Chapter 16: Stockholders' Equity: Retained Earnings

Stockholders' equity is divided into two major su headings: contri uted capital and retained earnings! "e discussed contri uted capital in chapter 1#! Earned capital$ or retained earnings$ is the su ject o% the current chapter! &% the %irm operates at a pro%it$ net assets increase! &% it operates at a loss$ net assets decrease! Retained earnings is the balance sheet account that is debited or credited for changes in net assets resulting from earnings activities. Retained earnings is: ' increased y net income! ' decreased y net loss! ' increased or decreased y prior period adjustments! ' decreased y declared cash or stock dividends! ' decreased y certain treasury stock transactions! Retained earnings is o%ten a signi%icant source o% internal financing %or %irms! Dividends (here are several di%%erent types o% dividends: cash dividends$ scrip dividends$ property dividends$ liquidating dividends and stock dividends! )ll dividends$ other than stock dividends$ represent a distri ution o% assets to stockholders$ and a corresponding reduction in stockholders' equity! "e will %irst %ocus on cash dividends$ then turn to the other types o% dividends! *Cash+ ,ividend -olicy Companies usually maintain sta le dividend policies over time! Reason: cutting the dividend is generally interpreted as . ad news. y the stock market! /irms will not increase their dividend until they are con%ident that it can e maintained at the new$ higher level! Companies usually pay considera ly less than total net income out in dividends! ' (hey may wish to %inance growth internally using retained earnings! ' Bond covenants may limit dividend payments in order to protect creditors! ' State law o%ten prohi its payment o% dividends i% legal capital is impaired! Note: ,ividends are a distri ution to the %irm's owners! (hey are not an expense %or the income Chapter 16: Stockholders' Equity: Retained Earnings$ p. 1

statement! Can the %irm pay a dividend0 1! ,oes it have a credit alance in retained earnings0 ' &% the %irm shows a deficit, it is usually prohi ited %rom paying a dividend! ' (he maximum dividend that can e paid equals the credit alance in retained earnings plus any additional paid'in capital! ' )ny dividend greater than the credit alance in retained earnings is considered a return o% investors' capital! *) .liquidating dividend!.+ 1! ,oes it have the cash0 ' 2ust consider other needs %or cash *lia ilities coming due$ new projects that require cash+! (ypes o% ,ividends 1! Cash dividends are a distri ution o% cash to stockholders! 3oth cash and retained earnings are reduced! Cash dividend e4ample: 5n ,ecem er 16$ 177#$ ,C Corporation has 16$666 shares o% common stock outstanding and declares a 81!#6 per share cash dividend paya le on 9anuary 16$ 1776 to shareholders o% record on ,ecem er :6$ 177#! ,ecem er 16 Retained earnings *1!#6 4 16$666+ ,ividends paya le (o record the declaration o% the cash dividend! Dividends payable is a current liability until paid! .Cash dividends declared. could e de ited$ rather than retained earnings! (his is a temporary account that is closed to retained earnings! ,ecem er :6 9anuary 16 *;o entry is required on the date of record!+ ,ividends paya le Cash (o record the payment o% the dividend! ,ividends are usually declared and paid quarterly! ,ividends on common shares are e4pressed as Chapter 16: Stockholders' Equity: Retained Earnings$ p. 2 1#$666 1#$666 1#$666 1#$666

some dollar amount per share! ,ividends on pre%erred shares are e4pressed as some percentage o% par value! 1! -roperty dividends are a distri ution o% noncash assets to shareholders! ' 2ost property dividends consist o% shares o% other companies' stock that is held as an investment$ ut could e merchandise$ real estate or any noncash asset! ' )ssets must %irst e adjusted to their %air market value and a gain or loss on the disposition recogni<ed! -roperty dividend e4ample: (he 3i<et Corporation holds #$=66 shares o% (rent &ndustries' common stock$ which it acquired at 8:6 per share! 3i<et declares a property dividend o% #66 shares o% (rent stock when the shares are selling at 8:= per share! &nvestment in (rent common >#66 4 *:=':6+? Aain on disposition o% investments @$666 @$666

(o recogni<e the gain on the #66 shares to e distri uted! Retained earnings *#66 4 :=+ -roperty dividend paya le (o record the property dividend! 17$666 17$666

-roperty dividend paya le &nvestment in (rent common (o record payment o% the property dividend!

17$666 17$666

:! Scrip dividends: are declared several months e%ore the cash is actually paid out! (he %irm issues .scrip. *a promissory note+ as evidence o% their intention to pay the dividend! Scrip dividends usually ear interest! Scrip dividend e4ample: -elico declares a scrip dividend o% 81!16 per share on :6$666 shares o% its outstanding common stock and issues 16B$ 76'day promissory notes to its stockholders! Retained earnings *:6$666 4 1!16+ Scrip dividends paya le (o record the declaration o% the scrip dividend! Scrip dividends paya le &nterest e4pense *:6$666 4 !1 4 76C:66+ Chapter 16: Stockholders' Equity: Retained Earnings$ p. 3 :6$666 766 :6$666 :6$666

Cash (o record payment o% the scrip dividend!

:6$766

) company might declare a scrip dividend i% it has su%%icient retained earnings to declare a dividend$ ut *at least immediately+ insu%%icient cash! @! Diquidating dividends: are distri utions to stockholders in e4cess o% the credit alance in retained earnings! Stockholders are receiving a return o% their capital investment$ and must e in%ormed o% this! Diquidating dividends are most o%ten declared y companies that are terminating operations! Journal entry *Aeneral %orm+ Retained earnings *%or the entire credit alance in the account+ Contri uted capital *Cash credit minus retained earnings de it+ Cash *%or the amount paid out+ (he de it to .contri uted capital. would %irst go to the paid'in capital in e4cess o% par accounts! "hen these are wiped out$ any remaining de it would e to the capital stock *par value+ accounts! (he com ined de it to contri uted capital accounts represents the return o% the stockholders' investment!

#! Stock dividends are a distri ution o% additional shares to the %irm's own stockholders$ in proportion to their percentage o% shares held! Each shareholder simply maintains his or her proportionate interest in the %irm! ;o change in the par value o% the shares takes place! ) stock dividend is not really a dividend in that it is not a distribution of assets!

Chapter 16: Stockholders' Equity: Retained Earnings$ p. !

"hy issue a stock dividend0 ' ' ' (o increase the num er o% shares outstanding and decrease the market price per share! (o satis%y shareholders' demand %or dividends while still retaining assets! (o reduce the amount o% retained earnings availa le %or %uture dividends! *Reclassi%y amounts %rom earned to contri uted capital!+

)ccounting %or stock dividends depends on the size o% the dividend! 1! Small stock dividends *less than 16'1#B o% shares outstanding+ are recorded at the market price o% the shares distri uted! 1! Darge stock dividends *greater than 16'1#B o% shares outstanding+ are recorded at the par value o% the shares distri uted! Darge stock dividends have the e%%ect o% reducing the market price per share! (hus$ they are similar to a stoc" split! ' ' ' ' &n a stock split$ the %irm increases the num er o% shares outstanding y some multiple! (he purpose is to reduce the market price per share to some amount that is elieved to e in a more marketa le range! &n a split$ the par value per share is divided y the multiple! 5nly a memorandum #ournal entry is needed %or a stock split!

Stock dividend e4ample: Arendle Corporation has the %ollowing stockholders' equity alances: Common stock *816 par$ 16$666 shares issued and outstanding+ Contri uted capital in e4cess o% par Retained earnings (otal 8166$666 =6$666 166$666 8:@6$666

&% Arendle declares a 16 percent *small+ stock dividend when the market price o% its shares is 8:1 per share$ the %ollowing entry is made: Retained earnings *!1 4 16$666 4 :1+ :1$666 Common stock dividend distri uta le *!1 4 16$666 4 16+ Contri uted capital in e4cess o% par *:1$666 ' 16$666+ 16$666 11$666

;ote that no asset or lia ility accounts have een a%%ected! (his is simply a .reshu%%ling. o% the stockholders' equity accounts! "hen the dividend is distri uted$ the %ollowing entry is made: Common stock dividend distri uta le Common stock 16$666 16$666

&% Arendle declares a #6 percent *large+ stock dividend$ the %ollowing entry is made: Retained earnings *!# 4 16$666 4 16+ Common stock dividend distri uta le "hen the dividend is distri uted: Common stock dividend distri uta le Common stock #6$666 #6$666 #6$666 #6$666

(he %ollowing ta le summari<es the e%%ect o% the stock dividend on total stockholders' equity %or oth the small and the large dividend:

3e%ore Stock ,ividend Common stock Contri ! capital in e4cess o% par Retained earnings (otal stockholders' equity 8166$666 =6$666 166$666 8:@6$666

)%ter Small Stock ,ividend 8116$666 161$666 11=$666 8:@6$666

)%ter Darge Stock ,ividend 81#6$666 =6$666 116$666 8:@6$666

&n oth cases$ total stockholders' equity is unchanged! (he transactions simply reshu%%le the amounts within the stockholders' equity accounts!

The E ect o Dividend !re erences on Dividend Distri"utions -re%erred shareholders' claims to dividends must e satis%ied e%ore dividends are paid to common shareholders! ' ' &% the pre%erred is cumulative, any dividends in arrears must e paid *and the current pre%erred dividend paid+ e%ore common dividends can e paid! $articipating pre%erred shares proportionately in dividends with the common over and a ove the stated rate on the pre%erred! (he participation may e full, or partial$ up to a ma4imum total rate!

,ividend pre%erences e4ample: )pache &ndustries has the %ollowing capital stock outstanding: Common *816 par$ :6$666 shares issued and outstanding+ =B pre%erred *8166 par$ 1$666 shares issued and outstanding+ 8:66$666 166$666

)pache plans to distri ute cash dividends o% 8=6$666 during the current year! (he pre%erred stock is cumulative and %ully participatingE dividends are in arrears %or the preceding year!

-re%erred Stock ,ividends in arrears *!6= 4 166 4 1$666+ Current year's dividend *!6= 4 par+ -articipating dividend *!6@= 4 par+ (otal dividends 816$666 16$666 *!6@= 4 166$666+ F 7$666 8@1$666

Common Stock

(otal 816$666

*!6= 4 16 4 :6$666+ F 81@$666 *!6@= 4 :66$666+ F 1@$@66 8:=$@66

@6$666 1@$666 8=6$666

#ppropriations o Retained Earnings Corporations o%ten wish to restrict the payment o% dividends to amounts considera ly less than the credit alance o% retained earnings! /or e4ample$ i% the %irm has e4pectations o% pro a le %uture losses *loss contingencies+$ the amount realistically availa le %or %uture dividends might e much less than the alance o% retained earnings! (he %irm can communicate this %act to %inancial statement users y appropriating retained earnings %or the amount o% the contingency! )ppropriations o% retained earnings are reclassifications o% retained earnings %or a speci%ic purpose! ' (he entry is optional! ' &t does not set aside cash! ' &t simply communicates to users that part o% retained earnings is not availa le %or dividends! &% a %ormal appropriations entry is not made$ restrictions on retained earnings should still e disclosed in the %ootnotes to the %inancial statements! )ppropriation o% retained earnings e4ample: Alennard &nc! has 816$666$666 in term onds that will come due at the end o% 16 years! Gnder the terms o% the ond indenture$ Alennard must set aside 81$666$666 each year to pay o%% this de t! (he cash is trans%erred to an account entitled . ond sinking %und!. &n addition$ Alennard must appropriate 81$666$666 o% retained earnings during each year o% the ond's li%e! Each year$ Alennard will make the %ollowing entries: 3ond sinking %und Cash (o trans%er cash to the ond sinking %und! Retained earnings 1$666$666 Retained earnings$ appropriated %or onded inde tedness (o reallocate unrestricted retained earnings to appropriated retained earnings! )t the end o% 16 years$ oth ond sinking %und and retained earnings$ appropriated %or onded inde tedness will have alances o% 816$666$666! (he %ollowing entries will e made: 3onds paya le 3ond sinking %und (o pay o%% the principal on the onds! 16$666$666 16$666$666 1$666$666 1$666$666 1$666$666

Retained earnings$ appropriated %or onded inde tedness Retained earnings

16$666$666 16$666$666

(o reallocate appropriated retained earnings ack to unrestricted retained earnings! *&t is no longer necessary to communicate to investors the %act that not all retained earnings is availa le %or dividends$ since the onds are now paid o%%!+

Huasi'Reorgani<ations /irms that are candidates %or quasi'restructuring: ' have huge de%icits! ' have overstated asset accounts *old managers have kept o solete inventory+! ' have .turned the corner. with a new management team that has .%i4ed. passed pro lems! (he purpose o% the quasi'reorgani<ation is to give the %irm an accounting .%resh start. y revaluing the assets to their %air values and resetting the retained earnings to <ero! (he %irm is a le to start paying dividends again$ and avoids %ormal reorgani<ation procedures! "hen a company %inishes a quasi'reorgani<ation$ the SEC requires three things to e true: 1! (he alance in retained earnings must e <ero! 1! (here must e no de%icit *de it alance+ in any -aid'in capital account! :! (he assets and lia ilities must e %airly *and conservatively+ stated! Journal entries 1! Restate all assets *and lia ilities$ i% applica le+ to their %air values! Retained earnings )sset accounts ;otice that this %urther e4acer ates the retained earnings de%icitI *&n this e4ample$ no lia ility adjustments are necessary!+ 1! )djust retained earnings to <ero! )dditional paid'in capital accounts Retained earnings (he amount o% this entry is the amount needed to reduce the de%icit to <ero! &%$ a%ter this entry$ additional paid'in capital has a credit alance$ the process is complete! &% not$ then the par value o% the stock must e reduced in order to o tain a credit alance in )dditional paid'in capital:

:! Capital stock *reduction in par value 4 num er o% outstanding shares+ )dditional paid'in capital

-ro lem 16'6

*,ividends are e4pressed in total dollar amounts$ rather than on a per'share asis!+ -re%erred dividend: 81#6$666 *par value+ 4 6!66 F 81#$666Cyear )t a 6B rate$ the common would receive: 81#6$666 4 6!66 F 87$666Cyear a$ #ssume that the pre erred is noncumulative and nonparticipating$ 177: 177@ 177# 1776 811$#66 paid out! )ll goes to the pre%erred shares! 816$666 paid out! 81#$666 to pre%erredE 811$666 to common! 8#J$666 paid out! 81#$666 to pre%erredE 8@1$666 to common! 8J1$666 paid out! 81#$666 to pre%erredE 8#J$666 to common!

"$ #ssume that the pre erred is cumulative and ully participating$ 1%%& 1%%, '1()*++ paid out$ )ll goes to the pre%erred shares! '(6)+++ paid out$

(o pre%erred: 8 1$#66 div! in arrears! 1#$666 current dividend! (o common: 7$666 *6B dividend!+ ,ispersed: 16$#66 "hoops$ didn't give out that much! (he common will only get 8=$#66! (he pre%erred will get 81J$#66!

1%%*

'*-)+++ paid out$

(o pre%erred: 81#$666 6B dividend (o common: 8 7$666 6B dividend ,ispersed: 1@$666 Remaining: #J$666 ' 1@$666 F ::$666

::$666C*1#6$666 K 1#6$666+ F 6!6=1# remaining participation rate! 6!6=1# 4 1#6$666 F 16$61# additional to pre%erred! 6!6=1# 4 1#6$666 F 11$:J# additional to common! So$ pre%erred gets: 81#$666 K 16$61# F 8:#$61# common gets: 7$666 K 11$:J# F 11$:J# 1%%6 '-()+++ paid out$

(o pre%erred: 81#$666 6B dividend (o common: 8 7$666 6B dividend ,ispersed: 1@$666 Remaining: J1$666 ' 1@$666 F @=$666

@=$666C*1#6$666 K 1#6$666+ F 6!11 remaining participation rate! 6!11 4 1#6$666 F :6$666 additional to pre%erred! 6!11 4 1#6$666 F 1=$666 additional to common! So$ pre%erred gets: 81#$666 K :6$666 F 8@#$666 common gets: 7$666 K 1=$666 F 1J$666