Cash dividends Net income results from management's activities.

The long-term effect of net income is an increase in the company's resources and its sources of resources (stockholders' equity, retained earnings). Corporations distribute to owners some of the resources generated by management (net income) in the form of cash dividends. A corporation's board of directors has the responsibility for declaring cash dividends. If it determines the company should distribute cash dividends to owners, the board of directors declares a cash dividend. The board determines the dollar amount of the dividends and the date on which they will be paid. Because it takes time to identify all the owners and distribute checks to them, dividends are paid several days or weeks after they are declared. Assume a corporation's board of directors declares a $2,000 cash dividend on July 10, with the dividend to be paid on August 12. Show the effects on the company's resources and sources of resources.

Total Resources Assets

= =

Sources of Borrowed Resources Liabilities + $2,000 dividends payable

+ +

Sources of Sources of Management Owner Invested Generated Resources + Resources Stockholders' Equity + - $2,000 dividends

The company's resources (assets) do not change as a result of the July 10 declaration of dividends because the cash will not be paid out until later (August 12). The company's sources of resources increase and decrease by the $2,000 dividends declared. Liabilities increase by $2,000 because the company now owes its owners $2,000 more. Stockholders' equity decreases by $2,000 because the owners now have rights to $2,000 less of the company's resources. In effect, the owners have given up their ownership rights to $2,000 of the company's resources for $2,000 of rights as creditors: the owners have become creditors. The decrease in stockholders' equity is shown as a decrease in sources of management generated resources because dividends, by definition, come out of those resources generated by management. Dividends are not returns to owners of some of the resources they invested in the corporation. Remembering that assets increase with debits and that debits must equal credits, prepare the journal entry to record the $2,000 cash dividend declaration.

Date July 10

Description Dividends Dividends Payable Cash dividends declared

Post. Ref.

Debits 2,000

Credits 2,000

On August 12, the corporation pays the $2,000 cash dividend declared on July 10. Show the effects on the company's resources and sources of resources.

Total Resources Assets - $2,000 cash

= = =

Sources of Borrowed Resources Liabilities - $2,000 dividends payable

+ +

Sources of Sources of Management Owner Invested Generated Resources + Resources Stockholders' Equity

The cash dividend payment reduces the company's resources (assets) as the cash flows out to owners. The company's sources of resources (liabilities) decrease by $2,000 because the company no longer owes them the $2,000 once the dividends are paid. Remembering that assets increase with debits and that debits must equal credits, prepare the journal entry to record the $2,000 cash dividend payment.

Date Aug. 12

Description Dividends Payable Cash Cash dividends paid

Post. Ref.

Debits 2,000

Credits 2,000

As a result of declaring and paying cash dividends, the company's resources and sources of resources both decreased by $2,000. While it is important to management to keep owners satisfied by giving them some of the resources generated by the company, cash dividends do decrease the amount of resources managers will be able to use in the future. Corporations must continually evaluate this need to pay owners versus the need to keep resources for management to use in the future. Distributing cash dividends If a corporation has both preferred stockholders and common stockholders, the distribution of cash dividends depends upon the number of shares of stock owned by the stockholders (called outstanding shares) and the preferences of the preferred stockholders. For example, consider a company with the contributed capital shown below.

Contributed Capital 8% Preferred Stock, $10 par, 5,000 shares authorized, 1,000 shares issued Common Stock, $2 par, 40,000 shares authorized, 10,000 shares issued Additional Paid-in Capital, Preferred Stock Additional Paid-in Capital, Common Stock
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$10,000 $20,000 $2,000 $30,000

Total Contributed Capital

$62,000

The company has both preferred stockholders and common stockholders. The preferred stockholders own 1,000 shares (shares issued by the company) out of a total of 5,000 shares the company's articles of incorporation allow it to issue (called authorized shares). The preferred stock has a par value of $10 per share and a dividend rate of 8%. Notice the $10,000 in the preferred stock account is the par value of the number of shares issued ($10 par x 1,000 shares issued = $10,000). The 8% dividend rate entitles the preferred stockholders to a dividend of 8% of the preferred stock's par value in the year in which a dividend is declared. Thus, on an annual basis, preferred stockholders could receive cash dividends of $.80 per share (.08 x $10 par = $.80). In total, preferred stockholders could receive cash dividends of $800 (.08 x $10 par x 1,000 shares outstanding = $800). The preferred stockholders would receive the $800 before any cash dividends would be paid to common stockholders. Based on the company's contributed capital, its $2,000 cash dividends would be distributed as follows.

Preferred stock dividends (.08 x $10 par x 1,000 shares) Common stock dividends ($2,000 - $800) Total dividends

$800 $1,200 $2,000

Preferred stockholders would receive cash dividends of $.80 per share before dividends would be paid to common stockholders. This is one of the advantages (preferences) of owning preferred stock. Common stockholders would receive cash dividends of $.12 per share ($1,200 dividends / 10,000 common shares outstanding = $.12).

** You now have the background to do text exercises 12.7, 12.8, and 12.9.

Cumulative preferred stock One popular way companies make preferred stock attractive to investors is to add the cumulative preference. Remember, preferred stock is issued to obtain resources for management to use. The more attractive the preferred stock is to investors, the easier it is to obtain resources. The cumulative preference entitles preferred stockholders to receive dividends before common stockholders, even if the company failed to pay dividends in a prior year. Again, remember that owners receive dividends only after they have been declared by the board of directors. If dividends are not declared, they cannot be received by owners. Thus, without the cumulative feature, preferred stockholders would not receive dividends for any year in which the board of directors did not declare them. With the cumulative feature, however, preferred stockholders are guaranteed to receive their dividends for all years before the company can distribute any dividends to common stockholders. Consider again the $2,000 cash dividend discussed previously. Assume the board of directors did not declare dividends in the previous year, but instead kept the resources in the company for management to use.
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Without the cumulative feature, preferred stockholders would have lost their right to the $800 cash dividends for that prior year. If, however, the preferred stock was cumulative, the $2,000 cash dividend declared this year would be distributed as follows.

Preferred stock dividends (last year's dividend) Preferred stock dividends (this year's dividend) Common stock dividends ($2,000 - $1,600) Total dividends

$800 $800 $400 $2,000

Preferred stockholders would receive cash dividends of $1.60 per share ($1,600 dividends / 1,000 shares = $1.60) before dividends would be paid to common stockholders. Thus, the preferred stockholders would receive last year's and this year's dividends. Common stockholders would receive cash dividends of $.04 per share ($400 dividends / 10,000 common shares outstanding = $.04). Dividends protection can be attractive to preferred stockholders, especially if a company has a history of not declaring dividends each year. If preferred stockholders find dividends protection attractive, it should be easier for a company to obtain resources from them. There are other popular preferences designed to make preferred stock attractive to investors. For example, preferred stock can be participating and/or convertible. Participating preferred stock allows preferred stockholders to receive dividends in excess of the stock's stated dividend percentage. For example, if the above 8% preferred stock were participating, under certain circumstances preferred stockholders could receive dividends greater than 8%. Convertible preferred stock allows owners to change (or convert) their preferred stock into common stock under certain conditions. This conversion to common stock would allow preferred stockholders to take advantage of rapid increases in the value of the company's common stock. Regardless of the preferred stock preferences, it is important to remember that preferred stock is a source of resources to companies. In order to obtain resources, companies make use of various preferences to make preferred stock attractive for investors.

Practice Exercise On January 31, the Christopher Corporation had 20,000 shares of $100 par, 10%, cumulative preferred stock outstanding and 5,000,000 shares of $.02 par common stock outstanding. On February 15, the Christopher Corporation paid cash dividends of $700,000 on shares outstanding on January 31. The Christopher Corporation did not pay cash dividends in the previous year. 1. Calculate the total cash dividends paid on February 15 to preferred stockholders. On an annual basis, the cash dividends to be paid to preferred stockholders are $200,000 (20,000 preferred shares x $100 par value per share x .10 dividend rate = $200,000). Since the preferred stock is cumulative, any unpaid dividends from previous years must be paid to preferred stockholders before any of this year's dividends can be paid. Thus, since the Christopher Corporation had not paid the $200,000 dividends in the previous year, this year the preferred stockholders would receive $400,000, $200,000 for the previous year and $200,000 for this year.
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2. Calculate the cash dividend per share paid to preferred stockholders on February 15. $400,000 cash dividends / 20,000 preferred shares = $20 dividends per share of preferred stock. 3. Calculate the total cash dividends paid on February 15 to common stockholders.

Total cash dividends Less: Dividends to preferred stockholders Dividends to common stockholders

$700,000 $400,000 $300,000

4. Calculate the cash dividend per share paid to common stockholders on February 15. $300,000 cash dividends / 5,000,000 common shares = $.06 dividends per share of common stock.

** You now have the background to do text exercises 12.10, 12.11, and 12.12.

Earnings per Share SFAS No. 128 Statement of Financial Accounting Standards (SFAS) No. 128 a. Earnings per Share b. Issued in February 1997 c. SFAS No. 128 supersedes APB Opinion No. 15, Earnings per Share, May 1969 Basic Earnings per Share (EPS) --> Basic EPS = BE / BS --> BE = income available to common stockholders --> BS = weighted-average number of common shares outstanding Income available to common stockholders --> Net income - dividends on preferred stock (declared in the period) - dividends on cumulative preferred stock (accumulated for the period) Diluted Earnings per Share (EPS) --> Diluted EPS = DE / DS --> DS = BS + Dilutive potential common shares --> DE = BE + --> DE = BE + + + Dilutive effect of assumed conversions convertible preferred dividends interest (after-tax) on convertible debt effect of assumed conversion of potential common shares

Antidilution is not allowed If assumed conversion has an antidilutive effect on EPS --> such conversion is not assumed. a. Antidilutive effect on EPS --> Diluted EPS > Basic EPS b. If income from continuing operations < 0, (loss from continuing operations) --> Potential common shares are not added. (Diluted EPS = Basic EPS) --> even if net income > 0. Treasury Stock Method --> Dilutive effect of call options and warrants a. Exercise of options and warrants --> assumed at the beginning of the period or at the time of issuance, whichever is later. b. Proceeds from exercise --> assumed to be used to purchase common stock

at the average market price during the period. c. Incremental shares --> included in the denominator of diluted EPS Stock-based compensation to employees Fixed awards and nonvested stock to be issued --> considered outstanding as of grant date. If-Converted Method --> Convertible securities a. Preferred dividends to convertible preferred stock --> added to income available to common stockholders. b. Interest charges (after-tax) to convertible debt --> added to income available to common stockholders. c. Convertible preferred stock or convertible debt --> assumed to be converted at the beginning of period or at the time of issuance, whichever is later. d. Conversion is not assumed --> if the effect is antidilutive. (Diluted EPS > Basic EPS) Stock Dividends or Stock Splits Basic and diluted EPS --> adjusted retroactively for all periods presented. Basic EPS Basic Earnings per Share (EPS) --> Basic EPS = BE / BS --> BE = income available to common stockholders --> BS = weighted-average number of common shares outstanding Example 1 (Issuance of stock)

Company A had 3,000,000 shares of common stock outstanding on January 1, 2011. Net income for 2006 is $4,500,000. Additional stock transactions: April 1, 2011 Issuance of common stock November 1, 2011 Purchase of treasury stock 600,000 shares 120,000 shares

Weighted average number of common shares:

Dates outstanding 1/1 - 3/31 Issuance on 4/1 4/1 - 10/31 Purchase on 11/1 11/1 - 12/31 Weighted average number of common shares outstanding

Shares outstanding 3,000,000 600,000 3,600,000 120,000 3,480,000

Fraction of period 3/12 7/12 2/12

Weighted average shares 750,000 2,100,000 580,000 3,430,000

Basic EPS = $4,500,000 / 3,430,000 shares = $1.31 Weighted average number of common shares: 3,000,000 shares x 3/12 = 750,000 shares 3,600,000 shares x 7/12 = 2,100,000 shares 3,480,000 shares x 2/12 = 580,000 shares Total 3,430,000 shares Example 2 (Stock dividend and split)

Company B had 3,000,000 shares of common stock outstanding on January 1, 2011. Net income for 2006 is $8,000,000. Additional stock transactions: April 1, 2011 Issuance of common stock May 1, 2011 10% stock dividend November 1, 2011 2-for-1 stock split Weighted average number of common shares: 600,000 shares

Dates outstanding 1/1 - 3/31 Issuance on 4/1 4/1 - 4/30 10% stock dividend, 5/1 5/1 - 10/31 2-for-1 stock split, 11/1

Shares outstanding 3,000,000 600,000 3,600,000 360,000 3,960,000 3,960,000

Effect of Stock Dividend 1.10 1.10

Effect of Stock Split 2.00 2.00 2.00

Fraction of period 3/12 1/12 6/12

Weighted average shares 1,650,000 660,000 3,960,000

11/1 - 12/31 Weighted average number of common shares outstanding

7,920,000

2/12

1,320,000 7,590,000

Basic EPS = $8,000,000 / 7,590,000 shares = $1.05 Alternatively, Weighted average number of common shares: 3,000,000 shares x 3/12 = 750,000 shares 3,600,000 shares x 9/12 = 2,700,000 shares Total 3,450,000 shares Effect of stock dividend Effect of stock split Weighted average x 1.1 x 2.0 = 7,590,000 shares

Stock Dividends or Stock Splits --> adjust the number of shares outstanding retroactively for all periods presented. Due to retroactive adjustments, --> dates (during the year) of stock dividends and splits do not affect the number of shares outstanding. Example 3 (Preferred stock dividend)

Company C had 3,000,000 shares of common stock outstanding on January 1, 2011. Preferred stock outstanding: 200,000 shares of 5% cumulative preferred stock ($10 par) Net income: 2011: $4,600,000 2012: - $1,100,000 (loss) Preferred stock dividend declared: 2011: $100,000 2012: $0 Weighted average number of common shares: 2011: 3,000,000 shares 2012: 3,000,000 shares Income available to common stockholders: 2011: $4,600,000 - $100,000 (*1) = $4,500,000

2012: - $1,100,000 - $100,000 (*2) = - $1,200,000 (loss) (*1) $100,000 dividend on preferred stock (declared in the period) (*2) $100,000 dividend on cumulative preferred stock (accumulated for the period) Preferred stock dividend = ($10 par x 5%) x 200,000 shares = $.50 x 200,000 shares = $100,000 Basic EPS: 2011: $4,500,000 / 3,000,000 shares = $1.50 per share 2012: - $1,200,000 / 3,000,000 shares = - $.40 per share (loss) Income available to common stockholders --> Net income - dividends on preferred stock (declared in the period) - dividends on cumulative preferred stock (accumulated for the period) If there is a loss, --> amount of loss is increased by preferred dividends. Diluted EPS, Treasury Stock Method Basic Earnings per Share (EPS) --> Basic EPS = BE / BS --> BE = income available to common stockholders --> BS = weighted-average number of common shares outstanding Diluted Earnings per Share (EPS) --> Diluted EPS = DE / DS --> DS = BS + Dilutive potential common shares Example 4 (Treasury stock method)

Company D had 3,000,000 shares of common stock outstanding on January 1, 2011. Net income for 2011 is $4,650,000. Stock options and warrants issued: April 1, 2011: Options for 200,000 shares, $20 per share exercise price October 1, 2011: Warrants for 250,000 shares, $30 per share exercise price Average market price of Company A's common stock during 2011: $50 Weighted average number of common shares: 3,000,000 Income available for common stockholders: $4,650,000 Basic EPS = $4,650,000 / 3,000,000 shares = $1.55 Incremental shares from stock options: a. Proceeds from assumed exercise: --> April 1, 2011: 200,000 shares x $20 = $4,000,000

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b. Number of shares assumed to be repurchased: --> $4,000,000 / $50 = 80,000 shares c. Incremental shares from assumed exercise: --> Incremental shares = 200,000 shares - 80,000 shares = 120,000 shares Alternatively, 200,000 shares - [(200,000 shares x $20 ) / $50] = 200,000 shares x (1 - $20/$50) = 200,000 shares x ($50/$50 - $20/$50) = 200,000 shares x [($50 - $20) / $50] = 200,000 shares x .60 = 120,000 shares Option shares x [(Average market price - Exercise price) / Average market price] Incremental shares from stock warrants: a. Proceeds from assumed exercise: --> October 1, 2011: 250,000 shares x $30 = $7,500,000 b. Number of shares assumed to be repurchased: --> $7,500,000 / $50 = 150,000 shares c. Incremental shares from assumed exercise: --> Incremental shares = 250,000 shares - 150,000 shares = 100,000 shares Alternatively, 250,000 shares - [(250,000 shares x $30 ) / $50] = 250,000 shares x (1 - $30/$50) = 250,000 shares x ($50/$50 - $30/$50) = 250,000 shares x [($50 - $30) / $50] = 250,000 shares x .40 = 100,000 shares Warrant shares x [(Average market price - Exercise price) / Average market price] Weighted average number of common shares: Dates outstanding 1/1 - 3/31 Incremental shares from options on 4/1 4/1 - 9/30 Incremental shares from warrants on 10/1 10/1 - 12/31 Weighted average number of common shares outstanding 3,000,000 shares x 3/12 = 750,000 shares 3,120,000 shares x 6/12 = 1,560,000 shares Shares outstanding 3,000,000 120,000 3,120,000 100,000 3,220,000 3/12 805,000 3,115,000 6/12 1,560,000 Fraction of period 3/12 Weighted average shares 750,000

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3,220,000 shares x 3/12 = 805,000 shares Total 3,115,000 shares Diluted EPS = $4,650,000 / 3,115,000 shares = $1.49 Diluted EPS, If-converted Method Basic Earnings per Share (EPS) --> Basic EPS = BE / BS --> BE = income available to common stockholders --> BS = weighted-average number of common shares outstanding Diluted Earnings per Share (EPS) --> Diluted EPS = DE / DS --> DS = BS + Dilutive potential common shares --> DE = BE + Dilutive effect of assumed conversions --> DE = BE + convertible preferred dividends + interest (after-tax) on convertible debt + effect of assumed conversion of potential common shares Example 5 (If-converted method, Convertible bonds)

Company E had 3,000,000 shares of common stock outstanding on January 1, 2011. Net income for 2011 is $4,500,000. Convertible Bonds: April 1, 2011: $1,000,000 convertible bonds, 8% annual interest rate. $1,000 bonds can be converted to 100 shares of common stock. Income tax rate: 40% Weighted average number of common shares: 3,000,000 Income available for common stockholders: $4,500,000 Basic EPS = $4,500,000 / 3,000,000 shares = $1.50 If convertible bonds are converted: a. Incremental shares: --> April 1, 2011: ($1,000,000 / $1,000) x 100 shares = 100,000 shares b. Weighted average number of common shares: --> 3,000,000 shares x 3/12 = 750,000 shares 3,100,000 shares x 9/12 = 2,325,000 shares Total = 3,075,000 shares c. Interest expense: --> $1,000,000 x 8% x 9/12 = $60,000 --> After tax: $60,000 x (1 - 40%) = $36,000 d. Income available to common stockholders: --> $4,500,000 + $36,000 = $4,536,000

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Diluted EPS = $4,536,000 / 3,075,000 shares = $1.48 Convertible preferred stock or convertible debt --> assumed to be converted at the beginning of period or at the time of issuance, whichever is later. Example 6 (If-converted method, Convertible preferred stock)

Company F had 2,000,000 shares of common stock outstanding on January 1, 2011. Net income for 2011 is $3,500,000. Cumulative preferred stock outstanding: 200,000 shares of 5% cumulative preferred stock ($10 par) 100,000 shares of 3% convertible cumulative preferred stock ($20 par) One share of convertible preferred stock ($20 par) is convertible into one share of common stock. Preferred stock dividends: 5% ($10 par) preferred stock: = ($10 par x 5%) x 200,000 shares = $.50 x 200,000 shares = $100,000 3% ($20 par) preferred stock: = ($20 par x 3%) x 100,000 shares = $.60 x 100,000 shares = $60,000 Income available for common stockholders = $3,500,000 - $100,000 - $60,000 = $3,340,000 For Basic EPS, --> Income available for common stockholders = Net income - all preferred stock dividends Weighted average number of common shares: 2,000,000 Basic EPS = $3,340,000 / 2,000,000 shares = $1.67 If convertible preferred stocks are converted: a. Incremental shares: --> 100,000 shares b. Weighted average number of common shares: --> 3,000,000 shares + 100,000 shares = 3,100,000 shares c. Dividends on convertible preferred stock: --> 3% ($20 par) preferred stock: = ($20 par x 3%) x 100,000 shares = $.60 x 100,000 shares = $60,000

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d. Income available to common stockholders: --> $3,340,000 + $60,000 = $3,400,000 For Diluted EPS (If-method method) --> Income available for common stockholders for Diluted EPS = Income available for common stockholders for Basic EPS + Dividends on convertible preferred stock Diluted EPS = $3,400,000 / 3,100,000 shares = $1.10

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