15 SHAREHOLDERS’ EQUITY After studying this chapter, you should be able to: Discuss the characteristics of the corporate form of organization, rights of shareholders, and different types of shares. Explain how to account for the issuance, reacquisition, and retirement of shares, stock splits, and dividend distribution. Understand the components of shareholders’ equity and how they are presented. Understand capital disclosure requirements. Calculate and interpret key ratios relating to equity. Identify the major differences in accounting between ASPE and IFRS, and what changes are expected in the near future.

Shareholders’ Equity Understanding the Corporate Form, Share Capital and Profit Distribution Corporate law and the share capital system Types of shares Limited liability of shareholders Formality of profit distribution Recognition, Derecognition, and Measurement Issuance of shares Reacquisition and retirement of shares Dividends Presentation, Disclosure, and Analysis Components of shareholders’ equity Capital disclosures Analysis IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking Ahead

Primary Forms of Business Organization Proprietorship Partnership Corporation Profit-oriented Engaged in making financial returns for their owners Shares publicly traded Shares privately held Private Sector Public Sector Not-for-profit No shares issued; created to provide services for members or society L01 Crown Created by government statute to provide public services Municipalities, Cities, Etc.

Corporate Law Articles of Incorporation Corporation Charter Issued Corporation Recognized as Legal Entity

Corporate Law The Canada Business Corporation Act (CBCA) is a relevant business corporation act Provincial business corporation acts also exist but vary from province to province Articles of incorporation prepared and submitted Company name Location of registered office Classes and authorized shares Share transfer restrictions (if any) Directors Business restrictions L01

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 L01

Share Capital System As a minimum each share has these basic or inherent rights To share proportionately in profits and losses The right to vote for directors To share proportionately in assets upon liquidation Preemptive right for any new share issues can also be assigned under CBCA L01

Types of Shares Common Shares Represent basic ownership interest Represents residual ownership interest - have ultimate risk of loss and benefit from success Dividends or assets on dissolution are not guaranteed True advantage is in the right of Common Shares to ultimately control by way of voting L01

Types of Shares 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 L01

Types of Shares 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 higher than the prescribed rate L01

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 the amount invested in the corporate shares L01

Formality of Profit Distribution No amounts may be distributed unless corporate capital is maintained intact Under the CBCA: There needs to be sufficient capital after the dividend to pay liabilities as they are due 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 must be in full agreement with share capital contracts Before declaration of a dividend, management should consider availability of funds to pay the dividend L01

Shareholders’ Equity Understanding the Corporate Form, Share Capital and Profit Distribution Corporate law and the share capital system Types of shares Limited liability of shareholders Formality of profit distribution Recognition, Derecognition, and Measurement Issuance of shares Reacquisition and retirement of shares Dividends Presentation, Disclosure, and Analysis Components of shareholders’ equity Capital disclosures Analysis IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking Ahead

Share 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: L02 Cash 5,000 Common Shares 5,000

Shares Sold on a Subscription Basis 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 L02

Shares Sold on a Subscription Basis Accounts in share subscription transaction Common Shares Subscribed Set up a separate one for each type/class of share An equity account, reported below the respective share capital account Subscriptions Receivable Normally considered a current asset May be reported as a contra account to the Shares Subscribed account in equity section Share Capital Credited only when the subscription is paid in full, or settled in some other manner in the case of default L02

Shares Sold on a Subscription Basis 500 shares are sold on subscription for $20 each. 50% is due as initial payment. The initial journal entries would be: Subscriptions Receivable 10,000 Common Shares Subscribed 10,000 Cash 5,000 Subscription Receivable 5,000 L02

Shares Sold on a Subscription Basis If all payments are made as scheduled, the entries would be: Cash 5,000 Subscription Receivable 5,000 Shares Subscribed 10,000 Share Capital 10,000 L02

Shares Sold on a Subscription Basis 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 L02

Shares Sold on a Subscription Basis Default after first payment – funds refunded with no penalty. Default after first payment – shares issued for amount paid. Shares Subscribed 10,000 Accounts Payable (or Cash) 5,000 Subscription Receivable 5,000 L02 Shares Subscribed 10,000 Share Capital 5,000 Subscription Receivable 5,000

Shares Sold on a Subscription Basis Default after first payment – funds held by corporation Shares Subscribed 10,000 Subscription Receivable 5,000 Contributed Surplus 5,000 L02

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 L02

Accounting for Share Issue Costs Direct incremental costs incurred to sell shares include legal fees, accounting fees, underwriter fees & commissions, printing and mailing costs, taxes, etc. These amounts are considered to be capital transactions (rather than operating transactions) and therefore should not be included in net income calculation Accounting treatment: debit to Share Capital L02

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 9,500 Share Capital 500 Share Capital 10,000 L02

Reacquisition and Retirement of Shares Major reasons for the reacquisition of a corporation’s 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 company’s shares Return cash to shareholders L02

Reacquisition and Retirement of Shares Shares may be retired when reacquired May also (in limited circumstances and jurisdictions) become Treasury Stock (held in treasury for reissue) In Canada, the CBCA requires repurchased shares be cancelled and restored to status of authorized but unissued if a limit to authorized shares exists L02

Reacquisition and Retirement of Shares Share capital debited with the original issue or assigned value only The difference then allocated to equity accounts: Contributed Surplus Retained Earnings L02

Reacquisition and Retirement of Shares - Example In January 2013, 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 L02

Dividends Two basic classes of dividends: Important dates: Return on capital Return of capital Important dates: Date of declaration Date of record Date of payment L02

Cash Dividends First journal entry is on Date of Declaration Dividend becomes legal obligation of the corporation Dividends (or Retained Earnings) xxx Dividends Payable xxx On Date of Payment, the liability is reduced L02

Cash Dividends Before the dividend is paid, a current list of shareholders needs to be prepared (as at the date of record) If a Dividends account is used rather than Retained Earnings at the date of declaration, this account is closed to Retained Earnings at year end L02

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 can be determined by referring to estimated realizable value of same or similar assets, quoted market prices, independent appraisals etc. L02

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 same proportionate interest in the corporation However, book value per share decreases L02

Stock Dividends - Example 1,000 common shares outstanding Retained earnings = $50,000 10% stock dividend declared Fair (market) value of share = $130 per share Stock Dividends Declared 13,000 Common Shares 13,000 1,000 x 10% = 100 Fair value $13,000 Total $13,000 L02

Liquidating Dividends Any dividends paid in excess of the accumulated income of the company represents a liquidating dividend Results in a return of the shareholders’ investment L02

Dividend Preferences Given: $50,000 total declared as dividends Common share capital: $400,000 1,000 $6 Preferred shares: $100,000 Preferred share dividends have been paid for the past 2 years Calculate the dividend distribution to common and preferred shareholders based on the different types of dividend preferences L02

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 The dividend distribution is therefore: Preferred Shareholders are paid $6,000 ($6 x 1000) Common Shareholders are paid the remaining amount of $44,000 L02

Cumulative If the preferred shares are cumulative and non-participating: The dividends that were not paid to preferred shareholders in the previous 2 years must also be paid The dividend distribution is therefore: 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) L02

Participating If preferred shares are non-cumulative and fully participating, using the previous data: Preferred Common Current year’s: Preferred ($6 x 1000) $6,000 Common (6% x $400,000) $24,000 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) $16,000 TOTAL $10,000 $40,000 L02

Stock Dividends vs. Stock Splits A form of dividend must follow the requirements of a dividend Both the number of shares and the amount of share capital generally 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 L02

Shareholders’ Equity Understanding the Corporate Form, Share Capital and Profit Distribution Corporate law and the share capital system Types of shares Limited liability of shareholders Formality of profit distribution Recognition, Derecognition, and Measurement Issuance of shares Reacquisition and retirement of shares Dividends Presentation, Disclosure, and Analysis Components of shareholders’ equity Capital disclosures Analysis IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking Ahead

Components of Shareholders’ Equity Share Capital: Common And/or Preferred shares Contributed Surplus Contributed Capital Retained Earnings Accumulated other Comprehensive Income L03 Earned Capital

Contributed Surplus Contributed Surplus transactions Par value share issue and/or retirement Treasury share transactions Liquidating dividends Financial reorganization Stock options and warrants Issue of convertible debt Share subscriptions forfeited Donated assets by a shareholder Redemption or conversion of shares L03

Retained Earnings DEBITS CREDITS Net loss Net Income Prior period adjustments, accounting principle changes Cash, property, stock dividends Some treasury share transactions CREDITS Net Income Prior period adjustments, accounting principle changes Adjustments from financial reorganization L03

Accumulated Other Comprehensive Income (AOCI) Cumulative change in equity from non-shareholder transactions which are excluded from net income Considered to be earned income Note that the concept of comprehensive income is not applicable under ASPE L03

Disclosure of Share Capital Following basic disclosure is required: Authorized share capital Issued share capital Changes in share capital since the last statement of financial position date L04

Disclosure of Share Capital Additional disclosures include: 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 (under IFRS, presented in statement of changes in equity) Restrictions on retained earnings L04

Shareholders’ Equity Ratios Rate of return on common shareholders’ equity Net income – Preferred dividends Average common shareholders’ equity Payout ratio Cash Dividends Net income – Preferred dividends Price earnings ratio Market price per share Earnings per share Book value per share Common shareholders’ equity Number of outstanding shares L05

Shareholders’ Equity Understanding the Corporate Form, Share Capital and Profit Distribution Corporate law and the share capital system Types of shares Limited liability of shareholders Formality of profit distribution Recognition, Derecognition, and Measurement Issuance of shares Reacquisition and retirement of shares Dividends Presentation, Disclosure, and Analysis Components of shareholders’ equity Capital disclosures Analysis IFRS/ASPE Comparison Comparison of IFRS and ASPE Looking Ahead

Looking Ahead There are several projects being undertaken by IASB and FASB that may impact accounting for shareholders’ equity These include financial statement project, and project on liabilities and equity L06

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