Question 1. Where Do Dividends Appear On The Financial Statements?
The dividends declared and paid by a corporation will be reported as a use of cash in the financing section of the statement of cash flows. Dividends are also reported on the statement of changes in stockholders’ equity.
Dividends on common stock are not reported on the income statement since they are not expenses. Dividends on preferred stock are not expenses, but will be deducted from net income in order to report the earnings available for common stock on the income statement.
Since the balance sheet reports only the ending account balances at an instant of time, the Cash and Retained Earnings amounts reflect the balances after past dividends and other transactions.
Question 2. What Is The Meaning Of Equity?
Equity is used in accounting in several ways. Often the word equity is used when referring to an ownership interest in a business. Examples include stockholders’ equity or owner’s equity.
Occasionally, equity is used to mean the combination of liabilities and owner’s equity. For example, some restate the basic accounting equation Assets = Liabilities + Owner’s Equity to become Assets = Equities.
Equity is also used to indicate an owner’s interest in a personal asset. The owner of a $200,000 house that has an $80,000 mortgage loan is said to have $120,000 of equity in the house.
Outside of accounting, the word equity is also used to indicate fairness or justice.
Question 3. How Do You Record A Dividend Payment To Stockholders?
A dividend to stockholders or shareholders involves two entries. The first entry occurs on the date that the board of directors declares the dividend. In this entry the account Retained Earnings is debited and Dividends Payable is credited for the amount of the dividend that will be paid. Retained Earnings is a stockholders’ equity account and Dividends Payable is a current liability account. Some corporations debit a temporary account Dividends instead of debiting Retained Earnings. Then at the end of the year, the Dividends account is closed to Retained Earnings.
The second entry occurs on the date of the payment to the stockholders. On that date the current liability account Dividends Payable is debited and the asset account Cash is credited.
Question 4. What Is Retained Earnings?
Generally, retained earnings is a corporation’s cumulative earnings since the corporation was formed minus the dividends it has declared since it began. In other words, retained earnings represents the corporation’s cumulative earnings that have not been distributed to its stockholders.
The amount of retained earnings as of a balance sheet’s date is reported as a separate line item in the stockholders’ equity section of the balance sheet.
A negative amount of retained earnings is reported as deficit or accumulated deficit.
Question 5. What Is The Difference Between Stocks And Bonds?
Stocks, or shares of stock, represent an ownership interest in a corporation. Bonds are a form of long-term debt in which the issuing corporation promises to pay the principal amount at a specific date.
Stocks pay dividends to the owners, but only if the corporation declares a dividend. Dividends are a distribution of a corporation’s profits. Bonds pay interest to the bondholders. Generally, the bond contract requires that a fixed interest payment be made every six months.
Every corporation has common stock. Some corporations issue preferred stock in addition to its common stock. Many corporations do not issue bonds.
The stocks and bonds issued by the largest corporations are often traded on stock and bond exchanges. Stocks and bonds of smaller corporations are often held by investors and are never traded on an exchange.
Question 6. How Do Cash Dividends Affect The Financial Statements?
When a corporation declares a cash dividend on its stock, its retained earnings are decreased and its current liabilities (Dividends Payable) are increased. When the cash dividend is paid, the Dividends Payable account is decreased and the corporation’s Cash account is decreased.
The net result of the declaration and payment of the dividend is that the corporation’s assets and stockholders’ equity have decreased. Specifically, the balance sheet accounts Cash and Retained Earnings were decreased.
The income statement is not affected by the declaration and payment of cash dividends on common stock. (The cash dividends on preferred stock are deducted from net income to arrive at net income available for common stock.)
The cash dividends will be reported as a use of cash in the financing activities section of the statement of cash flows.
Question 7. What Is The Difference Between Equity Financing And Debt Financing?
Equity financing often means issuing additional shares of common stock to an investor. With more shares of common stock issued and outstanding, the previous stockholders’ percentage of ownership decreases.
Debt financing means borrowing money and not giving up ownership. Debt financing often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates. Failure to meet the debt requirements will result in severe consequences. In the U.S. the interest on debt is a deductible expense when computing taxable income. This means that the effective interest cost is less than the stated interest if the company is profitable. Adding too much debt will increase the company’s future cost of borrowing money and it adds risk for the company.
Question 8. Are Retained Earnings An Asset?
Generally, the amount of a corporation’s retained earnings is the cumulative net income since the corporation began minus all of the dividends that the corporation has declared since it began. The amounts are recorded in the Retained Earnings account, which is reported in the Stockholders’ Equity section of the corporation’s balance sheet.
While the amount of retained earnings is reported in the stockholders’ equity section of the balance sheet (and in the accounting equation), the retained earnings are probably invested in assets that are also reported on the balance sheet. For example, let’s assume that you start a corporation to provide website consulting services. You invest $500 in the corporation, and immediately find a client who pays you $4,000 for your services. Your corporation’s Cash is now $4,500 which equals the Paid-in Capital of $500 plus the Retained Earnings of $4,000. On the next day, you spend $3,500 to acquire a computer and other equipment for your corporation plus $300 of supplies. Right after these items are purchased, your corporation will report $700 of Cash + $300 of Supplies + $3,500 of Equipment = Stockholders’ Equity of $4,500—of which $4,000 is Retained Earnings.
The Retained Earnings amount is clearly reported as part of Stockholders’ Equity, but the amount is usually invested in assets or used to reduce liabilities. Rarely will the retained earnings be entirely in cash. The retained earnings need to be invested in income producing assets or in the reduction of liabilities in order to earn a return for the stockholders, who have opted to reinvest their earnings in the corporation.
Question 9. What Is The Difference Between Public Sector And Private Sector?
Public sector refers to government-owned organizations and government-provided services.
Private sector refers to
1) organizations that are not government owned, and
2) the goods and services provided by organizations outside of the government.
For example, companies owned by individuals are part of the private sector. Even the largest corporation with its common stock publicly-traded on the New York Stock Exchange is part of the private sector.
Question 10. What Type Of Account Is The Dividends Account?
When a corporation declares a dividend on its common stock, it will credit a current liability account Dividends Payable and will debit either 1) Retained Earnings, or 2) Cash Dividends Declared. Cash Dividends Declared is a balance sheet account, but it is a temporary account. The reason it is a temporary account is that its debit balance will be closed to the Retained Earnings account before the end of the accounting year.
Question 11. What Is The Difference Between Stockholder And Stakeholder?
A stockholder or shareholder is the holder or owner of stock in a corporation.
A stakeholder is anyone that has an interest or is affected by a corporation. In other words, the stockholder isn’t the only party having a stake in the corporation. Other stakeholders in a corporation include the employees, the employees’ families, suppliers, customers, community, and others.
Some organizations do not have stockholders, but have stakeholders. For example, the state university doesn’t have stockholders, but it has many stakeholders: students, the students’ families, professors, administrators, employers, state taxpayers, the local community, the state community, society in general, custodians, suppliers, etc.
Question 12. What Is Stockholders’ Equity?
Stockholders’ equity (also known as shareholders’ equity) is one of the three elements of a corporation’s balance sheet and the accounting equation as outlined here: assets = liabilities+ stockholders’ equity.
Some view stockholders’ equity as a source (along with liabilities) of the corporation’s assets. Others think of stockholders’ equity as the owners’ residual claim after the liabilities have been paid. Stockholders’ equity is also the corporation’s total book value (which is different from the corporation’s worth or market value).
The amount of stockholders’ equity is presented in the balance sheet in the following subsections:
- Paid-in capital. Generally this subsection reports the amounts that the corporation received when it issued shares of capital stock.
- Retained earnings. Generally this is the cumulative earnings of the corporation minus the cumulative amount of dividends declared.
- Accumulated other comprehensive income. This is the cumulative amount of income (or loss) that has not been included in the net income reported on the corporation’s income statement.
- Treasury stock. This reduction of stockholders’ equity is the amounts spent by the corporation to repurchase but not retire its own shares of capital stock.
The changes which occurred in stockholders’ equity during the accounting period are reported in the corporation’s Statement of Stockholders’ Equity (one of the main financial statements).
Question 13. How Do You Record An Owner’s Money That Is Used To Start A Company?
If the owner of a sole proprietorship puts money into her or his business, the sole proprietorship will debit the asset received (Cash, Inventory, Equipment, etc.) and will credit the owner’s capital account (if it is an investment in the business) or will credit a liability account such as Notes Payable (if it is a loan to the business). The amount that is recorded is the cash amount. If cash was not involved, then the cash equivalent or fair market value is used.
If the business is a corporation and the owner’s infusion of cash is an investment, the account Common Stock is credited. (If the common stock has a par value, Paid-in Capital in Excess of Par is also used.) If the owner lends cash to the corporation, the liability account Notes Payable to Stockholder is credited. When the asset is not cash, the amount recorded is the cash equivalent or fair market value of the asset or the fair market value of the common stock issued, whichever is more clear.
You should consult with your accounting and tax professional about the pros and cons of investing versus lending.
Question 14. What Is A Capital Account?
In accounting and bookkeeping, a capital account is one of the general ledger accounts used to record 1) the amounts that were paid in to the company by an investor, and 2) the cumulative amount of the company’s earnings minus the cumulative distributions to the owners. The balances of the capital accounts are reported in the owner’s equity, partners’ equity, or stockholders’ equity section of the balance sheet.
In a corporation the capital accounts include:
- Paid-in capital accounts such as Common Stock, Preferred Stock, Paid-in Capital in Excess of Par. These accounts report the amounts received by the corporation when the shares of its capital stock were originally issued to investors.
- Retained earnings accounts which typically contain the amount of the corporation’s cumulative earnings since the corporation was formed minus the cumulative dividends distributed to the stockholders.
- Treasury stock account (a contra account because it has a debit balance) usually reporting the amount paid by the corporation to repurchase its own shares of stock that have not been retired.
In a sole proprietorship (such as one owned by Amy Fox) the capital accounts include:
- Amy Fox, Capital. This account begins with Amy’s original investment and is increased for each year’s earnings minus each year’s withdrawals by Amy.
- Amy Fox, Drawing. This account is a contra account because it will have a debit balance equal to the amount of business assets that Amy has withdrawn during the current accounting year for her personal use. At the end of each accounting year, Amy’s drawing account is closed by transferring its debit balance to the account Amy Fox, Capital.
The total of the balances in the capital accounts must be equal to the reported total of the company’s assets minus its liabilities. Because of the historical cost principle and other accounting principles the total amount reported in the capital accounts will not indicate the company’s market value or net worth.
Question 15. What Is The Difference Between Par And No Par Value Stock?
Some states’ laws require or may have required common stock issued by corporations residing in their states to have a par value. The par value on common stock has generally been a very small amount per share. Other states might not require corporations to issue stock with a par value. So the par value on common stock is a legal consideration.
From an accounting standpoint, the par value of an issued share of common stock must be recorded in an account separate from the amount received over and above the amount of par value. For example, if a corporation issues 100 new shares of its common stock for a total of $2,000 and the stock’s par value is $1 per share, the accounting entry is a debit to Cash for $2,000 and a credit to Common Stock—Par $100, and a credit to Paid-in Capital in Excess of Par for $1,900. In total the Cash account increased by $2,000 and the paid-in capital reported under stockholders’ equity increased by a total of $2,000 ($100 + $1,900).
If a corporation is not required to have a par value or a stated value and the corporation issues 100 shares for $2,000, then the accounting entry will be a debit to Cash for $2,000 and a credit to Common Stock for $2,000.
In other words, when the issued stock has a par value, the proceeds from the issuance gets divided between two of the paid-in capital accounts within stockholders’ equity. If the issued stock does not have a par value, the proceeds from the issuance goes into just one paid-in capital account within stockholders’ equity.
Question 16. What Is Comprehensive Income?
Comprehensive income for a corporation is the combination of the following amounts which occurred during a specified period of time such as a year, quarter, month, etc.:
- Net income or net loss (which is reported on the income statement), plus
- Other comprehensive income (if this is present, a statement of comprehensive income must be prepared)
Examples of other comprehensive income include:
- Unrealized gains/losses on available-for-sale investments
- Unrealized gains/losses on hedge/derivative financial instruments
- Foreign currency translation adjustments
- Unrealized gains/losses on postretirement benefit plans
Basically, comprehensive income consists of all of the revenues, gains, expenses, and losses that caused stockholders’ equity to change during the accounting period. (The corporation’s sale or purchase of its capital stock and its declaration of dividends are not a component of comprehensive income. The stock transactions and dividends are reported as separate items in the statement of stockholders’ equity.)
The amount of other comprehensive income for the period will be added to the accumulated other comprehensive income, which is a separate line within stockholders’ equity on the end-of-the-period balance sheet. (The net income or net loss reported on the income statement will be added to retained earnings as usual.)
Question 17. Where Is Treasury Stock Reported On The Balance Sheet?
Under the cost method of recording treasury stock, the cost of treasury stock is reported at the end of the Stockholders’ Equity section of the balance sheet. Treasury stock will be a deduction from the amounts in Stockholders’ Equity.
Treasury stock is the result of a corporation repurchasing its own stock and holding those shares instead of retiring them.
In the general ledger there will be an account Treasury Stock with a debit balance. (At the time of the purchase of treasury stock, the corporation will debit the account Treasury Stock and will credit the account Cash.)
Question 18. What Is Net Income?
In business, net income is the positive result of 1) revenues and gains minus 2) expenses and losses. A negative result is referred to as net loss. (Please note that some gains and losses are not included in the calculation of net income, but will be included in comprehensive income).
Net income is also known as net earnings. The details of the net income calculation is reported in the business’s income statement. The income statement is also known as the statement of income, statement of earnings, and statement of operations.
The net income of a regular U.S. corporation includes the income tax expense which pertains to the items reported in its income statement. The net income of a sole proprietorship, partnership, and Subchapter S corporation will not include income tax expense since the owners (and not the entity) are responsible for the business income tax.
A corporation’s net income will cause an increase in the Retained Earnings account, which will also result in an increase in stockholders’ equity. A net loss will cause a decrease.
A sole proprietorship’s net income will cause an increase in the owner’s capital account, which will also mean an increase in owner’s equity. A net loss will cause a decrease.
Question 19. What Is The Difference Between Dividends And Interest Expense?
Dividends are a distribution of a corporation’s earnings to its stockholders. Dividends are not an expense of the corporation and, therefore, dividends do not reduce the corporation’s net income or its taxable income. When a dividend of $100,000 is declared and paid, the corporation’s cash is reduced by $100,000 and its retained earnings (part of stockholders’ equity) is reduced by $100,000.
Interest on bonds and other debt is an expense of the corporation. The interest expense will reduce the corporation’s net income and its taxable income. When interest expense occurs and is paid, the corporation’s cash is reduced by the interest payment, but some cash will be saved by the reduction in income taxes. The corporation’s retained earnings will also be reduced by less than the amount of interest expense. For example, if a corporation has an incremental tax rate of 40%, interest expense of $100,000 will result in $40,000 less in income tax expense and income tax payments. This means that an interest payment of $100,000 will reduce the corporation’s cash and retained earnings by the net amount of $60,000 ($100,000 of interest minus $40,000 of tax savings).
Since interest is formally promised to the lenders, accountants must accrue interest expense and the related liability Interest Payable. If the payment for interest is not made, the corporation will face legal consequences.
Dividends on common stock are not legally required. Therefore, if the corporation does not declare a dividend there is no liability for the omitted dividends.
Question 20. What Is The Cost Of Capital?
The cost of capital is the weighted-average, after-tax cost of a corporation’s long-term debt, preferred stock, and the stockholders’ equity associated with common stock. The cost of capital is a percentage and it is often used to compute the net present value of the cash flows in a proposed investment. It is also considered to be the minimum after-tax internal rate of return to be earned on new investments.
For a profitable corporation, the costs of bonds and other long-term loans are usually the least expensive components of the cost of capital. One reason is that the interest will be deductible for U.S. income taxes. For example, a corporation paying 6% on its loans may have an after-tax cost of 4% when its combined federal and state income tax rate is 33%. On the other hand, the dividends paid on the corporation’s preferred and common stock are not tax deductible.
The cost of common stock (paid-in capital and retained earnings) is considered to be the most expensive component of the cost of capital because of the risks involved.
Let’s compute the cost of capital by assuming that a corporation has $40 million of long-term debt with an after-tax cost of 4%, $10 million of 7% preferred stock, and $50 million of common stock and retained earnings with an estimated cost of 15%. Its weighted-average, after-tax cost of capital is: ($40 million X 4% = $1.6 million) + ($10 million X 7% = $0.7 million) + ($50 million X 15% = $7.5 million) = $9.8 million divided by $100 million = 9.8%.
Question 21. What Is Par Value?
Par value is a per share amount appearing on stock certificates. It is also an amount that appears on bond certificates.
In the case of common stock the par value per share is usually a very small amount such as $0.10 or $0.01 or $0.001 and it has no connection to the market value of the share of stock. The par value is usually described as the common stock’s legal capital and it is part of the corporation’s paid-in (or contributed) capital.
When a share of common stock having a par value of $0.01 is issued for $25, the account Common Stock will be credited for $0.01 and an additional paid-in capital account will be credited for $24.99 (and Cash will be debited for $25.00).
If a state no longer requires a corporation’s common stock to have a par value, a corporation might issue no-par stock (which may or may not have a stated value).
In the case of bonds, the par value is also the face amount or maturity value of the bonds.
Question 22. What Is The Expanded Accounting Equation?
The expanded accounting equation replaces Owner’s Equity in the basic accounting equation (Assets = Liabilities + Owner’s Equity) with the following components: Owner’s Capital + Revenues – Expenses – Owner’s Draws. In other words, the expanded accounting equation for a sole proprietorship is: Assets = Liabilities + Owner’s Capital + Revenues – Expenses – Owner’s Draws.
In the expanded accounting equation for a corporation, Stockholders’ Equity in the basic accounting equation (Assets = Liabilities + Stockholders’ Equity) is replaced by these components: Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock. The resulting expanded accounting equation for a corporation is: Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock.
The expanded accounting equation allows you to see separately (1) the impact on equity from net income (increased by revenues, decreased by expenses), and (2) the effect of transactions with owners (draws, dividends, sale or purchase of ownership interest).
Question 23. What Is The Difference Between Paid-in Capital And Retained Earnings?
First, paid-in capital and retained earnings are the major categories of stockholders’ equity.
Paid-in capital, also referred to as contributed capital, is the amount that the corporation received from stockholders when the corporation issued its stock. Paid-in capital is also referred to as permanent capital.
Retained earnings is the cumulative amount of after tax net income earned by the corporation since its inception minus the dividends that have been distributed to the stockholders since the corporation began.
Question 24. What Is The Book Value Per Share Of Stock?
If a corporation does not have preferred stock outstanding, the book value per share of stock is a corporation’s total amount of stockholders’ equity divided by the number of common shares of stock outstanding on that date.
For example, if a corporation without preferred stock has stockholders’ equity on December 31 of $12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per share is $12.42.
Keep in mind that the book value per share will not be the same as the market value per share. One reason is that a corporation’s stockholders’ equity is simply the difference between the total amount of assets reported on the balance sheet and the total amount of liabilities reported. Noncurrent assets are generally reported at original cost less accumulated depreciation and some valuable assets such as trade names might not be listed on the balance sheet.
Question 25. What Is Treasury Stock?
Treasury stock is a corporation’s previously issued shares of stock which have been repurchased from the stockholders and the corporation has not retired the repurchased shares. The number of shares of treasury stock (or treasury shares) is the difference between the number of shares issued and the number of shares outstanding. Since the treasury shares result in fewer shares outstanding, there may be a slight increase in the corporation’s earnings per share.
Treasury Stock is also the title of a general ledger account that will typically have a debit balance equal to the cost of the repurchased shares being held by the corporation. (Some corporations use the par value method instead.) The cost of the treasury stock purchased with cash will reduce the corporation’s cash and the amount of its total stockholders’ equity.
The shares of treasury stock will not receive dividends, will not have voting rights, and cannot result in an income statement gain or loss. The shares of treasury stock can be sold, retired, or could continue to be held as treasury stock.
Question 26. What Is Common Stock?
Common stock is the type of ownership interest (expressed in “shares”) that exists at every U.S. corporation. (A relatively few corporations will have preferred stock in addition to the common stock.) The owners of common stock are known as common stockholders, common shareholders, or simply as stockholders or shareholders.
Common Stock is also the title of the general ledger account that is credited when a corporation issues new shares of common stock. (The amount of the credit will depend on the state’s regulations.) The balance in Common Stock will be reported in the corporation’s balance sheet as a component of paid-in capital, a section within stockholders’ equity.
Generally, the holders of common stock elect the corporation’s board of directors and will participate in a corporation’s success through increases in the market value of their shares of common stock and perhaps through cash dividends.
A drawback of common stock is that the common stockholders are last in line if the corporation is dissolved.
Question 27. What Are The Required Financial Statements?
The required financial statements for U.S. business corporations are:
- Statement of income. This financial statement is also known as the statement of operations, statement of earnings, or income statement. It reports the corporation’s revenues, expenses, gains and losses (except for items stipulated as other comprehensive income) for a period of time such as a year, quarter, 13 months, etc.
- Statement of comprehensive income. This financial statement begins with the bottom line of the income statement and then lists the items considered to be other comprehensive income. Some of these items involve currency translation, hedging, available-for-sale securities, and pensions.
- Balance sheet. This statement of financial position reports a corporation’s assets, liabilities and stockholders’ equity as of the final instant of the date shown in its heading (December 31, January 31, June 30, etc.)
- Statement of cash flows. This statement reports the major causes for the change in cash and cash equivalents during the accounting period. The cash flows are presented as operating, investing, or financing activities.
- Statement of stockholders’ equity. This financial statement is often presented as the statement of shareholders’ equity, statement of equity, statement of changes in stockholders’ equity, etc. It reports all of the changes in stockholders’ equity which occurred during the accounting period.
The five annual financial statements must be accompanied with notes to the financial statements. These notes are needed in order to disclose additional information about items that are reported or are not reported in the financial statements.
You can see examples of the required financial statements (and the required notes) for a publicly traded U.S. corporation by searching the Internet for the corporation’s name plus the words investor relations. Select Annual Reports (or select SEC filings and annual reports or 10-K).
Question 28. What Is Capital Stock?
Capital stock is the combination of a corporation’s common stock and preferred stock (if any).
Common stock is usually the first and only capital stock issued by corporations. However, some corporations will also issue preferred stock.
The amount received by the corporation when it issued shares of its capital stock is reported in the stockholders’ equity section of the balance sheet.
Question 29. What Are The Journal Entries For A Stock Split?
The only journal entry needed for a stock split is a memo entry to note that the number of shares has changed and that the par value per share has changed (if the stock has a par value). However, a typical journal entry with debits and credits is not needed since the total dollar amounts for the par value and other components of paid-in capital and stockholders’ equity do not change.
For example, if a corporation has 100,000 shares of $1.00 par value stock and it declares a 2-for-1 stock split, the corporation will have 200,000 shares with a par value of $0.50 per share. Before and after the stock split, the total par value is $100,000. Other account balances within stockholders’ equity also remain the same.
Question 30. What Is The Difference Between Public Companies And Public Sector?
Public companies are those businesses owned by individuals (and not by a government). If a public company is a corporation whose stock is traded on a stock exchange it is said that the stock is publicly traded or that the company is a publicly-traded corporation.
Public sector refers to government-owned organizations and government-provided services.
Question 31. What Is Stock?
In accounting there are two common uses of the term stock. One meaning of stock refers to the goods on hand which is to be sold to customers. In that situation, stock means inventory.
The term stock is also used to mean the ownership shares of a corporation. For example, an owner of a corporation will have a stock certificate which provides evidence of his or her ownership of a corporation’s common stock or preferred stock. The owner of the corporation’s common or preferred stock is known as a stockholder.
Question 32. What Is A Memorandum Entry?
A memorandum entry is a short message entered into the general journal and also entered into a general ledger account. It is not a complete journal entry because it does not contain debit and credit amounts.
An example of a memorandum entry might be the following:
“On May 1, 2013 a 2-for-1 stock split was declared for the common stockholders of record as of the end of the day May 22, 2013. The stock split will result in the number of issued and outstanding shares of common shares increasing from 200,000 shares to 400,000 shares.”
Since a stock split does not change the balance in the Common Stock account, a complete journal entry was not required. The memorandum entry merely notes for future reference that the number of shares of stock has changed.
Question 33. Is It Okay To Have Negative Amounts In The Equity Section Of The Balance Sheet?
If the current year’s net income is reported as a separate line in the stockholders’ equity or in the owner’s equity section of the balance sheet, a negative amount of net income must be reported. The negative net income occurs when the current year’s revenues are less than the current year’s expenses.
If the cumulative earnings minus the cumulative dividends declared result in a negative amount, there will be a negative amount of retained earnings. This negative amount of retained earnings will be reported as a separate line within stockholders’ equity.
If the amount of negative retained earnings is greater than the amount of paid-in capital, the total of the stockholders’ equity section will also be a negative amount.
To recap, negative amounts can occur and the negative amounts must be reported.
Question 34. What Is A Dividend?
A cash dividend is a distribution of a portion of a corporation’s earnings to its stockholders.
A stock dividend (as opposed to a cash dividend) is a distribution of more shares of a corporation’s own stock to its stockholders.
Question 35. What Is Preferred Stock?
Preferred stock is a type of capital stock issued by some corporations. Preferred stock is also known as preference stock.
The word “preferred” refers to the dividends paid by the corporation. Each year, the holders of the preferred stock are to receive their dividends before the common stockholders are to receive any dividend. In exchange for this preferential treatment for dividends, the preferred stockholders (or shareholders) generally will never receive more than the stated dividend. For example, the holder of 100 shares of a corporation’s 8% $100 par preferred stock will receive annual dividends of $800 (8% X $100 = $8 per share X 100 shares) before the common stockholders are allowed to receive any cash dividends for the year. Unless the preferred stock has a participating feature, this preferred stockholder will never receive more than $8 per share no matter how successful the corporation becomes.
The features of preferred stocks can vary. Examples include cumulative, convertible, callable, participating, and more.
Since the dividend on preferred stock is usually a fixed amount forever, once the preferred stock is issued its market value is likely to move in the opposite direction of inflation. The higher the rate of inflation, the less valuable is the fixed dividend amount. If the inflation rate declines, the value of the preferred stock is likely to increase, but no higher than the stock’s call price.
Most corporations do not issue preferred stock. Typically, corporations will issue only common stock and use debt.
Question 36. What Is The Meaning Of Arrears?
In accounting we use the word arrears in at least two ways. One use involves the omitted dividends on cumulative preferred stock. For example, if a corporation has cumulative preferred stock and due to a shortage of cash decides to omit the dividend on those preferred shares, the preferred dividend is in arrears. The result of having these dividends in arrears is that the owners of the common stock cannot receive a dividend until the preferred stock’s dividends in arrears are paid and the preferred stock’s current year dividend is also paid. Having dividends in arrears also requires a disclosure in the notes to the financial statements.
Arrears is also used in the context of annuities. When an annuity’s equal payments occur at the end of each period, the annuity is said to be an annuity in arrears or an ordinary annuity.
Arrears is also used to simply mean past due, or behind in payments.
Question 37. What Is The Difference Between Stockholder And Shareholder?
There is no difference between stockholder and shareholder. The terms are used interchangeably. Both terms mean the owner of shares of stock in a corporation and a part owner of a corporation.
Question 38. What Are The Reasons For A Stock Dividend Instead Of A Cash Dividend?
A corporation might declare a stock dividend instead of a cash dividend in order to 1) increase the number of shares of stock outstanding, 2) move some of its retained earnings to paid-in capital, and 3) minimize distributing the corporation’s cash to its stockholders.
If a corporation has 100,000 shares of stock outstanding and it declares a 10% stock dividend, the corporation ends up having 110,000 shares outstanding. An individual stockholder having 1,000 shares prior to the 10% stock dividend will have 1,100 shares after the stock dividend. This individual’s stake in the corporation was 1% (1,000 out of 100,000 shares) prior to the stock dividend and will remain at 1% (1,100 out of 110,000 shares) after the stock dividend.
Since the corporation hasn’t really changed because of the stock dividend, the total market value of the corporation should not change. In other words, if the total market value of the corporation was $1 million before the stock dividend, it should be $1 million after the stock dividend. However, the market value of each share should decrease: $1,000,000 divided by 100,000 shares = $10 per share, and $1,000,000 divided by 110,000 shares = $9.0909. The total market value of the individual’s holdings should also remain the same: 1,000 shares X $10 = $10,000, and 1,100 shares X $9.0909 = $10,000. If the market does not adjust for the increased number of shares, the individual stockholders will benefit.
Question 39. What Is Premium On Common Stock?
The premium on common stock involves the amount the issuing corporation receives when it issues common stock having a par value. The premium on common stock is the dollar amount that is in excess of the common stock’s par value.
To illustrate the premium on common stock, let’s assume that a corporation issues one share of its common stock having a par value of $0.10 per share. If the corporation receives $20 in exchange for the share, $19.90 will be recorded as the premium on common stock.
Accounting textbooks often refer to the premium on common stock as paid-in capital in excess of par value–common stock or as contributed capital in excess of par value–common stock.
Question 40. What Is The Meaning Of Pro Rata?
Pro rata is a Latin term that means in proportion. Pro rata is related to prorate, a term used in cost accounting.
To illustrate the term pro rata, let’s assume that a company’s standard costing system has an unfavorable materials price variance of $400,000. If that amount is significant, the company will prorate the $400,000 to its inventory and to its cost of goods sold. Let’s also assume that the proration will be based on the company’s $1 million of standard materials costs in its inventories and $9 million of standard materials costs in its cost of goods sold. On this basis the inventories’ pro rata share of the variance will be $40,000 ($1 million divided by the total of $10 million = 10% times the $400,000 variance). The pro rata share of the variance assigned to the cost of goods sold will be $360,000 ($9 million divided by $10 million = 90% times the $400,000 variance).
Question 41. A Corporation Has A Large Balance In Retained Earnings. Does That Mean That Its Dividends To Stockholders Will Be Increasing?
Not necessarily. The balance in retained earnings means that the company has been profitable over the years and its dividends to stockholders have been less than its profits. It is possible that a company with billions of dollars of retained earnings has very little cash available today.
One possible explanation for the small amount of cash in relation to the retained earnings is that the company invested in new plant assets in order to expand its operations. Rather than distributing the company’s cash to its stockholders, the company used the cash to pay for the factory and equipment in order to meet demand for its new product line.
Corporations might have a stated policy on dividends. For example, a corporation might pay dividends equal to approximately 40% of its earnings. Another corporation might have a plan to increase the amount of dividends each year by more than the rate of inflation. A new corporation might pay no dividends until its ratio of debt to equity is a specified percentage.
Question 42. What Does The Term Arrears Mean In Accounting?
In accounting, arrears is used in at least two situations. One use involves the past, omitted dividends on cumulative preferred stock. If a corporation fails to declare the preferred dividend, those dividends are said to be in arrears. The dividends in arrears must be disclosed in the notes (footnotes) to the financial statements. (Cumulative preferred stock requires that any past, omitted dividends must be paid to the preferred stockholders before the common stockholders will be paid any dividend.)
Another use of the word arrears occurs with annuities. (An annuity is a series of equal amounts occurring at equal time intervals…such as $1,000 per month for 20 years.) If the recurring amount comes at the end of each period, the annuity is described as an annuity in arrears or as an ordinary annuity. A loan repayment schedule is usually an annuity in arrears. For example, you borrow $10,000 on September 30 and your first monthly payment will be due on October 31, the second payment will be due on November 30, and so on.
Question 43. What Is A Stockholder?
A stockholder (also known as a shareholder) is the owner of one or more shares of a corporation’s capital stock. A stockholder is considered to be separate from the corporation and as a result will have limited liability as far the corporation’s obligations.
The owner of a corporation’s common stock is referred to as a common stockholder. The common stockholders elect the corporation’s board of directors and will vote on very significant transactions such as merging the corporation with another corporation. Generally it is the common stockholders who become wealthy when a corporation becomes increasingly more successful.
In addition to common stock, some corporations also issue preferred stock. An owner of these shares is known as a preferred stockholder (or preferred shareholder). A preferred stockholder usually accepts a fixed cash dividend that will be paid by the corporation before the common stockholders are paid a dividend. In exchange for this preferential treatment of dividends, the preferred stockholder will forego the potential financial gains that may occur for the common stockholder.
Question 44. What Are Dividends?
In accounting, dividends often refers to the cash dividends that a corporation pays to its stockholders (or shareholders). Dividends are often paid quarterly, but could be paid at other times. For a dividend to be paid, the corporation’s board of directors must formally approve/declare the dividend. Hence, the board of directors may decide that a dividend will not be declared.
It is important to note that the dividends declared and paid by a corporation are not an expense of the corporation. Rather, dividends are a distribution of the corporation’s earnings. This explains why state laws likely require corporations to have a credit balance in Retained Earnings before declaring and paying dividends. Practically speaking, the corporation must also have sufficient cash available to meet its current and future needs.
While all corporations have common stock, some corporations will also have preferred stock. In that situation the preferred stockholders must receive their dividend before the common stockholders.
When the board of directors declares a dividend, it will result in a debit to Retained Earnings and a credit to a liability such as Dividends Payable. When the corporation pays the dividend, Dividends Payable will be debited and Cash will be credited.
Since Retained Earnings is a component of stockholders’ equity, the declaration and payment of a dividend reduces the corporation’s assets and its stockholders’ equity.
Question 45. Why Aren’t Retained Earnings Distributed As Dividends To The Stockholders?
A corporation’s earnings are usually retained instead of being distributed to the stockholders in the form of dividends because the corporation is in need of money to strengthen its financial position, to expand its operations, or to keep up with the inflation in its present size of operations.
The stockholders may prefer to forego dividends in order to see its stock value increase from the corporation’s wise use of the retained earnings. This is especially true of U.S. individuals in high federal and state income tax brackets. These stockholders might end up paying 40% of the dividend amount in income taxes. They would rather have their stock appreciate in value with no tax payments and later sell their shares of stock at the lower capital gains tax rates.
Question 46. What Is The Return On Stockholders’ Equity (after Tax) Ratio?
The return on stockholders’ equity, or return on equity, is a corporation’s net income after income taxes divided by average amount of stockholders’ equity during the period of the net income.
To illustrate, let’s assume that a corporation’s net income after tax was $100,000 for the most recent year. Let’s also assume that it did not have any preferred stock outstanding and that its stockholders’ equity was $950,000 at the beginning of the year and was $1,050,000 at the end of the year. The increase was at a uniform rate throughout the year. The return on stockholders’ equity will be 10% ($100,000 divided by the average stockholders’ equity of $1,000,000).
If a corporation has preferred stock outstanding, the relevant name is return on common equity and will be calculated as follows: net income after tax minus the required dividends on its preferred stock, divided by the average amount of common stockholders’ equity during the period of the income.
As with most ratios, you should compare your corporation’s return on equity with the ratio for other corporations in your industry.
Question 47. Do Corporations Issue Both Common Stock And Preferred Stock?
Some corporations issue both common stock and preferred stock. However, most corporations issue only common stock. In other words, it is necessary that a business corporation issue common stock, but it is optional whether the corporation will decide to also issue preferred stock.
Usually the holders or owners of a corporation’s common stock elect the corporation’s directors, vote on significant matters, and enjoy increases in the value of their shares of common stock when the corporation becomes successful.
On the other hand, the holders of preferred stock usually receive only a fixed dividend, which must be paid before the common stock is paid a dividend. Because of that fixed dividend, the preferred stock will not increase in value as the corporation becomes increasingly successful.
Question 48. Does The Income Statement Explain The Change In The Equity Section Of A Balance Sheet?
The income statement could explain the change in the equity section of a balance sheet. However, there are likely to be some other explanations as well.
Here is a list of the items that would cause an increase in the total amount of a corporation’s stockholders’ equity:
- Positive net earnings or net income reported on the corporation’s income statement.
- Some positive Other Comprehensive Income items occurred but they are not to be reported on the income statement.
- Additional shares of stock were issued in exchange for cash or other assets.
- Donated capital was received.
Here is a list of items that could cause a decrease in the total amount of a corporation’s stockholders’ equity:
- Negative net earnings or a net loss reported on the corporation’s income statement.
- Some negative Other Comprehensive Income items occurred but they are not to be reported the income statement.
- The corporation declared cash dividends.
Question 49. Why Is There A Large Difference Between Share Value And Stockholders’ Equity?
There can be many reasons why the market value of a corporation’s stock is much greater than the amount of stockholders’ equity reported on the balance sheet. Let’s start by defining stockholders’ equity as the difference between the asset amounts reported on the balance sheet minus the liability amounts. Next, the accountant’s cost principle requires that only the cost of items purchased can be reported as an asset. This means that valuable trade names that were never purchased (but were developed over time) are not reported on the balance sheet. The same holds for a great management team and an amazing reputation. The cost principle also means that many long-term assets are reported at cost (and not at their current higher market value). Many plant assets are reported at minimal amounts because their costs have been reduced by the cumulative amount of depreciation taken over the years.
Other factors contributing to a high market value might be a corporation’s earnings and dividends that are consistently growing and/or a special niche for its products or services that is recognized by the market.
Lastly, a corporation’s stockholders’ equity may have been reduced from the purchase of treasury stock at a high cost.
Question 50. What Is Callable Stock?
Callable stock is an ownership interest (shares) in a corporation that can be “called in” by the corporation at a specified price.
For example, a corporation might issue 9% $100 Preferred Stock. The stock agreement (indenture) states that the stock is callable by the corporation after three years at $109 per share plus any accrued interest. If in the fourth year, market rates decline to say 7%, the corporation can call in the preferred stock by paying the call price of $109 plus any accrued interest.
The callable feature allows the corporation to get out of the preferred stock agreement requiring it to pay the $9 per share dividend. In turn, the stockholders will be deprived of receiving the $9 dividend in a 7% market. The call price has the effect of limiting how high the market value of preferred stock will rise.
Question 51. Which Financial Statement Shows A Corporation’s Worth?
Not one of the financial statements will show a corporation’s worth. The balance sheet, income statement, statement of cash flows, and stockholders’ equity statement merely provide information to assist financial experts in forming an opinion of a corporation’s worth.
In the past, some people mistakenly thought that a corporation’s stockholders’ equity was the corporation’s worth. However, stockholders’ equity (or the owner’s equity of a proprietorship) is merely the result of subtracting the reported amount of liabilities from the reported amount of assets. Since the reported amounts reflect the cost principle and other accounting principles, the net result cannot be assumed to be the company’s worth.
Question 52. Does A Dividend Reduce Profit?
When a corporation declares and pays a dividend, the dividend does not reduce the current accounting period’s profit reported on the income statement. In other words, a dividend is not an expense.
Dividends will reduce the amount of the corporation’s retained earnings. Retained earnings are reported in the stockholders’ equity section of the balance sheet.
If a corporation has very profitable uses for its cash, its future profits might be less if it pays dividends instead of reinvesting the cash dividend amounts into profitable projects.
Question 53. What Is The Definition Of Capital Market?
Often, capital market refers to the structured market for trading stocks and bonds. Examples are the New York Stock Exchange, the American Stock Exchange, NASDAQ, and the New York Bond Exchange.
However, capital market can also include less structured markets such as private placements for stocks, bonds, and other debt.
Question 54. What Is A Dividend And Why Is It Needed?
A dividend paid by a corporation is a distribution of profits to the owners of the corporation. The owners of a corporation are known as stockholders or shareholders. (In a sole proprietorship, the distribution of profits to the owner is referred to as a draw.)
A corporation’s board of directors, which is elected by the stockholders, decides if a cash dividend is needed. The considerations for paying or not paying a dividend include the stockholders’ wishes, the stock market’s reaction, and the corporation’s needs and opportunities for cash in the present and in the future.
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