References Keiso text pages 734- 742, 745 - 749, 751 - 754
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1. A separate legal entity
2. Limited liability
Shareholders may lose their investment, but they cannot lose more than their investment.
Exception **Special rules for stock issued below par**
3. Profit distribution (i.e. dividends)
 | - must be approved by the board of directors (are not required) |
| - must follow the law and the contract |
4. Two types of shares - Common and Preferred
Common shareholders usually have the following rights:
| share in profits/losses |
| right to vote |
| share in assets upon liquidation (liquidation means the closing of the company and the selling of all the assets) |
| "preemptive right" to share proportionally in new issues of stock |
For example: Assume a company has issued 200 common shares and I own 50 of the shares (50/200 = 25%) and therefore have a 25% ownership. If the company issues 100 new shares, then if I have a preemptive right, I am allowed to buy 25 of the new shares if I wish. If I purchase the shares, I will still have a 25% ownership in the company (75/300 = 25%) but if I do not purchase the shares, my ownership will decrease to 16.67% (50/300 = 16.67%). Therefore, the preemptive right allows shareholders to maintain the same percentage of ownership of the company.
Preferred shareholders have special rights usually related to dividends and liquidation.
Companies can choose whatever legal features they wish for the preferred stock. The most common features are:
1. Cumulative preferred stock - dividends not paid in any year must be paid in a later year before any profits can be distributed to common shareholders. The dividend is not a legal obligation so it is not recorded as a liability but is mentioned in the notes.
2. Participating preferred stock - holders of participating preferred stock share proportionally with the common shareholders in any profit distributions beyond the prescribed rate. Shares can also be partially participating up to a certain ceiling.
For example:
Falcon Company has common shares and participating 6% preferred shares. If Falcon Company decides to pay a dividend, the preferred shareholders would get 6%, then the common shareholders would get a 6% dividend, then the common and preferred shareholders would share in any remaining dividend.
(more details of these calculations will be covered in the next goal)
3. Convertible preferred stock - the stockholders may at their option exchange their preferred shares for common shares at a predetermined ratio.
4. Callable preferred stock - the issuing corporation can call or redeem at its option the outstanding preferred shares at specified future dates and at stipulated prices.
Par value stock – "Par value" is a fixed amount that is assigned to a share when it is authorized.
- credit common stock account at par value , difference goes to "Paid-in Capital in Excess of Par" account. (this could be a debit or a credit)
example 1: Issue 100 common shares for 30 dhs per share, par value of 20 dhs per share.
Cash 3000
Common Stock 2000
Paid-in Capital in Excess of Par- common 1000
example 2: Issue 100 common shares for 30 dhs per share, par value of 50 dhs per share
Cash 3000
Paid-in Capital in Excess of Par - common 2000
Common Stock 5000
In this case, the shareholder could be asked to contribute the 2000 dhs if the company experiences financial difficulty. (there is a contingent liability for the shareholder)
Example:
A company issues 100 common shares with a par value of 10 dh per share for 14 dhs per share and 50 preferred shares with a par value of 20 dh per share for 18 dh each.
No-Par Stock – is a type of stock that has no par value and therefore can have no contingent liability.
The common stock account is credited for the selling price of the stock.
Benefits:
| avoids the contingent liability to the shareholder |
| no confusion over fair value |
example: Issue 10 no-par common stock for 30 dhs per share.
Cash 300
Common Stock 300
Example:
A company issues 100 no par common shares for 20 dhs per share.
Stated Value – is a fixed amount assigned to a no-par stock by the Board of Directors. It is treated like a par value, however, the stock cannot be issued at a price lower than this stated value so no contingent liability can occur.
If no-par stock has a stated value, then it is treated like par-value stock in the journal entries.
Example:
A company issues 100 common shares with a stated value of 50 dh per share for 60 dhs each.
Sometimes a company gives away shares in exchange for other assets like land or buildings. You should record the transaction at either the fair market value of the stock or the fair market value of the asset, whichever is clearer to determine.
Why might a company issue shares in exchange for other assets?
Example 1:
ABC Company issues 100 common shares (par value of 30 dh each) in exchange for a piece of land with a fair market value of 4000 dhs.
Example 2:
ABC Company issues 100 common shares (par value of 30 dh each) in exchange for a piece of land. The fair market value of the land is not known. The company’s shares are currently selling for 32 dh per share on the stock market.
There can be many costs associated with issuing stock. For example: lawyers’ and accountants’ fees, advertising and printing fees, and filing fees.
Two methods for accounting for these fees: (both methods are equally acceptable)
Method 1 (debit a capital account)
Deduct the issue costs from the amounts paid in by debiting the "Paid-in-Capital in excess of par" account (for par value shares) or the stock account (for no-par shares). This method is preferred because it shows that the issue expenses are not related to the operations of the company.
Example 1: ( par value, issue price > par)
ABC Company issued 300 common shares with a par value of 30 dh each for 40 dhs per share. The issue costs for this transaction were 2000 dhs.
Example 2: ( par value, issue price < par)
ABC Company issued 300 common shares with a par value of 30 dh each for 25 dhs per share. The issue costs for this transaction were 2000 dhs.
Example 3: (no par value)
ABC Company issued 300 no par common shares for 25 dhs per share. The issue costs for this transaction were 2000 dhs.
Set up the issue fees as an intangible asset called "organization costs" and amortize this over some period (not more than 40 years) In this case, the fees are seen as a cost that will benefit the company over many years.
Example:
ABC Company issued 300 common shares with a par value of 30 dh each for 40 dhs per share. The issue costs for this transaction were 2000 dhs.
Donated capital is recorded when a government gives resources to a company. The donated asset should be recorded at fair market value. The Donated Capital account will be a part of the shareholder’s equity section of the balance sheet.
Why would a government give resources to a company?
Example:
The government of Dubai donates a building with a fair market value of 50,000 dhs to ABC Company.
Building 50,000
Donated Capital 50,000
Companies may decide to buy back some of their own shares from the market. This would be a major decision for a company and would be decided by the Board of Directors of the company. Companies do not often do this because it involves a lot of money to buy their own shares and often there are better ways to spend the money ( pay off debt, expand etc)
However, occasionally companies will repurchase some of their own stock for any of the following reasons:
|
For example: If a company has net income of AED 4000 and has 400 shares outstanding, EPS will be 10 dh per share (4000/400). However, if the company can have the same net income but reduce the shares outstanding to 300 by purchasing 100 shares, the EPS would increase to 13.33 dh per share (4000/300) |
When the stock of the company is repurchased, it is called Treasury Stock. This is not an asset of the company but is instead a reduction of the capital. It is essentially the same as un-issued capital stock and has no voting or dividend rights.
Although there are two methods for accounting for Treasury stock (cost and par value methods), we will only study the cost method.
Buying back the shares
When the stock is purchased, it is debited to the treasury stock account at the price paid. The initial issue price or the par value are not important unless you retire the stock. These shares are now considered to be issued but not outstanding.
Example: ABC Company purchases 10 shares of its own common stock (par value of 90 dh per share) at 100 dh each.
Treasury Stock 1000
Cash 1000
Reissuing the shares
When the stock is reissued, the treasury stock account is credited at the purchase price. (like a perpetual inventory account) The difference goes to the "Paid-in capital from Treasury Stock" account. ** However, this account can never have a debit balance. If this would result, you must use the "Retained Earnings" account.
Example: Assume that ABC Company reissues the 10 treasury shares purchased above in a series of three transactions:
Transaction 1 (reissue for an amount higher than the purchase price)
Reissue 4 treasury shares for 110 dh each.
Cash 440
Treasury stock 400
Paid-in Capital from Treasury stock 40
Transaction 2 (reissue for an amount lower than the purchase price and there is an existing balance in the Paid in Capital from Treasury Stock account from transaction 1)
Reissue 5 shares for 90 dh each
Cash 450
Paid-in Capital from Treasury stock 40
Retained Earnings 10
Treasury stock 500
Transaction 3 (reissue for an amount lower than the purchase price and there is no existing balance in the Paid in Capital from Treasury Stock account)
Reissue the last remaining share for 80 dh
Cash 80
Retained Earnings 20
Treasury stock 100
3. Retiring the shares
If the company does not want to reissue the shares, they can be retired. They are then considered to be authorized and un-issued shares. Shares must first be purchased for the treasury before they can be retired.
To record the retirement, the accounts used to originally record the issuance of the stock must be used again. Common shares and Paid-in capital in excess of par for the par value method and just common shares for the no-par method. When only a portion of the shares are retired, a portion of the common shares and paid in capital accounts must be calculated. The Treasury Stock account must be credited for the purchase price of the stock.
To balance the entry, the difference goes to the "Paid-in capital on retirement of shares"
account.** However, again this account can never have a debit balance. If this would result, you must again use the "Retained Earnings" account. If there is a credit balance in the "Paid-in Capital on retirement of shares account, then this would be used up first.
Assume that each of the following examples are independent.
Example 1: (purchased for the treasury for a price>par, originally issued above par)
ABC. Company purchases 10 shares of its own company at 100 dh each and then retires them. The shares were originally issued in 1998 for 120 dh and have a par value of 90 dh.
The original entry to record the issue of the shares in 1998, would have been:
Cash 1200
Common Shares 900
Paid in Capital in excess of par 300
(note: the entry above is not required at this time, but it is helpful to see it in order to determine the retirement entry)
To repurchase the shares:
Treasury Stock 1000
Cash 1000
To retire the shares:
Common shares 900
Paid-in capital in excess of par 300
Treasury stock 1000
Paid-in capital from retirement of Common Stock 200
(Notice that the debits in this entry are equal to the credits in the original entry)
Example 2: (purchased for the treasury for a price>par, originally issued below par)
Assume the shares in the example above were originally issued for 80 dh and have a par value of 90 dh and all 10 shares are retired.
Original entry to record the issue:
To repurchase the shares:
Treasury Stock 1000
Cash 1000
To retire the shares:
Common shares 900
Retained Earnings 200
Paid-in capital in excess of par 100
Treasury stock 1000
Example 3: (purchased for the treasury for a price<par, originally issued above par)
Assume the shares in the example above were originally issued for 125 dh and have a par value of 110 dh and all 10 shares are retired.
Original entry to record the issue:
To purchase the shares:
To retire the shares:
Common shares 1100
Paid-in capital in excess of par 150
Treasury stock 1000
Paid-in capital from retirement of Common Stock 250
Example 4: (purchased for the treasury for a price<par, originally issued below par)
Assume the shares in the example above were originally issued for 105 dh and have a 0 par value of 110 dh and all 10 shares are retired.
Original entry to record the issue:
To purchase the shares:
Treasury Stock 1000
Cash 1000
To retire the shares:
Common shares 1100
Example 5: (purchased for the treasury for a price=par, originally issued at par)
Assume the shares in the example above were originally issued at par value of 100 dh and all 10 shares are retired instead of reissued.
Original entry to record the issue:
To purchase the shares:
Treasury Stock 1000
Cash 1000
To retire the shares:
Observations:
When the shares are retired for an amount greater than their original issue price, the paid in capital from retirement account will be credited for that amount.
When the shares are retired for an amount lower than their original issue price, the retained earnings account will be debited for that amount.
The treasury stock is deducted from the total of the paid-in capital and retained earnings.
See example below and on Page 752 of the text.
Authorized shares – the total amount of shares that a corporation is allowed to issue.
Issued shares – the amount of shares that the corporation has issued (and NOT retired)
Outstanding shares – the amount of shares that are owed by shareholders other than the corporation itself (i.e. does NOT include Treasury Stock) If there is no treasury stock, then the outstanding shares will equal the issued shares.
Example:
|
Shareholder’s Equity: |
||
|
Common Shares (100 dh par value, 20,000 1,500,000 authorized,15,000 issued, 14,000 outstanding) |
1,500,000 | |
| Preferred Shares (5%, 50 dh par value, cumulative, participating 30,000 authorized, 18,000 issued and outstanding) | 900,000 | |
|
Total Capital Stock |
2,400,000 | |
|
Paid-in-Capital in excess of par-common |
400,000 | |
|
Paid-in-Capital in excess of par – preferred |
120,000 | |
|
Paid-in-Capital on retirement of shares |
100,000 | |
|
Paid-in Capital from Treasury Stock |
70,000 | |
|
Donated Capital |
250,000 | |
|
Total Additional Paid-in Capital |
940,000 | |
|
Total Paid-In Capital |
3,340,000 | |
|
Retained Earnings |
1,200,000 | |
|
Total Paid-in-Capital and Retained Earnings |
4,540,000 | |
|
Less: Treasury Stock – Common (1000 shares) |
(120,000) | |
|
Total Shareholder’s Equity |
4,420,000 |
Note: Total Paid-In Capital is also called Contributed Capital and Retained Earnings is sometimes called Earned Capital.
(Keiso text pages 772-776, 780-785, 789-790, 1313-1314)
A few definitions:
Contributed Capital = Capital stock (common and preferred)
+ Additional Paid in excess accountsEarned Capital = Retained earnings
Reminder:
|
Company Name Statement of Retained Earnings For the year ended Dec 31, 1999 |
|
|
Beginning Retained Earnings, Jan 1, 1999 |
10,000 |
|
+ Net Income |
75,000 |
|
- Dividends |
(15,000) |
|
Ending Retained Earnings, Dec 31, 1999 |
70,000 |
Paying Dividends
Why do companies pay dividends since they are not required?
| To distribute earnings to the shareholders (owners) |
| To meet shareholder expectations |
| To encourage future investors to purchase shares |
| To give a positive sign to the market that the company is doing well |
A company should consider two questions before declaring dividends:
1. Is the dividend legal? Are there any restrictions that might not allow a dividend to be paid?
2. Can the company afford to pay the dividend? (does it have enough earnings and cash?)
There are many reasons why a company might NOT pay a dividend:
2. Special agreements with certain creditors that limit the amount of dividends.
3. A desire to reinvest the earnings into the company for growth or repayment of debt
4. A desire to "smooth" out dividend payments over the years. (save some funds to pay out later)
5. A desire to build up a cushion against possible losses or errors in calculating profit.
6. Insufficient cash flow
Although there are many types of dividends, we will only study the most common two:
- Cash dividends – the company pays out cash
2. Stock dividends - the company gives out its own shares instead of cash
Cash Dividends
Date of declaration - the date that the corporation declares the dividend. It becomes a legal liability on this date and must be recorded in the books.
(the amount is based on the number of shares outstanding)
Retained Earnings debit
Dividends Payable credit
(Note: some companies may debit an account called "Dividends Declared" and then close this account into the retained earnings account at the end of the period. The end result is the same.)
Date of Record - All shareholders who own shares on this date will receive the dividend.
No entry is recorded.
Date of Payment - The dividend is paid out
Dividend Payable debit
Cash credit
Notes: Treasury stock does not receive cash dividends. Dividends Payable is a liability account.
Note: Preferred shareholders must be paid their dividend first before the common shareholders receive any dividends.
- giving out stocks of the company instead of cash. Each shareholder gets a proportionate amount of shares based on the number of shares that they own.
Why issue them?
1. To capitalize a part of retained earnings. These funds will then not be available to be paid out as dividends.
2. To make shareholders feel that they are receiving something.
3. To save cash.
4. A large stock dividend will cause the market price to decrease. (similar to a stock split)
Accounting for Stock Dividends
The accounting treatment for stock dividends differs depending on whether the dividend is large (over 20%) or small (20% and less).
Small (ordinary) Stock Dividends (20% and less)
The market value of the share on the date of declaration is used to record the dividend.
Example 1:
Assume that a company has 12,000 common shares outstanding with a par value of Dh. 20 per share. The company decides to issue a 10% stock dividend. The market value of the common shares on the declaration date is Dh. 50 per share.
at the date of declaration
Retained Earnings 60,000
Common Stock Dividend Distributable 60,000
(12000 * 10% * 50 = 60,000)
Note: the Common Stock Dividend Distributable account is included in the shareholders’
equity section of the balance sheet. It is not a liability account.at the date of distribution
Common Stock Dividend Distributable 60,000
Common Stock (at par) 24,000
Paid-in capital in excess of par 36,000
Note: if the common stock has no par value, the paid-in capital in excess of par account would
not be used.Treasury stock does not receive stock dividends.
Large Stock dividends (over 20%)
- the market value of the shares is ignored. Only the par value of the stock
is transferred from retained earnings to the common stock account.
- This is because a large dividend is considered to be a restructuring of the
capital and not a true dividend.
- If there is no par value, the average issue cost of the share could be used.
Example 1:
A company has 2000 common shares outstanding. The par value is Dh. 10 per share, the market value is Dh. 50 per share. The company declares and then issues a 50% stock dividend.
On declaration
Retained Earnings 10000
Stock Dividend Distributable 10000
On distribution
Stock Dividend Distributable 10000
Common Stock 10000
When a stock is split, the shareholders give in their shares and are given more new shares in return in a certain ratio. For example, if I own 4 shares with a market price of AED 100 per share and the company has a 2 for 1 stock split, I will end up with 8 shares and the market price will fall to approximately AED 50 per share.
Why do stock splits?
- to reduce the market price of the stock to encourage more trading. (a 2 for 1 stock split will usually cause the market price to split in half)
For accounting:
No journal entry is done for a stock split, however, the par value of the stock is decreased and the amount of shares authorized and issued is increased. If the company has shares in the treasury, these would also be split.
However, in a stock dividend, the par value stays the same and the amount of outstanding shares is increased.
Example:
ABC Company has the following shareholders’ equity accounts:
| Shareholders' Equity | AED |
|
Preferred Stock 10%, Dh. 5 par value, 10,000 shares authorized, 6,000 shares issued and outstanding. |
30,000 |
|
Common Stock Dh. 20 par value, 15,000 shares authorized, 7,000 shares issued and outstanding. |
140,000 |
|
Paid in Capital in excess of par – common |
70,000 |
|
Retained Earnings |
195,000 |
|
Total shareholders’ equity |
435,000 |
Required:
(a) ABC Company declares a 2 for 1 stock split for the common shares. What effect will this have on the shareholders’ equity section?
(b) ABC Company declares and pays a 100% stock dividend on the common shares. What effect will this have on the shareholders’ equity section?
(c) Compare your results from (a) and (b).
When there are two classes of shares, the preferred shareholders must get their dividend first. The amount of the dividend depends on the features of the preferred shares.
1. If preferred shares are non-cumulative and non-participating:
The preferred shareholders receive their dividend for one year first and then the common shareholders get the rest of the total dividend.
Example:
Assume that a company has 10,000 common shares outstanding with a par value of Dh
60 per share and 5,000, 6% non-cumulative preferred shares with a par value of Dh 40. The company wants to pay a total dividend of Dh. 88,000.
How much does each class of share receive?
2. If preferred shares are cumulative and non-participating:
The preferred shareholders receive their dividend for one year plus any dividend in arrears first and then the common shareholders get the rest of the total dividend.
Example:
Assume that a company has 10,000 common shares outstanding with a par value of Dh
60 per share and 5,000, 6% cumulative preferred shares with a par value of Dh 40. The company wants to pay a total dividend of Dh. 88,000.
The company has not paid any preferred dividends for this year and the past two years.
How much does each class of share receive?
3. If preferred shares are non-cumulative and fully participating:
Three step process:
1. Pay out the regular preferred dividend
2. Pay out a proportionate share to the common shareholders
3. Pay out the remaining dividend proportionately based on the amount of capital that the shareholders have contributed.
Example:
Assume that a company has 10,000 common shares outstanding with a par value of Dh
60 per share and 5,000, 6% non-cumulative, fully participating preferred shares with a par value of Dh 40. The company wants to pay a total dividend of Dh. 88,000.
How much does each class of share receive?
- is the amount each share would receive if the company liquidated (sold) all its assets and paid off all its debts. It is calculated separately for the common and the preferred shares.
This figure is not very useful if the book values of the company do not approximate fair market values.
Two Ways to calculate Book Value:
1. If there is no preferred stock:
Book Value = Total Shareholders’ Equity / number of shares outstanding
Example:
A company has 2000 shares of common stock outstanding with a par value of Dh. 100 per share. The shares were issued for Dh. 110 per share. There are no other paid-in capital accounts and retained earnings is Dh 264,000.
Calculate the book value per share.
2. If there is preferred stock, the capital must be split between the preferred stockholders and the common stockholders. Paid in capital accounts relating to the preferred shares will be allocated to them.
If the preferred shares are cumulative and there are preferred dividends that have not been paid (i.e. in arrears), these must be allocated to the preferred shareholders. If the preferred shares are noncumulative or are fully paid up, the dividends are not considered.
The rest of the retained earnings account will be allocated to the common shareholders.
If the preferred shares are participating, a further portion of the retained earnings must be allocated to them, but this calculation is too advanced for this course.
(Keiso Text Chapter 17 pages 833 - 837)
Earnings per share shows the income earned by each share of common stock.
It is only reported for common stock. (not preferred stock)
We will only calculate EPS for companies with a simple capital structure.
EPS = Net income - preferred dividends for the current year**
Weighted Average number of common shares outstanding
** Note: preferred dividends are subtracted if they are cumulative OR if they are noncumulative but have been declared or paid during the year. Noncumulative preferred dividends that are unpaid are not subtracted since the company is not obligated to pay them.
**Dividends in arrears (if any) are not considered.
Weighted Average example:
A company has 2400 common shares outstanding at the beginning of the year. On Mar 1, the company issues 600 common shares. On July 1, the company repurchases 1200 common shares for the treasury. The company also has 200 5% preferred shares outstanding with a par value of Dh 50 each.
(a) Calculate the weighted average number of shares outstanding.
(b) If the net income for the year is Dh 7,400, calculate EPS.
Extraordinary items are gains or losses that have all of the following features:
| occur rarely |
| are not part of the normal business activities of the company |
| do not depend mainly on decisions made by managers |
Some examples:
| Natural disasters – e.g. Floods, earthquakes |
| Government actions – e.g. expropriations, wars |
Each extraordinary item must be shown on a separate line on the income statement and explained in the notes. This will allow the users of the financial statements to realize that this event is not part of the usual operations.
EPS is calculated and disclosed separately for extraordinary items.
Example:
(assume 1,000 common shares are outstanding and cumulative preferred dividends total AED 5,000)
| AED | EPS | |
|
Net income before extraordinary item 35,000 |
35,000 | 30 |
|
Loss from Earthquake damage 10,000 |
10,000 | 10 |
| Net income | 25,000 | 20 |
Note: Notice that the preferred dividends are subtracted from the net income amounts only and not from the gain/loss amount.
If a company issues a stock dividend or a stock split during the year, you must treat it as if it happened at the beginning of the year when calculating the weighted average number of shares.
You would also need to restate the EPS for the previous year in order to make a proper comparison.
