978-1259722660 Chapter 18 Lecture Note Part 1

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CHAPTER 18

SHAREHOLDERS’ EQUITY

Overview

We turn our attention in this chapter from liabilities, which represent the creditors’ interests in the

assets of a corporation, to the shareholders’ residual interest in those assets. The discussions

distinguish between the two basic sources of shareholders’ equity: (1) invested capital and (2)

earned capital. We explore the expansion of corporate capital through the issuance of shares and the

contraction caused by the retirement of shares or the purchase of treasury shares. In our discussions

of retained earnings, we examine cash dividends, property dividends, stock dividends, and stock

splits.

Learning Objectives

After studying this chapter, you should be able to:

LO18–1 Describe the components of shareholders’ equity and explain how they are reported in a

statement of shareholders’ equity.

LO18–2 Describe comprehensive income and its components.

LO18–3 Understand the corporate form of organization and the nature of stock.

LO18–4 Record the issuance of shares when sold for cash and for noncash consideration.

LO18–5 Distinguish between accounting for retired shares and for treasury shares.

LO18–6 Describe retained earnings and distinguish it from paid-in capital.

LO18–7 Explain the basis of corporate dividends, including the similarities and differences

between cash and property dividends.

LO18–8 Explain stock dividends and stock splits and how we account for them.

LO18–9 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting for shareholders’ equity.

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Lecture Outline

Part A: The Nature of Shareholders’ Equity

I. Sources of Shareholders’ Equity

A. A company can raise money externally to fund operations in either of two ways:

1. Debt financing.

a. Takes the form of notes, bonds, leases, and other liabilities.

b. Creates creditors’ interest in the assets of the business.

2. Equity financing.

a. Creates ownership interests in the assets of the business.

b. Owners of a corporation are its shareholders.

c. Shareholders’ equity is a residual amount, the amount that remains after

creditor claims have been subtracted from assets.

B. Shareholders’ equity is created mainly by:

1. Amounts invested by shareholders—paid-in capital.

2. Amounts earned by the firm on behalf of its shareholders—retained earnings.

II. Financial Reporting Overview

A. The balance sheet reports annual balances of shareholders’ equity accounts.

B. Comprehensive income, a more expansive view of the change in shareholders’ equity than

traditional net income, is the total nonowner change in equity for a reporting period.

Transactions between the corporation and its shareholders primarily include dividends and

the sale or purchase of shares of the company’s stock. Nonowner changes other than those

that are part of traditional net income are the ones reported as “other comprehensive

income.” Other comprehensive income is reported in two places.

1. Components of comprehensive income created during the reporting period can be

reported either (a) as an additional section of the income statement, (b) as part of the

statement of shareholders’ equity, or (c) as a separate statement, often included in the

financial statements in a disclosure note. Each component is reported net of its related

income tax expense or income tax benefit.

2. The comprehensive income accumulated over the current and prior periods is reported

as a separate component of shareholders’ equity.

C. The statement of shareholders’ equity discloses transactions that cause changes in

shareholders’ equity account balances.

Part B: Paid-In Capital

I. Fundamental Share Rights

A. Usually ownership rights held by common shareholders include the right to:

1. Vote.

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2. Share in profits when dividends are declared.

3. Share in the distribution of assets if the company is liquidated.

B. Usually the special rights of preferred shareholders include a preference:

1. To a specified amount of dividends so that if the board of directors declares

dividends, preferred shareholders receive the designated dividend before any

dividends are paid to common shareholders.

2. Over common shareholders as to the distribution of assets in the event the

corporation is dissolved.

C. Dividends on cumulative preferred shares that are not declared in any given year must be

paid the next time dividends are paid before any can be paid to common shareholders.

D. When preferred shares are not “participating,” shareholders are entitled to no more than

the designated dividend preference.

II. The Concept of Par Value

A. Par value has little significance other than historical.

B. Par value originally indicated the actual value of shares, but this is no longer the case.

C. Companies usually assign shares a nominal par value to elude elaborate statutory rules

pertaining to par value shares.

D. When shares are issued, we record the par amount in common stock and the remainder of

the proceeds in additional paid-in capital.

III. Accounting for the Issuance of Shares

A. When shares are sold for cash, shareholders’ investment is allocated between stated

capital and additional paid-in capital.

B. At times, shares are sold for noncash consideration like a service or a noncash asset.

1. The transaction should be recorded at the fair value of either the shares or the

noncash consideration, whichever seems more clearly evident.

2. This is consistent with the general rule for accounting for any noncash transaction.

C. More than one security might be sold for a single price.

1. The cash received usually is the sum of the separate market values of the two

securities. Each is then recorded at its market value.

2. If only one security’s value is known, the second security’s market value is inferred

from the total selling price.

3. If the total selling price is not equal to the sum of the two market prices, the total

selling price is allocated between the two securities in proportion to their relative

market values.

E. Share issue costs are the costs of the legal, promotional, and accounting services

necessary to effect the sale of shares.

1. The costs reduce the net cash proceeds from selling the shares and thus paid-in

capital—excess of par.

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2. Share issue costs are not recorded separately.

F. U.S. GAAP and IFRS are generally compatible with respect to accounting for

shareholders’ equity. Some differences exist in presentation format and terminology and

in choices regarding reporting comprehensive income.

IV. Reacquired Shares

A. Companies sometimes reacquire shares previously sold.

1. The most common motivation is to support the market price of the shares.

2. All share repurchases are functionally the same.

3. Accounting treatment depends on whether the company states that it is formally

retiring the shares or purchasing treasury shares.

B. When a corporation formally retires previously issued shares, those shares assume the

same status as authorized but unissued shares—just the same as if they never had been

issued.

1. Payments to retire shares are viewed as a distribution of corporate assets to

shareholders.

2. We decrease precisely the same accounts that previously were increased when the

shares were sold—namely, common (or preferred) stock and paid-in capital –

excess of par.

3. The difference between the cash paid to buy the shares and the amount the shares

originally sold for are treated differently depending on whether that difference is

positive (credit) or negative (debit):

a. If a credit difference is created, we credit paid in capital – share repurchase.

b. If a debit difference is created, we debit retained earnings unless a credit balance

already exists in paid in capital – share repurchase, in which case we debit that

account.

C. Corporations often view a share buyback as a purchase of treasury stock.

1. The cost of acquiring the shares is “temporarily” debited to the treasury stock

account.

2. We delay recording the effects on specific shareholders’ equity accounts until later

when the shares are reissued.

3. Essentially, we view the purchase of treasury stock as a temporary reduction of

shareholders’ equity, reversed later when the treasury stock is resold.

4. When the treasury shares are resold, we treat the difference between the cash

received and the amount the shares originally cost differently depending on whether

that difference is positive (credit) or negative (debit):

a. If a credit difference is created, we credit paid-in capital – share repurchase.

b. If a debit difference is created, we debit retained earnings unless a credit balance

already exists in paid-in capital – share repurchase, in which case we debit that

account.

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Part C: Retained Earnings

I. Characteristics of Retained Earnings

A. In Part B, we studied invested capital. In Part C, we consider earned capital, usually

referred to as retained earnings.

B. In general, retained earnings represents a corporation’s accumulated, undistributed or

reinvested net income (or net loss).

C. Distributions of earned assets are dividends.

D. We refer to a debit balance in retained earnings as a deficit.

II. Dividends

A. Most corporate dividends are paid in cash. At the declaration date, retained earnings is

reduced and a liability is recorded. Registered owners of shares on the date of record are

entitled to receive the dividend.

B. Occasionally, a noncash asset is distributed. In that case it is referred to as a property

dividend. The fair market value of the assets to be distributed is the amount recorded for a

property dividend. Before recording the property dividend, the asset may need to be

written up or down to fair market value. This would create a gain or loss.

III. Stock Dividends and Splits

A. In a stock dividend, additional shares of stock are distributed to existing shareholders.

1. A stock dividend affects neither the assets nor the liabilities of the firm.

2. Because each shareholder receives the same percentage increase in shares, each

shareholder’s percentage ownership of the firm remains the same.

3. For a “small” stock dividend (25% or less), the fair value of the additional shares

distributed is transferred from retained earnings to paid-in capital. (T18-15)

B. A stock distribution of 25% or higher is a stock split. (T18-16)

1. If referred to merely as a stock split, no journal entry is recorded.

2. If referred to as a “stock split effected in the form of a stock dividend,” the par value

of the additional shares is reclassified within shareholders’ equity.

Decision Makers’ Perspective

A. Profitability is vital to a company’s long run survival.

B. The return on shareholders’ equity is a popular summary measure of profitability.

1. The return on shareholders’ equity is calculated by dividing net income by average

shareholders’ equity

2. The return on shareholders’ equity measures the ability of company management to

generate net income from the resources that owners provide.

C. Analysts often supplement the return on shareholders’ equity ratio with the earnings-price

ratio.

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1. This ratio relates earnings to the market value of equity rather than the book value

of equity.

2. It is calculated as the earnings per share divided by the market price per share.

3. A common variation is the inverse – the price-earnings ratio.

D. Shareholders’ equity transactions can affect the return to shareholders.

1. When a company buys back some of its shares, the return on shareholders’ equity

goes up.

2. On the other hand, the buyback of shares uses assets, which decreases the resources

available to earn net income in the future.

E. Analysts should evaluate dividend decisions with consideration for prevailing

circumstances. Management must decide whether shareholders are better off receiving

cash dividends or having funds reinvested in the firm.

Appendix 18: Quasi Reorganizations

A. A quasi reorganization aids a company that experiences financial difficulties, and yet has

favorable future prospects.

1. Inflated asset values are written down.

2. The accumulated deficit (debit balance in retained earnings) is eliminated.

B. Assets (and liabilities if necessary) are written up or down to reflect fair values.

1. Corresponding credits or debits are made to retained earnings.

2. The deficit usually is temporarily increased by this step.

C. The deficit in retained earnings (debit balance) is eliminated.

1. Retained earnings is credited; additional paid-in capital is debited.

2. If additional paid-in capital is not sufficient to absorb the entire deficit, common

stock is debited also.

D. Retained earnings is “dated” to indicate the date the deficit was eliminated and when the

new accumulation of earnings began.

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PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

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Suggestions for Class Activities

1. Research Activity

Ask students to look up three companies in the “Money & Investing” section of the Wall Street

Journal, the financial pages of another newspaper, or on the Internet. Have them find the

price-earnings ratio of each company. Using those data, have them determine the rate of return on

the market value of shareholders’ equity.

Suggestions:

Pose these questions:

1. What information does the rate of return provide?

2. How is the information different from that provided by the rate of return of shareholders’

equity as commonly calculated from financial statements?

Points to note:

The rate of return on the market value of shareholders’ equity is the inverse of the price-earnings

ratio (i.e., the earnings-price ratio). The rate of return on the market value of shareholders’ equity is a

summary measure of profitability. It measures the ability of management to generate earnings from

the resources that owners provide. Like other ratios, analysts must be careful not to view it in

isolation. That’s why it’s useful to supplement the return on shareholders’ equity ratio as commonly

calculated from financial statements (net income divided by average shareholders’ equity) with this

market-based ratio. This ratio is simply the earnings per share divided by the market price per share.

2. Real World Scenario

Hormel Foods Corp., which makes Spam and other prepared foods, distributed a two-for-one stock

split. At the time the split was announced, the company’s stock price was $49.

Suggestions:

Ask students to:

1. Speculate as to why Hormel declared the stock split.

2. Consider what the share price would be at the time of the distribution, other things being

equal.

Points to note:

Normally, as in this case, a split is made to reduce the per share price and thus enhance the

marketability of the stock by making it affordable to a larger number of potential investors. It also

might signal favorable performance. Other things equal, the new share price would be $24.50 after

the split. Of course, quite a few circumstances and events can cause the price to vary.

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3. Real World Scenario

Following is a news release from General Electric:

FAIRFIELD, Conn.–(BUSINESS WIRE) –The Board of Directors of GE today raised the

Company’s quarterly dividend 10% to $0.22 per outstanding share of its common stock and

authorized the repurchase of up to $15 billion of its common stock over the next three years.

“GE has tremendous prospects for growth in earnings and cash flow,” said GE Chairman and CEO

Jeff Immelt.

“We have been executing a clear strategy to build a capital-efficient portfolio of faster-growth

industrial businesses and higher-returning financial services businesses,” Immelt said. “That work is

now largely behind us, and we have the best set of GE businesses we’ve had in many years. We’re

confident that in 2005 we will return to solid double-digit earnings growth with expanding

incremental returns on capital and increasing cash flow from operating activities. As a result we fully

expect to have the flexibility to invest in technology and innovation while returning value to

shareowners through a substantial dividend and a share repurchase program.”

The dividend increase, from $0.20 per share, marks the 29th consecutive year in which GE has

raised its dividend. GE has paid a dividend every year since 1899. The dividend is payable January

25, to shareowners of record on December 27. The ex-dividend date is December 22.

Suggestions:

Ask students to consider the statement that GE has the “flexibility to invest in technology and

innovation while returning value to shareowners through a substantial dividend and a share

repurchase program.” This implies a choice. What are the choices? How do the choices return value

to shareholders?

Points to note:

Companies have choices regarding the disposition of earnings. One choice is to reinvest in

profit-making activities, hopefully benefiting shareholders through higher future earnings and

therefore future capital gains and dividends. Another choice is to distribute the earnings currently as

dividends. Another is to buy back shares. This supports the market price of stock and reduces

dilution that occurs when new shares are issued.

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4. Real World Scenario

Following is a news release from Northeast Community Bancorp:

Northeast Community Bancorp, Inc. (NASDAQ: NECB) today announced that its Board of

Directors declared an initial quarterly cash dividend of $0.03 per common share. The dividend

will be paid on or about November 15 to stockholders of record as of the close of business on

October 12.

Suggestions:

Ask students to:

1. Consider the effect on the share price on the ex-date, other things being equal.

2. Consider the ongoing effect of the decision on company assets, other things being equal.

3. Speculate as to why Northeast Community Bancorp declared the dividend after not

previously paying dividends.

Points to note:

Normally, the stock price declines by the amount of a cash dividend—$.03 in this case—the first

day the stock trades after the recipients of the dividend are determined. Dividends use cash that

otherwise would be available for reinvestment in company growth or other activities. Companies

typically pay cash dividends when they feel that is a better return to shareholders than would be

reinvesting with the expectation of higher future stock prices. Dividend decisions reflect managerial

strategy concerning the mix of internal versus external financing, alternative investment

opportunities, and industry conditions. High dividends often are found in mature industries and low

dividends in growth industries. Microsoft, for instance, like FedEx previously, for years paid no

dividends, focusing instead on plowing available cash into growth opportunities.

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