FINANCIAL ACCOUNTING & REPORTING II

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Accounting for Shareholders’ Equity

Module 013 Retained Earnings (Part 1)

Retained earnings are an important source of internal or self financing by a

company. The savings generated internally by a company in the form of
retained earnings are ploughed back into the company for diversification of
its business. Retention of earnings by companies reduces their dependence
on funds from external sources in order to finance their regular business
needs.
At the end of this module, you will be able to:
1. Define retained earnings and other equity terms
2. Familiarize yourself with different types of appropriation of retained
earnings
3. Know the accounting rules for each type of appropriation of retained
earnings
4. Define reserves and quasi-reorganization

Retained Earnings
This represent the cumulative balance of periodic net income or loss,
dividend distributions, prior period errors, changes in accounting policy and
other capital adjustments. This has two kinds, namely unappropriated
retained earnings and appropriated retained earnings.
Unappropriated retained earnings represent the portion which is free and can
be declared as dividends to shareholders while appropriated retained
earnings represent that portion which has been restricted and therefore is
not available for any dividend declaration.

Appropriation of retained earnings

The appropriation of retained earnings may be described as follows:
a. Legal appropriation
This arises from the fact that the legal capital cannot be returned to the
shareholders until the entity is dissolved and liquidated. If the entity acquires its
own shares, it must have sufficient retained earnings balance, otherwise the
acquisition is illegal. Accordingly, a portion of the retained earnings must be
appropriated for an amount equal to the cost of the treasury shares. This is
called “retained earnings appropriated for treasury shares”.

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b. Contractual appropriation
This 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 ensure the
eventual payment of the bonds and redemption of the preference share. This
case may be described as “retained earnings appropriated for sinking fund or
bond redemption” and “retained earnings appropriated for redemption of
preference share”.

c. Voluntary or discretionary appropriation

This is a matter of discretion on the part of management. It may arise from the
fact that management wishes to preserve the funds for expansion purposes or
for covering possible losses or contingencies.

The appropriation accounts 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 balance is recorded as follows:
Retained earnings xxx
Retained earnings appropriated xxx
When the appropriation is no longer necessary because the conditions for which it
is established no longer exist, the appropriation is simply reversed as follows:
Retained earnings appropriated xxx
Retained earnings xxx
Illustration:
An entity purchased treasury shares at a cost of P800,000. Legally, if the treasury
shares are not yet reissued at year-end, this would require appropriation of retained
earnings as follows:
Retained earnings 800,000
Retained earnings appropriated 800,000

Note that the above entry has no effect on either the total retained earnings or total
shareholders’ equity. In addition, 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 shareholder.

The appropriated balance shall be reverted to free retained earnings when no

longer necessary.
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Accounting for Shareholders’ Equity

Entry when treasury shares are subsequently reissued is as follows:

Retained earnings appropriated 800,000
Retained earnings 800,000
Statement of retained earnings
This statement shows the changes affecting directly the retained earnings of an
entity and relates the income statement to the statement of financial position. This is
no longer part of the components of financial statements but is a part of the
statement of changes in equity.

The following are the data that must be disclosed in the financial statements:
a. Net income or loss for the period
Net income is added because it increases retained earnings and net loss is
deducted. The IAS term for net income or loss is “profit or loss”.
b. Prior period errors
These are shown as adjustment to the beginning balance of retained earnings to
arrive at the corrected beginning balance.
c. Dividends to shareholders
The dividends declared or paid during the year shall be deducted from retained
earnings.
d. Effect of change in accounting policy
This is shown as an adjustment to the beginning balance of retained earnings.
e. Appropriation of retained earnings
The amount of appropriation is deducted from the unappropriated balance of
retained earnings.

Reserves
The term “reserves” is not officially defined in any accounting standard or
Framework. This forms a substantial part of the equity of an entity.
The use of equity reserves is based on whether a reserve is part of distributable
equity or nondistributable equity. Distributable equity is the portion that can be
distributed to shareholders as dividends without impairing the legal capital of the
entity. Nondistributable equity is that portion that cannot be distributed to the
shareholders in any form during the lifetime of the entity.
Nondistributable equity reserves usually include the following:
a. Share premium reserve is the excess over par or stated value.
b. Appopriation reserve is the earmarking of retained earnings for a certain
purpose which may be legal, contractual or voluntary.
c. Asset revaluation reserve arises from the revaluation of property, plant and
equipment. Normally called revaluation surplus.
d. Other comprehensive income reserve

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Quasi-reorganization
A quasi-reorganization is permissive but not a mandatory procedure under which a
financially troubled entity restates its accounts and establishers a “fresh start” in
accounting sense.
Specifically, a quasi-reorganization 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

A quasi-reorganization must be approved by the SEC.

The following are the circumstances that may justify quasi-reorganization:

a. When large deficit exists.
b. When approved by the shareholders and creditors.
c. When the cost basis of accounting for property, plant and equipment becomes
unrealistic.
d. When a fresh start appears to be desirable or advantageous to all parties
concerned.

Illustration- Recapitalization
The statement of financial position of an entity on December 31, 2017 prior to
quasi-reorganization is as follows:
Current assets 2,000,000
Property, plant and equipment 8,500,000
Accumulated depreciation (1,000,000) 7,500,000
Total Assets 9,500,000

Liabilities 5,500,000
Share capital 6,000,000
Retained earnings (deficit) (2,000,000)
Total Liab and SHE 9,500,000
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Accounting for Shareholders’ Equity

On December 31, 2017, 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 fair value of P7,000,000.
b. The inventory is overvalued to the extent of P200,000 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.
The pertinent adjustments are:
a. Accumulated depreciation 1,000,000
Retained earnings 500,000
Property, plant and equipment 1,500,000
b. Retained earnings 200,000
Inventory 200,000
c. Share capital 4,000,000
Share premium 4,000,000
d. Share premium 2,700,000
Retained earnings 2,700,000

Illustration- Revaluation
On December 31, 2017, an entity underdo quasi-reorganization due to heavy losses
over a period of time. The statement of financial position prior to reorganization is
shown below.
Current assets 1,000,000
PPE 6,000,000
Accumulated depreciation (1,500,000) 4,500,000
Goodwill 200,000
Total assets 5,700,00

Current liabilities 1,700,000

Share capital, P100 par 5,000,000
Share premium 1,000,000
Retained earnings (2,000,000)
Total liab and SHE 5,700,000
The SEC approved the reorganization on the basis of unrealistic valuation of
property, plant and equipment. Accordingly SEC recommended that the property,
plant and equipment be revalued by an independent expert.

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 1. The property, plant and equipment are determined to have replacement cost of
P10,000,000.
2. The inventory is to be written down by P500,000.
3. The goodwill is to be written off.
4. Unrecorded accounts payable amounted to P200,000.
5. Any resulting deficit is charged against revaluation surplus.

Adjustments
1. Property, plant and equipment 4,000,000
Accumulated depreciation 1,000,000
Revaluation surplus 3,000,000

Cost Replacement cost Increase

PPE 6,000,000 10,000,000 4,000,000

Accumulated dep(25%) 1,500,000 2,500,000 1,000,000

4,500,000 7,500,000 3,000,000

2. Retained earnings 500,000

Inventory 500,000
3. Retained earnings 200,000
Goodwill 200,000
4. Retained earnings 200,000
Accounts payable 200,000
5. Revaluation surplus 2,900,000
Retained earnings 2,900,000

Glossary
Prior period errors: Omissions from, and misstatements, in the entity’s financial
statements for one or more periods arising from a failure to use, or misuse of, reliable
information that was available when financial statements for those period were
authorized for issue and could reasonably be expected to have been obtained and taken
into account in the preparation and presentation of financial statements.
Quasi-reorganization: A procedure in which the corporation eliminates a deficit in
retained earnings by either revaluation on non-monetary assets or restatement of
invested capital balance.
Retained earnings: The portion of a corporate capital that represents the net
accumulated profits, after deducting the reported losses and distributions to
shareholders, also called as accumulated profits.
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Accounting for Shareholders’ Equity

References and Supplementary Materials

Books and Journals
1. Valix, C. T., Peralta, J. F., & Valix, C. M. (2017). Financial Accounting (2017 ed., Vol. 2).
Manila, Philippines: GIC Enterprises & Co., Inc.
2. Cabrera, M. B., & Ocampo, R. R. (n.d.). Financial Accounting & Reporting - Standards &
Application (2014-2015 ed., Vol. 2). Manila, Philippines: GIC Enterprises & Co., Inc.
Online Supplementary Reading Materials
1. Statement of retained earnings;
http://www.accountingformanagement.org/statement-of-retained-earnings/;
October 20, 2017
2. Retained earnings; https://www.slideshare.net/freddie2100/fm-retained-earnings;
October 20, 2017
Online Instructional Videos
1. Statement of Retained Earnings: Definition, Formula & Example;
http://study.com/academy/lesson/statement-of-retained-earnings-definition-
formula-example.html; October 20, 2017
2. Items Reported in Retained Earnings; http://study.com/academy/lesson/items-
reported-in-retained-earnings.html; October 20, 2017

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