LESSON 5

COMPANY ACCOUNTS-FORMATION OF COMPANIES

5.1 Introduction
In this lesson, we will describe how a company is formed and its types and explain the
essential characteristics of a company.

5.2 Learning outcomes

By the end of the lesson, you will be able to;

5.2.1 Describe how a Company is formed.

5.2.2 Types of a companies
5.2.3 Identify the major characteristics of a company.

5.2.1 Formation of a company

A company is an entity separate and distinct from its owners.
A company is created by law, and its continued existence depends upon the statutes of the
state in which it is incorporated. As a legal entity, a company has most of the rights and
privileges of a person. The major exceptions relate to privileges that only a living person can
exercise, such as the right to vote or to hold public office. A company is subject to the same
duties and responsibilities as a person. For example, it must abide by the laws, and it must
pay taxes.
Memorandum and Articles of Association
Each company is governed by two documents, known as the Memorandum of Association
and the Articles of Association, generally referred to as the memorandum and the articles.

The memorandum consists of five clauses for private companies, and six for public
companies containing the following details:
1. The name of the company.
2. The part of the country where the registered office will be situated.
3. The objects of the company.
4. A statement (if a limited liability company) that the liability of its members is limited.
5. Details of the share capital which the company is authorised to issue.
6. A public limited company will also have a clause stating that the company is a public
limited company.
The memorandum is said to be the document which discloses the conditions which govern
the company’s relationship with the outside world.
Two common ways to classify company are by purpose and by ownership. A corporation
may be organized for the purpose of making a profit, or it may be not for-profit.
Classification by ownership differentiates publicly held and privately held companies. A
publicly held company may have thousands of stockholders. Its stock is regularly traded on
Stock Exchange markets.. In contrast, a privately held company usually has only a few
stockholders, and does not offer its stock for sale to the general public. Privately held
companies are generally much smaller than publicly held companies, although some notable
exceptions exist.
5.2.2 Types of Companies
A company can be formed in various ways leading to different types of companies. But
generally there are three types of companies.
1. Unlimited Companies- unlimited liability means that if the business runs up debts that it
is unable to pay, the owners will become personally liable for the unpaid debts and would be
required if necessary to sell their private possessions to repay them.
2. Companies limited by Guarantee- These are companies in which each member
guarantees to contribute a fixed sum of money towards the liabilities of the company as long
as he remains a member. In the event of insolvency each member will be responsible for the
debts of the company to the fixed sum of money guaranteed.
3. Limited liability companies – Limited liability means that the maximum amount that an
owner stands to lose in the event that the company becomes insolvent and cannot pay off its
debts, is his share of the capital in the business.
A limited liability company can either be private or public. A private limited company has a
minimum of 2 members and the maximum may not exceed fifty.

A Public Limited Company is one whose membership is not less than seven but no maximum
is imposed. A private company is not allowed to call upon the public for funds in the form of
shares whereas a public limited company can expand through the sale of shares to the public.

5.2.3 The Major Characteristics of a Company

Separate Legal Existence
As an entity separate and distinct from its owners, the company acts under its own name
rather than in the name of its stockholders. A company may borrow money, and may enter
into legally binding contracts in its own name. It may also sue or be sued, and it pays its own
taxes. Remember that in a partnership the acts of the owners (partners) bind the partnership.
In contrast, the acts of its owners (stockholders) do not bind the corporation unless such
owners are agents of the company.
Limited Liability of Stockholders
Since a company is a separate legal entity, creditors have recourse only to corporate assets to
satisfy their claims. The liability of stockholders is normally limited to their investment in the
company. Creditors have no legal claim on the personal assets of the owners unless fraud has
occurred. Even in the event of bankruptcy, stockholders’ losses are generally limited to their
capital investment in the company.
Transferable Ownership Rights
Shares of capital stock give ownership in a company. These shares are transferable units.
Stockholders may dispose of part or all of their interest in a company simply by selling their
stock. Remember that the transfer of an ownership interest in a partnership requires the
consent of each owner. In contrast, the transfer of stock is entirely at the discretion of the
stockholder. It does not require the approval of either the company or other stockholders. The
transfer of ownership rights between stockholders normally has no effect on the daily
operating activities of the company. Nor does it affect the company’s assets, liabilities, and
total ownership equity. The transfer of these ownership rights is a transaction between
individual owners. After it first issues the capital stock, the company does not participate in
such transfers.
Ability to Acquire Capital
It is relatively easy for a company to obtain capital through the issuance of stock. Investors
buy stock in a company to earn money over time as the share price grows, and because a
stockholder has limited liability and shares of stock are readily transferable. Also, individuals
can become stockholders by investing relatively small amounts of money. In sum, the ability
of a successful company to obtain capital is virtually unlimited.

Continuous Life
Since a company is a separate legal entity, its continuance as a going concern is not affected
by the withdrawal, death, or incapacity of a stockholder, employee, or officer. As a result, a
successful company can have a continuous and perpetual life.
Corporation Management
Stockholders legally own the company. However, they manage the company indirectly
through a board of directors they elect. The board, in turn, formulates the operating policies
for the company. The board also selects management team, to execute policy and to perform
daily management functions.
Government Regulations
A company is subject to numerous government regulations and guided by company act. For
example, the laws usually prescribe the requirements for issuing stock, the distributions of
earnings permitted to stockholders, and the effects of retiring stock.
Additional Taxes
Owners of proprietorships and partnerships report their share of earnings on their personal
income tax returns. The individual owner then pays taxes on this amount. Companies, on the
other hand, must pay corporation income taxes as a separate legal entity. These taxes are
substantial. In addition, stockholders must pay taxes on cash dividends (pro rata distributions
of net income). Thus, many argue that the government taxes corporate income twice (double
taxation)—once at the corporate level, and again at the individual level.
5.3 Assessment Questions
a) Indicate whether each of the following statements is true or false.
______ 1. Similar to partners in a partnership, stockholders of a company have unlimited
liability.
______ 2. It is relatively easy for a company to obtain capital through the issuance of stock.
______ 3.The separation of ownership and management is an advantage of the corporate
form of business.
b) Discuss the major characteristics of a company
c) Your friend Joseph cannot understand how the characteristic of corporation management is
both an advantage and a disadvantage. Clarify this problem for Joseph.
Solution
1. False. The liability of stockholders is normally limited to their investment in the
corporation.
2. True.
3. False. The separation of ownership and management is a disadvantage of the corporate
form of business.

5.4 References

1. Weygandt, Kimmel & Kieso: Accounting Principles 10th ed.

2. N. Kulish, “Business Inventories Rose for November, Possibly Adding Evidence of
Slowdown,” Wall Street Journal, Interactive Edition (January 17, 2001).
3. Kieso. Intermediate Accounting IFRS Edition.
4. Frankwoods. Business Accounting 10th ed.
5. Sutton: Corporate Financial Accounting & Reporting. 2nd ed(2004)