Chapter 15 Shareholders’ Equity Prepared by: Patricia Zima, CA Mohawk College of Applied Arts and Technology

Shareholders’ Equity Presentation and Disclosure Special presentation issues Retained Earnings Formality of profit distribution Types of dividends Stock splits Other Components Contributed surplus Accumulated Other comprehensive income Corporate Form Corporate Law Share capital system Share Capital Types of shares Limited liability of shareholders Issuance Reacquisition Retirement Perspectives Analysis Appendix 15A – Par Value and Treasury Shares Par value shares Treasury shares Appendix 15B Financial Reorganization Comprehensive revaluation

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

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 Share 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 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 Crown Created by government statute to provide public services Municipalities, Cities, Etc.

Corporate Accounting Special characteristics that impact on accounting: Corporate law Share capital system Limited Liability

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

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

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

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

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

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

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 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

Accounting for the Issuance of Shares Shares basic Shares sold on a subscription basis Defaulted Subscription accounts Shares issued in combination with other securities

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 5,000 Common Shares 5,000

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

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

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

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 10,000 Shares Subscribed 10,000 Cash 5,000 Subscription Receivable 5,000

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

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

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

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

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 treatment—debit to Share Capital

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

Share Repurchase 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

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

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)

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

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

Items Affecting Retained Earnings DEBITS Net loss Prior period adjustments, accounting principle changes Cash, property, stock dividends Treasury stock CREDITS Net Income Prior period adjustments, accounting principle changes Adjustments from financial reorganization

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 are in full agreement with share capital contracts Before declaration of a dividend, management should consider availability of funds to pay the dividend

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

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

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

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

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

Stock Dividends 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 $ 130 Total $13,000

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)

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

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)

Participating If no specific participation agreement exists, participation generally follows these guidelines 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 Any remaining dividend amount is shared by both preferred and common in proportion to the carrying value of each share class

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

Stock Dividends vs. Stock Splits 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

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

Components of Shareholders’ Equity Accumulated Other Comprehensive Income Cumulative change in equity from non-shareholder transactions which are excluded from net income Considered to be earned income

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

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

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

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

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