GAAP dictate that you properly describe stock transactions on the balance sheet. To follow are the proper balance sheet descriptions for preferred and common stock:
✓ Preferred: Preferred stock, 5%, $200 par value, cumulative, 30,000 shares authorized, issued, and outstanding.
Because preferred stock has a debt-like characteristic, the amount of return the corporation has to pay is printed on each share. In this description it is 5 percent. The face value per the corporate charter is
$200. The limit for the number of shares the corporation can have out- standing is 30,000. All 30,000 are sold to investors.
✓ Common: Common stock, $5 par value, 500,000 shares authorized, 250,000 shares issued at December 31, 2012.
This means the par value of the stock in the corporate articles of incor- poration is $5 (remember this is usually an arbitrary number), the total number of shares the corporate can have outstanding is 500,000, and as of December 31, 2012, 250,000 shares have been sold to investors.
Recording Retained Earnings
The retained earnings account on the balance sheet shows the company’s total net income or loss from the first day it was in business to the date on the balance sheet. (See Chapter 10 for information on how to calculate net income or loss.) While paid-in capital is money contributed by the sharehold- ers, retained earnings is earned capital.
Keep in mind that retained earnings are reduced by dividends: earnings paid to shareholders based upon the number of shares they own. I discuss dividends in the next section.
For example, your company opens its doors on January 2, 2012. On January 2, retained earnings is 0 because the company didn’t previously exist. From January 2 to December 31, 2012, your company has a net income of $20,000 and pays out $5,000 in dividends.
On January 1, 2013, the retained earnings amount is $15,000 ($20,000 – $5,000).
Then, to figure retained earnings as of January 1, 2014, you start with $15,000 and add or subtract the amount of income the company made or lost during 2013 (and subtract out any dividends paid).
For a sole proprietorship or partnership, no distinction is usually made between the capital accounts and retained earnings.
Spotting Reductions to Stockholders’ Equity
Your financial accounting textbook probably discusses two different account- ing transactions (besides the net loss calculation) that reduce stockhold- ers’ equity: dividends and treasury stock. Though both transactions reduce equity, they are completely different types of accounts. While you may be scratching your head wondering what treasury stock is all about, you may be somewhat familiar with dividends. Don’t worry! I thoroughly explain both in this section.
Corrections of accounting errors made in prior periods and discovered in the current period also reduce equity. However, this topic relates to auditing and is probably given a paragraph at most in your financial accounting textbook.
To make sure I cover all the bases, I discuss this topic in Chapter 20.
Paying dividends
Dividends are distributions of company earnings to the shareholders. They can be made in the form of cash (yeah!) or in the form of stock. For me, get- ting stock dividends isn’t quite as exciting as getting a check in the mail.
However, stock dividends can be quite profitable in the long run when the investor finally gets around to selling the shares.
Dividends are not an expense of doing business. They are a balance sheet transaction only, serving to reduce both cash (in the case of cash dividends) and retained earnings.
Here’s an explanation of both cash and stock dividends:
✓ Cash dividends: Shareholders of record receive money in the form of cash or electronic transfer based upon how many shares of stock they own. For a company to pay cash dividends, two conditions have to be met:
• The company has positive retained earnings.
• The company has enough ready cash to pay the dividends.
For example, you own 1,500 shares of common stock in Penway Manufacturing Corporation. Penway has both a surplus of cash and positive retained earnings so the board of directors decides to pay a cash dividend of $12 per share. Your dividend is $18,000 (1,500 shares times $12).
✓ Stock dividends: While no money immediately changes hands, issuing stock dividends operates the same way as cash dividends: Each share- holder of record gets a certain number of extra shares of stock based on how many shares she already owns. This type of dividend is expressed as a percentage rather than a dollar amount. For example, if you receive a stock dividend of 5 percent on your Penway shares, you’ll receive an additional 75 shares of stock (1,500 × .05).
The reduction to retained earnings for a cash dividend is very straightfor- ward: You reduce retained earnings by the amount of the dividend. But what about when the company issues a stock dividend? No money changes hands, so you may be wondering how this dividend affects retained earnings. Well, read on!
Here’s an example of a typical financial accounting class assignment or test question you may encounter testing your knowledge of handling this type of transaction:
Penway declares a 5 percent stock dividend at a time when it has 30,000 shares of $10 par value common stock outstanding. At the date of decla- ration of the stock dividend, the fair market value (FMV) of the stock was
$15. (Fair market value is what an unpressured person would pay for the stock in an open marketplace.) How is the company’s retained earnings account affected by this dividend?
The stock dividend totals 1,500 shares (5 percent × 30,000 shares). The net effect is to decrease retained earnings by $22,500 (1,500 × FMV of $15 per share) and increase common stock dividends distributable by $15,000 (par value of $10 × 1,500 shares). Additional paid-in capital increases by the differ- ence between the two figures: $7,500.
When Penway issues the stock dividend, common stock increases by $15,000 and the common stock dividends distributable reduces to zero.
Corporations issue stock dividends when they are low in operating cash but still want to throw the investors a bone. The investors stay happy because they feel they are getting more of a return on their investment.