Hello I'm professor Brian Bushee and welcome back. In this video we're going to look at retained earnings and accumulated other comprehensive income. Which will put our focus on dividends both cash and stock dividends, stock splits, and all that stuff that we hide away in AOCIs so it doesn't have to show up on the income statement. Let's get started. So let's go back to our old friend, retained earnings that we've talked about a lot in this course. Remember, retained earnings is the cumulative income that has not been paid out over dividends. We build it up over time through net income. So anytime you have positive net income it increases retaining earnings. Negative net income and net loss with decreased retained earnings. Retained earnings also goes down when you pay a dividend, which is a viewed as a return of the equity back to shareholders. And now I want to talk about dividends in a little bit more detail than we've talked about them so far. So with cash dividends, there's a number of dates you have to keep in mind. First one is the declaration date. This is the date when the company declares the dividend will be paid. And it's going to be paid to all investors that hold shares as of a date of record. Which will usually happen about ten days after the declaration date. The date of record, is the date on which investors must hold the shares to be entitled to receive the dividend. So anyone that's on record as holding the shares as of that date, get the dividend. Even if they sell it after the date of record, the still get the dividend. The payment date is the date in which the firm actually mails the payment to the shareholders. Now note that firms are not required to pay dividends, and in fact there have been a lot of companies that have never paid any dividends in their entire lifetimes. However once a firm has declared a dividend then it is legally obligated to pay its shareholders as of the record date. And that's why we create this dividends payable account on the declaration date, to recognize this legal liability to pay the dividends that you've declared. >> When I read the business section of the Fort Worth Star Telegram in the morning with my prune juice and oatmeal, I often see references to the ex dividend date. What is the ex dividend date? Is that when you send your ex wife the alimony check? >> [LAUGH] Yes. So there is one more date that matters that I left off the slide for space reasons, and that's the ex-dividend date. So as it turns out, it takes about three days after a stock transaction happens before it gets recorded in the company's ledger. So that means that, any stock transactions that happen within two days of the date of record don't show up in time to be in the records to get the dividend. So three trading days before the date of record is the ex-dividend date. If you buy the stock after the ex-dividend date, you won't get the dividend. And so as a result, the stock price will go down after the ex-dividend date to reflect the fact that you're buying a stock. But you're not going to get paid the dividend that the other shareholders will get because those shareholders will be in the books on the date of record, whereas you bought it too late to show up in the date of record. So let's take a look an example of paying cash dividends and how we treat all these different dates. So on June 6th Stack Incorporated declares a $0.50 dividend per share to both common and preferred shareholders of record on June 16th, 2012. The dividend will paid in cash on June 26th, 2012. Now just as a reminder from the last video preferred shares we have 10,000 issued and 10,000 outstanding. For common shares, we have 11,000 issued and 10,000 outstanding. So I'll throw up the pause and why don't you take a crack at doing this journal entry. So for the entry we want to debit retained earnings for 10,000. So we debit retained earnings on the declaration date, June 6th, to reduce retained earnings. The 10,000 comes from the fact that we've got 10,000 shares of preferred outstanding and 10,000 shares of common shares outstanding. So we only pay dividends on outstanding shares. So that's 20,000 shares total times $0.50 per share is $10,000. The credit will go through dividends payable. We create this liability to pay you to cash your shareholders at some date in the future. >> Why are the dividends based on the number of shares outstanding, and not the number of shares issued? And how does a company come up with a number like $0.50? >> So shares outstanding are the shares held by the public. Where shares issued, remember is shares outstanding plus the shares held in treasury owned by the company. It doesn't make sense for the company to pay itself dividends as an owner. So we ignore the treasury shares and we just pay the dividends to shares outstanding. Now the $0.50 per share that the company's come up with. This is thought about very carefully, because there's this very important facet of dividends. It's really bad news if you ever cut a dividend. And we call this feature sticky dividends. So once you commit to a level of dividends, you really have to maintain that level. You could raise it in the future, but if you ever reduce the level of dividends your stock price will plummet. You'll get fired as a manager, because everyone will interpret it as bad news. So I don't know exactly how you come up with something like $0.50 per share. But what a company has to do is when they think about how much dividends to pay, not only think about what cash they have now, but what level of cash flow they're going to have in the future. So that they continue to maintain a certain level of dividends because again you don't ever want to have to cut this dividend. Because it would lead to dire consequences in terms of stock price and even the manager's job. And the next date we have to look at is June 16th, 2012, which is the date of record. I'll put up the pause sign and you can try to do the journal entry on the date of record. Sorry trick question there's no journal entry on the date of record. It's an important date because it's establishing which investors will get the dividend. But we actually record the dividend coming out of retained earnings in the declaration date. We haven't paid it yet, so there's nothing that goes in Stack's financial statements on the date of record. Now let's try the journal entry for June 26th, 2012 which is the day the dividend will be paid. So here we're going to debit dividends payable for $10,000 to get rid of the liability because we're crediting cash. Paying cash for $10,000 as we mail the checks out to the shareholders of record. Now I want to talk about stock dividends and stock splits. So a stock dividend is a dividend where each common shareholder is given new shares instead of cash. Each stockholder's percentage ownership of the company is going to be identical to what it was before the stock dividend, so every shareholder's getting the same percentage increase in their shares so their overall ownership percentage is not changing. And there's no cash flow involved. We're not mailing any checks. Instead, we're giving new shares to the shareholders. Now there's two ways to account for this. And it depends on how big the dividend is. So if the dividend is less than 25%, and this is sort of approximate. You reduce retained earnings just like you do for cash dividend. But instead of creating a dividends payable you increase common stock and you increase APIC using the current market price. So it's like you're issuing new shares as part of this dividend. If it's greater than 25% you still reduce retained earnings but now you just increase common stock using the par value of the shares. And the logic for these large stock dividends is that you're giving shareholders more than 25% of their current shares. And that's going to be big enough that it's going to change the stock price dramatically because there's a lot more shares out there. And so the market price isn't a good measure of how much this is worth, so we just use the par value in that situation. A stock split is even more extreme. Now what we're going to do is replace each common share with a given number of new common shares. It's going to have no effect on the balance sheet, the income statement, or the cash flow statement. All we're going to do is adjust the number of shares authorized, issued, and outstanding. As well as the par value. So if we exchange each common share for two new shares, then we'll obviously have to double the number of shares authorized, issued, and outstanding, and then cut the par value in half. >> Really? This whole slide seems silly. Why would a company pay a stock dividend instead of a cash dividend? And why do a stock split if nothing really changes? >> Those are both excellent questions. One reason to do a stock dividend might be that you don't have the cash to pay dividends, so you give stock instead. Although that would be viewed as bad news if you were doing that. Because it would mean that you're, you're constrained on cash flow. I think a more common reason that you see stock dividends, and especially stock splits, is there's this investor psychology finding out there about something called the natural trading range. And there's been research that found, that's found that investors don't like to trade in stocks where the stock price is too low, you know, say below $20 a share, or too high like in the hundreds, above a $100 a share. So what happens is the company is growing, it's stock price is going up. The managers see that their stock price is going to go outside of this trading range. They're afraid that they're going to lose some investors as a result. So a stock dividend, or specialty stock split will reduce the company's stock price back in to this natural range. [LAUGH] And it turns out that this kind of stock split or stock dividend would be interpreted as good news. Because it's managers saying, hey, we think our stock price is going to continue to go up substantially. And so to get it back in this range that you're comfortable with, we're going to split the stock and basically divide the stock price by two. Now there's obviously exceptions out there, like Berkshire Hathaway has a stock price which is in the tens of thousands. But the fact that I knew that off the top of my head indicates that they are the exception rather than the rule. If you look, most stocks have prices below $100. And part of it is that when the stock price starts getting too high, managers will do these stock dividends or stock splits to try to bring it down into this more comfortable range for investors. Now let's take a look at an example of a stock dividend. So on July 7th, 2012 Stack Incorporated declares a 10% common stock dividend. Which means that every shareholders going to get new shares equal to 10% of their current shares held. So if you had ten shares, you would get one new share as a stock dividend. The price of Stack stock on 7/7 was $11 per share. So at this point just catching us up to where we are, there Stack has 11,000 shares issued, 10,000 shares outstanding, so there's still 1,000 shares held in treasury. The dividend's going to be a total of 1,000 new shares. So we take the shares outstanding times 10%, which means we're going to issue 1,000 new shares. Remember we don't give dividends based on shares held in treasury, so the outstanding number rather than the issued is relevant here. So let me throw up the pause sign, and why don't you take a crack at doing this journal entry. Okay so we're going to debit retained earnings like we do with any other dividend. The amount's going to be $11,000. That's the 1,000 new shares times the $11 market price on July 7th. But instead of dividends payable which we do the cash dividend we're going to credit common stock for 1,000. That's 1,000 new shares times the dollar par value. And then credit is shown paid in capital for the other $10,000 for the plot. So stock dividend involved a new share issuance so we do both common stock and APIC. So that adds a 1,000, or a 1,000 shares, to our shares issued which now go up to 12,000. And now there are 11,000 shares outstanding with still 1,000 shares held in treasury. >> I am sorry, but this is really silly. This is like the journal entry for issuing stock. But, instead of getting cash, you are reducing retained earnings. Really? >> I agree with Sally. If you are going to issue new stock, why not get some cash for it? Then you could use the stock to pay a proper cash dividend. >> Yes this is the journal entry for issuing stock because we are issuing new stock, we are just not getting cash for it. Instead we're giving it to our current shareholders and it functions just like a dividend. Now the question is, why not issue stock for cash and then use that cash to save, pay dividends. The problem with issuing new stock to the market is that you dilute the ownership of current shareholders. Unless current shareholders can buy the new shares of stock issued their ownership percentage will go down. And some investors would be really unhappy if their ownership percentage went down in this way. So by doing a stock dividend you're keeping everybody's ownership percentage the same because everyone's getting the same percent of the dividend. So if a company really wanted to raise cash to pay cash dividend, they wouldn't issue stock because of this dilution problem, instead they would probably just borrow money and then use the borrowed money to pay dividends. Next let's look at the example of a stock split. So on August 8th, 2012 Stack Incorporated announces a two for one common stock split. So they're going to exchange one share of current stock for two shares of the new stock. At this point there are 12,000 shares issued, 11,000 shares outstanding and the par value is $1. So why don't you go ahead and try to do the journal entry to record the stock split? Trick question, there is no journal entry. All we do is adjust the number of shares issued. Where now there's going to be 24,000 shares issued instead of 12,000. There's going to be 22,000 shares outstanding instead of 11,000. And the par value's going to drop from $1 a share, down to $0.50 per share. As you can see, by dividing the par value in half as we double the number of shares it won't change our balance in common stock or additional paying capital. Because if we take the shares issued times the par value it's $12,000. Which is what the balance in common stock would have been before we did the split. >> Let me get this straight. If you do a two-for-one split, you have half the old par value to get the new par value. So a three-for-one split would cut the par value by one-third, right? >> And an infinity-to-one split would reduce the par value to zero. >> Hm. So let me try and remember my math. If we take one divided by infinity. Yeah, the par value would be zero in that case. I don't recall seeing many infinity to one splits in practice however. One thing I do want to mention though is one thing you sometimes see in practice is what's called a reverse split. Where instead of doing two for one, you do one for two. So for every two shares currently held you give one new share. And what that does is it basically doubles the stock price. Where you would see a reserves split is when your stock price gets too low. So again I thinking of have this natural trading range idea. If your stock price gets into the teens or it gets below ten you might do a one for two or one for three split to basically double or triple your stock price. Get it to a higher level. And I guess if you did a zero for his one reverse split your stock price would go to infinity? Hm. Next we're going to move on to talk about accumulated other comprehensive income. So we previewed it in week six, we did marketable securities. We saw it again last week with deferred taxes. We'll talk about it again more formally now. This is for all those debits and credits that bypass the income statement so they can go directly into shareholders equity. So instead of having an expense or a loss run through the income statement into retained earnings, we have this debit to AOCI to bypass the income statement. Similarly, instead of a revenue or a gain going on the income statement and then to retained earnings. We just do a credit to AOCI to get it to stockholder's equity without going through the income statement. The rational is that companies don't like volatile earnings caused by market movements. But we have some accounting methods out there that require marking assets or liabilities to fair value. Marking them to market value. Which then create unrealized gains and losses which would cause that volatility in net income. So as a compromise the U.S. GAAP and IFRS require companies to mark-to-market in these situations, but they sometimes allow unrealized gains and losses to bypass the income statement. Which is, sounds good in theory but in practice the balance sheet must balance so the unrealized gains and losses have to go somewhere. So we created this accumulated other comprehensive income account. Which is where they can go instead of going through net income and into retained earnings. Now if you remember from the deferred taxes week, items that go into AOCI have to go in on an after-tax basis. And so the tax effect of the item is going to go into a deferred tax account, either deferred tax asset or deferred tax liability. >> Really? Companies don't like volatile net income. Bu presumably it is volatile for a reason. There are big movements in market values. It sounds like managers are a bunch of crybabies. And now we have to learn accumulated other comprehensive nonsense. >> Yeah, I do think in some cases managers are crybabies. Because if they had to put these things on income statement, they could just put it in a separate line item. And do a voluntary disclosure where they gave you the net income with and without this, you know, volatility. But managers are so afraid that investors are going to overreact to this number on the income statement, they want to keep it off. And they try to make the argument that these are long term activities. And so if they're long term activities, it doesn't matter if there's quarter to quarter changes in market values. So that shouldn't have to show up on the income statement. Again I don't agree with that. But then companies also have the ability to make large donations to congressman and senators. And those congressman and senators can try to convince the FASB or internationally convince the ISB to make these compromises to protect their income against this volatility. Sorry, I mean to say this is the theoretically correct and proper way to do the accounting. So as of now there are four items that go into AOCI. Now of course the standard setters may put more things into here in the future. But right now the four are unrealized gains and losses on marketable security. So we saw this earlier in the course where under available sale method. Any unrealized gains and losses from marking the securities difference in their value, go into AOCI. Another item would be foreign currency translation adjustments. So if you have a subsidiary in another country. The end of the year you have to convert the assets and liabilities of that subsidiary from the foreign currency into the domestic currency. And we use something called the Current Method. There are unrealized gains and losses from the exchange rate movements that occur. Those unrealized gains and losses go into AOCI instead of in the income statement. Pensions. The difference between the actual gains and losses on assets that you set aside to meet pension plans. And the expected gains and losses on those assets. That difference goes into AOCI. And then for derivatives, for, specifically for cash flow hedges, the unrealized gains and losses from marking derivatives to fair value, really to cash flow hedges, goes into AOCI. >> professor, will we have to know these for the exam? No, these are all advanced topics that are beyond the scope of this course, except for the marketable securities, which we did cover. And I just wanted to expose them to you, so you had a little bit of an idea what they were but we're not going to cover any of them in detail. Okay, finally, we're going to talk about the Statement of Shareholders' Equity. >> Yay, you finally got to the Statement of Shareholders Equity! You have been putting this off since week 1! >> Finally! Did I ever mention that finally is my favorite word in the accounting language? >> Yes, here's the statement of shareholder's equity. Hopefully I haven't gotten your expectations too high about this. So anyway this statement will report all the changes in the stockholder's equity accounts. For giving you the beginning and ending balances in each account, showing all the increases and decreases during the year. So for common stock APIC, and treasury stock, you'll see any issuance's and repurchases of stock during the year. The effects of stock-based compensation which we'll talk about later in the week. For retained earnings you'll see net income, details on dividends, any effects of stock-based compensation on retained earnings. For accumulated other comprehensive income then you'll see those four items that we talked about that affect AOCI. Finally, there'll be disclosure of noncontrolling interest. The, this is for consolidated subsidiaries where you own less than 100% ownership. This noncontrolling interest shows the claim on those assets by outside owners. Now, I'm not going to go into this. This is beyond the scope of the class. I've just included it in here for completeness. But later one we're going to look at a disclosure example and when we do that we'll see what's on the statement of stockholder's equity. >> That's all? What a colossal let down! >> Now you know why I put it off for ten weeks. Wait, so maybe I under sold a little bit the statement of shareholders' equity. It's especially important for understanding what's going on with something like stock-based compensation, which is what we're going to talk about in the next video. I'll see you then. >> See you next video.
