9.4 Retained Earnings, Stock Splits, and Dividends

Retained Earnings

The retained earnings account accumulates all net income minus net losses and dividends declared over the corporation’s lifetime. Successful companies grow by reinvesting back into the business the assets they generate through profitable operations. 

The retained earnings account is not a reservoir of cash for paying dividends to the shareholders. Cash and retained earnings are two distinct accounts with no particular relationship. In fact, the corporation may have a large balance in retained earnings but not have enough cash to pay a dividend. 

$$\text{Retained Earnings} = \begin{gathered} \text{Cumulative} \\ \text{Net Income} \end{gathered} \ \ – \ \ \begin{gathered} \text{Cumulative} \\ \text{Net Losses} \end{gathered} \ \ – \ \ \begin{gathered} \text{Dividends} \\ \text{Declared} \end{gathered}$$

A credit balance in retained earnings is normal and indicates that the corporation’s lifetime earnings exceed lifetime losses and dividends. 

A debit balance in retained earnings is called a deficit and indicates that the corporation’s lifetime losses and dividends exceed lifetime earnings. This amount is subtracted to determine total shareholders’ equity.

Dividends

Dividends are a corporation’s distribution of its earnings to shareholders. Dividends can be in the following forms:

1. Cash dividends
2. Stock dividends

Cash Dividends

Before a company can pay a cash dividend, it must have the following:

1. Sufficient retained earnings to declare the dividend, and 
2. Sufficient cash to pay the dividend.

A corporation declares a dividend before paying it. Only the board of directors has the authority to declare a dividend. 

The corporation has no obligation to pay a dividend until the board declares one. Once declared, the dividend becomes a legal liability of the corporation (i.e., it is recorded as a dividend payable in the liabilities section of the balance sheet).

Due to the differences in timing between the declaration and payment of dividends, there are a number of important journal entries.

Three dates are important in relation to dividends:

1. Declaration date on which the board of directors officially approves a dividend (creates a liability). The company records a journal entry to recognize the liability:

2. Record date on which the corporation prepares a list of current shareholders. Dividends are paid only to shareholders who own shares on that date. No journal entry is required on this date.

3. Payment date on which a cash dividend is paid to the shareholders. The company records a journal entry to recognize the dividends payment.

Stock Dividends

A stock dividend is a proportional distribution of a company’s own stock to its shareholders.

Companies issue stock dividends for a number of reasons. In particular, stock dividends help manage cash flows, while rewarding stockholders. This is a means of continuing dividends in times of tight cash flow to conserve cash. Stock dividends may also be issued to dilute the existing share base and as a result reduce the per-share market price.

The value of stock dividends is determined by multiplying the number of shares to be issued by the market price of the shares. There are a couple of journal entries recorded to capture the declaration and issuance of stock dividends.

1. Journal entry on date of declaration:

2. Journal entry on date of issuance:

Stock dividends do not impact total shareholders’ equity as the increase in the share capital (common/preferred shares) is fully offset by the decrease in retained earnings.

Dividends on Preferred Shares

Dividends on preferred shares are expressed as an annual dollar figure (per share) or as percentage of a share’s stated value.

Preferred shareholders receive their dividends before common shareholders. In other words, common shareholders receive dividends only if the total declared dividend is greater than the amount payable to preferred shareholders.

The journal entries are the same as that for dividends on common shares, but the dividends payable account would be specified for preferred dividends (i.e., dividends payable, preferred).

Dividends on Common and Preferred Shares

When a company declares a dividend, they declare the total amount of dividends to preferred and common shareholders. Hence, the company must allocate the total dividends declared to preferred and common shares as follows:

1. Calculate the dividend on preferred shares (number of preferred shares outstanding times the annual dividend on preferred shares).
2. Assign the remaining balance of total dividends declared to common shares.

Let’s take a look at an example:

Pinecraft Industries Inc. has 100,000 shares of $1.50 cumulative preferred shares outstanding in addition to its common shares. Assume that in 2017, Pinecraft declares an annual dividend of $1,000,000. The allocation to preferred and common shareholders is as follows:

Dividends on Cumulative and Non-Cumulative Preferred Shares

When corporations fail to pay a dividend to preferred shareholders, it is called passing the dividend and passed dividends are called dividends in arrears. 

When preferred shareholders hold cumulative preferred shares: 

• Any dividends in arrears must be paid to preferred shareholders before the corporation can pay dividends to common shareholders. 
• When preferred shareholders hold non-cumulative preferred shares: 
  • The corporation is not obligated to pay any dividends in arrears. Only the current year's preferred dividends need to be paid out before paying out dividends to common shareholders. 
  • Unless otherwise stated, preferred shares are assumed to be non-cumulative.

Let’s take a look at an example:

Pinecraft Industries Inc. has 100,000 shares of $1.50 cumulative preferred shares outstanding in addition to its common shares.  Suppose the company passed the 2016 preferred dividend of $150,000. Assume that Pinecraft declared a dividend of $500,000. The following is the entry to record this declaration:

Now record the declaration assuming that the preferred shares are non-cumulative:

Stock Splits

Stock splits allow companies to increase or decrease their share price without altering their assets, liabilities, or shareholders’ equity. A stock split results in an increase or decrease in the number of issued and outstanding shares but does NOT affect financial statement balances. Hence, no journal entry is required for a stock split.

A normal stock split increases the number of shares and therefore, reduces the share price. For example, a 3-for-1 stock split approximately reduces the share price by 66%.

A reverse stock split decreases the number of shares and therefore, increases the share price. For example, a 1-for-3 stock split approximately increases the share price by 300%.

Summary of Share Related Transactions

This table summarizes the transactions covered in this unit and their impact on the balance sheet: