ACCOUNTING
PRINCIPLES
Third Canadian Edition
Prepared by:
Keri Norrie, Camosun College
CHAPTER 14
CORPORATIONS:
DIVIDENDS, RETAINED
EARNINGS, AND INCOME
REPORTING
DIVIDENDS
• Pro-rata (equal) distribution of a portion of a
corporation’s earnings to its shareholders
• Common types of dividends
– Cash dividends
– Stock dividends (normally common shares)
CASH DIVIDENDS
• Pro rata distribution of cash to
shareholders
• Corporation must have:
1. enough retained earnings,
2. enough cash, and
3. declared dividends
ENTRIES FOR CASH DIVIDENDS
The declaration date is when the corporation’s board of
directors formally declares (authorizes) the cash dividend and
announces it to shareholders.
Assume, for instance, that on September 1, 2005 the board of
directors declared a $50,000 cash dividend for common
shareholders.
Declaring a cash dividend commits the corporation to a legal
obligation that is binding and cannot be reversed
On September 1, an entry is required to recognize the decrease
in retained earnings and the increase in a current liability.
Assets
=
Liabilities
$50,000
+
Shareholders’ Equity
$50,000
ENTRIES FOR CASH DIVIDENDS
Account Titles and Explanations
Debit
Cash Dividends – Common
50,000
Dividends Payable
Credit
50,000
To record declaration of cash dividend.
Declaration date:
The entry on September 1 to record the declaration is as
above.
ENTRIES FOR CASH DIVIDENDS
On the record date, ownership of the shares is determined
so that the corporation knows who to pay the dividend to.
• On the assumed record date of September 15,
2005, the corporation updates its share
ownership records for changes in ownership
between the declaration and record dates.
• No journal entry required.
ENTRIES FOR CASH DIVIDENDS
On the payment date, dividend cheques are mailed to
shareholders and the payment of the dividend is recorded.
Assuming the dividend is paid on September 30, 2005, the
entry to record the payment would be:
Account Titles and Explanations
Debit
Dividends Payable
50,000
Cash
Credit
50,000
To record payment of cash dividend.
The cumulative effect of the declaration and payment of a
cash dividend is to decrease both shareholders’ equity
(through retained earnings) and total assets (through cash).
ALLOCATING CASH DIVIDENDS BETWEEN
PREFERRED AND COMMON SHARES
Preferred shares have a priority over common shares for
dividends, meaning that if dividends are declared, preferred
shares must be paid first.
To illustrate, assume that a corporation has 1,000 $8 noncumulative preferred shares and 40,000 common shares. On
March 15, 2005, the corporation declared a $20,000 dividend.
The first $8,000 must be paid to the preferred shareholders with
any remaining dividends being paid to the common shareholders.
Account Titles and Explanations
Debit
Cash Dividends—Preferred
8,000
Cash Dividends—Common
12,000
Dividend Payable
To record declaration of cash dividend.
Credit
20,000
ALLOCATING CASH DIVIDENDS
BETWEEN PREFERRED AND
COMMON SHARES
If the preferred shares have a cumulative dividend feature, any
dividends in arrears as well as the current year’s dividend must be
paid before any dividends can be paid to the common shareholders.
To illustrate, assume that a corporation has 1,000, $8 cumulative
preferred shares and 40,000 common shares. On March 15, 2005,
the corporation declared a $20,000 dividend. Assume that dividends
were not declared in 2004.
The first $16,000 must be paid to the preferred shareholders, with
any remaining dividends being paid to the common shareholders.
Account Titles and Explanations
Debit
Cash Dividends—Preferred
16,000
Cash Dividends—Common
4,000
Dividend Payable
To record declaration of cash dividend.
Credit
20,000
STOCK DIVIDENDS
• Pro rata distribution of the corporation’s own
shares to its shareholders
• Since it is a dividend, Retained Earnings is
decreased
• Since common shares are given, the account
Common Shares is increased
Assets
=
Liabilities
There is no change in total assets,
liabilities, or shareholders’ equity.
+
Shareholders’ Equity
Retained
Earnings
Common
Shares
PURPOSES AND BENEFITS OF
STOCK DIVIDENDS
• For the company
– To satisfy shareholders' dividend expectations without
spending cash
– To increase marketability of its shares by increasing
number of shares and decreasing market price per
share
– To emphasize that a portion of shareholders’ equity
has been permanently retained in the business and is
unavailable for cash dividends
STOCK DIVIDEND EFFECTS
Assume that a corporation declares a 10% stock dividend on its 50,000
common shares. In valuing a stock dividend, most corporations use fair
market value for the shares. Assuming a fair market value of $15 per
share, the effect would be as follows:
Before Stock Dividend
After Stock Dividend
Shareholders’ equity
Preferred shares
$100,000
100,000
Common shares
500,000
575,000
Retained earnings
300,000
$225,000
$900,000
900,000
50,000
$55,000
Total shareholders’ equity
Number of shares
Stock dividends change the composition of shareholders’ equity
because a portion of retained earnings is transferred to
contributed capital.
STOCK SPLITS
• A stock split, like a stock dividend, involves
the issue of additional shares to
shareholders according to their percentage
of ownership
• Its purpose is to increase the marketability
of the shares by lowering the market value
per share
STOCK SPLIT EFFECTS
A stock split is usually much larger than a stock dividend.
Assume that instead of a 10% stock dividend, a corporation
splits its 50,000 common shares on a two-for-one basis.
Before Stock Split
After Stock Split
Shareholders’ equity
Preferred shares
$100,000
$100,000
Common shares
500,000
500,000
Retained earnings
300,000
$300,000
$900,000
$900,000
50,000
$100,000
Total shareholders’ equity
Number of shares
A stock split does not affect the balance in any shareholders’ equity
accounts. Therefore, it is not necessary to journalize a stock split.
Only a memo entry noting the details of the split is needed.
EFFECTS OF CASH DIVIDENDS, STOCK
DIVIDENDS, AND STOCK SPLITS
(ILLUSTRATION 14-2)
Cash
Stock
Dividend Dividend
Total assets
Total liabilities
Total shareholders’ equity
Total share capital
Total retained earnings
Number of shares
% of shareholder ownership
NE = No effect

NE

NE

NE
NE
 = Increase
NE
NE
NE



NE
Stock
Split
NE
NE
NE
NE
NE

NE
 = Decrease
CORPORATION INCOME
STATEMENTS
• Income statement for a corporation includes
essentially the same sections as in a
proprietorship or a partnership
• Major difference is a section for income tax
expense
INCOME STATEMENT WITH INCOME TAX
LEADS INC.
Income Statement
Year Ended December 31, 2005
Sales
Cost of goods sold
Gross profit
Operating expenses
Income from operations
$800,000
600,000
200,000
50,000
150,000
Other revenues
10,000
Other expenses
4,000
Income before income tax
Income tax expense
Net Income
156,000
46,800
$109,200
COMPREHENSIVE
INCOME STATEMENT
• Comprehensive income statement scheduled to be
reported by Canadian companies for fiscal years
commencing on or after October 1, 2005 as part of the
international standards harmonization
• It shows profitability using an “all inclusive” basis
– It will include not only net income but any changes to
shareholders’ equity other than changes resulting from
the sale or repurchase of shares and from the payment
of dividends
RETAINED EARNINGS
• Retained earnings is the cumulative net earnings (less
losses) that is retained in the business (i.e., not distributed
to shareholders)
• The following illustrates a simple statement of retained
earnings:
LEADS INC.
Statement of Retained Earnings
Year Ended December 31, 2005
Retained earnings, January 1, 2005
Add: Net income
Less: Cash dividends
Retained earnings, December 31, 2005
$500,000
109,200
609,200
25,000
$584,200
RETAINED EARNINGS
RESTRICTIONS
• In some cases, there may be retained earnings
restrictions that make a portion of the balance
currently unavailable for dividends
• Restrictions result from one or more of the
following causes:
– Legal
– Contractual
– Voluntary
PRIOR PERIOD ADJUSTMENTS
• Prior period adjustment results from:
– the correction of a material error in reporting
net income in previously issued financial
statements, or
– the changing of an accounting principle
PRIOR PERIOD ADJUSTMENTS
• Correction of an error occurs after the books
are closed and relates to a prior accounting
period
• Change in an accounting principle occurs when
the principle used in the current year is different
from the one used in the preceding year
PRIOR PERIOD ADJUSTMENTS
Correction of an Error
To illustrate, assume that ABC Corporation discovers in 2005
that it did not record $40,000 of amortization in 2004. The
corporation has an income tax rate of 30%.
The adjusting entry in 2005 should debit the 2004 Amortization
Expense and credit Accumulated Amortization for $40,000.
However, the Amortization Expense account for 2004 was
closed to retained earnings at the end of 2004, so the debit
adjustment made in 2005 is to the Retained Earnings account.
Account Titles and Explanations
Retained Earnings
Accumulated Amortization
To correct error in 2004 amortization.
Debit
Credit
40,000
40,000
PRIOR PERIOD ADJUSTMENTS
Correction of an Error
With the previous adjusting entry, the 2004 fiscal year will
have $40,000 more amortization expense and therefore
$40,000 less income.
With a tax rate of 30%, it will reduce 2004 income tax expense
and payable by $12,000.
Since the 2004 income tax expense was closed to the
Retained Earnings account at the end of 2004, the net
adjusting entry needed in 2005 to adjust amortization and its
related income tax effect would be:
Account Titles and Explanations
Debit
Retained Earnings
28,000
Income Tax Payable
12,000
Accumulated Amortization
To correct error in 2004 amortization and income tax.
Credit
40,000
PRIOR PERIOD ADJUSTMENTS
Correction of an Error
• Prior period corrections are reported in the statement of
retained earnings, net of associated income tax
• Assuming that ABC Corporation has a beginning balance of
$500,000 in Retained Earnings and a calendar year end, the
correction is reported as follows:
ABC INC.
Statement of Retained Earnings (partial)
Year Ended December 31, 2005
Balance, January 1, 2005 as previously reported
Deduct: Correction for understatement of
amortization expense in 2004, net of $12,000
less of income tax expense
Balance, January 1, 2005, as adjusted
$500,000
28,000
472,000
PRIOR PERIOD ADJUSTMENTS
Journal entries and financial statement
presentation are similar for corrections of errors
and changes in policy
– Corrected amount or new principle should be used in
reporting the results of operations of the current year
– Cumulative effect of the correction or change should
be disclosed as an adjustment to opening retained
earnings net of applicable income tax
– Prior period financial statements should be corrected
or restated to make comparison easier
– Effects of the change should be detailed and
disclosed in a note to the statements
DEBITS AND CREDITS TO RETAINED
EARNINGS
(ILLUSTRATION 14-3)
Retained Earnings
Debits (Decreases)
Credits (Increases)
1. Correction of a prior period
error that overstated income
1. Correction of a prior period
error that understated
income
2. Cumulative effect of a change 2. Cumulative effect of a
in accounting principle that
change in accounting
decreased income
principle that increased
income
3. Net Loss
3. Net Income
4. Cash Dividends
5. Stock Dividends
6. Reacquisition of shares
EARNINGS PER SHARE
• Earnings per share (EPS) indicates the net
income earned by each common share
• Companies report earnings per share on the
income statement
• The formula to calculate earnings per share is
as follows:
Net Income –
Preferred
Dividends

Weighted Average
Number of
Common Shares
Earnings
per Share
EARNINGS PER SHARE
• Weighted average number of common
shares
– To find the equivalent number of whole
shares for the year, multiply by fraction of
year outstanding
PRICE-EARNINGS RATIO
• The price-earnings (PE) ratio helps investors determine
whether the shares are a good investment in relation to
earnings
• It is a per share calculation, calculated by dividing the
market price of the shares by its earnings per share.
Market Price
per Share

Earnings
per Share
Price-Earnings
Ratio
A high PE ratio can be one indicator that investors believe
the company has future growth potential.
PAYOUT RATIO
The payout ratio indicates what percentage of earnings
the company is distributing to its shareholders.
Cash
Dividends

Net Income
Payout Ratio
A high payout could mean that the corporation is failing
to reinvest enough of its earnings in its operations. It
may also mean that earnings are falling or that the
corporation is trying to attract investors.
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