CHAPTERSCHAPTERS

13-1613-16

FINANCING:FINANCING:

Part 3B: Equity, Dividends & Part 3B: Equity, Dividends & Retained EarningsRetained Earnings

DIVIDENDSDIVIDENDSWhat are they?What 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

CASH DIVIDENDSCASH DIVIDENDSRequirementsRequirements

• For a cash dividend to occur, a corporation must have:

1. Retained earnings,

2. Adequate cash, and

3. Declared dividends

CASH DIVIDENDSCASH DIVIDENDSPreferred Shares vs. Common SharesPreferred 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:1. Cumulative: all past dividends (in arrears)

must be paid before common shareholders get anything.

2. Non-cumulative: only the current year’s dividend must be paid before common shareholders get a dividend.

Before After Cash Dividend Cash Dividend

Shareholders’ equity Contributed Capital Retained earningsTotal shareholders’ equityIssued sharesBook value per share

CASH DIVIDENDCASH DIVIDENDThe EffectsThe 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.

$200,000 $200,000

$600,000 $550,000

$800,000 $750,000100,000 100,000

$8 $7.50

Date Particulars Debit Credit

Jan 1 Cash Dividends 50,000Cash Dividends Payable 50,000

Note: Like Drawings, Dividends are closed to Retained earnings in the closing entries.

Cash Dividends Payable 50,000Cash 50,000

Retained Earnings 50,000Cash Dividends 50,000

Dec 31

Mar 1

STOCK DIVIDENDSSTOCK DIVIDENDSThe EffectsThe Effects

• A stock dividend is 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.

Before After Stock Dividend Stock Dividend

Shareholders’ equity Contributed Capital Retained earningsTotal shareholders’ equityIssued sharesBook value per share

STOCK DIVIDENDSTOCK DIVIDENDThe EffectsThe 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.

$200,000 $290,000

$600,000 $510,000

$800,000 $800,000100,000 110,000

$8 $7.27

Date Particulars Debit Credit

Jan 1 Stock Dividends 90,000Stock Dividends Distributable 90,000

Stock Dividends Distributable 90,000Common Stock 90,000

Retained Earnings 90,000Stock Dividends 90,000

Dec 31

Mar 1

• 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

STOCK DIVIDENDSSTOCK DIVIDENDSPurposes and BenefitsPurposes and Benefits

STOCK SPLITSSTOCK SPLITSThe EffectsThe Effects

• A stock split involves 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.

Before After Stock Split Stock Split

Shareholders’ equity Contributed Capital Retained earningsTotal shareholders’ equityIssued sharesBook value per share

STOCK SPLITSTOCK SPLITThe EffectsThe Effects

• Only the number of shares and book value per share change.

• Observe the following 2-for-1 stock split:

$200,000 $200,000

$600,000 $600,000

$800,000 $800,000

100,000 200,000

$8 $4

Date Particulars Debit CreditDec 31

There is no journal entry since nothing of financial value changes.

DIVIDENDSDIVIDENDSA Summary of EffectsA Summary of Effects

Stock Stock Cash Split Dividend Dividend

Total assets NE NE Total liabilities NE NE NETotal shareholders’ equity NE NE Total share capital NE NETotal retained earnings NE Legal capital per share NE NEBook value per share Number of shares NE% of shareholder ownership NE NE NE

NE = No effect = Increase = Decrease

RETAINED EARNINGSRETAINED EARNINGSPrior Period AdjustmentsPrior Period Adjustments

• A prior period adjustment results from:

1. The correction of a material error– Occurs after the books are closed, and relates to a

prior accounting period.

2. Changing an accounting principle.– Occurs when the principle used in the current year

is different from the one used in the preceding years.

RETAINED EARNINGSRETAINED EARNINGSPrior Period AdjustmentsPrior Period Adjustments

• The cumulative effect of the correction or change (net of income tax) should be

1. Made directly to Retained Earnings;2. Reported in the current year’s retained earnings

section as an adjustment of the beginning balance of Retained Earnings;

3. Disclosed in a footnote to the financial statements;4. Corrected and restated in all prior period financial

statements presented.

RETAINED EARNINGSRETAINED EARNINGSPrior Period AdjustmentsPrior Period Adjustments

Shareholder’s EquityContributed Capital

Total Contributed CapitalRetained Earnings

Retained Earnings, January 1st as adjustedAdd: Net IncomeLess: Cash Dividends

Change in Retained Earnings for the period.Retained Earnings, December 31st

Total Shareholder’s Equity

$30,000

$39,000$150,000

(80,000)

70,000109,000

$139,000

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)Cumulative effect of a change in accounting principle net of $10,000 tax expense

$(6,000)

$15,000 $9,000

Retained Earnings, January 1st as previously reported $30,000

Less: Stock Dividends (20,000)

$50,000

$50,000$89,000

Retained EarningsRetained Earnings

RETAINED EARNINGSRETAINED EARNINGSSummary Of Things That Affect ItSummary Of Things That Affect It

Debits (Decreases) Credits (Increases)Debits (Decreases) Credits (Increases)

1. Correction of a prior period error that overstated income2. Cumulative effect of a

change in accounting principle that decreased income

3. Net loss4. Cash dividends5. 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

Do Problems:

BE15-1, -2 and BE15-4

E15-2

P15-2A

P15-5A

EARNINGS PER SHAREEARNINGS 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:

Net Income – Preferred Dividends

Number of Common Shares

Earnings per Share

PRICE - EARNINGS RATIOPRICE - EARNINGS RATIOThe 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.

Market price per share Earnings

per sharePrice-Earnings

Ratio