Stock Rights, Retained Earnings

Appropriated Retained Earnings

1. Declared Off-Limits -- This amount of retained earnings has been declared off-limits for dividends so that funds may be conserved for a specific purpose or objective. a. Financial Planning -- The purpose might be related to financial planning, such as debt retirement or plant expansion. b. Legal Requirement -- The purpose or objective might be related to some legal requirement, such as the appropriation of retained earnings related to treasury stock transactions. c. Contractual Obligation -- Finally, the purpose of the appropriation might be related to a contractual obligation, such as a clause in a loan agreement requiring the appropriation. 2. End Result -- The end result of appropriated retained earnings is quite simple. When retained earnings are appropriated, the amount of unappropriated retained earnings declines, and the amount of possible dividend declarations declines as well.

List the reasons for appropriating retained earnings.

1. Financial planning; 2. Legal requirement; 3. Contractual obligation.

Stock Rights

A Stock Right : Gives the holder the option to purchase a certain number of shares of the issuing firm at a specified price during a specified time period.

Statement of Retained Earnings (Purpose)

A. Purpose -- The purpose of the Statement of Retained Earnings is to provide the reader of the financial report with a detailed account of increases and decreases in retained earnings that were recorded in a given accounting period. The retained earnings statement may be shown separately, or more frequently, as part of the statement of changes in equity (see separate lesson on that topic).

Stock Rights

A. Stock rights are often used to convey preemptive rights. B. The existing shareholders are given rights (via a stock warrant) to purchase their pro rata number of shares to keep their current percentage in the firm. C. The rights have an expiration date and must be exercised by this date.

Unappropriated Retained Earnings

A. Unappropriated Retained Earnings -- 1. Available for Declaration -- This portion of retained earnings is available for dividend declaration. In other words, the future use of this amount of retained earnings has not been determined. 2. No Specific Purpose -- Unappropriated retained earnings have not been earmarked for a specific purpose. 3. Not All Are Paid -- Not all unappropriated retained earnings must be paid in dividends, however.

Define "restrictions on retained earnings".

An external constraint placed on a certain portion of retained earnings by an external party.

Stock Rights Entries

At issuance of rights: No journal entry is made. No resources have been transferred. At exercise of rights: The usual entry to record the issuance of stock is made. The issue price is the exercise price as specified in the stock warrant, not the market price on the date of exercise. If rights lapse: No entry is made if the shareholder does not exercise the rights.

Adjusted for Prior Adjustments

B. Adjusted for Prior Adjustments -- 1. As you can see, the beginning retained earnings balance is adjusted initially for any prior period adjustment (corrections of errors in prior year net income) recorded during the year and for the catch-up adjustment related to changes in accounting principle. 2. Restated Balance -- The restated balance is increased by reported income and decreased by any dividend declarations that occurred during the year.

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C. Other Transactions Affects -- 1. Other transactions may affect retained earnings and therefore appear in the statement. 2. Examples -- a. The removal of a deficit through quasi-reorganization (discussed in a later section). b. Certain treasury stock transactions as discussed in the treasury stock lessons.

What is the effect of retained earnings appropriations on assets?

No effect on assets.

Appropriation Entry

D. Appropriation Entry -- The entry for an appropriation is: Dr:Retained earnings amount appropriated Cr:Retained earnings, appropriated for X purpose amount appropriated 1. No Reduction -- This entry does not reduce total retained earnings nor does it necessarily reduce dividends. 2. When Purpose Fulfilled -- When the purpose for which an appropriation is made has been fulfilled, the above entry is reversed, reinstating the amount to unappropriated retained earnings. a. No Effect -- The entry to reverse the appropriation also has no effect on total retained earnings.

Start of CPAexcel Flashcards) How should restrictions and appropriations on retained earnings be reported?

Disclosed in footnotes.

Disclosure

Disclosure -- Both restrictions and appropriations are disclosed in the notes to the financial statements. Note:Both restrictions and appropriations may cause the amount of dividends to be reduced. However, a firm need not appropriate retained earnings or be subject to a constraint on retained earnings in order to lower the amount of dividends paid. The firm simply needs to reduce the amount of dividends declared. However, an appropriation supports this decision and may make such a decision more acceptable to shareholders.

Partition Retained Earnings

E. Partition Retained Earnings -- Retained earnings appropriations have no effect on assets. They do not "reserve" assets. They simply partition retained earnings into two parts.

Zinc Co.'s adjusted trial balance at December 31, 2005 includes the following account balances: Common stock, $3 par $600,000 Additional paid-in capital 800,000 Treasury stock, at cost 50,000 Net unrealized loss on non-current marketable equity securities 20,000 Retained earnings: appropriated for uninsured earthquake losses 150,000 Retained earnings: unappropriated 200,000 What amount should Zinc report as total stockholders' equity in its December 31, 2005 balance sheet?

Each item listed belongs in owners' equity. The treasury stock and net unrealized loss are negative items (debits), but the rest are positive items (credits). Therefore, total owners' equity is $1.68mn = $600,000 + $800,000 - $50,000 - $20,000 + $150,000 + $200,000.

Example: Restrictions on Retained Earnings

Example: States Restrict: States often restrict retained earnings in the amount of the cost of treasury stock held by the firm. This is a protection for the creditors. It forces the firm to maintain its legal capital. Bondholders Restrict: Bondholders often restrict retained earnings through the debt agreement or bond covenant. This is also a protection for the creditors but this time is protection for a specific group of creditors - the bondholders themselves who want the firm to conserve cash so that their claims can be met.

Example: Stock Rights Issued to Outside Parties for Services

Example: A firm issues 300 rights to an attorney for services rendered to the firm. Three rights entitle the holder to purchase one share of the firm's $5 common stock for $20. The market value of the stock on the day the rights were issued was $30. Entries: At issuance: Dr:Legal expenses ($30 - $20)(300/3) 1,000 Cr:Stock rights outstanding (OE) 1,000 The $1,000 recorded amount represents the opportunity cost to the firm of committing to an issuance of 100 shares of stock for $20 when the market price is currently $30. Subsequent changes in market price do not enter into the accounting. At exercise: Dr:Cash (300/3)($20) 2,000 Dr:Stock rights outstanding 1,000 Cr:Common stock (300/3)($5) 500 Cr:Contributed capital in excess of par, common 2,500

Appropriation Example

Example: If total retained earnings is $400,000, and a $100,000 appropriation is recorded, and the firm was planning to declare only $150,000 in dividends, the appropriation does not reduce dividends although it may still accomplish its communication objective.

Formal Communication

Formal Communication -- A retained earnings appropriation is management's formal communication that a portion of retained earnings has been declared off-limits for dividends.

Define "retained earnings appropriation".

Management's formal communication that a portion of retained earnings has been declared off-limits for dividends.

In September 2000, Cal Corp. made a dividend distribution of one right for each of its 240,000 shares of outstanding common stock. Each right was exercisable for the purchase of one-hundredth of a share of Cal's $50 variable-rate preferred stock at an exercise price of $80 per share. On March 20, 2005, none of the rights had been exercised, and Cal redeemed them by paying each stockholder $0.10 per right. As a result of this redemption, Cal's stockholders' equity was reduced by

None of the rights was exercised. The net effect on stockholders' equity is the $24,000 of cash paid to the shareholders: 240,000($.10).

Describe the accounting entry to record stock rights issued to outside parties for service at issuance.

Record an expense and owners' equity account equal to the difference between the market price and exercise price, times the number of shares under option.

Describe the accounting entry to record stock rights issued to outside parties for services at exercise of rights.

Record the stock issuance at the exercise price and remove the OE account credited at issuance of the rights.

Restrictions on Retained Earnings

Restriction on Retained Earnings : A constraint placed on a certain portion of retained earnings by an external party. A. Effect Like Appropriation -- It has the same effect as an appropriation and may be accompanied by an appropriation.

Stock Rights Issued to Outside Parties for Services

Stock Rights Issued to Outside Parties for Services: At issuance of rights: Record an expense and owners' equity account equal to the difference between the market price and exercise price, times the number of shares under option. At exercise of rights: Record the stock issuance at the exercise price and remove the OE account credited at issuance of the rights.

What is often used to convey preemptive rights regarding stocks?

Stock rights.

1. A typical Statement of Retained Earnings is shown on the other side.

The Tiger Company Statement of Retained Earnings For the Year Ended December 31, 20x7 Retained Earnings, January 1, 20x7 XX Prior Period Adjustment (+or-) XX Change in Accounting Principle - Catch-Up Adjustment (+or-) XX Restated Balance, January 1, 20x7 XX (+or-)Net Income (+or-)XX (-)Cash and Property Dividends Declared (-)XX (-)Stock dividends (-)XX (=)Retained Earnings, December 31, 20x7 XX Footnote: The retained earnings balance on December 31, 20x7 is $XX. Of that amount, $YY has been appropriated for...

In September 2001, West Corp. made a dividend distribution of one right for each of its 120,000 shares of outstanding common stock. Each right was exercisable for the purchase of one-hundredth of a share of West's $50 variable-rate preferred stock at an exercise price of $80 per share. On March 20, 2005, none of the rights had been exercised, and West redeemed them by paying each stockholder $0.10 per right. As a result of this redemption, West's stockholders' equity was reduced by

The dividend did not affect total OE, because no resources were expended or received. The payment of $0.10 per right reduces OE by a total of 120,000($0.10) = $12,000, because this amount of cash was paid.

Cricket Corp. issued, without consideration, rights allowing stockholders to subscribe for additional shares at an amount greater than par value, but less than both market and book values. When the rights are exercised, how are the following accounts affected?Retained earnings and Additional paid-in capital.

The exercise is treated as would be any issuance of stock. The exercise price determines the total proceeds, the common stock account is credited for the total par of stock issued, and additional paid-in capital is credited for the remainder. The exercise price exceeds par value, so additional paid-in capital is increased. Retained earnings are unaffected.

At December 31, 2004, Eagle Corp. reported $1.75m of appropriated retained earnings for the construction of a new office building, which was completed in 2005 at a total cost of $1.5mn. In 2005, Eagle appropriated $1.2mn of retained earnings for the construction of a new plant. Also, $2mn cash was restricted for the retirement of bonds due in 2006. In its 2005 balance sheet, Eagle should report what amount of appropriated retained earnings?

The first appropriation of $1.75mn was removed (returned to unappropriated retained earnings) when the office building was completed. Appropriations no longer needed are returned to unappropriated status. Therefore, only the new appropriation is needed at the end of 2005. The amount of unrestricted cash is reported separately and does not affect the appropriation amount. An appropriation of retained earnings is primarily a device for communicating the intention of management to restrict dividends, so that cash will be conserved for the specified purpose. The actual restriction of cash makes that amount of cash unavailable for normal operating use. Restricted cash is an investment account. It is not part of the cash account.

(Start of CPAexcel Exam Questions) On November 2, 2003, Finsbury, Inc. issued warrants to its stockholders, giving them the right to purchase additional $20 par value common shares at a price of $30. The stockholders exercised all warrants on March 1, 2004. The shares had market prices of $33, $35, and $40 on November 2, 2003, December 31, 2003, and March 1, 2004, respectively. What were the effects of the warrants on Finsbury's additional paid-in capital and net income?

The issuance of warrants to shareholders does not require a journal entry, because no resources are expended or received. Therefore, in 2003, there is no effect on owners' equity. When the warrants are exercised in 2004, the shareholders pay $30 per share for the stock purchased under the warrants. This issuance is recorded as a normal issuance at $30, even though that is not the market price at the date of issuance. Additional paid-in capital is increased by $10, the difference between the $30 exercise price and $20 par. Issuing warrants or stock has no effect on earnings. A firm does not profit on transactions with owners.

A retained earnings appropriation can be used to?

The purpose of appropriations is to restrict dividends and communicate that restriction to users of the financial statements. It is merely a partitioning of retained earnings into two parts: (1) available for dividends, and (2) unavailable. A firm need not record an appropriation in order to restrict dividends. However, it helps alert stockholders to the possibility that dividends may be curtailed, and informs them of the reason for that curtailment.

A company issued rights to its existing shareholders without consideration. The rights allowed the recipients to purchase unissued common stock for an amount in excess of par value. When the rights are issued, which of the following accounts will be increased? Common stock and Additional paid-in capital

There is no effect on OE when rights are issued to existing stockholders pursuant to a future stock issuance. No journal entry is needed, because no transaction has yet taken place.