How to Calculate Retained Earnings After Stock Dividend

Retained earnings represent a company’s accumulated profits that have not been distributed to shareholders as dividends. This financial metric offers insight into a company’s past profitability and its capacity for future growth through reinvestment. Stock dividends, a common corporate action, directly influence this accumulated profit figure. Understanding how these distributions affect retained earnings is important for anyone analyzing a company’s financial standing.

Understanding Retained Earnings

Retained earnings are the portion of a company’s net income that is not paid out as cash dividends to shareholders but is instead kept within the business. These accumulated profits can be reinvested into operations, used to fund expansion, or applied to reduce outstanding debt. The balance of retained earnings appears on the balance sheet, forming a component of stockholders’ equity. This figure reflects the cumulative undistributed earnings of a company since its inception.

The basic formula for calculating retained earnings involves starting with the balance from the previous period. Net income for the current period is added to this beginning balance, representing the profits generated. Any dividends declared and paid during the period are then subtracted from this sum. The resulting figure provides the ending retained earnings balance for the current accounting period.

Understanding Stock Dividends

A stock dividend involves a company distributing additional shares of its own stock to existing shareholders, rather than paying out cash. This differs significantly from a cash dividend, where shareholders receive a monetary payment. Stock dividends are typically issued proportionally to current shareholdings, meaning shareholders receive more shares based on the number they already own.

Accounting standards recognize two primary types of stock dividends based on their size relative to the outstanding shares. A “small stock dividend” is considered to be less than 20-25% of the shares previously outstanding. These smaller distributions are recorded at the fair market value of the shares issued on the declaration date. The fair market value reflects the price at which the shares could be bought or sold in the open market at that time.

Conversely, a “large stock dividend” typically involves a distribution of more than 20-25% of the outstanding shares. For large stock dividends, the value transferred from retained earnings is based on the par value of the shares issued. Par value is a nominal value assigned to each share in the company’s charter and is usually a very small amount, such as $0.01 or $1.00 per share.

How Stock Dividends Impact Retained Earnings

Stock dividends reduce the retained earnings balance by capitalizing a portion of the accumulated profits. This means that a specific amount is transferred from the retained earnings account to other equity accounts on the balance sheet. This accounting treatment does not involve any cash outflow from the company.

For small stock dividends, the amount transferred from retained earnings is equal to the fair market value of the shares being distributed. This value is then split between the common stock account, at the par value of the new shares, and the additional paid-in capital account, which captures the amount received above par.

Large stock dividends, however, reduce retained earnings by an amount equal to the par value of the shares distributed. In this scenario, the entire par value of the newly issued shares is transferred directly from retained earnings to the common stock account.

Calculating Retained Earnings After a Stock Dividend

Calculating the new retained earnings balance after a stock dividend involves a clear process, which depends on the dividend’s size. The first step requires determining whether the stock dividend is classified as small or large, based on the 20-25% threshold of previously outstanding shares. This classification dictates the valuation method applied to the shares issued.

Once the dividend type is identified, the next step involves calculating the total value of the shares being issued. For a small stock dividend, this value is determined by multiplying the number of new shares issued by their fair market value per share on the declaration date. For instance, if a company issues 10,000 new shares as a small stock dividend, and the market value is $20 per share, the total value is $200,000. This $200,000 is the amount by which retained earnings will be reduced.

Conversely, for a large stock dividend, the value to be transferred is calculated by multiplying the number of shares issued by their par value per share. If the same company issues 10,000 new shares as a large stock dividend, and the par value is $1 per share, the total value transferred would be $10,000. This $10,000 amount is then subtracted from the existing retained earnings balance.

Consider a company with a retained earnings balance of $5,000,000, 1,000,000 shares outstanding, and a par value of $1 per share. If the company declares a 10% stock dividend (100,000 shares) when the market price is $25 per share, this is a small stock dividend. The value transferred is 100,000 shares multiplied by $25, totaling $2,500,000. The new retained earnings balance becomes $5,000,000 minus $2,500,000, resulting in $2,500,000.

Now, consider the same company declares a 50% stock dividend (500,000 shares) when the market price is $25 per share. This is a large stock dividend. The value transferred is 500,000 shares multiplied by the par value of $1, totaling $500,000. The new retained earnings balance becomes $5,000,000 minus $500,000, resulting in $4,500,000. These examples illustrate how the classification as small or large fundamentally changes the calculation and the resulting impact on the retained earnings balance.