6 Equity

L E A R N IN G O B J E C T IV E S

LEARNING OBJECTIVES
After studying this chapter, you should be able to:

1. Discuss the characteristics of 5. Explain the accounting for and reporting

the corporate form of of preference shares.
organization. 6. Describe the policies used in
distributing dividends.
2. Identify the key components of equity.
7. Identify the various forms of dividend
3. Explain the accounting procedures for
distributions.
issuing shares.
8. Explain the accounting for share
4. Describe the accounting for treasury
dividends and share splits.
shares.
9. Indicate how to present and analyze
15-1
equity.
 CORPORATE FORM OF ORGANIZATION

Three primary forms of business organization.

Proprietorship Partnership Corporation

Special characteristics of the corporate form:

1. Influence of corporate law.
2. Use of the share system.
3. Development of a variety of ownership interests.

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 CORPORATE FORM OF ORGANIZATION

Corporate Law
 Corporation must submit articles of incorporation to the
appropriate governmental agency for the country in which
incorporation is desired.
 Governmental agency issues a corporation charter.
 Advantage to incorporate where laws favor the corporate
form of business organization.

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 CORPORATE FORM OF ORGANIZATION

Share System
In the absence of restrictive provisions, each share carries
the following rights:
1. To share proportionately in profits and losses.

2. To share proportionately in management (the right to vote

for directors).

3. To share proportionately in assets upon liquidation.

4. To share proportionately in any new issues of shares of

the same class—called the preemptive right.

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 CORPORATE FORM OF ORGANIZATION

Variety of Ownership Interests

Ordinary shares represent the residual corporate interest.
 Bears ultimate risks of loss.
 Receives the benefits of success.
 Not guaranteed dividends nor assets upon dissolution.

Preference shares are created by contract, when shareholders’

sacrifice certain rights in return for other rights or privileges,
usually dividend preference.

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 EQUITY

Equity is often subclassified on the statement of financial

position into the following categories
1. Share capital.

2. Share premium.

3. Retained earnings.

4. Accumulated other comprehensive income.

5. Treasury shares.

6. Non-controlling interest (minority interest).

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 EQUITY

Ordinary
OrdinaryShares
Shares
Account
Account
Contributed
Contributed Share
SharePremium
Premium
Capital
Capital Account
Account
Preference
PreferenceShares
Shares
Account
Account

Two Primary
Sources of Retained
RetainedEarnings
Earnings
Account
Account
Equity Assets –
Liabilities =
Less:
Less: Equity
Treasury
TreasuryShares
Shares
Account
Account

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 EQUITY

Issuance of Shares
Accounting problems involved in the issuance of shares:
1. Par value shares.

2. No-par shares.

3. Shares issued in combination with other securities.

4. Shares issued in non-cash transactions.

5. Costs of issuing shares.

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 EQUITY

Par Value Shares

Low par values help companies avoid a contingent liability.

Corporations maintain accounts for:

 Preference Shares or Ordinary Shares.
 Share Premium.

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 EQUITY

No-Par Shares
Reasons for issuance:
 Avoids contingent liability.
 Avoids confusion over recording par value versus fair
market value.

A major disadvantage of no-par shares is that some countries levy

a high tax on these issues. In addition, in some countries the total
issue price for no-par shares may be considered legal capital,
which could reduce the flexibility in paying dividends.

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 EQUITY

Illustration: Video Electronics Corporation is organized with

10,000 ordinary shares authorized without par value. If Video
Electronics issues 500 shares for cash at €10 per share, it
makes the following entry.

Cash 5,000
Share Capital—Ordinary 5,000

Video Electronics issues another 500 shares for €11 per share.
Cash 5,500
Share Capital—Ordinary 5,500

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 EQUITY

Illustration: Some countries require that no-par shares have a

stated value. If a company issued 1,000 of the shares with a €5
stated value at €15 per share for cash, it makes the following
entry.

Cash 15,000
Share Capital—Ordinary 5,000
Share Premium—Ordinary 10,000

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 EQUITY

Shares Issued with Other Securities

Two methods of allocating proceeds:
 Proportional method.
 Incremental method.

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 EQUITY
BE15-4: Ravonette Corporation issued 300 shares of $10 par value
ordinary shares and 100 shares of $50 par value preference shares
for a lump sum of $13,500. The ordinary shares have a market value
of $20 per share, and the preference shares have a market value of
$90 per share.

Number Amount Total Percent

Ordinary shares 300 x $ 20.00 = $ 6,000 40%
Preference shares 100 x 90.00 9,000 60%
Fair Market Value $ 15,000 100%

Allocation: Ordinary Preference

Issue price $ 13,500 $ 13,500 Proportional
Allocation % 40% 60% Method
Total $ 5,400 $ 8,100

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 EQUITY
BE15-4: Ravonette Corporation issued 300 shares of $10 par value
ordinary shares and 100 shares of $50 par value preference shares
for a lump sum of $13,500. The ordinary shares have a market value
of $20 per share, and the preference shares have a market value of
$90 per share.

Journal entry (Proportional):

Cash 13,500
Share Capital—Preference (100 X $50) 5,000
Share Premium—Preference 3,100
Share Capital—Ordinary (300 X $10) 3,000
Share Premium—Ordinary 2,400

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 EQUITY
BE15-4 (Variation): Ravonette Corporation issued 300 shares of $10
par value ordinary shares and 100 shares of $50 par value preference
shares for a lump sum of $13,500. The ordinary shares have a market
value of $20 per share, and the value of preference shares are unknown.

Number Amount Total

Ordinary shares 300 x $ 20.00 = $ 6,000
Preference shares 100 x -
Fair Market Value $ 6,000

Allocation: Ordinary Preference

Issue price $ 13,500
Incremental
Ordinary (6,000) Method
Total $ 6,000 $ 7,500

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 EQUITY
BE15-4 (Variation): Ravonette Corporation issued 300 shares of $10
par value ordinary shares and 100 shares of $50 par value preference
shares for a lump sum of $13,500. The ordinary shares have a market
value of $20 per share, and the value of preference shares are unknown.

Journal entry (Incremental):

Cash 13,500
Share Capital—Preference (100 X $50) 5,000
Share Premium—Preference 2,500
Share Capital—Ordinary (300 X $10) 3,000
Share Premium—Ordinary 3,000

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 EQUITY

Shares Issued in Noncash Transactions

The general rule: Companies should record shares
issued for services or property other than cash at the
 fair value of the goods or services received.
 If the fair value of the goods or services cannot be
measured reliably, use the fair value of the shares
issued.

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 EQUITY

Illustration: The following series of transactions illustrates

the procedure for recording the issuance of 10,000 shares of
€10 par value ordinary shares for a patent for Marlowe
Company, in various circumstances.

1. Marlowe cannot readily determine the fair value of the

patent, but it knows the fair value of the shares is €140,000.

Patent 140,000
Share Capital—Ordinary 100,000
Share Premium—Ordinary 40,000

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 EQUITY

2. Marlowe cannot readily determine the fair value of the

shares, but it determines the fair value of the patent is
€150,000.

Patent 150,000
Share Capital—Ordinary 100,000
Share Premium—Ordinary 50,000

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 EQUITY

3. Marlowe cannot readily determine the fair value of the

shares nor the fair value of the patent. An independent
consultant values the patent at €125,000 based on discounted
expected cash flows.

Patent 125,000
Share Capital—Ordinary 100,000
Share Premium—Ordinary 25,000

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 EQUITY

Costs of Issuing Stock

Direct costs incurred to sell shares, such as
 underwriting costs,
 accounting and legal fees,
 printing costs, and
 taxes,
should reduce the proceeds received from the sale of
the shares.

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 EQUITY

Reacquisition of Shares
Corporations purchase their outstanding shares to:
 Provide tax-efficient distributions of excess cash to
shareholders.
 Increase earnings per share and return on equity.
 Provide shares for employee compensation contracts or to
meet potential merger needs.
 Thwart takeover attempts or to reduce the number of
shareholders.
 Make a market in the shares.
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 EQUITY

Purchase of Treasury Shares

Two acceptable methods:
 Cost method (more widely used).
 Par or Stated value method.

Treasury shares reduce equity.

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 EQUITY

Illustration: Pacific Company issued 100,000 shares of $1 par

value ordinary shares at a price of $10 per share. In addition, it
has retained earnings of $300,000.

ILLUSTRATION 15-4
Equity with No Treasury
Shares

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 EQUITY

Illustration: Pacific Company issued 100,000 shares of $1

par value ordinary shares at a price of $10 per share. In
addition, it has retained earnings of $300,000.
On January 20, 2015, Pacific acquires 10,000 of its shares at
$11 per share. Pacific records the reacquisition as follows.

Treasury Shares 110,000

Cash 110,000

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 EQUITY

Illustration: The equity section for Pacific after purchase of the

treasury shares.

ILLUSTRATION 15-5
Equity with Treasury
Shares

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 EQUITY

Sale of Treasury Shares

 Above Cost
 Below Cost

Both increase total assets and equity.

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 EQUITY

Sale of Treasury Shares above Cost. Pacific acquired

10,000 treasury shares at $11 per share. It now sells 1,000
shares at $15 per share on March 10. Pacific records the entry
as follows.

Cash 15,000
Treasury Shares 11,000
Share Premium—Treasury 4,000

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 EQUITY

Sale of Treasury Shares below Cost. Pacific sells an

additional 1,000 treasury shares on March 21 at $8 per share,
it records the sale as follows.

Cash 8,000
Share Premium—Treasury 3,000
Treasury Shares 11,000

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 EQUITY

ILLUSTRATION 15-6
Treasury Share
Transactions in Share
Premium—Treasury
Account

Illustration: Assume that Pacific sells an additional 1,000 shares

at $8 per share on April 10.

Cash 8,000
Share Premium—Treasury 1,000
Retained Earnings 2,000
Treasury Shares 11,000
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 EQUITY

Retiring Treasury Shares

Decision results in
 cancellation of the treasury shares and
 a reduction in the number of shares of issued shares.

Retired treasury shares have the status of authorized and

unissued shares.

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 PREFERENCE SHARES

Features often associated with preference shares.

1. Preference as to dividends.

2. Preference as to assets in the event of liquidation.

3. Convertible into ordinary shares.

4. Callable at the option of the corporation.

5. Non-voting.

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 PREFERENCE SHARES

Features of Preference Shares

 Cumulative
A corporation may attach
 Participating whatever preferences or
 Convertible restrictions, as long as it does
not violate its
 Callable country’s incorporation law.
 Redeemable

The accounting for preference shares at issuance is similar

to that for ordinary shares.

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 PREFERENCE SHARES

Illustration: Bishop Co. issues 10,000 shares of £10 par

value preference shares for £12 cash per share. Bishop
records the issuance as follows:

Cash 120,000
Share Capital—Preference 100,000
Share Premium—Preference 20,000

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 DIVIDEND POLICY

Few companies pay dividends in amounts equal to

their legally available retained earnings. Why?
 Maintain agreements with creditors.
 Meet corporation requirements.
 To finance growth or expansion.
 To smooth out dividend payments.
 To build up a cushion against possible losses.

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 DIVIDEND POLICY

Financial Condition and Dividend Distributions

 Before declaring a dividend, management must
consider availability of funds to pay the dividend.
 Should not pay a dividend unless both the present and
future financial position warrant the distribution.

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 DIVIDEND POLICY

Types of Dividends

1. Cash dividends. 3. Liquidating dividends.

2. Property dividends. 4. Share dividends.

All dividends, except for share dividends, reduce the total

equity in the corporation.

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 DIVIDEND POLICY

Cash Dividends
 Board of directors vote on the declaration of cash
dividends.
 A declared cash dividend is a liability.

 Companies do not Three dates:

declare or pay cash a. Date of declaration
dividends on treasury b. Date of record
shares.
c. Date of payment

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 DIVIDEND POLICY

Illustration: Roadway Freight Corp. on June 10 declared a cash

dividend of 50 cents a share on 1.8 million shares payable July
16 to all shareholders of record June 24.

At date of declaration (June 10)

Retained Earnings 900,000
Dividends Payable 900,000

At date of record (June 24) No entry

At date of payment (July 16)

Dividends Payable 900,000
Cash 900,000

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 DIVIDEND POLICY

Property Dividends
 Dividends payable in assets other than cash.
 Restate at fair value the property it will distribute,
recognizing any gain or loss.

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 DIVIDEND POLICY

Illustration: Tsen, Inc. transferred to shareholders some of its

investments (held-for-trading) in securities costing HK$1,250,000
by declaring a property dividend on December 28, 2014, to be
distributed on January 30, 2015, to shareholders of record on
January 15, 2015. At the date of declaration the securities have a
fair value of HK$2,000,000. Tsen makes the following entries.

At date of declaration (December 28, 2014)

Equity Investments 750,000
Unrealized Holding Gain or Loss—Income 750,000
Retained Earnings 2,000,000
Property Dividends Payable 2,000,000

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 DIVIDEND POLICY

Illustration: Tsen, Inc. transferred to shareholders some of its

investments (held-for-trading) in securities costing HK$1,250,000
by declaring a property dividend on December 28, 2014, to be
distributed on January 30, 2015, to shareholders of record on
January 15, 2015. At the date of declaration the securities have a
fair value of HK$2,000,000. Tsen makes the following entries.

At date of distribution (January 30, 2015)

Property Dividends Payable 2,000,000
Equity Investments 2,000,000

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 DIVIDEND POLICY

Liquidating Dividends
Any dividend not based on earnings reduces amounts
paid-in by shareholders.

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 DIVIDEND POLICY

Illustration: McChesney Mines Inc. issued a “dividend” to its

ordinary shareholders of £1,200,000. The cash dividend
announcement noted that shareholders should consider £900,000
as income and the remainder a return of capital. McChesney Mines
records the dividend as follows.

Date of declaration
Retained Earnings 900,000
Share Premium—Ordinary 300,000
Dividends Payable 1,200,000

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 DIVIDEND POLICY

Illustration: McChesney Mines Inc. issued a “dividend” to its

ordinary shareholders of £1,200,000. The cash dividend
announcement noted that shareholders should consider £900,000
as income and the remainder a return of capital. McChesney Mines
records the dividend as follows.

Date of payment
Dividends Payable 1,200,000
Cash 1,200,000

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 DIVIDEND POLICY

Share Dividends
 Issuance by a corporation of its own shares to shareholders
on a pro rata basis, without receiving any consideration.
 Par value, not the fair value, is used to record the share
dividend.
 Share dividend does not affect any asset or liability.
 Journal entry reflects a reclassification of equity.
 Ordinary share dividend distributable reported in the equity
section as an addition to share capital—ordinary.

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 DIVIDEND POLICY

Illustration: Vine Corporation has outstanding 1,000 shares of £1

par value ordinary shares and retained earnings of £50,000. If Vine
declares a 10 percent share dividend, it issues 100 additional shares
to current shareholders. If the fair value of the shares at the time of
the share dividend is £8 per share, the entry is:

Date of declaration

Retained Earnings 10,000

Ordinary Share Dividend Distributable 10,000

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 DIVIDEND POLICY

Illustration: Vine Corporation has outstanding 1,000 shares of £1

par value ordinary shares and retained earnings of £50,000. If Vine
declares a 10 percent share dividend, it issues 100 additional shares
to current shareholders. If the fair value of the shares at the time of
the share dividend is £8 per share, the entry is:

Date of distribution

Ordinary Share Dividend Distributable 10,000

Share Capital—Ordinary 10,000

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 DIVIDEND POLICY

Share Splits
 To reduce the market value of shares.
 No entry recorded for a share split.
 Decrease par value and increased number of
shares.

ILLUSTRATION 15-13
Effects of a Share Split

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 DIVIDEND POLICY

Share Split and Share Dividend Differentiated

A share split differs from a share dividend. How?
 A share split increases the number of shares
outstanding and decreases the par or stated value per
share.
 A share dividend,
► increases the number of shares outstanding.
► does not decrease the par value.
► increases the total par value of outstanding shares.

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 PRESENTATION AND ANALYSIS

Presentation of Equity ILLUSTRATION 15-16

Comprehensive Equity
Presentation

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 PRESENTATION AND ANALYSIS

Presentation of Statement of Changes in Equity

ILLUSTRATION 15-17
Statement of Changes
in Equity
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