CHP 15 - Shareholder's equity

Question 1

CHP 15 - Corporate equity accounts

Question 2

IMPORTANT

Answer 2

1. Distinction between equity and liabilities is that equity does not embody a sacrifice of future economic benefits
2. We record an entry on January 1 because the contract creates an asset for the company – a subscription receivable
3. Offsetting credit is not revenue but there is an obligating event = signing of contract = obligation the company to issue shares once the shares are paid for
4. No this obligation of issuing shares does not create liability because would have to require settlement through a) transfer of assets b) provision of service c) yielding of an economic benefit, it’s an equity account called “shares subscribed”
5. When the shares are issued: common share account reduced because the subscribed shares have now turned into issued shares, subscriptions receivable account remain unchanged (reduced only when cash collected)
6. When receive partial payments:
   1) The money returned / no shares issued
   2) Keep the money and issue no shares
   3) Issue half of the shares subscribed by them because they only paid half of the installments
7. If the shares were trading in an active market at diff price, still record entries @ agreement specified price
8. Contributed surplus = equity account, as agreement allows company to keep the cash and not issue shares = free money/not earned so cannot credit revenue (it really was not earned), so increase equity by using this account
9. Cost of issuing shares
   1) Legal costs, not expense as not incurred to earn revenue, are part of cost of issuing shares, consequently Dr Common or Preferred shares rather than legal expense
   2) Administration fees recorded as expense
   3) Management overhead incurred recorded as expense
10. Shares issued in exchange for equipment, non-monetary transaction, valued at the most objective measure of the consideration received or given up, The journal entry would be:
    Dr Equipment, Cr Common shares
    a) based on value of equipment if it could be determined
    b) or value of the shares if they traded in active market
11. Secret reserve = gain from buying asset by issuing shares at lower price/understate value of appraisal, shares are now worth more
12. Waterstock = loss for shareholders, inflate/overstate value of appraisal, shares are now worth less
13. Only debt instruments (not equity) have legal requirement to pay out amounts like interest
14. When a business becomes incorporated, it must comply with the provisions of either the Canada Business Corporations Act (CBCA)
15. One of the advantages of incorporation is the concept of limited liability whereby a shareholder cannot lose any more than the amount they invested in the business
16. A company can only declare dividends through the formal approval of the board of directors
17. Authorized share capital of a class of shares = maximum number of shares that a company can issue

Question 3

IMPACT

Answer 3

1. Retained Earnings increase when: closing net income in profitable year
2. Retained Earnings decrease when: close net loss or dividend account, declare cash/stock/property/scrip dividend, sell treasury shares at loss (share that a company has reacquired but not cancelled), buyback shares at price exceeding carrying amount
3. AOCI change when closing the OCI into AOCI (IFRS only)

• AOCI + NI = CI
• OCI = unrealized gains/losses
• AOCI = portion of equity arising from revenues, expenses, gains, and losses from non-shareholder transactions that we do not report in net income
• Under IFRS = statement of shareholders’ equity
• Under ASPE = only need statement of retained earnings

4. Companies must issue shares without a nominal or par value = value determined by the legal counsel of a company, will credit a contributed surplus account for any excess received above the par value
5. Contributed surplus increases when: excess amount over par value of issued shares, received donated capital, sell treasury greater than carrying amount, stock options expired, subscribers forfeit their rights
6. Contributed surplus decreases when: selling stock at less than par value, selling treasury less than their carrying amount, buyback and cancel shares when the price paid is lesser than carrying amount, deficit, holder of stock option, distribute liquidating dividend

Question 4

Equity vs liabilities - SHARE CAPITAL

Distinction between equity and liabilities is that equity does not embody a sacrifice of future economic benefits

It represents instead a residual interest in the enterprise

Question 5

2 things shareholders’ equity consists of (2)

Answer 5

• 1) Contributed capital = common and preferred share capital and contributed surplus. Contributed surplus arises from donations received from owners or other persons, credits arising on forfeited shares, credits arising from the reacquisition of shares, and the excess of the proceeds received over the par value of shares sold.
  2) Retained earnings representing the undistributed earnings of the enterprise.

Question 6

5 FORMS OF BUSINESS ENTITIES (5)

Answer 6

1. Proprietorships = owned by one individual, unincorporated, account for proprietorships separate from their owner, the income from a proprietorship = income of its owner, single capital account
2. Partnerships = proprietorship that is owned by more than one person, does not issue shares, uses capital accounts
3. Joint ventures = requires vote of all owners before major business decisions
4. Income trusts = entity that does not have to pay any tax as long as it distributes most of its profit through distributions to unit holders, example: REITs = real estate investment trusts can be held in trusts without being taxed.
5. Public sector entities and other not-for-profit entities (in other course)

Question 7

3 forms of business ownership (3)

Answer 7

1. Proprietorships
2. Partnerships
3. Corporations

Question 8

4 typical equity accounts (4)

Answer 8

1. Common shares = claim to the assets of the corporation ranks lower, they have residual interest in assets only after liabilities settled/after capital returned to preferred shareholders, dividends earned can change, have voting rights
2. Preferred shares = investors owning these shares receive dividends and upon liquidation of a corporation they will receive their capital (the money they paid for their shares) back before the common shareholders receive their capital back, dividends earned remain unchanged, don’t have voting rights
3. Retained earnings
4. Accumulated OCI

Question 9

3 mandatory items annual meeting shareholders (3)

Answer 9

1. Elect the board of directors
2. Approve the annual financial statements
3. Appoint the auditor (if required)

Question 10

2 ways preferred shares can specify dividends (2)

Answer 10

1. Cumulative

minimize some of this risk, company fails to declare a dividend in a particular year, they will track this dividend in arrears and before paying out any common share dividends will pay out all the preferred arrears dividends first

2. Non-cumulative (assumed)

Recall that common shareholders rather than preferred shareholders have the residual interest in a company. This protects preferred shareholders who get to receive their capital back before common shareholders receive the residual interest (which may be nothing) in the event of a liquidation of the business. However, if the business is not liquidating and has grown rapidly, the residual interest will be rising and since this accrues to the common shareholder, the common share price will rise while the preferred share price will remain unchanged.

Not only will the common shareholders see a rise in the price of their shares, if they receive dividends the company will be able to increase their dividends while being under no obligation to increase dividends to the preferred shareholders.

So to placate the preferred shareholders, companies sometimes (but not always) attach some special features to preferred shares such as:

1) Making the dividends on preferred shares cumulative
2) Allowing the preferred shares to receive participating dividends

extra dividend that is paid out to both preferred and common shareholders but only after the preferred shareholders have received their dividends in arrears and their current year dividend AND the common shareholders have received a current year dividend with an equivalent rate of return that the preferred shareholders received on their current year dividend. The participating dividend is given on a pro-rata basis apportioning it between the preferred and common shareholder groups on the basis of their stated (usually carrying) amounts. The participating dividend may have a limit which makes them partially, rather than fully participating

Question 11

4 steps order when paying out dividends under law: (4)

Answer 11

1. Pay out the arrears dividends to the preferred shareholders first
2. Pay out the current year dividend to the preferred shareholders

3.Pay out a corresponding pro rata current year dividend to the common shareholders.

4.Once the current year dividends are paid, a participating dividend can be paid out. Unlike other dividends where the preferred shareholders receive their share first and then the common shareholders receive theirs, a participating is received “simultaneously” on a pro rata basis.

Question 12

Income Trusts

Answer 12

1. the government allowed businesses to be set up in trusts that must distribute most of their income to unit holders
2. The trust was exempt from tax
3. In 2007, the government closed this tax loophole for most companies except real estate trusts

Question 13

5 Common shares/ ordinary/ class A 
Characteristics (5)

Answer 13

1) Subordination – they rank last in terms of distribution of assets of the company upon wind-up 

2) Risks and reward of ownership – they bear all risks and rewards with no special provisions to mitigate risk 

3) No obligation to transfer value – the market values these shares based on the net assets and performance of the company, not some 
predetermined redemption value 

4) All shares in the class have the same rights 

5) Shareholders cannot redeem the shares and the company cannot force (retract) a buy back of the shares except on wind-up

Question 14

6 Preferred Shares characteristics (6)

Answer 14

1) Preference as to dividends that can be participating or cumulative. A preferred share usually has a fixed dividend rate. If the company fails to declare the dividend in a particular year, the right to receive that dividend exists in the future if the shares have a cumulative dividend feature. If the shares are not cumulative, the right to receive a dividend only occurs when the board of directors declares a dividend. 


2) Preference as to assets in the event of liquidation 

3) Convertible into common shares 

4) Callable (redeemable) at the option of the corporation – this means the corporation has the right to buy back the shares 

5) Retractable at the option of the shareholder – this means the shareholder has the right to sell the shares back to the corporation 

6) Nonvoting

Question 15

Instalment receipt

partially paid share that trades in the market that gives the holder the right to purchase a common share at a predetermined price

Question 16

(2) Shares issued with other securities (lump sum sales)
* When a company sells more than one class of shares as a unit, allocate the proceeds received to each class of share in one of two ways: incremental vs proportional method

Answer 16

1) Proportional method 


Under this method, we determine the fair value of each class of shares and the percentage of the total fair value of all shares that each class represents. Using these percentages, we allocate the proceeds received to each class. 


2) Incremental method


We use this method when we do not know the fair value of all classes of shares issued. First, we allocate the proceeds of the unit to the class of shares that have a determinable fair value. The proceeds allocated would be equal to that fair value. Secondly, we then allocate the remaining amount received to the other class of shares. If there were more than one class of shares that did not have a determinable fair value, then we would make an arbitrary allocation in this second step.

Question 17

6 Common reasons for the reacquisition of a company’s shares include (6)

Answer 17

1) To reduce the shares outstanding to increase earnings per share 

2) To have enough shares to meet employee stock option requirements 

3) To stop a take-over attempt 

4) To attempt to make a market in the company’s shares 

5) To return cash to shareholders 

6) To allow a public company to “go private” and create value for shareholders – this may occur with a leveraged buyout with employee 
participation

Question 18

16. 4 TYPES OF DIVIDENDS (4)

Answer 18

1. Cash Dividend

This is the most common type of dividend. The dividend process begins on the declaration date, which is the date on which the board meets and declares the dividend. The declaration will usually state an amount of dividend per share. At that time, we record the dividend by debiting the dividend account (that we will later close to retained earnings at the end of the year) and by crediting dividends payable.
On the declaration date, the board will specify that parties owning the company’s shares on a specific date will be eligible to receive the dividend. This date is the record date. We do not record a journal entry on the record date as no transaction occurs at that time.
Shortly after the record date, the company will pay the dividend. This is the payment date. At the time, we debit the dividends payable account and credit cash.

2. Dividends in Kind
   This type of dividend, sometimes called a property dividend, is a non-reciprocal transfer of non-monetary assets between the enterprise and its owners. We must record this dividend at the fair value of the asset given up. Therefore, if the asset given up has a carrying amount that is below its fair value, the asset is “written up” and a gain recorded in the statement of income before recording the payment of the dividend. A write- down of such an asset is also possible.
3. Stock dividends
   A stock dividend results in the issuance of stock rather than cash. In an economic sense, the receipt of such a dividend has no real economic value because shareholders are not receiving any company assets. The value of a stock dividend is determined by multiplying the shares issued by the share price at the date of declaration. Under ASPE, if the shares do not trade actively, the board may have to declare a value for the shares. Companies express stock dividends as a percentage of the outstanding shares prior to the dividend. When the board declares a stock dividend, we debit the dividends account and credit an equity account called “stock dividend distributable”. This last account is not a liability but is another equity account that we show under the share capital accounts. The reason why this is not a liability is because it does not involve the future sacrifice of an economic resource. When the company distributes the shares, we debit the stock dividend distributable account and credit the applicable share capital account.
4. Liquidating Dividends
   If a corporation pays out a dividend that is larger than its retained earnings, we can consider the portion that exceeds the retained earnings amount a return of capital and in theory, this is not a dividend at all. Nonetheless, the practice has developed to call such a return of capital a “liquidating” dividend. A company can pay out such a dividend in special circumstances, which requires the reduction of contributed surplus.

Question 19

Why can’t pay dividends?

*maximum dividend that a company can pay is the balance in retained earnings unless if you have contributed surplus

Answer 19

1. Many companies never pay dividends because the board desires all cash generated by the company to remain with the company in the future.
2. The CBCA prohibits the declaration of a dividend if it will result in the corporation being unable to pay its liabilities or if it results in the realizable value of the corporation’s assets being less than its liabilities and less than the stated capital of its equity (equity less retained earnings)

Question 20

Subscription basis

When a company sells its shares in this manner, it receives instalment payments before issuing shares.

Answer 20

1. OPTIONS if payments of subscription arrangement fall into default
   1) The money returned / no shares issued
   2) Keep the money and issue no shares = gain = contributed surplus
   3) Issue half of the shares subscribed by them because they only paid half of the installments
2. Journal entries
   1) When a company subscribes shares:
   * Subscriptions receivable account as contra equity account in B/S

Dr Subscriptions receivable
Cr Preferred or Common shares

2) When the company collects the instalments

Dr Cash
Cr Subscriptions receivable

3) Receive full amount of the subscription

Dr Common shares subscribed
Cr Common Shares

Question 21

Reacquisition of shares treatment

• Where a company redeems its own shares, or cancels its own shares that it has acquired, and the cost of such shares is equal to or greater than their par, stated or assigned value, the company must allocate the cost as follows:
• cannot record gain/loss

Answer 21

1. To share capital, in an amount equal to the par, stated or assigned value of the shares

   1) Any excess, to contributed surplus to the extent that the company has contributed surplus created by a net excess of proceeds over cost on cancellation or resale of shares of the same class
,
   2) Any excess, to contributed surplus in an amount equal to the pro rata share of the portion of contributed surplus that arose from transactions, other than those in(b) above, in the same class of shares
   3) Any excess, to retained earnings.
2. In the case where the cost to purchase shares is less than the par, stated, or assigned value, the cost would be allocated as follows
   1) To share capital in an amount equal to the par, stated, or assigned value of the shares
   2) The difference, to contributed surplus.

Question 22

STOCK SPLITS vs REVERSE SPLITS

• A stock or share split = when a company creates more shares without selling them or issuing a stock dividend = reduces price
• If a stock dividend represents a distribution of stock amounting to more than 25% of the previously outstanding stock, an argument exists to record this as a stock split
• Reverse split or share consolidation = opposite of a stock split
• No journal entry just note disclosure

Answer 22

1. The major reason for a share split is to allow most investors to have the ability to buy the company’s shares
2. Another advantage of a share split is that the price will not always fall by the expected amount and this is an advantage to the existing shareholders
3. From the company’s point of view, a stock split does not constitute a transaction and its only affect will be on the disclosures in the financial statements pertaining to the amount of authorized, issued, and outstanding shares, all of which will rise because of the split

Question 23

Under IFRS, companies show the following information in the statement of shareholders’ equity or in notes to the financial statements:

Answer 23

1. The authorized number of shares 

2. The existence of unique rights such as dividend features, redemption or retraction privileges, conversion rights, and cumulative 
characteristics 

3. The number of shares issued, and the amount received 

4. Whether the shares have a par value 

5. The amount of any dividends in arrears (if the shares have a cumulative dividend feature) 

6. Amounts and other details about changes to share capital during the year such as new issuances, redemptions, and conversions 

7. Restrictions on retained earnings

Question 24

Ratios

Answer 24

1. Rate of return on common shareholders’ equity =
   Net income - preferred dividends/ Average common shareholders’ equity
2. Payout ratio = Cash Dividends/ Net income - preferred dividends

This ratio measures the percentage of income attributable to the common shareholders paid out by way of dividends. The higher this amount, the less likely a company is committed to expanding.

3. Price Earnings ratio = Price of a share/ Earnings per share

Note that for this ratio we usually refer to common shares and express the amount as a ratio (i.e.: something to one), rather than a percentage. This ratio is very valuable in determining how highly priced a stock is. For example, if two companies are identical in every way but one has a price earnings ratio of 30 to 1 and the other has a ratio of 10 to 1, it would be better to buy the latter as it is a cheaper stock.

4. Book Value per Share = Common shareholders’ equity/ Number of outstanding shares

This ratio calculates the book value of the company per share. We express this ratio in dollars per common share. We often compare this ratio to the share price to determine if the market believes the value of a share is greater than its underlying book value. Usually, the share price is higher because companies show book values at historical cost.

Question 25

TRUE AND FALSE

Answer 25

a Treasury shares are contra equity accounts seen T
rarely in Canada but often in the USA.

b A stock dividend is recorded at the declaration T
date.

c Par value shares are not common in Canada and T
are just a legal value that is recorded when the
shares are issued rather than their actual value.

d Share splits are not recorded - just disclosed. T

e If a company issues shares and will collect the T
amount owed for the shares later, the resulting
receivable could be shown as a contra equity
account if collection is not certain.

f When shares are issued for non-monetary T
consideration, the transaction under IFRS is
usually valued based on the value of the
consideration received.

g A retractable preferred share is one that the F
company can buy back from the shareholder at
any time at a predetermined price.

h Gains and losses cannot be recorded on share capital T
transactions.

i A company that is in financial difficulty if more likely T
to have a low PE ratio and a book value per share that
is higher than its share price.

j We record a journal entry for dividends in arrears T