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					Chapter 14 - Companies: Share capital and the statement of financial position
CHAPTER OVERVIEW
In Chapter 13 you learned about the partnership form of organisation. In this chapter, we begin an indepth discussion of the company (corporate) form of organisation. Because the company is more complex than either sole proprietorships or partnerships, our discussion of companies (corporations) continues in Chapter 15, 16 and 17. Therefore, an understanding of the topics in this chapter is important before continuing to the next chapters. The learning objectives for this chapter are to: 1. 2. 3. 4. 5. 6. 7. Identify the characteristics of a company. Record the issue of shares. Prepare the shareholders’ equity section of a company’s statement of financial position. Account for cash dividends. Use different share values in decision-making. Evaluate a company’s return on assets and return on shareholders’ equity. Account for the income tax of a company.

CHAPTER REVIEW Objective 1 - Identify the characteristics of a company.
1. A company is a separate legal entity registered and regulated under the Australian Securities and Investments Commission (ASIC). The owners’ equity of a company is held by the shareholders. 2. A company has continuous life and transferability of ownership. A change in ownership of the shares does not affect the life of the company. Shares, especially in publicly listed companies, are easily bought and sold. 3. Mutual agency of owners is not present in companies. A shareholder cannot commit a company to a binding contract (unless that shareholder is also an officer of the company). 4. Shareholders have limited liability. That is, they have no personal obligation for the debts of the company. 5. Ownership and management are separated. Companies are controlled by boards of directors who appoint officers to manage the business. Directors are elected by the shareholders (stockholders). Thus, shareholders are not obligated to manage the business; ownership is separate from management. 6. Companies pay income taxes. A company pays a dividend to shareholders who then pay personal income taxes on their dividends but receive a (franking) credit for the tax the company has already paid. This removes double taxation of company earnings. 7. Government regulation: Because shareholders have limited liability, creditors have only the company’s asset available to satisfy claims. The government requires companies to provide more detailed disclosure than is required for sole traders and partnerships. Exhibit 14-1 in your text summarises the advantages and disadvantages of a company. Companies come into existence when a certificate of registration is obtained from ASIC. A company constitution which regulates the internal management is then adopted. The shareholders elect a board of directors, who appoint the officers of the company. The managing director or chief

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executive officer is charged with the day-to-day running of the company. (Review Exhibit 14-2 in your text.) Owners may receive share certificates or shareholding holding statement for their investment (see Exhibit 14-3 and 14-4). The basic unit of investment is a share. Shareholders’ equity is reported differently to owners’ equity of a proprietorship or a partnership because companies must report the sources of their capital. These sources are paid-up capital or issued capital (ordinary share capital) from sale of shares, and retained profits. Generally, paid-up capital is not subject to withdrawal (dividends). Retained Earnings is the account that at any time is the sum of earnings accumulated since incorporation, minus any losses, and minus all dividends distributed to shareholders. Revenues and expenses are closed into Profit and Loss Summary and then this account is closed to Retained Profits. To close net profit, debit Profit and Loss Summary and credit Retained Profits. To close net loss, do the reverse. Shareholders have four basic rights: 1. vote: to participate in management by voting 2. dividends: to receive a proportionate share of any dividend 3. liquidation: to receive a proportionate share of the remaining assets after payment of liabilities in the event of the company being wound up, and 4. preemption: to maintain their proportionate ownership in the company. Shares may be ordinary or preference, and once all shares had a par value, but now all Australian shares have no-par value. Par value was an arbitrary value that a company assigned to a share. Different classes of ordinary or preference shares may also be issued. Preference shareholders receive their dividends before ordinary shareholders and take priority over ordinary shareholders in the receipt of assets if the company liquidates, but often do not have voting rights. Exhibit 14-6 in your text compares ordinary shares, preference shares, and long-term debt.

Objective 2 - Record the issue of shares.
If a company sells ordinary shares for a cash receipt, the entry to record the transaction is: Cash at Bank Ordinary Share Capital XX XX

When a company receives non-cash assets as an investment, the assets are recorded by the company at the fair value of the shares issued. Accounting for preference shares follows the same pattern as accounting for ordinary shares. The difference is that instead of the word ‘Ordinary’, the word ‘Preference’ will appear in the titles of the general ledger accounts. Both issues of Telstra shares were by instalment, requiring a part payment with the application and a further payment (a call) one year later. Most companies require the full amount to be paid with the application (on application) but some may require some money on application, more when the shares are allotted and further payments, appropriately called calls. Companies issue a prospectus inviting the public to apply for shares by filling out the application form and attaching a cheque.

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The application money should initially be banked in a separate bank account (a trust account), because some or all of it may be refunded. The money received from investors applying for shares and is therefore called ‘application’. Cash Trust Application XX XX

When the shares are issued or allotted, the applications are accepted as purchasing ordinary share capital, the allotment money becomes due and the money in the trust account is transferred into the company’s normal bank account. Application Allotment Ordinary Share Capital Cash Cash Trust When the allotment money is received… Cash Allotment XX XX XX XX XX XX XX

If a call is made it follows the same pattern as the allotment: debit Call and credit Ordinary Share Capital. The receipt of the cash follows the same pattern: debit Cash, credit Allotment. The process of selling shares by asking for applications often results in more shares being applied for than are available for sale. This is known as oversubscription. The company may do two things with the excess application money: 1. Give the excess money back to the investor, i.e. refund. Application Cash Trust X X

2. Rather than refund the money and then ask for the allotment money (and call money), apply the excess application to allotment (and calls in advance). Application Allotment Calls in Advance X X X

Later when the cash is received for allotment and call, less will be received, because some or all has been paid on application. If the allotment or call money was not paid the company usually has the power to cancel the shares and the shareholder forfeits the shares. Money already paid is, at least initially, kept by the company and recorded as part of shareholders’ equity (Forfeited Shares account) but not ordinary share capital. Ordinary Share Capital Call Forfeited Shares Account X X X

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The shares may later be reissued, often at a discount, the discount effectively being paid by the original shareholder. Cash Forfeited Shares Account Ordinary Share Capital X X X

After paying the cost of reissue, any amount left in the Forfeited Shares Account may be refunded to the original shareholder. Ethical considerations may arise when assets other than cash are received in exchange for shares. The fair value may be open to interpretation, especially when an initial public offer (IPO) is made. The original owners provide assets in exchange for shares.

Objective 3 - Prepare the shareholders’ equity section of a company’s statement of financial position.
Preference shares always appear after ordinary shares in the shareholders’ equity section of the statement of financial position. Note also that the retained profits are money the shareholders have left in the company rather than money put in.

Study Tip: Review Exhibit 14.7 shareholders’ equity, on the statement of financial position, in your text. A dividend is a distribution of (usually) cash to the shareholders of a company. A company must have Retained Profits and sufficient cash in order to declare a dividend. A dividend must be declared by the board of directors before the company can pay it. Once a dividend has been declared, it is a legal liability of the company.

Objective 4 - Account for cash dividends.
On the declaration date the board also announces the date of record and the payment date. Those owning the shares on the date of record will receive the dividend. The payment date is the date the dividends are actually mailed or directly deposited into the shareholders’ nominated bank accounts. To declare the dividend, the company… Retained Profits Dividend Payable XX XX

When the dividend is paid the liability, Dividend Payable is debited and Cash is credited. Preference shares will usually require all dividends to be paid before any dividends can be paid to ordinary shareholders. Cumulative preference shares must receive all dividends in arrears plus the current year’s dividend before the company pays dividends to the ordinary shareholders. Preference shares usually carry a stated dividend percentage rate or a dollar amount per share.

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Dividends in arrears are not liabilities, but are disclosed in notes to the financial statements. Preference shares are considered cumulative unless specifically labelled as non-cumulative. Noncumulative preference shares does not accumulate dividends in arrears. Convertible preference shares can be exchanged by the holder for another class of shares. Suppose you have 200 preference shares and each share can be converted to four ordinary shares. If the market value of 800 ordinary shares exceeds the market value of 200 convertible preference shares, conversion would be to your advantage.

Objective 5 - Use different share values in decision-making.
Market value (market price) is the price at which a person could buy or sell a share on the Australian Stock Exchange (ASX). Daily newspapers (and many stockbrokers on the Internet) report the market price of publicly traded shares. Almost all share trade is between ‘existing’ shareholders and ‘new’ shareholders and the company does not receive any cash. Preference shares may be issued with a liquidation value. This is the amount the company agrees to pay preference shareholders if the company liquidates. Dividends in arrears are added to liquidation value to determine the amount to be paid if liquidation occurs. Book value is the amount of shareholders’ equity per ordinary share. If only ordinary shares are outstanding: Book value = Total shareholders’ equity Number of shares outstanding

If both preference and ordinary shares are outstanding, preference shareholders’ equity must be calculated first. Preference book value = Total preference equity + Dividends in arrears Number of preference shares outstanding Total equity - (Total preference equity + Dividends in arrears) Number of ordinary shares outstanding

Ordinary book value

=

There is often little relationship between book value per share and market value. Book value is based on historical accounting information while market value is based on investors’ expectations about the future of a company.

Objective 6 - Evaluate a company’s return on assets and return on shareholders’ equity.
1. Rate of return on total assets = Net profit before (interest and tax) Average total assets The return on total assets (or return on assets) measures how successfully the company was in using its (average) assets to earn a profit. This will be affected by the age of the assets (if still recorded at historical cost) and how the company acquires the assets for use (rent verses buy).

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2. Rate of return on ordinary shareholders’ equity =

Net profits - Preference dividends Average ordinary shareholders’ equity

The denominator, average ordinary shareholders’ equity, is equal to total equity minus preference equity. The rate of return on ordinary shareholders’ equity also measures profitability of the company. The return on equity should always be higher than the return on assets.

Objective 7 - Account for the income tax of a company.
Because companies have a distinct legal identity (they have the right to contract, to sue, and be sued - just as individuals have these rights), their income is taxed like individuals (at a flat rate rather than marginal progressive). However, unlike individuals, the amount of tax actually paid will differ from the expense incurred for the period (for individuals, these amounts are generally the same). The difference results from the following. Income tax expense is calculated by multiplying the applicable tax rate by the amount of pre-tax accounting profits as reported on the statement of financial performance, while income tax payable is calculated by multiplying the applicable tax rate by the amount of taxable income as reported on the company’s income tax return. Because these results will differ, a third type of account, Deferred Tax Liability, or Future Income Tax Benefit, is used to reconcile the entry, as follows: Income Tax Expense Future Income Tax Benefit* or Deferred Tax Liability** Income Tax Payable XX X XX X

* When the expense is less than the liability ** When the expense is greater than the liability

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TEST YOURSELF
All the self-testing materials in this chapter focus on information and procedures that your instructor is likely to test in quizzes and examinations.

I. Matching

Match each numbered term with its lettered definition. _____ 16. _____ 17. _____ 18. _____ 19. _____ 20. _____ 21. _____ 22. _____ 23. _____ 24. _____ 25. _____ 26. _____ 27. _____ 28. _____ 29. board of directors company constitution certificate of registration ordinary shares deficit dividends limited liability ordinary share capital par value preemption IAS 16 call income tax expense income tax payable

_____ 1. allotment _____ 2. book value _____ 3. chairperson of the board _____ 4. convertible shares _____ 5. cumulative shares _____ 6. application _____ 7. revenue from donations _____ 8. liquidation value _____ 9. market value _____ 10. instalments _____ 11. stated value _____ 12. preference shares _____ 13. shareholders’ equity _____ 14. retained profits _____ 15. deferred income tax

A. B. C. D. E. F. G. H. I. J. K. L. M. N. O. P. Q. R. S. T. U.

an account which reconciles the difference between income tax expense and income tax payable a company’s shareholders’ equity that is earned through profitable operation of the business a company’s capital from investments by the shareholders a debit balance in the retained profits account a group elected by the shareholders to set policy for a company and to appoint its officers an amount required to be paid on shares sold on instalment after the allotment money is paid the account created when a company receives a gift from a donor who receives no ownership interest in the company a shareholder’s right to maintain a proportionate ownership in a company an arbitrary amount assigned to a share an elected person on a company’s board of directors who is usually the most powerful person in the company the money received by the company when investors apply for shares distributions by a company to its shareholders means that the most that a shareholder can lose on her investment is the cost of the investment owners’ equity of a company amount contributed to the company by the shareholders preference shares that may be exchanged by the shareholders, if they choose, for another class of shares in the company preference shares whose owners must receive all dividends in arrears before the company pays dividends to the ordinary shareholders pre-tax accounting income times the tax rate the issuing of shares to investors shares that give their owners certain advantages such as the priority to receive dividends and the priority to receive assets if the company liquidates the amount that a company agrees to pay preference shareholders per share if the company liquidates

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V. the amount of owners’ equity on the company’s books for each share W. taxable income times the tax rate X. the constitution for governing a company Y. the document that gives ASIC’s permission to form a company Z. the International Accounting Standard on property, plant and equipment AA. the most basic form of shares BB. the price for which a person could buy or sell a share on the ASX CC. a process where investors may buy shares on a time payment or lay-by basis.

II. Multiple Choice

Circle the best answer.

1. The company board of directors is: A. appointed by the government B. elected by management C. elected by the shareholders D. appointed by ASIC

2. A shareholder has no personal obligation for company liabilities. This is called: A. mutual agency B. limited agency C. transferability of ownership D. limited liability

3. To determine the market value of publicly traded shares you would not normally look: A. on the Internet B. at the statement of financial position C. in the financial press D. at financial programs on television

4. A share certificate shows all of the following except: A. number of shares held B. shareholder name C. price paid for the shares D. company name

5. The ownership of ordinary shares entitles shareholders to all of the following rights except: A. B. C. D. right to receive guaranteed dividends voting right preemptive right right to receive a proportionate share of assets in a liquidation

6. When a company declares a cash dividend: A. B. C. D. liabilities decrease, assets decrease assets decrease, retained profits decreases assets decrease, retained profits increases liabilities increase, retained profits decrease

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7. When a company pays a cash dividend: A. B. C. D. liabilities decrease, assets increase assets decrease, retained profits decreases liabilities decrease, assets decrease retained profits decrease, liabilities increase

8. When a company issues shares in exchange for assets other than cash, the assets are recorded at: A. fair value of the shares B. original cost C. book value D. replacement cost

9. Dividends Payable is a(n): A. expense B. current liability C. ordinary share capital account D. shareholders’ equity account

10. Dividends in arrears on preference shares are reported: A. on the statement of financial position B. as a reduction of retained profits C. on the statement of financial performance D. as a footnote to the financial statements

III. Completion Complete each of the following.
1. Every company issues ___________________________ shares. 2. The company’s constitution is called the ___________________________. 3. Preference shareholders have preference over ordinary shareholders in ___________________ ______________________ and _________________________________________________. 4. Dividends are declared by _____________________________________. 5. Taxable income times the ___________________________________. 6. Shareholders’ equity minus ___________________________________. applicable preference tax rate equity equals

equals

7. The date of _______________________ determines who receives the dividend. 8. The date of _______________________ establishes the liability to pay a dividend. 9. The price at which a share is bought or sold is called the _____________________ value. 10. Companies come into existence _____________________________________________ is when issued by a the

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________________________________________________________________ administers the Corporations Act.

which

IV. Daily Exercises
1. Arrange the following shareholders’ equity items in the correct sequence. Retained Profits Ordinary Share Capital: Ordinary Shares Ordinary Share Capital: Preference Shares

2. To protect people who lend money to a company or buy shares in the company, the government monitors companies, requiring companies to disclose more information than sole traders and partnerships. Why is more disclosure required to protect people?

3. A company issues 10,000 ordinary shares for $30 per share. Record this transaction (omit explanation) assuming: a. the investors are required to pay $12 on application b. $10 on allotment c. and an $8 call.

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4. Refer to the information in Daily Exercise #3 and assume when the call was made the holder of 500 shares did not pay the call. Record the transactions to make the call, the receipt of the cash from the call, the forfeiture of the shares, the reissue of the forfeited shares at $24 per share and finally the refund of the balance in the Forfeited Shares Account to the original owner.

5. On June 10, the board of directors declares an annual dividend of $30,000 payable on July 31 to shareholders of record on June 20. Make the journal entries to record the declaration date, end of the financial year June 30, and payment date.

6. Refer to the information in Daily Exercise #5 and assume the company has 4,000 preference shares issued and 10,000 ordinary shares. The preference shares are non-cumulative and this is the first dividend the company has declared since the shares were issued four years ago. The dividend on preference shares is $2 per share. Calculate the amount due to each class of shareholder.

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7. Refer to the information in Daily Exercise #6, but assume the preference shares are cumulative. Calculate the amount due each class of shareholder.

V. Exercises
1. During the first year of operation, Berger Limited completed the following share-issuance transactions: March 1 March 10 March 28 Issued 40,000 ordinary shares for cash of $15 per share. Issued 5,000 6%, preference shares at a cash price of $50 per share. Received inventory valued at $25,000 and equipment with a market value of $60,000 in exchange for 2,000 ordinary shares.

Prepare the journal entries for March 1, 10, and 28.

2. Review the information in Exercise #1 and assume Retained Profits have a balance of $95,000. Prepare the shareholders’ equity section of the Berger’s statement of financial position at the end of the first year.

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3. Coles has 2,000 cumulative preference shares issued, paying $4 dividend per share. There were no dividends in arrears at the end of 2004, and no dividends were paid in 2005 or 2006. Coles also has 10,000 ordinary shares issued. a. If Coles pays a total of $60,000 in dividends in 2007, how much will each class of shareholders receive?

b. If Coles pays a total of $20,000 in dividends in 2007, how much will each class of shareholders receive?

4. The statement of financial position of Winter House Company reports total shareholders’ equity of $719,500, consisting of the following: a. redeemable preference shares; redemption value $22,000; 400 shares issued and outstanding b. ordinary shareholders’ equity, 15,500 shares issued c. Winter House has paid preference dividends for the current year and there are no dividends in arrears. Calculate the book value per share of the preference shares and ordinary shares.

5. Natural Fibres Limited reported pre-tax profits of $242,000 on their statement of financial performance and $186,000 taxable income on their tax return. Assuming a company tax rate of 30%, present the journal entry to record Natural Fibres’ taxes for the year. Date Accounts Debit Credit

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VI. Beyond the Numbers
1. Using the information in Daily Exercise #3, state the effect (increase, decrease, no effect), as of the end of the 2007 financial year on the return on assets, return on shareholders’ equity, and book value in each situation. Assume the preference shares’ redemption value is the issue price.

2. Explain why a shareholder would prefer to receive fully franked dividends - illustrate with an example. (This may require some research beyond the textbook and study guide.)

VII. Demonstration Problems
Demonstration Problem #1 On January 1, 2005 Video Productions Limited issued a prospectus offering 10,000 $25 preference shares and 100,000 ordinary shares ($10 payable on application, $8 on allotment and a call of $7. During January, the company completed the following selected transactions related to its shareholders’ equity: 10/1/05 Received applications for 10,000 preference shares, fully paid. 17/1/05 Received applications for 212,000 ordinary shares, one applicant for 4,000 shares paid in full. 19/1/05 Directors decided to issue the shares on the following basis: The applicant who paid in full and applied for 4,000 to be issued 4,000 shares. Applicants for another 16,000 shares to receive all the shares applied for. Applicants for 72,000 shares rejected and the application money refunded. The remaining applicants for 120,000 shares were allotted two shares for every three applied. 23/1/05 All allotment money owing received 25/1/05 Call was made. 27/1/05 Call money received except for the holder of 1,000 shares who did not pay the call. 29/1/05 The 1,000 shares on which the call was not paid forfeited.

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30/1/05 Reissued the forfeited shares for $22 each, receiving the money. 31/1/05 Refunded the balance in the Forfeited Shares account to the original shareholder. 31/1/05 Earned a small profit for January and closed the $3,800 credit balance of Profit and Loss Summary into the Retained Profits account.

Required: 1. Record the transactions in the general journal. 2. Post the journal entries into the equity accounts provided. 3. Prepare the shareholders’ equity section of Video Productions Limited statement of financial position at January 31.

Requirement 1 (Journal entries) Date Accounts Debit Credit

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Requirement 2 (Postings)

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Requirements 3 (Shareholders’ equity section) Video Productions Statement of Financial Position - Shareholders’ Equity Section January 31, 2005

SOLUTIONS I. Matching
1. 2. 3. 4. S V J P 5. 6. 7. 8. Q K G U 9. BB 10. CC 11. O 12. T 13. 14. 15. 16. N B A E 17. 18. 19. 20. X Y AA D 21. 22. 23. 24. L M C I 25. 26. 27. 28. H Z F R 29. W

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II. Multiple Choice
1. C Each ordinary share usually gives the shareholder one vote in the election of the board of directors. Recall that mutual agency is a characteristic of partnerships not present in a company. Transferability of ownership is a characteristic that the corporate form of organisation simplifies as compared with partnerships. Limited agency has no meaning. The statement of financial position shows the book value which often has little relation to the market value - the price the shares are trading for currently on the stock exchange information usually quoted from the other three sources.

2.

D

3.

B

4. 5. 6.

C A D

Price paid for the shares - see the example Exhibit 14.3. Dividends represent the distribution of the earnings of the company and are not guaranteed. The declaration has the effect of reducing Retained Profits and increasing the liability account, Dividends Payable, and reducing Retained Profits. The payment of a cash dividend results in cash being paid to shareholders to settle the liability created by the declaration of the dividend. When shares are issued in exchange for non-cash assets, the transaction should be recorded at fair value of the shares issued as per AASB 1015. The declaration of a dividend by the board of directors creates a current liability. Dividends in arrears are not liabilities since a dividend must be declared to create a liability. However, dividends in arrears do impair the amount of capital available to ordinary shareholders. Dividends in arrears are usually disclosed by a footnote.

7.

C

8.

A

9. 10.

B D

III. Completion
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. ordinary (Companies may also issue preference shares, but that is optional.) company constitution receiving dividends, in event of a liquidation the board of directors Income Tax Payable ordinary shareholders’ equity record declaration market certificate of registration, ASIC (Australian Securities and Investments Commission)

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Daily Exercises
1. Ordinary Share Capital: Ordinary Shares Preference Shares Retained Profits

Study Tip: Ordinary Share (contributed) capital is always listed first, followed by Retained Earnings. 2. The simple answer is limited liability; the creditors have only the assets of the company to satisfy any claims. Creditors of sole proprietorships or partnerships have access to the personal assets of the owners. Partners or sole traders may have few assets but would be very careful because they could have their car, TV, CD collection, etc. taken and sold to satisfy business debts. 3. Cash Trust Application (10,000  $12) Application Allotment (10,000  $10) Ordinary Share (Ordinary) Capital Cash Cash Trust Cash Allotment Call (10,000  $8) Ordinary Share Capital Cash Call 4. Call (10,000  $8) Ordinary Share Capital Cash (80,000 - [500  $8]) or (9500  $8) Call Ordinary Share Capital (500  [$12 + $10 + $8]) Call (500  $8) Forfeited Shares Account (500  [$12 + $10]) Cash (500  $24) Forfeited Shares Account (500  [$30 - $24]) Ordinary Share Capital (500  $30) Forfeited Shares Account ($11,000 - $3,000) Cash

120,000 120,000 120,000 100,000 220,000 120,000 120,000 100,000 100,000 80,000 80,000 80,000 80,000 80,000 80,000 76,000 76,000 15,000 4,000 11,000 12,000 3,000 15,000 8,000 8,000

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5. 10/6 20/6 10/30

Retained Profit Dividends Payable No entry Dividends Payable Cash

30,000 30,000

30,000 30,000

Study Tip: Remember no entry is required on the record date. This simply determines who will receive the dividends when mailed.

6. Preference: $2 per share  4,000 shares = $8,000. Ordinary: $30,000 - $8,000 = $22,000/10,000 = $2.20 per share. Since the preference shares are non-cumulative, the preference shareholders are entitled only to the current year’s dividend ($8,000). The balance is distributed to the ordinary shareholders.

7. Preference: $8,000 per year (see above)  4 years = $32,000. Since the board of directors declared only $30,000 for dividends, preference shareholders receive the entire amount ($7.50 per share) and still have $2,000 in arrears. The ordinary shareholders receive nothing!

V. Exercises
1. 1/3 Cash Ordinary Share Capital Cash Preference Share Capital Inventory Equipment Ordinary Share Capital 600,000 600,000 250,000 250,000 25,000 60,000 85,000

10/3

28/3

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2. Shareholders’ Equity Ordinary Share capital: 42,000 Ordinary Shares 5,000 Preference Shares, $50 stated value Retained Profits Total shareholders’ equity

685,000 250,000 95,000 1,080,000

3. a. Preference: Ordinary: 3 years  2,000 shares  $4 = $24,000 $60,000 - $24,000 = $36,000

b. Preference: 3 years  2,000 shares  $4 = $24,000 Since $20,000 is less than the $24,000 preference shareholders must receive before ordinary shareholders receive anything: all $20,000 goes to the preference shareholders.

4. Preference book value = Total preference equity + Dividends in arrears Number of preference shares outstanding $22,000 + $0 400 = $55

Preference book value

=

Ordinary book value

=

Total equity - (Total preference equity + Dividends arrears) Number of ordinary shares outstanding $719,500 - ($22,000 + $0) 15,500 = $45.00

Ordinary book value

=

5. Income Tax Expense Income Tax Payable Deferred Tax Liability Income Tax Expense = $242,000  5% = $72,600 Income Tax Payable = $186,000  30% = $55,800 Deferred Tax Liability = $72,600 - $55,800 = $7,500 72,600 55,800 19,600

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VI.

Beyond the Numbers

1. First the solution; then see below for the explanation. This may be more difficult than you might have first thought. Situation a. Preference shares are non-cumulative. b. Preference shares are cumulative. The formulas are: Rate of return on total assets = Net profits + Interest expense + Tax expense Average total assets Return on Assets increase increase Return on Shareholders’ Equity decrease decrease Book Value decrease decrease

Rate of return on ordinary shareholders’ equity

=

Net profits - Preference dividends Average ordinary shareholders’ equity

Book value per ordinary share

=

Total equity - (Total preference equity + Dividends arrears) Number of ordinary shares outstanding

For the return on assets, net profits, interest expense or tax expense change because dividends of $30,000 were paid (regardless of who got how much). However, average total assets will decrease because of the $30,000 reduction in cash. Therefore, return on assets will increase in both situations. For return on shareholders’ equity, the numerator (net profits less preference dividends) is smaller because of the dividend payment. The denominator (average shareholders’ equity) is also decreasing because the total dividends are debited to Retained Profits. In Exercise #3a, the numerator is decreasing by $8,000 while the denominator is decreasing by $30,000. In Exercise #3b, the numerator is decreasing by $30,000 while the denominator is decreasing by $32,000 (the $30,000 dividends recorded plus the $2,000 still in arrears to the preference shareholders). For book value per ordinary share, the numerator in both exercises is decreasing while the denominator remains constant.

2. Fully franked dividends are received by the shareholder with the tax already paid by the company ‘attached’ to them. The shareholders’ tax is calculated as if they received the dividends without the company tax having been paid (assumed to receive the dividend plus the tax already paid) and are then given credit for tax the company has already paid. An simply example will illustrate. A company’s taxable income is $10,000 and it pays tax at the rate of 30%. After paying $3,000 tax it has $7,000 available to pay dividends. A shareholder who owns 100% of the company would receive $7,000 in dividends. To calculate the tax payable on this $7,000 dividend the dividend plus the ‘imputation credit’ (tax paid by the company before the dividend was declared - in this case $3,000) is added to all other income, thereby increasing the shareholder’s taxable income by $10,000 ($7,000 + $3,000). If the

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shareholder had other income of $80,000 this would increase their taxable income to $90,000 (although they received only $7,000 cash). The tax payable on the extra $10,000 is approximately $5,000 (assuming a top personal marginal tax rate of 50% - it is in fact only 48.5%). But the taxpayer would receive credit for the $3,000 tax the company had already paid and the $7,000 dividend would increase the tax payable by only $2,000 ($5,000 - $3,000). Contrast this with an investor receiving $7,000 interest. Tax payable on this would be $3,500 ($7,000  50%) or $1,500 more than payable on a $7,000 fully franked dividend.

VII. Demonstration Problems
Demonstration Problem #1 Solved and Explained

Requirement 1 10/1 Cash Preference Share Capital 250,000 250,000

The payment of cash is recorded by debiting Cash and crediting Preference Share Capital for the number of shares times the value (10,000  $25).

17/1

Cash Trust Application

2,180,000 2,180,000

The money received is deposited into the cash trust because the shares have not been allotted and some or all of it may have to be returned. The amount is ($25  4,000) + ($10  208,000), 208,000 being a total of 212,000 minus the 4,000 paid in full.

19/1 There are a number of ways to show these transactions but let us go through each action as a separate journal entry. Application (4,000  $25) Ordinary Share Capital 100,000 100,000

The applicant who paid in full was allotted the 4,000 shares. It will depend on the conditions associated with allotting shares as set out in the prospectus if this could be considered the payment of $10 of Application money with the remainder going to Allotment and Call in Advance. Application Allotment Ordinary Share Capital (4,000  $10) 40,000 32,000 72,000

Record the application of $10 per share on 4,000 shares and the allotment money is now due (although it has already been paid).

Companies: Share capital and the statement of financial position

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Application 60,000 Allotment (4,000  $8) 32,000 Calls in Advance (4,000  $7) 28,000 Record the transfer of excess monies on application to Allotment and Calls in advance. Application (16,000  $10) 160,000 Allotment (16,000  $8) 128,000 Ordinary Share Capital 288,000 The applicants for 16,000 shares received all the shares they applied for and the allotment money is now due. Application (72,000  $10) Cash Trust Refunded the unsuccessful applications for 72,000 shares. 720,000 720,000

Application (80,000  $10) 800,000 Allotment (80,000  $8) 640,000 Ordinary Share Capital 1,440,000 Accepted the application for 80,000 shares (although applications for 120,000 were received). Application (40,000  $10) 400,000 Allotment 400,000 The remaining were allotted two shares for every three applied. Applications for 120,000 were received, 80,000 were allotted, leaving the money for 40,000 shares ($400,000) to be applied to Allotment.

Cash 1,460,000 Cash Trust 1,460,000 The money originally received ($2,180,000) minus the amount refunded ($720,000) can now be claimed by the company.

Cash 368,000 Allotment 368,000 A total of $800,000 (100,000 share  $8) is due on allotment but we have received $32,000 from the shareholder who paid the full price and $400,000 from the shareholders who applied for 120,000 shares but only received 80,000. Call (100,000  $7) Ordinary Share Capital

23/1

25/1

700,000 700,000

Cash (100,000 - 4,000 - 1,000)  $7 665,000 Calls in Advance 28,000 Call 693,000 The $700,000 minus the $28,000 received on the 4,000 shares minus the 1,000 shares times $7 per share is received in cash. 27/1

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Ordinary Share Capital (1,000  $25) 25,000 Call (1,000  $7) 7,000 Forfeited Shares Account (1,000  [$10 + $8]) 18,000 The Ordinary Share Capital has been previously credited with both the amounts paid (Application and Allotment) and the amount due (Call). The Call account after the money was received had a debit balance of $7,000 (the money not paid) and the Forfeited Shares Account contains the money already paid by the shareholder who forfeited the shares. 29/1 Cash (1,000  $22) Forfeited Shares Account (1,000  $3) Ordinary Share Capital (1,000  $25) The Forfeited Shares Account ‘pays’ the discount. 30/1 31/1 22,000 3,000 25,000

Forfeited Shares Account ($18,000 - $3,000) 15,000 Cash 15,000 Refunded the balance in the account. 31/1 Profit and Loss Summary 3,800 Retained Profits 3,800 At the end of each month or year, the balance of the Profit and Loss Summary account is transferred to Retained Profits. Video Productions earned a small profit in January. The closing entry will debit Profit and Loss Summary (to reduce it to zero) and credit Retained Profits (increasing shareholders’ equity to reflect profitable operations). Requirement 2 Cash Trust 2,180,000 Application 40,000 60,000 160,000 720,000 800,000 400,000 Bal 0 Allotment 32,000 128,000 640,000 Bal 0 Cash 250,000 1,460,000 368,000 665,000 32,000 400,000 368,000 Bal 0 Ordinary Share Capital 25,000 72,000 288,000 1,440,000 700,000 Call 700,000 693,000 7,000

720,000 1,460,000

2,180,000

Bal 0

15,000

Companies: Share capital and the statement of financial position

25

22,000 Bal 2,750,000 Bal 2,500,000

25,000

Calls in Advance 28,000

28,000

Forfeited Share Account 3,000 18,000 15,000

Preference Share Capital 250,000

Profit and Loss Summary 3,800 Zero balance because revenues and expenses have been closed here.

Retained Profits 3,800

The cash balance would probably be different because some of the revenue and expenses are likely to have affected cash.

Requirement 3 Video Productions Statement of Financial Position - Shareholders’ Equity Section January 31, 2005 Shareholders’ equity: $ Ordinary Share Capital 2,500,000 Preference Share Capital 250,000 Total ordinary share capital Retained profits Total shareholders’ equity 2,750,000 3,800 $2,753,800

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DOCUMENT INFO
Description: 1. Identify the characteristics of a company. 2. Record the issue of shares. 3. Prepare the shareholders’ equity section of a company’s statement of financial position. 4. Account for cash dividends. 5. Use different share values in decision-making. 6. Evaluate a company’s return on assets and return on shareholders’ equity. 7. Account for the income tax of a company.