1 Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm KIMMEL

2 Chapter 11 Reporting and Analysing Shareholders’ Equity After studying Chapter 11, you should be able to: 1.Identify and discuss the major characteristics of a corporation. 2.Record the issuance of common shares. 3.Differentiate preferred shares from common shares. 4.Prepare the entries for cash dividends and stock dividends.

3 Chapter 11 Reporting and Analysing Shareholders’ Equity After studying Chapter 11, you should be able to: 5.Identify the items that affect retained earnings. 6.Prepare a comprehensive shareholders' equity section. 7.Evaluate a corporation's dividend and earnings performance from a shareholder's perspective.

4 Corporation +Separate legal entity +Has most of the rights and privileges of a person +Classified by purpose and ownership +Purpose - profit or nonprofit +Ownership - public or private

5 Characteristics +Separate legal existence +Limited liability of shareholders +Transferable ownership rights +Ability to acquire capital +Continuous life +Corporation management +Government regulations +Additional taxes

6 Advantages and Disadvantages +Advantages +Corporate management- professional managers +Separate legal existence +Limited liability of shareholders +Deferred or reduced taxes +Transferable ownership rights +Ability to acquire capital +Continuous life + Disadvantages +Corporation management – ownership separated from management +Increased costs and complexity to adhere to government regulation +Additional taxes

7 Shareholder Rights +To raise capital, the corporation sells shares +If only one class of shares-common shares +Ownership rights specified in articles of incorporation or by-laws

Illustration 11-2

9 Share Terminology +Authorized shares – maximum amount of shares a corporation is allowed to sell as authorized by corporate charter +Issued shares – number of shares sold +Outstanding shares – number of shares held by shareholders

10 +How many shares should be authorized for sale? +How should the shares be issued? +At what price should the shares be issued? +What value should be assigned to the shares? Share Issue Consideration

11 Stock Market Price +Shares of publicly held companies are traded on organized exchanges at dollar prices per share established by the interaction between buyers and sellers

12 +Stated value – assigned value to no- par value shares +Par value – assigned legal capital value Stated and Par Share Values Must retain legal capital. Stated and par values have NO relationship to market value

13 No-Par Share Values +No assigned legal capital value +Legal capital equals issue price (proceeds) Must retain legal capital. No-par value has NO relationship to market value once issued.

14 Account Titles and Explanation Debit Credit Cash Common Shares (To record issuance of 1,000 no-par common shares) 8,000 8,000 When no-par shares do not have a stated value, the entire proceeds from the issue are credited to Common Shares Issuing No-Par Value Common Shares for Cash

15 +When common shares are issued for non-cash assets or services, cost is the fair market value of the consideration given up. If this is not identifiable, than the consideration received, is used Issuing Common Shares for Non-Cash

16 +Shareholders’ equity (owner’s equity) +The shareholders’ equity section of a corporation’s balance sheet consists of: 1. Share capital 2. Retained earnings Corporate Capital

17 Shareholders’ equity Share capital Common shares, 100,000 no-par value shares authorized, 50,000 issued and outstanding Retained earnings Total shareholders’ equity Shareholders’ Equity Section $800, ,000 $930,000

18 +Preferred shares have priority over common shares with regards to: 1.Dividends and 2.Assets in the event of liquidation +Preferred shareholders usually do not have voting rights +Preferred shares are shown first in the share capital section of shareholders' equity Preferred Shares

19 +Liquidation preference +Cumulative (dividends in arrears) +Convertible (book value) +Redeemable/callable (company option) +Retractable (shareholder option) Preferred Share Preferences

20 +Reacquired shares are a corporation’s own shares (either common or preferred) that have been issued, fully paid for, and reacquired by the corporation +Reacquired shares are normally retired and cancelled +In certain restricted circumstances, these shares are held as treasury shares for later reissue Reacquisition of Shares

21 Reacquisition of Shares +Why would a company choose to reacquire its shares? +Reduce quantity/raise share price +Increase EPS +If authorized share limit reached, may need additional shares for use in bonus or compensation plans or acquisitions

22 Dividends +Distribution by a corporation to its shareholders on a pro rata (equal) basis +Dividends may be in the form of +Cash +Property +Scrip (promissory note to pay cash) +Stock (common shares)

23 Cash Dividends +For a cash dividend to occur, a corporation must have 1.Retained earnings, 2.Adequate cash, and 3.Declared dividends

24 Entries for Cash Dividends Three dates are important in connection with dividends: 1. Declaration date 2. Record date 3. Payment date

25 Declaration Date +Date the Board of Directors declares cash dividend +Commits the corporation to a binding legal obligation that cannot be rescinded On December 1, 2002 the directors of Media General declare a $.50 per share cash dividend on 100,000 shares of no-par value common shares (100,000 x $.50=$50,000) 12/1 Cash Dividends (or Retained Earnings) 50,000 Dividends Payable 50,000

26 Record Date +Date ownership of the outstanding shares is determined for dividend purposes 12/1 No entry necessary

27 Payment Date +Date dividend cheques are mailed. January 20 is the payment date for Media General 1/20 Dividends Payable 50,000 Cash50,000

28 +Cumulative +Dividends in arrears must be paid to preferred shareholders before allocating dividends to common shareholders +Non-cumulative +Only the current year’s dividend must be paid to preferred shareholders before paying dividends to common shareholders Allocating Cash Dividends Between Preferred and Common Shares

29 Stock Dividends +Distributed (paid) in shares +Decreases retained earnings; increases contributed capital +In most cases, fair market value is assigned to the stock dividend shares +Total shareholders’ equity and the legal capital per share remain the same

30 +For company +To satisfy shareholders' dividend expectations without spending cash +To increase marketability of its shares by increasing number of shares outstanding and decreasing market price per share +To reinvest and restrict a portion of shareholders' equity Purposes and Benefits of Stock Dividends

31 Purposes and Benefits of Stock Dividends +For shareholder +More shares with which to earn additional dividend income +More shares for future profitable resale, as share price climbs again

32 Stock Dividends +Assume 2% ownership interest in Cetus Inc., owning 200 of its 10,000 shares of common shares +In a 10% stock dividend, 1,000 common shares (10,000 x 10%) would be issued. You would receive 20 shares (2% x 1,000), but your ownership interest would remain at 2% (220 /11,000)

33 Stock Dividends Cetus Inc. would journalize the stock dividend as follows, assuming FMV $25 (1,000 x $25 = $25,000): Declaration Date Stock Dividends (or Retained Earnings)25,000 Common Stock Dividends Distrib. 25,000 Record DateNo Entry Distribution Date Common Stock Dividends Distrib.25,000 Common Shares25,000

34 Before After Stock DividendStock Dividend Shareholders’ equity Common shares Retained earnings Total shareholders’ equity Outstanding shares Shareholder Number of shares Percentage ownership $500, ,000 $800,000 10, % $525, ,000 $800,000 11, % Stock Dividend Effects

35 Stock Splits +A stock split involves the issuance of additional shares to shareholders according to their percentage ownership +Number of shares is increased in the same proportion that legal capital per share is decreased. No change to dollar amount in share capital account

36 Stock Splits +A stock split has no effect on total share capital, retained earnings, and total shareholders’ equity +Market value of the shares will decrease roughly proportionately to the split +It is not necessary to formally journalize a stock split

37 Medland Corporation splits its 50,000 no-par value common shares on a 2-for-1 basis. This means that one no-par share is exchanged for two no-par shares Before After Stock SplitStock Split Shareholders’ equity Common shares Retained earnings Total shareholders’ equity Outstanding shares $500, ,000 $800,000 50,000 $500, ,000 $800, ,000 Stock Split Effects

38 Effects of Stock Splits, Stock Dividends and Cash Dividends Stock Stock Cash SplitDividendDividend Total assetsNENE  Total liabilitiesNENENE Total shareholders’ equityNENE  Total share capitalNE  NE Total retained earningsNE  Legal capital per share  NENE Number of shares  NE % of shareholder ownershipNENENE NE = No effect  = Increase  = Decrease

39 Retained Earnings +Retained earnings is the cumulative net earnings (less losses) that is retained in the business (i.e., not distributed to shareholders) Retained earnings, opening balance + Net earnings (or - net loss) - Dividends = Retained earnings, ending balance

40 A debit balance in retained earnings is identified as a DEFICIT and is reported as a deduction in the shareholders’ equity section Shareholders’ equity Share capital Common shares Retained earnings (deficit) Total shareholders’ equity $800,000 (50,000) $750,000 Deficit

41 Retained Earnings Restrictions +In some cases there may be retained earnings restrictions that make a portion of the balance currently unavailable for dividends +Restrictions result from one or more of the following causes +Legal +Contractual +Voluntary

42 Measuring Corporate Performance +Dividend record +Payout ratio +Dividend yield +Earnings performance +EPS +P/E ratio +Return on common shareholders’ equity

43 Payout Ratio +Measures the percentage of earnings distributed in the form of cash dividends to common shareholders Payout ratio = Total common cash dividends Net earnings

44 Dividend Yield +Reports the rate of return an investor earns from dividends Dividend yield = Cash dividends per common share Year end share price

45 Earnings Per Share +Measures the net earnings per common share Earnings per share = Net earnings – Preferred share dividends Average common shares outstanding

46 Price-Earnings Ratio +In order to make a meaningful comparison of earnings across firms, use the price- earnings ratio +The price-earnings ratio reflects the investors' assessment of a company's future earnings Price-earnings ratio = Market price per share Earnings per share

47 Return on Common Shareholders’ Equity +Measures the profitability from the shareholders’ point of view Return on common shareholders’ equity ratio = Net earnings – Preferred share dividends Average common shareholders’ equity

48 Decision Checkpoints +Should the company incorporate? +What portion of earnings does the company pay out in dividends? +What level of return can be earned on the company’s dividends? + Payout ratio + Dividend yield

49 Decision Checkpoints (continued) +How does the company’s earnings performance compare with that of previous years? +How does the market perceive the company’s prospects for future earnings? +What is the company’s return on common shareholders’ investment? + Earnings per share + Price-earnings ratio + Return on common shareholders’ equity

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