ch12 CORPORATIONS ORGANIZATION, STOCK TRANSACTIONS, DIVIDENDS, AND RETAINED EARNINGS .ppt

John Wiley & Sons, Inc.
Financial Accounting, 4e
Weygandt, Kieso, & Kimmel
Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee

After studying this chapter, you should be able to:
1 Identify the major characteristics of a
corporation.
2 Record the issuance of common stock.
3 Explain the accounting for treasury stock.
4 Differentiate preferred stock from common
stock.
CHAPTER 12
CORPORATIONS: ORGANIZATION, STOCK
TRANSACTIONS, DIVIDENDS, AND RETAINED EARNINGS

After studying this chapter, you should be able to:
5 Prepare the entries for cash dividends and
stock dividends.
6 Identify the items that are reported in a
retained earnings statement.
7 Prepare and analyze a comprehensive
stockholders’ equity section.
CHAPTER 12

PREVIEW OF CHAPTER 12
CORPORATIONS: Organization, Stock Transactions,
Dividends, and Retained Earnings
Retained Earnings



Retained earnings
restrictions
Prior period
adjustments
Retained earnings
statement
 Cash dividends
Stock dividends
Stock splits


Dividends
Corporate
Organization and
Stock Transactions




Characteristics
Forming a
corporation
Corporate capital
Common stock
issues
Treasury stock
Preferred stock
Stockholders’
Equity Presentation
and Analysis




Presentation
Analysis

 Two common bases that are used to classify
corporations are by purpose and ownership.
 A corporation may be organized for the purpose of
making a profit, or it may be nonprofit.
 Classification by ownership distinguishes between
publicly held and privately held corporations.
1 A publicly held corporation may have thousands of
stockholders and its stock is traded regularly on a
national securities market.
2 A privately held corporation (or closely held
corporation) usually has only a few stockholders
and does not offer its stock for sale to the general
public.
THE CORPORATE FORM
OF ORGANIZATION

 A number of characteristics distinguish a corporation
from proprietorships and partnerships.
 The most important of these characteristics are:
1 Separate legal existence – As an entity separate and
distinct from its owners, the corporation acts under its
own name rather than in the name of its stockholders.
2 Limited liability of stockholders – Since a corporation
is a separate legal entity, creditors ordinarily have
recourse only to corporate assets to satisfy their
claims.
3 Transferable ownership rights – Ownership of a
corporation is shown in shares of capital stock, which
are transferable units.
CHARACTERISTICS OF
A CORPORATION

4 Ability to acquire capital – It is relatively easy for a
corporation to obtain capital through the issuance of
stock.
5 Continuous life – The life of a corporation is stated in its
charter; it may be perpetual or it may be limited to a
specific number of years.
6 Corporate management – Although stockholders legally
own the corporation, they manage the corporation
indirectly through a board of directors they elect.
7 Government regulations – A corporation is subject to
numerous state and federal regulations.
8 Additional taxes – Corporations, unlike proprietorships
and partnerships, must pay federal and state income
taxes as a separate legal entity.
CHARACTERISTICS OF
A CORPORATION

ILLUSTRATION 12-1
CORPORATION ORGANIZATION CHART
Stockholders
Board of
Directors
President
Vice-President
Finance
Vice-President
Marketing
Corporate
Secretary
Vice-President
Production
Vice-President
Personnel
Treasurer Controller
The president is the The controller’s
chief executive officer responsibilities include
(CEO) with direct 1 maintaining the
responsibility for accounting records
managing the business. 2 maintaining adequate
The chief accounting internal control system
officer is the controller. 3 preparing financial
statements, tax returns
and internal reports.

ILLUSTRATION 12-2
ADVANTAGES AND DISADVANTAGES
OF A CORPORATION
Advantages Disadvantages
Separate legal existence Corporation management – separation of
Limited ownership ownership and management
Transferable ownership rights Government regulations
Ability to acquire capital Additional taxes
Continuous life
Corporation management – professional
managers

FORMING A CORPORATION
 The corporation, once it receives its charter from the
state of incorporation, must establish by-laws for
conducting its affairs.
 Regardless of the number of states in which a
corporation has operating divisions, it is incorporated in
only one state.
 Costs incurred in the formation of a corporation are
called organization costs.
 Organization costs include legal and state fees and
promotional expenditures involved in the organization
of the business.
 Organization costs are expensed as incurred.

CORPORATE CAPITAL
Owners’ equity in a corporation is
identified as stockholders’ equity,
shareholders’ equity, or corporate
capital.
The stockholders’ equity section of a
corporation’s balance sheet consists of:
1 paid-in (contributed) capital and
2 retained earnings (earned capital).

ILLUSTRATION 12-3
OWNERSHIP RIGHTS OF STOCKHOLDERS
1 To vote in election for board of
directors at annual meeting.
To vote on actions that require
stockholder approval.
2 To share the corporate earnings
through receipt of dividends.
3 To keep same percentage
ownership when new shares of
stock are issued (preemptive
right).
4 To share in assets upon
liquidation, in proportion to
their holdings. Called a
residual claim because owners
are paid with assets remaining
after all claims have been paid.
Before After
New
shares
issued
Dividends
Lenders
Creditors
Stockholders

CORPORATE CAPITAL
 When a corporation has only one class of
stock, it is identified as common stock.
 A printed or engraved form known as a stock
certificate serves as proof of stock ownership.
 The amount of stock that a corporation is
authorized to sell is indicated in its charter.
 The total amount of authorized stock at the
time of incorporation usually anticipates both
initial and subsequent capital needs of a
company.

 A corporation must choose whether to issue common
stock directly to investors or indirectly through an
investment banking firm (brokerage house) that
specializes in informing prospective investors about
securities.
 The investment banking firm may agree to
underwrite an entire indirect stock issue.
 Under such an arrangement, the investment banker
buys the stock from the corporation at a stipulated
price and resells the shares to investors.
 The prices set by the marketplace determine a stock’s
market value and tend to follow the trend of a
company’s earnings and dividends.
CORPORATE CAPITAL

ACCOUNTING IN ACTION
STOCK MARKET PRICE INFORMATION
Net
Stock Volume High Low Close Change
Lands End 3478 28 38
26
63 26 94 -119
A recent listing for Kellogg is shown above.
These numbers indicate that:
1 the trading volume for one day was 347,800 shares;
2 the high, low, and closing prices for that date were
$28.38, $26.63, and $26.94, respectively; and
3 the net change for the day was a decrease of $1.19 per
share.

CORPORATE CAPITAL
 Capital stock that has been assigned a value per
share in the corporate charter is par value stock.
 Par value is not indicative of the worth or market
value of the stock, but does represent the legal
capital per share that must be retained in the
business for the protection of corporate creditors.
 No-par value stock is capital stock that has not
been assigned a value in the corporate charter.
 In many states the board of directors is permitted
to assign a stated value to the no-par shares,
which becomes the legal capital per share.

Account Titles and Explanation Debit Credit
Cash
Common Stock
(To record issuance of 1,000 shares of $1
par common stock at par)
1,000
1,000
ACCOUNTING FOR
COMMON STOCK ISSUES
The primary objectives in accounting for the issuance of
common stock are to
1 identify the specific sources of paid-in capital and
2 maintain the distinction between paid-in capital and
retained earnings.
Hydro-Slide, Inc. issues 1,000 shares of $1 par value common
stock at par for cash. The entry to record this transaction is:

Cash
Common Stock
Paid-in Capital in Excess of Par Value
(To record issuance of 1,000 shares of
common stock in excess of par)
5,000
1,000
4,000
ACCOUNTING FOR
COMMON STOCK ISSUES
Hydro-Slide, Inc. issues an additional 1,000 shares
of the $1 par value common stock for cash at $5
per share. The entry to record this transaction is:

Stockholders’ equity
Paid-in capital
Common stock $ 2,000
Paid-in capital in excess of par value 4,000
Total paid-in capital 6,000
Retained earnings 27,000
Total stockholders’ equity $ 33,000
ILLUSTRATION 12-6
STOCKHOLDERS’ EQUITY – PAID-IN
CAPITAL IN EXCESS OF PAR VALUE
The total paid-in capital from these two transactions
is $6,000, and the legal capital is $2,000. If Hydro-
Slide, Inc. has retained earnings of $27,000, the
stockholders’ equity section is as follows:

ACCOUNTING FOR
COMMON STOCK ISSUES
Cash
Common Stock
Paid-in Capital in Excess of Stated Value
stated value no-par stock)
40,000
25,000
15,000
When no-par common stock has a stated value, the
entries are similar to those for par value stock. The
stated value represents legal capital and therefore is
credited to Common Stock. When the selling price of
no-par stock exceeds stated value, the excess is credited
to Paid-in Capital in Excess of Stated Value. Hydro-
Slide, Inc. issues 5,000 shares of $5 stated value no-par
stock at $8 per share for cash. The entry is:

Cash
Common Stock
(To record issuance of 5,000 shares of
no-par common stock)
40,000
40,000
ACCOUNTING FOR
COMMON STOCK ISSUES
Paid-in Capital in Excess of Stated Value is reported as
part of paid-in capital in the stockholders’ equity
section. When no-par stock does not have a stated
value, the entire proceeds from the issue become legal
capital and are credited to Common Stock. If
Hydro-Slide does not assign a stated value to its no-par
stock, the issuance of the 5,000 shares at $8 per share
for cash is recorded as follows:

ACCOUNTING FOR
COMMON STOCK ISSUES
 Stock may be issued for services or for
noncash assets.
 A question arises in such cases as to the cost
that should be recognized in the exchange
transaction.
 To comply with the cost principle in a noncash
transaction, cost is the cash equivalent price.
 Thus, cost is either the fair market value of the
consideration given up or the fair market
value of the consideration received, whichever
is more clearly determinable.

Organization Costs
Common Stock
par value common stock to attorneys)
5,000
4,000
1,000
ACCOUNTING FOR
COMMON STOCK ISSUES
The attorneys for The Jordan Company agrees to accept 4,000 shares
of $1 par value common stock in payment of their bill of $5,000 for
services performed in helping the company to incorporate. There is
no established market price for the stock at the time of the exchange.
Since the market value of the consideration received, $5,000 is more
clearly evident, the appropriate entry is:

Land
Common Stock
par value common stock for land)
80,000
50,000
30,000
ACCOUNTING FOR
COMMON STOCK ISSUES
Athletic Research Inc. is a publicly held corporation whose $5 par
value stock is actively traded at $8 per share. The company issues
10,000 shares of stock to acquire land recently advertised for sale at
$90,000. On the basis of these facts the market price of the
consideration given is the most clearly evident value. The par or
stated value of the stock is never a factor in determining the cost of the
assets received. The entry is:

ACCOUNTING FOR
TREASURY STOCK
 Treasury stock is a corporation’s own stock that has been
issued, fully paid for, and reacquired by the corporation
but not retired.
 A corporation may acquire treasury stock for the reasons
listed below.
1 Reissue the shares to officers and employees under
bonus and stock compensation plans.
2 Increase trading of the company’s stock in the securities
market in the hopes of enhancing its market value.
3 Have additional shares available for use in the
acquisition of other companies.
4 Reduce the number of shares outstanding and thereby
increase earnings per share.
5 Rid the company of disgruntled investors, perhaps to
avoid a takeover.

Paid-in capital
Common stock, $5 par value,100,000
shares issued and outstanding $ 500,000
Total stockholders’ equity
ILLUSTRATION 12-7
STOCKHOLDERS’ EQUITY
WITH NO TREASURY STOCK
The cost method is normally used in accounting for treasury stock.
Under the cost method, Treasury Stock is debited at the price paid to
reacquire the shares, and the same amount is credited to Treasury
Stock when the shares are sold. On January 1, 2002, the
stockholders’ equity section of Mead, Inc. has 100,000 shares of $5
par value common stock outstanding (all issued at par value) and
Retained Earnings of $200,000.
$ 700,000

Date Account Titles and Explanation Debit Credit
Feb. 1 Treasury Stock
Cash
(To record purchase of 4,000 shares of
treasury stock at $8 per share)
32,000
32,000
ACCOUNTING FOR
TREASURY STOCK
On February 1, 2002, Mead acquires 4,000 shares of its
stock at $8 per share. Treasury Stock is debited for the
cost of the shares purchased. The entry is as follows:

Paid-in capital
Common stock, $5 par value, 100,000 shares
issued and 96,000 shares outstanding $ 500,000
Total paid-in capital and retained earnings 700,000
Less: Treasury stock (4,000 shares) 32,000
ILLUSTRATION 12-8
WITH TREASURY STOCK
Treasury Stock is deducted from total paid-in capital and retained
earnings in the stockholders’ equity section. Both the number of shares
issued (100,000) and the number of shares in the treasury (4,000) are
disclosed. The difference is the number of shares of outstanding stock
(96,000). The term outstanding stock means the number of shares of
issued stock that are being held by stockholders. The stockholders’ equity
section of Mead, Inc., after purchase of treasury stock, is as follows:

July 1 Cash
Treasury Stock
Paid-in Capital from Treasury Stock
(To record sale of 1,000 shares of treasury
stock above cost)
10,000
8,000
2,000
ACCOUNTING FOR
TREASURY STOCK
Treasury stock is usually sold or retired and the accounting for its sale
is different when it is sold above cost than when it is sold below cost. If
the selling price of the treasury shares is equal to cost, the sale of the
shares is recorded with a debit to Cash and a credit to Treasury Stock.
When the selling price of the shares is greater than cost, the difference
is credited to Paid-in Capital from Treasury Stock. Assume that
$1,000 shares of treasury stock of Mead, Inc. previously acquired for
$8 per share, are sold at $10 per share on July 1. The entry is:

ACCOUNTING FOR
TREASURY STOCK
 The $2,000 credit in the July 1 entry is not made to
Gain on Sale of Treasury Stock for two reasons:
1 Gains on sales occur when assets are sold and
treasury stock is not an asset.
2 A corporation does not realize a gain or suffer a loss
from stock transactions with its own stockholders.
 Paid-in capital arising from the sale of treasury stock
should therefore not be included in the measurement
of net income.
 Paid-in Capital from Treasury Stock is listed
separately on the balance sheet as part of paid-in
capital.

Oct. 1 Cash
Treasury Stock
(To record sale of 800 shares of treasury
stock below cost)
5,600
800
6,400
ACCOUNTING FOR
TREASURY STOCK
When treasury stock is sold below its cost, the excess of cost
over selling price is usually debited to Paid-in Capital from
Treasury Stock. If Mead, Inc. sells an additional 800 shares
of treasury stock on October 1 at $7 per share, the entry is:

ILLUSTRATION 12-9
TREASURY STOCK ACCOUNTS
Treasury Stock Paid-in Capital from Treasury Stock
Feb. 1 32,000 July 1 8,000 Oct. 1 800 July 1 2,000
Oct. 1 6,400 Oct. 1 Bal. 1,200
Oct. 1 Bal. 17,600
 Observe from the two sales entries that
1 Treasury Stock is credited at cost for each entry,
2 Paid-in Capital from Treasury Stock is used for the difference between
the cost and the resale price of the shares, and
3 The original paid-in capital account, Common Stock, again is not affected.
 The sale of treasury stock increases both total assets and total stockholders’
equity.
 After posting the July 1 and October 1 entries, the treasury stock accounts
will show the following balances on October 1:

Dec. 1 Cash
Retained Earnings
Treasury Stock
(To record sale of 2,200 shares of treasury
stock at $7 per share)
15,400
1,200
1,000
17,600
ACCOUNTING FOR
TREASURY STOCK
When the credit balance in Paid-in Capital from Treasury Stock is
eliminated, any additional excess of cost over selling price is
debited to Retained Earnings. Mead, Inc. sells its remaining 2,200
shares at $7 per share on December 1. The excess of cost over
selling price is $2,200 [2,200 X ($8 – $7)]. In this case, $1,200 of the
excess is debited to Paid-in Capital from Treasury Stock and the
remaining $1,000 is debited to Retained Earnings. The entry is:

Oct. 1 Cash
Preferred Stock
– Preferred Stock
(To record the issuance of 10,000 shares of
$10 par value preferred stock)
120,000
100,00
0
20,000
PREFERRED STOCK
Preferred stock has contractual provisions that give it a preference
over common stock in certain areas. Preferred stockholders have a
priority as to 1 dividends and 2 assets in the event of liquidation.
They usually do not have voting rights. When a corporation has more
than one class of stock, each capital account title should identify the
stock to which it relates. Stine Corporation issues 10,000 shares of $10
par value preferred stock for $12 cash per share. The entry to record
the issuance is:

Dividends in arrears ($35,000 X 2) $ 70,000
Current-year dividends 35,000
Total preferred dividends $ 105,000
 Preferred stockholders have the right to share in the distribution of corporate
income before common stockholders.
 Preferred stock contracts often contain a cumulative dividend feature – which
means that preferred stockholders must be paid both current-year dividends and
any unpaid prior-year dividends before common stockholders receive dividends.
 Cumulative preferred dividends not declared in a given period are called
dividends in arrears.
 Scientific Leasing has 5,000 shares of 7%, $100 par value cumulative preferred
stock outstanding, and the annual dividend is $35,000 (5,000 X $7 per share).
 If dividends are 2 years in arrears, preferred stockholders are entitled to receive
the following dividends in the current year:
ILLUSTRATION 12-10
COMPUTATION OF TOTAL DIVIDENDS
TO PREFERRED STOCK

DIVIDENDS
 A dividend is distribution by a corporation
to its stockholders on a pro rata (equal)
basis.
 A cash dividend is a pro rata distribution of
cash to stockholders.
 For a cash dividend to occur, a corporation
must have:
1 retained earnings,
2 adequate cash, and
3 declared dividends.

ENTRIES FOR
CASH DIVIDENDS
Dec. 31 Retained Earnings
Dividends Payable
(To record declaration of cash dividend)
50,000
50,000
Three dates are important in connection with dividends: 1 the
declaration date, 2 the record date, and 3 the payment date.
Accounting entries are required on two of the dates – the
declaration date and the payment date. On the declaration date,
the board of directors formally declares the cash dividend and
announces it to the stockholders. An entry is required to
recognize the decrease in retained earnings and the increase in the
liability – Dividends Payable. On December 31, 2002, the
directors of Media General declare a $.50 per share cash dividend
on 100,000 shares of $10 par value common stock. The dividend is
$50,000 (100,000 X $.50), and the entry to record the declaration:

Dec. 31 Retained Earnings (or Dividends)
Dividends Payable
(To record $6 per share cash dividend to
preferred stockholders)
6,000
6,000
ENTRIES FOR
CASH DIVIDENDS
Preferred stock has priority over common stock in regard to
dividends. Cash dividends must be paid to preferred stockholders
before common stockholders are paid any dividends. IBR Inc. has
1,000 shares of 8%, $100 par value cumulative preferred stock and
50,000 shares of $10 par value common stock outstanding at
December 31, 2002. The dividend per share for preferred stock is $8
($100 par value X 8%), and the required annual dividend for
preferred stock is $8,000 (1,000 X $8). The directors declare a $6,000
cash dividend on December 31, 2002. The total dividend amount
goes to the preferred stockholders in this case due to their dividend
preference. The entry to record the dividend declaration is:

Dec. 31 Retained Earnings (or Dividends)
Dividends Payable
(To record declaration of cash dividends of
$10,000 to preferred stock and $40,000 to
Common stock)
50,000
50,000
ILLUSTRATION 12-12
ALLOCATING DIVIDENDS TO
PREFERRED AND COMMON STOCK
Total dividend $ 50,000
Allocated to preferred stock
Dividends in arrears, 2001 (1,000 X $2) $ 2,000
2002 dividend (1,000 X $8) 8,000 10,000
Remainder allocated to common stock $ 40,000
Since the preferred stock is cumulative, dividends of $2 per share are
in arrears on preferred stock for 2002 and must be paid before any
future dividends can be paid on common stock. On December 31,
2003, IBR declares a $50,000 cash dividend. The allocation of the
dividend to the two classes of stock shown above. The entry to record
the declaration of the dividend is:

STOCK DIVIDENDS
 A stock dividend is a pro rata distribution of the
corporation’s own stock to stockholders.
 A stock dividend results in a decrease in retained earnings
and an increase in paid-in capital.
 Corporations usually issue stock dividends for one or more
of the following reasons:
1 To satisfy stockholders’ dividend expectations
without spending cash.
2 To increase the marketability of its stock by increasing
the number of shares outstanding and thereby decreasing
the market price per share.
3 To emphasize that a portion of stockholders’ equity has
been permanently reinvested in the business and therefore
is unavailable for cash dividends.

STOCK DIVIDENDS
 The size of the stock dividend and the value to be assigned
to each dividend share are determined by the board of
directors when the dividend is declared.
 The per share amount must be at least equal to the par or
stated value in order to meet legal requirements.
 The accounting profession distinguishes between
1 a small stock dividend (less than 20-25% of the
corporation’s issued stock) and
2 a large stock dividend (greater than 20-25%).
 It is recommended that the directors assign the fair
market value per share for small stock dividends.
 Though the amount to be assigned for a large stock
dividend is not specified by the accounting profession, par
or stated value per share is normally assigned.

ENTRIES FOR
STOCK DIVIDENDS
Oct. 1 Retained earnings
Common Stock Dividends Distributable
(To record declaration of 10% stock
Dividend)
75,000
50,000
25,000
Medland Corporation has a balance of $300,000 in
retained earnings and declares a 10% stock dividend
on its 50,000 shares of $10 par value common stock.
The current fair market value of its stock is $15 per
share. The number of shares to be issued is 5,000
(10% X 50,000) and the total amount to be debited to
Retained Earnings is $75,000 (5,000 X $15). The entry
to record this transaction at the declaration date is:

Dec. 31 Common Stock Dividends Distributable
Common Stock
(To record issuance of 5,000 shares in a
stock dividend)
50,000
50,000
ILLUSTRATION 12-14 STATEMENT
PRESENTATION OF COMMON STOCK
DIVIDENDS DISTRIBUTABLE
Paid-in capital
Common stock dividends distributable 50,000 $ 550,000
Common Stock Dividends Distributable is a stockholders’ equity
account; if a balance sheet is prepared before the dividend shares
are issued, the distributable account is reported in paid-in capital
as additional common stock issued, as shown above. When the
dividends are issued, Common Stock Dividends Distributable is
debited and Common Stock is credited as follows:

ILLUSTRATION 12-15
STOCK DIVIDEND EFFECTS
 Stock dividends change the composition of stockholders’ equity because a portion
of retained earnings is transferred to paid-in capital.
 However, total stockholders’ equity remains the same.
 Stock dividends also have no effect on the par or stated value per share, but the
number of shares outstanding increases.
 These effects are shown below for Medland Corporation.
Before After
Stockholders’ equity Dividend Dividend
Paid-in capital
Common stock, $10 par $ 500,000 $ 550,000
Paid-in capital in excess of par value –0– 25,000
Total paid-in capital 500,000 575,000
Retained earnings 300,000 225,000
Total stockholders’ equity $ 800,000 $ 800,000
Outstanding shares 50,000 55,000

STOCK SPLITS
 A stock split, like a stock dividend, involves the issuance of
additional shares of stock to stockholders according to
their percentage of ownership.
 However, a stock split results in a reduction of par or
stated value per share.
 The purpose of a stock split is to increase the
marketability of the stock by lowering its market value per
share.
 In a stock split, the number of shares is increased in the
same proportion that par or stated value per share is
decreased.
 A stock split does not have any effect on total paid-in
capital, retained earnings, and total stockholders’ equity.
 However, the number of shares outstanding increases.

Before After
Stockholders’ equity Stock Split Stock Split
Paid-in capital
Common stock, $10 par $ 500,000 $ 500,000
Paid-in capital in excess of par value –0– –0–
Total paid-in capital 500,000 500,000
Retained earnings 300,000 300,000
Total stockholders’ equity $ 800,000 $ 800,000
Outstanding shares 50,000 100,000
ILLUSTRATION 12-16
STOCK SPLIT EFFECTS
Assume that Medland Corporation splits its 50,000 shares
of common stock on a 2-for-1 basis. Because a stock split
does not affect the balances in any stockholders’ equity
accounts, it is not necessary to journalize a stock split.

ILLUSTRATION 12-17 EFFECTS OF
STOCK SPLITS AND STOCK DIVIDENDS
DIFFERENTIATED
Significant differences between stock splits
and stock dividends are shown below.
Item Stock Split Stock Dividend
Total paid-in capital No change Increase
Total retained earnings No change Decrease
Total par value (common stock) No change Increase
Par value per share Decrease No change

ILLUSTRATION 12-18
RETAINED EARNINGS AND
CASH BALANCES
Retained earnings is net income that is retained in the
business.
The balance in retained earnings is part of the
stockholders’ claim on the total assets of the corporation.
The relationship of cash to retained earnings is shown
below (all figures in millions).
Company Retained Earnings Cash
Walt Disney Co. $12,281 $ 414
Sears, Roebuck Co. 5,952 729
The Home Depot 7,941 168
Amazon.com (882) 117

ILLUSTRATION 12-19
WITH DEFICIT
Net losses are debited to Retained Earnings, not to paid-in
capital accounts. To do so would destroy the distinction
between paid-in capital and earned capital. A debit
balance in retained earnings is identified as a deficit and is
reported as a deduction in the stockholders’ equity section,
as shown below.
Paid-in capital
Retained earnings (deficit) ( 50,000)

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:
1 Legal restrictions. Many states require a corporation to
restrict retained earnings for the cost of treasury stock
purchased which serves to keep intact the corporation’s
legal capital that is temporarily being held as treasury
stock.
2 Contractual restrictions. Long-term debt contracts may
impose a restriction on retained earnings as a condition
for the loan.
3 Voluntary restrictions. The board of directors of a
corporation may voluntarily create retained earnings
restrictions for specific purposes.

PRATT & LAMBERT
Note D Long-term Debt and Retained Earnings
Loan agreements contain, among other convenants, a restriction on the payment of
dividends, which limits future dividend payments to $20,565,000 plus 75% of future net
income.
ILLUSTRATION 12-22
DISCLOSURE OF RESTRICTION
Retained earnings restrictions are generally
disclosed in the notes to the financial
statements. Pratt & Lambert, a leading
producer of architectural finishes (paint), has
the following note in a recent financial
statement:

Dec. 31 Retained Earnings
Accumulated Depreciation
(To adjust for understatement of
depreciation in a prior period)
300,000
300,000
PRIOR PERIOD
ADJUSTMENTS
The correction of an error in previously issued financial statements is
known as a prior period adjustment. The correction is made directly
to Retained Earnings because the effect is now in this account; the net
income for the prior period has been recorded in retained earnings
through the journalizing and posting of closing entries. General
Microwave discovers in 2002 that it understated depreciation expense
in 2001 by $300,000 as a result of computational errors. These errors
overstated net income for 2001, and the current balance in retained
earnings is also overstated. The entry for the prior period adjustment,
assuming all tax effects are ignored, is as follows:

(Partial) Retained Earnings Statement
Balance, January 1, as reported $ 800,000
Correction for overstatement of net income in prior period (depreciation error) (300,000)
Balance, January 1, as adjusted $ 500,000
ILLUSTRATION 12-22
STATEMENT PRESENTATION OF
PRIOR PERIOD ADJUSTMENTS
Prior period adjustments are reported in the
retained earnings statement. They are added
to (or deducted from) the beginning retained
earnings balance to show the adjusted
beginning balance. General Microwave has a
beginning balance of $800,000 in retained
earnings and the prior period adjustment is
reported as follows:

Retained Earnings
Debit Credit
1. Net loss 1. Net income
2. Prior period adjustments for overstatement 2. Prior period adjustments for understatement
of net income of net income
3. Cash and stock dividends
4. Some disposals of treasury stock
ILLUSTRATION 12-23
DEBITS AND CREDITS TO
RETAINED EARNINGS
The retained earnings statement shows the
changes in retained earnings during the year. The
statement is prepared from the Retained Earnings
account. Transactions and events that affect
retained earnings are tabulated in account form as
shown below.

GRABER INC.
Retained Earnings Statement
For the Year Ended December 31, 2002
Balance, January 1, as reported $ 1,050,000
Correction for understatement of net income in prior period (inventory
error)
50,000
Balance, January 1, as adjusted 1,100,000
Add: Net income 360,000
1,460,000
Less: Cash dividends $ 100,000
Stock dividends 200,000 300,000
Balance, December 31 $ 1,160,000
ILLUSTRATION 12-24
RETAINED EARNINGS STATEMENT
Net income increases retained earnings and a net loss decreases retained earnings.
Prior period adjustment may either increase or decrease retained earnings. Both
cash and stock dividends decrease retained earnings. Treasury stock transactions
may decrease retained earnings. The retained earnings statement for Graber Inc. is
as follows:

PRESENTATION AND ANALYSIS
Two classifications of paid-in capital
are recognized:
1 Capital stock – which consists of
preferred and common stock.
2 Additional paid-in capital – which
includes the excess of amounts
paid in over par or stated value
and paid-in capital from treasury
stock.

GRABER INC.
Partial Balance Sheet
Paid-in capital
Capital stock
9% Preferred stock, $100 par value, cumulative, callable at $120,
10,000 shares authorized, 6,000 shares issued and outstanding $ 600,000
Common stock, no par, $5 stated value, 500,000 shares authorized,
400,000 shares issued and 390,000 outstanding $ 2,000,000
Common stock dividends distributable 50,000 2,050,000
Total capital stock 2,650,000
Additional paid-in capital
In excess of par value – preferred stock 30,000
In excess of stated value – common stock 1,050,000
Total additional paid-in capital 1,080,000
Total paid-in capital 3,730,000
Retained earnings (see Note R) 1,160,000
Total paid-in capital and retained earnings 4,890,000
Less: Treasury stock – common (10,000 shares) 80,000
Total stockholders’ equity $ 4,810,000
Note R: Retained earnings are restricted for the cost of treasury stock, $80,000.
ILLUSTRATION 12-25
COMPREHENSIVE
STOCKHOLDERS’ EQUITY SECTION

KNIGHT-RIDDER INC.
Stockholders’ equity (in millions)
Common stock, $.02½ par value; shares authorized – 250,000,000;
shares issued – 45,720,000 $ 1,143
Additional paid-in capital 342,201
Total stockholders’ equity $ 1,243,169
ILLUSTRATION 12-26
PUBLISHED STOCKHOLDERS’
EQUITY SECTION
 In published annual reports, subclassifications within the
stockholders’ equity section are seldom presented.
 The individual sources of additional paid-in capital are
often combined and reported as a single amount as
shown below:

ILLUSTRATION 12-27
RETURN ON COMMON STOCKHOLDERS’
EQUITY RATIO AND COMPUTATION


Net
Income
Preferred
Dividends
Average Common
Stockholders’ Equity
Return on Common
Stockholders’ Equity
($296.2 + $314.2)
($ 34.7 - $0) ÷ ——————————— - $0 =11%
2
 A popular ratio that measures profitability from the common stockholder’s
point of view is return on common stockholders’ equity.
 This ratio shows the amount of net income dollars earned for each dollar
invested by the owners.
 It is calculated by dividing net income by average stockholders’ equity.
If Lands’ End beginning of the year and end of year common stockholders’
equity were $296.2 and $314.2, net income was $34.7 million, and no preferred
stock was outstanding, the return on common stockholders’ equity ratio is:

COPYRIGHT
Copyright © 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or
translation of this work beyond that named in Section 117 of the 1976 United
States Copyright Act without the express written consent of the copyright owner is
unlawful. Request for further information should be addressed to the Permissions
Department, John Wiley & Sons, Inc. The purchaser may make back-up copies
for his/her own use only and not for distribution or resale. The Publisher assumes
no responsibility for errors, omissions, or damages, caused by the use of these
programs or from the use of the information contained herein.

CHAPTER 12

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