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Chapter: Owners‘ Equity
Corporate form of business:Reporting on shareholders‘ equity
profit distribution, reserves, retained earningswrite-down of capital
issues and purchase of own shares
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The corporate form of organization
The corporation is „an artificial being, invisible, intangible, and existing only in contemplation of law.“ (John Marshall, U.S. Chief Justice, 1819)
Characteristics that distinguish corporations from soletraders and partnerships:
� separate legal entity� limited liability of shareholders� transferable ownership rights� ability to acquire capital� indefinite life time� board structure of corporate management
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Corporate organization chart
Stockholders
Board ofDirectors
President
Corporate Vice President Vice President Vice President Vice PresidentSecretary Marketing Finance Production Personnel
Treasurer Controller
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Ownership rights of shareholders (ordinaryshares)Each share represents� a claim to a specified fraction of profits and losses� a claim to a specified fraction of corporate net assets u pon
liquidation� equal rights to control Management (voting rights)� to share proportionately in any new issues of shares of t he
same class (preemptive right)� can be dropped by shareholder approval, e.g.
• for issues to be granted to employees (incl. Management)• if convertible bonds are issued
Other classes of shares1. Preferred stock2. Shares with differential voting rights
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Corporate Capital
� Share capital (paid-in capital)� par value of the shares issued by the corporation,
contribution by shareholders
� Share premium (additional paid-in capital)� any excess proceeds from share issues
contributions by shareholders above par value� different notation in use by different corporations (see box
below)
� Retained profits� accumulated net income not distributed to owners
Company Name for share premium
AT&T additional paid-in capital PepsiCo capital in excess of par valueCoca-Cola capital surplus Qualcomm paid-in capitalMcDonald's additional paid-in capital Motorola additional paid-in capital
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Significance of par value
� share capital is the permanent capital of a company � can be returned to shareholders only under restrictive con ditions� similar purpose: non-distributable reserves (legal or s tatutory)
� shares issued „partly paid“ or at discount to par value� 25% of par value must be paid in on incorporation
Historical note:In the U.S., par value used to be $ 100 in the early 1900 s, now it‘s common to have par values of $1, $5, or $10, resp., but sometimeslower than that.
$ 2,50$ 1,25$ 1,00$ 0,0167$ 0,01$ 0,0001
Eastman KodakIBMFord Motor CompanyPepsiCoAmerica OnlineQualcomm
Par value of shareCompany
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Accounting for share issues
1. Issuance of shares for cashCompany Stock issues 100.000 shares with par value of € 10 at a price of € 12.
2. Issuance of shares for services or noncash assetsAttorney Jim Sleezy has helped Babel Company incorpora te. He billed the company € 5.000 for his services. Jim agr ees to receive 400 shares of € 10 par value. There is no activ e tradingof shares.
Issuance of shares on fully-paid basis
Cash 1.200.000Share capital (at par) 1.000.000Share premium 200.000
Issuance of shares to attorney
Organization expense 5.000Share capital (at par) 4.000Share premium 1.000
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Accounting for share issues
� issuing shares vs. transferring shares (registered share s)
� registered shares vs. bearer shares
Share issuance Share transfer / tradingShares
Investor A Investor A Investor BCash
Cash Shares
Company Company
Notification ofownership
change
Source: Sutton, p.364
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Payment of dividends
� dividend policy depends on a number of factors, e.g. currentcash position, dividends in prior years, (type of shar eholders), share buyback programs
� Why not pay dividends in amounts equal to retained earnings?� bond covenants require to retain a portion of earnings as
additional protection� desire to retain assets to finance growth
example: Toys ‘R‘ Us, Microsoft and other internet com panies arefast-growing companies. They adopted zero-dividend poli cies to reinvest earnings to support growth.
� desire to smooth out dividend paymentsexample: Eastman Kodak Company, has increased its div idendseach year since 1977. However, as a percentage of net i ncome, dividend payments accounted for 40 to over 100%.
? AT&T consistently declares dividends of about 30-40 percent of net income. Delta Air Lines only pays dividends of about 2 percent of net income, and Cisco Systems has never paid a dividend. Does this mean that AT&T is a better investmentthan Delta and Cisco? Explain and briefly discuss dividend policies.
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Payment of dividends
� Financial condition and dividend distribution:
� Types of dividends� cash dividends� property dividends (dividends in kind)� share dividends
Balance Sheet
Accounts receivable 60.000 Liabilities 200.000Inventory 100.000 Share capital 300.000Plant assets 520.000 Retained earnings 180.000
680.000 680.000
Balance Sheet
Cash 80.000 Current liabilities 50.000Inventory 100.000 Share capital 400.000Plant assets 500.000 Retained earnings 230.000
680.000 680.000
Ability to pay a cash dividenddoes not seemto be given in both cases!
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Cash dividends
� most popular form of dividends� different presentation in EU and US, resp.
A typical dividend announcement reads as follows:The board of directors of EnjoyD Corporation, at its reg ularmeeting of April 1, 2004, declared a quarterly dividen d of $ 7 per share, payable on April 22, 2004, to stockholder s of recordon April 10, 2004.
date of date of date ofdeclaration record payment
board of directors declares shareholders holding shares dividend is paid todividend and liability is at this date receive the shareholdersestablished dividend when paid of record
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Cash dividends
Journal entries to record announcement and payment of dividends:
Date of declarationApril 1 Retained income 350.000
Dividends payable 350.000To record the announcement of dividends to be
paid on April 22 to shareholders of record
as of April 10
Date of paymentApril 22 Dividends payable 350.000
Cash 350.000To pay dividends declared April 1 to
shareholders of record as of April 10
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Cash dividends – presentation of shareholders‘ equity
Facts : EnjoyD issued 50.000 shares with par value € 10 at a price of € 16. Itreports net income in year 1 of € 80.000 and net assets at the end of the yearof € 880.000. No dividend is paid out of year 1 income. In year 2 it reports netincome of € 200.000. The directors propose a dividend of € 2 a share (50.000 shares) in March year 3 when the year 2 results are published. The year 2 accounts and proposed dividend are approved by shareholders at the annualgeneral meeting in May year 3.
year 1 year 3year 2
IPO:50.000 @
16Net income:
80.000Net income:
200.000
March May
Dividendsdeclared:100.000
Dividendsapproved
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Cash dividends – presentation of shareholders‘ equity
Shareholders' equityEnd- End-
year 2 year 1
Format 1 Share capital 500 500(Dominant Share premium 300 300 in EU) Profit retained 80 0
Profit for the year 200 801.080 880
Format 2 Share capital 500 500(UK and Share premium 300 300 Ireland) Profit and loss account 180 * 80
980 880
Format 3 Common stock 500 500(USA) Additional paid-in capital 300 300
Retained earnings 280** 801.080 880
* Retained profits of years 1 and 2, after deducting proposed year 2 dividend of 100. Dividend payable of 100 shown as current liability in year 2 balance sheet.
** Dividend not declared at balance sheet date.
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Non-cash dividends
1. Property dividends (dividends in kind)� can be merchandise, real estate, or investments (shares of
other companies)� recorded at fair value of non-cash assets distributed, recognize
any gain or loss
Example:Ban Corp. holds 200.000 shares of Nab Corp. as an inves tment(original cost: € 2 per share). It decides to transfe r to shareholders 100.000 shares costing € 200.000 by declar ing a property dividend on December 29, 2003, to be distribut ed on January 31, 2004, to shareholders of record on January , 15, 2004. When the board of directors announces the propertydividend, shares of Nab Corp. are quoted at € 4 per sh are.
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Non-cash dividendsAt date of declaration (December 29, 2003)
Investment in Securities 200.000 Gain on Appreciation of Securities 200.000
Retained profits 400.000 Property Dividends Payable 400.000
At date of distribution (January 20, 2004)
Property Dividends Payable 400.000 Investment in Securities 400.000
An example from the real world: DuPont once held a 23% share interest in General Motors. The U.S. Supreme Court ruled that this constituted a violationof antitrust laws. DuPont was ordered to divest itself of the GM shares within10 years. The shares represented 63 million of GM‘s 281 million shares thenoutstanding. Neither selling all at once nor selling them in blocks over 10 yearswas possible due to the fact that the yearly trading volume of GM shares was just 6 million. DuPont distributed its GM shares as a property dividend to itsown shareholders.
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Non-cash dividends
2. Share dividends� offered to continue dividend „payments“ but to avoid cas h
outflow� recorded at par value in EU but at fair value in US
Example: EnjoyD had issued 50.000 shares with par value € 10. Now theyissue 5.000 additional shares (10% share dividend). Th e market priceis € 18 when the dividend is declared.
Share dividend: EU practice
Retained profits 50.000 Share capital 50.000
Share dividend: US practice
Retained earnings 90.000 Common stock 50.000 Additional paid-in capital 40.000
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Share splits
Why splitting shares?� market price per share above a certain level� wider share ownership� empirical evidence: share prices increase after announce ment
of share splits
Accounting treatment:� no accounts are adjusted� memorandum note to indicate change in par value and numb er
of shares
Why consolidating shares?� consolidating shares is the opposite of a share split� to avoid delisting, speculation
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Transfer of profits to reserve
� status of profits changes:distributable (retained earnings) ���� undistributable(reserves)� legal requirements or voluntary reserves� protection of creditors� EU: establishing a legal reserve expressed as a percen tage
of share capital
Example : Assume a company must transfer 5% of itsannual after-tax profits to a legal reserve (until a certain level is reached). Secure Corp. recorded an after-tax profit of € 100.000 in 2003.
To record transfer of profits to legal reserve
Profit for year 2003 5.000 Legal reserve 5.000
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Purchase of own shares
Why repurchasing own shares?� only very few investment opportunities available� to increase earnings per share and return on equity� to prevent takeover attempts
Example: some time ago CBS blocked a takeover attempt by Turner Broadcasting Systems Inc. by repurchasing a substantia l portion of itsoutstanding common stock
� provide shares for employee share option plan� to make market in the stock
Quote: “It‘s a simple formula: announce plans for a $ 3.5 billion stock buyback...watch the stock soar. It worked for IBM.“ (Busi ness Week, 12 May 1997)
� shares are undervalued� to increase financial leverage
Cancelled shares vs. shares held in treasury
Certain restrictions apply for buyback of shares.
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Purchase of own shares
Case study: Reebok� in late 1996, Reebok bought back nearly 1/3 of its
outstanding shares� serious reduction in cash� management stated, repurchase is a reaction to the
undervalued shares and should signal good futureearnings
What did critics say?� repurchase to block possible takeover attempts� repurchase to save jobs (the top managers‘ jobs...)
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Purchase of own shares
1. Shares held in treasury� repurchase usually recorded at cost� shares held in treasury are not an asset / gains from sale of
treasury shares are not incomeExample : EnjoyD buys back 10.000 shares at € 18 per share.
Example : EnjoyD sells the 10.000 treasury shares at € 20 per share.
To record repurchase of shares held in treasury
Treasury shares 180.000 Cash 180.000
To record sale of shares held in treasury
Cash 200.000 Treasury shares 180.000 Share premium from treasury shares _20.000
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Purchase of own shares
2. Cancelled shares� repurchasing and cancelling shares usually reduces share
capital (and share premium)
Example : EnjoyD repurchases 10.000 shares at € 18 and retiresthem.
To maintain the company‘s capital, a reserve for own sha rescan/must be recorded:
To record repurchase and cancellation of shares
Share capital 100.000Share premium 60.000Retained profit 20.000 Cash 180.000
Retained profits 160.000 Reserve for own shares 160.000
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Capital write-down
� If a company has accumulated large losses� upon shareholders‘ approval (general meeting) capital m ay
be written down
� Example: FlopCo‘s Balance sheet
� Journal entries for write-down
Current assets 100 Current debt 120Fixed assets 400 Long term debt 200Accumulated losses120 Share capital 100
share premium 200
Dr. Share capital 40share premium 80
cr. Accumulated losses 120
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Convertible Bonds and Warrants
� A Convertible Bond may be exchanged into a predetermined number of shares of the issuingcompany at the initiative of the bondholder during a specified time span to maturity
� A warrant may be attached to a straight bond thatrepresents the option to buy a specified number of shares of the issuing company at a prespecifiedprice during a specified period of time
� Convertible bonds and bonds with warrants use to have a lower stated interest rate� the present value of the interest benefit is equity capital that
is granted to the bondholder when (s)he exercises theoption or converts the bond, respectively.
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Accounting Treatment
� Example: 5 year convertible bond, €1 million, par� convertible first at the beginning of year 5 until maturi ty� stated annual interest rate 3%� straight debt would yield 8% annual interest� € 1000 of the bond may be converted into 50 shares of the
issuing company, par value € 1,-- each.
� Calculation of the equity component:� Present value of 3% interest for 5 years� + present value of repayment � = liability component of convertible bond
� Amount received at issue date� – Liability component � = equity component
discount rate 8%
1 000 000779 947220.053
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000.305
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=+= ∑=t
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Journal entries
� Issue date:� Dr.: Cash 1 000 000� Dr.: bond discount: 220 053� Cr.: Conv. Bonds payable 1 000 000� Cr.: equity component of conv bond 220 053
� Assume half of the bonds are converted beginning of year 5 .
� Carrying value of bond:� unamortized discount:
� Journal entries: � Dr.: Conv. Bonds payable 500 000� Dr.: Equity component of CB 110.026,5� Cr.: Bond discount 23.148� Cr.: Share capital: 500·50 shares @ 1,-- = 25 000� Cr.: Share premium 561.878,5
46.296704.953
08,1
000.030.1 ==L