Financial Accounting Second Canadian Edition by dominic.cecilia



Reporting and Analysing
 Shareholders’ Equity

• Separate legal entity
• Has most of the rights and privileges of
  a person
• Classified by purpose and ownership
  – Purpose: profit or nonprofit
  – Ownership: public or private
Characteristics of a Corporation

  •   Separate legal existence
  •   Limited liability of shareholders
  •   Transferable ownership rights
  •   Ability to acquire capital
  •   Continuous life
  •   Corporation management
  •   Government regulations
  •   Income taxes
Advantages and Disadvantages of
         a Corporation
       Advantages                  Disadvantages
– Corporate management          – Corporation
   • professional managers        management
– Separate legal existence          • ownership separated
– Limited liability of                from management
  shareholders                  – Increased costs and
– Deferred or reduced taxes       complexity in order to
                                  adhere to government
– Transferable ownership rights   regulation
– Ability to acquire capital    – Additional taxes
– Continuous life
           Shareholder Rights

• To raise capital, the corporation sells shares
• If there is only one class of shares, these are
  referred to as common shares
• Ownership rights are specified in articles of
  incorporation or in by-laws
          Share Terminology

• Authorized shares
  – maximum amount of shares a corporation is
    allowed to sell as authorized by corporate
• Issued shares
  – number of shares sold
          Stock Market Price

• Shares of publicly held companies are traded
  on organized exchanges at dollar prices per
  share established by the interaction between
  buyers and sellers
         No Par Value Shares

• Par and stated value shares seldom used
• Par value has no assigned legal capital value
• Legal capital equals issue price (proceeds)

           Must retain legal capital.
             No par value has NO
   relationship to market value once issued.
       Reacquisition of Shares

• Reacquired shares are a corporation’s own
  shares (either common or preferred) that
  have been issued and reacquired by the
• Reacquired shares are normally retired and
       Shareholders’ Equity

• The shareholders’ equity section of a
  corporation’s balance sheet consists of:
  1. Share capital (contributed capital)
  2. Retained earnings
           Shareholders’ Equity

Shareholders’ equity
 Share capital
  Common shares, 100,000 no par
  value shares authorized, 50,000
  issued                            $800,000
 Retained earnings                   130,000
Total shareholders’ equity          $930,000
            Preferred Shares

• Preferred shares have priority over common
  shares with regards to:
  1. Dividends
  2. Assets in the event of liquidation
• Preferred shareholders usually do not have
  voting rights
• Preferred shares are shown first in the share
  capital section of shareholders' equity
    Preferred Share Preferences

•   Liquidation preference
•   Cumulative (dividends in arrears)
•   Convertible
•   Redeemable/callable (company option)
•   Retractable (shareholder option)

• Dividends are distributed by a corporation to
  its shareholders on a pro rata (equal) basis
• They are normally in the form of:
  – Cash
  – Stock (common shares)
             Cash Dividends

• For a cash dividend to occur, a corporation
  must have:
     1.    Retained earnings
     2.    Adequate cash
     3.    Declared dividends
 Entries for Cash Dividends

Three dates are
important in
connection with
1. Declaration date
2. Record date
3. Payment date
              Declaration Date

• Date the Board of Directors declares cash dividend
• Commits the corporation to a binding legal
  obligation that cannot be rescinded

 On December 1, 2004, the directors of Media General
 declare a $0.50 per share cash dividend on 100,000
 common shares (100,000 x $0.50 = $50,000).

 Dec. 1 Cash Dividends                 50,000
            Dividends Payable                50,000
               Record Date

• Date ownership of shares is determined for
  dividend purposes

     Dec. 22     No entry necessary
             Payment Date

• Date dividend cheques are mailed

The payment date for Media General is
January 20.

Jan. 20 Dividends Payable   50,000
          Cash                   50,000
                Stock Dividends

• Distributed (paid) in shares
• In most cases, fair market value is assigned to the
  stock dividend shares
• Decreases retained earnings, increases common
  shares, total shareholder’s equity remains the
  same                           Before     After
                                 Stock      Stock
                                Dividend   Dividend
   Common shares                $500,000   $575,000
   Retained earnings             300,000    225,000
   Total shareholders’ equity   $800,000   $800,000
 Purposes and Benefits of Stock

• For company
   – To satisfy shareholders' dividend
     expectations without spending cash
   – To increase marketability of its shares
     by increasing number of shares and
     decreasing market price per share
   – To reinvest and restrict a portion of
     shareholders' equity
 Purposes and Benefits of Stock

• For shareholder
   – More shares with which to earn
     additional dividend income
   – More shares for future profitable
     resale, as share price increases
            Stock Dividends

• Assume 2% ownership interest in Cetus Inc.,
  owning 200 of its 10,000 common shares
• In a 10% stock dividend, 1,000 common
  shares (10,000 x 10%) would be issued
• You would receive 20 shares (2% x 1,000),
  but your ownership interest would remain at
  2% (220 /11,000)
                Stock Dividends

 Cetus Inc. would journalize the stock dividend as
 follows, assuming $25 FMV (1,000 x $25 = $25,000):

Declaration Date
Stock Dividends                           25,000
   Common Stock Dividends Distributable            25,000

Record Date   No Entry

Distribution Date
Common Stock Dividends Distributable      25,000
    Common Shares                                  25,000
                Stock Splits

• A stock split involves the issue
  of additional shares to
  shareholders according to their
  percentage ownership
• Number of shares is increased
• No change to dollar amount in
  share capital account
              Stock Splits

• A stock split has no effect on total share
  capital, retained earnings, or total
  shareholders’ equity
• Market value of the shares will decrease
  roughly proportionately to the split
• It is not necessary to formally journalize a
  stock split
  Effects of Stock Splits, Stock
 Dividends, and Cash Dividends

                                   Stock    Stock      Cash
                                   Split   Dividend   Dividend
Total assets                        NE       NE          
Total liabilities                   NE       NE         NE
Total shareholders’ equity          NE       NE          
Total share capital                 NE                 NE
Total retained earnings             NE                  
Number of shares                                      NE
% of shareholder ownership          NE       NE         NE

 NE = No effect            = Increase        = Decrease
          Retained Earnings

• Retained earnings is the cumulative net
  earnings (less losses) that is retained in the
  business (i.e., not distributed to shareholders)

Retained earnings, opening balance
+ Net earnings (or - net loss)
- Dividends
= Retained earnings, ending balance

A debit balance in retained earnings is identified
as a deficit and is reported as a deduction in the
shareholders’ equity section

Shareholders’ equity
   Common shares                       $800,000
   Retained earnings (deficit)           (50,000)
Total shareholders’ equity              $750,000
   Retained Earnings Restrictions

• In some cases there may be retained earnings
  restrictions that make a portion of the balance
  currently unavailable for dividends
• Restrictions result from one or more of the
  following causes:
   – Legal
   – Contractual
   – Voluntary
Measuring Corporate Performance

• Dividend record
  – Payout ratio
• Earnings performance
  – Return on common shareholders’ equity
             Payout Ratio

• Measures the percentage of earnings
  distributed in the form of cash dividends
  to common shareholders

                           Cash Dividends
      Payout Ratio =
                            Net Earnings
        Return on Common
        Shareholders’ Equity

• Measures the company’s profitability
  from the shareholders’ point of view

 Return on Common Shareholders’ Equity =
 Net Earnings – Preferred Share Dividends
  Average Common Shareholders’ Equity
Components of ROE
         Debt vs. Equity Decision

Companies must decide between issuing bonds
or selling shares to raise long-term capital
  – Do not affect shareholder control
  – Offer tax savings
  – Have the potential for a higher return on common
    shareholders’ equity
However, bonds do require a fixed payment which
may be difficult for a company to meet

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