Chapter+15+Notes+-+Corporations

Homework: SS1, SS2; BE15-1, BE15-2; E15-1, E15-3 (a) only Highlights: **dividends** refer to the pro rata distribution (equivalent to ownership stake in company) of a corporation's earnings to its shareholders at the discretion of the board of directors - dividends may either take the form of **cash payments** or the **company's own stock**
 * __SO 1__ **

- as noted in previous chapter, __if__ dividends are declared, dividends must first be paid to preferred shareholders before any dividends may be distributed to common shareholders

- also as noted in previous chapter, cash dividends on preferred shares are typically fixed and predetermined and may either be expressed as a (i) dollar amount per share (e.g., $2.50/share) or (ii) percentage of par or stated value (5%, $50 par or stated value)

- dividends on common shares are neither fixed nor predetermined, but rather announced at time of declaration

- dividends are most often declared quarterly or annual ly by board of directors

__**Cash dividends**__ - cash dividends refer to the pro rata distribution of cash to a company's shareholders

- before a corporation can distribute cash dividends to its shareholders, the company must (i) possess sufficient retained earnings (ii) possess sufficient cash on hand and (iii) formally declare the dividend by the board of directors

**(1) Date of declaration**: on the **date of declaration** of the dividend, the board of directors formally and publicly announces the amount of the dividend payable to all company shareholders as of a specified future **date of record** (shareholders of record) to be distributed as of a specified future **date of payment** and the accounting entry is as follows:

................................................................ ** Dividends Payable - Common - cr - 100,000 ** To record **declaration** of $2 per share cash dividend on 50,000 outstanding common shares payable to all shareholders of record as of June 15 with payment to be distributed on June 30
 * Jun 1 - ** Cash Dividends - Common ** (or Retained Earnings) - dr - 100,000 **


 * **Dividends Payable** is a current liability account that represents the **legal liability** created when the board of directors formally declares payment of a dividend
 * **Cash Dividends** is a temporary account that must be **closed into Retained Earnings** at the end of the period, and so some bookkeepers prefer to **debit Retained Earnings directly** (as do I) on the declaration date in order to avoid the need for a closing entry


 * (2) Date of record:** on the **date of record** (typically two to three weeks subsequent to the date of declaration, or June 15 in the above example), all shareholders in possession of company stock on that date become legally entitled to the payment of the dividend - **no accounting entry is necessary on the date of record**


 * (3) Date of payment:** on the **date of payment** (typically two to three weeks subsequent to the date of record, or June 30 in the above example), dividend cheques are mailed out to all shareholders of record as of the official date of record and the accounting entry is as follows:

..................................................................**Cash - cr - 100,000** To record **payment** of $2 per share cash dividend
 * Jun 30 - Dividends Payable - Common - dr - 100,000**

- net result of cash dividend is a **decrease to Retained Earnings** and a **decrease to Cash** - in other words, cash dividends decrease both total assets (Cash) and total shareholders' equity (Retained Earnings) leading to **decrease in book value per common share (total shareholders' equity / number of outstanding common shares)**

- as previously stated, preferred shareholders have priority over common shareholders with respect to payment of dividends, and __cumulative__ preferred shareholders must first receive their **dividends in arrear****s** (undeclared dividends from previous years __or__ partially unpaid dividends from previous years due to lack of sufficient dividend funds made available) before they receive their current year dividend and before any possible remaining dividends are allocated to the common shareholders


 * __Example of cash dividend with both common and preferred shares and dividends in arrears__**
 * Assume declaration of **$30,000 total annual cash dividend** with one year of dividends in arrears on 1000 $4 cumulative preferred no par value shares and 8000 no par value common shares

....................**Dividends Payable - Preferred - cr - 8,000 ($4000 dividends in arrears, $4000 current dividends)** .................... ** Dividends Payable - Common - cr - 22,000 (remainder of annual dividends) ** To record declaration of cash dividend assuming one year of dividends in arrears
 * Retained Earnings - dr - 30,000**

................................................... **Cash - cr - 30,000** To record payment of cash dividend
 * Dividends Payable - Preferred - cr - 8,000**
 * Dividends Payable - Common - cr - 22,000**

__ **Stock** __ __**dividends**__ - stock dividends refer to the pro rata distribution to company shareholders of the company's own shares - stock dividends are very rare in Canada today, especially in relation to cash dividends which are much more common


 * __ Example of stock dividend with common shares __**
 * assume declaration of **10% stock dividend** in corporation with **50,000 total outstanding common shares** -> stock dividend results in issue of 5,000 (10% of 50,000) additional common shares to all shareholders as of the date of record in proportion to their current holdings, so that company **shareholder of 10,000 common shares** holding 20% ownership stake __prior__ to stock dividend (10,000 of 50,000 outstanding shares) becomes entitled to stock dividend of additional 1,000 shares (10% of 10,000) but still holds same 20% ownership stake __following__ stock dividend (11,000 of 55,000 outstanding shares) -> in other words, __number__ of shares owned by each shareholder has increased, but __percentage__ of company shares owned by each shareholder remains the same
 * the __number of shares__ issued by way of a stock dividend and the __value assigned to each share__ are determined by the board of directors but federal law recommends shares be assigned their __fair market value__ at the time of declaration

...................................................................... ** Dividends Distributable - cr - 7,500 ** To record **declaration** of 10% stock dividend on 50,000 outstanding no par value common shares (5,000 shares) with current fair market value of $1.50 per share (5,000 x $1.50)
 * Jun 1 - ** Stock Dividends - Common ** (or Retained Earnings) - dr - 7,500 **

........................................... **Share Capital - Common - cr - 7,500** (legal capital) To record issue **(payment)** of stock dividend of 5,000 common shares
 * Jun 30 - Dividends Distributable - dr - 7,500**


 * ** Dividends Distributable ** is __not__ a liability account (as assets will not be used to pay the debt) but rather a __shareholders' equity__ account that must be listed as such on the balance sheet in the event that the financial statements are prepared __prior__ to the issue (payment) of the stock dividend - **please note that if the shares in the above example were either par value or stated value, only the par or stated value (legal capital) would be added to the Dividends Distributable (and later Common Shares) account while the excess over par or stated value would be added to an "Additional contributed capital" account such as Paid-in Capital Distributable (and later Paid-In Capital)**
 * ** Stock Dividends ** is a temporary account that must be **closed into Retained Earnings** at the end of the period, and so some bookkeepers prefer to debit Retained Earnings directly (as do I) on the declaration date in order to avoid the need for a closing entry

- stock dividends (i) satisfy shareholder demand for dividends without requiring any cash outlay on the part of the corporation and (ii) i ncrease the desirability of company shares by increasing supply and thereby **decreasing** **market value per share** (share price)

- net result of stock dividend is a **decrease to Retained Earnings** and an **increase to Share Capital (contributed capital),** but unlike cash dividends, stock dividends do not lead to a decrease in either total assets or total shareholders' equity - essentially a stock dividend results in the reconfiguration of shareholders' equity - given that total shareholders' equity remains the same while the number of outstanding shares increases following a stock dividend, **book value per share** **decreases** as a result

**__Stock splits__** - **stock splits** (like stock dividends) involve the issue of additional shares to shareholders according to their ownership stake in corporation

- primary objective of stock split is to increase attractiveness of shares by **reducing** **market value per share** (share price on public stock exchange) resulting from increased supply of shares on the market

- typical 2-for-1 stock split (e.g., shareholder of 50 $2 stated value common shares becomes owner of 100 $1 stated value common shares) effectively doubles the number of shares on the market and should result in share price falling to approximately 50% of original market value unless consumer demand for new cheaper stock drives up share price slightly

- **stock split does not affect any particular account and therefore should not be journalized**

- stock split has no effect on contributed capital or overall shareholders' equity and so stock split results in **reduced** **book value per share** (inversely related to size of split) given the increased number of outstanding shares

- startup corporations often employ **reverse stock splits** (e.g., typical 1-for-2 reverse stock split wherein shareholder of 100 $1 par value common shares becomes owner of 50 $2 par value common shares) in order to increase market value per share

Homework: SS3, SS4; BE15-5, BE15-6; E15-6 Highlights: ** retained earnings ** (shareholders' equity account) represents accumulated profits or losses since incorporation minus any dividends paid or declared - retained earnings account normally has credit balance - debit (negative) balance in retained earnings known as deficit - retained earnings and contributed capital (share capital and additional contributed capital) represent shareholders' claims on assets of firm - retained earnings is not related to cash reserves of firm - retained earnings are generally available for dividend distribution unless contractual restrictions (e.g., as demanded by lender in loan agreements) or voluntary restrictions (e.g., as established by board of directors for future plans) exist - retained earnings restrictions are reported in notes to financial statements
 * __SO 2 - 3__ **

- **statement of retained earnings** normally reports opening balance in retained earnings plus/minus net income/loss for period minus any dividends declared during period -> corporate revenues, expenses and dividends are effectively "closed" into retained earnings at end of each period

- **prior period adjustments** refer to either (a) **material accounting errors committed in prior periods** **that were not detected until current period** or (b) **recent changes in accounting policies/principles** (e.g., changes in depreciation or inventory valuation methods) **that affect comparisons of previous year's results** and require:

(i) correction or restatement of prior period financial figures via adjusting entries (ii) disclosure of __cumulative__ effect of correction or policy change net of (minus) corporate income tax effects (if applicable) in the form of an adjustment to current period's opening retained earnings figure as found in statement of retained earnings, and (iii) use of corrected amount or updated policy in reporting of current year's results

(a) **correction of prior period accounting error**: cumulative effect of correction of prior period accounting error is applied directly to opening balance of current period's retained earnings account (net of corporate income tax expense) assuming revenues or expenses were affected

(i) ** Merchandise Inventory - dr - 10,000 ** ...........................**Income Tax Payable - cr - 3,000** ...........................**Retained Earnings - cr - 7,000** To adjust for $10,000 __overstatement__ of cost of goods sold (resulting from corresponding understatement of ending inventory) in prior period assuming 30% corporate income tax rate

(ii) ..............................................__**Statement of Retained Earnings for 2017**__
 * Balance January 1, 2017, as previously reported ** ............................ ** $100,000 **
 * Add: Correction for overstatement of cost of goods sold**
 * in previous year, net of income tax expense** .......................................**__$7,000__**
 * Balance January 1, 2017, as adjusted ** .............................................. ** $107,000 **

(b) **retroactive change in accounting policy/principle**: current period financial statements should be prepared using same accounting policies/principles employed in prior period financial statements in order to maximize comparative value - GAAP consistency principle allows modifications in accounting policy when change results in more accurate representation of company's financial performance - like correction of prior period accounting error, cumulative effect of retroactive change in accounting policy/principle is applied directly to opening balance of current period's retained earnings account (net of corporate income tax expense) if applicable

(i) ** Income Tax Payable (Recoverable) - dr - 3,000 ** ....**Retained Earnings - dr - 7,000** ...............................**Accumulated Depreciation - cr - 10,000** To adjust for retroactive effect of change in depreciation method from straight-line to declining balance (resulting in $10,000 total increase in depreciation expense and corresponding decrease in net assets) and assuming 30% corporate income tax rate

(ii) .............................................**__Statement of Retained Earnings for 2017__**
 * Balance January 1, 2017, as previously reported ** .............................. ** $100,000 **
 * Less: Cumulative effect of change in depreciation method****, **
 * net of income tax expense ** ..................................................................... ** (__$7,000)__ **
 * Balance January 1, 2017, as adjusted ** ................................................... ** $93,000 **

> prior period accounting errors that are detected in subsequent periods, given that __income statement__ accounts for prior periods have already been closed out at the end of those prior periods but their effects have been carried forward into various balance sheet accounts **such as** **retained earnings** and **merchandise inventory**
 * note that only __balance sheet__ accounts (permanent accounts) can be updated due to changes in accounting policies/principles or
 * in order to account for a prior period adjustment, one must usually work through the domino-effect changes with respect to the cost of goods sold equation (BI + Pur = COGAFS - EI = COGS) and/or the profit equation (Rev - COGS = GP - OE = NI)
 * the corporate tax rate of 30% used in these examples is __not__ accurate - Ontario corporations actually pay between 15% and 26.5% corporate income tax on their profits today

- **statement of retained earnings** (see above) shows changes in retained earnings over course of year and may either be prepared separately or as part of balance sheet - decreases (debits) in retained earnings may result from annual net losses, declarations of cash or stock dividends, corrections of prior period accounting errors overstating net income, cumulative effects of changes in accounting principles decreasing net income - in creases (credits) in retained earnings may result from annual net profits, corrections of prior period accounting errors understating net income, cumulative effects of changes in accounting principles increasing net income

Homework: SS6, SS7, SS8, SS9, SS10, SS11; BE15-11 (a)(b), BE15-12, BE15-13; E15-13 Highlights: **income statements** **for corporations** are identical to those of sole proprietorships and partnerships other than the inclusion of **income tax expense**
 * __ SO 4 - 7 __**

- Ontario corporations must pay approximately 15% - 26.5% income tax on their annual profits

- **corporate income tax** is calculated at year end on annual profits (following preparation of T2 corporate income tax return) but must be __estimated and remitted__ monthly/quarterly during that same year, and so any difference between actual income taxes paid during the year and year-end calculation of annual income tax liability (by way of T2 return) is reported as a year-end adjusting entry (Income Tax Expense dr - Income Taxes Payable cr) and must be remitted within two to three months of year end

- **interperiod (between multiple periods) income tax allocation** refers to reporting of corporate income taxes in different periods due to timing differences between accounting rules/policies/objectives and income tax rules/policies/objectives, thereby resulting in both income taxes payable (current) and future income taxes/deferred income taxes (long term) appearing on the balance sheet

- contrast with **intraperiod (within one period) income tax allocation** which refers to separate reporting of **non-typical items net of (minus) income tax effects** within specific period:

- **non-typical items** (significant items not typical of regular operations) are reported separately on income statement following income from continuing (normal) operations

- non-typical items include (a) **discontinued operations** and (b) **extraordinary items**

(a) **discontinued operations** refer to disposal/sale of significant segment of business, e,g, sale of entire division of one's firm

- reportable income or loss from discontinued operations consists of both:

(i) **operating profits or losses** **earned on discontinued operations in year of disposa**l, and (ii) **gain or loss realized on actual disposal/sale of assets or shares of discontinued operations**, if applicable

- both items are presented separately (under discontinued operations) on income statement __net__ of applicable income tax

(b) **extraordinary items** refer to events and transactions that satisfy __all three__ of the following conditions:

(i) not expected to occur frequently within foreseeable future (ii) not typical of ordinary business operations, and (iii) not subject to management's decision-making powers

- examples of extraordinary items include gains or losses from major fire damage, newly-enacted laws, government expropriation (lawful seizure) of private property for public usage, natural disasters if uncommon in region, etc.

- extraordinary items are reported below discontinued operations on income statement

- extraordinary items are rarely reported in Canada given that all three above criteria must be satisfied

- like reporting of discontinued operations, extraordinary items must be reported __net__ of applicable income taxes

- please note that losses are reported at __less__ than actual monetary losses suffered owing to tax savings that result from ability to offset losses against unrelated gains occurring in same accounting year

................................. __**Income Statement (partial)**__

Income before income tax ...................................................... $500,000 Less income tax expense (25%) ............................................ (__125,000)__

Income from continuing operations............................................ 375,000

//Discontinued operations// ....... $100,000 loss from operations of discontinued foreign division, net of $25,000 income tax saving .................... (75,000) ....... $1,000,000 gain on sale of discontinued foreign division, net of $150,000 capital gains tax obligation...... __850,000__

Income before extraordinary item.............................................1,150,000

//Extraordinary items// ........ $100,000 loss from fire damage, net of $25,000 income tax saving ....................................................... __(75,000)__

Net income............................................................................ $1,075,000

- investors purchase corporate shares in anticipation of both **capital gains** (appreciation of market share price) and **dividend distributions** (payout of corporate profits)
 * __Corporate ratios__**

- consequently, investors are interested in both a corporation's **earnings performance** and **dividend record**

- **earnings (profits or losses) performance** is most often measured by way of **earnings per common share** and **price-earnings ratio**

(a) **earnings per common share (EPS) measures net income earned by each common share and is calculated as follows:**

**annual after-tax profits/losses (minus any dividends declared on preferred shares or dividends not declared on cumulative preferred shares in current year) divided by weighted average number of common shares outstanding during year**

- for example, ABC Corp has annual after-tax earnings of $2 million and 1 million outstanding common shares so its EPS is $2 per share

- earnings per share must be reported for public corporations and typically appears at bottom of corporate income statement below net income

- differences between __anticipated__ earnings per share and __actual__ earnings per share often lead to wild fluctuations in a public company's share price following reporting

- when income statement contains non-typical items (see above), EPS is often reported for each component of earnings, e.g., income from continuing operations, income before extraordinary item, net income

- EPS from continuing operations is most useful calculation by most standards

- when corporation has issued **convertible preferred shares** (which are potentially convertible into common shares at shareholder's discretion) to its shareholders or provided **stock option**s (right to purchase common shares of company at stated price within specified time frame) to its employees, **fully diluted EPS** may also be reported in income statement taking into account potential impact of increased number of outstanding common shares

(b) **price-earnings ratio (PE ratio) compares current market price of publicly traded common share to its earnings per share and is calculated as follows:**

**current market price of common share divided by annual earnings per common share**

- for example, ABC Corp's common stock trades at $10 per share on the TSX and its annual EPS is $2 so its PE ratio is 5 times

- high PE ratio indicates share price may be overvalued while low PE ratio indicated share price may be good bargain

- PE ratios are often compared to historical industry averages or company averages to determine whether they are "high" or "low"

- **dividend record** is most often measured by way of **payout ratio** and **dividend yield**

(c) **payout ratio measures percentage of earnings distributed to shareholders in form of cash dividends and is calculated as follows:**

**total annual cash dividends divided by annual after-tax net income x 100**

e.g., $100,000 annual cash dividends / $1,000,000 annual after-tax net income = 10% payout ratio

(d) ** dividend yield measures rate of return on corporate shares and is calculated as follows: **


 * annual cash dividend per share divided by current market price of share x 100 **

e.g., $1.80/share annual cash dividend / $100 current market price of share = 1.8% dividend yield

- major Canadian corporation BCE Inc. typically reports payout ratios of approximately 10-20% and dividend yields of 2-3%

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