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Chapter 1

ACTG 2010 Chapter 1: ACTG2010 - Chapter 10


Department
Accounting
Course Code
ACTG 2010
Professor
Douglas Kong
Chapter
1

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John Friedlan, Financial Accounting: A Critical Approach, 4th edition Page 10-1
Solutions Manual Copyright © 2013 McGraw-Hill Ryerson Ltd.
CHAPTER 10
Owners’ Equity
QUESTIONS
Q10-1.
Common shares represent the residual ownership of the entity, and the owners have a claim to
the earnings and assets of the entity after the claims of the creditors and preferred shareholders
have been satisfied. Preferred shares rank in claim ahead of common shares. Preferred shares
have rights that must be satisfied before common shareholders' rights. These preferred rights
pertain to the payment of dividends and/or to the distribution of assets in the event of liquidation.
Dividends on preferred shares must be paid before dividends can be paid to common
shareholders. If the corporation is liquidated, preferred shareholders' claims to assets must be
satisfied before the common shareholders' claims. Therefore it’s riskier for an investor to own
common shares than preferred shares because preferred shares have priority to dividends and
residual claim of a liquidated company.
Q10-2.
Leverage is the use of debt to attempt to increase the return earned on the equity investment of
the owners. Leverage is attractive because any profits earned from investing borrowed money,
above the cost of borrowing, go to the owners. But leverage is risky because the cost of
borrowing must be paid, regardless of how well or poorly the entity is performing. Another
advantage of leverage is that interest on debt is tax deductible and so part of the cost of
borrowing is financed by the government/taxpayers..
Q10-3.
Financing a new business with a high proportion of debt is difficult because lenders might be
reluctant to lend. The higher the debt to equity ratio the higher the risk therefore if debt was
approved it would be at a much higher interest rate and income made has to be allocated to
service the debt first. As primary concern of a lender is the repayment of the loan. When lending
to a corporation the owners of the company don’t have an obligation to payback any outstanding
debt should the company go bankrupt. As a result, lenders will often ask lenders to personally
secure loans to mitigate the risk of default. A company with a high proportion of debt (meaning
the owners have invested relatively little) may be problematic to lenders because with little to
lose the owners may be prepared to take more risk than if they had a larger stake in the company.
If a new entity was financed with 90% debt the lender would be absorbing a lot of risk and more
importantly the borrower would have relatively little risk because he would have little at stake in
the business (only a 10% interest in the total investment).

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John Friedlan, Financial Accounting: A Critical Approach, 4th edition Page 10-2
Solutions Manual Copyright © 2013 McGraw-Hill Ryerson Ltd.
Q10-4.
A corporation is a separate legal entity from its owners, whereas proprietorships and partnerships
are simply extensions of the owner(s). Corporations pay taxes whereas partnerships and
proprietorships don’t (the partners or proprietor pay the tax). The corporation continues to
operate when the owners die or no longer wish to own the business. The income of the
proprietorship or partnership is income in the hands of the owners when it’s earned, but in the
hands of shareholders of a corporation only when it’s distributed as dividends. The liability of
owners of a corporation is limited (unless the owners provide personal guarantees to creditors),
but the liability of proprietors and partners is unlimited except in the case of LLPs.
Q10-5.
Common shares represent the residual interest in an entity because the common shareholders
receive what is left over after all other claims are satisfied. This means that in the event of
liquidation, the common shareholders receive the remaining assets after all liabilities and claims
of creditors and other (preferred) shareholders have been settled. Common shareholders are
entitled to all profits of a corporation once interest and dividends to preferred shareholders have
been paid.
Q10-6.
Both debt and equity are sources of financing for an entity, but equity doesn’t provide any
binding commitments for repayment of the original amount, or any periodic payments. For debt,
failure to make payments as agreed is an event with legal consequences. The entity can issue
debt without sharing control of the entity or of profits over and above the agreed payments.
Equity implies ownership and owners will have a say in the activities of the corporation. Debt
holders have far less say than do shareholders. The cost of debt is tax deductible whereas the cost
of equity isn’t.
To the entity, equity is less risky because it’s possible to operate for many years without making
cash payments to the shareholders. However, a share in the votes of the entity must usually be
provided to the new shareholders and all shareholders are entitled to their share of the earnings.
When debt is issued, and the entity is successful, there is no requirement to share the success
with creditors.
It isn’t possible to determine which is best for a particular entity without understanding the
underlying risk of the business, the industry and related costs.

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John Friedlan, Financial Accounting: A Critical Approach, 4th edition Page 10-3
Solutions Manual Copyright © 2013 McGraw-Hill Ryerson Ltd.
Q10-7.
Not-for-profit organizations (NFPO) are economic entities whose objective is to provide services
and not to make a profit. NFPOs don’t have owners or ownership shares that can be traded or
sold. Any "income" earned by the NFPO is reinvested in the organization. An NFPO may be
formed to pursue environmental issues, or fund cancer research or to build homes for those who
otherwise may not be able to afford them. In many cases, the beneficiaries of the organization’s
activities may be different from those who contributed the funds. Success for NFPOs isn’t
measured by the ability to earn a profit, but by whether the organization has been effective in
pursuing its mission. As a result, the traditional income statement isn’t appropriate because the
“bottom line” doesn’t represent the residual gain or loss of the owners. It’s simply the excess of
revenues over expenses.
Q10-8.
There are no owners of NFPOs that have a residual claim on the equity of the organization.
Without owners, there can’t be a representation of the owners’ interest in the entity. However, to
prepare a balance sheet, the difference between assets and liabilities must be represented.
Instead, there is a statement of resources or net assets that shows the excess of assets over
liabilities. This section of the balance sheet represents contributions (often classified by any
restrictions on the contributions) to the NFPO and the extent to which the inflows of the entity
differ from the costs of operations.
Q10-9.
In limited liability partnerships, some of the partners have limited liability protection. Limited
liability partners aren’t liable personally for the debts of the limited liability partnership and are
less involved in management of the entity. General partners manage the organization and are
liable for debts just as in the case of proprietorships. The nature of a partnership is that the
partners aren’t protected from the risks of the partnership’s activities. The general partner
maintains the existence of the residual party that bears risk while providing protection to the
other partners. If there wasn’t at least one general partner, creditors would be much less willing
to lend to the entity, since the owners would have a minimal commitment to ensuring that the
obligations of the entity are met.
Q10-10.
Dividends are distributions of the earnings of a corporation to the owners and are discretionary.
Interest is a payment on debt to lenders. Interest isn’t discretionary and isn’t dependent on the
earning of profits. This treatment is consistent with the view that net income reflects changes in
the wealth of the shareholders. In this view, dividends aren’t a cost of doing business but a
distribution to the shareholders. In this sense, dividends don’t represent a change in the wealth of
the shareholders but a change in the form of the wealth (the wealth is cash in the hands of the
shareholders instead of an increased value of the shares). Interest payments are expensed because
interest is a cost that the corporation must incur to borrow money.
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