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Intermediate Financial Accounting. Shareholders' Equity- Retained Earnings. Objectives of the Chapter. To discuss the content of retained earnings. To study the accounting treatments for dividends (including cash dividend, property dividend, scrip dividend, and stock dividend).

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Intermediate Financial Accounting

Shareholders' Equity- Retained Earnings


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Objectives of the Chapter

  • To discuss the content of retained earnings.

  • To study the accounting treatments for dividends (including cash dividend, property dividend, scrip dividend, and stock dividend).

  • To learn the procedures for quasi-reorganization.

Stockholders' Equity (2)- Retained Earnings


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Content of Retained Earnings

  • Stockholders’ equity consists of primarily stockholders’ investments (i.e., contributed capital) and retained earnings.

  • The primary factors that affect retained earnings besides net income (or net loss) include (1) dividends, (2) prior period adjustments, (3) appropriations, and (4) quasi-reorganizations.

Stockholders' Equity (2)- Retained Earnings


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Dividends

  • While the net income increases the retained earnings, the distribution of dividends reduces the retained earnings.

  • In order to declare dividends, a company must meet legal requirements and have assets available for distribution.

Stockholders' Equity (2)- Retained Earnings


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Dividends (contd.)

  • Most companies regard the unrestricted retained earnings as the limit for dividends distribution.

  • However, most states allow liquidating dividends (i.e., dividends pay out of contributed capital).*

  • *Note: as long as the total assets after dividends equal or exceed the sum of total liabilities and the amount needed to satisfy the rights of other classes of shareholders with higher priority in receiving assts at liquidation (Revised Model Business Corporation Act, 1994).

Stockholders' Equity (2)- Retained Earnings


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Dividends (contd.)

  • Restrictions of retained earnings include:

  • 1) Legal restrictions: Many states require a corporation to restrict the cost of treasury stock from dividends distribution.

  • 2)Contractual restrictions: A long-term bond contract may limit the use of assets for payment of dividends as a loan condition, and therefore, restrict the use of retained earnings for dividends.

Stockholders' Equity (2)- Retained Earnings


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Dividends:(contd.)

  • Restrictions (contd.) 3)Voluntary restrictions: Appropriation of retained earnings for specific purposes.

  • The board of directors is responsible for the establishment of dividend policy and the determination of the amount, timing and types of dividends to be declared.

Stockholders' Equity (2)- Retained Earnings


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Dividends:(contd.)

  • A few types of dividends may be considered: (1) cash, (2) property, (3) scrip, (4) stock, and (5) liquidating dividends.

  • Cash, property and scrip dividends decrease retained earnings (R/E) and the stockholders’ equity.

Stockholders' Equity (2)- Retained Earnings


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Dividends:(contd.)

  • Stock dividend decreases R/E but increases contributed capital in the same amount. So, there is no change in the total stockholders’ equity.

  • Liquidating dividend decreases both contributed capital and the stockholders' equity.

Stockholders' Equity (2)- Retained Earnings


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Cash Dividends

  • A cash dividend is the most common type of dividend.

  • Four days are relevant to the cash dividend: 1) the date of declaration, 2) the ex-dividend date, 3) the date of record, and 4) the date of payment.

Stockholders' Equity (2)- Retained Earnings


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Cash Dividends:(contd.)

  • Example: on Nov. 3, 20x5, the board of directors declares preferred dividends totaled $10,000 and common dividends totaled $20,000.

  • These dividends are payable on 12/15/x5 to stockholders of record on 11/24/x5. In addition, the ex-dividend date is 11/20/x5. The journal entries for the declaration and other related events are:

Stockholders' Equity (2)- Retained Earnings


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Cash Dividends:(contd.)

  • 11/3/x5 the date of declaration

    Retained Earnings 30,000

    Dividends Payable: CS 20,000

    Dividends Payable: PS 10,000

  • Shares are traded with dividends attached after this date.

  • Companies are legally liable for declared dividends on this date.

Stockholders' Equity (2)- Retained Earnings


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Cash Dividends:(contd.)

  • 11/20/x5 Ex-dividend date. No entry or memo. It is usually 4 business dates prior to the date of record.

  • Shares purchased on or after this date are purchased ex dividend-without the right to receive the declared dividend.

  • Therefore, a decline in price equals the dividend declared in general occurs on this date.

Stockholders' Equity (2)- Retained Earnings


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Cash Dividends:(contd.)

  • 11/24/x5 The date of record

    Memo: the company will pay dividends on 12/15/x5 to preferred and common stockholders of record as of today, the date of record.

  • Stockholders on the record will be paid of dividend even if they sell those shares prior to 12/15/x5, the payment date.

Stockholders' Equity (2)- Retained Earnings


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Cash Dividends:(contd.)

  • 12/15/x5 Dividend payment date

    Div. Payable: Com. stk 20,000

    Div. Payable: Prefer.stk 10,000

    Cash 30,000

Stockholders' Equity (2)- Retained Earnings


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Preferred Stock Characteristics

  • Preferred stockholders have a preference to dividends.

  • A preference to dividends does not guarantee a dividend distribution.

  • Because a dividend declaration is at the discretion of the board of directors.

Stockholders' Equity (2)- Retained Earnings


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Preferred Stock Characteristics (contd.)

  • If a corporation fails to declare a dividend, or declares a dividend which is less than the stated rate of the preferred stock, the "passed" dividend of non-cumulativepreferred stock will never be paid.

Stockholders' Equity (2)- Retained Earnings


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Cumulative Preferred Stock

  • For cumulative preferred stock, the amount of passed dividend becomes "dividend in arrears”.

  • The “dividend in arrears” has the highest priority to be paid in the following periods.

  • Common stockholders cannot be paid any dividend until the preferred dividend in arrears has been paid.

Stockholders' Equity (2)- Retained Earnings


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Cumulative Preferred Stock

  • Dividend in arrears accumulate from period to period.

  • The “dividend in arrears” is not a liability because no liability exists until the dividend declaration.

Stockholders' Equity (2)- Retained Earnings


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Cumulative Preferred StockExamples

Year 1: Case I:

Dividends declared = $10,000

Com. STK shares outstanding: 10,000, @$5

Preferred STK outstanding : 5,000, @$10, dividend is 6% of the par value

Dividends for P.S. = 6% *10*5,000= $3,000.

Dividends for C.S. = ($10,000-3,000)=$7,000.

Or $0.7 per share ($7,000/10,000 shares)

Stockholders' Equity (2)- Retained Earnings


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Cumulative Preferred StockExamples (contd.)

Case II: Same information as in Case I except that dividends declared = $1,000.

  • Dividends for P.S. = $1,000. Div. Passed=$2,000

  • Dividends for C.S. = $0

    If this is a cumulative P.S. the dividends in arrears equal $2,000 ($3,000-1,000).

    If this is a non-cumulative P.S., the $2,000 will never been paid.

Stockholders' Equity (2)- Retained Earnings


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Cumulative Preferred Stock StockExamples (contd.)

Year 2: Continued from Case II of year 1, assuming a cumulative preferred stock and the dividends declared = $8,000.

Dividends for P.S. => $2,000 (div. In arrears)

$3,000 (div. Of year 2) $ 5,000

Dividends for C.S. => $8,000- $2,000-3,000 = $3,000

Stockholders' Equity (2)- Retained Earnings


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Participating Preferred Stock Stock

  • When preferred stock is participating, preferred stockholders share with the common stockholders in any "extra" dividends.

  • "Extra" dividends = the declared dividends - the stated dividends of preferred stock - Equal % of dividends as the preferred stock's stated dividends for common stock.

Stockholders' Equity (2)- Retained Earnings


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Participating Preferred Stock (contd.) Stock

  • Fully participating preferred stock: preferred stockholders share equally with the common stockholders in any "extra" dividends.

  • These extra dividends are distributed proportionally, based on the respective par value of each class of stock.

Stockholders' Equity (2)- Retained Earnings


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Participating Preferred Stock (contd.) Stock

  • Partially participating preferred stock: preferred stockholders share in "extra" dividends with common stockholders, but its participation is limited to a fixed rate or amount per share.

Stockholders' Equity (2)- Retained Earnings


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Allocation of Declared Dividends Stock

  • If the preferred stock is Not participating, the amount of dividends received by the common stockholders equals:

    the declared dividends - any "dividend in arrears" - the stated dividend of the preferred stock

  • If the preferred stock is participating in extra dividends, calculation needs to be made for the allocation of dividends.

Stockholders' Equity (2)- Retained Earnings


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Participating Preferred Stock Stock:(contd.)

  • Example: Assume a company issued 10% participating cumulative preferred stock with a total par value of $20,000 and common stock with a total par value of $30,000. Thus, preferred stock constitutes 40% and common stock 60% of the total par value. The company intends to distribute cash dividends of $9,000, and there are no dividends in arrears. The dividend distribution is as follows:

Stockholders' Equity (2)- Retained Earnings


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Participating Preferred Stock Stock:(contd.)

(A) Preferred stock is fully participating:

Preferred Common

1. 10% dividend to preferred (on $20,000 par) $2,000

2. Common dividends (equal to 10% of par) $3,000

Extra dividend proportionate to par values:

Total to allocate $9,000

Allocated (2,000 + 3,000) (5,000)

Extra Dividend (40% to preferred

and 60% to common) $4,000 $1,6002,400

Dividends to each class of stock $3,600$5,400

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Participating Preferred Stock Stock:(contd.)

(B) Preferred Stock Participates up to 12%:

PreferredCommon

1. 10% dividend to preferred $2,000

2. Common div. (equal to 10%) 3,000

3. 2% div. On par of preferred (2% * 20,000) 400

4. 2% div. On par of common (2% * 30,000) 600

5. Remainder to common

(9,000-2,000-3,000-400-600) _____ 3,000

Dividends to each class of stock 2,4006,600

  • If any preferred stock dividends had been in arrears, the dividends in arrears would have been distributed before any participation calculations.

Stockholders' Equity (2)- Retained Earnings


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Property Dividends Stock

  • A property dividend is that dividend is payable in assets other than cash.

  • Marketable securities are typically used for a property dividend.

  • Because they are more easily distributable to the stockholders.

Stockholders' Equity (2)- Retained Earnings


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Property Dividends Stock

  • A property dividend is recorded at the fair market value of the asset transferred on the date of declaration.

  • A gain or a loss is recognized (APB opinion no. 29, par. 18).

Stockholders' Equity (2)- Retained Earnings


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Property Dividends Stock:(contd.)

  • Examples:

    (A)Property dividend is an investment in debt held to maturity:

    Corp. Aron declares a property dividend, payable in bonds of Rock company being held to maturity. The bonds are carried on Aron’s book at a book value of $40,000 but the current market value on the declaration date is $48,000. The journal entries to record the property dividend are as follows:

Stockholders' Equity (2)- Retained Earnings


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Property Dividends Stock:(contd.)

Date of Declaration

1. Investments in Rock Company Bond 8,000

Gain on Disposal of Investment 8,000

2. Retained Earnings 48,000

Property Dividends Payable 48,000

Date of Payment

Property Dividends Payable 48,000

Investment in Rock Company Bonds 48,000

Stockholders' Equity (2)- Retained Earnings


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Property Dividends Stock:(contd.)

(B) Property dividend is an investment in equity securities “available for sale”:

The Remley company declares a property dividend on 3/15/x5, Payable in Welch company stock. The Welch stock had been purchased early in 20x4 for $24,000 and was reported as an asset at a fair value of $29,000 on 12/31/x4 balance sheet.

Stockholders' Equity (2)- Retained Earnings


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Property Dividends Stock:(contd.)

  • The market value of Welch stock is $31,000 on 3/15/x5. The following entries are made on 3/15/x5 (the declaration date):

  • Adj. prior to the recog. Of dividends payable:

    Fair Value Adjustment 2,000

    Unrealized holding gain 2,000

    Unrealized holding gain 7,000

    Gain on Disposal of Investment 7,000

Stockholders' Equity (2)- Retained Earnings


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Property Dividends Stock:(contd.)

J.E. on the declaration date:

Retained Earnings 31,000

Property Dividends Payable 31,000

J.E. on the payment date:

Property Dividends Payable 31,000

Investment in SAS 24,000

Fair value adjustment 7,000

Stockholders' Equity (2)- Retained Earnings


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Scrip Dividends Stock

  • A corporation with adequate retained earnings to meet legal dividend requirements but with insufficient funds to pay a current cash dividend may declare a scrip dividend.

  • That is the corporation issues promissory notes (called “scrip”) requiring the Corp. to pay dividends at some future date.

Stockholders' Equity (2)- Retained Earnings


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Scrip Dividends Stock:(contd.)

  • On the declaration date, the following entry will be made:

    Retained Earnings xxx

    Dividends Payable (or Notes Pay.) xxx

  • On the date of Payment:

    Dividends Payable xxx

    Interest Expense xxx

    Cash xxx

    * If the promissory notes are interest bearing

Stockholders' Equity (2)- Retained Earnings


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Stock Dividends Stock

  • A stock dividend is a pro rata (proportional) distribution of additional shares of a corporations own stock to its shareholders.

  • When a stock dividend is distributed, no corporate assets are distributed.

  • Each stockholder maintain the same percentage of ownership as before.

  • Stock dividend is similar to a stock split.

Stockholders' Equity (2)- Retained Earnings


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Stock Dividends (contd.) Stock

Accounting treatment:

a. Small stock dividend ( less than 25% of outstanding shares):

the stock dividends are accounted for by transferring from retained earnings to contributed capital an amount equals to the fair market value of the additional shares issued.

Stockholders' Equity (2)- Retained Earnings


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Stock Dividends Stock:(contd.)

b. A large stock dividend (no change in par value per share and is referred to as a stock split effected in the form of stock dividends): the accounting treatment is only to capitalize the par value of the stock, not the market value of the stock.

  • For example, a 100% stock dividend is equivalent to a two-for-one stock split regards to its impact on stock price and share outstanding.

Stockholders' Equity (2)- Retained Earnings


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Stock Dividends Stock:(contd.)

  • Example 1: Small Stock Dividend

    A Corporation with 20,000 shares outstanding declares and issues a 10% stock dividend. On the date of declaration, the stock is selling for $23 per share with a par value of $10 per share. The journal entry to recorded the stock dividend is :

Stockholders' Equity (2)- Retained Earnings


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Stock Dividends Stock:(contd.)

  • Date of Declaration:

    Retained Earnings 46,000

    C.S. To be Distributed ** 20,000

    Additional Paid-in Capital from Stock Dividend 26,000

  • Date of Issuance:

    C.S. To be Distributed 20,000

    C.S. $10 par 20,000

    ** reported as a component of contributed capital.

Stockholders' Equity (2)- Retained Earnings


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Stock Dividends Stock:(contd.)

  • Example 2: Large Stock Dividend

    Similar to example 1 except that the stock dividend increases from 10 % to 40% of the shares outstanding:

    Date Declaration:

    Additional paid in Capital* 80,000**

    C.S to be Distributed 80,000

    * An alternative account is retained earnings. If R/E is debited, the accounting standard does not prevent the capitalization of a larger amount per share.

Stockholders' Equity (2)- Retained Earnings


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Stock Dividends Stock:(contd.)

** $10*(40% *20,000 shares)

  • Date of Issuance:

    C.S to be Distributed 80,000

    C.S, $10 par 80,000

    • Reason of debiting paid-in capital rather than R/E for large stock dividends:

      to prevent transferring earned capital to invested capital.

Stockholders' Equity (2)- Retained Earnings


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Fractional Shares Stock

  • A stock dividend or a stock split often results in some shareholders being entitled to fractions of whole shares (fractional shares).

  • Cash payments (based on the fair value at declaration) are made to shareholders with fractional shares.

Stockholders' Equity (2)- Retained Earnings


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Liquidating Dividends Stock

  • Liquidating dividends are a return of contributed capital to stockholders rather than a distribution of earned capital (i.e., R/E). This may occur in the case of insolvency and assetsa are distributed to stockholders.

  • The liquidating portion of the dividend is debited to Additional Paid-in Capital.

  • a. assets which are not subject to a superior claim by creditors.

Stockholders' Equity (2)- Retained Earnings


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Prior Period Adjustments (Restatements) Stock

  • Items reported as prior period adjustments of retained earnings include:

    a. certain change in accounting treatment (when a retroactive approach is used),

    b. a change in accounting entry, and

    c. corrections of errors of prior periods.

Stockholders' Equity (2)- Retained Earnings


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Prior Period Adjustments (Restatements) Stock

  • Example: In 20x5, Fox Company discovered that it did not accrue $10,000 of interest expense for 20x4. The income tax effect is $3,000, the correct entries are:

    1. Retained Earnings 10,000

    Interest Payable 10,000

    2. Income Tax Refund Rece. 3,000

    Retained Earnings 3,000

Stockholders' Equity (2)- Retained Earnings


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Prior Period Adjustments (Restatements) Stock:(contd.)

  • Presentation on the Retained Earnings Statement:

    R/E, as previous reported Jan 1, 20x5 $102,400 Less: Correction of overstatement in 20x4 N/I due to interest expense understatement (Net of $3,000 I/T) (7,000) Adjusted Retained Earnings, Jan 1, 20x5 $95,400

Stockholders' Equity (2)- Retained Earnings


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Appropriation of Retained Earnings Stock

  • An appropriation (or restriction) of retained earnings is that the board of directors has "earmarked" a portion for the retained earnings (the appropriated amount) for a designated purpose.

  • This appropriated amount is not available for dividends.

Stockholders' Equity (2)- Retained Earnings


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Appropiraion of Retained Earnings Stock(contd.)

  • Reasons of appropriations: (1) to meet legal requirements, (2) to meet contractual restrictions,(3) a discretionary action of the board of directors.

    (1) Legal requirements: certain states require restrictions of R/E when treasury stock is acquired.

Stockholders' Equity (2)- Retained Earnings


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Appropiraion of Retained Earnings Stock(contd.)

(2) Contractual agreement: due to issue of long-term bonds.

(3) A discretionary action: based on the needs of the corporation.

Example: Assume $2,000 of retained earnings is appropriated for treasury stock:

Stockholders' Equity (2)- Retained Earnings


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Appropiraion of Retained EarningsExample

Retained Earnings 2,000

Retained Earnings: Appropriated for Treasury Stock 2,000

  • After the treasury stock is reissued, the board of directors would cancel the appropriation:

    R/E Appropriated for Treasury stock 2,000

    Retained earnings 2,000

Stockholders' Equity (2)- Retained Earnings


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Other C Earningsomponent of Stockholder's Equity

AccumulatedOther Comprehensive Incomea:

Other Comprehensive income accumulated over the current (reported in the combined income statement) and prior periods.

a. Comprehensive income: changes in equity other than from owner related transactions (i.e., additional investment and dividends distribution).

Stockholders' Equity (2)- Retained Earnings


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Other C Earningsomponent of Stockholder's Equity (contd.)

  • Comprehensive income includes:

    Net income

    Other Comprehensive Income (all net of tax):

    Unrealized gain (loss) from SAS

    Foreign currency translation adjustments

    Minimum Pension liability adjustment

    Deferred gain (loss) from derivatives

Stockholders' Equity (2)- Retained Earnings


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Example of Stockholders’ Equity and Statement of Changes in Stockholders’ Equity

  • KARDWELL CORPORATION

    Stockholders’ Equity December 31, 20x5

Note: R/E are restricted regarding dividends in the amount

of $3,000, the cost of the treasury stock.

Stockholders' Equity (2)- Retained Earnings


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Example of Stockholders’ Equity and Statement of Changes in Stockholders’ Equity: (Contd.)

  • Statement of Changes in Stockholders’ Equity for Year Ended December 31, 20x5

Stockholders' Equity (2)- Retained Earnings


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Quasi-Reorganization in Stockholders’ Equity: (Contd.)

  • A quasi-reorganization is primarily an accounting procedure, that involves a revaluation of corporate assets and liabilities, and a realignment of the corporate capital structure to enable the corporation to have a “fresh start” toward financial solvency and profitability.

Stockholders' Equity (2)- Retained Earnings


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Quasi-Reorganization in Stockholders’ Equity: (Contd.):(contd.)

  • The adjustment procedures are:

    1. The Corp. reports to the stockholders with the restatements proposed and obtains the stockholders’ formal consent.

    2. The Corp. presents a B/S as of the date of readjustment in which the assets and liabilities are reported at their market values.

Stockholders' Equity (2)- Retained Earnings


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Quasi-Reorganization in Stockholders’ Equity: (Contd.):(contd.)

  • The adjustment procedures (contd.):

    3. Any amount written off is first charged against retained earnings and then against additional paid-in capital.

    4. The Corp. begins its “fresh start” with a zero retained earnings balance.

Stockholders' Equity (2)- Retained Earnings


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Quasi-Reorganization in Stockholders’ Equity: (Contd.):(contd.)

  • Specific Accounting procedures are:

    1. A write-down of the assets to their market value, with the loss debited to R/E;

    2. An increase of additional paid-in capital accomplished by a decrease in the par-value of the capital stock;

    3. The elimination of the R/E deficit by a reduction of the additional paid-in capital.

Stockholders' Equity (2)- Retained Earnings


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Quasi-Reorganization in Stockholders’ Equity: (Contd.):(contd.) Example:

CMG Corp.'s property and equip. are determined to have a combined market value of $92,000 rather than the book value of $140,000. Its Inventories and A/R are overvalued by $8,000 and $4,000, respectively. The board of directors, with stockholders and the state's approval, has authorized a reduction in par value of $6 per share. CMG has a deficit of $50,000 prior to the quasi-reorganization.

Stockholders' Equity (2)- Retained Earnings


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Quasi-Reorganization in Stockholders’ Equity: (Contd.):(contd.) Example:(Contd.)

1. To write down the fixed assets to market value:Retained Earnings 48,000 Accu. depreciation 48,000

2. To write down the current assets: Retained earnings 12,000 Inventory 8,000 Accounts Receivable 4,000

Stockholders' Equity (2)- Retained Earnings


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Quasi-Reorganization in Stockholders’ Equity: (Contd.):(contd.) Example:(Contd.)

3. To reduce the par value of stock

Common Stock, $10 par 150,000 Common Stock, $4 Par 60,000 Additional Paid-in Capital 90,000

4. To eliminate the R/E Deficit:

Additional Paid-in Capital 110,000 Retained Earnings* 110,000

* 50,000 (the deficit) +48,000+12,000

Stockholders' Equity (2)- Retained Earnings


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Condensed B/S of CMG Corp. before the quasi-reorganization: in Stockholders’ Equity: (Contd.)

  • CMG Corporation

    Balance Sheet December 31, 20x5

Stockholders' Equity (2)- Retained Earnings


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Condensed B/S of CMG Corp. in Stockholders’ Equity: (Contd.)immediately after the quasi-reorganization:

  • CMG Corporation

    Balance Sheet December 31, 20x5

Stockholders' Equity (2)- Retained Earnings


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Condensed B/S of CMG Corp. in Stockholders’ Equity: (Contd.)immediately after the quasi-reorganization:(Contd.)

Note: Retained earnings as of December 31, 20x5 has a zero balance due to a quasi-reorganization on that date in which net assets were revalued, a deficit of $110,000 was charged against additional paid-in capital, and the par value of common stock was reduced from $10 to $4 per share.

Stockholders' Equity (2)- Retained Earnings


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