Shareholders’ Equity
Chapter
18
Shareholders’ Equity
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 noncash consideration.
LO18-5 Distinguish between accounting for retired shares and 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 we account for them.
LO18-9 Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting for shareholders’ equity.
Chapter Highlights
PART A: THE NATURE OF SHAREHOLDERS’ EQUITY
Businesses raise money externally to fund operations in two ways – debt financing and equity financing. Debt financing takes the form of notes, bonds, leases, and other liabilities. These create creditors’ interest in the assets of the business. Equity financing creates ownership interests in the assets of the business. Owners of a corporation are its shareholders. Shareholders’ equity is a residual amount. That is, it’s the amount that remains after creditor claims have been subtracted from assets (net assets). Remember, net assets equal shareholders’ equity:
Assets – Liabilities = Shareholders’ equity
Net Assets
Shareholders’ Equity in Financial Statements
Shareholders’ equity arises primarily from (a) amounts invested by shareholders and (b) amounts earned by the firm on behalf of its shareholders. These two amounts are reported in two categories on a balance sheet: paid-in capital and retained earnings.
The balance sheet reports balances of shareholders’ equity accounts. In addition, companies also disclose the reasons for changes in those accounts. The statement of shareholders’ equity serves that purpose. It reports the transactions that cause changes in shareholders’ equity account balances.
Illustration
Variety Brands Corporation
Statements of Shareholders’ Equity
For the Years Ended Dec. 31, 2013, 2014, 2015 (In millions)
Additional
Common Paid-in Retained Treasury Shareholders’
Stock Capital Earnings Stock Equity
Balance, Jan. 1, 2013 $30 $400 $250 $(180) $500
Net income – – 40 – 40
Cash dividends – – (25) – (25)
Common shares sold 5 60 – – 65
Balance, Dec. 31, 2013 35 460 265 (180) 580
Net income – – 50 – 50
Cash dividends – – (35) – (35)
Treasury shares – – – (20) (20)
Balance, Dec. 31, 2014 35 460 280 (200) 575
Net income – – 55 – 55
Cash dividends – – (35) – (35)
Balance, Dec. 31, 2015 $35 $460 $300 $(200) $595
PART B: PAID-IN CAPITAL
Fundamental Share Rights
Common Stock
Ownership rights held by common shareholders usually include:
a. The right to vote.
b. The right to share in profits when dividends are declared.
c. The right to share in the distribution of assets if the company is liquidated.
Preferred Stock
The special rights of preferred shareholders often include one or both of the following:
a. A preference 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.
b. A preference (over common shareholders) as to the distribution of assets in the event the corporation is dissolved.
If preferred shares are not cumulative, dividends not declared in any given year need never be paid. If preferred shares are not “participating,” shareholders are entitled to no more than the designated dividend preference.
The Concept of Par Value
Assigning a par value to shares has little significance other than historical. Although par value originally indicated the actual value of shares, this is no longer the case. Companies commonly assign shares a nominal par value to dodge elaborate statutory rules pertaining to par value shares. From an accounting perspective, we need to be concerned only that when shares are issued, we record the par amount in common stock, the remainder of the proceeds in additional paid-in capital.
Accounting for the Issuance of Shares
Shares Sold for Cash
When shares are sold for cash, shareholders’ investment is allocated between stated capital and additional paid-in capital:
Cash (proceeds from sale) xxx
Common stock (par amount of shares) xxx
Paid-in capital – excess of par (remainder) xxx
Shares Sold for Noncash Consideration
Occasionally, shares are sold for consideration other than cash, maybe services or a noncash asset. In those instances, the transaction should be recorded at the fair market value of the shares or the noncash consideration, whichever seems more clearly evident. This is consistent with the general rule for accounting for any noncash transaction.
Share Issue Costs
Share issue costs refer to the costs of obtaining the legal, promotional, and accounting services necessary to effect the sale of shares. The costs reduce the net cash proceeds from selling the shares and thus paid-in capital – excess of par, and are not recorded separately.
Reacquired Shares
Companies sometimes reacquire shares previously sold. There is a variety of reasons why, but the most common motivation is to support the market price of the shares. Although, all share repurchases are functionally the same, accounting treatment depends on whether the company states that it is formally retiring the shares or purchasing treasury shares.
Shares Formally Retired
When a corporation 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. Payments made to retire shares are viewed as a distribution of corporate assets to shareholders. We reduce 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.
Illustration
At the time it retired 1 million common shares, General Retailer’s balance sheet included the following:
($ in millions)
Common stock, 100 million shares at $1 par, $ 100
Paid-in capital – excess of par 500
If shares are bought back in 2013 at $4 per share:
Common stock (1 million shares at $1 par) 1
Paid-in capital – excess of par (1 million shares at $5 per share) 5
Paid-in capital – share repurchase (difference) 2
Cash (cost) 4
If another 1 million shares are bought back in 2015 at $9 per share:
Common stock (1 million shares at $1 par) 1
Paid-in capital – excess of par (1 million shares at $5 per share) 5
Paid-in capital – share repurchase (account balance) 2
Retained earnings (remaining difference) 1
Cash (cost) 9
We treat the difference between the cash paid to buy the shares and the amount the shares originally sold for differently depending on whether that difference is positive (credit) or negative (debit):
a. If a credit difference is created as in the first entry, we credit paid in capital – share repurchase.
b. If a debit difference is created, we debit retained earnings unless a credit balance already exists in paid-in capital – share repurchase, as in the second entry.
Shares Treated as Treasury Stock
The cost of acquiring the shares is “temporarily” debited to the treasury stock account. Recording the effects on specific shareholders’ equity accounts is delayed until later when the shares are reissued. In essence, we view the purchase of treasury stock as a temporary reduction of shareholders' equity, which is later reversed when the treasury stock is resold.
Illustration
At the time it purchased 1 million common shares, General Retailer’s balance sheet included the following:
($ in millions)
Common stock, 100 million shares at $1 par, $ 100
Paid-in capital – excess of par 500
If shares are bought back in 2013 at $4 per share:
Treasury stock (cost) 4
Cash 4
If the shares are later sold at $5 per share:
Cash (proceeds from sale) 5
Treasury stock (previous cost) 4
Paid-in capital – share repurchase (difference) 1
If, instead, the shares are later sold at $3 per share:
Cash (proceeds from sale) 3
Retained earnings (difference) 1
Treasury stock (previous cost) 4
At the time 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 as in the first entry, we credit paid-in capital – share repurchase.
b. If a debit difference is created as in the second entry, we debit retained earnings unless a credit balance already exists in paid-in capital – share repurchase (not present in this example).
PART C: RETAINED EARNINGS
In general, retained earnings represents a corporation's accumulated, undistributed or reinvested net income (or net loss). Distributions of earned assets are dividends.
Dividends
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.
Illustration
The board of directors of Marlin Properties declared a cash dividend of $.50 per share on its 50 million shares on March 1. The dividend was payable to shareholders of record March 15, to be paid March 30:
March 1 – declaration date ($ in millions)
Retained earnings 25
Cash dividends payable (50 million shares at $.50/share) 25
March 15 – date of record
no entry
March 30 – payment date
Cash dividends payable 25
Cash 25
Property Dividends
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.
Stock Dividends
In a stock dividend additional shares of stock are distributed to current shareholders. It’s important to note that a stock dividend affects neither the assets nor the liabilities of the firm. And, because each shareholder receives the same percentage increase in shares, a shareholder’s percentage ownership of the firm remains unchanged.
For a "small" stock dividend (less than 25%), the fair value of the additional shares distributed is transferred from retained earnings to paid-in capital.
Retained earnings (market value of new shares) xxx
Common stock (par value of new shares) xxx
Paid-in capital – excess of par (remainder) xxx
Stock Splits
A stock distribution of 25% or higher is a stock split. 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:
Paid-in capital – excess of par xxx
Common stock (par value of new shares) xxx
If referred to merely as a stock split, no journal entry is recorded.
Decision-Makers’ Perspective
The key to a company's long run survival is profitability. The return on shareholders' equity is a summary measure of profitability popular among investors, common shareholders in particular. This ratio is calculated by dividing net income by average shareholders' equity and measures the ability of company management to generate net income from the resources that owners provide.
To supplement the return on shareholders’ equity ratio, analysts frequently use the earnings-price ratio to relate earnings to the market value of equity rather than the book value of equity. This ratio is calculated as the earnings per share divided by the market price per share. A popular variation is the inverse – the price-earnings ratio.
The return to shareholders can be significantly affected by decisions that managers make with regard to shareholders’ equity transactions. When a corporation buys back shares of its own stock, for instance, the return on shareholders’ equity goes up. However, the buy back of shares uses assets, which reduces the resources available to earn net income in the future.
Dividend decisions should be evaluated in light of prevailing circumstances. When cash is available, management must decide whether shareholders are better off receiving cash dividends or having funds reinvested in the firm.
International Financial Reporting Standards
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. Shareholders’ equity is classified under IFRS into two categories: Share capital and “reserves.” The term reserves is considered misleading and thus is discouraged under U.S. GAAP.
Under U.S. GAAP, preferred stock normally is reported as equity, but is reported as debt with the dividends reported in the income statement as interest expense if it is “manditorily redeemable” preferred stock. Under IFRS, most non-mandatorily redeemable preferred stock (preference shares) also is reported as debt as well as some preference shares that aren’t redeemable. Under IFRS, the critical feature that distinguishes a liability is if the issuer is or can be required to deliver cash (or another financial instrument) to the holder.
With regard to the presentation of comprehensive income, both sets of standards permit either (1) single statement of comprehensive income or (2) two statements: a separate ‘income statement’ and ‘statement of comprehensive income.’ U.S. GAAP permits a third alternative: (3) include in the statement of shareholders’ equity.
Appendix 18: Quasi-Reorganizations
When a company undergoes financial difficulties, but has favorable future prospects, it may make use of a quasi-reorganization. The firm writes down inflated asset values and eliminates the accumulated deficit (debit balance in retained earnings) following these procedures:
1. Assets and perhaps liabilities are revalued (up or down) to reflect fair market values with corresponding credits or debits to retained earnings. The deficit usually is temporarily increased by this step.
2. Then the debit balance in retained earnings (deficit) is eliminated against additional paid-in capital. If additional paid-in capital is not sufficient to absorb the entire deficit, a reduction in capital stock may be necessary (with an appropriate restating of the par amount per share).
3. For several years, retained earnings is “dated” to indicate the date the deficit was eliminated and when the new accumulation of earnings began.
Self-Study Questions and Exercises
Concept Review
1. The two primary sources of shareholders’ equity are amounts invested by shareholders in the corporation and amounts earned by the corporation on behalf of its shareholders. Invested capital is reported as and earned capital is reported as .