14.2 Dividends and Retained Earnings

Dividends and Retained Earnings

Retained Earnings and Appropriations

Retained earnings represent the cumulative earned capital of a corporation that has not been distributed to stockholders. It is increased by net income and decreased by net losses and dividend declarations.

• Appropriations of Retained Earnings (ASC 505-10): The board of directors may restrict a portion of retained earnings (appropriation) for specific purposes, such as future factory expansion, legal contingencies, or debt covenants. Journal Entry:

  Debit: Retained Earnings
    Credit: Retained Earnings Appropriated for Plant Expansion
  

  Key Concept: Appropriations are a disclosure and reclassification mechanism within equity. They do not involve setting aside cash, do not create an expense, and do not affect Net Income or total Stockholders' Equity. They simply signal to shareholders that a portion of retained earnings is unavailable for dividend distributions. When the restriction is lifted, the entry is reversed.

Key Dates in Dividend Distribution

There are three critical dates for any dividend distribution:

1. Declaration Date: The date the board of directors formally votes to approve the dividend. On this date, the dividend becomes a legal liability of the corporation. Journal Entry:

   Debit: Retained Earnings (or Dividends Declared)
     Credit: Dividends Payable (a current liability)
   

2. Date of Record: The date established by the board to determine which shareholders own the stock and are eligible to receive the dividend. Shares must be owned by the close of business on this day. Journal Entry: No entry is recorded in the accounting records.
3. Payment Date: The date the corporation actually distributes the cash or assets to the eligible shareholders. Journal Entry:

   Debit: Dividends Payable
     Credit: Cash
   

Cash Dividends

Cash dividends are distributions of cash to shareholders. A corporation must have sufficient retained earnings and cash to declare and pay a cash dividend. The accounting entries follow the three key dates described above.

Property Dividends (Dividends in Kind)

A property dividend is a distribution of corporate assets other than cash (e.g., inventory, land, or investments in other companies' stock) to shareholders. Under US GAAP:

• Remeasurement at Declaration: On the declaration date, the property to be distributed must be remeasured to its fair value. Any gain or loss arising from this remeasurement is recognized in current earnings (Income Statement). Journal Entry (Appreciation):

  Debit: Investment in Corporate Bonds (Asset)
    Credit: Gain on Appreciation of Investment (Income Statement)
  

• Dividend Declaration: The dividend is recorded as a liability and a reduction in Retained Earnings at the asset's fair value.

  Debit: Retained Earnings
    Credit: Property Dividends Payable
  

• Dividend Distribution: Upon distribution, the liability is debited and the remeasured asset is credited.

  Debit: Property Dividends Payable
    Credit: Investment in Corporate Bonds
  

Stock Dividends

A stock dividend is a distribution of additional shares of the corporation's own stock to existing shareholders on a pro-rata basis. Stock dividends do not change the assets, liabilities, or total stockholders' equity of the company; they merely reshuffle amounts within the equity section. The accounting treatment depends on the size of the dividend:

1. Small Stock Dividends (< 20% to 25% of Outstanding Shares)

Under GAAP, stock dividends of less than 20-25% of outstanding shares are assumed to have a minimal impact on the market price of the stock. Therefore, they are recorded at the fair value of the shares on the declaration date. Retained Earnings is reduced by the fair value of the shares to be issued.

• On Declaration Date:

  Debit: Retained Earnings (Fair Value * Shares to Issue)
    Credit: Common Stock Distributable (Par Value * Shares to Issue)
    Credit: Additional Paid-in Capital - Common Stock (Excess)
  

• On Issuance Date:

  Debit: Common Stock Distributable
    Credit: Common Stock
  

2. Large Stock Dividends (> 20% to 25% of Outstanding Shares)

Stock dividends exceeding 20-25% are expected to significantly reduce the market price of the stock. To avoid double-counting fair value, GAAP requires that large stock dividends be capitalized at par value.

• On Declaration Date:

  Debit: Retained Earnings (Par Value * Shares to Issue)
    Credit: Common Stock Distributable (Par Value * Shares to Issue)
  

• On Issuance Date:

  Debit: Common Stock Distributable
    Credit: Common Stock
  

Stock Splits

A stock split is an increase in the number of shares outstanding with a proportional reduction in the par value per share. For example, in a 3-for-1 stock split, a shareholder who owned 100 shares of $15 par stock will now own 300 shares of $5 par stock.

• Accounting Treatment: No journal entry is required. The total dollar amounts in the Common Stock, APIC, and Retained Earnings accounts remain unchanged. Only a memorandum entry is made to update the number of shares and the par value per share.
• Stock Split in the Form of a Dividend: If a stock split is legally structured as a stock dividend under state law, the par value is not reduced. The transaction is accounted for as a large stock dividend, capitalizing Retained Earnings at the par value of the new shares issued.

Comparative Impact of Equity Transactions

The following table summarizes the financial statement impact of various distributions:

\Note: Property dividend declaration increases or decreases assets during the initial write-up or write-down to fair value, then decreases equity via Retained Earnings.