Stockholders Equity Retained Earnings

							         Chapter 16: Stockholders' Equity: Retained Earnings

Stockholders' equity is divided into two major subheadings: contributed capital and retained
earnings. We discussed contributed capital in chapter 15. Earned capital, or retained earnings,
is the subject of the current chapter.

If the firm operates at a profit, net assets increase. If 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 by net income.
   - decreased by net loss.
   - increased or decreased by prior period adjustments.
   - decreased by declared cash or stock dividends.
   - decreased by certain treasury stock transactions.

Retained earnings is often a significant source of internal financing for firms.


                                               Dividends

There are several different types of dividends: cash dividends, scrip dividends, property
dividends, liquidating dividends and stock dividends. All dividends, other than stock dividends,
represent a distribution of assets to stockholders, and a corresponding reduction in stockholders'
equity.

    We will first focus on cash dividends, then turn to the other types of dividends.


(Cash) Dividend Policy

Companies usually maintain stable dividend policies over time.

    Reason: cutting the dividend is generally interpreted as "bad news" by the stock market.
    Firms will not increase their dividend until they are confident that it can be maintained at the
    new, higher level.

Companies usually pay considerably less than total net income out in dividends.
  - They may wish to finance growth internally using retained earnings.
  - Bond covenants may limit dividend payments in order to protect creditors.

Chapter 16: Stockholders' Equity: Retained Earnings, p. 1
   -   State law often prohibits payment of dividends if legal capital is impaired.

Note: Dividends are a distribution to the firm's owners. They are not an expense for the income
      statement.


Can the firm pay a dividend?

   1. Does it have a credit balance in retained earnings?
         - If the firm shows a deficit, it is usually prohibited from paying a dividend.
         - The maximum dividend that can be paid equals the credit balance in retained
              earnings plus any additional paid-in capital.
         - Any dividend greater than the credit balance in retained earnings is considered a
              return of investors' capital. (A "liquidating dividend.")

   2. Does it have the cash?
         - Must consider other needs for cash (liabilities coming due, new projects that
              require cash).


Types of Dividends

1. Cash dividends are a distribution of cash to stockholders. Both cash and retained earnings
   are reduced.


Cash dividend example: On December 10, 1995, DC Corporation has 10,000 shares of common
stock outstanding and declares a $1.50 per share cash dividend payable on January 10, 1996 to
shareholders of record on December 30, 1995.


December 10       Retained earnings (1.50 x 10,000)                  15,000
                                    Dividends payable                                 15,000

               To record the declaration of the cash dividend.

Dividends payable is a current liability until paid. "Cash dividends declared" could be debited,
rather than retained earnings. This is a temporary account that is closed to retained earnings.


December 30       (No entry is required on the date of record.)

January 10     Dividends payable                            15,000


Chapter 16: Stockholders' Equity: Retained Earnings, p. 2
                                      Cash                                          15,000

                  To record the payment of the dividend.


Dividends are usually declared and paid quarterly. Dividends on common shares are expressed
as some dollar amount per share. Dividends on preferred shares are expressed as some
percentage of par value.


2. Property dividends are a distribution of noncash assets to shareholders.
   - Most property dividends consist of shares of other companies' stock that is held as an
      investment, but could be merchandise, real estate or any noncash asset.
   - Assets must first be adjusted to their fair market value and a gain or loss on the
      disposition recognized.

Property dividend example: The Bizet Corporation holds 5,800 shares of Trent Industries'
common stock, which it acquired at $30 per share. Bizet declares a property dividend of 500
shares of Trent stock when the shares are selling at $38 per share.

   Investment in Trent common [500 x (38-30)]                4,000
             Gain on disposition of investments                            4,000

   To recognize the gain on the 500 shares to be distributed.


   Retained earnings (500 x 38)                              19,000
              Property dividend payable                                    19,000

   To record the property dividend.



   Property dividend payable                        19,000
              Investment in Trent common                                   19,000

   To record payment of the property dividend.


3. Scrip dividends: are declared several months before the cash is actually paid out. The firm
    issues "scrip" (a promissory note) as evidence of their intention to pay the dividend. Scrip
    dividends usually bear interest.
Scrip dividend example: Pelico declares a scrip dividend of $1.20 per share on 30,000 shares of


Chapter 16: Stockholders' Equity: Retained Earnings, p. 3
its outstanding common stock and issues 10%, 90-day promissory notes to its stockholders.

   Retained earnings (30,000 x 1.20)                           36,000
          Scrip dividends payable                                              36,000

   To record the declaration of the scrip dividend.

   Scrip dividends payable                                     36,000
   Interest expense (36,000 x .1 x 90/360)                        900
           Cash                                                                36,900

   To record payment of the scrip dividend.

A company might declare a scrip dividend if it has sufficient retained earnings to declare a
dividend, but (at least immediately) insufficient cash.


4. Liquidating dividends: are distributions to stockholders in excess of the credit balance in
   retained earnings. Stockholders are receiving a return of their capital investment, and must
   be informed of this. Liquidating dividends are most often declared by companies that are
   terminating operations.

   Journal entry: (General form)

           Retained earnings (for the entire credit balance in the account)
           Contributed capital (Cash credit minus retained earnings debit)
                             Cash (for the amount paid out)

   The debit to "contributed capital" would first go to the paid-in capital in excess of par
   accounts. When these are wiped out, any remaining debit would be to the capital stock (par
   value) accounts. The combined debit to contributed capital accounts represents the return of
   the stockholders' investment.



5. Stock dividends are a distribution of additional shares to the firm's own stockholders, in
   proportion to their percentage of shares held. Each shareholder simply maintains his or her
   proportionate interest in the firm. No change in the par value of the shares takes place.

       A stock dividend is not really a dividend in that it is not a distribution of assets.




Chapter 16: Stockholders' Equity: Retained Earnings, p. 4
Why issue a stock dividend?

   -   To increase the number of shares outstanding and decrease the market price per share.
   -   To satisfy shareholders' demand for dividends while still retaining assets.
   -   To reduce the amount of retained earnings available for future dividends. (Reclassify
       amounts from earned to contributed capital.)


Accounting for stock dividends depends on the size of the dividend.

   1. Small stock dividends (less than 20-25% of shares outstanding) are recorded at the
      market price of the shares distributed.

   2. Large stock dividends (greater than 20-25% of shares outstanding) are recorded at the par
      value of the shares distributed.

   Large stock dividends have the effect of reducing the market price per share. Thus, they are
   similar to a stock split.

   -   In a stock split, the firm increases the number of shares outstanding by some multiple.
   -   The purpose is to reduce the market price per share to some amount that is believed to be
       in a more marketable range.
   -   In a split, the par value per share is divided by the multiple.
   -   Only a memorandum journal entry is needed for a stock split.


Stock dividend example: Grendle Corporation has the following stockholders' equity balances:

   Common stock ($10 par, 10,000 shares issued and outstanding)             $100,000
   Contributed capital in excess of par                                              80,000
   Retained earnings                                                                160,000
      Total                                                                        $340,000

If Grendle declares a 10 percent (small) stock dividend when the market price of its shares is $32
per share, the following entry is made:

   Retained earnings (.1 x 10,000 x 32)                     32,000
              Common stock dividend distributable (.1 x 10,000 x 10)               10,000
              Contributed capital in excess of par (32,000 - 10,000)               22,000

   Note that no asset or liability accounts have been affected. This is simply a "reshuffling" of
   the stockholders' equity accounts.



Chapter 16: Stockholders' Equity: Retained Earnings, p. 5
When the dividend is distributed, the following entry is made:

   Common stock dividend distributable                        10,000
           Common stock                                                            10,000


If Grendle declares a 50 percent (large) stock dividend, the following entry is made:

   Retained earnings (.5 x 10,000 x 10)                       50,000
          Common stock dividend distributable                                      50,000


When the dividend is distributed:

   Common stock dividend distributable                        50,000
        Common stock                                                               50,000



The following table summarizes the effect of the stock dividend on total stockholders' equity for
both the small and the large dividend:



                          Before Stock            After Small              After Large
                          Dividend                Stock Dividend           Stock Dividend
 Common stock             $100,000                $110,000                 $150,000
 Contrib. capital in
   excess of par            80,000                  102,000                   80,000
 Retained earnings         160,000                  128,000                 110,000

 Total stockholders'
       equity             $340,000                $340,000                 $340,000


In both cases, total stockholders' equity is unchanged. The transactions simply reshuffle the
amounts within the stockholders' equity accounts.




Chapter 16: Stockholders' Equity: Retained Earnings, p. 6
                The Effect of Dividend Preferences on Dividend Distributions

Preferred shareholders' claims to dividends must be satisfied before dividends are paid to
common shareholders.

   -   If the preferred is cumulative, any dividends in arrears must be paid (and the current
       preferred dividend paid) before common dividends can be paid.

   -   Participating preferred shares proportionately in dividends with the common over and
       above the stated rate on the preferred.

           The participation may be full, or partial, up to a maximum total rate.



Dividend preferences example: Apache Industries has the following capital stock outstanding:

   Common ($10 par, 30,000 shares issued and outstanding)                             $300,000
   8% preferred ($100 par, 2,000 shares issued and outstanding)                        200,000

Apache plans to distribute cash dividends of $80,000 during the current year. The preferred
stock is cumulative and fully participating; dividends are in arrears for the preceding year.



                         Preferred Stock           Common Stock             Total

 Dividends in arrears
 (.08 x 100 x 2,000)     $16,000                                            $16,000
 Current year's                                    (.08 x 10 x 30,000) =
 dividend (.08 x par)      16,000                  $24,000                   40,000
 Amount available for participation:           Total par value of shares:
 $80,000 - 16,000 - 40,000 = $24,000          $500,000

 Participation rate: 24,000/500,000 = .048
 Participating           (.048 x 200,000) =        (.048 x 300,000) =
 dividend (.048 x par)      9,600                    14,400                  24,000

 Total dividends         $41,600                   $38,400                  $80,000




Chapter 16: Stockholders' Equity: Retained Earnings, p. 7
                             Appropriations of Retained Earnings

Corporations often wish to restrict the payment of dividends to amounts considerably less than
the credit balance of retained earnings. For example, if the firm has expectations of probable
future losses (loss contingencies), the amount realistically available for future dividends might be
much less than the balance of retained earnings. The firm can communicate this fact to financial
statement users by appropriating retained earnings for the amount of the contingency.

Appropriations of retained earnings are reclassifications of retained earnings for a specific
purpose.
   - The entry is optional.
   - It does not set aside cash.
   - It simply communicates to users that part of retained earnings is not available for
       dividends.

If a formal appropriations entry is not made, restrictions on retained earnings should still be
disclosed in the footnotes to the financial statements.

Appropriation of retained earnings example: Glennard Inc. has $10,000,000 in term bonds that
will come due at the end of 10 years. Under the terms of the bond indenture, Glennard must set
aside $1,000,000 each year to pay off this debt. The cash is transferred to an account entitled
"bond sinking fund." In addition, Glennard must appropriate $1,000,000 of retained earnings
during each year of the bond's life. Each year, Glennard will make the following entries:

   Bond sinking fund                          1,000,000
      Cash                                                                    1,000,000

To transfer cash to the bond sinking fund.

   Retained earnings                              1,000,000
      Retained earnings, appropriated for bonded indebtedness                        1,000,000

To reallocate unrestricted retained earnings to appropriated retained earnings.

At the end of 10 years, both bond sinking fund and retained earnings, appropriated for bonded
indebtedness will have balances of $10,000,000. The following entries will be made:

   Bonds payable                              10,000,000
      Bond sinking fund                                                              10,000,000

   To pay off the principal on the bonds.




Chapter 16: Stockholders' Equity: Retained Earnings, p. 8
    Retained earnings, appropriated for bonded indebtedness              10,000,000
       Retained earnings                                                              10,000,000

    To reallocate appropriated retained earnings back to unrestricted retained earnings. (It is no
    longer necessary to communicate to investors the fact that not all retained earnings is
    available for dividends, since the bonds are now paid off.)



                                        Quasi-Reorganizations

Firms that are candidates for quasi-restructuring:
   - have huge deficits.
   - have overstated asset accounts (old managers have kept obsolete inventory).
   - have "turned the corner" with a new management team that has "fixed" passed problems.

The purpose of the quasi-reorganization is to give the firm an accounting "fresh start" by
revaluing the assets to their fair values and resetting the retained earnings to zero. The firm is
able to start paying dividends again, and avoids formal reorganization procedures.

When a company finishes a quasi-reorganization, the SEC requires three things to be true:

    1. The balance in retained earnings must be zero.
    2. There must be no deficit (debit balance) in any Paid-in capital account.
    3. The assets and liabilities must be fairly (and conservatively) stated.

Journal entries:

1. Restate all assets (and liabilities, if applicable) to their fair values.

        Retained earnings
               Asset accounts

    Notice that this further exacerbates the retained earnings deficit! (In this example, no liability
    adjustments are necessary.)

2. Adjust retained earnings to zero.

        Additional paid-in capital accounts
               Retained earnings

    The amount of this entry is the amount needed to reduce the deficit to zero.



Chapter 16: Stockholders' Equity: Retained Earnings, p. 9
If, after this entry, additional paid-in capital has a credit balance, the process is complete. If not,
then the par value of the stock must be reduced in order to obtain a credit balance in Additional
paid-in capital:

3. Capital stock (reduction in par value x number of outstanding shares)
              Additional paid-in capital




Chapter 16: Stockholders' Equity: Retained Earnings, p. 10
Problem 16-6

(Dividends are expressed in total dollar amounts, rather than on a per-share basis.)


Preferred dividend: $250,000 (par value) x 0.06 = $15,000/year

At a 6% rate, the common would receive: $150,000 x 0.06 = $9,000/year


a. Assume that the preferred is noncumulative and nonparticipating.

1993      $12,500 paid out. All goes to the preferred shares.

1994      $26,000 paid out. $15,000 to preferred; $11,000 to common.

1995      $57,000 paid out. $15,000 to preferred; $42,000 to common.

1996      $72,000 paid out. $15,000 to preferred; $57,000 to common.


b. Assume that the preferred is cumulative and fully participating.

1993      $12,500 paid out. All goes to the preferred shares.

1994      $26,000 paid out.

To preferred: $ 2,500 div. in arrears.
               15,000 current dividend.

To common: 9,000 (6% dividend.)

Dispersed:        26,500            Whoops, didn't give out that much. The common
                                    will only get $8,500. The preferred will get
                                    $17,500.



Chapter 16: Stockholders' Equity: Retained Earnings, p. 11
1995      $57,000 paid out.

To preferred: $15,000 6% dividend

To common: $ 9,000 6% dividend

Dispersed:       24,000             Remaining: 57,000 - 24,000 = 33,000

33,000/(250,000 + 150,000) = 0.0825 remaining participation rate.

0.0825 x 250,000 = 20,625 additional to preferred.
0.0825 x 150,000 = 12,375 additional to common.

So, preferred gets: $15,000 + 20,625 = $35,625
    common gets: 9,000 + 12,375 = 21,375

1996      $72,000 paid out.

To preferred: $15,000 6% dividend

To common: $ 9,000 6% dividend

Dispersed:       24,000             Remaining: 72,000 - 24,000 = 48,000

48,000/(250,000 + 150,000) = 0.12 remaining participation rate.

0.12 x 250,000 = 30,000 additional to preferred.
0.12 x 150,000 = 18,000 additional to common.

So, preferred gets: $15,000 + 30,000 = $45,000
    common gets: 9,000 + 18,000 = 27,000




Chapter 16: Stockholders' Equity: Retained Earnings, p. 12