Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm 1 Chapter 11 Reporting and Analysing Shareholders’ Equity 1. 2. 3. 4. After studying Chapter 11, you should be able to: Identify and discuss the major characteristics of a corporation. Record the issuance of common shares. Differentiate preferred shares from common shares. Prepare the entries for cash dividends and stock dividends. 2 Chapter 11 Reporting and Analysing Shareholders’ Equity After studying Chapter 11, you should be able to: 5. Identify the items that affect retained earnings. 6. Prepare a comprehensive shareholders' equity section. 7. Evaluate a corporation's dividend and earnings performance from a shareholder's perspective. 3 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 4 Characteristics Separate legal existence Limited liability of shareholders Transferable ownership rights Ability to acquire capital Continuous life Corporation management Government regulations Additional taxes 5 Advantages and Disadvantages Advantages Disadvantages Corporate managementprofessional managers Separate legal existence Limited liability of shareholders Deferred or reduced taxes Transferable ownership rights Ability to acquire capital Continuous life Corporation management – ownership separated from management Increased costs and complexity to adhere to government regulation Additional taxes 6 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 7 Illustration 11-2 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 Outstanding shares – number of shares held by shareholders 9 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? 10 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 11 Stated and Par Share Values Stated value – assigned value to nopar value shares Par value – assigned legal capital value Must retain legal capital. Stated and par values have NO relationship to market value 12 No-Par Share Values 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. 13 Issuing No-Par Value Common Shares for Cash When no-par shares do not have a stated value, the entire proceeds from the issue are credited to Common Shares Account Titles and Explanation Cash Common Shares (To record issuance of 1,000 no-par common shares) Debit Credit 8,000 8,000 14 Issuing Common Shares for Non-Cash When common shares are issued for non-cash assets or services, cost is the fair market value of the consideration given up. If this is not identifiable, than the consideration received, is used 15 Corporate Capital Shareholders’ equity (owner’s equity) The shareholders’ equity section of a corporation’s balance sheet consists of: 1. Share capital 2. Retained earnings 16 Shareholders’ Equity Section Shareholders’ equity Share capital Common shares, 100,000 no-par value shares authorized, 50,000 issued and outstanding $800,000 Retained earnings Total shareholders’ equity 130,000 $930,000 17 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 18 Preferred Share Preferences Liquidation preference Cumulative (dividends in arrears) Convertible (book value) Redeemable/callable (company option) Retractable (shareholder option) 19 Reacquisition of Shares Reacquired shares are a corporation’s own shares (either common or preferred) that have been issued, fully paid for, and reacquired by the corporation Reacquired shares are normally retired and cancelled In certain restricted circumstances, these shares are held as treasury shares for later reissue 20 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 21 Dividends Distribution by a corporation to its shareholders on a pro rata (equal) basis Dividends may be in the form of Cash Property Scrip (promissory note to pay cash) Stock (common shares) 22 Cash Dividends For a cash dividend to occur, a corporation must have 1. Retained earnings, 2. Adequate cash, and 3. Declared dividends 23 Entries for Cash Dividends Three dates are important in connection with dividends: 1. Declaration date 2. Record date 3. Payment date Month and ye ar 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 Monday Tue sday Wedne sday Thursday Friday Saturday Sunday 24 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, 2002 the directors of Media General declare a $.50 per share cash dividend on 100,000 shares of no-par value common shares (100,000 x $.50=$50,000) 12/1 Cash Dividends (or Retained Earnings) Dividends Payable 50,000 50,000 25 Record Date Date ownership of the outstanding shares is determined for dividend purposes 12/1 No entry necessary 26 Payment Date Date dividend cheques are mailed. January 20 is the payment date for Media General 1/20 Dividends Payable 50,000 Cash 50,000 27 Allocating Cash Dividends Between Preferred and Common Shares Cumulative Dividends in arrears must be paid to preferred shareholders before allocating dividends to common shareholders Non-cumulative Only the current year’s dividend must be paid to preferred shareholders before paying dividends to common shareholders 28 Stock Dividends Distributed (paid) in shares Decreases retained earnings; increases contributed capital In most cases, fair market value is assigned to the stock dividend shares Total shareholders’ equity and the legal capital per share remain the same 29 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 outstanding and decreasing market price per share To reinvest and restrict a portion of shareholders' equity 30 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 31 Stock Dividends Assume 2% ownership interest in Cetus Inc., owning 200 of its 10,000 shares of 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) 32 Stock Dividends Cetus Inc. would journalize the stock dividend as follows, assuming FMV $25 (1,000 x $25 = $25,000): Declaration Date Stock Dividends (or Retained Earnings) Common Stock Dividends Distrib. Record Date 25,000 25,000 No Entry Distribution Date Common Stock Dividends Distrib. Common Shares 25,000 25,000 33 Stock Dividend Effects Shareholders’ equity Common shares Retained earnings Total shareholders’ equity Outstanding shares Shareholder Number of shares Percentage ownership Before Stock Dividend $500,000 300,000 $800,000 10,000 200 2% After Stock Dividend $525,000 275,000 $800,000 11,000 220 2% 34 Stock Splits A stock split involves the issuance of additional shares to shareholders according to their percentage ownership Number of shares is increased in the same proportion that legal capital per share is decreased. No change to dollar amount in share capital account 35 Stock Splits A stock split has no effect on total share capital, retained earnings, and 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 36 Stock Split Effects Medland Corporation splits its 50,000 no-par value common shares on a 2-for-1 basis. This means that one no-par share is exchanged for two no-par shares Shareholders’ equity Common shares Retained earnings Total shareholders’ equity Outstanding shares Before Stock Split After Stock Split $500,000 300,000 $800,000 50,000 $500,000 300,000 $800,000 100,000 37 Effects of Stock Splits, Stock Dividends and Cash Dividends Total assets Total liabilities Total shareholders’ equity Total share capital Total retained earnings Legal capital per share Number of shares % of shareholder ownership NE = No effect Stock Split Stock Dividend Cash Dividend NE NE NE NE NE NE NE NE NE NE NE NE NE NE NE NE = Increase = Decrease 38 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 39 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 40 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 41 Measuring Corporate Performance Dividend record Payout ratio Dividend yield Earnings performance EPS P/E ratio Return on common shareholders’ equity 42 Payout Ratio Measures the percentage of earnings distributed in the form of cash dividends to common shareholders Payout ratio = Total common cash dividends Net earnings 43 Dividend Yield Reports the rate of return an investor earns from dividends Dividend yield = Cash dividends per common share Year end share price 44 Earnings Per Share Measures the net earnings per common share Earnings per share = Net earnings – Preferred share dividends Average common shares outstanding 45 Price-Earnings Ratio In order to make a meaningful comparison of earnings across firms, use the priceearnings ratio The price-earnings ratio reflects the investors' assessment of a company's future earnings Price-earnings ratio = Market price per share Earnings per share 46 Return on Common Shareholders’ Equity Measures the profitability from the shareholders’ point of view Return on common shareholders’ equity ratio = Net earnings – Preferred share dividends Average common shareholders’ equity 47 Decision Checkpoints Should the company incorporate? What portion of earnings does the company pay out in dividends? What level of return can be earned on the company’s dividends? Payout ratio Dividend yield 48 Decision Checkpoints (continued) How does the company’s Earnings per share earnings performance compare with that of previous years? Price-earnings ratio How does the market perceive the company’s prospects for future earnings? Return on common What is the company’s shareholders’ equity return on common shareholders’ investment? 49 Copyright Copyright © 2001 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. 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