MODULE 12 Shareholder’s equity
Economic resources come from 2 sources (Owners and non-owners)
-Non-owners provide FUNDS to the company which can be found under LIABILTIES of the BS
-Owners also provide FUNDS to the company which can be found under OWNER’S EQUITY of the BS
A = L + OE OR A= Claims to assets
CORPORATION (shareholder’s equity)
-provides shareholder limited liability
Incorporation
+raising vast amounts of capital
+limited liability
+easy transfer of ownership
-Double taxation
-more government regulation
Incorporation act
A corporation is an artificial legal person created with approval by government = can sue, be sued, enter
into contracts, and pay income taxes as individuals would.
-can incorporate A)FEDEREALLY under Canada business corporations act B) Provincially, under one of
the provincial corporations act
Public corporations:
-offers shares to general public
-listed under the stock exchange
-Most Large companies are public
Private corporations (closely held) :
Private company- owns by a small number of people. Not listed/sold on stock exchange.
Size test to meet private: Gross rev < 10 mill, total assets <5 mill
Key difference: Not required a annual audit unless shareholders request. Filling Fin statement is not
required.
Implications of being privately held:
a) will not have to face costly bureaucratic red tape that large corp face
b)public has no access to their fin statement
Public companies listed on stock exchange need to have audits and must follow GAAP rules to achieve
statement reliability and comparability goals
Capital contributions
-those who contribute funds to a corporations receives a share certificate in return. These people are
also known as “shareholders”
-actual control of the company will be on the hands of a few individuals who OWN or CONTROL enough
shares to elect the board of directors
-minority shareholders participate “little” – they view it as investments
Rights and obligations of shareholder
-articles of incorporation are chartered: K between provincial government and company
-Board of directors est. by laws of corp (rules and regulations of internal affairs of corp)
-share K –has own provisions
Classes of shares
-corp can issue more than 1 class of shares each representing ownership in the business
-“common” or “preferred” are shares that are mostly issued
-need to have a min of 1 class of share
Common shares: have claim to earnings of corporation after commitments to preferred shareholders
have been established. Normally, this type of shares are the only voting shares of the company. In the
event of dissolution, money left over will be distributed to the common shareholders.
Preferred shares: allows its holders to receive dividends at a certain rate , which must be paid before
dividend s can be paid to common shareholders
Dividend preference
-dividend is only legal obligation if declared
-Preferred shares have cumulative feature (attractive)
-not liability
Issuance of shares
For cash: company may incur legal fees, accounting fees, underwriting commissions, mailing,
registration and advertising costs. We treat these COSTS as a reduction of the net proceeds received for
the share issuance –these costs are charged to an account called “Organization costs” on the BS. These
costs are amortized over an arbitrary period, 5 years normally assumed to benefit in the early years.
Organization costs are classified with other deferred costs on the BS.
For non cash assets: giving property as a share rather than cash. Property acquired should be recorded
at their current FAIR VALUE or at FAIR VALUE OF SHARE ISSUED.
Should firm raise funds by issuing SHARES OR BONDS??!
Dividends are not deductible in calculating taxable income. Bond interest is deductable! The after tax
accounting cost of borrowing may be less than the after tax accounting cost of issuing shares, even
though the interest rate of the bonds is higher than the dividend rate
When bonds are issued, both preferred and common shares become more risky B/C bondholders have a
claim on future cash flows senior to the claim of shareholders.
When preferred shares are issued, common shares become more risky.
When shares become more risky, rate of return on those shares required by the market increases.
Retained earnings
-when corp earns profit, it may generate additional shareholders equity from undistributed earnings
called “retained earnings”
-cash flow statement shows how cash provided by operations and other sources are used during a
period
- a well managed firm keeps its cash at a reasonable minimum –firm may start paying off its obligations,
increase its inventory, buy more inventory, equip or declare dividends.
-an increase in retained earnings results in increased net assets (Increase in excess of all assets over all
liabilities)
Cash dividends
Shareholders of a corp do not directly control distributions of corporate assets generated by Net income
When dividend is declared:
Retained earnings
XXX,XXX
Dividends Payable
XXX,XXX
To record declaration of dividends
Sometimes an account dividends or dividends declared is DR. The dividends account balance reduces
retained earnings reported at the end of the period. Once the board of directors declar a dividend , the
dividend becomes a legal liability of the corporation.
Dividends payable is shown as a current liability on BS if dividends have not been paid at end of the
accounting period. When dividends are PAID, entry is:
Dividends Payable
XXX,XXX
Cash
XXX,XXX
Dividend in kind or property dividend
-dividend in kind is when distributions are made in a form other than cash eg. Property
-amount of dividend will equal the money value of the property received
Stock Dividends
-retention of earnings will lead to a substantial increase in shareholders’ equity
-to indicate a permanent commitment of reinvested earnings, board of directors may declare a ‘stock
dividend”
DR Retained earnings
Capital accounts
When a stock dividend is issued, shareholders receive additional shares in proportion to their existing
holdings ie. If 5% stock dividend is issued, each shareholders receives one additional share for every 20
shares held before the dividends.
Stock dividends are just as welcome as cash dividends to investors but offer more flexibility. Investor can
sell the new shares immediately to generate cash flow or hold the shares and wait for capital gain
appreciation.
DR retained earnings
XXX,XXX
CR
Stock dividends distributable
XXX,XXX
DR Stock dividends
CR
common stock
CR
contributed surplus
XXX,XXX
XXX,XXX
XXX,XXX
Stock dividend
Dividend policy
Director, consider whether or not to declare cash dividends, must conclude both 1)that the declaration
of a dividend is legal and 2) that it is financially expedient.
Dividends are rarely declared up to the maximum legal limit
Directors may allow retained earnings to increase as a matter of corporate financial policy for several
reasons:1) earnings are not reflected in a corresponding increase of available cash
2)restricting dividends in prosperous years may permit continued dividend payments in poor years
3)funds may be needed for expansion of working capital or plant and equip
4. Reducing amount of borrowings, rather than paying dividends
Solvency test
Purpose of income statement is to report the causes of the change in the cash account
A company’s performance can be compared with other companies or with itself over time , and more
informed projections can be made about the future
Full disclosure -- all changes in shareholders equity must be explained in the financial statement