Chapter 12 PPT

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Chapter 12

The Corporate Income Statement and the Statement of Stockholders’ Equity

12–1

Motorola, Inc.

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

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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

Quality of Earnings

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

The Impact of Estimates and Methods

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

Ordinary Gains and Losses

appear in the other revenue and expense section of the income statement,

one-time events

should not go here but often are

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12–5

Write-Downs and Restructurings

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

Nonrecurring Items

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

Discussion: Ethics on the Job

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

Stop & Review

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

Stop & Review

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 Versus GAAP

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

Deferred Income Taxes

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

Deferred Income Taxes Illustrated

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

Deferred Income Taxes

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

Example of Temporary Difference

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

Net of Taxes

 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

Stop & Review

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

Stop & Review

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

LO3 Earnings Per Share (EPS)

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

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

Calculating Weighted-Average

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

Diluted EPS

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

Dilution of Ownership

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

Stop & Apply

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

Stop & Apply

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

LO4 Comprehensive Income

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

Retained Earnings

• 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

Stop & Review

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

Stop & Review

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

LO5 Stock Dividend

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

Why Issue a Stock Dividend?

 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

Stock Dividends Illustrated

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

Stock Dividends Illustrated

(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

Stock Dividends Illustrated

(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

Effects of Stock Dividends on

Contributed Capital

Shares outstanding

Percentage of ownership

Proportionate investment ($540,000 x .0333)

Common stock

Stockholders’ Equity

Additional paid-in capital

Before

Dividend

$ 75,000

15,000

$ 90,000 Total contributed capital

Retained earnings

Total stockholders’ equity

Shares outstanding

Stockholders’ equity per share

450,000

$540,000

15,000

$ 36.00

One Stockholder’s Investment

Shares owned 500

15,000

3 1/3 %

$18,000*

After

Dividend

$ 82,500

37,500

$ 120,000

420,000

540,000

16,500

$ 32.73

550

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

Stock Split

• 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

Stock Split Illustrated

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

15,000

$5.00

$75,000

After Stock Split

30,000

$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

Stop & Review

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

LO6 Book Value per Share

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

Book Value per Share Illustrated

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

Book Value per Share Illustrated

(Dividends in Arrears)

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

Less: Call value of outstanding preferred shares

Dividends in arrears ($300,000 x .08)

Equity allocated to preferred shareholders

Equity pertaining to common shareholders

$4,028,800

$630,000

48,000

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

Stop & Review

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

Stop & Apply

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

Less: Call value of outstanding preferred shares

Dividends in arrears ($200,000 x .06)

Equity allocated to preferred shareholders

Equity pertaining to common shareholders

$1,945,000

$220,000

12,000

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

Chapter Review Problem

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

Chapter Review Problem (Solution)

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

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