Chapter 7: Shareholders’ Equity: Retained Earnings and Dividends

Retained Earnings

Retained earnings represents the amount of the assets that are generated through profitable operations of corporations and are not distributed to the shareholders in the form of dividend. It means corporations retain some part of their net income in the corporation.

Retained earnings account’s credit balance indicates that the corporation’s lifetime earnings exceed lifetime losses and dividends

A net income increases the retained earnings but net loss decreases the retained earnings. If there is a debit balance in Retained Earnings, this is called a deficit (debit balance) in Retained Earnings. A deficit is shown in the shareholder’s equity part of the balance sheet as a deduction from contributed capital.

Accounting for Cash Dividends

Profitable corporations may make distributions to their shareholders in the form of dividends. Dividends are distributions of cash, other property, or share of the business to the shareholders of a corporation on a pro rata (proportional to ownership) basis. In other words, a dividend is a distribution of some portion of earnings to the shareholders by a corporation.

A cash dividend is a cash distribution of earnings by a corporation to its shareholders.

If a corporation wants to pay cash dividends, three conditions required are as follows:

1. Sufficient retained earnings
2. Adequate cash
3. Declared dividends by the board of directors

After the decision of paying dividends, three dates are important for a corporation. These are Declaration date, the Record date, and Payment date.

The Dividend on Preferred Shares

If a corporation has already issued both common and preferred shares, the shareholders who have preferred shares should receive dividends at first. After the preferred shareholders receive cash dividends, the common shareholders may receive cash if there is still any remaining amount from the total amount of dividends. Because preferred shares have some priorities over the common shares.

Usually, the dividend rate on preferred shares is expressed as a percentage of preferred share par value (such as 5%) on the certificate. The preferred dividend is calculated as follow:

The preferred dividend = Outstanding preferred shares x Par value x Preferred dividend rate

Unfortunately, preferred share cannot guarantee that a corporation will pay a dividend equal to the preferred amount and sometimes a corporation may fail to pay any dividends. If a corporation cannot pay any dividends, the preferred share is called dividend in arrears . But, generally preferred shares are issued as cumulative preferred shares and preferred shareholders can receive all the dividends in arrears before the common shareholders receive any dividend in the next period.

A preferred dividend is in arrears if it has not been paid for the period.

A cumulative preferred share is a preferred share that can also receive all dividends in arrears while receiving a new preferred dividend.

Recording Declaration and Payment of Cash Dividends

Firstly, on the date of the declaration, the corporation’s liability amount is determined and it should be recorded. If a corporation has already issued both common and preferred shares, the liabilities about the preferred dividend and common dividend should be recorded in separate accounts after being declared.

Dividend Payable accounts are current liability accounts in which debts about the preferred dividend and common dividend should be recorded.

In some different practices, it is possible to use Cash Dividends account instead of Retained earnings, but debiting Retained Earnings is the most common practice.

Just on the declaration date and payment date journal entries are required. No journal entry is required in the recording date.

Accounting for Share Dividends and Share Splits

Share Dividends

The second popular way to distributing dividends to the shareholders is to share dividends. In this case, the distributed item is different than cash dividends. Share dividend is a distribution of a corporation’s own shares to the shareholders as dividends.

After the decision of paying share dividends, similar to the cash dividends distributions, three dates are important for a corporation. These are: Declaration date, Record date and Distribution date.

At first, on the declaration date, the corporation has declared its intention to distribute its shares. A journal entry is required to show the change between shareholders’ equity items. Secondly, the corporation determines the shareholders who receive share dividends separately on the record date. In this case, a new journal entry is not required. Because this determination has no financial effect. Finally, the corporation distributes the dividend that is determined to the shareholders on the distribution date and a new journal entry should be prepared. Briefly, on the declaration date and distribution date journal entries are required in the process of accounting for cash dividends.

According to the size of the dividends, share dividends transactions are usually divided into two groups:

• Small share dividends : Th ese are the dividends which are less than 20%–25% of the corporation’s issued shares.
• Large share dividends : These are the dividends which are greater than 20%–25% of the corporation’s issued shares.

Similar to cash dividends, it is possible to use Share Dividends account instead of Retained Earnings at first. If Share Dividends is used, it should be closed to Retained Earnings at the end of the accounting period.

Share Splits

A share split is increasing the number of issued and outstanding shares of a corporation that results in decreasing of shares’ par value.

It is significantly different than Share Dividends. If a corporation decides to split its common shares 2 for 1, it has twice shares after the split and par value of per share is cut in half.

Usually, the reason for share splits is to decrease the market price and make the shares more appropriate and attractive for the investors. But share splits have no financial effect on any account balance. Thus no classical journal entry is required. It should be recorded in a memorandum entry that represents a note without any balance.

In a share split the par value per share is decreasing in the determined proportion. But recall that in a share dividend the par value per share doesn’t change.

Restrictions on Retained Earnings

To reserve cash or to be conservative about possible risks or some specific reasons such as loan agreements, to distribute the regular amount of dividends etc. there may be some restrictions on retained earnings.

A restriction on retained earnings is an amount of retained earnings that is unavailable for dividends.

Restricted retained earnings amount presents the amount of that is unavailable for distribution to the shareholders. In other words, restricted retained earnings show a reduction from a possible amount of dividends. On the footnotes of the financial statements, all of the details should be explained clearly.

Usually, the restrictions may occur in three different types: Legal restrictions, contractual restrictions, and voluntary restrictions.

Regulations in different countries may require legal restrictions to protect the capital of the corporations. Long term liabilities agreement may require to restrict the retained earnings. Other than these restrictions, the board of the directors may require some restrictions on retained earnings for specific proposes.

Changes in Shareholders’ Equity

For shareholders, it is very important to understand the changes in shareholders’ equity to decide on their investment plans. Besides, these changes are important for other financial statement users to analyze the financial strength, performance, and position of the corporation. Hence, the requirements for the information about the change in the shareholders’ equity could be changed according to different parties. For this reason, on the balance sheet, the most basic and general information should be represented as a summary. Then on the footnotes of the balance sheet, the financial statement users who need some more information can find many details about different items of the balance sheet.

Because of the importance of the information about the changes in shareholders’ equity especially for the investors, another specific financial statement named Statement of Shareholder’s Equity is prepared by the corporations.

Corporations prepare the statement of equity to provide more information about the change in the shareholders’ equity. This statement starts with the beginning balances of different components of Shareholders’ Equity, and additions and subtractions.

Statement of shareholders’ equity is a financial report that represents the details about the changes in shareholders’ equity for a period of time.

Earnings and Evaluating Ratios

Corporations should give accurate, reliable, comparable information to the users of financial statements about their financial performance.

In reporting the components of net income in the traditional way, which is explained above, some gains and losses are not included. These are components of the Comprehensive Income. Comprehensive income is all changes in the shareholders’ equity from all sources except owners’ investments and dividends.

Comprehensive income components are as follows:

• Unrealized gains or losses
• Foreign-currency translation adjustments
• Gains (losses) from post-retirement benefit plans
• Deferred gains (losses) derivatives.

By some ratios, the relationship between shareholders’ equity items, their positions, results, and effects can be understood clearly. Thus the information on the financial statements can be used in some decision making processes.

One of the ratios that is used for analysis is the Return on Equity (ROE).

Return on Equity is a measure of a corporation’s profitability that presents how much profit it generates with each item (TL) of shareholders’ equity.