Splits and Large Stock Dlyldends What is the difference between a 2-for-l stock split and a 100% stock dividend? There is very little difference; both will double the number of outstanding shares without changing total stockholders’ equity, and both should serve to cut the market price of the stock approximately in half.
The stock” dividend, .however, will cause a transfer from the Retained Earnings account to the COIltributed capital accourits. For large stock dividends (that is, ‘over 25% of the outstanding stock), the transfer is usually limited to the par or stated value”of the stock.
This transfer is made for the sole purpose of maintaining a balaJ\Cein the stock account that reflects-the number of shares that have been issued. A 2-for-l. stock split will reduce the par value per share by one-half, but it will not change the dollar balance of any account.
After an increase in the number of shares as a result of a stock split or stock dividend, earnings per share are computed in terms of the increased number of shares. In presenting 5- or lO-year summaries; the earnings per share for earlier years are retroactively restated to reflect the increased number of shares currently outstanding- and thus make the year-to-year trend of earnings p~r share a rrv ”<)mparison.
Statement of Retained Earnings
The term retained earnings refers to the portion of stockholders’ equity derived from profitable operations. Retained earnings is increased t)/ earning net income and is reduced by incurring net losses and by the declaration rot dividends, In addition to a balance sheet, an incomestatemenl, and a statement of cash flows, a complete set of financial statements includes a statement of retained earnings, as illustrated below revenue and expense accounts are brought to a zero balance, and the net amount of these items (either net income or net loss) is added to or subtracted from owner’s equity. For a .corporation, net income or loss is added to or subtracted from owner’s equity (retained earnings for a corporation). The addition of net income in the statement of retained earnings is a reflection of this closing process.
Notice, also, in the statement of retained earnings that the balance is reduced by the amounts of cash dividends declared during the year, as well as the amount of the stock dividend that was declared. These dividend adjustments to retained earnings are made based on their declaration, even though cash may -not have been paid yet (cash dividends) or the stock may not have been issued yet (stock dividend). Prior Period Adjustments On occasion, a company may discover that a material error was made in the measurement of net income in a prior year.
Because net income is closed into the Retained Earnings account, an error in reported net income will cause an error-in ‘the amount of remained earnings consequent balance sheets. When such errors are discovered, they should be correlation, called a prior period adjustment, is shown in the statement of, J limitings as an adjustment to the balance of retained earnings at the beginning or the current year.
The amount of the adjustment is shown net of any related income tax effects. To illustrate. assume that late in 2001 Shore Line Corporation discovers that it failed to record depreciation on certain assets in 2000. After considering the income tax effects of this error. the company finds. that the net income reported in-2000 was overstated by . Thus the current balance of the Retained Earnings account ($600,000 at Decernber 31. 2000) also is overstated by $35,000.
The statement of retained earnings’ in 2001 will include. a correction of the retained earnings at the beginning of the year. (See the illustration below.)Prior period adjustments rarely appear in the financial statements of large, publicly owned corporations. The financial statements of these corporations are audited annually by Certified Public Accountants and are not likely to contain material errors that subsequently will require correction by prior period adjustments.
Such adjustments are much more likely to appear in the financial statements of closely held corporations that are not audited on an annual basis. Restrictions of Retained Earnings Some portion of retained screaming be restricted because of various contractual agreements. A restriction of retained earnings prevents a company from declaring a dividend that would cause retained earnings to fall below a designated level.
MQst nondisclosure restrictions of retained earnings in notes accompanying the financial statements. For example, a company with retained earnings of ,$10 mullion might include, the following’note in its, financial statements Note’11 Restriction of retaliate dreamland As of December31.
•.certain long-term debt agreements prohibited the declaration of cash dividends that would reduce the amount of retained earnings below $S,200,00Q. Retained earnings in excess of this restriction total $4,800,000.Comprhenslve Income .The, Financial Accounting’ Standards Board (FASB),’ has identified certain changes in financial position that should be recorded but should not enter into the determination of net income.
One way to, describe these’ events is that they ate recognized’ (that is recorded and become a, part of the financial statements) but not realized:(that is, not of the determination of the company’s net income).
We have studied one of these items earlierin this text=-rhe charige inmarket value of available-for-sale debt and equity investments. . Recall from the ‘way’ changes in value for varioustypes of investments are recorded. For those investments tdentifled as available for sale, at the end of each accounting period ,the investments are revalued to their current’ market value and the adjustment to the asset is accumulated in a separate stockholders’ equity account.
The change in value does not enter into the determination of net income as it would had investments been sold.
The change in market value of available-for-sale investments adds, to the amount of stockholders’ equity if the value has ,gone up; it subtracts from the amount of stockholders’ equity if the value has gone down.
This adjustment is described as an element of other comprehensive income Comprehensive income is a term that is used to identify the total of net income plus or minus the elements of other comprehensive income. Comprehensive income may be “displayed to users of financial statements in any of the following ways:
• As a second income statement. One income statement displays the components of net income and the other displays the components of comprehensive income, one element of which is net income.
• As a single income statement that includes both the components of net income and the components of other comprehensive income.
• As an element in the changes in stockholders’ equity displayed as a column in the statement of stockholders’ equity (discussed later in this In addition to the presentation of each year’s changes in the elements of other comprehensive income, the accumulated amount of these changes is an element in the stock.holders’ equity section of the balance sheet. The components of comprehensive income arepresented net of income tax, much like an extraordinary item.