Page 529 - Accounting Principles (A Business Perspective)

13. Corporations: Paid-in capital, retained earnings, dividends, and treasury stock

dividends, the stockholders of that corporation might pay themselves a cash dividend or have the corporation buy
back their stock, leaving no funds available for the corporation's creditors.
The board of directors of a corporation possesses sole power to declare dividends. The legality of a dividend

generally depends on the amount of retained earnings available for dividends—not on the net income of any one
period. Firms can pay dividends in periods in which they incurred losses, provided retained earnings and the cash
position justify the dividend. And in some states, companies can declare dividends from current earnings despite an
accumulated deficit. The financial advisability of declaring a dividend depends on the cash position of the
corporation.
Normally, dividends are reductions of retained earnings since they are distributions of the corporation's net
income. However, dividends may be distributions of contributed capital. These dividends are called liquidating

dividends.
Accountants debit liquidating dividends to a paid-in capital account. Corporations should disclose to
stockholders the source of any dividends that are not distributions of net income by indicating which paid-in capital
account was debited as a result of the dividend. The legality of paying liquidating dividends depends on the source
of the paid-in capital and the laws of the state of incorporation.

An accounting perspective:

Business insight

The Private Securities Litigation Reform Act, passed in 1995, seeks to protect investors against
white-collar crime. Auditors are required by this law to become more aggressive in looking for
fraud in companies they audit. Risk factors that might encourage management to engage in

fraudulent activities include weak internal controls, an aggressive effort to drive up the stock price
by reporting higher earnings, and/or executive bonuses or stock options based on earnings. A
strong company code of ethics and an effective internal control structure can help deter fraud from
occurring.

Retained earnings appropriations

The amount of retained earnings that a corporation may pay as cash dividends may be less than total retained
earnings for several contractual or voluntary reasons. These contractual or voluntary restrictions or limitations on
retained earnings are retained earnings appropriations. For example, a loan contract may state that part of a
corporation's USD 100,000 of retained earnings is not available for cash dividends until the loan is paid. Or a board
of directors may decide to use assets resulting from net income for plant expansion rather than for cash dividends.

An example of a voluntary restriction was General Electric's annual report statement that cash dividends were
limited "to support enhanced productive capability and to provide adequate financial resources for internal and
external growth opportunities".
Companies formally record retained earnings appropriations by transferring amounts from Retained Earnings
to accounts such as "Appropriation for Loan Agreement" or "Retained Earnings Appropriated for Plant Expansion".

530