Chapter 11: Corporations:

Organization, Share Transactions,

Dividends, and Retained Earnings

Prepared by :
Sinda Basly –Chartered Accountant & Master Degree in Accounting
Plant Assets, Natural Resources and
Intangible Assets

The Corporate Form of

Organization

Accounting for Share Transactions

Plant Assets, Natural Resources and
Intangible Assets

Dividends

Retained Earnings

Statement Presentation and

Analysis
 The Corporate Form of Organization
 The corporation is an entity separate and
distinct from its owners : an artificial being,
invisible, intangible, and existing only in
contemplation of law => it is created by law, and
its continued existence depends upon the
statutes of the jurisdiction in which it is
incorporated.

 As a legal entity, a corporation has most of

the rights and duties of a person like acquiring
capital, paying taxes ..
 The Corporate Form of Organization
 Corporations may be classified by purpose:
 For-profit corporation: is organized for the purpose of
making a profit.
 Not-for-profit corporation: is organized for
charitable, medical or educational purposes.

Corporation may be classified by ownership :

 publicly held corporation that have thousands of
shareholders, its shares are regularly traded on a
national securities exchange;
 privately held corporation that usually has only a few
shareholders, and does not offer its shares for sale to
the general public.
 The Corporate Form of Organization
 We will explain a number of characteristics that distinguish
corporations from proprietorships and partnerships.

SEPARATE LEGAL EXISTENCE

 A corporation acts under its own name, it may borrow money
and enter into legally binding contracts in its own name; It may
also sue or be sued, and it pays its own taxes.
LIMITED LIABILITY OF SHAREHOLDERS
 Since a corporation is a separate legal entity, creditors have
recourse only to corporate assets to satisfy their claims: the
liability of shareholders is limited to their capital investment in the
corporation => creditors have no legal claim on the personal
assets of shareholders.
 The Corporate Form of Organization
TRANSFERABLE OWNERSHIP RIGHTS
 Ordinary shares give ownership in a corporation,
these shares are transferable units.
 The transfer of shares is entirely at the discretion of
the shareholders, it does not require the approval of
either the corporation or other shareholders.
 The transfer has no effect on the daily operating
activities of the corporation; nor does it affect the
assets, liabilities and total equity.
 The transfer of these shares is a transaction between
individual owners.
 The Corporate Form of Organization
ABILITY TO ACQUIRE CAPITAL
 It is relatively easy for a corporation to obtain capital
through the issuance of shares: investors like to invest
in shares because they have limited liability and shares
are readily transferable.
CONTINUOUS LIFE

 The life of a corporation is stated in its

charter: it is usually perpetual, but it can be
also limited to a specific number of years.
 The Corporate Form of Organization
CORPORATION MANAGEMENT
 Shareholders legally own the corporation; however they
manage the corporation indirectly through a board of directors
they elect => the board formulates the operating policies for the
company and selects officers to execute policy and perform daily
management functions.
 The Chief Executive Officer (CEO) has overall responsibility for
managing the business => The CEO delegates responsibility to
other officers, for example, the chief accounting officer is the
controller responsible for maintaining the accounting records,
maintaining an adequate system of internal control, preparing
financial statements, tax returns, and reports.
 The Corporate Form of Organization
GOVERNMENT REGULATIONS
 A corporation is subject to governmental
regulations designed to protect the owners of the
corporation.
ADDITIONAL TAXES
 Corporations must pay government taxes as a
separate legal entity; in addition shareholders must in
some countries pay taxes on cash dividends => thus,
many argue that in this case there is a double taxation
on the same revenue once at the corporate level
(when taxing profit), and again at the individual level
(when taxing dividend).
The Corporate Form of Organization
Ownership Rights of Shareholders
 When chartered, the corporation may begin selling
ownership rights in the form of shares.
 When a corporation has only one class of shares, it
is ordinary shares.
 Shareholders have the right to :
 Vote in election of board of directors at annual
meeting and on actions that require shareholder
approval.
 Share the corporate earning through receipt of
dividends.
The Corporate Form of Organization
Ownership Rights of Shareholders

 Keep the same percentage ownership when

new shares are issued (preemptive right).
 Share in assets upon liquidation in
proportion to their holdings => this is called a
residual claim : shareholders are paid with
assets that remain after all creditors’ claims
have been paid.
 Proof of share ownership is evidenced by a
form known as a share certificate.
 The Corporate Form of Organization
 In the following sections, we will see considerations that
the company must resolve when issuing shares.
AUTHORIZED SHARES
 The charter -that is the first legal document containing all
basic data about the company and approved by the
government - indicates the amount of shares that a corporation
is authorized to sell: this amount normally anticipates both
initial and subsequent capital needs => as a result, the number
of shares authorized generally exceeds the number initially
sold.
 In case the company sells all authorized shares, it must
obtain consent of the jurisdiction to amend its charter before it
can issue additional shares.
 The Corporate Form of Organization
 The authorization of ordinary shares does not result in a
formal accounting entry => this event has no immediate effect
on either corporate assets or equity, however , the number of
authorized shares is often reported in the equity section.
ISSUANCE OF SHARES

 A corporation can issue ordinary shares directly to investors,

this is typical in closely held companies.

 A corporation can also issue the shares indirectly through an

investment banking firm that is specialized in bringing securities
to the attention of prospective investors, this is customary for a
publicly held corporation.
 MARKET PRICE OF SHARES
The shares of publicly held companies are traded on
organized exchanges => the interaction between buyers and
sellers determines the prices per share.
 In general, the market prices tend to follow the trend of a
company’s earnings and dividends; but other factors beyond
company’s control may cause day-to-day fluctuations in
market prices such as: an oil embargo, changes in interest
rates, outcome of a presidential election..
PAR AND NO-PAR VALUE SHARES
 Par value shares are ordinary shares to which the charter has
assigned a value per share in order to determine the legal capital
that a company must retain in the business for the protection of
creditors: that amount is not available for withdrawal by
shareholders.
 However, par value is often immaterial comparing with the
market value of shares, thus, today many government do not
require a par value and they use other means to protect creditors =>
today, no-par value that are ordinary shares with no charter
assigned value are most common.
CORPORATE CAPITAL
 Equity is identified by various names : stockholder’s equity,
shareholder’s equity, or corporate capital.
 Equity section of a company’s statement of financial position
consists of 02 parts:
 share capital; and
 retained earnings (earned capital).
 Share capital is cash and other assets paid in to the corporation
by shareholders in exchange for ordinary shares.
 Retained earnings is net income that a corporation retains for
future use.
 The Corporate Form of Organization
To close income summary and transfer net income to retained earnings Net income
increases
Account Debit Credit Equity
Income Summary X through
retained
Retained earnings X earnings

Net loss
To close income summary and transfer net loss to retained earnings decreases
Account Debit Credit Equity
through
Retained earnings X retained
earnings
Income Summary X
 Accounting for Share Transactions

Accounting for Ordinary share Issues

Let’s now look at how to account for issues of ordinary shares.
ISSUING PAR VALUE ORDINARY SHARES FOR
CASH
As discussed earlier, par value does not
indicate a share’s market price; usually, the
cash proceeds from issuing par value shares
is greater than par value.
 Accounting for Ordinary share Issues
ISSUING PAR VALUE ORDINARY SHARES FOR
CASH

To record issuance of shares

Account Debit Credit
Cash X MARKET PRICE
Share Capital - Ordinary Y PAR VALUE
Share Premium - Ordinary X- Y
 Accounting for Share Transactions

ISSUING NO – PAR ORDINARY SHARES FOR CASH

 When no-par ordinary shares have a stated value,

the entries are similar to those illustrated for par value
shares.
To record issuance of shares
Account Debit Credit
Cash X MARKET PRICE
Share Capital - Ordinary Y STATED VALUE
Share Premium - Ordinary X- Y
 Accounting for Share Transactions

ISSUING NO – PAR ORDINARY SHARES FOR CASH

 When no-par ordinary shares do not have a stated

value, the corporation credits the entire proceeds to
Share Capital – Ordinary.
To record issuance of shares
Account Debit Credit
Cash X MARKET PRICE
Share Capital - Ordinary X MARKET PRICE
 Accounting for Share Transactions
ISSUING ORDINARY SHARES FOR SERVICES OR
NON-CASH ASSETS
 When a corporation issues shares for services or for non-
cash assets (land, building and equipment), it recognizes the
cash equivalent price.
 In case of services the cash equivalent price is the fair
value of services or the market price of shares given in
exchange of these services, whichever is more clearly
determinable.
 In case of asset the cash equivalent price is the fair value
of the asset or the market price of shares given in exchange
of these asset, whichever is more clearly determinable.
 ISSUING ORDINARY SHARES FOR SERVICES OR
NON-CASH ASSETS
To record issuance of shares : case of services
Account Debit Credit
X Fair value of the service or
Expense market price of the shares
Share Capital - Ordinary Y PAR VALUE
Share Premium - Ordinary X- Y

To record issuance of shares : case of asset

Account Debit Credit
X Fair value of the asset or
Land /Building/Equipment market price of the shares
Share Capital - Ordinary Y PAR VALUE
Share Premium - Ordinary X- Y
 Accounting for Share Transactions

Accounting for Treasury Shares

 Treasury shares are shares that the company has issued and
then required from shareholders, but not retired.
 A corporation may acquire treasury shares for various reasons:
 to reissue the shares to employees under bonus.
 to give a signal to the securities market in order to enhance the
share’s market price
 to have additional shares available for use in case of acquisition
of other companies
 to increase earnings per share by reducing the number of shares
outstanding (held by shareholders)
 to eliminate hostile shareholders by buying them out.
 Accounting for Treasury Shares

PURCHASE OF TREASURY SHARES

 Companies account for treasury shares by

the cost method => it debits Treasury Shares
account for the price paid to reacquire the
shares.
 Treasury Shares is a contra-equity
account; thus the acquisition of treasury
shares reduces equity.
 Accounting for Treasury Shares

PURCHASE OF TREASURY SHARES

To record purchase of treasury shares
Account Debit Credit
Treasury Shares Acquisition Price
Cash Acquisition Price

Statement of Financial Position (partial)

Equity
Share capital - ordinary X
Retained Earnings Y
Less: Treasury shares Z
Total Equity X+Y-Z
 Accounting for Treasury Shares

SALE OF TREASURY SHARES ABOVE COST

 Treasury shares are usually sold, when the selling

price of the shares is greater than their cost, the
company credits the difference to Share Premium-
Treasury which is an equity account.
To record sale of treasury shares above cost
Account Debit Credit
Cash X Selling Price
Treasury Shares Y Acquisition Cost
Share Premium - Treasury X- Y
 Accounting for Treasury Shares

SALE OF TREASURY SHARES BELOW COST

 When Treasury shares are sold below cost, the

company debits the difference to Share Premium-
Treasury which is an equity account.
To record sale of treasury shares below cost
Account Debit Credit
Cash X Selling Price
Share Premium - Treasury Y-X
Treasury Shares Y Acquisition Cost
 Accounting for Share Transactions

Accounting for Preference Shares

 Preference shares are an additional class of shares
issued by the company that have some priority over
ordinary shares.
Typically, preference shareholders have a priority as to :
 Distributions of earnings (dividends)
 Corporate assets in the event of liquidation.
 However, they sometimes do not have voting rights.
 Corporations may issue preference shares for cash or
for non-cash assets; and the entries in these cases are
similar to the entries for ordinary shares.
 Accounting for Share Transactions
Accounting for Preference Shares

To record the issuance of preference shares

Account Debit Credit
Cash X market price
Share Capital - Preference Y Par value
Share Premium - Preference X-Y
 Let’s now discuss various features associated
with the issuance of preference shares .
 Accounting for Preference Shares

DIVIDEND PREFERENCES
 Preference shareholders have the right to receive
dividends before ordinary shareholders => ordinary
shareholders will not receive any dividends in a current
year until preference shareholders have received their
dividend.
 However, the first claim to dividend does not
guarantee the payment because this depends on many
factors like adequate retained earnings and availability
of cash => if a company does not pay dividends to
preference shareholders, it cannot of course pay
dividends to ordinary shareholders.
 Accounting for Preference Shares

CUMULATIVE DIVIDEND

 When preference shares are cumulative,

preference shareholders must be paid both current-
year dividends and any unpaid prior-year dividends
(called « dividends in arrears ») before ordinary
shareholders receive dividends.

 Companies that are enable to meet their

dividend obligations are not looked upon favorably
by the investment community.
 Accounting for Preference Shares

LIQUIDATION PREFERENCE

 Most preference shares have also a

preference on corporate assets in case of
bankruptcy.
 The liquidation preference establishes
the respective claims of creditors, then
preference shareholders, then ordinary
shareholders in litigation involving
bankruptcy lawsuits.
 Dividends
 A dividend is a corporation’s distribution of
cash or shares to shareholders on a pro rata
basis that is proportional to ownership => if you
own 10% of the ordinary shares, you will receive
10% of the dividend.
 Dividends can take 04 forms : cash, property,
scrip (promissory note to pay cash), shares.
In practice, cash dividends and share dividends
predominate.
In the financial press, dividends are generally
reported quarterly on a per share basis.
 Dividends
Cash Dividends
 To pay cash dividend the company must have:
 Retained earnings : Payment of cash dividends from
retained earnings is legal in all jurisdictions.
 Adequate cash : before declaring a cash dividend,
the board of directors must carefully consider current
and future demands on cash resources.
 A declaration of dividends: the board of directors
has fully authority to determine the amount of income
to distribute in the form of dividends and the amount
to retain in the business.
 Cash Dividends
ENTRIES FOR CASH DIVIDENDS

 Three dates are important in connection

with dividends: the declaration date, the
record date and the payment date.
 Companies make accounting entries on
the declaration date and on the payment
date; at the record date the company
updates and determines its share
ownership records.
 Cash Dividends
ENTRIES FOR CASH DIVIDENDS

 On the declaration date, the board of directors formally

declares the cash dividend and announces it to
shareholders => this declaration commits the corporation
to a legal obligation.

To record declaration of cash dividend

Account Debit Credit
Cash Dividends X
Dividends Payable X
 Cash Dividends
ENTRIES FOR CASH DIVIDENDS

Cash Dividends is an Dividends Payable is a

equity’s account that current liability’s
decreases retained account
earnings

To record payment of cash dividend

Account Debit Credit
Dividends Payable X
Cash X
 Cash Dividends
ALLOCATING CASH DIVIDENDS BETWEEN PREFRENCE
AND ORDINARY SHARES

 As explained earlier, holders of preference

shares must be paid any unpaid prior-year
dividends and their current year’s dividend before
ordinary shareholders receive dividends.
Preference shares 1,000 of 8% , 100 $ par value
Ordinary shares 50,000 , 10 $ par value
At december 31, 2014 : cash dividend declared = 6,000 $
At december 31, 2015 : cash dividend declared = 50,000 $
 Cash Dividends
ALLOCATING CASH DIVIDENDS BETWEEN PREFRENCE
AND ORDINARY SHARES

Compute dividend for preference shares in 2014

Record declaration of cash dividend in 2014
Record declaration of cash dividend in 2015
Dividend for preference shares = 1,000*100*8%= 8,000 $
6,000 $ for
Since cash dividend declared in 2014 is 6,000 $ this entire dividend preference
amount goes to preference shareholders shareholders
To record declaration of cash dividend in 2014
Account Debit Credit
Cash Dividends 6,000
Dividends Payable 6,000
 ALLOCATING CASH DIVIDENDS BETWEEN PREFRENCE
AND ORDINARY SHARES

in 2015, cash dividend = 50,000 10,000 $ for

preference shares (2014 dividends in arrears) preference
shareholders
(8,000-6,000=2,000 $) (2,000)
preference shares (2015) (8,000) 40,000 $ for
remainder for ordinary shares 40,000 ordinary
shareholders

To record declaration of cash dividend in 2015

Account Debit Credit
Cash Dividends 50,000
Dividends Payable 50,000
 Dividends
Share Dividends
 A share dividend is a pro rata distribution to
shareholders of the corporation’s own shares : in this
case the company issues shares.
 Corporations issue share dividends for many reasons:
 To satisfy shareholder’s dividend expectations
without spending cash;
 To increase the marketability of the corporation’s
shares.
 To emphasize that a portion of equity has been
reinvested in the business.
 Share Dividends
ENTRIES FOR SHARE DIVIDENDS
To record declaration of share dividend
Account Debit Credit
Share Dividends Market price X
Ordinary Shares Dividends Distributable Par value Y
Share Premium - Ordinary X-Y

To record issuance of share dividend

Account Debit Credit
Ordinary Shares Dividends Distributable Par value Y
Share Capital - Ordinary Par value Y
 Share Dividends
ENTRIES FOR SHARE DIVIDENDS

All accounts used in reporting

declaration and issuance of
share dividends are equity
accounts

Share dividends account

decreases Retained Earnings
 Dividends
Share splits
 A share split involves issuance of additional shares to
shareholders but not as a result of a distribution of
dividend from retained earnings (net profit), but as a
result from a reduction in the par value per share: for
example, a 2-for-1 share split means that one 10$ par
value share will be exchanged for two 5$ par value shares
=> in a share split, the number of shares increases in the
same proportion that the par value per share decreases.
 A share split does not have any effect on share capital,
share premium, retained earnings or total equity => no
entry is necessary for this operation.
 Dividends
Share splits
 The purpose of this operation is to stimulate
the market activity by lowering the market price.

Increase of Decrease of
shares’ number market’s price

Demand’s Increase of
Increase market’s price
 Retained Earnings
 Retained earnings is net income that the
company retains in the business, however the
balance amount of retained earnings does not
mean that there is the same amount available in
cash because the company may have used the
cash resulting from the excess of revenues over
expenses to purchase buildings, equipment and
other assets => In practice, the balance amount
of retained earnings is different from the cash
balance.
 Retained Earnings
To record closing summary income in case of net income
Account Debit Credit
Dividends
Income Summary are
Net Income
Retained earnings possible Net Income

To record closing summary income in case of net loss

Account Debit Credit
No
Retained earnings Dividends Net Loss
Income Summary Net Loss
 Retained Earnings
 Ifcumulative losses exceed cumulative income over
company’s life (from year to year), a debit balance in
Retained Earnings results: this is identified as a deficit that is
reported as a deduction in the equity section:
Statement of Financial position (partial)
Equity $
Share capital-ordinary 800,000
Retained earnings (deficit) (50,000)
Total Equity 750,000
 Retained Earnings
 The balance in retained earnings is generally
available for dividend declarations.
 In some cases, there may be retained earnings
restrictions:
 Legal retained earnings restrictions required by
some governments.
 Contractual retained earnings restrictions required
by some long-term debt contracts.
 Voluntary retained earnings restrictions required by
the board of directors of the company itself in case for
example of a future plant expansion.
 Companies generally disclose retained earnings
restrictions in the notes to the financial statements.
 Retained Earnings
Case of a Prior Period Adjustments

 In some cases, the company may discover a

material error in reporting net income of a prior
year, after it has closed its books and issued
financial statements => the correction of such an
error is called a prior period adjustment and it is
made directly in the Retained Earnings account ;
because the net income for the prior period is
recorded in retained earnings through the
journalizing of closing entries.
 Retained Earnings
Case of a Prior Period Adjustments

Error discovered => depreciation expense on equipment for prior year was understated by 300,000 $
Record the prior period adjustment in the current year

To record the prior adjustment

Account Debit Credit
Retained earnings 300,000
Accumulated Depreciation-Equipment 300,000
 Retained Earnings
Retained Earnings Statement
 The Retained Earnings Statement shows the changes in
retained earnings during the year and is prepared from the
Retained Earnings Account.
Company's Name
Retained Earnings Statement
For the year ended December 31, 2014
Balance January 1 1 050 000 (1)
Prior Period Adjustments 50 000 (2)
Balance January 1 adjusted 1 100 000 (3)=(1)+(2)
Net Income 360 000 (4)
Total before dividends distribution 1 460 000 (5)=(3)+(4)
Cash dividends 100 000 (6)
Share dividends 200 000 (7)
Balance, December 31 1 160 000 (8)=(5)-(6)-(7)
 Statement Presentation
 The equity section of the statement of financial position
reports share capital, share premium and retained
earnings.
Company's Name
Statement of Financial Position (partial)
Equity $
Share capital-preference 600 000 (1)
Share capital-ordinary 2 000 000 (2)
Ordinary share dividends 50 000 (3)
Share premium -preference 30 000 (4)
Share premium - ordinary 1 050 000 (5)
Retained earnings 1 160 000 (6)
Treasury shares 80 000 (7)
Total equity 4 710 000 =(1)+(2)- (3) +(4)+(5)+(6) -(7)
 Statement Analysis
 Investors and analysts can measure profitability from
the viewpoint of the investor s in ordinary shares by the
Return on Ordinary Shareholders’ Equity.

Return on Ordinary Shareholders’ Equity =

Net Income Available to Ordinary
shareholders / Average Ordinary
Shareholders’ Equity

Net income available to ordinary shareholders = Net income –

Preference shares dividends.
Average ordinary shareholders’ equity = (beginning ordinary
equity + ending ordinary equity) /2
 Statement Analysis
beginning ordinary shareholders' equity= 10,161 million EUR
ending ordinary shareholders' equity = 10,663 EUR
Net income = 1,271.8 million EUR
Preference shares dividends =0 EUR
Compute return on ordinary shareholders' equity
ROE = (1,271,8 - 0)/[(10,663+10,161)/2]= 12,2%
=> every 100 EUR invested in the company provides a profitability of 12,2 EUR
57