Question

Companies are not allowed to report profit on transactions relating to their own stock. That is, they don’t report income when stock is sold, nor do they report an expense when dividends are paid to shareholders. Why is this the case?

Answer 1

Profit is generated from sale of merchandise,ie.net amount after meeting all associated costs -from the point of acquisition of trading merchandise to the point of its sale to final consumers--ie. For the purpose of which the business was formed by contributing capital ,by one or more persons/companies

That said, sale of its own stock for an increased value,over& above the stated or par value , is also considered additional capital ,and carried on the liability side of the balance sheet of the company, as additional paid-in-capital & NOT CONSIDERED AS PROFIT nor as an income to the company.

The journal entry for this sale will be :

Debit         CASH (Current Asset-Balance Sheet )

Credit       COMMON STOCK (Equity account-Liability side of Balance Sheet)

Credit       ADDITIONAL PAID-IN CAPITAL in excess of par-Common Stock (Equity account-Liability side of Balance         Sheet)

Thus, the above entry does not pass through any of the Income Statement Accounts .

Similarly

Dividends are paid out of the after-tax earnings --ie.They are a portion of the retained earnings returned to the shareholders--ie. Excess of income over all expenses including taxes,

The journal entry for payment/declaration of dividend will be :

Debit         RETAINED EARNINGS (Equity account-Liability side of Balance Sheet)

Credit       CASH/DIVIDENDS PAYABLE (Current asset/Current Liability in Balance Sheet)

Thus, the above entry also does not pass through any of the expense heads of the Income Statement Accounts .