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Module 12.docx

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Administrative Studies
ADMS 2510
Kuk/ Riddell

Module 12: Shareholders’ equity Shareholders’ Equity: A Permanent Source Of Capital This module covers the following topics: ƒ Incorporating Acts and Capital Contributions ƒ Issuances of Shares for Cash ƒ Costs of Issuing Shares ƒ Issuances of Shares for Assets Other than Cash ƒ Retained Earnings ƒ Dividend Policy ƒ Other Changes in Shareholders‟ Equity Accounts ƒ Disclosure of Changes in Shareholders' Equity Play Advantages of incorporation [viewing time 3 min: 5 sec] The economic resources of a firm come from two major sources. Non owners provide funds to a firm; the sources of these funds are shown on the balance sheet as Liabilities. Owners provide funds; the sources of these funds are shown on the balance sheet as owners' equity. Assets=Claims to Assets Or Assets = Liabilities + Owners' Equity Incorporating Acts A corporation is an artificial legal "person" created with the approval of government. As such, it can sue, be sued, enter into contracts, and pay income taxes as would an individual. A firm may choose to be incorporated federally under the jurisdiction of the Canada Business Corporations Act (CBCA) or provincially under one of the provincial corporations acts. Variations exist in the rules among these acts, especially with respect to the accounting and disclosure of capital transactions. Play Public vs Private Companies [viewing time 2 min] Implications of being private/closely held: 1. First, small, closely held companies can escape much of the costly bureaucratic red tape that large corporations face 2. Second, because most Canadian companies are small, closely held companies, the public has no access to their financial statements. 3. Third, public companies listed on stock exchanges must have audits and follow strict GAAP to achieve financial statement reliability and comparability goals Capital Contributions A corporation is a legal entity separate from its owners. Individuals or other entities make capital contributions under a contract between themselves and the corporation. Because those who contribute funds receive and hold share certificates, they are known as shareholders (The terminology in the shareholders (The terminology in the United States is stockholder (and stock instead of shares). Many Canadian companies now use the term capital stock instead of share capital.) Play Rights and Obligations of Shareholders [viewing time 1min: 3 sec] Some closely held corporations have a small number of shareholders and operate much like a partnership. The few people involved agree to the amount of capital to be contributed, elect each other to be members of the board of directors and officials to the firm, and agree on policies regarding dividends and salaries. They may restrict the transfer of shares to outsiders, and may even become liable for debts of the corporation by endorsing its notes and bonds. In the case of large, widely held corporations, the effect of the corporation's being a separate legal entity is more pronounced. Officials and directors may own few or no shares in the corporation. Actual control is likely to be in the hands of a few individuals or a group who own or control enough shares to elect a majority of the board of directors. Most "minority" shareholders think of their shareholdings merely as passive investments, and they participate little, if at all, in the conduct of the affairs of the corporation. The shareholders assume no obligation for the debts of the business. Shares change hands at the will of the shareholders, and the record of who owns shares is usually kept by a trust company. Classes of Shares Corporations are often authorized to issue more than one class of shares, each representing ownership in the business. Most shares issued are either common or preferred. Occasionally, there may be several classes of common or preferred shares, each with different rights and privileges. All corporations must have at least one class of shares. They are usually called "common shares," but they may be designated by another name, such as Class A shares. Preferred shares may, but need not be, issued by a corporation. Common shares have the claim to earnings of the corporation after commitments to preferred shareholders have been satisfied. Frequently, common shares are the only voting shares of the company. In the event of corporate dissolution, all of the proceeds of asset disposition, after the set- ting of claims of creditors and required distributions to preferred shareholders, are distributable to the common shareholders. Preferred shares have special privileges. Although these privileges vary considerably from issue to issue, a preferred share usually entitles its holder to receive dividends at a certain rate, which must be paid before dividends can be paid to common shareholders. Sometimes, though, these dividends may be postponed or omitted. Play Dividend Preference [viewing time 1 min: 37 sec] A company attaches whatever features are needed to market its shares and over time can end up with many different classes of shares. Some classes are more like debt than equity Issuance of Shares FOR CASH: In order to issue and market its shares, a company may incur legal fees; accounting fees; underwriting commissions; and mailing, registration, and advertising costs. It is common practice to treat these costs as a reduction of the net proceeds received for the share issuance. These costs are usually charged to an account called Organization Costs and are carried as an asset on the balance sheet. The cots are amortized over an arbitrary period, usually up to five years (a short period as the amounts tend not to be significant and are assumed to most benefit the early years). Organization Costs are classified with other deferred costs on the balance sheet. Play Costs of Issuing Shares [viewing time 50 sec] FOR NON CASH ASSETS: When shares are issued for property other than cash or for services, the accountant must carefully determine the amount recorded. The general valuation principle applied is that property or services acquired should be recorded at their current fair value or at the fair value of the shares issued, whichever is more clearly determinable. If the shares are actively traded on a securities exchange, the market price of the shares issued may indicate an appropriate value. Play Example of Issuing Shares for Land Should a Firm Raise Funds by Issuing Shares or Bonds? A major consideration in the issue of common or preferred shares is that dividends are not deductible in calculating taxable income. Bond interest is, however, deductible. Thus, the after tax accounting cost of borrowing may be less than the after tax accounting cost of issuing shares, even though the interest rate of the bonds is higher than the dividend rate. However, the economic costs of risk should be factored into the analysis. When bonds are issued, both preferred and common shares become more risky, because bondholders have a claim on future cash flows senior to the claim of shareholders. When preferred shares are issued, common shares become more risky. When shares become more risky, all else being equal, the rate of return on those shares required by the market increases. (For a given dollar amount of return from an investment in a share, this means that the price of the share must fall.) Even though a project financed with a bond issue may result in a larger earnings -per share increase than one financed by a common stock issue, one cannot conclude that raising new funds by borrowing is better than raising new funds with share issues. Leverage (the raising of funds by borrowing) is a two-edged sword. In the module on financial statement analysis we pay very close attention to how a firm raises its capital. A firm that uses very high leverage (mostly debt) will be attractive to investors in good times but will look most unattractive in bad times. There are ratios we can calculate to assess the degree of leverage. Retained Earnings After a new business has established itself and is profitable, it usually generates additional shareholders' equity from undistributed earnings. These undistributed earnings represent the accumulated periodic net income that remains after dividends have been declared and are called retained earnings. A common misconception about retained earnings is that it represents a fund of cash available for distribution or expansion. Earnings from operations usually involve cash at some stage: goods are sold to customers, the cash is collected, more goods are acquired, bills are paid, more sales are made, and so on. Assets generated by earnings do not, however, remain in the form of cash . Only under most unrealistic conditions would this be so. Play Income not equal Cash [viewing time 38 sec] The Cash Flow Statement shows how the cash provided by operations and other sources are used during a period. A well-managed firm keeps its cash at a reasonable minimum. If cash starts to accumulate, the firm may pay some obligations, increase its inventory, buy more equipment, or declare dividends. Thus, there is no way of knowing how retaining earnings affects the individual asset and liability accounts. The only certain statement is that an increase in retained earnings results in increased net assets (that is, an increase in the excess of all assets over all liabilities). Cash Dividends The shareholders of a corporation do not directly control distributions of corporate assets generated by net income. Corporate bylaws almost always delegate the authority to declare dividends to the board of directors. When a dividend is declared, the entry is: Sometimes an account called Dividends or Dividends Declared is debited. The Dividends account balance reduces the Retained Earnings reported at the end of the period. Once the board of directors declares a dividend, the dividend becomes a legal liability of the corporation. Dividends Payable is shown as a current liability on the balance sheet if the dividends have not been paid at the end of the accounting period. When the dividends are paid, the entry is: Play Property Dividends [viewing time 32 sec] Stock Dividends The retention of earnings may lead to a substantial increase in shareholders' equity, which represents a relatively permanent commitment by shareholders to the business. The commitment is relatively permanent because the net assets generated have been invested in operating assets such as inventories and plant. To indicate such a permanent commitment of reinvested earnings, the board of directors may declare a stock dividend. The accounting involves a debit to Retained Earnings and a credit to the capital accounts. When a stock dividend is issued, shareholders receive additional shares in proportion to their existing holdings. If a 5 percent stock dividend is issued, each shareholder receives one additional share for every twenty shares held before the dividend. The usual accounting practice is to base the valuation of the newly issued shares on the market value of the shares issued. Stock dividends are just as welcome as cash dividends to investors but offer more flexibility. The investor can sell the new shares immediately to generate a cash flow or hold the shares and wait for capital gain appreciation. Play Example of a Stock Dividend [viewing time 48 sec] The stock dividend relabels a portion of the retained earnings that had been legally available for dividend declarations as a more permanent form of shareholders' equity. A stock dividend formalizes the fact that some of the funds represented by past earnings have been used for plant expansion, to replace assets at increased prices, or to retire bonds. Play Economic Substance of a Stock Dividend [viewing time 1min: 22 sec] Dividend Policy The directors, in considering whether or not to declare cash dividends, must conclude both (1) that the declaration of a dividend is legal and (2) that it is financially expedient. Dividends are seldom declared up to the maximum legal limit. The directors may allow the retained earnings to increase as a matter of corporate financial policy for several reasons: 1. Earnings are not reflected in a corresponding increase of available cash. 2. Restricting dividends in prosperous years may permit continued dividend payments in poor years. 3. Funds may be needed for expansion of working capital or plant and equipment. 4. Reducing the amount of borrowings, rather than paying dividends, may seem prudent. Play Statutory Limits [listening time 1min: 56 sec] Play Contractual Limits [listening time 1 min: 19 sec] Play Shareholder Preferences [listening time 1 min: 55 sec] Other Accounting Issues in Shareholders’ Equity Play Stock Splits [listening time 2 min] Play Compound Financial Instruments [listening time 52 sec] Play Options & Warrants[listening time 1 min: 9 sec] Play Stock Compensation Plans [listening time 1 min: 55 sec] Most accounting issues in Shareholders' Equity have legal consequences. The Incorporating Corporations Acts and Stock Exchange Regulations prescribe in detail acceptable practices and dictate what is acceptable GAAP. Accountants have to be very familiar with these regulations and others which impinge on corporate conduct. Reporting Income and Retained Earnings Adjustments What is the purpose of the income statement? It is not just to show net income for the period. The reader of the financial statements can generally ascertain net income by subtracting the beginning balance of Retained Earnings from its ending balance and adding dividends. The purpose of the income statement is to show the causes of income. (Parallel statements can be made about the cash flow statement. The purpose of the cash flow statement is not to report the change in cash for the period. That can be deduced by subtracting the balance in the Cash account at the start of the period from that at the end of the period. The purpose is to report the causes of the change in the Cash account.) Then, a company's performance can be compared with other companies or with itself over time, and more informed projections can be made about the future. To help the reader understand the causes of income, GAAP principles require the separate reporting of certain items in the income statement. Extraordinary items and the results of operations attributable to Discontinued Segments should be separately identified. In addition, the company should separately disclose gains and losses resulting from normal business activities that are both abnormal in size and caused by rare or unusual circumstances. With this information, the reader is able to select or calculate the measure of income that is relevant to the decision. Play Disclosure of Changes in Shareholders‟ Equity [listening time 29 sec] Note to Students: Module 11 is a highly technical module with numerous explanatory embedded movies. Regrettably, the print and capture functions do not work on movies. The purpose of this Appendix is to provide you with “hard copy” support for the movies to facilitate your study of the topic. Each page of the Appendix is cross referenced to a page in the main module. Page: 332 Advantages of Incorporation (page 319) There are three major advantages to incorporation: 1. The corporate form provides the owner (shareholder) with limited liability. That is, should the corporation become insolvent, creditors' claims are limited to the assets of the corporate entity. The corporation's creditors cannot claim the assets of the individual owners. On the other hand, creditors of partnerships and sole proprietorships have a claim on both the owners' personal and the business assets to settle such firms' debts. Note that, with small firms, the directors/ owners are often required to guarantee the firm's liabilities. 2. The corporate form allows the raising of funds by the issuing of shares. The general public can acquire the shares in varying amounts. Individual investments can range from a few dollars to hundreds of millions of dollars. 3. The corporate form makes transfer of ownership interests relatively easy, because individual shares can be sold by current owners to others without interfering with the ongoing operations of the business. Changes in ownership do not affect the continuity of the management and of operations. There are also disadvantages to incorporation. The major disadvantage is double taxation - corporations must pay income tax on earnings whether or not earnings are distributed to shareholders. Remaining earnings, distributed as dividends, are taxed again in the shareholders' hands. Dividends received from Canadian corporations are eligible for a dividend tax credit. Depending on the individual's personal tax rate, this can largely eliminate the double taxation. Another disadvantage is that corporations are generally subject to more government regulation and supervision than unincorporated businesses face. Page: 333 Public vs Private Companies (page 320) Two fundamentally different types of corporations exist in Canada: public corporations and private corporations. Although the terms were created under the predecessor Canada Corporations Act and have been discontinued in the CBCA, they are still widely used. A public company offers its shares to the general public and is usually listed on a stock exchange such as the Toronto Stock Exchange (The TSE - the market in Canada for senior equities), the Montreal Exchange (a focus of derivatives trading), t
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