Chapt 14: Corporations: Additional Topics and IFRS Flashcards
Why would a company repurchase some of its shares? Give some reasons.
A company would repurchase its shares for the following reasons:
- To increase trading of the company’s shares in the securities market in the hope of increasing the company’s fair value.
- To reduce the number of shares issued, which will increase earnings per share.
- To eliminate hostile shareholders by buying them out.
- To have additional shares available so that they can be reissued to officers and employees through bonus and stock compensation plans, or used to acquire other companies.
Wilmor, Inc. repurchases 1,000 of its own common shares. What effect does this transaction have on (a) total assets, (b) total liabilities, and (c) total shareholders’ equity?
This transaction:
(a) decreases total assets, (b) has no effect on total liabilities and, (c) decreases total shareholders' equity.
Explain how the accounting for the reacquisition of shares changes depending on whether the reacquisition price is greater or lower than average cost.
If the reacquisition price is less than the average cost, the difference is considered contributed to the remaining shareholders. This amount is reported as contributed surplus from share reacquisition in the share capital section of shareholders’ equity. If the reacquisition price is more than the average cost, the difference is debited to Contributed Surplus from the same class of shares to the extent of any pre-existing balance in the contributed surplus account, and then debited to Retained Earnings.
Ciana Chiasson is confused. She says, “I don’t understand why sometimes, when the price paid to reacquire shares is greater than their average cost, the ‘loss on reacquisition’ is debited to a contributed surplus account. But at other times, it is debited to the Retained Earnings account. And sometimes it is even debited to both!” Help Ciana understand.
If there have been gains from similar transactions in the past, the resulting credit balance of the contributed surplus account is available to absorb some or all of the loss on reacquisition. However, the balance of the contributed surplus account cannot go below zero. If the loss exceeds the balance in the contributed surplus account, the excess amount is debited to retained earnings.
Explain the terms “comprehensive income,” “other comprehensive income,” and “accumulated other comprehensive income.” Include in your explanation how and where they are reported in the financial statements.
Comprehensive income includes all changes to shareholders’ equity during a period except those resulting from changes that result from the sale or repurchase of shares and from the payment of dividends. This includes not only the profit presented in a traditional income statement, but also other comprehensive income. Other comprehensive income includes certain gains and losses that are not included in profit, such as unrealized gains and losses from some long-term strategic equity investments and foreign currency translation. Other comprehensive income is reported on the comprehensive income statement in an all-inclusive format with the income statement or as a separate financial statement. Other comprehensive income is closed to Accumulated Other Comprehensive Income, which appears in the equity section of the balance sheet, immediately after Retained Earnings.
Explain the two methods of preparing a statement of comprehensive income.
Other comprehensive income is reported on the comprehensive income statement in an all-inclusive format with the income statement or as a separate financial statement.
When is a company allowed to change an accounting policy? How should it be accounted for in the financial statements?
A company is allowed to change an accounting policy when the change is required by generally accepted accounting principles or when the resulting financial statements will provide more reliable and relevant information. When there is a change in accounting policy, companies are required to retroactively apply the new standards except if it is impractical to do so. This means the company must recalculate and restate all of the related accounts as if it had always followed the new policy. But, if significant estimates are required, or if the required information is not available, then it is not possible for prior financial statements to be restated for comparative purposes. Whether or not the prior periods are restated, companies must disclose the details of the change to the new policy in their notes to the financial statements.
Under what circumstances will a company change an accounting estimate? How is it accounted for, and why is it not considered an error?
A company can make a change in accounting estimate on an as needed basis, whenever circumstances, conditions and events change and a better estimate is established. Changes in estimates are common and are not a result of an error. Consequently, the change in estimate is not applied retroactively but implemented prospectively to the current and future accounting periods.
If there was an error in a revenue or expense in a prior period, why isn’t that account adjusted when the error is corrected? Instead, how is that error corrected in the accounting records and how is it reported in the financial statements?
Since revenue and expense accounts are closed at the end of each fiscal year, corrections related to a previous period cannot be made to those accounts. However, the balances in the permanent accounts must be restored to what they would have been, had the error not been made. If the error affected an income statement account, retained earnings will be adjusted for the after-tax impact of the error. Prior year statements that are issued with the current statement will be restated to eliminate the error, if needed. Restated financial statements are labelled as restated and notes to the financial statements explain the nature and effect of the restatement caused by the prior period error.
How is comprehensive income reported in the statement of changes in shareholders’ equity?
Comprehensive income includes profit (or loss) and other comprehensive income (or loss). The profit or loss is reported in the retained earnings section of the statement of changes in shareholders’ equity. Other comprehensive income (or loss) is reported in the accumulated other comprehensive income section of the statement of changes in shareholders’ equity.
Distinguish between basic earnings per share and fully diluted earnings per share.
Earnings per share is calculated by dividing profit less preferred dividends by the weighted-average number of common shares outstanding. The fully diluted earnings per share adjusts earnings per share for the maximum possible dilution that would occur if securities were converted into common shares.
When calculating EPS: (a) Why is profit available to the common shareholders not always the same as profit? (b) Why is the weighted average number of shares used instead of the number of shares issued at the end of the year?
(a) When calculating earnings per share, the amount of profit available to common shareholders is not always the same as profit because preferred shareholders rank ahead of common shareholders for dividends. Preferred shareholders dividend entitlement must be satisfied before dividends can be declared on common shares. The preferred share dividend declared will reduce profit available to common shareholders. Also, the annual dividend entitlement of the preferred shares will not be available to common shareholders if the shares are cumulative.
(b) Weighted average number of shares is used in the earnings per share calculation and not simply the number of shares at the end of the year because the profit available for common shareholders has been generated over the period of the year. The numbers of shares issued and outstanding during the fiscal year may vary tremendously and affect the company’s ability to generate profit. Using the weighted average number of shares in the calculation provides a less biased and fairer measure of performance.
Company A has a price-earnings ratio of 9 times and a payout ratio of 40%. Company B has a price-earnings ratio of 22 times and a payout ratio of 5%. Which company’s shares would be better for an investor interested in large capital gains versus steady income? Why?
Company B would be a better choice. The price-earnings ratio indicates investors’ assessment of the company’s future earnings. A price-earnings ratio of 22 times means that investors are willing to pay 22 times earnings per share to purchase a share of Company B. If Company A and Company B are in the same industry, investors are more optimistic are Company B’s future earnings. There are potentially higher capital gains for a share of Company B. A very high price-earnings ratio may also mean that a company’s share price has reached its maximum.
If all other factors stay the same, indicate whether each of the following is generally considered favourable or unfavourable by a potential investor: (a) a decrease in return on equity, (b) an increase in earnings per share, (c) a decrease in the price-earnings ratio, and (d) an increase in the payout ratio.
(a) Unfavourable
(b) Favourable
(c) Either favourable or unfavourable depending on the interpretation of the investor. That is, a decrease in the PE ratio makes the shares more affordable to purchase. An increase in the PE ratio means the shares will sell at a higher price and there exists more risk that the price will increase even further.
(d) Favourable from the perspective of a shareholder receiving the dividend.
Why do companies report the number of shares issued? The number of shares authorized?
Reporting the number of shares authorized and issued allows shareholders to determine how many additional shares can be sold and how much their share ownership can potentially be diluted. If there are a maximum number of shares authorized, this would also determine how many additional shares can be issued to raise capital.
