Chapter 10: Shareholder’s Equity

1. WHAT’S THE BEST WAY TO ORGANIZE A BUSINESS?

SEPARATE LEGAL ENTITY

Corporation (Incorporated/ Limited): is a business entity formed under law. It is a distinct entity, an
artificial person that exists apart from its owners, the shareholders
 Corporation has many rights that a person has: e.g. buy, own and sell property
 Assets and Liabilities belong to the corporation and not to its owners
 Corporation may enter into contracts, sue and be sued

CONTINUOUS LIFE AND TRANSFERABILITY OF OWNERSHIP

 Corporations have continuous lives regardless of change in their ownership  The transfer of
shares from one person to another does not affect the continuity of the corporation

LIMITED LIABILITY
 Shareholders have limited liability for the corporation’s debts  no personal obligation for
corporate liabilities
 This enables corporations to raise more capital from a wider group of investors
 In contrast: proprietors and partners are personally liable for all the debts of their business and
can therefore lose more than their investment

SEPARATION OF OWNERSHIP AND MANAGEMENT

 Shareholders own the corporation but the board of directors – elected by the shareholders –
appoints officers to manage the business
 Management’s goal should be to maximize the firm’s value for the shareholders
 Separation may create problems  Agency problem

CORPORATE TAXATION
 Proprietorship and partnerships pay no business income tax  the business’ tax falls solely on
the owners
 corporations are separate taxable entities and have to pay taxes  corporate tax
 there are specific rules on taxation varying from country to country

GOVERNMENT REGULATION
 Outsiders doing business with the corporation cannot look further than the corporation if it fails
to pay because shareholders have only limited liability for corporation debt
 To protect a corporation’s creditors and shareholders, governments monitor corporations
 The bigger a company becomes, the more rules and regulations it will have to comply with 
regulations ensure that corporations disclose the information that investors and creditors need
to make informed decisions

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2. ORGANIZING A CORPORATION

 Creation of a corporation begins when its organizers apply for registration as a company with the
relevant authority: require the entity to have a constitution, charter and memorandum (and
articles) of association
Constitution: authorization for the corporation to issue a certain number of shares
Share: Basic unit of ownership for a corporation
 Ultimate control of the corporation rests with the shareholders  elect a board of directors that
sets company policies and appoints officers
 The board elects a chairperson/ chairman who usually is the most influential person in the
organization  may be involved in the running of the corporation as the CEO or be independent
appointing someone else as CEO (may also designate a COO)

SHAREHOLDERS’ RIGHTS
 Ownership of shares entitles shareholders to four basic rights, unless a specific right is withheld
by agreement with the shareholders

FOUR BASIC RIGHT OF SHAREHOLDERS

1. Vote. The right to participate in management by voting on matters that come before the
shareholders, usually in an annual general meeting (AGM)  one vote for each share owned
2. Dividends. The right to receive a proportionate part of any dividend
3. Liquidation. The right to receive a proportionate share of any assets remaining after the
corporation pays its liabilities in liquidation (Liquidation means to go out of business, sell the
assets, pay all liabilities, distribute any remaining cash to the owners)
4. Preemption. The right to maintain one’s proportionate ownership in the corporation 
Preemptive right
3. SHAREHOLDERS’ EQUITY

Shareholders’ Equity: represents the shareholders´ residual ownership interest in the assets of a
corporation after deducting all liabilities from total assets  divided into two major parts:

1. Paid in capital (contributed capital/share capital): the amount of shareholders’ equity the
shareholders have contributed to the corporation, including the share´s par values and any
additional paid-in capital
2. Retained Earnings: the amount of shareholders’ equity the corporation has earned through
profitable operations and has not used for dividends

 Companies report both separately because the declaration of cash dividends from paid-in capital
is prohibited, thus cash dividends are declared from retained earnings

 Corporation issues share certificates to its owners when the company receives their investment
in the business  includes the company name, shareholder name, number of shares & par value
of share (usually electronic)
 Because shares represent the corporation’s capital, it is often called share capital

CLASSES OF SHARES
 “stock” is often used as a synonym for shares
 Shares of a corporation may be either ordinary/ preference shares or with/ without par values

ORDINARY AND PREFERENCE SHARES

Ordinary shares (common stock): the basic form of share capital
 Unless stated otherwise, the word share is understood to mean ordinary share
 Ordinary shareholders have the four basic shareholder rights, as mentioned above  they are
the owners of the corporation and stand to benefit the most if the corporation succeeds because
they take the most risk

PREFERENCE SHARES
Preference shares: give their owners certain advantages over ordinary shareholders
 Companies may issue different classes of preference shares

ADVANTAGES FOR PREFERENCE SHAREHOLDERS

1. Priority to receive dividends as well as assets (if the corporation enters into liquidation) before
the ordinary shareholders
2. Have the four basic shareholder rights and may have additional features that make it something
of a hybrid between ordinary shares and long-term debt
3. Preference shareholders expect to earn a fixed dividend on their investments, but the dividend is
not required to be paid unless the board of directors declares the dividend

 Companies have no obligation to pay back true preference shares, unless they are designated as
redeemable preference shares
Redeemable preference shares: A corporation reserves the right to buy an issue of shares back from
its shareholders with the intent to retire the share

PAR VALUE AND NO-PAR SHARES

Par value: an arbitrary nominal amount assigned by a company to its share. Most companies set the
par value of their shares low to avoid legal difficulties from issuing their shares below par
 Shares may be Par Value or No-Par Value Shares depending on the applicable regulatory
framework

VOTING RIGHTS
 Companies may have different classes of shares with different voting rights

3. ISSUING SHARES
 Corporations may sell shares directly to the shareholder or use the service of an underwriter
 Companies often advertise the issuance of their shares to attract investors  they are
colloquially called “tombstones” (Wall Street Journal as most popular platform)
 Announcements include: Number of shares offered to the public, Company issuing the shares,
Class of shares, Par value per share, Issue price: the amount per share that the company received
for the share, Lead US underwriter, Lead International Underwriter

ORDINARY SHARES
ORDINARY SHARES AT PAR
 The assets and shareholder’s equity increase by the same amount, when shares are issued
 cash increases on the debit side and ordinary shares increase on the credit side by the same
amount

ORDINARY SHARES ABOVE PAR

 Most corporations set par values low and issue ordinary shares for a price above par
 The difference between the issue price and the par value is additional paid-in capital (or capital
in excess of par or share premium)  both the par value of the share and the additional amount
are part of paid-in capital
 Cash increases on the debit side and ordinary shares and paid in capital in excess of par increase
on the credit side
 A company neither earns a profit nor incurs a loss when it sells its shares to, or buys its shares
from, its own shareholders  issuance of shares is not gain, income or profit
 Assets and equity increase by the same amount  only difference is that on the equity side the
corporation pays in two accounts

ORDINARY SHARES WITH NO-PAR VALUES

 To record the issuance of no-par shares, the company debits the assets received and credits the
share capital for the cash value of the assets received (Issuance recorded with Share Capital only)

SHARES ISSUED FOR ASSETS OTHER THAN CASH

 the company records the assets received (e.g. Building, Equipment) at their current market value
and credits the share capital and additional paid-in capital accounts accordingly
 The assets’ prior book value is not relevant because the shareholders will demand shares equal
to the market value of the asset contributed

ORDINARY SHARES ISSUED FOR SERVICES

 Sometimes a corporation will issue shares in exchange for service rendered, either by employees
or outsiders
 No cash is exchanged  transaction should be recognized at fair market value
 Share capital is increased for its par value and additional paid-in capital in increased for any
difference
 Debit Services Rendered (e.g. Website development) and credit Ordinary Shares (par value, if
any) as well as Paid-in Capital in Excess of Par  in this case retained earnings (SE) is decreased
and paid-in-capital is increased (SE) for the same amount

SHARE ISSUANCE FOR OTHER THAN CASH CAN CREATE AN ETHICAL CHALLENGE
 Companies are required to record its shares at the fair market value of whatever the corporation
receives in exchange for the shares
 When receiving cash, there is clear evidence of the value of the shares because cash is worth its
face value
 When receiving an asset other than cash, the value of the asset can create an ethical challenge
 may be worth millions or may be worthless

TWO TAKE-AWAY LESSONS

1. Some accounting values better represent the underlying economic phenomenon than others
2. Not all financial statements mean exactly what they say—compliance with accounting standards
and an audit by an independent CPA lend more credibility to the financial reporting process

PREFERENCE SHARES
 When a company issues preference share, it credits the Preference Share Account at its par
value, with any excess credited to Paid-in Capital in excess of Par
 Many companies combine paid-in capital in excess of par from both preference and ordinary
share transactions into once account
 Accounting for no-par preference shares follows the pattern for no-par ordinary shares
 Preference shares may be convertible to ordinary shares, for this: Debit Preference Share Capital
and Credit Ordinary Share Capital with the amount of your preference share capital (to record
conversion of preference shares into ordinary shares)

4. AUTHORIZED, ISSUED AND OUTSTANDING SHARES

 important to distinguish among three distinctly different numbers in relation to a company’s

shares:

1. Authorized share capital: maximum number of shares the company can issue under its
constitution
2. Issued shares: number of shares the company has issued to its shareholders
3. Outstanding shares: number of shares that the shareholders own. Outstanding shares are issued
shares minus treasury shares

4. TREASURY SHARES

Treasury Shares: A company’s own shares that it has issued and later reacquired
 Corporations hold these shares in its treasury

REASONS WHY CORPORATIONS BUY BACK THEIR SHARES

1. It offers employee share option compensation or an employee share ownership plan but it does
not wish to issue new shares  buys the shares from the market and passes them to employees
2. The management wants to avoid a takeover by an outside party
3. The management wants to increase its reported earnings per share or EPS

HOW IS TREASURY SHARE RECORDED?

 Purchases of Treasury Shares: Reacquired shares are classified as treasury shares and presented
as a deduction from total equity, treasury shares are recorded at cost (the market value of the
share on the purchase date)
 The treasury shares account is a contra shareholder’s equity account  carries a debit balance
 reported on the balance sheet as a negative amount

Treasury Shares (Contra SE Account) (SE-) 5,000,000

Cash (A-) 5,000,000
To record purchases of treasury shares

 The purchase pf treasury shares has the opposite effect of issuing shares: Issuing shares grows
assets and equity, Purchasing treasury shares shrinks assets and equity
RESALE OF TREASURY SHARES
 Resale of Treasury Shares: Reselling treasury shares grows assets and equity exactly as issuing
new shares does
 The company never records gains or losses on transactions involving its own treasury shares 
amounts received in excess of amounts originally paid for treasury shares are recorded as paid-in
capital from treasury share transactions, thus bypassing the income statement
 If the proceeds from the resale of treasury shares were less than the amounts originally paid to
acquire them, the difference would be debited to paid-in-capital

If the amount from the resale were more than originally paid:
Cash (A+) 6,000,000
Treasury Shares (SE+) 5,000,000
Share Capital (SE+) 1,000,000
To record resale of treasury shares

If the amount from the resale were less than originally paid:
Cash (A+) 4,000,000
Share Capital (SE-) 1,000,000
Treasury Shares (SE+) 5,000,000
To record resale of treasury shares

ISSUING TREASURY SHARES AS COMPENSATION

 most common use of treasury shares

Share Option Compensation 2,400,000

Treasury Shares 2,400,000
To record reissuance of treasury shares for employee share options

RETIRING TREASURY SHARES

 A corporation may purchase its own share and retire it by canceling the shares  retired shares
cannot be reissued and will permanently reduce the amount of outstanding shares

Share Capital 1,500,000

Treasury Shares 1,500,000
To record cancellation of shares from treasury shares

4. RETAINED EARNINGS, DIVIDENDS AND SPLITS

Retained Earnings: profits from prior periods that have not been distributed to owners, carries the
balance of the business´ net income, less its net losses and less any declared dividends that have
been accumulated over the corporation´s lifetime  says nothing about the cash balance
 Not a reservoir of cash for paying dividends to shareholders  corporation may have a large
amount of retained earnings but not enough cash to pay a dividend
 Credit balance in retained earnings is normal, indicating that the corporation’s lifetime earnings
exceed lifetime losses and dividends
 Debit balance arises when a corporation’s lifetime losses and dividends exceed lifetime earnings
 Cash and Retained Earnings are two entirely separate accounts with no particular relationship.

Deficit: When a corporation’s lifetime losses and dividends exceed lifetime earnings, this amount is
subtracted (debit side of retained earnings) to determine total shareholders’ equity

SHOULD THE COMPANY DECLARE AND PAY CASH DIVIDENDS?

Dividends: distribution by a corporation to its shareholders usually based on earnings. Usually take
one of three forms:
1. Cash
2. Shares
3. Non-cash assets

 For a non-cash dividend, debit Retained Earnings, credit the asset for the current market value
oft he asset

CASH DIVIDENDS
 Most common
 To give out cash dividends, a company must have both:
1. Enough Retained Earnings to declare the dividends
2. Enough Cash to pay the dividend

Final dividend: the dividend that follows the end of the financial year when financial results are
published and the corporation’s annual general meeting (AGM) is held  recommended by the
board but is not payable until the shareholders vote to do so
Interim dividends: are paid during the financial year  declared by the board and become payable
immediately

THREE RELEVANT DATES FOR DIVIDENDS

1. Declaration Date: announcement by the board of directors, creates a liability for interim
dividends, recorded by debiting retained earnings and crediting dividends payable
2. Date of Record: follows declaration date by a few weeks, Shareholders on the record date
will receive the dividend, No journal entry
3. Payment Date: Follows record date by a week or two, recorded by debiting Dividends
payable and crediting cash
 net effect of a dividend declaration and its payment is a decrease in assets and a corresponding
decrease in shareholder’s equity

DIVIDENDS ON PREFERENCE SHARES

 Preference shareholders receive their dividend first  ordinary shareholders receive dividends
only if the total dividend is large enough to pay the preference shareholders first
 Dividends for preference shares are usually labeled as a percentage of par value, if the
preference share is a no-par share, then it will be based on the share’s issuance price

DIVIDENDS ON CUMULATIVE AND NON-CUMULATIVE PREFERENCE SHARES

 Preference Shareholders are typically promised a fixed return for their investments but
corporations sometimes fail to pay a dividend to preference shareholders  called passing the
dividend, and the passed dividends are said to be in arrears
 Sometimes preference shares are automatically “cumulative”  The owners of cumulative
preference shares must receive all dividends in arrears plus the current year’s dividend before
any dividends go to ordinary shareholders
 Although cumulative dividends must be paid before other dividends, they must still be declared
by the company´s board of directors
 If the preference share is non-cumulative, the corporation is not obligated to pay dividends in
arrears – until the board of directors declares the dividend
 Entry to record the declaration of a cumulative preference share: debit Retained Earnings (by the
amount of all Dividends), credit Dividends Payable, Preference (by the cumulative amount +
current dividends) and credit Dividends Payable, Ordinary (by the amount remaining)

SHARE DIVIDEND
Share dividend: a proportional distribution by a corporation of its own shares to its shareholders.
Share dividends increase the Share Capital account and decrease Retained Earnings (Total Equity is
unchanged and no asset or liability is affected)
 are distributed to shareholders in proportion to the number of shares they already own

REASONS WHY A CORPORATIONS MAY CHOOSE TO DISTRIBUTE SHARE DIVIDENDS

1. To continue dividends but conserve cash
2. To reduce the market price of its share (Due to the increased number of shares outstanding) 
to make the shares more attractive to more investors

STOCK SPLITS
Stock Split: increase in the number of shares authorized, issued and outstanding, coupled with a
proportionate reduction in the share’s par value
 Decreases the market price of the share – with the intention of making the share more attractive
in the market
 A lower share price also allows a more active and liquid market
2-FOR-1 STOCK SPLIT MEANS
 The company will have twice as many shares authorized, issued and outstanding after the split as
it had before,
 Each share’s par value will be cut in half
 All account balances are the same after the stock split as before, only three items will be
affected:
1. Par value per share
2. Shares authorized
3. Shares issued