Chapter 12: Owners‘ Equity

Chapter 12: Owners‘ Equity
The corporate form of organization
The corporation is „an artificial being, invisible, intangible, and existing
only in contemplation of law.“
(John Marshall, U.S. Chief Justice, 1819)
Characteristics that distinguish corporations from sole traders and
partnerships:
• separate legal entity
• limited liability of shareholders
• transferable ownership rights
• indefinite life time
• board structure of corporate management
1
Corporate organization chart
Stockholders
Board of
Directors
President
Corporate
Secretary
Vice President
Marketing
Vice President
Finance
Treasurer
Vice President
Production
Controller
Vice President
Personnel
2
Ownership rights of shareholders
(ordinary shares)
Each share represents
• a claim to a specified fraction of profits and losses
• a claim to a specified fraction of corporate net assets upon
liquidation
• equal rights to control Management (voting rights)
• to share proportionately in any new issues of shares of the same
class (preemptive right)
– can be dropped by shareholder approval, e.g.
• for issues to be granted to employees (incl. Management)
• if convertible bonds are issued
Other classes of shares
1. Preferred stock
2. Shares with differential voting rights
3
Corporate Capital
•
Share capital (paid-in capital)
– par value of the shares issued by the corporation, contribution by
shareholders
•
Share premium (additional paid-in capital)
– any excess proceeds from share issues
contributions by shareholders above par value
– different notation in use by different corporations (see box below)
•
Retained profits
– accumulated net income not distributed to owners
Company
Name for share premium
AT&T
Coca-Cola
McDonald's
additional paid-in capital
capital surplus
additional paid-in capital
PepsiCo
Qualcomm
Motorola
capital in excess of par value
paid-in capital
additional paid-in capital
4
Significance of par value
•
share capital is the permanent capital of a company
– can be returned to shareholders only under restrictive conditions
– similar purpose: non-distributable reserves (legal or statutory)
•
shares issued „partly paid“ or at discount to par value
– 25% of par value must be paid in on incorporation
Historical note:
In the U.S., par value used to be $ 100 in the early 1900s, now it‘s
common to have par values of $1, $5, or $10, resp., but sometimes
lower than that.
Company
Par value of share
Eastman Kodak
IBM
Ford Motor Company
PepsiCo
America Online
Qualcomm
$ 2,50
$ 1,25
$ 1,00
$ 0,0167
$ 0,01
$ 0,0001
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Accounting for share issues
1. Issuance of shares for cash
Company Stock issues 100.000 shares with par value of € 10 at a
price of € 12.
Issuance of shares on fully-paid basis
Cash
Share capital (at par)
Share premium
1.200.000
1.000.000
200.000
2. Issuance of shares for services or noncash assets
Attorney Jim Sleezy has helped Babel Company incorporate. He
billed the company € 5.000 for his services. Jim agrees to receive
400 shares of € 10 par value. There is no active trading of shares.
Issuance of shares to attorney
Organization expense
Share capital (at par)
Share premium
5.000
4.000
1.000
6
Accounting for share issues
•
issuing shares vs. transferring shares (registered shares)
Share issuance
Investor A
Cash
Share transfer / trading
Shares
Investor A
Investor B
Cash
Shares
Company
Notification of
ownership
change
Company
Source: Sutton, p.364
•
registered shares vs. bearer shares
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Payment of dividends
•
•
dividend policy depends on a number of factors, e.g. current cash position,
dividends in prior years, (type of shareholders), share buyback programs
Why not pay dividends in amounts equal to retained earnings?
– bond covenants require to retain a portion of earnings as additional
protection
– desire to retain assets to finance growth
example: Toys ‘R‘ Us, Microsoft and other internet companies are fastgrowing companies. They adopted zero-dividend policies to reinvest
earnings to support growth.
– desire to smooth out dividend payments
example: Eastman Kodak Company, has increased its dividends each
year since 1977. However, as a percentage of net income, dividend
payments accounted for 40 to over 100%.
? AT&T consistently declares dividends of about 30-40 percent of net income.
Delta Air Lines only pays dividends of about 2 percent of net income, and Cisco
Systems has never paid a dividend. Does this mean that AT&T is a better
investment than Delta and Cisco? Explain and briefly discuss dividend policies.
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Payment of dividends
•
Financial condition and dividend distribution:
Balance Sheet
Accounts receivable
Inventory
Plant assets
60.000
100.000
520.000
Liabilities
Share capital
Retained earnings
680.000
200.000
300.000
180.000
680.000
Balance Sheet
Cash
Inventory
Plant assets
80.000
100.000
500.000
Current liabilities
Share capital
Retained earnings
680.000
•
Ability to pay a
cash dividend
does not seem
to be given in
both cases!
50.000
400.000
230.000
680.000
Types of dividends
– cash dividends
– property dividends (dividends in kind)
– share dividends
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Cash dividends
•
•
most popular form of dividends
different presentation in EU and US, resp.
date of
declaration
date of
record
date of
payment
board of directors declares
dividend and liability is
established
shareholders holding shares
at this date receive the
dividend when paid
dividend is paid to
shareholders
of record
A typical dividend announcement reads as follows:
The board of directors of EnjoyD Corporation, at its regular meeting
of April 1, 2012, declared a quarterly dividend of $ 7 per share,
payable on April 22, 2012, to stockholders of record on April 10,
2012.
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Cash dividends
Journal entries to record announcement and payment of dividends:
April 1
Date of declaration
Retained income
Dividends payable
350.000
350.000
To record the announcement of dividends to be
paid on April 22 to shareholders of record
as of April 10
Date of payment
April 22 Dividends payable
Cash
350.000
350.000
To pay dividends declared April 1 to
shareholders of record as of April 10
11
Cash dividends –
presentation of shareholders‘ equity
Facts: EnjoyD issued 50.000 shares with par value € 10 at a price of € 16. It
reports net income in year 1 of € 80.000 and net assets at the end of the year
of € 880.000. No dividend is paid out of year 1 income. In year 2 it reports net
income of € 200.000. The directors propose a dividend of € 2 a share (50.000
shares) in March year 3 when the year 2 results are published. The year 2
accounts and proposed dividend are approved by shareholders at the annual
general meeting in May year 3.
IPO:
50.000 @
16
Net income:
80.000
Dividends
declared:
100.000
Net income:
200.000
March
year 1
Dividends
approved
year 2
May
year 3
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Cash dividends – presentation of shareholders‘ equity
Shareholders' equity
Endyear 2
Format 1
(Dominant
in EU)
Share capital
Share premium
Profit retained
Profit for the year
Format 2
(UK and
Ireland)
Share capital
Share premium
Profit and loss account
Format 3
(USA)
Common stock
Additional paid-in capital
Retained earnings
500
300
80
200
1.080
Endyear 1
500
300
0
80
880
500
300
180 *
980
500
300
80
880
500
300
280 **
1.080
500
300
80
880
* Retained profits of years 1 and 2, after deducting proposed year 2 dividend of 100. Dividend payable of 100
shown as current liability in year 2 balance sheet.
** Dividend not declared at balance sheet date.
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Non-cash dividends
1. Property dividends (dividends in kind)
• can be merchandise, real estate, or investments (shares of other
companies)
• recorded at fair value of non-cash assets distributed, recognize any
gain or loss
Example:
Ban Corp. holds 200.000 shares of Nab Corp. as an investment
(original cost: € 2 per share). It decides to transfer to shareholders
100.000 shares costing € 200.000 by declaring a property dividend
on December 29, 2003, to be distributed on January 31, 2004, to
shareholders of record on January, 15, 2004. When the board of
directors announces the property dividend, shares of Nab Corp. are
quoted at € 4 per share.
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Non-cash dividends
At date of declaration (December 29, 2003)
Investment in Securities
Gain on Appreciation of Securities
200.000
Retained profits
Property Dividends Payable
400.000
200.000
400.000
At date of distribution (January 20, 2004)
Property Dividends Payable
Investment in Securities
400.000
400.000
An example from the real world: DuPont once held a 23% share interest in
General Motors. The U.S. Supreme Court ruled that this constituted a violation
of antitrust laws. DuPont was ordered to divest itself of the GM shares within
10 years. The shares represented 63 million of GM‘s 281 million shares then
outstanding. Neither selling all at once nor selling them in blocks over 10 years
was possible due to the fact that the yearly trading volume of GM shares was
just 6 million. DuPont distributed its GM shares as a property dividend to its
own shareholders.
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Non-cash dividends
2. Share dividends
• offered to continue dividend „payments“ but to avoid cash outflow
• recorded at par value in EU but at fair value in US
Example: EnjoyD had issued 50.000 shares with par value € 10. Now they
issue 5.000 additional shares (10% share dividend). The market price is €
18 when the dividend is declared.
Share dividend: EU practice
Retained profits
Share capital
50.000
50.000
Share dividend: US practice
Retained earnings
Common stock
Additional paid-in capital
90.000
50.000
40.000
16
Share splits
Why splitting shares?
• market price per share above a certain level
• wider share ownership
• empirical evidence: share prices increase after announcement of
share splits
Accounting treatment:
• no accounts are adjusted
• memorandum note to indicate change in par value and number of
shares
Why consolidating shares?
• consolidating shares is the opposite of a share split
• to avoid delisting, speculation
17
Transfer of profits to reserve
•
status of profits changes:
distributable (retained earnings) Æ undistributable (reserves)
– legal requirements or voluntary reserves
– protection of creditors
– EU: establishing a legal reserve expressed as a percentage of share
capital
Example: Assume a company must transfer 5% of its annual after-tax
profits to a legal reserve (until a certain level is reached). Secure
Corp. recorded an after-tax profit of € 100.000 in 2003.
To record transfer of profits to legal reserve
Profit for year 2003
Legal reserve
5.000
5.000
18
Purchase of own shares
Why repurchasing own shares?
• only very few investment opportunities available
• to increase earnings per share and return on equity
• to prevent takeover attempts
Example: some time ago CBS blocked a takeover attempt by Turner
Broadcasting Systems Inc. by repurchasing a substantial portion of its
outstanding common stock
•
•
provide shares for employee share option plan
to make market in the stock
Quote: “It‘s a simple formula: announce plans for a $ 3.5 billion stock
buyback...watch the stock soar. It worked for IBM.“ (Business Week, 12
May 1997)
•
•
shares are undervalued
to increase financial leverage
Cancelled shares vs. shares held in treasury
Certain restrictions apply for buyback of shares.
19
Purchase of own shares
Case study: Reebok
• in late 1996, Reebok bought back nearly 1/3 of its outstanding
shares
• serious reduction in cash
• management stated, repurchase is a reaction to the undervalued
shares and should signal good future earnings
What did critics say?
• repurchase to block possible takeover attempts
• repurchase to save jobs (the top managers‘ jobs...)
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Purchase of own shares
1. Shares held in treasury
• repurchase usually recorded at cost
• shares held in treasury are not an asset / gains from sale of treasury
shares are not income
Example: EnjoyD buys back 10.000 shares at € 18 per share.
To record repurchase of shares held in treasury
Treasury shares
Cash
180.000
180.000
Example: EnjoyD sells the 10.000 treasury shares at € 20 per share.
To record sale of shares held in treasury
Cash
Treasury shares
Share premium from treasury shares
200.000
180.000
_20.000
21
Purchase of own shares
2. Cancelled shares
• repurchasing and cancelling shares usually reduces share capital
(and share premium)
Example: EnjoyD repurchases 10.000 shares at € 18 and retires them.
To record repurchase and cancellation of shares
Share capital
100.000
Share premium
60.000
Retained profit
20.000
Cash
180.000
To maintain the company‘s capital, a reserve for own shares can/must
be recorded:
Retained profits
Reserve for own shares
160.000
160.000
22
Capital write-down
•
If a company has accumulated large losses
– upon shareholders‘ approval (general meeting) capital may be written
down
•
Example: FlopCo‘s Balance sheet
Current assets
100
Fixed assets
400
Accumulated losses
•
Current debt
120
Long term debt 200
120
Share capital
100
share premium 200
Journal entries for write-down
Dr. Share capital 40
share premium 80
cr. Accumulated losses
120
23
Convertible Bonds and Warrants
•
•
•
A Convertible Bond may be exchanged into a predetermined
number of shares of the issuing company at the initiative of the
bondholder during a specified time span to maturity
A warrant may be attached to a straight bond that represents the
option to buy a specified number of shares of the issuing company
at a prespecified price during a specified period of time
Convertible bonds and bonds with warrants use to have a lower
stated interest rate
– the present value of the interest benefit is equity capital that is granted
to the bondholder when (s)he exercises the option or converts the bond,
respectively.
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Accounting Treatment
•
Example: 5 year convertible bond, €1 million, par
–
–
–
–
•
convertible first at the beginning of year 5 until maturity
stated annual interest rate 3%
straight debt would yield 8% annual interest
€ 1000 of the bond may be converted into 50 shares of the issuing
company, par value € 1,-- each.
Calculation of the equity component:
– Present value of 3% interest for 5 years
– + present value of repayment
– = liability component of convertible bond
L=
5
30 .000
∑ (1,08 ) t
t =1
+
1000 .000
(1,08 )
5
discount rate 8%
= 800 .364 , 2
– Amount received at issue date
– – Liability component
– = equity component
1 000 000
800.364
199.636
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Journal entries
•
Issue date:
– Dr.: Cash
1 000 000
– Dr.: bond discount: 199 636
–
Cr.: Conv. Bonds payable
1 000 000
–
Cr.: equity component of conv bond 199 636
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