RETAINED EARNINGS - Appropriation

and quasi-reorganization
AC 1201
• APPROPRIATION OF RETAINED EARNINGS
• Retained earnings can be classified into appropriated retained earnings and
unappropriated retained earnings.
• In order to limit the restrict the payment of dividends, the entity may transfer a
portion of retained earnings unappropriated to retained earnings appropriated.
• The appropriation of retained earnings may be described as follows:
• a. Legal appropriation
• b. Contractual appropriation
• c. Voluntary or discretionary appropriation
• Legal appropriation arises from the fact that the legal capital cannot be returned
to the shareholders until the entity is dissolved and liquidated.
• Thus, if an entity acquire its own shares, it must have sufficient retained earnings
balance, otherwise, the acquisition is illegal.
• Such appropriation is called “retained earnings appropriated for treasury shares”
• Contractual appropriation arises from the fact that the terms of the bond issue
and preference share issue may impose restriction on the payment of dividends.
• This is to insure the eventual payment of the bonds and redemption of PS.
• The appropriation may be described as “retained earnings appropriated for
sinking fund or bond redemption” and “retained earnings appropriated for
redemption of preference shares”.
• Voluntary appropriation
• Voluntary appropriation is a matter of discretion on the part of management.
• This may arise form the fact that management wishes to preserve the funds for
expansion purposes or for covering possible losses or contingencies. The
appropriation may be described as follows:
• a. Retained earnings appropriated for plant expansion
• b. Retained earnings appropriated for increase in working capital.
• c. Retained earnings appropriated for contingencies
• Whether legal, contractual or voluntary, the intent of the appropriation is simply to
limit the declaration of dividend.
• Accounting for appropriation
• The establishment of the appropriation is recorded as:
• Retained earnings xx
• Retained earnings appropriated xx
• When the appropriation is no longer necessary because the conditions for which it
is established no longer exist, the appropriation is simply reversed.
• Retained earnings appropriated xx
• Retained earnings xx
• Illustration:
• An entity purchased treasury shares at a cost of P500,000. Legally, if the treasury
shares are not reissued at year-end, this would require legally an appropriation of
retained earnings.
• Retained earnings 500,000
• Retained earnings appropriated for treasury shares 500,000
• If the treasury shares are subsequently reissued, the appropriation balance is
canceled and the journal entry reversed.
• Retained earnings appropriated for treasury shares 500,000
• Retained earnings 500,000
• Note: The appropriation account does not imply that there is a cash fund
established for the same. It simply indicates that the portion appropriated cannot
be used as basis in paying dividends to the shareholders.
• When no longer necessary, the appropriation balance shall be reverted to free
retained earnings.
• 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 directly retained earnings:
• a. Net income or loss for the period – net income is added because it increases
retained earnings and net loss is deducted.
• 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
the prior period is understated, the amount of error is added to retained
earnings. If the net income of the prior period is overstated, the amount of the
error is deducted from the retained earnings.
• c. Dividends to shareholders – The dividends declared or paid during the year shall
be deducted from the retained earnings.
• d. Effect of changes in accounting policy - This is shown as an adjustment to the
beginning balance of retained earnings. (Continue next slide)
• If the income of prior period is understated because of the change in accounting
policy, the effect is added to the beginning retained earnings.
• If the net income of the prior period is overstated because of the change in
accounting policy, the effect is deducted from beginning retained earnings.
• e. Appropriation of retained earnings
• The amount of appropriation is deducted from the unappropriated balance of
retained earnings. Conversely, if the appropriation is canceled, it is reverted or
added back to the unappropriated balance.
• f. Components of other comprehensive income reclassified subsequently to
retained earnings
• g. Retirement of treasury shares
• If the retirement of treasury shares results in “loss”, the excess of the loss over the
share premium from original issue and share premium from treasury shares is
charged against retained earnings.
• The loss on retirement of treasury shares occurs when the cost of treasury shares
exceeds the par value of the shares retired.
• h. Recognition of share issuance cost
• If the share premium from current and previous issue of shares is insufficient to
absorb the share issuance cost, the difference is charged against retained
earnings.
• i. Call of preference shares
• If the call price exceeds the original issue price of the preference shares, the excess
is charged to retained earnings.
• j. Conversion of preference shares into ordinary shares
• If the total par value of the ordinary shares issued in exchange exceeds the original
issue price of the preference shares, the excess is charged against retained
earnings.
• Reserves
• Under IAS, the use of equity reserves is based on whether a reserve is part of
distributable equity or non-distributable equity
• Distributable equity is that portion that can be distributed to shareholders as
dividends without impairing the legal capital of the entity. The distributable equity
squarely pertains to unappropriated retained earnings.
• Non-distributable equity is that portion that cannot be distributed
to the shareholders in any form during the lifetime of the entity. It
represent those items of equity other than the aggregate par or
stated value of share capital and retained earnings
unappropriated.
• Non-distributable equity reserves usually include the following:
• 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 which may be legal, contractual or voluntary. It is
technically known as retained earnings appropriated.
• c. Asset revaluation reserve arises from the revaluation of property,
plant and equipment. It is the excess of fair value or depreciated
replacement cost of the revalued property over the carrying
amount. Technically, it is called revaluation surplus.
• d. Other comprehensive income reserve
• 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 shareholders’ equity.
• An entity shall present a statement of changes in equity showing the following:
• a. Total comprehensive income for the period
• b. For each component of equity, the effects of changes in accounting policies and
corrections or errors.
• c. For each component of equity, a reconciliation between the carrying amount at
the beginning and end of the period, separately disclosing changes from:
• 1. Profit or loss
• 2. Each item of other comprehensive income
• 3. Transactions with 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 revaluation surplus.
• e. Unrealized gain or loss from derivative contracts designated as cash flow hedge.
• f. Remeasurements 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.
• Simple illustration:
• Share Share Retained
• capital premium earnings
• Balance – January 1 5,000,000 2,000,000 1,000,000
• Issuance share capital of 10,000 shares
• with P100 par value at P150 per share 1,000,000 500,000
• Net income 1,550,000
• Dividends paid (200,000)
• ------------- ------------ --------------
• Balance – December 31 6,000,000 2,500,000 2,350,000
• Comprehensive illustration:
• Share Retained
• Capital Reserves earnings
• Balance –January 1 5,000,000 2,000,000 1,000,000
• Correction of error-prior year under-depreciation ( 100,000)
• Change in accounting policy from average to
• FIFO – credit 300,000
• Issuance of 10,000 ordinary shares of P100 par value
• at P150 per share 1,000,000 500,000
• Issuance of 5,000 preference shares of P50 par value
• at P100 per share 250,000 250,000
• Comprehensive income:
• Net income 1,550,000
• Other comprehensive income 50,000
• Dividends paid ( 400,000)
• Current appropriation for contingencies 200,000 (200,000)
• ------------- ------------- -------------
• Balance – December 31 6,250,000 3,000,000 2,150,000
• ======== ======== ========
• QUASI-REORGANIZATION
• A quasi-reorganization is a permissive but not a mandatory procedure under
which a financially troubled entity restates its accounts and establishes a “fresh
start” in accounting sense. Specifically, it is the procedure of restating assets,
liabilities and share capital balances in conformity with fair value for the purpose
of eliminating a deficit.
• Quasi-reorganization is also called corporate readjustment and may be
accomplished thru:
• a. Recapitalization
• b. Revaluation of property, plant and equipment
• Circumstances that may justify quasi-reorganization:
• a. When a large deficit exists.
• b. When approved by the shareholders and creditors.
• c. When the cost basis of the accounting for property, plant and equipment
becomes unrealistic.
• d. When a “fresh start” appears to be desirable or advantageous to all parties.
• Note: A quasi-reorganization must be approved by the SEC.
• Illustration 1 – thru recapitalization
• An entity provided the following statement of financial position at year-end prior
to quasi-reorganization:
• Current assets 1,000,000
• Property, plant and equipment 7,500,000
• Accumulated depreciation 1,000,000 6,500,000
• Total assets 7,500,000
• Liabilities 4,500,000
• Share capital, P100 par, 50,000 shares 5,000,000
• Retained earnings (deficit) (2,000,000)
• Total liabilities and equity 7,500,000
• The shareholders and creditors agreed to a quasi-reorganization. Accordingly, the
following restatements should be made:
• a. The property, plant and equipment shall be recorded at the fair value of
P6,000,000.
• b. The inventory is overvalued to the extent of P250,000 and shall be revalued
accordingly.
• c. The share capital is reduced to P2,000,000, 20,000 shares, P100 par value.
• d. The resulting deficit is charged to the share premium arising from the reorganization.
• Adjustments :
• a. Accumulated depreciation 1,000,000
• Retained earnings 500,000
• Property, plant and equipment 1,500,000
• b. Retained earnings 250,0 00
• Inventory 250,000
• c. Share capital 3,000,000
• Share premium 3,000,000
• d. Share premium 2,750,00 0
• Retained earnings 2,750,000
• After the quasi-reorganization, the statement of financial position of the entity would appear as follows:
• Assets
• Current assets 750,000
• Property, plant and equipment 6,000,000
• Total assets 6,750,000
• Liabilities and Shareholders’ Equity
• Liabilities 4,500,000
• Share capital, P100 par, 20,000 shares 2,000,000
• Share premium 250,000
• Total liabilities and Shareholders’ Equity 6,750,000
• Illustration 2 – thru revaluation
• An entity has sustained heavy losses over a period of time and conditions warrant that the entity
should undergo a quasi-reorganization at year-end.
• The statement of financial position at year-end prior to the reorganization is:
• Current asset 1,000,000
• Property, plant and equipment 5,000,000
• Accumulated depreciation 1,500,000 3,500,000
• Goodwill 100,000
• Total assets 4,600,000
• Current liabilities 1,100,000
• Share capital, P100 par 5,000,000
• Share premium 500,000
• Retained earnings (2,000,000)
• Total liabilities and shareholders’ equity 4,600,000
• The SEC approved the quasi-reorganization on the basis of the unrealistic valuation of property,
plant and equipment.
• Accordingly, the SEC recommended that the property, plant and equipment be revalued by an
independent expert.
• 1. The property, plant and equipment are determined to have a replacement cost of P9,000,000.
• 2. The inventory is to be written down by P400,000.
• 3. The goodwill is to be written off.
• 4. Unrecorded accounts payable amounted to P200,000.
• 5. Any resulting deficit is charged against the revaluation surplus.
• Adjustments:
• 1. Property, plant and equipment 4,000,000
• Accumulated depreciation 1,200,000
• Revaluation surplus 2,800,000
• Replacement
• Cost cost Increase
• Property, plant and equipment 5,000,000 9,000,000 4,000,000
• Accumulated depreciation (30%) 1,500,000 2,700,000 1,200,000
• 3,500,000 6,300,000 2,800,000
• 2. Retained earnings 400,000
• Inventory 400,000
• 3. Retained earnings 100,000
• Goodwill 100,000
• 4. Retained earnings 200,000
• Accounts payable 200,000
• 5. Revaluation surplus 2,700,000
• Retained earnings 2,700,000
• The statement of financial position of the entity after the quasi-reorganization is as
follows:
• Assets
• Current assets 600,000
• Property, plant and equipment 9,000,000
• Accumulated depreciation (2,700,000)
• Total assets 6,900,000
• Liabilities and Shareholders’ equity
• Current liabilities 1,300,000
• Share capital 5,000,000
• Share premium 500,000
• Revaluation surplus 100,000
• Total liabilities and shareholders’ equity 6,900,000
• SEC requirements:
• a. If the quasi-reorganization is the result of revaluation of property, plant
and equipment, the appraisal must be made by an independent expert or
specialist.
• b. The increase in value of the property, plant and equipment is credited
to “revaluation surplus”.
• c. The adjustments concerning “other assets” such as inventory,
investment and intangible asset are made through retained earnings.
• d. The resulting deficit from the reorganization is offset against the
revaluation surplus.
• e. Retained earnings subsequent to the quasi-reorganization shall be
restricted to the extent of the deficit wiped out during the reorganization
and therefore cannot be declared as dividend.
• f. Losses subsequent to quasi-reorganization cannot be charged to the
remaining revaluation surplus.
• Problem 1:
• Elvis Co. reported the following shareholders’ equity on January 1, 2020:
• Share capital, P5 par, 600,000 shares authorized,
• 200,000 shares issued and outstanding 1,000,000
• Share premium 6,000,000
• Retained earnings 2,800,000
• On January 31, 2020, the entity reacquired 10,000 shares at P30 per share to be held as treasury.
On July 1, 2020, the entity declared and issued a 30% share dividend.
• On December 31, 2020, the entity declared and paid cash dividend of P10 per share. The net
income for current year was P3,000,000
• Required: What is the unappropriated balance of retained earnings on December 31,2020?
• Answer: Retained Earnings, 1/1/2020 2,800,000
• Share dividend (57,000 shares x 5) ( 285,000)
• Cash dividend (247,000 shares x 10) (2,470,000)
• Net income 3,000,000
• Appropriation for treasury shares (10,000 shares x 30) ( 300,000)
• Unappropriated balance of retained earnings, 12/31/2020 2,745,000
• Note: 200,000 – 10,000 = 190,000 x 30% = 57,000 shares (for share dividend)
• 200,000 – 10,000 = 190,000 + 57,000 = 247,000 shares (for cash dividend)
• Problem 2:
• Mega Co. provided the following information:
• * Dividends on 10,000 cumulative preference shares of 6% P100 par value have
not been declared or paid for 3 years.
• * Treasury shares were acquired at a cost of P1,500,000. The treasury shares had
not been reissued as of year-end.
• Required: What amount of retained earnings should be appropriated?
• Answer: P1,500,000 (Legally, retained earnings must be appropriated to the
extent of the cost of treasury shares)
• Problem 3:
• On January 1, 2020, Rama Co. had 20,000 treasury shares of P100 par value that
had been previously acquired at P120 per share.
• In December 2020, the entity reissued 15,000 of these treasury shares at P150 per
share. The cost method is used to record treasury transactions.
• Required: On December 31, 2020, what amount should be reported in the notes
to FS as a restriction of retained earnings as a result of the TS transactions?
• Answer: Remaining cost of treasury shares (5,000 shares x 120) = 600,000
• Problem 4:
• Subic Co. has suffered substantial operating losses for several years.
• The entity’s ability to service debts and pay operating expenses has been impaired.
• Consequently, the owners, and creditors have decided to execute a quasi- reorganization.
• The statement of financial position of the company prior to the reorganization is as follows:
• Assets
• Cash 200,000
• Accounts receivable 300,000
• Inventory 500,000
• Property, plant and equipment 9,900,000
• Accumulated depreciation (3,100,0 00)
• Goodwill 1,200,000
• Total assets 9,000,000
• Liabilities and Shareholders’ equity
• Accounts payable 1,100,000
• Note payable 500,000
• Mortgage payable 4,200,000
• Ordinary share capital, P100 par, 50,000 shares 5,000,000
• Share premium 1,000,000
• Retained earnings (2,800,000)
• Total liabilities and shareholders’ equity 9,000,000
• The entity provided the following information in relation to the quasi-
reorganization:
• 1. An independent appraisal of the entity’s inventory reveals goods with carrying
amount of P150,000 to be obsolete and worthless.
• 2. Equipment costing P2,000,000 and with accumulated depreciation of
P1,200,000 is expected to be sold for P300,000. However, the holder of the note
payable agrees to accept the equipment in full satisfaction of the note.
• 3. The goodwill is to be written off as loss.
• 4.The mortgage holder agrees to accept 40,000 new preference shares with P100
par value in satisfaction of the liability.
• 5.The par value of the ordinary shares is reduced to P20.
• 6. The resulting deficit is offset against the share premium.
• Required:
• a. Prepare journal entries to give effect to the quasi-reorganization.
• b. Prepare a statement of financial position immediately after the reorganization.
• Answers:
• a. Journal entries:
• 1. Retained earnings 150,000
• Inventory 150,000
• 2. Notes payable 500,000
• Accumulated depreciation 1,200,000
• Retained earnings 300,000
• Equipment 2,000,000
• 3. Retained earnings 1,200,000
• Goodwill 1,200,000
• 4. Mortgage payable 4,200,000
• Preference shares (40,000 shares x 100) 4,000,000
• Share premium 200,000
• 5. Ordinary share capital (50,000 shares x 80) 4,000,000
• Share premium 4,000,000
• 6. Share premium 4,450,000
• Retained earnings 4,450,000
• Note: Total Retained earnings (debit balance):
• 2,800,000 +150,000 + 300,000 + 1,200,000 = 4,450,000
• b. Statement of financial position immediately after the reorganization.
• Subic Company
• Statement of financial position
• Assets
• Cash 200,000
• Accounts receivable 300,000
• Inventory (500,000 – 150,000) 350,000
• Property, plant and equipment (9,900,000 – 2,000,000) 7,900,000
• Accumulated depreciation (3,100,000 – 1,200,000) (1,900,000)
• Total assets 6,850,000
• Liabilities and Shareholders’ Equity
• Accounts payable 1,100,000
• Preference share capital, 40,000 shares, P100 par 4,000,000
• Ordinary share capital, 50,000 shares, P20 par 1,000,000
• Share premium (1,000,000 + 200,000 + 4,000,000 - 4,450,000) 750,000
• Total liabilities and shareholders’ equity 6,850,000
• Problem 5: Cerritos Co. began operations on January 1, 2017. During the first three years of
operation, the company reported net income of P1,500,000 for 2017, P2,500,000 for 2018, and
P3,000,000 for 2019.
• The entity also declared and paid dividends of P1,000,000 for 2018 and P1,000,000 for 2019.
• The entity reported the following data for 2020:
• Income before income tax 5,000,000
• Prior period adjustment-understatement of 2018 depreciation before tax 500,000
• Cumulative decrease in income from change in inventory method before tax 1,000,000
• Dividend declared (of the amount, P500,000 will be paid on January 15, 2021) 2,000,000
• Income tax rate 30%
• Required: What amount should be reported as retained earnings on December 31, 2020?
• Answer: Net income in 2017, 2018 and 2019 7,000,000
• Dividends declared in 2018 and 2019 (2,000,000)
• Retained earnings – Jan. 1, 2020 5,000,000
• Net income -2020 (5,000,000 x 70%) 3,500,000
• Prior period adjustment- (500,000 x 70%) (350,000)
• Cumulative decrease in 2020 income (1,000,000 x70%) (700,000)
• Dividends declared in 2020 (2,000,000)
• Retained earnings – December 31, 2020 5,450,000