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Shareholders’ Equity9Learning Objectives

1 Explain the advantages anddisadvantages of a corporation

2 Measure the effect of issuingshares on a company’sfinancial position

3 Describe how sharerepurchase transactions affecta company

4 Account for dividends andmeasure their impact on acompany

5 Use different share values indecision making

6 Evaluate a company’s returnon assets and return onshareholders’ equity

7 Report shareholders’ equitytransactions on the cash flowstatement

If you are like most college students, you have been to Shoppers Drug Mart but you have proba-

bly not given much thought to its capital structure. In this chapter you will learn how Shoppers

Drug Mart and other corporations account for shareholders’ equity transactions.

What does it mean to “go public”? A corporation goes public when it sells its shares to the general

public. A common reason for going public is to raise money for expansion. By offering its shares to the

public, a company can raise more money than if the shareholders remain private. Shoppers Drug Mart

Corporation was able to place 30 million shares in the market at $18 per share when it went public and

sold those shares in its initial public offering (IPO)in November 2001. Shoppers Drug Mart’s balance

sheet indicates that through January 1, 2005, the company had received over $1.4 billion from its share-

holders.

Chapters 4 to 8 discussed accounting for the assets and the liabilities of a company. By this time,

you should be familiar with all the assets and liabilities listed on a company’s balance sheet. Let’s focus

now on the last part of the balance sheet—a corporation’s shareholders’ equity. In this chapter, we dis-

cuss some of the decisions a company faces when issuing and buying back its shares and when declar-

ing and paying dividends. In the process, we cover the elements of shareholders’ equity in detail. Let’s

begin by reviewing how a corporation is organized.

Shoppers Drug Mart Inc.Partial Balance Sheet (Thousands)

For the 52 Weeks Ended January 1, 2005 and 53 Weeks Ended January 3, 2004

▼

01/01/2005 03/01/ 2004

Share capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,421,980 $1,411,878Contributed surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,641 216Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 733,682 435,304Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,157,303 $1,847,398

Share Capital AuthorizedUnlimited number of common sharesUnlimited number of preferred shares, issuable in series without nominal or par value

Outstanding

01/01/2005 01/01/2004

Number of Number of Stated Common shares Stated Value Common shares Value

Beginning balance . . . . . . . . . . . . . . . . . . . . . 209,724,407 $ 1,411,878 209,703,488 $ 1,419,783Shares issued . . . . . . . . . . . . . . . . . . . . . . . . . 275,632 5,008 29,691 377Shares repurchased . . . . . . . . . . . . . . . . . . . . . (9,194) (62) (8,772) (59)Share purchase loans, net . . . . . . . . . . . . . . . . — 5,156 — (8,223)Ending balance . . . . . . . . . . . . . . . . . . . . . . . . 209,990,845 $ 1,421,980 209,724,407 $ 1,411,878

During the period ended January 1, 2005, the Company issued 275,632 common shares (2003 – 29,691) with a stated value of$5,008, net of tax of $nil (2003 – $377). In addition, 9,194 common shares (2003 – 8,772) were repurchased for cancellation.

DECISION: What Is the Best Way to Organize a Business?Anyone starting a business must decide whether to organize the entity as a propri-etorship, a partnership, or a corporation. Many businesses choose the corporation.Why is the corporate form of business so attractive? The ways in which corporationsdiffer from proprietorships and partnerships provide some reasons.

Separate Legal Entity. A corporation is a business entity formed under federal orprovincial law. The federal or provincial government grants articles of incorporation,which consist of documents giving the governing body’s permission to form a corpo-ration. A corporation is a distinct entity, an artificial person that exists apart from itsowners, who are called shareholders. The corporation has many of the rights that aperson has. For example, a corporation may buy, own, and sell property. Assets andliabilities in the business belong to the corporation rather than to its owners. Thecorporation may enter into contracts, sue, and be sued.

Nearly all well-known companies, such as Shoppers Drug Mart Inc.,TransCanada Corporation, Bombardier Inc., and Sobeys Inc., are corporations. Theirfull names include Limited, Corporation, or Incorporated (abbreviated Ltd., Corp., andInc.) to indicate that they are corporations

Continuous Life and Transferability of Ownership. Corporations have continuouslives regardless of changes in the ownership of their shares. The shareholders ofShoppers Drug Mart or any corporation may transfer shares as they wish. They may sellor trade the shares to another person, give them away, bequeath them in a will, or dis-pose of them in any other way. The transfer of the shares does not affect the continuity ofthe corporation. In contrast, proprietorships and partnerships terminate when owner-ship changes.

Limited Liability. Shareholders have limited liability for the corporation’s debts.They have no personal obligation for corporate liabilities. The most that a share-holder can lose on an investment in a corporation’s shares is the cost of the invest-ment. In contrast, proprietors and partners are personally liable for all the debts oftheir businesses. Limited liability is one of the most attractive features of the corpo-rate form of organization. It enables corporations to raise more capital from a widergroup of investors than proprietorships and partnerships can.

Separation of Ownership and Management. Shareholders own the corpora-tion, but a board of directors—elected by the shareholders—appoints officers to man-age the business. Thus, shareholders may invest $1,000 or $1 million in the corpora-tion without having to manage the business or disrupt their personal affairs.

Management’s goal is to maximize the firm’s value for the shareholders. But theseparation between owners and managers may create problems. Corporate officersmay run the business for their own benefit and not for the shareholders. For exam-ple, the chief financial officer (CFO) of Enron Corporation set up outside partner-ships and paid himself millions of dollars to manage the partnerships—unknown toEnron shareholders.

Corporate Taxation. Corporations are separate taxable entities. They pay a varietyof taxes not borne by proprietorships or partnerships, such as federal and provincialincome taxes. Corporate earnings are subject to double taxation of their income.First, corporations pay income taxes on their corporate income. Then shareholders

456 Chapter 9 Shareholders’ Equity

ShareholderA person who owns shares in a

corporation. Also called ashareholder.

Objective

1Explain the advantages anddisadvantages of a corporation

Limited liabilityNo personal obligation of ashareholder for corporation

debts. A shareholder can lose nomore on an investment in a

corporation’s shares than thecost of the investment.

Double taxationCorporations pay income taxes on

corporate income. Then, theshareholders pay personal income

tax on the cash dividends thatthey receive from corporations.

Canada’s tax laws attempt tominimize double taxation.

pay personal income tax on the cash dividends that they receive from corporations.Canada’s tax laws attempt to minimize double taxation. Proprietorships and partner-ships pay no business income tax. Instead, the tax falls solely on the owners, who aretaxed on their share of the proprietorship or partnership income.

Government Regulation. Because shareholders have only limited liability for cor-poration debts, outsiders doing business with the corporation can look no furtherthan the corporation if it fails to pay. To protect the creditors and the shareholders ofa corporation, both federal and provincial governments monitor corporations. Thisgovernment regulation consists mainly of ensuring that corporations disclose theinformation that investors and creditors need to make informed decisions.Accounting provides much of this information.

Exhibit 9-1 summarizes the advantages and disadvantages of the corporateform of business organization.

Organizing a Corporation 457

Exhibit 9-1Advantages and Disadvantages of aCorporation

▼

Advantages Disadvantages

1. Can raise more capital than a proprietorship 1. Separation of ownership and or partnership can management

2. Continuous life 2. Corporate taxation3. Ease of transferring ownership 3. Government regulation4. Limited liability of shareholders

BylawsConstitution for governing acorporation.

Board of directorsGroup elected by theshareholders to set policy for acorporation and to appoint itsofficers.

ChairpersonElected by a corporation’s boardof directors, usually the mostpowerful person in thecorporation.

PresidentChief operating officer in chargeof managing the day-to-dayoperations of a corporation.

Organizing a CorporationThe process of creating a corporation begins when its organizers, called the incorpo-rators, submit articles of incorporation to the federal or provincial government forapproval. The articles of incorporation include the authorization for the corporationto issue a certain number of shares of stock, which are shares of ownership in the cor-poration. The incorporators pay fees, sign the charter, and file the required docu-ments with the incorporating jurisdiction. The corporation then comes intoexistence. The incorporators then agree to a set of bylaws, which act as the constitu-tion for governing the corporation.

Ultimate control of the corporation rests with the shareholders. The sharehold-ers elect a board of directors, which sets policy and appoints officers. The boardelects a chairperson, who usually is the most powerful person in the organization.The board also designates the president, who is the Chief Executive Officer (CEO) incharge of day to day operations. Most corporations also have vice presidents incharge of sales, manufacturing, accounting and finance (the chief financial officer, orCFO), and other key areas. Exhibit 9-2 shows the authority structure in a corpora-tion.

Shareholders’ RightsOwnership of shares entitles shareholders to five basic rights, unless specific rightsare withheld by agreement with the shareholders:

1. The right to sell the shares. This right might be restricted in certain circumstancesbut such discussion is beyond the scope of this text.

2. Vote. The right to participate in management by voting on matters that comebefore the shareholders. This is the shareholder’s sole voice in the managementof the corporation. A shareholder is normally entitled to one vote for each shareof common stock owned. There are various classes of common shares that givethe holder multiple votes or no vote.

3. Dividends. The right to receive a proportionate part of any distributed payment,or dividend. Each share of stock in a particular class receives an equal dividend.

4. Liquidation. The right to receive a proportionate share (based on number ofshares held) of any assets remaining after the corporation pays its liabilities inliquidation. Liquidation means to go out of business, sell the entity’s assets, payits liabilities, and distribute any remaining cash to the owners.

5. Preemption. The right to maintain one’s proportionate ownership in the corpora-tion. Suppose you own 5% of a corporation’s shares. If the corporation issues100,000 new shares, it must offer you the opportunity to buy 5% (5,000) of thenew shares. This right is called the preemptive right.

Shareholders’ EquityAs we saw in Chapter 1, shareholders’ equity represents the shareholders’ owner-ship interest in the assets of a corporation. Shareholders’ equity is divided into twomain parts:

1. Contributed capital, also called capital stock. This is the amount of share-holders’ equity the shareholders have contributed to the corporation.

2. Retained earnings. This is the amount of shareholders’ equity the corporationhas earned through profitable operations and has not used for dividends.

Companies report shareholders’ equity by source. They report contributed cap-ital separately from retained earnings because most incorporating acts prohibit thedeclaration of cash dividends from contributed capital. Thus, cash dividends aredeclared from retained earnings.


▼

Controller(Accounting Officer)

Treasurer(Finance Officer)

Shareholders

Board of Directors

Chief Executive Officer

Chief Operating Officer

Vice President,Manufacturing

Vice President,Sales

Vice President,Personnel

SecretaryChief FinancialOfficer

Exhibit 9-2Authority Structure in aCorporation

Shareholders’ equityThe shareholders’ ownership

interest in the assets of acorporation.

Contributed capitalThe amount of shareholders’

equity that shareholders havecontributed to the corporation.

Also called capital stock.

Retained earningsThe amount of shareholders’

equity that the corporation hasearned through profitable

operation of the business and hasnot given back to shareholders.

The owners’ equity of a corporation is divided into shares of stock. A corpora-tion issues share certificates to its owners in exchange for their investment in the busi-ness. The basic unit of contributed capital is called a share. A corporation may issue ashare certificate for any number of shares it wishes—one share, 100 shares, or anyother number—but the total number of authorized shares is limited by charter.Exhibit 9-3 shows an actual common share certificate for Danier Leather Inc.

The terms authorized, issued, and outstanding are frequently used todescribe a corporation’s shares. Authorized refers to the maximum number of shares acorporation is allowed to distribute to shareholders. Companies incorporated underthe Canada Business Corporations Act are permitted to issue an unlimited number ofshares. Issued refers to the number of shares sold or transferred to shareholders.Outstanding refers to the number of shares actually in the hands of shareholders.Sometimes a company repurchases shares it has previously issued so that the numberof shares outstanding will be less than the number of shares issued. For example, if acorporation issued 100,000 shares and later repurchased 20,000 shares, then thenumber of shares outstanding would be 80,000. The total number of shares of stockoutstanding at any time represents 100% ownership of the corporation.

Classes of SharesCorporations issue different types of shares to appeal to a variety of investors. Theshares of a corporation may be either

• Common • Preferred

Common and Preferred. Every corporation issues common shares, the basicform of capital stock. Unless designated otherwise, the word share is understood tomean “common share.” Common shareholders have the five basic rights of shareownership, unless a right is specifically withheld. For example, some companiesissue Class A common shares, which usually carry the right to vote, and Class B com-mon shares, which may be nonvoting. In describing a corporation, we would say thecommon shareholders are the owners of the business.


StockShares into which the owners’equity of a corporation isdivided.

Exhibit 9-3Share Certificate

▼

Outstanding sharesShares in the hands ofshareholders.

Common sharesThe most basic form of capitalstock. Common shareholdersown a corporation.

Company name

Shareholder name

Number of shares

Preferred shares give their owners certain advantages over common share-holders. Preferred shareholders receive dividends before the common shareholdersand receive assets before the common shareholders if the corporation liquidates.Owners of preferred shares also have the five basic shareholder rights, unless a rightis specifically denied. Companies may issue different classes of preferred shares(Class A and Class B or Series A and Series B, for example). Each class is recorded ina separate account.

Preferred shares are a hybrid between common shares and long-term debt. Likedebt, preferred shares pay a fixed dividend amount to the investor. But like shares,the dividend is not required to be paid unless the board of directors has declared thedividend. Also, companies have no obligation to pay back true preferred shares.Preferred shares that must be redeemed (paid back) by the corporation are a liabilitymasquerading as a stock.

Preferred shares are rarer than you might think. A recent survey of 200 corpora-tions revealed that only 31% of them had preferred shares outstanding (Exhibit 9-4).1

All corporations have common shares.Exhibit 9-5 summarizes the similarities and differences among common shares,

preferred shares, and long-term debt.

No-Par-Value Shares. No-par-value shares are shares of stock that do not have avalue assigned to them by the articles of incorporation. The board of directors assignsa value to the shares when they are issued; this value is known as the stated value.For example, Dajol Inc. has authorization to issue 100,000 shares of common stock,having no par value assigned to them by the articles of incorporation. Dajol Inc.needs $50,000 at incorporation, and might issue 10,000 shares for $5.00 per share,2,000 shares at $25.00 per share, or 1,000 shares at $50.00 per share, and so on. Thepoint is that Dajol Inc. can assign whatever value to the shares the board of directorswishes. Normally, the stated value would be credited to Common Shares when theshares are issued.

The recorded value of a corporation’s contributed capital or stated capital is thesum of the shares issued times the stated values of those shares at the time of issue.For example, if YDR Ltd. issued 1,000 common shares at a stated value of $8.00 pershare, 2,000 shares at $12.00 per share, and 500 shares at $15.00 per share, its con-tributed capital or stated capital would be $39,500 [(1,000 × $8) + (2,000 × $12) +(500 × $15)].


Preferred sharesShares that give their owners

certain advantages, such as thepriority to receive dividends

before the common shareholdersand the priority to receive assets

before the common shareholdersif the corporation liquidates.

▼

Exhibit 9-4Preferred Shares

Corporationswith preferred

shares

69%31%

Corporationswith no

preferred share

✔ Check Point 9-2▼Exhibit 9-5

Comparison of Common Shares,Preferred Shares, and Long-TermDebt

Common Shares Preferred Shares Long-Term Debt

1.Corporate obligation No No Yesto repay principal

2.Dividends/interest Dividends not Dividends not Tax-deductible tax-deductible tax-deductible interest expense

3.Corporate obligation Only after Only after At fixed datesto pay dividends/interest declaration declaration

1Byrd, Clarence, Ida Chen, and Heather Chapman. Financial Reporting in Canada, 27th Edition, (Toronto:Canadian Institute of Chartered Accountants, 2002), p. 344.

No-par-value sharesShares of stock that do not havea value assigned to them by the

articles of incorporation.

Stated valueArbitrary amount assigned by acompany to a share of its stock

at the time of issue.

The Canada Business Corporations Act and most provincial incorporating actsnow require common and preferred shares to be issued without nominal or parvalue. The full amount of the proceeds from the sale of shares by a company must beallocated to the capital account for those shares. For example, if Canadian TireCorporation, Limited were to issue 100 common shares for $2,500 (that is, theshares sold for $25.00 per share), $2,500 would be credited to Common Shares.

Issuing SharesLarge corporations such as Nortel Networks Corporation, Hudsons Bay Company,and EnCana Corp. need huge quantities of money to operate. Corporations may sellshares directly to the shareholders or use the service of an underwriter, such as thebrokerage firms Scotia McLeod and BMO Nesbitt Burns. Companies often advertisethe issuance of their shares to attract investors. The Globe and Mail Report on Businessand the National Post are the most popular mediums for such advertisements, whichare also called tombstones.

Exhibit 9-6 on page 426 is a reproduction of Mega Bloks Inc.’s tombstone,which appeared in the Globe and Mail. The lead underwriter of Mega Bloks Inc.’s pub-lic offering was Merrill Lynch Canada Inc. Several other Canadian firms wereinvolved in the issue. In this 2003 public offering (illustrated in Exhibit 9-6), MegaBloks Inc. sought to raise $133,799,660 of capital.

Issuing Common Shares at a Stated Value. Suppose George Weston Limited, aleadng food processing and food distribution company, issues 100,000 commonshares for cash, and the directors determine that the shares will be issued with astated value (selling price) of $70 per share. The share issuance entry is

2005Jan. 8 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000,000

Common Shares . . . . . . . . . . . . . . 7,000,000To issue common shares at $70.00 per share (100,000 × $70.00)

We assume George Weston Ltd. received $7,000,000. The amount invested inthe corporation, $7,000,000 in this case, is called contributed capital. The credit toCommon Shares records an increase in the contributed capital of the corporation.

George Weston, in its annual report dated December 31, 2004, indicated therewere 128,913,579 common shares outstanding with a stated value of $126,000,000.After this assumed transaction, George Weston would report 129,031,579 outstandingshares and the balance in its share capital account would be increased by $7 million.

All the transactions recorded in this section include a receipt of cash by the cor-poration as it issues new shares. These transactions are different from those reportedin the financial press. In those transactions, one shareholder sells shares to anotherinvestor, and the corporation makes no journal entry.

Issuing Shares 461

Objective

2Measure the effect of issuingshares on a company’sfinancial position

✔ Check Point 9-3

✔ Check Point 9-4


▼ Exhibit 9-6 Announcement of Public Offering of Mega Blocks Inc. Common Shares

Number of sharesoffered to the public

Company issuingthe shares

Class of shares

Lead underwriter

Issue price: the amountper share received by Mega Bloks Inc.

Common Shares Issued for Assets Other Than Cash. When a corporationissues shares in exchange for assets other than cash, it records the assets received attheir current market value and credits the capital accounts accordingly. The assets’prior book value does not matter because the shareholder will demand shares equalto the market value of the asset given. Kahn Corporation issued 15,000 commonshares for equipment worth $4,000 and a building worth $120,000. KahnCorporation’s entry is

Nov. 12 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000

Common Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 124,000To issue common shares in exchange for equipment and a building.

ASSETS � LIABILITIES � SHAREHOLDERS’ EQUITY

�4,000

�120,000� 0 + �124,000

Issuing Shares 463

Examine Shoppers Drug Mart’s balance sheet at January 3, 2004, given at the beginning of thechapter (page 419). Answer these questions about Shoppers Drug Mart’s actual stock transactions (amounts in thousands of dollars, except per share):

1. What was Shoppers’ contributed capital from common shares at January 1, 2005? At January 3, 2004?

2. How many common shares were issued through January 1, 2005? Through January 3, 2004?

3. What was the average issue price of the common shares that Shoppers issued during theyear-ended January 1, 2005 and January 3, 2004?

Answers:

January 1, 2005 January 3, 2004

1. Total contributed capital $1,421,980 + $1,641 $1,411,878 + $216= $1,423,621 = $1,412,094

2. Number of common shares issued 275,632 29,691

3. Average issue price of shares $5,008,000 ÷ 275,632 $377,000 ÷ 29,691issued during year ended Jan. 1, = $18.17 = $10.682005 or Jan. 3, 2004

STOP & THINK

✔ Check Point 9-5


ACCOUNTING ALERTA Stock Issuance for Other Than Cash Can Pose an Accounting ProblemGenerally accepted accounting principles say to record shares at the fair market value of whatever thecorporation receives in exchange for the shares. When the corporation receives cash, the cash receivedprovides clear evidence of the value of the shares because cash is worth its face amount.

Many entrepreneurs start up companies with an asset other than cash. They invest the asset andreceive the new corporation’s shares. A computer whiz may contribute some computer hardware andsoftware. The software may be market-tested or it may be new. It may be worth millions or it may beworthless. An artist may contribute paintings or sculpture to start an art gallery. A real-estate agent mayinvest in a building to start a realty company.

The corporation must record the asset received and the shares given with a journal entry such asthe following:

Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXXCommon Shares . . . . . . . . . . . . . . . . . . . . XXX

Issued shares in exchange for software.

In effect, the new corporation is buying the software and paying for it by issuing common shares.Therefore, the business must assign a value to the software and to the common shares. The market valueof the software determines the value assigned to the shares. What is the software really worth? Let’s con-sider two possibilities:

Situation 1. The software has been on the market for several months and is selling well. The creator ofthe software has standing orders for 2,000 copies, and an industry expert values the software at$500,000. To start up the new corporation, the company makes this entry:

Software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000Common Shares . . . . . . . . . . . . . . . . . . . . 500,000


Situation 2. The software is new and untested. The entrepreneur believes it is worth millions butdecides to be conservative and values it at $500,000. For its first transaction, the company makes thisentry:

Software . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000Common Shares . . . . . . . . . . . . . . . . . 500,000


Suppose both entrepreneurs need $200,000 to market the software. They invite you to invest in theirnew business. Both balance sheets look identical:

Gee-Whiz Computer SolutionsBalance Sheet

December 31, 20X8

ASSETS LIABILITIESCompute software . . . . . $500,000 $ -0-

SHAREHOLDER EQUITYCommon shares . . . . . . . . . . . . 500,000

Total assets . . . . . . . . . . . $500,000 Total liabilities and equity . . . . $500,000

Both companies are debt-free and both appear to have a valuable asset. Which company will you investin? Here are three takeaway lessons:

• Be careful when you invest your money.• Some accounting values are more solid than others.• Not all financial statements mean exactly what they say—unless they are audited by independent

CPAs.

Preferred SharesAccounting for preferred shares follows the pattern we illustrated for commonshares. The company records a Preferred Shares account at its stated value. Whenreporting shareholders’ equity on the balance sheet, a corporation lists preferredshares, common shares, and retained earnings—in that order, illustrated as followsfor George Weston Limited:

2004 2003

Common share capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $126 $120

Preferred shares, series 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228 228

Preferred shares, series 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260 260

Share capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 614 608

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,170 4,046

Cumulative foreign currency translation adjustment . . . . . . . (404) (192)

Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,380 $4,462

On April 18, 2005 George Weston Ltd. announced the completion of the sale of8,000,000 Series III Preferred Shares for proceeds of $200 million. The journal entryto record this issuance would be:

2005Apr 18 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Preferred shares, class 3 . . . . . . . . . . . . . . . . . . . . . . 200To record issuance of 8,000,000 Series III preferred shares.

After this issuance the shareholders’ equity section would appear as follows:

Common share capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 126

Preferred shares, series 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228



Share capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $814

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,170

Cumulative foreign currency translation adjustment . . . . . . . . . . . . . . . . . . (404)

Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,580

Ethical ConsiderationsIssuance of shares for cash poses no serious ethical challenge. The company simplyreceives cash and records the shares at the amount received, as illustrated in the pre-ceding sections of this chapter. There is no difficulty in valuing shares issued for cashbecause the value of the cash—and the shares—is obvious.

Issuing shares for assets other than cash can pose an ethical challenge. Thecompany issuing the shares often wishes to record a large amount for the noncashasset 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 thebusiness look more prosperous and more creditworthy.

A company is supposed to record an asset received at its current market value.But one person’s perception of a particular asset’s market value can differ from

Issuing Shares 465


Mid-Chapter Summary Problem

another person’s opinion. One person may appraise land at a market value of$400,000. Another may honestly believe the land is worth only $300,000. A com-pany receiving land in exchange for its shares must decide whether to record the landreceived and the shares issued at $300,000, at $400,000, or at some amount inbetween.

The ethical course of action is to record the asset at its current fair market value,as determined by a good-faith estimate of market value from independent appraisers.It is rare for a public corporation to be found guilty of understating the asset values onits balance sheet, but companies have been embarrassed by overstating these values.Investors who rely on the financial statements may be able to prove in a court of lawthat an overstatement of asset values caused them to pay too much for the company’sshares. In this case, the court may render a judgment against the company. For thisreason, companies often value assets conservatively.

1. Test your understanding of the first half of this chapter by deciding whether each of thefollowing statements is true or false.

a. The policy-making body in a corporation is called the board of directors.b. The owner of 100 shares of preferred stock has greater voting rights than the owner of

100 shares of common stock.c. Issuance of 1,000 common shares at $12 per share increases contributed capital by

$12,000.d. A corporation issues its preferred shares in exchange for land and a building with a

combined market value of $200,000. This transaction increases the corporation’s own-ers’ equity by $200,000 regardless of the assets’ prior book values.

e. Preferred shares are a riskier investment than common shares.

2. Magna International Inc., a global leader in assemblies and components for automobilemanufacturers, has two classes of common shares. Class A shares are entitled to one vote,whereas Class B shares are entitled to 500 votes and are convertible on a one-for-one basisinto Class A shares. The two classes rank equally for dividends. The following is extractedfrom a recent annual report:

Shareholders’ Equity (in millions of U.S. dollars)

Capital stockClass A subordinate voting shares (issued 94,477,224 shares) $2,487Class B shares (issued 1,096,509 shares) . . . . . . . . . . . . . . 1

Preferred securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277Other paid in capital* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,570Currency translation adjustment . . . . . . . . . . . . . . . . . . . . . . 22

$5,421

*This balance represents the present-value of the face amount of subordinated debentures issued by Magna

Required

a. Record the issuance of the Class A common shares. Use the Magna account titles.b. Record the issuance of the Class B common shares. Use the Magna account titles.

✔ Check Point 9-6

✔ Check Point 9-7

Name: Magna International Inc.Industry: Auto parts manufacturing corporation Fiscal Period: A recent fiscal year

Repurchase of Shares by a Corporation 467

c. How much of Magna’s shareholders’ equity was contributed by the shareholders? Howmuch was provided by profitable operations? Does this division of equity suggest thatthe company has been successful? Why or why not?

d. Write a sentence to describe what Magna’s shareholders’ equity means.

Answers1. a. True b. False c. True d. True e. False2. a. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,487,000,000

Class A Subordinate Voting Shares . . . . . . . . . . . . . . 2,487,000,000To record issuance of Class A common shares.

b. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000Class B Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

To record issuance of Class B common shares.

c. Contributed by the shareholders: $2,488,000,000 ($2,487,000,000 � $1,000,000).Provided by profitable operations: $2,570,000,000.This division suggests that the company has been successful because more than half ofits shareholders’ equity has come from profitable operations.

d. Magna shareholders’ equity of $5,421,000,000 means that the company’s shareholdersown $5,421,000,000 of the business’s assets.

Repurchase of Shares by a CorporationCorporations may repurchase their own shares for several reasons:

1. The company needs the repurchased shares to fulfill future share issuancecommitments, such as those related to share option plans and conversions ofbonds and preferred shares into common shares.

2. The purchase may help support the share’s current market price by decreasingthe supply of shares available to the public; that is, repurchase is anti-dilutive.

3. Management wants to avoid a takeover by an outside party.

Firms incorporated under certain provincial jurisdictions are permitted to reac-quire shares that they previously issued and hold these shares for future issuance.Such shares, called treasury shares, are accounted for as a contra account to share-holders’ equity beneath Retained Earnings. Corporations that are incorporated underthe Canada Business Corporations Act are required to immediately cancel any reac-quired shares so treasury shares do not exist for federally incorporated companies.During 2004, for example, George Weston Ltd. purchased 587,500 of its commonshares for $59 million for cancellation.

DECISION: Should a Company Buy Back Its Own Shares?Let’s illustrate the accounting for repurchased shares by using the data of Ava SmallcoLtd. If Ava Smallco Ltd. had not repurchased any of its shares, the company wouldhave reported the following shareholders’ equity at December 31, 2006:

Objective

3 Describe how sharerepurchase transactions affecta company

Repurchased sharesA corporation’s own shares thatit has issued and laterreacquired.

b. Preferred shareholders typically do nothave voting rights. e. Preferred shares areless risky because they usually have a fixeddividend rate.

a. and b. Share issuances increase assets(cash) and shareholders’ equity.

Compare the fraction of shareholders’equity contributed by shareholders to thefraction contributed by retained earnings. Agreater retained earnings fraction is posi-tive.

Shareholders’ equity is the net worth of thecompany (assets – liabilities).

(Before Repurchase of Shares)

Common shares (100,000 shares authorized; 10,000 shares issued) $ 70,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193,632Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $263,632

During 2007, Ava Smallco Ltd. paid $12,000 to repurchase 1,000 of its commonshares for cancellation. Ava Smallco Ltd. recorded the share repurchase as follows:

2007Nov. 12 Common Shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Repurchased common shares for cancellation.

When a company repurchases its shares for more than the shares were issued fororiginally, it is deemed to be distributing profits (from Retained Earnings) to thoseshareholders who are selling their shares back to the company. When the companyrepurchases its shares for less than the issue price, the difference is considered con-tributed surplus arising from the share repurchases and Contributed Surplus—ShareRepurchase is credited for the difference between the issue price and repurchase price.

Ava Smallco Ltd.’s shareholders’ equity would be shown as follows after therepurchase:

(After Repurchase of Shares)

Common shares (99,000 shares authorized; 9,000 shares issued) . . $ 63,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188,632Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $251,632

Compare Ava Smallco Ltd.’s total equity before the repurchase of shares($263,632) and after ($251,632). You will see that Ava Smallco Ltd.’s total equitydecreased by $12,000, the amount the company paid to buy back its own shares. Therepurchase of shares has the opposite effect of issuing shares:

• Issuing shares grows a company’s assets and equity.

• Repurchasing shares shrinks assets and equity.

In most cases the company cancels the shares when they are repurchased.Shares that are reissued are accounted for in exactly the same way as shares that areissued for the first time.


Retained Earnings, Dividends, and SplitsWe have seen that the equity section of the corporation balance sheet is called share-holders’ equity. The contributed capital accounts and retained earnings make up theshareholders’ equity section.

The Retained Earnings account carries the balance of the business’s net incomeless its net losses and less any declared dividends accumulated over the corporation’slifetime. Retained means “held on to.” Successful companies grow by reinvesting backinto the business the assets they generate through profitable operations. BombardierInc. is an example; about 60 percent of its equity comes from retained earnings.

The Retained Earnings account is not a reservoir of cash waiting for the board ofdirectors to pay dividends to the shareholders. In fact, the corporation may have a largebalance in Retained Earnings but not have the cash to pay a dividend. Cash andRetained Earnings are two separate accounts with no particular relationship. A$500,000 balance in Retained Earnings simply means that $500,000 of owners’equity has been created by profits reinvested in the business. It says nothing aboutthe company’s Cash balance or about any specific asset.

A credit balance in Retained Earnings is normal, indicating that the corporation’slifetime earnings exceed its lifetime losses and dividends. A debit balance in RetainedEarnings arises when a corporation’s lifetime losses and dividends exceed its lifetimeearnings. Called a deficit, this amount is subtracted from the sum of the other equityaccounts to determine total shareholders’ equity. In a recent survey, 47 of 200 com-panies (23.5%) had a retained earnings deficit (Exhibit 9-7).2

DECISION: Should the Company Declare and Pay CashDividends?

A dividend is a corporation’s return to its shareholders of some of the benefits ofearnings, commonly in the form of cash payments. Corporate finance coursesaddress the question of how a company decides on its dividend policy. Accounting

Retained Earnings, Dividends, and Splits 469

Report Ava Smallco Ltd.’s shareholders’ equity after issuing 1,000 new shares for $14,000.

Answer:

Common shares (99,000 shares authorized; 10,000 shares issued) . . . . . . . . . . $ 77,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188,632Total equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $265,632

Now compare total equity after selling the new shares to total equity before Ava Smallco Ltd.repurchased shares. What was the net effect of buying shares for cancellation and selling newshares?

Answer:

Total equity after repurchase and sale of new shares . . . . . . . . . . . . . . . . . . . . . $265,632Total equity before repurchase of shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263,632Increase in shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000The number of shares authorized has decreased by 1,000 shares.

STOP & THINK

DeficitDebit balance in the RetainedEarnings account.

✔ Check Point 9-8

✔ Check Point 9-9

▼

Exhibit 9-7Retained Earnings of theFinancial Reporting inCanada 200 Companies

23.5%

Corporationswith RetainedEarnings deficits

Corporations withpositive balance ofRetained Earnings

76.5%

2 Byrd, Clarence, Ida Chen, and Heather Chapman. Financial Reporting in Canada, 27th Edition (Toronto:Canadian Institute of Chartered Accountants, 2002), p. 342.

DividendDistribution (usually cash) by acorporation to its shareholders.

Objective

4 Account for dividends andmeasure their impact on acompany

tells a company if it has the wherewithal to pay cash dividends. To do so, a companymust have

• sufficient retained earnings to declare the dividend

• sufficient enough Cash to pay the dividend

A corporation declares a dividend before paying it. Only the board of directorshas the authority to declare a dividend. The corporation has no obligation to pay adividend until the board declares one, but once declared, the dividend becomes alegal liability of the corporation.

Dividends cannot be paid from contributed capital without special permissionfrom creditors and firms may be restricted from paying dividends due to contractualarrangements with creditors. Further restrictions are imposed on firms incorporatedunder the Canada Business Corporations Act, which requires firms to meet the follow-ing liquidity tests:

1. the dividend must not render the firm unable to meet obligations to creditors;

2. the dividend must not result in the net realizable of assets being less than thesum of liabilities plus stated capital.

Following is a list of some common terms related to dividends along with their defi-nitions.

Key terms and definitions related to dividends

Retained Earnings The portion of net income accumulated to date not distributed toshareholders as dividends

Declaration Date The date on which the next dividend payment is announced by aCompany’s Board of Directors.

Date of Record The specified future date set by the firm’s directors on which all personswhose names are recorded as shareholders are entitled to receive a declareddividend.

Ex Dividend The date after which shares are sold without the right to receive the currentdividend. The date is usually set two days before the record date to allow forthe transfer of shares among buyers and sellers. Dividends declared onshares transferred after the ex-dividend date go to the seller.

Payment Date The actual date on which the firm makes the dividend payment toshareholders of record.

Payment Payout Ratio The percentage of net income paid out in dividends to shareholders. During2004, for example, TD Financial Group paid out 40% of earnings asdividends.

Cum Dividend When a buyer of shares is entitled to receive a dividend that has beendeclared, but not paid.

Journal entries are recorded only for the dates that dividends are declared and paid.For example assume the following quarterly dividend payment information for600,000 TD Financial Group common shares:

Rate $0.40 per shareEx-dividend Date Sept 13, 2005Record Date Sept 15, 2005Payment Date Oct 31, 2005


Journal entries are recorded on the dates that dividends are declared and when theyare paid as follows:

Sept. 15 Retained Earnings or Dividends . . . . . . . . . . . . . . . . . . . . . . 240,000Dividends Payable (600,000 � $0.40) . . . . . . . . . . . . . . . 240,000Declared cash dividend

Oct. 31 Dividends Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240,000Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240,000

Paid cash dividend.

Dividends on Preferred SharesWhen a company has issued both preferred and common shares, the preferred share-holders receive their dividends first. The common shareholders receive dividends onlyif the total declared dividend is large enough to pay the preferred shareholders first.

Pinecraft Industries Inc., a furniture manufacturer, has 100,000 shares of $1.50cumulative preferred shares outstanding in addition to its common shares. This$1.50 designation means that preferred dividends are paid at the annual amount of$1.50 per share. Assume that in 2006, Pinecraft declares an annual dividend of$1,000,000. The allocation to preferred and common shareholders is as follows:

Preferred dividend (100,000 shares � $1.50 per share) . . . . . . . . . . . . . . $ 150,000Common dividend (remainder: $1,000,000 � $150,000) . . . . . . . . . . . . 850,000Total dividend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

If Pinecraft declares only a $200,000 dividend, preferred shareholders receive$150,000, and the common shareholders receive the remainder, $50,000 ($200,000� $150,000).

Expressing the Dividend on Preferred Shares. Dividends on preferred sharesare stated as a dollar amount since preferred shares do not have a nominal or parvalue. For example, preferred shares may be “$3 preferred,” which means that share-holders receive an annual dividend of $3 per share.

Dividends on Cumulative and Noncumulative Preferred Shares. The alloca-tion of dividends may be complex if the preferred shares are cumulative. Corporationssometimes fail to pay a dividend to preferred shareholders. This is called passing thedividend, and the passed dividends are said to be in arrears. The owners ofcumulative preferred shares must receive all dividends in arrears plus the currentyear’s dividend before the corporation can pay dividends to the common sharehold-ers. The law considers preferred shares noncumulative unless they are specifically labelled

If the preferred shares are noncumulative, the corporation is not obligated to paydividends in arrears. A liability for dividends arises only when the board of directorsdeclares the dividend.

Some preferred shares have a participation feature. The following events willoccur when a company pays out extra dividends on participating preferred shares:

• preferred shareholders receive their usual dividend • common shareholders receive dividends proportionate to preferred • the excess above these amounts is shared by common and preferred in propor-

tion to the total value of both classes of shares or according to some otheragreed formula

The details of determining dividends for participating preferred shares will be left toan intermediate accounting course.

Limited Voting Rights Preferred shares are generally non-voting. However, limited voting is sometimesgranted to preferred shareholders under the following conditions:

• When the company wants to liquidate a large portion of corporate assets• When the company wants to merge with another company• When the company wants to issue new bonds or preferred shares

Call Provisions Preferred shares may be callable. This allows the issuing company to repurchase theshares from shareholders at a predetermined price and retire them. The call priceincludes the payment of any dividends in arrears and generally includes a premiumto compensate the preferred shareholders for the inconvenience of having theirshares called. A call price of 102 means that call price is 102% of the book value ofthe preferred shares called. If on April 1 a company called $100,000 of preferredshares that have $3,000 of dividends in arrears at 102, the following entry would bemade to record the call.

Apr. 1 Preferred shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000Loss on call of preferred shares . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000Dividends or Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Cash (102% � $100,000 � $3,000) . . . . . . . . . . . . . . . . . . 105,000 To call $100,000 of preferred shares at 102, with $3,000 dividends in arrears.

DECISION: Why Issue a Stock Dividend?A stock dividend is a proportional distribution by a corporation of its own stock toits shareholders. Stock dividends increase the shares account and decrease RetainedEarnings. Total equity is unchanged, and no asset or liability is affected.

The corporation distributes stock dividends to shareholders in proportion tothe number of shares they already own. If you own 300 common shares ofTransCanada PipeLines Limited (TCPL) and TCPL distributes a 10% common stockdividend, you will receive 30 (300 � 0.10) additional shares. You would then own330 common shares. All other TCPL shareholders would also receive additionalshares equal to 10% of their prior holdings.


Stock dividendA proportional distribution by acorporation of its own stock to

its shareholders.

In distributing a stock dividend, the corporation gives up no assets. Why, then,do companies issue stock dividends? A corporation may choose to distribute stockdividends for the following reasons:

1. To continue dividends but conserve cash. A company may want to keep cash foroperations and yet wish to continue dividends in some form. So the corporationmay distribute a stock dividend. Shareholders pay no tax on stock dividends.

2. To reduce the per-share market price of its shares. Distribution of a stock div-idend may cause the market price of a share of the company’s stock to fallbecause of the increased supply of the stock. The objective is to make the sharesless expensive and thus more attractive to a wider range of investors.

Suppose TCPL declared a 2% stock dividend in 2006. At the time, assumeTCPL had 480 million common shares outstanding. TCPL is incorporated under theCanada Business Corporation Act, which suggests that the market value of the shares atthe time of declaration be used to value the dividend. At the time of the stock divi-dend, assume TCPL’s shares are trading for $30 per share. TCPL would record thisstock dividend as follows:

2006Jan. 19 Retained Earnings (480,000,000 shares of common

outstanding � 0.02 stock dividend � $30 market value per common share) (�ve) $ . . . . . . . . . . . . . 288,000,000

Common Shares (�ve) . . . . . . . . . . . . . . . . . . . 288,000,000Distributed a 2% stock dividend.

Retained Earnings, Dividends, and Splits 473

A corporation issued 1,000 common shares as a stock dividend when the stock’s market price was$25 per share. Assume that the 1,000 shares issued are (1) 10% of the outstanding shares and (2)100% of the outstanding shares. Does either stock dividend change total shareholders’ equity?

Answer:No, neither a large stock dividend nor a small stock dividend affects total shareholders’ equity.Why? Because all the accounts affected by a stock dividend are part of shareholders’ equity.

STOP & THINK

Stock SplitsA stock split is an increase in the number of authorized, issued, and outstandingshares of stock, coupled with a proportionate reduction in the share’s book value. Forexample, if a company splits its stock 2 for 1, the number of outstanding shares isdoubled and each share’s value is halved. A stock split, like a stock dividend,decreases the market price of the shares—with the intention of making the sharesmore attractive in the market. Leading companies in Canada—Bank of Nova Scotia,MDS Inc., Dofasco Inc., and others—have split their stock.

Winpak Ltd., one of the leading packaging companies in Canada, is based inWinnipeg. Recent market price of Winpak’s common shares has been in the $120-per-share range. Assume that Winpak wishes to decrease the market price to approx-imately $60. Winpak may decide to split its common shares 2 for 1. A 2-for-1 stocksplit means that the company would have twice as many shares outstanding after thesplit as it had before and that each share’s value would be cut in half. Before the split,Winpak had approximately 6.5 million common shares issued and outstanding.Compare Winpak’s shareholders’ equity before and after a 2-for-1 stock split:

✔ Check Point 9-12

Stock splitAn increase in the number of authorized, issued, and outstanding shares of stock coupled with a proportionate reduction in the share’s book value.

All account balances are the same after the stock split as before. Only the num-ber of shares issued is affected. Total equity does not change.

The following table summarizes the effects of cash dividends, stock dividends,and stock splits on various balance sheet elements and on the percentage of share-holder ownership:

Cash Dividend Stock Split Stock Dividend

Total assets Decrease No effect No effect

Total liabilities No effect No effect No effect

Total share capital No effect No effect Increase

Total retained earnings Decrease No effect Decrease

Total shareholders’ equity Decrease No effect No effect

Number of shares No effect Increase Increase

% of shareholder ownership No effect No effect No effect

Retained Earnings RestrictionsAs emphasized in previous chapters, Retained Earnings represent a corporation’s life-time earnings minus lifetime dividends to date (both cash dividends and stock divi-dends). In some cases restrictions to protect creditors are imposed that make aportion of the current Retained Earnings balance unavailable for dividends.

Restrictions are disclosed in the notes accompanying financial statements andresult from one or more of the following causes:

Legal Regulatory agencies limit dividend payments to the balance of retainedearnings.

Contractual Debt covenants related to bank loans may restrict dividends to a speci-fied percent of retained earnings.

Voluntary Corporate directors may limit dividends so that cash can be used in thebusiness to take advantage of investment opportunities.

Measuring the Value of SharesThe business community measures share values in various ways, depending on thepurpose of the measurement. These values include market value, redemption value,liquidation value, and book value.


Objective

5 Use different share values indecision making

Winpak’s Shareholders’ Equity (Adapted)Before 2-for-1 Stock Split: (In thousands) After 2-for-1 Stock Split (In thousands)

Common shares, unlimited number of shares Common shares, unlimited number of shares authorized, 6.5 million shares issued . . . . . . . . $ 44,669 authorized, 13 million shares issued . . . . . . $ 44,669

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . 173,938 Retained earnings . . . . . . . . . . . . . . . . . . . . . . 173,938Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,788 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,788Total shareholders’ equity . . . . . . . . . . . . . . . . . . . $227,395 Total shareholders’ equity . . . . . . . . . . . . . . . . $227,395

Market, Redemption, Liquidation, and Book ValueA share’s market value, or market price, is the price for which a person can buy or sella share of stock. The issuing corporation’s net income, financial position, and futureprospects and the general economic conditions determine market value. In almost allcases, shareholders are more concerned about the market value of a share than about any ofthe other values discussed next. In the chapter opening story, we discussed IntrawestCorporation. Its shares, at the time of writing, were trading at around $17 per share.Therefore, if Intrawest were issuing 1,000 common shares, Intrawest would receive$17,000 (1,000 shares � $17.00 per share).

Preferred shares that require the company to redeem (pay to retire) the shares ata set price are called redeemable preferred shares. The company is obligated to redeemthe preferred shares, so redeemable preferred shares are really not shareholders’equity but instead are a liability. The price the corporation agrees to pay for theshares, which is set when the shares are issued, is called the redemption value.Liquidation value is the amount that a company must pay a preferred shareholder inthe event the company liquidates (sells out) and closes its doors.

The book value per common share is the amount of owners’ equity on thecompany’s books for each common share. If the company has only common sharesoutstanding, its book value is computed by dividing total equity by the number ofcommon shares outstanding. For example, a company with shareholders’ equity of$180,000 and 5,000 common shares outstanding has a book value of $36 per share($180,000 ÷ 5,000 shares).

If the company has both preferred shares and common shares outstanding, thepreferred shareholders have the first claim to owners’ equity. Preferred shares oftenhave a specified liquidation or redemption value. The preferred equity is its redemp-tion value plus any cumulative preferred dividends in arrears. Book value per com-mon share is then computed as follows:

Assume that the company balance sheet reports the following amounts:

Shareholders’ Equity

Preferred shares, $6.00, 400 shares issued, redemption value $130 per share . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000

Common shares, 5,000 shares issued . . . . . . . . . . . . . . . . . . . . . . . 131,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $241,000

Suppose that four years (including the current year) of cumulative preferreddividends are in arrears and observe that preferred shares have a redemption value of$130 per share. The book-value-per-share computations for this corporation are asfollows:

Book valueper common

share

Total shareholders’equity Preferred equity

Number of common shares outstanding=

−

Measuring the Value of Shares 475

Market value (of a share)Price for which a person couldbuy or sell a share of stock.

Book value (of a share)Amount of owners’ equity on thecompany’s books for each shareof its stock.

Preferred equityRedemption value (400 shares � $130) . . . . . . . . . . . . . . . . . . . . . . . . $ 52,000Cumulative dividends (400 � $6.00 � 4 years) . . . . . . . . . . . . . . . . . . 9,600Preferred equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 61,600*

Common equityTotal shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $241,000Less preferred equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (61,600)Common equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $179,400Book value per share [$179,400 � 5,000 shares outstanding] . . . . . . . $ 35.88

*If the preferred shares had no redemption value, then preferred equity would be $40,000.

DECISION: Using Book Value Per ShareCompanies negotiating the purchase of a corporation may wish to know the bookvalue of its shares. The book value of shareholders’ equity may figure into the negoti-ated purchase price. Corporations—especially those whose shares are not publiclytraded—may buy out a retiring executive, agreeing to pay the book value of the per-son’s shares in the company.

Some investors compare the book value of a company’s shares with the shares’market value. The idea is that a share selling below its book value is underpriced andthus a good buy. Let’s compare two companies, Sobeys Inc. and Leon’s Furniture Ltd.:


✔ Check Point 9-13

Book Value Per ShareRecent Share Common share- Number of common Book

Company Price holders’ equity shares outstanding Value

Sobeys Inc. $37.31 $1,402,000,000/ 65,744,856 � $ 21.32Leon’s Furniture Ltd $24.25 $234,000,000/ 19,490,144 � $ 12.01

( ( ))/

Neither company’s shares are selling below their book value. But Sobeys’ book valueper share is somewhat closer to its market value than Leon’s. Does this mean Sobeys’shares are the better investment? Not necessarily. Investment decisions should bebased on more than one ratio. Let’s turn now to two widely used measures of operat-ing performance.

DECISION: Relating Profitability to a Company’s SharesInvestors and creditors are constantly evaluating managers’ ability to earn profits.Investors search for companies whose shares are likely to increase in value.Investment decisions often include a comparison of companies. But a comparison ofSobeys Inc.’s net income with the net income of a new dot-com startup is not mean-ingful. Sobey’s profits may run into the millions of dollars, which far exceed a newcompany’s net income. Does this automatically make Sobeys a better investment? Notnecessarily. To make relevant comparisons among companies of different size,investors use some standard profitability measures. Two prominent measures of prof-itability are return on assets and return on equity.

Objective

6 Evaluate a company’s returnon assets and return onshareholders’ equity

investments is called using leverage. Leverage increases net income as long as operat-ing income exceeds the interest expense from borrowing.

Investors and creditors use return on common shareholders’ equity in much thesame way they use return on total assets—to compare companies. The higher the rate ofreturn, the more successful the company. In most industries, 15% is considered good.Therefore, the Sobeys’ 17.7% return on common shareholders’ equity is quite good.

The Decision Guidelines feature (page 440) offers suggestions for what to con-sider when investing in shares.

Reporting Shareholders’ Equity Transactions

Cash Flow StatementMany of the transactions discussed in this chapter are reported on the cash flow state-ment. Shareholders’ equity transactions are financing activities because the company isdealing with its owners, the shareholders—the basic group of people who finance thecompany. Financing transactions that affect shareholders’ equity and cash (and thusappear on the cash flow statement) fall into three main categories: issuances ofshares, repurchases of shares, and dividends.

Issuances of Shares. Issuances of shares include basic transactions in which a com-pany issues its shares for cash.

During 2004 George Weston Ltd. paid dividends of $1.44 per common shareand $1.45 and $1.29 on its Series I and II preferred shares, respectively. The com-pany reported the following financing cash flow information related to shareholders’equity in its cash flow statement:


Objective

7 Report shareholders’ equitytransactions on the cash flowstatement

▼Exhibit 9-8George Weston Corporation’sFinancing Activities (Adapted)

($ millions)

Financing activities:Share capital – retired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (59)Dividends – to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (205)

– to minority shareholders . . . . . . . . . . . . . . . . . . . . . . . . . (80)✔ Check Point 9-16

Repurchases of Shares. As we discussed earlier, a company can repurchase itsshares. During 2004, Ssuppose Shoppers Drug Mart, for example, repurchased com-mon shares for $358,000 and reported the payment as a financing activity.

Dividends. Most companies pay cash dividends to their shareholders. Dividend pay-ments are a type of financing transaction because the company is paying its share-holders for the use of their money. Stock dividends are not reported on the cash flowstatement because the company pays no cash. George Weston paid dividends in theamount of $285 million during 2004.

Variations in Reporting Shareholders’ EquityBusinesses often use terminology and formats in reporting shareholders’ equity thatdiffer from our examples. We use a more detailed format in this book to help youlearn all the components of shareholders’ equity. Companies assume that readers oftheir statements already understand the details.

One of the most important skills you will learn in this course is the ability tounderstand the financial statements of real companies. Exhibit 9-9 presents a side-by-side comparison of our general teaching format and the format you are morelikely to encounter in real-world balance sheets.


▼ Exhibit 9-9 Formats for Reporting Shareholders’ Equity

General Teaching Format Real-World Format

Shareholders’ equity Shareholders’ equityCapital stock:

Preferred shares, $0.80, cumulative, 30,000 shares authorized and issued. . . . . . . . . . . . . $ 300,000

Common shares, 100,000 shares authorized, 60,000 shares issued . . . . . . . . . . . 2,200,000

Contributed surplus from retirement of preferred shares. . . . . . . . . . . . . . . . . . . . . . . 11,000

Total capital stock . . . . . . . . . . . . . . . . . . . . . . 2,511,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 1,542,000Total shareholders’ equity . . . . . . . . . . . . . . . . . . $4,053,000

Preferred shares, $0.80, cumulative, 30,000shares authorized and issued . . . . . . . . . . . . . $ 300,000

Common shares, 100,000 shares authorized, 60,000 shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200,000

Contributed surplus . . . . . . . . . . . . . . . . . . . . . . 11,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 1,542,000Total shareholders’ equity . . . . . . . . . . . . . . . . . . $4,053,000

Decision Guidelines

INVESTING IN STOCKSuppose you’ve saved $5,000 to invest. You visit a nearby Scotia McLeod office, where the broker probesyou for your risk tolerance capacity. Are you investing mainly for dividends, or for growth in the shareprice? You must make some key decisions.

Investor Decision Guidelines

Which category of shares to buy for:

• A safe investment? Preferred shares are safer than common, but for even more safety, invest inblue chip stocks, high-grade corporate bonds, or government securities.

• Steady dividends? Cumulative preferred shares. However, the company is not obligated to declarepreferred dividends, and the dividends are unlikely to increase.

• Increasing dividends? Common shares, as long as the company’s net income is increasing and thecompany has adequate cash flow to pay a dividend after meeting all obligationsand other cash demands.

• Increasing share price? Common shares, but again only if the company’s net income and cash flow areincreasing.

How to identify a good stock to buy? There are many ways to pick share investments. One strategy that works rea-sonably well is to invest in companies that consistently earn higher rates ofreturn on assets and on equity than competing firms in the same industry. Also,select industries that are expected to grow.


End-of-Chapter Summary Problem

Excel Application ProblemGo to the CD included with this book, and create an Excel spreadsheet to compare the financialperformance of several publicly traded companies’ shares.

*The common shares were issued at a stated value of $8.00 per share.

1. The balance sheet of Trendline Corp. reported the following at December 31, 2006:


Preferred shares, $0.40, 10,000 shares authorized and issued (redemption value, $110,000) . . . . . . . . . . . . . . . $100,000

Common shares, 100,000 shares authorized* . . . . . . . . . . . . . . 400,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476,500Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $976,500

Required

a. Are the preferred shares cumulative or noncumulative? How can you tell?b. What is the total amount of the annual preferred dividend?c. How many common shares are outstanding?d. Compute the book value per share of the common shares. No preferred dividends are in

arrears, and Trendline Corp. has not yet declared the 2006 dividend.2. Use the following accounts and related balances to prepare the classified balance sheet of

Whitehall Inc. at September 30, 2006. Use the account format of the balance sheet.

Common shares, Property, plant, and50,000 shares authorized, equipment, net . . . . . . . . . . . . . . $226,00020,000 shares issued . . . . . . . . . . $100,000 Accounts receivable, net . . . . . . . . . 23,000

Dividends payable . . . . . . . . . . . . . . 4,000 Preferred shares, $3.75, Cash . . . . . . . . . . . . . . . . . . . . . . . . 9,000 10,000 shares authorized, Accounts payable . . . . . . . . . . . . . . 28,000 2,000 shares issued . . . . . . . . . . . 24,000Long-term note payable . . . . . . . . . 80,000 Accrued liabilities . . . . . . . . . . . . . . 3,000Inventory . . . . . . . . . . . . . . . . . . . . 85,000 Retained earnings . . . . . . . . . . . . . . 104,000

Answers1. a. The preferred shares are not cumulative because they are not specifically labelled

cumulative.b. Total annual preferred dividend: $4,000 (10,000 � $0.40).c. Common shares outstanding: 50,000 shares ($400,000 � $8 stated value).d. Book value per common share:

Common:Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $976,500Less shareholders’ equity allocated to preferred . . . . . . . . . . . . . . . . . . . . (110,000)*Shareholders’ equity allocated to common . . . . . . . . . . . . . . . . . . . . . . . $866,500Book value per share ($866,500 � 50,000 shares) . . . . . . . . . . . . . . . . . $17.33

*Redemption value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $110,000

All features must be specified in the finan-cial statements.

Details given on the balance sheet.

Each common share was sold for the $8stated value.

Book value per common share mustexclude any amounts pertaining to pre-ferred shares.

Review Shareholder’s Equity 481

2.

Whitehall Inc.Balance Sheet

September 30, 2006

Assets LiabilitiesCurrent Current

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000 Accounts payable . . . . . . . . . . . . . $ 28,000Accounts receivable, net . . . . . . . . . . . . . 23,000 Dividends payable . . . . . . . . . . . . . 4,000Inventory . . . . . . . . . . . . . . . . . . . . . . . . 85,000 Accrued liabilities . . . . . . . . . . . . . 3,000

Total current assets . . . . . . . . . . . . . . . 117,000 Total current liabilities . . . . . . . . 35,000Property, plant, and equipment, net . . . . . . 226,000 Long-term note payable . . . . . . . . . . . 80,000

Total liabilities . . . . . . . . . . . . . . . . $115,000

Shareholders’ EquityPreferred shares, $3.75,

10,000 shares authorized, 2,000 shares issued . . . . . . . . . . . . $ 24,000

Common shares, 50,000 shares authorized, 20,000 shares issued . . . . . . . . . . . 100,000

Retained earnings . . . . . . . . . . . . . . . 104,000Total shareholders’ equity . . . . . . . . . . . . . . . . . 228,000

Total liabilities and Total assets . . . . . . . . . . . . . . . . . . . . . . . $343,000 shareholders’ equity . . . . . . . . . . . . . . . . . . . . . $343,000

Review Shareholder ’s EquitySummary of Learning Objectives

1. Explain the advantages and disadvantages of a corpo-ration. Corporations are legal entities that exist apart fromtheir owners. The advantages of corporations are theirability to raise capital, continuous life, transferability ofownership, and limited liability of owners. The disadvan-tages are the separation of ownership from management,corporate taxation, and government regulation.

2. Measure the effect of issuing shares on a company’sfinancial position. Corporations may issue common orpreferred shares. Regardless of the type of shares, theirissuance increases assets and equity.

3. Describe how share repurchase transactions affect acompany. Repurchased shares are a corporation’s ownshares that it has issued and later reacquired. The pur-chase of its own shares decreases the company’s assets andequity.

4. Account for dividends and measure their impact on acompany. Companies may issue dividends in cash orshares. Preferred shares have priority over common. Allcash dividends decrease assets and equity.

A stock dividend is a proportional distribution by a cor-poration of its own shares to its shareholders. Stock divi-dends increase the shares account and decrease RetainedEarnings. Total shareholders’ equity is unchanged.

5. Use different share values in decision making. A share’smarket value is the price for which a person could buy orsell a share of the stock. The price a company agrees to payfor a share when buying it back is the share’s redemptionvalue. Liquidation value is the amount the corporationagrees to pay the preferred shareholders per share if thecorporation liquidates. Book value is the amount of owners’equity on the company’s books for each outstanding share.

6. Evaluate a company’s return on assets and return onshareholders’ equity. Return on assets and return onequity are two measures of profitability. Return on assetsmeasures a company’s success in using assets to earnincome for both creditors and the shareholders. Return onequity measures success in earning net income for thecommon shareholders. A healthy company’s return onequity will exceed its return on assets.

The classified balance sheet must specify current assets and current liabilities. Make sure thatTotal assets = Total liabilities + Shareholders’ equity.


Chapter Review Quiz1. Lauren Corporation is authorized to issue 40,000 common shares. On January 15, 2008,

it issued 10,000 shares at $15 per share. Lauren’s journal entry to record these factsshould include aa. credit to Common Shares for $600,000.b. credit to Common Shares for $150,000.c. debit to Cash for $600,000.d. debit to Common Shares for $150,000.

Questions 2–5 use some of the following account balances of ABC Corp. at March 31, 2007:

Cash . . . . . . . . . . . . . . . . . . . . . $ 74,000 Dividends Payable . . . . . . . . . . . $ 22,000Common Shares . . . . . . . . . . . . $630,000 Preferred Shares . . . . . . . . . . . . . 500,000Retained Earnings . . . . . . . . . . . $231,000 Number of common sharesContributed Surplus . . . . . . . . . $ 45,000 authorized . . . . . . . . . . . . . . . 1,000,000 . . . . . . . . . . . . . . . . . . . . . . . . . Number of common shares . . . . . . . . . . . . . . . . . . . . . . . . . sold . . . . . . . . . . . . . . . . . . . . . 180,000

2. The average issue price of an ABC common share wasa. $1.00 c. $3.50b. $1.25 d. Some other amount

3. ABC’s total contributed capital at March 31, 2007, isa. $495,000 c. $1,175,000b. $680,000 d. Some other amount

4. ABC’s total shareholders’ equity as of March 31, 2007, isa. $1,406,000 c. $1,175,000b. $1,249,000 d. $1,480,000

5. What would ABC’s total shareholders’ equity be if there were $5,000 of common sharespurchased? $____________

6. Charlie Inc. repurchased common shares in 2006 at a price of $30 per share that had an

9. When does a cash dividend become a legal liability?a. On the date of declaration. c. On the date of payment.b. On the date of record. d. It never becomes a liability because it is paid.

10. When do dividends decrease shareholders’ equity? On the date of ____________.

11. Wallace Corporation has 15,000 $1 cumulative preferred shares and 100,000 $1 com-mon shares outstanding. At the beginning of the current year preferred dividends werethree years in arrears. Wallace’s board of directors wants to pay a $1.25 cash dividend oneach outstanding common share. To accomplish this, what total amount of dividendsmust Wallace declare?

First, determine the annual preferred dividend amount: $____________a. $170,000 c. $125,000b. $185,000 d. Some other amount $____________

12. Stock dividendsa. are distributions of cash to shareholders.b. have no effect on total shareholders’ equity.c. reduce the total assets of the company.d. All of the above.

13. What is the effect of a stock dividend and a stock split on total assets?

Stock dividend Stock splita. Decrease No effectb. Decrease Decreasec. No effect Decreased. No effect No effect

14. A 2-for-1 stock split has the same effect on the number of shares being issued as aa. 100% stock dividend. c. 200% stock dividend.b. 20% stock dividend. d. 50% stock dividend.

15. The numerator for computing the rate of return on total assets isa. net income.b. net income plus interest expense.c. net income minus interest expense.d. net income minus preferred dividends.

16. The numerator for computing the rate of return on common equity isa. net income plus preferred dividends.b. net income minus interest expense.c. net income minus preferred dividends.d. net income.

Answers1. b [10,000 shares × $15 = $150,000]

2. c [($630,000/$180,000) = $3.50 per share]

3. c ($630,000 + $45,000 + $500,000 = $608,000)

4. a ($1,175,000 + $231,000 = $1,406,000)

5. $1,401,000 = $1,406,000 − $5,000

6. a [No gain or loss (for the income statement) on Retained Earnings will be debited]

7. c

8. d

9. a

10. Declaration, because of the debit to Retained Earnings

Review Shareholder’s Equity 483

11. b [First, annual preferred dividend = $15,000 (15,000 × $1)]

[($15,000 × 4) + (100,000 × $1.25) = $185,000]

12. b

13. d

14. a

15. b

16. c


board of directors (p. 422)

book value (of a share) (p. 435)

bylaws (p. 421)

chairperson (of board) (p. 422)

common shares (p. 424)

contributed capital stock (p. 423)

cumulative preferred shares (p. 433)

deficit (p. 431)

dividend (p. 432)

double taxation (p. 421)

limited liability (p. 420)

market value (of a share) (p. 435)

no-par-value shares (p. 424)

outstanding shares (p. 423)

preferred shares (p. 424)

president (p. 422)

rate of return on commonshareholders’ equity (p. 437)

rate of return on total assets (p. 437)

repurchased shares (p. 430)

retained earnings (p. 423)

shareholder (p. 420)

shareholders’ equity (p. 423)

stated value (p. 425)

stock (p. 423)

stock dividend (p. 433)

stock split (p. 434)

Questions

1. Why is a corporation called a “creature of the state”? Brieflyoutline the steps in the organization of a corporation.

2. Identify the characteristics of a corporation and explainwhy corporations face a tax disadvantage.

3. Suppose National Bank of Canada (www.nbc.ca) issued1,000 shares of its $1.60, preferred shares for $25 per share.By how much would this transaction increase the company’scontributed capital? By how much would it increaseNational Bank’s retained earnings? By how much would itincrease National Bank’s annual cash dividend payments?

4. Rank the following accounts in the order they wouldappear on the balance sheet: Common Shares, Equipment,Preferred Shares, Retained Earnings, Dividends Payable.Also, give each account’s balance sheet classification.

5. What effect does the repurchase of shares have on the (a)assets, (b) issued shares, and (c) outstanding shares ofthe corporation?

6. What are the more common reasons that might prompt acorporation to repurchase its own shares on the openmarket?

7. Georgian Stone Corp. repurchases 1,000 of its commonshares for $12.00 a share. They were issued originallyfor $10.00 a share. What would the journal entry be torecord the repurchase?

8. Briefly discuss the three important dates for a dividend.

9. As a preferred shareholder, would you rather owncumulative or noncumulative preferred? If all other fac-tors are the same, would a corporation prefer to issuecumulative or noncumulative preferred shares? Giveyour reason.

10. IPSCO Inc. reported a cash balance of $23 million and aretained earnings balance of $495 million. Explain howIPSCO can have so much more retained earnings thancash. In your answer, identify the nature of retained earn-ings and state how it relates to cash.

11. A friend of yours receives a stock dividend on an invest-ment. He believes that stock dividends are the same ascash dividends. Explain why the two are not the same.

12. Distinguish between the market value of shares and thebook value of shares. Which is more important toinvestors?

13. Why should a healthy company’s rate of return on share-holders’ equity exceed its rate of return on total assets?

14. Which financing activities that affect shareholders’ equityincrease cash, and which activities decrease cash?

Accounting VocabularyAccounting, like many other subjects, has a special vocabulary. It is important that you understand the following terms. They are defined in the chapterand also in the glossary at the end of the book.

Assess Your Progress 485

Assess Your Progress

Check Points

CP9-1 Consider the authority structure in a corporation, as diagrammed in Exhibit 9-2,page XXX.

1. What group holds the ultimate power in a corporation?

2. Who is the most powerful person in the corporation?

3. Who is in charge of day-to-day operations?

4. Who has primary responsibility for the corporation’s cash?

5. Who manages the accounting?

CP9-2 Answer the following questions about the characteristics of a corporation’s shares:

1. Which right clearly distinguishes a shareholder from a creditor (who has lent money tothe corporation)?

2. Which shareholders are the real owners of a corporation?

3. What privileges do preferred shareholders have over common shareholders?

4. Which class of shareholders reap greater benefits from a highly profitable corporation?Why?

CP9-3 Study George Weston Limited’s July 23 share issuance entry given on page 425 andanswer these questions about the nature of the transaction.

1. If George Weston had sold the shares for $80, would the $10 ($80 – $70) be profit forGeorge Weston Limited?

2. Suppose the shares had been issued at different times and different prices. Will sharesissued at higher prices have more rights than those issued for lower prices? Give the rea-son for your answer.

CP9-4 FPI Limited is a seafood enterprise engaged in harvesting, processing, global sourc-ing, producing, and marketing a range of seafood products. As at December 31, 2004, theCompany had acquired 139,500 shares for cancellation at an aggregate cost of $1,187,000 ofwhich $467,000 was charged to share capital, based on the average per share amount in theshare capital account at the date of purchase, and the balance of $720,000 was charged tocontributed surplus. During 2004 FPI paid dividends of $3,069,000.

2004 2003

Share capital 50,901 51,268Contributed surplus 71,012 71,435Retained earnings 77,444 76,073

1. By how much did FPI’s total contributed capital change during 2004? What caused con-tributed capital to increase?

2. Journalize the FPI share repurchase.

3. Based only on the above information, did FPI earn a profit during 2004?

Authority structure in a corporation(Obj. 1)

Characteristics of preferred andcommon shares(Obj. 1)

Effect of a share issuance on netincome(Obj. 2)

Issuing shares and analyzingretained earnings(Obj. 2)

CP9-5 This Check Point shows the similarity and the difference between two ways toacquire capital assets.

Case A—Issue shares and buy the assets Case B—Issue shares to acquire in separate transactions: the assets in a single transaction:

Stagecoach Corporation issued 10,000 Stagecoach Corporation issued 10,000common shares for cash of $500,000. In a shares to acquire a warehouse separate transaction, Stagecoach used the building valued at $400,000 and cash to purchase a warehouse building for equipment worth $100,000. $400,000 and equipment for $100,000. Journalize this transaction.Journalize the two transactions.

Compare the balances in all accounts after making both sets of entries. Are the account bal-ances similar or different?

CP9-6 LaRue Office Supplies Inc. provides employer services for other companies. Thefinancial statements of LaRue reported the following accounts (adapted, dollar amounts inmillions except for par value):

Total revenues . . . . . . . . . . $1,099 Other shareholders’ equity . . . . . . . . 29Accounts payable . . . . . . . 22 Common shares;Retained earnings . . . . . . . 846 376 million shares issued . . . . . . . 4Other current liabilities . . . 2,566 Long-term liabilities . . . . . . . . . . . . . 25Total expenses . . . . . . . . . . 805

Prepare the shareholders’ equity section of the LaRue Office Supplies balance sheet. Netincome has already been closed to Retained Earnings.

CP9-7 Use the LaRue Office Supplies Inc., data in Check Point 9-6 to compute LaRue’s

a. Net incomeb. Total liabilitiesc. Total assets (use the accounting equation)

CP9-8 Assume Clearly Canadian Beverage Corp., the Vancouver bottler, reported the fol-lowing shareholders’ equity (adapted in millions):

Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 243Additional contributed capital . . . . . . . . . . . . . . . . 297Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 1,468Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . $2,008

During the next year, Clearly Canadian repurchased common shares at a cost of $28 millionand sold shares for $7 million. The repurchased shares had a stated value of $30 million.

Record the repurchase and sale of common shares. Overall, how much did shareholders’equity increase or decrease as a result of the two share transactions?

CP9-9 Return to the Clearly Canadian data of Check Point 9-8. Explain the Journal entryfor the shares repurchased.

CP9-10 Turnberry Corporation earned net income of $60,750 during the year endedDecember 31, 2006. On December 15, Turnberry declared the annual cash dividend on its$0.225 preferred shares (10,000 shares issued for $70,000) and a $0.50 per share cash divi-dend on its common shares (25,000 shares issued for $250,000). Turnberry then paid thedividends on January 4, 2007.

Journalize for Turnberry Corporation:

a. Declaring the cash dividends on December 15, 2006.


Issuing shares to finance thepurchase of assets(Obj. 2)

Preparing the shareholders’ equitysection of a balance sheet(Obj. 2)

Using shareholders’ equity data(Obj. 2)

Accounting for the purchase andrepurchase of shares(Obj. 3)

Explaining treasury stocktransactions(Obj. 3)

Accounting for cash dividends(Obj. 4)

b. Paying the cash dividends on January 4, 2007.

Did Retained Earnings increase or decrease during 2006? By how much?

CP9-11 Refer to the allocation of dividends for Pinecraft Industries Inc. on page XXX.Answer these questions about Pinecraft’s cash dividends.

1. How much in dividends must Pinecraft declare each year before the common share-holders receive cash dividends for the year?

2. Suppose Pinecraft declares cash dividends of $300,000 for 2006. How much of the div-idends go to preferred? How much goes to common?

3. Are Pinecraft’s preferred shares cumulative or noncumulative? How can you tell?

4. Pinecraft passed the preferred dividend in 2005 and 2006. Then in 2007, Pinecraftdeclares cash dividends of $650,000. How much of the dividends go to preferred? Howmuch goes to common?

CP9-12 Highland Corporation has 60,000 common shares outstanding. Suppose Highlanddistributes a 5% stock dividend when the market value is $11.50 per share.

1. Journalize Highland’s distribution of the stock dividend on August 12. An explanation isnot required.

2. What was the overall effect of the stock dividend on Highland’s total assets? On total lia-bilities? On total shareholders’ equity?

CP9-13 Refer to the Real-World Format of Shareholders’ Equity in Exhibit 9-9, page 439.The company has passed its preferred dividends for the current year. Compute the book valueof a share of the company’s common shares.

CP9-14 Give the formula for computing (a) rate of return on common shareholders’ equity(ROE) and (b) rate of return on total assets (ROA). Then answer these questions about therate-of-return computations.

1. Why are preferred dividends subtracted from net income to compute ROE? Why arepreferred dividends not subtracted from net income to compute ROA?

2. Why is interest expense added to net income in the computation of ROA?

CP9-15 BakeIt’s 2004 financial statements reported the following items, with 2003 figuresgiven for comparison (adapted, in millions). Compute BaleIt’s return on assets and return oncommon equity for 2004. Evaluate the rates of return as strong or weak.

2004 2003

Balance sheetTotal assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,046 $12,184Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,632 $7,494Total shareholders’ equity (substantially all common) . . . . 5,414 4,690Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . $13,046 $12,184

Income statementNet sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26,209Operating expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,557Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239Income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 968

CP9-16 During fiscal year 2006 Kmart Corporation incurred a net loss of $244 million.The company borrowed $397 million and paid off $151 million of debt. Kmart raised $53million by issuing common shares and paid $139 million to repurchase shares. Determine theamount of Kmart’s net cash flow from financing activities during 2005.


Dividing cash dividends betweenpreferred and common stock(Obj. 4)

Recording a small stock dividend(Obj. 4)

Computing book value per share(Obj. 5)

Computing and explaining returnon assets and return on equity(Obj. 6)

Computing return on assets andreturn on equity for a leadingcompany(Obj. 6)

Measuring cash flows fromfinancing activities(Obj. 7)

Exercises

E9-1 Katy Jax and Marta Fraser are opening a deli to be named The Red Tomato. Theyneed outside capital, so they plan to organize the business as a corporation. Because youroffice is in the same building, they come to you for advice. Write a memorandum inform-ing them of the steps in forming a corporation in the province of Manitoba. Identify spe-cific documents used in this process, and name the different parties involved in the own-ership and management of a corporation.

E9-2 Steakley Mazda, Inc. obtained articles of incorporation that authorized the issuance ofan unlimited number of common shares and 5,000 preferred shares. During its first year, thebusiness completed the following share issuance transactions:

Feb. 19 Issued 1,000 common shares for cash of $6.80 per share.Mar. 3 Sold 500 of $1.50 preferred shares for $55,000 cash.

11 Received inventory valued at $12,000 and equipment with marketvalue of $8,500 for 3,300 of the common shares.

Required

1. Journalize the transactions. Explanations are not required.

2. Prepare the shareholders’ equity section of Steakley’s balance sheet. The ending balanceof retained earnings is a deficit of $42,000.

E9-3 Assume the charter of Baker Corporation is authorized to issue 5,000 preferred sharesand 10,000 common shares. During a 2-month period, Baker completed these share-issuancetransactions:

June 23 Issued 1,000 common shares for cash of $22 per share.July 2 Sold 300 shares of $4.50 preferred shares for $20,000 cash.

12 Received inventory valued at $25,000 and equipment with marketvalue of $43,000 for 3,000 common shares.

Required

Prepare the shareholders’ equity section of the Baker Corporation balance sheet for the trans-actions given in this exercise. Retained earnings has a balance of $88,000. Journal entries arenot required.

E9-4 Laser Medical Corporation was recently organized. The company issued commonshares to an attorney who provided legal services of $20,000 to help organize the corporation.Laser Medical issued common shares to an inventor in exchange for his patent with a marketvalue of $150,000. In addition, Laser Medical received cash both for the issuance of 5,000 ofits preferred shares at $110 per share and for the issuance of 50,000 common shares at $15per share. During the first year of operations, Laser Medical earned net income of $85,000and declared a cash dividend of $26,000. Without making journal entries, determine the totalcontributed capital created by these transactions.


Organizing a corporation(Obj. 1)

Issuing shares and reportingshareholders’ equity(Obj. 2)

Shareholders’ equity section of abalance sheet(Obj. 2)

Measuring the paid-in capital of acorporation(Obj. 2)

E9-5 Jass Golf Equipment Inc. had the following selected account balances in its 2004 year-end financial statements.

Common shares, unlimited $5,740,873 Inventory $2,432,437 number of shares authorized, 26,621,074 issued

Deficit 7,035,540 Capital assets 209,977

Accounts receivable, net 1,551,845 Contributed surplus – share 313,135repurchase

Accounts payable 1,326,000 Class B shares, unlimited 46,083number authorized, 110,108 issued

1. Prepare the shareholders’ equity section of Jass’s balance sheet (in thousands).

2. Explain what is meant by “deficit.”

E9-6 Journalize the following assumed transactions of Aliant Communications Inc.:

Jan. 19 Issued 10,000 common shares at $5 per share.Oct. 22 Repurchased 900 shares at $7 per share.Dec. 11 Sold 800 shares at $12 per share.

What was the overall effect of these transactions on Aliant’s shareholders’ equity?

E9-7 At December 31, 2006, Spandex Corporation reported the shareholders’ equityaccounts shown here (as adapted, with dollar amounts in millions).

Common shares,1,829 million shares issued . . . . . . . . . . . . . . . $12,820

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . 261Total shareholders’ equity . . . . . . . . . . . . . . . . . $13,081

Spandex’s 2007 transactions included the following:

a. Net income, $440 million.b. Issuance of 6 million common shares for $15.50 per share.c. Repurchased 1 million shares for $14 million.d. Declaration and payment of cash dividends of $30 million.

Journalize Spandex’s transactions in b, c, and d. Explanations are not required.

E9-8 Use the Spandex Corporation data in Exercise 9-7 to prepare the shareholders’ equitysection of the company’s balance sheet at December 31, 2006.

E9-9 Delta Corporation reported the following shareholders’ equity on its balance sheet:

Shareholders’ Equity December 31,(Dollars and shares in millions) 2007 2006

Preferred shares; $0.10 shares authorized 20 shares;Convertible Preferred Shares; issued and outstanding:2007 and 2006—0 and 2 shares, respectively . . . . . . . . . . . $ -0- $ 2

Common shares—$1 per share par value; authorized1,000.0 shares; issued: 2007 and 2006—408and 364 shares, respectively . . . . . . . . . . . . . . . . . . . . . . . . 8,114 5,900

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,045 4,791Total Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,159 10,693Total Liabilities and Shareholders’ Equity . . . . . . . . . . . . . . . . $53,756 $49,539


Shareholders’ equity section of abalance sheet(Obj. 2, 3)

Recording share transactions andmeasuring their effects onshareholders’ equity(Obj. 2, 3)

Recording stock issuance anddividend transactions(Obj. 2, 3, 4)

Reporting shareholders’ equityafter a sequence of transactions(Obj. 2, 3, 4)

Inferring transactions from acompany’s shareholders’ equity(Obj. 2, 3, 4, 5)

Required

1. What caused Delta’s preferred shares to decrease during 2007? Cite all the causes.

2. What caused Delta’s common shares to increase during 2007? Identify all the causes.

3. How many shares of Delta common shares were outstanding at December 31, 2007?

4. Assume that during 2007, Delta sold no shares. What average price per share did Deltapay for the shares the company purchased during the year? During 2007, the marketprice of Delta’s common shares ranged from a low of $38.25 to a high of $53.13.Compare the average price Delta paid for its repurchased shares during 2007 to therange of market prices during the year.

5. Delta’s net income during 2007 was $1,550 million. How much were Delta’s dividendsduring the year?

E9-10 Gulf States Financial Corporation reported the following:

Gulf States Financial CorporationShareholders’ Equity

Preferred shares, cumulative, $0.06, 60,000 shares issued . . . . . . . $ 60,000Common shares, 9,130,000 shares issued . . . . . . . . . . . . . . . . . . . 913,000

Gulf States Financial has paid all preferred dividends through 2003.

Required

Compute the total amounts of dividends to both preferred and common for 2006 and 2007 iftotal dividends are $100,000 in 2006 and $100,000 in 2007.

E9-11 The shareholders’ equity for Electronic Motor Systems, Inc. (EMS) on December 31,2006, follows (adapted in millions):


Common shares, 2,000 shares authorized,500 shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,012

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,479Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,491

On April 15, 2007, the market price of EMS common shares was $51.50 per share. AssumeEMS distributed a 10% stock dividend on this date.

Required

1. Journalize the distribution of the stock dividend.

2. Prepare the shareholders’ equity section of the balance sheet after the stock dividend.

3. Why is total shareholders’ equity unchanged by the stock dividend?

4. Suppose EMS had a cash balance of $3,000 million on April 16, 2007. What is the max-imum amount of cash dividends EMS can declare?

E9-12 Identify the effects—both the direction and the dollar amount—of these assumedtransactions on the total shareholders’ equity of Halcrow Automotive. Each transaction is inde-pendent.

a. 10% stock dividend. Before the dividend, 69 million common shares were outstanding;the market value was $7.625 at the time of the dividend.

b. A 50% stock dividend. Before the dividend, 69 million common shares were outstanding;the market value was $13.75 at the time of the dividend.

c. Repurchase of 2,000 common shares at $4.25 per share.


Computing dividends on preferredand common shares(Obj. 4)

Recording a stock dividend andreporting shareholders’ equity(Obj. 4)

Measuring the effects of stockissuance, dividends, and sharetransactions(Obj. 2, 3, 4)

d. Sale of 600 common shares for $5.00 per share.e. A 3-for-1 stock split. Prior to the split, 69 million common shares were outstanding.

E9-13 Clublink Corporation had the following shareholders’ equity (adapted) at January 31(dollars in thousands):

Common shares, $0.05, unlimited number of shares authorized,17.2 million shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $156,887

Contributed surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,130Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,652

Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $178,989

Assume that on March 7, Clublink split its common shares 2 for 1. Prepare the shareholders’equity section of the balance sheet immediately after the split.

E9-14 The balance sheet of Frost Bank Corporation reported the following, with allamounts, including shares, in thousands:

Redeemable preferred shares, 6%, redemption value$5,900; outstanding 100 shares . . . . . . . . . . . . . . . . . . . . . . $ 4,800

Common shareholders’ equity10,500 shares issued and outstanding . . . . . . . . . . . . . . . . . . 87,200

Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $92,000

Required

1. Compute the book value per share for the common shares, assuming all preferred divi-dends are fully paid up (none in arrears).

2. Compute the book value per share of the common shares, assuming that 3 years’ pre-ferred dividends, including the current year, are in arrears.

3. Frost’s common shares recently traded at market value of $7.75. Does this mean thatFrost’s shares are a good buy at $7.75?

E9-15 Elsimate, Inc., reported these figures for 2007 and 2006 (adapted, in millions):

2007 2006

Balance sheet:Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,695 $20,757Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . 43 388Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 8,607 7,216

Income statement:Operating income . . . . . . . . . . . . . . . . . . . . . . . . $ 4,021 $ 3,818Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . 219 272Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,662 2,543

Compute Elsimate’s return on assets and return on common shareholders’ equity for 2007.Do these rates of return suggest strength or weakness? Give your reason.


Reporting stockholders’ equityafter a stock split(Obj. 4)

Measuring the book value pershare of common stock(Obj. 5)

Evaluating profitability(Obj. 6)

E9-16 Maple Leaf Foods Inc., included the following items in its financial statements for2004, the current year (amounts in thousands):

Dividends paid . . . . . . . . . . $18,136 Payment of long-term debt . . . . .$772,101Interest expense: Proceeds from issuance

Current year . . . . . . . . . . 83,478 of common shares . . . . . . . . . . 166,243Preceding year . . . . . . . . . 68,369 Total liabilities:

Net income: Current year end . . . . . . . . . . .2,042,069Current year . . . . . . . . . . 106,759 Preceding year end . . . . . . . . .1,335,466Preceding year . . . . . . . . . 35,068 Total shareholders’ equity:

Operating income: Current year end . . . . . . . . . . . 905,553Current year . . . . . . . . . . 256,364 Preceding year end . . . . . . . . . 743,187Preceding year . . . . . . . . . 134,696 Borrowings . . . . . . . . . . . . . . . . .1,052,195

Compute Maple Leaf’s return on assets and return on common equity during 2004 (the cur-rent year). Maple Leaf has no preferred shares outstanding. Do Maple Leaf’s rates of returnlook strong or weak? Give your reason.

Challenge Exercises

E9-17 Use the Maple Leaf Foods data in Exercise 9-16 to show how Maple Leaf reportedcash flows from financing activities during 2004 (the current year). List items in descendingorder from largest to smallest dollar amount.

E9-18 Golinda Corporation began operations on January 1, 2007, and immediately issuedits shares, receiving cash. Golinda’s balance sheet at December 31, 2007, reported the follow-ing shareholders’ equity:

Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . $249,000Contributed surplus . . . . . . . . . . . . . . . . . . . . . . . 800Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . 30,000Total shareholders’ equity . . . . . . . . . . . . . . . . . . . $286,000

During 2007, Golinda

a. Issued 50,000 shares for $5 per share.b. Reacquired 800 shares of its own stock cancellation, paying $4 per share.c. Issued shares for $6 each.d. Earned net income of $56,000, and declared and paid cash dividends.

Required

Journalize all of Golinda’s shareholders’ equity transactions during the year. Golinda’s entry toclose net income to Retained Earnings was:

Revenues . . . . . . . . . . . . . . . . . . . . . . 171,000Expenses . . . . . . . . . . . . . . . . . . . 115,000Retained Earnings . . . . . . . . . . . . 56,000

E9-19 Gemini Corporation reported the following shareholders’ equity data (all dollars inmillions):

December 31,2007 2006

Preferred shares . . . . . . . . . . . . . . . . . . . . . . . . . $ 604 $ 686Common shares . . . . . . . . . . . . . . . . . . . . . . . . . 2,466 2,359Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 17,818 16,465


Reporting cash flows fromfinancing activities(Obj. 7)

Reconstructing transactions fromthe financial statements(Obj. 2, 3, 4)

Explaining the changes inshareholders’ equity(Obj. 2, 3, 4)

Evaluating profitability(Obj. 6)

Gemini earned net income of $3,604 during 2007. For each account except RetainedEarnings, one transaction explains the change from the December 31, 2006, balance to theDecember 21, 2007, balance. Two transactions affected Retained Earnings. Give a full expla-nation, including the dollar amount, for the change in each account.

E9-20 Northeast Powersports, Inc., began 2007 with 8 million common shares issued andoutstanding. The average issue price was $1.50. Beginning additional paid-in capital was $13million, and retained earnings totalled $40 million. In March 2007, Northeast issued 2 mil-lion common shares at a price of $2 per share. In May, the company distributed a 10% stockdividend at a time when Northeast’s common shares had a market value of $3 per share. Thenin October, Northeast’s stock price dropped to $1 per share and the company purchased 2million shares. For the year, Northeast earned net income of $26 million and declared cashdividends of $17 million.

Complete the following tabulation to show what Northeast should report for sharehold-ers’ equity at December 31, 2007. Journal entries are not required.

ContributedSurplus,

Common Retained Shares(Amounts in millions) Stock Earnings Repurchase Total

Balance, Dec. 31, 2006 . . . . . . . . . $12 $40 $52Issuance of stock . . . . . . . . . . . . . .Stock dividend . . . . . . . . . . . . . . . .Purchase of treasury stock . . . . . . . $Net income . . . . . . . . . . . . . . . . . .Cash dividends . . . . . . . . . . . . . . .Balance, Dec. 31, 2007 . . . . . . . . . $ $ $ $

Problems(Group A)

P9-1A Grabow & Eisenbarth, an engineering firm, is conducting a special meeting of itsboard of directors to address some concerns raised by its shareholders. Shareholders havesubmitted the following questions. Answer each question.

1. Why are share capital and retained earnings shown separately in the shareholders’equity section of the balance sheet?

2. Ann Martinelli, a shareholder of Grabow & Eisenbarth, proposes to give some land sheowns to the company in exchange for company shares. How should Grabow &Eisenbarth determine the number of shares to issue for the land?

3. Preferred shares generally are preferred with respect to dividends and in the event ofliquidation. Why would investors buy common shares when preferred shares are avail-able?

4. What does the redemption value of our preferred shares require us to do?

5. One of the shareholders owns 100 shares of Grabow & Eisenbarth shares and someonehas offered to buy his shares for their book value. What is the formula for computing thebook value of his shares.

P9-2A The partners who own Bhanapol & Cink (B&C) wished to avoid the unlimited per-sonal liability of the partnership form of business, so they incorporated as B&C Exploration,Inc. The articles of incorporation authorize the corporation to issue 10,000 $6 preferred sharesand 250,000 common shares. In its first month, B&C Exploration completed the followingtransactions?:


Accounting for changes instockholders’ equity(Obj. 2, 3, 4)

Explaining the features of acorporation’s stock(Obj. 1, 2, 5)

Recording corporate transactionsand preparing the shareholders’equity section of the balance sheet(Obj. 2)

Dec. 3 Issued 500 common shares to the promoter for assistance with issuance of the common shares. The promotionalfee was $5,000.

3 Issued 5,100 common shares to Bhanapol and 3,800 shares to Cink in return for cash equal to the market value of$10 per share;.

12 Issued 1,000 preferred shares to acquire a patent with a market value of $115,000.

22 Issued 1,500 common shares for $10 cash per share.

Required

1. Record the transactions in the journal.

2. Prepare the shareholders’ equity section of the B&C Exploration, Inc., balance sheet atDecember 31. The ending balance of Retained Earnings is $89,000.

P9-3A Srixon Inc. has the following shareholders’ equity information:

Srixon’s charter authorizes the company to issue 10,000 shares of $2.50 cumulative pre-ferred shares and an unlimited number of no-par common shares. The company issued1,000 preferred shares at $104 per share. It issued 40,000 common shares for a total of$220,000. The company’s retained earnings balance at the beginning of 2007 was$40,000, and net income for the year was $95,000. During 2007, Srixon declared thespecified dividend on preferred and a $0.50 per-share dividend on common. Preferreddividends for 2006 were in arrears.

Required

Prepare the shareholders’ equity section of Srixon Inc.’s balance sheet at December 31, 2007.Show the computation of all amounts. Journal entries are not required.

P9-4A Prairie Imports Corporation is positioned ideally in its line of business. Located inWinnipeg, Prairie Imports is the only company between Alberta and Manitoba with reliablesources for its imported gifts. The company does a brisk business with specialty stores such asPier 1 Imports. Prairie’s recent success has made the company a prime target for a takeover.An investment group from Mexico City is attempting to buy 51% of Prairie’s outstandingsthares against the wishes of Prairie’s board of directors. Board members are convinced thatthe Mexico City investors would sell the most desirable pieces of the business and leave littleof value.

At the most recent board meeting, several suggestions were advanced to fight off the hos-tile takeover bid. The suggestion with the most promise is to repurchase a huge quantity ofshares. Prairie Imports has the cash to carry out this plan.

Required

1. Suppose you are a significant shareholder of Prairie Imports Corporation. Write a mem-orandum to explain to the board how the repurchase of shares would make it more dif-ficult for the Mexico City group to take over Prairie Imports. Include in your memo adiscussion of the effect that repurchasing shares would have on shares outstanding andon the size of the corporation.

2. Suppose Prairie Imports management is successful in fighting off the takeover bid andlater resells the shares at prices greater than the repurchase price. Explain what effectthese sales will have on assets, shareholders’ equity, and net income.

P9-5A The articles of incorporation of Hebrides Woolens, Inc., issued by the province ofNova Scotia, authorizes the company to issue 1,000,000 common shares and 100,000 $3cumulative preferred shares.

In its initial public offering during 2004, Hebrides issued 200,000 common shares for$6.50 per share. Over the next 5 years, Hebrides’ common share price increased in value, and


Preparing the shareholders’ equitysection of the balance sheet(Obj. 2, 4)

Repurchasing common shares tofight off a takeover of thecorporation(Obj. 3)

Measuring the effects of shareissuance, share repurchase, anddividend transactions onshareholders’ equity(Obj. 2, 3, 4)

the company issued 100,000 more shares at prices ranging from $7 to $11. The average issueprice of these shares was $9.25.

During 2006, the price of Hebrides’ common shares dropped to $8, and Hebrides repur-chased 30,000 common shares. After the market price of the common shares increased in 2007,Hebrides sold 20,000 shares for $9 per share.

During the 5 years 2004 to 2008, Hebrides’ earned net income of $405,000 and declaredand paid cash dividends of $119,000. The company distributed a 10% stock dividend during2005 on the 290,000 shares outstanding when the market price was $10. At December 31,2008, total assets of the company are $5,365,000, and liabilities add up to $2,914,000.

Required

Show the computation of Hebrides Woolens’ total shareholders’ equity at December 31, 2008.Present a detailed computation of each element of shareholders’ equity.

P9-6A Miller Feed Mills Ltd., which makes food products and livestock feeds in OwenSound, Ontario, included the following shareholders’ equity on its year-end balance sheet atFebruary 28:

Shareholders’ Equity (In Thousands)

Voting preferred shares, $1.30 cumulative—authorized 100,000 shares in each class;

Class A—issued 75,473 shares . . . . . . . . . . . . . . . . . . . $ 1,736Class B—issued 92,172 shares . . . . . . . . . . . . . . . . . . . 2,120

Common shares;authorized 5,000,000 shares;issued 2,870,950 shares . . . . . . . . . . . . . . . . . . . . . . . . . . 19,903

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,336$32,095

Required

1. Identify the different issues of shares Miller Feed Mills has outstanding.

2. Give the summary entries to record issuance of all the shares. Assume that all the shareswere issued for cash. Explanations are not required.

3. Suppose Miller Feed Mills passed its preferred dividends for 3 years. Would the com-pany have to pay those dividends in arrears before paying dividends to the commonshareholders? Give your reason.

4. What amount of preferred dividends must Miller Feed Mills Ltd. declare and pay eachyear to avoid having preferred dividends in arrears?

5. Assume that preferred dividends are in arrears for 2006. Record the declaration of an$800,000 dividend in the year ended February 28, 2007. An explanation is not required.

P9-7A Breton Internet Corporation reported the following summarized balance sheet atDecember 31, 2006:

AssetsCurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $18,200Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . 34,700Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,900

Liabilities and EquityLiabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,200Shareholders’ equity:

$5 cumulative preferred shares, 100 shares issued . . . . . . . . 1,800Common shares, $1 par . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,900

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,900


Accounting for share issuance,dividends, and share repurchase(Obj. 2, 3, 4)

Analyzing the shareholders’ equityand dividends of a corporation(Obj. 2, 4)

During 2007, Breton completed these transactions that affected shareholders’ equity:

Jan. 22 Issued 1,000 common shares for $14 per share.Aug. 4 Declared the regular cash dividend on the preferred shares.

24 Paid the cash dividend.Oct. 9 Distributed a 10% stock dividend on the common shares.

Market price of the common shares was $15 per share.Nov. 19 Reacquired 800 common shares, paying $12 per share.Dec. 8 Sold 600 common shares for $16 per share.

Required

1. Journalize Breton’s transactions. Explanations are not required.

2. Report Breton’s shareholders’ equity at December 31, 2007. Net income for 2007 was$44,000.

P9-8A Assume Steak & Stein Inc. completed the following transactions during 2007:

Jan. 15 Purchased 3,000 shares of the company’s own common sharesat $12 per share.

Mar. 17 Sold 700 common shares for $16 per share.July 6 Declared a cash dividend on the 10,000 shares of $1.70

preferred shares.Aug. 1 Paid the cash dividends.Nov. 18 Distributed a 10% stock dividend on the 30,000

common shares outstanding. The market value of thecommon shares was $21 per share.

Required

Analyze each transaction in terms of its effect on the accounting equation of Steak & Stein, Inc.

P9-9A The following accounts and related balances of Air Control Specialists, Inc., as ofSeptember 30, 2007, are arranged in no particular order.

Interest expense . . . . . . . . . . . . $ 6,100 Cash . . . . . . . . . . . . . . . . . . . . . $15,000Capital assets 365,000 Accounts receivable, net . . . . . . . 24,000Common shares . . . . . . . . . . . . Accrued liabilities . . . . . . . . . . . 26,000

500,000 shares authorized, Long-term note payable . . . . . . . 72,000115,000 shares issued . . . . . . 13,400 Inventory . . . . . . . . . . . . . . . . . . 57,000

Prepaid expenses . . . . . . . . . . . 10,000 Dividends payable . . . . . . . . . . . 9,000Common shareholders’ equity, Retained earnings . . . . . . . . . . . . ?

September 30, 2006 . . . . . . . 192,000 Accounts payable . . . . . . . . . . . . 31,000Net income . . . . . . . . . . . . . . . . 31,000 Trademark, net . . . . . . . . . . . . . . 6,000Total assets,

September 30, 2006 . . . . . . . 404,000 Preferred shares, $0.20,10,000 Goodwill, net . . . . . . . . . . . . . . 17,000 shares authorized and issued . 27,000

Required

1. Prepare the company’s classified balance sheet in the account format at September30, 2007.

2. Compute rate of return on total assets and rate of return on common shareholders’equity for the year ended September 30, 2007.

3. Do these rates of return suggest strength or weakness? Give your reason.


Measuring the effects of dividendand share transactions on acompany(Obj. 3, 4)

Preparing a corporation’s balancesheet; measuring profitability(Obj. 3, 6)

P9-10A The statement of cash flows of CAE reported the following (adapted) for the yearended March 31, 2004:

Cash flows from financing activities—amounts in millionsCash dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (27.4)Issuance of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 176.4Proceeds from issuance of long-term debt . . . . . . . . . . . . . . . 525.3Share issue costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7.5)Payments of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . (650.4)

Required

1. Make the journal entry that CAE Inc. would use to record each of these transactions.

2. From these transactions, would you expect CAE’s total liabilities, total shareholders’equity, and total assets to have grown or shrunk during 2004? CAE’s net income for2004 was $67.1 million. Show your work.

(Group B)

P9-1B The board of directors of Akin & Gump, Inc., investment bankers, is meeting toaddress the concerns of shareholders. Shareholders have submitted the following questionsfor discussion at the board meeting. Answer each question.

1. Why did Akin & Gump organize as a corporation if a corporation must pay an addi-tional layer of income tax?

2. How are preferred shares similar to common shares? How are preferred shares similar todebt?

3. Akin & Gump repurchased shares for $50,000 and a year later sold them for $65,000.Explain to the shareholders whether the $15,000 excess is profit to be reported on thecompany’s income statement. Explain your answer.

4. Would Akin & Gump investors prefer to receive cash dividends or stock dividends?Explain your reasoning.

P9-2B The partnership of Grant and Hoffman needed additional capital to expand into newmarkets, so the business incorporated as GH, Inc. The articles of incorporation from PEIauthorizes GH, Inc. to issue 10,000 preferred shares and 100,000 common shares. In its firstmonth, GH, Inc. completed the following transactions:

Feb. 2 Issued 300 common shares to the promoter for assistance withissuance of the common shares. The promotional fee was$1,800. Debit the asset account Organization Cost.

2 Issued 9,000 common shares to Grant and 12,000 shares toHoffman in return for cash equal to the share’s market value of$6 per share.

10 Issued 400 preferred shares to acquire a patent with a marketvalue of $40,000.

16 Issued 2,000 common shares for cash of $12,000.

Required

1. Record the transactions in the journal.

2. Prepare the shareholders’ equity section of the GH, Inc. balance sheet at February 28.The ending balance of Retained Earnings is $119,000.


Analyzing the statement of cashflows(Obj. 7)

Explaining the features of acorporation’s shares(Obj. 1, 3, 4)

Recording corporate transactionsand preparing the shareholders’equity section of the balance sheet(Obj. 2)

P9-3B The following summary provides the information needed to prepare the sharehold-ers’ equity section of the Eli Jackson Company balance sheet:

Jackson’s articles of incorporation authorize the company to issue 5,000 $5, cumulativepreferred shares and 500,000 common shares. Jackson issued 1,000 preferred shares at$105 per share. It issued 100,000 common shares for $519,000. The company’s retainedearnings balance at the beginning of 2007 was $71,000. Net income for 2007 was$80,000, and the company declared a $5 cash dividend on preferred stock for 2007.Preferred dividends for 2006 were in arrears.

Required

Prepare the shareholders’ equity section of Eli Jackson Company’s balance sheet atDecember 31, 2007. Show the computation of all amounts. Journal entries are not required.

P9-4B Guilford Distributing Company is positioned ideally in the clothing business.Located in Regina, Guilford is the only company with a distribution network for its importedgoods. The company does a brisk business with specialty stores such as Holt Renfrew.Guilford’s recent success has made the company a prime target for a takeover. Against thewishes of Guilford’s board of directors, an investment group from the U.S. is attempting tobuy 51% of Guilford’s outstanding shares. Board members are convinced that the U.S.investors would sell off the most desirable pieces of the business and leave little of value. Atthe most recent board meeting, several suggestions were advanced to fight off the hostiletakeover bid.

Required

Suppose you are a significant shareholder of Guilford Distributing Company. Write a shortmemo to the board to propose an action that would make it difficult for the investor group totake over Guilford. Include in your memo a discussion of the effect your proposed actionwould have on the company’s assets, liabilities, and total shareholders’ equity.

P9-5B The carticles of incorporation of House of Carpets authorizes the company to issue5,000,000 common shares and 50,000 $2.50 cumulative preferred shares.

In its initial public offering during 2003, House of Carpets issued 500,000 commonshares for $5.00 per share. Over the next 5 years, House of Carpets’ share price increased invalue and the company issued 400,000 more shares at prices ranging from $6 to $10.75. Theaverage issue price of these shares was $8.50.

During 2005, the price of House of Carpets’ common shares dropped to $7, and thecompany repurchased 60,000 common shares. After the market price of the common sharesrose in 2006, House of Carpets sold 40,000 common shares for $8 per share.

During the 5 years 2003 through 2007, House of Carpets earned net income of$1,020,000 and declared and paid cash dividends of $640,000. During 2007 the companydistributed a 10% stock dividend to the shareholders on the 880,000 shares outstanding. Themarket price was $9.00 per share when the stock dividend was distributed. At December 31,2007, the company has total assets of $13,100,000 and total liabilities of $6,920,000.

Required

Show the computation of House of Carpets’ total shareholders’ equity at December 31, 2007.Present a detailed computation of each element of shareholders’ equity.


Preparing the shareholders’ equitysection of the balance sheet(Obj. 2, 4)

Fighting off a takeover of thecorporation(Obj. 3)

Measuring the effects of shareissuance, share repurchase, anddividend transactions onshareholders’ equity(Obj. 2, 3, 4)

P9-6B Alcan, Inc., one of Canada’s 10 largest companies, is listed on stock exchanges inCanada, the U.S., and the U.K. The following shareholders’ equity section has been adaptedfrom a recent Alcan annual report.

Shareholders’ Equity (millions of U.S. dollars)

Preferred shares—Authorized—an unlimited number issuable in series.

The quarterly dividend is based on the Canadian prime interest rate and is cumulative

Series C: 5,700,000 redeemable shares outstanding . . . . . . . . . . . . . . . . . . $106Series E: 3,000,000 redeemable shares outstanding . . . . . . . . . . . . . . . . . . 54Common shares—Authorized—an unlimited number,321,470,000 outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,703Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,503Deferred translation adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99

$8,465

Required

1. Identify the different issues of shares Alcan has outstanding.

2. What was the stated value at which the Series E preferred shares were issued?

3. The number of preferred shares was the same at December 31 of the past three years,but the preferred dividend was $10 million, $8 million, and $5 million respectively.Explain how these different amounts could occur.

4. Suppose Alcan passed its preferred dividends for one year. Would the company have topay these dividends in arrears before paying dividends to the common shareholders?Why?

5. Assume preferred dividends are in arrears for 2005 and the total preferred dividend for2005 was $10 million and for 2006 was $7 million. Journalize the declaration of a $210million dividend for 2006. No explanation is needed.

P9-7B Safety Network Corporation reported the following summarized balance sheet atDecember 31, 2006:

AssetsCurrent assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,400Property and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . 51,800Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,200

Liabilities and EquityLiabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $37,800Shareholders’ equity

$0.50 cumulative preferred shares, 400 shares issued . . . . 2,000Common shares, 6,000 shares issued . . . . . . . . . . . . . . . . 23,400Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . . . $85,200

During 2007, Safety Network Corporation completed these transactions that affected share-holders’ equity:

Mar. 13 Issued 2,000 common shares for $4 per share.July 7 Declared the regular cash dividend on the preferred shares.

24 Paid the cash dividend.Sept. 9 Distributed a 10% stock dividend on the common shares.

Market price of the common shares was $5 per share.Oct. 26 Reacquired 500 common shares, paying $7 per share.Nov. 20 Sold 200 common shares for $8 per share.


Analyzing the shareholders’ equityand dividends of a corporation(Obj. 2, 4)

Accounting for share issuance,dividends, and share repurchase(Obj. 2, 3, 4)

Required

1. Journalize Safety Network’s transactions. Explanations are not required.

2. Report Safety Network’s shareholders’ equity at December 31, 2007. Net income for2007 was $47,000.

P9-8B Assume that Brascan Corporation completed the following selected transactionsduring the current year:

April 18 Distributed a 10% stock dividend on the 2.1 million commonshares outstanding. The market value of the common shares was$25 per share.

May 23 Declared a cash dividend on the $5 preferred shares (1,000shares outstanding).

July 30 Paid the cash dividends.Oct. 26 Repurchased 2,500 shares of the company’s own common

shares at $24 per share.Nov. 8 Sold 1,000 common shares for $29 per share.

Required

Analyze each transaction in terms of its effect on the accounting equation of Brascan.

P9-9B The following accounts and related balances of InterMax Graphics, Inc., are arrangedin no particular order.

Accounts payable . . . . . . . . . . . $ 31,000 Dividends payable . . . . . . . . . . . $ 3,000Retained earnings . . . . . . . . . . . ? Total assets, November 30,Common shares; 2006 . . . . . . . . . . . . . . . . . . . 481,000

100,000 shares authorized, Net income . . . . . . . . . . . . . . . . 36,20042,000 shares issued . . . . . . . 350,000 Common shareholders’ equity,

Inventory . . . . . . . . . . . . . . . . . 170,000 November 30, 2006 . . . . . . . . 383,000Capital assets 181,000 Interest expense . . . . . . . . . . . . . 12,800Goodwill, net . . . . . . . . . . . . . . 6,000 Prepaid expenses . . . . . . . . . . . . 13,000Preferred shares, $0.40, Patent, net . . . . . . . . . . . . . . . . . 31,000

25,000 shares authorized, Accrued liabilities . . . . . . . . . . . 17,0003,700 shares issued . . . . . . . . 37,000 Long-term note payable . . . . . . . 7,000

Cash . . . . . . . . . . . . . . . . . . . . . 32,000 Accounts receivable, net . . . . . . . 102,000

Required

1. Prepare InterMax’s classified balance sheet in the account format at November 30, 2007.

2. Compute rate of return on total assets and rate of return on common shareholders’equity for the year ended November 30, 2007.

3. Do these rates of return suggest strength or weakness? Give your reason.

P9-10B Assume the statement of cash flows of Mayfair International, Inc. reported the fol-lowing for the year ended December 31, 2007.

Cash flows from financing activities—amounts in millionsDividends [declared and] paid . . . . . . . . . . . . . . . . . . . . . . . . . $ (28.3)Proceeds from issuance of common stock . . . . . . . . . . . . . . . . 14.1Payments of short-term notes payable . . . . . . . . . . . . . . . . . . . (36.9)Repayments of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . (1.3)Proceeds from long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . 632.1Repurchases of common stock . . . . . . . . . . . . . . . . . . . . . . . . . (686.3)


Measuring the effects of dividendand share transactions on acompany(Obj. 3, 4)

Preparing a corporation’s balancesheet; measuring profitability(Obj. 3, 6)

Analyzing the statement of cashflows(Obj. 7)

Required

1. Make the journal entry that Mayfair used to record each of these transactions.

2. From these transactions, would you expect Mayfair’s total liabilities, total shareholders’equity, and total assets to have grown or shrunk during 2007? Mayfair’s net income for2007 was $135 million. Show your work.

Apply Your Knowledge 501

Apply Your Knowledge

Decision CasesCase 1. At December 31, 2000, Enron Corporation reported the following data (condensedin millions):

Shareholders’ equity . . . . . . . . . . $11,470 Total current liabilities . . . . . . . . $28,406Long-term liabilities . . . . . . . . . . 25,627 Investments and other assets . . . 23,379Capital assets . . . . . . . . . . . . . . . . 11,743 Total current assets . . . . . . . . . . 30,381Total expenses for 2000 . . . . . . . . 99,810 Total revenues for 2000 . . . . . . . 100,789

During 2001, Enron restated company financial statements for 1997 to 2000, after reportingthat some data had been omitted from those prior-year statements. Assume that the startlingevents of 2001 included the following:

• Several related companies should have been, but were not, included in the Enron state-ments for 2000. These companies had revenues of $90 million, total assets of $5,700 mil-lion, expenses of $220 million, and liabilities totalling $5,600 million.

• In January 2001, Enron’s shareholders got the company to exchange $2,000 million of12% long-term notes payable for their common stock. Interest is accrued at year end.

Take the role of an analyst with Moody’s Investors Service. It is your job to analyze EnronCorporation and rate the company’s long-term debt.

Required1. Measure Enron’s expected net income for 2001 two ways:

a. Assume 2001’s net income should be approximately the same as the amount of netincome that Enron actually reported for 2000.

b. Recompute expected net income for 20X5 taking into account all the new develop-ments of 2001.

c. Evaluate Enron’s likely trend of net income for the future. Discuss why this trend isdeveloping. Ignore income tax.

2. Write Enron’s accounting equation two ways:a. As actually reported at December 31, 2000.b. As adjusted for the events of 2001.

3. Measure Enron’s debt ratio as reported at December 31, 2000, and after again making theadjustments for the events of 2001.

4. Based on your analysis, make a recommendation to the Debt-Rating Committee ofMoody’s Investor Services. Would you recommend upgrading, downgrading, or leavingEnron’s debt rating undisturbed (currently, it is “high-grade”).

Case 2. John Vines and Larry Price have written a computer program for a video game thatthey believe will rival Playstation and Xbox. They need additional capital to market the prod-uct, and they plan to incorporate their partnership. They are considering alternative capitalstructures for the corporation. Their primary goal is to raise as much capital as possible with-out giving up control of the business. The partners plan to receive 110,000 shares of the cor-poration’s common shares in return for the net assets of the partnership. After the partnership

Evaluating the financial positionand profitability of a real company(Obj. 2, 3, 4, 5)

Evaluating alternative ways ofraising capital(Obj. 2)

books are closed and the assets adjusted to current market value, Vines’ capital balance will be$60,000, and Price’s balance will be $50,000.

The corporation’s plans for a charter include an authorization to issue 5,000 preferredshares and 500,000 common shares. Vines and Price are uncertain about the most desirablefeatures for the preferred shares. Prior to incorporating, the partners are discussing their planswith two investment groups. The corporation can obtain capital from outside investors undereither of the following plans:

• Plan 1. Group 1 will invest $160,000 to acquire 1,400 shares of $6 par nonvoting, non-cumulative preferred shares.

• Plan 2. Group 2 will invest $105,000 to acquire 1,000 shares of $5, preferred shares and$70,000 to acquire 70,000 common shares. Each preferred share receives 50 votes onmatters that come before the shareholders.

RequiredAssume that the corporation is chartered.

1. Journalize the issuance of common shares to Vines and Price. Debit each partner’s capitalaccount for its balance.

2. Journalize the issuance of shares to the outsiders under both plans.

3. Assume that net income for the first year is $140,000 and total dividends are $19,000. Preparethe shareholders’ equity section of the corporation’s balance sheet under both plans.

4. Recommend one of the plans to Vines and Price. Give your reasons.

Case 3. Big Rock Brewery Income Trust had the following shareholders’ equity amounts onDecember 31, 2007 (adapted, in millions):

Common shares, 5.86 shares issued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16.69Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.71Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $29.40

Assume that during 2007, Big Rock paid a cash dividend of $0.715 per share. Assumethat, after paying the cash dividends, Big Rock distributed a 10% stock dividend. Assume fur-ther that the following year Big Rock declared and paid a cash dividend of $0.65 per share.

Suppose you own 10,000 common shares, acquired 3 years ago, prior to the 10% stockdividend. The market price of Big Rock shares was $61.02 per share before the stock divi-dend.

Required1. How does the stock dividend affect your proportionate ownership in Big Rock? Explain.

2. What amount of cash dividends did you receive last year? What amount of cash dividendswill you receive after the above dividend action?

3. Assume that immediately after the stock dividend was distributed, the market value of BigRock’s stock decreased from $61.02 per share to $55.47 per share. Does this decrease rep-resent a loss to you? Explain.

4. Suppose Big Rock announces at the time of the stock dividend that the company will con-tinue to pay the annual $0.715 cash dividend per share, even after distributing the stockdividend. Would you expect the market price of the shares to decrease to $55.47 per shareas in Requirement 3? Explain.


Analyzing cash dividends and stockdividends(Obj. 4)

Ethical IssuesIssue 1. Note: This case is based on a real situation

George Campbell paid $50,000 for a franchise that entitled him to market SuccessAssociates software programs in the countries of the European Union. Campbell intended tosell individual franchises for the major language groups of western Europe—German, French,English, Spanish, and Italian. Naturally, investors considering buying a franchise fromCampbell asked to see the financial statements of his business.

Believing the value of the franchise to be greater than $50,000, Campbell sought to cap-italize his own franchise at $500,000. The law firm of McDonald & LaDue helped Campbellform a corporation chartered to issue 500,000 common shares and suggested the followingchain of transactions:

a. A third party borrows $500,000 and purchases the franchise from Campbell.

b. Campbell pays the corporation $500,000 to acquire all its shares.

c. The corporation buys the franchise from the third party, who repays the loan.

In the final analysis, the third party is debt-free and out of the picture. Campbell owns allthe corporation’s shares, and the corporation owns the franchise. The corporation balancesheet lists a franchise acquired at a cost of $500,000. This balance sheet is Campbell’s mostvaluable marketing tool.

Required

1. What is unethical about this situation?

2. Who can be harmed in this situation? How can they be harmed? What role does account-ing play here?

Issue 2. St. Genevieve Petroleum Company is an independent oil producer. In February,company geologists discovered a pool of oil that tripled the company’s proven reserves. Priorto disclosing the new oil to the public, St. Genevieve quietly repurchased most of its shares.After the discovery was announced, the company’s share price increased from $6 to $27.

Required

1. Did St. Genevieve managers behave ethically? Explain your answer.

2. Identify the accounting principle relevant to this situation.

3. Who was helped and who was harmed by management’s action?

Financial Statement CasesCase 1. Mullen Transportation Inc.Refer to the financial statements of Mullen Transportation in Appendix A at the end of thisbook and answer the following questions:

1. Describe the transactions that affected Mullen’s shareholders’ equity during 2004.

2. Journalize the following transactions:

a) Issued common shares under the company’s stock option program.b) Declared cash dividends during 2004. c) Net income is transferred to owners’ equity.

3. According to the cash flow statement how much cash was paid for dividends during 2004?How could you arrive at this same figure without referring to the cash flow statement?

4. Compute Mullen’s return on equity and return on assets for 2004. Interpret the relation-ship between these two ratios.

Apply Your Knowledge 503

Case 2. SunRype Products LimitedRefer to SunRype Products Limited financial statements in Appendix B at the end of this book.

1. How many common shares were issued during 2004? How much cash was received?

2. How many shares did the company repurchase and cancel during 2004? Show how thiswould be journalized.

3. Prepare a T-account to show the beginning and ending balance plus all the activity in theRetained Earnings account for the year ended December 31, 2004.

4. Compute Sun-Rype’s return on equity and return on assets for 2004. Interpret the rela-tionship between these two ratios.


Owners’ Equity of PartnershipsIn chapter 1 you were introduced to the three main forms of business ownership,proprietorship, partnership, and corporation. Exhibit 1-2 on page XXX provides aconcise summary of the essential features of these entities. In this appendix weexpand on the basic principles of partnership accounting.

A partnership is an association of two or more persons who co-own a business.The legal life of a partnership terminates with the admission of a new partner, thewithdrawal or death of a partner, voluntary dissolution by the partners, or involun-tary dissolution such as bankruptcy proceedings. The essential characteristics of apartnership include the following features:

• Limited life – Life of a partnership is limited by the length of time that all part-ners continue to own a share of the business. When a partner withdraws fromthe partnership the partnership must be dissolved.

• Unlimited personal liability – When a partnership can not pay its debts withbusiness assets, the partners must use their own personal assets to pay off thisdebt.

• Mutual agency – Every partner can bind the business to a contract within thescope of the partnership’s regular business operations.

• Co-ownership of property – All assets that a partner invests in the partnershipbecome the joint property of all the partners.

• No partnership income taxes – A partnership does not pay income taxes on thenet income of the business. Instead, net income is divided among the partnersand each partner is personally liable for the income taxes on their share of thebusiness’ net income – even if income is not withdrawn from the partnership.

A partnership may be formed by a simple oral agreement among two or morepeople to operate a business for profit. A partnership agreement should preferably bein writing to avoid misunderstanding and should specify information such as:

• The types of products and services to be provided

• Each partner’s initial investment

• Additional investment conditions

• Each partner’s rights and responsibilities

• Rules for withdrawing assets, such as cash, from the partnership

• Procedures for dissolving the partnership

• Profit and loss sharing formulas

Initial Investment by Partners:Assets contributed to a partnership are debited for their market values. Market valuesare also applied to any liabilities assumed by the partnership and separate capitalaccounts and drawing accounts are maintained for each partner. Assume that on

Appendix 9A

January 2, 2007 Jones and Wong establish a partnership whereby Jones contributes$80,000 cash and Wong contributes a building that has a fair market value of$200,000 and an outstanding mortgage of $60,000. The journal entry to establishthe partnership is as follows:

Jan. 2Cash 80,000Building 200,000Mortgage Payable 60,000Jones, Capital 80,000Wong, Capital 140,000

Profit and loss sharing formulas may be based on contributions from the partnerssuch as their relative investments, time and effort each plans to devote to the busi-ness, and the talents and expertise each partner brings to the business. Profits andlosses must be divided equally among the partners if the partnership agreement doesnot specify a profit and loss formula. Usually, however, the partnership agreementwill contain provisions that share profits and losses based on salary, percent return oninvested capital, and stated ratio for dividing up any balance remaining.

Assume Jones and Wong agree to share profits and losses in a 2:3 ratio. If netincome during the first year of operations is $300,000 the following entry would bemade to allocate net income to the partners:

Income summary 300,000Jones, Capital (2/5 � $300,000) 120,000Wong, Capital (3/5 � $300,000) 180,000To close income summary and allocate net income to the partners

If Jones and Wong withdrew cash of $30,000 and $40,000, respectively, these with-drawals would be recorded as follows:

Jones, Withdrawals 30,000Wong, Withdrawals 40,000Cash 70,000

At the end of the period the Statement of Partners’ Equity would appear as follows:

Partners’ Capital StatementFor the Year Ended December 31, 2007

Jones Wong Total

Capital, January 2 $ 80,000 $140,000 $220,000Add: Net income 120,000 180,000 300,000

200,000 320,000 520,000Less: Drawings 30,000 30,000 60,000Capital, December 31 $170,000 $290,000 $460,000

Let’s take a more complex example. Assume the partnership agreement specifies thatJones and Wong will receive a salary of $40,000 and $60,000, respectively, and eachpartner will receive an interest allowance equal to 10% of the balance of their begin-ning capital balance. Any remaining balance will be allocated equally.


Division of Net Income

Amount to beJones Wong Total Distributed

Partnership net income $300,000Salary allowance $40,000 $60,000 $100,000 200,000Interest allowance 12,000 18,000 30,000 170,000Remainder 85,000 85,000 170,000 0Total division $137,000 $163,000 $300,000

The following period end entry transfers net income to the partners’ capital accounts:

Income summary 300,000Jones, Capital 137,000Wong, Capital 163,000To close income summary and allocate net income to the partners

Although Jones and Wong were allocated net incomes of $137,000 and $163,000respectively, this does not indicate that the partners actually withdrew those amountsfrom the partnership. However, for income tax purposes Jones and Wong mustrecord these amounts as income on their income tax returns whether they withdrewassets from the partnership or not.

Assume instead that the partnership had a net loss of $200,000. The net losswould be allocated as follows:Division of Net Income

Division of Net Income

Amount to beJones Wong Total Distributed

Partnership net income ($200,000)Salary allowance $40,000 $60,000 $100,000 (300,000)Interest allowance 12,000 18,000 30,000 (330,000)Remainder (165,000) (165,000) (330,000) 0Total division ($113,000) ($87,000) ($200,000)

Since there was a net loss, income summary must have had a debit balance and theclosing entry results in reductions to Jones and Wong’s capital accounts as follows:

Jones, Capital 113000Wong, Capital 87,000Income summary 200,000

ProblemOn January 2, 2007, B. Able, D. Nile, and R. Wright formed the ANW Partnership bymaking capital contributions of $91,875, $65,625, and $105,000, respectively. Theyanticipate annual net incomes of $300,000 and are considering the following alterna-tive plans of sharing net incomes and losses: (a) equally; (b) in the ratio of their ini-tial investments; (c) a ratio of 2:3:4; or (d) salary allowances of $45,000 to Able,$35,000 to Nile, and $50,000 to Wright; interest allowances of 10% on initial invest-ments, with any remaining balance shared equally.

Required

1. For alternatives a), b), and c) prepare a schedule showing the distribution of a $300,000net income among the partners. Round your answers to the nearest whole dollar

2. For alternative d) prepare a schedule showing the distribution of a $40,000 net income.

Appendix 9A Owner’s Equity of Partnerships 507

3. Prepare a statement of changes in partners’ equity showing the allocation of income to thepartners, assuming they agree to use alternative (c) and the net income earned is$120,000. During the year, Able, Nile, and Wright withdraw $18,000, $20,000, and$35,000, respectively.

4. Prepare the December 31 journal entries to record the withdrawals by the partners, allo-cate profit or losses to the partners, close the withdrawals accounts and the IncomeSummary using the information in part 2.


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