Shareholders Equity - Assignment Example

Shareholders’ Equity Introduction This write up contains different corporate scenarios relating to shareholders equity, its calculations and reporting according to available GAAP. The subjects of comprehensive income, issuance and buy back of shares, retained earnings, and corporate dividends have been discussed in depth under different possibilities. Shareholders’ Equity Shareholders’ equity is that part of assets of the entity that is owned by its owners. In fact shareholders equity represents the net worth of the entity. Simply it is difference between total assets and total liabilities as on a particular date shown in the balance sheet or statement of positions of an entity. Broadly shareholders’ equity constitutes the following two elements a) The capital investments of the owners of the entity, and b) Income/ profits earned by the entity that has not been distributed among owners as dividend or otherwise used but retained in the business for its further exploitation by the business. This is also technically called retained earnings. Calculations of Shareholders equity Total shareholders’ equity is the sum total of common stock issued and outstanding, preference capital issued and outstanding, additional paid in capital, retained earnings, and accumulated other comprehensive income. Common Stock issued and outstanding: It may be noted that common stock may be issued in exchange of cash, services, or property. It can also be issued as the result of the incorporation of an existing business. When stocks are issued in exchange of property, the amount included in the shareholders equity is the fair value of property or fair value of stock whichever is readily available. When stocks are issued in exchange of services, the value included in shareholders equity is the fair value of stock at the time agreement is entered into, if known. Otherwise the fair value of services is taken as part of shareholders equity. When an existing business is incorporated, fair value of the assets and liabilities including goodwill is computed and net amount taken as proceed from issuance of stock is included in the shareholders equity. It is important to note that shares issued equal the number of shares that have been issued minus shares that are retired. This number is not affected by treasury stock held by the company. Shares outstanding equals the number of shares issued minus the number of shares of treasury stock held by the company. The number that will be extended for common stock to be added in shareholders’ equity is the number of shares that are issued and outstanding (after reducing number of treasury stock held) multiplied by the par or stated value per share. Preference capital issued and outstanding: Companies also raise capital by issuing preference capital. Preference stockholders do not have generally right to vote, but do have preference in several other respects like preference in receiving the dividend, liquidity preference and like that. The amount of preference stock to be included in shareholders’ equity is calculated in same way as the calculations of amount for common stock. Additional paid up capital: This is also called capital in excess of par value and is calculated separately for common stocks and preference capital. Although it is possible for common stock or preference stock to be issued for some amount less than par value (that is issuance at discount), it is very unlikely to occur. If that happens then the issuance value is net amount, i.e., stated valued less the discount amount, that is included in shareholders equity. Retained Earnings: The shareholders equity also includes retained earnings. Retained earnings that are not appropriated are included in the shareholders’ equity. Accumulated other comprehensive income: Components of other comprehensive, defined elsewhere in this write- up, are calculated as adjustments affecting directly to shareholders’ equity. Generally these are adjustments like unrealized gains and losses due to change in values of marketable securities, or of derivates that are effective as hedges, rate adjustments on foreign exchange transactions of foreign subsidiaries, and many other such adjustments that are calculated and taken in other comprehensive income as translation adjustments. Reporting of shareholders’ equity The shareholders’ equity section of the balance sheet will include various segments. Contributed capital will be reported first, including preference stock, common stock, and additional paid in capital. Retained earnings including appropriated and unappropriated amounts will be reported next. Adjustments that are made directly to shareholders equity, such as unrealized gains or losses on securities available for sale, are reported in a separate section of shareholders equity. It is entitled “Accumulated other comprehensive income” and appears after retained earnings. Normally the components of shareholders’ equity calculated as above are reported after ‘total liabilities’, but it is seen in some printed balance sheets that ‘net assets’(that is the difference between total assets and liabilities) are calculated and shown after the figure of ‘total liabilities’, and thereafter the section containing different components of shareholders equity is shown. The idea is to reflect that sum total of shareholders equity equals the amount of total of net assets shown in the balance sheet. When reporting common stock in the shareholders’ equity section of the balance sheet, the number of share authorized, issued, and outstanding are all disclosed. Share authorized are the total number of shares the company is authorized to issue. Share issued equals the number of shares issued as reduced by number of shared retired. Shares outstanding is number of share issued reduced by number of treasury stock held by the company. It is seen that the ‘other comprehensive income’ in shareholders equity section is shown as single line item as per convention under US GAAP. However, the details of comprehensive income are provided in a separate ‘statement of comprehensive income’ in which comprehensive income is reported consisting of net income and the components of comprehensive income classified according to their nature. As an alternative, other comprehensive income may be added to or deducted from net income from on income statement to derive comprehensive income. Reporting position of presentation of comprehensive income as part of shareholders’ equity at present is different under International accounting standards as compared to FARSs. There are two options. In the first option a statement of recognized income and gains comprising changes in owners’ equity is presented separately and changes in owners’ equity are provided as a note. In the other option a separate statement of equity comprising both changes in owners equity as well non- owners’ equity is presented. However IFRS 1 has brought changes in presentation of shareholders equity and the position now is more or less akin to US GAAP (FARSs). These changes will be effective from January 2009. As per amended IFRS 1, now a non- mandatory statement of changes in equity may be presented that will include the changes in owners’ equity only. The changes in non-owners’ equity will be presented as single line item in this statement of changes in equity as- other comprehensive income. Another change is presentation of details of comprehensive income. These changes in comprehensive income will either be a part of income statement or appended as second part income statement. The purpose of such changes is to bring more clarity and to separate the current income from the details of comprehensive income. Detail about taxes in the items of comprehensive income may either be shown in the statement of comprehensive income that may now be second part of income statement, or provided in the notes to accounts. Comprehensive Income Comprehensive income is the net change in owners’ equity excluding the effects of investments by owners and distributions to owners. As a result, comprehensive income includes all the components that make net income. In addition, several items that are reported as adjustments directly to stockholders’ equity, and that are not included in computation of net income, are included in comprehensive income. Adjustments that are made directly to shareholders equity make up a component of comprehensive income referred to as “other Comprehensive income”. Few examples of adjustments that comprise other comprehensive income are as under: Unrealized gains and losses due to change in values of marketable securities classified as available for sale. Unrealized gains and losses due to the changes in values of certain derivatives those are effective as hedges. Translation adjustments due to change in the foreign currency exchange rate affecting a foreign subsidiary Amounts in excess of unrecognized prior service cost reported when accruing an addition pension liability based on the excess of accumulated benefit obligation over plan assets. Unrealized gains or losses that results from transfer of a debt security from the category of available for sale to the category of securities held to maturity. The effect of subsequent increases or decreases in the fair value of securities that are in the category of available for sale and were earlier written off as impaired. As has been stated above that the comprehensive income includes both changes in owners’ equity as well as changes effected by non- owners’ equity in the shape of other comprehensive income. Keeping this in view and using the rules framed under IFRS the major items comprising comprehensive income are: “ profits for the period (net income); current period movement in the asset revaluation reserve; current period adjustments recognized directly in equity for the changes in the fair value of available- for- sale investments; current period movements in cash flow hedges deferred in equity; the current period movements in the foreign currency translation reserve; and recognized directly equity for investment accounting for using the equity method.” (Janice Loftus and Maxwell Stevenson, page 6)1 Influence of comprehensive income on equity: Comprehensive income comprises both net income calculated as per income statement for the current period as well as the result of transactions and other event that do not form part on income statements. Simply it comprises the changes brought into owners’ equity as well as changes effected from non- owners’ equity. As per FASB 130 comprehensive income has two components. One is net income for the current period and the other is called ‘other comprehensive income’. The effects of other comprehensive income are not considered in net income. But both being part of comprehensive income, they effect the total shareholders’ equity. This is because comprehensive income is one of components of total shareholders equity that is presented in the balance sheet of the company. As it is understood, the total shareholders equity is net result of total assets and total liabilities. Besides, the items of other comprehensive income reported in the statement of comprehensive income affect total shareholders’ equity because of their counter effects on assets reported in balance sheet. The counter effects of items reported in other comprehensive income offset the value of trading securities from their original invested values. That is to say values of items shown as investments in the balance sheet of the company are directly affected by the counter effects of items shown as other comprehensive income. Such changes in value of investments shown in balance sheet will bring changes in net assets of the company on the reporting date; and thereby the value of net assets on reporting date will be affected. Net assets are in fact the total value of reported total shareholders’ equity on that reporting date. Effects on shareholders’ equity on issuance of more shares and buy back of shares in open market Issuance of more shares When further shares are issued, they are added to the number that will be reported in the shareholders’ section of the balance sheet of common stock or preference capital, as the case may be. Shares issued will also include those resulting from stock dividends and stock split. Periodically companies may distribute additional shares to its shareholders instead of regular cash or other dividends. In some cases it is done in the form of stock dividend while in others it is done in the form of stock split. When a stock dividend is declared, it is usually expressed as a percentage like 5% stock dividend. It indicates that for every 100 shares a stockholder owns, he will receive an additional 5 shares when the dividend is distributed. The effect of stock dividend is that retained earnings are reduced with the fair market value of shares distributed as stock dividend. Common stock gets increased for the par or stated value of shares; and Additional paid in capital is increased by the difference between market value and stated value of shares issued as dividend. When a stock split is announced it is usually expressed in the form of a ratio, for example 2 for 1 stock split. This indicates that a stockholder will end up with 2 shares of stock for every share previously held. In most cases a company issuing a stock split will reduce the par or stated value of the shares in proportion to the increase in the shares. As a result, the total par or stated value of shares issued and outstanding will remain the same. For example a company with 10000 shares of $10 par common stock may issue a 2 for 1 stock split, reducing the par value to $5 per share. Before the split, the total par value of common stock would be 10000 * $10 or $100000. After the split, the total par value of common stock would be 20000 * $5 or $100000. Bye back of shares in open market When shares are reacquired, they are held as treasury stock or they may be retired and their effects are under: If the shares are held as treasury stock they will reduce the number of shares outstanding, but the number of shares issued is not reduced. Treasury stocks may be subsequently resold, issued to individuals exercising rights, warrants, or options, or ultimately retired. Treasury stock is accounted for either under cost method or the par value method. When accounted for under cost method, the balance of treasury stock reduces total stockholders equity; and when accounted for under par value method, it is reported as reduction of contributed capital. If the shares are retired, both the number of shares issued and the number of shares outstanding are reduced. Retained Earnings Retained earnings are the cumulative amount of earnings that has not been distributed as dividends or otherwise. It is important to note that companies appropriate earnings for a number of reasons like legal requirements, contractual requirements, and at discretionary actions of the company. It is the amount of retained earnings that is not appropriated is included in shareholders’ equity. A company that has significant balance in retained earnings is generally expected by the stockholders to distribute dividends. So far as accounting of retained earning is concerned, on appropriation of retained earnings, the regular balance is reduced and appropriated balance is established. When the need for the appropriation is eliminated, the entry is reversed. Each period a company will report the changes to retained earnings in a statement of retained earnings. The statement will report the beginning balance. The amount will be increased by net income and reduced by dividends. The result will generally be ending balance .Certain other items that may be included are: A prior period adjustment will be reported as an increase or decrease to the beginning balance. Appropriations decrease the retained earnings balance and elimination of appropriation increase it. Corporate dividends Mostly, a company will periodically pay cash dividends to stockholders. When they do so, preferred stockholders will first receive their normal dividends. Any remaining dividend will be paid to common stockholders. In some cases preferred stockholders may be entitled to more than normal dividend, when preferred dividends are cumulative or participating. Dividends are recognized on the date when they are declared. On that date the company will reduce retained earnings and report dividends payable. Company will normally specify a record date and a distribution date. Record date is used to determine who will receive dividends. Dividends are paid on shares outstanding as on record date. Distribution date is the date on which the dividend will be paid. Dividends may be paid in cash, scrip, or in property. In addition, a company may issue stock dividends. Dividends are not considered a liability until they are declared. If a company decides not to declare dividend, no liability is recognized. If the company decides to declare dividends in a subsequent period, the preferred stockholders will not be entitled to the dividends that were not declared in the previous period unless the preferred stock is cumulative. When preferred stock is cumulative, preferred stockholders will be entitled to receive dividends from previous years in which no dividends were declared. These unpaid dividends, considered dividend in arrears, will be paid to preferred stockholders in a subsequent year if dividend are declared. Despite the fact that preferred stockholders may receive dividend in arrears, they are not considered a liability until the period in which they are declared. Holders of participating preferred stock will share in dividends proportionately with common stockholders. When a company is short of cash, but has sufficient retained earnings to pay a dividend, it may issue promissory notes in lieu of cash. This is called scrip dividend. A company may distribute property as a dividend to its shareholders, instead of cash. The property may be in form in the forms of shares of stock in another company, being held as investment, land, inventory or other assets. Property dividends are recorded at fait value at declaration date. The difference in fair value and carrying value of property is recognized as gain or loss on disposal of property. Companies also distribute additional shares of their stocks to shareholders instead of cash and other dividends. Such distributions take the form of stock dividend or stock split, as explained in the section issuance of more shares herein above. References Read More