Shareholders’ Equity

1. What are the characteristics of a common share?

2. What are the characteristics of a senior (preferred) share?

- Fixed dividend

- Senior

- Cumulative vs. non-cumulative

- Convertible

- Redeemable

- Retractable

1
3. What does it mean if a share has a “par value”?

Issue at Par Value

Issue at No Par Value

Shares may be sold on a prescription bases – receivable, Common stock adjunct

4. What are treasury shares? How are they presented on the balance sheet?

2
5. Why do companies occasionally repurchase common shares from investors?

• Boost EPS and ROCE % by increasing financial leverage

• To avoid dilution caused by employees exercising stock options

• Signalling

• Return money to shareholders

Lack of attractive investment opportunities

Tax advantages

6. What is the accounting procedure for canceling shares that have been
repurchased and cancelled? What about resale of shares from treasury?

Repurchase Price > Avg. Issue Price
Repurchase and (A) Dr to share capital, in an amount equal
Cancellation to the par or assigned value of the shares;
(B) Any excess, Dr to contributed surplus,
to the extent that contributed surplus was
created by a net excess of proceeds over
cost on previous cancellations or resale of
shares of the same class;
Repurchase Price < Avg. Issue Price
(A) Dr to share capital, in an amount
equal to the par or assigned value of the
shares;
(B) The difference, Cr to contributed
surplus.

(C) Any excess, Dr to contributed surplus

in an amount equal to the pro rata share of
the portion of contributed surplus that
arose from previous transactions, other
than those in (B) above, in the same class
of shares;

(D) Any excess, Dr to retained earnings.

Sale Price < Avg. Treasury Cost
Resale from - Any deficiency should be charged to
Treasury contributed surplus to the extent that a
previous net excess from resale or
cancellation of shares of the same class is
included therein, otherwise to retained
earnings.
Sale Price > Avg. Treasury Cost
- Where a company resells shares that it
has acquired, any excess of the proceeds
over cost should be credited to contributed
surplus

3
7. Transactions not part of normal business operations are included in equity.
– Costs of issuing shares
– Revaluation surplus (rare)
– Unrealized foreign exchange gains/losses (common)
– Dividend distributions

8. Retained earnings and dividends

– Retained earnings
= Beg. R/E + NI – Div
= Cumul NI – Cumul Div ± Other adjustments
(e.g., share repurch.)

– Dividend considerations
– Cash flow
– Future performance
– Signalling

9. Accumulated other comprehensive income

• Certain types of unrealized gains and losses are recorded in “Other

Comprehensive Income”. This is typically shown as an addition to the
income statement.
• This type of income is shown on the B/S in “Accumulated Other
Comprehensive Income”.
• These unrealized gains and losses arise from adjusting the B/S carrying
value of items such as “available for sale securities” to their fair value.
• When the gain/loss is realized it is moved from Accum. Other
Comprehensive Income into Net Income (and shown on the B/S retained
earnings).

4
10. What is a stock dividend? Why do companies declare/issue stock dividends?

11. What is a stock split? Why do companies occasionally “split” their shares?

Do questions 1,2,3

5
Question #1 Contraction of Shareholders’ Equity

Shareholders' Equity 1/1/x9

Common Stock ($1 Par Value, 1,000,000 issued and outstanding) $1,000,000

Contributed Surplus:
Type A) Re: Original issuance of shares (proceeds over par) 8,000,000
Type B) Re: Previous resales/cancellations 200,000
Type C) Re: Other sources (same class) 100,000

Retained Earnings 600,000 CR

$9,900,000

Case A: Acquired on 1/2/x9 100,000 shares and retired/cancelled

Acquisition Price: is < Issue Price; $5 is > Issue Price; $20

Cash 500,000 2,000,000
Common (Par)
Cont. S. Type A*
Cont. S. Type B
Cont. S. Type C
Retained Earnings

*Note: If the common shares had no par value, then there would be no “Type
A” contributed surplus. Thus common shares would be DR for the full
$900,000 (the average issue price). With par value shares, we also DR at the
average issue price. The only difference is that the $900,000 has to be split
between the par value and the proceeds over par.

Case B: Assume 100,000 shares held as treasury stock (acquired at $15)

Cash
Treasury Shares

Resold at: $20 $10_______

Cash 2,000,000 1,000,000
Treasury Shares
Cont. S. Type B
6
Retained Earnings
Question #2 Shareholder Equity Transactions
Milton Ltd. had the following balances in shareholders’ equity as at January 1, 2008:

Preferred shares (see * below)

$10 par value; $1 cumulative annual dividend; Redeemable at $30;
Convertible at the rate of 2 common shares for 1 preferred share;
1,000,000 authorized; 700,000 issued and outstanding……………… $ 7,000,000
Contributed surplus (initial issuance of preferred shares)…….. 10,500,000

Common shares
No par value; Unlimited number authorized; 1,200,000 issued……… 9,600,000
Contributed surplus (previous common share transactions).… 120,000

Contributed surplus – Warrants (see ** below).………………….. 200,000

Retained earnings…………………………………………………… 23,450,000

Treasury shares
320,000 common shares……………………………………………… (1,920,000)

* 2 years of preferred share dividends are in arrears as at January 1, 2008.

** 100,000 warrants are outstanding as at January 1, 2008. Each warrant allows the holder to
purchase one common share at a price of $7.

The following transactions occurred during the year ended December 31, 2008:
a. January 31st, the company resold half of the shares in treasury for $7.50 each.
b. March 27th, all 100,000 warrants were exercised and the company immediately issued
common shares in settlement of the transaction.
c. March 30th, the company repurchased (in the open market) and immediately cancelled
100,000 common shares in exchange for $860,000. This was done to offset the
dilution caused by the warrants being exercised.
d. June 1st, 175,000 preferred shares were redeemed at the specified price of $30. These
preferred shares lost rights to any dividends (current and in arrears).
e. July 13th, the company issued 250,000 common shares in exchange for some heavy
machinery. The market price of the common shares was $9 on this day.
f. August 1st, the remaining shares held in treasury were retired/cancelled.
g. November 1st, 25,000 preferred shares converted to common. These shares lost rights
to any dividends (current and in arrears). The company uses the book value method to
record share conversions.
h. December 31st, when the common shares were trading at $9.75, the company’s board
of directors approved a common stock dividend of 5% that was issued on the same
day.

7
Required:
Prepare all of the necessary journal entries for the year ended December 31,
2008.

Date Accounts/Description DR CR

1/31 Cash
Treasury shares
Contr. surplus (prev. C/S tranx.)

3/27 Cash
Contr. surplus - Warrants
Common shares

3/30 Common shares

Contr. surplus (prev. C/S tranx.)
Cash

6/1 Preferred shares (par)

Contr. surplus (initial issuance)
Retained earnings
Cash

7/13 Machinery
Common shares

8/1 Common shares

Treasury shares
Contr. surplus (prev. C/S tranx.)

11/1 Preferred shares (par)

Contr. surplus (initial issuance)
Common shares

12/31 Retained earnings (pref. dividends)

Cash

Retained earnings
Common shares

8
Supporting calculations:

1: (320,000 x 50%) x $7.50

2: $1,920,000 x 50%

3: ($9,600,000 + $900,000from warrants) / (1,200,000 + 100,000from warrants) x

100,000

4: 175,000 x $10

5: 175,000 / 700,000 x $10,500,000

6: Plug  This amount must go to R/E as you cannot draw down the
“Contributed surplus on initial issuance” any further (it is a type “A” surplus
account). Also, you cannot draw down the contributed surplus relating to the
common shares (different class of share).

7: ($9,600,000+$900,000–$807,692+$2,250,000) / (1,200,000+100,000–
100,000+250,000) x 160,000

8: This represents the remaining half of the original $1,920,000 in treasury

shares.

9: 25,000 x $10

10: 25,000 / (700,000 – 175,000redemption) x ($10,500,000 – $2,625,000redemption)

11: Remember that preferred shareholders must be satisfied in full (i.e., current
year dividends and all dividends in arrears) if a common share dividend is
declared at any point during the year.

(700,000 – 175,000 – 25,000) x $1 x 3 years

12: [1,200,000 + 100,000 – 100,000 + 250,000 – 160,000 + [2 x 25,000]] x 5% x

$9.75

9
Question #3 Shareholder Equity Transactions & Balances (Self-Study)

Year 20x8
January 1: Playa Inc. was incorporated with 10,000,000 authorized shares of no
par value common stock. The corporation issued 700,000 shares of its
common stock for a total of $1,400,000. December 31 is the fiscal
year-end.

January 1: Granted 300,000 stock options to executives. The exercise price is

$5.00 and these options vest immediately. They can be exercised from
January 1, 20x8 until July 31, 2012. The options have a clause to
adjust for any stock dividend or stock split. Using the Black-Scholes
option pricing model the value of each option is $1.50 each on January
1, 20x8.

June 30: Playa bought 200,000 shares at $3.00 per share and placed them in
treasury.

Dec. 31: Reported net income for the year was $1,300,000. Share price was
$4.50

Year 20x9
July 31: Playa bought 100,000 shares for treasury at $5.00 each.

Aug. 30: Declared and issued a 10% stock dividend on common shares. The
market price per share was $6.

Sept. 30: One third of the options were exercised when the market price was $7
per share.

Nov. 30: Sold 100,000 of the treasury shares at $8 per share.

Dec. 31: Declared and paid a dividend of $1.00 per common share.
Reported net income for the year was $1,600,000.

Required:
a. Prepare the shareholders’ equity section as at December 31, 20x8.
b. Prepare the shareholders’ equity section as at December 31, 20x9.

Note: Although not required, doing the journal entries will help in determining
the year-end balances in shareholders’ equity.

10
January 1, 20x8
DR Cash 1,400,000
CR Common shares 1,400,000

DR Stock option expense 450,000*

CR Contributed surplus – Stock options 450,000

As the options vest immediately (as opposed to over a period of a few years), the full
amount of the expense is recorded in the current year.

June 30, 20x8

DR Treasury shares 600,000
CR Cash 600,000

December 31, 20x8

DR Income Summary (various I/S accounts) 1,300,000
CR Retained earnings 1,300,000

July 31, 20x9

DR Treasury shares 500,000
CR Cash 500,000

August 30, 20x9

DR Retained Earnings 420,000*
CR Common shares 420,000

* 700,000 x 10% x $6
Note: Treasury shares are not eligible to receive cash dividends. However, they do
accrue stock dividends in order to maintain parity with shares that are issued and
outstanding. That is why we use the 700,000 (issued) in the calculation and not
400,000 (issued and outstanding  700,000 – 200,000 – 100,000).

September 30, 20x9

DR Cash 500,000**
DR Contributed surplus – Stock options 150,000***
CR Common shares 650,000

** (300,000 x 1.10) x ($5/1.10) x 1/3

*** 1/3 x $450,000

11
November 30, 20x9
DR Cash 800,000
CR Treasury shares 333,333
CR Contributed surplus – Previous C/S transactions 466,667

**** ($600,000 + $500,000)/((200,000 + 100,000) x 1.10) x 100,000

December 31, 20x9

DR Retained Earnings 650,000****
CR Cash 650,000

**** 700,000 – 200,000 – 100,000 + (70,000 – 30,000)***** + 110,000 (Stock

options) + 100,000 (Resale of treasury) x $1

***** 10% Stock dividend and corresponding increase in treasury shares

12
Required:
a. Prepare the shareholders’ equity section at December 31, 20x8.

Shareholders’ Equity at December 31, 20x8

Common Shares (10,000,000 authorized, 700,000 issued) $1,400,000

Treasury Shares (200,000 shares) (600,000)
Contributed Surplus – Stock Options (300,000) 450,000
Retained Earnings 1,300,000
$2,550,000

There are 300,000 stock options outstanding, exercisable at $5.00@, expiring on

July 31, 20x5

b. Prepare the shareholder's equity section at December 31, 20x9.

Shareholder's Equity at December 31, 20x9

Common Shares (11,000,000 authorized, 880,000 issued) $2,470,000

Treasury Shares (230,000 shares) (766,667)
Contributed Surplus – Previous C/S transactions 466,667
Contributed Surplus – Stock Options (220,000) 300,000
Retained Earnings 1,830,000
$4,300,000

There are 220,000 stock options outstanding, exercisable at $4.55@, expiring on

July 31, 2012

13