Corporations: Paid-in Capital, Retained Earnings, Dividends, and Treasury Stock
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:
| Stockholders' equity: | ||
| Paid-in capital: | ||
| Preferred stock – 6%, $100 par value; authorized, issued, and outstanding, 4,000 shares | $400,000 | |
| Common stock – no-par value, $5 stated value; authorized, issued, and outstanding, 400,000 shares | 2,000,000 | $2,400,000 |
| Paid-in capital - | ||
| From preferred stock issuances* | $ 40,000 | |
| From donations | 10,000 | 50,000 |
| Total paid-in capital | $2,450,000 | |
| Retained earnings | 500,000 | |
| Total stockholders' equity | $2,950,000 |
* 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:
| 2010 Jan. 21 | Retained earnings (-SE) | |
| Dividends payable (+L) | 2,000 | |
| Dividends declared: 2% on $100,000 of outstanding preferred stock, payable 2010 March 1, to stockholders of record on 2010 February 5. | 2,000 | |
| Mar. 1 | Dividends payable (-L) | |
| Cash (-A) | 2,000 | |
| Paid the dividend declared on 2010 January 21. | 2,000 |
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.
| Number of Companies | ||||
|---|---|---|---|---|
| Cash dividends paid to common stock shareholders | 2006 | 2005 | 2004 | 2003 |
| Per share amount disclosed in retained earnings statements | 213 | 219 | 229 | 239 |
| Per share amount not disclosed in retained earning statements | 157 | 135 | 156 | 164 |
| Total: | 370 | 354 | 385 | 403 |
| Cash dividends paid to preferred stock shareholders | ||||
| Per share amount disclosed in retained earnings statements | 22 | 22 | ||
| Per share amount not disclosed in retained earnings statements | 32 | 38 | ||
| Total: | 54 | 60 | ||
| **Dividends paid by pooled companies | X | X | X | X |
| Stock dividends | 4 | 6 | 4 | 12 |
| Dividends in kinds | 7 | 10 | 14 | 7 |
| Stock purchase rights | 1 | 4 | 7 | 9 |
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:
| Aug. 10 | Retained earnings (or Stock Dividends) (800shares x $125) (-SE) | 100,000 |
| Stock dividend distributable – Common (800 shares x $100) (+SE) | 80,000 | |
| Paid-In capital – Stock dividends (+SE) | 20,000 | |
| To record the declaration of a 10% stock dividend; shares to be distributed on 2010 September 20, to stockholders of record on 2010 August 31. |
This entry records the issuance of the shares:
| Sept. 20 | Stock dividends distributable – Common (-SE) | 80,000 |
| Common stock (+SE) | 80,000 | |
| To record the distribution of 800 shares of common stock as authorized in stock dividends declared on 2010 August 10. | 20,000 |
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:
| Stockholders' equity: | ||
| Paid-in capital: | ||
| Common stock - $100 par value; authorized, 20,000 shares; issued and outstanding, 8,000 shares | $800,000 | |
| Stock dividend distributable on 2010 September 20, 800 shares at par value | 80,000 | |
| Total par value of shares issued and to be issued | $880,000 | |
| Paid-in capital | 20,000 | |
| Total paid-in capital | $900,000 | |
| Retained earnings | 150,000 | |
| Total stockholders' equity | $1,050,000 |
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:
| Retained earnings (800 shares x $125) (-SE) | 100,000 |
| Stock dividends distributable – Common (800 shares x $50) (+SE) | 40,000 |
| Paid-in capital – stock dividends (800 shares x $75) (+SE) | 60,000 |
| To record the declaration of a stock dividend |
The entry to record the issuance of the stock dividend is:
| Stock dividend distributable – Common (-SE) | 40,000 |
| Common stock (+SE) | 40,000 |
| To record the issuance of the stock dividend. |
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
| Sept. 20 | Retained earnings (or Stock Dividends) (1,500 shares x $10) (-SE) | 15,000 |
| Stock dividend distributable – Common (+SE) | 15,000 | |
| To declare a 30% stock dividend. | ||
| Oct. 15 | Stock dividend distributable – Common (-SE) | 15,000 |
| Common stock (+SE) | 15,000 | |
| To issue the 30% stock dividend. |
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:
| Common stock - $20 par value (-SE) | 100,000 |
| Common stock - $10 par value (+SE) | 100,000 |
| To record a two- for-one stock split; 5,000 shares of $20 par value common stock were replaced by 10,000 shares of $10 par value common stock. |
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.
| Stock dividends: | Total Stockholders' equity | Common Stock | Paid-in Capital - common | Retained Earnings | Number of Shares outstanding | Par value Per share |
|---|---|---|---|---|---|---|
| Small | No effect | Increases | Increases* | Decreases | Increases | No effect |
| Large | No effect | Increases | No effect | Decreases | Increases | No effect |
| Stock splits | No effect | No effect | No effect | No effect | Increases | Decreases |
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.