12–1


Motorola had good earnings in 2005 and
2006 but had a decrease in revenue of 15% in 2007
 Additionally
Motorola experienced a large operating loss of
$553 million in 2007
© Royalty Free/ Corbis
What important questions should investors ask about
Motorola’s future? Can the improvements be made and can
Motorola come back to prominence?
Click here for the Motorola financial reports archive.
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12–2

LO1
The substance of a company’s earnings and their sustainability into future accounting periods
What methods or estimates might affect the quality of earnings?

Gains and losses on transactions

Write-downs and restructurings

Nonoperating items
Investors should understand which items included in earnings are recurring and which are one-time items.
Income from continuing operations (before nonoperating items) gives a clear signal about future results.
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12–3

Different accounting methods have different effects on net income
Net sales
Goods available for sale
Less ending inventory
Cost of goods sold
Gross margin
Less depreciation expense
Less other expenses
Total operating expenses
Income from continuing operations before income taxes
FIFO and
Straight-Line
$462,500
LIFO and Double-
Declining-
Balance
$462,500
$200,000
30,000
$170,000
$292,500
$200,000
25,000
$175,000
$287,500
$20,000
85,000
$105,000
$40,000
85,000
$125,000
$187,500 $162,500
LIFO produces a higher cost of goods sold. An accelerated depreciation method yields a higher depreciation expense.
Produces a lower operating income
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12–4



should not go here but often are
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12–5

Imagine that a company decides to “writedown” the value of a large asset below its carrying value on the balance sheet
How does this affect income?
Reduces current operating income and boosts future income by shifting future costs to the current accounting period
Often called “big baths” or taking all possible losses
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12–6

Reported on the income statement:

Discontinued operations

Extraordinary gains and losses
The effects of changes in accounting principles are no longer reported on the income statement.
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12–7

Charles Brink, the new CEO of RDR Industries, instructs the
CFO to take all possible losses in the current year. He says he wants to wipe the slate clean of costs associated with the previous management.
Q. Do you think the CEO’s instructions are ethical? How will this action affect future years’ performance?
While the CEO’s actions are legal, taking a ‘big bath’ on losses makes it possible for him to claim large improvements in future years. The decision may be more about his personal gain than the best interest of stockholders, and is not an ethical action.
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12–8

Q. If an analyst believes that a company has a poor quality of earnings, what does this mean?
A. In general, the analyst believes that the substance of a company’s earnings is not sustainable into the future.
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12–9

Q. Does a company’s choice of inventory costing method have an impact on its quality of earnings? Why or why not?
A. Yes. Certain methods will produce a higher cost of goods sold, thus yielding a lower operating income. If a company makes choices that continually manipulate its earnings, it will not be seen as able to sustain these earnings if they are created through accounting methods alone.
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12–10

LO2
Taxable Income

Determined by deducting allowable expenses from income
 Federal tax laws dictate which expenses corporations may deduct
Accounting Income

Determined in accordance with
GAAP

Income taxes expense is recognized on an accrual basis
The difference between accounting income and taxable income, especially in large businesses, can be material
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12–11

Represents the amount by which income taxes expense differs from income taxes payable
Income tax allocation
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
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12–12

Vistula Corporation has income taxes expense of
$289,000 on its income statement, but has actual income taxes payable of
$184,000.
Record the estimated income taxes expense applicable to income from continuing operations using the income tax allocation procedure:
Dec. 31 Income Taxes Expense
Income Taxes Payable
Deferred Income Taxes
To record estimated current and deferred income taxes
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289,0000
184,000
105,000
12–13

Rules for recording, measuring, and classifying deferred income taxes

Deferred income taxes are recognized for the estimated future tax effects resulting from temporary differences in the valuation of assets, liabilities, equity, revenues, expenses, gains, and losses for tax and financial reporting purposes.
What are temporary differences?
Revenues and expenses or gains and losses that are included in taxable income before or after they are included in accounting income
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12–14

Treatment of advance payment for goods

Accounting income
(Revenue is not recognized until goods are shipped)

Taxable income
(Revenue is recognized when cash is received)
Result

Taxes paid > Taxes expense

Creates a deferred income taxes asset (prepaid taxes)
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12–15

 taxes have been taken into account in reporting an item on the income statement

Used for one time items
 keeps from distorting income taxes associated with ongoing operations
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12–16

Q. Why are taxable income and accounting income usually different?
A. They are calculated using different rules.
Taxable income is calculated using tax rules and allowable expenses. Accounting income is calculated using GAAP. Thus, the two amounts are usually different.
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12–17

Q. What is the income tax allocation procedure?
A. A procedure used to account for the difference between income taxes expense based on accounting income and the actual income taxes payable based on taxable income. The difference goes to the Deferred
Income Taxes account.
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12–18

Used to evaluate a company’s performance and compare it with other companies

Should be presented on the face of the income statement

Usually disclosed just below net income

Show earnings per share for income from continuing operations and other major components of net income
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12–19
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Basic EPS

Weighted
Net Income
Average Common Shares Outstandin g
Vistula Corporation had net income of $669,000 and
200,000 shares of common stock outstanding.
Basic EPS

$669,000
200,000 shares

$ 3 .
35 per share
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12–20

Suppose that from Jan. 1 to March 31, Vistula had 200,000 shares outstanding; from April 1 to Sept. 30, it had 240,000 shares outstanding; and from Oct. 1 to Dec. 31, 260,000 shares were outstanding. Vistula had net income of $669,000.
200,000 shares × 3/12 year
240,000 shares × 6/12 year
260,000 shares × 3/12 year
Weighted-average common shares outstanding = 12/12
50,000
120,000
65,000
235,000
Basic EPS

$669,000
235,000 shares

$ 2 .
85 per share
Dividends for nonconvertible preferred stock outstanding should be subtracted from net income before earnings per share for common stock are computed .
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12–21

Simple
Capital
Structure
Complex
Capital
Structure
No preferred stocks, bonds, or stock options that can be converted into common stock
Issued securities or stock options that can be converted to common stock
Has the potential to dilute EPS of common stock
Diluted earnings per share are calculated by adding all potentially dilutive securities to the denominator of the basic earnings per share calculation.
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12–22

S. Green owns 10,000 shares of a company’s common stock, which equals 2 percent of the outstanding shares of 500,000.
Suppose holders of convertible bonds convert the bonds into
100,000 shares of stock.
Now, S. Green’s 10,000 shares would equal only 1.67 percent (10,000 ÷ 600,000) of the outstanding shares.
Reporting requirements
Companies with a complex capital structure must report basic and diluted earnings per share.
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12–23

Q. Kraffton Corporation had net income of $495,300 and 200,000 shares of common stock outstanding.
Compute earnings per share.
A.
Basic EPS

$495,300
200,000 shares

$ 2 .
48 per share *
* Rounded
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12–24

Q. Possible Corporation had net income of $759,500 and 500,000 shares of common stock outstanding. It also issued preferred stock that could be converted into 100,000 shares of common stock. Compute diluted earnings per share.
A.
Diluted EPS

$759,500
600,000 shares

$ 1 .
27
* per share
* Rounded
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12–25

Transactions that affect stockholders’ equity, but are not stock transactions
Includes items like:

Net income

Changes in unrealized investment gains and losses
 Foreign currency translation adjustments
Comprehensive income can be shown as part of the statement of stockholders’ equity or in a separate statement
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12–26

Statement of Stockholders’ Equity
Summarizes changes in the components of the stockholders’ equity section of the balance sheet
Preferred
Stock$100 Par
Value 8%
Convertible
Common Stock
$10 Par Value
Additional Paidin Capital
Retained
Earnings Treasury Stock
Accumulated
Other Compre- hensive Income Total
$800,000 $600,000 $600,000 $1,200,000
540,000
Balance, December 31, 2009
Net income
Foreign currency translation adjustment
Issuance of 10,000 shares of common stock
Conversion of 2,000 shares of preferred stock to 6,000 shares of common stock
10 percent stock dividend on common stock, 7,600 shares
Purchase of 1,000 shares of treasury stock
Cash dividends
Preferred stock
Common stock
Balance, December 31, 2010
(200,000)
$600,000
100,000
60,000
76,000
$836,000
400,000
140,000
304,000
$1,444,000
(380,000)
(48,000)
(95,200)
$1,216,800
($48,000)
($48,000)
($20,000)
($20,000)
$3,200,000
540,000
(20,000)
500,000
—
—
(48,000)
(48,000)
(95,200)
$4,028,800
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12–27

• Represent stockholders’ claims to assets arising from the earnings of the business
• Assets kept in the company to help it grow
• Retained Earnings may have a debit or credit balance
• A debit balance means that past dividends and losses have been greater than its previous profits
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12–28

Q. If you were interested in the changes that occurred in each of the stockholders’ equity accounts, which financial statement would be most useful?
A. Statement of Stockholders’ Equity
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12–29

Q. Where are foreign currency translations reported?
A. As part of comprehensive income on the statement of stockholders’ equity or in a separate comprehensive income statement.
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12–30

Proportional distribution of shares of a corporation’s stock to its shareholders
 changes the content of stockholders’ equity

Involves no distribution of assets

Moves $ from RE to
Contributed Capital
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12–31

 Gives stockholders some evidence of the company’s success without using cash unlike a cash dividend

Nontaxable distribution to stockholders
 Increases the company’s permanent capital by transferring an amount from retained earnings to contributed capital
 May reduce the stock’s market price since the number of shares outstanding increases
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12–32

Rivera Corporation has the following stockholders’ equity structure before stock dividends are declared:
Contributed Capital
Common stock, $5 par value, 50,000 shares authorized, 15,000 shares issued and outstanding
Additional paid-in capital
Total contributed capital
Retained earnings
Total stockholders’ equity
$ 75,000
15,000
$ 90,000
450,000
$540,000
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12–33

(cont’d)
Rivera Corporation declares a 10 percent stock dividend on February 24, distributable on March 31 to stockholders of record on March 15. The market price of the stock on February 24 is $20 per share.
Date of Declaration:
Feb. 24 Stock Dividend Declared
Common Stock Distributable
Additional Paid-in Capital
Declared a 10 percent stock dividend on common stock, distributable March 31
30,000 to stockholders of record on March 15
15,000 shares x .10 = 1,500 shares
1,500 shares x $20/share = $30,000
1,500 shares x $5/share = $7,500
7,500
22,500
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12–34

(cont’d)
Rivera Corporation declares a 10 percent stock dividend on February 24, distributable on March 31 to stockholders of record on March 15. The market price of the stock on February 24 is $20 per share.
Date of Record:
• No entry is required
• Recall that this date is used to determine the owners of stock who will receive dividends
Date of Distribution:
Mar. 31 Common Stock Distributable
Common Stock
Distributed a stock dividend of 1,500 shares
7,500
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7,500
12–35

Shares outstanding
Percentage of ownership
Proportionate investment ($540,000 x .0333)
Common stock
Stockholders’ Equity
Additional paid-in capital
Before After
Dividend
$ 75,000
Dividend
$ 82,500
15,000 37,500
$ 90,000 $ 120,000 Total contributed capital
Retained earnings
Total stockholders’ equity
Shares outstanding
Stockholders’ equity per share
450,000
$540,000
420,000
540,000
15,000 16,500
$ 36.00 $ 32.73
One Stockholder’s Investment
Shares owned 500 550
15,000
3 1/3 %
$18,000*
16,500
3 1/3%
$18,000*
* Rounded
 Total stockholders’ equity is the same before and after a stock dividend
 The assets of a corporation are not reduced as they would have been if a cash dividend had been declared and paid
 The proportionate ownership in the corporation of any individual is the same before and after a stock dividend
12–36

• A corporation increases the number of shares of stock issued and outstanding and reduces the par or stated value proportionally
• Has the effect of lowering a stock’s market value per share and increasing the demand for the stock at this lower price
• Stock splits and stock dividends reduce earnings per share because they increase the number of shares issued and outstanding.
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12–37

July 15: MUI Corporation’s 15,000 shares of $5 par value common stock issued and outstanding were split 2 for 1.
Common Stock
Shares issued and outstanding
Par value per share
Amount of common stock equity
Each stockholder’s proportionate interest in the company remains the same because each share of $5 par value stock was converted to 2 shares of $2.50 par value stock.
Before Stock Split After Stock Split
15,000 30,000
$5.00
$75,000
$2.50
$75,000
A stock split does not increase the number of shares authorized, nor does it change the balances in the accounts in the stockholders’ equity section of the balance sheet.
No journal entry required, memorandum entry is appropriate.
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12–38

Q. What is the difference between a stock split and a stock dividend?
A. A stock dividend changes the makeup of stockholders’ equity in that it transfers capital from retained earnings to permanent capital accounts. A stock split does not change the makeup of stockholders’ equity.
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12–39

When a company has only common shares outstanding, calculate book value per share as follows:
Book Value per Share

Total Stockholde
Total Common Shares rs' Equity
Outstandin g
Shares outstanding
• Includes common stock distributable
• Does not include treasury stock
When a company has both common and preferred stock, subtract the call value of the preferred stock plus any dividends in arrears from total stockholders’ equity. (Use par value if call value is not specified.)
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12–40

Crisanti Corporation has total stockholders’ equity of $4,028,800 that includes:
6,000 shares of $100 par 8 percent convertible preferred stock outstanding;
83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares of treasury stock. No dividends are in arrears and the preferred stock is callable at $105. What is the book value per share for both preferred and common stock?
Total stockholders’ equity
Less equity allocated to preferred shareholders
(6,000 shares x $105)
Equity pertaining to common shareholders
$4,028,800
630,000
$3,398,800
Preferred Stock : $630,000

6,000 shares

$105.00
per share
Common Stock
* Rounded
: $3,398,800

82,600 shares

$41.15
* per share
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12–41

Crisanti Corporation has total stockholders’ equity of $4,028,800 that includes:
6,000 shares of $100 par 8 percent cumulative preferred stock outstanding;
83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares of treasury stock.
One year of dividends are in arrears and the preferred stock is callable at
$105. What is the book value per share for both preferred and common stock?
Total stockholders’ equity $4,028,800
Less: Call value of outstanding preferred shares $630,000
Dividends in arrears ($300,000 x .08) 48,000
Equity allocated to preferred shareholders
Equity pertaining to common shareholders
678,000
$3,350,800
Preferred Stock
Common Stock
: $678,000

: $3,350,800
6,000
 shares
82,600

$113.00
shares
 per share
*
$40.57
per share
* Rounded
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12–42

Q. What is the meaning of book value per share of stock?
A. It represents the equity of the owner of one share of stock in the net assets of a company.
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12–43

Q. Grapple Corporation has 2,000 shares of 6 percent $100 par value cumulative preferred stock and 50,000 shares issued and
48,400 outstanding of $10 par value common stock. Total stockholders’ equity is $1,945,000. One year of dividends are in arrears and the preferred stock is callable at $110. What is the book value per share for both classes of stock?
A.
Total stockholders’ equity $1,945,000
Less: Call value of outstanding preferred shares $220,000
Dividends in arrears ($200,000 x .06) 12,000
Equity allocated to preferred shareholders
Equity pertaining to common shareholders
232,000
$1,713,000
Preferred Stock
Common Stock
: $232,000

2,000 shares

$116.00
per share
: $1,713,000

48,400 shares

$35.39
* per share
* Rounded
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12–44

The stockholders’ equity of Latte Company on July 31, 20x7, was as follows:
Contributed capital
Common stock, no par value, $6 stated value,
500,000 shares authorized, 300,000 shares issued and outstanding $1,800,000
800,000 Additional paid-in capital
Total contributed capital
Retained earnings
Total stockholders’ equity
$2,600,000
670,000
$3,270,000
The board declares a 10 percent stock dividend on August 15, 20x7, distributable on September 9 to stockholders of record on September 1. The market price on Aug. 15 is $20 per share.
Required: Record the stock dividend in the general journal on the date of declaration. Determine the book value per share after the dividend.
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12–45

Aug. 15 Stock Dividend Declared
Common Stock Distributable
Additional Paid-in Capital
Declared a 10 percent stock dividend on
600,000 common stock, distributable on September 9 to stockholders of record on September 1
300,000 shares x .10 = 30,000 shares
30,000 shares x $20/share = $600,000
30,000 shares x $5/share = $150,000
Book Value per Share

$3,270,000
330,000 shares

$ 9 .
91
* per share
* Rounded
150,000
450,000
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12–46