Chapter 11: Shareholder's Equity

Question 1

Share capital

Answer 1

represents the amount that investors paid for the shares when they were initially issued by the company

Question 2

Retained earnings

Answer 2

represents the company’s accumulated earnings that have not been distributed as dividends to shareholders.

Question 3

shareholders’ equity section

Answer 3

Comprises of Share capital
Retained earnings
Accumulated other comprehensive income
Contributed surplus

Question 4

Accumulated Other Comprehensive Income

Answer 4

Changes in net asset values representing unrealized gains and losses, which are not included in net earnings but are included in comprehensive income.

Question 5

accumulated other comprehensive income (AOCI)

Answer 5

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

Question 6

Contributed Surplus

Answer 6

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.

Question 7

Market capitalization

Answer 7

the value of the company determined by multiplying the number of issued shares times the trading price of the company’s shares

Question 8

When a business operates as a corporation the company is incorporated either under:

Answer 8

federal legislation, the Canada Business Corporations Act, or under similar provincial or territorial acts

Question 9

Articles of incorporation

Answer 9

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.

Question 10

Authorized shares

Answer 10

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!!!

Question 11

There are two main types of shares:

Answer 11

1) common shares

2) preferred shares

Question 12

Within Common and preferred shares are:

Answer 12

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)

Question 13

All companies are required to have at least

Answer 13

one class of common shares

Question 14

Three terms are used to refer to the number of company shares:

Answer 14

1) authorized shares
2) issued shares
3) outstanding shares

Question 15

Issued shares

Answer 15

Shares that have been issued (sold) by the company

Question 16

Outstanding shares

Answer 16

As long as the shares remain in the possession of shareholders outside the company (anyone outside the corporation, excludes treasury shares)

Question 17

Treasury shares

Answer 17

Shares that are repurchased by a corporation and held internally. Repurchased shares are normally cancelled immediately upon purchase

Question 18

Dividends are paid only on shares that are:

Answer 18

Issued and outstanding

Dividends are not paid on treasury shares

Question 19

Legal capital

Answer 19

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

Question 20

Par value (not permitted in Canada in most places)

Answer 20

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

Question 21

No par value shares

Answer 21

When no par value shares are issued, the total amount received for the shares is credited to the Common Shares or Share Capital account

Question 22

Share repurchases aka buybacks

Answer 22

When a company repurchases or buys back shares that it has previously issued to shareholders

Question 23

Why a company would buy back shares

Answer 23

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.

Question 24

Consequences of repurchasing shares

Answer 24

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)

Question 25

The repurchase of shares that are then cancelled / retired

Answer 25

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.

Question 26

Different classes or types of shares can have different rights that accrue to their holders, resulting in different risk and return characteristics. These include:

Answer 26

• 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)

Question 27

A company must have common shares but does not have to have ______

Answer 27

Preferred shares

Question 28

Underwriters

Answer 28

Corporations generally issue shares through a firm of investment bankers known as this

Question 29

Prospectus

Answer 29

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

Question 30

Initial public offering (IPO)

Answer 30

The first time a company issues shares on a public stock exchange

Question 31

Common shares (aka ordinary shares outside of north america)

Answer 31

Certificates that represent portions of ownership in a corporation. These shares usually carry a right to vote.

Question 32

At least one class of a company’s common shares must have all three of the following rights:

Answer 32

1. the right to vote at meetings of the company’s shareholders
2. the right to receive dividends, if declared
3. the right to a share of the company’s net assets upon liquidation of the company

Question 33

1) The Right to Vote at Meetings of the Company’s Shareholders.

Answer 33

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

Question 34

Annual meeting (must have at least one meeting per year)

Answer 34

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

Question 35

Canadian public companies must have at least _____ independent directors

Answer 35

three (3)

Question 36

A director is considered to be independent if they meet a number of conditions:

Answer 36

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.

Question 37

Board of directors

Answer 37

• 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.

Question 38

2) The Right to Receive Dividends, if Declared.

Answer 38

-A company is not obligated to declare dividends

Question 39

_____ shares normally have no restrictions on the amount of dividends they can receive, once the preferred shareholders have received their dividends

Answer 39

Common

if a company’s board does declare dividends, different types or classes of shares may be entitled to different dividend amounts

Question 40

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

Answer 40

Important shit

Question 41

3) The Right to a Share of the Company’s Net Assets upon Liquidation of the Company.

Answer 41

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

Question 42

Other Common Shareholder Rights

Answer 42

1. Right to purchase subsequent issues of shares

2. Special voting rights.

Question 43

1. Right to purchase subsequent issues of shares (pre-emptive right)

Answer 43

-Common shareholders may have the right to share proportionately in any new issuance of shares. This is known as a pre-emptive right.

Question 44

Pre-emptive right (aka anti-dilution provision)

Answer 44

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

Question 45

Minority interest (aka non-controlling interest)

Answer 45

A block of shares owed by an investor that represents less than 50% of the outstanding shares

Question 46

2. Special voting rights

Answer 46

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

Question 47

Multiple voting shares or super voting shares

Answer 47

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.

Question 48

Preferred Shares (preference shares outside of NA)

Answer 48

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

Question 49

Fixed dividend rate (stated dividend rate)

Answer 49

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

Question 50

Perpetuals

Answer 50

preferred shares that pay a fixed dividend for as long as the shares remain outstanding

Example: $2 every year

Question 51

Floating rate

Answer 51

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

Question 52

Rate reset

Answer 52

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

Question 53

Three (3) types of preferred shares in Canada

Answer 53

1) Perpetuals
2) Floating rate
3) Rate reset

Question 54

Hybrid securities

Answer 54

Shares or investments that include features of both debt and equity

Question 55

How are preferred shares similar to bonds

Answer 55

Given that they are normally non-voting, tend to pay a fixed dividend, and may have a maturity date (redemption provision)

Question 56

How are preferred shares are similar to common shares

Answer 56

they represent an ownership interest, dividends (rather than interest) are paid to investors, and they are normally reported as part of shareholders’ equity.

Question 57

Companies issue preferred shares for a number of reasons, including the following:
(why issue preferred shares)

Answer 57

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.

Question 58

Cumulative vs. Non-cumulative Preferred Shares

Answer 58

f-f-f-fight

Question 59

Cumulative preferred shares

Answer 59

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

Question 60

Dividends in arrears

Answer 60

Dividends on cumulative preferred shares that have not yet been declared from a prior year

Question 61

Non-cumulative shares

Answer 61

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

Question 62

When a company has dividends in arrears

Answer 62

they are not recorded as a liability on the statement of financial position
-has no present obligation

Question 63

Redeemable Preferred Shares (aka callable preferred shares)

Answer 63

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

Question 64

Retractable Preferred Shares

Answer 64

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

Question 65

Convertible Preferred Shares

Answer 65

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.

Question 66

Participating Preferred Shares

Answer 66

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

Question 67

Do Companies Have to Pay Dividends?

Answer 67

No. Companies are not required to pay dividends

Question 68

Early-stage or growing companies

Answer 68

do not normally pay dividends because they need to retain any profits in the organization to finance growth and expansion

Question 69

Two conditions to declare dividends

Answer 69

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**

Question 70

Special dividend or one-time dividend

Answer 70

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

Question 71

There are four key dates in the dividend declaration process:

Answer 71

1. the date of declaration
2. the ex-dividend date
3. the date of record
4. the date of payment

Question 72

Date of Declaration

Answer 72

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)

Question 73

Ex-dividend Date

Answer 73

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)

Question 74

Date of Record

Answer 74

Shareholders on the date of record will be entitled to receive the dividend payment

Question 75

Date of Payment

Answer 75

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

Question 76

Why the delay for dividends??

Answer 76

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.

Question 77

How Are the Declaration and Payment of Dividends Recorded?

Answer 77

Exhibit 11.6 (Journal entry required for only Date of Declaration and Date of Payment

Question 78

Date of Declaration accounts

Answer 78

DR Dividends Declared

 CR Dividends Payable

Question 79

Date of Payment accounts

Answer 79

DR Dividends Payable

 CR Cash

Question 80

Cash Dividends

Answer 80

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.

Question 81

Stock Dividends

Answer 81

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

Question 82

For accounting purposes, companies must determine a value for the new shares being issued as a result of the stock dividend

Answer 82

This is done using the MARKET VALUE (the value that the shares were trading at) on the date the stock dividend was declared.

Question 83

Stock dividend three step approach

Answer 83

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.

Question 84

Stock dividends accounts

Answer 84

DR Stock Dividends Declared
  CR   Stock Dividends Issuable
(hence no liability)

Question 85

Sock dividends account (part 2)

Answer 85

DR Stock Dividends Issuable

  CR   Common Shares

Question 86

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

Answer 86

1. Stock dividends allow the company to capitalize a portion of its retained earnings
2. 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.

Question 87

For the company

Answer 87

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

Question 88

For the investor

Answer 88

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.

Question 89

Stock Splits

Answer 89

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

Question 90

Why Would a Company Split Its Shares?

Answer 90

• 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

Question 91

Stock split accounts

Answer 91

Non needed!

-no change in either share capital or retained earnings

Question 92

Memorandum entry

Answer 92

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

Question 93

Reverse stock splits (also known as consolidations)

Answer 93

Decrease the number of outstanding shares and have the effect of increasing share prices
-Ratios of one-for-two or one-for-five

Question 94

They are used by companies whose low share price:

Answer 94

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

Question 95

Comparison of Different Types of Dividends and Stock Splits

Answer 95

exhibit 11.9

Question 96

_____________________________________

Four different measures that investors and analysts use when assessing investment performance

Answer 96

1) the price/earnings ratio
2) the dividend payout ratio
3) the dividend yield
4) the return on shareholders’ equity ratio

Question 97

price/earnings ratio (P/E ratio)

Answer 97

First determine the company’s earnings per share (EPS)

Question 98

The price/earnings ratio relates

Answer 98

• 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

Question 99

P/E ratio =

equation

Answer 99

Market price per share / earnings per share

Question 100

High or low for P/E ratio?

Answer 100

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

Question 101

Dividend payout ratio

Answer 101

measures the portion of a company’s earnings that is distributed as dividends

Question 102

More mature or stable companies (Dividend payout ratio)

Answer 102

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

Question 103

Young companies (Dividend payout ratio)

Answer 103

need to finance their growth from internal sources and generally distribute little, if any, of their earnings as dividends

Question 104

Dividend payout ratio =

equation

Answer 104

Dividends per share / earnings per share

Example: $0.43÷$3.75=11.5%

Question 105

Dividend yield

Answer 105

measures the dividends an investor will receive relative to the share price, measures the return provided by dividends

Question 106

Mature companies (Dividend yield)

Answer 106

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

Question 107

young companies (Dividend yield)

Answer 107

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.

Question 108

Dividend yield =

equation

Answer 108

Dividends per share / price per share

ex: $0.43÷$99.16=0.43%

Question 109

Return on Shareholders’ Equity Ratio (ROE)

Answer 109

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

Question 110

Return on equity ratio =

equation ROE

Answer 110

Net income - preferred dividends / Average common shareholders equity

Question 111

Average common shareholders equity

Answer 111

(Opening common shareholders’ equity + Ending common shareholders’ equity) ÷ 2

Question 112

What Are the Advantages and Disadvantages of Financing with Equity?

Answer 112

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

Question 113

The advantages of financing with equity instead of debt are:

Answer 113

1. Equity financing does not have to be repaid (permanent capita)
2. Dividends are optional.

Question 114

The disadvantages of using equity financing instead of debt are

Answer 114

1. Ownership interests may be diluted.

2. Dividends are not deductible for tax purposes.

Question 115

Share capital and retained earnings are normally found in the

Answer 115

shareholders’ equity section of the statement of financial position.

Question 116

Company buying back / repurchasing shares for less than originally issued

accounts

Answer 116

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

Question 117

Company buying back / repurchasing shares for more than originally issued
accounts

Answer 117

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

Question 118

Different classes or types of shares can have different rights that accrue to their holders, resulting in different risk and return characteristics. These include:

Answer 118

• 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)

Question 119

By offering securities that provide different levels of risk and return (aka have all sorts of shares)

Answer 119

companies can attract a wider group of investors, which may make it easier to raise capital

Question 120

Financial statement users can find information about the different types of shares a company is authorized to issue in the _______ in the financial statements.

Answer 120

share capital note

Question 121

Most companies that pay dividends do so

how often do companies pay dividends?

Answer 121

quarterly

Question 122

If a shareholder sells shares before the ex-dividend date,

Answer 122

the new owner of the shares will then be entitled to receive the dividend.

Question 123

Earnings per share =

equation

Answer 123

Company’s profit / outstanding common shares

Question 124

Explain why the shareholders’ equity section is significant to users.

Answer 124

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.

Question 125

The components of shareholders’ equity on the statement of financial position

Answer 125

(1) share capital,
(2) retained earnings,
(3) accumulated other comprehensive income, and
(4) contributed surplus.

Question 126

How should dividends in arrears on cumulative preferred shares be treated in the financial statements?

Answer 126

They should not be accrued, but only disclosed in the notes.