Chapter 10

• Stockholder’s Equity
 Learning Objectives
• Explain the features of a corporation
• Account for the issuance of shares
• Account for treasury shares
• Account for other equity transactions
• Understand the different value of shares
• Evaluate a company's return to Equity holders
 Features of a corporation
 Separate Legal Entity
 Continuous Life & Transferability of
Ownership
 Limited Liability
 Separation of Ownership & Management
 Corporate Taxation
 Government Regulation
 Is it advantageous?
Advantages Disadvantages

1. Can raise more capital than a 1. Separation of ownership &

proprietorship or partnership. management.

2. Continuous life. 2. Corporate taxation

3. Ease of transferring ownership 3. Government regulation

4. Limited liability of shareholders

Organizing a Corporation/
Authority structure…
 Shareholder’s Equity
• It represents the shareholder’s residual ownership interest in the
assets of a corporation(after deducting all liabilities from total
assets).

• Shareholder’s equity is divided into:

1. Paid-in capital
2. Retained earnings

Shares:
Usually the owner’s equity of a corporation is divided into shares
through which corporation issues share certificates to its owners
when the company receives their investment in the business.
 Classes of shares
• Ordinary shares or preference shares
– Every corporation issues ordinary shares, the basic form of
share capital. The ordinary shareholders are the owners of
the corporation.
– Preference shares give the owners certain advantage over
ordinary shareholders. They receive dividend before
ordinary shareholders.
• Par value
– Par value is an arbitrary nominal amount assigned by a
company to its share.
Comparison of Ordinary shares, Preference
Share and Long-term debt
Particular Ordinary Share Preference Share Long-term Debt

1. Obligation to repay No No Yes

principal

2. Dividends/interest Dividends are not Dividends are not Interest expense

tax-deductible tax-deductible is tax-deductible

3. Obligation to pay Only after Only after At fixed rates

dividends/interest declaration declaration and dates
 Share Issuance for other than cash can
create an Ethical Challenge….
• Accounting standards require a company to record its shares at the
fair market value when a corporation receives in exchange for the
shares.
• But when the corporation receives an asset, the value of the asset can
create an ethical challenge.
• Suppose, a corporation receives a software for the share capital
which is worth of $100,00. the entry would be:
• Software 100,000
• Share Capital 100,000
• Issued shares in exchange for software.
• Here, if the software is really worth $100,000, the accounting is fine.
But is the software is really new and untested, the assets and equity
may be overstated.
 Distinct numbers in relation to a
company’s shares:
1. Authorized share capital
It is the maximum number of shares the company
can issue under its constitution.
2. Issued shares
It is the number of shares the company has issued
to its shareholders.
3. Outstanding shares
These are the number of shares that the
shareholders own.
 Account for Treasury Shares
• A company’s own shares that it has issued and later
reacquired are called treasury shares.
• Corporations purchase their own shares for several
reasons:
1. It offers employee share option compensation but it
dos not wish to issue new shares.
2. The management may avoid a takeover by an outside
party.
3. The management wants to increase its reporting
earnings per share(EPS)
How are treasury shares recorded?
• The entry to record the treasury share would
be:

Nov 2 Treasury Shares 200,000

Cash 200,000
To record purchases of treasury
shares.
 Resale of Treasury Shares
• Reselling treasury shares grows assets and
equity exactly as issuing new shares does.
• But it never records gains or losses on
transactions involving its own treasury shares.
Rather, amounts received in excess of amounts
originally paid for treasury shares are recorded
as paid in capital.
 Retiring Treasury Shares
• A corporation may purchase its own shares and retire it by
cancelling the shares. The retired shares cannot be reissued.
• It will permanently reduce the number of outstanding shares.
• Suppose AMC corporation has canceled 10,000 shares
amounting to $15,000,the entry would be:

Dec Share Capital 15,000

Treasury Shares 15,000
To record cancellation of shares from treasury shares.
 Account for other equity
transactions
• Retained Earnings
– This account carries the balance of the business’s net
income less net losses and less any declared dividend that
have been accumulated.

Dividends
A dividend is a distribution by a corporation to its
shareholders, usually based on earnings. It takes 3 forms:
• Cash
• Shares
• Non-cash assets
 Cash dividends
• Most dividends are cash dividends. To have
cash dividend, a company must have both:
 Enough Retained Earnings
 Enough Cash to pay the dividend.
 Different Dates…
• Declaration Date
On this date, the board of Directors announces the dividend, which creates a
liability for the corporation.

Date of record
As a part of the declaration, the corporation announces the record date,
which follows the declaration date by a few week.
The shareholders on the record date will receive the dividend

Payment date
Payment of dividend usually follows the record date by a week or two.
 Dividends on Preference Shares
 Preference shareholders receive their
dividends first.
 Dividends on preference shares are usually
described as a percentage of par value.
 Suppose An & Co has 100,000, 2% preference
shares (par value $100) outstanding.
 So the dividend would be 100,000*$100 * 2%
= $200,000.
 Dividends on cumulative and Non-
cumulative Preference shares.
• Cumulative preference shares
– This means that the owners must receive all
dividends in arrears plus current year’s dividend
before any dividend go to the ordinary
shareholders.

Non cumulative preference shares

To these shareholders, the arrears are not paid, only the current year
dividend is paid.
 Share dividends
A share dividend is a proportional distribution by a corporation of
its own shares to its shareholders.
Reasons for Share dividend:
 To continue dividends but conserve cash
A company may need to conserve cash and yet wish to
continue dividends in some form.
 To reduce the market price of its share
 Distribution of share dividend usually causes share’s market
price to fall as the number of outstanding shares will increase.
 Stock splits
• It is an increase in the number of shares
authorized, issued and outstanding, coupled
with a proportionate reduction in the share’s
par value.

• Suppose, if the company splits its shares 2 for

1, the number of outstanding shares is doubled
and each share’s par value is halved.
Summary of the Effects on Assets, Liabilities
and Shareholders Equity
 Different Values of Shares
• Share’s Market value
• It is the price at which a person can buy or sell one share. It
varies with the corporation’s net income, financial position,
future prospects and with general economic conditions
• Redemption Value
• The price at which the corporation agrees to pay for the share,
set when the share is issued, is called redemption value.
• Liquidation Value
• It is the amount that a company must pay a preference
shareholder in the event the company liquidates and goes out of
business.
 Continued…
• Book value
• It is the amount of owner's equity on the
company’s books for each ordinary share.
• It can be calculated as:
• = Total shareholder’s equity – Preference
equity
• Number of ordinary shares outstanding
Reporting Shareholder’s Equity Transactions

• Statement of Cash flows:

1. Issuance of shares
2. Treasury shares
3. Dividends

All these transaction will be reported under the

financing activity of the cash flow statement.
 Evaluate a company’s return to
Equity holders
• Investors can measure their return on the
company with:
1. Earnings per share
2. Return on Equity
 Earnings per share (EPS)
• It is the company’s net income divided by its outstanding
ordinary shares.

• It is the key measure of a business’s success as it shows how

much income the company earned for each share.

• EPS= Net income – Preferred dividends

• Average number of ordinary shares outstanding
 Return on Equity
• Rate of return on ordinary equity often simply
referred as Return on Equity (ROE).
• It shows the relationship between net income
available and average ordinary shareholder’s equity.
• = Net Income
• Average Equity
• Net income = net income – preference dividends
• Average Equity = (beginning +ending balance)/2
How to decide while investing on shares?
 Question!
• The shareholder’s equity section of a
corporation’s Balance Sheer reports
• Discount on Bonds Payable Treasury Shares
a) No No
b) Yes Yes
c) No Yes
d) Yes No
 Solution!!
• C) No Yes
 Question!
• The purchase of treasury shares

a) Has no effect on total assets, total liabilities or total

shareholder’s equity.
b) Decreases total assets and decreases total
shareholder’s equity.
c) Increases one asset and decreases another asset.
d) Decreases total assets and increases total
shareholder’s equity
 Solution!!
• B) Decreases total assets and decreases total
shareholder’s equity.
 Question!
• When do dividends increase shareholder’s
equity?

a) On date of payment
b) On date of declaration
c) On date of record
d) Never
 Solution!!
• D) Never
 Question!
• A 2 for 1 stock split has the same effect on the
number of shares being issued as a

a) 200% share dividend

b) 20 % share dividend
c) 50 % share dividend
d) 100 % share dividend
 Solution!!
• D) 100 % share dividend
• End of chapter 10