Chapter 15

Shareholders Equity

Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology

Shareholders Equity
Corporate Share Capital Form
Corporate Types of Law shares Share capital system Limited liability of shareholders Issuance Reacquisition Retirement Retained Earnings Formality of profit distribution Types of dividends Stock splits Other Components Contributed surplus Accumulated Other comprehensive income Presentation and Perspectives Disclosure Analysis Special presentation issues

Appendix 15B Financial Reorganization

Comprehensive revaluation

Appendix 15A Par Value and Treasury Shares

Par value shares Treasury shares
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Components of Shareholders Equity Share Capital:

Common And/or Preferred shares Contributed Surplus Retained Earnings Accumulated other Comprehensive Income Contributed Capital

Earned Capital

Major Sources of Changes in Shareholders Equity

All Transactions and Events That Cause Changes in Shareholders Equity

Net Income

Transfers Between Entity and Owners

Revenues & Expenses

Gains and Losses

Investments by Owners

Distributions to Owners
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Defining Capital
Legal capital (stated capital)
the full price received for shares issued

If par value shares are issued, then legal/stated capital = par value
Par value shares are not permitted under CBCA Permitted under some provincial jurisdictions (see Appendix)

Defining Capital
Accounting definition of capital
Shareholders equity which includes:

Share capital
the legal/stated capital

Contributed surplus
equity transactions not specifically included elsewhere

Retained earnings
all undistributed income that remains invested in the business

Accumulated other comprehensive income

Cumulative change in equity due to revenues and expenses, and gains and losses from transactions not included in net income

Primary Forms of Business Organization

Proprietorship Partnership Corporation Profit-oriented Private Sector Not-for-profit Shares privately held Shares publicly traded Engaged in making financial returns for their owners

Public Sector

No shares issued; created to provide services for members or society

Municipalities, Cities, Etc. Crown Created by government statute to provide public services
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Corporate Accounting
Special characteristics that impact on accounting:
1. Corporate law 2. Share capital system 3. Limited Liability

Corporate Law

Articles of Incorporation

Corporation Recognized as Legal Entity

Corporation Charter Issued

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Corporate Law
Canada Business Corporation Act (CBCA) Articles of incorporation prepared and submitted
Company name Location of registered office Classes and authorized shares Share transfer restrictions (if any) Directors Business restrictions

CBCA regulations required financial statements be prepared in accordance with GAAP

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Share Capital System

Shares grouped by class (e.g. Class A Common) Within each class, each share equal Each share contains certain rights and privileges Ease of transfer of ownership Advantage to both issuing corporation and investor Share becomes more attractive investment
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Share Capital System

As a minimum each share has these basic or inherent rights 1. To share proportionately in profits and losses 2. The right to vote for directors 3. To share proportionately in assets upon liquidation 4. Preemptive right for any new share issues
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Share Capital
Common shares Represent basic ownership interest Represents residual ownership interest have ultimate risk of loss and benefit from success Dividends, or assets on dissolution, not guaranteed True advantage is in the right of Common Shares to ultimately control by way of voting
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Share Capital
Preferred Shares Certain inherent rights given up or exchanged for other special rights or privileges Preference given on Dividends (usually at a stated rate) Claim to assets on dissolution Preferred shares features (some or all may be attached to a preferred share Cumulative Callable/redeemable Convertible Retractable Participating

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Share Capital
Preferred Shares Features
Cumulative: Dividends in arrears must be paid before any profits can be distributed to common shareholders Convertible: The company or holder can exchange the shares for common shares at a predetermined ratio Callable/Redeemable: The issuing company can call at its option the preferred shares at specified future dates at stipulated prices Retractable: The holders can put (or sell) their shares to the company Participating: Holders can participate with common shareholders in any profit distributions 15 higher than the prescribed rate

Limited Liability
Limited Liability of Shareholders Unlike partnership or proprietorship form of business Shareholders not generally liable for the obligations of the corporation Shareholders losses restricted to Amount invested in the corporate shares

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Accounting for the Issuance of Shares

Shares basic Shares sold on a subscription basis Defaulted Subscription accounts Shares issued in combination with other securities

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Shares Issue - Basic

Full amount of proceeds received is credited to the respective share capital account (preferred/common/class type) 500 common shares are sold for $10.00 each (issuance costs not included in this transaction). The journal entry is:

Cash
Common Shares

5,000
5,000
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Shares Sold by Subscription

Shares are sold, with instalment payments Shares are not issued, and any rights are not given (e.g., voting, dividends) until the full subscription price is received Dividends may be attached to some subscription shares, once the initial payment is received

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Shares Sold by Subscription

Accounts in share subscription transaction
Shares Subscribed
Set up a separate one for each type/class of share An equity account, reported below the respective share capital account on the Balance Sheet

Subscription Receivable
Normally considered a current asset May be reported as a contra account to the Shares Subscribed account in equity section of the Balance Sheet

Share Capital
Credited only when the subscription is paid in full, or settled in some other manner, in the case of default
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Shares Sold by Subscription

If a subscription contract is defaulted there are generally three possible consequences:
Funds paid to date are refunded, often with a deduction for expenses, and the balance of the contract is cancelled Funds paid to date are forfeited transferring it to the Contributed Surplus account, with no refund or shares being issued; balance of the contract is cancelled Shares are issued for the amount paid to date, with the balance of the contract cancelled
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Shares Sold by Subscription

500 shares are sold on subscription for $20.00 each. 50% is due as initial payment. The initial journal entries would be:
Subscription Receivable Shares Subscribed Cash Subscription Receivable 5,000 5,000
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10,000 10,000

Shares Sold by Subscription

If all payments are made as scheduled, the entries would be:
Cash 5,000 Subscription Receivable Shares Subscribed Share Capital 10,000 10,000 5,000

If the subscriber defaults, one of the following may happen (depending on the contract terms and applicable legislation).

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Shares Sold by Subscription

Default after first payment funds refunded with no penalty. Shares Subscribed 10,000 5,000

Accounts Payable (or Cash)

Subscription Receivable

5,000

Default after first payment shares issued for amount paid.

Shares Subscribed
Share Capital Subscription Receivable

10,000
5,000 5,000
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Shares Sold by Subscription

Default after first payment funds held by corporation.
Shares Subscribed Subscription Receivable Contributed Surplus 10,000 5,000 5,000

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Shares Issued With Other Securities

When two or more classes of shares are sold for a lump sum Accounting problem is the allocation of the funds received to the respective share classes Two methods available Proportional method (relative market value method) Incremental method
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Accounting for Share Issue Costs

Include legal fees, accounting fees, underwriter fees & commissions, printing and mailing costs, advertising and administrative expenses of preparation CICA Handbook (Section 3610) deems these amounts to be capital transactions (rather than operating transactions) and therefore should not be included in net income calculation Accounting treatmentdebit to Share Capital
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Accounting for Share Issue Costs

Reduction of the amount paid in 1,000 shares sold for $10.00 each, with $500 in issue costs
Cash
Share Capital Share Capital

9,500
500 10,000

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Share Repurchase
Major reasons for the reacquisition of a corporations own shares
Reduce the shares outstanding to increase EPS Have enough shares on hand to meet employee share compensation contracts Buy out a particular ownership interest Meet the needs of a potential merger Stop (or slow down) takeover attempts Reduce number of shareholders Make a market in the companys shares Return cash to shareholders
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Share Repurchase
Other reasons may include:
Reduce the operations of the business Change the debt-to-equity ratio Settle a debt Provide a boost to shareholders (remaining shareholders end up with a larger portion of the entity) Fulfill the terms of a contract Satisfy a claim from a shareholder Change from a public to a private corporation
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Reacquisition of Shares
Shares may be retired when reacquired May also (in limited circumstances and jurisdictions) become Treasury Stock (see Appendix) In Canada, the CBCA requires repurchased shares be cancelled and restored to status of authorized but unissued, if a limit to authorized shares exists In either case, the accounts affected are:
Share Capital Contributed Surplus Retained Earnings Treasury Stock (for Treasury Stock only)
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Reacquisition of Shares
Share capital debited with the original issue or assigned value only The difference then allocated to equity accounts:
Contributed Surplus Retained earnings

Contributed Surplus NEVER goes to a debit balance

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Reacquisition of Shares - Retired

In January 2007, Cooke Corp. purchased and cancelled 500 Class A shares at $4 per share. There are 10,500 shares issued and outstanding, with total share capital of $63,000
Common Shares (500 [$63,000/10,500] ) 3,000 Cash (500 shares@ $4.00) 2,000 Contributed Surplus (500 @$2.00) 1,000 Assigned share value = $63,000/10,500 = $ 6.00 Acquisition cost = per share price/cost 4.00 Value over assigned value $2.00
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Items Affecting Retained Earnings

1. 2.

3. 4.

DEBITS Net loss Prior period adjustments, accounting principle changes Cash, property, stock dividends Treasury stock

CREDITS 1. Net Income 2. Prior period adjustments, accounting principle changes 3. Adjustments from financial reorganization

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Formality of Profit Distribution

No amounts may be distributed unless corporate capital is maintained intact Under the CBCA:

1. There needs to be sufficient capital after the dividend to pay liabilities as they are due 2. The realizable value of the corporate assets does not fall below the total of the liabilities and the stated and legal capital for all classes of shares
Formal approval of the Board of Directors required Dividends are in full agreement with share capital contracts Before declaration of a dividend, management should consider availability of funds to pay the dividend

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Dividend Distributions
Types of dividends 1. Return on capital Cash dividend Stock dividend 2. Return of capital Liquidating dividends 3. Important dates Date of declaration Date of record Date of payment

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Cash Dividends
First journal entry is on Date of Declaration Dividend becomes legal obligation of the corporation Equity account is debited, liability account is credited Cash Dividends Declared (or Retained Earnings) xxx Dividends Payable

xxx

On Date of Payment liability is reduced

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Cash Dividends
Before the dividend is paid, a current list of shareholders needs to be prepared (as at the date of record) If a Cash Dividends Declared account is used rather than Retained Earnings at the date of declaration, this account is closed to Retained Earnings at year end

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Dividends in Kind
Dividends payable in corporation assets other than cash These dividends are normally measured at the fair value of the asset given up Fair value is determined by referring to: estimated realizable value of same or similar assets, quoted market prices, independent appraisals

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Stock Dividends
No assets distributed (unlike cash dividends) Unlike with cash dividends or dividends in kind, total shareholders equity does not change Amounts are re-arranged as a result of the stock dividend The transaction is measured at the fair value of the shares at declaration date Each shareholder has the exact same proportionate interest in the corporation However, book value per share decreases
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Stock Dividends
1,000 common shares outstanding Retained earnings = $50,000 10% stock dividend declared Fair (market) value of share = $130 per share 13,000 13,000

Stock Dividends Declared

Common Shares 1,000 x 10% = 100 Fair value $ 130 Total $13,000

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Dividend Preferences
Example Data
$50,000 total declared as dividends Common share capital = $400,000 Preferred shares: 1,000 $6 outstanding (issued at $100,000)

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Non-cumulative
If shares are non-cumulative and non-participating Dividends are distributed only when declared, up to the stated amount of the share No amount is paid for years where dividends were not declared
Referring to previous data: Preferred Shareholders are paid $6,000 ($6 x 1000) and Common Shareholders are paid the remaining amount of $44,000
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Cumulative
If the preferred shares are cumulative and non-participating, and dividends not paid to the preferred shareholders in previous 2 years:
Preferred Shareholders are paid $18,000 ( ($6 x 1000 x 2) + $6,000) Common Shareholders are paid the remaining $32,000 ($50,000 - $18,000)
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Participating
If no specific participation agreement exists, participation generally follows these guidelines
a. Following assignment to preferred shares of current year dividends (any cumulative dividends have been allocated first); common shares receive an amount to give them the same return rate as the preferred b. Any remaining dividend amount is shared by both preferred and common in proportion to the carrying value of each share class
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Participating
If preferred shares are non-cumulative and fully participating, using the previous data: Preferred Common 1. Current years:
Preferred ($6 x 1000) Common (6% x $400,000) $6,000 $24,000

2. Remaining $20,000 at a rate of $20,000/$500,000 (i.e. 4%):

Preferred (4% x $100,000) $4,000 Common (4% x $400,000) TOTAL $10,000 $16,000 $40,000
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Stock Dividends vs. Stock Splits

Stock Dividend As form of dividend must follow the requirements of a dividend Both the number of shares, and the amount of share capital are affected Shares are not exchanged Stock Split Increases the number of shares outstanding Amount of share capital is not affected Results in a market price manipulation
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Components of Shareholders Equity

Contributed Surplus transactions Par value share issue and/or retirement Liquidating dividends Financial reorganization Stock options and warrants Issue of convertible debt Share subscriptions forfeited Donated shares Redemption or conversion of shares
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Components of Shareholders Equity

Accumulated Other Comprehensive Income Cumulative change in equity from nonshareholder transactions which are excluded from net income Considered to be earned income

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Disclosure of Share Capital

Per CICA Handbook, Section 3240, the following disclosure is required: Authorized share capital Issued share capital Changes in share capital since last balance sheet date May be disclosed in the notes to the financial statements, or in the body of the Balance Sheet
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Disclosure of Share Capital

Note disclosure will contain the following information: Authorized number of shares (if no limit, then so stated) The existence of unique rights Number of shares issued, and the amount received Whether the shares are par-value or no-par value Amount of any dividends in arrears for cumulative preferred shares Changes during the year, including new issuances and redemptions Restrictions on retained earnings 51

Shareholders Equity Ratios

1. Rate of return on common shareholders equity
Net income Preferred dividends Average common shareholders equity

2.

Payout ratio
Cash Dividends Net income Preferred dividends

3.

Price earnings ratio

Market price per share Earnings per share

4.

Book value per share

Common shareholders equity Number of outstanding shares

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International
IAS requires a separate statement for changes in all equity accounts Canadian GAAP only requires separate retained earnings statement

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COPYRIGHT
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.

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