Van Meter Industrial, Inc., an electrical-parts distributor in Cedar Rapids, Iowa, is 100% employee-owned. For many years, the company has issued bonuses in the form of shares of company stock to all of its employees. These bonus distributions typically have a value equal to several weeks of pay. Top management always thought that this was a great program. Therefore, it came as quite a surprise a few years ago when an employee stood up at a company-wide meeting and said that he did not see any real value in receiving the company's shares. Instead, he wanted “a few hundred extra bucks for beer and cigarettes.”
As it turned out, many of the company's 340 employees felt this way. Rather than end the stock bonus program, however, the company decided to educate its employees on the value of share ownership. The employees are now taught how to determine the worth of their shares, the rights that come with share ownership, and what they can do to help increase the value of those shares.
As part of the education program, management developed a slogan, “Work ten, get five free.” The idea is that after working 10 years, an employee's shares would be worth the equivalent of about five years’ worth of salary. For example, a person earning a $30,000 salary would earn $300,000 in wages over a 10-year period. During that same 10-year period, it was likely that the value of the employee's shares would accumulate to about $150,000 (five years’ worth of salary). This demonstrates in more concrete terms why employees should be excited about share ownership.
A 12-member employee committee has the responsibility of educating new employees about the program. The committee also runs training programs so that employees understand how their cost-saving actions improve the company's results—and its stock price. It appears that the company's education program to encourage employees to act like owners is working. Profitability has increased rapidly, and employee turnover has fallen from 18% to 8%. Given Van Meter's success, many of the 10,000 other employee-owned companies in the United States might want to investigate whether their employees understand the benefits of share ownership.
Source: Adapted from Simona Covel, “How to Get Workers to Think and Act Like Owners,” Wall Street Journal Online (February 15, 2008).
Preview of Chapter 14
As indicated in the Feature Story, a profitable corporation like Van Meter Industrial, Inc. can provide real benefits to employees through its stock bonus plan. And as employees learn more about the role of dividends, retained earnings, and earnings per share, they develop an understanding and appreciation for what the company is providing to them.
The content and organization of Chapter 14 are as follows.
A dividend is a corporation's distribution of cash or stock to its stockholders on a pro rata (proportional to ownership) basis. Pro rata means that if you own 10% of the common shares, you will receive 10% of the dividend. Dividends can take four forms: cash, property, scrip (a promissory note to pay cash), or stock. Cash dividends predominate in practice. Also, companies declare stock dividends with some frequency. These two forms of dividends are the focus of discussion in this chapter.
Investors are very interested in a company's dividend practices. In the financial press, dividends are generally reported quarterly as a dollar amount per share. (Sometimes they are reported on an annual basis.) For example, Nike's quarterly dividend rate in the fourth quarter of 2011 was 36 cents per share. The dividend rate for the fourth quarter of 2011 for GE was 15 cents, and for ConAgra Foods it was 24 cents.
A cash dividend is a pro rata distribution of cash to stockholders. Cash dividends are not paid on treasury shares. For a corporation to pay a cash dividend, it must have the following.
A dividend declared out of paid-in capital is termed a liquidating dividend. Such a dividend reduces or “liquidates” the amount originally paid in by stockholders. Statutes vary considerably with respect to cash dividends based on paid-in capital in excess of par or stated value. Many states permit such dividends.
Before declaring a cash dividend, a company's board of directors must carefully consider both current and future demands on the company's cash resources. In some cases, current liabilities may make a cash dividend inappropriate. In other cases, a major plant expansion program may warrant only a relatively small dividend.
The amount and timing of a dividend are important issues for management to consider. The payment of a large cash dividend could lead to liquidity problems for the company. On the other hand, a small dividend or a missed dividend may cause unhappiness among stockholders. Many stockholders expect to receive a reasonable cash payment from the company on a periodic basis. Many companies declare and pay cash dividends quarterly. On the other hand, a number of high-growth companies pay no dividends, preferring to conserve cash to finance future capital expenditures.
Three dates are important in connection with dividends: (1) the declaration date, (2) the record date, and (3) the payment date. Normally, there are two to four weeks between each date. Companies make accounting entries on the declaration date and the payment date.
On the declaration date, the board of directors formally declares (authorizes) the cash dividend and announces it to stockholders. The declaration of a cash dividend commits the corporation to a legal obligation. The company must make an entry to recognize the increase in Cash Dividends and the increase in the liability Dividends Payable.
To illustrate, assume that on December 1, 2014, the directors of Media General declare a 50 cents per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is $50,000 (100,000 × $0.50). The entry to record the declaration is:
Media General debits the account Cash Dividends. Cash dividends decrease retained earnings. We use the specific title Cash Dividends to differentiate it from other types of dividends, such as stock dividends. Dividends Payable is a current liability. It will normally be paid within the next several months. When using a Cash Dividends account, the company transfers the balance of that account to Retained Earnings at the end of the year by a closing entry. For homework problems, you should use the Cash Dividends account for recording dividend declarations.
At the record date, the company determines ownership of the outstanding shares for dividend purposes. The stockholders’ records maintained by the corporation supply this information. In the interval between the declaration date and the record date, the corporation updates its stock ownership records. 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.
On the payment date, the company makes cash dividend payments to the stockholders of record (as of December 22) and records the payment of the dividend. If January 20 is the payment date for Media General, the entry on that date is:
Note that payment of the dividend reduces both current assets and current liabilities. It has no effect on stockholders’ equity. The cumulative effect of the declaration and payment of a cash dividend is to decrease both stockholders’ equity and total assets. Illustration 14-1 (page 652) summarizes the three important dates associated with dividends for Media General.
Helpful Hint The purpose of the record date is to identify the persons or entities that will receive the dividend, not to determine the amount of the dividend liability.
As explained in Chapter 13, preferred stock has priority over common stock in regard to dividends. Holders of cumulative preferred stock must be paid any unpaid prior-year dividends and their current year's dividend before common stockholders receive dividends.
To illustrate, assume that at December 31, 2014, IBR Inc. has 1,000 shares of 8%, $100 par value cumulative preferred stock. It also has 50,000 shares of $10 par value common stock outstanding. The dividend per share for preferred stock is $8 ($100 par value × 8%). The required annual dividend for preferred stock is therefore $8,000 (1,000 shares × $8). At December 31, 2014, the directors declare a $6,000 cash dividend. In this case, the entire dividend amount goes to preferred stockholders because of their dividend preference. The entry to record the declaration of the dividend is:
Because of the cumulative feature, dividends of $2 ($8 − $6) per share are in arrears on preferred stock for 2014. IBR must pay these dividends to preferred stockholders before it can pay any future dividends to common stockholders. IBR should disclose dividends in arrears in the financial statements.
At December 31, 2015, IBR declares a $50,000 cash dividend. The allocation of the dividend to the two classes of stock is as follows.
The entry to record the declaration of the dividend is:
If IBR's preferred stock is not cumulative, preferred stockholders receive only $8,000 in dividends in 2015. Common stockholders receive $42,000.
ACCOUNTING ACROSS THE ORGANIZATION
Up, Down, and ??
The decision whether to pay a dividend, and how much to pay, is a very important management decision. As the chart below shows, from 2002 to 2007, many companies substantially increased their dividends. Total dividends paid by U.S. companies hit record levels. One reason for the increase is that Congress lowered, from 39% to 15%, the tax rate paid by investors on dividends received, making dividends more attractive to investors.
Then the financial crisis of 2008 occurred. As result, in 2009, 804 companies cut their dividends (see chart) at the highest rate since the S&P started collecting data in 1995. In 2010, more companies started increasing their dividends. However, potential higher taxes on dividends in the future and the possibility of a low-growth economy may stall any significant increase.
Source: Matt Phillips and Jay Miller, “Last Year's Dividend Slash Was $58 Billion,” Wall Street Journal (January 8, 2010), p. C5.
What factors must management consider in deciding how large a dividend to pay? (See page 681.)
DO IT!
Dividends on Preferred and Common Stock
MasterMind Corporation has 2,000 shares of 6%, $100 par value preferred stock outstanding at December 31, 2014. At December 31, 2014, the company declared a $60,000 cash dividend. Determine the dividend paid to preferred stockholders and common stockholders under each of the following scenarios.
1. The preferred stock is noncumulative, and the company has not missed any dividends in previous years.
2. The preferred stock is noncumulative, and the company did not pay a dividend in each of the two previous years.
3. The preferred stock is cumulative, and the company did not pay a dividend in each of the two previous years.
Determine dividends on preferred shares by multiplying the dividend rate times the par value of the stock times the number of preferred shares.
Understand the cumulative feature. If preferred stock is cumulative, then any missed dividends (dividends in arrears) and the current year's dividend must be paid to preferred stockholders before dividends are paid to common stockholders.
Solution
1. The company has not missed past dividends and the preferred stock is noncumulative. Thus, the preferred stockholders are paid only this year's dividend. The dividend paid to preferred stockholders would be $12,000 (2,000 × .06 × $100). The dividend paid to common stockholders would be $48,000 ($60,000 − $12,000).
2. The preferred stock is noncumulative. Thus, past unpaid dividends do not have to be paid. The dividend paid to preferred stockholders would be $12,000 (2,000 × .06 × $100). The dividend paid to common stockholders would be $48,000 ($60,000 − $12,000).
3. The preferred stock is cumulative. Thus, dividends that have been missed (dividends in arrears) must be paid. The dividend paid to preferred stockholders would be $36,000 (3 × 2,000 × .06 × $100). The dividend paid to common stockholders would be $24,000 ($60,000 − $36,000).
Related exercise material: E14-2 and DO IT!14-1.
A stock dividend is a pro rata (proportional to ownership) distribution of the corporation's own stock to stockholders. Whereas a company pays cash in a cash dividend, a company issues shares of stock in a stock dividend. A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. Unlike a cash dividend, a stock dividend does not decrease total stockholders’ equity or total assets.
To illustrate, assume that you have a 2% ownership interest in Cetus Inc. That is, you own 20 of its 1,000 shares of common stock. If Cetus declares a 10% stock dividend, it would issue 100 shares (1,000 × 10%) of stock. You would receive two shares (2% × 100). Would your ownership interest change? No, it would remain at 2% (22 ÷ 1,100). You now own more shares of stock, but your ownership interest has not changed.
Cetus has disbursed no cash and has assumed no liabilities. What, then, are the 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 the corporation's stock. When the number of shares outstanding increases, the market price per share decreases. Decreasing the market price of the stock makes it easier for smaller investors to purchase the shares.
3. To emphasize that a company has permanently reinvested in the business a portion of stockholders’ equity, which therefore is unavailable for cash dividends.
When the dividend is declared, the board of directors determines the size of the stock dividend and the value assigned to each dividend.
Generally, if the company issues a small stock dividend (less than 20–25% of the corporation's issued stock), the value assigned to the dividend is the fair value per share. This treatment is based on the assumption that a small stock dividend will have little effect on the market price of the shares previously outstanding. Thus, many stockholders consider small stock dividends to be distributions of earnings equal to the market price of the shares distributed. If a company issues a large stock dividend (greater than 20–25%), the price assigned to the dividend is the par or stated value. Small stock dividends predominate in practice. Thus, we will illustrate only entries for small stock dividends.
To illustrate the accounting for small stock dividends, assume that Medland Corporation has a balance of $300,000 in retained earnings. It declares a 10% stock dividend on its 50,000 shares of $10 par value common stock. The current market price of its stock is $15 per share. The number of shares to be issued is 5,000 (10% × 50,000). Therefore, the total amount to be debited to Stock Dividends is $75,000 (5,000 × $15). The entry to record the declaration of the stock dividend is as follows.
Medland debits Stock Dividends for the market price of the stock issued ($15 × 5,000). (Similar to Cash Dividends, Stock Dividends decrease retained earnings.) Medland also credits Common Stock Dividends Distributable for the par value of the dividend shares ($10 × 5,000) and credits Paid-in Capital in Excess of Par—Common Stock for the excess of the market price over par ($5 × 5,000).
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 the company prepares a balance sheet before it issues the dividend shares, it reports the distributable account under paid-in capital as shown in Illustration 14-3.
When Medland issues the dividend shares, it debits Common Stock Dividends Distributable and credits Common Stock, as follows.
How do stock dividends affect stockholders’ equity? They change the composition of stockholders’ equity because they transfer to paid-in capital a portion of retained earnings. However, total stockholders’ equity remains the same. Stock dividends also have no effect on the par or stated value per share. But the number of shares outstanding increases. Illustration 14-4 shows these effects for Medland Corporation.
In this example, total paid-in capital increases by $75,000 (50,000 shares × 10% × $15) and retained earnings decreases by the same amount. Note also that total stockholders’ equity remains unchanged at $800,000. The number of shares increases by 5,000 (50,000 × 10%).
A stock split, like a stock dividend, involves issuance of additional shares to stockholders according to their percentage ownership. However, a stock split results in a reduction in the par or stated value per share. The purpose of a stock split is to increase the marketability of the stock by lowering its market price per share. This, in turn, makes it easier for the corporation to issue additional stock.
The effect of a split on market price is generally inversely proportional to the size of the split. For example, after a 2-for-1 stock split, the market price of Nike's stock fell from $111 to approximately $55. The lower market price stimulated market activity. Within one year, the stock was trading above $100 again. Illustration 14-5 shows the effect of a 4-for-1 stock split for stockholders.
Helpful Hint A stock split changes the par value per share but does not affect any balances in stockholders’ equity.
In a stock split, the number of shares increases in the same proportion that par or stated value per share decreases. For example, in a 2-for-1 split, 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, or total stockholders’ equity. But, the number of shares outstanding increases, and par value per share decreases. Illustration 14-6 shows these effects for Medland Corporation, assuming that it splits its 50,000 shares of common stock on a 2-for-1 basis.
A stock split does not affect the balances in any stockholders’ equity accounts. Therefore, it is not necessary to journalize a stock split.
Illustration 14-7 summarizes the differences between stock splits and stock dividends.
INVESTOR INSIGHT
A No-Split Philosophy
Warren Buffett's company, Berkshire Hathaway, has two classes of shares. Until recently, the company had never split either class of stock. As a result, the class A stock had a market price of $97,000 and the class B sold for about $3,200 per share. Because the price per share is so high, the stock does not trade as frequently as the stock of other companies. Buffett has always opposed stock splits because he feels that a lower stock price attracts short-term investors. He appears to be correct. For example, while more than 6 million shares of IBM are exchanged on the average day, only about 1,000 class A shares of Berkshire are traded. Despite Buffett's aversion to splits, in order to accomplish a recent acquisition, Berkshire decided to split its class B shares 50 to 1.
Source: Scott Patterson, “Berkshire Nears Smaller Baby B's,” Wall Street Journal Online (January 19, 2010).
Why does Warren Buffett usually oppose stock splits? (See page 681.)
DO IT!
Stock Dividends and Stock Splits
Sing CD Company has had five years of record earnings. Due to this success, the market price of its 500,000 shares of $2 par value common stock has tripled from $15 per share to $45. During this period, paid-in capital remained the same at $2,000,000. Retained earnings increased from $1,500,000 to $10,000,000. President Joan Elbert is considering either a 10% stock dividend or a 2-for-1 stock split. She asks you to show the before-and-after effects of each option on retained earnings and total stockholders’ equity.
Action Plan
Calculate the stock dividend's effect on retained earnings by multiplying the number of new shares times the market price of the stock (or par value for a large stock dividend).
Recall that a stock dividend increases the number of shares without affecting total stockholders’ equity.
Recall that a stock split only increases the number of shares outstanding and decreases the par value per share.
Solution
Sing CD Company has had five years of record earnings. Due to this success, the market price of its 500,000 shares of $2 par value common stock has tripled from $15 per share to $45. During this period, paid-in capital remained the same at $2,000,000. Retained earnings increased from $1,500,000 to $10,000,000. President Joan Elbert is considering either a 10% stock dividend or a 2-for-1 stock split. She asks you to show the before-and-after effects of each option on retained earnings and total stockholders’ equity.
Related exercise material: BE14-3, E14-3, E14-4, E14-5, E14-6, E14-7, and DO IT! 14-2.
As you learned in Chapter 13, retained earnings is net income that a company retains in the business. The balance in retained earnings is part of the stockholders’ claim on the total assets of the corporation. It does not, though, represent a claim on any specific asset. Nor can the amount of retained earnings be associated with the balance of any asset account. For example, a $100,000 balance in retained earnings does not mean that there should be $100,000 in cash. The reason is that the company may have used the cash resulting from the excess of revenues over expenses to purchase buildings, equipment, and other assets.
To demonstrate that retained earnings and cash may be quite different, Illustration 14-8 shows recent amounts of retained earnings and cash in selected companies.
Remember from Chapter 13 that when a company has net income, it closes net income to retained earnings. The closing entry is a debit to Income Summary and a credit to Retained Earnings.
When a company has a net loss (expenses exceed revenues), it also closes this amount to retained earnings. The closing entry in this case is a debit to Retained Earnings and a credit to Income Summary. This is done even if it results in a debit balance in Retained Earnings. Companies do not debit net losses to paid-in capital accounts. To do so would destroy the distinction between paid-in and earned capital. If cumulative losses exceed cumulative income over a company's life, a debit balance in Retained Earnings results. A debit balance in Retained Earnings is identified as a deficit. A company reports a deficit as a deduction in the stockholders’ equity section, as shown in Illustration 14-9.
Helpful Hint Remember that Retained Earnings is a stockholders’ equity account, whose normal balance is a credit.
The balance in retained earnings is generally available for dividend declarations. Some companies state this fact. For example, Lockheed Martin Corporation states the following in the notes to its financial statements.
In some cases, there may be retained earnings restrictions. These make a portion of the retained earnings balance currently unavailable for dividends. Restrictions result from one or more of the following causes.
1. Legal restrictions. Many states require a corporation to restrict retained earnings for the cost of treasury stock purchased. The restriction keeps intact the corporation's legal capital that is being temporarily held as treasury stock. When the company sells the treasury stock, the restriction is lifted.
2. Contractual restrictions. Long-term debt contracts may restrict retained earnings as a condition for the loan. The restriction limits the use of corporate assets for payment of dividends. Thus, it increases the likelihood that the corporation will be able to meet required loan payments.
3. Voluntary restrictions. The board of directors may voluntarily create retained earnings restrictions for specific purposes. For example, the board may authorize a restriction for future plant expansion. By reducing the amount of retained earnings available for dividends, the company makes more cash available for the planned expansion.
Companies generally disclose retained earnings restrictions in the notes to the financial statements. For example, as shown in Illustration 14-11, Tektronix Inc., a manufacturer of electronic measurement devices, had total retained earnings of $774 million, but the unrestricted portion was only $223.8 million.
Suppose that a corporation has closed its books and issued financial statements. The corporation then discovers that it made a material error in reporting net income of a prior year. How should the company record this situation in the accounts and report it in the financial statements?
The correction of an error in previously issued financial statements is known as a prior period adjustment. The company makes the correction directly to Retained Earnings because the effect of the error is now in this account. The net income for the prior period has been recorded in retained earnings through the journalizing and posting of closing entries.
To illustrate, assume that General Microwave discovers in 2014 that it understated depreciation expense on equipment in 2013 by $300,000 due to computational errors. These errors overstated both net income for 2013 and the current balance in retained earnings. The entry for the prior period adjustment, ignoring all tax effects, is as follows.
A debit to an income statement account in 2014 is incorrect because the error pertains to a prior year.
Companies report prior period adjustments in the retained earnings statement.1 They add (or deduct, as the case may be) these adjustments from the beginning retained earnings balance. This results in an adjusted beginning balance. For example, assuming a beginning balance of $800,000 in retained earnings, General Microwave reports the prior period adjustment as follows.
Again, reporting the correction in the current year's income statement would be incorrect because it applies to a prior year's income statement.
The retained earnings statement shows the changes in retained earnings during the year. The company prepares the statement from the Retained Earnings account. Illustration 14-13 shows (in T-account form) transactions that affect retained earnings.
As indicated, net income increases retained earnings, and a net loss decreases retained earnings. Prior period adjustments may either increase or decrease retained earnings. Both cash dividends and stock dividends decrease retained earnings. The circumstances under which treasury stock transactions decrease retained earnings are explained in Chapter 13, page 623.
A complete retained earnings statement for Graber Inc., based on assumed data, is as follows.
DO IT!
Retained Earnings Statement
Vega Corporation has retained earnings of $5,130,000 on January 1, 2014. During the year, Vega earned $2,000,000 of net income. It declared and paid a $250,000 cash dividend. In 2014, Vega recorded an adjustment of $180,000 due to the understatement (from a mathematical error) of 2013 depreciation expense. Prepare a retained earnings statement for 2014.
Action Plan
Recall that a retained earnings statement begins with retained earnings, as reported at the end of the previous year.
Add or subtract any prior period adjustments to arrive at the adjusted beginning figure.
Add net income and subtract dividends declared to arrive at the ending balance in retained earnings.
Solution
Related exercise material: BE14-4, BE14-5, E14-8, E14-9, and DO IT! 14-3.
Illustration 14-15 (page 662) presents the stockholders’ equity section of Graber Inc.'s balance sheet. Note the following. (1) “Common stock dividends distributable” is shown under “Capital stock,” in “Paid-in capital.” (2) A note (Note R) discloses a retained earnings restriction.
Instead of presenting a detailed stockholders’ equity section in the balance sheet and a retained earnings statement, many companies prepare a stockholders’ equity statement. This statement shows the changes (1) in each stockholders’ equity account and (2) in total that occurred during the year. An example of a stockholders’ equity statement appears in Apple's financial statements in Appendix A.
Investors and analysts can measure profitability from the viewpoint of the common stockholder by the return on common stockholders’ equity. This ratio, as shown in Illustration 14-16, indicates how many dollars of net income the company earned for each dollar invested by the common stockholders. It is computed by dividing net income available to common stockholders (which is net income minus preferred stock dividends) by average common stockholders’ equity.
To illustrate, Walt Disney Company's beginning-of-the-year and end-of-the-year common stockholders’ equity were $31,820 and $30,753 million, respectively. Its net income was $4,687 million, and no preferred stock was outstanding. The return on common stockholders’ equity is computed as follows.
As shown on page 662, if a company has preferred stock, we would deduct the amount of preferred dividends from the company's net income to compute income available to common stockholders. Also, the par value of preferred stock is deducted from total stockholders’ equity when computing the average common stockholders’ equity.
Income statements for corporations are the same as the statements for proprietorships or partnerships except for one thing: the reporting of income taxes. For income tax purposes, corporations are a separate legal entity. As a result, corporations report income tax expense in a separate section of the corporation income statement, before net income. The condensed income statement for Leads Inc. in Illustration 14-17 shows a typical presentation. Note that the corporation reports income before income taxes as one line item and income tax expense as another.
Companies record income tax expense and the related liability for income taxes payable as part of the adjusting process. Using the data for Leads Inc., in Illustration 14-17, the adjusting entry for income tax expense at December 31, 2014, is:
The income statement of Apple (in Appendix A) presents another illustration of income taxes.
The financial press frequently reports earnings data. Stockholders and potential investors widely use these data in evaluating the profitability of a company. A convenient measure of earnings is earnings per share (EPS), which indicates the net income earned by each share of outstanding common stock.
The existence of preferred dividends slightly complicates the calculation of EPS. When a corporation has both preferred and common stock, we must subtract the current year's preferred dividend from net income, to arrive at income available to common stockholders. Illustration 14-18 shows the formula for computing EPS.
Ethics Note
In order to meet market expectations for EPS, some managers engage in elaborate treasury stock transactions. These transactions can be very costly for the remaining shareholders.
To illustrate, assume that Rally Inc. reports net income of $211,000 on its 102,500 weighted-average common shares.2 During the year, it also declares a $6,000 dividend on its preferred stock. Therefore, the amount Rally has available for common stock dividends is $205,000 ($211,000 − $6,000). Earnings per share is $2 ($205,000 ÷ 102,500). If the preferred stock is cumulative, Rally deducts the dividend for the current year, whether or not it is declared. Remember that companies report earnings per share only for common stock.
Investors often attempt to link earnings per share to the market price per share of a company's stock.3 Because of the importance of earnings per share, most companies must report it on the face of the income statement. Generally, companies simply report this amount below net income on the statement. For Rally Inc., the presentation is as follows.
DO IT!
Stockholder's Equity and EPS
On January 1, 2014, Siena Corporation purchased 2,000 shares of treasury stock. Other information regarding Siena Corporation is provided below.
Compute (a) return on common stockholders’ equity for each year and (b) earnings per share for each year, and (c) discuss the changes in each.
Determine return on common stockholders’ equity by dividing net income available to common stockholders by the average common stockholders’ equity.
Determine earnings per share by dividing net income available to common stockholders by the weighted-average number of common shares outstanding.
Solution
Related exercise material: BE14-6, BE14-7, BE14-9, BE14-10, E14-12, E14-13, E14-14, E14-15, E14-16, E14-17, and DO IT! 14-4.
Instructions
(a) Journalize the transactions and the closing entry for net income.
(b) Prepare a stockholders’ equity section at December 31.
Solution to Comprehensive DO IT!
Action Plan
Award dividends to outstanding shares only.
Adjust the par value and number of shares for stock splits but make no journal entry.
Use market price of stock to determine the value of a small stock dividend.
Close Income Summary to Retained Earnings.
1 Prepare the entries for cash dividends and stock dividends. Companies make entries for both cash and stock dividends at the declaration date and at the payment date. At the declaration date, the entries are: cash dividend—debit Cash Dividends and credit Dividends Payable; small stock dividend—debit Stock Dividends, credit Paid-in Capital in Excess of Par (or Stated Value)—Common Stock, and credit Common Stock Dividends Distributable. At the payment date, the entries for cash and stock dividends are: cash dividend—debit Dividends Payable and credit Cash; small stock dividend—debit Common Stock Dividends Distributable and credit Common Stock.
2 Identify the items reported in a retained earnings statement. Companies report each of the individual debits and credits to retained earnings in the retained earnings statement. Additions consist of net income and prior period adjustments to correct understatements of prior years’ net income. Deductions consist of net loss, adjustments to correct overstatements of prior years’ net income, cash and stock dividends, and some disposals of treasury stock.
3 Prepare and analyze a comprehensive stockholders’ equity section. A comprehensive stockholders’ equity section includes all stockholders’ equity accounts. It consists of two sections: paid-in capital and retained earnings. It should also include notes to the financial statements that explain any restrictions on retained earnings and any dividends in arrears. One measure of profitability is the return on common stockholders’ equity. It is calculated by dividing net income minus preferred stock dividends by average common stockholders’ equity.
4 Describe the form and content of corporation income statements. The form and content of corporation income statements are similar to the statements of proprietorships and partnerships with one exception: Corporations must report income taxes or income tax expense in a separate section before net income in the income statement.
5 Compute earnings per share. Companies compute earnings per share by dividing net income by the weighted-average number of common shares outstanding during the period. When preferred stock dividends exist, they must be deducted from net income in order to calculate EPS.
__________
1A complete retained earnings statement is shown in Illustration 14-14 on the next page.
2The calculation of the weighted average of common shares outstanding is discussed in advanced accounting courses.
3The ratio of the market price per share to the earnings per share is called the price/earnings (P/E) ratio. The financial media report this ratio for common stocks listed on major stock exchanges.