Notes Chapter 11

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Chapter 11: Stockholders’ equity: Paid-in capital.

T11-2 Corporations are entities created by law that exist separately from their owners and have
rights and privileges. The assets of a corporation belong to a corporation itself, not to the
stockholders. Ownership in a corporation can be publicly or privately held.

Learning objective number 1 is to discuss the advantages and disadvantages of organizing a


business as a corporation.

T11-3 The corporate form of organization has several advantages. Corporations are separate legal
entities that can enter into contracts, sue, and be sued. Stockholders’ losses are limited to the
amount invested in the corporation. Ownership rights are transferable (ownership is represented
by transferable shares of capital stock. This makes ownership of the business a highly liquid
investment, which can be bought and sold in organized exchanges. Most corporations have a
professional management team that runs the business on a day-to-day basis. The corporation
continues to exist even when ownership changes. All these make the corporation the best form of
organization for pooling the resources of a great many equity investors.

T11-4 There are also several disadvantages of incorporation. There are extra governmental
regulations imposed on corporations and corporate taxation of earnings. Corporations pay taxes
on their earnings and if they distribute a dividend to stockholders, the stockholders pay taxes on
the dividends received. This is sometimes referred to as double taxation. It’s also costly to form a
corporation. And, the separation of stockholder owners from management can create problems
as well if management does not act in the best interest of the owners, but rather in the best interest
of the management teamà agency conflict.
Review exhibit 11-1 page 490

T11-5 The requirements for forming a corporation are determined by the laws of the place or
country where the corporation is incorporated. The Memorandum and Articles of Corporation
(M&A) is enclosed for the application for corporate status.
The organization costs incurred to incorporate a business are expensed immediately for financial
reporting purposes. However, these costs are amortized over 5 years for tax purposes. Once a
corporate charter is obtained, the stockholders elect a Board of directors and pass bylaws that
will govern the corporation’s activities. The directors in turn appoint top corporate officers and
managers.

Learning objective number 2 is to explain the rights of stockholders and the roles of corporate
directors and officers.

T11-6 Stockholders’ownership is determined by the numbers of shares owned. A stock certificate


determines the number of shares owned. Stockholders have several rights. They have a right to
vote at stockholders’ meetings; one vote for each share owned they can sell and buy shares of
stock; they receive dividends declared by the Board of Directors, dividends are paid to all
shareholders in proportion to the number of shares owned, and in the event of liquidation, they
share equally in any remaining assets in [proportion of the number of shares owned) after
creditors are paid.

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NB: any stockholder-or a group of stockholders that owns more than 50% of the capital stock has
the power to elect the board of directors and set basic corporate policiesà control the corporation.
Proxy statements are statements sent by shareholders to management granting them the voting
right s associated with their shares.

T11-7 At their annual meeting, stockholders elect the Board of Directors and vote on important
management issues facing the company.BOD set corporate policies and protects the interest of the
stockholders. Directors’s duties include hiring several corporate officers, setting their salaries,
declaring dividends and reviewing the finding s of both internal and independent auditors. BOD
include not only top officers of the firm but also outside directors.

T11-8 The executive management team manages the day-to-day decisions for the corporation. It
includes a CEO or president, a CFO (controller),a treasurer and a secretary.The latter are
directly related to the accounting phase of business operation(budgeting, tax
planning ,preparation of F/S, tax returns and accounting records…)Treasury responsible for
planning and controlling cash and deals with creditors, secretary represent the firm in legal and
contractual matters. In addition, a vice president usually oversees each functional area, such as
sales , personnel, and production.

Learning objective number 3 is to distinguish between publicly owned and closely held
corporations.

T11-9 By law, Publicly owned corporations must prepare financial statements in accordance
with relevant accounting standards, say IFRS, have their financial statements audited by an
independent certified public accountant, comply with federal securities laws, and submit financial
information to the Securities and Exchange Commission for review.
Closely held corporations which are smaller are not traded on any organized stock exchanges
They are usually exempt from these requirements.

T11-10 To keep track of the actual owners of a corporation, a shareholder ledger is often
maintained by a share transfer agent or share registrar. This ledger keeps track of contact
information of current shareholders who own the corporation. Each unit of ownership is called a
share. Share certificates serve as proof that a shareholder has purchased shares. When share is sold,
the seller signs a transfer endorsement on the back of the share certificate. Old certificates are sent
to the transfer agent who cancels them and prepare new certificates for the owner of the shares.
This new certificates then must be registered with the share registrar.

T11-15 Once the stockholders elect the Board of Directors, the Board has the ultimate
responsibility for managing the company. The Board also hires the executive management team
for the corporation.

Learning objective number 4 is to account for paid-in capital and prepare the equity section of a
corporate balance sheet.

T11-11 Shareholders ’ equity can be increased in two ways. First, equity is increased by issuing
shares to investors. This is an increase in Paid-in Capital or contributed capital. Second, equity

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is increased by the retention of profits earned by the corporation. This is an increase in Retained
Earnings.

T11-12 There are several terms related to stock that must be understood. Authorized shares is the
maximum number of shares that can be sold to the public. The number of authorized shares is
identified in the corporation’s corporate charter, issued by the state.

T11-13 Authorized shares can be classified as Issued and Unissued. Unissued shares are shares
of stock that have never been sold to the public. Issued shares are shares of stock that have been
sold to the public at some point.
Underwriter is an investment banker which guarantees the issuing corporation a specific price for
the stock and makes a profit by selling the shares to the investing public at a slightly higher price.
Use of an underwriter assures the corporation that the entire stock issue will be sold without delay
and that the entire amount of funds to be raised will be available on a specific date.
Price for a new share is based on:
• Expected future earnings and dividends
• Financial strength of the company
• Current state of the investments markets.

T11-14 Issued shares can be classified as Outstanding shares and Treasury shares. Outstanding
shares are shares that are currently owned by stockholders.
Treasury shares are shares that once were owned by stockholders but were repurchased by the
corporation in the stock market. Thus, the corporation is now the owner of those shares.

T11-15 Par value is an arbitrary amount assigned to each share of stock in the company’s charter.
It represents the Legal Capital per share –the amount below which the stockholder’s equity
cannot be reduced. Par value is the minimum cushion of equity capital existing to protect the
creditors. Par value is typically a nominal amount ($1,or $5..). It is not related in any manner to
market value, which is the selling price of a share of stock. It indicates the amount per share to
be entered in the Share Capital account.

T11-16 Share can have a par value, not have a par value, or have a stated value.
Let’s look at how to account for par value stock. Accounting entries for stated value stock are very
similar to accounting for par value stock. When a company has no-par stock, all the proceeds are
credited to the Share Capital account.

T11-17 When par value share is sold for cash, the Ordinary Share Capital account is credited
for the par value of the share sold. Remember that par value and market value are not related.
The difference between the par value of the share and the market value of the share is credited to
Share Premium (or Contributed Capital in Excess of Par). If the amount of par value in the
Ordinary Share Capital account and the amount in the Share Premium were added together, the
result would be the market value of the sale of the shares.

Let’s record the entry for the issue of 10,000 shares of $2 par value common stock for $25 per
share.

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T11-18 To record this stock issue, debit Cash for the market value of the share sold: 10,000 shares
times $25 per share. Credit Ordinary Share for the par value of the share sold: 10,000 shares times
$2 per share. Finally, credit Share Premium for the excess of market over par: 10,000 times $23
per share.
NB: When a no par stock is issued , the entire issue price is credited to the Share Capital account
and is viewed as legal capital not subject for withdrawal.
NB: when shares are issued in exchange for assets other than cash, land or inventory for ex the
appropriate asset is debited for a value that is either the fair value of the asset received or the
shares issued whichever can be more objectively determined.

T11-19 This slide shows how to report the share in the statement of financial position.. The
$20,000 is the par value of the share sold and the $230,000 is the excess over par value for the
share. These two accounts total $250,000 and equal the amount of cash received for the sale of the
share.

Learning objective number 5 is to contrast the features of Ordinary Shares with those of
Preference Shares.

T11-20 Preference share is a separate class of share that typically has priority over ordinary
share in dividend distributions and distribution of assets in a liquidation. NB: Specific preference
share characteristics can affect the presentation of preference share in the statement of financial
position as liabilities instead of equity. For example, preference shares that are mandatorily
redeemable by the issuing company is required by IAS 32 classified as a liability in the statement
of financial position. Details of such presentation will be covered in more advanced accounting
courses.
Preference share usually has a stated dividend that is expressed as a percentage of its par value. It
normally does not have voting rights and is often callable by the corporation at a stated value.
Another less common feature of some preferred stock is the conversion of P/S into Ordinary
Share at the option of the holder.

Let’s take a closer look at the cumulative dividend rights of preference share on the next screen.

T11-21 Cumulative preference share has the right to be paid in both the current and all prior
periods’ unpaid dividends before any dividends are paid to ordinary shareholders. When the
preference share is cumulative and the directors do not declare a dividend to preference
shareholders, the unpaid dividend is called a dividend in arrears and must be disclosed in the
financial statements. Dividends in arrears accumulates from year to year and must be paid before
any dividend can be paid on Ordinary Share.
NB: Noncumulative preference share has no rights to prior periods’ dividends if they were not
declared in those prior periods.
NB: A corporation is obligated to pay dividends to stockholders only when the BOD declares a
dividend and this is done when profits are earned and cash is available.

Let’s look at an example

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T11-22 This company has both ordinary share and preference share. The directors declare a small
dividend of $5,000 in 2011. In 2012, the directors declare and pay cash dividends of $42,000.
Let’s see how this dividend is distributed if the preference share is cumulative, and if it is
noncumulative.

T11-23 Preference share receives any declared dividends before Ordinary share. In 2012, the
preference share received all of the $5,000 in dividends and ordinary share received none. If the
preference share is noncumulative, these shareholders have no rights to the missed portion of
dividends in the year 2013. However, they get first distribution of the dividends declared in 2013.
The dividend for the preference share in 2013 is calculated as follows: $100 par value times 9%
times 1,000 shares. Since $42,000 in dividends were declared, preference share would first get
$9,000 and the remaining $33,000 would be divided evenly among the ordinary shareholders.
If the preference share is cumulative, the shareholders have rights to the missed dividends in the
year 2012 and the full dividends in 2013. The preference shareholders first get a distribution of
$42,000 for the missed dividends in 2012. Then, they get another $9,000 for the dividends in 2013.
Since $42,000 in dividends were declared, preference share would first get $13,000 and the
remaining $29,000 would be divided evenly among the ordinary shareholders.

T11-24 Some Preference shares have an additional preference to be converted into ordinary
shares at the shareholder’s choice. This conversion feature entitles the preferred stockholders to
exchange their shares for ordinary shares at a stipulated ratio. If the corporation prospers, its
ordinary shares will probably rise in market value, and dividends on the ordinary shares will
probably increase.The investor who buys a convertible preference shares rather than ordinary
shares has greater assurance of regular dividends and an opportunity to share in capital gains of the
company’s ordinary shares when corporation prospers and both its share price and dividends
increase.

T11-25 This is an example of an equity section of a statement of financial position for a company
that has both preference share and ordinary share. Notice that each share is reported separately at
its par value.

Learning objective number 6 is to discuss the factors affecting the market price of preferred stock
and common stock.

T11-26 For the corporation issuing the share, the market value on the date of sale can be
determined by adding together the par value of the share with the share premium account.
For the investor, the market value of the share will be in the asset account for Marketable
securities and shown at market value .
NB: market price may differ substantially from par value , original issue price or current book
valueà issuing company and stockholders apply different accounting principles to the same
outstanding shares.

T`11-27 Several factors impact the market price of preference share, including the dividend rate
on the share, the risk level of the company, and the interest rates in the market. The return based
on market value is called the dividend yield. In summary, the market price of preferred stock
varies inversely with interest rates.

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T11-28 The market price of ordinary share is impacted by expectations of future profitability of
the corporation and the risk that this profitability level will not be achieved. Although the market
price of its share is important to the corporation, it is not recorded anywhere in the accounting
records of the corporation.

Learning objective number 7 is to explain the significance of par value, book value, and market
value of capital stock.

T11-29 Book value is used in evaluating the reasonableness of the market price of a share in other
words if the stock is selling at a price per share greater than book à than there is value creation
since the business is worth more than the historical costà the relationship between Book value
and market price is one measure of investor’s confidence in a company’s management.
Book value per share is the amount of net assets represented by each share.
The Book Value per Ordinary Share ratio records the amount of shareholders’ equity applicable
to ordinary shares on a per share basis. It is calculated as Shareholders’ Equity divided by the
Number of Ordinary Shares Outstanding.
NB: Remember to deduct the preference share value and any preference dividends in arrears from
total shareholders’ equity when calculating this ratio for ordinary share. Book value is not the same
as market value.

Learning objective number 8 is to explain the purpose and effects of a stock split

T11-30 Share splits are the distribution of additional shares of share capital to shareholders
according to their percent ownership. When a share split occurs, the corporation calls in the
outstanding shares and issues new shares.The purpose of a stock split is to reduce substantially the
market price of a company’s common stock with the intent of making it more affordable to
investors. In the process of a share split, the par value of the share changes is reduced in proportion
to the size of the split.

Let’s look at an example.

T11-31 This corporation has five thousand shares of one dollar par value stock prior to a 2 for 1
stock split. After the split, the number of shares doubled and the par value was cut in half. Notice
that an accounting entry is not required.
NB: Since the stock split does not change the balance of any accounts in the balance sheet , the
transaction is recorded merely by a memorandum entry.

Learning objective number 9 is to account for treasury stock transactions.

T11-32 Treasury shares are shares of a corporation’s own capital stock that have been issued and
later reacquired by the issuing company, have not been canceled or permanently retired.
Sometimes corporations buy their own shares back in the market. They do this to increase the
shares needed in the acquisition of another company, to limit the shares available for a hostile
takeover, and to increase shares for use in employee share option programs. Share options plans
are an important purpose for treasury shares purchases for many companies. Buying back a

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company’s own shares also reduces the supply of shares available and may increase the market
value of the shares. Treasury shares has no voting or dividend rights. Treasury share is a
contra equity account and is subtracted from the equity section in the statement of financial
position. NB: in the computation of EPS ,shares held in the treasury are not regarded as
outstanding.

Let’s look at an example.

T11-33 Riley Corporation purchased 3,000 of its own shares in the market for $55 per share. Let’s
look at the entry for this transaction.
The entry includes a debit to Treasury Share and a credit to Cash for $165,000, which is the
amount of the purchase.
NB: treasury share is debited for the cost of the shares purchased and not their par value.
The Treasury Share account will be reported in the statement of financial position in the
equity section as a reduction from total equity.
When a treasury share is purchased ,the corporation is eliminating part of its Shareholders equity
by payment to one or more stockholders.

T11-34 Riley Corporation reissued 1,000 shares of the treasury share for $75 per share. Remember
that Riley paid $55 to acquire the treasury shares.
This entry includes a debit to Cash for $75,000. The credit to Treasury Share is for $55,000. This
is the original cost of $55 per share times 1,000 shares sold. The difference between the selling
price and the cost of the treasury share is credited to Share Premium from Treasury Share. In this
example, that amount is $20,000.

T11-35 On the equity section of the statement of financial position, the ending balance in the
Treasury Share account of $110,000 is subtracted. The balance in the Treasury Share account is
from the original debit entry for $165,000 less the credit entry for the sale for $55,000.

T11-36 Some corporations have buyback programs, in which they repurchase large amounts of
their own ordinary share. As a result of these programs, treasury share has become a material item
in the statement of financial position of many corporations.
Share option plans are an important part of employee compensation for many companies. Treasury
share purchases are an effective means by which the company can have available the shares
needed to satisfy the requirement of share option plans to issue the shares to employees.

T11-37 The return on total assets (ROA) is calculated by dividing profit for the year by the
average total assets. Average total assets is equal to total assets at the beginning of the year plus
total assets at the end of the year divided by 2. It is a measure of the return earned based on the
company’s investment in assets.
The return on ordinary shareholders’ equity (ROE) is equal to profit less preference dividends
divided by average ordinary shareholders’ equity. Average ordinary shareholders’ equity is equal
to ordinary shareholders’ equity at the beginning of the year plus ordinary shareholders’ equity at
the end of the year divided by 2.This measure the return on ordinary shareholders’ equity when a
company has both ordinary and preference share.

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