CHAPTER 11:

Shareholders’
Equity

Prepared by Debra Lee-Hue, CPA, CMA

© 2021 MCGRAW HILL
 YOUR
LEARNIN
G LO11-1 Explain the role of shares (also called
OBJECTI stocks) in financing a corporation.

VES LO11-2 Explain and analyze common share

transactions.

LO11-3 Explain and analyze cash dividends, stock

dividends, and stock split transactions.

LO11-4 Describe the characteristics of preferred shares

and analyze transactions affecting preferred shares.

LO11-5 Analyze the earnings per share (EPS), return on

equity (ROE), and price/earnings (P/E) ratios.

LO11-S1 Account for owners’ equity in other forms of

business.

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UNDERSTAN In the most basic form, a corporation must have one
D THE type of share, appropriately called common shares.
Owners of common shares usually enjoy a number of
BUSINESS benefits:
1.Voting rights. For each share you own, you get a set
number of votes on major issues. Some classes of
common shares can carry more votes than others.
2.Dividends. Shareholders receive a share of the
corporation’s profits when distributed as dividends.
3.Residual claim. If the company ceases operations,
shareholders share in any assets remaining after
creditors have been paid.
4.Pre-emptive rights. To retain their ownership
percentages, existing shareholders may be given the
first chance to buy newly issued shares before they
are offered to others.

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Organization EXHIBIT 11.1

al Structure
Typical Organizational Structure of a Corporation

The ownership
structure of a
corporation can vary
from one company
to the next.
In the most basic
form, a corporation
must have one type
of share,
appropriately called
common shares.

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 Equity Whenever a company needs a large amount of long-term
financing, its executives will have to decide whether to
versus Debt obtain it by issuing new shares to investors (called equity
financing) or by borrowing money from lenders (debt
Financing financing).

Each form of financing has certain advantages:

Advantages of Equity Financing include:

1. Equity does not have to be repaid.
2. Dividends are optional.

Advantages of Debt Financing include:

3. Interest on debt is tax-deductible.
4. Debt does not change shareholder control.
over the other

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STUDY THE The shareholders’ equity section of the balance sheet
includes four main elements:
ACCOUNTIN
1. Contributed Capital is the amount received from
G METHODS investors in exchange for shares.
2. Retained Earnings is the cumulative net income
less cumulative dividends declared.
3. Treasury Shares are shares previously issued to
and owned by shareholders but have been
reacquired and are now held by the corporation.
4. Accumulated Other Comprehensive Income
(Loss) reports unrealized gains and losses which
are temporary changes in the value of certain
assets and liabilities the company holds

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Authorization, Before a share can be issued, its specific rights and
characteristics must be authorized and defined in the
Issuance and corporate charter.
Repurchase of 1. Authorized shares is the maximum number of
Shares common shares that the corporation is allowed to
issue, as specified in the corporation’s charter.
2. Issued shares have been distributed by the
corporation and will be owned forever by one
shareholder or another, unless the company
repurchases them.
3. Treasury shares are issued shares that have been
repurchased and are held by the company. The
shares do not carry voting, dividend, or other
shareholder rights.
4. Outstanding shares are shares currently held by
shareholders.

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 Share Assume that during the next fiscal year, Molson
Coors issues 100,000 no-par value shares at the $10
Issuance per share market price existing at the time of
issuance.
A share issuance
occurs when a The accounting equation effects of this share
corporation issuance and the journal entry to record them:
distributes its shares
to existing or new
shareholders, usually
in exchange for cash.
The very first
issuance of a
company’s shares to
the public is called an
initial public offering,
or IPO.

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Repurchase A corporation may want to repurchase its shares to:
of Shares 1. send a signal to investors that the company
believes its own shares are worth acquiring,
2. obtain shares so that new shares can be issued as
payment for purchases of other companies,
3. obtain shares so that new shares can be issued to
employees as part of employee stock option plans,
and
4. reduce the number of outstanding shares to
increase per-share measures of earnings and share
value.

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 Example
1: Assume that during the next fiscal year, Molson Coors
repurchases 50,000 shares for $5 per share ( 50,000 shares x
Repurchas $ 5 = $ 250,000 ).

e of Shares Molson Coors had a total of 225.8 million common shares

issued for a total consideration of $622 million, or an
average issue price of $2.75 per share.

Molson Coors would have accounted for this transaction as

follows:

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 Example If Molson Coors had repurchased the shares for
2: $1 instead of for $5, creating a “gain” instead of
a “loss,” the credit needed to balance the
Repurchas journal entry would have been made to a
e of Shares Contributed Capital account called Contributed
Surplus, as follows:

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Dividends Investors acquire common shares because they
expect a return on their investment which can come
on in two forms: dividends and increases in share price.

Common Some investors prefer to buy shares that pay little or

Shares no dividend (called a growth investment). Other
investors prefer to receive their return in the form of
consistently paid dividends(called an income
investment)

A company’s board of directors also need to consider

two key financial requirements when declaring a
cash dividend:
 
1. Sufficient retained earnings accumulated to cover
the amount of the dividend.
2. Sufficient cash to pay the dividend.

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Declaratio On the declaration date the board of directors
formally approves the dividend, thereby creating a
n Date legal liability for the corporation.

The dividend declaration is accounted for by

increasing Dividends Payable and increasing a
temporary account called Dividends Declared
(deducted from Retained Earnings when it is closed
at year-end).

The accounting equation effects and journal entry to

record the cash dividend declared would be as
follows:

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 Date of
Record The record date is the cut-off date for determining the
specific shareholders to be paid the dividend. The
and Date dividend is payable only to those names listed on the
date of record. No journal entry is recorded on this date.
of
Payment The payment date is the date on which the cash is
disbursed to pay the dividend liability owed to each
shareholder.

The distribution of cash and reduction in liability are

recorded on this date as follows:

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Year End All temporary accounts, including Dividends Declared,
are closed into Retained Earnings at each accounting
year-end.

This closing journal entry zeroes out the temporary

account Dividends Declared by transferring its (debit)
balance to its permanent home in Retained Earnings.

The closing entry has no effect on total shareholders’

equity.

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 Stock Stock dividends are not paid in cash but in
Dividends additional shares and are distributed to a
corporation’s shareholders on a pro rata basis at no
cost to the shareholder.

The phrase pro rata basis means that each

shareholder receives additional shares equal to the
percentage of shares held.

Three possible explanations for stock dividends are

as follows:
1. To lower the market price per share.
2. To demonstrate commitment to shareholders
while conserving cash during difficult times.
3. To signal an expectation of significant future
earnings.

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Example: Assume a company issued a 2 percent stock
dividend when the share price was $4 per share,
Stock and there were 10.8 million common shares
outstanding prior to the stock dividend.
Dividend
The company would account for this stock
dividend by moving $ 864,000 ( = 10.8 million x
2 % x $ 4 share value ) from Retained Earnings to
Common Shares as follows:

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Stock
Splits In a stock split, the total number of authorized
shares is increased by a specified amount, such
as 2 for 1.

In this instance, each issued share is called in

and two new shares are issued in its place.

Cash is not affected when the company splits its

shares, so the total resources of the company do
not change.

A stock split involves reducing the carrying

value of all issued shares, so that the total
carrying value of the shares is unchanged.

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Example:
Stock
Splits

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Compariso
n of
Distribution
to
Shareholde
rs A 100% Stock Dividend
doubles the number of
A 2-for-1 Stock Split outstanding shares, but A Cash Dividend does
doubles the number does not change the book not change the
of outstanding value per share. number of
shares, and halves outstanding shares or
the book value per The value of Common the book value.
share. Shares increases and
Retained Earnings Retained Earnings
There is no change in decreases. decreases.
total shareholders’ There is no change in total Total shareholders’
equity shareholders’ equity. equity decreases.

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 Preferred shares can carry anywhere from no voting
Preferred rights to super-voting rights allowing a corporation to
Shares separate share ownership from voting control.
Dividends on preferred shares, if any, may be paid at
a fixed rate which is specified as a dollar amount per
share.
Preferred shareholders have higher priority than
common shareholders if a corporation distributes
assets to its owners through dividends or at
liquidation.
That is, any dividends the corporation declares must
be paid to preferred shareholders before they can be
paid to common shareholders.
Also, if the corporation goes out of business, its assets
will be sold and used to pay creditors and then
preferred shareholders.

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 Assume that a company issued 10,000 preferred
Preferred shares for $5 per share ( $ 5 x 10,000 shares = $
Share 50,000 cash received ).

Issuance As shown below, the Preferred Shares account

increases by the share price for each share issued
( $ 5 x 10,000 = $50,000 ) and so does the
amount of cash received.

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 Current The two most common dividend preferences are
called current and cumulative.
Dividend A current dividend preference requires that dividends
Preference on preferred shares be paid before any dividends are
paid to holders of common shares.
Assume that the preferred shares carry only a current
dividend preference and that the company declared
dividends totalling $8,000 in 2019 and $10,000 in
2020.
In each year, a fixed amount of the total dividends
would first go to the preferred shareholders, and only
the excess would go to the common shareholders.

Total Dividends Dividends on 6% Preferred Dividends on Common

Year
Declared Shares* Shares†
2019 $ 8,000 $2,400 $5,600
2020 10,000 2,400 7,600

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 A cumulative dividend preference states that if all or a
Cumulative part of the current dividend is not paid in full, the
Dividend cumulative unpaid amount, known as dividends in
arrears, must be paid before any future common
Preference dividends can be paid.
Assume that dividends were in arrears for 2017 and
2018. In 2019, dividends in arrears are satisfied first,
followed by the current dividend preference, and the
excess goes to common shareholders.
In 2020, preferred dividends include only the current
preference of that year because dividends in arrears
were fulfilled in 2019.
Dividends on 6%
Preferred Shares
Year Total In Arrears Current Dividends on
Dividends Common
Declared Shares

2019   $ 8,000 $4,800 $2,400 $  800

2020  10,000 —   2,400   7,600

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 Retained The Retained Earnings account represents the
Earnings company’s total earnings that have been retained in
the business (rather than being distributed to
and the shareholders).
Statement of The balance in this account increases when the
Shareholder company reports net income, and it decreases when
the company reports a net loss (expenses greater than
s’ Equity revenues) or declares cash or stock dividends to
shareholders.
The statement of shareholders’ equity has a column
for each shareholders’ equity account and shows the
factors that increased and decreased these account
balances during the period.

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EVALUATE Earnings per share (EPS), reports how much profit is
earned for each common share outstanding.
THE Return on equity (ROE) reports a company’s return to
RESULTS investors by relating net income to the average dollars of
shareholder investment and earnings reinvested in the
company.
The price/earnings ratio measures how many times more
than current year’s earnings investors are willing to pay for
a company’s shares.

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 A sole proprietorship is an unincorporated business owned
Supplement 11A: by one person.
Owner’s Equity The capital account of a sole proprietorship serves two
For Other Forms purposes:
Of Business 1. to record investments by the owner and
2. to accumulate periodic income or loss.

The drawings account is used to record the owner’s

withdrawals of cash or other assets from the business,
similar to recording dividends declared by corporations.

The drawings account is closed to the capital account at

the end of each accounting period which then reflects the
cumulative total of all capital contributions by the owner
and all earnings of the business less all withdrawals from
the entity by the owner.

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Partnership A partnership is formed by two or more persons reaching mutual
agreement about the terms of the relationship to carry on as co-
owners of a business for profit.
The agreement is a contract and should specify matters such as:
• division of income,
• management responsibilities,
• transfer or sale of partnership interests,
• disposition of assets upon liquidation, and
• procedures to be followed in case of the death of a partner.

If the partnership agreement does not specify these matters, the

applicable provincial or territorial laws are binding.
The primary advantages of a partnership are:
1. ease of formation,
2. complete control by the partners, and
3. lack of income taxes on the business itself.

The primary disadvantage is the unlimited liability of each partner

for the partnership’s debts.

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 Limited
Liability A limited liability partnership (LLP) combines legal
Partnership characteristics of corporations (separate legal
identity and limited liability) with the tax treatment
(LLP) of partnerships (tax paid by individual owners
rather than business itself).

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 End of •Shares provide a number of rights,
Chapter including the right to vote, to receive
dividends, and to share in residual assets at
Summary liquidation.
•A number of key transactions involve
common shares including issuance of
shares, repurchase and cancellation of
shares, repurchase of shares into treasury,
and reissuance of treasury shares.
•Cash dividends reduce shareholders’ equity
(Retained Earnings), increase liabilities
(upon declaration) and reduce liabilities
and cash when paid (on the date of
payment)

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 End of •Stock dividends are pro rata distributions of a
Chapter company’s shares to owners, while stock splits
Summary involve the distribution of additional shares to
owners reducing the book value of the shares.
•Preferred shares provide investors with current
dividend preferences and company asset
liquidation.
•If preferred shares carry cumulative dividend
rights, any part of current dividends that are not
paid (called dividends in arrears) must be paid
in full before any additional dividends can be
paid.
•Analysis of the earnings per share (EPS), the
return on equity (ROE) and price/earnings (P/E)
ratios.

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