LEARNING OBJECTIVES

1. Discuss the characteristics of the corporate form of organization. 2. Identify the key components of equity. 3. Explain the accounting procedures for issuing shares. 4. Describe the accounting for treasury shares. 5. Explain the accounting for and reporting of preference shares. 6. Describe the policies used in distributing dividends. 7. Identify the various forms of dividend distributions. 8. Explain the accounting for small and large share dividends, and for share splits. 9. Indicate how to present and analyze equity. *10. Explain the different types of preference share dividends and their effect on book value per share. *This material is covered in an Appendix to the chapter.

CHAPTER REVIEW
1. This topic focuses on the equity section of the corporate form of business organization. Equity represents the amount contributed by the shareholders and the portion that was earned and retained by the enterprise. There is a definite distinction between liabilities and equity that must be understood if one is to effectively grasp the accounting treatment for equity issues. This chapter addresses the accounting issues related to capital contributed by owners of a business organization, and the means by which profits are distributed through dividends. The Corporate Form of Entity 2. (L.O. 1) The corporate form of business organization begins with the submitting of articles of incorporation to the appropriate governmental agency in the country in which incorporation is desired. While a company can operate in many different countries, it is incorporated in only one country. Since laws and restrictions vary from country to country, its to a companys advantage to incorporate where laws favor the corporate form of business. Assuming the requirements are properly fulfilled, the corporation charter is issued and the corporation is recognized as a legal entity subject to the laws of the country of incorporation. Many countries have their own business incorporation acts, and the accounting for equity transactions follows these acts. 3. Within a given class of shares, each share is exactly equal to every other share. A persons percent of ownership in a corporation is determined by the number of shares he or she possesses in relation to the total number of shares owned by all shareholders. In the absence of restrictive provisions, each share carries the right to participate proportionately in: (a) profits, (b) management, (c) corporate assets upon liquidation, and (d) any new issues of shares of the same class (preemptive right). 4. The transfer of ownership between individuals in the corporate form of organization is accomplished by one individual selling or transferring his or her shares to another individual. The only requirement in terms of the corporation involved is that it be made aware of the name of the individual owning the shares. A subsidiary ledger of shareholders is maintained by the corporation for the purpose of dividend payments,
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issuance of share rights, and voting proxies. Many corporations employ independent registrars and transfer agents who specialize in providing services for recording and transferring shares. 5. The basic ownership interest in a corporation is represented by ordinary shares. Ordinary shares are guaranteed neither dividends nor assets upon dissolution of the corporation. Thus, ordinary shareholders are considered to hold a residual interest in the corporation. However, ordinary shareholders generally control the management of the corporation and tend to profit most if the company is successful. In the event that a corporation has only one authorized issue of capital shares, that issue is by definition ordinary shares, whether or not it is so designated in the charter. Equity 6. (L.O. 2) Equity in a corporation is the residual interest in the assets of the company after deducting all liabilities. Equity is often subclassified, and the following categories are commonly used. a. Share capital. b. Share premium. c. Retained earnings. d. Accumulated other comprehensive income. e. Treasury shares. f. Non-controlling interest (minority interest). Equity: Contributed Capital and Earned Capital 7. Contributed capital is the amount paid in by shareholders and includes par value and any premiums (less any discounts). Earned capital results from the companys profitable operations (reduced by any dividends distributed). 8. Equity is the difference between the assets and the liabilities of the companyalso known as the residual interest. Equity is not a claim to specific assets but a claim against a portion of the total assets. Equity is not specified or fixed, it increases when the company is profitable and decreases when the company loses money. Accounting for the Issuance of Shares 9. (L.O. 3) The process for issuing shares begins with authorization by the appropriate governmental agency to issue shares (often the corporate charter), next the corporation offers the shares for sale, after receiving the sales price the shares are issued and recorded in the companys accounting records. The par value of a share has no relationship to its fair value. At present, the par value associated with most ordinary share issues is very low. Low par values help companies avoid the contingent liability associated with shares sold below par. 10. When par value shares are issued, the Share Capital (Ordinary or Preference) account is credited for an amount equal to par value times the number of shares issued. Any amount received in excess of par value is credited to Share Premium. For example, if 200 ordinary shares with a par value of $2 per share are sold for $500, the following journal entry would be made: Cash......................................................................................500 Share CapitalOrdinary................................................... 400 Share PremiumOrdinary ............................................... 100
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Par value shares are always credited at issue date for par value times the number of shares issued. 11. When no-par shares are issued, the Share Capital account is credited for an amount equal to the value of the consideration received. Some no-par shares have a stated value. Most corporations account for no-par shares with a stated value as if they were par value shares with par equal to the stated value. Lump Sum Sales 12. More than one class of shares is sometimes issued for a single payment or lump sum amount. Such a transaction requires allocation of the proceeds between the classes of securities involved. The two methods of allocation used are (a) the proportional method and (b) the incremental method. The former method is used when the fair value for each class of security is readily determinable, and the latter method is used when only one classs market value is known. Shares Issued in Noncash Transactions 13. Shares issued for consideration other than cash should be recorded using the fair value of the consideration received. If that fair value cannot be measured reliably, the fair value of the shares issued should be used. In cases where the fair market value of both items is not clearly determinable, an appropriate valuation technique should be used. Depending on available data, the valuation may be based on market transactions involving comparable assets or the use of discounted cash flows. Generally, the board of directors has the power to set the value of non-cash transactions. If the BOD abuses this power watered shares or secret reserves can result. Costs of Issuing Shares 14. Direct costs incurred to sell shares such as underwriting costs, accounting and legal fees, and printing costs should be recorded as reductions of amounts paid in (debited to Share Premium). Management salaries and other indirect costs related to the share issuances should be expensed as incurred. Treasury Shares 15. (L.O. 4) Treasury shares are a corporations own shares that (a) were outstanding, (b) have been reacquired by the corporation, and (c) are not retired. Treasury shares are not an asset and should be shown in the statement of financial position as a reduction of equity. Treasury shares are essentially the same as unissued shares. The reasons corporations purchase their outstanding shares include: (a) to provide tax efficient distributions of excess cash to shareholders; (b) to increase earnings per share and return on equity; (c) to provide shares for employee share compensation; (d) to contract operations or thwart takeover attempts; and (e) to make a market in the shares.
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16. Two methods are used in accounting for treasury shares, the cost method and the par value method. The par or stated value method records all transactions in treasury shares at their par value and reports the treasury shares as a deduction from share capital only. Under the cost method (the method most frequently used), treasury shares are recorded in the accounts at acquisition cost. When the treasury shares are reissued the Treasury Shares account is credited for the acquisition cost. If treasury shares are reissued for more than their acquisition cost, the excess amount is credited to Share PremiumTreasury. If treasury shares are reissued for less than their acquisition cost, the difference should be debited to any Share PremiumTreasury from previous treasury share transactions. If the balance in this account is insufficient, the remaining difference is charged to retained earnings. The cost of treasury shares is shown in the statement of financial position as a deduction from equity, generally as the last item in the equity section. The following example shows the accounting for treasury shares under the cost method. 10,000 ordinary shares with a par value of $5 per share were originally issued at $12 per share. A. 2,000 ordinary shares are reacquired for $20,000. Entry for Purchase Treasury Shares.................................................. 20,000 Cash................................................................................ 20,000 B. 1,000 treasury shares are resold for $8,000. Entry for Resale Cash...................................................................... 8,000 Retained Earnings ....................................................... 2,000 Treasury Shares .......................................................... 10,000 17. The BOD may approve the retirement of treasury shares. When this occurs, the treasury shares are cancelled, the number of issued shares is reduced, and the retired treasury shares have the status of authorized and unissued shares. Preference Shares 18. (L.O. 5) Preference shares is the term used to describe a class of shares that possesses certain preferences or features not possessed by the ordinary shares. The following features are those most often associated with preference share issues: a. Preference as to dividends. b. Preference as to assets in the event of liquidation. c. Convertible into ordinary shares. d. Callable at the option of the corporation. e. Nonvoting. Some features used to distinguish preference shares from ordinary shares tend to be restrictive. For example, preference shares may be nonvoting, noncumulative, and nonparticipating. A corporation may attach whatever preferences or restrictions in whatever combination it desires to a preference share issue so long as it does not specifically violate its countrys incorporation law. The dividend preference of preference shares is normally stated as a percentage of the preference shares par value. For example, 9% preference shares with a par value of $100 entitle its holder to an annual dividend of $9 per share.
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However, a preference as to dividends does not assure the payment of dividends; it merely assures that corporations must pay the applicable amount to the preference shares prior to paying any dividends on the ordinary shares. 19. Certain terms are used to describe various features of preference shares. These terms are the following: a. Cumulative. Dividends not paid in any year must be made up in a later year before paying any dividends to ordinary shareholders. Unpaid annual dividends on cumulative preference shares are referred to as dividends in arrears and are disclosed in a note to the financial statements. b. Participating. Holders of participating preference shares share with the ordinary shareholders in any profit distribution beyond a prescribed rate. This participation involves a pro rata distribution based on the total par value of the outstanding preference and ordinary shares. c. Convertible. Preference shareholders may, at their option, exchange their preference shares for ordinary shares on the basis of a predetermined ratio. d. Callable. At the option of the issuing corporation, preference shares can be redeemed at specified future dates and at stipulated prices. e. Redeemable. The shares have a mandatory redemption period or a redemption feature that the issuer cannot control. Reporting of Preference Shares 20. Preference shares generally have no maturity date and therefore no legal obligation exists to pay preference shares. As a result, preference shares are classified as part of equity. Redeemable preference shares, however, are required by IFRS to be reported as a liabilities and accounted for similar to liabilities. Dividends 21. (L.O. 6) Very few companies pay dividends in amounts equal to their legally available retained earnings. The major reasons are: (a) agreements with creditors, (b) corporation laws may require corporations to restrict contributed capital from distribution as dividends to protect creditors, (c) to finance growth or expansion, (d) to provide for continuous dividends whether in good or bad years, and (e) to build a cushion. 22. Before a dividend is declared, management must consider availability of funds to pay the dividend. Directors must also consider economic conditions, most mportantly, liquidity. 23. (L.O. 7) Dividends may be paid in cash (most common means), shares, or some other asset. Dividends other than a share dividend reduce the equity in a corporation through an immediate or promised distribution of assets. When a share dividend is declared, the corporation does not pay out assets or incur a liability. It issues additional shares to each shareholder and nothing more. Liquidating dividends, which are dividends not based on retained earnings, should be disclosed to shareholders so they do not misunderstand the source of the dividend.
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Cash Dividends 24. The accounting for a cash dividend requires information concerning three dates: (a) date of declaration, (b) date of record, and (c) date of payment. A liability is established by a charge to retained earnings on the declaration date for the amount of the dividend declared. No accounting entry is required on the date of record. The shareholders who have earned the right to the dividend are determined by who owns the shares on the date of record. The liability is liquidated on the payment date through a distribution of cash. The following journal entries would be made by a corporation that declared a $50,000 cash dividend on March 10, payable on April 6 to shareholders of record on March 25. Declaration Date (March 10) Retained Earnings (or Cash Dividends Declared) ...... 50,000 Dividends Payable........................................................ 50,000 Record Date (March 25) No entry Payment Date (April 6) Dividends Payable........................................................50,000 Cash................................................................................. 50,000 Property Dividends 25. Property dividends, or dividends in kind, represent distributions of corporate assets otherthan cash. Such transfers should be recorded at the fair value of the assets transferred. When the property dividend is declared, fair value should be recognized in the accounts with the appropriate gain or loss recorded. The fair value then serves as the basis used in accounting for the property dividend. For example, if a corporation held shares of another company that it intended to distribute to its own shareholders as a property dividend, it would first be required to make sure the carrying amount reflected current fair value. If on the date the dividend was declared, the difference between the cost and fair value of the shares to be distributed was $75,000, the following additional entry would be made. Equity Investments .......................................... 75,000 Unrealized Holding Gain or LossIncome ............ 75,000 Liquidating Dividends 26. Liquidating dividends represent a return of the shareholders investment rather than a distribution of profits. In a more general sense, any dividend not based on profits must be a reduction of corporate capital, and to that extent, it is a liquidating dividend. Share Dividends 27. (L.O. 8) When a company issues a share dividend, no assets are distributed and each shareholder has exactly the same proportionate interest in the company before and after the dividend. The book value per share will decrease since there are more shares outstanding, but overall equity does not change. It can be defined as a capitalization of retained earnings that results in a reduction in retained earnings and a corresponding increase in certain contributed capital accounts. 28. When the share dividend is less than 2025% of the ordinary shares outstanding at the time of the dividend declaration, the dividend is recorded at the fair value of the shares
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issued. When a small share dividend is declared, Retained Earnings is debited at the fair value of the shares to be distributed. The entry includes a credit to Ordinary Share Dividend Distributable at par value times the number of shares, with any excess credited to Share PremiumOrdinary. If a statement of financial position is prepared between the dates of declaration and distribution, it should show the ordinary share dividend distributable in the equity section as an addition to share capital ordinary. For example, consider the following set of facts. Vonesh Corporation, which has 50,000 ordinary $10 par value shares outstanding, declares a 10% share dividend on December 3. On the date of declaration the shares have a fair value of $25 per share. The following entry would be made when the share dividend is declared: Retained Earnings (5,000 X $25)..................... 125,000 Ordinary Share Dividend Distributable .................... 50,000 Share PremiumOrdinary ...................................... 75,000 When the shares are issued, the entry is: Ordinary Share Dividend Distributable............... 50,000 Share CapitalOrdinary............................................. 50,000

Share Split 29. A share split results in an increase or decrease in the number of shares outstanding with a corresponding decrease or increase in the par or stated value per share. In general, no accounting entry is required for a share split as the total dollar amount of all equity accounts remains unchanged. A share split is usually intended to improve the marketability of the shares by reducing the market price of the shares being split. In general, the difference between a share split and a share dividend is based upon the size of the distribution. If the number of shares issued in a share dividend exceeds 20 or 25% of the shares outstanding, it should not be called a share dividend but instead a share split or a split-up effected in the form of a dividend, and only the par value of the shares issued is transferred from retained earnings. Restrictions on Retained Earnings 30. In many corporations restrictions on retained earnings or dividends exist, but no formal journal entries are made. Such restrictions are best disclosed by note. Presentation and Analysis of Equity 31. (L.O. 9) An example of a comprehensive equity section taken from a statement of financial position is given in the textbook. A company should disclose the pertinent rights and privileges of the various securities outstanding. Examples of information that should be disclosed are dividend and liquidation preferences, participation rights, call prices, and dates. 32. IFRS requires companies to present a statement of changes in equity which includes the following: a. Total comprehensive income for the period, showing separately the amounts attributable to owners of the parent and the non-controlling interests. b. Effects of retrospective application or retrospective restatement on each component of equity.
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c. For each component of equity, a reconciliation between carrying amount at the beginning and the end of the period, showing separately changes resulting from: (1) profit or loss, (2) each item of comprehensive income, and (3) transactions with owners. 33. Several ratios use shares equity related amounts to evaluate a companys profitability and long-term solvency. The following three ratios are discussed and illustrated in the chapter: (1) rate of return on ordinary shares equity, (2) payout ratio, (3) book value per share. Rate ofReturn OnOrdinary ShareEquity = Net incomePreference dividends Average ordinary stockholders' equity PayoutRatio = Cashdividends Net incomePreference dividends Book ValuePer Share = Ordinary hareholders' equity Outstanding shares Dividend Preferences *34.(L.O. 10) Preference shares generally have a preference in the receipt of dividends. Preference shares can also carry features which require consideration at the time a dividend is declared and at the time of payment. These features are (a) the cumulative feature, and (b) the participating feature. The text material includes computational examples if these features in various combinations showing their impact on dividend distributions when both ordinary and preference shares are involved. When computing book value per share there are additional complications.