BAT4M Grade 12 University College Accounting Chapter 14 Test Study Notes Corporations: Dividends, Retained Earnings, and Income Reporting Dividends – A distribution of a corporation’s retained earnings to shareholders – Most often cash, but can also be stock Cash Dividends – Distribution of cash to shareholders – Corporation must have enough retained earnings in order to pay dividends – dividends are distributed from retained earnings – Corporations must also have enough cash because a lack of cash means that the company cannot give out cash dividends – The board of directors must formally declare dividends – Once declared, the dividends become payable to shareholders – Dividends are not required by any laws or regulations Journalizing Cash Dividends 1. Declaration Date – the formal declaration of dividends by the board of directors – legally binds the corporation to pay dividends – often to preferred shareholders, but if to common shareholders, preferred shareholders still hold priority DR Cash Dividends – Preferred/Common (depending on situation), CR Dividends Payable (number of shares on the market X amount per-share of dividend) – Dividends Payable are recorded as current liabilities 1. Record Date – corporations determine who is going to receive dividends No entry required because there is no change financially 1. Payment Date – dividends are mailed out to shareholders DR Dividends Payable, CR Cash – The declaration of cash dividends decreases shareholders’ equity and increases liabilities – The payment of cash dividends decreases both assets and liabilities – Overall effect of dividends: decreases shareholders’ equity (through Retained Earnings) and decreases assets (through cash) Stock Dividends – Distribution of the corporation’s own shares to shareholders – Similar to cash dividends except stocks are used rather than cash – Decreases retained earnings but increases share capital – Does not change total shareholders’ equity – Shareholders retain the same percentage of ownership – Simply an increase in the number of stocks on the market – Corporations often give out stock dividends to: – Satisfy shareholders’ dividend expectations without giving cash – Increase marketability of shares – more shares on the market means lower market price – making stocks more affordable – Emphasize a portion of shareholders’ equity has been permanently retained and not available to be distributed as cash Journalizing Stock Dividends 1. Declaration Date – DR Stock Dividends – Common, CR Common Stock Dividends Distributable Amount of the entry is equal to the number of stocks being issued multiplied by the market value per share on the date of declaration, NOT payment or record date 1. Record Date – same as cash dividends, no entry required 2. Payment Date – DR Common Stock Dividends Distributable, CR Common Shares – Effect of stock dividends: Increase common shares account, increased number of common shares, decrease retained earnings account, no change in total shareholders’ equity Stock Splits – Issue of additional shares to shareholders based on their percentage ownership – Increases marketability of shares to investors – Number of shares is increased proportionate to a specified number – Only changes the number of shares – does not affect common shares or retained earnings – Reduces the average market value of the share – No journal entry required – only a memo is needed Effects of Dividends Cash Dividend: Decreases assets through cash and decrease shareholders’ equity through retained earnings Stock Dividend: No overall change to shareholders’ equity but increases share capital and decreases retained earnings Stock Split: No change to anything Corporate Income Taxes – Income tax appears on both the income statements as an expense and on the balance sheets as a payable to the government – Estimates of income tax must be made during the fiscal period – An adjusting entry at the end of the period is made to update the income tax expense and reconcile the estimated amount to the actual amount – Interperiod Tax Allocation: dividing tax expenses between amounts due soon and amounts due in the future – Intraperiod Tax Allocation: pairing income taxes with their related item of income – Interperiod occurs over two or more periods while intraperiod allocation follows a certain item or category Comprehensive Income Statement – features any sources or income or expenses not listed on the income statement Retained Earnings – Includes: opening balance of retained earnings, net income, cash dividends, ending balance of retained earnings – Beginning balance plus net income less cash dividends = ending balance – Contractual Restrictions – protective measure of creditors ensuring the corporation has enough money to pay off their debts before handing out dividends – Debt covenants limit the use of corporate assets – Voluntary Restrictions – restrictions set in place by the board of directors for certain purposes – e.g. a minimum amount of retained earnings is kept for a future expansion – No journal entry required but any restrictions must be disclosed in the notes Prior Period Adjustments – if an error is located within previous years or policies have changed, corrections must be made 1. Corrected amount should be used in reporting operations of the current year 2. Cumulative effect of correction should be an adjustment to the opening retained earnings less income tax – effect must be reported on statement of retained earnings rather than the current income statement 3. All previous statements should be corrected to keep consistency 4. A note to the statements should include the effect of the change Correction of a Prior Period Error – Corrections must be made directly to retained earnings because net income has been closed to this account – Correcting entries will also increase or decrease income tax payable because retained earnings has changed, meaning the tax payable will also change Change in Accounting Principle – Occurs when the principle in the current year is different from the one used in previous years – Same concept as previous errors – retained earnings and income tax payable/recoverable should be a part of the journal entry Statement of Retained Earnings – Shows changes in retained earnings during the period – Debits (Decreases): prior period error that overstated income, change in accounting principle that decreased income, net loss, cash/stock dividends, reacquisition of shares – Credits (Increases): prior period error that understated income, change in accounting principle that increased income, net income Earnings Per Share – net income earned per common share – Earnings Per Share = Net Income (less preferred dividends) / Weighted Avg Number of Common Shares – Weighted avg number of common shares is calculated by taking number of shares and multiplying it by a fraction of the year it has been active – Complex Capital Structure: when a corporation has securities that can be converted to common shares – Basic Earnings Per Share was the above formula – Fully Diluted Earnings Per Share calculated theoretical earnings as though all securities that can be converted to common shares have been converted – Fully diluted earnings per share will never be higher than basic earnings per share Price Earnings Ratio – Gives the ratio of the market price of each common share to its earnings per share – Price Earnings Ratio = Market Price per Share / Earnings Per Share – The ratio of price to earnings will be higher if investors believe income will increase – Vice versa if investors believe income will decrease Dividend Record – Payout ratio gives info of what percentage of income the company is distributing to shareholders – Very high percentages could mean the company is demonstrating poor management – High percentages could also be used by the company to attract investors who are interested in dividends – Payout Ratio = Cash Dividends / Net Income – Low payout ratios often mean the corporation is choosing to use net income to reinvest in the company rather than pay dividends