Corporations: Paid-in Capital, Retained Earnings, Dividends, and Treasury Stock

Learning objectives

After studying this chapter, you should be able to:

• Identify the different sources of paid-in capital and describe how to present them on a balance sheet.
• Account for a cash dividend, a stock dividend, a stock split, and a retained earnings appropriation.
• Account for the acquisition and reissuance of treasury stock.
• Describe the proper accounting treatment of discontinued operations, extraordinary items, and changes in accounting principle. 
• Define prior period adjustments and show their proper presentation in the financial statements.
• Analyze and use the financial results – earnings per share and price-earnings ratio.

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The accountant as a financial analyst

The primary purpose of financial reporting is to provide information to investors and creditors. Investors use financial information in purchasing and selling of stocks, while creditors (such as banks) use financial information in reviewing the credit-worthiness of companies wishing to obtain loans. In making these types of decisions, investors and creditors rely on financial analysts to give them accurate assessments of the value and strength of the company. The role of the financial analysts is to take the financial information reported by a company and translate that into a rating of company performance. It should therefore be no surprise that a successful financial analyst is one that has a deep understanding of financial accounting. Who better to analyze the financial statements than the person who prepared them? Who would have a better understanding of the data and information contained in financial statements than the accountant? Financial statements are becoming ever more complex and difficult to interpret by users. Thus, accountants are becoming increasingly important in assisting others to understand and interpret financial information.

Helping users understand financial information involves such tasks as developing graphs, common-size statements, and performing horizontal and vertical analysis. Analysis could also involve performing data comparisons with relevant financial and nonfinancial data. The Altman Z Model is an example of a tool used by analysts to predict bankruptcy. The model includes such items as retained earnings/total assets and sales/total assets as variables in the calculation. Based upon this test, Cooper Tire & Rubber Company earned a score of 6.07 in a recent year. A score below 2.675 was considered an indication of possible bankruptcy. Therefore, analysts evaluated Cooper as a very healthy company not likely to go bankrupt.

Financial analysts make numerous judgments about the financial condition of companies, as in the example above. These services are essential to the decisions of investors and creditors. Thus, financial analysts with a strong accounting background are well compensated for their efforts.

As owners of a corporation, stockholders provide much of the capital for its activities. On the balance sheet, we show the stockholders' capital investment in the corporation as paid-in capital under stockholders' equity. Also included in stockholders' equity is the capital accumulated through the retention of corporate earnings (retained earnings). Paid-in capital is a relatively permanent portion of stockholders' equity; the retained earnings balance is a relatively temporary portion of corporate capital and is the source of stockholders' dividends.

The preceding chapter discussed the paid-in capital obtained by issuing shares of stock for cash, property, or services. This chapter describes additional sources of paid-in capital and items affecting retained earnings.

Paid-in (or contributed) capital

As you have learned in the preceding chapter, paid-in capital, or contributed capital, refers to all of the contributed capital of a corporation, including the capital carried in the capital stock accounts. The general ledger does not contain an account titled "Paid-In Capital". Instead, paid-in capital is a category, and companies establish a separate account for each source of paid-in capital.

In Exhibit 21, we summarize several sources of stockholders' equity and list general ledger account titles used to record increases and decreases in capital from each of these sources. Chapter 12 discussed some of these general ledger accounts. This chapter discusses other general ledger accounts that record sources of stockholders' equity.

The stockholders' equity section of a balance sheet shows the different sources of the corporation's paid-in capital because these sources are important information. For example, these additional sources may be from stock dividends, treasury stock transactions, or donations.

Exhibit 21: Sources of stockholders' equity

Paid-in capital – Stock dividends

When it declares a stock dividend, a corporation distributes additional shares of stock (instead of cash) to its present stockholders. A later section discusses and illustrates how the issuance of a stock dividend results in a credit to a Paid-In Capital – Stock Dividends account.

Paid-in capital – Treasury stock transactions

Another source of capital is treasury stock transactions. Treasury stock is the corporation's own stock, either preferred or common, that it has issued and reacquired. It is legally available for reissuance. By reacquiring shares of its own outstanding capital stock at one price and later reissuing them at a higher price, a corporation can increase its capital by the difference between the two prices. If the reissue price is less than acquisition cost, however, corporate capital decreases. We discuss treasury stock transactions at length later in this chapter.

Paid-in capital – Donations

Occasionally, a corporation receives a gift of assets, such as a USD 500,000 building. These donated gifts increase stockholders' equity and are called donated capital. The entry to record the gift of a USD 500,000 building is a debit to Buildings and a credit to Paid-In Capital – Donations. Accountants would make this entry in the amount of the USD 500,000 fair market value of the gift when received.

Retained earnings

The retained earnings portion of stockholders' equity typically results from accumulated earnings, reduced by net losses and dividends. Like paid-in capital, retained earnings is a source of assets received by a corporation. Paid-in capital is the actual investment by the stockholders; retained earnings is the investment by the stockholders through earnings not yet withdrawn.

The balance in the corporation's Retained Earnings account is the corporation's net income, less net losses, from the date the corporation began to the present, less the sum of dividends paid during this period. Net income increases Retained Earnings, while net losses and dividends decrease Retained Earnings in any given year. Thus, the balance in Retained Earnings represents the corporation's accumulated net income not distributed to stockholders.

When the Retained Earnings account has a debit balance, a deficit exists. A company indicates a deficit by listing retained earnings with a negative amount in the stockholders' equity section of the balance sheet. The firm need not change the title of the general ledger account even though it contains a debit balance. The most common credits and debits made to Retained Earnings are for income (or losses) and dividends. Occasionally, accountants make other entries to the Retained Earnings account. We discuss some of these entries later in the chapter.

Paid-in capital and retained earnings on the balance sheet

The following stockholders' equity section of a balance sheet presents the various sources of capital in proper form:

* This label is not the exact account title but is representative of the descriptions used on balance sheets. The exact account title could be used, but shorter descriptions are often shown.

In their highly condensed, published balance sheets, companies often omit the details regarding the sources of the paid-in capital in excess of par or stated value and replace them by a single item, such as:

Paid-in capital in excess of par (or stated) value USD 50,000

Dividends are distributions of earnings by a corporation to its stockholders. Usually the corporation pays dividends in cash, but it may distribute additional shares of the corporation's own capital stock as dividends. Occasionally, a company pays dividends in merchandise or other assets. Since dividends are the means whereby the owners of a corporation share in its earnings, accountants charge them against retained earnings.

Before dividends can be paid, the board of directors must declare them so they can be recorded in the corporation's minutes book. Three dividend dates are significant:

• Date of declaration. The date of declaration indicates when the board of directors approved a motion declaring that dividends should be paid. The board action creates the liability for dividends payable (or stock dividends distributable for stock dividends).
• Date of record. The board of directors establishes the date of record; it determines which stockholders receive dividends. The corporation's records (the stockholders' ledger) determine its stockholders as of the date of record.
  
• Date of payment. The date of payment indicates when the corporation will pay dividends to the stockholders.

To illustrate how these three dates relate to an actual situation, assume the board of directors of the Allen Corporation declared a cash dividend on 2010 May 5, (date of declaration). The cash dividend declared is USD 1.25 per share to stockholders of record on 2010 July 1, (date of record), payable on 2010 July 10, (date of payment). Because financial transactions occur on both the date of declaration (a liability is incurred) and on the date of payment (cash is paid), journal entries record the transactions on both of these dates. No journal entry is required on the date of record.

Exhibit 22 shows the frequencies of dividend payments made by a sample of representative companies for the years 1996-99. Note that cash dividends are far more numerous than stock dividends or dividends in kind (paid in merchandise or other assets).

An accounting perspective:

Uses of technology

After original issuance, investors may trade the stock of a company on secondary markets, such as the New York Stock Exchange. The company makes no entry on its books for these outside trades after issuance. Often, a company uses a spreadsheet or database program to note trades between shareholders. These computer programs can print a report on the date of record. This information allows a company that declares a dividend to be certain the money or stock goes to the stockholders who own the stock on the date of record rather than to the stockholders who originally purchased the stock.

Cash dividends are cash distributions of accumulated earnings by a corporation to its stockholders. To illustrate the entries for cash dividends, consider the following example. On 2010 January 21, a corporation's board of directors declared a 2 percent quarterly cash dividend on USD 100,000 of outstanding preferred stock. This dividend is one-fourth of the annual dividend on 1,000 shares of USD 100 par value, 8 percent preferred stock. The dividend will be paid on 2010 March 1, to stockholders of record on 2010 February 5. An entry is not needed on the date of record; however, the entries at the declaration and payment dates are as follows:

Often a cash dividend is stated as so many dollars per share. For instance, the quarterly dividend could have been stated as USD 2 per share. When they declare a cash dividend, some companies debit a Dividends account instead of Retained Earnings. (Both methods are acceptable.) The Dividends account is then closed to Retained Earnings at the end of the fiscal year.

Exhibit 22: Types of dividends

Once a cash dividend is declared and notice of the dividend is given to stockholders, a company generally cannot rescind it unless all stockholders agree to such action. Thus, the credit balance in the Dividends Payable account appears as a current liability on the balance sheet.

An accounting perspective:

Business insight

Fleetwood Enterprises, Inc., is the nation's leading producer of manufactured housing and recreational vehicles. Often investors believe a company that pays dividends is doing well. Therefore, companies try to maintain a record of paying dividends, as Fleetwood noted in a 2001 press release.

The directors of Fleetwood Enterprises, Inc. (NYSE: FLE) have declared the company's regular quarterly cash dividend of 19 cents per share of Common stock, payable 2000 November 8, to shareholders of record 2000 October 6.

A company that lacks sufficient cash for a cash dividend may declare a stock dividend to satisfy its shareholders. Note that in the long run it may be more beneficial to the company and the shareholders to reinvest the capital in the business rather than paying a cash dividend. If so, the company would be more profitable and the shareholders would be rewarded with a higher stock price in the future.

Stock dividends are payable in additional shares of the declaring corporation's capital stock. When declaring stock dividends, companies issue additional shares of the same class of stock as that held by the stockholders.

Corporations usually account for stock dividends by transferring a sum from retained earnings to permanent paid-in capital. The amount transferred for stock dividends depends on the size of the stock dividend. For stock dividends, most states permit corporations to debit Retained Earnings or any paid-in capital accounts other than those representing legal capital. In most circumstances, however, they debit Retained Earnings when a stock dividend is declared.

Stock dividends have no effect on the total amount of stockholders' equity or on net assets. They merely decrease retained earnings and increase paid-in capital by an equal amount. Immediately after the distribution of a stock dividend, each share of similar stock has a lower book value per share. This decrease occurs because more shares are outstanding with no increase in total stockholders' equity.

Stock dividends do not affect the individual stockholder's percentage of ownership in the corporation. For example, a stockholder who owns 1,000 shares in a corporation having 100,000 shares of stock outstanding, owns 1 percent of the outstanding shares. After a 10 percent stock dividend, the stockholder still owns 1 percent of the outstanding shares – 1,100 of the 110,000 outstanding shares.

A corporation might declare a stock dividend for several reasons:

• Retained earnings may have become large relative to total stockholders' equity, so the corporation may desire a larger permanent capitalization.
• The market price of the stock may have risen above a desirable trading range. A stock dividend generally reduces the per share market value of the company's stock.
• The board of directors of a corporation may wish to have more stockholders (who might then buy its products) and eventually increase their number by increasing the number of shares outstanding. Some of the stockholders receiving the stock dividend are likely to sell the shares to other persons.
• Stock dividends may silence stockholders' demands for cash dividends from a corporation that does not have sufficient cash to pay cash dividends.
  

The percentage of shares issued determines whether a stock dividend is a small stock dividend or a large stock dividend. Firms use different accounting treatments for each category.

Recording small stock dividends A stock dividend of less than 20 to 25 percent of the outstanding shares is a small stock dividend and has little effect on the market value (quoted market price) of the shares. Thus, the firm accounts for the dividend at the current market value of the outstanding shares.

Assume a corporation is authorized to issue 20,000 shares of USD 100 par value common stock, of which 8,000 shares are outstanding. Its board of directors declares a 10 percent stock dividend (800 shares). The quoted market price of the stock is USD 125 per share immediately before the stock dividend is announced. Since the distribution is less than 20 to 25 percent of the outstanding shares, the dividend is accounted for at market value. The entry for the declaration of the stock dividend on 2010 August 10, is:

This entry records the issuance of the shares:

The stock dividend distributable – common account is a stockholders' equity (paid-in capital) account credited for the par or stated value of the shares distributable when recording the declaration of a stock dividend. Since a stock dividend distributable is not to be paid with assets, it is not a liability. When a balance sheet is prepared between the date the 10 percent dividend is declared and the date the shares are issued, the proper statement presentation of the effects of the stock dividend is:

Suppose, on the other hand, that the common stock in the preceding example is no-par stock and has a stated value of USD 50 per share. The entry to record the declaration of the stock dividend (when the market value is USD 125) is:

The entry to record the issuance of the stock dividend is:

Recording large stock dividends A stock dividend of more than 20 to 25 percent of the outstanding shares is a large stock dividend. Since one purpose of a large stock dividend is to reduce the market value of the stock so the shares can be traded more easily, firms do not use the current market value of the stock in the entry. They account for such dividends at their par or stated value rather than at their current market value. The laws of the state of incorporation or the board of directors establish the amounts for stocks without par or stated value.

To illustrate the treatment of a stock dividend of more than 20 to 25 percent, assume X Corporation has been authorized to issue 10,000 shares of USD 10 par value common stock, of which 5,000 shares are outstanding. X Corporation declared a 30 percent stock dividend (1,500 shares) on 2010 September 20, to be issued on 2010 October 15. The required entries are:

Exhibit 23: Stock dividends

Note that although firms account for the small stock dividend at current market value, they account for the 30 percent stock dividend at par value (1,500 shares X USD 10 = USD 15,000). Because of the differences in accounting for large and small stock dividends, accountants must determine the relative size of the stock dividend before making any journal entries.

To see the effect of small and large stock dividends on stockholders' equity, look at Exhibit 23.

A stock split is a distribution of 100 percent or more of additional shares of the issuing corporation's stock accompanied by a corresponding reduction in the par value per share. The corporation receives no assets in this transaction. A stock split causes a large reduction in the market price per share of the outstanding stock. A two-for-one split doubles the number of shares outstanding, a three-for-one split triples the number of shares, and so on. The split reduces the par value per share at the same time so that the total dollar amount credited to Common Stock remains the same. For instance, a two-for-one split halves the par value per share. If the corporation issues 100 percent more stock without a reduction in the par value per share, the transaction is a 100 percent stock dividend rather than a two-for-one stock split.

The entry to record a stock split depends on the particular circumstances. Usually, firms change only the number of shares outstanding and the par or stated value in the records. (The number of shares authorized may also change.) Thus, they would record a two-for-one stock split in which the par value of the shares decreases from USD 20 to USD 10 as follows:

In Exhibit 24, we summarize the effects of stock dividends and stock splits. Stock dividends and stock splits have no effect on the total amount of stockholders' equity. In addition, stock splits have no effect on the total amount of paid-in capital or retained earnings. They merely increase the number of shares outstanding and decrease the par value per share. Stock dividends increase paid-in capital and decrease retained earnings by equal amounts.

Exhibit 24: Summary of effects of stock dividends and stock splits

The preceding chapter discussed how corporate laws differ regarding the legality of a dividend. State law establishes the legal or stated capital of a corporation as that portion of the stockholders' equity that must be maintained intact, unimpaired by dividend declarations or other distributions to stockholders. The legal capital often equals the par or stated value of the shares issued or a minimum price per share issued.

The objective of these state corporate laws is to protect the corporation's creditors, whose claims have priority over those of the corporation's stockholders. To illustrate the significance of the legal capital concept, assume a corporation in severe financial difficulty is about to go out of business. If there were no legal capital restrictions on dividends, the stockholders of that corporation might pay themselves a cash dividend or have the corporation buy back their stock, leaving no funds available for the corporation's creditors.

The board of directors of a corporation possesses sole power to declare dividends. The legality of a dividend generally depends on the amount of retained earnings available for dividends – not on the net income of any one period. Firms can pay dividends in periods in which they incurred losses, provided retained earnings and the cash position justify the dividend. And in some states, companies can declare dividends from current earnings despite an accumulated deficit. The financial advisability of declaring a dividend depends on the cash position of the corporation.

Normally, dividends are reductions of retained earnings since they are distributions of the corporation's net income. However, dividends may be distributions of contributed capital. These dividends are called liquidating dividends.

Accountants debit liquidating dividends to a paid-in capital account. Corporations should disclose to stockholders the source of any dividends that are not distributions of net income by indicating which paid-in capital account was debited as a result of the dividend. The legality of paying liquidating dividends depends on the source of the paid-in capital and the laws of the state of incorporation.

An accounting perspective:

Business insight

The Private Securities Litigation Reform Act, passed in 1995, seeks to protect investors against white-collar crime. Auditors are required by this law to become more aggressive in looking for fraud in companies they audit. Risk factors that might encourage management to engage in fraudulent activities include weak internal controls, an aggressive effort to drive up the stock price by reporting higher earnings, and/or executive bonuses or stock options based on earnings. A strong company code of ethics and an effective internal control structure can help deter fraud from occurring.

Retained earnings appropriations

The amount of retained earnings that a corporation may pay as cash dividends may be less than total retained earnings for several contractual or voluntary reasons. These contractual or voluntary restrictions or limitations on retained earnings are retained earnings appropriations. For example, a loan contract may state that part of a corporation's USD 100,000 of retained earnings is not available for cash dividends until the loan is paid. Or a board of directors may decide to use assets resulting from net income for plant expansion rather than for cash dividends. An example of a voluntary restriction was General Electric's annual report statement that cash dividends were limited "to support enhanced productive capability and to provide adequate financial resources for internal and external growth opportunities". Companies formally record retained earnings appropriations by transferring amounts from Retained Earnings to accounts such as "Appropriation for Loan Agreement" or "Retained Earnings Appropriated for Plant Expansion". Even though some refer to retained earnings appropriations as retained earnings reserves, using the term reserves is discouraged.

Other reasons for appropriations of retained earnings include pending litigation, debt retirement, and contingencies in general. Such appropriations do not reduce total retained earnings. They merely disclose to balance sheet readers that a portion of retained earnings is not available for cash dividends. Thus, recording these appropriations guarantees that the corporation limits its outflow of cash dividends while repaying a loan, expanding a plant, or taking on some other costly endeavor. Recording retained earnings appropriations does not involve the setting aside of cash for the indicated purpose; it merely divides retained earnings into two parts - appropriated retained earnings and unappropriated retained earnings. The establishment of a separate fund would require a specific directive from the board of directors. The only entry required to record the appropriation of USD 25,000 of retained earnings to fulfill the provisions in a loan agreement is:

When the retained earnings appropriation has served its purpose of restricting dividends and the loan has been repaid, the board of directors may decide to return the appropriation intact to Retained Earnings. The entry to do this is:

On the balance sheet, retained earnings appropriations appear in the stockholders' equity section as follows:

Note that a retained earnings appropriation does not reduce either stockholders' equity or total retained earnings but merely earmarks (restricts) a portion of retained earnings for a specific reason.

The formal practice of recording and reporting retained earnings appropriations is decreasing. Footnote explanations such as the following are replacing these appropriations:

Note 7. Retained earnings restrictions. According to the provisions in the loan agreement, retained earnings available for dividends are limited to USD 20,000. Such footnotes appear after the formal financial statements in "Notes to Financial Statements". The Retained Earnings account on the balance sheet would be referenced as follows: "Retained Earnings ... USD 45,000".

Changes in the composition of retained earnings reveal important information about a corporation to financial statement users. A separate formal statement - the statement of retained earnings - discloses such changes.

Statement of retained earnings

A statement of retained earnings is a formal statement showing the items causing changes in unappropriated and appropriated retained earnings during a stated period of time. Changes in unappropriated retained earnings usually consist of the addition of net income (or deduction of net loss) and the deduction of dividends and appropriations. Changes in appropriated retained earnings consist of increases or decreases in appropriations.

Note Ward Corporation's statement of retained earnings in Exhibit 25. The only new appropriation during 2010 was an additional USD 35,000 for plant expansion. Ward added this new USD 35,000 to the USD 25,000 beginning balance in that account and subtracted that amount from unappropriated retained earnings. An alternative to the statement of retained earnings is the statement of stockholders' equity.

Ward Corporation
Statement of Retained Earnings
For Year Ended 2010 December 31

Exhibit 25: Statement of retained earnings

Statement of stockholders' equity

Most corporations include four financial statements in their annual reports: a balance sheet, an income statement, a statement of stockholders' equity (in place of a statement of retained earnings), and a statement of cash flows (discussed in Chapter 16). A statement of stockholders' equity is a summary of the transactions affecting the accounts in the stockholders' equity section of the balance sheet during a stated period. These transactions include activities affecting both paid-in capital and retained earnings accounts. Thus, the statement of stockholders' equity includes the information contained in a statement of retained earnings plus some additional information. The columns in the statement of stockholders' equity reflect the major account titles within the stockholders' equity section: the types of stock issued and outstanding, paid-in capital in excess of par (or stated) value, retained earnings, and treasury stock. Each row indicates the effects of major transactions affecting one or more stockholders' equity accounts.

Look at Exhibit 26, a statement of stockholders' equity. The first row indicates the beginning balances of each account in the stockholders' equity section. This summary shows that Larkin Corporation issued 10,000 shares of common stock, declared a 5 percent stock dividend on common stock, repurchased 1,200 shares of treasury stock, earned net income of USD 185,000, and paid cash dividends on both its preferred and common stock. After the transactions' effects are indicated within each row, Larkin added or subtracted each column's components to determine the ending balance in each stockholders' equity account.

Treasury stock

Treasury stock is the corporation's own capital stock that it has issued and then reacquired; this stock has not been canceled and is legally available for reissuance. Because it has been issued, we cannot classify treasury stock as unissued stock.

Recall that when a corporation has additional authorized shares of stock that are to be issued after the date of original issue, in most states the preemptive right requires offering these additional shares first to existing stockholders on a pro rata basis. However, firms may reissue treasury stock without violating the preemptive right provisions of state laws; that is, treasury stock does not have to be offered to current stockholders on a pro rata basis.

Larkin Corporation
Statement of stockholders' equity
For the Year ended 2010 December 31

Exhibit 26: Statement of stockholders' equity

A corporation may reacquire its own capital stock as treasury stock to: (1) cancel and retire the stock; (2) reissue the stock later at a higher price; (3) reduce the shares outstanding and thereby increase earnings per share; or (4) issue the stock to employees. If the intent of reacquisition is cancellation and retirement, the treasury shares exist only until they are retired and canceled by a formal reduction of corporate capital.

For dividend or voting purposes, most state laws consider treasury stock as issued but not outstanding, since the shares are no longer in the possession of stockholders. Also, accountants do not consider treasury shares outstanding in calculating earnings per share. However, they generally consider treasury shares outstanding for purposes of determining legal capital, which includes outstanding shares plus treasury shares.

In states that consider treasury stock as part of legal capital, the cost of treasury stock may not exceed the retained earnings at the date the shares are reacquired. This regulation protects creditors by preventing the corporation in financial difficulty from using funds to purchase its own stock instead of paying its debts. Thus, if a corporation is subject to such a law (as is assumed in this text), the retained earnings available for dividends must exceed the cost of the treasury shares on hand.

When firms reacquire treasury stock, they record the stock at cost as a debit in a stockholders' equity account called Treasury Stock.  They credit reissuances to the Treasury Stock account at the cost of acquisition. Thus, the Treasury Stock account is debited at cost when shares are acquired and credited at cost when these shares are sold. Any excess of the reissue price over cost represents additional paid-in capital and is credited to Paid-In Capital – Common (Preferred) Treasury Stock Transactions.

To illustrate, assume that on 2010 February 18, the Hillside Corporation reacquired 100 shares of its outstanding common stock for USD 55 each. (The company's stockholders' equity consisted solely of common stock and retained earnings.) On 2010 April 18, the company reissued 30 shares for USD 58 each. The entries to record these events are:

When the reissue price of subsequent shares is less than the acquisition price, firms debit the difference between cost and reissue price to Paid-In Capital – Common Treasury Stock Transactions. This account, however, never develops a debit balance. By definition, no paid-in capital account can have a debit balance. If Hillside reissued an additional 20 shares at USD 52 per share on 2010 June 12, the entry would be:

At this point, the credit balance in the Paid-In Capital – Common Treasury Stock Transactions account would be USD 30. If the remaining 50 shares are reissued on 2010 July 16, for USD 53 per share, the entry would be:

Notice that Hillside has exhausted the Paid-In Capital –Common Treasury Stock Transactions account credit balance. If more than USD 30 is debited to that account, it would develop a debit balance. Thus, the remaining USD 70 of the excess of cost over reissue price is a special distribution to the stockholders involved and is debited to the Retained Earnings account.

Sometimes stockholders donate stock to a corporation. Since donated treasury shares have no cost to the corporation, accountants make only a memo entry when the shares are received. The only formal entry required is to debit Cash and credit the Paid-In Capital – Donations account when the stock is reissued. For example, if donated treasury stock is sold for USD 5,000, the entry would be:

When treasury stock is held on a balance sheet date, it customarily appears at cost, as a deduction from the sum of total paid-in capital and retained earnings, as follows:

Hypothetical Corporation
Partial balance sheet 2010 December 31

Exhibit 27: Stockholders' equity section of the balance sheet

An accounting perspective:

Business insight

General Mills is a leading producer of ready-to-eat cereals, desserts and baking mixes, snack products, and dinner and side dish mixes. Popular brand names include Hamburger Helper, Betty Crocker, and Yoplait. For 2001 and 2000, General Mills reported common stock in the treasury (treasury stock) of 123,100,000 and 122,900,000 shares, respectively. General Mills deducted the cost of these shares in the stockholders' equity section of the balance sheet.

To summarize much of what we have discussed in Chapters 12 and 13, we present the stockholders' equity section of the balance sheet in Exhibit 27. This partial balance sheet shows: (1) the amount of capital assigned to shares outstanding; (2) the capital contributed for outstanding shares in addition to that assigned to the shares; (3) other forms of paid-in capital; and (4) retained earnings, appropriated and unappropriated.

Anson Company Income Statement
For the Year Ended
2010 December 31

Exhibit 28: Income statement

Net income inclusions and exclusions

Accounting has long faced the problem of what to include in the net income reported for a period. Should net income include only the revenues and expenses related to normal operations? Or should it include the results of discontinued operations and unusual, nonrecurring gains and losses? And further, should the determination of net income for 2010, for example, include an item that can be clearly associated with a prior year, such as additional federal income taxes for 2009? Or should such items, including corrections of errors, be carried directly to retained earnings? How are the effects of making a change in accounting principle to be reported?

APB Opinion No. 9 (December 1966) sought to provide answers to some of these questions. The Opinion directed that unusual and nonrecurring items having an earnings or loss effect are extraordinary items (reported in the income statement) or prior period adjustments (reported in the statement of retained earnings). Extraordinary items are reported separately after net income from regular continuing activities.

In Exhibit 28 and Exhibit 30, we show the reporting of discontinued operations, extraordinary items, and prior period adjustments. For Exhibit 28 and Exhibit 30, assume that the Anson Company has 1,000,000 shares of common stock outstanding and the company's earnings are taxed at 40 percent. Also, assume the following:

• Anson sold its Cosmetics Division on 2010 August 1, at a loss of USD 500,000. The net operating loss of that division through 2010 July 31, was USD 2,000,000.
• Anson had a taxable gain in 2010 of USD 40,000 from a sale of a subsidiary at an amount greater than what was on the company's balance sheet (extraordinary item).
• In 2010, Anson discovered that the USD 200,000 cost of land acquired in 2009 had been expensed for both financial accounting and tax purposes. A prior period adjustment was made in 2010.

Next, we explain the effects of these assumptions in greater detail.

A discontinued operation occurs when a business sells a segment (usually an unprofitable department or division) to another company or abandons it. When a company discontinues a segment, it shows the relevant information in a special section of the income statement immediately after income from continuing operations and before extraordinary items. Two items of information appear:

• The income or loss (net of tax effect) from the segment's operations for the portion of the current year before it was discontinued.
  
• The gain or loss (net of tax effect) on disposal of the segment.
  

To illustrate, Anson's sale of its Cosmetics Division on August 1 led to a before-tax loss of USD 500,000. The after-tax loss was USD 500,000 X 60 percent = USD 300,000. The operating loss before taxes through July 31 was USD 2,000,000. The after-tax operating loss for that period was USD 2,000,000 X 60 percent = USD 1,200,000. Note this information on the income statement in Exhibit 28.

Prior to 1973, companies reported a gain or loss as an extraordinary item if it was either unusual in nature or occurred infrequently. As a result, companies were inconsistent in the financial reporting of certain gains and losses. This inconsistency led to the issuance of APB Opinion No. 30 (September 1973). Opinion No. 30 redefined extraordinary items as those unusual in nature and occurring infrequently. Note that both conditions must be met – unusual nature and infrequent occurrence. Accountants determine whether an item is unusual and infrequent in light of the environment in which the company operates. Examples of extraordinary items include gains or losses that are the direct result of a major catastrophe (a flood or hurricane where few have occurred before), a confiscation of property by a foreign government, or a prohibition under a newly enacted law.

Extraordinary items are included in the determination of periodic net income, but are disclosed separately (net of their tax effects) in the income statement below "Income from continuing operations". As shown in Exhibit 28, Anson reported the extraordinary items after reporting the loss from discontinued operations.

Gains or losses related to ordinary business activities are not extraordinary items regardless of their size. For example, material write-downs of uncollectible receivables, obsolete inventories, and intangible assets are not extraordinary items. However, such items may be separately disclosed as part of income from continuing operations.

Exhibit 29: Extraordinary items

In Exhibit 29, note that in a sample of 600 companies for the years 2000-2003, most companies do not report extraordinary items.

Changes in accounting principle can materially alter a company's reported net income and financial position. Changes in accounting principle are changes in accounting methods pertaining to such items as inventory. Such a change includes a change in inventory valuation method from FIFO to LIFO.

According to APB Opinion No. 20, a company should consistently apply the same accounting methods from one period to another. However, a company may make a change if the newly adopted method is preferable and if the change is adequately disclosed in the financial statements. In the period in which a company makes a change in accounting principle, it must disclose on the financial statements the nature of the change, its justification, and its effect on net income. Also, the company must show on the income statement for the year of the change and the cumulative effect of the change on prior years' income (net of tax).

According to FASB Statement No. 16, prior period adjustments consist almost entirely of corrections of errors in previously published financial statements. Corrections of abnormal, nonrecurring errors that may have been caused by the improper use of an accounting principle or by mathematical mistakes are prior period adjustments. Normal, recurring corrections and adjustments, which follow inevitably from the use of estimates in accounting practice, are not treated as prior period adjustments. Also, mistakes corrected in the same year they occur are not prior period adjustments. To illustrate a prior period adjustment, suppose that Anson purchased land in 2009 at a total cost of USD 200,000 and recorded this amount in an expense account instead of in the Land account. Discovery of the error on 2010 May 1, after publication of the 2009 financial statements, would require a prior period adjustment. The adjustment would be recorded directly in the Retained Earnings account. Assuming the error had resulted in an USD 80,000 underpayment of taxes in 2009, the entry to correct the error would be:

An ethical perspective:
Ace chemical company

Ace Chemical Company is a small, privately held manufacturer that has been operating at a profit for years. The current balance in the Cash account is USD 8 million, and the balance in Retained Earnings is USD 4 million. The company's plant assets consist of special purpose equipment that can produce only certain chemicals. The company has long-term debt with a principal balance of USD 10 million. Its officers (all of whom are stockholders) are concerned about the future prospects of the company. Many similar firms have been sued by customers and employees claiming that toxic chemicals produced by the company caused their health problems. No such suits have yet been filed against Ace, but the officers fully expect them to be filed within the next two years.

The company's stock is not listed on a stock exchange, nor has it recently been traded. The officers hold 70 percent of the stock and estimate that their total stockholdings have a current market value of about USD 8 million (although its value would be much lower if all the facts were known). They are worried that if suits are filed and the company loses, there will not even be enough remaining assets to satisfy creditors' claims, and the officers' stock would be worthless. Private legal counsel has informed the officers that the company is likely to lose any suits that are filed.

One of the officers suggested that they could at least receive something for their stock by having the company buy half of the shares held by the officers at a total price of USD 4 million. Another officer asked if such a treasury stock transaction would be legal. The response was that the transaction would be legal because it did not dip into the present legal capital of the company. Retained earnings would be reduced to a zero balance, but would not develop a debit balance as a result of the transaction.

Prior period adjustments do not appear on the income statements but in the current-year financial statements as adjustments to the opening balance of retained earnings on the statement of retained earnings (Exhibit 30).

Most discontinued operations, extraordinary items, changes in accounting principle, and prior period adjustments affect the amount of income taxes a corporation must pay. To report the income tax effect, FASB Statement No. 96 requires reporting all of these items net of their tax effects, as shown in Exhibit 28 and Exhibit 30. Net-of-tax effect means that items appear at the dollar amounts remaining after deducting the income tax effects. Thus, the total effect of a discontinued operation, an extraordinary item, a change in accounting principle, or a prior period adjustment appears in one place in the appropriate financial statement. The reference to "Income from continuing operations" on the income statement represents the results of transactions (including income taxes) that are normal for the business and may be expected to recur. Note that the tax effect of an item may appear separately, as it does for the gain on voluntary early retirement of debt in Exhibit 28. Or the company may mention it parenthetically with only the net amount shown (see loss from discontinued operations and change in accounting principle in Exhibit 28 and correction of error in Exhibit 30).

Anson Company
Statement of Retained Earnings For the Year Ended
2010 December 31

Exhibit 30: Statement of retained earnings

• Income from continuing operations of USD 5,550,000 (Exhibit 28) is more representative of the continuing earning power of the company than is the net income figure of USD 4,077,600.
• Following income, the special items from continuing operations appear at their actual impact on the company – that is, net of their tax effect.
• EPS is reported both before (USD 5.550) and after (USD 4.078) the discontinued operations, extraordinary item, and the cumulative effect of a change in accounting principle (Exhibit 28).
• The correction of the USD 200,000 error adds only USD 120,000 to retained earnings (Exhibit 30). This result occurs because the mistake was included in the 2009 tax return and taxes were underpaid by USD 80,000. In the 2010 return, the USD 80,000 of taxes would have to be paid.

Analyzing and using the financial results – Earnings per share and price-earnings ratio

Understanding the learning objectives

• Paid-in capital is presented in the stockholders' equity section of the balance sheet. Each source of paid-in capital is listed separately.

• Sources of paid-in capital are:

(a) Common stock.
(b) Preferred stock.
(c) In excess of par value or stated value (common and preferred).
(d) Stock dividends.
(e) Treasury stock transactions.
(f) Donations.

• Cash dividend of 3 percent on USD 100,000 of outstanding common stock: declared on July 1 and paid on September 15.

Ten percent stock dividend on 10,000 shares of common stock outstanding; par value, USD 100; market value at declaration, USD 125 per share (declared on January 1 and paid on February 1).

• Thirty percent stock dividend on 10,000 shares of common stock outstanding: declared on January 1 and payable on February 1; par value, USD 100.

• Stock split: 1,000 shares of USD 50 par value common stock replaced by 2,000 shares of USD 25 par value common stock.

• Retained earnings appropriation: USD 75,000 appropriated for plant expansion.

• Treasury stock transactions: 100 shares of common stock were reacquired at USD 100 each and reissued for USD 105 each.
  

• The income or loss (net of tax effect) from the segment's operations for the portion of the current year before it was discontinued is reported on the income statement below "Income from continuing operations".

• The gain or loss (net of tax effect) on disposal of the segment is also reported in that same section of the income statement.

• Extraordinary items are both unusual in nature and infrequent in occurrence. Extraordinary items appear on the income statement (net-of-tax effect) below "Income from continuing operations".

• In the period in which a change in principle is made, the nature of the change, its justification, and its effect on net income must be disclosed in the financial statements. Also, the cumulative effect of the change on prior years' income (net of tax effect) must be shown on the income statement for the year of the change below "Income from continuing operations".

• Prior period adjustments consist of errors in previously published financial statements. Prior period adjustments appear (net-of-tax effect) as a correction to the beginning retained earnings balance on the statement of retained earnings.

• EPS equals the income available to common stockholders divided by the weighted-average number of common shares outstanding. Income available to common stockholders is net income less any dividends on preferred stock. EPS provides information on the return of an investment in common stock.

• The price-earnings ratio equals the current market price per share of common stock divided by EPS. The price-earnings ratio indicates whether a stock has a future high income potential as compared to other stocks.