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.
Buying treasury stock
Before I started studying accounting, I thought treasury stock had something to do with investments offered by the U.S. government. When I took my first financial accounting class, I learned I was dead wrong. Treasury stock is a term given to shares of corporate stock previously sold to investors and then bought back by the issuing corporation.
You record treasury stock on the balance sheet as a contra stockholders’
equity account. Contra accounts carry a balance opposite to the normal account balance. Because equity accounts normally have a credit balance, a contra equity account weighs in with a debit balance.
Under generally accepted accounting principles (GAAP), it is not appropriate to record any sort of gain or loss on treasury stock transactions.
One reason a corporation may buy back shares of its own stock is to prevent a hostile takeover. The fewer shares trading in the open market, the smaller the chance that a controlling interest in the corporation could be purchased by another company.
Learning about Stock Splits
One other type of stock transaction that does not reduce retained earnings is a stock split. A stock split increases the number of shares outstanding by issu- ing more shares to current stockholders proportionally by the amount they already own. Stock splits are typically done when a company believes the trading price of its stock is too high; the split reduces the price per share.
For example, Penway Manufacturing Corporation stock is trading for $100, and the company thinks this high price affects the average investor’s desire to purchase the stock. To get the price of the stock down to $25 per share, the company would issue a 4-for-1 split. Every outstanding share would now be equal to four shares.
The common stock caption, which is the descriptive line on the balance sheet, changes to reflect the split on the books. If the caption originally read
“Common stock, 1,000 shares at $100 par,” it now reads “Common stock, 4,000 shares at $25 par.” Note that the total dollar value remains the same —
$100,000 — so there is no reduction to retained earnings.
Accounting for Accumulated Other Comprehensive Income
It may seem weird to have an item of income showing up on the balance sheet. After all, isn’t that what the income statement is for? Too true — however, revenue, expenses, gains, and losses that under GAAP are part of comprehensive income but not included on the income statement show up in the equity section on the balance sheet.
Your financial accounting textbook will not delve into this subject at any great length. But if you have a basic knowledge of the following two exam- ples, you’ll be way ahead of the game for this part of your financial account- ing class:
✓ Unrealized gain or loss from foreign currency translation: This situa- tion occurs if the corporation has a foreign subsidiary and its financial statements are combined with the U.S. parent company. During the com- bination, the currency of the company in which the subsidiary operates has to be converted to U.S. dollars. The gain or loss on the conversion reflects in this category.
✓ Unrealized gain or loss on available-for-sale investments: These are investments in other companies’ stocks or bonds (see Chapter 8).
Originally, you record the purchase of the investment at its cost. After that, a company periodically adjusts the value of the investment on its books to match fair market value, which is what the stocks or bonds are trading for in the open marketplace.
If fair market value is more than cost, the value of the investment on the balance sheet and accumulated other comprehensive income increases.
When fair market value is less than cost, the value of the investment and accumulated other comprehensive income decreases.
Seeing a Sample Equity Section of the Balance Sheet
Figure 9-3 shows you how to prepare the equity section of a balance sheet for a corporation. While assets and liabilities are merely a line item in Figure 9-3, you can go to Chapter 7 to see the asset section fully developed, and Chapter 8 shows the liability section in all its debt-filled glory!
First up is always an accounting of stock. As you can see from the captions, the corporation has issued 100 shares of preferred and 250 shares of common stock. Additional paid-in capital of $4,500 means that investors paid $4,500 over par value for shares purchased. Retained earnings tells us that the corporation has $8,000 of earned capital from the day it opened its doors to December 31, 2012. Plus, the corporation has lost a bit of money on invest- ment sales and foreign currency transactions. Finally, the balance in treasury stock tells you that the company purchased back some of its shares of stock.
Figure 9-3:
The equity section of a balance sheet.
Total Assets Total Liabilities Stockholders’ Equity Capital Stock
Total Liabilities & Equity
Preferred stock, 5%, $15 par value, cumulative, 100 shares authorized, issued and outstanding.
Common stock, $75 par value, 500 shares authorized, 250 shares issued at December 31, 2012 Additional paid-in capital
Retained earnings
Accumulated other comprehensive income (loss):
Net unrealized loss on available for sale investments Unrealized loss from foreign currency translation Less: Treasury stock
Total Stockholders’ Equity
1,500.00 18,750.00 4,500.00 8,000.00 (7,500.00) (3,971.12) (5,000.00) 16,278.88 75,245.00 75,245.00 58,966.12