Financial & Managerial
Accounting 2002e
Belverd E. Needles, Jr.
Marian Powers
Susan Crosson
----------Multimedia Slides by:
Harry Hooper
Santa Fe Community College
Copyright © by Houghton Mifflin Company. All rights reserved.
1
Chapter 13
The Corporate Income
Statement and the
Statement of
Stockholders’ Equity
LEARNING OBJECTIVES
1. Identify the issues related to evaluating the
quality of a company’s earnings.
2. Prepare a corporate income statement.
3. Show the relationships among income taxes
expense, deferred income taxes, and net of
taxes.
4. Describe the disclosure on the income
statement of discontinued operations,
extraordinary items, and accounting
changes.
Copyright © by Houghton Mifflin Company. All rights reserved.
3
LEARNING OBJECTIVES
(continued)
5. Compute earnings per share.
6. Prepare a statement of stockholders’
equity.
7. Account for stock dividends and stock
splits.
8. Calculate book value per share.
Copyright © by Houghton Mifflin Company. All rights reserved.
4
Performance Measurement:
Quality of Earnings Issues
OBJECTIVE 1
Identify the issues related
to evaluating the quality
of a company’s earnings.
Quality of Earnings Issues



Current and expected earnings are important
factors to consider in evaluating a company’s
performance and analyzing its prospects.
Because of the importance of net income (bottom
line), there is significant interest in evaluating the
quality of earnings.
Quality of earnings refers to the substance of
earnings and their sustainability into future
accounting periods and may be affected by:
1. Accounting methods and estimates chosen by
management.
2. The nature of nonoperating items on the income
statement.
Copyright © by Houghton Mifflin Company. All rights reserved.
6
Choice of Accounting Methods and
Estimates
 Choices
of accounting methods and estimates affect a
firm’s operating income.
 The choice of estimates affects both current and
future operating income.
 Due to the considerable latitude in the choice of
estimates, management and other financial statement
users must be aware of the impact of accounting
estimates on reported operating income.
 The relative importance of each estimate depends on
the industry in which the firm operates.
Copyright © by Houghton Mifflin Company. All rights reserved.
7
Accounting estimates include:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Percentage of uncollectible accounts receivable.
Sales returns.
Useful life of an asset.
Residual or salvage value of an asset.
Total units of production.
Total recoverable units of natural resource.
Amortization period.
Expected warranty claims.
Expected environmental cleanup costs.
Copyright © by Houghton Mifflin Company. All rights reserved.
8
Choices of Accounting Methods include:
1. Net sales or aging to estimate
uncollectibles.
2. LIFO, FIFO, or average cost to value
inventory.
3. Accelerated, production, or straight-line
depreciation.
4. Revenue recognition methods.
Copyright © by Houghton Mifflin Company. All rights reserved.
9
Effect of Accounting Methods and Estimates


An accounting method or estimate that results in
lower current earnings produces a better quality of
operating income.
The existence of alternatives could cause problems
in the interpretation of financial statements.
The following conventions help overcome these problems:
1. Full disclosure.
Requires that management explain the significant
accounting policies used in preparing the financial
statements in a note to the financial statements.
2. Consistency.
Requires that the same accounting procedures be
followed from year to year.
Copyright © by Houghton Mifflin Company. All rights reserved.
10
Nature of Nonoperating Items
 The
top of the income statement shows
income from continuing operations.
 The lower part of the corporate income
statement can contain such nonoperating
items as discontinued operations,
extraordinary gains and losses, and effects of
accounting changes.
 When analyzing financial statements, the
analyst must be careful to look beyond a
“bottom line” that may have been influenced
by nonoperating items that are not expected
to recur.
Copyright © by Houghton Mifflin Company. All rights reserved.
11
Discussion
Q. What is the basis of the statement,
“Accounting income is a useless
measurement because it is based on
so many arbitrary decisions”? Is the
statement true?
Copyright © by Houghton Mifflin Company. All rights reserved.
12
Discussion
(continued)
A.
This question addresses the issue of quality of
earnings. Net income may differ depending on the
accounting methods and estimates used. Thus, the
same events may produce different income figures.
Also, the timing of transactions and other actions
may affect the reporting of discontinued
operations, extraordinary gains and losses, and
accounting changes in the income statement. This
does not mean that reported net income is useless,
however. Rather, it means that the user must not
read reported figures blindly. Further, financial
statements must conform to GAAP. Departures
from GAAP must be reported in the notes to the
financial statements.
Copyright © by Houghton Mifflin Company. All rights reserved.
13
The Corporate Income Statement
OBJECTIVE 2
Prepare a corporate income statement.
The Corporate Income Statement
 Either
single-step or multi-step formats can be
used.
 The accounting profession has taken the position
that income for a period should be all-inclusive
comprehensive income.
 Comprehensive income is the change in a
company’s equity during a period from sources
other than owners and includes net income, change
in unrealized investment gains and losses and other
items affecting equity.
 Several items must be added to the income
statement: discontinued operations, extraordinary
items, accounting changes, earnings per share.
Copyright © by Houghton Mifflin Company. All rights reserved.
15
Discussion
Q. Define the concept of comprehensive
income.
A. Comprehensive income is the change in a
company’s equity during a period from
sources other than owners and includes
newt income, change in unrealized
investment gains or losses and other items
affecting equity.
Copyright © by Houghton Mifflin Company. All rights reserved.
16
Income Taxes Expense
OBJECTIVE 3
Show the relationships among
income taxes expense, deferred
income taxes, and net of taxes.
Income Taxes Expense
 Income
taxes expense is the expense recognized in
the accounting records on an accrual basis that
applies to income from continuing operations.
 The amount payable is determined from taxable
income, measured according to the rules and
regulations of the income tax code.
 For convenience, many small companies maintain
their accounting records on a tax basis.
 The purpose of accounting is to determine net
income in accordance with GAAP, not taxable
income and tax liability.
Copyright © by Houghton Mifflin Company. All rights reserved.
18
Income Taxes Expense (continued)
 Management
has an incentive to use
accounting methods that minimize the
firm’s tax liability.
 There can be a material difference between
accounting income and taxable income.
 This discrepancy can result from
differences in the timing of the recognition
of revenues and expenses between GAAP
and income tax accounting.
Copyright © by Houghton Mifflin Company. All rights reserved.
19
Deferred Income Taxes


The amount by which income taxes expense differs from
income taxes payable is reconciled in an account called
deferred income taxes.
Income tax allocation is a technique used to account for the
difference between income taxes expense based on
accounting income and the actual income taxes payable
based on taxable income.
Dec. 31 Income Taxes Expense
144,500
Income Taxes Payable
92,000
Deferred Income Taxes
52,500
To record estimated
current and deferred
income taxes
Copyright © by Houghton Mifflin Company. All rights reserved.
20
Net of Taxes
 Net
of taxes means that the effect of
applicable taxes (usually income taxes) has
been considered in determining the overall
effect of an item on the financial statements.
 The phrase is used when a company has
items that must be disclosed in a separate
section.
 Each such item should be reported net of the
applicable taxes.
 The same procedure is used for both gains
and losses.
Copyright © by Houghton Mifflin Company. All rights reserved.
21
Discussion
Q. “Accounting income should be
geared to the concept of taxable
income because the public
understands that concept.”
Comment on this statement, and
tell why income tax allocation is
necessary.
Copyright © by Houghton Mifflin Company. All rights reserved.
22
Discussion
(continued…)
A.
Accounting income and taxable income should
not be treated the same because they serve
different purposes. The purpose of accounting
income is to give some indication (however
imperfect) of the increase or decrease in the
business’s well-being; the sole purpose of
taxable income is to provide a basis for the
collection of government revenues from the
taxpayer. Income tax allocation is necessary
because there are differences between
accounting and taxable income caused by the
timing of revenues and expenses.
Copyright © by Houghton Mifflin Company. All rights reserved.
23
Discontinued Operations, Extraordinary
Items, and Accounting Changes
OBJECTIVE 4
Describe the disclosure on the income
statement of discontinued operations,
extraordinary items, and accounting
changes.
Discontinued Operations
A segment
may be a separate major
line of business or a separate class of
customer.
Discontinued operations are segments
of a business that are no longer part of
its ongoing operations.
GAAP require that gains or losses from
discontinued operations be reported
separately on the income statement.
Copyright © by Houghton Mifflin Company. All rights reserved.
25
Extraordinary Items
 APB
# 30 defines extraordinary items as “events or
transactions that are distinguished by their unusual
nature and by the infrequency of their occurrence.”
 Extraordinary material items should be reported
separately from continuing operations on the
income statement, net of taxes.
 Extraordinary items include:
An uninsured loss from flood, earthquake, fire, or theft.
 Gain or loss from the passage of a new law.
 Taking of property by a foreign government.
 Gain or loss from an early retirement of debt.

Copyright © by Houghton Mifflin Company. All rights reserved.
26
Accounting Changes
 Although
a violation of the consistency principle, a
company is allowed to make accounting changes if
current procedures are incorrect or inappropriate.
 A change from LIFO to FIFO inventory method can
be made if adequate justification exists.
 The cumulative effect of an accounting change is the
effect that the new accounting principle would have
had on net income in prior periods if it had been
applied instead of the old principle.
 Accounting changes are shown on the income
statement immediately after extraordinary items,
net of taxes, and explained in the notes to the
financial statements.
Copyright © by Houghton Mifflin Company. All rights reserved.
27
Discussion
Q. Why should a gain or loss on
discontinued operations be
disclosed separately on the
income statement?
Copyright © by Houghton Mifflin Company. All rights reserved.
28
Discussion
(continued…)
A.
A gain or loss on discontinued operations
should be disclosed separately on the income
statement because the usefulness of the
income statement and the evaluation of the
ongoing activities of the business are
enhanced if results from continuing
operations are reported separately from
those of discontinued operations. Such
disclosure allows for comparisons with past
continuing operations and projections to
future operations.
Copyright © by Houghton Mifflin Company. All rights reserved.
29
Earnings Per Share
OBJECTIVE 5
Compute earnings per share.
Earnings Per Share (EPS)
The APB concluded that earnings per share of
common stock should be presented on the face
of the income statement.
 It is disclosed just below the net income.
 An EPS amount is always shown for:

Income from continuing operations.
 Income before extraordinary items.
 The cumulative effect of accounting changes.
 Net income.
 Gain or loss from discontinued operations or
extraordinary items.

Copyright © by Houghton Mifflin Company. All rights reserved.
31
EPS Calculation
Basic EPS =
Net Income
Weighted-Average Common Shares
Outstanding
 If
the number of common shares changed, or the
company paid preferred stock dividends during
the year, the weighted average must be calculated.
 When a company has only common stock and has
the same number of shares outstanding throughout
the year, the EPS calculation is simple.
Copyright © by Houghton Mifflin Company. All rights reserved.
32
EPS Calculation
(continued…)
If
the number of shares outstanding
changes during the year, it is necessary
to figure the weighted-average number
of shares outstanding for the year.
If a company has nonconvertible
preferred stock, the dividend must be
subtracted from net income before EPS
for common stock is computed.
Copyright © by Houghton Mifflin Company. All rights reserved.
33
Complex Capital Structures
 Some
companies have a complex capital
structure that may include exercisable stock
options or convertible stocks and bonds.
 These convertible securities have the
potential of diluting the EPS of common
stock.
 Potential dilution means that a stockholder’s
proportionate share of ownership in a
company could be reduced by conversion,
which would increase the total shares
outstanding.
Copyright © by Houghton Mifflin Company. All rights reserved.
34
Complex Capital Structures
(continued)
A company
with a complex capital
structure must report two earnings per
share figures:
 Basic
earnings per share.
 Diluted earnings per share.
Diluted
EPS is calculated by adding all
potentially dilutive securities to the
denominator of the basic EPS
calculation.
Copyright © by Houghton Mifflin Company. All rights reserved.
35
Discussion
Q. When does a company have a simple
capital structure? A complex capital
structure?
A. A company has a simple capital
structure when it has only common
stock or nonconvertible preferred
stock and no other securities that can
be converted into common stock. A
complex capital structure exists when
there are additional securities that can
be converted to common stock.
Copyright © by Houghton Mifflin Company. All rights reserved.
36
The Statement of
Stockholders’ Equity
OBJECTIVE 6
Prepare a statement of
stockholders’ equity.
The Statement of
Stockholders’ Equity
 Also
called the statement of changes in
stockholders' equity, summarizes the
changes in the components of the
stockholders’ equity section of the balance
sheet.
 It is used because it reveals much more
about the year’s stockholders’ equity
transactions than the statement of retained
earnings.
Copyright © by Houghton Mifflin Company. All rights reserved.
38
Retained Earnings
earnings are the part of stockholders’
equity that represents claims to assets arising from
the earnings of the business.
 Retained earnings equal a company’s profits since
the date of its inception, less any losses, dividends
to stockholders, or transfers to contributed capital.
 Retained earnings are not directly associated with
a specific asset.
 The existence of retained earnings means that
assets generated by profitable operations have
been kept in the business.
 Retained
Copyright © by Houghton Mifflin Company. All rights reserved.
39
Retained Earnings Balances
 A credit
balance does not mean that cash
or designated assets have been set aside.
 A debit balance in Retained Earnings
represents a deficit, meaning dividends
and subsequent losses are greater than
accumulated profits.
Copyright © by Houghton Mifflin Company. All rights reserved.
40
Restrictions on
Retained Earnings
 A corporation
may be required to or may want
to restrict all or part of its retained earnings.
 A restriction means that dividends can be
declared only to the extent of unrestricted
retained earnings.
 Reasons for restricting retained earnings
include:
A contractual agreement.
 State law.
 Voluntary action by the board of directors.

Copyright © by Houghton Mifflin Company. All rights reserved.
41
Restrictions on
Retained Earnings (continued)
 A restriction
does not change the total
retained earnings or stockholders’ equity
of the company.
 It simply divides retained earnings into
restricted and unrestricted.
 The most common way to disclose
restricted retained earnings is by reference
to a note to the financial statements.
Copyright © by Houghton Mifflin Company. All rights reserved.
42
Discussion
Q. What is the difference between
the statement of stockholders’
equity and the stockholders’
equity section of the balance
sheet?
Copyright © by Houghton Mifflin Company. All rights reserved.
43
Discussion
(continued…)
A.
The statement of stockholders’ equity is a
financial statement that summarizes changes
that occurred during the accounting period
in components of the stockholders’ equity
section of the balance sheet. The
stockholders’ equity section of the balance
sheet lists the items in contributed capital
and retained earnings on the balance sheet
date.
Copyright © by Houghton Mifflin Company. All rights reserved.
44
Stock Dividends and
Stock Splits
OBJECTIVE 7
Account for stock dividends
and stock splits.
Stock Dividends
A stock
dividend is a proportional
distribution of shares of a
corporation’s stock to its shareholders.
It represents no change in the firm’s
assets and liabilities because no assets
are distributed as when a cash
dividend is paid.
Copyright © by Houghton Mifflin Company. All rights reserved.
46
Reasons for Declaring
a Stock Dividend
 A board
of directors may declare a stock
dividend for several reasons:
 To
give stockholders some evidence of the
company’s success without paying a cash
dividend.
 To reduce the stock’s market price by increasing
the number of shares outstanding.
 To make a nontaxable distribution to
stockholders.
 To increase the company’s permanent capital.
Copyright © by Houghton Mifflin Company. All rights reserved.
47
Accounting for Stock Dividends
The
effect of a stock dividend is to
transfer a dollar amount from
retained earnings to the contributed
capital section on the date of
declaration.
The amount transferred is the FMV
(usually market price) of the
additional shares to be issued.
Copyright © by Houghton Mifflin Company. All rights reserved.
48
 Entries
to record the declaration and distribution
of the stock dividend are:
Feb. 24 Stock Dividends Declared
Common Stock Distributable
Paid-in Capital in Excess of Par
Value, Common
Declared a 10% stock dividend
on common stock
Mar. 15
60,000
15,000
45,000
Date of Record; no entry required.
Copyright © by Houghton Mifflin Company. All rights reserved.
49
(continued):
Entries to record the declaration and distribution
of the stock dividend are:
Mar. 31 Common Stock Distributable
15,000
Common Stock
15,000
Distributed stock
dividend of 3,000 shares



Stock Dividends Declared account is closed out to Retained
Earnings at the end of the accounting period.
The effect of the stock dividend is to:
 Permanently transfer the market value of the stock,
$60,000, from retained earnings to contributed capital.
 Increase the number of shares outstanding by 3,000.
Common Stock Distributable is not a liability account
because there is no obligation to distribute assets.
Copyright © by Houghton Mifflin Company. All rights reserved.
50
Stockholders’ Equity
Before and After Stock Dividends
Common Stock
Paid-in Capital in Excess of
Par Value, Common
Total Contributed Capital
Retained Earnings
Total Stockholders’ Equity
Shares Outstanding
Stockholders’ Equity per Share
BEFORE
AFTER
$150,000
$165,000
30,000
$180,000
900,000
$1,080,000
75,000
$240,000
840,000
$1,080,000
30,000
$36.00
33,000
$32.73
Copyright © by Houghton Mifflin Company. All rights reserved.
51
Stockholders’ Investment
Before and After Stock Dividends
Shares owned (individual)
Shares outstanding
Percentage of ownership
Proportionate investment
($1,080,000 x .03 1/3)



BEFORE
1,000
30,000
3 1/3%
AFTER
1,100
33,000
3 1/3%
$36,000
$36,000
Before and after the stock dividend, the stockholder owns
3 1/3 % of the company.
All stock dividends have an effect on the market price.
Some are so large that they have a material effect.
A large stock dividend (> 20-25%) should be accounted
for by a transfer of the par or stated value of the stock on
the date of declaration from Retained Earnings to
Contributed
Capital.
Copyright © by Houghton Mifflin Company. All rights reserved.
52
Stock Splits
 A stock
split occurs when a corporation
increases the number of issued shares of
stock and reduces the par or stated value
proportionally.
 This may be done when a company wants to
lower the stock’s market value per share of
stock and increase its liquidity, since a high
market price hinders marketability.
 A stock split does not increase the number of
shares authorized.
Copyright © by Houghton Mifflin Company. All rights reserved.
53
Before Stock Split
Contributed Capital
Common Stock, $5 par value,
100,000 shares authorized,
30,000 shares issued and
outstanding
Paid-in Capital in Excess of
Par Value, Common
Total Contributed Capital
Retained Earnings
Total Stockholders’ Equity
Copyright © by Houghton Mifflin Company. All rights reserved.
$ 150,000
30,000
$ 180,000
900,000
$1,080,000
54
After Stock Split
Contributed Capital
Common Stock, $2.50 par value,
100,000 shares authorized,
60,000 shares issued and
outstanding
Paid-in Capital in Excess of
Par Value, Common
Total Contributed Capital
Retained Earnings
Total Stockholders’ Equity
Copyright © by Houghton Mifflin Company. All rights reserved.
$ 150,000
30,000
$ 180,000
900,000
$1,080,000
55
Stock Splits
 No
journal entry is necessary, but a
memorandum entry in the general journal,
identifying the change in shares is issued and par
value is made.
 After a stock split, equity per share is cut in half.
 However, the shareholders’ proportionate
interest in the company remains the same.
 If the number of split shares exceeds the number
of authorized shares, the board of directors must
secure state and stockholders’ approval before
additional shares can be issued.
Copyright © by Houghton Mifflin Company. All rights reserved.
56
Discussion
Q. What is the difference between a stock
dividend and a stock split?
Copyright © by Houghton Mifflin Company. All rights reserved.
57
Discussion
(continued…)
A. A stock dividend is a distribution of
shares to stockholders that involves a
transfer from retained earnings to
contributed capital. A stock split
involves an increase in the number of
shares outstanding and a proportional
decrease in par or stated value, but it
has no effect on the balances in the
stockholders’ equity accounts.
Copyright © by Houghton Mifflin Company. All rights reserved.
58
Book Value
OBJECTIVE 8
Calculate book value per share.
Book Value
book value of a company’s
stock represents the total assets of
the company less its liabilities.
It is stockholders’ equity or net
assets.
The
Copyright © by Houghton Mifflin Company. All rights reserved.
60
Book Value Per Share
 Book
value per share represents the equity of the
owner of one share of stock in the net assets of the
corporation.
 Book value per share does not necessarily equal the
amount the shareholder would receive if the
company were sold or liquidated.
 Book value per share (common stock only) equals:
Total Stockholders’ Equity ÷ Shares Outstanding.
 If
a company has both preferred and common stock,
the determination of book value per share is more
complex.
Copyright © by Houghton Mifflin Company. All rights reserved.
61
Discussion
Q. What is the significance of book
value per share of stock?
A. Book value per share represents
the equity of one share of stock in
the net assets (assets minus
liabilities) of a corporation. It can
apply to both common and
preferred stock.
Copyright © by Houghton Mifflin Company. All rights reserved.
62
OK, LET’S REVIEW . . .
1. Identify the issues related to evaluating
the quality of a company’s earnings.
2. Prepare a corporate income statement.
3. Show the relationships among income
taxes expense, deferred income taxes, and
net of taxes.
Copyright © by Houghton Mifflin Company. All rights reserved.
63
CONTINUING OUR
REVIEW . . .
4. Describe the disclosure on the income
statement of discontinued operations,
extraordinary items, and accounting
changes.
5. Compute earnings per share.
6. Prepare a statement of stockholders’ equity.
Copyright © by Houghton Mifflin Company. All rights reserved.
64
AND FINALLY . . .
7. Account for stock dividends and stock
splits.
8. Calculate book value per share.
Copyright © by Houghton Mifflin Company. All rights reserved.
65