Intermediate Financial Accounting Shareholders Equity Retained Earnings by

Intermediate Financial Accounting Shareholders' Equity. Retained Earnings by Professor Hsieh

Objectives of the Chapter n n n To discuss the content of retained earnings. To study the accounting treatments for dividends (including cash dividend, property dividend, scrip dividend, and stock dividend). To learn the procedures for quasireorganization. Stockholders' Equity (2)- Retained Earnings 2

Content of Retained Earnings n n Stockholders’ equity consists of primarily stockholders’ investments (i. e. , contributed capital) and retained earnings. The primary factors that affect retained earnings besides net income (or net loss) include (1) dividends, (2) prior period adjustments, (3) appropriations, and (4) quasi-reorganizations. Stockholders' Equity (2)- Retained Earnings 3

Dividends n n While the net income increases the retained earnings, the distribution of dividends reduces the retained earnings. In order to declare dividends, a company must meet legal requirements and have assets available for distribution. Stockholders' Equity (2)- Retained Earnings 4

Dividends (contd. ) n n n Most companies regard the unrestricted retained earnings as the limit for dividends distribution. However, most states allow liquidating dividends (i. e. , dividends pay out of contributed capital). * *Note: as long as the total assets after dividends equal or exceed the sum of total liabilities and the amount needed to satisfy the rights of other classes of shareholders with higher priority in receiving assts at liquidation (Revised Model Business Corporation Act, 1994). Stockholders' Equity (2)- Retained Earnings 5

Dividends (contd. ) § Restrictions of retained earnings include: § 1) Legal restrictions: Many states require a corporation to restrict the cost of treasury stock from dividends distribution. § 2)Contractual restrictions: A long-term bond contract may limit the use of assets for payment of dividends as a loan condition, and therefore, restrict the use of retained earnings for dividends. Stockholders' Equity (2)- Retained Earnings 6

Dividends: (contd. ) Restrictions (contd. ) 3)Voluntary restrictions: Appropriation of retained earnings for specific purposes. n The board of directors is responsible for the establishment of dividend policy and the determination of the amount, timing and types of dividends to be declared. n Stockholders' Equity (2)- Retained Earnings 7

Dividends: (contd. ) n n A few types of dividends may be considered: (1) cash, (2) property, (3) scrip, (4) stock, and (5) liquidating dividends. Cash, property and scrip dividends decrease retained earnings (R/E) and the stockholders’ equity. Stockholders' Equity (2)- Retained Earnings 8

Dividends: (contd. ) n n Stock dividend decreases R/E but increases contributed capital in the same amount. So, there is no change in the total stockholders’ equity. Liquidating dividend decreases both contributed capital and the stockholders' equity. Stockholders' Equity (2)- Retained Earnings 9

Cash Dividends n n A cash dividend is the most common type of dividend. Four days are relevant to the cash dividend: 1) the date of declaration, 2) the ex-dividend date, 3) the date of record, and 4) the date of payment. Stockholders' Equity (2)- Retained Earnings 10

Cash Dividends: (contd. ) n n Example: on Nov. 3, 20 x 5, the board of directors declares preferred dividends totaled $10, 000 and common dividends totaled $20, 000. These dividends are payable on 12/15/x 5 to stockholders of record on 11/24/x 5. In addition, the ex-dividend date is 11/20/x 5. The journal entries for the declaration and other related events are: Stockholders' Equity (2)- Retained Earnings 11

Cash Dividends: (contd. ) 11/3/x 5 the date of declaration Retained Earnings 30, 000 Dividends Payable: CS 20, 000 Dividends Payable: PS 10, 000 n Shares are traded with dividends attached after this date. n Companies are legally liable for declared dividends on this date. n Stockholders' Equity (2)- Retained Earnings 12

Cash Dividends: (contd. ) n n n 11/20/x 5 Ex-dividend date. No entry or memo. It is usually 4 business dates prior to the date of record. Shares purchased on or after this date are purchased ex dividend-without the right to receive the declared dividend. Therefore, a decline in price equals the dividend declared in general occurs on this date. Stockholders' Equity (2)- Retained Earnings 13

Cash Dividends: (contd. ) 11/24/x 5 The date of record Memo: the company will pay dividends on 12/15/x 5 to preferred and common stockholders of record as of today, the date of record. n Stockholders on the record will be paid of dividend even if they sell those shares prior to 12/15/x 5, the payment date. n Stockholders' Equity (2)- Retained Earnings 14

Cash Dividends: (contd. ) n 12/15/x 5 Dividend payment date Div. Payable: Com. stk 20, 000 Div. Payable: Prefer. stk 10, 000 Cash 30, 000 Stockholders' Equity (2)- Retained Earnings 15

Preferred Stock Characteristics n n n Preferred stockholders have a preference to dividends. A preference to dividends does not guarantee a dividend distribution. Because a dividend declaration is at the discretion of the board of directors. Stockholders' Equity (2)- Retained Earnings 16

Preferred Stock Characteristics (contd. ) n If a corporation fails to declare a dividend, or declares a dividend which is less than the stated rate of the preferred stock, the "passed" dividend of non-cumulative preferred stock will never be paid. Stockholders' Equity (2)- Retained Earnings 17

Cumulative Preferred Stock n n n For cumulative preferred stock, the amount of passed dividend becomes "dividend in arrears”. The “dividend in arrears” has the highest priority to be paid in the following periods. Common stockholders cannot be paid any dividend until the preferred dividend in arrears has been paid. Stockholders' Equity (2)- Retained Earnings 18

Cumulative Preferred Stock n n Dividend in arrears accumulate from period to period. The “dividend in arrears” is not a liability because no liability exists until the dividend declaration. Stockholders' Equity (2)- Retained Earnings 19

Stock Cumulative Preferred Examples Year 1: Case I: Dividends declared = $10, 000 Com. STK shares outstanding: 10, 000, @$5 Preferred STK outstanding : 5, 000, @$10, dividend is 6% of the par value Dividends for P. S. = 6% *10*5, 000= $3, 000. Dividends for C. S. = ($10, 000 -3, 000)=$7, 000. Or $0. 7 per share ($7, 000/10, 000 shares) Stockholders' Equity (2)- Retained Earnings 20

Stock Cumulative Preferred Examples (contd. ) Case II: Same information as in Case I except that dividends declared = $1, 000. n. Dividends for P. S. = $1, 000. Div. Passed=$2, 000 n. Dividends for C. S. = $0 If this is a cumulative P. S. the dividends in arrears equal $2, 000 ($3, 000 -1, 000). If this is a non-cumulative P. S. , the $2, 000 will never been paid. Stockholders' Equity (2)- Retained Earnings 21

Cumulative Preferred Stock Examples (contd. ) Year 2: Continued from Case II of year 1, assuming a cumulative preferred stock and the dividends declared = $8, 000. Dividends for P. S. => $2, 000 (div. In arrears) $3, 000 (div. Of year 2) $ 5, 000 Dividends for C. S. => $8, 000 - $2, 000 -3, 000 = $3, 000 Stockholders' Equity (2)- Retained Earnings 22

Participating Preferred Stock n n When preferred stock is participating, preferred stockholders share with the common stockholders in any "extra" dividends. "Extra" dividends = the declared dividends - the stated dividends of preferred stock - Equal % of dividends as the preferred stock's stated dividends for common stock. Stockholders' Equity (2)- Retained Earnings 23

Participating Preferred Stock (contd. ) n n Fully participating preferred stock: preferred stockholders share equally with the common stockholders in any "extra" dividends. These extra dividends are distributed proportionally, based on the respective par value of each class of stock. Stockholders' Equity (2)- Retained Earnings 24

Participating Preferred Stock (contd. ) n Partially participating preferred stock: preferred stockholders share in "extra" dividends with common stockholders, but its participation is limited to a fixed rate or amount per share. Stockholders' Equity (2)- Retained Earnings 25

Allocation of Declared Dividends n n If the preferred stock is Not participating, the amount of dividends received by the common stockholders equals: the declared dividends - any "dividend in arrears" - the stated dividend of the preferred stock If the preferred stock is participating in extra dividends, calculation needs to be made for the allocation of dividends. Stockholders' Equity (2)- Retained Earnings 26

Participating Preferred Stock : (contd. ) n Example: Assume a company issued 10% participating cumulative preferred stock with a total par value of $20, 000 and common stock with a total par value of $30, 000. Thus, preferred stock constitutes 40% and common stock 60% of the total par value. The company intends to distribute cash dividends of $9, 000, and there are no dividends in arrears. The dividend distribution is as follows: Stockholders' Equity (2)- Retained Earnings 27

Participating Preferred Stock : (contd. ) (A) Preferred stock is fully participating: Preferred Common 1. 10% dividend to preferred (on $20, 000 par) $2, 000 2. Common dividends (equal to 10% of par) $3, 000 Extra dividend proportionate to par values: Total to allocate $9, 000 Allocated (2, 000 + 3, 000) (5, 000) Extra Dividend (40% to preferred and 60% to common) $4, 000 2, 400 Stockholders' Equity (2)- Retained Earnings $1, 600 28

Participating Preferred Stock : (contd. ) (B) Preferred Stock Participates up to 12%: Preferred Common 1. 10% dividend to preferred $2, 000 2. Common div. (equal to 10%) 3, 000 3. 2% div. On par of preferred (2% * 20, 000) 400 4. 2% div. On par of common (2% * 30, 000) 600 5. Remainder to common (9, 000 -2, 000 -3, 000 -400 -600) _____ 3, 000 Dividends to each class of stock Stockholders' Equity (2)- Retained Earnings 2, 400 29

Property Dividends n n n A property dividend is that dividend is payable in assets other than cash. Marketable securities are typically used for a property dividend. Because they are more easily distributable to the stockholders. Stockholders' Equity (2)- Retained Earnings 30

Property Dividends n n A property dividend is recorded at the fair market value of the asset transferred on the date of declaration. A gain or a loss is recognized (APB opinion no. 29, par. 18). Stockholders' Equity (2)- Retained Earnings 31

Property Dividends : (contd. ) Examples: (A)Property dividend is an investment in debt held to maturity: n Corp. Aron declares a property dividend, payable in bonds of Rock company being held to maturity. The bonds are carried on Aron’s book at a book value of $40, 000 but the current market value on the declaration date is $48, 000. The journal entries to record the property dividend are as follows: Stockholders' Equity (2)- Retained Earnings 32

Property Dividends : (contd. ) Date of Declaration 1. Investments in Rock Company Bond 8, 000 Gain on Disposal of Investment 8, 000 2. Retained Earnings 48, 000 Property Dividends Payable 48, 000 Date of Payment Property Dividends Payable 48, 000 Stockholders' Equity (2)- Retained Earnings 33

Property Dividends : (contd. ) (B) Property dividend is an investment in equity securities “available for sale”: The Remley company declares a property dividend on 3/15/x 5, Payable in Welch company stock. The Welch stock had been purchased early in 20 x 4 for $24, 000 and was reported as an asset at a fair value of $29, 000 on 12/31/x 4 balance sheet. Stockholders' Equity (2)- Retained Earnings 34

Property Dividends : (contd. ) n n The market value of Welch stock is $31, 000 on 3/15/x 5. The following entries are made on 3/15/x 5 (the declaration date): Adj. prior to the recog. Of dividends payable: Fair Value Adjustment 2, 000 Unrealized holding gain 7, 000 Gain on Disposal of Investment 7, 000 Stockholders' Equity (2)- Retained Earnings 35

Property Dividends : (contd. ) J. E. on the declaration date: Retained Earnings 31, 000 Property Dividends Payable 31, 000 J. E. on the payment date: Property Dividends Payable Investment in SAS Fair value adjustment 7, 000 31, 000 24, 000 Stockholders' Equity (2)- Retained Earnings 36

Scrip Dividends n n A corporation with adequate retained earnings to meet legal dividend requirements but with insufficient funds to pay a current cash dividend may declare a scrip dividend. That is the corporation issues promissory notes (called “scrip”) requiring the Corp. to pay dividends at some future date. Stockholders' Equity (2)- Retained Earnings 37

Scrip Dividends : (contd. ) n n On the declaration date, the following entry will be made: Retained Earnings xxx Dividends Payable (or Notes Pay. ) xxx On the date of Payment: Dividends Payable xxx Interest Expense xxx Cash xxx * If the promissory notes are interest bearing Stockholders' Equity (2)- Retained Earnings 38

Stock Dividends n n A stock dividend is a pro rata (proportional) distribution of additional shares of a corporations own stock to its shareholders. When a stock dividend is distributed, no corporate assets are distributed. Each stockholder maintain the same percentage of ownership as before. Stock dividend is similar to a stock split. Stockholders' Equity (2)- Retained Earnings 39

Stock Dividends (contd. ) Accounting treatment: a. Small stock dividend ( less than 25% of outstanding shares): the stock dividends are accounted for by transferring from retained earnings to contributed capital an amount equals to the fair market value of the additional shares issued. Stockholders' Equity (2)- Retained Earnings 40

Stock Dividends : (contd. ) b. A large stock dividend (no change in par value per share and is referred to as a stock split effected in the form of stock dividends): the accounting treatment is only to capitalize the par value of the stock, not the market value of the stock. § For example, a 100% stock dividend is equivalent to a two-for-one stock split regards to its impact on stock price and share outstanding. Stockholders' Equity (2)- Retained Earnings 41

Stock Dividends : (contd. ) n Example 1: Small Stock Dividend A Corporation with 20, 000 shares outstanding declares and issues a 10% stock dividend. On the date of declaration, the stock is selling for $23 per share with a par value of $10 per share. The journal entry to recorded the stock dividend is : Stockholders' Equity (2)- Retained Earnings 42

Stock Dividends : (contd. ) n Date of Declaration: Retained Earnings 46, 000 C. S. To be Distributed ** 20, 000 Additional Paid-in Capital from Stock Dividend 26, 000 n Date of Issuance: C. S. To be Distributed C. S. $10 par 20, 000 Stockholders' Equity (2)- Retained Earnings 43

Stock Dividends : (contd. ) n Example 2: Large Stock Dividend Similar to example 1 except that the stock dividend increases from 10 % to 40% of the shares outstanding: Date Declaration: Additional paid in Capital* C. S to be Distributed 80, 000** * An alternative account is retained earnings. If R/E is debited, the accounting standard does not prevent the capitalization of a larger Stockholders' Equity (2)- Retained Earnings 44

Stock Dividends : (contd. ) ** $10*(40% *20, 000 shares) § Date of Issuance: C. S to be Distributed 80, 000 C. S, $10 par 80, 000 § Reason of debiting paid-in capital rather than R/E for large stock dividends: to prevent transferring earned Stockholders' Equity (2)- Retained Earnings 45

Fractional Shares §A stock dividend or a stock split often results in some shareholders being entitled to fractions of whole shares (fractional shares). §Cash payments (based on the fair value at declaration) are made to shareholders with fractional shares. Stockholders' Equity (2)- Retained Earnings 46

Liquidating Dividends n n n Liquidating dividends are a return of contributed capital to stockholders rather than a distribution of earned capital (i. e. , R/E). This may occur in the case of insolvency and assetsa are distributed to stockholders. The liquidating portion of the dividend is debited to Additional Paid-in Capital. a. assets which are not subject to a superior claim by creditors. Stockholders' Equity (2)- Retained Earnings 47

Prior Period Adjustments (Restatements) Items reported as prior period adjustments of retained earnings include: a. certain change in accounting treatment (when a retroactive approach is used), b. a change in accounting entry, and c. corrections of errors of prior periods. n Stockholders' Equity (2)- Retained Earnings 48

Prior Period Adjustments (Restatements) Example: In 20 x 5, Fox Company discovered that it did not accrue $10, 000 of interest expense for 20 x 4. The income tax effect is $3, 000, the correct entries are: 1. Retained Earnings 10, 000 Interest Payable 10, 000 2. Income Tax Refund Rece. 3, 000 Retained Earnings 3, 000 n Stockholders' Equity (2)- Retained Earnings 49

Prior Period Adjustments (Restatements) : (contd. ) n Presentation on the Retained Earnings Statement: R/E, as previous reported Jan 1, 20 x 5 $102, 400 Less: Correction of overstatement in 20 x 4 N/I due to interest expense understatement (Net of $3, 000 I/T) (7, 000) Adjusted Retained Earnings, Jan 1, 20 x 5 $95, 400 Stockholders' Equity (2)- Retained Earnings 50

Appropriation of Retained Earnings n n An appropriation (or restriction) of retained earnings is that the board of directors has "earmarked" a portion for the retained earnings (the appropriated amount) for a designated purpose. This appropriated amount is not available for dividends. Stockholders' Equity (2)- Retained Earnings 51

Appropiraion of Retained Earnings (contd. ) Reasons of appropriations: (1) to meet legal requirements, (2) to meet contractual restrictions, (3) a discretionary action of the board of directors. (1) Legal requirements: certain states require restrictions of R/E when treasury stock is acquired. n Stockholders' Equity (2)- Retained Earnings 52

Appropiraion of Retained Earnings (contd. ) (2) Contractual agreement: due to issue of long-term bonds. (3) A discretionary action: based on the needs of the corporation. Example: Assume $2, 000 of retained earnings is appropriated for treasury stock: Stockholders' Equity (2)- Retained Earnings 53

Earnings Appropiraion of Retained Example Retained Earnings 2, 000 Retained Earnings: Appropriated for Treasury Stock 2, 000 n After the treasury stock is reissued, the board of directors would cancel the appropriation: R/E Appropriated for Treasury stock 2, 000 Retained earnings Stockholders' Equity (2)- Retained Earnings 54

Other Component of Stockholder's Equity Accumulated Other Comprehensive Incomea: Other Comprehensive income accumulated over the current (reported in the combined income statement) and prior periods. a. Comprehensive income: changes in equity other than from owner related transactions (i. e. , additional investment and dividends distribution). Stockholders' Equity (2)- Retained Earnings 55

Other Component of Stockholder's Equity (contd. ) § Comprehensive income includes: Net income Other Comprehensive Income (all net of tax): Unrealized gain (loss) from SAS Foreign currency translation adjustments Minimum Pension liability adjustment Deferred gain (loss) from derivatives Stockholders' Equity (2)- Retained Earnings 56

Example of Stockholders’ Equity and Statement of Changes in Stockholders’ Equity n KARDWELL CORPORATION Stockholders’ Equity December 31, 20 x 5 Note: R/E are restricted regarding dividends in the amount of $3, 000, the cost of the Stockholders' treasury stock. Equity (2)- Retained Earnings 57

Example of Stockholders’ Equity and Statement of Changes in Stockholders’ Equity: (Contd. ) n Statement of Changes in Stockholders’ Equity for Year Ended December 31, 20 x 5 Stockholders' Equity (2)- Retained Earnings 58

Quasi-Reorganization n A quasi-reorganization is primarily an accounting procedure, that involves a revaluation of corporate assets and liabilities, and a realignment of the corporate capital structure to enable the corporation to have a “fresh start” toward financial solvency and profitability. Stockholders' Equity (2)- Retained Earnings 59

Quasi-Reorganization : (contd. ) The adjustment procedures are: 1. The Corp. reports to the stockholders with the restatements proposed and obtains the stockholders’ formal consent. 2. The Corp. presents a B/S as of the date of readjustment in which the assets and liabilities are reported at their market values. n Stockholders' Equity (2)- Retained Earnings 60

Quasi-Reorganization : (contd. ) The adjustment procedures (contd. ): 3. Any amount written off is first charged against retained earnings and then against additional paid-in capital. 4. The Corp. begins its “fresh start” with a zero retained earnings balance. n Stockholders' Equity (2)- Retained Earnings 61

Quasi-Reorganization : (contd. ) n Specific Accounting procedures are: 1. A write-down of the assets to their market value, with the loss debited to R/E; 2. An increase of additional paid-in capital accomplished by a decrease in the parvalue of the capital stock; 3. The elimination of the R/E deficit by a reduction of the additional paid-in capital. Stockholders' Equity (2)- Retained Earnings 62

: (contd. ) Quasi-Reorganization Example: CMG Corp. 's property and equip. are determined to have a combined market value of $92, 000 rather than the book value of $140, 000. Its Inventories and A/R are overvalued by $8, 000 and $4, 000, respectively. The board of directors, with stockholders and the state's approval, has authorized a reduction in par value of $6 per share. CMG has a deficit of $50, 000 prior to the quasi-reorganization. Stockholders' Equity (2)- Retained Earnings 63

: (contd. ) Quasi-Reorganization Example: (Contd. ) 1. To write down the fixed assets to market value: Retained Earnings 48, 000 Accu. depreciation 48, 000 2. To write down the current assets: Retained earnings 12, 000 Inventory 8, 000 Accounts Receivable 4, 000 Stockholders' Equity (2)- Retained Earnings 64

: (contd. ) Quasi-Reorganization Example: (Contd. ) 3. To reduce the par value of stock Common Stock, $10 par 150, 000 Common Stock, $4 Par 60, 000 Additional Paid-in Capital 90, 000 4. To eliminate the R/E Deficit: Additional Paid-in Capital 110, 000 Retained Earnings* 110, 000 * 50, 000 (the deficit) +48, 000+12, 000 Stockholders' Equity (2)- Retained Earnings 65

Condensed B/S of CMG Corp. before the quasi-reorganization: n CMG Corporation Balance Sheet December 31, 20 x 5 Stockholders' Equity (2)- Retained Earnings 66

Condensed B/S of CMG Corp. immediately after the quasireorganization: CMG Corporation Balance Sheet December 31, 20 x 5 n Stockholders' Equity (2)- Retained Earnings 67

Condensed B/S of CMG Corp. immediately after the quasireorganization: (Contd. ) Note: Retained earnings as of December 31, 20 x 5 has a zero balance due to a quasi-reorganization on that date in which net assets were revalued, a deficit of $110, 000 was charged against additional paid-in capital, and the par value of common stock was reduced from $10 to $4 per share. Stockholders' Equity (2)- Retained Earnings 68