CHAPTER 11 CORPORATIONS: ORGANIZATION, SHARE TRANSACTIONS, AND DIVIDENDS

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1 1. No. ordinary share with a higher par is not necessarily a better investment than ordinary share with a lower par because par is an amount assigned to the shares. 2. The broker is not correct. Corporations are not legally liable to pay dividends until the dividends are declared. If the company that issued the preference share has operating losses, it could omit dividends first on its ordinary share, and later on its preference share. 3. The company may not have had enough cash on hand to pay a dividend on the ordinary share or resources may be needed for plant expansion, replacement of facilities, payment of liabilities, etc. 4. a. No change. b. Total equity is the same. 5. a. Current liability b. Equity CHAPTER 11 CORPORATIONS: ORGANIZATION, SHARE TRANSACTIONS, AND DIVIDENDS 6. a. It has no effect on revenue or expense. b. It reduces equity by $3,000, a. It has no effect on revenue. b. It increases equity by $3,750,000. DISCUSSION QUESTIONS 8. The three classifications of restrictions on retained earnings are legal, contractual, and discretionary. Restrictions are normally reported in the notes to the financial statements. 9. Such prior period adjustments should be reported as an adjustment to the beginning balance of retained earnings. 10. The primary purpose of a stock split is to bring about a reduction in the market price per share and thus to encourage more investors to buy the company s shares. 11-1

2 11. Fund Sources U.S. GAAP IFRS Contributed/ Common/Preferred Stock Ordinary/Preference Share Issued/Paid-in Capital stock Common/Preferred Share capital Ordinary/Preference Capital Paid-in-capital in excess of par or Additional paid-in capital Share premium Ordinary/Preference Earned Capital Retained earnings or retained profits or accumulated Retained earnings or Reinvested earnings or Reserves profits and loss Reserves Accumulated other comprehensive income General reserves and other reserves accounts 12. Not apply. It is the IFRS presentaton. 13. The term reserves refers to all equity accounts other than contributed capital. Retained earnings is generally the primary component of a firm s reserves. Other reserve accounts reflect components of other comprehensive income (e.g. revaluation of assets and certain foreign exchange differences). 14. For share repurchase transactions, IFRS provides only the principle that the cost of treasury shares should be accounted for and presented as a reduction of equity. Other than that, IFRS provides no specific guidance on the allocation of the purchase cost to individual accounts. Therefore, it is up to companies decision to debit the cost of the transaction to those accounts such as treasury share, share capital and premium, retained earnings, reverses, or some combination of the above. 11-2

3 15. (Note: Revised as Ex 11-9) March 4 Treasure Shares $ Cash $ Buy back company's own shares. August 27 Cash $ Teasure Shares $ Capital Surplus Reissue treasure shares. November 11 Cash $640,000 Capital Surplus 32,000 Treasure Shares $672,000 Reissue treasure shares. 11-3

4 Ex a. Total dividend declared $24,000 $81,000 $92,000 $139,000 Preference dividend (current) $24,000 $51,000 * $54,000 $ 54,000 Preference dividend in arrears 30,000 3,000 b. Total preference dividends $24,000 $81,000 $57,000 $ 54,000 Preference shares outstanding 30,000 30,000 30,000 30,000 Preference dividend per share $ 0.80 $ 2.70 $ 1.90 $ 1.80 * $51,000 = $81,000 $30,000 Dividend for ordinary shares EXERCISES 1st Year 2nd Year 3rd Year 4th Year (a. b.) $ $ $ 35,000 $ 85,000 Ordinary shares outstanding 125, ,000 Ordinary dividend per share $ 0.28 $

5 Ex a. Feb. 25 Cash (120,000 shares $40) 4,800,000 Share Capital Ordinary (120,000 shares $36) 4,320,000 Share Premium Ordinary [120,000 shares ($40 $36)] 480,000 June 3 Cash (50,000 shares $9) 450,000 Share Capital Preference (50,000 shares $8) 400,000 Share Premium Preference [50,000 shares ($9 $8)] 50,000 b. $5,250,000 ($4,800,000 + $450,000) Ex May 10 Land (3,600 shares $28) 100,800 Share Capital Ordinary (3,600 shares $4) 14,400 Share Premium Ordinary [3,600 shares ($28 $4)] 86,

6 Ex a. Cash 900,000 Share Capital Ordinary (45,000 shares $20) 900,000 b. Organizational Expenses 8,000 Share Capital Ordinary (400 shares $20) 8,000 Cash 1,200,000 Share Capital Ordinary (60,000 shares $20) 1,200,000 c. Land 150,000 Building 600,000 Interest Payable* 1,500 Mortgage Note Payable 450,000 Share Capital Ordinary (14,925 shares $20) 298,500 * An acceptable alternative would be to credit Interest Expense. Ex Oct. 1 Cash (120,000 shares $31.50) 3,780,000 Share Capital Ordinary (120,000 shares $30.00) 3,600,000 Share Premium Ordinary [120,000 shares ($31.50 $30.00)] 180,000 Oct. 1 Buildings 2,380,000 Land 840,000 Share Capital Preference (35,000 shares $80) 2,800,000 Share Premium Preference [35,000 shares ($92 $80)] 420,

7 Ex Feb. 1 Cash 4,500,000 Share Capital Ordinary (180,000 shares $25) 4,500,000 1 Organizational Expenses 10,000 Share Capital Ordinary (400 shares $25) 10,000 Mar. Apr. 9 Land 200,000 Buildings 550,000 Equipment 135,000 Share Capital Ordinary (30,000 shares $25.00) 750,000 Share Premium Ordinary [30,000 shares ($29.50 $25.00)] 135, Cash (8,500 shares $131) 1,113,500 Share Capital Preference (8,500 shares $120) 1,020,000 Share Premium Preference [8,500 shares ($131 $120)] 93,

8 Ex July Aug. Sept. 10 Cash Dividends 187,500 Cash Dividends Payable 187,500 9 No entry required. 18 Cash Dividends Payable 187,500 Cash 187,500 Ex a. (1) Stock Dividends [(300,000 shares 5%) $40] 600,000 Stock Dividends Distributable (15,000 shares $18) 270,000 Share Premium Ordinary [15,000 shares ($40 $18)] 330,000 (2) Stock Dividends Distributable 270,000 Share Capital Ordinary 270,000 b. (1) $6,900,000 ($5,400,000 + $1,500,000) (2) $78,000,000 (3) $84,900,000 ($6,900,000 + $78,000,000) c. (1) $7,500,000 ($5,400,000 + $1,500,000 + $270,000 + $330,000) (2) $77,400,000 ($78,000,000 $600,000) (3) $84,900,000 ($7,500,000 + $77,400,000) 11-8

9 Ex a. Mar. 4 Treasury Share (33,000 shares $84) 2,772,000 Cash 2,772,000 Aug. Nov. 27 Cash (25,000 shares $90) 2,250,000 Treasury Share (25,000 shares $84) 2,100,000 Share Premium from Sale of Treasury Share [25,000 shares ($90 $84)] 150, Cash (8,000 shares $80) 640,000 Share Premium from Sale of Treasury Share [8,000 shares ($84 $80)] 32,000 Treasury Share (8,000 shares $84) 672,000 b. $118,000 ($150,000 $32,000) credit c. Crystal Lake may have purchased the stock to support the market price of the stock, to provide shares for resale to employees, or for reissuance to employees as a bonus according to stock purchase agreements. Ex a. Feb. 17 Treasury Share (50,000 shares $12) 600,000 Cash 600,000 Apr. July 29 Cash (31,000 shares $15) 465,000 Treasury Share (31,000 shares $12) 372,000 Share Premium from Sale of Treasury Share [31,000 shares ($15 $12)] 93, Cash (12,000 shares $17) 204,000 Treasury Share (12,000 shares $12) 144,000 Share Premium from Sale of Treasury Share [12,000 shares ($17 $12)] 60,000 b. $153,000 ($93,000 + $60,000) credit c. $84,000 (7,000 shares $12) debit d. The balance in the treasury share account is reported as a deduction from the total of the paid-in capital and retained earnings. 11-9

10 Ex a. May 14 Treasury Share (23,500 shares $75) 1,762,500 Cash 1,762,500 Sept. Nov. 6 Cash (14,000 shares $81) 1,134,000 Treasury Share (14,000 shares $75) 1,050,000 Share Premium from Sale of Treasury Share [14,000 shares ($81 $75)] 84, Cash (9,500 shares $72) 684,000 Share Premium from Sale of Treasury Share [9,500 shares ($75 $72)] 28,500 Treasury Share (9,500 shares $75) 712,500 b. $55,500 ($84,000 $28,500) credit c. Equity section d. Biscayne Bay Water Inc. may have purchased the stock to support the market price of the stock, to provide shares for resale to employees, or for reissuance to employees as a bonus according to stock purchase agreements

11 Ex Equity Share capital: Share ordinary preference, 2%, $120 par (85,000 shares authorized, 70,000 shares issued) $8,400,000 Share capital ordinary, no par, $14 stated value (375,000 shares authorized, 320,000 shares issued) 4,480,000 Share premium 735,000 Total paid-in capital $13,615,000 Ex Equity Share capital: Share capital ordinary, $45 par (80,000 shares authorized, 68,000 shares issued) $3,060,000 Excess of issue price over par 272,000 $ 3,332,000 From sale of treasury share 115,000 Total paid-in capital $ 3,447,000 Retained earnings 20,553,000 Total $24,000,000 Deduct treasury share (9,000 shares at cost) 324,000 Total equity $23,676,

12 Ex Equity Share capital: Share capital preference, 1%, $150 par (50,000 shares authorized, 48,000 shares issued) $ 7,200,000 Excess of issue price over par 384,000 $ 7,584,000 Share capital ordinary, $36 par (300,000 shares authorized, 280,000 shares issued) $10,080,000 Excess of issue price over par 420,000 10,500,000 From sale of treasury share 340,000 Total paid-in capital $18,424,000 Retained earnings 71,684,000 Total $90,108,000 Deduct treasury share capital ordinary (24,000 shares at cost) 1,008,000 Total equity $89,100,000 Ex ATLAS PUMPS CORPORATION Retained Earnings Statement For the Year Ended January 31, 2014 Retained earnings, February 1, 2013 $48,110,000 Net profit $9,330,000 Less dividends declared 2,400,000 Increase in retained earnings 6,930,000 Retained earnings, January 31, 2014 $55,040,

13 Ex Retained earnings is not part of paid-in capital. 2. The cost of treasury share should be deducted from the total equity. 3. Dividends payable should be included as part of current liabilities and not as part of equity. 4. Ordinary share should be included as part of paid-in capital. 5. The amount of shares of ordinary share issued of 825,000 times the par value per share of $20 should be extended as $16,500,000, not $17,655,000. The difference, $1,155,000, probably represents share premium. 6. Organizing costs should be expensed as Organizational Expenses when incurred and not included as a part of equity. One possible corrected Equity section of the statement of financial position using Method 2 of Exhibit 4 is as follows: Equity Share capital: Share capital preference 2%, $80 par (125,000 shares authorized and issued) $10,000,000 Share capital ordinary, $20 par (1,000,000 shares authorized, 825,000 shares issued) 16,500,000 Share premium 1,655,000 Total paid-in capital $ 28,155,000 Retained earnings* 96,400,000 Total $124,555,000 Deduct treasury share (75,000 shares at cost) 1,755,000 Total equity $122,800,000 * $96,700,000 $300,000. Since the organizing costs should have been expensed, the retained earnings should be $300,000 less

14 Ex I-CARDS INC. Statement of Stockholders Equity For the Year Ended December 31, 2014 Share Capital Ordinary Share Treasury Retained $40 par Premium Share Earnings Balance, Jan. 1, 2014 $4,800,000 $ 960,000 $11,375,000 Issued 30,000 shares of share capital ordinary 1,200, ,000 Purchased 12,000 shares as treasury share $(552,000) Net profit 3,780,000 Dividends (276,000) Balance, Dec. 31, 2014 $6,000,000 $1,260,000 $(552,000) $14,879,000 Total $17,135,000 1,500,000 (552,000) 3,780,000 (276,000) $21,587,000 Ex a. 160,000 shares (40,000 4) b. $75 per share ($300 4) Ex Assets Liabilities (1) Authorizing and issuing stock certificates in a stock split 0 0 (2) Declaring a stock dividend 0 0 (3) Issuing stock certificates for the stock dividend declared in (2) 0 0 (4) Declaring a cash dividend 0 + (5) Paying the cash dividend declared in (4) Equity

15 Ex Jan. 8 No entry required. The shareholders ledger would be revised to record the increased number of shares held by each stockholder. Apr. 30 Cash Dividends {[(18,000 shares $0.75) + (150,000 shares $0.28)] = $13,500 + $42,000 = $55,500} 55,500 Cash Dividends Payable 55,500 July 1 Cash Dividends Payable 55,500 Cash 55,500 Oct. 31 Cash Dividends {[(18,000 shares $0.75) + (150,000 shares $0.14)] = $13,500 + $21,000 = $34,500} 34,500 Cash Dividends Payable 34, Stock Dividends [(150,000 shares 5% $52) = $390,000] 390,000 Stock Dividends Distributable (7,500 shares $40) 300,000 Share Premium Ordinary [7,500 shares ($52 $40)] 90,000 Dec. 31 Cash Dividends Payable 34,500 Cash 34, Stock Dividends Distributable 300,000 Share Capital Ordinary 300,000 Ex Earnings per Share = Earnings per Share Earnings per Share = Net Profit Preferred Dividends Avg. Number of Ordinary Shares Outstanding $316,000 ($ ,000 shares) 40,000 shares = $7.30 per share 11-15

16 Ex a. Earnings per Share Year 3 Earnings per Share = = $1,105 $ shares = $2.86 per share Net Profit Preferred Dividends Avg. Number of Ordinary Shares Outstanding Year 2 Earnings per Share = Year 1 Earnings per Share = $1,208 $ shares = $3.24 per share $1,312 $ shares = $3.64 per share b. Year 3 Year 2 Year 1 Earnings per share $2.86 $3.24 $3.64 Growth as a percent of Year 1 (base year) 79% 89% 100% Net profit $1,105 $1,208 $1,312 Growth as a percent of Year 1 (base year) 84% 92% 100% Net profit has declined over the three-year period. Year 2 Net profit declined 8% (100% 92%) of Year 1, while Year 3 earnings declined 16% (100% 84%) of Year 1. The decline in earnings per share is slightly more than the decline in earnings. Year 2 earnings per share declined 11% (100% 89%) of Year 1, while Year 3 earnings per share declined 21% (100% 79%) of Year

17 Ex a. OfficeMax: Staples: Earnings per Share Earnings per Share Earnings per Share Earnings per Share = = $71,155,000 $2,527,000 84,908,000 shares = $0.81 per share = = $881,948, ,596,000 shares = $1.23 per share Net Profit Preferred Dividends Avg. Number of Ordinary Shares Outstanding Net Profit Preferred Dividends Avg. Number of Ordinary Shares Outstanding b. Staples net profit of $881,948,000 is much greater than OfficeMax s net income of $71,155,0000. This is because Staples is a much larger business than OfficeMax. Staples also has over 8 times more shares of ordinary share outstanding than does OfficeMax. Regardless of these size differences, however, earnings per share can be used to compare their relative earnings. As shown above, Staples has a better earnings per share of $1.23 than does OfficeMax, which has earnings per share of $

18 Prob. 11 1A 1. Year Preference Dividends Ordinary Dividends Total Per Per Dividends Total Share Total Share 2009 $ 18,000 $18,000 $0.45 $ 0 $ ,000 40, ,000 32,000* , ,000 30, , ,000 30, , ,000 30, , $4.50 $2.28 * $32,000 = (2010 dividends in arrears of $2,000) + (2011 current dividend of $30,000) 2. Average annual dividend for preference: $0.75 per share ($4.50 6) Average annual dividend for ordinary: $0.38 per share ($2.28 6) 3. a. 0.60% ($0.75 $125) b. 5.0% ($0.38 $7.60) PROBLEMS 11-18

19 Prob. 11 2A a. Cash (360,000 shares $22) 7,920,000 Share Capital Ordinary (360,000 shares $12) 4,320,000 Share Premium Ordinary [360,000 shares ($22 $12)] 3,600,000 b. Cash (14,000 shares $43) 602,000 Share Capital Preference (14,000 shares $40) 560,000 Share Premium Preference [14,000 shares ($43 $40)] 42,000 c. Treasury Share (66,000 shares $18) 1,188,000 Cash 1,188,000 d. Cash (51,000 shares $21) 1,071,000 Treasury Share (51,000 shares $18) 918,000 Share Premium from Sale of Treasury Share [51,000 shares ($21 $18)] 153,000 e. Cash (10,000 shares $16) 160,000 Share Premium from Sale of Treasury Share [10,000 shares ($18 $16)] 20,000 Treasury Share (10,000 shares $18) 180,000 f. Cash Dividends {(59,000 shares $0.40) + [(1,250,000 shares + 360,000 shares 66,000 shares + 51,000 shares + 10,000 shares) 0.03]} 71,750 Cash Dividends Payable 71,750 g. Cash Dividends Payable 71,750 Cash 71,

20 Prob. 11 3A 1. and 2. Share Capital Ordinary Jan. 1 Bal. 7,500,000 Apr. 10 1,500,000 Aug ,000 Dec. 31 Bal. 9,360,000 Share Premium Ordinary Jan. 1 Bal. 825,000 Apr ,000 July 5 90,000 Dec. 31 Bal. 1,215,000 Retained Earnings Dec ,800 Jan. 1 Bal. 33,600,000 Dec. 31 1,125,000 Dec. 31 Bal. 34,231,200 Treasury Share Jan. 1 Bal. 450,000 June 6 450,000 Nov ,000 Dec. 31 Bal. 570,000 Share Premium from Sale of Treasury Share June 6 200,000 Stock Dividends Distributable Aug ,000 July 5 360,000 Stock Dividends July 5 450,000 Dec ,000 Cash Dividends Dec ,800 Dec ,

21 Prob. 11 3A (Continued) 2. Jan. 22 Cash Dividends Payable [(375,000 shares 25,000 shares) $0.08] 28,000 Cash 28,000 Apr. 10 Cash (75,000 shares $24) 1,800,000 Share Capital Ordinary (75,000 shares $20) 1,500,000 Share Premium Ordinary [75,000 shares ($24 $20)] 300,000 June 6 Cash (25,000 shares $26) 650,000 Treasury Share (25,000 shares $18) 450,000 Share Premium from Sale of Treasury Share 200,000 [25,000 shares ($26 $18)] July 5 Stock Dividends [(375,000 shares + 75,000 shares) 4% $25] 450,000 Stock Dividends Distributable (18,000 shares $20) 360,000 Share Premium Ordinary [18,000 shares ($25 $20)] 90,000 Aug. 15 Stock Dividends Distributable 360,000 Share Capital Ordinary 360,000 Nov. 23 Treasury Share (30,000 shares $19) 570,000 Cash 570,000 Dec. 28 Cash Dividends [(375,000 shares + 75,000 shares + 18,000 shares 30,000 shares) $0.10] 43,800 Cash Dividends Payable 43, Income Summary 1,125,000 Retained Earnings 1,125, Retained Earnings 493,800 Stock Dividends 450,000 Cash Dividends 43,

22 Prob. 11 3A (Concluded) 3. MORROW ENTERPRISES INC. Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1, 2014 $33,600,000 Net profit $1,125,000 Less: Cash dividends -43,800 Stock dividends -450,000 Increase in retained earnings 631,200 Retained earnings, December 31, 2014 $34,231, Equity Share Capital: Share Capital Ordinary, $20 stated value (500,000 shares authorized, 468,000 shares issued) $9,360,000 Excess of issue price over stated value 1,215,000 From sale of treasury share 200,000 Total paid-in capital $10,775,000 Retained earnings 34,231,200 Total $45,006,200 Deduct treasury share (30,000 shares at cost) 570,000 Total equity $44,436,

23 Prob. 11 4A Jan. 9 No entry required. The shareholders ledger would be revised to record the increased number of shares held by each stockholder and new par value. Feb. 28 Treasury Share (40,000 shares $28) 1,120,000 Cash 1,120,000 May 1 Cash Dividends {(75,000 shares $0.80) + [(1,200,000 shares 40,000 shares) + $0.12]} 199,200 Cash Dividends Payable 199,200 July 10 Cash Dividends Payable 199,200 Cash 199,200 Sept. 7 Cash (30,000 shares $34) 1,020,000 Treasury Share (30,000 shares $28) 840,000 Share Premium from Sale of Treasury Share [30,000 shares ($34 $28)] 180,000 Oct. 1 Cash Dividends {(75,000 shares $0.80) + [(1,200,000 shares 10,000 shares) $0.12]} 202,800 Cash Dividends Payable 202,800 1 Stock Dividends [(1,200,000 shares 10,000 shares) 2% $36] 856,800 Stock Dividends Distributable (23,800 shares $25) 595,000 Share Premium Ordinary [23,800 shares ($36 $25)] 261,800 Dec. 1 Cash Dividends Payable 202,800 Cash 202,800 1 Stock Dividends Distributable 595,000 Share Capital Ordinary 595,

24 Prob. 11 1B 1. Year Preference Dividends Ordianry Dividends Total Per Per Dividends Total Share Total Share 2009 $ 24,000 $ 24,000 $ 0.96 $ 0 $ ,000 10, , ,000* , ,000 45, , ,000 45, , ,000 45, , $10.80 $2.40 * $101,000 =(2009 dividends in arrears of $11,000) + (2010 dividends in arrears of $45,000) + (2011 current dividend of $45,000) 2. Average annual dividend for preference: $1.80 per share ($ ) Average annual dividend for ordinary: $0.40 per share ($2.40 6) 3. a. 1.8% ($1.80 $100) b. 8.0% ($0.40 $5.00) 11-24

25 Prob. 11 2B Oct. 9 Cash 1,500,000 Mortgage Note Payable 1,500, Cash (20,000 shares $126) 2,520,000 Share Capital Preference (20,000 shares $120) 2,400,000 Share Premium Preference [20,000 shares ($126 $120)] 120, Building 4,150,000 Land 800,000 Share Capital Ordinary (300,000 shares $15) 4,500,000 Share Premium Preference [300,000 shares ($16.50 $15.00)] 450,

26 Prob. 11 3B a. Treasury Share (87,500 shares $8) 700,000 Cash 700,000 b. Cash (55,000 shares $11) 605,000 Treasury Share (55,000 shares $8) 440,000 Share Premium from Sale of Treasury Share [55,000 shares ($11 $8)] 165,000 c. Cash (20,000 shares $84) 1,680,000 Share Capital Preference (20,000 shares $80) 1,600,000 Share Premium Preference [20,000 shares ($84 $80)] 80,000 d. Cash (400,000 shares $13) 5,200,000 Share Capital Ordinary (400,000 shares $9) 3,600,000 Share Premium Ordinary [400,000 shares ($13 $9)] 1,600,000 e. Cash (18,000 shares $7.50) 135,000 Share Premium from Sale of Treasury Share 9,000 [18,000 shares ($8.00 $7.50)] Treasury Share (18,000 shares $8) 144,000 f. Cash Dividends {(80,000 shares $1.60) + [(1,750,000 shares 87,500 shares + 55,000 shares + 400,000 shares + 18,000 shares) $0.05]} 234,775 Cash Dividends Payable 234,775 g. Cash Dividends Payable 234,775 Cash 234,

27 Prob. 11 4B 1. and 2. Share Capital Ordinary Jan. 1 Bal. 3,100,000 Apr. 13 1,000,000 July ,000 Dec. 31 Bal. 4,223,000 Share Premium Ordinary Jan. 1 Bal. 1,240,000 Apr ,000 June 14 61,500 Dec. 31 Bal. 1,901,500 Retained Earnings Dec ,068 Jan. 1 Bal. 4,875,000 Dec ,000 Dec. 31 Bal. 5,401,932 Treasury Share Jan. 1 Bal. 288,000 Mar ,000 Oct ,000 Dec. 31 Bal. 300,000 Share Premium from Sale of Treasury Share Mar ,000 Stock Dividends Distributable July ,000 June ,000 Stock Dividends June ,500 Dec ,500 Cash Dividends Dec ,568 Dec ,

28 Prob. 11 4B (Continued) 2. Jan. 15 Cash Dividends Payable [(620,000 shares 48,000 shares) $0.06] 34,320 Cash 34,320 Mar. 15 Cash (48,000 shares $6.75) 324,000 Treasury Share (48,000 shares $6.00) 288,000 Share Premium from Sale of Treasury Share [48,000 shares ($6.75 $6.00)] 36,000 Apr. 13 Cash (200,000 shares $8) 1,600,000 Share Capital Ordinary (200,000 shares $5) 1,000,000 Share Premium Ordinary [200,000 shares ($8 $5)] 600,000 June 14 Stock Dividends [(620,000 shares + 200,000 shares) 3% $7.50] 184,500 Stock Dividends Distributable (24,600 shares $5) 123,000 Share Premium Ordinary [24,600 shares ($7.50 $5.00)] 61,500 July 16 Stock Dividends Distributable 123,000 Share Capital Ordinary 123,000 Oct. 30 Treasury Share (50,000 shares $6) 300,000 Cash 300,000 Dec. 30 Cash Dividends [(620,000 shares + 200,000 shares + 24,600 shares 50,000 shares) $0.08] 63,568 Cash Dividends Payable 63, Income Summary 775,000 Retained Earnings 775, Retained Earnings 248,068 Stock Dividends 184,500 Cash Dividends 63,

29 Prob. 11 4B (Concluded) NAV-GO ENTERPRISES INC. Retained Earnings Statement For the Year Ended December 31, 2014 Retained earnings, January 1, 2014 $4,875,000 Net profit $ 775,000 Less: Cash dividends -63,568 Stock dividends -184,500 Increase in retained earnings 526,932 Retained earnings, December 31, 2014 $5,401, Equity Share capital: Share Capital Ordinary, $5 stated value (900,000 shares authorized, 844,600 shares issued) $4,223,000 Excess of issue price over stated value 1,901,500 From sale of treasury share 36,000 Total paid-in capital $ 6,160,500 Retained earnings 5,401,932 Total $11,562,432 Deduct treasury share (50,000 shares at cost) 300,000 Total equity $11,262,

30 Prob. 11 5B Jan. 15 No entry required. The shareholders ledger would be revised to record the increased number of shares held by each shareholder and new par value. Mar. 1 Cash Dividends [(100,000 shares $0.25) + (800,000 shares $0.07)] 81,000 Cash Dividends Payable 81,000 Apr. 30 Cash Dividends Payable 81,000 Cash 81,000 May 31 Treasury Share (60,000 shares $32) 1,920,000 Cash 1,920,000 Aug. 17 Cash (40,000 shares $38) 1,520,000 Treasury Share (40,000 shares $32) 1,280,000 Share Premium from Sale of Treasury Share [40,000 shares ($38 $32)] 240,000 Sept. 1 Cash Dividends {(100,000 shares $0.25) + [(800,000 shares 60,000 shares+ 40,000 shares) $0.09]} 95,200 Cash Dividends Payable 95,200 1 Stock Dividends [(800,000 shares 60,000 shares + 40,000 shares) 1% $40] 312,000 Stock Dividends Distributable (7,800 shares $30) 234,000 Share Premium Ordinary [7,800 shares ($40 $30)] 78,000 Oct. 31 Cash Dividends Payable 95,200 Cash 95, Stock Dividends Distributable 234,000 Share Capital Ordinary 234,

31 CASES & PROJECTS CP 11 1 At the time of this decision, the WorldCom board had come under intense scrutiny. This was the largest loan by a company to its CEO in history. The SEC began an investigation into this loan, and Bernie Ebbers was eventually terminated as the CEO, with this loan being cited as part of the reason. The board indicated that the decision to lend Ebbers this money was to keep him from selling his stock and depressing the share price. Thus, it claimed that it was actually helping shareholders by keeping these shares from being sold. However, this argument wasn t well received, given that the share price dropped from around $15 per share at the time of the loan to about $2.50 per share when Ebbers was terminated. In addition, critics were scornful of the low sweetheart interest rate given to Ebbers for this loan. In addition, many critics viewed the loan as risky, given that it was not supported by any personal assets. WorldCom has since entered bankruptcy proceedings, Ebbers has gone to prison, and the Ebbers loan went uncollected. Some press comments: 1. When he borrowed money personally, he used his WorldCom stock as collateral. As these loans came due, he was unwilling to sell at depressed prices of $10 to $15 (it s now around $2.50). So WorldCom lent him the money to consolidate his loans, to the tune of $366 million. How a board of directors, representing you and me at the table, allowed this to happen is beyond comprehension. They should resign with Bernie. (Source: Andy Kessler, Bernie Bites the Dust, The Wall Street Journal, May 1, 2002, p. A18.) 2. It was astonishing to read the other day that the board of directors of the United States second-largest telecommunications company claims to have had its shareholders interests in mind when it agreed to grant more than $430 million in low-interest loans to the company s CEO, mainly to meet margin calls on his stock. Yet that s the level to which fiduciary responsibility seems to have sunk on the board of Clinton, Mississippi-based WorldCom, the deeply troubled telecom giant, as it sought to bail Bernard Ebbers out of the folly of speculating in shares of WorldCom itself. Sadly, WorldCom is hardly alone. The very essence of why Mr. Ebbers was granted a loan was to protect shareholder value, said a WorldCom spokesman in mid-march, just as the U.S. Securities & Exchange Commission was unfurling a probe of the loan and 23 other matters related to WorldCom s finances. Yes, folks, you read that right. On March 14, 2002, a spokesman for a publicly traded, $20 billion company actually stood up and declared that of all the uses to which the company could have put almost half-a-billion dollars, the 11-31

32 CP 11 1 (Concluded) best one by far at least from the point of view of the shareholders was to spend it on some sort of stock-parking scheme in order to keep the CEO out of bankruptcy court. (Source: Christopher Byron, Bernie s Bad Idea, Red Herring, April 16, 2002.) Note to Instructors: Bernie Ebbers is currently serving a 25-year prison sentence for conspiracy, securities fraud, and making false statements to securities regulators. CP 11 2 Lou and Shirley are behaving in a professional manner as long as full and complete information is provided to potential investors in accordance with federal regulations for the sale of securities to the public. If such information is provided, the marketplace will determine the fair value of the company s stock. CP This case involves a transaction in which a security has been issued that has characteristics of both stock and debt. The primary argument for classifying the issuance of the ordinary share as debt is that the investors have a legal right to an amount equal to the purchase price (face value) of the security. This is similar to a note payable or a bond payable. The additional $120 payment could be argued to be equivalent to an interest payment, whose payment has been deferred until a later date. Arguments against classifying the security as debt include the fact that the investors will not receive fixed annual interest payments. In fact, if Epstein Engineering Inc. does not generate any net sales, the investors do not have a right to receive any payments. One could argue that the payments of 5% of net sales are, in substance, a method of redeeming the stock. As indicated in the case, the shareholders must surrender their stock for $120 per share after the $25 million payment has been made. Overall, the arguments would seem to favor classifying the security as ordinary share. 2. In practice, the $25 million stock issuance would probably be classified as ordinary share. However, full disclosure should be made of the 5% of net sales and $120 per share payment obligations in the notes to the financial statements. In addition, as Epstein Engineering Inc. generates net sales, a current liability should be recorded for the payment to shareholders. Such payments would be classified as dividend payments rather than as interest payments. Dan Fisher should also investigate whether such payments might violate any loan agreements with the banks. Banks often restrict dividend payments in loan agreements. If such an agreement has been violated, Epstein Engineering Inc. should notify the bank immediately and request a waiver of the violation

33 CP 11 4 a. 500 shares ($0.80 4) = $100 b. (0.4)% = ($31.74 $31.87) $31.87 c. 34.8% = ($31.87 $23.65) $23.65 d. 500 shares $31.74 = $15,870 plus brokerage commission e. The $15,870 paid for 500 shares of Microsoft ordinary share goes to the seller of the ordinary share (another shareholder). CP Before a cash dividend is declared, there must be sufficient retained earnings and cash. On December 31, 2014, the retained earnings balance of $4,630,000 is available for use in declaring a dividend. This balance is sufficient for the payment of the normal quarterly cash dividend of $0.50 per share, which would amount to $90,000 ($ ,000). Motion Designs Inc. s cash balance at December 31, 2014, is $250,000, of which $100,000 is committed as the compensating balance under the loan agreement. This leaves only $150,000 to pay the dividend of $90,000 and to finance normal operations in the future. Unless the cash balance can be expected to increase significantly in early 2015, it is questionable whether sufficient cash will be available to pay a cash dividend and to provide for future cash needs. Other factors that should be considered include the company s working capital (current assets current liabilities) position and the loan provision pertaining to the current ratio, resources needed for plant expansion or replacement of facilities, future business prospects of the company, and forecasts for the industry and the economy in general. The working capital is $5,000,000 ($7,000,000 $2,000,000) on December 31, The current ratio is therefore 3.5:1 ($7,000,000 $2,000,000) on December 31, However, after deducting the $3,000,000 committed to store modernization and product-line expansion, the ratio drops to 2:1 ($4,000,000 $2,000,000). If the cash dividend were declared and paid and the other current assets and current liabilities remain unchanged, the current ratio would drop to 1.955:1 ($3,910,000 $2,000,000), and this would violate the loan agreement. Further, working capital commitments for 2015 and any additional funds that might be required, such as funds for the replacement of property, plant, and equipment, would suggest that the declaration of a cash dividend for the fourth quarter of 2014 might not be wise. 2. Given the cash and working capital position of Motion Designs Inc. on December 31, 2014, a stock dividend might be an appropriate alternative to a cash dividend

34 CP 11 5 (Concluded) a. From the point of view of a stockholder, the declaration of a stock dividend would continue the dividend declaration trend of Motion Designs Inc. In addition, although the amount of the equity and proportional interest in the corporation would remain unchanged, the shareholders might benefit from an increase in the fair market value of their total holdings of Motion Designs Inc. stock after distribution of the dividend. b. From the point of view of the board of directors, a stock dividend would continue the dividend trend, while the cash and working capital position of the company would not be jeopardized. Many corporations use stock dividends as a way to plow back retained earnings for use in acquiring new facilities or for expanding their operations. Motion Designs Inc. has sufficient unissued ordinary share to declare a stock dividend without changing the amount authorized. CP 11 6 Note to Instructors: The purpose of this activity is to familiarize students with sources of information about corporations and how that information is useful in evaluating the corporation s activities. The following information was prepared for Google Inc. based upon the SEC 10-K filing for the year ending December 31, Google Inc. 2. Delaware 3. The following is taken from Google s 10-K: Google is a global technology leader focused on improving the ways people connect with information. We aspire to build products that improve the lives of billions of people globally. Our mission is to organize the world s information and make it universally accessible and useful. Our innovations in web search and advertising have made our website a top internet property and our brand one of the most recognized in the world. We generate revenue primarily by delivering relevant, cost-effective online advertising. Businesses use our AdWords program to promote their products and services with targeted advertising. In addition, the third parties that comprise the Google Network use our AdSense program to deliver relevant ads that generate revenue and enhance the user experience

35 CP 11 6 (Continued) 4. $72,574,000, $37,905,000, $9,737,000, Convertible preference share, $0.001 par value, 100,000 shares authorized; no shares issued and outstanding. Class A and Class B ordinary share and additional paid-in capital, $0.001 par value per share: 9,000,000 shares authorized; 321,301 (Class A 250,413, Class B 70,888) and par value of $321 (Class A $250, Class B $71) and 324,895 (Class A 257,553, Class B 67,342) and par value of $325 (Class A $258, Class B $67) shares issued and outstanding. Note to Instructors: The rights of Class A and Class B ordinary share are identical except for voting rights. Specifically, each share of Class A ordinary share is entitled to one vote per share. Each share of Class B ordinary share is entitled to 10 votes per share. Shares of Class B ordinary share may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A ordinary share. The Class A ordinary share is the stock that is actively traded on the New York Stock Exchange. The Class B ordinary share allows the founders of Google (Sergey Brin and Larry Page) and Executive Chairman (Eric Schmidt) to maintain control of the corporation. Specifically, the following stated in Google s 10-K: As of December 31, 2011, Larry, Sergey, and Eric beneficially owned approximately 92% of our outstanding Class B ordinary share, representing approximately 66% of the voting power of our outstanding share capital ordinary. Larry, Sergey, and Eric therefore have significant influence over management and affairs and over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. 8. $ as of close on February 28, $ $

36 CP 11 6 (Concluded) 10. Google Inc. does not pay dividends. In its SEC 10-K filing for the year ending December 31, 2011, Google states: We have never declared or paid any cash dividend on our ordinary share. We intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future. Note to Instructors: The preceding information, which may be updated as needed, can be used as a basis for class discussion. Some issues that you may want to raise in class are (1) the high price of Google s Class A stock; (2) control of the corporation by the founders, using the voting rights of their Class B stock; (3) the no dividend policy; and (4) future prospects for Google, including appreciation in value of the Class A stock