Chapter # 4 Accounting for Company –

Retained Earnings

Principles of Accounting – XII

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Accounting for Company – Retained Earnings

Chapter # 4

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WHAT THE EXAMINER USUALLY ASK?

Declaration of cash and stock dividend. Payment of stock and cash dividend. Classification of reserves. Creation of reserves. Disposal of reserves. Statement of retained earnings. Multiple Choice Questions (MCQs).

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Chapter # 4

ACCOUNTING FOR COMPANY –

RETAINED EARNINGS RETAINED EARNINGS

Retained earnings are accumulated earnings that have not been distributed to shareholders but rather reinvested in the business. A company's retained earnings are disclosed at or near the bottom of the shareholders equity section of the balance sheet. Accountants may prepare a separate "statement of retained earnings" that shows the change in retained earnings during the accounting period; however, the statement of retained earnings is often combined with the income statement.

RESERVES AND FUNDS

RESERVE FUND 1. It is created out of retained earnings. 1. It is created out of cash. 2. Reserve is a voluntary provision made

out of net income. 2. A provision is a change expense and

revenue. 3. Reserve is part of owner’s equity. 3. Fund is an asset. 4. It is shown on the credit side of the

balance sheet under owner’s equity. 4. It is shown on the debit side of the

balance sheet among assets. 5. It represents a portion of profits or

liability. 5. It represents on assets.

TYPES OF RESERVES

Capital Reserve:

Capital reserves are the reserves that may not be distributed according to Company Act 1985. They include share capital, share premium, capital redemption reserve, certain unrealized profits, or any other reserves that the company may not distribute according to some other act or its own article of association.

Secret Reserve: Funds held in the reserve but not disclosed in the balance sheet. They arise when an asset is deliberately either undisclosed or undervalued.

Valuation Reserve: Allowance, created by a charge against earnings, to provide for changes in the value of a company's assets. Examples include accumulated depreciation and allowance for bad debts.

Surplus Reserve: Amount appropriated out of earned surplus (retained earnings) for future planned or unforeseen expenditure.

Liability Reserve: Liability reserve is used to reflect a known liability.

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RESERVES

No. Purpose Entry to Create Reporting on Balance Sheet

Entry to Write Off

Nature of Reserve: Contra Assets or Valuation Reserve 1. To decrease

accounts receivable to their realizable value

Bad debts expense (Dr.) Allowance for bad debts (Cr.)

Deduction in accounts receivable

Allowance for bad debts (Dr.) Accounts receivable (Cr.)

2. To accumulate expired cost of fixed assets

Depreciation expense (Dr.) Allowance for depreciation (Cr.)

Deduction in related fixed asset

Allowance for depreciation (Dr.) Fixed asset (Cr.)

Nature of Reserve: Estimated Liability 3. To recognize

estimated liability Income tax expense (Dr.) Reserve for income tax (Cr.)

Shown as a current liability

Reserve for income tax (Dr.) Bank (Cr.)

Nature of Reserve: Appropriation of Retained Earnings 4. To restrict

distributable profit for building extension

Retained earnings (Dr.) Reserve for building extension (Cr.)

Shown as a part of retained earnings

Reserve for building extension (Dr.) Retained earnings (Cr.)

5. To restrict distributable profit for plant expansion

Retained earnings (Dr.) Reserve for plant expansion (Cr.)

Shown as a part of retained earnings

Reserve for plant expansion (Dr.) Retained earnings (Cr.)

6 To restrict distributable profit for debenture redemption

Retained earnings (Dr.) Reserve for debenture redemption (Cr.)

Shown as a part of retained earnings

Reserve for debenture redemption (Dr.) Retained earnings (Cr.)

7 To restrict distributable profit for contingencies

Retained earnings (Dr.) Reserve for contingencies (Cr.)

Shown as a part of retained earnings

Reserve for contingencies (Dr.) Retained earnings (Cr.)

FUNDS

No. Purpose Entry to Create Reporting on Balance Sheet

Entry to Write Off

Nature of Reserve: Petty Cash 1. To set aside cash

for petty expenses Petty cash fund (Dr.) Bank (Cr.)

Shown as a part of cash

All expenses (Dr.) Petty cash fund (Cr.)

Nature of Reserve: Sinking 2. To set aside cash

for sinking fund Sinking fund (Dr.) Bank (Cr.)

Shown as a part of cash

Bonds payable (Dr.) Sinking fund (Cr.)

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ILLUSTRATION # 1: (Retained Earnings)

The retained earnings account on ABC Company Ltd. showed a credit balance of Rs.400,000 on December 31, 2010. The expense and revenue summary for the year ending on that date showed a net income of Rs.150,000 which is transferred to retained earnings account. The company decided on December 31, 2010 as under:

(a) To declare a cash dividend of Rs.50,000 and stock dividend of Rs.40,000. (b) To appropriate Rs.40,000 for reserve for plant expansion. (c) To appropriate Rs.27,000 for reserve for contingencies. (d) To establish reserve for building extension for Rs.80,000. (e) Cash dividend paid through bank. (f) 4,000 shares issued in settlement of stock dividend.

REQUIRED Give entries in General Journal to give effect to the above decisions.

SOLUTION # 1:

ABC Company Ltd. General Journal

Date Particulars P/R Debit Credit 1 Expense and revenue summary 150,000 Retained earnings 150,000 (To record the transfer of net income to the retained

earnings account)

2 Retained earnings 50,000 Cash dividend payable 50,000 (To record the declaration of cash dividend) 3 Retained earnings 40,000 Stock dividend payable 40,000 (To record the declaration of stock dividend) 4 Retained earnings 40,000 Reserve for plant expansion 40,000 (To record the reserve for plant expansion) 5 Retained earnings 27,000 Reserve for contingencies 27,000 (To record the reserve for contingencies) 6 Retained earnings 80,000 Reserve for building extension 80,000 (To record the reserve for building extension) 7 Cash dividend payable 50,000 Bank 50,000 (To record the payment of cash dividend) 8 Stock dividend payable 40,000 Ordinary shares capital (4,000 x 10) 40,000 (To record the issue of shares in settlement of stock

dividend at par)

STATEMENT OF RETAINED EARNINGS

A financial statement outlining the changes in retained earnings for a specified period. The statement of retained earnings is prepared in accordance with generally accepted accounting principles (GAAP). The statement of retained earnings reconciles the beginning and ending retained earnings for the period, using information such as net income from the other financial statements.

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Format of Statement of Retained Earnings

Name of Company Statement of Retained Earnings

For the Period Ended ______ Retained earnings (opening balance) XXX Add: Net income for the period XXX Total retained earning XXX Less: Reserves: Reserve for contingencies XXX Reserve for plant expansion XXX Total reserves (XXX) XXX Less: Dividends: Cash dividend XXX Stock dividend XXX Total dividends (XXX) Retained earnings (ending balance) XXX

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Practice questions

Question # 1: 1994, 1995, & 1996 Regular & Private – BIEK (a) From the viewpoint of accounting distinguish between a Reserve and a Fund. (b) Give the necessary journal entry in skeleton form to record the creation and disposal of the

following types of reserves:- (i) Reserve representing liabilities. (ii) Reserve representing retained earnings.

(c) Give the necessary journal entry in skeleton form to record the creation & disposal of a fund. Question # 2: 1998 & 1999 Regular & Private – BIEK

(a) Define reserves and funds. (b) Differentiate between reserves and funds. (c) Name the three types of reserves and give an example of each. (d) Give the necessary General journal entries to record the creation and disposal of fund.

Question # 3: 2000, 2001, & 2007 Regular & Private – BIEK

(a) Distinguish between Reserve and Fund. (b) Give one example of each of the following types of reserves mentioning also the General

Journal entries to record, creation and disposition of each: (i) Reserves related to assets. (ii) Reserves representing liabilities. (iii) Reserves representing retained earnings.

Question # 4: 1997 Regular & Private – BIEK State which of the following is liability reserve, contra account or reserve representing retained earnings:-

(i) Allowance for bad debts. (ii) Reserve for building extension. (iii) Reserve for income tax.

Question # 5: 2002 Private – BIEK The following accounts are available on the books of a company.

(i) Reserve for bad debts. (ii) Reserve for machinery replacement. (iii) Cash dividend payable. (iv) Stock dividend payable. (v) Petty cash fund.

REQUIRED (a) Classify the above accounts into (i) Assets, (ii) Asset valuation, (iii) Liability (iv) and

Owner’s equity accounts. (b) Give journal entries that are made for creating and disposing of the above accounts.

Question # 6: 1993 Regular & Private – BIEK The net income of Moazzam & Co. Ltd. for the year 1992 was Rs.320,000. The company declared a stock dividend of Rs.100,000 (at par) and appropriated Rs.75,000 for plant expansion. REQUIRED Give entries in the General Journal of the company to close the income summary, and to record the stock dividend and the appropriation.

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Question # 7: 1996 Regular & Private – BIEK The following reserves appear on the balance sheet of Adnan Company Ltd. as of Dec. 31, 1995:-

(i) Allowance for depreciation – Building Rs. 20,000 (ii) Reserve for income tax 5,000 (iii) Reserve for contingencies 10,000

REQUIRED (i) Classify each of the above reserves into three categories:-

Valuation reserve, Liability reserve and Surplus reserve. (ii) Give the journal entries that must have been made to create each of the three reserves. (iii) Give the entries that will be made dispose of each of the three reserves.

Question # 8: 2001 Regular & Private – BIEK The retained earnings account on Jawedan Company showed a credit balance of Rs.165,000 on March 31, 2001. The expense and revenue summary for the year ending on that date showed a net income of Rs.145,000 which is transferred to retained earnings account. The company decided on March 31, 2001 as under:

(a) To declare a cash dividend of Rs.50,000. (b) To appropriate Rs.20,000 for reserve for sinking fund. (c) To appropriate Rs.15,000 for reserve for contingencies. (d) To establish reserve for building extension for Rs.30,000.

REQUIRED Give entries in General Journal to give effect to the above decisions. Question # 9: 2012 Regular – BIEK Asghar Flours Mills Ltd. Has retained earnings balance of Rs.1,240,000 on June 30, 2010 before transfer of net income. The net income for the year was Rs.360,000. The following resolutions were passed in annual general meeting:

i) To declare cash dividend Rs.36,000. ii) To establish reserve for contingencies Rs.126,000. iii) To appropriate Rs.40,000 for sinking fund. iv) To declare stock dividend Rs.18,000.

REQUIRED: Set up retained earnings account. Question # 10: 2012 Private – BIEK On June 30, 2011, the retained earnings account in the books of Indus Company Ltd. showed a credit balance of Rs.300,000. The expense and revenue summary of the company for the year ending on that date shows net income of Rs.550,000, which is transferred to retained earnings account. The company’s directors decided as follows:

i) Declare cash dividend of Rs.250,000. ii) Establish reserve for building extension in the amount of Rs.100,000. iii) Appropriated Rs.50,000 for reserve for debenture redemption. iv) Establish a reserve for contingencies in the amount of Rs.45,000.

REQUIRED Prepare retained earnings account. Question # 11: 2004 Regular & Private – BIEK On December 31, 2003, Adnan Co. Ltd. had a credit balance of Rs.300,000. The income summary account of the company showed a net income of Rs.295,000 which has been transferred to retained earnings. The company made the following decisions:

(i) Cash dividend Rs.15,000. (ii) Reserve for plant extension Rs.122,500. (iii) Reserve for contingencies Rs.23,500.

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(iv) Reserve for income tax Rs.3,000. REQUIRED Prepare journal entries in the books of the company to record the above transactions. Question # 12: 1992 Regular & Private – BIEK The data were extracted from the balance sheet of Al-Mehran Company Limited on December 31, 1990:- Authorized Capital: 200,000 ordinary shares of Rs.10 each Rs.2,000,000 Issued and Paid-up Capital: 100,000 ordinary shares of Rs.10 each Rs.1,000,000 Retained earnings Rs.150,000 On December 31, 1991, the income summary of the company sowed net income of Rs.300,000. At this date the company decided as under:-

(i) To declare cash dividend of 15%. (ii) To appropriate Rs.100,000 for plant expansion. (iii) To appropriate Rs.50,000 for contingencies. (iv) To appropriate Rs.50,000 for debenture redemption.

REQUIRED (a) Give the entry in the General Journal of the company to transfer the net income to

retained earnings account. (b) Give entries in the General Journal to give effect to the above decision of the company. (c) Prepare partial balance sheet of the company as of December 31, 1991.

Question # 13: 2013 Private – BIEK The following data is extracted from the balance sheet of Talha & Co. Ltd. as on December 31, 2012: Authorized Capital: 500,000 ordinary shares of Rs.10 each. Rs.5,000,000 Issued and Paid – up Capital: 200,000 ordinary shares of Rs.10 each. Rs.2,000,000 Retained Earnings (Credit Balance): Rs.250,000 On December 31, 2012, the income summary of the company showed a net income of Rs.750,000. The company decided as under:

i) To declare cash dividend @ 15%. ii) To appropriate Rs.200,000 for plant expansion. iii) To appropriate Rs.120,000 for contingencies. iv) To appropriate Rs.180,000 for sinking fund.

REQUIRED Prepare necessary entries in the General Journal of Talha & Co. Ltd. Question # 14: 2010 Regular & Private – BIEK The following balances appearing in the books of Anum Company Ltd. on December 31, 2009: Authorized Capital: 500,000 ordinary shares @ Rs.10 each Rs.5,000,000 Issued and Paid-up Capital: 450,000 ordinary shares @ Rs.10 each Rs.4,500,000 Retained earnings Rs.255,000 On December 31, 2009 the income summary of the company showed a credit balance of Rs.650,000. At this date the company decided as under:

(1) To declare cash dividend of Rs.0.50 per ordinary share and 10% stock dividend. (2) To appropriate Rs.40,000 for contingencies.

REQUIRED (a) Give the entry in the General Journal of the company to transfer the net income to

retained earnings account.

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(b) Give entry in the General Journal to give the effect to the above decisions of the Co. Question # 15: 2013 Regular – BIEK Ubaid Co. Ltd. has the following shares holder’s equity as shown in balance sheet as on Dec. 31, 2012: Authorized capital 100,000 shares of Rs.10/- each Rs. 1,000,000/- Issued and paid up capital 50,000 shares of Rs.10/- Rs. 500,000/- Share premium Rs. 100,000/- Reserve for building extensions Rs. 60,000/- Reserve for contingencies Rs. 50,000/- Retained earnings Rs. 600,000/- During year 2012 the company’s net income Rs. 450,000/- Following decisions were made and executed:

i) Declaration of cash dividend @ 10%. ii) Building extension reserve increased by Rs.100,000/-. iii) Reserve for contingencies increased upto Rs.100,000/-. iv) Bank paid cash dividend warrants.

REQUIRED Record the above transactions in General Journal of the company. Question # 16: 2005 Regular & Private – BIEK The shareholders equity of Habeeb Limited on January 1, 2004, appears as follows: Ordinary share capital: 60,000 shares of Rs.10 par value Rs.600,000 Ordinary shares premium Rs.300,000 Unappropriated retained earnings Rs.584,000 During the year 2004, the following transactions occurred: July 16: The board of directors of the company appropriated Rs.160,000 of retained

earnings for the plant expansion. Dec. 12: Declared a stock dividend of Rs.1.50 per share. Dec. 31: Closed the net of Rs.200,000 from income summary account to retained

earnings. REQUIRED

(a) Prepare journal entries to record the above transactions. (b) Prepare retained earnings statement for the year 2004. (c) The stock dividend was issued on January 10, 2005. The market value of ordinary shares

is Rs.15 per share. Make necessary journal entries. Question # 17: 2008 Regular & Private – BIEK The income statement of Sana Mariam Ltd. for the year ended 31st March, 2008, showed the net income of Rs.500,000. The board of directors decided:

(i) To declare Rs.100,000 cash dividend and Rs.150,000 stock dividend. (No. of issued shares 15,000 of Rs.10 each against the stock dividend).

(ii) To appropriate reserve for contingencies Rs.100,000 and plant extension Rs.300,000. REQUIRED

(a) Pass journal entry for the transfer of net income to retained earnings having credit balance of Rs.400,000.

(b) Journalize the directors’ decision No. 1 and 2 above. (c) Prepare the statement of retained earnings on 31.3.2008.

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Question # 18: 1990 Regular & Private – BIEK The following balances appeared in the ledger of Shahid and Co. Ltd. on December 31, 1989:- 50,000 7% preference shares of Rs.20 each Rs.1,000,000 100,000 ordinary shares of Rs.10 each Rs.1,000,000 Retained earnings un-appropriated Rs.500,000 At this date the company decided as under:-

(i) To declare cash dividend at 15% on ordinary shares. (ii) To declare normal dividend on preference shares for which ordinary shares at par were

issued. (iii) To appropriate Rs.40,000 for contingencies. (iv) To appropriate Rs.60,000 for debenture redemption, and (v) To appropriate Rs.30,000 for plant expansion.

The company was informed by its bankers that cash dividend was collected on 64,000 ordinary shares and stock dividend was collected on 44,000 preference shares by December 31, 1989. REQUIRED

(a) Give entries in General Journal in proper form on the books of Shahid and Co. Ltd. to give effect to the above decision, and

(b) Prepare a partial Balance Sheet of the above company as of December 31, 1989 after giving effect to the above decisions.

Question # 19: 2011 Private – BIEK The following balances appeared in the ledger of Aqeel Company Ltd. on December 31st, 2010: 500,000 Ordinary shares of Rs.10/- each Rs.5,000,000/- Retained earnings un-appropriated Rs.1,400,000/- On this date, the company decided as under:

(i) To declare cash dividend at 15% on ordinary shares. (ii) To declare stock dividend at 10% on ordinary shares. (iii) To appropriate Rs.70,000/- for contingencies. (iv) The company was informed by its banker that cash dividend was collected by 400,000

ordinary shareholders on December 31st, 2010. REQUIRED Give entries in General Journal in proper form on the books of Aqeel Company Ltd. to give effect to the above decisions. Question # 20: 2011 Regular – BIEK Few transactions were posted in Retained Earnings account of Man & Co.

Retained Earnings Dec. 31, 2010 Jan. 1. 2010 Balance 1,500,000 ii) Cash dividend 400,000 i) Expense & revenue summary 400,000 iii)Reserve for building expansion 160,000 iii) Reserve for sinking fund 60,000 iv) Reserve for contingencies 80,000 Balance (Cr.) 1,200,000 1,900,000 1,900,000

REQUIRED Prepare journal entries from above ledger.

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Question # 21: 1997 Regular & Private – BIEK The following are the selected balances of Star Company Ltd.:- Reserve for income tax 12,000 Retained earnings 140,000 Reserve for plant extension 15,000 Reserve for legal charges 20,000 REQUIRED With reference to the above data record the following in the General Journal:-

(i) Reserve for contingencies is created with Rs.20,000. (ii) Income tax liability is paid. (iii) Reserve for plant extension is disposed of completely. (iv) Reserve for legal charges is raised by Rs.10,000. (v) Reserve for depreciation on machine is created with Rs.7,000.

Question # 22: 2002 Regular – BIEK Gul & Company Ltd. decide to appropriate Rs.40,000/- for the replacement of machinery. For this purpose, the company sets aside Rs.40,000/- cash, and the amount is invested in government securities. At the end of the year, the interest accrued was Rs.4,000/-. REQUIRED Prepare General Journal entries to record the above transactions, giving explanation below each entry. Question # 23: 2003 Private – BIEK Rafat Limited had a debit balance of Rs.35,000 in cash account and a credit balance of Rs.50,000 in retained earnings account. It appropriated Rs.20,000 for debenture redemption, and set aside an equal amount of cash for this purpose. REQUIRED Prepare:

(i) General Journal entries for the creation of reserves and fund. (ii) Partial balance sheet, reporting the relevant data.

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MULTIPLE CHOICE QUESTIONS (MCQS)

1) At the beginning of the current year, Wilson Corporation had 200,000 shares of Rs.10 par ordinary shares outstanding and had retained earnings of Rs.4,800,000. During the year, the company earned Rs.1,675,000 & paid a year-end cash dividend of Rs.3 per share. What were Wilson’s retained earnings at the end of the year?

a) Rs.4,800,000 b) Rs.5,875,000 c) Rs.6,275,000 d) Rs.6,475,000 2) After the first year of operations, the Retained Earnings account has a debit balance

of Rs.4,000. This most likely indicates which of the following occurred? a) An error in the closing entries b) A reported net loss for the period c) All revenue accounts were not closed d) A posting error 3) XYZ Ltd has a net profit of Rs.180,000, a dividend on ordinary share capital of

Rs.45,000 has been declared and the company will transfer Rs.50 000 to a capital reserve. What is the retained profit figure for the year?

a) Rs.180,000 b) Rs.135,000 c) Rs.85,000 d) Rs.267,000 4) XYZ Ltd has declared an ordinary share dividend of Rs.200,000 at 1.12.2001. Which

of the following correctly explains the accounting entries for the dividend at the year end?

a) Expense in profit and loss account, creditor on the balance sheet b) Appropriation of profit, reserve on the balance sheet c) Appropriation of profit, current liability on the balance sheet d) Expense in profit and loss account, reserve on the balance sheet 5) When net income is transferred to retained earnings account which account is

debited? a) Expense and revenue summary account b) Retained earnings account c) Reserve for plant extension account d) Reserve for contingencies account 6) General reserves is/are classified as: a) Assets b) Liabilities c) Shareholders’ equity d) None of these 7) This account is not closed at the end of accounting period: a) Retained earning b) Purchases c) Sales d) None of these 8) Negative retained earnings means: a) Net loss b) Gross profit c) Net profit d) None of these 9) Dividend can be described as: a) A share of a company's profit b) Interest paid on a company's borrowings c) Always paid to banks and other creditors d) None of the above 10) Joint stock company paid profit to its shareholders known as: a) Commission b) Interest c) Dividend d) Profit

11) Which of the following account is used for holding of accumulated profit of the

Corporation? a) Expense and revenue summary b) Share capital c) Retained earnings d) Reserve account

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12) Which of the following account is used in terms of limited company for transfer of net income or loss?

a) Income summary account b) Share capital c) Retained earnings d) Reserve account

13) Profit is paid by corporations to its shareholders in shape of cash is known as: a) Stock dividend b) Bank dividend c) Cash dividend d) Rupees dividend

14) Profit is paid by corporations to its shareholders in shape of shares is known as: a) Stock dividend b) Bank dividend c) Cash dividend d) Rupees dividend

15) Retained earnings is increases by: a) Net loss b) Gross profit c) Share premium d) Net profit

16) Retained earnings is classified as: a) Expense b) Equity c) Asset d) Liability

17) The normal balance of retained earnings account is: a) Credit b) Debit c) Negative d) Zero