Reporting and Analyzing Shareholders’ Equity

The Corporate Form of Organization

The corporation is a distinct legal entity, separate from its owners, with most of the rights and privileges of a person. Corporations may be public or private, depending on the number of shareholders and whether shares are publicly traded.

• Public Corporation: Many shareholders; shares are publicly traded and held.

• Private Corporation: Few shareholders; shares are closely held and not traded.

Characteristics of a Corporation

• Separate Legal Existence: The corporation acts as its own legal entity.

• Limited Liability of Shareholders: Shareholders are only liable up to their investment.

• Transferable Ownership Rights: Shares can be bought and sold without affecting the corporation’s operations.

• Ability to Acquire Capital: Corporations can raise funds by issuing shares.

• Continuous Life: The corporation continues to exist even if ownership changes.

• Corporation Management: Managed by a board of directors and officers, separate from owners.

• Government Regulations: Subject to extensive regulation and reporting requirements.

• Income Tax: Corporations are taxed as separate entities.

Advantages and Disadvantages of a Corporation

• Advantages:

  • Separate legal entity

  • Limited liability of shareholders

  • Ease of transferring ownership rights

  • Ability to acquire capital by issuing shares

  • Continuous life

  • Separation of management and ownership

  • Potential for reduced income tax

• Disadvantages:

  • Increased cost and complexity to follow government regulations

  • Increased reporting and disclosure requirements

Share Capital and Share Transactions

Share Issue Considerations

To raise capital, corporations sell ownership rights in the form of shares. Shares can be divided into different classes, typically common (ordinary) shares and preferred shares. Ownership rights, such as voting, dividends, and liquidation, are specified in the articles of incorporation or by-laws.

• Authorized Shares: Maximum number of shares a corporation can issue (may be limited or unlimited; disclosed, not recorded).

• Issued Shares: Number of shares actually sold to shareholders.

• Legal Capital: The portion of share capital that cannot be distributed to shareholders (unlike retained earnings).

Fair Value Shares

Shares are first issued through an Initial Public Offering (IPO), with the price set by the company. Once issued, shares trade on organized exchanges at market-determined prices. The fair value of shares is established by market forces and does not directly impact the company after the initial issue.

Issuing Common Shares

• Share Capital: The amount shareholders have paid to the corporation for their shares.

• Shares are usually issued for cash, but may also be issued in exchange for services or noncash assets.

Example Journal Entry (for cash):

• Debit: Cash

• Credit: Common Shares

Example Journal Entry (for noncash asset):

• Debit: Asset (e.g., Land)

• Credit: Common Shares

Preferred Shares

Preferred shares have contractual provisions that give them priority over common shares, especially regarding dividends and liquidation. They usually do not have voting rights. Accounting for preferred shares is similar to common shares.

• Dividend Preference: May be cumulative (dividends in arrears must be paid before common dividends).

• Liquidation Preference: Priority in receiving assets upon liquidation.

• Other Preferences: Convertible, redeemable/callable (company option), retractable (shareholder option).

Repurchase of Common Shares

Reasons to Repurchase Common Shares

• Distribute cash to shareholders

• Increase trading on securities markets

• Reduce number of shares issued (increases earnings per share and return on equity)

• Buyout hostile shareholders

• Have shares available for compensation or other uses

Accounting for Repurchase of Common Shares

• Repurchased shares are usually retired and cancelled (removed from share capital account).

• In some jurisdictions, shares may be held as treasury shares for future resale.

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 (affects contributed surplus or retained earnings)

Repurchase Below Average Cost (Example):

• Credit: Contributed Surplus for the difference between average cost and repurchase price

Repurchase Above Average Cost (Example):

• Debit: Retained Earnings for the excess of repurchase price over average cost (after using contributed surplus)

Dividends and Stock Splits

Dividends

A dividend is a pro rata (equal) distribution of a portion of a corporation’s retained earnings to its shareholders. The most common type is a cash dividend, but stock dividends may also be issued.

Formula for Retained Earnings:

Cash Dividends

For a cash dividend to occur, a corporation must:

• Meet a two-part solvency test (CBCA)

• Effect a formal declaration of dividends by the board of directors

Three Important Dates:

1. Declaration Date: Board formally authorizes the dividend (creates a legal obligation)

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

3. Payment Date: Date dividends are paid to shareholders

Example Journal Entry (Declaration):

• Debit: Dividends Declared

• Credit: Dividends Payable

Example Journal Entry (Payment):

• Debit: Dividends Payable

• Credit: Cash

Stock Dividends

A stock dividend is a distribution of additional shares to shareholders, rather than cash. The fair value of the shares on the declaration date is assigned to the stock dividend. The same three dates apply as for cash dividends.

• Satisfies shareholders’ dividend expectations without spending cash

• Increases marketability of shares by increasing number of shares and decreasing market price per share

• Reinvests and restricts a portion of shareholders’ equity (unavailable for future cash dividends)

Example: If 50,000 common shares are outstanding and a 10% stock dividend is declared, 5,000 new shares are issued. If the market price is $15, the amount debited to Dividends Declared is $75,000.

Stock Dividend Journal Entries (Example):

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

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

A stock split increases the number of shares outstanding by issuing additional shares to shareholders according to their percentage ownership. Unlike a stock dividend, a stock split does not affect total share capital, retained earnings, or total shareholders’ equity. The market value per share decreases proportionately. Stock splits are not journalized.

Presentation of Shareholders’ Equity

Statement of Financial Position

• Share Capital: Preferred and common shares

• Contributed Surplus: Amounts contributed from repurchasing and retiring shares

• Retained Earnings: Cumulative net incomes (net losses) since incorporation; annual net income is added, net losses and dividends declared are deducted; a portion may be restricted and unavailable for dividends

Accumulated Other Comprehensive Income (IFRS)

• Reported only under IFRS

• Includes certain gains and losses that bypass net income (e.g., revaluation gains/losses on property, plant, and equipment)

• Accumulated other comprehensive income is the cumulative change in shareholders’ equity from OCI

Formula for Total Comprehensive Income:

Statement of Changes in Equity (IFRS)

Discloses changes in total shareholders’ equity for the period, including share capital, contributed surplus, retained earnings, and accumulated other comprehensive income (loss). Required under IFRS.

Statement of Retained Earnings (ASPE)

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

Measuring Corporate Performance

Dividend Record

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

Formula:

• Higher payout ratio is preferred by income-seeking investors; lower ratio may indicate reinvestment for growth.

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

Formula:

• Higher yield is preferred by income investors; lower yield may indicate growth potential.

Earnings Performance

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

Formula:

• Not comparable between companies; useful for trend analysis within a company.

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

Formula:

• Indicates how many dollars were earned for each dollar invested by common shareholders; higher is better.

Additional info: The notes include exercises and journal entry examples to reinforce concepts, as well as summary tables for the effects of dividends and stock splits on financial statement elements.