Does Issuing New Stock Affect Retained Earnings?
A public corporation can issue additional common stock and new or additional preferred stock. If you run a private company, you can issue stock through private placements or through an initial public offering. However performed, the effect is to increase stockholders’ equity. The effects on retained earnings are more subtle.
Stockholders’ equity represents the ownership interests of shareholders. It includes accounts for equity -- common and preferred stock -- and retained earnings, the accumulated profits of the corporation. The accounting equation requires that stockholders' equity be equal to assets minus liabilities. When a company issues new stock, it collects cash that it credits to a common or preferred stock capital account. Issuing additional common stock dilutes the value of existing shares, because more shares must now share corporate earnings.
A corporation’s annual income statement reports income, gains, expenses and costs for the year. The bottom line is net income, the year’s profit or loss. When the company accountants close out the annual books, they transfer the net income to retained earnings. There it remains unless allocated to specific costs or distributed to shareholders as dividends. All dividends must be paid from retained earnings. The balance in the retained earnings account drops by the value of the dividends the corporation pays out.
The cash a company raises from issuing new shares can indirectly affect the retained earnings account. For example, the corporation might pay down debt, streamline operations or start new profitable projects. These uses of the cash raise profits and cut costs. The beneficial effects will show up in a higher net income and therefore a higher contribution to retained earnings. However, if management invests the cash unwisely, it might create losses that reduce net income and retained earnings.
Cash dividends are profits paid to shareholders. Dividends on common stock are optional, but they are required for preferred stock. If a company issues additional dividend-paying common stock, it must either cut the dividend per share or increase the draw from retained earnings. Companies generally can’t cut preferred stock dividends, so issuing new preferred stock will cause retained earnings to fall. Even though retained earnings decrease because of additional dividends, stockholders’ equity might increase because the company raises cash when it issues new shares.
A corporation can issue new shares to existing shareholders through stock dividends and stock splits. These are not dilutive, because the new shares received exactly compensate for the lowered share value. The company reduces dividends per share on a prorated basis. The “cost” of the new stock dividend shares is paid from retained earnings. This cost is either the market value or par value of the new shares, depending on the size of the stock dividend. The corporation transfers retained earnings to the stock’s capital accounts to pay for the stock dividend.
Stock splits are large stock issuances to existing shareholders. They have no cost and do not affect retained earnings.