Question

AP11-11A (Dividend distributions) Sauro Brothers Inc. is currently considering declaring a dividend to its common shareholders, according to one of the following plans: 1. Declare a cash dividend of $10 per share. 2. Declare a 20% stock dividend. Sauro Brothers would distribute one common share for every fi ve common shares currently held. The company’s common shares are currently selling for $20 per share. Sauro Brothers is authorized to issue 125,000 common shares. To date, the company has issued 75,000 shares at $10 per share and is currently holding 5,000 of these as treasury shares.

Required

a. How many common shares are eligible to receive a dividend?

b. Prepare the entries necessary on the date of declaration, date of record, and date of payment of the cash dividend.

c. Prepare the entry to record the stock dividend, assuming that the dividend is declared and the shares are issued on the same date.

d. Describe how each dividend would aff ect Sauro’s debt/equity ratio. e. Which of the two dividends would you, as an investor, prefer to receive? Why?

Answer 1

issued common shares common shares held as treasury = | common shares eligible to receive dividend 75,000 5,000 70,000

account titles and explanation debit credit calculation on the date of declaration - $ 700,000 70,000 * $10 dividends dividends payable (cash dividends declared) $ 700,000 on the date of record - ii) no entry required on the date of payment - $ 700,000 iii) dividends payable cash (cash dividends paid) $ 700,000

account titles and explanation debit credit calculation $ 280,000 retained earnings common stock additional paid in capital-common stock (stock dividends declared) $ 140,000 $ 140,000 70000*20%*$20 70000*20%*$10 70000*20%*$10

debt / equity ratio = total liabilities / total stockholders' equity cash dividends would reduce the retained earnings and hence reduce the stockholders' equity, so the debt / equity ratio shall increase. stock dividends would reduce the retained earnings but also increase the paid in capital by the same amount. Hence, there would be no effect on stockholders' equity, so the debt/ equity ratio shall remain same.

the investor would prefer a cash dividend reason - because only cash dividend is a real dividend. Stock dividend is just a transfer of retained earnings balance to paid in capital balance. Investor is the owner of both of these accounts, hence there is no gain to investor in a stock dividend.