Problem 6 - Accounting Principles

Question

Raptor Inc. has retained earnings of \(\$ 500,000\) and total stockholders' equity of \(\$ 2,000,000\). It has 100,000 shares of \(\$ 8\) par value common stock outstanding, which is currently selling for \(\$ 30\) per share. If Raptor declares a \(10 \%\) stock dividend on its common stock: (a) net income will decrease by \(\$ 80,000\). (b) retained earnings will decrease by \(\$ 80,000\) and total stockholders' equity will increase by \(\$ 80,000\). (c) retained earnings will decrease by \(\$ 300,000\) and total stockholders' equity will increase by \(\$ 300,000\). (d) retained earnings will decrease by \(\$ 300,000\) and total paid-in capital will increase by \(\$ 300,000\).

Step-by-Step Solution

Answer

(d) retained earnings will decrease by $300,000 and total paid-in capital will increase by $300,000.

Step 1: Calculate Number of Shares for Dividend

A 10% stock dividend means that 10% of the existing 100,000 shares will be issued as additional shares. Calculate the number of dividend shares: \(100,000 \times 0.10 = 10,000\) shares.

Step 2: Determine Value of Stock Dividend

The stock dividend is valued at the market price of \(\\(30\) per share. So, the value of the dividend is \(10,000 \times 30 = \\)300,000\).

Step 3: Impact on Retained Earnings

When a stock dividend is declared, retained earnings decrease by the value of the stock dividend. Hence, retained earnings will decrease by \(\$300,000\).

Step 4: Impact on Stockholders' Equity

While retained earnings decrease, the total stockholders' equity remains unchanged because stock dividends reallocate between retained earnings and paid-in capital. The total stockholders' equity does not increase or decrease; it stays at \(\\(2,000,000\), but within equity, retained earnings decrease by \(\\)300,000\) and paid-in capital increases by \(\$300,000\).

Step 5: Impact on Total Paid-In Capital

The additional 10,000 shares issued at the market value (\\(30 per share) go into paid-in capital, which increases by \(\\)300,000\).

Key Concepts

Retained Earnings

Retained earnings represent the cumulative amount of net income that a company maintains instead of distributing it as dividends. They act as a reservoir of funds a company can use for investment and growth. When a stock dividend is declared, like in the case of Raptor Inc., retained earnings reduce by the value of those dividends. The company issues additional new shares, valued at their current market price, using retained earnings as a source. For Raptor Inc., with a 10% stock dividend on 100,000 shares originally priced at $30 each, the value transferred from retained earnings equates to:

• 10% of 100,000 shares = 10,000 shares
• Market price of $30 per share
• Retained earnings decrease by: 10,000 shares × $30 = $300,000

Thus, the retained earnings drop by $300,000, which is the value of the stock dividend. While this results in fewer retained earnings, it's a non-cash activity, meaning Raptor does not physically lose cash from this process.

Stockholders' Equity

Stockholders' equity refers to the ownership interest of shareholders in a company. It represents the residual value of assets after satisfying liabilities and obligations. In Raptor Inc.'s scenario, the total stockholders' equity stays constant at $2,000,000, despite the stock dividend issuance. Stockholders' equity encompasses various components:

• Retained earnings
• Paid-in capital
• Common stock

When stock dividends are issued, there is a shift within the equity components. Retained earnings decrease due to the stock dividend worth $300,000, whilst paid-in capital, another facet of the equity setups, increases equivalently by $300,000. This balance means that the overall stockholders' equity does not deviate from its original sum pre-dividend, maintaining the $2,000,000 value. This shift highlights how the company decides to reward shareholders through additional shares rather than affecting overall equity figures.

Paid-In Capital

Paid-in capital, or additional paid-in capital, reflects the extra funds that investors contribute over and above the par value of stock during issuance. For Raptor Inc., this component increases due to the stock dividend issuance. The process effectively routes part of the company's retained earnings into paid-in capital:

• The 10% stock dividend leads to issuing 10,000 extra shares.
• Each share has a market price of $30, leading to a total increase in paid-in capital by $300,000.

Hence, paid-in capital rises by $300,000, balancing out the deduction from retained earnings. This action does not directly affect incoming cash but redistributes existing equity resources to reflect new shareholder shares. Through this mechanism, Raptor Inc. exhibits benefits to shareholders while reallocating equity, without altering the cash position or the total value of stockholders' equity.