University of New Brunswick Memorial University of Newfoundland Financial Accounting: Tools for Business Decision-Making Second Canadian Edition Prepared by: Barbara Trenholm University of New Brunswick & Peggy Coady Memorial University of Newfoundland

Reporting and Analysing Shareholders’ Equity 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 Corporate management professional managers Separate legal existence Limited liability of shareholders Deferred or reduced taxes Transferable ownership rights Ability to acquire capital Continuous life Disadvantages Corporation management ownership separated from management Increased costs and complexity in order to adhere to government regulation Additional taxes

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 Issued 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

Must retain legal capital. relationship to market value once issued. 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 Legal capital The shareholders’ equity section of a corporation’s balance sheet consists of: 1. Share capital (contributed capital) 2. Retained earnings Legal capital

Shareholders’ Equity Shareholders’ equity Share capital Common shares, 100,000 no par value shares authorized, 50,000 issued $800,000 Retained earnings 130,000 Total shareholders’ equity $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 50,000 Dividends Payable 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 50,000 Cash 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 same Before Stock Dividend After Stock Dividend Common shares $500,000 $575,000 Retained earnings 300,000 225,000 Total shareholders’ equity $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)

Common Stock Dividends Distributable 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 25,000 Record Date No Entry Distribution Date Common Shares

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 Total assets NE  Total liabilities Total shareholders’ equity Total share capital  Total retained earnings 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 Cash Dividends 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

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