Chapter 11: Shareholder's Equity Flashcards
Share capital
represents the amount that investors paid for the shares when they were initially issued by the company
Retained earnings
represents the company’s accumulated earnings that have not been distributed as dividends to shareholders.
shareholders’ equity section
Comprises of Share capital
Retained earnings
Accumulated other comprehensive income
Contributed surplus
Accumulated Other Comprehensive Income
Changes in net asset values representing unrealized gains and losses, which are not included in net earnings but are included in comprehensive income.
accumulated other comprehensive income (AOCI)
A component of shareholders’ equity representing the cumulative amount of unrealized increases and decreases in the values of an entity’s net assets.
-Can not be used for dividends until they are realized
Contributed Surplus
The account that records a surplus arising from certain transactions with shareholders that involve the sale or repurchase of a company’s shares or the issuance of stock options, and that do not fit the definitions of share capital or retained earnings.
If the company repurchases these shares for less than they were originally issued for, the difference is considered contributed surplus (share is $40, bought back for $30, that’s a contributed surplus)
It is not reported as a gain on the statement of income because that statement only reports transactions with external parties and not those with owners.
Market capitalization
the value of the company determined by multiplying the number of issued shares times the trading price of the company’s shares
When a business operates as a corporation the company is incorporated either under:
federal legislation, the Canada Business Corporations Act, or under similar provincial or territorial acts
Articles of incorporation
A document filed with federal or provincial regulatory authorities when a business incorporates under that jurisdiction.
The articles include, among other items, the authorized number of shares and dividend preferences for each class of shares that is to be issued.
Authorized shares
The maximum number of shares that a company is authorized to issue under its articles of incorporation.
Most important section of a company’s articles of incorporation!!!
There are two main types of shares:
1) common shares
2) preferred shares
Within Common and preferred shares are:
1)Classes
(such as Class A common, Class B common, Class A preferred, and Class B preferred)
2) Series
(Class A preferred, series A, and so on)
All companies are required to have at least
one class of common shares
Three terms are used to refer to the number of company shares:
1) authorized shares
2) issued shares
3) outstanding shares
Issued shares
Shares that have been issued (sold) by the company
Outstanding shares
As long as the shares remain in the possession of shareholders outside the company (anyone outside the corporation, excludes treasury shares)
Treasury shares
Shares that are repurchased by a corporation and held internally. Repurchased shares are normally cancelled immediately upon purchase
Dividends are paid only on shares that are:
Issued and outstanding
Dividends are not paid on treasury shares
Legal capital
The amount that is recorded in the common share account when shares are first issued
This amount must be kept intact and cannot be paid out as dividends or returned to shareholders, except under specific circumstances
Par value (not permitted in Canada in most places)
In the past, a company’s articles of incorporation could assign a specific dollar value to each share.
When the shares were issued, the par value of each share was credited to the Common Shares account and any excess was credited to an account called Contributed Surplus
No par value shares
When no par value shares are issued, the total amount received for the shares is credited to the Common Shares or Share Capital account
Share repurchases aka buybacks
When a company repurchases or buys back shares that it has previously issued to shareholders
Why a company would buy back shares
A company might do this when:
1) It has cash that is surplus to its needs
2) enable the company to return cash to shareholders without having to commit to a dividend
3) may also be done if a company has a stock option plan that enables its employees to purchase shares in the company
4) repurchases or redeems its shares as a way of retiring them, similar to repaying principal when paying off debt.
Consequences of repurchasing shares
1) reduces the number of shares outstanding
2) Fewer outstanding shares results in an increase in the company’s earnings per share (which may increase / raise share price)
The repurchase of shares that are then cancelled / retired
reduces the share capital account by the amount that the shares were originally issued for
if the company buys them back at a higher or lower price than it issued them for, there is a form of gain or loss on the repurchase
The gain or loss is not considered part of the company’s earnings. Instead, it is recorded in either the Contributed Surplus account or the Retained Earnings account.
Different classes or types of shares can have different rights that accrue to their holders, resulting in different risk and return characteristics. These include:
- whether the share allows its holder to vote and, if so, the number of votes per share
- whether it pays regular dividends
- how large the dividend is
- whether the shareholder gets priority on liquidation
- whether it can be redeemed (bought back by the company)
A company must have common shares but does not have to have ______
Preferred shares
Underwriters
Corporations generally issue shares through a firm of investment bankers known as this
Prospectus
A document filed with a securities commission by a corporation when it wants to issue public debt or shares to the public
Distributed to investors BEFORE the shares are sold
Initial public offering (IPO)
The first time a company issues shares on a public stock exchange
Common shares (aka ordinary shares outside of north america)
Certificates that represent portions of ownership in a corporation. These shares usually carry a right to vote.
At least one class of a company’s common shares must have all three of the following rights:
- the right to vote at meetings of the company’s shareholders
- the right to receive dividends, if declared
- the right to a share of the company’s net assets upon liquidation of the company
1) The Right to Vote at Meetings of the Company’s Shareholders.
Common shareholders have the right to vote at shareholder meetings. Public companies must have at least one meeting per year, which is known as the annual meeting
one share equals one vote
Annual meeting (must have at least one meeting per year)
Meeting of shareholders required to be held every year by public companies during which shareholders elect the corporation’s board of directors, among other things
one share equals one vote
Canadian public companies must have at least _____ independent directors
three (3)
A director is considered to be independent if they meet a number of conditions:
Including that they are not an employee of the company, not related to members of senior management, and not an employee of the company’s external auditor.
Board of directors
- One of the board’s key responsibilities is hiring (and firing) the company’s senior management team
- The board oversees senior management, including establishing performance targets and approving budgets, but the company’s day-to-day operations are the responsibility of management.
- determining whether or not dividends should be declared and being ultimately responsible for the financial information that is prepared by management and examined by the company’s external auditors.
2) The Right to Receive Dividends, if Declared.
-A company is not obligated to declare dividends
_____ shares normally have no restrictions on the amount of dividends they can receive, once the preferred shareholders have received their dividends
Common
if a company’s board does declare dividends, different types or classes of shares may be entitled to different dividend amounts
All shareholders of the same class of shares must receive the same dividend per share.
DIfferent classes and series may offer different amounts, but within a class the price must be the same
Important shit
3) The Right to a Share of the Company’s Net Assets upon Liquidation of the Company.
If a company goes bankrupt or otherwise liquidates, there is an established order in which creditors and shareholders are paid
1) Proceeds must first be used to settle the company’s liabilities to its creditors
2) Leftover amounts are paid to Preferred Shareholder up to the amount of their share capital
3) Leftovers are then given to common shareholders and divided proportionally among them based on # of shares
Other Common Shareholder Rights
- Right to purchase subsequent issues of shares
2. Special voting rights.
- Right to purchase subsequent issues of shares (pre-emptive right)
-Common shareholders may have the right to share proportionately in any new issuance of shares. This is known as a pre-emptive right.
Pre-emptive right (aka anti-dilution provision)
The right of shareholders to share proportionately in new issuances of shares so that their ownership interest will not be diluted by future share issuances
1) not obligated to purchase additional shares
2) are not automatic
Minority interest (aka non-controlling interest)
A block of shares owed by an investor that represents less than 50% of the outstanding shares
- Special voting rights
A number of Canadian companies have what are known as dual-class share structures. These provide holders of a certain class of common shares with special voting rights
Multiple voting shares or super voting shares
A class of common shares granting special voting rights so that the holder is entitled to more than one vote for each of the common shares owned
normally owned by the founding shareholder(s) (or their families) and are used to maintain control of the company in spite of additional common shares being issued by the company.
Preferred Shares (preference shares outside of NA)
An ownership right in which the shareholder has some preference over common shareholders as to dividends
1) preferred shareholders receive dividends first (but dividends are no guaranteed at the board may not declare any dividends at all)
2) for example, most preferred shares are non‐voting (no say in electing the company’s board of directors)
3) If company is liquidated, they get return of capital before common shares
4) Have a fixed dividend rate (or stated dividend rate)
5) typically issued at $25 per share
Fixed dividend rate (stated dividend rate)
Stated amount of dividends paid on preferred shares, stated as either a dollar amount per share (a quarterly or annual dividend rate per share per year) or as a percentage of the share’s issue price
Example: $2 every year
Perpetuals
preferred shares that pay a fixed dividend for as long as the shares remain outstanding
Example: $2 every year
Floating rate
preferred shares pay a dividend that is linked to a measure such as the prime rate, which means the amount of the dividend will change or “float” as the measure they are linked to changes
Example: One year might be $3, another may be $1.50, always changes
Rate reset
preferred shares pay a fixed dividend from their issuance until a pre-established reset date.
Example: $2 per share until 2016, than it rests to x amount
Three (3) types of preferred shares in Canada
1) Perpetuals
2) Floating rate
3) Rate reset
Hybrid securities
Shares or investments that include features of both debt and equity
How are preferred shares similar to bonds
Given that they are normally non-voting, tend to pay a fixed dividend, and may have a maturity date (redemption provision)
How are preferred shares are similar to common shares
they represent an ownership interest, dividends (rather than interest) are paid to investors, and they are normally reported as part of shareholders’ equity.
Companies issue preferred shares for a number of reasons, including the following:
(why issue preferred shares)
1) They enable a company to raise capital without having to dilute the ownership interests of their common shareholders.
2) Because dividends are at the discretion of the board, dividends can be postponed in periods of financial difficulty (which is not an option with interest on bonds or other forms of debt).
3) They provide new capital to a company while improving the debt to equity ratio, which is closely monitored by many financial statement users.
4) They do not result in the dilution of future earnings because preferred shareholders would only be entitled to their fixed or stated dividend amount regardless of any increase in earnings.
Cumulative vs. Non-cumulative Preferred Shares
f-f-f-fight
Cumulative preferred shares
have a feature where dividends that are not declared in one year carry over to the next year. These undeclared dividends are known as dividends in arrears
If many years go by with no dividends, these cumulative preferred shares and paid for all prior years dividends, plus this years, before COMMON SHARES GET THEIR DIVIDENDS
Dividends in arrears
Dividends on cumulative preferred shares that have not yet been declared from a prior year
Non-cumulative shares
Shares that do not guarantee payments of dividends in arrears if no dividend payment is declared
If prior year dividends are not paid, you miss out sucker
When a company has dividends in arrears
they are not recorded as a liability on the statement of financial position
-has no present obligation
Redeemable Preferred Shares (aka callable preferred shares)
Preferred shares with a feature that gives the issuer the right to repurchase (or redeem) them from shareholders at specified future dates and amounts
In 202 i will buy back the share for $20 a piece
Retractable Preferred Shares
Shares that can be sold back to a company (retired) at the shareholder’s option. The price that must be paid for them and the periods of time within which they can be sold are specified in the articles of incorporation
Different from redeemable as it is the shareholders choice to sell, opposed to issuer demanding the share back
Convertible Preferred Shares
can be converted, at the shareholder’s option, into other types of preferred shares based on a ratio stated in the articles of incorporation.
While it is uncommon, some preferred shares are convertible into common shares.
Participating Preferred Shares
are preferred shares that not only have a preference with regard to dividends, but, if dividends are declared to common shareholders beyond the level declared to the preferred shareholders, this feature allows the preferred shareholders to also share in the excess dividends
-uncommon and most preferred shares are non-participating
Do Companies Have to Pay Dividends?
No. Companies are not required to pay dividends
Early-stage or growing companies
do not normally pay dividends because they need to retain any profits in the organization to finance growth and expansion
Two conditions to declare dividends
1) The first condition is that the company must have retained earnings (past profits) greater than or equal to the amount of the dividend
2) The second condition is that the company must have enough cash to be able to fund the dividend
**To declare dividends, a company must have:
retained earnings
sufficient cash**
Special dividend or one-time dividend
A dividend declared and paid by a company periodically without any regularity
- wants to declare dividends, but doesnt want them to become expected
- or has a unusual gain (like selling of a division) and has excess cash available
There are four key dates in the dividend declaration process:
- the date of declaration
- the ex-dividend date
- the date of record
- the date of payment
Date of Declaration
the date on which the board of directors votes to declare a dividend
- once declared they must pay them (become a liability)
- usually pays 2 weeks from declaration (which is known as the date of record)
Ex-dividend Date
two business days prior to the date of record
- Because it takes three business days for share trades to be completed, trades made in the two business days prior to the date of record will not be completed until after the date of record
- will not be entitled to the dividends (would be paid to previous owner of the share)
Date of Record
Shareholders on the date of record will be entitled to receive the dividend payment
Date of Payment
the date that the dividend payment is made to shareholders and the company’s liability for the dividends is settled, or extinguished
-payment is normally at least two weeks after the date of record
Why the delay for dividends??
Again, a delay is needed so that the company can update its list of shareholders and calculate the total amount of dividends owed to each.
How Are the Declaration and Payment of Dividends Recorded?
Exhibit 11.6 (Journal entry required for only Date of Declaration and Date of Payment
Date of Declaration accounts
DR Dividends Declared
CR Dividends Payable
Date of Payment accounts
DR Dividends Payable
CR Cash
Cash Dividends
Dividends are paid to shareholders only if the board of directors has voted to declare a dividend.
Dividends are normally cash dividends; that is, the shareholder receives a cash payment from the company.
Stock Dividends
Shareholders will receive additional shares instead of cash
- used when a company wants to declare dividends but does not want to spend cash (or does not have the money)
-normally declared as a percentage of the total shares outstanding
For accounting purposes, companies must determine a value for the new shares being issued as a result of the stock dividend
This is done using the MARKET VALUE (the value that the shares were trading at) on the date the stock dividend was declared.
Stock dividend three step approach
Step 1.
Determine the number of shares issued and outstanding at the time the stock dividend is declared.
Step 2.
Determine the number of new shares being issued as a result of the stock dividend.
Step 3.
Determine the value of the new shares being issued.
Stock dividends accounts
DR Stock Dividends Declared
CR Stock Dividends Issuable
(hence no liability)
Sock dividends account (part 2)
DR Stock Dividends Issuable
CR Common Shares
If shareholders are expected to be no better off after a stock dividend than they were before, why would a company issue such a dividend?
Why issue stock dividends
- Stock dividends allow the company to capitalize a portion of its retained earnings
- also possible that the shareholders are better off after a stock dividend. Often the market price does not fully compensate for the increase in the number of shares.
For the company
both a cash dividend and a stock dividend cause retained earnings to decrease (meaning they can take the money out of their retained earnings (temporary account) and put it into the business’s share capital (permanent account) that can not be distributed to shareholders)
With cash dividends, cash leaves the company, so both assets and shareholders’ equity have decreased and the company’s net assets are reduced
With stock dividends, while retained earnings have decreased, share capital increased by the same amount
For the investor
Cash dividend: investor receives cash and therefore their wealth, or personal net assets, increases
Stock dividend:they received more shares of the company but, if the share price falls by an amount proportionate to the dividend, there is no net change in their wealth.
Stock Splits
A distribution of new shares to shareholders. The new shares take the place of existing shares, and existing shareholders receive new shares in proportion to the number of old shares they already own
-no effect on retained earnings
Why Would a Company Split Its Shares?
- share prices have increased to an amount that makes the shares seem unaffordable to certain types of investors
- may actually increase demand for the shares, which can result in an increase in the market price of the shares
Stock split accounts
Non needed!
-no change in either share capital or retained earnings
Memorandum entry
An entry made to record a stock split. No general ledger accounts are affected; only the record of the number of shares issued is affected
Reverse stock splits (also known as consolidations)
Decrease the number of outstanding shares and have the effect of increasing share prices
-Ratios of one-for-two or one-for-five
They are used by companies whose low share price:
1) puts the company at risk of being delisted from a stock exchange because its share price is barely above the minimum threshold for listing on the exchange
2) makes them ineligible investments for certain institutional investors (for example, some pension funds are not allowed to invest in stocks trading at less than $1.00 per share)
3) prevents them from listing on a public exchange
Comparison of Different Types of Dividends and Stock Splits
exhibit 11.9
_____________________________________
Four different measures that investors and analysts use when assessing investment performance
1) the price/earnings ratio
2) the dividend payout ratio
3) the dividend yield
4) the return on shareholders’ equity ratio
price/earnings ratio (P/E ratio)
First determine the company’s earnings per share (EPS)
The price/earnings ratio relates
- EPS to the current market price per share
- The price/earnings ratio relates the accounting earnings to the market price at which the shares trade
P/E ratio =
equation
Market price per share / earnings per share
High or low for P/E ratio?
The higher the better to a degree, a company with a higher price may have high earning potential in the future, lower risk with debt repayment, or higher future competitive position
HIGH = GOOD
Dividend payout ratio
measures the portion of a company’s earnings that is distributed as dividends
More mature or stable companies (Dividend payout ratio)
generally pay out a higher portion of their earnings as dividends, because they have fewer growth opportunities and less need to retain funds inside the company to finance growth
Young companies (Dividend payout ratio)
need to finance their growth from internal sources and generally distribute little, if any, of their earnings as dividends
Dividend payout ratio =
equation
Dividends per share / earnings per share
Example: $0.43÷$3.75=11.5%
Dividend yield
measures the dividends an investor will receive relative to the share price, measures the return provided by dividends
Mature companies (Dividend yield)
tend to be low-growth stocks (their share prices do not increase dramatically) and pay out a larger portion of their earnings as dividends
larger portion of an investor’s total return will come from dividends rather than from capital appreciation
young companies (Dividend yield)
As their operations grow and expand, so can their share price. These companies normally pay out little or no dividends, choosing instead to use any profits to finance future growth.
Dividend yield =
equation
Dividends per share / price per share
ex: $0.43÷$99.16=0.43%
Return on Shareholders’ Equity Ratio (ROE)
relates the earnings available to common shares to total common shareholders’ equity
- the rate of return that the common shareholders are earning on the amount that they have invested in the company, which includes assets represented by undistributed retained earnings
- higher ratio is better than a lower one
Return on equity ratio =
equation ROE
Net income - preferred dividends / Average common shareholders equity
Average common shareholders equity
(Opening common shareholders’ equity + Ending common shareholders’ equity) ÷ 2
What Are the Advantages and Disadvantages of Financing with Equity?
When a company issues additional shares, it is using equity to finance growth, such as expanding facilities, purchasing competitors, stocking additional product lines, or opening new locations
The advantages of financing with equity instead of debt are:
- Equity financing does not have to be repaid (permanent capita)
- Dividends are optional.
The disadvantages of using equity financing instead of debt are
- Ownership interests may be diluted.
2. Dividends are not deductible for tax purposes.
Share capital and retained earnings are normally found in the
shareholders’ equity section of the statement of financial position.
Company buying back / repurchasing shares for less than originally issued
accounts
DR Common Shares ((10,000 × ($2,700,000 ÷ 1,200,000)) (buyback # x (price original ÷ # orignal)
CR Cash (10,000 × $1.50)
CR Contributed Surplus
Proceeds go to contributed surplus
Company buying back / repurchasing shares for more than originally issued
accounts
DR Common Shares (10,000 × ($2,700,000 ÷ 1,200,000))
DR Retained Earnings
CR Cash (10,000 × $3.00)
Any remaining balance is allocated to retained earnings
Different classes or types of shares can have different rights that accrue to their holders, resulting in different risk and return characteristics. These include:
- whether the share allows its holder to vote and, if so, the number of votes per share
- whether it pays regular dividends
- how large the dividend is
- whether the shareholder gets priority on liquidation
- whether it can be redeemed (bought back by the company)
By offering securities that provide different levels of risk and return (aka have all sorts of shares)
companies can attract a wider group of investors, which may make it easier to raise capital
Financial statement users can find information about the different types of shares a company is authorized to issue in the _______ in the financial statements.
share capital note
Most companies that pay dividends do so
how often do companies pay dividends?
quarterly
If a shareholder sells shares before the ex-dividend date,
the new owner of the shares will then be entitled to receive the dividend.
Earnings per share =
equation
Company’s profit / outstanding common shares
Explain why the shareholders’ equity section is significant to users.
It is important for shareholders to understand how shareholders’ equity is measured and disclosed in the financial statements, so they can assess their return on investment, have an awareness of the various types and classes of shares a company can issue, and understand the reasons for changes in a company’s equity.
The components of shareholders’ equity on the statement of financial position
(1) share capital,
(2) retained earnings,
(3) accumulated other comprehensive income, and
(4) contributed surplus.
How should dividends in arrears on cumulative preferred shares be treated in the financial statements?
They should not be accrued, but only disclosed in the notes.
