Shareholders' Equity

Explain the Features of a Corporation

• Separate legal entity
• Continuous life and transferability of ownership
• Limited liability
• Separation of ownership and management
• Corporate taxation
• Government regulation

Organizing a Corporation

• Corporate organizers (incorporators) apply for registration as a company with relevant authority.
• Constitution (charter) – authorizes corporation to issue a certain number of shares.
• Authority Structure in a Corporation (Exhibit 10-2).

Shareholders’ Rights

• Vote Right to vote on matters that come before the shareholders.
• Dividends Right to receive a proportionate part of any dividend.
• Liquidation Right to receive a proportionate share of any assets remaining upon liquidation.
• Preemption Right to maintain one’s proportionate ownership in the corporation.

Shareholders’ Equity

• Paid-in capital (contributed capital)
  • Amount of shareholders’ equity the shareholders have contributed to the corporation.
  • Includes share accounts and additional paid-in capital.
• Retained earnings
  • Amount of shareholders’ equity the corporation has earned through profitable operations.
  • Reduced by dividends.
• Other equity accounts (e.g., reserves and non-controlling interests).

Classes of Shares

Ordinary Shares (common stock)

• Basic form of shares, all corporations issue these.
• The owners of the corporation.
• Four basic rights.
• Stand to benefit most if corporation succeeds.

Preference Shares

• Certain advantages over ordinary shares
  • Receive dividends first
  • Receive assets first in liquidation
• Four basic rights
• Not common

Comparison of Ordinary Shares, Preference Shares, and Long-Term Debt (Exhibit 10-4)

Par Value and No-Par

• Par value – arbitrary amount assigned by a company upon issuing shares
  • Usually set low to avoid legal issues
• No-Par share does not have a par value
  • May have a stated value
  • Rare in practice (less then 9%)

Account for the Issuance of Shares

Ordinary Shares at Par

• ABC sought to raise $62$ million ($6.2$ million shares at $10$ per share). Suppose ABC’s ordinary share had carried a par value equal to its issuance price of $10$ per share. The entry for issuance of $6.2$ million shares of ordinary shares at par would be:

Ordinary Shares Above Par

• ABC needs to raise $100$ million through issuance of stock. Suppose ABC’s ordinary shares had a par value of $0.01$. The entry for issuance of at $10$ per share would be:

Ordinary Shares with No-Par Values

• If L’Occitane shares had been no-par shares, the issuance would be recorded to share capital only. The entry is as follows (in millions):

Shares Issued for Assets Other than Cash

• On November 12, Kahn Corporation issued $15,000$ shares of its $1$ par ordinary shares for equipment worth $4,000$ and a building worth $120,000$. Kahn’s entry is:

Ordinary Shares Issued for Services

• Kahn Corporation engages an attorney. The attorney bills the corporation $25,000$ for services and agrees to accept $2,500$ shares of $1$ par common stock, in settlement of the fee. The fair market value of the stock is $10$ per share.

Share Issuance for Other than Cash – Ethical Challenge

• When corporations receive an asset other than cash, the corporation must record the asset received and the stock issued at fair market value.
• If software worth $500,000$ is received for ordinary share, the following entry would be appropriate:
• Corporations like to report large asset/equity amounts on their Balance Sheets, which makes them look prosperous.

Preference Shares

• Follows same pattern as accounting for ordinary shares
• May be separate accounts for paid-in capital in excess of par for preference and ordinary shares
• Can be issued with conversion feature to allow preference shareholders to exchange preference shares for ordinary shares (at the discretion of preferred shareholders)

Authorized, Issued, and Outstanding Shares

• Authorized shares – maximum number of shares the company can issue under its constitution
• Issued shares – number of shares the company has issued to its shareholders
• Outstanding shares – number of shares that the shareholders actually own = Issued shares – Treasury shares

Account for Treasury Shares

• Treasury Shares – a company’s own shares that it had issued and later reacquired
• Reasons to buy back treasury shares:
  • Need shares for distributions to employees
  • Buying its shares low and selling at a higher price
  • Avoid takeover
  • Increase earnings per share (EPS)
  • Repurchase program to return excess cash to shareholders

How are Treasury Shares Recorded?

• Recorded at cost on the date of purchase
• Disregard par value
• Contra shareholders’ equity account
  • Debit balance
• Reported beneath Retained Earnings on the balance sheet
• Credit cash

Example

• In the fiscal year 2016, L’Occitane bought $2.6$ million shares (in L’Occitane itself) amounting to about €$4$ million. This would be recorded as:
• Equity and assets (cash) are reduced: a buy-back (acquiring treasury shares) shrinks equity and assets (while an issuance of shares grows equity and assets)

Resale of Treasury Stock

• Increases assets and equity by amount of cash received (similar to an issuance)
• Amounts received in excess (or short) of original amount paid are recorded as Paid-in Capital from Treasury Share Transactions
• Never a gain or loss on treasury share transactions

Resale of Treasury Share

• L’Occitane did not resell any treasury shares in its fiscal year 2016. Assuming it actually sold $10,000$ treasury shares for €$2.00$ per share, the journal entry to record the resale of treasury shares would have been as follows:
• What if L’Occitane had sold the treasury shares at €$1.20$?

Retiring Treasury Share

• Cancel share certificates
• Retired shares cannot be reissued
• Once repurchased, neither total assets nor total liabilities are affected
• Memorandum entry to decrease the amount of outstanding shares
• Example: Suppose L’Occitane canceled $10,000$ shares amounting to €$15,000$ during 2016:

Summary of Treasury-Share Transactions

• Buying treasury share – assets and equity decrease by the cost of treasury stock purchased
• Reselling treasury share – assets and equity increase by the sale price of treasury stock sold
• Issuing share for employee compensation – expenses, capital stock, and additional paid-in capital all increase
• Retiring treasury share – remove it from common stock and treasury

Account for Other Equity Transactions

Retained Earnings

• Net income less net losses less dividends declared
• Accumulated over corporation’s life
• Credit balance lifetime net earnings exceed lifetime losses and dividends
• Debit balance lifetime losses and dividends exceed earnings (deficit)

Dividends

• Distribution by a corporation to its stockholders, usually based on earnings
• Usually take one of three forms:
  • Cash
  • Shares (buy-backs)
  • Non-cash assets

Cash Dividends

• Most common type of dividend
• Must have enough retained earnings to declare the dividend and enough cash to pay the dividend
• Board of directors has the authority to declare – Corporation has no obligation until declared
• Three relevant dates:
  • Declaration date
  • Date of record
  • Payment date

Example

• On June 19, the board of directors declares a $50,000$ cash dividend. The company records (on the declaration date) the cash dividend as follows:

Example

• July 1 – As part of the declaration, the corporation announces the record date (book closure date), which follows the declaration date by a few weeks. The shareholders on the record date will receive the cash dividend. There is no journal entry for the date of record.

Example

• On July 10, the company paid the cash dividend declared on June 19 (payment usually follows the record date by a week or two). The entry (on the payment date) to record the payment is as follows:
• Thus, the net effect of declaring and paying the cash dividend is a decrease in assets (cash) and an off-setting decrease in equity.

Dividends on Preference Shares

• Receive dividends before ordinary shareholders
• Stated as either:
  • Percent of par value, or
  • Amount per share
• May be cumulative
  • Receive all dividends in arrears before ordinary shareholders get any dividend

Example

• Avant Garde, Inc. has $100,000$ 2% cumulative preference shares (par value $100$) outstanding. Avant Garde passed the preference dividend of $200,000$ in 20X6. Avant Garde does not declare any dividends in 20X6. Before paying dividends to ordinary share in 20X7, it must first pay preference dividends of $200,000$ for both 20X6 and 20X7—a total of $400,000$. On September 6, 20X7, it declares a $600,000$ dividend.

Share Dividends

• Proportional distribution of corporation’s share to its shareholders
• Increases Share Capital
• Decreases Retained Earnings
• Total equity is unchanged
• Reasons for share dividends:
  • Continue dividends, but conserve cash
  • Reduce the market price of share

Example

• Suppose L’Occitane declared 10% share dividend when the share is trading at €10 per share (recall par value is €$0.03$). Assuming that there are $20,000,000$ shares outstanding, L’Occitane would record the share dividend as follows:

Stock Splits

• An increase in the number of shares authorized, issued, and outstanding
• Proportionate reduction in par value
• Decreases the market price of each share
  • Makes share more attractive in the market (they feel)
• No accounts affected, nothing really changes

Example

• Before the split, Ryssa Biscuits Factory Ltd. had around $250$ million shares of €$0.50$ issued and outstanding. Ryssa records a 2-for-1 stock split, as shown below:

Effects on Assets, Liabilities, and Equity (Exhibit 10-6)

Understand the Different Values of Shares

• Market, Redemption, Liquidation, and Book Value
  • Share’s market value, or market capitalization – market price multiplied by number of shares outstanding
  • Overall market assessment of the worth of a share of ordinary share is reflected in the price-earnings ratio
  • Redeemable preference share requires company to redeem share at a set price
  • Liquidation value of preference share: amount that a company must pay a preferred shareholder in the event the company goes out of business
  • Book value per share: amount of shareholders’ equity on a company’s books for each share

Example

• Crusader Corporation’s Balance Sheet reports the following amounts:
• Assume Crusader’s cumulative preference dividends are in arrears for four years (including the current year) and have a redemption value of $130$ per share. The book value per share computations for Crusader Corporation are: