Chapter (14)

Corporations: Dividends, Retained

Earnings, and Income Reporting
Dividends:
• Dividends distribution by a corporation to its stockholders on a
pro rata (proportional) basis
• Dividends may be in the form of cash, property, scrip (promissory
note to pay cash), or stock
• Dividends may be expressed in one of two ways:
1. as a percentage of the par or stated value of the stock
2. as a dollar amount per share

Cash Dividends:
• A cash dividend is a prorate distribution of cash to stockholders.
For a corporation to pay a cash dividend it must have:
(a) Retained earnings.
(b) Adequate cash.
(c) A declaration of dividends by board of directors.
Dividends are not considered a liability until
declared.

Entries for Cash Dividends:

Three important dates are important in connection with
dividends:
• Declaration date: on the declaration date, the board of directors
formally declares a cash dividend and a liability is recorded.
• Record date: The record date marks the time when ownership of
outstanding shares is determined from the records maintained by
the corporation. No entry is required on this date.
• Payment date : On the payment date dividend checks are mailed
to the stockholders and the payment of the dividend is recorded.

Example (1): Declaration Date

Assume that on December 1, 2005, the directors of Media General
declare a 50 cent per share cash dividend on 100,000 shares of $10
par value common stock.

The dividend = 100,000 shares × $0.50 = $50,000

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 The entry to record the declaration is:

Date Account Title and Explanation Dr. Cr.

Dec. 1 Retained Earnings 50000
Dividends Payable 50000
(To record declaration of cash dividends)

Example (2): Record Date

The purpose of the record date is to identify the persons or
entities that will receive the dividend, not to determine the dividend
liability. For Media General, the record date is December 22. No
entry is required on this date because the corporation’s liability
recognized on the declaration date is unchanged.

Date Account Title and Explanation Dr. Cr.

Dec. 22 No entry is necessary

Example (3): Payment Date

Assume that the payment date is January 20 for Media
General, the entry on that date is:

Date Account Title and Explanation Dr. Cr.

Jan. 20 Dividends Payable 50000
Cash 50000
(To record payment of cash dividends)

* Note that payment of the dividend REDUCES both current

assets and current liabilities but has no effect on stockholders’ equity.
The cumulative effect of the declaration and payment of a cash dividend
is to decrease both total assets and stockholders’ equity.

Allocating Cash Dividends between Preferred and Common Stock:

• Cash dividends:
– Preferred stock has priority over common stock. Preferred
stockholders must be paid first before any common
stockholders are paid.

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 • Cumulative preferred stock:
– Any dividends in arrears and the current year dividend
must be paid to preferred stockholders before allocating
any dividends to common stockholders.
• Preferred stock is not cumulative:
– Only the current year’s dividend must be paid to preferred
stockholders before paying any dividends to common
stockholders.
Example:
Assume that IBR Inc. has 1,000 shares of 8%, $100 par value
cumulative preferred stock and 50,000 shares of $10 par value
common stock outstanding at December 31, 2005. If the Board of
Directors declares a $6,000 cash dividend on December 31, the entire
$6,000 will go to preferred stockholders because their annual dividend
is $8,000, computed as shown below:

Dividends per share =$100 par value × 8% = $8

Total dividends = 1,000 shares × $8 per share = $8000
The entry to record the declaration of the $6000 dividend is:
Date Account Title and Explanation Dr. Cr.
2005 Retained Earnings 6000
Dec. 31 Dividends Payable 6000
(To record $6 per share cash dividends to
preferred stockholders)

* Because of the cumulative feature, $2 per share, or $2000 in

total are in arrears on preferred stock for 2005. These dividends must
be paid to preferred stockholders before any future dividends can be
paid to common stockholders.

Example:
At December 31, 2006, IBR declares a $50,000 cash dividend.
The allocation of the dividend to the two classes of stock is shown below:

Total dividend $50000

Allocated to preferred stock
Dividends in arrears, 2005 (1000 × $2) $2000
2006 dividends (1000 shares × $8) 8000
Total dividends to preferred stockholders $10000
Remainder allocated to common stockholders $40000

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 The entry to record the declaration of the $50000 dividend is:

Date Account Title and Explanation Dr. Cr.

2006 Retained Earnings 50000
Dec. 31 Dividends Payable 50000
(To record declaration of cash dividends of
$10000 to preferred stock and $40000 to
common stock)

* If the preferred stock was NON-cumulative, preferred

stockholders would have received only $8,000 in dividends in 2006 and
common stockholders would have received $42,000.

Stock Dividends:
• A stock dividend is a pro rata distribution to stockholders of the
corporation’s own stock. Whereas a cash dividend is paid in cash,
a stock dividend is paid in stock.
– A stock dividend results in a decrease in retained earnings
and an increase in paid-in capital

• A stock dividend does NOT decrease Total Assets or Total

Stockholders’ equity.

Purposes and Benefits of a Stock Dividend:

Corporations issue stock dividends generally for one or more of
the following reasons:
1) To satisfy stockholders’ dividend expectations without
spending cash
2) To increase the marketability of stock by increasing the
number of shares
3) To emphasize that a portion of stockholders’ equity has been
permanently reinvested in the business and unavailable for
cash dividends

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Stock Dividends Distinguished:
• SMALL stock dividend
– less than 20-25% of the corporation’s issued stock
– assign fair market value to SMALL stock dividends
• assumption that a small stock dividend will have little
effect on the market price of the shares previously
outstanding.
• LARGE stock dividend
– greater than 20-25% of the corporation’s issued stock
– par or stated value per share is normally assigned to
LARGE stock dividends.

Entries for Stock Dividends:

Example:
Assume that Medland Corporation has a balance of $300,000 in
retained earnings and declares a 10% stock dividend on its 50,000
shares of $10 par value common stock. The current fair value of its
stock is $15 per share.

The number of shares to be issued is = 50,000 shares × 10% = 5,000.

The amount to be debited to Retained Earnings

= 5,000 shares ×$15 market value per share = $75,000

The entry to record the declaration of the stock dividend is as

follows:
Date Account Title and Explanation Dr. Cr.
Retained Earnings (5000 shares × 15) 75000
Common Stock Dividends Distributable 50000
(5000 shares × $10 par value)
Paid-in capital in Excess of Par Value 25000
(5000 shares × $5)
To record declaration of 10% stock dividend.

* Note: Retained Earnings is debited for the fair market value of

the stock issued because this is a SMALL stock dividend. Common
Stock Dividends Distributable is credited for the par value of the
dividend shares (5,000 x $10), and the excess is credited to Paid-in
capital.

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Statement Presentation of Common Stock Dividends Distributable:
* Common Stock Dividends Distributable is a stockholders’
equity account; it is not a liability because assets will NOT be used to
pay the dividend. If a balance sheet is prepared before the dividend
shares are issued, the distributable account is reported in paid-in capital
as an addition to common stock.

Paid-in capital
Common Stock $500000
Common stock dividends distributable 50000 $550000

* When the dividend shares are issued, Common Stock Dividends

Distributable is debited and Common Stock is credited as shown below:

Date Account Title and Explanation Dr. Cr.

Common Stock Dividends Distributable 50000
Common Stock 50000
To record issuance of 5000 shares in a stock
dividend.

Effect of Stock Dividends:

* Stock dividends change the composition of stockholders’ equity
because a portion of retained earnings is transferred to paid-in capital.
However, total stockholders’ equity and the par or stated value per
share remain the same. But the number of shares outstanding
increases, and the book value per share decreases. These effects are
shown below for Medland Corporation:

Before After
Dividend Dividend
Stockholders’ Equity
Paid-in capital
Common stock, $10 par $500000 $550000
Paid-in capital in excess of par -- 25000
Total paid-in capital $500000 $575000
Retained Earnings 300000 225000
Total stockholders’ equity $800000 $800000
Outstanding shares 50000 55000
Book value per share $16.00 $14.55

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Stock Splits:
• Stock split, like a stock dividend, involves the issuance of
additional shares to stockholders according to their percentage
ownership.
• The purpose of a stock split is to increase the marketability of the
stock by lowering its market value per share.
• With a stock split, the number of shares is increased in the same
proportion that par or stated value per share is decreased.
• A stock split has no effect on total paid-in capital, retained
earnings, and total stockholders’ equity.
• It is not necessary to formally journalize a stock split.
• The effects of stock split are shown below for Medland
Corporation.
Example:
Assume that Medland Corporation splits its 50,000 shares of
common stock on a 2-for-1 basis. This means that one share of $10 par
value stock is exchanged for two shares of $5 par value stock. A stock
split DOES NOT have any effect on total paid-in capital, retained
earnings, and total stockholders’ equity. However, number of shares
increases and book value per share decreases.

Before After
Stock Split Stock Split
Stockholders’ Equity
Paid-in capital
Common stock $500000 $500000
Paid-in capital in excess of par -0- -0-
Total paid-in capital $500000 $500000
Retained Earnings 300000 300000
Total stockholders’ equity $800000 $800000
Outstanding shares 50000 100000
Book value per share $16.00 $8.00

Differences between the Effects of Stock Splits and Stock Dividends:

Item Stock Split Stock Dividend
Total paid-in capital No change Increase
Total retained earnings No change Decrease
Total par value (common stock) No change Increase
Par value per share Decrease No change

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Retained Earnings:
• Retained earnings is net income retained in the business.
• The balance in retained earnings is part of the stockholders’ claim
on the total assets of the corporation.
– A net loss is recorded in Retained Earnings by a closing
entry in which Retained Earnings is debited and Income
Summary is credited.

* A debit balance in retained earnings is identified as

a DEFICIT. It is reported as a deduction in the
stockholders’ equity section, as shown below:

Balance Sheet (partial)

Stockholders’ Equity
Paid-in capital
Common stock $800000
Retained earnings (deficit) (50000)
Total stockholders’ equity $750000

Prior Period Adjustments:

The Correction of an error in previously issued financial
statements is known as a prior period adjustment.

1) The adjustment is made directly to Retained Earnings because

the effect of the error is now in the retained earnings account.

2) The adjustment is reported in the current year’s

retained earnings statement as an adjustment of the
beginning balance of Retained Earnings.

Example:
Assume that General Microwave discovers in 2005 that it
understated depreciation expense in 2004 by $300,000 as a result of
computational errors.

These errors overstated net income for 2004, and the current
balance in retained earnings is also overstated by $300,000.

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 The entry for the prior period adjustment, assuming all tax effects
are ignored, is as follows:

Date Account Title and Explanation Dr. Cr.

Retained Earnings 300000
Accumulated Depreciation 300000
To adjust for understatement of depreciation
In a prior period.

Statement Presentation of Prior Period Adjustments:

Assuming that General Microwave has a beginning balance of
$800,000 in retained earnings, the prior period adjustment is reported
as follows:

General Microwave
Retained Earnings Statement (partial)

Balance, January 1, as reported $800000

Correction for overstatement of net income
in prior period (depreciation error) (300000)
Balance, January 1, as adjusted $500000

Retained Earnings Statement:

Many corporations prepare a retained earnings statement to
explain the changes in retained earnings during the year.

A complete retained earnings statement for Graber Inc., based on

assumed data is shown below:

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 Graber Inc.,
Retained Earnings Statement
For the year ended December 31, 2005

Balance, January 1, as reported $1,050,000

Correction for understatement of net income
in prior period (depreciation error) 50,000
Balance, January 1, as adjusted 1,100,000
Add: Net income 360,000
1,460,000
Less: Cash dividends $100,000
Stock dividends 200,000 300,000
Balance, December 31 $1,160,000

Corporation Income Statements:

• Income statement for a corporation includes essentially
the same sections as in a proprietorship or a partnership
except for the reporting of income taxes
• For tax purposes, corporations are considered to be a
separate legal entity.
• Income tax expense
– Reported in a separate section of the corporation
income statement before net income.
* The income statement for Leads Inc., is shown below:

Leads Inc.,
Income Statement
For the Year Ended December 31, 2005
Sales $800,000
Cost of Goods Sold 600,000
Gross Profit 200,000
Operating Expenses 50,000
Income from Operation 150,000
Other Revenues and Gains 10,000
Other Expenses and Losses (4,000)
Income Before Income Taxes 156,000
Income Tax Expense 46,800
Net Income $109,200

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Income Tax Expense:
Using the preceding Income Statement, the adjusting entry
for income tax expense at December 31, 2005 would be as follows:

Date Account Title and Explanation Dr. Cr.

Income Tax Expense 46,800
Income Taxes Payable 46,800
To record income taxes for 2005.

Earnings per Share (EPS):

• Earnings data frequently reported in the financial press
• They are used by stockholders and investors to evaluate the
profitability of the company.
• A convenient measure of earnings is earnings per share (EPS)
which indicates the net income earned by each share of
outstanding common stock.

EPS and Preferred Stock Dividends:

 When a corporation has both preferred and common stock,
the current year’s dividend declared on preferred stock is
subtracted from net income to arrive at income available to
common stockholders.

 The formula for computing EPS is:

EPS = Net income Weighted Average

Minus ÷ of Common
Preferred Dividends Shares Outstanding

Example:
Assume that Rally Inc. reports net income of $211,000 on its
102,500 weighted average common shares. During the year it also
declares a $6,000 dividend on its preferred stock.

EPS = 211,000 - $6,000 / 102,500 = $2

Remember that Earnings per share is reported only for common

stock.

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