CHAPTERS

1. CHAPTERS 13-16 FINANCING: Part 3B: Equity, Dividends & Retained Earnings

2. DIVIDENDSWhat are they? • A dividend is a return of wealth by a corporation to its shareholders on an equal basis. • Dividends may be in the form of • Cash, or • Shares

3. CASH DIVIDENDSRequirements • For a cash dividend to occur, a corporation must have: • Retained earnings, • Adequate cash, and • Declared dividends

4. CASH DIVIDENDSPreferred Shares vs. Common Shares • Cash dividends must be paid to preferred shareholders before any common shareholders are paid. • There are two kinds of preferred shares: • Cumulative: all pastdividends (in arrears) must be paid before common shareholders get anything. • Non-cumulative: only the current year’s dividend must be paid before common shareholders get a dividend.

5. Date Particulars Debit Credit Jan 1 CASH DIVIDENDThe Effects • On Jan. 1, this company declares a $0.50 dividend per share (or $50,000 total) to all shareholders on record Feb. 1. The dividend is paid Mar. 1. • This dividend represents a “drawings” on the wealth of the corporation, and is returned to the shareholders. • After a cash dividend shareholder’s equity falls. Cash Dividends 50,000 Cash Dividends Payable 50,000 Before After Cash DividendCash Dividend Shareholders’ equity Contributed Capital Retained earnings Total shareholders’ equity Issued shares Book value per share Cash Dividends Payable 50,000 Mar 1 Cash 50,000 $200,000 $200,000 Dec 31 Retained Earnings 50,000 $550,000 $600,000 Cash Dividends 50,000 $750,000 $800,000 Note: Like Drawings, Dividends are closed to Retained earnings in the closing entries. 100,000 100,000 $8 $7.50

6. STOCK DIVIDENDSThe Effects • A stock dividendis an equal distribution of the corporation’s own shares to its shareholders. • Fair market value is usually the value assigned to the dividend shares. • The FMV is transferred from retained earnings to share capital (legal capital). Total equity, however, is unchanged.

7. Date Particulars Debit Credit Jan 1 STOCK DIVIDENDThe Effects • On Jan. 1 a company issues an additional 10,000 shares of common stock proportionally to current shareholders on record as of Feb. 1. The Stock is issued Mar. 1. Fair market value is $90,000. • This value is now part of legal capital and must be transferred there from retained earnings. • Note how total shareholders’ equity will remain the same. • The number of shares increases and this means that the book value per share decreases. Stock Dividends 90,000 Before After Stock DividendStock Dividend Shareholders’ equity Contributed Capital Retained earnings Total shareholders’ equity Issued shares Book value per share Stock Dividends Distributable 90,000 Stock Dividends Distributable 90,000 Mar 1 Common Stock 90,000 $290,000 $200,000 Dec 31 $510,000 $600,000 Retained Earnings 90,000 Stock Dividends 90,000 $800,000 $800,000 100,000 110,000 $8 $7.27

8. STOCK DIVIDENDSPurposes and Benefits • For company • Satisfies dividend expectations without spending cash • Increases marketability of its shares by increasing number and decreasing price • For shareholder • More shares with which to earn additional dividend income • More shares for future profitable resale, as share price climbs again

9. STOCK SPLITSThe Effects • A stock splitinvolves the issue of additional shares to shareholders according to their current ownership percentage. • A stock split has no effect on equity, or ownership control, and therefore requires no journal entry.

10. Date Particulars Debit Credit Dec 31 STOCK SPLITThe Effects • Only the number of shares and book value per share change. • Observe the following 2-for-1 stock split: Before After Stock SplitStock Split Shareholders’ equity Contributed Capital Retained earnings Total shareholders’ equity Issued shares Book value per share $200,000 $200,000 $600,000 $600,000 $800,000 $800,000 There is no journal entry since nothing of financial value changes. 100,000 200,000 $8 $4

11. DIVIDENDSA Summary of Effects Stock Stock Cash SplitDividendDividend Total assets NE NE  Total liabilities NE NE NE Total shareholders’ equity NE NE  Total share capital NE  NE Total retained earnings NE   Legal capital per share  NE NE Book value per share    Number of shares   NE % of shareholder ownership NE NE NE NE = No effect  = Increase  = Decrease

12. RETAINED EARNINGSPrior Period Adjustments • A prior period adjustmentresults from: • The correction of a material error • Occurs after the books are closed, and relates to a prior accounting period. • Changing an accounting principle. • Occurs when the principle used in the current year is different from the one used in the preceding years.

13. RETAINED EARNINGSPrior Period Adjustments • The cumulative effect of the correction or change (net of income tax) should be • Made directly to Retained Earnings; • Reported in the current year’s retained earnings section as an adjustment of the beginning balance of Retained Earnings; • Disclosed in a footnote to the financial statements; • Corrected and restated in all prior period financial statements presented.

14. RETAINED EARNINGSPrior Period Adjustments Shareholder’s Equity Contributed Capital • Total Contributed Capital $30,000 $50,000 Retained Earnings $30,000 Retained Earnings, January 1st as previously reported Less: Correction of $10,000 overstated Net Income due to excess recorded sales in prior year less $4,000 of income tax (40% tax rate) $(6,000) Cumulative effect of a change in accounting principle net of $10,000 tax expense $15,000 $9,000 Retained Earnings, January 1st as adjusted $39,000 Add: Net Income $150,000 Less: Cash Dividends (80,000) Less: Stock Dividends (20,000) 70,000 $50,000 Change in Retained Earnings for the period. • Retained Earnings, December 31st $89,000 109,000 Total Shareholder’s Equity $139,000

15. RETAINED EARNINGSSummary Of Things That Affect It Retained Earnings Debits (Decreases) Credits (Increases) 1. Correction of a prior period error that overstated income 2. Cumulative effect of a change in accounting principle that decreased income 3. Net loss 4. Cash dividends 5. Stock dividends 1. Correction of a prior period error that understated income 2. Cumulative effect of a change in accounting principle that increased income 3. Net income

16. Do Problems: BE15-1, -2 and BE15-4 E15-2 P15-2A P15-5A

17. Net Income – Preferred Dividends Number of Common Shares Earnings per Share  EARNINGS PER SHARE • Earnings per share (EPS)indicates the net income earned by each common share. • Companies report earnings per share on the income statement • The formula to calculate earnings per share when there has been no change in shares during the year is as follows:

18. Market price per share Earnings per share Price-Earnings Ratio  PRICE - EARNINGS RATIO The price-earnings (P/E) ratio helps investors determine whether the shares are a good investment in relation to earnings. It is a per share calculation, calculated by dividing the market price of the shares by its earnings per share. A high P/E ratio can be one indicator that investors believe the company has future growth potential.