1. Reporting and Analysing Shareholders’ Equity CHAPTER 11

2. Corporation Separate legal entitySeparate legal entity Has most of the rights and privileges of a personHas most of the rights and privileges of a person Classified by purpose and ownershipClassified by purpose and ownership –Purpose: profit or nonprofit –Ownership: public or private

3. Characteristics of a Corporation Separate legal existenceSeparate legal existence Limited liability of shareholdersLimited liability of shareholders Transferable ownership rightsTransferable ownership rights Ability to acquire capitalAbility to acquire capital Continuous lifeContinuous life Corporation managementCorporation management Government regulationsGovernment regulations Income taxesIncome taxes

4. Advantages and Disadvantages of a Corporation Advantages –Corporate management professional managersprofessional 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

5. Shareholder Rights To raise capital, the corporation sells sharesTo raise capital, the corporation sells shares If there is only one class of shares, these are referred to as common sharesIf 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-lawsOwnership rights are specified in articles of incorporation or in by-laws

6. Share Terminology Authorized sharesAuthorized shares –maximum amount of shares a corporation is allowed to sell as authorized by corporate charter Issued sharesIssued shares –number of shares sold

7. 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 sellersShares of publicly held companies are traded on organized exchanges at dollar prices per share established by the interaction between buyers and sellers

8. No Par Value Shares Par and stated value shares seldom usedPar and stated value shares seldom used Par value has no assigned legal capital valuePar value has no assigned legal capital value Legal capital equals issue price (proceeds)Legal capital equals issue price (proceeds) Must retain legal capital. No par value has NO relationship to market value once issued. relationship to market value once issued.

9. Reacquired shares are a corporation’s own shares (either common or preferred) that have been issued and reacquired by the corporationReacquired 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 cancelledReacquired shares are normally retired and cancelled Reacquisition of Shares

10. The shareholders’ equity section of a corporation’s balance sheet consists of:The shareholders’ equity section of a corporation’s balance sheet consists of: 1. Share capital (contributed capital) 2. Retained earnings 2. Retained earnings Shareholders’ Equity

11. Shareholders’ equity Share capital Common shares, 100,000 no par value shares authorized, 50,000 issued $800,000 Retained earnings 130,000 130,000 Total shareholders’ equity $930,000

12. Preferred shares have priority over common shares with regards to: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 rightsPreferred shareholders usually do not have voting rights Preferred shares are shown first in the share capital section of shareholders' equityPreferred shares are shown first in the share capital section of shareholders' equity Preferred Shares

13. Liquidation preferenceLiquidation preference Cumulative (dividends in arrears)Cumulative (dividends in arrears) ConvertibleConvertible Redeemable/callable (company option)Redeemable/callable (company option) Retractable (shareholder option)Retractable (shareholder option) Preferred Share Preferences

14. Dividends Dividends are distributed by a corporation to its shareholders on a pro rata (equal) basisDividends are distributed by a corporation to its shareholders on a pro rata (equal) basis They are normally in the form of:They are normally in the form of: –Cash –Stock (common shares)

15. Cash Dividends For a cash dividend to occur, a corporation must have:For a cash dividend to occur, a corporation must have: 1.Retained earnings 2.Adequate cash 3.Declared dividends

16. Entries for Cash Dividends Three dates are important in connection with dividends: 1. Declaration date 2. Record date 3. Payment date

17. Declaration Date Date the Board of Directors declares cash dividendDate the Board of Directors declares cash dividend Commits the corporation to a binding legal obligation that cannot be rescindedCommits 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 Payable50,000 Dividends Payable 50,000

18. Record Date Date ownership of shares is determined for dividend purposesDate ownership of shares is determined for dividend purposes Dec. 22 No entry necessary

19. Payment Date Date dividend cheques are mailed Date dividend cheques are mailed The payment date for Media General is January 20. Jan. 20 Dividends Payable 50,000 Cash50,000

20. Stock Dividends Distributed (paid) in sharesDistributed (paid) in shares In most cases, fair market value is assigned to the stock dividend sharesIn most cases, fair market value is assigned to the stock dividend shares Decreases retained earnings, increases common shares, total shareholder’s equity remains the sameDecreases 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 300,000 300,000 225,000 225,000 Total shareholders’ equity $800,000$800,000

21. For companyFor 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

22. For shareholderFor shareholder –More shares with which to earn additional dividend income –More shares for future profitable resale, as share price increases

23. Stock Dividends Assume 2% ownership interest in Cetus Inc., owning 200 of its 10,000 common sharesAssume 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 issuedIn 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)You would receive 20 shares (2% x 1,000), but your ownership interest would remain at 2% (220 /11,000)

24. 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 25,00025,000 Record DateNo Entry Distribution Date Common Stock Dividends Distributable Common Shares Common Shares 25,00025,000

25. Stock Splits A stock split involves the issue of additional shares to shareholders according to their percentage ownershipA stock split involves the issue of additional shares to shareholders according to their percentage ownership Number of shares is increasedNumber of shares is increased No change to dollar amount in share capital accountNo change to dollar amount in share capital account

26. Stock Splits A stock split has no effect on total share capital, retained earnings, or total shareholders’ equityA 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 splitMarket value of the shares will decrease roughly proportionately to the split It is not necessary to formally journalize a stock splitIt is not necessary to formally journalize a stock split

27. Effects of Stock Splits, Stock Dividends, and Cash Dividends NE = No effect  = Increase  = Decrease Stock Split Stock Dividend Cash Dividend Total assets NENE Total liabilities NENENE Total shareholders’ equity NENE Total share capital NENE Total retained earnings NE Number of shares NE % of shareholder ownership NENENE

28. 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 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

29. 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 Common shares Retained earnings (deficit) Retained earnings (deficit) Total shareholders’ equity $800,000 $800,000 (50,000) (50,000)$750,000

30. Retained Earnings Restrictions In some cases there may be retained earnings restrictions that make a portion of the balance currently unavailable for dividendsIn 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:Restrictions result from one or more of the following causes: –Legal –Contractual –Voluntary

31. Measuring Corporate Performance Dividend recordDividend record –Payout ratio Earnings performanceEarnings performance –Return on common shareholders’ equity

32. Payout Ratio Measures the percentage of earnings distributed in the form of cash dividends to common shareholdersMeasures the percentage of earnings distributed in the form of cash dividends to common shareholders Payout Ratio = Cash Dividends Net Earnings

33. Return on Common Shareholders’ Equity Measures the company’s profitability from the shareholders’ point of viewMeasures the company’s profitability from the shareholders’ point of view Return on Common Shareholders’ Equity = Net Earnings – Preferred Share Dividends Average Common Shareholders’ Equity Average Common Shareholders’ Equity

34. Components of ROE

35. Debt vs. Equity Decision Companies must decide between issuing bonds or selling shares to raise long-term capital BondsBonds –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