Chapter 10: Reporting and Analyzing Shareholder's Equity

Question 1

What unique characteristics does a corporation have?(Super important)

Answer 1

-A corporation is a form of business organization.
-A corporation serves as a separate legal, tax, and accounting entity with a legal identity that is distinct from it’s owners.
-A corporation conducts business with the rights, duties, and responsibilities of a person.
-A corporation’s shareholders are subject to limited liability.

Question 2

What are the advantages of a corporation?

Answer 2

1) Can raise more capital because both small and large investors can participate in ownership.
2) It’s easy to transfer ownership.
3) Shareholder’s incur a limited amount of liability

Question 3

What are the disadvantages of a corporation?

Answer 3

1) The corporation can sue and be sued.
2) Ownership is separated from management, and their interests can often conflict.
3) Government regulation compliance needs
4) Double taxation-Income is taxed at the corporate level first, and then taxed a second time at the shareholder’s level.

Question 4

What is sole proprietorship?

Answer 4

Sole proprietorship is an unincoporated business owned by one person. There are no “company taxes.” Taxes are paid once on the owner’s personal income tax return. Sole proprietors include accountants, doctors, and lawyers.

Question 5

What are the advantages of sole proprietorship?

Answer 5

1) Ease of formation
2) Complete control by the partners
3) No income taxes on the business

Question 6

What are the disadvantages of sole proprietorship?

Answer 6

1) Unlimited liability: Each partner is personally responsible for the business’s debts.
2) Creditors can seize personal assets if business debts exceed available funds.

Question 7

What is the typical organizational structure of a company?

Answer 7

-Shareholder’s, owners of voting shares, elect the board of directors.
-The board of directors, including internal (managers) and external (non-managers) appoints the president.
-The president employs the vice-president of production, marketing, finance, and the controller.

Question 8

What is shareholder’s equity composed of?

Answer 8

1) Contributed capital
2) Earned capital(retained earnings)
3) Accumulated Other Comprehensive Income
4) Treasury Shares or Repurchased Shares

Question 9

What falls under contributed capital?

Answer 9

1) Preferred Stock
2) Common Stock(which includes par value and additional paid in capital or contributed surplus)
3) Options, Warrants, Rights, and Convertibles

Question 10

What is shareholder’s equity fundamentally?

Answer 10

-Shareholder’s equity is the residual claim on assets after settling claims of creditors (ie., assets-liabilities)

Question 11

What is the formula for ending retained earnings?

Answer 11

Ending Retained Earnings=Beginning Retained Earnings+Net Income-Dividends

Question 12

What is accumulated other comprehensive income?

Answer 12

Items that bypass the income statement

Question 13

What is preferred stock?

Answer 13

-Preferred stock has less claim on assets than debt holder, but more claim on assets than common stockholders.
-They do not get voting rights, but pay a fixed dividend that must be paid before common dividends.
-May be callable, convertible, or redeemable.

Question 14

What is a callable bond?

Answer 14

A callable bond is a type of bond that gives the issuer the right to redeem the bond before its maturity date at a predetermined price.

Question 15

What is a redeemable bond?

Answer 15

A redeemable bond is a bond that can be bought back by the issuer before the maturity date, if certain conditions are met.

Question 16

What is a convertible bond?

Answer 16

A convertible bond is a form of debt that can be converted into equity in the form of shares if the company’s share price rises above a certain point.

Question 17

What is common stock?

Answer 17

-The most common type of stock with voting rights, but less claim to assets.

Question 18

What is par value?

Answer 18

-Stated value on shares used to compute balance in Common Stock or Preferred stock, but there is no par value for many Canadian corporations
-It’s the minimum amount a company must save to give to it’s investors in case of tough times.

Question 19

What is additional paid in capital or contributed surplus?

Answer 19

-Amount received by company for shares in excess of par value.

Question 20

What are authorized shares?(super important)

Answer 20

-Authorized shares are the maximum number of shares that can be issued.

Question 21

What are outstanding shares?

Answer 21

-The number of shares currently owned by shareholders, minus the total number of un-issued shares, minus the number of treasury share repurchases.
-Outstanding shares serve as the basis for dividends per share and earnings per share.

Question 22

Why would a company issue preferred stock?

Answer 22

-Preferred shares have no voting rights
-Preferred shareholders are paid a fixed dividend rate and any excess in profits goes to the common shareholder.

Question 23

What are the six types of preferred stock?

Answer 23

1) Cumulative preferred stock
-Ensures that shareholders receive all past dividends and current dividends before the common shareholders.
-Unpaid dividends called dividends in arrears appear on the balance sheet as a liability. If the company skips dividends in one year, they must pay them in the future before paying common shareholders.
2) Non-Cumulative Preferred Stock
-Shareholders of non-cumulative preferred stock are only entitled to the current periods dividends. If the company skips dividends in previous years, those dividends are lost.
3) Participating preferred stock/partially participating preferred stock
-Preferred shareholders may get additional dividends in excess of the stated amount.
4) Convertible preferred shares
-Can be converted into common shares.
-Have priority in distribution of dividends.
-Conversion will allows preferred shareholders to share the increase in market value of common shares.
5) Redeemable preferred shares
-May be bought back by the company with fixed redemption price as debt.
6) Retractable preferred shares
-Can be sold back to company at the option of the shareholder.

Question 24

What rights do common shareholders have?

Answer 24

-Allowed to vote
-Pro-rata share of dividends-set by the Board of Directors. That means they have a right to dividends.
-Liquidation- right to share the remaining assets at
liquidation only after liabilities (creditors) and preferred
shareholder received their dividends
-Right to sell their stock
-Preemptive rights. Common shareholders have the first opportunity to buy new shares before they are offered to the public.

Question 25

What are treasury shares?

Answer 25

-Issued shares that have been repurchased by the corporation.

Question 26

What is the declaration date? What entry do we make on the declaration date?

Answer 26

-The date when the board of directores declares the dividend, and announces their intention to pay that dividend. -DR Dividends Declared(-SE) -CR Dividends Payable(+L)

Question 27

What is the date of record? What entry do we record on the date of record?

Answer 27

-Shereholders holding shares on the date of record will receive a dividend. -During the date of record no entry is made.

Question 28

What is the date of payment? What journal entry is recorded on the date of payment.

Answer 28

-The date of payment is the actual date when shareholders are paid. -This day usually follows the date of record by 2 to 4 weeks. -DR Dividends Payable(-L) -CR Cash(-A)

Question 29

What are the two conditions necessary for the declaration of cash dividends? What else should you know about cash dividends?

Answer 29

1) Sufficient retained earnings 2) Sufficient cash -The board of directors declares and approves cash dividends.

Question 30

What is the formula for dividend yield ratio? What does it measure? When is this ratio used?

Answer 30

-Dividend Yield Ratio=Dividends per share/Market price per share -The dividend yield ratio shows for every dollar invested, the percentage of dividends that it gives the share purchaser. -This ratio is often used to compare the dividend-paying performance of different investment alternatives-say compare to the interest received on a long term receivable.

Question 31

What is the formula for retained earnings at the end of the period?

Answer 31

Retained earnings(end of period)=Retained earnings beginning of period-Cash dividends+Net income

Question 32

What is a stock dividend?

Answer 32

-While a cash dividend reduces both assets and sherholder's equity, a stock dividend has no effect on asset, liabilities, or total shareholder's equity. -Stock dividends are a transfer from retained earnings to common stock. -Each shareholder retains the same percentage ownership in the company. -Stock dividends can help keep down the market price of the stock, making it available to more investors.

Question 33

How do you calculate share price when stock dividends have been issued?

Answer 33

-If the stock dividend is less than 20-25%, use current market price of the shares. -If the stock dividend is greater than 20-25%, use the average issue price per share.

Question 34

What is a stock split?

Answer 34

-A stock split occurs when each common share is replaced with a given number of new common shares. -This often reduces the market price of the stock, and may result in more trading activity at the lower price as less wealthy people are now able to buy that stock. -A stock split does not affect any of the 3 main financial statements, however, it does affect number of shares authorized, issued and outstanding.

Question 35

Do companies pay out cash dividends for treasury stock?

Answer 35

No

Question 36

When calculating the par value of shares, do we look at shares outstanding or shares issued?

Answer 36

We look at shares issued.

Question 37

What is the difference between current dividend preference and cumulative dividend preference?

Answer 37

-Current dividend preference is the preferred dividends that must be paid before paying any dividends to common shares. -Cumulative dividend preference include any dividends from previous years (dividends in arrears) which must be paid before common dividends can be paid.

Question 38

What is the difference between common stock and preferred stock?

Answer 38

1) While preferred shares have states dividends, common shares do not. 2) Preferred shares might have voting rights, while common shares usually have voting rights. 3) In the event of liquidation, preferred shares have priority to receive assets. 4) While preferred shares will either be cumulative or not, common shares will certainly not be cumulative.

Question 39

What is the difference between common stock, preferred stock, and long term debt.

Answer 39

1) What is the investment risk: Common stock carries high risk. Preferred stock carries medium risk. Long term debt carries low risk. 2) What is the issuer's expectation that principal is repaid: Common stock holders and preferred stockholders don't expect to have their principal repaid, while long term debt holders do have that expectation. 3) Do they pay dividends or interest: Common stock and preferred stock pays dividends. Meanwhile, long term debt carries a tax deductible interest expense. 4) What is the corporation's obligation to pay dividends or interest: With common stock and preferred stock, companies are only obligated to pay dividends after they declare them. However, long term debt must be paid at fixed dates. 5) How much does market value fluctuate under normal conditions: Common stock value fluctuates a lot, while preferred stock value fluctuates a medium amount, and long term debt has low fluctuations.

Question 40

What is treasury stock?

Answer 40

-Treasury stock is the company's share repurchases. -Companies should recognize treasury stock based on the amount paid to repurchase it's shares. -It is a reduction of shareholder's equity, acting as a contra-equity account.

Question 41

What is the accounting treatment when treasury shares are re-issued?

Answer 41

-Reissued treasury stock is removed from the treasury stock account at the original price paid to repurchase. -When there is a difference between the price paid for treasury stock and the price that treasury stock was sold for, that impact will not affect net income, because companies cannot book gains or losses trading their own stock. -A gain on the reissuance of treasury shares should be credit to additional paid in capital, while a loss should be debited to additional paid in capital.

Question 42

When a company repurchases it's shares, what is the journal entry?

Answer 42

-If there is a gain, it is credited to "contributed capital from retirement of common stock." -If there is a loss, it is debited under retained earnings, because the company is giving up their retained earnings to get cash which is less valuable than what they give up. -But before debiting retained earnings, you should first debit any additional paid in capital or contributed capital that you credited previously, to wipe out that balance.

Question 43

How is retained earnings impacted if the repurchase price is higher than the initial issue price?

Answer 43

Retained earnings is reduced.

Question 44

When are journal entries made for contributed surplus?

Answer 44

Journal entries are only made for contributed surplus on the sale of those shares, not on the purchases of the shares.

Question 45

What is contributed surplus?

Answer 45

Contributed surplus is a part of shareholder's equity and represents the amount paid by shareholder's for amounts that exceeds the share price or value.

Question 46

What is the treasury stock account?

Answer 46

The treasury stock account is a contra equity account which reduces shareholder's equity.

Question 47

What are the two types of stock based compensation?

Answer 47

1) Restricted stock plans -Restricted stock is granted directly to employees as compensation, but it often comes with restrictions, such as a vesting period or performance conditions. -Employees receive shares upfront, but may not receive them until performance conditions are met. 2) Stock Option plans -Stock options offers employees the right but not the obligation to purchase company stock at a pre-determined price, after a certain period. -The exercise price is the price at which employees can buy shares in the future, usually a higher price than the current one. This encourages employees to do what they can to improve share price. -The expiry date is the deadline by which the employee must exercise the stock options, or they will expire worthless. -The vesting period is the time employees must wait until they gain ownership of their stock based compensation, with a typical duration of 1-4 years.

Question 48

What is the formula for total compensation cost?

Answer 48

Total compensation cost=Number of options*Fair value per option

Question 49

What is the formula for annual compensation expense?

Answer 49

Annual compensation expense=Total compensation cost/vesting period

Question 50

How do cash dividends impact assets, liabilities, common shares, retained earnings, and number of shares?

Answer 50

-Assets: Decrease -Liabilities: No impact -Common shares: No impact -Retained earnings: Decrease -#of shares: no impact

Question 51

How do stock dividends impact assets, liabilities, common shares, retained earnings, and number of shares?

Answer 51

-Assets: No impact -Liabilities: No impact -Common shares: Increase -Retained earnings: Decrease -#of shares: Increase

Question 52

How does stock split impact assets, liabilities, common shares, retained earnings, and number of shares?

Answer 52

-Assets: No impact -Liabilities: No impact -Common shares: No impact -Retained earnings: No impact -#of shares: Increase

Question 53

How do stock repurchase impact assets, liabilities, common shares, retained earnings, and number of shares?

Answer 53

-Assets: Decrease -Liabilities: No impact -Common shares: Decrease -Retained earnings: Depends on how repurchase price compares to stock price. -#of shares: Decrease

Question 54

How does issuing new shares in exchange for an asset impact assets, liabilities, common shares, retained earnings, and number of shares?

Answer 54

-Assets: Increase -Liabilities: No impact -Common shares: Increase -Retained earnings: No impact -#of shares: No impact

Question 55

How does the issuance of cash dividends affect assets, liabilities, and shareholder's equity?

Answer 55

-Assets: Decrease -Liabilities: No impact -Shareholder's Equity: Decrease

Question 56

How does a stock split affect assets, liabilities and shareholder's equity?

Answer 56

-It doesn't impact any of them.

Question 57

How does a stock repurchase affect assets, liabilities, and shareholder's equity?

Answer 57

-Assets: Decrease -Liabilities: No impact. -Shareholder's equity: Decrease

Question 58

What is the formula for return on shareholders equity? What does it measure?

Answer 58

-ROE=Net income-Preferred dividends/Average shareholder's equity -It measures a company's ability to provide returns to their shareholders. -A higher number is better.

Question 59

What is the formula for Price/Earnings ratio?

Answer 59

-Price/Earnings ratio=Market price per share/Earnings per share

Question 60

What is accumulated other comprehensive income?

Answer 60

-Other comprehensive income is like retained earnings in that it starts with the opening balanced and is increased by other comprehensive income and decreases by other comprehensive losses in each period.

Question 61

What are the two conditions that must be met in order for a company to announce cash dividends?

Answer 61

-For a company to announce cash dividends: 1) Retained earnings must be above the amount of the dividend issued; 2) there must be enough cash on hand to pay for it. -Even when negative net earnings occur, cash dividends can be announced.

Question 62

What is the formula for retained earnings at the end of the year?

Answer 62

-EOY Retained Earnings=BOY Retained Earnings+Net earnings-Dividends Paid

Question 63

What is the formula for average issuance price?

Answer 63

-Average issuance price=Carrying amount of repurchased shares/#of shares -Average issue price=Amount charged to share capital/# of shares

Question 64

What is the formula to calculate how stock dividends impact retained earnings?

Answer 64

Impact on RE=Average issue price of common shares*#of shares*%stock dividend