Problem 10 - Accounting

Question

Organic Health Co. is an HMO for businesses in the Chicago area. The following account balances appear on the balance sheet of Organic Health Co.: Common stock ( 300,000 shares authorized), \(\$ 100\) par, \(\$ 10,000,000\); Paid-in capital in excess of parcommon stock, \(\$ 2,000,000\); and Retained earnings, \(\$ 45,000,000\). The board of directors declared a \(2 \%\) stock dividend when the market price of the stock was \(\$ 125\) a share. Organic 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

Before: Total Equity = $57,000,000; After: Total Equity = $57,000,000; No net change in Equity.

Step 1: Determine the Stock Dividend

The company declared a 2% stock dividend, which means that each shareholder receives additional shares equal to 2% of their current holdings. With a 300,000 shares authorized, let's calculate the number of new shares issued: Number of shares = 300,000 * 2% = 6,000 shares The market price of the stock is $125 per share. Therefore, the total value of the stock dividend = 6,000 * $125 = $750,000.

Step 2: Record Declaration of Dividend

When the board declares the stock dividend, we need to record it by debiting 'Retained Earnings' and crediting 'Common Stock Dividend Distributable' and 'Paid-in Capital in Excess of Par - Common Stock'. 1. Debit 'Retained Earnings' for $750,000. 2. Credit 'Common Stock Dividend Distributable' for the par value amount of the new shares. New shares = 6,000, Par Value per share = $100 So, Credit 'Common Stock Dividend Distributable' = 6,000 * $100 = $600,000 3. Credit 'Paid-in Capital in Excess of Par - Common Stock' for the remainder. Remainder = $750,000 - $600,000 = $150,000.

Step 3: Record Issuance of Stock Certificates

Now, we record the issuance of stocks where we move the amount from 'Common Stock Dividend Distributable' to 'Common Stock'. 1. Debit 'Common Stock Dividend Distributable' for $600,000. 2. Credit 'Common Stock' for $600,000.

Step 4: Determine Amounts Before Dividend

Calculate the total accounts before the dividend: 1. Total Paid-in Capital = Common Stock + Paid-in Capital in Excess of Par = $10,000,000 + $2,000,000 = $12,000,000 2. Total Retained Earnings = $45,000,000 3. Total Stockholders' Equity = Total Paid-in Capital + Total Retained Earnings = $12,000,000 + $45,000,000 = $57,000,000.

Step 5: Determine Amounts After Dividend

Update the account balances after the dividend: 1. Total Paid-in Capital: Common Stock has increased by $600,000 and Paid-in Capital in Excess of Par by $150,000. Total Paid-in Capital = $12,000,000 + $600,000 + $150,000 = $12,750,000 2. Total Retained Earnings decrease by $750,000 due to stock dividend: New Retained Earnings = $45,000,000 - $750,000 = $44,250,000 3. Total Stockholders' Equity remains unchanged: $57,000,000

Key Concepts

Journal Entries

When a company declares a stock dividend, it is vital to accurately track this financial event through journal entries. This process involves specific accounting actions to reflect changes in the company's financial statements.

• First, the declaration of a dividend is recorded. In this step, the company debits the 'Retained Earnings' account for the total value of the stock dividend, which is calculated by multiplying the number of shares to be issued by the market price per share.
• Then, the company credits 'Common Stock Dividend Distributable' for the aggregate par value of the new shares. If the par value is \(100\) per share and we have 6,000 new shares, the credit amount is \(\text{6,000} \times \text{100} = \text{600,000}\).
• The remainder, which is the difference between the total value of the dividend and the par value, is credited to 'Paid-in Capital in Excess of Par - Common Stock'. This recognizes the equity above the nominal value of the stock.
• Finally, when stock certificates are issued, the company debits 'Common Stock Dividend Distributable' and credits 'Common Stock' for the par value of these shares.

These entries ensure that the financial records accurately reflect the equitable distribution of stock dividends without changing the total equity.

Retained Earnings

Retained earnings represent the profits of the company that have not been distributed to shareholders as dividends. They are an essential component of shareholder equity. A stock dividend impacts retained earnings as it involves reallocating part of these earnings.

• When a stock dividend is declared, the company's retained earnings are reduced by an amount equal to the market value of the distributed stocks. In our case, the company debits \(750,000\) from retained earnings, reflecting the stock's market value.
• This reduction is a reflection of distribution to shareholders in the form of additional stock. Hence, while the shareholders gain more shares, these do not directly result in a cash outflow, but instead adjust internal components of equity.
• Retained earnings act as a cushion, representing a pool available for investment back into the company or for future dividends. Despite the deduction due to dividends, other equity components increase, maintaining overall financial balance.

It's key to remember, the deduction from retained earnings does not affect total stockholders' equity, as this is merely a reclassification of amounts under equity categories.

Stockholders' Equity

The overall concept of stockholders' equity reflects the owners' claim after all the liabilities have been satisfied. This equity comprises paid-in capital and retained earnings, and is directly influenced by activities like stock dividends.

• Before a stock dividend, stockholders' equity is calculated with two main components: total paid-in capital and total retained earnings. Paid-in capital originates from shareholders when they purchase stock directly from the company and includes common stock and any amount above par value.
• In this situation, before the dividend, Organic Health Co.'s total paid-in capital was \\(12,000,000 and retained earnings were \\)45,000,000, adding up to a total stockholders' equity of \\(57,000,000.
• Post-distribution, the total retained earnings decrease due to the stock dividend by \\)750,000, but this is counterbalanced by a rise in paid-in capital by \\(750,000 (\\)600,000 par value adjustment and \\(150,000 in excess of par value).
• Thus, the total stockholders' equity remains unchanged at \\)57,000,000, demonstrating how internal equity accounts are rebalanced.

Through this mechanism, companies can reward shareholders by increasing their stake without distributing cash, thus preserving liquidity for further growth opportunities.