Review of Chapter 7

Cost of Property, Plant and Equipment Capital versus Operating Expenditure Depreciation Straight-line, Units of Production and Diminishing balance Additional depreciation topics Intangible Assets

Liabilities

Chapter 8

Current and Long-Term Liabilities

liabilities are debts borrowing is one way a company finances its operations liabilities are classified as current or long-term

Learning Objective 1 Account for current liabilities and contingent liabilities.

Current Liabilities
Current liabilities are obligations due within one year or within the companys normal operating cycle if it is longer Examples: accounts payable, short-term notes payable, taxes payable, current portion of longterm debt, accrued expenses, unearned revenue, etc.

Current Liabilities That Must Be Estimated

Estimated Warranty Payable Assume that Black & Decker made sales of $200,000 subject to product warranties. Black & Decker estimates that 3% of the products it sells this year will require repair or replacement. What is the estimated warranty expense?

Estimated Warranty Payable

$200,000 $200,000 0.03 0.03 = = $6,000 $6,000 Warranty 6,000 Warranty Expense Expense 6,000 Estimated Estimated Warranty Warranty Payable Payable To To accrue accrue warranty warranty expense expense

6,000 6,000

Contingent Liabilities
They are a potential liability that depends on a future event arising out of past events Examples: Lawsuits in progress, guarantees of a subsidiarys debt, audit by Canada Revenue Agency These liabilities are disclosed in the notes to the financial statements (if it is likely that they will become actual liabilities).

Question #1
On January 1, a company signs a $200,000, 4% 9-month note. Interest is due at maturity. What is the adjusting entry required if the company prepares financial statements on June 30. a. b. c. d. Dr Interest expense; Cr Interest payable, $4,000 Dr Interest expense; Cr Cash, $4,000 Dr Interest expense; Cr Cash, $6,000 Dr Interest expense; Cr Interest payable, $6,000

Bonds: An Introduction
A A bond bond is is an an interest interest bearing bearing long-term long-term note note payable. payable. Bonds Bonds are are groups groups of of notes notes payable payable issued issued to to multiple multiple lenders lenders called called bondholders. bondholders. Principal Principal Interest Interest rate rate Payment Payment dates dates

Learning Objective 4 Understand the advantages and disadvantages of borrowing.

Financing Operations With Bonds or Shares

Issuing Shares Creates no liabilities or interest expense Issuing Notes or Bonds Does not dilute share ownership or control of the corporation Results in higher earnings per share because the earnings on borrowed money usually exceeds interest expense

Less risky to the issuing corporation

Financing Operations With Bonds or Shares

Suppose a corporation needs $500,000 for expansion. It has net income of $300,000 and 100,000 common shares outstanding. Management is considering two financing plans: Plan 1 is to issue $500,000 of 10% bonds payable. Plan 2 is to issue 50,000 common shares for $500,000.

Financing Operations With Bonds or Shares

Plan 1: Borrow $500,000 at 10% Net income before expansion Project income before interest and taxes Less interest expense ($500,000 0.10) Project income before income tax Less income tax expense (40%) Expected project net income Total company net income Earnings per share after expansion: ($390,000/100,000 shares) $300,000 $200,000 50,000 $150,000 60,000 90,000 $390,000 $3.90

Financing Operations With Bonds or Shares

Plan 2: Issue 50,000 Common Shares for $500,000 Net income before expansion Project income before interest and taxes Less interest expense Project income before income tax Less income tax expense (40%) Expected project net income Total company net income Earnings per share after expansion: ($420,000/150,000 shares) $300,000 $200,000 0 $200,000 80,000 120,000 $420,000 $2.80

Using Debt in Decision Making

liabilities are a popular way to finance operations managers use ratios to determine how much credit risk it is taking both creditors and investors worry when a companys debt grow there is a risk that the company cannot pay its debts as they become due

Using Debt in Decision Making

2 ratios to determine how much credit risk the company is taking are:

1) Times Interest Earned 2) Debt Ratio

Using Debt in Decision Making

Times Interest Earned = Operating income Interest expense It measures the number of times that operating income can cover interest expense. A high ratio indicates ease in paying interest expense

Using Debt in Decision Making

Debt ratio = Total liabilities Total assets It states the proportion of a companys assets that is financed with debt

Learning Objective 5 Report liabilities on the balance sheet.

Reporting Liabilities
Amounts in millions

Bank Loans Accounts payable and accrued liabilities Income taxes (current and future) Current installments of long-term debt Total current liabilities Long-term debt Other long-term liabilities

14 234 4 21 $ 273 99 8

Reporting Financing Activities on the Cash Flow Statement

Amounts in millions For the Year Ended December 31

Cash Flow used in Financing Activities: Issue of common shares (net) Repayment of bank loans Payments of long-term debt Net cash provided by financing activities

$140 (118) (72) $(50)

End of Chapter 8

Shareholders Equity Chapter 9

Learning Objective 1 Explain the features of a corporation.

What is the Best Way to Organize a Business?

Proprietorship Partnership

Corporation

Corporations
Corporations are legal entities apart from their owners Public corporations Private corporations

Advantages and Disadvantages of a Corporation

Advantages 1. Can raise more capital than a proprietorship or partnership can 2. Continuous life 3. Ease of transferring ownership 4. Limited liability of shareholders Disadvantages 1. Separation of ownership 2. Corporate taxation 3. Government regulation

Organizing a Corporation
Incorporators Articles of Incorporation Set bylaws

Authority Structure of a Corporation

Shareholders Board of Directors Chief Executive Officer Chief Operating Officer

Shareholders Rights
The The right right to to sell sell shares shares Vote Vote Dividends Dividends Liquidation Liquidation Preemption Preemption

Shareholders Equity
Assets = Liabilities + Shareholders Equity
Shareholders Equity represents the ownership interest in the assets of the business It is divided into 2 main parts: 1) Contributed capital (capital stock) 2) Retained earnings

Capital Shares
Corporate ownership is evidenced by a share certificate, which may be for any number of shares. The total number of shares authorized is limited by the articles of incorporation.

Contributed Capital
Common Shares The most basic form of capital issued by every corporation. Preferred Shares A class of shares that has several preferences over common shares.

Intrawest Corporation Shareholders Equity

(In thousands of U.S. dollars)
Preferred shares Common shares Retained earnings Foreign currency translation adjust. Total shareholders equity June 30 2011 2011 $453,299 $400,262 241,665 187,922 (31,295) (33,780) $ 667,269 $568,362

Retained Earnings
The amount that the company has earned through profitable operations Beginning balance Add: Net income Less: Dividends Losses = Ending balance

Learning Objective 2 Account for the issuance of shares.

Issuing Shares
Corporations need money to operate from sources other than borrowing. They sell (issue) shares directly to the shareholders or use the service of an underwriter.

Common Shares
When a company issues shares, it debits the asset received and credits the share account. January 8 Cash (700,000 $10) Common Shares To issue common shares

7,000,000 7,000,000

Preferred Shares
Accounting for preferred shares follows the pattern illustrated for common shares. Shareholders equity on the balance sheet lists preferred shares, common shares, and retained earnings in that order.

Ethical Considerations
Issuing shares for assets other than cash can pose an ethical challenge. The company issuing the shares often wishes to record a large amount for the noncash asset received and for the shares that it is issuing.

Question #2
ABC Company is authorized to issue 50,000 common shares. On Feb. 10, 2009, it issued 10,000 shares at $11 per share. The journal entry to record these facts include a a. b. c. d. Credit to Common shares $110,000 Credit to Common shares $550,000 Debit to Cash for $550,000 Debit to Common shares for $110,000

Learning Objective 3 Describe how share repurchase transactions affect a company.

Share Repurchase Transactions

Repurchased shares are shares that a company has issued and later reacquired. Issuing shares grows a companys assets and equity. Repurchasing shares shrinks assets and equity.

Ava Smallco Ltd. Before Share Repurchase Transaction

Shareholders Equity December 31, 2010 ($000s) Common Shares (10,000 shares) Retained earnings Total equity $ 70,000 193,632 $263,490

Ava Smallco Ltd. Repurchase of Shares

During During 2011, 2011, Ava Ava Smallco Smallco Ltd. Ltd. paid paid $12,000 $12,000 to to repurchase repurchase 1,000 1,000 shares shares of of its its common common shares. shares. November November 12, 12, 2011 2011 Common 7,000 Common shares shares 7,000 Retained 5,000 Retained earnings earnings 5,000 Cash 12,000 Cash 12,000 Repurchased Repurchased common common shares shares for for cancellation cancellation

Ava Smallco Ltd. After Repurchase of Shares

Shareholders Equity at November 12, 2011 ($000s) Common Shares, 9,000 issued Retained earnings Total equity $ 63,000 188,632 $251,320

Learning Objective 4

Account for dividends

Cash Dividend
Three relevant dates for dividends are: Declaration date

Date of record

Payment date

Declaration Date
Declaration date, June 19, the board of directors announces the dividend. Assume a $50,000 dividend. June 19 Retained earnings Dividends payable Declared a cash dividend

50,000 50,000

Date of Record
Date of record, July 1. This follows the declaration date by a few weeks. The shareholders on the record date will receive the dividend. There is no journal entry for the date of record

Payment Date
Payment date, July 10. Dividends payable Cash Paid cash dividend 50,000 50,000

Dividends on Preferred Shares

When a company has issued both preferred and common shares, the preferred shareholders receive their dividends first Common shareholders receive dividends only if the total declared dividend is large enough to pay preferred dividends first

Dividends on Preferred Shares

Dividend rate stated as a dollar amount Cumulative if dividends are omitted in any given year, they must be paid before common shareholders receive their dividend Non-cumulative if dividends are not paid in any given year, they are lost

Example: Preferred Share Dividends

Pinecraft Pinecraft Industries Industries Inc. Inc. has has 100,000 100,000 of of $1.50 $1.50 cumulative cumulative preferred preferred shares shares and and common common shares shares outstanding. outstanding.

Preferred Share Dividends

Preferred dividends are paid at the annual rate of $1.50 per share. Assume that in 2010, the company declares an annual dividend of $1,000,000.
Preferred dividend (100,000 $1.50 per share) $150,000 Common dividend (remainder: $1,000,000 $150,000) 850,000 Total dividend $1,000,000

Preferred Share Dividends

The preferred shares of Pinecraft are cumulative. Suppose the company passed the 2010 preferred dividend of $150,000. In 2011, the company declares a $500,000 dividend. Retained Earnings 500,000 Dividends Payable, Preferred 300,000* Dividends Payable, Common ($500,000 $300,000) 200,000 To declare a cash dividend
*($150,000 2 years)

Question #3
XYZ Corporation has 10,000, $2 cumulative preferred shares and 110,000 common shares outstanding. At the beginning of the current year, preferred dividends were 3 years in arrears. The Board of Directors wants to pay a $1.50 cash dividend on each outstanding common share. To accomplish this, what TOTAL amount of dividends must they declare? a. $225,000 b. $165,000 c. $245,000

Why Issue a Stock Dividend?

To continue dividends, but conserve cash

To reduce the per-share market price of its shares

Stock Dividend
Trans Canada Pipelines (TCP) declared a 2% stock dividend. TCP had 480 million common shares outstanding. The shares are trading for $30 per share. How would this stock dividend be recorded?

Stock Dividend
Retained Earnings (48,000,000 2% $30) 28,800,000 Common Shares 28,800,000 Distributed a 2% stock dividend

Stock Splits
A stock split is an increase in the number of authorized, issued, and outstanding shares, coupled with a proportionate reduction in the shares par value. A stock split decreases the market price of shares.

Stock Splits
The market price of a share of Winpak Ltd. has been approximately $120. Assume that the company wants to decrease it to approximately $60.00. This 2-for-1 split means that the company would have twice as many shares outstanding after the split as is had before the split.

Learning Objective 5 Use share values in decision making.

Share Values
Fair value value a person buy or sells the shares Redemption value value company pays to buy back shares Liquidation value amount company pays to preferred shareholders if a company liquidate Book value Total shareholders equity Preferred equity divided by Number of common shares outstanding

Book Value
Assume that a companys balance sheet reports the following: Shareholders Equity Preferred shares, $6.00, 400 shares issued, redemption value $130 per share Common shares, 5,000 shares issued Retained earnings Total shareholders equity $ 40,000 131,000 70,000 $241,000

Book Value
Suppose that four years (including the current year) cumulative preferred dividends are in arrears and that preferred shares have a redemption value of $130 per share. The book-value-per-share computations for this company are as follows:

Book Value
Preferred equity: Redemption value (400 shares 130) Cumulative dividends (400 $6.00 4 years) Preferred equity Common equity: Total shareholders equity Less preferred equity Common equity Book value per share: $179,400 5,000 shares

$ 52,000 9,600 $ 61,600 $241,000 61,600 $179,400 $ 35.88

Learning Objective 6 Compute return on assets and return on equity.

Financial Ratios
Return on Assets = Net income + interest expense Average total assets It is a measure of a companys ability to generate profits from the use of its assets Return on Equity = Net income Preferred dividends Average common SH equity Measures income earned on shareholders investment

Return on Equity
Leverage borrow at one rate and invest the funds to earn a higher rate Positive leverage if ROE > ROA The difference results from the interest expense component of return on assets

Question #4
Use the following information to calculate Return on Equity for 2010 (rounded). 2010 2009 Total assets $21,695 $20,757 Common shares 43 388 Retained earnings 8,607 7,216 Operating income 4,021 3,818 Interest expense 219 272 Net income 2,662 2,543 a. 16.4% b. 12.5% c. 24.7% d. 32.8%

Learning Objective 7 Report equity transactions on the cash flow statement.

Shareholders Equity and the Cash Flow Statement

3 main financing categories that affect shareholders equity are:

1) Issuance of shares 2) Repurchase of shares 3) Payment of dividends

Reporting Shareholders Equity Transactions

During 2010, George Weston Ltd. paid dividends and retired shares. Following is their report of cash flows from financing activities illustrating the effect on their shareholders equity.
Financing activities: Share capital: retired Dividends (59) (285)

End of Chapter 9