Chapter 11 Reporting and Analyzing Shareholders' Equity Flashcards
The major characteristics of a corporation
The major characteristics of a corporation are separate legal existence, limited liability of shareholders, transferable ownership rights, the ability to acquire capital, a continuous life, separation of corporation management from ownership, increased cost and complexity of government regulations, and the possibility of reduced corporate income tax.
Corporations issue shares for sale to investors. The proceeds received from the issue of shares become the company’s legal capital. Shares then trade among investors on the secondary stock market and do not affect the company’s financial position.
RE limited liability of shareholders:
Shareholders cannot be made to pay for the company’s liabilities out of their personal assets. They may lose the amount that they have invested in the shares of the company, but they will not lose more than their investment. Limited liability is a significant advantage for the corporate form of organization. However, in smaller private corporations, creditors may demand a personal guarantee from the controlling shareholder. This has the effect of making the controlling shareholder’s personal assets available, if required, to satisfy the creditor’s claim—which, of course, reduces or eliminates the advantage of limited liability.
RE transferable ownership rights:
In a public corporation, the transfer of shares is entirely up to the shareholder. It does not require the approval of either the corporation or other shareholders. In contrast, many private corporations impose limitations on the sale or transfer of shares by shareholders.
RE corporate management:
Shareholders manage the company indirectly through a board of directors they elect. The board, in turn, sets the broad strategic objectives for the company. The board also selects officers, such as a president and one or more vice-presidents, to execute policy and to perform daily management functions.
Record share transactions
If only one class of shares is issued, they are considered to be common shares. When shares are issued for noncash goods or services in a company using IFRS, the fair value of the goods or services received is used to record the transaction if it can be reliably determined. If not, the fair value of the common shares is used. For a private company following ASPE, the more reliable of the two fair values should be used, which is usually also the fair value of the goods or services received.
The accounting for preferred shares is similar to the accounting for common shares. Preferred shares have contractual provisions that give them preference over common shares for dividends and assets in the event of liquidation. Dividends are quoted as an annual rate (such as $5 preferred), but are normally paid quarterly.
In addition, preferred shares may have other preferences, such as the right to convert, redeem, and/or retract. However, preferred shares do not have the right to vote—only common shares have voting rights.
Note that the shares of the company are divided into different classes, such as Class A, Class B, and so on. The rights and privileges for each class of shares are stated in articles of incorporation, which form the “constitution” of the company. The different classes are usually identified by the generic terms common shares and preferred shares. Combined, they form the share capital of the company. When a corporation has only one class of shares, that class has the rights and privileges of common shares.
Common shareholders are considered to be the “owners” of the corporation. Only common shareholders have the right to vote on certain matters, such as the election of the board of directors and appointment of external auditors. Each shareholder normally has one vote for each common share owned.
Prepare the entries for cash dividends, stock dividends, and stock splits, and understand their financial impact.
Entries for both cash and stock dividends are required at the declara- tion date and the payment or distribution date. There is no entry (other than a memo entry) for a stock split. The overall impact of a cash dividend is to reduce assets (cash) and share- holders’ equity (retained earnings). Stock dividends increase common shares and decrease retained earnings but do not affect assets, liabilities, or shareholders’ equity in total. Stock splits also have no impact on assets, liabilities, or sharehold- ers’ equity. The number of shares increases with both stock dividends and stock splits.
Indicate how shareholders’ equity is presented in the financial statements.
In the shareholders’ equity section of the statement of financial position for companies using IFRS, share capital, retained earnings, and accumulated other comprehensive income, if any, are reported separately. If additional contrib- uted capital exists, then the caption “Contributed capital” is used for share capital (preferred and common shares) and ad- ditional contributed capital that may have been created from various sources. A statement of changes in equity explains the changes in each shareholders’ equity account, and in total, for the reporting period. Notes to the financial statements explain details about authorized and issued shares, restrictions on re- tained earnings, and dividends in arrears, if there are any.
For private companies reporting using ASPE, compre- hensive income is not reported and a statement of changes in equity is not required. Instead, a statement of retained earn- ings is prepared that explains the changes in the retained earnings account for the reporting period. Changes to share capital and any other equity items are disclosed in the notes to the statements.
Evaluate dividend and earnings performance.
A company’s dividend record can be evaluated by looking at what percente of profit it chooses to pay out in dividends, as measured by the dividend payout ratio (dividends divided by profit) and the dividend yield ratio (dividends per share divided by the share price).
Earnings performance can be measured by two profitability ratios: earnings per share (profit less preferred dividends divided by the weighted average number of common shares) and the return on common shareholders’ equity ratio (profit less preferred dividends divided by average common shareholders’ equity).
Accumulated other comprehensive income (AOCI)
The cumulative change in shareholders’ equity that results from the gains and losses that bypass profit (recorded in OCI) but affect shareholders’ equity.
Authorized shares
The amount of share capital that a corporation is authorized to sell. The amount (indicated in its articles of incorporation) may be unlimited or specified.
Most companies in Canada have an unlimited amount of authorized shares. If a specific number of shares is authorized, the amount normally anticipates a company’s initial and later capital needs.
The authorization of share capital does not result in a journal entry, because the event has no effect on either corporate assets or shareholders’ equity. It is the issue (sale) of shares by the corporation that results in a transaction that must be journalized, and not the authorization of shares.
Cash dividend
A pro rata (proportional) distribution of cash to shareholders.
Contributed capital
The total amount paid or contributed by shareholders in exchange for shares of ownership. It consists of share capital and additional contributed capital, if any.
Cumulative
A feature of preferred shares that entitles the shareholder to receive current-year and unpaid prior-year dividends when dividends are declared before common shareholders receive any dividends
Declaration date
The date the board of directors formally declares (approves) a dividend and announces it to shareholders.
Dividend yield
A measure of the percentage of the share price that is paid in dividends. It is calculated by dividing dividends per share by the share price.
Dividends in arrears
Dividends that were not declared on cumulative preferred shares during a period. (
Initial public offering (IPO)
The initial offering of a corporation’s shares to the public.
Issued shares
The portion of authorized shares that has been sold.
