SOURCE OF CAPITAL PROCESSES (STUDY OBJECTIVE 2)

The operation of any organization requires long-term capital assets such as land, buildings, and equipment. To purchase these capital assets, top management must have capital available. Capital is the funds used to acquire the long-term capital assets of an organization. Capital usually comes from long-term debt or equity. Long-term debt results from borrowing funds via loans or bonds payable, and equity results from issuing common or preferred stock. These financial instruments provide the capital necessary to acquire long-term capital assets. Source of capital processes are those processes to authorize the raising of capital, execute the raising of capital, and properly account for that capital. Because of the magnitude and importance of these methods of raising capital, these financial instruments should be used only when necessary.

The transactions and resulting processes related to loans, bonds payable, and stock should be executed only when top management or the board of directors authorizes them, and use of the resulting capital must be properly controlled. These processes are administrative processes because top managers, the administrators of the organization, are responsible for the authorization, control, and use of the capital. The processes related to expenditures of capital (purchases of fixed assets) were described in Chapter 10.

Exhibit 12-3 Source of Capital Process Map

Occasionally, top management may recognize the need to raise capital. This need might arise from the desire to accomplish organizational goals that require substantial funds, such as expanding the organization, replacing a substantial amount of plant, property, and equipment, or acquiring other businesses. To accomplish any of these goals, management would need access to a substantially large amount of capital. Top management would then investigate the most appropriate method of raising the needed capital.

The board of directors must decide between the two general sources of capital funds: debt or equity. If equity is chosen as the source of capital, the corporation will need to sell common or preferred stock. Corporations are usually unable to access the stock market directly and must conduct a sale of stock through an underwriter. An underwriter is a third party that contracts with a corporation to bring new securities issues to the public market.

Since top management directs these capital processes, there is inherent control. The fact that these processes cannot occur without specific authorization and oversight by top management is a strong internal control.