CHAPTER
11
Reporting and Analysing
Shareholders’ Equity
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
Characteristics of a Corporation
•
•
•
•
•
•
•
•
Separate legal existence
Limited liability of shareholders
Transferable ownership rights
Ability to acquire capital
Continuous life
Corporation management
Government regulations
Income taxes
Advantages and Disadvantages of
a Corporation
Advantages
Disadvantages
– Corporate management
– Corporation
management
• professional managers
• ownership separated
– Separate legal existence
from management
– Limited liability of
– Increased costs and
shareholders
complexity in order to
– Deferred or reduced taxes
adhere to government
– Transferable ownership rights
regulation
– Ability to acquire capital
– Additional taxes
– Continuous life
Shareholder Rights
• To raise capital, the corporation sells shares
• If there is only one class of shares, these are
referred to as common shares
• Ownership rights are specified in articles of
incorporation or in by-laws
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
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
No Par Value Shares
• Par and stated value shares seldom used
• Par value has 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.
Reacquisition of Shares
• Reacquired shares are a corporation’s own
shares (either common or preferred) that
have been issued and reacquired by the
corporation
• Reacquired shares are normally retired and
cancelled
Shareholders’ Equity
• The shareholders’ equity section of a
corporation’s balance sheet consists of:
1. Share capital (contributed capital)
2. Retained earnings
Shareholders’ Equity
Shareholders’ equity
Share capital
Common shares, 100,000 no par
value shares authorized, 50,000
issued
Retained earnings
Total shareholders’ equity
$800,000
130,000
$930,000
Preferred Shares
• Preferred shares have priority over common
shares with regards to:
1. Dividends
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 Share Preferences
•
•
•
•
•
Liquidation preference
Cumulative (dividends in arrears)
Convertible
Redeemable/callable (company option)
Retractable (shareholder option)
Dividends
• Dividends are distributed by a corporation to
its shareholders on a pro rata (equal) basis
• They are normally in the form of:
– Cash
– Stock (common shares)
Cash Dividends
• For a cash dividend to occur, a corporation
must have:
1.
Retained earnings
2.
Adequate cash
3.
Declared dividends
Entries for Cash Dividends
Three dates are
important in
connection with
dividends:
1. Declaration date
2. Record date
3. Payment date
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, 2004, the directors of Media General
declare a $0.50 per share cash dividend on 100,000
common shares (100,000 x $0.50 = $50,000).
Dec. 1 Cash Dividends
Dividends Payable
50,000
50,000
Record Date
• Date ownership of shares is determined for
dividend purposes
Dec. 22
No entry necessary
Payment Date
• Date dividend cheques are mailed
The payment date for Media General is
January 20.
Jan. 20 Dividends Payable
Cash
50,000
50,000
Stock Dividends
• Distributed (paid) in shares
• In most cases, fair market value is assigned to the
stock dividend shares
• Decreases retained earnings, increases common
shares, total shareholder’s equity remains the
Before
After
same
Common shares
Retained earnings
Total shareholders’ equity
Stock
Dividend
Stock
Dividend
$500,000
$575,000
300,000
225,000
$800,000
$800,000
Purposes and Benefits of Stock
Dividends
• For company
– To satisfy shareholders' dividend
expectations without spending cash
– To increase marketability of its shares by
increasing number of shares and
decreasing market price per share
– To reinvest and restrict a portion of
shareholders' equity
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 increases
Stock Dividends
• Assume 2% ownership interest in Cetus Inc.,
owning 200 of its 10,000 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)
Stock Dividends
Cetus Inc. would journalize the stock dividend as
follows, assuming $25 FMV (1,000 x $25 = $25,000):
Declaration Date
Stock Dividends
Common Stock Dividends Distributable
Record Date
25,000
25,000
No Entry
Distribution Date
Common Stock Dividends Distributable
Common Shares
25,000
25,000
Stock Splits
• A stock split involves the issue of
additional shares to
shareholders according to their
percentage ownership
• Number of shares is increased
• No change to dollar amount in
share capital account
Stock Splits
• A stock split has no effect on total share
capital, retained earnings, or 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
Effects of Stock Splits, Stock
Dividends, and Cash Dividends
Stock
Split
Stock
Dividend
Cash
Dividend
Total assets
NE
NE

Total liabilities
NE
NE
NE
Total shareholders’ equity
NE
NE

Total share capital
NE

NE
Total retained earnings
NE




NE
NE
NE
NE
Number of shares
% of shareholder ownership
NE = No effect
 = Increase
 = Decrease
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
Deficit
A debit balance in retained earnings is identified
as a deficit and is reported as a deduction in the
shareholders’ equity section
Shareholders’ equity
Common shares
Retained earnings (deficit)
Total shareholders’ equity
$800,000
(50,000)
$750,000
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
Measuring Corporate Performance
• Dividend record
– Payout ratio
• Earnings performance
– Return on common shareholders’ equity
Payout Ratio
• Measures the percentage of earnings
distributed in the form of cash dividends
to common shareholders
Payout Ratio =
Cash Dividends
Net Earnings
Return on Common
Shareholders’ Equity
• Measures the company’s profitability
from the shareholders’ point of view
Return on Common Shareholders’ Equity =
Net Earnings – Preferred Share Dividends
Average Common Shareholders’ Equity
Components of ROE
Debt vs. Equity Decision
Companies must decide between issuing bonds
or selling shares to raise long-term capital
•Bonds
– Do not affect shareholder control
– Offer tax savings
– Have the potential for a higher return on common
shareholders’ equity
However, bonds do require a fixed payment which
may be difficult for a company to meet