Corporations: Paid-in Capital, Retained Earnings, Dividends, and Treasury Stock
Read this chapter, which outlines the different sources of paid-in capital and how they are presented on the balance sheet. This chapter also covers treasury stock, dividends, stock splits, and price-per-share and price-per-earnings ratios.
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:
Appropriation per loan agreement (+SE) 25,000
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:
Retained earnings (+SE) 25,000
To return balance in appropriation per Loan
On the balance sheet, retained earnings appropriations appear in the
stockholders' equity section as follows:
Preferred stock – 8%, $50 par value; 500
shares authorized; issued and outstanding
Common stock - $5 par value; 10,000
shares authorized, issued and outstanding
|Total paid-in capital
|Per loan agreement
Total retained earnings
Total stockholders' equity
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
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.