CHAPTER 23

RETAINED EARNINGS
APPROPRIATION AND QUASI-REORGANIZATION
APPROPRIATION OF RETAINED EARNINGS

• Retained earnings can be classified into unappropriated

retained earnings and appropriated retained earnings.

• In order to limit or restrict the payment of dividends, the entity

may transfer a portion of the retained earnings
unappropriated to retained earnings appropriated.
• The appropriation of retained earnings may be described as
follows:

 Legal appropriation

 Contractual appropriation

 Voluntary or discretionary appropriation

 LEGAL APPROPRIATION

• Legal appropriation arises from the fact that the legal capital
cannot be returned to the shareholders until the entity is
dissolved and liquidated.

• Accordingly, a portion of the retained earnings must be

appropriated for an amount equal to the cost of the treasury
shares.
 CONTRACTUAL APPROPRIATION

• 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.

• 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 from 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 entry purchased treasury shares at a cost of P500,000. Legally,

if the treasury shares are not yet reissued at year-end, this would
require legally an appropriation of retained earnings.

Retained earnings  500,000 
Retained earnings appropriated for  500,000
treasury shares

• 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
 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.

• The statement of retained earnings is no longer a required

component of financial statements but it is a part of the
statement of changes in equity.
 ITEMS AFFECTING DIRECTLY RETAINED
EARNINGS:

a) Net income or loss for the period

b) Prior period errors

c) Dividends to shareholders

d) Effect of changes in accounting policy

e) Appropriation of retained earnings

f) Components of other comprehensive income reclassified

subsequently to retained earnings.
 RESERVES

 Under international accounting standard, 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

b) Appropriation reserve

c) Asset revaluation reserve

d) Other comprehensive income reserve

 STATEMENT OF CHANGES IN EQUITY

 The statement of changes in equity is a normal statement that

shows the movements in the elements or components of the
shareholders’ equity.
 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.
SIMPLE ILLUSTRATION (ALL AMOUNTS ARE ASSUMED)

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 (AMOUNTS ARE ASSUMED)

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.

• Quasi-reorganization is also called corporate readjustment and

may be accomplished thru:
• a. Recapitalization
• b. Revaluation of property, plant and equipment
 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
a. The shareholders and creditors agreed to a quasi-reorganization.
Accordingly, the following restatements should be made:
b. The property, plant and equipment shall be recorded at the
fair value of P6,000,000.
c. The inventory is overvalued to the extent of P250,000 and shall
be revalued accordingly.
d. The share capital is reduced to P2,000,000, 20,000 shares, P100
par value.
e. The resulting deficit is charged to the share premium arising
from the reorganization.
Adjustments:

• Accumulated depreciation  1,000,000
  Retained earnings  500,000
Property, plant and equipment  1,500,000

• Retained earnings  250,000
Inventory  250,000

• Share capital  3,000,000
Share premium  3,000,000

• Share premium  2,750,000
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 properly, 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.
The goodwill is to be written off.
3. Unrecorded accounts payable amounted to P200,000.
4. 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