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Intermediate Financial Accounting

Intermediate Financial Accounting. Shareholders' Equity- Retained Earnings. Objectives of the Chapter. To discuss the content of retained earnings. To study the accounting treatments for dividends (including cash dividend, property dividend, scrip dividend, and stock dividend).

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Intermediate Financial Accounting

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  1. Intermediate Financial Accounting Shareholders' Equity- Retained Earnings

  2. Objectives of the Chapter • 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 quasi-reorganization. Stockholders' Equity (2)- Retained Earnings

  3. Content of Retained Earnings • 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

  4. Dividends • 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

  5. Dividends (contd.) • 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

  6. 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

  7. Dividends:(contd.) • Restrictions (contd.) 3)Voluntary restrictions: Appropriation of retained earnings for specific purposes. • 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. Stockholders' Equity (2)- Retained Earnings

  8. Dividends:(contd.) • 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

  9. Dividends:(contd.) • 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

  10. Cash Dividends • 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

  11. Cash Dividends:(contd.) • Example: on Nov. 3, 20x5, the board of directors declares preferred dividends totaled $10,000 and common dividends totaled $20,000. • These dividends are payable on 12/15/x5 to stockholders of record on 11/24/x5. In addition, the ex-dividend date is 11/20/x5. The journal entries for the declaration and other related events are: Stockholders' Equity (2)- Retained Earnings

  12. Cash Dividends:(contd.) • 11/3/x5 the date of declaration Retained Earnings 30,000 Dividends Payable: CS 20,000 Dividends Payable: PS 10,000 • Shares are traded with dividends attached after this date. • Companies are legally liable for declared dividends on this date. Stockholders' Equity (2)- Retained Earnings

  13. Cash Dividends:(contd.) • 11/20/x5 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

  14. Cash Dividends:(contd.) • 11/24/x5 The date of record Memo: the company will pay dividends on 12/15/x5 to preferred and common stockholders of record as of today, the date of record. • Stockholders on the record will be paid of dividend even if they sell those shares prior to 12/15/x5, the payment date. Stockholders' Equity (2)- Retained Earnings

  15. Cash Dividends:(contd.) • 12/15/x5 Dividend payment date Div. Payable: Com. stk 20,000 Div. Payable: Prefer.stk 10,000 Cash 30,000 Stockholders' Equity (2)- Retained Earnings

  16. Preferred Stock Characteristics • 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

  17. Preferred Stock Characteristics (contd.) • 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-cumulativepreferred stock will never be paid. Stockholders' Equity (2)- Retained Earnings

  18. Cumulative Preferred Stock • 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

  19. Cumulative Preferred Stock • 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

  20. Cumulative Preferred StockExamples 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

  21. Cumulative Preferred StockExamples (contd.) Case II: Same information as in Case I except that dividends declared = $1,000. • Dividends for P.S. = $1,000. Div. Passed=$2,000 • 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

  22. Cumulative Preferred StockExamples (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

  23. Participating Preferred Stock • 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

  24. Participating Preferred Stock (contd.) • 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

  25. Participating Preferred Stock (contd.) • 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

  26. Allocation of Declared Dividends • 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

  27. Participating Preferred Stock :(contd.) • 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

  28. 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 $1,6002,400 Dividends to each class of stock $3,600$5,400 Stockholders' Equity (2)- Retained Earnings

  29. Participating Preferred Stock :(contd.) (B) Preferred Stock Participates up to 12%: PreferredCommon 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 2,4006,600 • If any preferred stock dividends had been in arrears, the dividends in arrears would have been distributed before any participation calculations. Stockholders' Equity (2)- Retained Earnings

  30. Property Dividends • 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

  31. Property Dividends • 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

  32. Property Dividends :(contd.) • Examples: (A)Property dividend is an investment in debt held to maturity: 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

  33. 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 Investment in Rock Company Bonds 48,000 Stockholders' Equity (2)- Retained Earnings

  34. 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/x5, Payable in Welch company stock. The Welch stock had been purchased early in 20x4 for $24,000 and was reported as an asset at a fair value of $29,000 on 12/31/x4 balance sheet. Stockholders' Equity (2)- Retained Earnings

  35. Property Dividends :(contd.) • The market value of Welch stock is $31,000 on 3/15/x5. The following entries are made on 3/15/x5 (the declaration date): • Adj. prior to the recog. Of dividends payable: Fair Value Adjustment 2,000 Unrealized holding gain 2,000 Unrealized holding gain 7,000 Gain on Disposal of Investment 7,000 Stockholders' Equity (2)- Retained Earnings

  36. 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 31,000 Investment in SAS 24,000 Fair value adjustment 7,000 Stockholders' Equity (2)- Retained Earnings

  37. Scrip Dividends • 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

  38. Scrip Dividends :(contd.) • 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

  39. Stock Dividends • 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

  40. 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

  41. 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

  42. Stock Dividends :(contd.) • 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

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

  44. Stock Dividends :(contd.) • 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* 80,000** 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 amount per share. Stockholders' Equity (2)- Retained Earnings

  45. 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 capital to invested capital. Stockholders' Equity (2)- Retained Earnings

  46. 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

  47. Liquidating Dividends • 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

  48. 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. Stockholders' Equity (2)- Retained Earnings

  49. Prior Period Adjustments (Restatements) • Example: In 20x5, Fox Company discovered that it did not accrue $10,000 of interest expense for 20x4. 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 Stockholders' Equity (2)- Retained Earnings

  50. Prior Period Adjustments (Restatements) :(contd.) • Presentation on the Retained Earnings Statement: R/E, as previous reported Jan 1, 20x5 $102,400 Less: Correction of overstatement in 20x4 N/I due to interest expense understatement (Net of $3,000 I/T) (7,000) Adjusted Retained Earnings, Jan 1, 20x5 $95,400 Stockholders' Equity (2)- Retained Earnings

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