Final answer:
When issuing a 5% common stock dividend, a company should transfer the fair value of the shares from retained earnings to paid-in capital, which signifies the market value of the additional shares given to shareholders.
Step-by-step explanation:
The question asks about the proper accounting treatment when issuing a stock dividend. When a company issues a 5% common stock dividend to its shareholders, it should transfer from retained earnings to paid-in capital the fair value of the shares issued. This reflects the current market value of the new shares distributed to the shareholders which, in turn, becomes the cost basis for the dividend distributed.
A stock dividend can be contrasted with a cash dividend, where the company distributes part of its profits in the form of cash. However, in the case of stock dividends, no cash is disbursed; instead, shareholders receive additional shares, thereby diluting the overall equity but preserving the company's cash reserves. It is essential for the issuing firm to consider the implications on shareholder value and expectations surrounding the rate of return, which can manifest both as dividends and potential capital gains when the stock's value increases.