Prepared by Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 16 Shareholders’ Equity: Contributed Capital

Learning Objectives 1. Discuss the characteristics of the corporate form of organization. 2. Identify the rights of shareholders. 3. Explain the key components of shareholders’ equity. 4. Explain the accounting procedures for issuing shares. 5. Identify the major reasons for repurchasing shares.

Learning Objectives 6. Explain the accounting procedures required for reacquiring, retiring, and canceling shares. 7. Describe the major features of preferred shares. 8. Distinguish between debt and equity. 9. Identify items reported as contributed surplus. 10. Identify the major disclosure requirements.

Shareholders’ Equity The Corporate Form Corporate Law Share capital system Variety of ownership interests Limited liability of shareholders Formality of profit distribution Presentation and Disclosure Corporate Capital Issuance of shares Reacquisition of shares Retirement of reacquired shares Preferred Shares Features Special presentation issues Contributed Surplus

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

Corporate Accounting Special characteristics that impact on accounting: 1.Corporate law 2.Share capital system 3.Development of a variety of ownership interests 4.Limited liability of shareholders 5.Formality of profit distribution

Characteristics of the Corporate Entity that Affect Accounting Corporate Law Canada Business Corporation Act (CBCA) Articles of incorporation prepared and submitted Company name Location of registered office Classes and authorized shares Directors Business restrictions CBCA regs. state that financial statements are to be prepared in accordance with GAAP

Characteristics of the Corporate Entity that Affect Accounting Use of Share Capital System Shares grouped by “class” (e.g. Class A Common) Each share contains certain rights and privileges Within each class, each share equal Variety of Ownership Interests Common shares vs. Preferred shares Different share types and classes appeal to greater variety of investors Common shares Residual ownership interest Bear the greater risk

Characteristics of the Corporate Entity that Affect Accounting Limited Liability of Shareholders Unlike partnership or proprietorship form of business Shareholders not generally liable for the obligations of the corporation Formality of Profit Distribution No amounts may be distributed unless corporate capital is maintained intact Sufficient capital remains after the dividend to pay liabilities as they are due The realizable value of the corporate assets does fall below the total of the liabilities Formal approval of the Board of Directors required Dividends are in full agreement with share provisions

The Rights of Shareholders The shareholders have the right to: 1.Share proportionately in profits and losses 2.Share proportionately in management 3.Share proportionately in corporate assets upon liquidation 4.Share proportionately in any new issues of stock of the same class (preemptive right)

Shareholders’ equity is represented by: Amounts contributed by shareholders That portion of the assets retained by the enterprise which are retained by the corporation When classifying liabilities and equities one must look at the substance of the financial instrument, rather than the legal form (i.e. Redeemable Preferred Shares) Shareholders’ Equity

Contributed Capital Earned Capital Share Capital Contributed Surplus Retained Earnings Components of Shareholders’ Equity

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) Accounting definition of capital Shareholders’ equity which includes: Share capital (the legal/stated capital as defined above) Contributed surplus (equity transactions not specifically included elsewhere) Retained earnings (all undistributed income that remains invested in the business) Defining Capital

All Transactions and Events That Cause Changes in Shareholders’ Equity Net IncomeTransfers Between Entity and Owners Revenues & Expenses Gains and Losses Investments by Owners Distributions to Owners Major Sources of Changes in Shareholders’ Equity

Shares basic Shares sold on a subscription basis Shares issued in combination with other securities Shares issued in non-monetary transactions Accounting for costs related to issuance Accounting for the Issuance of Shares

The full amount of the proceeds received is credited to the respective share capital account (preferred/common/class type) 1000 shares are sold for $2.00 each (issuance costs are not included in this transaction). The journal entry is: Cash2,000 Share Capital2,000 Shares Issue - Basic

Shares are sold, with “instalment” payments Shares are not issued, and any rights are not given (e.g., voting, dividends) until the full price is paid and the contract is settled Dividends may be attached to some subscription shares, once the initial payment is received Shares Sold by Subscription

Accounts involved 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 forfeited, with no refund or shares being issued; balance of the contract is cancelled Funds paid to date are refunded, often with a deduction, and the 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

1000 shares are sold on subscription for $10.00 each. 20% is due as initial payment. The initial journal entries would be: Subscription Receivable10,000 Shares Subscribed10,000 Cash 2,000 Subscription Receivable 2,000 Shares Sold by Subscription

If all payments are made as scheduled, the entries would be: Cash8,000 Subscription Receivable8,000 Shares Subscribed10,000 Share Capital10,000 If the subscriber defaults, one of the following may happen (depending on the contract terms and applicable legislation).

Default after first payment – funds held by corporation. Shares Subscribed10,000 Subscription Receivable8,000 Contributed Surplus2,000 Shares Sold by Subscription

Default after first payment – funds refunded with a 20% penalty charge. Shares Subscribed10,000 Cash1,600 Contributed Surplus 400 Subscription Receivable8,000 Default after first payment – shares issued for amount paid. Shares Subscribed10,000 Share Capital2,000 Subscription Receivable8,000 Shares Sold by Subscription

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 Shares Issued With Other Securities

Proportional method When the FMV is available for each class of share involved The lump sum received is allocated between the share classes sold on a proportional basis Shares Issued With Other Securities Given: 1,000 common shares and 1,000 preferred shares issued for a total of $30,000 Common share market value = $20.00 per share Preferred share market value = $12.00 per share

Shares Issued With Other Securities First Step: Find the total market value of the shares Common: $20.00=$20,000 Preferred: $12.00= 12,000 Total Market Value$32,000 Second Step: Allocate the total price proportional based on the market values Common: 20,000/32,000*30,000 =$18,750 Preferred: 12,000/32,000*30,000= 11,250 Total Allocation$30,000

Shares Issued With Other Securities Incremental method When the FMV is not available for all classes of shares involved FMV may be available for some, but not all share classes Use the FMV to allocate the funds for those shares with the known FMV Remainder is allocated to the shares where the FMV is not known If the FMV is not known for any of the share classes, then an arbitrary method will have to be used (this should be well documented)

Shares Issued With Other Securities Given: 1,000 common shares and 1,000 preferred shares issued for a total of $30,000 Common share market value = $20.00 per share Preferred share market value = Unknown First Step: Allocate to the shares with the known FMV Total Amount Received$30,000 Allocate to Common (1,000*$20.00) 20,000 Balance Allocated to Preferred$10,000

Shares issued in exchange for non- monetary goods or services Recorded at the FMV of the shares issued, or the FMV of goods or services received CICA Handbook, Section 3830 Shares Issued in Non-Monetary Transactions

If FMV of both the goods/services and the shares is known there should be little or no difference in their respective FMV (based on the transaction being at arms length) If FMV of neither the goods/services or the shares is known the value will be determined by management or the Board of Directors (independent appraisal is the best tool to use in this case)

Use of historical values for establishing FMV should be used with caution Watered stock: occurs when the value of the goods/services received for the shares is overvalued Secret reserves: occurs when the value of the goods/services received is undervalued Shares Issued in Non-Monetary Transactions

Include legal fees, accounting fees, underwriter fees & commissions, printing and mailing costs, advertising and administrative expenses of preparation CICA Handbook deems these amounts to be capital transactions and therefore should not be included in net income calculation Accounting treatment - debit to Contributed Surplus Accounting for Share Issue Costs

Reduction of the amount paid in 1000 shares sold for $10.00 each, with $500 in issue costs Cash9,500 Contributed Surplus 500 Share Capital10,000 Accounting for Share Issue Costs

Reasons for the reacquisition of a corporation’s own shares Have enough shares on hand to meet employee stock option contracts Reduce the shares outstanding to increase EPS Buy out a particular ownership interest Make a market in the company’s shares Reduce the operations of the business Meet the needs of a potential merger Change the debt-to-equity ratio Settle a debt Provide a kind of 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 either case, the accounts affected are: Share Capital Contributed Surplus Retained Earnings Treasury Stock (for Treasury Stock only) Reacquisition of Shares

Share capital is debited with the original issue or assigned value only The difference is then allocated to: Contributed Surplus (to an amount up to any contributed surplus created by the cancellation or resale of the same class of share) Contributed Surplus (pro rata share of the portion of contributed surplus resulting from other transaction) Retained Earnings Contributed Surplus NEVER goes to a debit balance Reacquisition of Shares - Retired

In 1997, Glider Co. issued 100,000 of its 500,000 authorized common shares at $35 per share. In January 1998, Glider repurchased and retired 1,600 shares at $30 per share. Assume these are the only share transactions the company has ever had. Common Shares (1,600 x $35)56,000 Cash (1,600 x $30) 48,000 Contributed Surplus- Excess of Carrying Value over Reacquisition Cost 8,000 Reacquisition of Shares - Retired

Preference as to dividends Preference as to assets in the event of liquidation Convertible into common shares Callable (redeemable) at the option of the corporation Retractable at the option of the shareholder Nonvoting Preferred Share Characteristics

Preferred Stock - Features Cumulative preferred stock Participating preferred stock Fully Participating Partially Participating Convertible preferred stock Callable preferred stock Redeemable preferred stock, not equity

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) If any unique rights attached to share class, which rights and to which shares Number of shares issued, and the amount received Whether the shares are par-value or no-par value Amount of any dividends in arrears Changes during the year, including new issuances, redemptions and resale of treasury shares Disclosure of Share Capital

COPYRIGHT Copyright © 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.