Reporting and Analyzing Shareholders’ Equity

The Corporate Form of Organization

Corporations are a distinct legal form of business organization, separate from their owners, with unique rights and responsibilities.

• Separate Legal Entity: Corporations exist independently from their shareholders.

• Public vs. Private: Public corporations have many shareholders and their shares are traded on exchanges; private corporations have few shareholders and shares are not publicly traded.

Characteristics of a Corporation

Corporations possess several defining characteristics that distinguish them from other business forms.

• Separate legal existence

• Limited liability of shareholders

• Transferable ownership rights

• Ability to acquire capital

• Continuous life

• Corporation management

• Government regulations

• Income tax

Advantages and Disadvantages of a Corporation

Corporations offer several advantages, but also face certain disadvantages compared to other business forms.

Share Issue Considerations

Corporations raise capital by selling ownership rights in the form of shares, which can be divided into different classes.

• Common (Ordinary) Shares: Basic ownership with voting rights.

• Preferred Shares: Priority in dividends and liquidation, usually no voting rights.

• Authorized Shares: Maximum number of shares a corporation can issue (disclosed, not recorded).

• Issued Shares: Number of shares actually sold.

• Legal Capital: Amount of share capital that cannot be distributed to shareholders.

Fair Value Shares

Shares are first issued through an Initial Public Offering (IPO), after which their price is determined by market forces on exchanges.

• Share price at IPO: Set by the company.

• Market price: Determined by supply and demand after issuance.

Issuing Common Shares

Common shares are typically issued for cash, but may also be issued in exchange for services or noncash assets.

• Journal Entry for Cash Issue: Debit Cash, Credit Common Shares.

• Journal Entry for Noncash Issue: Debit Asset (e.g., Land), Credit Common Shares.

Preferred Shares and Preferences

Preferred shares have contractual provisions that give them priority over common shares in dividends and liquidation.

• Dividend Preference: May be cumulative (dividends in arrears).

• Liquidation Preference: Paid before common shareholders in case of liquidation.

• Other Preferences: Convertible, redeemable/callable, retractable.

Repurchase of Common Shares

Corporations may repurchase their own shares for various strategic reasons.

• Distribute cash to shareholders

• Increase trading activity

• Reduce number of shares issued (increases EPS and return on equity)

• Buyout hostile shareholders

• Hold shares for compensation or other uses

Repurchased shares are usually retired and cancelled, but may be held as treasury shares in some jurisdictions.

• Steps to Repurchase:

  1. Remove cost of shares from share capital account

  2. Record the cash paid

  3. Record the gain or loss on repurchase

Dividends

Dividends are distributions of a corporation’s retained earnings to its shareholders, most commonly paid in cash.

• Cash Dividends: Distribution of cash to shareholders.

• Stock Dividends: Distribution of additional shares to shareholders.

Formula for Retained Earnings:

Cash Dividends: Key Dates and Entries

Three important dates for cash dividends:

1. Declaration Date: Board formally authorizes dividend; creates a legal obligation.

2. Record Date: Determines which shareholders are entitled to receive the dividend.

3. Payment Date: Date dividend is paid to shareholders.

Example Journal Entry (Declaration Date):

• Debit Dividends Declared, Credit Dividends Payable

• Amount:

Effects of Cash Dividends:

Stock Dividends

Stock dividends distribute additional shares to shareholders, increasing the number of shares and decreasing the market price per share.

• Fair value on the date of declaration is assigned to the stock dividend shares.

• Same three dates as cash dividends: declaration, record, distribution.

Purposes and Benefits:

• Satisfy dividend expectations without spending cash

• Increase marketability of shares

• Reinvest and restrict a portion of shareholders’ equity

Example: 10% stock dividend on 50,000 shares at $15/share:

• Shares issued:

• Amount debited:

Journal Entries:

• Declaration Date: Debit Dividends Declared, Credit Stock Dividends Distributable

• Distribution Date: Debit Stock Dividends Distributable, Credit Common Shares

Effects of Stock Dividends:

Stock Splits

A stock split increases the number of shares outstanding by issuing additional shares to shareholders, with no effect on total share capital, retained earnings, or total shareholders’ equity.

• Market value per share decreases proportionately.

• Stock splits are not journalized.

Effect of Stock Split:

Comparison of Dividends and Stock Splits

Dividends and stock splits have different effects on shareholders’ equity.

Presentation of Shareholders’ Equity in Financial Statements

Shareholders’ equity is presented in the statement of financial position and includes several components:

• Share Capital: Preferred and common shares.

• Contributed Surplus: Amounts from repurchasing and retiring shares.

• Retained Earnings: Cumulative net income (losses) since incorporation, less dividends and net losses.

• Accumulated Other Comprehensive Income (IFRS): Includes certain gains and losses that bypass net income, such as revaluation gains/losses.

Formula for Total Comprehensive Income:

Statement of Changes in Equity (IFRS)

This statement discloses changes in total shareholders’ equity for the period, including share capital, contributed surplus, retained earnings, and accumulated other comprehensive income. Required under IFRS.

Statement of Retained Earnings (ASPE)

For private companies, the statement of retained earnings shows the amounts and changes in retained earnings during the period. Required under ASPE.

Measuring Corporate Performance

Key ratios and measures are used to evaluate dividend and earnings performance.

• Payout Ratio: Measures the percentage of profit distributed as cash dividends to common shareholders.

• Formula:

• Dividend Yield: Measures the profit generated by each share, based on market price.

• Formula:

• Basic Earnings per Share (EPS): Measures income earned by each common share.

• Formula:

• Return on Common Shareholders’ Equity: Measures profitability from the shareholders’ viewpoint.

• Formula:

Example: If a company has net income of $100,000, pays $10,000 in preferred dividends, and has 45,000 weighted average common shares, then:

• per share

Higher payout ratios and dividend yields are preferred by income-seeking investors, while lower ratios may indicate potential for share price appreciation.