Problem 10 - Accounting

Question

Earthworks Health Co. is an HMO for 12 businesses in the St. Louis area. The following account balances appear on the balance sheet of Earthworks Health Co.: Common stock \((400,000\) shares authorized), \(\$ 100\) par, \(\$ 30,000,000\); Paid-in capital in excess of par-common stock, \(\$ 4,500,000\); and Retained earnings, \(\$ 50,600,000\). The board of directors declared a \(2 \%\) stock dividend when the market price of the stock was \(\$ 120\) a share. Earthworks Health Co. reported no income or loss for the current year. a. Journalize the entries to record (1) the declaration of the dividend, capitalizing an amount equal to market value, and (2) the issuance of the stock certificates. b. Determine the following amounts before the stock dividend was declared: (1) total paid-in capital, (2) total retained earnings, and (3) total stockholders' equity. c. Determine the following amounts after the stock dividend was declared and closing entries were recorded at the end of the year: (1) total paid-in capital, (2) total retained earnings, and (3) total stockholders' equity.

Step-by-Step Solution

Answer

The journal entries adjust retained earnings for the stock dividend. Stockholders' equity remains $85,100,000 pre and post-dividend.

Step 1: Declaration of the stock dividend

When the board declares a stock dividend, Earthworks Health Co. needs to make a journal entry to record the declaration by distributing part of retained earnings into paid-in capital. Given that a 2% stock dividend is declared on 400,000 shares at a market price of \(120 per share, calculate the value of the stock dividend: \[ \text{Shares for Dividend} = 400,000 \times 0.02 = 8,000 \text{ shares} \]\[ \text{Value of Dividend} = 8,000 \times 120 = \text{\\)960,000} \]The journal entry to record this declaration is:- Debit Retained Earnings: \(960,000- Credit Common Stock Dividend Distributable: 8,000 shares \times \)100 par = \(800,000- Credit Paid-in Capital in Excess of Par: \)160,000 (since \(120 market price - \)100 par for 8,000 shares = $160,000)

Step 2: Issuing the stock certificates

After declaring the stock dividend, Earthworks Health Co. issues new stock certificates. Thus, we need to reclassify the common stock dividend distributable to common stock in the journal: - Debit Common Stock Dividend Distributable: $800,000 - Credit Common Stock: $800,000 This finalizes the transfer of ownership of 8,000 additional shares to the shareholders.

Step 3: Calculate before dividend amounts

Before the stock dividend is declared, calculate the following: 1. Total Paid-in Capital: - Common Stock: $30,000,000 - Paid-in Capital in Excess of Par: $4,500,000 - Total Paid-in Capital: $34,500,000 2. Total Retained Earnings: $50,600,000 3. Total Stockholders' Equity: - Total Paid-in Capital + Total Retained Earnings = $34,500,000 + $50,600,000 = $85,100,000

Step 4: Calculate after dividend amounts

After the stock dividend and issuance of stock certificates: 1. Total Paid-in Capital: - Original: $34,500,000 - Add $800,000 (new Common Stock due to issuance) - Add $160,000 (additional Paid-in Capital in Excess of Par) - New Total Paid-in Capital: $35,460,000 2. Total Retained Earnings: - Original: $50,600,000 - Subtract value of the stock dividend: $960,000 - New Total Retained Earnings: $49,640,000 3. Total Stockholders' Equity: - New Total Paid-in Capital + New Total Retained Earnings = $35,460,000 + $49,640,000 = $85,100,000 - Stockholders' equity remains unchanged since dividends involve internal equity realignment.

Key Concepts

Stock Dividends

A stock dividend is a way for companies to reward shareholders by issuing additional shares instead of cash. When Earthworks Health Co. declares a 2% stock dividend, it means each shareholder receives extra shares amounting to 2% of the total shares they already own. This doesn't change the overall equity of the company, but it does redistribute part of the retained earnings into paid-in capital.

Here’s how it works:

• A stock dividend takes a percentage of the existing shares; in this case, 400,000 shares result in an additional 8,000 shares being issued (as calculated by multiplying 400,000 by 0.02).
• To give these new shares a value, we use the market price. Since the market value is $120 per share, the total value of the dividend thus becomes $960,000.

This total value of the dividend is transferred from retained earnings (where profits are stored) into paid-in capital (total investment in the company by shareholders). By doing this, the company increases the number of shares, but not the payout in terms of shareholder's equity.

Retained Earnings

Retained earnings represent the accumulated profit that a company keeps after paying out any dividends. When a company like Earthworks Health Co. declares a stock dividend, it takes part of these retained earnings and reallocates them.

Here's a closer look:

• Initially, Earthworks Health Co. has $50,600,000 in retained earnings.
• With the declaration of a stock dividend valued at $960,000, we decrease retained earnings by this amount to capitalize the stock issued.
• After this reallocation, the new retained earnings balance is $49,640,000.

Retained earnings are crucial because they reflect the company's ability to reinvest in its own operations and continue to fund growth without needing to increase debt or issue new equity. A stock dividend doesn't change the company's cash position, but it does affect how retained profits are presented in the equity section of the balance sheet.

Stockholders' Equity

Stockholders' equity represents the ownership interest held by the shareholders in the company. It is the net difference between the company's total assets and total liabilities, showcasing what would be left for shareholders if all debts were paid.

At Earthworks Health Co., the following happened during the stock dividend process:

• Before the stock dividend, total paid-in capital plus retained earnings equaled $85,100,000.
• After declaring and issuing the stock dividend, although the components of equity shifted (retained earnings decreased by $960,000, while paid-in capital increased by the same amount), the total stockholders' equity remained $85,100,000.

Understanding stockholders' equity is crucial; it indicates not just the value returned to shareholders but also acts as a cushion for covering potential losses or debts incurred by the company. In scenarios involving stock dividends, the equity distribution changes, but the total equity does not. This lack of change signifies the internal reallocation of resources without losing company value.