Third Canadian Edition
Prepared by:
Keri Norrie, Camosun College

• 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)

• Pro rata distribution of cash to shareholders
• Corporation must have:
1.
enough retained earnings,
2.
enough cash, and
3.
declared 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 + Shareholders’ Equity
$50,000 $50,000

Account Titles and Explanations
Cash Dividends – Common
Dividends Payable
To record declaration of cash dividend.
Debit Credit
50,000
50,000
Declaration date:
The entry on September 1 to record the declaration is as above.

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.

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
Dividends Payable
Cash
To record payment of cash dividend.
Debit Credit
50,000
50,000
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) .

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
Cash Dividends —Preferred
Cash Dividends —Common
Dividend Payable
To record declaration of cash dividend.
Debit Credit
8,000
12,000
20,000

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
Cash Dividends —Preferred
Cash Dividends —Common
Dividend Payable
To record declaration of cash dividend.
Debit Credit
16,000
4,000
20,000

• 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 +
Shareholders’ Equity
There is no change in total assets, liabilities, or shareholders’ equity.
Retained
Earnings
Common
Shares

• 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

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
Common shares
Retained earnings
Total shareholders’ equity
Number of shares
$100,000
500,000
300,000
$900,000
50,000
100,000
575,000
$225,000
900,000
$55,000
Stock dividends change the composition of shareholders’ equity because a portion of retained earnings is transferred to contributed capital.

• 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

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
Common shares
Retained earnings
Total shareholders’ equity
Number of shares
$100,000
500,000
300,000
$900,000
50,000
$100,000
500,000
$300,000
$900,000
$100,000
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.

Total assets
Total liabilities
Total shareholders’ equity
Total share capital
Total retained earnings
Number of shares
% of shareholder ownership
Cash Stock Stock
Dividend Dividend Split

NE

NE

NE
NE
NE NE
NE NE
NE



NE
NE
NE
NE

NE
NE = No effect

= Increase

= Decrease

• 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

LEADS INC.
Income Statement
Year Ended December 31, 2005
Sales
Cost of goods sold
Gross profit
Operating expenses
Income from operations
Other revenues
$800,000
600,000
200,000
50,000
150,000
10,000
Other expenses
Income before income tax
Income tax expense
Net Income
4,000
156,000
46,800
$109,200

• 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 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
$500,000
109,200
609,200
25,000
Retained earnings, December 31, 2005 $584,200

• 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

he correction of a material error in reporting net income in previously issued financial statements, or
– the changing of an accounting principle

• 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

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

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
Retained Earnings
Income Tax Payable
Accumulated Amortization
To correct error in 2004 amortization and income tax.
Debit Credit
28,000
12,000
40,000

• 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

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

Retained Earnings
Debits (Decreases)
1. Correction of a prior period error that overstated income
2. Cumulative effect of a change in accounting principle that decreased income
Credits (Increases)
1. Correction of a prior period error that understated income
2. Cumulative effect of a change in accounting principle that increased income
3. Net Income 3. Net Loss
4. Cash Dividends
5. Stock Dividends
6. Reacquisition of shares

• 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

– To find the equivalent number of whole shares for the year, multiply by fraction of year outstanding

• 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.

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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