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Retained Earning Treatment: Stock Dividends, Stock Splits and Appropriations

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If a company decides to pay a dividend in the form of its own shares, this is called a stock dividend. If this dividend is less than 20 to 25% of the company’s outstanding common stock (at the date of declaration) then retained earnings should be debited for the fair market value of the stock dividend. This is called a small (ordinary) stock dividend. Otherwise it is a large stock dividend and retained earnings is debited at par.

Example:

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Suppose a corporation has 100,000 shares of common stock, $10 par outstanding, with a market value of $15 per share. It declares a stock dividend of 10%. It will therefore pay out to the stockholders a total of 10,000 shares (100,000×10%) as a dividend. Since this is less than 20 to 25%, fair market value must be used as the basis for debiting Retained Earnings.

The journal entries would be:

Date of declaration:

[Debit]. Retained Earnings = 150,000*
[Credit]. Stock Dividend Distributable = 100,000 (par)
[Credit]. Paid-in Capital in Excess of Par = 50,000

Date of payment (when the shares were issued):

[Debit]. Stock Dividend Distributable = 100,000
[Credit]. Common Stock = 100,000
?(10,000 × $15)

 

The Stock Dividend Distributable account is not a liability account. It is a temporary capital account which is replaced by the Common Stock account at the date of payment.

Example:

If in the previous example a 30% dividend was declared, then 30,000 shares (100,000 × 30%) would be issued and par value, rather than market value, would be used. The journal entries would be:

[Debit]. Retained Earnings = 300,000?
[Credit]. Stock Dividend Distributable = 300,000
[Debit]. Stock Dividend Distributable = 300,000
[Credit]. Common Stock = 300,000
?(30,000 × $10 par)

 

Stock Splits

If a corporation’s stock is selling at a very high price on the market, many people will not be able to afford it. To make the stock less expensive and thus more attractive to the buying public, the corporation may effect what is called a stock split. This involves two steps:

1. Increasing the number of shares outstanding.
2. Reducing the par of each share proportionately.

 

Example:

Suppose a corporation has 100,000 shares outstanding, $12 par. It then splits the stock 2 : 1 by distributing another 100,000 shares to the stockholders and halving the par of all the shares from $12 to $6.

The total shares outstanding will now be 200,000.
The par value of every share will now be $6.

A stockholder who held 100 shares of $12 par will now hold 200 shares of $6 par. No journal entry is made for a stock split. However, a memorandum note is made to indicate that there are now more shares outstanding.

Notice that in the above example the total par has not changed. Originally, it was $1,200,000 (100,000 × $12), and now it is also $1,200,000 (200,000 × $6).

Example:

If in the previous example the stock is split 3:1 then:

The total shares outstanding will now be 300,000.
The par value of each share will now be $4.

A stockholder who held 100 shares of $12 par will now be holding 300 shares of $4 par.

 

Appropriations Of Retained Earnings

As discussed, dividends are paid out of retained earnings. For various reasons, companies may wish to restrict the amount of retained earnings available for dividends. These restrictions are called appropriations.

In some states restrictions must be placed on retained earnings prohibiting dividends in an amount equal to the cost of any treasury stock acquired. It should be emphasized that appropriations do not involve the actual setting aside of cash for these purposes. They are, rather, merely journal entries indicating that a “lock” has been placed on retained earnings prohibiting a certain amount of dividends from being distributed.

Example:

A company decides to appropriate $10,000 each year for the next 5 years for the purpose of plant expansion. Each year the journal entry would be:

[Debit]. Retained Earnings = 10,000
[Credit]. Retained Earnings Appropriated for Plant Expansion = 10,000

This entry removes $10,000 from retained earnings (by debiting it) and places it in a restricted “area.” Of course, the total retained earnings has not changed at all—it has merely been split into two parts: the restricted (“appropriated”) part, and the unrestricted part.

Example:

In the previous example the appropriated retained earnings account will eventually contain a balance of $50,000. At that point, if we assume that the plant expansion has been completed, there will no longer be a need for the restriction.

Accordingly, the following entry reverses the previous entries and returns the $50,000 back to the unrestricted “area”:

[Debit]. Retained Earnings Appropriated for Plant Expansion = 50,000
[Credit]. Retained Earnings = 50,000

1 Comment

1 Comment

  1. Fudayl

    Jun 4, 2010 at 11:01 am

    Only unapropriated retained earnings could be used to pay dividends. Understood. I am seeking opinion on the following transaction:

    A new shareholder is inducted in a company and pays a premium over the par value of shares. Instead of crediting the premium in Premium Reserves, the company decides to pay it to the old shareholders in cash or in stocks at par value. Could this be done?

    If it is cash distribution, the old shareholders will record it in their books as what? Dividends received?

    If it is stocks, the old shareholders will record it in their books as what? Stock dividends? Capital gains? Nothing at all? What?

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