Thursday, September 29, 2011

Stock dividends and other accounting mysteries

Eisner v. Macomber, that ancient Supreme Court case on realization of gross income for income tax purposes, gives us a chance to dabble in some corporate accounting matters.  It’s not necessary to understand the accounting completely in order to grasp the holding and rationale of the case –  Mrs. Macomber had no gross income because she owned the same thing after her receipt of the stock dividend as she did before.  But if the accounting intrigues you, as it did the Court to some extent, here’s a look at it.

The stock dividend is a maneuver that lowers the price per share of a company’s  stock by diluting the existing shares with new shares.  The transaction is recorded on the issuing corporation’s  balance sheet – one of its financial statements – but it has little economic significance.  No real assets leave the corporation, and the shareholders’ relationships with each other do not change.  The market senses the presence of the new shares, and adjusts accordingly; the price per share decreases, but since the shareholders have received new shares, the value of their holdings doesn’t change.

To understand the corporation’s accounting for the transaction, an introduction to  the balance sheet is helpful.  A balance sheet is a crude snapshot of the financial condition of a person or enterprise  at a given moment in time.  It’s divided into two sides – Assets and Liabilities.   The bottom line on one side will always match the bottom line on the other side -- hence, the name “balance sheet.”

The liabilities side is divided into two portions, Debt and Equity:

Assets
Liabilities


Debt



Equity

Total Assets

Total Liabilities (Debt + Equity)


On the Liabilities side, the  Debt plus the Equity equal the Total Liabilities.  And the Total Liabilities always equal the Total Assets (the bottom line on the other side).

The  Equity portion of the Liabilities side of the balance sheet (also known as “net  worth”) represents who owns the corporation – namely, the shareholders.  Let’s say that two people form a corporation,  each contributing $10,000 cash to get it started.  Each receives 1,000 shares for his or her investment, or $10 per share.  The balance sheet just after the corporation is formed would look like this:

Assets
Liabilities
Cash
$20,000
Debt
-0-


Equity: 2,000 shares, stated value $10 per share
$20,000
Total Assets
$20,000
Total Liabilities
$20,000

Now let’s assume that the corporation borrows $30,000 from a bank.  The resulting balance sheet would look like this:

Assets
Liabilities
Cash
$50,000
Debt: Bank
$30,000


Equity: 2,000 shares, stated value $10 per share
$20,000
Total Assets
$50,000
Total Liabilities (Debt + Equity)
$50,000

Next, let’s assume that the corporation uses half of its $50,000 cash to buy machinery and equipment:

Assets
Liabilities
Cash
$25,000
Debt: Bank
$30,000
Machinery and equipment
$25,000
Equity: 2,000 shares, stated value $10 per share
$20,000
Total Assets
$50,000
Total Liabilities (Debt + Equity)
$50,000

Note that the machinery and equipment are entered on the books at their historical cost, which is the same basic standard that’s used for determining basis for income tax purposes.  The value that an asset has on the balance sheet is called its “book value.” 

Next, let’s assume that the corporation has a successful year, bringing in a great deal of additional cash.  Its machinery and equipment wears out a little, which is reflected by a lowering of its “book  value,” but the increase in cash shows that it had a profitable year.  Here’s the asset side of the balance sheet at the end of the year:
Assets
Liabilities
Cash
$80,000


Machinery and equipment
$20,000


Total Assets
$100,000



Assume that the corporation has paid back $5,000 of the bank debt, leaving an outstanding balance on the loan of $25,000.  That would be reflected on the balance sheet, too:

Assets
Liabilities
Cash
$80,000
Debt: Bank
$25,000
Machinery and equipment
$20,000


Total Assets
$100,000



Since the Total Assets are now $100,000, and the bank debt is $25,000, the corporation’s Total Equity now must be $75,000.  That’s going to be entered on the right side of the sheet to make the two sides balance:

Assets
Liabilities
Cash
$80,000
Debt: Bank
$25,000
Machinery and equipment
$20,000
Total Equity
$75,000
Total Assets
$100,000
Total Liabilities (Debt + Equity)
$100,000

Total Equity is typically divided into two categories: the stated value of the stock,  and retained earnings (a.k.a. “earned surplus”).  The stated value of the stock (a.k.a. “par value”) is typically what the stock was originally issued for by the company, and the rest of Total Equity is "retained earnings," or "earned surplus."  In this case, the stock’s stated value was $20,000, and so after the profitable year, there would be $55,000 of retained earnings on the balance sheet:

Assets
Liabilities
Cash
$80,000
Debt: Bank

$25,000
Machinery and equipment
$20,000
Equity: 2,000 shares, stated value $10 per share
$20,000



Retained Earnings (Earned Surplus)
$55,000



Total Equity

$75,000
Total Assets
$100,000
Total Liabilities (Debt + Equity)

$100,000

Now let’s assume that the board of directors is contemplating paying a cash dividend of $20 per share to the shareholders. If it did this, $40,000 of cash would leave the Assets side of the  balance sheet, which would mean that $40,000 would have to leave the Liabilities side as well.  From which account on the Liabilities side would the cash dividend be subtracted?  Retained Earnings (Earned Surplus).  And so after the cash dividend, which would be gross income to the shareholders, the balance sheet would look like this: 

Assets
Liabilities
Cash
$40,000
Debt: Bank

$25,000
Machinery and equipment
$20,000
Equity: 2,000 shares, stated value $10 per share
$20,000



Retained Earnings (Earned Surplus)
$15,000



Total Equity

$35,000
Total Assets
$60,000
Total Liabilities (Debt + Equity)

$60,000

Now let’s assume that shortly after the cash dividend is paid, the corporation  declares a stock dividend of the kind at issue in Eisner v. Macomber.  For every 2 shares currently held by the shareholder, in the stock dividend he or she would receive 1 additional share, each with the same stated value as the existing stock, or $10 per share.  Since 1,000 new shares will be issued – 500 to each shareholder – the stated value of the company’s stock will increase by $10,000.   Where will that amount come from on the Liabilities side? Retained Earnings (Earned Surplus).  And so after the stock dividend, the balance sheet would look like this:

Assets
Liabilities
Cash
$40,000
Debt: Bank

$25,000
Machinery and equipment
$20,000
Equity: 3,000 shares, stated value $10 per share
$30,000



Retained Earnings (Earned Surplus)
$ 5,000



Total Equity

$35,000
Total Assets
$60,000
Total Liabilities (Debt + Equity)

$60,000

It’s the same old corporation – same Assets, Debt, and Total Equity.  For that reason, the shareholders, who still each own 50 percent of the outstanding stock, aren’t taxed.  All that’s occurred is a bookkeeping entry within the Equity section of the Liabilities side. 

A stock split is similar, except that arguably even less happens on the balance  sheet.  In a stock split, Earned Surplus is left alone, and the stated value per share of each share is reduced to  account for the additional shares outstanding.  Let’s say that instead of a stock dividend of 1 new share for every 2  shares held, the corporation splits the stock, 3 for 2.  That is, every 2 shares of stock are split into 3 shares.  After the stock split, the balance sheet would look like this:

Assets
Liabilities
Cash
$40,000
Debt: Bank

$25,000
Machinery and equipment
$20,000
Equity: 3,000 shares, stated value $6.67 per share
$20,000



Retained Earnings (Earned Surplus)
$15,000



Total Equity

$35,000
Total Assets
$60,000
Total Liabilities (Debt + Equity)

$60,000

Again, it’s the same old corporation  – same Assets, Debt, and Total Equity.   For that reason, the shareholders, who still each own 50 percent of the outstanding stock, aren’t taxed.  All that’s occurred is a bookkeeping entry within the Equity section of the Liabilities side – and arguably an even more minor one than with a stock dividend.

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