Shareholders' Equity and Corporate Transactions: Study Notes for Financial Accounting

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Shareholders' Equity and Corporations

Learning Objectives

Explain the main features of a corporation
Account for the issuance of shares
Explain why a company repurchases shares
Account for retained earnings, dividends, and stock splits
Distinguish between fair value and book value per share
Evaluate a company's return on assets and return on equity
Report equity transactions and events in the financial statements

Corporations

A corporation is a legal entity that is separate from its owners, providing unique advantages and disadvantages compared to other business forms.

Separate legal entity: Has most rights and privileges of a person.
Classification: By purpose (profit or non-profit) and by ownership (public or private).
Advantages:
- Professional corporate management
- Limited liability of shareholders
- Transferable ownership rights
- Unlimited life
- Ability to acquire capital
- Continuous existence
Disadvantages:
- Corporation management: ownership separated from management
- Increased costs and complexity
- Additional taxes (double taxation: corporate earnings are taxed, then shareholders are taxed for dividends received)

Shareholders' Equity

Classes of Shares

Shareholders' equity represents the ownership interest in a corporation, typically in the form of shares.

Common shares: Owners have voting rights and share in profits.
Preferred shares: Holders have preference in dividends and assets upon liquidation, but usually lack voting rights.
Priority in liquidation: Secured creditors > Unsecured creditors > Preferred shareholders > Common shareholders.

Components of Shareholders' Equity

Share capital: Amount contributed by shareholders in exchange for shares.
Retained earnings: Cumulative net income not distributed as dividends.
Contributed surplus: Other contributions not included in share capital.
Other comprehensive income: Includes unrealized gains/losses on foreign exchange held.

Accounting for the Issuance of Shares

Authorized, Issued, and Outstanding Shares

Corporations specify the maximum number of shares they can issue (authorized shares). Shares sold to investors are issued shares; shares currently held by investors are outstanding shares.

Authorized shares: Maximum shares a company can issue.
Issued shares: Shares that have been sold to investors.
Outstanding shares: Issued shares minus repurchased shares.

Journal Entries for Share Transactions

Issuance of shares:
- Dr. Cash
- Cr. Common shares
Repurchase of shares:
- Dr. Common shares
- Cr. Cash

Dividends: Preferred and Common

Dividend Policy and Types

Corporations distribute profits to shareholders as dividends. Dividends can be paid on common or preferred shares, with preferred shares often having priority.

Preferred dividends: Paid first; may be cumulative (unpaid dividends accumulate).
Common dividends: Paid after preferred dividends.
Non-cumulative preferred shares: Unpaid dividends do not accumulate.
Cumulative preferred shares: Unpaid dividends accumulate and must be paid before common dividends.

Example: Cumulative Preferred Dividends

If preferred dividends are in arrears for 2018 and 2019, and the company declares dividends in 2020, preferred shareholders receive dividends for all three years before common shareholders receive any.

Accounting for Dividends

Important Dates

Declaration date: Board declares a dividend; liability is created.
Date of record: Shareholders registered on this date receive the dividend (no journal entry).
Payment date: Dividend is paid to shareholders.

Journal Entries for Dividends

Declaration of cash dividend:
- Dr. Retained earnings
- Cr. Dividends payable
Payment of cash dividend:
- Dr. Dividends payable
- Cr. Cash
Declaration of stock dividend:
- Dr. Retained earnings
- Cr. Stock dividend distributable (an adjunct equity account, not a liability)
Payment of stock dividend:
- Dr. Stock dividend distributable
- Cr. Common shares

Note: Stock dividend distributable is not a liability; it is an adjunct equity account.

Stock Splits

Purpose and Effect

Stock splits increase the number of shares outstanding and reduce the market price per share, but do not affect total shareholders' equity.

Example: If a company declares a 6-for-1 stock split, each share becomes six shares, and the price per share adjusts accordingly.
Stock splits: No journal entry required; no effect on shareholders' equity.

Summary Tables

Shareholders' Equity Transactions

Transaction	Debit	Credit
Issuance of shares	Cash	Common shares
Repurchase of shares	Common shares	Cash
Declaration of cash dividend	Retained earnings	Dividend payable
Payment of cash dividend	Dividend payable	Cash
Declaration of stock dividend	Retained earnings	Stock dividend distributable
Payment of stock dividend	Stock dividend distributable	Common shares
Stock split	Journal entry not required

Effect on Total Assets, Liabilities, and Shareholders' Equity

Transaction	Assets	Liabilities	Shareholders' Equity
Issuance of shares	Increase	No effect	Increase
Repurchase of shares	Decrease	No effect	Decrease
Declaration of cash dividend	No effect	Increase	Decrease
Payment of cash dividend	Decrease	Decrease	No effect
Stock dividend	No effect	No effect	No effect
Stock split	No effect	No effect	No effect

Note: For stock dividends and stock splits, there is no effect on total assets, liabilities, or shareholders' equity because no journal entry is required for stock splits, and stock dividends only reclassify equity accounts.

Key Formulas

Book Value per Share:
Return on Equity (ROE):

Additional info:

Stock dividends and stock splits are used to manage share price and equity structure, but do not affect total equity.
Double taxation is a key disadvantage of corporations, as both corporate profits and shareholder dividends are taxed.