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

DIVIDENDS 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 DIVIDENDS Requirements For a cash dividend to occur, a corporation must have: Retained earnings, Adequate cash, and Declared dividends

CASH DIVIDENDS Preferred 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 past dividends (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.

CASH DIVIDEND The 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. Date Particulars Debit Credit Jan 1 Cash Dividends 50,000 Before After Cash Dividend Cash Dividend Shareholders’ equity Contributed Capital Retained earnings Total shareholders’ equity Issued shares Book value per share Cash Dividends Payable 50,000 Mar 1 Cash Dividends Payable 50,000 Cash 50,000 $200,000 $200,000 Dec 31 Retained Earnings 50,000 $600,000 $550,000 Cash Dividends 50,000 $800,000 $750,000 Note: Like Drawings, Dividends are closed to Retained earnings in the closing entries. 100,000 100,000 $8 $7.50

STOCK DIVIDENDS The 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.

STOCK DIVIDEND The 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. Date Particulars Debit Credit Jan 1 Stock Dividends 90,000 Before After Stock Dividend Stock Dividend Shareholders’ equity Contributed Capital Retained earnings Total shareholders’ equity Issued shares Book value per share Stock Dividends Distributable 90,000 Mar 1 Stock Dividends Distributable 90,000 Common Stock 90,000 $200,000 $290,000 Dec 31 Retained Earnings 90,000 $600,000 $510,000 Stock Dividends 90,000 $800,000 $800,000 100,000 110,000 $8 $7.27

STOCK DIVIDENDS Purposes 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

STOCK SPLITS The 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.

STOCK SPLIT The Effects Only the number of shares and book value per share change. Observe the following 2-for-1 stock split: Before After Stock Split Stock Split Shareholders’ equity Contributed Capital Retained earnings Total shareholders’ equity Issued shares Book value per share $200,000 $200,000 Date Particulars Debit Credit Dec 31 $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

DIVIDENDS A Summary of Effects Stock Stock Cash Split Dividend Dividend 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

RETAINED EARNINGS Prior Period Adjustments A prior period adjustment results 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.

RETAINED EARNINGS Prior 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.

RETAINED EARNINGS Prior Period Adjustments Shareholder’s Equity Contributed Capital Total Contributed Capital $30,000 $50,000 Retained Earnings Retained Earnings, January 1st as previously reported $30,000 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) $(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) Change in Retained Earnings for the period. 70,000 $50,000 Retained Earnings, December 31st $89,000 109,000 Total Shareholder’s Equity $139,000

RETAINED EARNINGS Summary Of Things That Affect It 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

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

Net Income – Preferred Dividends Number of Common Shares 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: Net Income – Preferred Dividends Number of Common Shares Earnings per Share 

 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. Market price per share  Earnings Price-Earnings Ratio A high P/E ratio can be one indicator that investors believe the company has future growth potential.