Accounting
Lecture no 8
Prepared by:
Jan Hájek
CORPORATE CAPITAL
Shareholders’ equity (owner’s equity)
 The shareholders’ equity section of a
corporation’s balance sheet consists of:

 Contributed capital
○ Share capital
○ Additional contributed capital
 Retained earnings
SHAREHOLDERS’ EQUITY
SECTION
Shareholders’ equity
Contributed capital
Common shares, 100,000 no par value
shares authorized, 50,000 issued
$800,000
Retained earnings
Total shareholders’ equity
130,000
$930,000
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

 Voting…owners
SHARE TERMINOLOGY
shares – maximum amount of
shares a corporation is allowed to sell as
authorized by corporate charter
 Issued shares – number of shares sold
 Authorized
SHARE ISSUE CONSIDERATION
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?

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
STATED AND PAR SHARE VALUES
Stated value – assigned value to no-par
value shares
 Par value – assigned legal capital value

Must retain legal capital.
Stated and par values have not
relationship to market value
NO PAR SHARE VALUES
No assigned legal capital value
 Legal capital equals issue price
(proceeds)

Must retain legal capital.
No-par value has not
relationship to market value once issued.
RELATIONSHIP OF PAR, NO PAR
AND
STATED VALUE SHARES TO
LEGAL CAPITAL
Shares
Legal Capital per Share
Par value
No par value
Par value
Entire proceeds
Stated value
Stated value
ISSUING NO PAR VALUE
COMMON SHARES FOR CASH
Shares are most commonly issued for cash.
When no par value common shares are issued,
the entire proceeds from the issue becomes legal
capital.
Account Titles and Explanation
Cash
Common Shares
To record issue of 1,000 shares.
Debit
1,000
Credit
1,000
ISSUING STATED VALUE
COMMON SHARES FOR CASH
When common shares have a stated value, the stated
value is credited to Common Shares. When the selling
price exceeds the stated value, the excess is credited
to Contributed Capital in Excess of Stated Value.
Account Titles and Explanation
Cash
Common Shares
Contributed Capital in Excess of Stated Value
To record issue of 1,000 shares.
Debit
Credit
5,000
1,000
4,000
SHAREHOLDERS’ EQUITY CONTRIBUTED CAPITAL IN EXCESS
OF STATED VALUE
Shareholders’ equity
Contributed capital
Common shares, 10,000 shares of $1 stated value authorized,
2,000 shares issued
Contributed capital in excess of stated value
Total contributed capital
Retained earnings
Total shareholders’ equity
$ 2,000
4,000
6,000
27,000
$33,000
ISSUING COMMON SHARES FOR
SERVICES OR NON-CASH ASSETS


Shares may be issued for services, such as
compensation to lawyers, or for non-cash
assets, such as land.
When common shares are issued for services or
non-cash assets, cost is either the fair market
value of the consideration given up or the
consideration received, whichever is more
clearly determinable.
REACQUIRED SHARES
Reacquired shares are a corporation’s
own shares that have been issued, fully
paid for, and then reacquired by the
corporation.
 Reacquired shares are generally retired
and cancelled.
 In certain restricted circumstances, these
shares are not retired, but are held as
treasury shares for later reissue.

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
PREFERRED SHARES
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 SHARE
PREFERENCES
Liquidation preference
 Cumulative (dividends in arrears)
 Convertible (book value)
 Redeemable/callable (company option)
 Retractable (shareholder option)

DIVIDEND PREFERENCES
CUMULATIVE DIVIDEND



A cumulative dividend requires that preferred
shareholders be paid both current and prior year
dividends before common shareholders receive any
dividends.
Preferred dividends not declared in a given period
are called dividends in arrears.
Dividends in arrears are not considered a liability, but
the amount of the dividends in arrears should be
disclosed in the notes to the financial statements.
CONVERTIBLE PREFERRED
SHARES





Convertible preferred shares allow the exchange
of preferred shares into common shares at a
specified ratio.
This kind of share is purchased by investors who
want the greater security of a preferred share, but
who also desire the added option of conversion.
In recording the conversion, the book value of the
preferred shares is used.
The conversion of preferred shares does not
result in either gain or loss to the corporation.
The market value of the shares is not considered.
REDEEMABLE PREFERRED



Redeemable (callable) preferred shares grant the issuing
corporation the right to purchase the shares from
shareholders at specified future dates and prices.
This call feature allows some flexibility to a corporation
by enabling it to eliminate this type of equity when
it is advantageous to do so.
While convertible shares are for the
benefit of the shareholder, redeemable
shares are for the benefit of the
corporation.
RETRACTABLE PREFERRED




Retractable preferred shares are similar to
redeemable preferred shares except that the
shareholder can redeem shares at their option
instead of the corporation’s.
Retractable preferred shares and debt have many
similarities.
Both offer a rate of return to the investor, and with the
redemption of the shares they both offer a repayment
of the principal investment.
Retractable preferred shares are presented in the
liability section of the balance sheet rather than in the
equity section because it has more of the features of
debt than equity.
STATEMENT PRESENTATION OF
SHAREHOLDERS’ EQUITY


In the shareholders’ equity section of the balance
sheet, contributed capital and retained earnings
are reported and the specific sources of
contributed capital are identified.
Within contributed capital, two classifications are
recognized:
1.
Share capital
2.
Additional contributed capital
SHAREHOLDERS’ EQUITY
PRESENTATION
ZABOSCHUK INC.
Partial Balance Sheet
Shareholders’ equity
Contributed capital
Share capital
$ 770,000
$9 preferred shares, no-par value,
cumulative, 10,000 shares authorized,
6,000 shares issued
2,000,000
Common shares, $5 stated value, unlimited shares
authorized, 400,000 shares issued
2,770,000
Total share capital
Additional contributed capital
Contributed capital in excess of stated value - common shares 860,000
3,630,000
Total contributed capital
1,058,000
Retained earnings
$4,688,000
Total shareholders’ equity
BOOK VALUE VS. MARKET VALUE



Book value per share seldom equals market value.
Book value is based on historical costs; market
value reflects the subjective judgement of
thousands of shareholders and prospective
investors about the company’s potential for future
earnings and dividends.
Market value per share may exceed book value
per share, but that fact does not necessarily mean
that the shares are overpriced.
DIVIDENDS
A dividend is a distribution by a
corporation to its shareholders on a pro
rata (equal) basis.
 Dividends may be in the form of

 Cash
 Shares (normally common shares)
CASH DIVIDENDS
A cash dividend is a pro rata distribution
of cash to shareholders.
 For a cash dividend to occur, a
corporation must have:
1. retained earnings,
2. adequate cash, and
3. declared dividends

ENTRIES FOR CASH DIVIDENDS

Three dates are important in connection
with dividends:
 Declaration date
 Record date
 Payment date
ALLOCATING CASH DIVIDENDS
BETWEEN PREFERRED AND
COMMON SHARES



Cash dividends must first be paid to preferred
shareholders before any common shareholders
are paid.
When preferred shares are cumulative, any
dividends in arrears must be paid to preferred
shareholders before allocating any dividends to
common shareholders.
When preferred shares are non-cumulative, only
the current year’s dividend must be paid to
preferred shareholders before paying any
dividends to common shareholders.
STOCK DIVIDENDS




A stock dividend is a pro rata distribution of the
corporation’s own shares to its shareholders.
A stock dividend results in a decrease in retained
earnings and an increase in share capital since a
portion of retained earnings is transferred to
legal capital.
In most cases, the fair market value is assigned
to the dividend shares.
Total shareholders’ equity and the legal capital
per share remain the same.
STOCK DIVIDEND EFFECTS
Before dividend
Shareholders’ equity
Common shares
Retained earnings
Total shareholders’ equity
Issued shares
Book value per share
$500,000
300,000
$800,000
50,000
$ 16.00
After dividend
$575,000
225,000
$800,000
55,000
$ 14.55
Stock dividends change the composition of shareholders’
equity because a portion of retained earnings is transferred to
contributed capital. However, total shareholders’ equity
remains the same. The number of shares increases and this
means that the book value per share decreases.
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 climbs again
STOCK SPLITS




A stock split involves the issue of additional
shares to shareholders according to their
percentage of ownership.
In a stock split, the number of shares is
increased in the same proportion that
legal capital per share is decreased.
A stock split has no effect on
total share (contributed) capital, retained
earnings, or shareholders’ equity.
It is not necessary to formally journalize
a stock split.
STOCK SPLIT EFFECTS
A stock split does not affect total share capital, retained earnings, or
shareholders’ equity. However, the number of shares increases and
book value per share decreases.
Before
Stock Split
Shareholders’ equity
Common shares
Retained earnings
Total shareholders’ equity
Issued shares
Book value per share
$500,000
300,000
$800,000
50,000
$ 16.00
After
Stock Split
$500,000
300,000
$800,000
100,000
$ 8.00
EFFECTS OF STOCK SPLITS,
STOCK DIVIDENDS, AND CASH
DIVIDENDS
Stock
Split
Total assets
Total liabilities
Total shareholders’ equity
Total share capital
Total retained earnings
Legal capital per share
Book value per share
Number of shares
% of shareholder ownership
NE = No effect
NE
NE
NE
NE
NE



NE
 = Increase
Stock
Dividend
NE
NE
NE


NE


NE
Cash
Dividend

NE

NE

NE

NE
NE
 = 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
Shareholders’ equity
Share capital
Common shares
Retained earnings (deficit)
Total shareholders’ equity
$800,000
(50,000)
$750,000
A debit balance in retained earnings is identified
as a DEFICIT and is reported as a deduction in
the shareholders’ equity section
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
PRIOR PERIOD ADJUSTMENTS

A prior period adjustment results
from
1. the correction of a material error
in reporting net income in
previously issued financial
statements, or
2. changing an accounting
principle.
PRIOR PERIOD ADJUSTMENTS
A correction of an error occurs after the
books are closed, and relates to a prior
accounting period.
 A change in an accounting principle
occurs when the principle used in the
current year is different from the one used
in the preceding year.

PRIOR PERIOD ADJUSTMENTS

The cumulative effect of the correction or
change (net of income tax) should be
 made directly to Retained Earnings;
 reported in the current year’s retained earnings
statement as an adjustment of the beginning
balance of Retained Earnings;
 disclosed in a footnote to the financial statements;
 corrected and restated in all prior period financial
statements presented; and
 the corrected amount or new principle should be
used in reporting the results of operations of the
current year.
DEBITS AND CREDITS TO
RETAINED EARNINGS
Retained Earnings
Debits (Decreases)
1. Correction of a prior period
error that overstated income
2. Cumulative effect of a
change in accounting
principle that decreased
income
3. Net loss
4. Cash dividends
5. Stock dividends
Credits (Increases)
1. Correction of a prior period
error that understated
income
2. Cumulative effect of a
change in accounting
principle that increased
income
3. Net income
Many corporations prepare a statement of retained earnings
to explain the changes in retained earnings during the year.
Some companies combine this statement of retained earnings
with their income statement.
CORPORATION INCOME
STATEMENTS
• The income statement for a corporation includes essentially
the same sections as in a proprietorship or a partnership.
• The major difference is a section for income tax expense.
• For tax purposes, corporations are considered to be a
separate legal entity.
INCOME STATEMENT WITH INCOME
TAX
LEADS INC.
Income Statement
For the Year Ended December 31, 2003
Sales
$800,000
Cost of goods sold
600,000
Gross profit
200,000
Operating expenses
50,000
Income from operations
150,000
Other revenues and gains
10,000
4,000
Other expenses and losses
156,000
Income before income tax
46,800
Income tax expense
$109,200
Net Income
INTRAPERIOD TAX ALLOCATION
• Intraperiod tax allocation refers to the procedure of
associating income taxes within the income statement to
the specific item that directly affects the income taxes for
the period.
• In contrast, interperiod tax allocation allocates income
taxes between two or more periods.
• Under intraperiod tax allocation, the income tax expense or
tax saving is shown for income before income tax.
• Each non-typical item discussed next is also shown net of
tax.
ADDITIONAL SECTIONS OF AN
INCOME STATEMENT



Additional sections should be added to the income
statement to report material items not
typical of regular operations.
These non-typical times include:
1. discontinued operations
2. extraordinary items
Each item should be carefully explained in notes to
the financial statements, and the income statement
should report the income tax expense or savings
applicable to each item.
DISCONTINUED OPERATIONS
Discontinued operations refers to the disposal of a
significant segment of a business, such as the
elimination of an entire activity or of a major class of
customers.
 Income statement reports both income (loss) from
continuing operations and income (loss) from
discontinued operations.
 Income (loss) from discontinued operations consists of
1) income (loss) from operations and 2) gain (loss) on
disposal of the segment.
 Both components are reported net of applicable income
tax in a section entitled Discontinued Operations, which
follows Income from Continuing Operations.

STATEMENT PRESENTATION OF
DISCONTINUED OPERATIONS
HWA ENERGY INC.
Income before income tax
Income tax expense
Income from continuing operations
Discontinued operations
Loss from operations of chemical division,
net of $60,000 income tax saving
Loss from disposal of chemical division,
net of $30,000 income tax saving
Total tax savings
Net income
$800,000
240,000
560,000
140,000
70,000
210,000
$350,000
Note that the caption “Income from continuing operations” is used
and that a section “Discontinued operations” is added. Within the new
section, both the operating loss and the loss on disposal are reported
net of applicable income tax.
EXTRAORDINARY ITEMS

Extraordinary items are events and
transactions that meet three conditions:
 Infrequent
 Non-typical
 Not subject to management decision

Extraordinary items are reported net of
income tax in a separate section of the
income statement immediately following
discontinued operations.
EXAMPLES OF
EXTRAORDINARY AND ORDINARY
ITEMS
Extraordinary Items
Ordinary Items
1. Effects of major
casualties (acts of God) if
rare in the area
2. Expropriation
(takeover) of property by a
government
3. Effects of a newly
enacted law or regulation,
such as a condemnation
action
1. Effects of major
casualties (acts of God) if
frequent in the area
2. Write down of
inventories or write off of
receivables
3. Losses attributable to
labour disputes
4. Gains or losses from
sale of capital assets
STATEMENT PRESENTATION OF
EXTRAORDINARY ITEMS
HWA ENERGY INC.
Income Statement (partial)
For the Year Ended December 31, 2003
Income before income tax
Income tax expense
Income from continuing operations
Discontinued operations
Loss from operations of chemical division, net
of $60,000 income tax saving
Loss from disposal of chemical division, net of
$30,000 income tax saving
Income before extraordinary item
$800,000
240,000
560,000
$140,000
Extraordinary item
Expropriation of property, net of $21,000 income tax saving
Net income
70,000
210,000
350,000
49,000
$301,000
ADDITIONAL EARNINGS PER SHARE
DISCLOSURES
HWA ENERGY, INC.
Net income
Earnings per share
Income from continuing operations
Loss from discontinued operations
Income before extraordinary item
Extraordinary loss
Net income
$301,000
$5.60
(2.10)
3.50
(.49)
$3.01
When the income statement contains any non-typical item, EPS
should be disclosed for each component.