1. Prepared by: Keri Norrie, Camosun College
ACCOUNTING PRINCIPLES
Third Canadian Edition
Prepared by: Keri Norrie, Camosun College

2. CORPORATIONS: DIVIDENDS, RETAINED EARNINGS, AND INCOME REPORTING
CHAPTER 14
CORPORATIONS: DIVIDENDS, RETAINED EARNINGS, AND INCOME REPORTING

3. DIVIDENDS
Pro-rata (equal) distribution of a portion of a corporation’s earnings to its shareholders
Common types of dividends
Cash dividends
Stock dividends (normally common shares)

4. CASH DIVIDENDS Pro rata distribution of cash to shareholders
Corporation must have:
1. enough retained earnings,
2. enough cash, and
3. declared dividends

5. ENTRIES FOR CASH DIVIDENDS
The declaration date is when the corporation’s board of directors formally declares (authorizes) the cash dividend and announces it to shareholders.
Assume, for instance, that on September 1, 2005 the board of directors declared a $50,000 cash dividend for common shareholders.
Declaring a cash dividend commits the corporation to a legal obligation that is binding and cannot be reversed
On September 1, an entry is required to recognize the decrease in retained earnings and the increase in a current liability.
Assets
Liabilities
Shareholders’ Equity = +
$50,000
$50,000

6. ENTRIES FOR CASH DIVIDENDS
Account Titles and Explanations
Debit
Credit
Cash Dividends – Common
50,000
Dividends Payable
To record declaration of cash dividend.
Declaration date:
The entry on September 1 to record the declaration is as above.

7. ENTRIES FOR CASH DIVIDENDS
On the record date, ownership of the shares is determined so that the corporation knows who to pay the dividend to.
On the assumed record date of September 15, 2005, the corporation updates its share ownership records for changes in ownership between the declaration and record dates.
No journal entry required.

8. ENTRIES FOR CASH DIVIDENDS
On the payment date, dividend cheques are mailed to shareholders and the payment of the dividend is recorded.
Assuming the dividend is paid on September 30, 2005, the entry to record the payment would be:
Account Titles and Explanations
Debit
Credit
Dividends Payable
50,000
Cash
To record payment of cash dividend.
The cumulative effect of the declaration and payment of a cash dividend is to decrease both shareholders’ equity (through retained earnings) and total assets (through cash).

9. ALLOCATING CASH DIVIDENDS BETWEEN PREFERRED AND COMMON SHARES
Preferred shares have a priority over common shares for dividends, meaning that if dividends are declared, preferred shares must be paid first.
To illustrate, assume that a corporation has 1,000 $8 non-cumulative preferred shares and 40,000 common shares. On March 15, 2005, the corporation declared a $20,000 dividend.
The first $8,000 must be paid to the preferred shareholders with any remaining dividends being paid to the common shareholders.
Account Titles and Explanations
Debit
Credit
Cash Dividends—Preferred
8,000
Cash Dividends—Common
12,000
Dividend Payable
20,000
To record declaration of cash dividend.

10. ALLOCATING CASH DIVIDENDS BETWEEN PREFERRED AND COMMON SHARES
If the preferred shares have a cumulative dividend feature, any dividends in arrears as well as the current year’s dividend must be paid before any dividends can be paid to the common shareholders.
To illustrate, assume that a corporation has 1,000, $8 cumulative preferred shares and 40,000 common shares. On March 15, 2005, the corporation declared a $20,000 dividend. Assume that dividends were not declared in 2004.
The first $16,000 must be paid to the preferred shareholders, with any remaining dividends being paid to the common shareholders.
Account Titles and Explanations
Debit
Credit
Cash Dividends—Preferred
16,000
Cash Dividends—Common
4,000
Dividend Payable
20,000
To record declaration of cash dividend.

11. STOCK DIVIDENDS
Pro rata distribution of the corporation’s own shares to its shareholders
Since it is a dividend, Retained Earnings is decreased
Since common shares are given, the account Common Shares is increased
Assets
Liabilities
Shareholders’ Equity = +
There is no change in total assets, liabilities, or shareholders’ equity.
Retained Earnings
Common Shares

12. PURPOSES AND BENEFITS OF STOCK DIVIDENDS
For the company
To satisfy shareholders' dividend expectations without spending cash
To increase marketability of its shares by increasing number of shares and decreasing market price per share
To emphasize that a portion of shareholders’ equity has been permanently retained in the business and is unavailable for cash dividends

13. STOCK DIVIDEND EFFECTS
Assume that a corporation declares a 10% stock dividend on its 50,000 common shares. In valuing a stock dividend, most corporations use fair market value for the shares. Assuming a fair market value of $15 per share, the effect would be as follows:
Before Stock Dividend
After Stock Dividend
Shareholders’ equity
Preferred shares
$100,000
100,000
Common shares
500,000
575,000
Retained earnings
300,000
$225,000
Total shareholders’ equity
$900,000
900,000
Number of shares
50,000
$55,000
Stock dividends change the composition of shareholders’ equity because a portion of retained earnings is transferred to contributed capital.

14. STOCK SPLITS
A stock split, like a stock dividend, involves the issue of additional shares to shareholders according to their percentage of ownership
Its purpose is to increase the marketability of the shares by lowering the market value per share

15. STOCK SPLIT EFFECTS
A stock split is usually much larger than a stock dividend. Assume that instead of a 10% stock dividend, a corporation splits its 50,000 common shares on a two-for-one basis.
Before Stock Split
After Stock Split
Shareholders’ equity
Preferred shares
$100,000
Common shares
500,000
Retained earnings
300,000
$300,000
Total shareholders’ equity
$900,000
Number of shares
50,000
A stock split does not affect the balance in any shareholders’ equity accounts. Therefore, it is not necessary to journalize a stock split. Only a memo entry noting the details of the split is needed.

16. EFFECTS OF CASH DIVIDENDS, STOCK DIVIDENDS, AND STOCK SPLITS (ILLUSTRATION 14-2)
Cash Stock Stock Dividend Dividend Split
Total assets  NE NE
Total liabilities NE NE NE
Total shareholders’ equity  NE NE
Total share capital NE  NE
Total retained earnings   NE
Number of shares NE  
% of shareholder ownership NE NE NE
NE = No effect  = Increase  = Decrease

17. CORPORATION INCOME STATEMENTS
Income statement for a corporation includes essentially the same sections as in a proprietorship or a partnership
Major difference is a section for income tax expense

18. INCOME STATEMENT WITH INCOME TAX
LEADS INC.
Income Statement
Year Ended December 31, 2005
Sales
$800,000
Cost of goods sold
600,000
Gross profit
200,000
Operating expenses
50,000
Income from operations
150,000
Other revenues
10,000
Other expenses
4,000
Income before income tax
156,000
Income tax expense
46,800
Net Income
$109,200

19. COMPREHENSIVE INCOME STATEMENT
Comprehensive income statement scheduled to be reported by Canadian companies for fiscal years commencing on or after October 1, 2005 as part of the international standards harmonization
It shows profitability using an “all inclusive” basis
It will include not only net income but any changes to shareholders’ equity other than changes resulting from the sale or repurchase of shares and from the payment of dividends

20. Statement of Retained Earnings
Retained earnings is the cumulative net earnings (less losses) that is retained in the business (i.e., not distributed to shareholders)
The following illustrates a simple statement of retained earnings:
LEADS INC.
Statement of Retained Earnings
Year Ended December 31, 2005
Retained earnings, January 1, 2005
$500,000
Add: Net income
109,200
609,200
Less: Cash dividends
25,000
Retained earnings, December 31, 2005
$584,200

21. RETAINED EARNINGS RESTRICTIONS
In some cases, there may be retained earnings restrictions that make a portion of the balance currently unavailable for dividends
Restrictions result from one or more of the following causes:
Legal
Contractual
Voluntary

22. PRIOR PERIOD ADJUSTMENTS
Prior period adjustment results from:
the correction of a material error in reporting net income in previously issued financial statements, or
the changing of an accounting principle

23. PRIOR PERIOD ADJUSTMENTS
Correction of an error occurs after the books are closed and relates to a prior accounting period
Change in an accounting principle occurs when the principle used in the current year is different from the one used in the preceding year

24. PRIOR PERIOD ADJUSTMENTS
Correction of an Error
To illustrate, assume that ABC Corporation discovers in 2005 that it did not record $40,000 of amortization in The corporation has an income tax rate of 30%.
The adjusting entry in 2005 should debit the 2004 Amortization Expense and credit Accumulated Amortization for $40,000.
However, the Amortization Expense account for 2004 was closed to retained earnings at the end of 2004, so the debit adjustment made in 2005 is to the Retained Earnings account.
Account Titles and Explanations
Debit
Credit
Retained Earnings
40,000
Accumulated Amortization
To correct error in 2004 amortization.

25. PRIOR PERIOD ADJUSTMENTS
Correction of an Error
With the previous adjusting entry, the 2004 fiscal year will have $40,000 more amortization expense and therefore $40,000 less income.
With a tax rate of 30%, it will reduce 2004 income tax expense and payable by $12,000.
Since the 2004 income tax expense was closed to the Retained Earnings account at the end of 2004, the net adjusting entry needed in 2005 to adjust amortization and its related income tax effect would be:
Account Titles and Explanations
Debit
Credit
Retained Earnings
28,000
Income Tax Payable
12,000
Accumulated Amortization
40,000
To correct error in 2004 amortization and income tax.

26. PRIOR PERIOD ADJUSTMENTS Statement of Retained Earnings (partial)
Correction of an Error
Prior period corrections are reported in the statement of retained earnings, net of associated income tax
Assuming that ABC Corporation has a beginning balance of $500,000 in Retained Earnings and a calendar year end, the correction is reported as follows:
ABC INC.
Statement of Retained Earnings (partial)
Year Ended December 31, 2005
Balance, January 1, 2005 as previously reported
$500,000
Deduct: Correction for understatement of amortization expense in 2004, net of $12,000 less of income tax expense
28,000
Balance, January 1, 2005, as adjusted
472,000

27. PRIOR PERIOD ADJUSTMENTS
Journal entries and financial statement
presentation are similar for corrections of errors
and changes in policy
– Corrected amount or new principle should be used in reporting the results of operations of the current year
– Cumulative effect of the correction or change should be disclosed as an adjustment to opening retained earnings net of applicable income tax
– Prior period financial statements should be corrected or restated to make comparison easier
– Effects of the change should be detailed and disclosed in a note to the statements

28. DEBITS AND CREDITS TO RETAINED EARNINGS (ILLUSTRATION 14-3)
Debits (Decreases)
Credits (Increases)
1. Correction of a prior period error that overstated income
1. Correction of a prior period error that understated income
2. Cumulative effect of a change in accounting principle that decreased income
2. Cumulative effect of a change in accounting principle that increased income
3. Net Loss
3. Net Income
4. Cash Dividends
5. Stock Dividends
6. Reacquisition of shares

29. 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 is as follows:
Net Income – Preferred Dividends
Weighted Average Number of Common Shares
Earnings per Share 

30. EARNINGS PER SHARE Weighted average number of common shares
To find the equivalent number of whole shares for the year, multiply by fraction of year outstanding

31.  PRICE-EARNINGS RATIO
The price-earnings (PE) 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.
Market Price
per Share 
Earnings
Price-Earnings Ratio
A high PE ratio can be one indicator that investors believe the company has future growth potential.

32. PAYOUT RATIO
The payout ratio indicates what percentage of earnings the company is distributing to its shareholders.
Cash Dividends 
Net Income
Payout Ratio
A high payout could mean that the corporation is failing to reinvest enough of its earnings in its operations. It may also mean that earnings are falling or that the corporation is trying to attract investors.

33. COPYRIGHT
Copyright © 2004 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.