Shareholders Equity. 1 Explain the advantages and disadvantages of a corporation

Transcription

1 9 Shareholders Equity Learning Objectives 1 Explain the advantages and disadvantages of a corporation 2 Measure the effect of issuing shares on a company s financial position 3 Describe how share repurchase transactions affect a company 4 Account for dividends and measure their impact on a company 5 Use different share values in decision making 6 Evaluate a company s return on assets and return on shareholders equity 7 Report shareholders equity transactions on the cash flow statement

2 Shoppers Drug Mart Inc. Partial Balance Sheet (Thousands) For the 52 Weeks Ended January 1, 2005 and 53 Weeks Ended January 3, /01/ /01/ 2004 Share capital $1,421,980 $1,411,878 Contributed surplus , Retained earnings , ,304 Shareholders equity $2,157,303 $1,847,398 Share Capital Authorized Unlimited number of common shares Unlimited number of preferred shares, issuable in series without nominal or par value Outstanding 01/01/ /01/2004 Number of Number of Stated Common shares Stated Value Common shares Value Beginning balance ,724,407 $ 1,411, ,703,488 $ 1,419,783 Shares issued ,632 5,008 29, Shares repurchased (9,194) (62) (8,772) (59) Share purchase loans, net ,156 (8,223) Ending balance ,990,845 $ 1,421, ,724,407 $ 1,411,878 During the period ended January 1, 2005, the Company issued 275,632 common shares ( ,691) with a stated value of $5,008, net of tax of $nil (2003 $377). In addition, 9,194 common shares (2003 8,772) were repurchased for cancellation. If you are like most college students, you have been to Shoppers Drug Mart but you have probably not given much thought to its capital structure. In this chapter you will learn how Shoppers Drug Mart and other corporations account for shareholders equity transactions. What does it mean to go public? A corporation goes public when it sells its shares to the general public. A common reason for going public is to raise money for expansion. By offering its shares to the public, a company can raise more money than if the shareholders remain private. Shoppers Drug Mart Corporation was able to place 30 million shares in the market at $18 per share when it went public and sold those shares in its initial public offering (IPO)in November Shoppers Drug Mart s balance sheet indicates that through January 1, 2005, the company had received over $1.4 billion from its shareholders. Chapters 4 to 8 discussed accounting for the assets and the liabilities of a company. By this time, you should be familiar with all the assets and liabilities listed on a company s balance sheet. Let s focus now on the last part of the balance sheet a corporation s shareholders equity. In this chapter, we discuss some of the decisions a company faces when issuing and buying back its shares and when declaring and paying dividends. In the process, we cover the elements of shareholders equity in detail. Let s begin by reviewing how a corporation is organized.

3 456 Chapter 9 Shareholders Equity Objective 1Explain the advantages and disadvantages of a corporation Shareholder A person who owns shares in a corporation. Also called a shareholder. DECISION: What Is the Best Way to Organize a Business? Anyone starting a business must decide whether to organize the entity as a proprietorship, a partnership, or a corporation. Many businesses choose the corporation. Why is the corporate form of business so attractive? The ways in which corporations differ from proprietorships and partnerships provide some reasons. Separate Legal Entity. A corporation is a business entity formed under federal or provincial law. The federal or provincial government grants articles of incorporation, which consist of documents giving the governing body s permission to form a corporation. A corporation is a distinct entity, an artificial person that exists apart from its owners, who are called shareholders. The corporation has many of the rights that a person has. For example, a corporation may buy, own, and sell property. Assets and liabilities in the business belong to the corporation rather than to its owners. The corporation may enter into contracts, sue, and be sued. Nearly all well-known companies, such as Shoppers Drug Mart Inc., TransCanada Corporation, Bombardier Inc., and Sobeys Inc., are corporations. Their full names include Limited, Corporation, or Incorporated (abbreviated Ltd., Corp., and Inc.) to indicate that they are corporations Continuous Life and Transferability of Ownership. Corporations have continuous lives regardless of changes in the ownership of their shares. The shareholders of Shoppers Drug Mart or any corporation may transfer shares as they wish. They may sell or trade the shares to another person, give them away, bequeath them in a will, or dispose of them in any other way. The transfer of the shares does not affect the continuity of the corporation. In contrast, proprietorships and partnerships terminate when ownership changes. Limited liability No personal obligation of a shareholder for corporation debts. A shareholder can lose no more on an investment in a corporation s shares than the cost of the investment. Double taxation Corporations pay income taxes on corporate income. Then, the shareholders pay personal income tax on the cash dividends that they receive from corporations. Canada s tax laws attempt to minimize double taxation. Limited Liability. Shareholders have limited liability for the corporation s debts. They have no personal obligation for corporate liabilities. The most that a shareholder can lose on an investment in a corporation s shares is the cost of the investment. In contrast, proprietors and partners are personally liable for all the debts of their businesses. Limited liability is one of the most attractive features of the corporate form of organization. It enables corporations to raise more capital from a wider group of investors than proprietorships and partnerships can. Separation of Ownership and Management. Shareholders own the corporation, but a board of directors elected by the shareholders appoints officers to manage the business. Thus, shareholders may invest $1,000 or $1 million in the corporation without having to manage the business or disrupt their personal affairs. Management s goal is to maximize the firm s value for the shareholders. But the separation between owners and managers may create problems. Corporate officers may run the business for their own benefit and not for the shareholders. For example, the chief financial officer (CFO) of Enron Corporation set up outside partnerships and paid himself millions of dollars to manage the partnerships unknown to Enron shareholders. Corporate Taxation. Corporations are separate taxable entities. They pay a variety of taxes not borne by proprietorships or partnerships, such as federal and provincial income taxes. Corporate earnings are subject to double taxation of their income. First, corporations pay income taxes on their corporate income. Then shareholders

4 pay personal income tax on the cash dividends that they receive from corporations. Canada s tax laws attempt to minimize double taxation. Proprietorships and partnerships pay no business income tax. Instead, the tax falls solely on the owners, who are taxed on their share of the proprietorship or partnership income. Government Regulation. Because shareholders have only limited liability for corporation debts, outsiders doing business with the corporation can look no further than the corporation if it fails to pay. To protect the creditors and the shareholders of a corporation, both federal and provincial governments monitor corporations. This government regulation consists mainly of ensuring that corporations disclose the information that investors and creditors need to make informed decisions. Accounting provides much of this information. Exhibit 9-1 summarizes the advantages and disadvantages of the corporate form of business organization. Organizing a Corporation 457 Advantages Disadvantages 1. Can raise more capital than a proprietorship 1. Separation of ownership and or partnership can management 2. Continuous life 2. Corporate taxation 3. Ease of transferring ownership 3. Government regulation 4. Limited liability of shareholders Exhibit 9-1 Advantages and Disadvantages of a Corporation Organizing a Corporation The process of creating a corporation begins when its organizers, called the incorporators, submit articles of incorporation to the federal or provincial government for approval. The articles of incorporation include the authorization for the corporation to issue a certain number of shares of stock, which are shares of ownership in the corporation. The incorporators pay fees, sign the charter, and file the required documents with the incorporating jurisdiction. The corporation then comes into existence. The incorporators then agree to a set of bylaws, which act as the constitution for governing the corporation. Ultimate control of the corporation rests with the shareholders. The shareholders elect a board of directors, which sets policy and appoints officers. The board elects a chairperson, who usually is the most powerful person in the organization. The board also designates the president, who is the Chief Executive Officer (CEO) in charge of day to day operations. Most corporations also have vice presidents in charge of sales, manufacturing, accounting and finance (the chief financial officer, or CFO), and other key areas. Exhibit 9-2 shows the authority structure in a corporation. Shareholders Rights Ownership of shares entitles shareholders to five basic rights, unless specific rights are withheld by agreement with the shareholders: Bylaws Constitution for governing a corporation. Board of directors Group elected by the shareholders to set policy for a corporation and to appoint its officers. Chairperson Elected by a corporation s board of directors, usually the most powerful person in the corporation. President Chief operating officer in charge of managing the day-to-day operations of a corporation. 1. The right to sell the shares. This right might be restricted in certain circumstances but such discussion is beyond the scope of this text.

5 458 Chapter 9 Shareholders Equity Exhibit 9-2 Authority Structure in a Corporation Shareholders Board of Directors Chief Executive Officer Chief Operating Officer Vice President, Sales Vice President, Manufacturing Chief Financial Officer Vice President, Personnel Secretary Controller (Accounting Officer) Treasurer (Finance Officer) 2. Vote. The right to participate in management by voting on matters that come before the shareholders. This is the shareholder s sole voice in the management of the corporation. A shareholder is normally entitled to one vote for each share of common stock owned. There are various classes of common shares that give the holder multiple votes or no vote. 3. Dividends. The right to receive a proportionate part of any distributed payment, or dividend. Each share of stock in a particular class receives an equal dividend. 4. Liquidation. The right to receive a proportionate share (based on number of shares held) of any assets remaining after the corporation pays its liabilities in liquidation. Liquidation means to go out of business, sell the entity s assets, pay its liabilities, and distribute any remaining cash to the owners. 5. Preemption. The right to maintain one s proportionate ownership in the corporation. Suppose you own 5% of a corporation s shares. If the corporation issues 100,000 new shares, it must offer you the opportunity to buy 5% (5,000) of the new shares. This right is called the preemptive right. Shareholders equity The shareholders ownership interest in the assets of a corporation. Contributed capital The amount of shareholders equity that shareholders have contributed to the corporation. Also called capital stock. Retained earnings The amount of shareholders equity that the corporation has earned through profitable operation of the business and has not given back to shareholders. Shareholders Equity As we saw in Chapter 1, shareholders equity represents the shareholders ownership interest in the assets of a corporation. Shareholders equity is divided into two main parts: 1. Contributed capital, also called capital stock. This is the amount of shareholders equity the shareholders have contributed to the corporation. 2. Retained earnings. This is the amount of shareholders equity the corporation has earned through profitable operations and has not used for dividends. Companies report shareholders equity by source. They report contributed capital separately from retained earnings because most incorporating acts prohibit the declaration of cash dividends from contributed capital. Thus, cash dividends are declared from retained earnings.

6 Organizing a Corporation 459 Exhibit 9-3 Share Certificate Company name Shareholder name Number of shares The owners equity of a corporation is divided into shares of stock. A corporation issues share certificates to its owners in exchange for their investment in the business. The basic unit of contributed capital is called a share. A corporation may issue a share certificate for any number of shares it wishes one share, 100 shares, or any other number but the total number of authorized shares is limited by charter. Exhibit 9-3 shows an actual common share certificate for Danier Leather Inc. The terms authorized, issued, and outstanding are frequently used to describe a corporation s shares. Authorized refers to the maximum number of shares a corporation is allowed to distribute to shareholders. Companies incorporated under the Canada Business Corporations Act are permitted to issue an unlimited number of shares. Issued refers to the number of shares sold or transferred to shareholders. Outstanding refers to the number of shares actually in the hands of shareholders. Sometimes a company repurchases shares it has previously issued so that the number of shares outstanding will be less than the number of shares issued. For example, if a corporation issued 100,000 shares and later repurchased 20,000 shares, then the number of shares outstanding would be 80,000. The total number of shares of stock outstanding at any time represents 100% ownership of the corporation. Stock Shares into which the owners equity of a corporation is divided. Outstanding shares Shares in the hands of shareholders. Classes of Shares Corporations issue different types of shares to appeal to a variety of investors. The shares of a corporation may be either Common Preferred Common and Preferred. Every corporation issues common shares, the basic form of capital stock. Unless designated otherwise, the word share is understood to mean common share. Common shareholders have the five basic rights of share ownership, unless a right is specifically withheld. For example, some companies issue Class A common shares, which usually carry the right to vote, and Class B common shares, which may be nonvoting. In describing a corporation, we would say the common shareholders are the owners of the business. Common shares The most basic form of capital stock. Common shareholders own a corporation.

7 460 Chapter 9 Shareholders Equity Preferred shares Shares that give their owners certain advantages, such as the priority to receive dividends before the common shareholders and the priority to receive assets before the common shareholders if the corporation liquidates. Exhibit 9-4 Preferred Shares 69% Check Point 9-2 Corporations with preferred shares 31% Corporations with no preferred share No-par-value shares Shares of stock that do not have a value assigned to them by the articles of incorporation. Stated value Arbitrary amount assigned by a company to a share of its stock at the time of issue. Preferred shares give their owners certain advantages over common shareholders. Preferred shareholders receive dividends before the common shareholders and receive assets before the common shareholders if the corporation liquidates. Owners of preferred shares also have the five basic shareholder rights, unless a right is specifically denied. Companies may issue different classes of preferred shares (Class A and Class B or Series A and Series B, for example). Each class is recorded in a separate account. Preferred shares are a hybrid between common shares and long-term debt. Like debt, preferred shares pay a fixed dividend amount to the investor. But like shares, the dividend is not required to be paid unless the board of directors has declared the dividend. Also, companies have no obligation to pay back true preferred shares. Preferred shares that must be redeemed (paid back) by the corporation are a liability masquerading as a stock. Preferred shares are rarer than you might think. A recent survey of 200 corporations revealed that only 31% of them had preferred shares outstanding (Exhibit 9-4). 1 All corporations have common shares. Exhibit 9-5 summarizes the similarities and differences among common shares, preferred shares, and long-term debt. No-Par-Value Shares. No-par-value shares are shares of stock that do not have a value assigned to them by the articles of incorporation. The board of directors assigns a value to the shares when they are issued; this value is known as the stated value. For example, Dajol Inc. has authorization to issue 100,000 shares of common stock, having no par value assigned to them by the articles of incorporation. Dajol Inc. needs $50,000 at incorporation, and might issue 10,000 shares for $5.00 per share, 2,000 shares at $25.00 per share, or 1,000 shares at $50.00 per share, and so on. The point is that Dajol Inc. can assign whatever value to the shares the board of directors wishes. Normally, the stated value would be credited to Common Shares when the shares are issued. The recorded value of a corporation s contributed capital or stated capital is the sum of the shares issued times the stated values of those shares at the time of issue. For example, if YDR Ltd. issued 1,000 common shares at a stated value of $8.00 per share, 2,000 shares at $12.00 per share, and 500 shares at $15.00 per share, its contributed capital or stated capital would be $39,500 [(1,000 $8) + (2,000 $12) + (500 $15)]. Exhibit 9-5 Comparison of Common Shares, Preferred Shares, and Long-Term Debt Common Shares Preferred Shares Long-Term Debt 1.Corporate obligation No No Yes to repay principal 2.Dividends/interest Dividends not Dividends not Tax-deductible tax-deductible tax-deductible interest expense 3.Corporate obligation Only after Only after At fixed dates to pay dividends/interest declaration declaration 1 Byrd, Clarence, Ida Chen, and Heather Chapman. Financial Reporting in Canada, 27th Edition, (Toronto: Canadian Institute of Chartered Accountants, 2002), p. 344.

8 Issuing Shares 461 The Canada Business Corporations Act and most provincial incorporating acts now require common and preferred shares to be issued without nominal or par value. The full amount of the proceeds from the sale of shares by a company must be allocated to the capital account for those shares. For example, if Canadian Tire Corporation, Limited were to issue 100 common shares for $2,500 (that is, the shares sold for $25.00 per share), $2,500 would be credited to Common Shares. Issuing Shares Large corporations such as Nortel Networks Corporation, Hudsons Bay Company, and EnCana Corp. need huge quantities of money to operate. Corporations may sell shares directly to the shareholders or use the service of an underwriter, such as the brokerage firms Scotia McLeod and BMO Nesbitt Burns. Companies often advertise the issuance of their shares to attract investors. The Globe and Mail Report on Business and the National Post are the most popular mediums for such advertisements, which are also called tombstones. Exhibit 9-6 on page 426 is a reproduction of Mega Bloks Inc. s tombstone, which appeared in the Globe and Mail. The lead underwriter of Mega Bloks Inc. s public offering was Merrill Lynch Canada Inc. Several other Canadian firms were involved in the issue. In this 2003 public offering (illustrated in Exhibit 9-6), Mega Bloks Inc. sought to raise $133,799,660 of capital. Objective 2Measure the effect of issuing shares on a company s financial position Issuing Common Shares at a Stated Value. Suppose George Weston Limited, a leadng food processing and food distribution company, issues 100,000 common shares for cash, and the directors determine that the shares will be issued with a stated value (selling price) of $70 per share. The share issuance entry is 2005 Jan. 8 Cash ,000,000 Common Shares ,000,000 To issue common shares at $70.00 per share (100,000 $70.00) We assume George Weston Ltd. received $7,000,000. The amount invested in the corporation, $7,000,000 in this case, is called contributed capital. The credit to Common Shares records an increase in the contributed capital of the corporation. George Weston, in its annual report dated December 31, 2004, indicated there were 128,913,579 common shares outstanding with a stated value of $126,000,000. After this assumed transaction, George Weston would report 129,031,579 outstanding shares and the balance in its share capital account would be increased by $7 million. All the transactions recorded in this section include a receipt of cash by the corporation as it issues new shares. These transactions are different from those reported in the financial press. In those transactions, one shareholder sells shares to another investor, and the corporation makes no journal entry. Check Point 9-3 Check Point 9-4

9 462 Chapter 9 Shareholders Equity Exhibit 9-6 Announcement of Public Offering of Mega Blocks Inc. Common Shares Company issuing the shares Number of shares offered to the public Class of shares Issue price: the amount per share received by Mega Bloks Inc. Lead underwriter

10 Issuing Shares 463 Examine Shoppers Drug Mart s balance sheet at January 3, 2004, given at the beginning of the chapter (page 419). Answer these questions about Shoppers Drug Mart s actual stock transactions (amounts in thousands of dollars, except per share): 1. What was Shoppers contributed capital from common shares at January 1, 2005? At January 3, 2004? 2. How many common shares were issued through January 1, 2005? Through January 3, 2004? 3. What was the average issue price of the common shares that Shoppers issued during the year-ended January 1, 2005 and January 3, 2004? STOP & THINK Answers: January 1, 2005 January 3, Total contributed capital $1,421,980 + $1,641 $1,411,878 + $216 = $1,423,621 = $1,412, Number of common shares issued 275,632 29, Average issue price of shares $5,008, ,632 $377,000 29,691 issued during year ended Jan. 1, = $18.17 = $ or Jan. 3, 2004 Common Shares Issued for Assets Other Than Cash. When a corporation issues shares in exchange for assets other than cash, it records the assets received at their current market value and credits the capital accounts accordingly. The assets prior book value does not matter because the shareholder will demand shares equal to the market value of the asset given. Kahn Corporation issued 15,000 common shares for equipment worth $4,000 and a building worth $120,000. Kahn Corporation s entry is Nov. 12 Equipment ,000 Building ,000 Common Shares ,000 To issue common shares in exchange for equipment and a building. Check Point 9-5 ASSETS LIABILITIES SHAREHOLDERS EQUITY 4, , ,000

11 464 Chapter 9 Shareholders Equity ACCOUNTING ALERT A Stock Issuance for Other Than Cash Can Pose an Accounting Problem Generally accepted accounting principles say to record shares at the fair market value of whatever the corporation receives in exchange for the shares. When the corporation receives cash, the cash received provides clear evidence of the value of the shares because cash is worth its face amount. Many entrepreneurs start up companies with an asset other than cash. They invest the asset and receive the new corporation s shares. A computer whiz may contribute some computer hardware and software. The software may be market-tested or it may be new. It may be worth millions or it may be worthless. An artist may contribute paintings or sculpture to start an art gallery. A real-estate agent may invest in a building to start a realty company. The corporation must record the asset received and the shares given with a journal entry such as the following: Software Common Shares Issued shares in exchange for software. In effect, the new corporation is buying the software and paying for it by issuing common shares. Therefore, the business must assign a value to the software and to the common shares. The market value of the software determines the value assigned to the shares. What is the software really worth? Let s consider two possibilities: Situation 1. The software has been on the market for several months and is selling well. The creator of the software has standing orders for 2,000 copies, and an industry expert values the software at $500,000. To start up the new corporation, the company makes this entry: XXX XXX Software ,000 Common Shares ,000 Issued shares in exchange for software. Situation 2. The software is new and untested. The entrepreneur believes it is worth millions but decides to be conservative and values it at $500,000. For its first transaction, the company makes this entry: Software ,000 Common Shares ,000 Issued shares in exchange for software. Suppose both entrepreneurs need $200,000 to market the software. They invite you to invest in their new business. Both balance sheets look identical: Gee-Whiz Computer Solutions Balance Sheet December 31, 20X8 ASSETS LIABILITIES Compute software..... $500,000 $ -0- SHAREHOLDER EQUITY Common shares ,000 Total assets $500,000 Total liabilities and equity.... $500,000 Both companies are debt-free and both appear to have a valuable asset. Which company will you invest in? Here are three takeaway lessons: Be careful when you invest your money. Some accounting values are more solid than others. Not all financial statements mean exactly what they say unless they are audited by independent CPAs.

12 Issuing Shares 465 Preferred Shares Accounting for preferred shares follows the pattern we illustrated for common shares. The company records a Preferred Shares account at its stated value. When reporting shareholders equity on the balance sheet, a corporation lists preferred shares, common shares, and retained earnings in that order, illustrated as follows for George Weston Limited: Common share capital $126 $120 Preferred shares, series Preferred shares, series Share capital Retained earnings ,170 4,046 Cumulative foreign currency translation adjustment (404) (192) Total shareholders equity $4,380 $4,462 On April 18, 2005 George Weston Ltd. announced the completion of the sale of 8,000,000 Series III Preferred Shares for proceeds of $200 million. The journal entry to record this issuance would be: 2005 Apr 18 Cash Preferred shares, class To record issuance of 8,000,000 Series III preferred shares. After this issuance the shareholders equity section would appear as follows: Common share capital $ 126 Preferred shares, series Preferred shares, series Preferred shares, series Share capital $814 Retained earnings ,170 Cumulative foreign currency translation adjustment (404) Total shareholders equity $4,580 Ethical Considerations Issuance of shares for cash poses no serious ethical challenge. The company simply receives cash and records the shares at the amount received, as illustrated in the preceding sections of this chapter. There is no difficulty in valuing shares issued for cash because the value of the cash and the shares is obvious. Issuing shares for assets other than cash can pose an ethical challenge. The company issuing the shares often wishes to record a large amount for the noncash asset received (such as land or a building) and for the shares that it is issuing. Why? Because large asset and shareholders equity amounts on the balance sheet make the business look more prosperous and more creditworthy. A company is supposed to record an asset received at its current market value. But one person s perception of a particular asset s market value can differ from

13 466 Chapter 9 Shareholders Equity another person s opinion. One person may appraise land at a market value of $400,000. Another may honestly believe the land is worth only $300,000. A company receiving land in exchange for its shares must decide whether to record the land received and the shares issued at $300,000, at $400,000, or at some amount in between. The ethical course of action is to record the asset at its current fair market value, as determined by a good-faith estimate of market value from independent appraisers. It is rare for a public corporation to be found guilty of understating the asset values on its balance sheet, but companies have been embarrassed by overstating these values. Investors who rely on the financial statements may be able to prove in a court of law that an overstatement of asset values caused them to pay too much for the company s shares. In this case, the court may render a judgment against the company. For this reason, companies often value assets conservatively. Mid-Chapter Summary Problem 1. Test your understanding of the first half of this chapter by deciding whether each of the following statements is true or false. a. The policy-making body in a corporation is called the board of directors. b. The owner of 100 shares of preferred stock has greater voting rights than the owner of 100 shares of common stock. c. Issuance of 1,000 common shares at $12 per share increases contributed capital by $12,000. d. A corporation issues its preferred shares in exchange for land and a building with a combined market value of $200,000. This transaction increases the corporation s owners equity by $200,000 regardless of the assets prior book values. e. Preferred shares are a riskier investment than common shares. 2. Magna International Inc., a global leader in assemblies and components for automobile manufacturers, has two classes of common shares. Class A shares are entitled to one vote, whereas Class B shares are entitled to 500 votes and are convertible on a one-for-one basis into Class A shares. The two classes rank equally for dividends. The following is extracted from a recent annual report: Shareholders Equity (in millions of U.S. dollars) Check Point 9-6 Check Point 9-7 Capital stock Class A subordinate voting shares (issued 94,477,224 shares) $2,487 Class B shares (issued 1,096,509 shares) Preferred securities Other paid in capital* Retained earnings ,570 Currency translation adjustment $5,421 *This balance represents the present-value of the face amount of subordinated debentures issued by Magna Name: Magna International Inc. Industry: Auto parts manufacturing corporation Fiscal Period: A recent fiscal year a. Record the issuance of the Class A common shares. Use the Magna account titles. b. Record the issuance of the Class B common shares. Use the Magna account titles.

14 Repurchase of Shares by a Corporation 467 c. How much of Magna s shareholders equity was contributed by the shareholders? How much was provided by profitable operations? Does this division of equity suggest that the company has been successful? Why or why not? d. Write a sentence to describe what Magna s shareholders equity means. Answers 1. a. True b. False c. True d. True e. False 2. a. Cash ,487,000,000 Class A Subordinate Voting Shares ,487,000,000 To record issuance of Class A common shares. b. Cash ,000,000 Class B Shares ,000,000 To record issuance of Class B common shares. c. Contributed by the shareholders: $2,488,000,000 ($2,487,000,000 $1,000,000). Provided by profitable operations: $2,570,000,000. This division suggests that the company has been successful because more than half of its shareholders equity has come from profitable operations. d. Magna shareholders equity of $5,421,000,000 means that the company s shareholders own $5,421,000,000 of the business s assets. b. Preferred shareholders typically do not have voting rights. e. Preferred shares are less risky because they usually have a fixed dividend rate. a. and b. Share issuances increase assets (cash) and shareholders equity. Compare the fraction of shareholders equity contributed by shareholders to the fraction contributed by retained earnings. A greater retained earnings fraction is positive. Shareholders equity is the net worth of the company (assets liabilities). Repurchase of Shares by a Corporation Corporations may repurchase their own shares for several reasons: 1. The company needs the repurchased shares to fulfill future share issuance commitments, such as those related to share option plans and conversions of bonds and preferred shares into common shares. 2. The purchase may help support the share s current market price by decreasing the supply of shares available to the public; that is, repurchase is anti-dilutive. 3. Management wants to avoid a takeover by an outside party. Firms incorporated under certain provincial jurisdictions are permitted to reacquire shares that they previously issued and hold these shares for future issuance. Such shares, called treasury shares, are accounted for as a contra account to shareholders equity beneath Retained Earnings. Corporations that are incorporated under the Canada Business Corporations Act are required to immediately cancel any reacquired shares so treasury shares do not exist for federally incorporated companies. During 2004, for example, George Weston Ltd. purchased 587,500 of its common shares for $59 million for cancellation. Objective 3Describe how share repurchase transactions affect a company Repurchased shares A corporation s own shares that it has issued and later reacquired. Should a Company Buy Back Its Own Shares? DECISION: Let s illustrate the accounting for repurchased shares by using the data of Ava Smallco Ltd. If Ava Smallco Ltd. had not repurchased any of its shares, the company would have reported the following shareholders equity at December 31, 2006:

15 468 Chapter 9 Shareholders Equity (Before Repurchase of Shares) Common shares (100,000 shares authorized; 10,000 shares issued) $ 70,000 Retained earnings ,632 Total equity $263,632 During 2007, Ava Smallco Ltd. paid $12,000 to repurchase 1,000 of its common shares for cancellation. Ava Smallco Ltd. recorded the share repurchase as follows: 2007 Nov. 12 Common Shares ,000 Retained earnings ,000 Cash ,000 Repurchased common shares for cancellation. When a company repurchases its shares for more than the shares were issued for originally, it is deemed to be distributing profits (from Retained Earnings) to those shareholders who are selling their shares back to the company. When the company repurchases its shares for less than the issue price, the difference is considered contributed surplus arising from the share repurchases and Contributed Surplus Share Repurchase is credited for the difference between the issue price and repurchase price. Ava Smallco Ltd. s shareholders equity would be shown as follows after the repurchase: (After Repurchase of Shares) Common shares (99,000 shares authorized; 9,000 shares issued).. $ 63,000 Retained earnings ,632 Total equity $251,632 Compare Ava Smallco Ltd. s total equity before the repurchase of shares ($263,632) and after ($251,632). You will see that Ava Smallco Ltd. s total equity decreased by $12,000, the amount the company paid to buy back its own shares. The repurchase of shares has the opposite effect of issuing shares: Issuing shares grows a company s assets and equity. Repurchasing shares shrinks assets and equity. In most cases the company cancels the shares when they are repurchased. Shares that are reissued are accounted for in exactly the same way as shares that are issued for the first time.

16 Retained Earnings, Dividends, and Splits 469 Report Ava Smallco Ltd. s shareholders equity after issuing 1,000 new shares for $14,000. Answer: Common shares (99,000 shares authorized; 10,000 shares issued) $ 77,000 Retained earnings ,632 Total equity $265,632 STOP & THINK Now compare total equity after selling the new shares to total equity before Ava Smallco Ltd. repurchased shares. What was the net effect of buying shares for cancellation and selling new shares? Answer: Total equity after repurchase and sale of new shares $265,632 Total equity before repurchase of shares ,632 Increase in shareholders equity $ 2,000 The number of shares authorized has decreased by 1,000 shares. Check Point 9-8 Check Point 9-9 Retained Earnings, Dividends, and Splits We have seen that the equity section of the corporation balance sheet is called shareholders equity. The contributed capital accounts and retained earnings make up the shareholders equity section. The Retained Earnings account carries the balance of the business s net income less its net losses and less any declared dividends accumulated over the corporation s lifetime. Retained means held on to. Successful companies grow by reinvesting back into the business the assets they generate through profitable operations. Bombardier Inc. is an example; about 60 percent of its equity comes from retained earnings. The Retained Earnings account is not a reservoir of cash waiting for the board of directors to pay dividends to the shareholders. In fact, the corporation may have a large balance in Retained Earnings but not have the cash to pay a dividend. Cash and Retained Earnings are two separate accounts with no particular relationship. A $500,000 balance in Retained Earnings simply means that $500,000 of owners equity has been created by profits reinvested in the business. It says nothing about the company s Cash balance or about any specific asset. A credit balance in Retained Earnings is normal, indicating that the corporation s lifetime earnings exceed its lifetime losses and dividends. A debit balance in Retained Earnings arises when a corporation s lifetime losses and dividends exceed its lifetime earnings. Called a deficit, this amount is subtracted from the sum of the other equity accounts to determine total shareholders equity. In a recent survey, 47 of 200 companies (23.5%) had a retained earnings deficit (Exhibit 9-7). 2 DECISION: Should the Company Declare and Pay Cash Dividends? A dividend is a corporation s return to its shareholders of some of the benefits of earnings, commonly in the form of cash payments. Corporate finance courses address the question of how a company decides on its dividend policy. Accounting Exhibit 9-7 Retained Earnings of the Financial Reporting in Canada 200 Companies 23.5% Corporations with Retained Earnings deficits 76.5% Corporations with positive balance of Retained Earnings Deficit Debit balance in the Retained Earnings account. Objective 4 Account for dividends and measure their impact on a company Dividend Distribution (usually cash) by a corporation to its shareholders. 2 Byrd, Clarence, Ida Chen, and Heather Chapman. Financial Reporting in Canada, 27th Edition (Toronto: Canadian Institute of Chartered Accountants, 2002), p. 342.

17 470 Chapter 9 Shareholders Equity tells a company if it has the wherewithal to pay cash dividends. To do so, a company must have sufficient retained earnings to declare the dividend sufficient enough Cash to pay the dividend A corporation declares a dividend before paying it. Only the board of directors has the authority to declare a dividend. The corporation has no obligation to pay a dividend until the board declares one, but once declared, the dividend becomes a legal liability of the corporation. Dividends cannot be paid from contributed capital without special permission from creditors and firms may be restricted from paying dividends due to contractual arrangements with creditors. Further restrictions are imposed on firms incorporated under the Canada Business Corporations Act, which requires firms to meet the following liquidity tests: 1. the dividend must not render the firm unable to meet obligations to creditors; 2. the dividend must not result in the net realizable of assets being less than the sum of liabilities plus stated capital. Following is a list of some common terms related to dividends along with their definitions. Key terms and definitions related to dividends Retained Earnings Declaration Date Date of Record Ex Dividend Payment Date Payment Payout Ratio Cum Dividend The portion of net income accumulated to date not distributed to shareholders as dividends The date on which the next dividend payment is announced by a Company s Board of Directors. The specified future date set by the firm s directors on which all persons whose names are recorded as shareholders are entitled to receive a declared dividend. The date after which shares are sold without the right to receive the current dividend. The date is usually set two days before the record date to allow for the transfer of shares among buyers and sellers. Dividends declared on shares transferred after the ex-dividend date go to the seller. The actual date on which the firm makes the dividend payment to shareholders of record. The percentage of net income paid out in dividends to shareholders. During 2004, for example, TD Financial Group paid out 40% of earnings as dividends. When a buyer of shares is entitled to receive a dividend that has been declared, but not paid. Journal entries are recorded only for the dates that dividends are declared and paid. For example assume the following quarterly dividend payment information for 600,000 TD Financial Group common shares: Rate $0.40 per share Ex-dividend Date Sept 13, 2005 Record Date Sept 15, 2005 Payment Date Oct 31, 2005

18 Journal entries are recorded on the dates that dividends are declared and when they are paid as follows: Sept. 15 Retained Earnings or Dividends ,000 Dividends Payable (600,000 $0.40) ,000 Declared cash dividend Oct. 31 Dividends Payable ,000 Cash ,000 Paid cash dividend. Retained Earnings, Dividends, and Splits 471 Dividends on Preferred Shares When a company has issued both preferred and common shares, the preferred shareholders receive their dividends first. The common shareholders receive dividends only if the total declared dividend is large enough to pay the preferred shareholders first. Pinecraft Industries Inc., a furniture manufacturer, has 100,000 shares of $1.50 cumulative preferred shares outstanding in addition to its common shares. This $1.50 designation means that preferred dividends are paid at the annual amount of $1.50 per share. Assume that in 2006, Pinecraft declares an annual dividend of $1,000,000. The allocation to preferred and common shareholders is as follows: Preferred dividend (100,000 shares $1.50 per share) $ 150,000 Common dividend (remainder: $1,000,000 $150,000) ,000 Total dividend $1,000,000 If Pinecraft declares only a $200,000 dividend, preferred shareholders receive $150,000, and the common shareholders receive the remainder, $50,000 ($200,000 $150,000). Expressing the Dividend on Preferred Shares. Dividends on preferred shares are stated as a dollar amount since preferred shares do not have a nominal or par value. For example, preferred shares may be $3 preferred, which means that shareholders receive an annual dividend of $3 per share. Dividends on Cumulative and Noncumulative Preferred Shares. The allocation of dividends may be complex if the preferred shares are cumulative. Corporations sometimes fail to pay a dividend to preferred shareholders. This is called passing the dividend, and the passed dividends are said to be in arrears. The owners of cumulative preferred shares must receive all dividends in arrears plus the current year s dividend before the corporation can pay dividends to the common shareholders. The law considers preferred shares noncumulative unless they are specifically labelled as cumulative. The preferred shares of Pinecraft Industries Inc. are cumulative. Suppose the company passed the 2006 preferred dividend of $150,000. Before paying dividends to its common shareholders in 2007, the company must first pay preferred dividends of $150,000 for both 2006 and 2007, a total of $300,000. Assume that Pinecraft Industries Inc. passes its 2006 preferred dividend. In 2007, the company declares a $500,000 dividend. The entry to record the declaration is 2005 Sept. 6 Retained Earnings ,000 Dividends Payable, Preferred ($150,000 2) ,000 Dividends Payable, Common ($500,000 $300,000) 200,000 To declare a cash dividend. Cumulative preferred shares Preferred shares whose owners must receive all dividends in arrears before the corporation can pay dividends to the common shareholders. Check Point 9-10 Check Point 9-11

19 472 Chapter 9 Shareholders Equity If the preferred shares are noncumulative, the corporation is not obligated to pay dividends in arrears. A liability for dividends arises only when the board of directors declares the dividend. Some preferred shares have a participation feature. The following events will occur when a company pays out extra dividends on participating preferred shares: preferred shareholders receive their usual dividend common shareholders receive dividends proportionate to preferred the excess above these amounts is shared by common and preferred in proportion to the total value of both classes of shares or according to some other agreed formula The details of determining dividends for participating preferred shares will be left to an intermediate accounting course. Limited Voting Rights Preferred shares are generally non-voting. However, limited voting is sometimes granted to preferred shareholders under the following conditions: When the company wants to liquidate a large portion of corporate assets When the company wants to merge with another company When the company wants to issue new bonds or preferred shares Call Provisions Preferred shares may be callable. This allows the issuing company to repurchase the shares from shareholders at a predetermined price and retire them. The call price includes the payment of any dividends in arrears and generally includes a premium to compensate the preferred shareholders for the inconvenience of having their shares called. A call price of 102 means that call price is 102% of the book value of the preferred shares called. If on April 1 a company called $100,000 of preferred shares that have $3,000 of dividends in arrears at 102, the following entry would be made to record the call. Apr. 1 Preferred shares ,000 Loss on call of preferred shares ,000 Dividends or Retained Earnings ,000 Cash (102% $100,000 $3,000) ,000 To call $100,000 of preferred shares at 102, with $3,000 dividends in arrears. Stock dividend A proportional distribution by a corporation of its own stock to its shareholders. DECISION: Why Issue a Stock Dividend? A stock dividend is a proportional distribution by a corporation of its own stock to its shareholders. Stock dividends increase the shares account and decrease Retained Earnings. Total equity is unchanged, and no asset or liability is affected. The corporation distributes stock dividends to shareholders in proportion to the number of shares they already own. If you own 300 common shares of TransCanada PipeLines Limited (TCPL) and TCPL distributes a 10% common stock dividend, you will receive 30 ( ) additional shares. You would then own 330 common shares. All other TCPL shareholders would also receive additional shares equal to 10% of their prior holdings.

20 In distributing a stock dividend, the corporation gives up no assets. Why, then, do companies issue stock dividends? A corporation may choose to distribute stock dividends for the following reasons: 1. To continue dividends but conserve cash. A company may want to keep cash for operations and yet wish to continue dividends in some form. So the corporation may distribute a stock dividend. Shareholders pay no tax on stock dividends. 2. To reduce the per-share market price of its shares. Distribution of a stock dividend may cause the market price of a share of the company s stock to fall because of the increased supply of the stock. The objective is to make the shares less expensive and thus more attractive to a wider range of investors. Suppose TCPL declared a 2% stock dividend in At the time, assume TCPL had 480 million common shares outstanding. TCPL is incorporated under the Canada Business Corporation Act, which suggests that the market value of the shares at the time of declaration be used to value the dividend. At the time of the stock dividend, assume TCPL s shares are trading for $30 per share. TCPL would record this stock dividend as follows: Retained Earnings, Dividends, and Splits Jan. 19 Retained Earnings (480,000,000 shares of common outstanding 0.02 stock dividend $30 market value per common share) ( ve) $ ,000,000 Common Shares ( ve) ,000,000 Distributed a 2% stock dividend. A corporation issued 1,000 common shares as a stock dividend when the stock s market price was $25 per share. Assume that the 1,000 shares issued are (1) 10% of the outstanding shares and (2) 100% of the outstanding shares. Does either stock dividend change total shareholders equity? Answer: No, neither a large stock dividend nor a small stock dividend affects total shareholders equity. Why? Because all the accounts affected by a stock dividend are part of shareholders equity. STOP & THINK Stock Splits A stock split is an increase in the number of authorized, issued, and outstanding shares of stock, coupled with a proportionate reduction in the share s book value. For example, if a company splits its stock 2 for 1, the number of outstanding shares is doubled and each share s value is halved. A stock split, like a stock dividend, decreases the market price of the shares with the intention of making the shares more attractive in the market. Leading companies in Canada Bank of Nova Scotia, MDS Inc., Dofasco Inc., and others have split their stock. Winpak Ltd., one of the leading packaging companies in Canada, is based in Winnipeg. Recent market price of Winpak s common shares has been in the $120- per-share range. Assume that Winpak wishes to decrease the market price to approximately $60. Winpak may decide to split its common shares 2 for 1. A 2-for-1 stock split means that the company would have twice as many shares outstanding after the split as it had before and that each share s value would be cut in half. Before the split, Winpak had approximately 6.5 million common shares issued and outstanding. Compare Winpak s shareholders equity before and after a 2-for-1 stock split: Check Point 9-12 Stock split An increase in the number of authorized, issued, and outstanding shares of stock coupled with a proportionate reduction in the share s book value.