

Curtis has operated his coffee shop for 2 years. He buys coffee, muffins, and cookies from a local supplier. Natalie’s business consists of giving cookie-making classes and selling fine European mixers. The plan is for Natalie to use the premises Curtis currently rents as a location for her cookie-making classes and demonstrations of the mixers that she sells. Natalie will also hire, train, and supervise staff hired to bake cookies and muffins sold in the coffee shop. By offering her classes on the premises, Natalie will save on travel, and the coffee shop will provide one central location for selling the mixers. Combining forces will also allow Natalie and Curtis to pool their resources and buy a few more assets to run their new business venture.

The current market values of the assets of both businesses are as follows.

Description	Curtis’ Coffee	Cookie Creations
Cash	$ 7,500	$12,000
Accounts receivable	100	500
Merchandise inventory	450	1,130
Equipment	2,500	1,000
	$10,550	$14,630

Curtis and Natalie meet with a lawyer and form their corporation, called Cookie & Coffee Creations Inc., on November 1, 2021. The new corporation is authorized to issue 50,000 shares of $1 par common stock and 10,000 shares of no par, $6 cumulative preferred stock.

The assets held by each business will be transferred into the corporation at current market value of $1 per share. Curtis will receive 10,550 common shares, and Natalie will receive 14,630 common shares in the corporation.

Natalie and Curtis are very excited about this new business venture. They come to you with the following questions.

Answer the following:

1.   Curtis’ dad and Natalie’s grandmother are interested in investing $5,000 each in the new business venture. Curtis and Natalie are considering issuing them preferred shares. What would be the advantage of issuing them preferred stock instead of common?

2.   What would be the advantages and disadvantages of issuing cumulative preferred?

3.   “Our lawyer sent us a bill for $750. When we talked the bill over with her, she said she would be willing to receive common stock in our corporation instead of cash. We would be happy to issue her stock, but we’re worried about accounting for this transaction. Can we do this? If so, how do we determine how many shares to give her?”

Answer 1

Solution:

1. The advantage of issuing preference shares instead of common stock from the company's point of view is that there would be no further dilution of ownership. Although preference shares are entitled to a certain amount of dividend, they do not have voting rights or ownership like equity shares do.

The advantage of issuing them preferred stock over common stock are as follows

i)Preferred stock holders always have predence over common stock holders in case of getting dividends.They get a fixed amount of dividend & are considered to be safer investment than common stock

ii)Preferred stock holders also get their money first in the case of liquidation of the company.After the debt holders are paid back their money,preferred stock holders get their money & then the common stock holders recieve any money.

2. Advantages of Preference Shares:
Owners of preference shares receive fixed dividends, well before common shareholders see any money. In either case, dividends are only paid if the company turns a profit. But there is a wrinkle to this situation because a type of preference shares known as cumulative shares allow for the accumulation of unpaid dividends that must be paid out at a later date. So, once a struggling business finally rebounds and is back in the black, those unpaid dividends are remitted to preferred shareholders before any dividends can be paid to common shareholders.

Higher Claim one Company Assets:
In the event that a company experiences a bankruptcy and subsequent liquidation, preferred shareholders have a higher claim on company assets than common shareholders do. Not surprisingly, preference shares attract conservative investors, who enjoy the comfort of the downside risk protection baked into these investments.

Additional Investor Benefits:
A subcategory of preference shares known as convertible shares lets investors trade in these types of preference shares for a fixed number of common shares, which can be lucrative if the value of common shares begins climbing. Such participating shares let investors reap additional dividends that are above the fixed rate if the company meets certain predetermined profit targets.

Disadvantages of Preference Shares:
The main disadvantage of owning preference shares is that the investors in these vehicles don't enjoy the same voting rights as common shareholders. This means that the company is not beholden to preferred shareholders the way it is to traditional equity shareholders. Although the guaranteed return on investment makes up for this shortcoming, if interest rates rise, the fixed dividend that once seemed so lucrative can dwindle. This could cause buyer's remorse with preference shareholder investors, who may realize that they would have fared better with higher interest fixed-income securities.

Company Benefits
Preference shares benefit issuing companies in several ways. The aforementioned lack of voter rights for preference shareholders places the company in a strength position, by letting it retain more control. Furthermore, companies can issue callable preference shares, which affords them the right to repurchase shares at their discretion. This means that if callable shares are issued with a 6% dividend but interest rates fall to 4%, then a company can purchase any outstanding shares at the market price, then reissue those shares with a lower dividend rate. This ultimately reduces the cost of capital. Of course, this same flexibility is a disadvantage to shareholders.

3. Shares can be issued instead of settling the bill by cash. The accounting entry would be debiting the Lawyer's personal account and crediting the common stock account. Since the fair value per share is $1 and the amount to be paid is 750$, the number of shares to be issued would be 750.

Date	General Journal		Debit	Credit
	Legal fees A/c..Dr		$750
	To Common stock			$750
	(Being common stock given in the settlement of legal fees )