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Chapter18: Shareholders’ Equity

Stock Dividends and Splits

Stock Dividends

A stock dividend distribution of additional shares of stock to current shareholders of the corporation. is the distribution of additional shares of stock to current shareholders of the corporation. Be sure to note the contrast between a stock dividend and either a cash or property dividend. A stock dividend affects neither the assets nor the liabilities of the firm. Also, because each shareholder receives the same percentage increase in shares, shareholders' proportional interest in (percentage ownership of) the firm remains unchanged.

 

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   The prescribed accounting treatment of a stock dividend requires that shareholders' equity items be reclassified by reducing one or more shareholders' equity accounts and simultaneously increasing one or more paid-in capital accounts. The amount reclassified depends on the size of the stock dividend. For a small stock dividend, typically less than 25%, the fair market value of the additional shares distributed is transferred from retained earnings to paid-in capital as demonstrated in Illustration 18-9.20


p. 1034

ILLUSTRATION 18-9

Stock Dividend

A small stock dividend requires reclassification to paid-in capital of retained earnings equal to the fair value of the additional shares distributed.

Craft declares and distributes a 10% common stock dividend (10 million shares) when the market value of the $1 par common stock is $12 per share.

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ADDITIONAL CONSIDERATION

The entry above is recorded on the declaration date. Since the additional shares are not yet issued, some accountants would prefer to credit “common stock dividends issuable” at this point, instead of common stock. In that case, when the shares are issued, common stock dividends issuable is debited and common stock credited. The choice really is inconsequential; either way the $10 million amount would be reported as part of paid-in capital on a balance sheet prepared between the declaration and distribution of the shares.

  

STOCK MARKET REACTION TO STOCK DISTRIBUTIONS.   As a Craft shareholder owning 10 shares at the time of the 10% stock dividend, you would receive an 11th share. Since each is worth $12, would you benefit by $12 when you receive the additional share from Craft? Of course not. If the value of each share were to remain $12 when the 10 million new shares are distributed, the total market value of the company would grow by $120 million (10 million shares × $12 per share).

   A corporation cannot increase its market value simply by distributing additional stock certificates. Because all shareholders receive the same percentage increase in their respective holdings, you, and all other shareholders, still would own the same percentage of the company as before the distribution. Accordingly, the per share value of your shares should decline from $12 to $10.91 so that your 11 shares would be worth $120—precisely what your 10 shares were worth prior to the stock dividend. Any failure of the stock price to actually adjust in proportion to the additional shares issued probably would be due to information other than the distribution reaching shareholders at the same time.

   Then, what justification is there for recording the additional shares at market value? In 1941 (and reaffirmed in 1953), accounting rule-makers felt that many shareholders are deceived by small stock dividends, believing they benefit by the market value of their additional shares. Furthermore they erroneously felt that these individual beliefs are collectively reflected in the stock market by per share prices that remain unchanged by stock dividends. Consequently, their prescribed accounting treatment is to reduce retained earnings by the same amount as if cash dividends were paid equal to the market value of the shares issued.21

   This obsolete reasoning is inconsistent with our earlier conclusion that the market price per share will decline in approximate proportion to the increase in the number of shares distributed. Our intuitive conclusion is supported also by formal research.22

   Besides being based on fallacious reasoning, accounting for stock dividends by artificially reclassifying “earned” capital as “invested” capital conflicts with the reporting objective of reporting shareholders' equity by source. Despite these limitations, this outdated accounting standard still applies.

 

The market price per share will decline in proportion to the increase in the number of shares distributed in a stock dividend.

Early rule-makers felt that per share market prices do not adjust in response to an increase in the number of shares.


Capitalizing retained earnings for a stock dividend artificially reclassifies earned capital as invested capital.

p. 1035

REASONS FOR STOCK DIVIDENDS.   Since neither the corporation nor its shareholders apparently benefits from stock dividends, why do companies declare them?23 Occasionally, a company tries to give shareholders the illusion that they are receiving a real dividend.

   Another reason is merely to enable the corporation to take advantage of the accepted accounting practice of capitalizing retained earnings. Specifically, a company might wish to reduce an existing balance in retained earnings—otherwise available for cash dividends—so it can reinvest the earned assets represented by that balance without carrying a large balance in retained earnings.

 

Companies sometimes declare a stock dividend in lieu of a real dividend.

Companies sometimes declare a stock dividend so they can capitalize retained earnings.

Stock Splits

A frequent reason for issuing a stock dividend is actually to induce the per share market price decline that follows. For instance, after a company declares a 100% stock dividend on 100 million shares of common stock, with a per share market price of $12, it then has 200 million shares, each with an approximate market value of $6. The motivation for reducing the per share market price is to increase the stock's marketability by making it attractive to a larger number of potential investors.

 
FINANCIAL
Reporting Case

Q4, p.1007
  
ADDITIONAL CONSIDERATION

No cash dividends are paid on treasury shares. Usually stock dividends aren't paid on treasury shares either. Treasury shares are essentially equivalent to shares that never have been issued. In some circumstances, though, the intended use of the repurchased shares will give reason for the treasury shares to participate in a stock dividend. For instance, if the treasury shares have been specifically designated for issuance to executives in a stock option plan or stock award plan it would be appropriate to adjust the number of shares by the stock distribution.

  

   A stock distribution of 25% or higher can be accounted for in one of two ways: (1) as a “large” stock dividend or (2) as a stock split stock distribution of 25% or higher, sometimes called a large stock dividend..24 Thus, a 100% stock dividend could be labeled a 2-for-1 stock split and accounted for as such. Conceptually, the proper accounting treatment of a stock distribution is to make no journal entry. This, in fact, is the prescribed accounting treatment for a stock split.

   Since the same common stock account balance (total par) represents twice as many shares in a 2-for-1 stock split, the par value per share will be reduced by one-half. In the previous example, if the par were $1 per share before the stock distribution, then after the 2-for-1 stock split, the par would be $.50 per share.

   As you might expect, having the par value per share change in this way is cumbersome and expensive. All records, printed or electronic, that refer to the previous amount must be changed to reflect the new amount. The practical solution is to account for the large stock distribution as a stock dividend rather than a stock split.

 

A large stock dividend is known as a stock split.

 Following on the heels of an enormous run up in price in shares, Apple Computer announced Friday a two-for-one stock split. Each share held on Feb. 18 gets an additional share. The company plans to start trading on a split-adjusted basis at the end of February. “It potentially makes it more attractive to individual investors,” said Steve Lidberg, an analyst at Pacific Crest Securities, who doesn't own shares of Apple. “Outside of that, it doesn't impact at all the way I think of the company.”25 

Stock Splits Effected in the Form of Stock Dividends (Large Stock Dividends)

To avoid changing the per share par value of the shares, the stock distribution is referred to as a stock split effected in the form of a stock dividend, or simply a stock dividend. In that case, a journal entry increases the common stock account by the par value of the additional shares. To avoid reducing retained earnings in these instances, most companies reduce (debit) paid-in capital—excess of par to offset the credit to common stock (Illustration 18-10).

p. 1036

ILLUSTRATION 18-10

Stock Split Effected in the Form of a Stock Dividend

If a stock split is effected in the form of a stock dividend, a journal entry prevents the par per share from changing.

Craft declares and distributes a 2-for-1 stock split effected in the form of a 100% stock dividend (100 million shares) when the market value of the $1 par common stock is $12 per share:

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   Notice that this entry does not reclassify earned capital as invested capital. Some companies, though, choose to debit retained earnings instead.26

Some companies capitalize retained earnings when recording a stock split effected in the form of a stock dividend.

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Nike, Inc. described a stock split in its disclosure notes as shown in Graphic 18-7.

GRAPHIC 18-7
Stock Split Disclosure—Nike, Inc.

Real World Financials

 

Note 1—Summary of Significant Accounting Policies
Stock Split
On February 15the Board of Directors declared a two-for-one stock split of the Company's Class A and Class B common shares, which was effected in the form of a 100% common stock dividend distributed on April 2. All references to share and per share amounts in the consolidated financial statements and accompanying notes to the consolidated financial statements have been retroactively restated to reflect the two-for-one stock split.


  
ADDITIONAL CONSIDERATION

A company choosing to capitalize retained earnings when recording a stock split effected in the form of a stock dividend may elect to capitalize an amount other than par value. Accounting guidelines are vague in this regard, stating only that legal amounts are minimum requirements and do not prevent the capitalization of a larger amount per share.

Source: FASB ASC 505–20–30–4: Equity–Stock Dividends and Stock Splits–Initial Measurement (previously “Restatement and Revision of Accounting Research Bulletins,” Accounting Research Bulletin No. 43 (New York: AICPA, 1961), Chap. 7, sec. B, par. 14).

  

REVERSE STOCK SPLIT.   A reverse stock split when a company decreases, rather than increases, its outstanding shares. occurs when a company decreases, rather than increases, its outstanding shares. After a 1-for-4 reverse stock split, for example, 100 million shares, $1 par per share, would become 25 million shares, $4 par per share. No journal entry is necessary. Of course the market price per share theoretically would quadruple, which usually is the motivation for declaring a reverse stock split. Companies that reverse split their shares frequently are struggling companies trying to accomplish with the split what the market has been unwilling to do—increase the stock price. Often this is to prevent the stock's price from becoming so low that it is delisted from a market exchange. Reverse splits are not unusual occurrences, particularly during stock market downturns. Time Warner Cable was one of many in 2009, declaring a 1-for-3 reverse split.

p. 1037

FRACTIONAL SHARES.   Typically, a stock dividend or stock split results in some shareholders being entitled to fractions of whole shares. For example, if a company declares a 25% stock dividend, or equivalently a 5-for-4 stock split, a shareholder owning 10 shares would be entitled to 2½ shares. Another shareholder with 15 shares would be entitled to 3¾ shares.

   

Cash payments usually are made to shareholders for fractional a stock dividend or stock split results in some shareholders being entitled to fractions of whole shares. shares and are called “cash in lieu of payments.” In the situation described above, for instance, if the market price at declaration is $12 per share, the shareholder with 15 shares would receive 3 additional shares and $9 in cash <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_im1803.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

 

Cash payments usually are made when shareholders are entitled to fractions of whole shares.

DECISION MAKER'S PERSPECTIVE

Profitability is the key to a company's long-run survival. A summary measure of profitability often used by investors and potential investors, particularly common shareholders, is the return on shareholders' equity. This ratio measures the ability of company management to generate net income from the resources that owners provide. The ratio is computed by dividing net income by average shareholders' equity. A variation of this ratio often is used when a company has both preferred and common stock outstanding. The return to common shareholders' equity is calculated by subtracting dividends to preferred shareholders from the numerator and using average common shareholders' equity as the denominator. The modified ratio focuses on the profits generated on the assets provided by common shareholders.

   Although the ratio is useful when evaluating the effectiveness of management in employing resources provided by owners, analysts must be careful not to view it in isolation or without considering how the ratio is derived. Keep in mind that shareholders' equity is a measure of the book value of equity, equivalent to the book value of net assets. Book value measures quickly become out of line with market values. An asset's book value usually equals its market value on the date it's purchased; the two aren't necessarily the same after that. Equivalently, the market value of a share of stock (or of total shareholders' equity) usually is different from its book value. As a result, to supplement the return on shareholders' equity ratio, analysts often relate earnings to the market value of equity, calculating the earnings-price ratio. This ratio is simply the earnings per share divided by the market price per share.

   To better understand the differences between the book value ratio and the market value ratio, let's consider the following condensed information reported by Sharp-Novell Industries for 2011 and 2010:

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The return on shareholders' equity is a popular measure of profitability.

Book value measures have limited use in financial analysis.

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   The 2011 return on shareholders' equity is computed by dividing net income by average shareholders' equity:

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   The earnings-price ratio is the earnings per share divided by the market price per share:

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p. 1038

   Obviously, the return on the market value of equity is much lower than on the book value of equity. This points out the importance of looking at more than a single ratio when making decisions. While 23.1% may seem like a desirable return, 5.9% is not nearly so attractive. Companies often emphasize the return on shareholders' equity in their annual reports. Alert investors should not accept this measure of achievement at face value. For some companies this is a meaningful measure of performance; but for others, the market-based ratio means more, particularly for a mature firm whose book value and market value are more divergent.

   Decisions managers make with regard to shareholders' equity transactions can significantly impact the return to shareholders. For example, when a company buys back shares of its own stock, the return on shareholders' equity goes up. Net income is divided by a smaller amount of shareholders' equity. On the other hand, the share buyback uses assets, reducing the resources available to earn net income in the future. So, managers as well as outside analysts must carefully consider the decision to reacquire shares in light of the current economic environment, the firm's investment opportunities, and cost of capital to decide whether such a transaction is in the long-term best interests of owners. Investors should be wary of buybacks during down times because the resulting decrease in shares and increase in earnings per share can be used to mask a slowdown in earnings growth.

 

Share retirement and treasury stock transactions can affect the return to owners.

Dividend decisions should be evaluated in light of prevailing circumstances.

   The decision to pay dividends requires similar considerations. When earnings are high, are shareholders better off receiving substantial cash dividends or having management reinvest those funds to finance future growth (and future dividends)? The answer, of course, depends on the particular circumstances involved. Dividend decisions should reflect managerial strategy concerning the mix of internal versus external financing, alternative investment opportunities, and industry conditions. High dividends often are found in mature industries and low dividends in growth industries. <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/818573/orange_dot.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a>

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ETHICAL DILEMMA
 

Interworld Distributors has paid quarterly cash dividends since 1980. The dividends have steadily increased from $.25 per share to the latest dividend declaration of $2.00 per share. The board of directors is eager to continue this trend despite the fact that revenues fell significantly during recent months as a result of worsening economic conditions and increased competition. The company founder and member of the board proposes a solution. He suggests a 5% stock dividend in lieu of a cash dividend to be accompanied by the following press announcement:

   “In lieu of our regular $2.00 per share cash dividend, Interworld will distribute a 5% stock dividend on its common shares, currently trading at $40 per share. Changing the form of the dividend will permit the Company to direct available cash resources to the modernization of physical facilities in preparation for competing in the 21st century.”

   What do you think?

CONCEPT REVIEW EXERCISE

CHANGES IN RETAINED EARNINGS

Situation: The shareholders' equity section of the balance sheet of National Foods, Inc., included the following accounts at December 31, 2011:

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p. 1039

Required:

1.

During 2012, several events and transactions affected the retained earnings of National Foods. Prepare the appropriate entries for these events.

a.

On March 1, the board of directors declared a cash dividend of $1 per share on its 120 million outstanding shares (122 million − 2 million treasury shares), payable on April 3 to shareholders of record March 11.

b.

On March 5, the board of directors declared a property dividend of 120 million shares of Kroger common stock that National Foods had purchased in February as an investment (book value: $900 million). The investment shares had a fair value of $8 per share and were distributed March 30 to shareholders of record March 15.

c.

On April 13, a 3-for-2 stock split was declared and distributed. The stock split was effected in the form of a 50% stock dividend. The market value of the $1 par common stock was $20 per share.

d.

On October 13, a 10% common stock dividend was declared and distributed when the market value of the $1 par common stock was $12 per share. Cash in lieu of payments was distributed for fractional shares equivalent to 1 million whole shares.

e.

On December 1, the board of directors declared the 9.09% cash dividend on the 11 million preferred shares, payable on December 23 to shareholders of record December 11.

2.

Prepare a statement of shareholders' equity for National Foods reporting the changes in shareholders' equity accounts for 2010, 2011, and 2012. Refer to the previous two Concept Reviews in this chapter for the 2010 and 2011 changes. For 2011, assume that shares were reacquired as treasury stock. Also, look back to the statement of shareholders' equity in Graphic 18-4 on page 1014 for the format of the statement. Assume that net income for 2012 is $225 million.

SOLUTION

1.

During 2012, several events and transactions affected the retained earnings of National Foods. Prepare the appropriate entries for these events.

a.

Cash dividend of $1 per share on its 120 million outstanding common shares (122 million − 2 million treasury shares), payable on April 3 to shareholders of record March 11 (Note: Dividends aren't paid on treasury shares.):

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b.

Property dividend of 120 million shares of Kroger common stock:

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p. 1040

c.

3-for-2 stock split effected in the form of a 50% stock dividend:

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*Alternatively, retained earnings may be debited.

d.

10% common stock dividend—with cash in lieu of payments for shares equivalent to 1 million whole shares:

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*(120 million + 60 million) × 10% = 18 million shares

e.

9.09% cash dividend on the 11 million preferred shares, payable on December 23 to shareholders of record December 11:

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2.

Prepare a statement of shareholders' equity for National Foods reporting the changes in shareholders' equity accounts for 2010, 2011, and 2012.

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<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/chap18_7.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

p. 1041

FINANCIAL REPORTING CASE SOLUTION

1.

 

Do you think the stock price increase is related to Textron's share repurchase plan?(p. 1024) The stock price increase probably is related to Textron's buyback plan. The marketplace realizes that decreasing the supply of shares supports the price of remaining shares. However, the repurchase of shares is not necessarily the best use of a company's cash. Whether it is in the shareholders' best interests depends on what other opportunities the company has for the cash available.

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2.

 

What are Textron's choices in accounting for the share repurchases?(p. 1025) When a corporation reacquires its own shares, those shares assume the same status as authorized but unissued shares, just as if they never had been issued. However, for exactly the same transaction, companies can choose between two accounting alternatives: (a) formally retiring them or (b) accounting for the shares repurchased as treasury stock. In actuality, Textron's uses alternative (b).

3.

 

What effect does the quarterly cash dividend of 23 cents a share have on Textron's assets? Its liabilities? Its shareholders' equity?(p. 1032) Each quarter, when directors declare a cash dividend, retained earnings are reduced and a liability is recorded. The liability is paid with cash on the payment date. So, the net effect is a decrease in Textron's assets and its shareholders' equity. The effect on liabilities is temporary.

4.

 

What effect does the stock split have on Textron's assets? Its liabilities? Its shareholders' equity?(p. 1035) Conceptually, the proper accounting treatment of a stock split is to make no journal entry. However, since Textron refers to the stock distribution as a “stock split effected through a 100% stock dividend,” a journal entry would increase the common stock account by the par value of the additional shares and would reduce paid-in capital—excess of par. This merely moves an amount from one part of shareholders' equity to another. Regardless of the accounting method, there is no change in Textron's assets, liabilities, or total shareholders' equity.




20The Committee on Accounting Procedure prescribes this accounting treatment in FASB ASC 505–20: Equity–Stock Dividends and Stock Splits (previously “Restatement and Revision of Accounting Research Bulletins,” Accounting Research Bulletin No. 43 (New York: AICPA, 1961), Chap. 7, sec. B, pars. 10–14). In this pronouncement, a small stock dividend is defined as one 20 to 25% or less. For filings with that agency, the SEC has refined the definition to comprise stock distributions of less than 25%.

21FASB ASC 505–20–30–3: Equity–Stock Dividends and Stock Splits–Initial Measurement (previously “Restatement and Revision of Accounting Research Bulletins,” Accounting Research Bulletin No. 43 (New York: AICPA, 1961), chap. 7).

22Foster and Vickrey, “The Information Content of Stock Dividend Announcements,” Accounting Review (April 1978), and Spiceland and Winters, “The Market Reaction to Stock Distributions: The Effect of Market Anticipation and Cash Returns,” Accounting and Business Research (Summer 1986).

23After hitting a high in the 1940s, the number of stock dividends has declined significantly. Currently, about 3% of companies declare stock dividends in any given year.

24FASB ASC 505–20–25–2: Equity–Stock Dividends and Stock Splits–Recognition (previously “Restatement and Revision of Accounting Research Bulletins,” Accounting Research Bulletin No. 43 (New York: AICPA, 1961), Chap. 7, sec. B, par. 11).

25“Apple's Share Price Surge Results in Stock Split,” CNN Money, February 11, 2005.

26The 2009 Accounting Trends & Techniques (p. 508) reports that 10 of its 500 sample companies reported a stock split. Of those, none debited additional paid-in capital, 1 debited retained earnings, and 9 made no entry.

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