Shareholders' equity: share capital, dividends and reserves

Equity is the residual interest in a company's assets after deducting its liabilities. Lessons 1 to 9 dealt with liabilities; this lesson turns to the owners' claim. It looks at how shares are issued and recorded, what happens when a company buys back its own shares, how dividends of cash, property and shares are accounted for, how preferred shares are classified, and how the components of equity are presented. Canadian corporate law and US state corporate law shape the accounting here more than in most areas, so the two countries' practices differ in vocabulary and in some mechanics. Canadian companies speak of share capital, contributed surplus and shareholders' equity; this page follows that usage.

The corporate form and classes of shares

Most Canadian corporations are incorporated under the Canada Business Corporations Act (CBCA) or a provincial act such as Ontario's Business Corporations Act. These statutes require shares to be without nominal or par value, so the full amount received for shares is credited to the stated capital account for that class, called share capital in the financial statements. A corporation may have several classes of shares with different rights to vote, receive dividends and share in assets on liquidation. Common shares carry the residual interest; preferred shares usually carry a fixed dividend and priority over common shares. The articles of incorporation set out the authorized classes and any limits on the number of shares.

Shares can also be issued for non-cash consideration, such as property, services or a business. They are recorded at the fair value of what is received or, if that cannot be measured reliably, at the fair value of the shares issued. Shares issued to employees for services are share-based payment, covered in lesson 11. When shares and other securities are sold together for a lump sum, the proceeds are allocated using relative fair values or, when only one fair value is known, the incremental method.

Repurchasing and cancelling shares

Companies buy back their own shares to return cash to shareholders, offset dilution from employee options or signal that the shares are undervalued. Under the CBCA, shares a corporation acquires are cancelled or, if the articles limit the number of authorized shares, restored to the status of authorized but unissued shares. A corporation may not repurchase shares if it would fail the solvency tests in section 34 of the CBCA. Accounting follows the cancellation: share capital is reduced by the average per-share carrying amount of the class. If the price paid exceeds that amount, the excess is charged first to contributed surplus arising from earlier cancellations or resales of the same class, and then to retained earnings. If the price is less than average carrying amount, the difference is credited to contributed surplus. Holding repurchased shares as treasury shares is rare in Canada, though IAS 32 allows it and requires them to be deducted from equity.

Dividends

A dividend is a distribution to shareholders. Three dates matter. On the declaration date, the board declares the dividend and it becomes a legal obligation, so a liability is recorded and retained earnings are reduced. On the record date, the company determines who owns shares and will receive the dividend; no entry is made. On the payment date, the dividend is paid and the liability settled. Because declaration creates the liability, dividends declared after the reporting period are not liabilities at year end; they are disclosed.

Corporate law restricts dividends to protect creditors. Under section 42 of the CBCA, a corporation may not declare or pay a dividend if there are reasonable grounds for believing that it would then be unable to pay its liabilities as they become due, or that the realizable value of its assets would be less than the aggregate of its liabilities and stated capital of all classes. Directors who authorize an improper dividend can be personally liable. Loan covenants often add tighter limits.

Dividends need not be in cash. A property dividend distributes non-cash assets, such as shares of another company held as an investment. Under IFRIC 17 a dividend payable in non-cash assets is measured at the fair value of the assets to be distributed; when the dividend is settled, the difference between that fair value and the assets' carrying amount is recognized in profit or loss.

A liquidating dividend returns contributed capital rather than distributing earnings, and is charged to share capital or APIC.

Stock dividends and stock splits

A stock dividend distributes additional shares to existing shareholders in proportion to their holdings. No assets leave the company and each shareholder's percentage ownership is unchanged; the dividend simply moves an amount from retained earnings to share capital. IFRS does not specify the amount, and Canadian companies commonly transfer the fair value of the shares issued, consistent with the CBCA requirement that shares issued as a dividend be added to stated capital at the amount the directors determine. A stock split increases the number of shares and reduces the per-share price proportionately; with no-par shares, no entry is needed beyond updating the share count. Both are applied retroactively in earnings per share (lesson 11).

Preferred shares: equity or liability?

Preferred shares come in many forms. Cumulative preferred shares carry a right to dividends that accumulate if unpaid (dividends in arrears) and must be paid before any common dividend. Participating preferred shares share in dividends beyond their fixed rate. Convertible preferred shares can be exchanged for common shares. Redeemable or retractable preferred shares can be bought back by the issuer, or must be bought back at the holder's request or on a fixed date.

IAS 32 classifies an instrument by its substance, not its legal form. A preferred share that requires the issuer to redeem it for a fixed amount on a fixed date, or at the holder's option, contains a contractual obligation to deliver cash and is a financial liability; its dividends are interest expense. A non-redeemable preferred share with discretionary dividends is equity. ASPE Section 3856 contains a narrow exception: preferred shares issued in certain tax planning arrangements, such as estate freezes, that are redeemable at the holder's option may be presented as equity, at par or redemption value, with disclosure.

# Allocating a dividend between cumulative preferred and common shares
pref_shares, pref_par, pref_rate = 50_000, 100, 0.05
years_in_arrears = 2
declared = 900_000
annual_pref = pref_shares * pref_par * pref_rate
pref_owed = annual_pref * (years_in_arrears + 1)
to_pref = min(declared, pref_owed)
to_common = declared - to_pref
print(f"Annual preferred dividend: {annual_pref:,.0f}")
print(f"Arrears ({years_in_arrears} years) plus current year: {pref_owed:,.0f}")
print(f"Paid to preferred: {to_pref:,.0f}; paid to common: {to_common:,.0f}")
common_shares = 2_000_000
print(f"Common dividend per share: {to_common / common_shares:.3f}")
# If only $400,000 were declared:
small = 400_000
print(f"With {small:,} declared: preferred {min(small, pref_owed):,}; common {max(0, small - pref_owed):,}; arrears left {pref_owed - min(small, pref_owed):,.0f}")

Annual preferred dividend: 250,000
Arrears (2 years) plus current year: 750,000
Paid to preferred: 750,000; paid to common: 150,000
Common dividend per share: 0.075
With 400,000 declared: preferred 400,000; common 0; arrears left 350,000

Northlake's 5 per cent cumulative preferred shares carry a $250,000 annual dividend. With two years in arrears, the preferred shareholders must receive $750,000 before common shareholders get anything; from a $900,000 declaration, common shareholders receive $150,000, or 7.5 cents a share. Dividends in arrears are not a liability until declared, but they must be disclosed, because they stand ahead of common shareholders. If the board declared only $400,000, all of it would go to the preferred shareholders, and $350,000 of arrears would remain.

Retained earnings, reserves and the statement of changes in equity

Retained earnings are the cumulative profits not distributed as dividends. Other components of equity under IFRS include contributed surplus (from share-based payment, cancellations below average cost and the equity component of convertible debt) and reserves of accumulated other comprehensive income, such as revaluation surplus (ACCT-211 lesson 10), fair value reserves for equity investments, cash flow hedge reserves and foreign currency translation reserves. Some companies appropriate retained earnings for specific purposes, such as a reserve required by a loan agreement; an appropriation is only a label within equity and does not set aside cash. The statement of changes in equity reconciles the opening and closing balance of each component, showing profit or loss, OCI, dividends, share issues and repurchases separately.