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Chapter: Owners‘ Equity

Corporate form of business:Reporting on shareholders‘ equity

profit distribution, reserves, retained earningswrite-down of capital

issues and purchase of own shares

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The corporate form of organization

The corporation is „an artificial being, invisible, intangible, and existing only in contemplation of law.“ (John Marshall, U.S. Chief Justice, 1819)

Characteristics that distinguish corporations from soletraders and partnerships:

� separate legal entity� limited liability of shareholders� transferable ownership rights� ability to acquire capital� indefinite life time� board structure of corporate management

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Corporate organization chart

Stockholders

Board ofDirectors

President

Corporate Vice President Vice President Vice President Vice PresidentSecretary Marketing Finance Production Personnel

Treasurer Controller

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Ownership rights of shareholders (ordinaryshares)Each share represents� a claim to a specified fraction of profits and losses� a claim to a specified fraction of corporate net assets u pon

liquidation� equal rights to control Management (voting rights)� to share proportionately in any new issues of shares of t he

same class (preemptive right)� can be dropped by shareholder approval, e.g.

• for issues to be granted to employees (incl. Management)• if convertible bonds are issued

Other classes of shares1. Preferred stock2. Shares with differential voting rights

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Corporate Capital

� Share capital (paid-in capital)� par value of the shares issued by the corporation,

contribution by shareholders

� Share premium (additional paid-in capital)� any excess proceeds from share issues

contributions by shareholders above par value� different notation in use by different corporations (see box

below)

� Retained profits� accumulated net income not distributed to owners

Company Name for share premium

AT&T additional paid-in capital PepsiCo capital in excess of par valueCoca-Cola capital surplus Qualcomm paid-in capitalMcDonald's additional paid-in capital Motorola additional paid-in capital

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Significance of par value

� share capital is the permanent capital of a company � can be returned to shareholders only under restrictive con ditions� similar purpose: non-distributable reserves (legal or s tatutory)

� shares issued „partly paid“ or at discount to par value� 25% of par value must be paid in on incorporation

Historical note:In the U.S., par value used to be $ 100 in the early 1900 s, now it‘s common to have par values of $1, $5, or $10, resp., but sometimeslower than that.

$ 2,50$ 1,25$ 1,00$ 0,0167$ 0,01$ 0,0001

Eastman KodakIBMFord Motor CompanyPepsiCoAmerica OnlineQualcomm

Par value of shareCompany

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Accounting for share issues

1. Issuance of shares for cashCompany Stock issues 100.000 shares with par value of € 10 at a price of € 12.

2. Issuance of shares for services or noncash assetsAttorney Jim Sleezy has helped Babel Company incorpora te. He billed the company € 5.000 for his services. Jim agr ees to receive 400 shares of € 10 par value. There is no activ e tradingof shares.

Issuance of shares on fully-paid basis

Cash 1.200.000Share capital (at par) 1.000.000Share premium 200.000

Issuance of shares to attorney

Organization expense 5.000Share capital (at par) 4.000Share premium 1.000

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Accounting for share issues

� issuing shares vs. transferring shares (registered share s)

� registered shares vs. bearer shares

Share issuance Share transfer / tradingShares

Investor A Investor A Investor BCash

Cash Shares

Company Company

Notification ofownership

change

Source: Sutton, p.364

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Payment of dividends

� dividend policy depends on a number of factors, e.g. currentcash position, dividends in prior years, (type of shar eholders), share buyback programs

� Why not pay dividends in amounts equal to retained earnings?� bond covenants require to retain a portion of earnings as

additional protection� desire to retain assets to finance growth

example: Toys ‘R‘ Us, Microsoft and other internet com panies arefast-growing companies. They adopted zero-dividend poli cies to reinvest earnings to support growth.

� desire to smooth out dividend paymentsexample: Eastman Kodak Company, has increased its div idendseach year since 1977. However, as a percentage of net i ncome, dividend payments accounted for 40 to over 100%.

? AT&T consistently declares dividends of about 30-40 percent of net income. Delta Air Lines only pays dividends of about 2 percent of net income, and Cisco Systems has never paid a dividend. Does this mean that AT&T is a better investmentthan Delta and Cisco? Explain and briefly discuss dividend policies.

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Payment of dividends

� Financial condition and dividend distribution:

� Types of dividends� cash dividends� property dividends (dividends in kind)� share dividends

Balance Sheet

Accounts receivable 60.000 Liabilities 200.000Inventory 100.000 Share capital 300.000Plant assets 520.000 Retained earnings 180.000

680.000 680.000

Balance Sheet

Cash 80.000 Current liabilities 50.000Inventory 100.000 Share capital 400.000Plant assets 500.000 Retained earnings 230.000

680.000 680.000

Ability to pay a cash dividenddoes not seemto be given in both cases!

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Cash dividends

� most popular form of dividends� different presentation in EU and US, resp.

A typical dividend announcement reads as follows:The board of directors of EnjoyD Corporation, at its reg ularmeeting of April 1, 2004, declared a quarterly dividen d of $ 7 per share, payable on April 22, 2004, to stockholder s of recordon April 10, 2004.

date of date of date ofdeclaration record payment

board of directors declares shareholders holding shares dividend is paid todividend and liability is at this date receive the shareholdersestablished dividend when paid of record

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Cash dividends

Journal entries to record announcement and payment of dividends:

Date of declarationApril 1 Retained income 350.000

Dividends payable 350.000To record the announcement of dividends to be

paid on April 22 to shareholders of record

as of April 10

Date of paymentApril 22 Dividends payable 350.000

Cash 350.000To pay dividends declared April 1 to

shareholders of record as of April 10

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Cash dividends – presentation of shareholders‘ equity

Facts : EnjoyD issued 50.000 shares with par value € 10 at a price of € 16. Itreports net income in year 1 of € 80.000 and net assets at the end of the yearof € 880.000. No dividend is paid out of year 1 income. In year 2 it reports netincome of € 200.000. The directors propose a dividend of € 2 a share (50.000 shares) in March year 3 when the year 2 results are published. The year 2 accounts and proposed dividend are approved by shareholders at the annualgeneral meeting in May year 3.

year 1 year 3year 2

IPO:50.000 @

16Net income:

80.000Net income:

200.000

March May

Dividendsdeclared:100.000

Dividendsapproved

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Cash dividends – presentation of shareholders‘ equity

Shareholders' equityEnd- End-

year 2 year 1

Format 1 Share capital 500 500(Dominant Share premium 300 300 in EU) Profit retained 80 0

Profit for the year 200 801.080 880

Format 2 Share capital 500 500(UK and Share premium 300 300 Ireland) Profit and loss account 180 * 80

980 880

Format 3 Common stock 500 500(USA) Additional paid-in capital 300 300

Retained earnings 280** 801.080 880

* Retained profits of years 1 and 2, after deducting proposed year 2 dividend of 100. Dividend payable of 100 shown as current liability in year 2 balance sheet.

** Dividend not declared at balance sheet date.

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Non-cash dividends

1. Property dividends (dividends in kind)� can be merchandise, real estate, or investments (shares of

other companies)� recorded at fair value of non-cash assets distributed, recognize

any gain or loss

Example:Ban Corp. holds 200.000 shares of Nab Corp. as an inves tment(original cost: € 2 per share). It decides to transfe r to shareholders 100.000 shares costing € 200.000 by declar ing a property dividend on December 29, 2003, to be distribut ed on January 31, 2004, to shareholders of record on January , 15, 2004. When the board of directors announces the propertydividend, shares of Nab Corp. are quoted at € 4 per sh are.

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Non-cash dividendsAt date of declaration (December 29, 2003)

Investment in Securities 200.000 Gain on Appreciation of Securities 200.000

Retained profits 400.000 Property Dividends Payable 400.000

At date of distribution (January 20, 2004)

Property Dividends Payable 400.000 Investment in Securities 400.000

An example from the real world: DuPont once held a 23% share interest in General Motors. The U.S. Supreme Court ruled that this constituted a violationof antitrust laws. DuPont was ordered to divest itself of the GM shares within10 years. The shares represented 63 million of GM‘s 281 million shares thenoutstanding. Neither selling all at once nor selling them in blocks over 10 yearswas possible due to the fact that the yearly trading volume of GM shares was just 6 million. DuPont distributed its GM shares as a property dividend to itsown shareholders.

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Non-cash dividends

2. Share dividends� offered to continue dividend „payments“ but to avoid cas h

outflow� recorded at par value in EU but at fair value in US

Example: EnjoyD had issued 50.000 shares with par value € 10. Now theyissue 5.000 additional shares (10% share dividend). Th e market priceis € 18 when the dividend is declared.

Share dividend: EU practice

Retained profits 50.000 Share capital 50.000

Share dividend: US practice

Retained earnings 90.000 Common stock 50.000 Additional paid-in capital 40.000

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Share splits

Why splitting shares?� market price per share above a certain level� wider share ownership� empirical evidence: share prices increase after announce ment

of share splits

Accounting treatment:� no accounts are adjusted� memorandum note to indicate change in par value and numb er

of shares

Why consolidating shares?� consolidating shares is the opposite of a share split� to avoid delisting, speculation

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Transfer of profits to reserve

� status of profits changes:distributable (retained earnings) ���� undistributable(reserves)� legal requirements or voluntary reserves� protection of creditors� EU: establishing a legal reserve expressed as a percen tage

of share capital

Example : Assume a company must transfer 5% of itsannual after-tax profits to a legal reserve (until a certain level is reached). Secure Corp. recorded an after-tax profit of € 100.000 in 2003.

To record transfer of profits to legal reserve

Profit for year 2003 5.000 Legal reserve 5.000

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Purchase of own shares

Why repurchasing own shares?� only very few investment opportunities available� to increase earnings per share and return on equity� to prevent takeover attempts

Example: some time ago CBS blocked a takeover attempt by Turner Broadcasting Systems Inc. by repurchasing a substantia l portion of itsoutstanding common stock

� provide shares for employee share option plan� to make market in the stock

Quote: “It‘s a simple formula: announce plans for a $ 3.5 billion stock buyback...watch the stock soar. It worked for IBM.“ (Busi ness Week, 12 May 1997)

� shares are undervalued� to increase financial leverage

Cancelled shares vs. shares held in treasury

Certain restrictions apply for buyback of shares.

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Purchase of own shares

Case study: Reebok� in late 1996, Reebok bought back nearly 1/3 of its

outstanding shares� serious reduction in cash� management stated, repurchase is a reaction to the

undervalued shares and should signal good futureearnings

What did critics say?� repurchase to block possible takeover attempts� repurchase to save jobs (the top managers‘ jobs...)

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Purchase of own shares

1. Shares held in treasury� repurchase usually recorded at cost� shares held in treasury are not an asset / gains from sale of

treasury shares are not incomeExample : EnjoyD buys back 10.000 shares at € 18 per share.

Example : EnjoyD sells the 10.000 treasury shares at € 20 per share.

To record repurchase of shares held in treasury

Treasury shares 180.000 Cash 180.000

To record sale of shares held in treasury

Cash 200.000 Treasury shares 180.000 Share premium from treasury shares _20.000

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Purchase of own shares

2. Cancelled shares� repurchasing and cancelling shares usually reduces share

capital (and share premium)

Example : EnjoyD repurchases 10.000 shares at € 18 and retiresthem.

To maintain the company‘s capital, a reserve for own sha rescan/must be recorded:

To record repurchase and cancellation of shares

Share capital 100.000Share premium 60.000Retained profit 20.000 Cash 180.000

Retained profits 160.000 Reserve for own shares 160.000

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Capital write-down

� If a company has accumulated large losses� upon shareholders‘ approval (general meeting) capital m ay

be written down

� Example: FlopCo‘s Balance sheet

� Journal entries for write-down

Current assets 100 Current debt 120Fixed assets 400 Long term debt 200Accumulated losses120 Share capital 100

share premium 200

Dr. Share capital 40share premium 80

cr. Accumulated losses 120

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Convertible Bonds and Warrants

� A Convertible Bond may be exchanged into a predetermined number of shares of the issuingcompany at the initiative of the bondholder during a specified time span to maturity

� A warrant may be attached to a straight bond thatrepresents the option to buy a specified number of shares of the issuing company at a prespecifiedprice during a specified period of time

� Convertible bonds and bonds with warrants use to have a lower stated interest rate� the present value of the interest benefit is equity capital that

is granted to the bondholder when (s)he exercises theoption or converts the bond, respectively.

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Accounting Treatment

� Example: 5 year convertible bond, €1 million, par� convertible first at the beginning of year 5 until maturi ty� stated annual interest rate 3%� straight debt would yield 8% annual interest� € 1000 of the bond may be converted into 50 shares of the

issuing company, par value € 1,-- each.

� Calculation of the equity component:� Present value of 3% interest for 5 years� + present value of repayment � = liability component of convertible bond

� Amount received at issue date� – Liability component � = equity component

discount rate 8%

1 000 000779 947220.053

947.779)08,1(

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000.305

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=+= ∑=t

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27

Journal entries

� Issue date:� Dr.: Cash 1 000 000� Dr.: bond discount: 220 053� Cr.: Conv. Bonds payable 1 000 000� Cr.: equity component of conv bond 220 053

� Assume half of the bonds are converted beginning of year 5 .

� Carrying value of bond:� unamortized discount:

� Journal entries: � Dr.: Conv. Bonds payable 500 000� Dr.: Equity component of CB 110.026,5� Cr.: Bond discount 23.148� Cr.: Share capital: 500·50 shares @ 1,-- = 25 000� Cr.: Share premium 561.878,5

46.296704.953

08,1

000.030.1 ==L