Chapter Reserves: Retained Earnings Review Questions The character of preference shares can be altered by being cumulative or noncumulative, participating or nonparticipating, convertible or nonconvertible, and/or callable or noncallable The dividend policy of a company is influenced by (1) the availability of cash, (2) the stability of earnings, (3) current earnings, (4) prospective earnings, (5) the existence or absence of contractual restrictions on working capital or retained earnings, and (6) a retained earnings balance In declaring a dividend, the board of directors must consider the condition of the corporation such that a dividend is (1) legally permissible and (2) economically sound In general, directors should give consideration to the following factors in determining the legality of a dividend declaration: Retained earnings, unless legally encumbered in some manner, is usually the correct basis for dividend distribution Revaluation capital is seldom the correct basis for dividends (except possibly share dividends) Additional paid-in capital may be used for dividends, although such dividends may be limited to preference shares Deficits in retained earnings and debits in paid-in capital accounts must be restored before payment of any dividends Dividends may not reduce retained earnings below the cost of treasury shares held In order that dividends be economically sound, the board of directors should consider: (1) the availability (liquidity) of assets for distribution; (2) agreements with creditors; (3) the effect of a dividend on investor perceptions (e.g maintaining an expected “pay-out ratio”); and (4) the size of the dividend with respect to the possibility of paying dividends in future bad years In addition, the ability to expand or replace existing facilities should be considered 2 Chapter Dividends, at least cash dividends, are paid out of working capital A balance must exist in retained earnings to permit a legal distribution of profits, but having a balance in retained earnings does not ensure the ability to pay a dividend if the cash situation does not permit it A cash dividend is a distribution in cash while a property dividend is a distribution in assets other than cash Dividends payable in assets of the corporation other than cash are called property dividends Any dividend not based on retained earnings is a liquidating dividend A share dividend is the issuance of additional shares of the corporation in a nonreciprocal exchange involving existing shareholders with no change in the par or stated value A share dividend results in the transfer from retained earnings to paid-in capital of an amount equal to the market value of each share (if the dividend is less than 20-25%) or the par value of each share (if the dividend is greater than 20-25%) No formal journal entries are required for a share split, but a notation in the ledger accounts would be appropriate to show that the par value of the shares has changed Retained earnings are restricted because of legal or contractual restrictions, or the necessity to protect the working capital position Restrictions are best disclosed in a note to the financial statements This allows a more complete explanation of the restriction Exercises Exercise Aug Aug 15 Sept Retained Earnings 3,000,000 Dividends Payable 3,000,000 No entry Dividends Payable 3,000,000 Cash 3,000,000 Reserves: Retained Earnings Exercise Sept 21 Available-for-Sale Securities 525,000 Gain on Appreciation of Securities 525,000 Retained Earnings 1,400,000 Property Dividends Payable 1,400,000 Oct No entry Oct 23 Property Dividends Payable 1,400,000 Available-for-Sale Securities 1,400,000 Exercise Declaration Date Retained Earnings 650,000 Ordinary Share Dividend Distributable 100,000 Paid-in Capital in Excess of Par 550,000 (10,000 X P65 = P650,000; (10,000 X P10 = P100,000) Distribution Date Ordinary Share Dividend Distributable 100,000 Ordinary Shares 100,000 4 Chapter Exercise Item Assets Liabilitie s Equity Paid-in Capital Retained Earnings Net Income I NE I NE I I NE I D NE D NE NE NE NE NE NE NE NE NE NE NE NE NE D NE D NE D D D D NE NE NE NE NE I D NE D D NE NE NE I D NE NE NE NE NE NE NE Exercise (a) 6/1 Retained Earnings Dividends Payable 6/14 No entry on date of record 6/30 Dividends Payable Cash 8,000,000 8,000,000 8,000,000 8,000,000 (b) If this were a liquidating dividend, the debit entry on the date of declaration would be to Paid-in Capital rather than Retained Earnings (c) One may observe that paying a dividend to the corporation is rather circular It does raise some potential for misdirection However, this scenario would simplify the routine cash disbursement to the registrar which acts as the dividend disbursing agent The dividend is not income, rather it is a correction Cash 240,000 Retained Earnings 240,000 Reserves: Retained Earnings Exercise (a) (b) Retained Earnings (15,000 X P37) Ordinary Share Dividend Distributable Paid-in Capital in Excess of Par 555,000 Ordinary Share Dividend Distributable Ordinary Share Capital 150,000 150,000 405,000 150,000 Retained Earnings (300,000 X P10) Ordinary Share Dividend Distributable 3,000,000 Ordinary Share Dividend Distributable Ordinary Share Capital 3,000,000 (c) 3,000,000 3,000,000 No entry, the par becomes P5.00 and the number of shares outstanding increases to 600,000 Exercise Total income since corporation Less: Total cash dividends paid Total value of share dividends Current balance of retained earnings P317,000 P60,000 30,000 90,000 227,000 Exercise Event a b c d e Current Assets I NE NE D NE Equity I I NE D I Net Income NE NE NE NE NE Net Cash Flow (from Any Source) I NE NE D NE 6 Chapter Exercise The error would be reported as an adjustment to the beginning Retained Earnings balance in the 2008 statement of retained earnings or statement of changes in equity Retained earnings, January 1, 2008 P 86,500 Adjustment for depreciation error in 2007 (36,000) Retained earnings, adjusted, January 1, 2008 P 50,500 Net income 106,000 Dividends (30,000) Retained earnings, December 31, 2008 P 126,500 Exercise 10 (1) Calculation of number of shares outstanding: Jan Feb May 1 12 June 15 800,000 shares 550,000 shares 100,000 shares (1,000 100) 950,000 shares 104,500 shares (950,000 0.11) 1,054,500 shares outstanding Amount to be paid in dividends for the third quarter, 1,054,500 P1.50 = P1,581,750 (2) Total dividends for 2007: Mar June, Sept., and Dec = = P1.50 850,000 = P1,581,750 = P1,275,000 4,745,250 P6,020,250 Exercise 11 Retained Earnings Share Dividends Distributable Declaration of 25% share dividend; transfer at stated value 20,000 20,000 Share Dividends Distributable Ordinary Shares, P1 stated value 20,000 20,000 Reserves: Retained Earnings Issuance of share dividend The issuance of the share dividend had no effect on each shareholder in the corporation For each representing an equity of P19.375 (P1,550,000 shareholder now holds 1¼ shares, representing an (P1,550,000 ÷ 100,000 shares), or P19.375 the ownership equity of share previously held ÷ 80,000 shares), the equity of 1¼ P15.50 Retained Earnings 120,000 Share Dividends Distributable Paid-In Capital in Excess of Stated Value Declaration of 15% share dividend; transfer at market value Share Dividends Distributable Ordinary Shares, P1 stated value Issuance of share dividend Test Material Test Material 9-1 12,000 108,000 12,000 12,000 8 Chapter P 736,000 a Total dividends paid in third year Dividends on 9% cumulative preference shares: P 360,000 Dividends (P50 09 40,000 years) 180,000 Current year’s dividend (P50 09 40,000) Total paid on 9% cumulative preference shares P 540,000 Dividends on 12% noncumulative preference shares: 96,000 636,000 Current year’s dividend (P100 12 8,000) Dividends on ordinary shares in third year P 100,000 b Dividends per share: P 13.50 per share Preference shares, 9% cumulative (P540,000 40,000 shares) P 12.00 per share Preference shares, 12% noncumulative (P96,000 8,000 shares) P 0.25 per share Ordinary shares (P100,000 400,000 shares) c The equity section of the balance sheet reports no additional paid-in capital Thus, the preference shares must have been issued at their respective par values (P50 per share for the 9% cumulative preference shares, and P100 per share for the noncumulative preference shares) Reserves: Retained Earnings Test Material 9-2 JFC Corporation EQUITY December 31, 2008 Paid-in Capital: Preference shares, P100 par value 10,000 shares authorized, 4,000 shares issued & outstanding Ordinary shares, P50 par value 15,000 shares authorized, 8,000 shares issued 7,700 shares outstanding Additional Paid-in Capital: Paid-in capital in excess of par— Preference Paid-in capital in excess of par— ordinary Paid-in capital from treasury shares— Preference Total Paid-in Capital Retained Earnings: Less cost of treasury shares (300 shares—ordinary) Total Equity *P610,000 – P312,600 – P62,000 P400,000 400,000 P 800,000 52,000 61,000 4,700 117,700 917,700 235,400* 1,153,100 19,800 P1,133,300 10 Chapter ...2 Chapter Dividends, at least cash dividends, are paid out of working capital A balance must exist in retained earnings to permit a legal distribution of profits, but having a... assets of the corporation other than cash are called property dividends Any dividend not based on retained earnings is a liquidating dividend A share dividend is the issuance of additional shares of. .. from retained earnings to paid-in capital of an amount equal to the market value of each share (if the dividend is less than 20-25%) or the par value of each share (if the dividend is greater