Intermediate Accounting - McGraw-Hill Education … fees, underwriter commissions, legal and accounting fees, printing costs, clerical costs, and promotional costs. These expenditures

b a c k n e x th o m e

Thomas H. BeechySchulich School of Business,

York University

Joan E. D. ConrodFaculty of Management,

Dalhousie University

PowerPoint slides by:Bruce W. MacLean,Bruce W. MacLean,

Faculty of Management,Faculty of Management,

Dalhousie UniversityDalhousie University

Copyright 1998 McGraw-Hill Ryerson Limited, Canada

Intermediate Accounting


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Chapter 14

Shareholders’ Equity


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The Corporate Form Of Organization Advantages And Disadvantages

■ The primary advantages are:

■ Limited liability.

■ Capital accumulation. frominvestors with diverse investmentobjectives are possible

■ Ease of ownership transfer. Thecontinuity, transfer, expansion, andcontraction of ownership interests.

■ Potential for an expanded equitybase. issue debt or equity securitiesto the public.

■ These disadvantages include:

■ Increased taxation. There is thepotential of double taxation forthe owner-managers ofcorporations.

■ Difficulties of control. shares areheld by a diverse group

■ Limited power of minorityshareholders. can be outvotedby the majority shareholders

■ Cost to operate. Legal andaccounting fees are generallyhigher.


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Private Vs. Public Corporations

■ Federal and provincial legislationgoverns the formation and operationof corporations; a corporation maybe formed either provincially orfederally

■ About half of the 300 Canadianpublic companies surveyed byFinancial Reporting in Canada 1995are incorporated federally. Another25% of the survey companies areincorporated in Ontario, while therest are spread among the otherprovinces

■ Canada Business Corporations Act,1975

■ Private companies have a limitednumber of shareholders(maximum of 50 by the provincialsecurities acts) and the sharescannot be publicly traded. Privatecorporations generally have ashareholders’ agreement

■ the 50% Finanncial Post list of the500 largest Canadian corporationsare private

■ Public companies are thosewhose securities, either debt orequity, are traded on stockexchanges


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Share Capital

■ Share capital, represented by sharecertificates, represent ownership in acorporation. Shares may be bought,sold, or otherwise transferred by theshareholders without the consent ofthe corporation unless there is anenforceable agreement to the contrary

■ Classes of shares

■ At least one class of shares has theright to vote, and that class receivesthe residual interest (if any) in theassets if the company is liquidated ordissolved. This class of sharesnormally is described as the commonshares

■ Preferred shares are sodesignated because they confercertain preferences, ordifferences, over common shares.

• Voting rights..

• Dividends.Cumulative,participation in dividends.

• Assets upon liquidation

• Convertibility to othersecurities.

• Guarantee. return of theirinvested amount

• Restricted shares or specialshares


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Par Value Versus No-Par Value Shares

■ While the CBCA and most provincialbusiness corporations acts prohibitthe use of par value shares, one ortwo provincial jurisdictions do allowtheir issuance.

■ Par value shares– have a designated dollar amount per

share, as stated in the articles ofincorporation and as printed on theface of the share certificates. Parvalue shares may be either commonor preferred

– less than par are issued at adiscount. above par are issued at apremium.

■ No-par shares do not carry adesignated or assigned valueper share

■ Only 7% of Canadian publiccompanies surveyed byFinancial Reporting in Canada1997 reported a par (or stated)value


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Fundamental Share Equity Concepts AndDistinctions

■ Separate legal entity. nonpersonalentity that may own assets, owe debts,and conduct operations as anindependent entity separate from eachshareholder.

• Sources of shareholders' equity. Theprimary sources of shareholders' equityare organized, accounted for, andreported separately on the balancesheet to provide useful data for financialstatement users.

• Contributed capital fromshareholders..

• Retained earnings.

• Cost-base accounting.

• Authorized share capital. Themaximum number of sharesthat can be legally issued.

• Issued share capital..

• Unissued share capitalauthorized - issued

• Outstanding share capital.issued and currently owned byshareholders.

• Treasury shares. Outstandingshares reacquired.

• Subscribed shares. Unissuedshares set aside for contracts


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EXHIBIT 14-1Example of Shareholders’ Equity Section – RoyalBank of Canada, 1997

Shareholders’ equity (inmillions of dollars)

1997 1996

Capital stock Preferred $ 1,784 $ 1,752 Common 2,907 2,876Retained earnings 5,699 4,786

$ 10,390 $ 9,414


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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 maybe recorded as a memo entry in the general journal and in the ledgeraccount by the following notation:

– Common Shares – No-par Value (Authorized: Unlimited Shares)

■ No-par Value Shares Issued for Cash. When shares are issued, ashare certificate, specifying the number of shares represented, isprepared for each shareholder. An entry reflecting the number of sharesheld by each shareholder is made in the shareholder ledger, asubsidiary ledger to the share capital account.

Th e iss uan ce o f 1 0,00 0 com mon sh ares, n o-p ar, for cash of $1 0 .20 p er sh areC as h 1 02 ,0 00 C o mmo n s hares , n o par value (10 ,0 00 sh ares) 1 02 ,0 00


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■ Shares Sold on a Subscription Basis. Prospective shareholders maysign a contract to purchase a specified number of shares on credit, withpayment due at one or more specified future dates

120 no -par common sha res o f B T C orporat ion are subscribed for at $12 by J. Doe.The total is payable in th ree ins talments of $480 each .

S tock subscrip tions receivable – common shares (D oe) 1 ,440* C ommon sha res subsc ribed , 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


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■ Default on Subscriptions. When a subscriber defaults after partialfulfilment of the subscription contract, certain complexities arise. In caseof default, the corporation may decide to (1) return all paymentsreceived to the subscriber; (2) issue shares equivalent to the numberpaid for in full, rather than the total number subscribed; or (3) keep themoneys received.

■ Non-Cash Sale of Share Capital. Corporations sometimes issue sharecapital for non-cash assets. When a corporation issues its shares fornon-cash assets or services or to settle debt, the transaction should berecorded at the fair value – but there are two fair values present, the fairvalue 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


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■ Share Issue Costs. Corporations often incur substantial expenditureswhen they issue shares in a public offering. These expenditures includeregistration fees, underwriter commissions, legal and accounting fees,printing costs, clerical costs, and promotional costs. These expendituresare called share issue costs.

– Offset method. Under this method, share issue costs are treated asa reduction of the amount received from the sale of the related sharecapital.

– Retained Earnings method. Companies will charge share issuecosts directly to retained earnings in a variation of the offsetmethod..

– Deferred charge method. Under this method, share issue costs arerecorded as a deferred charge and are then amortized over a‘reasonable’ period. All methods are found in practice, although thedeferred charge method is less common.


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Retirement Of Shares

■ Some preferred shared are retractable,which means that, at the option of theshareholder, and at a contractuallyarranged price, a company is required tobuy back its shares.

■ Other preferred shares are callable, orredeemable, which means that there arespecific buy-back provisions, at the optionof the company. In these transactions, thecompany deals directly with theshareholder.

■ However, a company can buy back any ofits shares, preferred or common, at anytime, if they are offered for sale.

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

• To increase earnings per share(EPS). EPS is the ratio obtained bydividing net income by outstandingshares. EPS increases, so shouldmarket price

• To provide cash flow to shareholdersin lieu of dividends

• To acquire shares when they appearto be undervalued.

• To buy out one or more particularshareholders and to thwart take-overbids.

• To reduce future dividend paymentsby reducing the shares outstanding.


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Retained Earnings

■ Decreases (debits):

• Net loss (including extraordinaryitems)

• Error correction (may also be a credit)

• Effect a change in accounting policyapplied retroactively (may also be acredit)

• Cash and other dividends

• Stock dividends

• Share retirement and treasury stocktransactions

• Share issue costs

■ Increases (credits):

• Net income (includingextraordinary items)

• Removal of deficit in a financialreorganization

• Unrealized appreciation ofinvestments valued at market(such as by an investmentfund)


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Appropriations And RestrictionsOf Retained Earnings

■ Appropriated retained earnings are the result of discretionarymanagement action.

■ Restricted retained earnings are the result of a legal contract orcorporate law.

• To fulfil a contractual agreement, as in the case of a debt covenantrestricting the use of retained earnings for dividends that would resultin the disbursement of assets.

• To report a discretionary appropriation made to constrain a specifiedportion of retained earnings as an aspect of financial planning.

• To report a discretionary appropriation of a specified portion ofretained earnings in anticipation of possible future losses.

• To fulfil a legal requirement, as in the case of a provincial corporatelaw requiring a restriction on retained earnings equivalent to the costof treasury stock held.


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Reporting Retained Earnings

■ 1. Beginning balance of retained earnings.

■ 2. Restatement of beginning balance for error corrections.

■ 3. Restatement of beginning balance for retroactively applied accounting changes.

■ 4. Net income or loss for the period.

■ 5. Dividends declared for the period.

■ 6. Appropriations and restrictions of retainedearnings (may alternatively be disclosed in thenotes).

■ 7. Adjustments made pursuant to a financial reorganization.

■ 8. Adjustments resulting from some share retirements.

■ 9. Ending balance of retained earnings.


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Dividends

■ A dividend is a distribution of earnings to shareholders inthe form of assets or shares. A dividend typically resultsin a credit to the account that represents the itemdistributed (cash, non-cash asset, or share capital) and adebit to retained earnings.

■ Instead of paying a dividend, the corporation may wantto:

• Conserve cash for immediate use.

• Expand, grow, and modernize by investing in new assets.

• Provide a cushion of resources to minimize the effect of arecession or various unforeseen contingencies.


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Relevant Dividend Dates

■ Date of Declaration. On this date, the corporation's board ofdirectors formally announces the dividend declaration.

■ Date of Record. . The date of record is the date on which the list ofshareholders of record is prepared. Individuals holding shares at thisdate, as shown in the corporation's shareholders' record, receive thedividend, regardless of sales or purchases of shares after this date

■ Ex-Dividend Date. Technically, the ex-dividend date is the dayfollowing the date of record

■ Date of Payment. This date is also determined by the board ofdirectors and is usually stated in the declaration. The date ofpayment typically follows the declaration date by four to six weeks


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Legality Of Dividends

■ (1) dividends may not be paid from legal capital (usuallyrepresented in the share capital accounts) withoutpermission from creditors, and

■ (2) retained earnings are available for dividends unlessthere is a contractual or statutory restriction.

■ Under the Canada Business Corporations Act, a liquiditytest must also be met: Dividends may not be declared orpaid if the result would be that the corporation becameunable to meet its liabilities as they came due, or if thedividend resulted in the realizable value of assets beingless than liabilities plus stated capital.


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Cumulative Dividend Preferences On PreferredShares

■ Cumulative preferred shares provide that dividends notdeclared in a given year accumulate at the specified rate onsuch shares.

■ This accumulated amount must be paid in full if and whendividends are declared in a later year before any dividendscan be paid on the common.

■ If cumulative preference dividends are not declared in a givenyear, they are said to have been passed and are calleddividends in arrears on the cumulative preferred shares.

■ The CICA Handbook requires that arrears of dividends forcumulative preference shares be disclosed, usually in thenotes to the financial statements.


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Property Dividends And Spin-OffsDividends with non-cash assets.

■ Property dividends or dividends inkind.

■ The property may be investments inthe securities of other companies heldby the corporation, real estate,merchandise, or any other non-cashasset designated by the B of D

■ A property dividend is recorded at thecurrent market value of the assetstransferred.

■ Book value different from its marketvalue - recognize a gain or loss ondisposal of the asset as of thedeclaration data

■ Spin-off, in which the shares ofa wholly or substantially ownedsubsidiary are distributed to theparent company's shareholders.

■ The parent company'sshareholders now directly ownthe subsidiary rather thanexercise control indirectlythrough the corporation.

■ Since a spin-off is a splitting upof a reporting entity, the spin-offis usually valued at the bookvalue of the spun off shares, notat market value.


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Liquidating Dividends

■ Distributions that are a return of the amount received when shareswere issued, rather than assets acquired through earnings, arecalled liquidating dividends. Owner's equity accounts other thanretained earnings are debited. Since such dividends reducecontributed capital, they typically require creditor approval.

■ Liquidating dividends are appropriate when there is no intention oropportunity to conserve resources for asset replacement. A miningcompany might pay such a liquidating dividend when it is exploitinga nonreplaceable asset.

■ Shareholders must be informed of the portion of any dividend thatrepresents a return of capital, since the liquidation portion of thedividend is not income to the investor and is usually not taxable asincome; it reduces the cost basis of the shares.


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Scrip Dividends

■ A corporation that has a temporary cash shortage might declare adividend to maintain a continuing dividend policy by issuing a scripdividend.

■ A scrip dividend (also called a liability dividend) occurs when theboard 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 monthsor one year) will elapse between the declaration and payment dates.In most cases, scrip dividends are declared when a corporation hassufficient retained earnings as a basis for dividends but is short ofcash.


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Accounting Issues Related To Stock Dividends

■ The two primary issues in accounting for stock dividends are thevalue that should be recognized and the timing of accountingrecognition.

■ Accountants disagree about the value that should be used inrecognizing stock dividends. The shares issued for the dividend couldbe recorded at market value, at stated (or par) value, or at some othervalue.

■ The AcSB has made no recommendation on the matter; however, theCanada Business Corporations Act requires shares to be issued atfair market value. In Ontario, on the other hand, legislation permits theboard of directors to capitalize any amount it desires. In the UnitedStates, small stock dividends (i.e., less than 20 to 25% of theoutstanding shares) must be recorded at market value, while largestock dividends are recorded only as a memo entry.


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Special Stock Dividends

■ A special stock dividend is a dividend in a share class differentfrom the class held by the recipients, such as a stock dividendconsisting of preferred shares issued to common shareholders. Inthis case, the market value of the dividend (the preferred shares)should be capitalized.

■ When a stock dividend is issued, not all shareholders may ownexactly the number of shares needed to receive whole shares. Forexample, when a firm issues a 5% stock dividend and a shareholderowns 30 shares, the shareholder is entitled to 1.5 shares (30 × 5%).When this happens, the firm may issue fractional share rights forportions of shares to which individual shareholders are entitled


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Stock Splits

■ A stock split is a change in the number of shares outstanding with nochange in the recorded capital accounts. A stock split usually increasesthe number of shares outstanding by a significant amount, such asdoubling or tripling the number of outstanding shares. The primarypurpose of a stock split is to increase the number of shares outstandingand decrease the market price per share, increase the market activity ofthe shares, reduce earnings per share.

■ In contrast, a reverse stock split decreases the number of shares. Itresults in a proportional reduction in the number of shares issued andoutstanding and an increase in the average book value per share.Reverse splits may be used to increase the market price of so-calledpenny stocks, often in preparation for a new public offering of shares. Theproportions of a reverse split can be dramatic, such as the 1-for-1,000stock split announced by Ottawa Structural Steel in 1996


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EXHIBIT 14-3Split Corporation −−−− Stock Dividend and Stock SplitCompared

Total Prior toShare Issue

After 100%StockDividend

After200% StockSplit

Initial issue 40,000 × $10 = $400,000100% stock dividend: 80,000 × $10 = $800,000*Two-for-one stock split: 80,000 × $5 = $400,000Total contributed capital 400,000 800,000* 400,000Retained earnings 450,000 50,000* 450,000Total shareholders' equity $850,000 $850,000* $850,000

*Retained earnings capitalized: 40,000 shares × $10 = $400,000;entry:

debit retained earnings, $400,000;credit contributed capital accounts, $400,000.

After the stock dividend, contributed capital equals $800,000, which is$400,000 + $400,000.Retained earnings is $450,000 − $400,000, or $50,000.


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Exhibit 14-4 Additional Contributed Capital

■ Decrease:

■ Retirement of shares at a pricegreater than average issue price todate, when previous contributedcapital has been recorded.

■ Treasury stock transactions, sharesissued below cost, when previouscontributed capital has beenrecorded.

■ In a financial restructuring (explainedin the Appendix to Chapter 15).

■ Increase:

■ Receipt of donated assets.

■ Retirement of shares at a priceless than average issue priceto date.

■ Issue of par value shares at aprice or assigned value higherthan par.

■ Treasury stock transactions,shares reissued above cost


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Other Components Of Shareholders’ Equity

■ Comprehensive revaluation of assetsand liabilities from cost to market value.Only permitted when there is:

■ Comprehensive revaluation isdiscussed more fully in Chapter 11.

■ A change in control such that thecontrolling shareholder has 90% ormore of equity interests, or

■ A financial reorganization signalling afresh start for the entity followingreceivership or bankruptcy or followinga voluntary restructuring agreementwith the corporation’s creditors andshareholders

■ Cumulative foreign currencytranslation account. This itemrepresents unrealized gains andlosses that arise from a certaintype of foreign currencyexposure.

■ Finally, life insurance and mutualfund companies, which arerequired to carry their investmentassets at market values, willreport an unrealized capitalincrement that represents thedifference between the cost andthe market value of theirinvestments


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Shareholders’ Equity Disclosure

■ Corporations must disclose the changes in their equityaccounts that take place during the year.

■ In particular, companies must disclose the changes inshare capital accounts in terms of the number of sharesissued, repurchased, and retired and the dollar amountassigned to the transactions.

■ Changes in contributed capital must be clearly disclosed.Some companies do this in a disclosure note, but manypresent a schedule or statement to demonstratecontinuity from one year to the next

Intermediate Accounting - McGraw-Hill Education … fees, underwriter commissions, legal and accounting fees, printing costs, clerical costs, and promotional costs. These expenditures

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