Chapter 10

KNOWLEDGE CHECK 10.1

What is a not-for-profit organization (NFPO)? Why don’t NFPOs have “owners’ equity”?

Not-for-profit organizations (NFPOs) are economic entities whose objectivesare to provide services and to not make a profit. NFPOs don’t have owners or ownership shares that can be traded or sold. Because an NFPO doesn’t have owners, it won’t have an owners’ or shareholders’ equity section in its financial statements.

What characteristics distinguish equity from debt?

  • Equity investors have a voice in certain decisions of the company, debt holders usually don’t.
  • Interest payment must be paid on debt, no payments are required on equity.
  • Return of principal is required with debt, no return of investment is required with equity.
  • The rights of shareholders come after those of debt holders.
  • Interest payments on debt are tax deductible; dividends paid on equity investments aren’t tax deductible.

Explain the terms authorized capital stock and outstanding shares.

  • Authorized capital stock—the maximum number of each type of share that can be issued is by the corporation.
  • Outstanding shares—the number of shares currently in the hands of shareholders.

KNOWLEDGE CHECK 10.2

What is retained earnings? Why is retained earnings considered an indirect investment in an entity?

Retained earnings are the accumulated earnings of a company that haven’t been distributed to the owners. Retained earnings are considered an indirect investment because the company is making the decision to keep the earnings in the business, so the investment is indirect.

What economic events affect retained earnings?

  • Net income or net loss
  • Dividends
  • Correction of errors
  • Retroactive application of accounting policies
  • Share retirement (in certain situations)

What is a stock dividend? Is an investor better off when he or she receives a stock dividend?

A stock dividend is the distribution of a corporation’s own shares to its existing shareholders. Instead of cash, a shareholder receives company shares as the dividend. A shareholder is no better or worse off as a result of a stock dividend. The shareholder owns exactly the same proportion of the company before and offer the stock dividend, but the ownership is divided into a larger number of shares.

KNOWLEDGE CHECK 10.3

What is leverage?

Leverage is the use of debt to attempt to increase the return earned on the equity investment of the owners.

What are the advantages and disadvantages of using leverage when financing a business?

Leverage is attractive because any profits earned from investing borrowed money, above the cost of borrowing, go to the owners. But leverage is risky because the cost of borrowing must be paid, regardless of how well or poorly the entity is performing.

For a given total amount of debt and equity financing, why does the return on equity to the owners increase as the proportion of equity financing and the amount of net income decrease?

If the return on the borrowed money is greater than the cost of borrowing the return on equity increases as the proportion of debt increases because amount of income being earned as a proportion of the equity investment is increasing. Income decreases because of the increasing cost of borrowing.