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MODULE 5 PACKET
ELEC 2 – Valuation Concepts and Methods
MODULE 5 RETAINED EARNINGS

Welcome to Module 5
In this module, we will discuss accounting for Retained Earnings

CONSULTATION HOURS:
Virtual time: During your class schedule (either Monday or Tuesday)
Phone or Messenger: Every Thursday from 8am to 11am and 1pm to 4pm

MODULE 5 LEARNING OBJECTIVES:

By the end of this module, the students will be able to:
1. Define retained earnings
2. Understand the nature of dividends
3. Recognize and measure cash, property and share dividends
4. Understand the purpose of appropriation of retained earnings
5. Identify the circumstances that may require an appropriation of retained earnings
6. Identify the items affecting retained earnings
7. Know the conditions of a quasi-reorganization

COURSE CONTENT FOR MODULE 5:

ACTIVITY DESCRIPTION TIME TO COMPLETE

Lecture Discussion Dividends 1.5 hour

Appropriation and quasi-organization 1.5 hour

Activity Problem Solving 2 hours

Summative quiz for module 4 (to be

Quiz 1 hour
announced)

2020-2021 Module Packet for ELEC 2 (Valuation Concepts and Methods) | College of Commerce |
University of San Agustin, Iloilo City, 5000, Philippines
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LECTURE DISCUSSIONS

5.1 RETAINED EARNINGS

Retained earnings (accumulated profits) represent the cumulative balance of:

a. Net income or loss for the period
b. Dividend distributions
c. Prior period errors
d. Reclassifications of some components of other comprehensive income
e. Other capital adjustments

Kinds of retained earnings

Unappropriated retained earnings represent that portion which is free and can be declared as
dividends to shareholders.

Appropriated retained earnings represent that portion which has been restricted and is not available
for any dividend declaration.

Retained earnings are normally credit. A debit balance is called a deficit which is a deduction from
shareholder’s equity.

5.2 DIVIDENDS

Dividends are distributions of earnings or capital to the shareholders in proportion to their

shareholdings.

Dividends can be declared only from retained earnings. If the entity has a deficit, it is illegal to
pay dividends or if the entity declares dividend in excess of the retained earnings balance, the
excess is a return of capital and violates the trust fund doctrine.

The SEC has ruled that stock dividends may be declared from premium on par value share.

Dividend declaration is reposed on the board of directors of the corporation. The three essential
dates for accounting purposes are:
1. Date of declaration
2. Date of record
3. Date of payment

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University of San Agustin, Iloilo City, 5000, Philippines
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Dividends out of earnings

Cash dividends
Nov. 30 Board of Directors at their meeting Retained earnings 200,000
declared a dividend of P10 per share for its 20,000 Dividends payable 200,000
outstanding shares with par value of P100, payable
April 30 to shareholders of record on December 31. No entry on December 31
Dividends payable 200,000
April 30 entry Cash 200,000

Property dividends

When an entity settles the dividend payable, the difference between the carrying amount of the
dividend payable and the carrying amount of the asset distributed shall be recognized in profit or
loss.

An entity shall measure a noncurrent asset classified for distribution to owners at the lower of
carrying amount and fair value less cost to distribute. If the fair value less cost to distribute is less
than the carrying amount of the assets at the end of the reporting period, there is impairment loss.

Illustration

An entity owned 50,000 unquoted shares of another entity accounted for under the cost method.
The carrying amount of the investment is P1,000,000. On December 1, 2020, the entity declared
these shares as property dividend to be distributed on January 31, 2021. The investment had the
following fair value less cost to distribute:

December 1, 2020 1,500,000

December 31, 2020 1,800,000
January 31, 2021 1,900,000

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University of San Agustin, Iloilo City, 5000, Philippines
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University of San Agustin, Iloilo City, 5000, Philippines
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If an entity gives its owners a choice of either a noncash asset or a cash alternative, the entity shall
estimate the dividend payable by considering both the fair value of each alternative and the
associated probabilities of owners selecting each alternative.

At the end of each reporting period and at the date of settlement, the entity shall adjust the dividend
payable based on the alternative chosen through equity or retained earnings.

Illustration

On December 31, 2020, an entity declared dividends on ordinary shares payable on April 1, 2021.
The shareholders may choose between a total cash dividend of P1,000,000 or property dividend in
noncash asset from inventory with carrying amount of P1,400,000 and fair value less cost to
distribute of P1,800,000.

The entity estimated that 75% of the shareholders will take the option of the cash dividend and
25% of the noncash asset.

Cash alternative (75% x P1,000,000) P 750,000

Noncash alternative (25% x P1,800,000) 450,000
Dividend Payable 1,200,000

Dec. 31 To recognize the Retained Earnings 1,200,000

declaration of the dividend Dividend payable 1,200,000
April 1 If the shareholders chose Dividend payable 1,200,000
the cash alternative, payment of Cash 1,000,000
the dividend is recognized Retained Earnings 200,000

If the shareholders chose the Retained Earnings 600,000

noncash alternative and FV of Dividend payable 600,000
inventory remained at (FV P1.8M – Dividend payable in Dec. 31 P1.2M)
P1,800,000
Dividend payable 1,800,000
Inventory 1,400,000
Gain distribution of property dividend 400,000

If the shareholders chose the Retained Earnings 800,000

noncash alternative and FV of Dividend payable 800,000
inventory is P2,000,000 (FV P2.0M – Dividend payable in Dec. 31 P1.2M)

Dividend payable 2,000,000

Inventory 1,400,000
Gain distribution of property dividend 600,000

2020-2021 Module Packet for ELEC 2 (Valuation Concepts and Methods) | College of Commerce |
University of San Agustin, Iloilo City, 5000, Philippines
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Liability dividends in the form of bond and scrip

Dividends are declared in the amount of Retained earnings 500,000

P500,000 payable in entity’s own 12% bonds Bonds dividends payable 500,000
To record issuance of the 5-year bonds at face Bonds dividends payable 500,000
value Bonds payable 500,000
To record payment of periodic semiannual Interest expense 30,000
interest on bonds (500,000 x 12% x ½) Cash 30,000
To record redemption of bonds on maturity Bonds payable 500,000
date Cash 500,000

Scrip dividends are declared in the amount of Retained Earnings 100,000

P100,000 payable in 4 months at 12% interest. Scrip dividends payable 100,000
Scrip dividends are redeemed. Scrip is a Scrip dividends payable 100,000
formal evidence of indebtedness to pay a sum Interest expense 4,000
of money in the future Cash 104,000
Compute interest (100,000x12%x4/12)

Share dividends or bonus issue

Share dividends are distributions of the earnings on the entity in the form of the entity’s own
shares. When they are declared, the retained earnings of the entity or in effect capitalized or
transferred to share capital. It decreases the retained earnings and increases share capital. The
assets of the entity remain the same.

Ordinary share dividends are in terms of ordinary share given to ordinary shareholders or
preference share given to preference shareholders. Special share dividends are ordinary share
given to preference shareholders or preference share given to ordinary shareholders.

If the share dividend is less than 20%, the amount charged to retain earnings is equal to the fair
value on the date of declaration provided it is not lower than the par or stated value. Otherwise,
the par or stated value is used. This is a small share dividend and does not result in a reduced
market price for the outstanding shares.

If the share dividend is 20% or more, the par or stated value is capitalized because it is conceived
to materially effect a reduction in the share market value. It is considered as a large share dividend.

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University of San Agustin, Iloilo City, 5000, Philippines
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Illustrations taken from IA 2020 edition, Valix

The share dividends payable shall be recorded only to the extent of the par value

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Treasury shares as share dividends

Treasury shares may be re-issued as dividends in which case the cost of the shares shall be charged
to retained earnings.
Distributed as share dividend 2,000 treasury Retained Earnings 200,000
shares costing P200,000 and MV of P220,000. Share dividend payable 200,000
To record payment Share dividend payable 200,000
Treasury shares 200,000

Special cases on share dividend

When shareholders may elect to receive cash in lieu of share dividend, the amount to be charged
to retain earnings should be equivalent to the optional cash dividend.

In closely held entities, if share dividends are declared, retained earnings shall be capitalized only
to the extent of par value or stated value of the shares.

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University of San Agustin, Iloilo City, 5000, Philippines
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Fractional share dividends

When share dividends are issued, it is usually impossible to issue full shares to all of the
stockholders.

Example is when a 10% share dividend is declared and a shareholder owns 45 shares, then he will
be entitled to 4.5 shares. With respect to the fractional share, in this case 0.5 shares, the entity may
issue warrants for the fractional shares and give the holders thereof enough time to accumulate
sufficient warrants for a full share or the entity may pay cash in lieu of fractional share. This is
possible only if the source of share dividends is retained earnings. If it is from share premium, the
cash payment is illegal.

2020-2021 Module Packet for ELEC 2 (Valuation Concepts and Methods) | College of Commerce |
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Dividends out of capital

Capital returned to shareholders is known as dividend out of capital or liquidating dividends.

These are paid to shareholders when the entity is dissolved and liquidated.

Dividends as expense

Dividends out of earnings are charged to retained earnings. However, distributions to holders of
an equity instrument classified as financial liability (ex: redeemable preference share) are
recognized in the same way as interest expense on the bond. It further provides that dividends
classified as an expense may be presented in the income statement either with interest on other
liabilities or as a separate line item.

5.3 APPROPRIATION OF RETAINED EARNINGS

Retained earnings can be classified into unappropriated and appropriated retained earnings.

The appropriation of retained earnings may be described as follows:

a. Legal appropriation
b. Contractual appropriation – to ensure eventual payment of bonds and redemption of
preference shares
c. Voluntary appropriation – when management wishes to preserve funds for plant expansion,
increasing working capital, contingencies to limit the declaration of dividends

Accounting for appropriation

To establish the appropriation Retained earnings xxx

Retained earnings appropriated xxx

When the appropriation is no longer necessary, the appropriation is simply reversed.

Illustration. When an entity purchased treasury shares at a cost of P100,000, this would require
legally an appropriation of retained earnings.

Entry has no effect on either the total Retained earnings 100,000

retained earnings or shareholder’s equity Retained earnings approp - TS 100,000

The entry simply indicates that these are not available for dividends. If the treasury shares are
subsequently were issued, the appropriated balance is reversed.

2020-2021 Module Packet for ELEC 2 (Valuation Concepts and Methods) | College of Commerce |
University of San Agustin, Iloilo City, 5000, Philippines
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5.4 STATEMENT OF RETAINED EARNINGS

The statement of retained earnings shows the changes affecting directly the retained earnings of
an entity and relates the income statement to the statement of financial position.

Items affecting retained earnings:

a. Income (increases) or loss (decreases) for the period
b. Prior period errors are shown as adjustment to the beginning balance of retained earnings
to arrive at the corrected beginning balance. If the net income of prior period is understated,
the amount of error is added to retained earnings. If otherwise, the amount is deducted.
c. Dividends declared or paid during the year shall be deducted from retained earnings.
d. Change in accounting policy is an adjustment to the beginning balance of retained earnings.
e. Appropriation of retained earnings is deducted from unappropriated balance of retained
earnings. Cancellation of appropriation results to reversal of entries.
f. Components of other comprehensive income reclassified subsequently to retained
earnings.
g. Retirement of treasury shares that results in a loss is charged to retained earnings when
share premium from original issuance and from treasury shares have been fully exhausted
(there is loss when cost of shares exceeds the par value of shares retired)
h. If share premium from current and previous issue of shares is insufficient to absorb the
share issuance cost, it is charged against retained earnings.
i. If call price exceeds the original issue price of the preference shares, the excess is charged
to retained earnings
j. If the total par value of the ordinary shares issued in exchange exceeds is the original issue
price of the preference shares, the excess is charged to retained earnings

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Non-distributable equity reserves represent those items of equity other than the aggregate par or
stated value of share capital and retained earnings unappropriated.

a. Share premium reserve is the excess over par or stated value.

b. Appropriation reserve is the earmarking of retained earnings for a certain purpose
c. Asset revaluation reserve arises from the revaluation of property, plant and equipment
d. Other comprehensive income reserve

5.4 STATEMENT OF CHANGES IN EQUITY

The statement of changes in equity is a formal statement that shows the movements in the elements
or components of the shareholder’s equity.
a. Total comprehensive income for the period.
b. For each component of equity, the effects of changes in accounting policies and corrections
of errors
c. For each component of equity, a reconciliation between the carrying amount at the
beginning and end of the period, separately disclosing the changes from profit or loss, each
item of other comprehensive income and transactions with the owners in their capacity as
owners showing separately contributions by and distributions to owners.

Components of comprehensive income

1. Net income or loss

2. Other comprehensive income which comprises items of income and expense that are not
recognized in profit or loss as required or permitted by PFRS
a. Unrealized gain or loss on equity investment designated at FVOCI
b. Unrealized gain or loss on debt investment measured at FVOCI
c. Gain or loss from translating the financial statements of a foreign operation
d. Change in the revaluation surplus
e. Unrealized gain or loss from derivative contracts designated as cash flow hedge
f. Remeasurement of defined benefit plan, such as actuarial gain or loss recognized in the
current year
g. Change in the fair value attributable to the credit risk of a financial liability irrevocably
designated at FVPL

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Illustrations taken from IA 2020 edition, Valix

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University of San Agustin, Iloilo City, 5000, Philippines
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5.5 QUASI-REORGANIZATION

Quasi-reorganization is a procedure of restating assets, liabilities and share capital balances in

conformity with fair value for the purpose of eliminating a deficit. It is also called corporate
readjustment and may be accomplished through recapitalization or revaluation of property, plant
and equipment.

Quasi-reorganization may be resorted to when a large deficit exists, approved by the shareholders
and creditors, when the cost basis of accounting for PPE becomes unrealistic, and when a fresh
start appears to be desirable to all parties concerned.

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Illustrations taken from IA 2020 edition, Valix

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LET’S TRY:

ACTIVITY

1.

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2.

3.

4.

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5.

6.

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7.

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