Shareholders Equity Overview

We turn our attention in this chapter from liabilities, which represent the creditors’ interests in the assets of a corporation, to the shareholders’ residual interest in those assets. The discussions distinguish between the two basic sources of shareholders’ equity – (1) invested capital and (2) earned capital. These two sources are the subjects of Parts B and C of this chapter – paid-in capital and retained earnings. We explore the expansion of corporate capital through the issuance of shares as well as the contraction caused by the retirement of shares or the purchase of treasury shares. Within the context of our discussions of retained earnings, we examine cash dividends, property dividends, stock dividends, and stock splits.

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:

After studying this chapter, you should be able to:LO18-1 Describe the components of shareholders’ equity and explain how they are reported in a

statement of shareholders' equity.LO18-2 Describe comprehensive income and its components. LO18-3 Understand the corporate form of organization and the nature of stock. LO18-4 Record the issuance of shares when sold for cash and noncash consideration.LO18-5 Distinguish between accounting for retired shares and treasury shares.LO18-6 Describe retained earnings and distinguish it from paid-in capital.LO18-7 Explain the basis of corporate dividends, including the similarities and differences

between cash and property dividends.LO18-8 Explain stock dividends and stock splits and we account for them.LO18-9 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting for shareholders’ equity.

Lecture OutlinePart A: The Nature of Shareholders’ Equity

I. Sources of Shareholders’ Equity A. A company can raise money externally to fund operations in either of two ways:

1. Debt financing. a. Takes the form of notes, bonds, leases, and other liabilities. b. Creates creditors’ interest in the assets of the business.

2. Equity financing. a. Creates ownership interests in the assets of the business. b. Owners of a corporation are its shareholders. c. Shareholders’ equity is a residual amount, the amount that

remains after creditor claims have been subtracted from assets. (T18-1)

B. Shareholders’ equity is created mainly by:1. Amounts invested by shareholders – paid-in capital.2. Amounts earned by the firm on behalf of its shareholders – retained earnings.

II. Shareholders’ Equity in Financial Statements A. The balance sheet reports balances of shareholders’ equity accounts. (T18-2)B. Comprehensive income, a more expansive view of the change in shareholders’ equity than

traditional net income, is the total nonowner change in equity for a reporting period. Transactions between the corporation and its shareholders primarily include dividends and the sale or purchase of shares of the company’s stock. Nonowner changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.” Other comprehensive income is reported in two places.1. Components of comprehensive income created during the reporting period - can be

reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement, often included in the financial statements in a disclosure note. Each component is reported net of its related income tax expense or income tax benefit. (T18-3)

2. The comprehensive income accumulated over the current and prior periods – is reported as a separate component of shareholders’ equity.

C. The statement of shareholders’ equity discloses transactions that cause changes in shareholders’ equity account balances. (T18-4)

Part B: Paid-In CapitalI. Fundamental Share Rights

A. Usually ownership rights held by common shareholders include the right to:1. Vote.2. Share in profits when dividends are declared. 3. Share in the distribution of assets if the company is liquidated.

B. Usually the special rights of preferred shareholders include a preference:1. To a specified amount of dividends so that if the board of directors declares

dividends, preferred shareholders receive the designated dividend before any dividends are paid to common shareholders.

2. Over common shareholders as to the distribution of assets in the event the corporation is dissolved.

C. Dividends on cumulative preferred shares that are not declared in any given year must be paid the next time dividends are paid before any can be paid to common shareholders.

D. When preferred shares are not “participating,” shareholders are entitled to no more than the designated dividend preference.

II. The Concept of Par ValueA. Par value has little significance other than historical. B. Par value originally indicated the actual value of shares, but this is no longer the case. C. Companies usually assign shares a nominal par value to elude elaborate statutory rules

pertaining to par value shares. D. When shares are issued, we record the par amount in common stock and the remainder of

the proceeds in additional paid-in capital. III. Accounting for the Issuance of Shares

A. When shares are sold for cash, shareholders’ investment is allocated between stated capital and additional paid-in capital. (T18-5)

B. At times, shares are sold for noncash consideration like a service or a noncash asset. (T18-6)1. The transaction should be recorded at the fair value of either the shares or the

noncash consideration, whichever seems more clearly evident. 2. This is consistent with the general rule for accounting for any noncash transaction.

C. More than one security might be sold for a single price. 1. The cash received usually is the sum of the separate market values of the two

securities. Each is then recorded at its market value. 2. If only one security’s value is known, the second security’s market value is inferred

from the total selling price. (T18-7)3. If the total selling price is not equal to the sum of the two market prices, the total

selling price is allocated between the two securities in proportion to their relative market values.

E. Share issue costs are the costs of the legal, promotional, and accounting services necessary to effect the sale of shares. 1. The costs reduce the net cash proceeds from selling the shares and thus paid-in

capital – excess of par.2. Share issue costs are not recorded separately.

F. U.S. GAAP and IFRS are generally compatible with respect to accounting for shareholders' equity. Some differences exist in presentation format and terminology and in choices regarding reporting comprehensive income. (T18-8)

IV. Reacquired SharesA. Companies sometimes reacquire shares previously sold.

1. The most common motivation is to support the market price of the shares. 2. All share repurchases are functionally the same.3. Accounting treatment depends on whether the company states that it is formally

retiring the shares or purchasing treasury shares. (T18-9) (T18-10) (T18-11)B. When a corporation formally retires previously issued shares, those shares assume the

same status as authorized but unissued shares – just the same as if they never had been issued. 1. Payments to retire shares are viewed as a distribution of corporate assets to

shareholders. 2. We decrease precisely the same accounts that previously were increased when the

shares were sold – namely, common (or preferred) stock and paid-in capital – excess of par.

3. The difference between the cash paid to buy the shares and the amount the shares originally sold for are treated differently depending on whether that difference is positive (credit) or negative (debit):a. If a credit difference is created, we credit paid in capital – share repurchase.b. If a debit difference is created, we debit retained earnings unless a credit

balance already exists in paid in capital – share repurchase, in which case we debit that account.

C. Corporations often view a share buyback as a purchase of treasury stock. 1. The cost of acquiring the shares is “temporarily” debited to the treasury stock

account.2. We delay recording the effects on specific shareholders’ equity accounts until later

when the shares are reissued. 3. Essentially, we view the purchase of treasury stock as a temporary reduction of

shareholders' equity, reversed later when the treasury stock is resold. 4. When the treasury shares are resold, we treat the difference between the cash

received and the amount the shares originally cost differently depending on whether that difference is positive (credit) or negative (debit):a. If a credit difference is created, we credit paid-in capital – share repurchase.b. If a debit difference is created, we debit retained earnings unless a credit

balance already exists in paid-in capital – share repurchase, in which case we debit that account.

Part C: Retained Earnings

I. The Nature of Retained Earnings A. In Part B, we studied invested capital. In Part C, we consider earned capital, usually

referred to as retained earnings. (T18-12)B. In general, retained earnings represents a corporation's accumulated, undistributed or

reinvested net income (or net loss). C. Distributions of earned assets are dividends.D. We refer to a debit balance in retained earnings as a deficit.

II. DividendsA. Most corporate dividends are paid in cash. At the declaration date, retained earnings is

reduced and a liability is recorded. Registered owners of shares on the date of record are entitled to receive the dividend. (T18-13)

B. Occasionally, a noncash asset is distributed. In that case it is referred to as a property dividend. The fair market value of the assets to be distributed is the amount recorded for a property dividend. Before recording the property dividend, the asset may need to be written up or down to fair market value. This would create a gain or loss. (T18-14)

III. Stock DistributionsA. In a stock dividend, additional shares of stock are distributed to existing shareholders.

1. A stock dividend affects neither the assets nor the liabilities of the firm. 2. Because each shareholder receives the same percentage increase in shares, each

shareholder’s percentage ownership of the firm remains the same.3. For a "small" stock dividend (25% or less), the fair value of the additional shares

distributed is transferred from retained earnings to paid-in capital. (T18-15)

B. A stock distribution of 25% or higher is a stock split. (T18-16)1. If referred to merely as a stock split, no journal entry is recorded.2. If referred to as a "stock split effected in the form of a stock dividend," the par value

of the additional shares is reclassified within shareholders’ equity.

Decision-Makers’ PerspectiveA. Profitability is vital to a company's long run survival. B. The return on shareholders' equity is a popular summary measure of profitability.

1. The return on shareholders' equity is calculated by dividing net income by average shareholders' equity

2. The return on shareholders' equity measures the ability of company management to generate net income from the resources that owners provide.

C. Analysts often supplement the return on shareholders’ equity ratio with the earnings-price ratio.1. This ratio relates earnings to the market value of equity rather than the book value

of equity. 2. It is calculated as the earnings per share divided by the market price per share. 3. A common variation is the inverse – the price-earnings ratio.

D. Shareholders’ equity transactions can affect the return to shareholders. 1. When a company buys back some of its shares, the return on shareholders’ equity

goes up. 2. On the other hand, the buyback of shares uses assets, which decreases the resources

available to earn net income in the future.E. Analysts should evaluate dividend decisions with consideration for prevailing

circumstances. Management must decide whether shareholders are better off receiving cash dividends or having funds reinvested in the firm.

Appendix 18: Quasi-ReorganizationsA. A quasi-reorganization aids a company that experiences financial difficulties, and yet has

favorable future prospects. 1. Inflated asset values are written down.2. The accumulated deficit (debit balance in retained earnings) is eliminated.

B. Assets (and liabilities if necessary) are written up or down to reflect fair values.1. Corresponding credits or debits are made to retained earnings. 2. The deficit usually is temporarily increased by this step.

C. The deficit in retained earnings (debit balance) is eliminated.1. Retained earnings is credited; additional paid-in capital is debited. 2. If additional paid-in capital is not sufficient to absorb the entire deficit, common

stock is debited also.D. Retained earnings is “dated” to indicate the date the deficit was eliminated and when the

new accumulation of earnings began.

PowerPoint SlidesA PowerPoint presentation of the chapter is available at the textbook website.

An alternate version of the PowerPoint presentation also is available.

Teaching Transparency MastersThe following can be reproduced on transparency film as they appear here, or

you can use the disk version of this manual and first modify them to suit your particular needs or preferences.

SHAREHOLDERS’ EQUITY

Shareholders’ equity accounts represent the ownership interests of shareholders. Shareholders’ equity is a residual amount – what’s left over after creditor claims have been subtracted from assets (in other words, net assets).

Assets – Liabilities = Shareholders’ equity

Net Assets

Ownership interests of shareholders arise primarily from two sources – (1) amounts invested by shareholders in the corporation and (2) amounts earned by the corporation on behalf of its shareholders. These two sources are reported as (1) paid-in capital and (2) retained earnings.

A third source is Accumulated Other Comprehensive Income

T18-1Exposition Corporation

Balance Sheet ($ in millions)December 31, 2013

Assets[$3,000]

Liabilities[$1,000]

Shareholders’ equityPAID-IN CAPITAL:Capital stock (par):

Preferred stock, 10%, $10 par, cumulative, nonparticipating $100Common stock, $1 par 55Common stock dividends distributable 5

Additional Paid-in Capital:Paid-in capital – excess of par, common 260Paid-in capital – excess of par, preferred 50Paid-in capital – share repurchase 8Paid-in capital – conversion of bonds 7Paid-in capital – stock options 9Paid-in capital – stock award plan 5Paid-in capital – lapse of stock options 1Total paid-in capital $ 500

RETAINED EARNINGS 1,670ACCUMULATED COMPONENTS OF COMPREHENSIVE INCOME:

Unrealized gains (losses) on investment securities (85)Unrealized net loss on pensions (75)Deferred gains (losses) on derivatives (4)Foreign currency translation adjustments -0 - (164)

TREASURY STOCK (at cost) (6 ) Total shareholders’ equity $2,000

T18-2

COMPREHENSIVE INCOME

Encompasses all changes in equity other than from transactions with owners.

Nonowner changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.”

Comprehensive income accumulated over the current and prior periods is reported in the shareholders’ equity section of the balance sheet.

Components of comprehensive income created during the reporting period can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) as a separate statement in a disclosure note:

($ in millions)Net income $xxxOther comprehensive income:

Net unrealized holding gains (losses) on investments (net of tax)† $ x Gains (losses) from and amendments to postretirement plans (net of tax)‡ (x)

Deferred gains (losses) from derivatives (net of tax)§ (x)Gains (losses) from foreign currency translation (net of tax)* x xx

Comprehensive income $xxx

† Changes in the fair value of some securities.‡ Gains and losses due to revising assumptions or market returns differing from expectations

and prior service cost from amending the plan (described in Chapter 17).§ When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is

deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the text).

* Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum.)

T18-3

STATEMENT OF SHAREHOLDERS' EQUITY

     

Wal-Mart Accum. TotalCapital in Other Walmart

Common Excess of Retained Compr. Sh/Hdrs’(In millions, except per share amounts) Shares Stock Par Value Earnings Income Equity

Balances – February 1, 2008 3,973 $397 $3,028 $57,022 $3,864 $64,311Consolidated net income — — — 13,381 — 13,381Other comprehensive income — — — —  (6,552)  (6,552) Cash dividends ($0.95 per share) — — — (3,746)  —  (3,746) Purchase of Company stock (61) (6) (95) (3,315) — (3,416)Other     13     2     987   2     — 991

                   

           

           

         

Balances – January 31, 2009   3,925   393   3,920   63,344  (2,688)  64,969       

Consolidated net income   —   —   —   14,370 — 14,370       

Other comprehensive income       2,618     2,618        

Cash dividends ($1.09 per share)   —   — —   (4,217)   — (4,217)Purchase of Company stock   (145)  (15)   (246)   (7,136)   —  (7,397) Purchase of redeemable noncontrolling interest   —   —   (288)   — —  (288) Other     6     —     417   (4 )     — 413        

                  

                 

           

Balances – January 31, 2010 3,786 378      3,803   66,357     (70)   70,468       

Consolidated net income   —   —      —   16,389     —   16,389       

Other comprehensive income   —   —      —     716  716       

Cash dividends ($1.21 per share)  — —   —   (4,437)    — (4,437)Purchase of Company stock   (280)   (28)     (487)   (14,319)     —  (14,834)Other     10 2       261   (23 )     —     240

                          

                 

           

Balances – January 31, 2011 3,516 $352   $3,577 $63,967  $646  $68,542          

       

       

       

       

 

T18-4

SHARES SOLD FOR CASH When shares are sold for cash, the capital stock account

(usually common or preferred) is credited for the amount representing stated capital. When shares have a designated par value, that amount denotes stated capital and is credited to the stock account. Proceeds in excess of this amount are credited to paid-in capital – excess of par.

Dow Industrial sells 100,000 of its common shares, $1 par per share, for $10 per share:

($ in 000s)Cash (100,000 shares at $10 price per share)....................... 1,000

Common stock (100,000 shares at $1 par )................... 100Paid-in capital – excess of par (remainder).............. 900

The entire proceeds from the sale of nopar stock are deemed stated capital and recorded in the stock account.

If the shares are nopar, the entry is as follows:

Cash (100,000 shares at $10 price per share)....................... 1,000Common stock .................................................... 1,000

T18-5

SHARES SOLD FOR NONCASH CONSIDERATION

Occasionally, a company might issue its shares for consideration other than cash. It is not uncommon for a new company, yet to establish a reliable cash flow, to pay for promotional and legal services with shares rather than with cash. Similarly, shares might be given in payment for land, or for equipment, or for some other noncash asset.

Shares should be issued at whichever evidence of fair market value seems more clearly evident.

DuMont Chemicals issues 1 million of its common shares, $1 par per share, in exchange for a custom-built factory for which no cash price is available. Today’s issue of the Wall Street Journal lists DuMont’s stock at $10 per share:

($ in millions)Property, plant, and equipment (1 million shares at $10).... 10

Common stock (1 million shares at $1 par )..................... 1Paid-in capital – excess of par (remainder)................. 9

T18-6

MORE THAN ONE SECURITY SOLD FOR A SINGLE PRICE

More than one security might be sold for a single price. The cash received usually is the sum of the separate market values of the two securities. Each is then recorded at its market value.

If only one security’s value is known, the second security’s market value is inferred from the total selling price.

AP&P issues 4 million of its common shares, $1 par per share, and 4 million of its preferred shares, $10 par, for $100 million. Today’s issue of the Wall Street Journal lists AP&P’s common at $10 per share. There is no established market for the preferred shares:

($ in millions)Cash........................................................................... 100Common stock (4 million shares x $1 par) ...................... 4Paid-in capital – excess of par, common................. 36Preferred stock (4 million shares x $10 par)..................... 40Paid-in capital – excess of par, preferred................ 20

If the total selling price is not equal to the sum of the two market prices, the total selling price is allocated between the two securities in proportion to their relative market values.

T18-7

INTERNATIONAL FINANCIAL REPORTING STANDARDS

Use of the term “reserves” and other terminology differences. Shareholders’ eq-uity is classified under IFRS into two categories: Share capital and “reserves.” The term reserves is considered misleading and thus is discouraged under U.S. GAAP. Here are some other differences in equity terminology:

U.S. GAAP IFRSCapital stock: Share capital: Common stock Ordinary shares Preferred stock Preference shares Paid-in capital—excess of par, common Share premium, ordinary shares Paid-in capital—excess of par, preferred Share premium, preference sharesAccumulated other comprehensive income: Reserves: Net gains (losses) on investments—AOCI Investment revaluation reserve

Net gains (losses) currency translation —AOCI Translation reserve {N/A: adjusting P,P, & E to fair value not permitted} Revaluation reserve

Retained earnings Retained earnings Total shareholders’ equity Total equity

Presented after Liabilities Often presented before Liabilities

T18-8

COMPARISON OF SHARE RETIREMENT AND TREASURY STOCK ACCOUNTING

– SHARE BUYBACKSAmerican Semiconductor’s balance sheet included the following:

Shareholders' Equity ($ in millions)Common stock, 100 million shares at $1 par ............ $ 100Paid-in capital – excess of par.................................... 900Paid-in capital – share repurchase.............................. 2Retained earnings........................................................ 2,000

Retirement Treasury StockReacquired 1 million of its common shares Case 1: Shares repurchased at $7 per shareCommon stock ($1 par x 1 million sh) 1 Treasury stock (cost).............. 7PIC – excess of par ($9 per sh)......... 9

PIC – share repurchase (difference) 3Cash............................................ 7 Cash................................... 7

OR

Case 2: Shares repurchased at $13 per shareCommon stock ($1 par x 1 million sh) 1 Treasury stock (cost)............... 13PIC – excess of par ($9 per sh)......... 9PIC – share repurchase .................. 2*Retained earnings (difference).......... 1

Cash............................................ 13 Cash................................... 13

*Because there is a $2 million credit balance.

T18-9

COMPARISON OF SHARE RETIREMENT AND TREASURY STOCK ACCOUNTING – SUBSEQUENT SALE OF SHARES

American Semiconductor sold 1 million shares after reacquiring shares at $13 per share (Case 2 in Illustration 18-10)

Retirement Treasury StockCase A: Shares sold at $14 per shareCash................................... 14 Cash............................................ 14

Common stock (par)....... 1 Treasury stock (cost) .............. 13PIC – excess of par........ 13 PIC – share repurchase.......... 1

OR

Case B: Shares sold at $10 per shareCash................................... 10 Cash............................................ 10

Common stock (par)....... 1 Retained earnings (to balance)...... 1PIC – excess of par ......... 9 PIC – share repurchase .............. 2*

Treasury stock (cost).............. 13

*Because there is a $2 million credit balance.

T18-10

REPORTING SHARE BUYBACKS IN THE BALANCE

SHEET When a share repurchase is viewed as treasury

stock, the cost of the treasury stock is simply reported as a reduction in total shareholders’ equity.

Shares TreasuryRetired Stock

Shareholders’ Equity ($ in millions)

Paid-in capital:Common stock, 100 million shares at $1 par$ 99 $ 100Paid-in capital – excess of par 891 900Paid-in capital – share repurchase 2Retained earnings 1,999 2,000Less: Treasury stock, 1 million shares (at cost) (13)Total shareholders’ equity $2,989 $2,989

T18-11

Formally retiring shares restores the balances in both the Common stock account and Paid-in capital – excess of par to what those balances would have been if the shares never had been issued at all. o Any

net increase in assets resulting from the sale and subsequent repurchase is reflected as Paid-in capital –

RETAINED EARNINGS

In general, retained earnings represents a corporation's accumulated, undistributed, or reinvested net income (or net loss). It also is called “reinvested capital” or “earned capital.”

Distributions of earned assets are dividends.

A debit balance in retained earnings is referred to as a deficit.

A restriction of retained earnings communicates management’s intention to withhold assets represented by a specified portion of the retained earnings balance (normally indicated by a disclosure note).

T18-12

CASH DIVIDENDS On June 1, the board of directors of Craft Industries declares a cash dividend of $2 per share on its 100 million shares, payable to shareholders of record June 15, to be paid July 1:

($ in millions)June 1 – declaration dateRetained earnings............................................... 200

Cash dividends payable (100 million shares at $2/share) ........................... 200

June 13 – ex-dividend date no entry

June 15 – date of record no entry

July 1 – payment dateCash dividends payable ..................................... 200

Cash ............................................................. 200

T18-13

PROPERTY DIVIDENDS

Before recording a property dividend, the asset first must be written up to fair market value.

On October 1, the board of directors of Craft Industries declares a property dividend of 2 million shares of Beaman Corporation’s preferred stock that Craft had purchased in March as an investment (book value: $9 million).

The investment shares have a fair market value of $5 per share and are payable to shareholders of record October 15, to be distributed November 1:

October 1 – declaration date ($ in millions)Investment in Beaman Corporation preferred stock .......................................... 1

Gain on appreciation of investment ($10 – $9) 1

Retained earnings (2 million shares at $5 per share) 10Property dividends payable ................... 10

October 15 – date of record no entry

November 1 – payment dateProperty dividends payable .......................... 10

Investment in Beaman Corporation preferred stock .................................... 10

T18-14

STOCK DIVIDENDS

A stock dividend is the distribution of additional shares of stock to current shareholders of the corporation.

Because each shareholder receives the same percentage increase in shares, shareholders' proportional interest in (percentage ownership of) the firm remains unchanged.

For a "small" stock dividend (less than 25%), the fair market value of the additional shares distributed is transferred from retained earnings to paid-in capital.

Craft declares and distributes a 10% common stock dividend (10 million shares) when the market value of the $1 par common stock is $12 per share:

($ in millions)Retained earnings (10 million shares at $12 per share)..... 120

Common stock (10 million shares at $1 par per share) . . 10Paid-in capital – excess of par (remainder)............ 110

T18-15

STOCK SPLITS

A stock distribution of 25% or higher is referred to as a stock split.

A frequent reason for issuing a stock split is to reduce the market price per share (by half in a 2 for 1 split, for example).

The proper accounting treatment of stock split is to make no journal entry, unless the stock distribution is referred to as a "stock split effected in the form of a stock dividend."

Craft declares and distributes a 2 for 1 stock split effected in the form of a 100% stock dividend (100 million shares) when the market value of the $1 par common stock is $12 per share:

($ in millions)Paid-in capital – excess of par.......................... 100

Common stock (100 million shares at $1 par) ........ 100

Some companies choose to debit retained earnings instead:

Retained earnings.............................................. 100Common stock (100 million shares at $1 par) ........ 100

T18-16

Suggestions for Class Activities1. Research Activity

Ask students to look up three companies in the Money & Investing section of the Wall Street Journal, the financial pages of another newspaper, or on the Internet. Have them find the price-earnings ratio of each company. Using those data, have them determine the rate of return on the market value of shareholders' equity.

Suggestions:Pose these questions:1. What information does the rate of return provide?2. How is the information different from that provided by the rate of return of shareholders'

equity as commonly calculated from financial statements?

Points to note:

The rate of return on the market value of shareholders' equity is the inverse of the price-earnings ratio, i.e., the earnings-price ratio. The rate of return on the market value of shareholders' equity is a summary measure of profitability. It measures the ability of management to generate earnings from the resources that owners provide. Like other ratios, analysts must be careful not to view it in isolation That’s why it’s useful to supplement the return on shareholders’ equity ratio as commonly calculated from financial statements (net income divided by average shareholders' equity) with this market-based ratio. This ratio is simply the earnings per share divided by the market price per share.

2. Real World Scenario

Hormel Foods Corp., which makes Spam and other prepared foods, distributed a two-for-one stock split in March 2011. At the time the split was announced, the company's stock price was $49.

Suggestions:Ask students to:1. Speculate as to why Hormel declared the stock split.2. Consider what the share price would be at the time of the distribution, other things being

equal.

Points to note:

Normally, as in this case, a split is made to reduce the per share price and thus enhance the marketability of the stock by making it affordable to a larger number of potential investors. It also might signal favorable performance. Other things equal, the new share price would be $24.50 after the split. Of course, quite a few circumstances and events can cause the price to vary.

3. Real World Scenario

   Following is a news release from General Electric:

FAIRFIELD, Conn.--(BUSINESS WIRE)--Dec. 10, 2004--The Board of Directors of GE today raised the Company's quarterly dividend 10% to $0.22 per outstanding share of its common stock and authorized the repurchase of up to $15 billion of its common stock over the next three years.    "GE has tremendous prospects for growth in earnings and cash flow," said GE Chairman and CEO Jeff Immelt.    "We have been executing a clear strategy to build a capital-efficient portfolio of faster-growth industrial businesses and higher-returning financial services businesses," Immelt said. "That work is now largely behind us, and we have the best set of GE businesses we've had in many years. We're confident that in 2005 we will return to solid double-digit earnings growth with expanding incremental returns on capital and increasing cash flow from operating activities. As a result we fully expect to have the flexibility to invest in technology and innovation while returning value to shareowners through a substantial dividend and a share repurchase program."    The dividend increase, from $0.20 per share, marks the 29th consecutive year in which GE has raised its dividend. GE has paid a dividend every year since 1899. The dividend is payable January 25, 2005, to shareowners of record on December 27, 2004. The ex-dividend date is December 22.    The new share repurchase program replaces a program first authorized in 1994. Since 1994, GE has returned more than $75 billion to shareowners through dividends and the repurchase of more than 1.1 billion shares.

Suggestions:Ask students to consider the statement that GE has the “flexibility to invest in technology and innovation while returning value to shareowners through a substantial dividend and a share repurchase program.” This implies a choice. What are the choices? How do the choices return value to shareholders?

Points to note: Companies have choices regarding the disposition of earnings. One choice is to reinvest in profit-making activities, hopefully benefiting shareholders through higher future earnings and therefore future capital gains and dividends. Another choice is to distribute the earnings currently as dividends. Another is to buy back shares. This supports the market price of stock and reduces dilution that occurs when new shares are issued.

4. Real World Scenario

   Following is a news release from Northeast Community Bancorp:

Northeast Community Bancorp, Inc. (NASDAQ: NECB) today announced that its Board of Directors declared an initial quarterly cash dividend of $0.03 per common share. The dividend will be paid on or about November 15 to stockholders of record as of the close of business on October 12.

Suggestions:Ask students to:1. Consider the effect on the share price on the ex-date, other things being equal.2. Consider the ongoing effect of the decision on company assets, other things being equal.3. Speculate as to why Northeast Community Bancorp declared the dividend after not

previously paying dividends.

Points to note:

Normally, the stock price declines by the amount of a cash dividend, $.03 in this case, the first day the stock trades after the recipients of the dividend are determined. Dividends use cash that otherwise would be available for reinvestment in company growth or other activities. Companies typically pay cash dividends when they feel that is a better return to shareholders than would be reinvesting with the expectation of higher future stock prices. Dividend decisions reflect managerial strategy concerning the mix of internal versus external financing, alternative investment opportunities, and industry conditions. High dividends often are found in mature industries and low dividends in growth industries. Microsoft, for instance, like FedEx previously, for years paid no dividends, focusing instead on plowing available cash into growth opportunities.

5. Professional Skills Development ActivitiesThe following are suggested assignments from the end-of-chapter material that will help your

students develop their communication, research, analysis, and judgment skills.

Communication Skills. Analysis Case 18-2, Exercise 18-23, and Problem 18-6 are suitable for student presentation(s). In addition to Communication Cases 18-3 and 18-6, Research Case 18-4 can be adapted to ask students to prepare a memo to the Controller outlining the findings of the research. Communication Cases 18-3 and 18-10 requires group interaction. Problem 18-12 and Analysis Case 18-7 do well as group assignments. Questions 18-11, 18-21, Exercise 18-14, and Research Case 18-10 create good class discussions.

Research Skills. In their professional lives, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. In addition to Research Case 18-4, Communication Cases 18-3 and 18-10 provide an excellent opportunity to help students develop this skill. In addition, Judgment Case 18-5 can be adapted to require students to research the authoritative literature on accounting for stock splits.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct students to gather, assemble, organize, process, or interpret date to provide options for making business and investment decisions. In addition to Analysis Cases 18-2 and 18-7, Exercise 18-1, Problem 18-7, and Real World 18-11 also provide opportunities to develop analysis skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require students to critically analyze issues to apply concepts learned to business situations in order to evaluate options for decision-making and provide an appropriate conclusion. In addition to Judgment Case 18-5, Communication Case 18-3 also requires students to exercise judgment.

6. Ethical Dilemma

The chapter includes the following ethical dilemma.

ETHICAL DILEMMA

Interworld Distributors has paid quarterly cash dividends since 1985. The dividends have steadily increased from $.25 per share to the latest dividend declaration of $2.00 per share. The board of directors is eager to continue this trend despite the fact that revenues fell significantly during recent months as a result of worsening economic conditions and increased competition. The company founder and member of the board proposes a solution. He suggests a 5% stock dividend in lieu of a cash dividend to be accompanied by the following press announcement:

"In lieu of our regular $2.00 per share cash dividend, Interworld will distribute a 5% stock dividend on its common shares, currently trading at $40 per share. Changing the form of the dividend will permit the Company to direct available cash resources to the modernization of physical facilities in preparation for competing in the 21st century."

What do you think?

You may wish to discuss this in class. If so, discussion should include these elements:

Step 1 - The Facts:

The founder of Interworld Distributors suggests distributing a 5% stock dividend in lieu of its regular $2.00 per share cash dividend. The board of directors wants to continue providing dividends to shareholders despite the fact that revenues have recently declined. The stock dividend will permit Interworld to conserve cash and reinvest cash resources in modernization of physical facilities. Shareholder percentage of ownership in the company does not change as a result of a small stock dividend. Distribution of a small stock dividend results in a reclassification of retained earnings to paid-in capital. Retained earnings are reduced just as if a cash dividend had been paid. Per share stock prices usually decline after a company issues a small stock dividend in order to maintain the same overall value of investment in the company. The company founder is attempting to produce the illusion that current shareholders will be receiving a real dividend and camouflage the fact that revenues have declined.

Step 2 - The Ethical Issue and the Stakeholders:The ethical issue or dilemma is whether the board’s obligation to protect the company’s image

(and perhaps their jobs) is greater than its obligation to protect investors’ and creditors’ interests by providing full disclosure of relevant information.

Stakeholders include the founder of Interworld, other members of the board of directors, company management, employees, current and future creditors, and current and future investors.

Step 3 - Values: Values include honesty, integrity, objectivity, loyalty to the company, loyalty to shareholders,

and responsibility to users of financial statements.

Step 4 - Alternatives:1. Distribute and record a 5% stock dividend to current holders of common stock.2. Do not declare a stock dividend.

Step 5 - Evaluation of Alternatives in Terms of Values:1. Alternative 1 illustrates loyalty to protecting the company image to current shareholders.2, Alternative 2 reflects values of honesty, integrity, objectivity, and responsibility for fair

reporting to current shareholders and to other users of the financial statements.

Step 6 - Consequences:Alternative 1Positive consequences: The company and its management may look better in the eyes of some

shareholders. The company reserves cash to invest in the future modernization of plant facilities.Negative consequences: Some shareholders may falsely believe they are receiving a distribution

of value from the company. Users of the financial statements would be misinformed. The founder and the board may lose the respect of some shareholders and the financial community.

Alternative 2Positive consequences: The founder and board members maintain self-respect and gain the

respect of the financial community. Users of the financial statements are better informed regarding the true financial position of the company.

Negative consequences: Shareholders become displeased about the lack of dividend distribution and reinvest elsewhere. The stock price per share may decline due to the lack of a dividend distribution. Some managers’ jobs may be in jeopardy.

Step 7 - Decision: Student(s) must decide their course of action.

preferred stock