As was introduced at the beginning of the course, equity is the investment in a business
by the owners of the business. Equity is often considered one of the more difficult
concepts in introductory financial accounting, so a quick review of the fundamental
concepts is in order.
The accounting equation states ASSETS = LIABILITIES + EQUITIES. This statement
can be rearranges to state EQUITIES = ASSETS - LIABILITIES, defining equity as the net
assets in the business. Regardless of the way in which the accounting equation is
arranged, the fundamental concept is that a business must record not only the assets its
owns, but the source of its assets. Assets may be acquired in three different ways. An
asset may be acquired through the payment of cash or other assets, in which case total
assets do not change. An asset may be acquired and the business promises to make
payment in the future, in which case both total assets and total liabilities increase. Thirdly,
owners of the business may contribute assets to the business either directly through the
sale of shares, or indirectly by allowing the profits generated by the business to remain in
the business. In this case, total assets will increase, as will total equities.
This provides several different ways to define or describe equity. Equity is the investment
in the business by the owners. This investment contributes assets to the business and
equity is therefore the investment in assets funded by the owners of the business, which
excludes the cost of assets funded by creditors.
The equity accounts on the financial statements of a business record the amount of the
investment in a business by the owners, at the historical cost of that investment.
Consider the following example:
Jo Blow wants to start up a business selling balloons for various occasions. Jo has
determined that the business needs $10,000 cash prior to starting business in order to
pay the rent on the premises, pay for the advertising for the grand opening, obtain the
necessary office supplies, and to purchase inflation equipment, a supply of balloons,
helium, ribbons, baskets and other novelty items. As the business has no history of
profitability, no faithful clientele, and no assets, the bank will not lend the business any
money. Jo has liquidated some of her investments and has $10,000 to contribute to the
business. Jo then opens a bank account in the name of the business, We’R Balloons Ltd.
, deposits the $10,000, and accepts 1 common share in return.
The transaction to be recorded in the accounting records of We’R Balloons Ltd. is the sale
of 1 common share to Jo Blow for $10,000. When balance sheets are prepared, We’R
Balloons will report common share capital of $10,000. This amount will not change until
We’R Balloons Ltd. either issues additions common shares, or repurchases the share
from the shareholder.
Let’s look at We’R Balloons Ltd. at the end of its first year of operations. The business
has been very successful, supplying balloons to restaurants, banquet halls and individual
customers. After all expenses have been taken into consideration, We’R Balloons Ltd.
has generated a profit of $20,000 for the year, giving an ending balance in Retained
Earnings of $20,000. The single common share issued and outstanding will continue to
be recorded at $10,000 on the balance sheet, however if Jo Blow wishes to sell the
business, she should be able to sell the common share to another investor for $30,000.
Ownership of the one common share results in ownership of 100% of the business that
now has a value of $30,000. The common share has a fair market value of $30,000 but
remains recorded at the value of the contribution by the shareholder when the share was
issued, in this case $10,000.
If Jo sells the common share to Tom Thumb for $30,000, the balance sheet of We’R
Balloons Ltd. will not change as this sale has no effect on the business. Tom pays out the
cash and Jo receives the cash, the business is not a party to this transaction.
If Tom wishes to become an owner with Jo, We’R Balloons Ltd. can issue one common
share to Tom for $30,000. The business will then own net assets worth $60,000, there
will be two common shares outstanding, each worth $30,000. The balance sheet,
however, will report common share capital of $40,000 and Retained Earnings of $20,000.
This reflects the transactions that occurred in the business. We’R Balloons Ltd. issued
two common shares, one at $10,000 and one at $30,000, for total proceeds of $40,000.
The business earned $20,000 in profit and the increased assets were retained in the
business. The creditors have no claim on the profit of the business. The profit benefits
the owners, whose investment is increased by the passive act of allowing the profit to
remain in the business.
The key concept here is that equity is recorded at historical cost, the value of the assets
contributed to the business by the owners, whether the investment is active, such as
assets contributed to acquire shares, or a passive investment that occurs when profits are
earned but not distributed to owners.
The textbook concentrates on businesses structured as sole proprietorships when
introducing the bookkeeping process. The emphasis in this material will be on a business
structured as a corporation.
A corporation may be a public or private corporation. A public corporation is one whose
shares are traded on a public stock exchange such as the Toronto Stock Exchange or the
New York Stock Exchange. A private corporation is one whose shares are not traded on
a stock exchange but are owned by a relatively small number of owners (closely held). A
shareholder of a public corporation may sell his or her shares to any interested party, but
if the corporation is a private corporation, the purchaser must be approved by the
A corporation is a separate legal entity, independent of its owners. A corporation may be
owned by one or more individuals, by a partnership, or by other corporations, or any
combination of individuals, partnerships and corporations. To create a corporation, the
owners must register the entity under a corporations act. Many corporations are
registered under the Canada Business Corporations Act, which gives the corporation
legal status across Canada. If the owners intend for the corporation to operate in only one
province, the corporation can be registered under that province’s corporations act, for
instance the Manitoba Corporations Act. If offices are required in other provinces, the
corporation would need to register in the other provinces as well.
When a corporation is registered or incorporated, Articles of Incorporation are issued.
One of the functions of the Articles of Incorporation is to identify the types of shares and
the quantity of each that the corporation is legally entitled to issue.
TYPES OF SHARES
First of all, the ownership interest in a corporation is commonly called shares or stock.
The terms are interchangeable. Ownership is evidenced by a share or stock certificate
issued by the corporation.
A corporation may issue many types of shares, but these shares are generally classified
as either common or preferred shares. The corporation can choose to attach specific
characteristics to class of shares by describing the characteristics in the Articles of
Incorporation. The characteristics attached to shares can differ significantly between
public and private corporations.
All corporations must issue at least one class of common shares, unless the corporation
is a not-for-profit corporation with no owners. Not-for-profit corporations are beyond the
scope of this course.
If a share is described as a common share, the investor is entitled to believe that the
share is a voting share and has a residual interest in the corporation. Voting privileges
are normally one vote per share. A residual interest means that if the corporation were to
wind up and cease to exist, the assets would be converted to cash, the cash would be
used to pay creditors first and any residual left over would be paid to the common
shareholders proportionate to the number of shares owned.
The concept of residual interest has several very important implications. First, although
the corporation is a separate legal entity which owns its assets and owes its debts,
ultimately the net assets benefit the common shareholders of the corporation. If a
corporation winds up or liquidates, this benefit is direct; the shareholders receive a
distribution of the residual assets. A corporation has an unlimited life, however, and may
never wind up. Because the corporation is a separate legal entity, the shareholders do
not have a claim on the individual assets of the business. For example, ownership of
shares in Microsoft does NOT allow a shareholder to walk into the premises and take
software home! The net assets that accumulate in the corporation still benefit the
shareholders, however. The corporation may choose to pay dividends to its
shareholders, which will distribute a portion of the assets to the shareholders even though
the corporation is still operating. Even if a corporation chooses not to pay dividends, the
common shareholders will benefit from increasing net assets through an increase in the
trading price of the common shares. If a shareholder owns 10% of the corporation and
through profitable operations, the net assets of the corporation double, the trading price of
the shares should double as well. This means that even if the corporation chooses not to
distribute any assets to the shareholders, the shareholder’s personal wealth increases by
the increase in value of the shares. Additionally, the shareholder may obtain extra cash
by selling a portion of the shares owned. This will, however, reduce the percentage of the
Secondly, if the common shareholders are entitled to the residual net assets in the
corporation, there is no need to set a dividend rate on common shares. As long as the
dividends do not reduce the assets in the corporation below the amount needed to pay
creditors and other claims with priority, the corporation can choose the dividend amount
according to the availability and need for cash within the business.
Thirdly, the value of the common share will depend on the value of the net assets owned
by the corporation. This includes assets such as goodwill and patents, which may exist
but may not be included on the balance sheet.
The common shares of a publicly traded corporation normally have the characteristics
described above. They are voting shares, one vote per share, and have a residual
interest with unrestricted dividend rights. Unless the Articles of Incorporation state
otherwise, all common shares have these rights.
Small businesses are often structured as private corporations, and the characteristics of
the common shares may be varied. Every small business is required to have at least one
class of common shares that are voting with a residual interest and unrestricted dividend
rights. Often small businesses stay within the family, however, and other classes of
common shares may be issued for estate planning purposes. It is possible, for example,
for parents to own voting common shares and the children own non-voting common
shares. In this situation, the parents control the operations of the business, but the
children can benefit from the growth of the business. In this situation, the shares might be
described as Class A common shares, and Class B non-voting common shares. The
description of the Class B shares indicates they are non-voting. As there is no indication
to the contrary, these shares are residual interest with unrestricted dividend rights.
CHARACTERISTICS OF EQUITY
Whenever a reference is made to equity, such as comparing the characteristics of debt
and equity, it is the unrestricted common share that is meant. In addition to the ability to
vote, and the ability to benefit from the growth of the business, common shares do not
have a maturity date and are expected to be outstanding over the life of the corporation.
A share is considered outstanding if it has been issued by the corporation and is still
owned by a shareholder. An additional characteristic which will be expanded upon in the
material on dividends is that a corporation has no legal obligation to pay dividends until
dividends are declared by the board of directors of the corporation.
PAR VALUE AND NO-PAR VALUE COMMON SHARES
Every text still refers to par value common shares, although their use today is limited.
Corporations incorporated under the Canada Business Corporations Act and most
provincial corporations acts do not allow par value common shares.
Par value is simply a stated value per common share. It is usually the amount at which a
common share was originally issued. For example, if a corporation was created and
needed $100,000 cash to begin operations, it may have issued 10,000 common shares
with a par value of $10 each. As noted above, however, if the corporation operates
profitably the value of each common share will increase, rendering the par value useless
as an indicator of current value.
If a corporation issues par value shares after it has operated profitably, the shares will be
issued at fair market value which may be substantially greater than the par value
assigned to the shares in the Articles of Incorporation. If the existing common shares are
currently worth $75 each, that is the amount the corporation will charge the new investors
for the newly issued shares. As an example, consider a situation where the corporation
issues 10,000 shares for cash of $75 each. If these were no-par value shares the journal
entry would be:
Common shares $750,000
Since these are par value shares, however, the entry differs. For par value shares, only
the par value is credited to the common share account. Any excess is credited to a new
equity account, called Contributed Surplus. This results in the following journal entry:
Common shares $100,000
Contributed surplus 650,000
The term preferred shares is used to describe shares that have preference over the
common shares. The actual term used depends on the wording in the Articles of
Incorporation and these shares are sometimes called Preference shares.
Preference shares are often described as more like debt than equity because of the
characteristics normally attached to the shares. The characteristics are described in the
Articles of Incorporation, and there are many different features that can exist. These
shares can be tailored to the needs of the corporation and investor, although the most
frequently assigned characteristics are described below.
Preferred shares do not have a residual interest in the net assets of the corporation.
Normally preferred shares have a par value or stated value which identifies the amount
the investor will receive when the corporation winds up. If the shares are Class A par
value $1000 Preferred shares, the investor is entitled to $1000 on wind up of the
corporation, if there are sufficient assets remaining after paying creditors. Preferred
shareholders have preference over common shareholders on wind up of the corporation.
All preferred shareholders must be paid in full before any common shareholders receive
payment. If insufficient funds are available to pay the preferred shareholders in full, all will
receive partial payments, for instance 50 cents for each dollar of preferred shares owned.
In order of priority, the creditors are paid in full before any shareholders receive cash, then
the preferred shareholders are paid in full before any common shareholders receive cash,
then the common shareholders share any cash remaining. If the corporation has been
very profitable, the common shareholders may receive a great deal. If the wind up is due
to poor financial performance, the common shareholders may receive nothing. As a
result, common shares are considered to be a much riskier investment than preferred
It was noted earlier that the residual interest of the common shares meant that there was
no need to stipulate a dividend rate for common shares, as those shareholders were
entitled to all of the net assets. When a corporation issues both common and preferred
shares, the preferred shareholders may have a priority to assets on liquidation but that
claim on assets is at a fixed amount. In order to make preferred shares desirable, the
Articles of Incorporation specify a dividend rate that each share is entitled to, and may
also specify a maturity date for the preferred shares. This allows the investor to
determine whether the return on investment is sufficient to warrant purchasing preferred
shares, making preferred shares very similar to investing in bonds or other debt
instruments. The dividend rate on preferred shares can be stated as a fixed amount per
share, or a fixed percentage of the stated value of the share.
Since a preferred share is not a residual share, its selling price is not affected by the
success of the business unless the business is on the verge of bankruptcy. Instead, the
price of a preferred share fluctuates depending on whether or not the stated dividend rate
is competitive with the rate of return demanded by the market at that point in time. Due to
preferential tax treatment of dividends in Canada, the rate of return on preferred shares is
lower than the interest rate, but the two move together.
Typically, preferred shares are non-voting shares, although in a small business voting
preferred shares may be used for estate planning purposes. It is common for retiring
parents to exchange their common shares for voting preferred shares of equal value to
maintain control until the children have demonstrated competence in management. If the
children own common shares, the increase in the value of the business will cause their
shares to increase in value while the parents’ retirement fund (the preferred shares) stay
a constant value. As the preferred shares are redeemed, control passes to the common
shares and the parents can enjoy their retirement funds.
Retractable preferred shares are shares that can be repurchased by the corporation at
the option of the shareholder for a stated price. This reduces the risk to the shareholder if
market rates of return rise and the selling price of the preferred shares drops, which
allows the corporation to issue the preferred shares at a lower dividend rate than if the
shares were not retractable.
Redeemable preferred shares are shares that can be repurchased by the corporation at
the option of the corporation for a stated price. This reduces the risk to the corporation; if
it wishes to buy back preferred shares because market rates of return have dropped, the
redemption price sets the maximum cost to the corporation. Since this increases the risk
to the investor, the dividend rate on redeemable preferred shares must normally be
greater than if there was no redemption feature.
The journal entries required to record the issuance of shares are quite straightforward.
The asset received as proceeds on the issuance is debited, and the appropriate share
account is credited. If the shares are no-par value shares, the common share or preferred
share account is credited for the entire amount of the proceeds received from the
issuance of the shares. If the shares are par-value shares, an amount equal to the par
value of the shares issued is credited to the share account and the excess over par is
credited to the Contributed Surplus account. A corporation is prohibited from issuing
shares for less than the par value assigned to the shares. If assets other than cash are
received, the assets are recorded at their fair market values at the date acquired. If more
than one class of shares is issued, the proceeds are allocated between the classes of
shares, with the preferred shares normally being issued at their par or stated value, and
the balance assigned to the common shares.
Brandon Enterprises Ltd. issued 10,000 Class C common shares with a par value of $20
for proceeds of $600,000. At the same time 5,000 Class A common shares were issued
for proceeds of $60 per share, and 400 Class H Preferred shares with a stated value of
$200 per share were issued for equipment with a fair market value of $50,000 and
inventory with a fair market value of $ 30,000. The accounting records of the investor
showed that the equipment had a net book value of $48,000 and the inventory was
carried at $26,000.
Required: Prepare the journal entries to record the share issue by Brandon Enterprises
First, the value of the assets in the accounting records of the investor acquiring preferred
shares is irrelevant. That business will have to record a gain on the sale of equipment and
will show gross profit from the sale of inventory, but this has nothing to do with the
operations of Brandon Enterprises Ltd.
Class C common shares $200,000
Contributed surplus 400,000
Class A common shares $300,000
Inventory $ 30,000
Class H Preferred shares $ 80,000
BOOK VALUE OF SHARE CAPITAL
The book value of issued shares is the amount recorded in the share account in the
general ledger. The book value per share is an average, and is calculated by dividing the
balance in the share capital account by the number of shares of that class that are issued
and outstanding on the same date.
New Corporation was incorporated in 1999 and issued shares on the following occasions:
On January 1, 1999, 10,000 preferred shares with a stated value of $100 per share and
50,000 common shares were issued for $1,500,000 cash. On July 1, 2000, 500 preferred
shares, stated value of $100 and 1,000 common shares were issued for $72,000 cash.
On November 30, 2001, 3,000 common shares were issued for $108,000 in cash.
a) Determine the amount to be reported as share capital on the balance sheet as at
December 31, 1999, 2000, and 2001.
b) Calculate the book value for each class of share December 31, 1999, 2000, and 2001.
c) Calculate the issue price per common share for each date shares were issued.
a) January 1, 1999
Total issue proceeds $1,500,000
Preferred $100 stated value X 10,000 shares 1,000,000
Common shares 1,500,000 - 1,000,000 500,000
July 1, 2000
Total issue proceeds $ 72,000
Preferred $100 stated value X 500 shares 50,000
Common shares 72,000 - 50,000 22,000
Preferred shares Common shares
Jan 1, 1999 1,000,000 500,000
December 31, 1999 1,000,000 500,000
July 1, 2000 50,000 22,000
December 31, 2000 1,050,000 522,000
November 1, 2001 - 108,000
December 31, 2001 1,050,000 630,000
Equity reported on the balance sheet on December 31
1999 2000 2001
Preferred shares 1,000,000 1,050,000 1,050,000
Common shares 500,000 522,000 630,000
1,500,000 1,572,000 1,680,000
b) book value per share 1999 2000 2001
$1,000,000/10,000 shares $100
$1,050,000/10,500 shares $100 $100
$500,000/50,000 shares $ 10
$522,000/51,000 shares $10.23
$630,000/54,000 shares $11.67
c) Issue price per common share
$500,000/50,000 shares $10
$22,000/1,000 shares $22
$108,000/3,000 shares $36
Please note that the issue price per share has gone up dramatically over the three year
period while the book value per common shares has gone up much less. The reason?
Far fewer shares were issued at the higher amounts than at the original issue price of
The increase in share price indicates the corporation has increased in value. This
increase in value is most likely to have been caused by profitable operations over the
three year period. If the full balance sheet was available, it would likely show a significant
balance in retained earnings. As the profit benefits the common shareholders, the
common shares rise in value.
This example illustrates the difference between fair market value of a share and its book
value. On November 1, 2001, the fair market value of a share is $36. Each share will
have this value, whether issued in 1999 or 2001, as the common shares are of the same
class. Each share represents 1/54,000 of the corporation. The book value of the share is
$11.67 and this amount will not change unless the corporation issues additional shares.
The fact that the corporation has operated profitably does not affect the fair market value
of the preferred shares. On the windup of the corporation, the preferred shareholders are
entitled to the stated value of the shares, $100 each, regardless of how successful the
operating activities have been.
REACQUISITION OF SHARES
Outstanding shares of a corporation can be reacquired through a purchase on the stock
market, by redeeming shares or by a retraction by the shareholders. Regardless of the
method or reacquisition, it is necessary to reduce the share capital account by the book
value of the shares reacquired.
SHARES REACQUIRED AT BOOK VALUE
When shares are reacquired at book value, the amount paid to reacquire the shares
equals the amount by which the share capital account must be reduced, and the journal
entry is very straight forward.
Using the information from the last example, New Corporation has 54,000 common
shares outstanding on November 1, 2001, and the common share account on the
balance sheet is $630,000. On March 1, 2002, New repurchased 1,500 common shares
Prepare the journal entry necessary to record the reacquisition of common shares on
March 1, 2002.
The first step is to determine the book value of the reacquired shares.
$630,000 / 54,000 shares X 1,500 shares reacquired = $17,500.
The second step is to compare the book value to the assets given up to reacquire the
Cash paid to reacquire shares $17,500
Book value 17,500
Common shares $17,500
The reacquisition of the common shares does not affect the book value of the remaining
common shares, because the reacquired shares have been removed at average book
Before reacquisition $630,000 / 54,000 = $11.67 per share
After reacquisition $612,500 / 52,500 = $11.67 per share
$630,000 - $17,500 = $612,500
54,000 - 1,500 = 52,500 shares
SHARES REACQUIRED FOR AN AMOUNT OTHER THAN BOOK VALUE
Because shares are generally reacquired at an amount equal to fair market value, the
cost is often greater, but may be less, than the book value of the shares. According to
Generally Accepted Accounting Principles, a corporation cannot create profit or loss
through issuing and reacquiring its own shares.
Shares reacquired at less than book value create Contributed Surplus. As in most cases,
the names used in accounting are descriptive of the nature of the transaction. Here equity
(also called surplus) has been contributed to the entity by spending less than the book
value of the shares.
Shares reacquired at more than book value must reduce other equity accounts besides
the share capital account. If previous transactions have created Contributed Surplus
from the reacquisition of shares, this Contributed Surplus is debited, although it cannot
ever end up with a debit balance. If there is no Contributed Surplus, or if the balance is
insufficient to absorb the entire excess of cost over book value, the debit entry is to
Retained Earnings. Essentially, the corporation is utilizing part of the profits it has
generated to reacquire shares.
Again consider New Corporation with its 54,000 common shares and $630,000 common
share account balance in the general ledger and balance sheet. On March 1, 1,800
common shares were reacquire at a cost of $18,000, or $10 per common share. On June
1, 2,400 common shares were reacquired at a cost of $ 14 per share, or $33,600.
Prepare the necessary journal entries to record both common share reacquisitions.
Cost to reacquire shares $18,000
Book value of shares $630,000 / 54,000 X 1,800 shares 21,000
Difference - creates contributed surplus 3,000
Common shares $21,000
Contributed Surplus 3,000
As a credit entry is required to balance the journal entry, the use of the Contributed
Surplus account is appropriate. The corporation has spent $18,000 to repay an original
investment of $21,000, which leaves it with equity of $3,000 attributable to the remaining
shareholders. This is never classified as a gain, as gains are reported on the income
statement. Remember a corporation cannot create income from buying back its own
Cost to reacquire shares $33,600
Book value of shares $609,000 / 52,200 X 2,400 shares 28,000
Difference - reduces contributed surplus/ retained earnings 5,600
Common shares $28,000
Contributed Surplus 3,000
Retained earnings 2,600
The corporation has spent $33,600 to repay an original investment of $28,000. In this
situation, the excess is allocated first to contributed surplus. The $3,000 underspent,
relative to book value, on the first reacquisition has been used to reacquire the next lot of
shares. The remaining excess of $2,600 reduces retained earnings. This is appropriate
because the book value does not represent the fair market value of the shares. If a
corporation operates profitably, the value of the corporation as a whole increases. If the
number of shares issued remains constant, the value of the individual shares increases
as well. The profit earned and not yet distributed as dividends appears as retained
earnings on the balance sheet. When shares are reacquired at fair market value, the
share capital account is reduced by the historical value of the shares and the increase in
value reduces retained earnings.
If these reacquisitions occurred in the opposite order, no contributed surplus would have
existed when the 2,400 shares were reacquired. The entire $5,600 excess cost would
have been recorded as a debit to retained earnings. When the 1,800 common shares
were subsequently reacquired, contributed surplus of $3,000 would have been created.
Retained earnings is never credited on a share reacquisition. The only source of retained
earnings is profits recorded on the income statement.
If a business is owned as a proprietorship or partnership, the owners are entitled to
withdraw the profits from the business, and these withdrawals are classified as drawings.
If the business is structured as a corporation, the owners still have the ability to receive
distributions of profit from the business. The distribution of these profits to the
shareholders of the corporation are called dividends.
Unlike a proprietorship, the individual shareholders do not decide the timing or amount of
the profit distributions from the business. The shareholders elect a Board of Directors,
and it is the responsibility of the Board of Directors to declare dividends. The corporation
has no legal obligation to pay dividends unless the Board of Directors declares dividends
payable. Additionally, dividends may only be declared if the corporation has sufficient
retained earnings, which is the corporation’s accumulated profit, to absorb the dividend.
DIVIDEND DECLARATION DATE
On the date that the Board of Directors meets and declares a dividend, a liability is
created. The dividends payable are recorded in the accounting records and appear as a
liability on the balance sheet on the declaration date.
DATE OF RECORD
It is very difficult to identify who the individual shareholders are on any specific date, due
to the large number of transactions and the time it takes to process the share transfer
information. A corporation will specify a date of record when declaring dividends, and all
investors recorded as shareholders on that date will receive the dividends declared. The
date or record is normally two to three weeks after the date of declaration of the dividends.
There is no accounting significance to this date, but it is an important date for investors
buying and selling shares.
DIVIDEND PAYMENT DATE
When dividends are declared, the Board of Directors specify a payment date, the date on
which the cheques will be issued. This date is usually two or three weeks after the date of
record, to allow for the shareholder records to be updated for transactions up to the date
of record. When the cheques are issued, cash is reduced as is the dividend liability.
Dividends are not an expense of doing business, they are a distribution of profits.
Accordingly, when dividends are declared there is no effect on the income statement.
Dividends are recorded on the statement of retained earnings, as a direct reduction of
retained earnings. The balance in retained earnings represents the total profits earned by
the corporation over its life time, less dividends paid to distribute profits to shareholders.
Again, the accounting terminology is descriptive - retained earnings represents the
undistributed profits of the business. Dividends should never appear on the income
statement as part of the calculation of net income.
On February 1, 2001, the Board of Directors of Highlight Ltd. declared total dividends of
$100,000 to be paid on March 10, 2001. The date of record for determining the
shareholders to receive the payments was set as February 20, 2001.
a) Prepare the necessary journal entries arising from the decision by the Board of
b) Prepare the statement of retained earnings for the year ended December 31, 2001, if
opening retained earnings was $826,496 and the income statement reported net income
Feb.1 Retained earnings $100,000
Dividends payable $100,000
to record declaration of dividends
Mar. 10 Dividends payable $100,000
b) Highlight Ltd.
Statement of Retained Earnings
for the year ended December 31, 2001
Retained earnings, beginning of year $ 826,496
Net income for the year 168,599
Dividends declared during the year 100,000
Retained earnings, end of year $ 895,095
TYPES OF DIVIDENDS
The most common types of dividends are cash dividends and stock dividends, although
other assets may be distributed to shareholders as dividends.
Cash dividends are the most straightforward to record, as a liability is created when the
dividend is declared, and cash is reduced when the dividend is paid. The preceding
example illustrates this clearly.
Stock dividends are more complex, in terms of both the conceptual issues underlying a
stock dividend and the accounting entries necessary to record the stock dividend. This
material illustrates the most basic concepts for a small stock dividend.
When a stock dividend is declared, the shareholders receive additional shares of the
corporation as their dividend. This means that a shareholder who owns 10% of a
corporation before a stock dividend will still own 10% of the corporation after the stock
dividend, but will own a greater number of shares. A stock dividend should theoretically
result in a drop in the selling price of the share proportionate to the stock dividend so that
it will cost the same total amount to purchase 10% of the shares before and after the stock
dividend. This does not occur, however, as investors appear to perceive the declaration
of a stock dividend as a positive sign that the company is doing well. Any drop in
individual share price is usually not proportionate to the stock dividend so that the investor
would receive more cash from selling all his or her shares after a stock dividend than
The proper accounting treatment of a stock dividend is to transfer the fair market value of
the stocks issued as dividends from Retained earnings to Share capital. This is the same
result as would occur if the corporation paid cash dividends to shareholders and then
issued new shares to recover the cash paid out as dividends. A stock dividend is less
costly, though, as the majority of the share issue costs can be avoided. This also explains
why the stock dividend is perceived to have value to the shareholders. The declaration of
a dividend indicates the business has been operating successfully while the need for
cash often suggests that the business has additional investment opportunities that will
improve the profitability of its operations in the future.
On March 31, 2002, Lucky Corp. declared a 5% stock dividend on its common shares,
which resulted in the issuance of an additional 80,000 common shares. On the
declaration date, the common shares were trading at 37.50 each. On May 15, 2002, the
shares were distributed to the shareholders in satisfaction of the stock dividend.
a) Prepare the necessary journal entries to record the stock dividend.
Value of the stock dividend 80,000 shares X $37.50 = $3,000,000
Mar. 31 Retained earnings 3,000,000
Stock dividend payable 3,000,000
May 15 Stock dividend payable 3,000,000
Common shares 3,000,000
ALLOCATION OF DIVIDENDS
As previously mentioned, common shares do not have a stated dividend rate, as the
common shareholders have a residual interest in the profit of the corporation and may
receive dividends of any amount from the accumulated profits of the firm. Dividends
cannot create a debit balance in retained earnings. This is a legal restriction to ensure the
corporation has sufficient assets to satisfy its creditors.
Preferred shareholders are entitled to only the stated annual dividend authorized by the
Articles of Incorporation. Again there is no legal obligation to pay the dividends unless
declared by the Board of Directors. The financial statements usually disclose the annual
dividend entitlement of the preferred shares in the notes to the financial statements. The
stated annual dividend rate may take two different forms. The dividend rate may be
stated as a fixed dollar amount per share, for example a preferred share may be entitled
to a $4 dividend per year. The dividend rate may also be stated as a percentage of the
stated or par value of the preferred share. For example, a corporation may issue
preferred shares with a stated value of $200 per share and a dividend entitlement of
3.5%. This would entitle the preferred shareholder to receive $7 per share each year, if
declared by the Board of Directors.
As noted earlier, dividends on preferred shares must be paid in full before any common
shareholder may receive dividends. Complexity is added by the existence of cumulative
preferred shares, however. The first priority when dividends are declared is the payment
of any cumulative preferred dividends that are in arrears. When cumulative preferred
dividends in arrears are paid in full, the second priority is the payment of current period
preferred dividends, and then the common dividends may be paid.
The corporation only becomes liable to pay dividends when the Board of Directors
declares dividends payable. If dividends are not declared in a particular year, the
common shareholders and the shareholders who have invested in non-cumulative
preferred shares do not receive any dividend for that year. As the dividend paid on
common shares may vary considerably from year to year, this is not a concern to the
common shareholder, as the corporation may pay a large dividend in a future year to
compensate for the current year’s lost dividend. This failure to pay does affect the owner
of the non-cumulative preferred share, however, as the annual dividend rate is fixed and
the dividend not declared during the year will not ever be received by the shareholder.
If a corporation fails to declare dividends in a particular year, and there are cumulative
preferred shares outstanding, the corporation does not record a liability for the unpaid
cumulative dividends because the obligation to pay, or liability, is not created until
dividends are declared. Undeclared cumulative dividends are referred to as dividends in
arrears. If, for any reason, there are more than one year of cumulative dividends in
arrears, the oldest dividends in arrears are paid first.
Glendale Industries has three types of shares: Class A $4 cumulative preferred shares,
stated value of $100; Class B 5%non-cumulative preferred shares, stated value of $1000;
and common shares. Glendale has 20,000 Class A preferred shares, 2,000 Class B
preferred shares, and 300,000 common shares outstanding on December 31, 2001, the
end of the current fiscal year. No shares have been issued or redeemed at any time
during the last five years. Glendale has been expanding its facilities over the last five
years, and has not declared any dividends in the three previous years 1998, 1999, and
Required: (each part of this question is independent of the other)
a) Determine the total amount of dividends to be paid to each class of shares if Glendale’s
Board of Directors declares a dividend of $2.20 per common share.
b) Determine the total amount of dividends to be paid to each class of shares if Glendale’s
Board of Directors declares total dividends of $645,000. What is the dividend per
Reading through the characteristics of the shares gives us the following information:
1) the Class A preferred shares are each entitled to a $4 annual dividend. The stated
value is relevant on windup of the corporation, but is irrelevant for the calculation of the
dividends, because the dividend is stated as a fixed dollar amount. The shares are
cumulative which means that the cumulative dividends in arrears must be paid in full
before any other dividends may be paid. No shares have been issued or reacquired
during the last five years, so there have been 20,000 Class A preferred shares
outstanding for the last five years. It is currently 2001, and no dividends were paid during
1998, 1999, and 2000, so that there are three years of dividends in arrears.
20,000 Class A preferred shares X $4 annual dividend per share = $80,000 cumulative
dividends in arrears per year.
$80,000 dividends in arrears X 3 years = $240,000 total dividends in arrears.
$20,000 dividends for 2001. (Current period dividend)
2) Class B preferred shares are non-cumulative so no dividends in arrears exist for these
shares. The dividend rate is stated as 5% so the stated value must be determined. The
stated value is given as $1,000 per share, so that the annual dividend per Class B
preferred share is 5% X $1,000 stated value = $50.
Current period dividends on Class B shares $50 per share X 2,000 shares = $100,000.
No dividends in arrears
3) There are 300,000 common shares.
Solution to Required part a):
First, if common shareholders receive dividends, all preferred dividends in arrears and
current period preferred dividends must have been paid in full first.
Class A Arrears $240,000
Current year div’s 80,000
Total dividends paid to Class A shares $ 320,000
Class B no arrears - non-cumulative
Current year div’s $ 100,000
300,000 shares X $2.20 per share $ 660,000
Total dividends paid $1,080,000
Solution to Required part b):
Total dividends paid $645,000
Class A dividends in arrears 240,000
Excess dividends available to pay current year dividends 405,000
Current period preferred dividends
Class A 80,000
Class B 100,000
Total current period dividends 180,000
Excess dividends available to common shareholders 225,000
Total dividends for each class of shares:
Class A preferred arrears $240,000
Class B no arrears - non-cumulative
Common shares $225,000
Total dividends paid $645,000
Dividend per common share:
$225,000 total common dividends / 300,000 common shares = $0.75
The dividend per common share was 75 cents.