Discuss corporate distributions to shareholders

Answer 1

CORPORATE DISTRIBUTIONS

Firms use net assets (assets minus liabilities) to generate more net assets through the earnings
process. Firms typically retain some or all of the net assets generated by earnings, causing
net assets to increase, along with retained earnings, which is the component of shareholders'
equity showing the cause of that increase in net assets. The retention of net assets generated
by earnings generally increases the market price of the firm's common shares. Some firms pay periodic dividends to the common shareholders. Each common shareholder receives the same dividend per share as all other common shareholders, unless a firm has more than one class of common stock and their dividend rights differ. This section discusses corporate dividend policies and the accounting for dividends.

Firms may also choose to use the net assets generated by earnings to repurchase common
shares. Repurchases result in cash outflows for a firm, similar to paying a cash dividend.
In the case of share repurchases, only those shareholders that choose to sell their shares to
the firm receive cash. This section discusses business reasons for stock repurchases and the
accounting for such repurchases.

DIVIDENDS

The board of directors has the legal authority to declare dividends. When considering whether to declare dividends, directors must conclude that declaring a dividend is both legal (under law and contract) and financially desirable.

Legal Limits on Dividends—Statutory (by Law)

Jurisdiction-specific corporate laws limit directors' freedom to declare dividends. Without these limits, directors might dissipate the firm's assets for the benefit of common shareholders, harming other nonshareholding stakeholders, in particular creditors.

One example of a limitation of the declaration of dividends provides that the board may not declare dividends "out of capital," that is, debited against the contributed capital accounts, which result from fund-raising transactions with owners, but must declare them "out of earnings" by debiting them against the Retained Earnings account, which results from earnings transactions. The wording and the interpretation of this rule vary among jurisdictions. "Capital" may mean the par or stated value of outstanding common shares or the total amount paid in by shareholders. Some jurisdictions allow corporations to declare dividends out of the earnings of the current period even if the Retained Earnings account has a debit (negative) balance because of accumulated losses from previous periods.

Statutory limits generally do not influence the accounting for shareholders' equity and dividends. A balance sheet does not provide the details of amounts legally available for dividends, but it should disclose information necessary for the user to apply the legal rules of the corporation's jurisdiction of incorporation.

Legal Limits on Dividends—Contractual

Contracts with bondholders, other lenders, and preferred shareholders often limit dividend payments and thereby compel the retention of earnings. For example, a bond contract may require that total liabilities not exceed the total amount of shareholders' equity or that firms retire debt "out of earnings.". Such a provision involves curtailing dividends so that the necessary debt service payments, plus any dividends, do not exceed the amount of earnings for the period. This provision forces the shareholders to increase their investment in the business by limiting the amount of dividends that the board might otherwise declare for them. Financial statement notes must disclose significant limitations on dividend declarations.