Shareholders’ Equity

Powerpoint slides by:

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada

Michael L. Hockenstein Commerce Department • Vanier College

Intermediate Accounting

Thomas H. BeechySchulich School of Business, York University

Joan E. D. ConrodFaculty of Management

Dalhousie University

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 14-2

Shareholders’ Equity

Chapter 14


The Corporate Form of Organization Advantages and Disadvantages

The primary advantages are:

limited liabilitycapital accumulationease of ownership transferpotential for an expanded equity base


The Corporate Form Of Organization Advantages and Disadvantages (cont.)

The disadvantages include:

increased taxationdifficulties of controllimited power of minority shareholderscost to operate


Private vs. Public Corporations

Federal and provincial legislation governs the formation and operation of corporations

A corporation may be formed either provincially or federally

About half of the 200 Canadian public companies surveyed by Financial Reporting in Canada 2000 are incorporated federally


Private vs. Public Corporations (cont.) Private companies have a limited number of

shareholders (maximum of 50 by the provincial securities acts) and the shares cannot be publicly traded

Private corporations generally have a shareholders’ agreement that describes the way in which shares can be transferred

Approximately 50% of the corporations on the Financial Post list of the 500 largest Canadian corporations are private


Private vs. Public Corporations (cont.)

Public companies: companies whose securities, either debt or equity, are traded on stock exchanges

Private placement: issuing financial instruments to a single buyer or a syndicate of buyers; not made available to the public; benefits include the ability to modify terms to address specific investor needs and to avoid requirements imposed by securities regulators (OSC, SEC, etc.)


Share Capital Share capital, represented by share certificates,

represent ownership in a corporation Shares may be bought, sold, or otherwise transferred

by the shareholders without the consent of the corporation unless there is an enforceable agreement to the contrary

At least one class of shares has the right to vote, and that class receives the residual interest (if any) in the assets if the company is liquidated or dissolved

This class of shares normally is described as the common shares


Share Capital (cont.) Preferred shares are so designated because they

confer certain preferences, or differences, over common shares

Preference may involve one of the following:voting rightsdividends

- cumulative- participating

assets upon liquidationconvertibility to other securitiesguarantee


Par Value versus No-Par Value Shares

While the CBCA and most provincial business corporations acts prohibit the use of par value shares, one or two provincial jurisdictions do allow their issuance

Par value shares: have a designated dollar amount per share, as stated in the articles of incorporation and as printed on the face of the share certificates

Premiums and discounts are recognized and recorded in separate equity accounts


Par Value versus No-Par Value Shares (cont.)

No-par shares do not carry a designated or assigned value per share

The entire amount of proceeds received by the company is credited to share capital


Fundamental Share Equity Concepts and Distinctions

The fundamental concepts that underlie the accounting and reporting of shareholders’ equity may be summarized as follows:separate legal entitysources of shareholders' equitycost-base accountingno impact on income


Fundamental Share Equity Concepts and Distinctions (cont.)

Authorized share capital: the maximum number of shares that can be legally issued

Issued share capital: the number of shares that have been issued to shareholders to date

Unissued share capital: the number of shares of authorized share capital that have not been issued when there is a limit on the number of authorized shares, that is, the difference between authorized and issued shares


Fundamental Share Equity Concepts and Distinctions (cont.)

Outstanding share capital: issued and currently owned by shareholders

Treasury shares: outstanding shares reacquired

Subscribed shares: unissued shares set aside to meet subscription contracts


Exhibit 14-1


Accounting for Share Capital at Issuance

Authorization: the articles of incorporation will authorize an unlimited (or, less frequently, a limited) number of shares

This authorization may be recorded as a memo entry in the general journal and in the ledger account by the following notation:common shares – no-par value

(authorized: unlimited shares)


Accounting for Share Capital at Issuance (cont.)

No-par Value Shares Issued for Cash: when shares are issued, a share certificate, specifying the number of shares represented, is prepared for each shareholder

An entry reflecting the number of shares held by each shareholder is made in the shareholder ledger, a subsidiary ledger to the share capital account

The issuance of 10,000 common shares, no-par, for cash of $10.20 per shareCash 102,000 Common shares, no par value (10,000 shares) 102,000


Accounting for Share Capital at Issuance (cont.) Shares Sold on a Subscription Basis: Prospective

shareholders may sign a contract to purchase a specified number of shares on credit, with payment due at one or more specified future dates

120 no-par common shares of BT Corporation are subscribed for at $12 by J. Doe.The total is payable in three instalments of $480 each.

Stock subscriptions receivable – common shares (Doe) 1,440* Common shares subscribed, no-par (120 shares) 1,440

To record the collection:Cash 480 Stock subscriptions receivable – common shares (Doe) 480

To record issuance of shares:Common shares subscribed, no-par (120 shares) 1,440 Common shares, no-par (120 shares) 1,440



Default on Subscriptions: When a subscriber defaults after partial fulfilment of the subscription contract, certain complexities arise

In case of default, the corporation may decide to (1) return all payments received to the subscriber (2) issue shares equivalent to the number paid for

in full, rather than the total number subscribed (3) keep the moneys received.



Non-Cash Sale of Share Capital: Corporations sometimes issue share capital for non-cash assets

When a corporation issues its shares for non-cash assets or services or to settle debt, the transaction should be recorded at the fair value–but there are two fair values present the fair value of the asset received, and the fair value of the shares issued



To illustrate, assume that Bronex Corp. issued 136,000 Class A shares inexchange for land. The land was appraised at $420,000, while the shares,based on the one prior transaction in the shares, were valued at $450,000.The board of directors passed a motion approving the issuance of sharesto be valued at the average of these two prices, $435,000.

Land 435,000Class A share capital (136,000 shares) 435,000



Basket Sales of Share Capital: a corporation sells two or more classes for one lump-sum amount (often referred to as a basket sale)

Two methods used in such situations are: the proportional method, in which the lump

sum received is allocated proportionately among the classes of shares on the basis of the relative market value of each security


Accounting For Share Capital At Issuance (cont.)

the incremental method, in which the market value of one security is used as a basis for that security and the remainder of the lump sum is allocated to the other class of security

- when there is no market value for any

of the issued securities, proceeds may

be allocated arbitrarily



Share Issue Costs: costs corporations incur when they issue shares in a public offering, e.g., registration fees, underwriter commissions, legal and accounting fees, printing costs, clerical costs, and promotional costs



Two methods of accounting for share issue costs are found in practice:

offset method: share issue costs are treated as a reduction of the amount received from the sale of the related share capital

retained earnings method: share issue costs are charged directly to retained earnings in a variation of the offset method


Retirement of Shares Some preferred shared are retractable, which

means that, at the option of the shareholder, and at a contractually arranged price, a company is required to buy back its shares.

Other preferred shares are callable, or redeemable, which means that there are specific buy-back provisions, at the option of the company

A company can buy back any of its shares, preferred or common, at any time, if they are offered for sale

Such a sale can be a private transaction, or a public (stock market) transaction


Retirement of Shares (cont.) A company may retire shares for the following

reasons:

to increase earnings per share

to provide cash flow to shareholders in lieu of dividends

to acquire shares when they appear to be undervalued

to buy out one or more particular shareholders and to thwart take-over bids

to reduce future dividend payments by reducing the shares outstanding


Retirement of Shares (cont.)

When shares are purchased and immediately retired, all capital items relating to the specific shares are removed from the accounts

If cumulative preferred shares are retired, and there are dividends in arrears, such dividends are paid and charged to retained earnings in the normal manner


Retirement of Shares (cont.) Where the reacquisition cost of the acquired shares is

different from the average original issuance price, the CICA Handbook recommends that the cost be allocated as follows for no-par shares:

Reacquisition cost is higher than the average price per share issued to date, the cost should be charged in this sequence: to share capital at the average price per issued

share to any contributed capital that was created by

earlier treasury stock transactions in the same class of shares

any remaining amount to retained earnings


Retirement of Shares (cont.)

Reacquisition cost is lower than the average price per share issued to date, the cost should be charged: to share capital at the average price per issued

shareany remaining amount to contributed capital

The effect of these rules is to ensure that a corporation records no income effect (i.e., no gain or loss on the income statement) on buying back its own shares


Treasury Stock

A firm may also buy its own shares and hold them for eventual resale

Such shares may not vote at shareholder meetings or receive dividends

The Canada Business Corporations Act (and provincial legislation modelled after the act) provides that corporations that reacquire their own shares must immediately retire those shares


Retained Earnings

Retained earnings represent accumulated net income or net loss (including all gains and losses), error corrections, and retroactive changes in accounting policy, if any, less accumulated cash dividends, property dividends, stock dividends, and other amounts transferred to contributed capital accounts


Retained Earnings (cont.)

The following items affect retained earnings: Decreases (debits):

net loss (including extraordinary items)error correction (may also be a credit)affect a change in accounting policy applied

retroactively (may also be a credit)cash and other dividendsstock dividendsshare retirement and treasury stock transactionsshare issue costs


Retained Earnings (cont.)

Increases (credits):net income (including extraordinary items) removal of deficit in a financial reorganizationunrealized appreciation of investments valued at

market (such as by an investment fund)


Appropriations and Restrictions of Retained Earnings

Appropriated retained earnings are the result of discretionary management action

Restricted retained earnings are the result of a legal contract or corporate law

The following are examples of some of the ways in which appropriations and restrictions may arise: to fulfil a contractual agreement, as in the case of

a debt covenant restricting the use of retained earnings for dividends that would result in the disbursement of assets


Appropriations and Restrictions of Retained Earnings (cont.)

to fulfil a contractual agreement, as in the case of a debt covenant restricting the use of retained earnings for dividends that would result in the disbursement of assets

to report a discretionary appropriation made to constrain a specified portion of retained earnings as an aspect of financial planning

to report a discretionary appropriation of a specified portion of retained earnings in anticipation of possible future losses


Reporting Retained Earnings

The statement of retained earnings may include the following:beginning balance of retained earningsrestatement of beginning balance for error

correctionsrestatement of beginning balance for

retroactively applied accounting changesnet income or loss for the period


Reporting Retained Earnings (cont.)

dividends declared for the periodappropriations and restrictions of retained

earnings (may alternatively be disclosed in the notes)

adjustments made pursuant to a financial reorganization

adjustments resulting from some share retirements

ending balance of retained earnings


Exhibit 14-2


Exhibit 14-2 (cont.)


Dividends

A dividend is a distribution of earnings to shareholders in the form of assets or shares

A dividend typically results in a credit to the account that represents the item distributed (cash, non-cash asset, or share capital) and a debit to retained earnings


Relevant Dividend Dates

Date of Declaration: the date the corporation's board of directors formally announces the dividend declaration

Date of Record: the date on which the list of shareholders of record is prepared individuals holding shares at this date, as shown

in the corporation's shareholders' record, receive the dividend, regardless of sales or purchases of shares after this date


Relevant Dividend Dates (cont.)

Ex-Dividend Date: the day following the date of record

Date of Payment: the actual day of the payment of the dividend the date of payment typically follows the

declaration date by four to six weeks


Legality of Dividends

The following two provisions must be present for dividends to be declared: dividends may not be paid from legal capital

(usually represented in the share capital accounts) without permission from creditors

retained earnings are available for dividends unless there is a contractual or statutory restriction


Legality of Dividends (cont.)

Under the Canada Business Corporations Act, a liquidity test must also be met

Dividends may not be declared or paid if the result would be that the corporation became unable to meet its liabilities as they came due, or if the dividend resulted in the realizable value of assets being less than liabilities plus stated capital


Cumulative Dividend Preferences on Preferred Shares

Cumulative preferred shares provide that dividends not declared in a given year accumulate at the specified rate on such shares

This accumulated amount must be paid in full if and when dividends are declared in a later year before any dividends can be paid on the common


Cumulative Dividend Preferences on Preferred Shares (cont.)

If cumulative preference dividends are not declared in a given year, they are said to have been passed and are called dividends in arrears on the cumulative preferred shares

The CICA Handbook requires that arrears of dividends for cumulative preference shares be disclosed, usually in the notes to the financial statements


Participating Dividends

Participating preferred shares provide that the preferred shareholders participate above the stated preferential rate on a pro rata basis in dividend declarations with the common shareholders first, preferred shareholders receive their

preference ratesecond, the common shareholders receive a

specified matching dividend then, if the total declared dividend is larger than

these two amounts, the excess is divided on a pro rata basis between the two share classes


Property Dividends and Spin-Offs

Property dividends or dividends in kind: payment of a dividend with non cash assets

The property may be investments in the securities of other companies held by the corporation, real estate, merchandise, or any other non-cash asset designated by the board of directors

A property dividend is recorded at the current market value of the assets transferred


Property Dividends and Spin-Offs (cont.)

Spin-off: the shares of a wholly or substantially owned subsidiary are distributed to the parent company's shareholders

The parent company's shareholders now directly own the subsidiary rather than exercise control indirectly through the corporation

Since a spin-off is a splitting up of a reporting entity, the spin-off is usually valued at the book value of the spun off shares, not at market value


Liquidating Dividends

Liquidating dividends: distributions that are a return of the amount received when shares were issued, rather than assets acquired through earnings

Liquidating dividends are appropriate when there is no intention or opportunity to conserve resources for asset replacement

A mining company might pay such a liquidating dividend when it is exploiting a non-replaceable asset


Scrip Dividends

A corporation that has a temporary cash shortage might declare a dividend to maintain a continuing dividend policy by issuing a scrip dividend

A scrip dividend (also called a liability dividend) occurs when the board of directors declares a dividend and issues promissory notes, called scrip, to the shareholders

This declaration means that a relatively long time (e.g., six months or one year) will elapse between the declaration and payment dates


Stock Dividends

Ordinary stock dividend: a stock dividend is of the same class as that held by the recipients

Special stock dividend: a stock dividend is of a class of share capital other than the one already held by the recipients is issued (e.g., preferred shares issued to the owners of common)


Stock Dividends (cont.)

A stock dividend: a proportional distribution to shareholders of additional common or preferred shares of the corporation

A stock dividend does not change the assets, liabilities, or total shareholders' equity of the issuing corporation

It does not change the proportionate ownership of any shareholder

It simply increases the number of shares



Numerous reasons exist for a company to issue a stock dividend: to reveal that the firm plans to permanently

retain a portion of earnings in the business to increase the number of shares outstanding,

which reduces the market price per share and which, in turn, tends to increase trading of shares in the market

to continue dividend distributions without disbursing assets (usually cash) that may be needed for operations



stock dividends do not subject the shareholders to income tax

shareholders may actually prefer to receive stock dividends because they can sell these additional shares only if they choose to do so


Accounting Issues Related to Stock Dividends

The two primary issues in accounting for stock dividends are the value that should be recognized and the timing of accounting recognition.

Accountants disagree about the value that should be used in recognizing stock dividends

The shares issued for the dividend could be recorded at market value, at stated (or par) value, or at some other value


Accounting Issues Related to Stock Dividends (cont.)

The AcSB has made no recommendation on the matter

The Canada Business Corporations Act requires shares to be issued at fair market value

In Ontario, legislation permits the board of directors to capitalize any amount it desires


Special Stock Dividends

A special stock dividend: a dividend in a share class different from the class held by the recipients, e.g., such as a stock dividend consisting of preferred shares issued to common shareholders

In this case, the market value of the dividend (the preferred shares) should be capitalized


Stock Splits A stock split: change in the number of shares

outstanding with no change in the recorded capital accounts

A stock split usually increases the number of shares outstanding by a significant amount, such as doubling or tripling the number of outstanding shares

The primary purpose of a stock split is to increase the number of shares outstanding and decrease the market price per share, increase the market activity of the shares, reduce earnings per share


Stock Splits (cont.)

A reverse stock split results in a proportional reduction in the number of shares issued and outstanding and an increase in the average book value per share

Reverse splits may be used to increase the market price of so-called penny stocks, often in preparation for a new public offering of shares


Exhibit 14-4


Other Components of Shareholders’ Equity

Comprehensive revaluation of assets and liabilities from cost to market value is only permitted when there is:a change in control such that the controlling

shareholder has 90% or more of equity interests

a financial reorganization signalling a fresh start for the entity following receivership or bankruptcy or following a voluntary restructuring agreement with the corporation’s creditors and shareholders


Other Components of Shareholders’ Equity (cont.)

Cumulative foreign currency translation account: unrealized gains and losses that arise from a certain type of foreign currency exposure

Life insurance and mutual fund companies, which are required to carry their investment assets at market values, will report an unrealized capital increment that represents the difference between the cost and the market value of their investments


Shareholders’ Equity Disclosure Corporations must disclose the items and

conditions of all class shares Companies must disclose the changes in

share capital accounts in terms of the number of shares issued, repurchased, and retired and the dollar amount assigned to the transactions

Corporations must disclose the changes in their equity accounts that take place during the year


Shareholders’ Equity Disclosure (cont.)

Changes in contributed capital must be clearly disclosed

Some companies do this in a disclosure note, but many present a schedule or statement to demonstrate continuity from one year to the next


Exhibit 14-5


Exhibit 14-5 (cont.)

Documents

Shareholders’ Equity