Lecture #10: Corporate Dividends and Other Stock Transactions
1. Retained Earnings and Dividends.
Most state laws say that a corporation cannot pay cash dividends unless retained earnings are available. Even if a corporation had a credit balance for retained earnings, it must have enough cash on hand to pay the dividend. If a corporation has a credit balance for retained earnings and adequate cash, it still may not declare dividends, because it wants the cash for emergencies or to finance expansion of the business.
2. Stock Dividends.
Sometimes a corporation will distribute additional shares of its own stock to its stockholders without receiving any consideration from the stockholders. This type of distribution is called a stock dividend. A cash and stock dividends are different. A cash dividend transfers assets from the corporation to the stockholders. The corporation’s assets and stockholders’ equity both decrease. A stock dividend does not transfer assets from the corporation to the stockholders. No effect on the corporation’s assets or total stockholders’ equity . It does have an effect on the components of stockholders’ equity. For example:
On December 31, the board of directors declared a 10% (or 1,000 share) stock dividend distributed on January 20 to the stockholders. The market value of the stock is $15 per share.
To record the declaration of a 1,000 share common stock dividend.
The year-end closing entry for the Stock Dividends Declared account is:
The distribution of the stock on Jan. 20 is recorded as follows:
To record the distribution of a 1,000 share common stock dividend.
Now looking at Stockholders’ Equity:
The corporation’s assets do not change. However, you transferred $15,000 from retained earnings to the contributed capital accounts. You capitalized $15,000 of retained earnings. Why are stock dividends distributed? When the market price of the stock becomes too high, this can discourage some investors from buying the stock. Thus, the corporation may declare stock dividends to keep the price of its shares from increasing too much.
Stockholders also like stock dividends, because the corporation usually pays the same amount of dividends per share. For example, if I have 1,000 shares and the corporation declares a $1 per share dividend, then I will receive a check for $1,000. If the corporation declares a 10% stock dividend, then I will receive an extra 100 shares of stock. In the future if the corporation declares a $1 dividend, then I will receive a check for $1,100.
3. Stock Splits.
This is another technique to lower the stock price. For example, the corporation has outstanding $100 par value stock selling for $375 a share. The corporation wants to lower the market price. The corporation tells the stockholders to send their shares in. For each share an investor turns in, he will receive 4 new shares (for example) with a par value of $25. This will cause the market price of the stock to decrease and facilitate trading in this stock.
1. Corporations often re-acquire shares of their own stock.
When a corporation issues its stock and then reacquires this stock, then we call it treasury stock. It has to be the corporation’s own stock. If the corporation buys stock of another corporation, then this is investment.
2. When a corporation purchases its own stock, it reduces in equal amounts both its assets and its stockholders’ equity. For example, on May 1, Curry Corp. purchased 1,000 shares of its outstanding stock at $11.50 per share. The journal entry:
3. In most states, the sum of treasury stock and cash dividends cannot exceed the amount of the corporation’s retained earnings. The purchase of treasury stock does not reduce the balance of retained earnings. Instead the purchase places a restriction on the amount of retained earnings available for dividends.
4. Reissuing Treasury Stock.
The treasury stock may be reissued at cost, above cost, or below cost.
(a) If the treasury stock is sold at a price that is above cost, the amount received in excess of cost is credited to the Contributed Capital, Treasury Stock Transactions. For example, if Curry Corp. sells 500 treasury shares for $12 per share purchased at $11.50 per share, the entry to record the transaction is as follows:
(b) When treasury stock is reissued at a price below cost, then you debit the amount below cost to the Contributed Capital, Treasury Stock Transactions. For example, if Curry Corporation sells its remaining 500 shares of treasury stock at $10 per share, the entry to record the sale is:
Note: There was only a credit balance of $250 for the account, Contributed Capital, Treasury Stock Transactions. The remaining loss of this sale is debited to the Retained Earnings account. This is why some states put a restriction on corporations of purchasing treasury stock. Remember, the value of the treasury stock plus cash dividends cannot exceed the amount of retained earnings.
5. Retirement of Stock.
A corporation may purchase shares of its own stock in order to retire the stock rather than holding it as treasury stock. The purchased shares are permanently canceled upon receipt. This is only permissible if the interests of creditors and stockholders are not jeopardized. For example, assume a corporation originally issued its $10 par value common stock at $12 per share. If the corporation later purchased and retired 1,000 shares of this stock at $12 per share, then:
If on the other hand the corporation paid $11 per share instead of $12, the entry for the retirement is: (It originally sold the stock for $12 and buys it back for $11).
Or if the corporation paid $15 per share, the entry for the purchase and retirement is:
Reporting Income and Retained Earnings Information
The company’s single-step income statement will show revenues followed by a list of operating expenses, and finally by net income. However all business activities should be included that are not closely related to its continuing operations.
1. The first section is the standard single-step income statement.
2. Discontinued Operations.
Large companies often have several different lines of business operations or have several different classes of customers. The business may break-down the business activities, assets, and financial reports into segments, which reflects each segment. When a business sells or disposes of a business segment, the results of that segment must be separated and reported as you see in section 2. The separation allows investors to evaluate the financial statements better. (Please note, the numbers are reported as net of taxes).
3. Extraordinary Items.
This discloses gains and losses that are defined as extraordinary. To meet this definition, the item must be both unusual and infrequent. For example, a hurricane destroys one of your warehouses. The following items do not qualify as an extraordinary item.
4. Changes in Accounting Principles.
After a company chooses to use a particular accounting method, it must continue to use the same principle each period. This is required by the Consistency Principle. A company may change from one accounting principle to another as long it justifies the change as an improvement in financial reporting.
In this example, the company changed its method of depreciation for one asset. The $27,000 represents the gain of income of all the previous years before Dec. 31, 1990. The $18,000 is the gain in income after taxes are paid. The depreciation expense for this year would be listed under the first section.
5. Earnings per Share on the Income Statement.
In section 5, that earnings per share information is presented on the income statement for each of the categories.
Earnings per Share
Among the most commonly quoted statistics on the financial pages of daily newspapers is earnings per share of common stock. Investors use earnings per share data, when they evaluate the past performance of a corporation, project its future earnings, and weigh investment opportunities. Let us consider a company that has only common stock and nonconvertible preferred stock outstanding.
Convertible preferred stock is preferred stock that can be exchanged for the corporation’s common stock. This is a preferred stockholder’s option and makes the stock a more attractive investment. When a company has only common stock and nonconvertible preferred stock, we call this a simple capital structure. The formula:
Earning per share = (Net income - Preferred dividends) / Common shares outstanding
For example, a company earned $40,000 net income and paid its preferred dividends of $7,500. The company has 5,000 common shares outstanding and this number did not change during the year. The earnings per share this year is:
Earnings per share = ($40,000 - $7,500) / 5,000 = $6.50
This statistic is useful, because you can compare the earnings per share for several corporations.
(a) Adjusting the denominator for sales or purchases of common shares.
If additional shares are sold or treasury shares are purchased during the year, earnings per share is based on the weighted-average number of shares outstanding during the year. For example, in 1990, a company earned $40,000 and has preferred dividends of $7,500. On July 1, 1990, this company sold 4,000 additional common shares. On November 1, 1990, a company purchased 3,000 treasury shares. The calculation:
Earnings per share = ( $40,000 - $7,500 ) / 6,500 = $5
(b) Adjusting the denominator for stock splits and stock dividends.
A stock split or stock dividend is different from a stock sale. Stock splits do not provide additional assets for the company. Instead a stock split means that the company’s earnings must be allocated to a larger number of outstanding shares. Using the last example:
Jan. 1: 5,000 common shares were outstanding.
July 1: 4,000 additional shares of common stock was sold.
Nov. 1: 3,000 common shares of treasury stock was purchased.
Dec. 1: Outstanding common shares were split 2 for 1.
Earnings per share = ( $40,000 - $7,500 ) / 13,000 = $2.50
Companies with Complex Capital Structures
When a company has preferred stock (or bonds) that are convertible into common stock, then this company has a complex capital structure. This makes the earnings per share calculation more complicated. These companies usually calculate two earnings per share numbers.
1. The first is called Primary Earnings per Share (or simply Earnings per Share).
If there is a high probability that the preferred stock will be converted into common stock, the earnings per share is calculated as if this preferred stock was already converted. In the calculation, the weighted-average of common shares outstanding increases, causing the earnings per share to be lower.
2. The second calculation is called Full Diluted Earnings per Share.
The earnings per share is calculated as if all convertible preferred stock was converted to common stock.