Corporation, Shares Issuance, Repurchasing Shares, Stock Splits, Fair vs. Book Value, ROA
Main Features of a Corporation
How Do Corporations Differ From Sole Proprietorships & Partnerships?
Separate Legal Entity
A corporation is a business entity formed under federal or provincial law, where the government grants articles of incorporation. A corporation is a distinct entity & has many of the same rights as a person. For example, a corporation may buy, own & sell property. Assets & liabilities belong to the corporation, not to its owners. The corporation may also enter into contracts, sue & be sued. Their legal names include Limited, Corporation, or Incorporated (Ltd., Corp., & Inc.) at the end.
Continuous Life & Transferability of Ownership
Corporations have continuous lives regardless of changes in ownership. Shareholders may sell or trade the shares to another person, give them away, bequeath them in a will, or dispose of them in any other way. In contrast, proprietorships and partnerships terminate when ownership changes.
Shareholders have limited liability for the corporation’s debts, so they have no personal obligation to repay the company’s liabilities. The most a shareholder can lose is the cost of their investment. This enables corporations to raise more capital. In contrast, proprietors & partners are personally liable for all the debts of their businesses (unless the business is organized as a limited liability partnership [LLP] or a limited liability company [LLC]).
Separation of Ownership & Management
Shareholders own the corporation, but a board of directors—elected by the shareholders—appoints officers to manage the business. Managers should run the business in the best interests of shareholders.
Corporations must pay income tax separate from those borne by their individual shareholders.
This regulation consists mainly of ensuring that corporations disclose the information in financial statements that investors and creditors need to make informed decisions.
Controlling & Managing a Corporation
Ultimate control of a corporation rests with shareholders. Shareholders elect a board of directors, which sets company policy & appoints officers. The board elects one of their board members to be a chairperson, who usually is the most powerful person in the organization. The board appoints the chief executive officer (CEO), who often also acts as the president in charge of day-to-day operations. Large corporations may also have vice-presidents in charge of sales, manufacturing, accounting and finance (the chief financial officer, or CFO), and other key areas.
Shareholders’ 4 Basic Rights
- Right to Sell Shares
- Right to Vote: They have the right to participate in management by voting on important matters. 1 vote per share. Some classes of common shares give shareholders multiple votes or no vote.
- Right to Receive Dividends
- Right to Receive a Residual Interest Upon Liquidation: They have the right to receive a proportionate share of any assets remaining after the corporation pays all liabilities upon liquidation.
4 Common & Separate Components of Shareholders’ Equity
- Share Capital: Amounts contributed by shareholders in exchange for shares in the corporation.
- Contributed Surplus: Any amounts contributed by shareholders in excess of amounts allocated to share capital.
- Accumulated Other Comprehensive Income: IFRS require companies to report Accumulated Other Comprehensive Income, which is an accumulation of past earnings not included in retained earnings. ASPE do not require companies to account for this item.
- Retained Earnings: Net income less net loss & dividends. When it’s negative, the term deficit is used.
What are Share Certificates?
A corporation issues share certificates to its owners in exchange for their investment—usually cash. The basic unit of share capital is called a share. Shares are sometimes referred to as stock.
Common Terms Regarding Shares
- Authorized: The maximum number of shares a corporation can distribute to shareholders. Companies incorporated under the Canada Business Corporations Act are permitted to issue an unlimited number of shares.
- Issued: The number of shares sold or transferred to shareholders.
- Outstanding Shares: Shares that are in the hands of shareholders. Sometimes, the amount of shares issued can be higher than the amount of outstanding shares.
Different Classes of Shares
- Common Shares: IFRS also refers to these are ordinary shares. Every corporation issues these shares, and the word share means common shares. Common shareholders have 4 basic rights, unless specifically withheld. For example, companies can issue voting & non-voting common shares.
- Preferred Shares: Preferred shareholders have advantages that common shareholders don’t. They receive dividends earlier & they receive assets earlier (if company liquidates). Generally, these are non-voting shares but have the 3 other rights. Preferred shares that must be redeemed (paid back) by the corporation are a liability masquerading as a stock & must be accounted for as such. These shares are much less frequently used.
Par Value & Stated Value
Par value shares are shares of stock that have a value assigned to them by the articles of incorporation. The Canada Business Corporations Act & most provincial incorporating acts now require common and preferred shares to be issued without par value. Instead, the shares are assigned a value when they are issued; this value is known as the stated value.
Account for the Issuance of Shares
What is an Underwriter?
A bank or other financial institution that pledges to buy all the unsold shares in an issue of new shares.
Issuing Shares for Cash
Issuing Shares for Assets (Other than Cash)
Cooking the Books with Share Capital
The issuance of shares for cash poses no ethical challenge. Issuing shares for assets other than cash, however, can pose an ethical challenge. The company issuing the shares often wishes to record a large amount for the non-cash asset received (such as land or a building) and for the shares that it is issuing. Why? Because large asset and shareholders’ equity amounts on the balance sheet make the business look more prosperous and more creditworthy.
Accounting for Shares Other than Common Shares
Accounting for the issuance of preferred shares (or other kinds of non-voting shares) for cash or other assets is the same as that for common shares, except for the name of the share capital account used, which will match the type of shares being issued.
Why Would a Company Repurchase Shares?
- The company needs repurchased shares to fulfill future share issuance commitments, such as those related to share option plans, and conversions of bonds & preferred shares into common shares.
- The purchase may help support the share’s current market price by decreasing the supply, which will usually result in an increase in the market price per share.
- Management wants to avoid a takeover by an outside party, so it repurchases a significant proportion of its own shares to prevent the other party from acquiring them.
In basic terms, when a company repurchases shares, share capital & shareholders’ equity decrease.
Retained Earnings, Dividends & Stock Splits
The Retained Earnings account is not a reservoir of cash available for paying dividends or investing. Cash & Retained Earnings are two entirely separate accounts with no relationship to each other.
Before a company can pay a cash dividend, it must have:
- retained Earnings more than the desired dividend.
- Enough Cash to pay the dividend.
3 Relevant Dates for Dividends
- Date of Declaration: The board of directors declares a dividend before paying it, & doesn’t have an obligation to pay dividends until it’s declared. Once declared, it’s a liability. The entry to account for it is:
- Date of Record: To receive the declared dividend, one must be officially registered as a shareholder of the company on this date. This date follows the declaration date.
- Date of Payment: The dividend is paid to shareholders. The entry to account for it is:
What are Stock Dividends?
When a company declares a stock dividend, it eventually pays dividends by issuing additional shares. The total dollar value of a stock dividend is determined by multiplying the number of shares to be issued by the market price of the shares on the date of declaration.
The relevant dates for stock dividends are the same as those for cash dividends, but journal entries differ. On the date of declaration, we debit Retained Earnings & credit Stock Dividends Distributable (a contra-equity account). On the date of payment, we debit Stock Dividends Distributable & credit the relevant Share Capital account. A stock dividend, therefore, has no impact on the total shareholders’ equity balance because Share Capital increases & Retained Earnings decreases by the same amount. Shareholders pay tax on stock dividends the same way they pay tax on cash dividends.
Why would a company issue a stock dividend instead of a cash dividend?
- Continue Dividends but Conserve Cash
- Reduce the Per-Share Market Price of its Shares
Dividends on Preferred Shares
Expressing the Dividend on Preferred Shares
Preferred share dividends are expressed as an annual dollar figure or a percent of share’s stated value.
Dividends on Preferred & Common Shares
Suppose a company declares an annual dividend of $1,000,000, and there are 100,000 shares of $1.50.
A dividend of $150,000 or less would result in the common shareholders receiving no dividend.
Dividends on Cumulative & Non-Cumulative Preferred Shares
Corporations sometimes fail to pay a dividend to preferred shareholders. This is called passing the dividend, & any passed dividends on cumulative preferred shares are said to be in arrears. The owners of cumulative preferred shares must receive all dividends in arrears plus the current year’s dividend before the corporation can pay dividends to the common shareholders. Preferred shares are assumed to be non-cumulative, unless otherwise stated.
When a company wishes to increase or decrease its market value per share without altering its assets, liabilities, or shareholders’ equity, it can declare a stock split, which results in an increase or decrease in the number of issued and outstanding shares of the company, but does not affect any financial statement balances. For example, a company can execute a 2-for-1 stock split where each share is broken up into 2 shares. This would halve the market share price. There are also reverse stock splits. This change would be disclosed in the statement of owners’ equity & the notes.
Summary of the Effects on the Accounting Equation
Fair Value & Book Value per Share
What is the Fair Value of a Share?
The fair value (or market price) of a share of a company’s stock is the price that a willing buyer would pay a willing seller to acquire the share. Shares of private companies do not trade on public exchanges, so their fair values must generally be determined with the assistance of professional business valuators.
What is the Book Value of a Share?
The book value of a share of a company’s common stock indicates the dollar value of net assets a common shareholder would receive for each share after any preferred shareholders have received their share of the company’s net assets.
Evalute Return on Assets & Return on Equity
To compare profitability of companies of different size, investors use standard profitability measures, including return on assets and return on equity.
What is Return on Assets?
Rate of return on total assets, or return on assets (ROA), measures a company’s success in using its assets to earn income.
*Average total assets is computed by taking the average of the company’s total assets at each of the last two fiscal year-ends.
10% is considered a strong benchmark in most industries, but it can vary. The higher, the better.
What is Return on Equity?
The rate of return on common shareholders’ equity, or return on equity (ROE), shows the relationship between net income & common shareholders’ equity. Return on equity is computed only on common share capital because the return to preferred shareholders is usually limited to a specified dividend (for example, 5%).
*Average common shareholders’ equity = average of the beginning and ending amounts of common shares (total - preferred).
Borrowing at a lower rate than the company’s return on investments is called using leverage. Leverage increases net income if operating income exceeds the interest expense from borrowing. ROE is always higher than ROA for a successful company.
In many industries, 15% is considered a good ROE. The higher, the better.
Decision Guidelines For Investing in Stock
Reporting Equity Transactions & Events
What is the Statement of Changes in Shareholders’ Equity?
The statement of changes in shareholders’ equity reports the details of all the changes in the shareholders’ equity section of the balance sheet during the period.
Reporting in the Balance Sheet & Notes
In general, the following are a few of the key pieces of equity information that must be disclosed in the balance sheet, statement of changes in owners’ equity, or the notes:
- Number of authorized, issued, and outstanding shares, and changes in these amounts during the year, for each class of share capital; their par value, if any; dividend rights and preferences; and other restrictions and features.
- Contributed surplus.
- Accumulated other comprehensive income (IFRS only).
- Retained earnings.