A company's pattern of sales and net income are important
factors in evaluating its financial success. Consider Procter & Gamble Company, for example. Two billion times a day, P&G
products are sold around the world. The company has one of the largest and strongest portfolios of recognizable brands,
including Pampers, Tide, Ariel, Always, Whisper, Pantene, Bounty, Pringles, Folgers, Charmin, Downy, Lenor, lams, Crest,
Clairol, Actonel, Dawn, and day, Ninety-eight thousand people work for P&G in almost 80 countries worldwide,
One of the attributes of financially successful companies like P&G is their consistent growth over time in terms of
primary measures of financial performance, such as net sales and net earnings, Net sales, measuring the value of merchandise sold less returns, increased from $56,741 million in 2005 to $68,222 million in 2006 and to $76,476 million
in 2007. This represents an approximate 20 percent increase in 2006 and approximately 12 percent in 2007, or a
combined increase for the two years of an impressive 32 percent, Net income, which starts with sales and is reduced by
various expenses required to generate those sales, increased from $6,923 million in 2005 to $8,684 million in 2006 (an
approximate 25 percent increase) and to $10,340 million in 2007 (an approximate 19 percent increase), or a combined
increase for the two years of approximately 44 percent. These figures represent impressive financial performance in terms
of the company's ability to provide goods to its customers and to operate in a manner that results in a profit that benefits
the company's stockholders,
Chapter 12 Income and Changes in Retained Earnings
For investors seeking companies in which to place their funds, a pattern of increases in
key performance figures such as sales and net income is very attractive. In this chapter, we
look more closely at the income statement and learn about the useful information available in that financial statement for making important investment and credit decisions. In
addition to learning more about how an income statement is prepared, you will learn about
earnings per share, dividends, and other key factors that indicate the financial success of
a company.
Reporting the Results of Operations
The most important aspect of corporate financial reporting, in the view of many investors, is
periodic income. Both the market price of common stock and the amount of cash dividends
per share depend on the current and future earnings of the corporation.
DEVELOPING PREDICTIVE INFORMATION
Revenue is a measure of the value of products and services that have been sold to customers.
Revenue represents the increases in the company's assets that result from its profit-directed
activities. Generally, revenue increases cash either at the time it is included in the income
statement or at an earlier or later date. Expenses, on the other hand, are measures of the cost
of producing and distributing the products and services that are sold to customers. They
represent decreases in the company's assets that result from its profit-directed activities.
Expenses decrease cash at the time they are incurred, or at an earlier or later date. An income
statement presents a company's revenue and expenses for a stated period of time, such as a
quarter or year.
As this brief description of revenue and expenses indicates, the income statement provides
important information for investors and creditors as they attempt to make estimates of future
cash flows. Because of the importance of income reporting in making assessments about the
future, events and transactions that are irregular require careful attention in the preparation
and interpretation of an income statement.
For information about financial performance to be of maximum usefulness to investors,
creditors, and other financial statement users, the results of items that are unusual and not
likely to recur should be presented separately from the results of the company's normal, recurring activities. Two categories of unusual, nonrecurring events that require special treatment
are (1) the results of discontinued operations and (2) the impact of extraordinary items. One
of the challenges that has faced the accounting profession is to define these terms with sufficient clarity that users of financial statements can reliably compare the information provided
by different companies and by the same company over time.
REPORTING IRREGULAR ITEMS: AN ILLUSTRATION
To illustrate the presentation of irregular items in an income statement, assume that Farmer
Corporation operates both a small chain of retail stores and two motels. Near the end of the
current year, the company sells both motels to a national hotel chain. In addition, Farmer
Corporation reports two "extraordinary items." An income statement illustrating the correct
format for reporting these events appears in Exhibit 12—1.
CONTINUING OPERATIONS
The first section of the Farmer Corporation income statement contains only the results of
continuing business activities—that is, the retail stores. Notice that the income tax expense
shown in this section ($300,000) relates only to continuing operations. The income taxes
relating to the irregular items are shown separately in the income statement as adjustments to
the amounts of these items.
I n c o m e from C o n t i n u i n g O p e r a t i o n s The subtotal income from continuing operations measures the profitability of the ongoing operations. This subtotal should be helpful in
making predictions of the company's future earnings. For example, if we predict no significant
529
Reporting the Results of Operations
Exhibit 12-1
INCOME STATEMENT WITH
NONRECURRING ITEMS
Net sales
$8,000,000
Cost and expenses:
Cost of goods sold
$4,500,000
Selling expenses
1,500,000
General and administrative expenses
920,000
Loss on settlement of lawsuit
80,000
Income tax (on continuing operations)
300,000
Income from continuing operations
7,300,000
$ 700,000
Discontinued operations:
Operating loss on motels (net of $90,000
income tax benefit)
Gain on sale of motels (net of $195,000
income tax)
$ (210,000)
455,000
Income before extraordinary items
245,000
$ 945,000
Extraordinary items:
Gain on condemnation of land by
State Highway Department (net of $45,000
income tax)
$
105,000
Loss from earthquake damage to
New York store (net of $75,000 income
tax benefit)
Net income
(175,000)
(70,000)
$ 875,000
change in the profitability of its retail stores, we would expect Farmer Corporation to earn a
net income of approximately $700,000 next year.
DISCONTINUED OPERATIONS
When management enters into a formal plan to sell or discontinue a segment of the business,
the results of that segment's operations are shown separately in the income statement. Excluding that part of the business that will no longer be part of the company's operations enables
users of the financial statements to better evaluate the performance of the company's ongoing
(continuing) operations.
Two items are included in the discontinued operations section of the income statement:
(1) the income or loss from operating the segment prior to its disposal and (2) the gain or
loss on disposal of the segment. The income taxes relating to the discontinued operations are
shown separately from the income tax expense relating to continuing business operations.
EXTRAORDINARY ITEMS
The second category of irregular events requiring disclosure in a separate section of the income
statement is extraordinary items. An extraordinary item is a gain or loss that is (1) unusual
in nature and (2) not expected to recur in the foreseeable future. By definition, extraordinary
items are rare and do not appear often in the same company's income statements. An example
of an extraordinary item is the loss of a company's plant due to an earthquake in a geographic
location where earthquakes rarely occur.
When a gain or loss qualifies as an extraordinary item, it appears after the section on discontinued operations (if any), following the subtotal income before extraordinary items. This
subtotal is necessary to show investors what the net income would have been if the extraordinary gain or loss had not occurred. Extraordinary items are shown net of any related income
tax effects.
Chapter 12 Income and Changes in Retained Earnings
O t h e r U n u s u a l Gains and L o s s e s Some transactions are not typical of normal
operations but also do not meet the criteria for separate presentation as extraordinary items.
Among such events are losses incurred because of labor strikes and the gains or losses resulting from sales of plant assets. Such items, if material, should be individually listed as items of
revenue or expense, rather than being combined with other items in broad categories such as
sales revenue or general and administrative expenses.
In the income statement of Farmer Corporation (Exhibit 12-1), the $80,000 loss resulting
from the settlement of a lawsuit is listed separately in the income statement but is not shown
as an extraordinary item. This loss is important enough to bring to the attention of readers of
the income statement by presenting it as a separate item, but it is not considered unusual or
infrequent enough to be an extraordinary item.
R e s t r u c t u r i n g C h a r g e s One important type of unusual loss relates to the restructuring of operations. The restructuring of operations has become a common aspect of the
American economy. In fact, the 1990s were sometimes described as the decade of corporate
downsizing. As companies straggle to meet the competitive challenges of a global economy,
they incur significant costs to close plants, reduce workforces, and consolidate operating
facilities.
Restructuring charges consist of items such as losses from write-downs or sales of plant
assets, severance pay for terminated workers, and expenses related to the relocation of operations and remaining personnel. In determining operating income, they are presented in the
company's income statement as a single item like the loss incurred in the settlement of a lawsuit in the Farmer Corporation income statement in Exhibit 12-1. If the restructuring involves
discontinuing a segment of the business, the expenses related to that aspect of the restructuring are presented as discontinued operations.
Distinguishing between the Unusual and the Extraordinary in the
past, some corporate managements had a tendency to classify many losses as extraordinary,
while classifying many gains as a part of normal, recurring operations. This resulted in
reporting higher income before extraordinary items, but the final net income figure was
not affected. To counter this potentially misleading practice, the accounting profession now
defines extraordinary items very carefully and intends for them to be quite rare. There is no
comprehensive list of extraordinary items. Thus the classification of a specific event is a
matter of judgment.
One of the most important determinants of a company's stock price is expected future
earnings. Assume that you are considering investing in Worsham Corporation and are
evaluating the company's profitability in the current year. The net income of the corporation, which amounted to $4,000,000, includes the following items:
Loss on a discontinued segment of the business (net of
income tax benefit)
Extraordinary gain (net of income tax paid)
$750,000
300,000
Adjust net income to develop a number that represents a good starting point for predicting the future net income of Worsham Corporation. Explain the reason for each of the
adjustments. Explain how this adjusted number may help you predict future earnings for
the company.
(See our comments on the Online Learning Center Web site.)
Reporting the Results of Operations
EARNINGS PER SHARE (EPS)
One of the most widely used accounting statistics is earnings per share on common stock.
Investors who buy or sell stock in a corporation need to know the annual earnings per share.
Stock market prices are quoted on a per-share basis. If you are considering investing in a
company's stock at a price of $50 per share, you need to know the earnings per share and the
annual dividend per share to decide whether this price is reasonable.
To compute earnings per share, the common stockholders' share of the company's net
income is divided by the average number of common shares outstanding. Earnings per share
applies only to common stock; preferred stockholders have no claim to earnings beyond the
stipulated preferred stock dividends.
Computing earnings per share is easiest when the corporation has issued only common
stock and the number of outstanding shares has not changed during the year. In this case,
earnings per share is equal to net income divided by the number of shares outstanding.
In many companies, the number of shares of stock outstanding changes during the year.
If additional shares are sold, or if shares of common stock are retired (repurchased from
the shareholders), the computation of earnings per share is based on the weighted-average
number of shares outstanding.'
The weighted-average number of shares for the year is determined by multiplying the
number of shares outstanding by the fraction of the year that number of shares outstanding
remained unchanged. For example, assume that 80,000 shares of common stock were outstanding during the first nine months of 2009 and 140,000 shares were outstanding during the
last three months. The increase in shares outstanding resulted from the sale of 60,000 shares
for cash. The weighted-average number of shares outstanding during 2009 is 95,000, determined as follows:
By using the weighted-average number of shares in calculating earnings per share, we
recognize that the cash received from the sale of the 60,000 additional shares was available to
generate earnings only during the last three months of the year.
Preferred Dividends and Earnings per Share When a company has preferred
stock outstanding, the preferred stockholders participate in net income only to the extent
of the preferred stock dividends. To determine the earnings applicable to the common
stock, we first deduct from net income the amount of current year preferred dividends. The
annual dividend on cumulative preferred stock is always deducted, even if not declared by
the board of directors for the current year. When there are preferred dividends in arrears,
only the current year's cumulative preferred stock dividend is deducted in the earnings per
share computation. Noncumulative preferred dividends are deducted only if they have been
declared.
To illustrate, let us assume that Perry Corporation has 200,000 shares of common stock and
12,000 shares of $6 cumulative preferred stock outstanding throughout the year. Net income
' When the number of shares outstanding changes as a result of a stock split or a stock dividend (discussed
later in this chapter), the computation of the weighted-average number of shares outstanding should be
adjusted retroactively rather than weighted for the period the new shares were outstanding. This makes
earnings per share data for prior years consistent in terms of the current capital structure.
Chapter 12 Income and Changes in Retained Earnings
for the year totals $595,000. Earnings per share of common stock would be computed as
follows:
Presentation of Earnings per Share in the Income Statement ALL publicly
owned corporations are required to present earnings per share figures in their income statements.2 If an income statement includes subtotals for income from continuing operations, or for
income before extraordinary items, per-share figures are shown for these amounts as well as for
net income. These additional per-share amounts are computed by substituting the amount of the
appropriate subtotal for the net income figure in the preceding calculation.
To illustrate all of the potential per-share computations, we will expand our Perry Corporation example to include income from continuing operations and income before extraordinary
items. We should point out, however, that all of these figures seldom appear in the same
income statement. The condensed income statement shown in Exhibit 12-2 is intended to
illustrate the proper format for presenting earnings per share figures and to provide a review
of the calculations.
Exhibit 12-2
EARNINGS PER SHARE
PRESENTATION
To informed users of financial statements, each of these figures has a different significance. Earnings per share from continuing operations represents the results of continuing and
ordinary business activity. This figure is the most useful one for predicting future operating
results. Net earnings per share, on the other hand, shows the overall operating results of the
current year, including any discontinued operations and extraordinary items.
2
The FASB has exempted closely held corporations (those not publicly owned) from the requirement of
computing and reporting earnings per share, although some do it voluntarily.
533
Reporting the Results of Operations
Financial Analysis and Decision Making
The relationship between earnings per share and stock price is
expressed by the price-earnings (p/e) ratio. This ratio is simply the current stock price divided by the earnings per share
for the year. (A p/e ratio is not computed if the company has
sustained a net loss for this period.) Price-earnings ratios are
of such interest to investors that they are published daily in the
financial pages of major newspapers. Price-earnings ratios and
other measures useful for evaluating financial performance are
covered in Chapter 14.
Stock prices actually reflect investors' expectations of future
earnings. The p/e ratio, however, is based on the earnings over
the past year. Thus, if investors expect earnings to increase substantially from current levels, the p/e ratio will be quite high—
perhaps 20,30, or even more. But if investors expect earnings to
decline from current levels, the p/e ratio will be quite low, say,
8 or less. A mature company with stable earnings usually sells
between 10 and 12 times earnings. Thus the p/e ratio reflects
investors' expectations of the company's future prospects.3
Unfortunately, the term earnings per share often is used
without qualification in referring to various types of per-share
data. When using per-share information, it is important to
know exactly which per-share statistic is being presented. For
example, the price-earnings ratios (market price divided by
earnings per share) for common stocks listed on major stock
exchanges are reported daily in The Wall Street Journal and
other newspapers. Which earnings per share figures are used
in computing these ratios? If a company reports an extraordinary gain or loss, the price-earnings ratio is computed using
the per-share earnings before the extraordinary item. Otherwise, the ratio is based on net earnings.
Valuation multiples such as price-earnings ratios are often used to estimate a
firm's value. The use of price multiples to compare firms from different countries is challenging for many reasons. One important reason is that national
differences in accounting principles are a source of cross-country differences. For example, research has shown that such differences in accounting principles cause p/e ratios
in Japan to be generally lower than in the United States for comparable companies with
similar financial results.
You as a Financial Analyst
You are working for a stock market research firm
and your boss asks you to present an analysis
of Foster, Inc.'s performance, focusing primarily on earnings per share. Her primary purpose for having
you do this analysis is to consider whether Foster, Inc., is a
good investment in terms of the company's expectations for
future profitability. In analyzing Foster, Inc.'s income statement you determine the following:
Ryan McVay/Getty Images
3
A word of caution—if current earnings are very low, the p/e ratio tends to be quite high regardless of whether
future earnings are expected to rise or fail. In such situations, the p/e ratio is not a meaningful measurement.
(continued)
On the basis of only the limited information presented above, what is your recommendation to your boss regarding Foster, Inc.'s prospects for future profitability? Justify
your conclusion.
(See our comments on the Online Learning Center Web site.)
Basic and Diluted Earnings per Share
Let us assume that a company has an outstanding issue of
preferred stock that is convertible into shares of common
stock at a rate of two shares
of common stock for each
share of preferred stock. The
conversion of this preferred
stock would increase the
number of common shares outstanding and might dilute
(reduce) earnings per share. Any common stockholder interested in the trend of earnings per share needs to know what
effect the conversion of the preferred stock would have on
earnings per share of common stock. Keep in mind that the
decision to convert the preferred shares into common shares
is made by the stockholders, not the corporation.
To inform investors of the potential dilution that might
occur, two figures are presented for each income number
from the income statement. The first figure, called basic
earnings per share, is based on the weighted-average number of common shares actually outstanding during the year.
This figure excludes the potential dilution represented by
the convertible preferred stock. The second figure, called
diluted earnings per share, incorporates the impact that
conversion of the preferred stock would have on basic earnings per share.
Basic earnings per share is computed in the same manner
as illustrated in our preceding example of Perry Corporation.
Diluted earnings per share, on the other hand, is computed on
the assumption that all the preferred stock has been converted
into common stock as of the beginning of the current year.4
(The mechanics of computing diluted earnings per share are
covered in more advanced accounting courses.)
The purpose of showing diluted earnings per share is to alert
common stockholders to what could have happened. When the
difference between basic and diluted earnings per share is significant, investors should recognize the risk that future earnings
per share may be reduced by conversions of other securities into
additional shares of common stock. When a company reports
both basic and diluted earnings per share, the price-earnings
ratio shown in news papers is based on the basic figure.
Convertible preferred stock is not the only potential diluter of
earnings per share. Convertible debt instruments (e.g., convertible
bonds) are another type of financial instrument that may reduce
earnings per share if the holders choose to redeem them. Similarly, stock options may reduce earnings per share if the holders
choose to exercise them and purchase additional shares of stock.
4
If the preferred stock had been issued during the current year, we would assume that it was converted into
common stock on the date it was issued.
Other Transactions Affecting
Retained Earnings
CASH DIVIDENDS
534
Investors buy stock in a corporation with the expectation of getting their original investment
back as well as earning a reasonable return on that investment. The return on a stock investment is a combination of two forms: (1) the increase in value of the stock (stock appreciation)
and (2) cash dividends.
Some profitable corporations do not pay dividends. Generally, these corporations are in an
early stage of development and must conserve cash for the purchase of plant and equipment
or for other needs of the company. These so-called growth companies cannot obtain sufficient
financing at reasonable interest rates to finance their operations, so they must rely on their
Other Transactions Affecting Retained Earnings
53S
earnings. Often only after a significant number of years of profitable operations does the
board of directors decide that paying cash dividends is appropriate.
The preceding discussion suggests three requirements for the payment of a cash dividend.
These are:
1. Retained earnings. Since dividends are a distribution of assets that represent earnings to
stockholders, the theoretical maximum for dividends is the total undistributed net income of
the company, represented by the credit balance of the Retained Earnings account. As a practical matter, many corporations limit dividends to amounts significantly less than annual net
income, on the basis that a major portion of the net income must be retained in the business
if the company is to grow and keep pace with its competitors.
2. An adequate cash position. The fact that the company reports earnings does not necessarily
mean that it has a large amount of cash on hand. Cash generated from earnings may have been
invested in new plant and equipment, or it may have already been used to pay off debts or to acquire a larger inventory. There is no necessary relationship between the balance in the Retained
Earnings account and the balance in the Cash account. The common expression of "paying
dividends out of retained earnings" is misleading. Cash dividends can be paid only out of cash.
3. Dividend action by the board of directors. Even though a company's net income is substantial
and its cash position seemingly satisfactory, dividends are not paid automatically. A formal
action by the board of directors is necessary to declare a dividend.
DIVIDEND DATES
Four significant dates are involved in the distribution of a dividend. These are:
1. Date of declaration. On the day on which the dividend is declared by the board of directors,
a liability to make the payment comes into existence.
2. Ex-dividend date. The ex-dividend date is significant for investors in companies whose stocks
trade on stock exchanges. To permit the compilation of the list of stockholders as of the record
date, it is customary for the stock to go ex-dividend three business days before the date of
record (see following discussion). A person who buys the stock before the ex-dividend date is
entitled to receive the dividend that has already been declared; conversely, a stockholder who
sells shares before the ex-dividend date does not receive the dividend. A stock is said to be
selling ex-dividend on the day that it loses the right to receive the latest declared dividend.
3. Date of record. The date of record follows the date of declaration, usually by two or three
weeks, and is always stated in the dividend declaration. To be eligible to receive the dividend,
a person must be listed in the corporation's records as the owner of the stock on this date.
4. Date of payment. The declaration of a dividend always includes announcement of the date
of payment as well as the date of record. Usually the date of payment comes two to four
weeks after the date of record.
Journal entries are required only on the dates of declaration and of payment, as these
are the only transactions affecting the corporation declaring the dividend. These entries are
illustrated below.
Dec. 15
Dividends
125,000
Dividends Payable
125,000
To record declaration of a cash dividend of $1 per
share on the 125,000 shares of common stock
outstanding. Payable Jan. 25 to stockholders of
record on Jan. 10.
Jan. 25
Dividends Payable
Cash
To record payment of $1 per share dividend declared
Dec. 15 to stockholders of record on Jan. 10.
125,000
125,000
Chapter 12 Income and Changes in Retained Earnings
No entries are made on either the ex-dividend date or the date of record. These dates are of
importance only in determining to whom the dividend checks will be sent. From the stockholders' point of view, it is the ex-dividend date that determines who receives the dividend. The
date of record is of significance primarily to the stock transfer agent and the stock registrar.
At the end of the accounting period, a closing entry is required to transfer the debit balance of the Dividends account into the Retained Earnings account. (Some companies follow
the alternative practice of debiting Retained Earnings when the dividend is declared instead
of using a Dividends account. Under either method, the balance of the Retained Earnings
account ultimately is reduced by all dividends declared during the period.)
LiQUiDATiNG DIVIDENDS
A liquidating dividend occurs when a corporation pays a dividend that exceeds the balance in
the Retained Earnings account. Thus the dividend returns to stockholders all or part of their
paid-in capital investment. Liquidating dividends usually are paid only when a corporation is
going out of existence or is making a permanent reduction in the size of its operations. Stockholders may assume that a dividend represents a distribution of profits unless they are notified
by the corporation that the dividend is a return of invested capital.
STOCK DIVIDENDS
Stock dividend is a term used to describe a distribution of additional shares of stock to a
company's stockholders in proportion to their present holdings. In other words, the dividend
is payable in additional shares of stock rather than in cash. Most stock dividends consist of
additional shares of common stock distributed to holders of common stock. Therefore, our
discussion focuses on this type of stock dividend.
An important distinction exists between a cash dividend and a stock dividend. A cash
dividend is a distribution of cash by a corporation to its stockholders. A cash dividend reduces
both assets and stockholders' equity. In a stock dividend, however, no assets are distributed.
Thus a stock dividend causes no change in assets or in total stockholders' equity. Each stockholder receives additional shares, but his or her percentage ownership in the corporation is no
larger than before, and the company receives no assets in the transaction.
To illustrate this point, assume that a corporation with 2,000 shares of stock is owned
equally by James Davis and Susan Miller, each owning 1,000 shares of stock. The corporation declares a stock dividend of 10 percent and distributes 200 additional shares (10 percent
of 2,000 shares), with 100 shares going to each of the two stockholders. Davis and Miller
now hold 1,100 shares apiece, but each still owns one-half of the business. Furthermore, the
corporation has not changed in size; its assets and liabilities and its total stockholders' equity
are exactly the same as before the dividend.
Now let us consider the logical effect of this stock dividend on the market price of the
company's stock. Assume that, before the stock dividend, the outstanding 2,000 shares in
our example had a market price of $110 per share. This price indicates a total market value
for the corporation of $220,000 (2,000 shares X $110 per share). As the stock dividend does
not change total assets or total stockholders' equity, the total market value of the corporation
should remain $220,000 after the stock dividend. As 2,200 shares are now outstanding, the
market price of each share should fall to $100 ($220,000 2,200 shares). In other words,
the market value of the stock should fall in proportion to the number of new shares issued.
Whether the market price per share will fall in proportion to a small increase in the number of
outstanding shares is another matter.
Entries tO Record a S t o c k Dividend In accounting for relatively small stock dividends (say, less than 20 percent), the market value of the new shares is transferred from the
Retained Earnings account to the paid-in capital accounts. This process sometimes is called
capitalizing retained earnings. The overall effect is the same as if the dividend had been paid
in cash, and the stockholders had immediately reinvested the cash in the business in exchange
for additional shares of stock. Of course, no cash actually changes hands—the new shares of
stock are sent directly to the stockholders.
537
Other Transactions Affecting Retained Earnings
To illustrate, assume that on June 1, Aspen Corporation has outstanding 100,000 shares of
$5 par value common stock with a market value of $25 per share. On this date, the company
declares a 10 percent stock dividend, distributable on July 15 to stockholders of record on
June 20. The entry at June 1 to record the declaration of this dividend is:
Retained Earnings
Stock Dividend to Be Distributed
Additional Paid-in Capital: Stock Dividends
Declared a 10% stock dividend consisting of 10,000 shares
(100,000 shares x 10%) of $5 par value common stock, market
price $25 per share. Distributable July 15 to stockholders of
record on June 20.
250,000
50,000
200,000
The Stock Dividend to Be Distributed account is not a liability because there is no obligation to distribute cash or any other asset. If a balance sheet is prepared between the date of
declaration of a stock dividend and the date of distribution of the shares, this account, as well
as the Additional Paid-in Capital: Stock Dividends account, should be presented in the stockholders' equity section of the balance sheet.
Notice that the Retained Earnings account was reduced by the market value of the shares
to be issued (10,000 shares X $25 per share = $250,000). Notice also that no change occurs
in the total amount of stockholders' equity. The amount removed from the Retained Earnings
account was simply transferred into two other stockholders' equity accounts.
On July 15, the entry to record the distribution of the dividend shares is:
Stock Dividend to Be Distributed
Common Stock
Distributed 10,000-share stock dividend declared June 1.
50,000
50,000
R e a s o n s for S t o c k D i v i d e n d s Although stock dividends cause no change in total
assets, liabilities, or stockholders' equity, they are popular both with management and with
stockholders. Management often finds stock dividends appealing because they allow management to distribute something of perceived value to stockholders while conserving cash
which may be needed for other purposes like expanding facilities and introducing new product lines.
Stockholders like stock dividends because they receive more shares, often the stock price
does not fall proportionately, and the dividend is not subject to income taxes (until the shares
received are sold). Also, large stock dividends tend to keep the stock price down in a trading
range that appeals to most investors.
An investor who purchased 100 shares of Home Depot, inc., in 1985 would have paid
about $1,700. Fifteen years later, that stock was worth about $273,000!
Does this mean that each share increased in value from $17 to more than $2,730? No—
in fact, this probably couldn't happen. Investors like to buy stock in lots of 100 shares. At
$2,730 per share, who could afford 100 shares? Certainly not the average small investor.
Home Depot's board of directors wanted to attract small investors. These investors
help create more demand for the company's stock—and in many cases, they also become
loyal customers.
So as the price of Home Depot's stock rose, the board declared numerous stock splits
and stock dividends. An investor who had purchased 100 shares in 1985 owned over
3,900 shares 15 years later without ever having had to purchase additional shares. Each
share had a market value of $70, a price considered affordable to the average investor.
538
Chapter 12 Income and Changes in Retained Earnings
Distinction between Stock Splits and Stock Dividends What is the difference between a stock dividend and a stock split (discussed in Chapter 11)? In some respects
the two are similar. Both involve the distribution of shares of a company's own stock to its
present stockholders without payment by those stockholders to the company. Both stock dividends and stock splits increase the number of outstanding shares of stock in the company's
stockholders' equity. The difference between a stock dividend and a stock split lies in the
intent of management and the related issue of the size of the distribution. A stock dividend
usually is intended to substitute for a cash dividend and is small enough that the market price
of the stock is relatively unaffected. Stock dividends typically increase the number of outstanding shares by 5 percent, 10 percent, or even 20 percent. Stock splits, on the other hand,
have the intent of reducing the market price of the stock to bring it down to a desired trading
range. Stock splits typically represent much greater increases in the number of outstanding
shares, such as 100 percent (2:1 split) or 200 percent (3:1 split).
The previous discussion focuses on the purposes and management intent of stock dividends and stock splits. Accounting for the two also varies. Stock dividends do not result in
a change in the par value of the stock, and usually an amount equal to the market value of
the shares issued is transferred from retained earnings to the par value and additional paid-in
capital accounts. Stock splits, on the other hand, result in a pro rata reduction in the par value
of the stock and no change in the actual dollar balances of the stockholders' equity accounts.
Both stock dividends and stock splits are integral parts of management strategy with regard to
the company's ownership, and the accounting differences parallel these differences in management intent.
STATEMENT OF RETAINED EARNINGS
The term retained earnings refers to the portion of stockholders' equity derived from profitable operations. Retained earnings is increased by earning net income and is reduced by incurring net losses and by the declaration of dividends. Prior period adjustments, discussed later
in this chapter, may increase or decrease retained earnings.
In addition to a balance sheet, an income statement, and a statement of cash flows, some
companies present a statement of retained earnings, as in Exhibit 12-3.
Exhibit 12-3
STATEMENT OF RETAINED
EARNINGS FOR SALT
LAKE CORPORATION
Notice that the 2009 net income is added to the beginning balance of retained earnings.
Earlier in this text when we studied the accounting cycle, we learned that, as part of the
end-of-period process of closing the books and preparing financial statements, the revenue
and expense accounts are brought to a zero balance, and the net amount of these items
(either net income or net loss) is added to or subtracted from owners' equity. For a corporation, net income or loss is added to or subtracted from retained earnings. The addition of net
income in the statement of retained earnings is a reflection of this closing process. Notice,
also, that in the statement of retained earnings the balance is reduced by the amounts of
cash dividends declared during the year, as well as the amount of the stock dividend that
was declared.
539
Other Transactions Affecting Retained Earnings
PRIOR PERIOD ADJUSTMENTS
On occasion, a company may discover that a material error was made in the measurement of
net income in a prior year. Because net income is closed into the Retained Earnings account,
an error in reported net income will cause an error in the amount of retained earnings shown
in all subsequent balance sheets. When such errors are discovered, they should be corrected.
The correction, called a prior period adjustment, is shown in the statement of retained earnings as an adjustment to the balance of retained earnings at the beginning of the current year.
The amount of the adjustment is shown net of any related income tax effects.
To illustrate, assume that late in 2009 Salt Lake Corporation discovers that it failed to record
depreciation on certain assets in 2008. After considering the income tax effects of this error, the
company finds that the net income reported in 2008 was overstated by $35,000. Thus the beginning 2009 balance of the Retained Earnings account ($750,000 at December 31, 2008) also is
overstated by $35,000. The statement of retained earnings in 2009 must include a correction of
the retained earnings at the beginning of the year. (See the illustration in Exhibit 12-4.)
Exhibit 12-4
STATEMENT OF RETAINED
EARNINGS WITH PRIOR
PERIOD ADJUSTMENT
Prior period adjustments rarely appear in the financial statements of large, publicly owned
corporations. The financial statements of these corporations are audited annually by certified
public accountants and are not likely to contain material errors that subsequently will require
correction by prior period adjustments. Such adjustments are much more likely to appear in
the financial statements of closely held corporations that are not audited on an annual basis.
R e s t r i c t i o n s of R e t a i n e d E a r n i n g s Some portion of retained earnings may be
restricted because of various contractual agreements. A restriction of retained earnings prevents a company from declaring a dividend that would cause retained earnings to fall below
a designated level. Most companies disclose restrictions of retained earnings in notes accompanying the financial statements. For example, a company with total retained earnings of
$10 million might include the following note in its financial statements:
Note 7: Restriction of retained earnings
As of December 31, 2009, certain long-term debt agreements prohibited the declaration
of cash dividends that would reduce the amount of retained earnings below $5,200,000.
Retained earnings in excess of this restriction total $4,800,000.
COMPREHENSIVE INCOME
The Financial Accounting Standards Board (FASB) has identified certain changes in financial
position that should be recorded but should not enter into the determination of net income.
One way to describe these events is that they are recognized (that is, recorded and incorporated in the financial statements) but not realized (that is, not included in the determination of
Chapter 12 Income and Changes in Retained Earnings
the company's net income). We have studied one of these items earlier in this text—the change
in market value of available-for-sale debt and equity investments.
Recall from Chapter 7 the way changes in value for various types of investments are
recorded. Those investments identified as available for sale are revalued to their current market value at the end of each accounting period. These changes in value are accumulated and
reported in a separate stockholders' equity account. The change in value does not enter into the
determination of net income as it would had investments been sold. The change in market value
of available-for-sale investments adds to the amount of stockholders' equity if the value has
gone up; it reduces the amount of stockholders' equity if the value has gone down. This adjustment is described as an element of other comprehensive income.
Comprehensive income is a term that identifies the total of net income plus or minus the
elements of other comprehensive income. Comprehensive income may be displayed to users
of financial statements in any of the following ways:
• As a second income statement. One income statement displays the components of net
income and the other displays the components of comprehensive income, one element of
which is net income.
• As a single income statement that includes both the components of net income and the
components of other comprehensive income.
• As an element in the changes in stockholders' equity displayed as a column in the statement
of stockholders' equity (discussed later in this chapter).
In addition to the presentation of each year's changes in the elements of other comprehensive income, the accumulated amount of these changes is an element in the stockholders'
equity section of the balance sheet. The components of comprehensive income are presented
net of income tax, much like an extraordinary item.
Home Depot, Inc., whose financial statements for the year ended February 3, 2008, are
included in Appendix A of this text, follows the third of these alternatives and presents comprehensive income as a column in its Consolidated Statement of Stockholders' Equity and
Comprehensive Income. For each of the three years presented, the primary adjustments to
'Accumulated Other Comprehensive Income (Loss)" are gains from translation adjustments
related to the company's foreign operations. These are considered part of the company's overall income history, but are not part of its net income that is presented in the income statement.
The majority of publicly held companies present the elements of other comprehensive income
in a manner similar to Home Depot, Inc.
STATEMENT OF STOCKHOLDERS' EQUITY
Many coiporations expand their statement of retained earnings to show the changes during the
year in all of the stockholders' equity accounts. This expanded statement, called a statement
of stockholders' equity, is illustrated in Exhibit 12-5 for Salt Lake Corporation.
The top line of the statement includes the beginning balance of each major category of
stockholders' equity. Notice that the fourth column, Retained Earnings, includes the same
information as the statement of retained earnings for Salt Lake Corporation that was presented
in Exhibit 12-4. We have added several other stock transactions to illustrate the full range of
information you will typically find in a statement of stockholders' equity:
• Issuance of common stock for $260,000 (resulting in an increase in both common stock
and additional paid-in capital).
• Conversion of shares of preferred stock into common stock at $100,000, resulting in a
decrease in 5 percent convertible preferred stock and an increase in common stock and
additional paid-in capital.
• Purchase of $47,000 of treasury stock, increasing the amount of treasury stock and
decreasing the total of stockholders' equity (as discussed in Chapter 11).
STOCKHOLDERS' EQUITY SECTION OF THE BALANCE SHEET
The stockholders' equity section of Salt Lake Corporation's balance sheet for the year ended
December 31, 2009, is shown in Exhibit 12-6. Note that these figures are taken directly from
541
Other Transactions Affecting Retained Earnings
the last line of the statement of stockholders' equity as illustrated in Exhibit 12-5. You should
be able to explain the nature and origin of each account and disclosure printed in red as a
result of having studied this chapter.
The published financial statements of leading corporations indicate that there is no one
standard arrangement for the various items making up the stockholders' equity section. Variations occur in the selection of titles, in the sequence of items, and in the extent of detailed
classification. Many companies, in an effort to avoid excessive detail in the balance sheet,
combine several related ledger accounts into a single balance sheet item.
Exhibit 12-6
STOCKHOLDERS' EQUITY
SECTION OF BALANCE
SHEET
542
Chapter 12 Income and Changes in Retained Earnings
As discussed in this chapter, the most important aspect of
periodic reporting for many investors is the reporting of net
income. Investors often are attracted to companies that report
increasing income each year. As a result, overstating net
income is the most common objective for engaging in inappropriate financial reporting.
The Securities and
Exchange Commission
(SEC) brought a series of
enforcement actions against
Just for Feet, Inc., its former employees, and employees of former vendors related to the overstatement of Just for
Feet's reported income. Although Just for Feet overstated its
income through a number of different techniques, two prominent techniques used to overstate income related to fictitious
co-op revenue and fictitious "booth" income.
Just for Feet was a national retailer of athletic and outdoor
footwear and apparel. Just for Feet filed for bankruptcy protection, and it began the process of liquidating its assets and
settling its liabilities.
Just for Feet incurred large amounts of advertising
expenses. A vendor (e.g., Adidas, Fila, Nike) would often
reduce the amount that Just for Feet owed for merchandise
purchases if a particular advertisement featured the vendor's
products. These reductions in amounts owed were referred to
as "advertising co-op" or "vendor allowances." These vendor
allowances were unwritten and not guaranteed. Just for Feet
sent vendors copies of advertisements placed, and the vendor
determined whether to grant an advertising allowance.
In one fiscal year, Just for Feet recorded $19.4 million
in co-op receivables (and recognized revenue as a result of
recording the receivables) that was not earned. The fictitious
revenue of over $19 million was a substantial percentage of
Just for Feet's reported income of $43 million.
A marketing strategy employed by Just for Feet was the
concept of a "store within the store." A particular vendor would
install a "booth" in a Just for Feet store that sold its products.
For example, if a customer entered a Just for Feet store and
was interested in a Nike product, the customer could go to the
Nike booth where only Nike products were displayed. When
this marketing strategy was introduced, the vendor absorbed
the cost of purchasing and installing the booth., Just for Feet
was ostensibly buying the booths from vendors and receiving back from vendors reductions in the amounts owed for
merchandise purchases (merchandise credits). The net effect
of these transactions—which the SEC describes as "roundtrip" transactions—was that merchandise purchases would be
reduced because of the credits issued by vendors, and fixed
assets, the booths, were increased by a like amount. This had
the effect of overstating current period income.
In addition, Just for Feet was reducing advertising
expenses (this is how the booth income was recognized) and
reducing accounts payable based on projected purchases of
booths during the year. Vendors did not bill Just for Feet
for the booths it ostensibly purchased, so Just for Feet had
no support for the $9 million in booth income recognized
as a reduction of advertising expenses. Just for Feet's auditor confirmed with vendors the dollar amounts owed due to
purchases of booths (a confirmation of accounts payable).
In a number of instances, Just for Feet's management was
able to persuade representatives of the vendor to return false
confirmations.
One important facet of the Just for Feet fraud is that the
SEC has brought enforcement actions against a number of
vendor representatives for providing false confirmations to
Just for Feet's auditor. When fraud exists, management at the
company committing the fraud often tries to convince customers to falsely confirm to the auditors that they owe amounts
that are in fact not owed. Such behavior has always represented a crime. It is worth noting that the criminal penalties
for lying to external auditors have been substantially increased
under the Sarbanes-Oxley Act, and that the SEC and the U.S.
Justice Department are more likely to prosecute individuals
for this type of behavior than has been the case in the past.
Individuals in sales and marketing positions are often targets
for requests to falsely confirm facts to external auditors (i.e.,
to lie)—please be aware of the substantial civil and criminal
penalties that can result from lying to auditors.
Concluding Remarks
Concluding Remarks
We discussed various aspects of stockholders' equity, focusing first on paid-in capital in Chapter 11 and then on earned capital in Chapter 12. These discussions complete our detailed coverage of assets, liabilities, and stockholders' equity, which began in Chapter 7 and included
financial assets, inventories, plant and intangible assets, liabilities, and, finally, stockholders'
equity. While these chapters generally follow a balance sheet organization, in Chapter 12 we
also covered the income statement, including the presentation of irregular income items and
earnings per share.
In the next chapter, we turn our attention to the statement of cash flows. Recall that companies present three primary financial statements to their stockholders, creditors, and other interested parties—a balance sheet, an income statement, and a statement of cash flows. We leave
the detailed coverage of the statement of cash flows to the end because of the importance of
the material we have now covered, particularly in Chapters 7 to 12, for a full understanding
of that financial statement.
543
545
Demonstration Problem
date of record (p. 535) The date on which a person must be
listed as a shareholder to be eligible to receive a dividend. Follows
the date of declaration of a dividend by two or three weeks.
diluted earnings per share (p. 534) Earnings per share computed
under the assumption that all convertible securities were converted
into additional common shares at the beginning of the current year.
The purpose of this pro forma computation is to alert common
stockholders to the risk that future earnings per share might be
reduced by the conversion of other securities into common stock.
discontinued operations (p. 529) The net operating results
(revenue and expenses) of a segment of a company that has been
or is being sold, as well as the gain or loss on disposal.
earnings per share (p. 531) Net income applicable to the
common stock divided by the weighted-average number of
common shares outstanding during the year.
ex-dividend date (p. 535) A date three days prior to the
date of record specified in a dividend declaration. A person
buying a stock prior to the ex-dividend date also acquires the
right to receive the dividend. The three-day interval permits the
compilation of a list of stockholders as of the date of record.
extraordinary items (p. 529) Transactions and events that are
unusual in nature and occur infrequently—for example, most
large earthquake losses. Such items are shown separately in
the income statement after the determination of income before
extraordinary items.
price-earnings (p/e) ratio (p. 533) Market price of a share of
common stock divided by annual earnings per share.
prior period adjustment (p. 539) A correction of a material
error in the earnings reported in the financial statements of a
prior year. Prior period adjustments are recorded directly in the
Retained Earnings account and are not included in the income
statement of the current period.
restructuring charges (p. 530) Costs related to reorganizing
and downsizing the company to make the company more
efficient. These costs are presented in the income statement as a
single line item in determining operating income.
segment of the business (p. 529) Those elements of a business
that represent a separate and distinct line of business activity or
that service a distinct category of customers.
statement of retained earnings (p. 538) A financial statement
explaining the change during the year in the amount of retained
earnings. May be expanded into a statement of stockholders'
equity.
statement of stockholders' equity (p. 540) An expanded
version of a statement of retained earnings. Summarizes the
changes during the year in all stockholders' equity accounts. Not
a required financial statement, but widely used as a substitute for
the statement of retained earnings.
stock dividend (p. 536) A distribution of additional shares to
common stockholders in proportion to their holdings.
Demonstration Problem
Transactions affecting stockholders' equity during 2009 are as follows:
Mar. 31
A 5-for-4 stock split proposed by the board of directors was approved by vote of the
stockholders. The 10,000 new shares were distributed to stockholders.
Apr.
1
The company purchased 2,000 shares of its common stock on the open market
at $37 per share.
July
1
The company reissued 1,000 shares of treasury stock at $48 per share.
July
1
The company issued for cash 20,000 shares of previously unissued $8 par value
common stock at a price of $47 per share.
Dec.
1
A cash dividend of $1 per share was declared, payable on December 30, to stockholders of record at December 14.
Dec. 22
A 10 percent stock dividend was declared; the dividend shares are to be distributed on
January 15 of the following year. The market price of the stock on December 22 was
$48 per share.
Chapter 12 Income and Changes in Retained Earnings
The net income for the year ended December 31, 2009, amounted to $173,000, after an extraordinary loss of $47,400 (net of related income tax benefits).
Instructions
a.
Prepare journal entries (in general journal form) to record the transactions affecting stockholders' equity that took place during the year.
b. Prepare the lower section of the income statement for 2009, beginning with income before
extraordinary items and showing the extraordinary loss and the net income. Also illustrate the
presentation of earnings per share in the income statement, assuming that earnings per share is
determined on the basis of the weighted-average number of shares outstanding during the year.
Ò Prepare a statement of retained earnings for the year ending December 31, 2009.
Solution to the Demonstration Problem
a.
Self-Test Questions
547
—
Self-Test Questions
The answers to these questions appear on page 567.
1.
a.
Increase earnings per share.
b.
Assist users of the income statement in evaluating the
profitability of normal, ongoing operations.
Ò
Minimize the income taxes paid on the results of ongoing operations.
d.
2.
c.
Hamilton's accountant discovers that the entire price
paid several years ago to purchase company offices
in Texas had been charged to a Land account; consequently, no depreciation has ever been taken on these
buildings.
d.
As a result of labor union contract changes, Hamilton
paid increased compensation expense during the year.
The primary purpose of showing special types of events
separately in the income statement is to:
Prevent unusual losses from recurring.
Which of the following situations would not be presented in
a separate section of the current year's income statement of
Hamilton Corporation? During the current year:
a.
b.
Hamilton's Los Angeles headquarters are destroyed by
a tornado.
Hamilton sells its entire juvenile furniture operations
and concentrates on its remaining children's clothing
segment.
3.
When a corporation has outstanding both common and preferred stock:
a.
Basic and diluted earnings per share are reported only
if the preferred stock is cumulative.
b.
Earnings per share is reported for each type of stock
outstanding.
Ò
Earnings per share is computed without regard to the
amount of the annual preferred dividends.
d.
Earnings per share is computed without regard to the
amount of dividends declared on common stock.
548
4.
1.
2.
3.
4.
5.
6.
7.
8.
Chapter 12 Income and Changes in Retained Earnings
Which of the following is (are) not true about a stock dividend?
5.
The statement of retained earnings:
a.
Total stockholders' equity does not change when a stock
dividend is declared but does change when it is distributed.
a.
Includes prior period adjustments, cash dividends, and
stock dividends.
b.
Between the time a stock dividend is declared and
when it is distributed, the company's commitment is
presented in the balance sheet as a current liability.
b.
Indicates the amount of cash available for the payment
of dividends.
c.
Ò
Stock dividends do not change the relative portion of
the company owned by individual stockholders.
Need not be prepared if a separate statement of
stockholders' equity accompanies the financial
statements.
d.
Stock dividends have no impact on the amount of the
company's assets.
d.
Shows revenue, expenses, and dividends for the
accounting period.
What is the purpose of arranging an income statement to
show subtotals for income from continuing operations and
income before extraordinary items!
Frank's Fun Company owns 30 pizza parlors and a minor
league baseball team. During the current year, the company
sold three of its pizza parlors and closed another when the
lease on the building expired. Should any of these events
be classified as discontinued operations in the company's
income statement? Explain.
Define extraordinary items. How are extraordinary items
distinguished from items that are presented as separate line
items in an income statement, but are not extraordinary?
In an effort to make the company more competitive, FastGuard, Inc., incurred significant expenses related to a reduction in the number of employees, consolidation of offices
and facilities, and disposition of assets that are no longer
productive. Explain how these costs should be presented in
the financial statements of the company, and describe how
an investor should view these costs in predicting future
earnings of the company.
A prior period adjustment relates to the income of past
accounting periods. Explain how such an item is shown in
the financial statements.
In evaluating the potential future profitability of a company,
how would you consider irregular income items, such as
extraordinary items, discontinued operations, and prior
period adjustments?
Earnings per share and book value per share are statistics that relate to common stock. When both preferred and
common stock are outstanding, explain the computation
involved in determining the following:
a.
Earnings allocable to the common stockholders.
b.
Aggregate book value allocable to the common
stockholders.
Assume a corporation has only common stock outstanding.
Is the number of common shares used in the computation of
earnings per share always the same as the number of common shares used in computing book value per share for this
corporation? Is the number of common shares used in computing these two statistics ever the same? Explain.
9. Explain how each of the following is computed:
a.
Price-earnings ratio.
b.
Basic earnings per share.
c.
Diluted earnings per share.
10. Throughout the year, Baker Construction Company had
3 million shares of common stock and 150,000 shares of
convertible preferred stock outstanding. Each share of preferred is convertible into two shares of common. What number of shares should be used in the computation of (a) basic
earnings per share and (b) diluted earnings per share?
11. A financial analyst notes that Collier Corporation's earnings
per share have been rising steadily for the past five years.
The analyst expects the company's net income to continue
to increase at the same rate as in the past. In forecasting
future basic earnings per share, what special risk should the
analyst consider if Collier's basic earnings are significantly
larger than its diluted earnings?
12. Explain the significance of the following dates relating to
cash dividends: date of declaration, date of record, date of
payment, ex-dividend date.
13. What is the purpose of a stock dividend!
14. Distinguish between a stock split and a stock dividend. Is
there any reason for the difference in accounting treatment
of these two events?
15. What are restructuring charges? How are they presented in
financial statements?
16. Identify three items that may appear in a statement of retained
earnings as changes in the amount of retained earnings.
17. If a company's total stockholders' equity is unchanged by
the distribution of a stock dividend, how is it possible for
a stockholder who received shares in the distribution of the
dividend to benefit?
18. What is a liquidating dividend, and how does it relate to a
regular (nonliquidating) dividend?
19. In discussing stock dividends and stock splits in an investments class you are taking, one of the students says, "Stock
splits and stock dividends are exactly the same—both are
distributions of a company's stock to existing owners without
payment to the company." Do you agree? Why or why not?
20. A statement of stockholders' equity sometimes is described
as an "expanded" statement of retained earnings. Why?
Brief Exercises
549
Brief Exercises
Fellups, Inc., had net income for the year just ended of $75,000, without considering the following item or its tax effects. During the year, a tornado damaged one of the company's warehouses
and its contents. Tornado damage is quite rare in Fellups's location. The estimated amount of
the loss from the tornado is S100,000 and the related tax effect is 40 percent. Prepare the final
section of Fellups's income statement, beginning with income before extraordinary items.
Walker Company had total revenue and expense numbers of $1,500,000 and $1,200,000, respectively, in the current year. In addition, the company had a gain of $230,000 that resulted from the
passage of new legislation, which is considered unusual and infrequent for financial reporting
purposes. The gain is expected to be subject to a 35 percent income tax rate. Prepare an abbreviated
income statement for Walker for the year.
Wabash, Inc., had revenue and expenses from ongoing business operations for the current year
of $480,000 and $430,000, respectively. During the year, the company sold a division which had
revenue and expenses (not included in the previous figures) of $100,000 and $75,000, respectively.
The division was sold at a loss of $55,000. All items are subject to an income tax rate of 40 percent.
Prepare an abbreviated income statement for Wabash for the year.
Gannon, Inc., had 100,000 shares of common stock outstanding. During the current year, the company distributed a 10 percent stock dividend and subsequently paid a $.50 per share cash dividend.
Calculate the number of shares outstanding at the time of the cash dividend and the amount of cash
required to fund the cash dividend.
Messer Company had retained earnings at the beginning of the current year of $590,000. During
the year, the following activities occurred:
•
Net income of $88,000 was earned.
•
A cash dividend of $ 1.20 per share was declared and distributed on the 50,000 shares of common stock outstanding.
Prepare a statement of retained earnings for the year.
Salt & Pepper, Inc., had retained earnings at the beginning of the current year of $460,000. During
the year the company earned net income of $250,000 and declared dividends as follows:
•
$1 per share for the current-year dividend on the 10,000 shares of preferred stock
outstanding.
•
$1 per share for the dividend in arrears for one year on the 10,000 shares of preferred stock
outstanding.
•
$.50 per share for the current-year dividend on the 200,000 shares of common stock
outstanding.
In addition, the company discovered an overstatement in the prior year's net income of $65,000
and corrected that error in the current year. Prepare a statement of retained earnings for the year.
Gammon, Inc., declared dividends during the current year as follows:
•
The current year's cash dividend on the 6 percent, $100 par value preferred stock. 100,000
shares were outstanding at the time of the declaration.
•
A cash dividend of $.75 per share on the $10 par value common stock. 750,000 shares were
outstanding at the time of the declaration.
Prepare the general journal entries to record the declaration and payment of these dividends,
assuming the declaration is recorded directly to retained earnings.
550
Chapter 12 Income and Changes in Retained Earnings
WOW. Inc. declared a 5 percent stock dividend on its 500,000 shares of common stock. The $10
par value common stock was originally sold for $12 and was selling at $15 at the time the stock dividend was declared. Prepare the general journal entries to record and distribute the stock dividend.
Alexander, Inc., declared and distributed a 10 percent stock dividend on its 700,000 shares of
outstanding $5 par value common stock when the stock was selling for $12 per share. The outstanding shares had originally been sold at $8 per share. The balance in retained earnings before
the declaration of the stock dividend, but after the addition of the current year's net income, was
$995,000. Prepare the stockholders' section of Alexander's balance sheet to reflect these facts.
Crasher Company had net income in the current year of $500,000. In addition, the company had an
unrealized gain on its portfolio of available-for-sale investments of $20,000, net of related income
taxes. Assuming the company uses the two-income statement approach for presenting elements of
other comprehensive income to its investors and creditors, prepare the statement of comprehensive
income for the current year.
Exercises
Assume that when you were in high school you saved $1,000 to invest for your college education.
You purchased 200 shares of Smiley Incorporated, a small but profitable company. Over the three
years that you have owned the stock, the corporation's board of directors have taken the following
actions:
1.
Declared a 2-for-1 stock split.
2.
Declared a 20 percent stock dividend.
3.
Declared a 3-for-1 stock split.
The current price of the stock is $12 per share.
a.
Calculate the current number of shares and the market value of your investment.
b.
Explain the likely reason the board of directors of the company has not declared a cash dividend.
c.
State your opinion as to whether or not you would have been better off if the board of directors
had declared a cash dividend instead of the stock dividend and stock splits.
The following are 10 technical accounting terms introduced or emphasized in Chapters 11 and 12:
P/e ratio
Stock dividend
Basic earnings per share
Comprehensive income
Treasury stock
Extraordinary item
Additional paid-in capital
Discontinued operations
Prior period adjustment
Diluted earnings per share
Each of the following statements may (or may not) describe one of these technical terms. For
each statement, indicate the term described, or answer "None" if the statement does not correctly
describe any of the terms.
a.
A gain or loss that is unusual in nature and not expected to recur in the foreseeable future.
b.
The asset represented by shares of capital stock that have not yet been issued.
c.
A distribution of additional shares of stock that reduces retained earnings but causes no change
in total stockholders' equity.
d.
The amount received when stock is sold in excess of par value.
e.
An adjustment to the beginning balance of retained earnings to correct an error previously
made in the measurement of net income.
f.
A statistic expressing a relationship between the current market value of a share of common
stock and the underlying earnings per share.
g.
A separate section sometimes included in an income statement as a way to help investors
evaluate the profitability of ongoing business activities.
551
Exercises
h.
i.
A pro forma figure indicating what earnings per share would have been if all securities convertible into common stock had been converted at the beginning of the current year.
A broadly defined measure of financial performance that includes, but is not limited to, net
income.
During the current year, Sports +, Inc., operated two business segments: a chain of surf and dive
shops and a small chain of tennis shops. The tennis shops were not profitable and were sold near
year-end to another corporation. Sports + operations for the current year are summarized below.
The first two captions, "Net sales" and "Costs and expenses," relate only to the company's continuing operations.
Net sales
Costs and expenses (including applicable income tax)
Operating loss from tennis shops (net of income tax benefit)
Loss on sale of tennis shops (net of income tax benefit)
$12,500,000
8,600,000
192,000
348,000
The company had 182,000 shares of a single class of capital stock outstanding throughout the
year.
a. Prepare a condensed income statement for the year. At the bottom of the statement, show
any appropriate earnings per share figures. (A condensed income statement is illustrated in
Exhibit 12-2.)
b. Which earnings per share figure in part a do you consider most useful in predicting future
operating results for Sports +, Inc.? Why?
For the year ended December 31, Global Exports had net sales of $7,750,000, costs and other
expenses (including income tax) of $6,200,000, and an extraordinary gain (net of income tax) of
$420,000.
a. Prepare a condensed income statement (including earnings per share), assuming that 910,000
shares of common stock were outstanding throughout the year. (A condensed income statement is illustrated in Exhibit 12-2.)
b. Which earnings per share figure is used in computing the price-earnings ratio for Global
Exports reported in financial publications such as The Wall Street Journal1. Explain briefly.
The net income of Foster Furniture, Inc., amounted to $1,920,000 for the current year.
a. Compute the amount of earnings per share assuming that the shares of capital stock outstanding throughout the year consisted of:
1. 400,000 shares of $1 par value common stock and no preferred stock.
2. 100,000 shares of 8 percent, $100 par value preferred stock and 300,000 shares of $5 par
value common stock.
b. Is the earnings per share figure computed in part a(2) considered to be basic or diluted? Explain.
The 2008 annual report of Software City, Inc., included the following comparative summary of
earnings per share over the last three years:
Earnings per share
2008
2007
2006
$3.15
$2.40
$1.64
In 2009, Software City, Inc., declared and distributed a 100 percent stock dividend. Following
this stock dividend, the company reported earnings per share of $1.88 for 2009.
Chapter 12 Income and Changes in Retained Earnings
a.
Prepare a three-year schedule similar to the one above, but compare earnings per share during the years 2009, 2008, and 2007. (Hint: All per-share amounts in your schedule should be
based on the number of shares outstanding after the stock dividend.)
b.
In preparing your schedule, which figure (or figures) did you have to restate? Why? Explain
the logic behind your computation.
HiTech Manufacturing Company has 1,000,000 shares of $1 par value capital stock outstanding on
January 1. The following equity transactions occurred during the current year:
Apr. 30
Distributed additional shares of capital stock in a 2-for-l stock split. Market price of
stock was $35 per share.
June
1
Declared a cash dividend of 60 cents per share.
July
1
Paid the 60-cent cash dividend to stockholders.
Aug.
1
Declared a 5 percent stock dividend. Market price of stock was $19 per share.
Sept. 10
Issued shares resulting from the 5 percent stock dividend declared on August 1.
a.
Prepare journal entries to record the above transactions.
b.
Compute the number of shares of capital stock outstanding at year-end.
Ò
What is the par value per share of HiTech Manufacturing stock at the end of the year?
d.
Determine the effect of each of the following on total stockholders' equity: stock split, declaration and payment of a cash dividend, declaration and distribution of a stock dividend. (Your
answers should be either increase, decrease, or no effect.)
Express, Inc., has a total of 80,000 shares of common stock outstanding and no preferred stock.
Total stockholders' equity at the end of the current year amounts to $5 million and the market value
of the stock is $66 per share. At year-end, the company declares a 10 percent stock dividend—one
share for each 10 shares held. If all parties concerned clearly recognize the nature of the stock
dividend, what should you expect the market price per share of the common stock to be on the
ex-dividend date?
Five events pertaining to Lubbock Manufacturing Co. are described below.
a.
Declared and paid a cash dividend.
b.
Issued a 10 percent stock dividend.
Ò
Issued a 2-for-l stock split.
d.
Purchased treasury stock.
e.
Reissued the treasury stock at a price greater than the purchase price.
Indicate the immediate effects of the events on the financial measurements in the four columnar
headings listed below. Use the code letters I for increase, D for decrease, and NE for no effect.
Explain the immediate effects, if any, of each of the following transactions on a company's earnings per share:
a.
Split the common stock 3-for-l.
b.
Realized a gain from the sale of a discontinued operation.
c.
Declared and paid a cash dividend on common stock.
d.
Declared and distributed a stock dividend on common stock.
e.
Acquired several thousand shares of treasury stock.
Exercises
553
You have now learned about the following financial statements issued by corporations: balance
sheet, income statement, statement of retained earnings, statement of stockholders' equity, and
statement of cash flows. Listed below are various items frequently of interest to a corporation's
owners, potential investors, and creditors, among others. You are to specify which of the above corporate financial statements, if any, reports the desired information. If the listed item is not reported
in any formal financial statement issued by a corporation, indicate an appropriate source for the
desired information.
a.
b.
Number of shares of stock outstanding as of year-end.
Total dollar amount of cash dividends declared during the current year.
c.
d.
Market value per share at balance sheet date.
Cumulative dollar effect of an accounting error made in a previous year.
e.
Detailed disclosure of why the number of shares of stock outstanding at the end of the current year is greater than the number of shares of stock outstanding at the end of the prior
year.
f.
g.
Earnings per share of common stock.
Book value per share.
h. Price-earnings (p/e) ratio.
i. The total amount the corporation paid to buy back shares of its own stock, which it now
holds.
Minor, Inc., had revenue of $572,000 and expenses (other than income taxes) of $282,000 for the
current year. The company is subject to a 35 percent income tax rate. In addition, available-for-sale
investments, which were purchased for $17,500 early in the year, had a market value at the end of
the year of $19,200.
a. Determine the amount of Minor's net income for the year.
b. Determine the amount of Minor's comprehensive income for the year.
Ò
How would your answers to parts a and b differ if the market value of Minor's investments at
the end of the year had been $14,200?
Kosmier Company has outstanding 500,000 shares of $50 par value common stock that originally
sold for $60 per share. During the three most recent years, the company carried out the following
activities in the order presented: declared and distributed a 10 percent stock dividend, declared and
paid a cash dividend of $1 per share, declared and distributed a 2-for-l stock split, and declared
and paid a $.60 per share cash dividend.
a.
b.
Ò
Determine the number of shares of stock outstanding after the four transactions described
above.
Determine the amount of cash that the company paid in the four transactions described
above.
If you were a stockholder who held 100 shares of stock that you purchased four years ago
when the market value of the shares was $65, how many shares would you own after the four
transactions described above? If the market value of the stock was $40 after the four transactions, would you be better or worse off than before the four transactions?
Home Depot, Inc.'s income statements for 2005, 2006, and 2007 show basic earnings per share
of $2.73, $2.80, and $2.38, respectively. Diluted earnings per share figures are slightly lower than
these numbers, indicating the impact of potential capital stock activity that could reduce earnings
per share for current stockholders.
The company paid cash dividends of $.40, $.675, and $.90 per share in 2005, 2006, and 2007,
respectively.
a. Why do you think Home Depot is paying out only about 15 percent to 38 percent of its net
income to stockholders in the form of cash dividends?
b.
If you were an investor in Home Depot's stock, would you be unhappy because your dividends represented such a small percentage of the company's net income?
554
Chapter 12 Income and Changes in Retained Earnings
Use the financial statements of Home Depot, Inc., in Appendix A of this text to answer these
questions:
a.
Study the income statements of Home Depot, Inc., for the three years ending on or about
February 1, 2008, 2007, and 2006. Do these statements include any irregular items that might
affect your use of the information to project future earnings?
b.
Review the stockholders' equity section of the company's balance sheet at January 29, 2008.
What type of capital stock is in the capital structure, and how many shares are authorized,
issued, and outstanding, and held in treasury on that date?
Ò
Locate the statement of stockholders' equity and comprehensive income. What treasury stock
transactions has Home Depot engaged in during the three-year period presented? Has any
additional stock (other than treasury stock) been issued during the period reported? If so, what
were the circumstances in which that stock was issued?
Problem Set A
Atlantic Airlines operated both an airline and several motels located near airports. During the
year just ended, all motel operations were discontinued and the following operating results were
reported:
Continuing operations (airline):
Net sales
Costs and expenses (including income taxes on continuing operations) . . . .
$55,120,000
43,320,000
Other data:
Operating income from motels (net of income tax)
864,000
Gain on sale of motels (net of income tax)
4,956,000
Extraordinary loss (net of income tax benefit)
3,360,000
The extraordinary loss resulted from the destruction of an airliner by an earthquake. Atlantic Airlines had 1,000,000 shares of capital stock outstanding throughout the year.
Instructions
a.
Prepare a condensed income statement, including proper presentation of the discontinued motel operations and the extraordinary loss. Include all appropriate earnings per share
figures.
b.
Assume that you expect the profitability of Atlantic Airlines operations to decline by 5 percent
next year, and the profitability of the motels to decline by 10 percent. What is your estimate of
the company's net earnings per share next year?
The following data relate to the operations of Slick Software, Inc., during 2009.
Continuing operations:
Net sales
Costs and expenses (including applicable income tax)
$19,850,000
16,900,000
Other data:
Operating income during 2009 on segment of the business
discontinued near year-end (net of income tax)
140,000
Loss on disposal of discontinued segment (net of income
tax benefit)
550,000
Extraordinary loss (net of income tax benefit)
900,000
Prior period adjustment (increase in 2008 depreciation
expense, net of income tax benefit)
350,000
Cash dividends declared
950,000
Problem Set A
555
Instructions
a.
Prepare a condensed income statement for 2009, including earnings per share figures. Slick
Software, Inc., had 200,000 shares of Si par value common stock and 80,000 shares of $6.25,
$100 par value preferred stock outstanding throughout the year.
b.
Prepare a statement of retained earnings for the year ended December 31, 2009. As originally
reported, retained earnings at December 31, 2008, amounted to $7,285,000.
Ò
Compute the amount of cash dividend per share of common stock declared by the board of
directors for 2009. Assume no dividends in arrears on the preferred stock.
d.
Assume that 2010 earnings per share is a single figure and amounts to $8.00. Assume also that
there are no changes in outstanding common or preferred stock in 2010. Do you consider the
$8.00 earnings per share figure in 2010 to be a favorable or unfavorable statistic in comparison with 2009 performance? Explain.
The income statement below was prepared by a new and inexperienced employee in the accounting
department of Phoenix, Inc., a business organized as a corporation.
Instructions
a.
Prepare a corrected income statement for the year ended December 31, 2009, using the format
illustrated in Exhibit 12-2. Include at the bottom of your income statement all appropriate
earnings-per-share figures. Assume that throughout the year the company had outstanding a
weighted average of 180,000 shares of a single class of capital stock.
b.
Prepare a statement of retained earnings for 2009. (As originally reported, retained earnings at
December 31, 2008, amounted to $2,175,000.)
c.
What does the $62,000 "gain on sale of treasury stock" represent? How would you report this
item in Phoenix's financial statements at December 31, 2009?
Chapter 12 Income and Changes in Retained Earnings
At the beginning of the year, Albers, Inc., has total stockholders' equity of $840,000 and 40,000
outstanding shares of a single class of capital stock. During the year, the corporation completes the
following transactions affecting its stockholders' equity accounts:
Jan. 10
A 5 percent stock dividend is declared and distributed. (Market price, $20 per share.)
Mar. 15
The corporation acquires 2,000 shares of its own capital stock at a cost of $21.00 per
share.
May 30
All 2,000 shares of the treasury stock are reissued at a price of $31.50 per share.
July 31
The capital stock is split 2-for-l.
Dec. 15
The board of directors declares a cash dividend of $1.10 per share, payable on
January 15.
Dec. 31
Net income of $525,000 is reported for the year ended December 31.
Instructions
Compute the amount of total stockholders' equity, the number of shares of capital stock outstanding, and the book value per share following each successive transaction. Organize your solution
as a three-column schedule with these separate column headings: (1) Total Stockholders' Equity,
(2) Number of Shares Outstanding, and (3) Book Value per Share.
PROBLEM 12.5A
Preparing a
Statement of
Stockholders' Equity
A summary of the transactions affecting the stockholders' equity of Strait Corporation during the
current year follows:
Prior period adjustment (net of income tax benefit)
Issuance of common stock: 10,000 shares of $10 par value
capital stock at $34 per share
Declaration and distribution of 5% stock dividend (6,000 shares,
market price $36 per share)
Purchased 1,000 shares of treasury stock at $35
Reissued 500 shares of treasury stock at a price of $36 per share
Net income
Cash dividends declared
$ (80,000)
340,000
(216,000)
(35,000)
18,000
845,000
(142,700)
Note: Parentheses ( ) indicate a reduction in stockholders' equity.
Instructions
a.
Prepare a statement of stockholders' equity for the year. Use these column headings and beginning balances. (Notice that all additional paid-in capital accounts are combined into a single
column.)
b.
What was the overall effect on total stockholders' equity of the 5 percent stock dividend
of 6,000 shares? What was the overall effect on total stockholders' equity of the cash dividends declared? Do these two events have the same impact on stockholders' equity? Why
or why not?
Problem Set A
557
At the beginning of 2009, Thompson Service, Inc., showed the following amounts in the stockholders' equity section of its balance sheet:
The transactions relating to stockholders' equity during the year are as follows:
Jan.
3
Declared a dividend of $1 per share to stockholders of record on January 31, payable
on February 15.
Feb. 15
Paid the cash dividend declared on January 3.
Apr. 12
The corporation purchased 6,000 shares of its own capital stock at a price of $40 per
share.
May
9
Reissued 4,000 shares of the treasury stock at a price of $44 per share.
June 1
Declared a 5 percent stock dividend to stockholders of record at June 15, to be
distributed on June 30. The market price of the stock at June 1 was $42 per share.
(The 2,000 shares remaining in the treasury do not participate in the stock dividend.)
June 30
Distributed the stock dividend declared on June 1.
Aug.
Reissued 600 of the 2,000 remaining shares of treasury stock at a price of $37 per
share.
4
Dec. 31
The Income Summary account, showing net income for the year of $1,928,000, was
closed into the Retained Earnings account.
Dec. 31
The $382,000 balance in the Dividends account was closed into the Retained Earnings
account.
Instructions
a.
Prepare in general journal form the entries to record the above transactions.
b.
Prepare the stockholders' equity section of the balance sheet at December 31, 2009. Use the
format illustrated in Exhibit 12-6. Include a supporting schedule showing your computation
of retained earnings at that date.
Ò
Compute the maximum cash dividend per share that legally could be declared at December
31. 2009, without impairing the paid-in capital of Thompson Service. (Hint: The availability
of retained earnings for dividends is restricted by the cost of treasury stock owned.)
Tech Process, Inc., manufactures a variety of computer peripherals, such as tape drives and printers. Listed below are five events that occurred during the current year.
1.
Declared a $1.00 per share cash dividend.
2.
Paid the cash dividend.
3.
Purchased 1,000 shares of treasury stock for $20.00 per share.
4.
Reissued 500 shares of the treasury stock at a price of $ 18.00 per share.
5.
Declared a 15 percent stock dividend.
Instructions
a.
Indicate the effects of each of these events on the financial measurements listed in the four
columnar headings listed below. Use the following code letters: I for increase, D for decrease,
and NE for no effect
558
Chapter 12 Income and Changes in Retained Earnings
Event
Current
Assets
Stockholders'
Equity
Net
Income
Net Cash Flow
(from any
source)
b. For each event, explain the reasoning behind your answers. Be prepared to explain this reasoning in class.
The Mandella family decided early in 2008 to incorporate their family-owned vineyards under the
name Mandella Corporation. The corporation was authorized to issue 500,000 shares of a single
class of $10 par value capital stock. Presented below is the information necessary to prepare the
stockholders' equity section of the company's balance sheet at the end of 2008 and at the end of
2009.
2008. In January the corporation issued to members of the Mandella family 150,000 shares
of capital stock in exchange for cash and other assets used in the operation of the vineyards.
The fair market value of these assets indicated an issue price of $30 per share. In December,
Joe Mandella died, and the corporation purchased 10,000 shares of its own capital stock from
his estate at $34 per share. Because of the large cash outlay to acquire this treasury stock, the
directors decided not to declare cash dividends in 2008 and instead declared a 10 percent stock
dividend to be distributed in January 2009. The stock price at the declaration date was $35 per
share. (The treasury shares do not participate in the stock dividend.) Net income for 2008 was
$940,000.
2009. In January the corporation distributed the stock dividend declared in 2008, and in February, the 10,000 treasury shares were sold to Maria Mandella at $39 per share. In June, the capital
stock was split 2-for-l. (Approval was obtained to increase the authorized number of shares to
1 million.) On December 15, the directors declared a cash dividend of $2 per shave, payable in
January 2010. Net income for 2009 was $1,080,000.
Instructions
Using the format illustrated in Exhibit 12-6, prepare the stockholders' equity section of the balance sheet at:
a. December 31, 2008.
b. December 31, 2009.
Show any necessary computations in supporting schedules.
The following information is excerpted from the financial statements in a recent annual report of
Esper Corporation. (Dollar figures and shares of stock are in thousands.)
Extraordinary toss on extinguishment of debt
Loss from continuing operations
Income from discontinued operations
Preferred stock dividend requirements
Weighted-average number of shares of common stock outstanding
$ (8,490)
$(16,026)
$ 6,215
$ (2,778)
39,739
Instructions
a.
b.
Rearrange the items to present in good form the last portion of the income statement for Esper
Corporation, beginning with "Loss from continuing operations."
Calculate the amount of net loss per share for the period. (Do not calculate per-share amounts
for subtotals, such as income from continuing operations, loss before extraordinary items, etc.
You are required to compute only a single earnings per share amount.)
Problem Set ¬
559
Problem Set ¬
Pacific Airlines operated both an airline and several rental car operations located near airports.
During the year just ended, all rental car operations were discontinued and the following operating
results were reported:
Continuing operations (airline):
Net sales
Costs and expenses (including income taxes on continuing operations) . . . .
Other data:
Operating income from car rentals (net of income tax)
Gain on sale of rental car business (net of income tax)
Extraordinary loss (net of income tax benefit)
$61,440,000
53,980,000
670,000
4,330,000
3.120,000
The extraordinary loss resulted from the destruction of an airliner by terrorists. Pacific Airlines had
4,000,000 shares of capital stock outstanding throughout the year.
Instructions
a.
Prepare a condensed income statement, including proper presentation of the discontinued
rental car operations and the extraordinary loss. Include all appropriate earnings per share
figures.
b.
Assume that you expect the profitability of Pacific's airline operations to decline by 10percent
next year and the profitability of the rental car operation to decline by 10 percent. What is your
estimate of the company's net earnings per share next year?
Shown below are data relating to the operations of Beach, Inc., during 2009.
Continuing operations:
Net sales
Costs and expenses (including applicable income taxes)
Other data:
Operating income during 2009 on segment of the business
discontinued near year-end (net of income taxes)
Loss on disposal of discontinued segment (net of income
tax benefit)
Extraordinary loss (net of income tax benefit)
Pnor period adjustment (increase in 2008 amortization
expense, net of income tax benefit)
Cash dividends declared
$37,400,000
21,500,000
205,000
510,000
930,000
310,000
2,000,000
Instructions
a.
Prepare a condensed income statement for 2009, including earnings per share statistics. Beach,
Inc., had 200,000 shares of $1 par value common stock and 100,000 shares of $6, $100 par
value preferred stock outstanding throughout the year.
b.
Prepare a statement of retained earnings for the year ended December 31, 2009. As originally
reported, retained earnings at December 31, 2008, amounted to $10,700,000.
c.
Compute the amount of cash dividend per share of common stock declared by the board of
directors for 2009. Assume no dividends in arrears on the preferred stock.
560
Chapter 12 Income and Changes in Retained Earnings
d.
Assume that 2010 earnings per share is a single figure and amounts to $75. Assume also that
there are no changes in outstanding common or preferred stock in 2010. Do you consider the
$75 earnings per share figure in 2010 to be a favorable or unfavorable statistic in comparison
with 2009 performance? Explain.
The income statement below was prepared by a new and inexperienced employee in the accounting
department of Dexter, Inc., a business organized as a corporation:
Instructions
a.
Prepare a corrected income statement for the year ended December 31, 2009, using the format
illustrated in Exhibit 12-2. Include at the bottom of your income statement all appropriate
earnings per share figures. Assume that throughout the year the company had outstanding a
weighted average of 500,000 shares of a single class of capital stock.
b.
Prepare a statement of retained earnings for 2009. (As originally reported, retained earnings at
December 31, 2008, amount to $3,200,000.)
Ò
What does the $56,000 "Gain on sale of treasury stock" represent? How would you report this
item in Dexter's financial statements at December 31, 2009?
At the beginning of the year, Jessel, Inc., has total stockholders' equity of $600,000 and 20,000
outstanding shares of a single class of capital stock. During the year, the corporation completes the
following transactions affecting its stockholders' equity accounts:
Jan. 16
A 5 percent stock dividend is declared and distributed. (Market price, $50 per share.)
Feb. 9
The corporation acquires 300 shares of its own capital stock at a cost of $55 per share.
Mar. 3
All 300 shares of the treasury stock are reissued at a price of $65 per share.
Jul.
5
The capital stock is split 2-for-1.
Nov. 22
The board of directors declares a cash dividend of $6 per share, payable on January 22.
Dec. 31
Net income of $87,000 is reported for the year ended December 31.
Problem Set ¬
561
Instructions
Compute the amount of total stockholders' equity, the number of shares of capital stock outstanding, and the book value per share following each successive transaction. Organize your solution as
a three-column schedule with these separate column headings: (1) "Total Stockholders' Equity,"
(2) "Number of Shares Outstanding," and (3) "Book Value per Share."
The following is a summary of the transactions affecting the stockholders' equity of Dry Wall, Inc..
during the current year:
Prior period adjustment (net of income tax benefit)
$ (47,000)
Issuance of common stock: 20,000 shares of $1 par value
capital stock at $15 per share
300,000
Declaration and distribution of 10% stock dividend (15,000 shares,
market price $17 per share)
255,000*
Purchased 3,000 shares of treasury stock at $16
(48,000)
Reissued 1,000 shares of treasury stock at a price of $18 per share
Net income
Cash dividends declared ($1 per share)
18,000
1,200,000
(163,000)
Note: Parentheses { ) indicate a reduction in stockholders' equity. Asterisk * indicates no change in total shareholders' equity.
Instructions
a.
Prepare a statement of stockholders' equity for the year. Use the column headings and beginning balances shown below. (Notice that all additional paid-in capital accounts are combined
into a single column.)
b.
What was the overall effect on total stockholders' equity of the 10 percent stock dividend
of 15,000 shares? What was the overall effect on total stockholders' equity of the cash dividends declared? Do these two events have the same impact on stockholders' equity? Why or
why not?
At the beginning of 2009, Greene, Inc., showed the following amounts in the stockholders' equity
section of its balance sheet:
562
Chapter 12 Income and Changes in Retained Earnings
The transactions relating to stockholders' equity during the year are as follows:
Jan.
5
Declared a dividend of $1 per share to stockholders of record on January 31, payable
on February 18.
Feb. 18
Paid the cash dividend declared on January 5.
Apr. 20
The corporation purchased 1,000 shares of its own capital stock at a price of $ 10 per
share.
May 25
Reissued 500 shares of the treasury stock at a price of $12 per share.
June 15
Declared a 5 percent stock dividend to stockholders of record at June 22, to be distributed on June 30. The market price of the stock at June 15 was $11 per share.
(The 500 shares remaining in the treasury do not participate in the stock dividend.)
June 30
Distributed the stock dividend declared on June 15.
Aug. 12
Reissued 300 of the 500 remaining shares of treasury stock at a price of $9.75 per
share.
Dec. 31
The Income Summary account, showing net income for the year of $1,750,000, was
closed into the Retained Earnings account.
Dec. 31
The $560,000 balance in the Dividends account was closed into the Retained Earnings
account.
Instructions
a.
Prepare in general journal form the entries to record the above transactions.
b.
Prepare the stockholders' equity section of the balance sheet at December 31, 2009. Use the
format illustrated in Exhibit 12-6. Include a supporting schedule showing your computation
of retained earnings at that date.
Ò
Compute the maximum cash dividend per share that legally could be declared at December 31, 2009, without impairing the paid-in capital of Greene, Inc. (Hint: The availability of
retained earnings for dividends is restricted by the cost of treasury stock owned.)
Hot Water, Inc., manufactures a variety of dry cleaning equipment. Listed below are five events
that occurred during the current year:
1.
Declared a $5 per share cash dividend.
2.
Paid the cash dividend.
3.
Purchased 1,000 shares of treasury stock for $37 per share.
4.
Reissued 600 shares of the treasury stock at a price of $36 per share.
5.
Declared a 5 percent stock dividend.
Instructions
a.
Indicate the effects of each of these events on the financial measurements listed in the four
column headings listed below. Use the following code letters: I for increase, D for decrease,
and NE for no effect.
b.
For each event, explain the reasoning behind your answers. Be prepared to explain this reasoning in class.
The Adams family decided early in 2008 to incorporate their family-owned farm under the
name Adams Corporation. The corporation was authorized to issue 100,000 shares of a single
class of $1 par value capital stock. Presented below is the information necessary to prepare the
stockholders' equity section of the company's balance sheet at the end of 2008 and at the end
of 2009.
Critical Thinking Cases
563
2008. In January the corporation issued to members of the Adams family 20,000 shares of capita] stock in exchange for cash and other assets used in the operation of the farm. The fair market
value of these assets indicated an issue price of $25 per share. In December, George Adams died
and the corporation purchased 4,000 shares of its own capital stock from his estate at $30 per
share. Because of the large cash outlay to acquire this treasury stock, the directors decided not to
declare cash dividends in 2008 and instead declared a 10 percent stock dividend to be distributed
in January 2009. The stock price at the declaration date was $31 per share. (The treasury shares do
not participate in the stock dividend.) Net income for 2008 was $850,000.
2009. In January the corporation distributed the stock dividend declared in 2008, and in February,
the 4,000 treasury shares were sold to Joan Adams at $35 per share. In June, the capital stock was
split 2-for-l. (Approval was obtained to increase the authorized number of shares to 200,000.) On
December 11, the directors declared a cash dividend of $1 per share, payable in January 2010. Net
income for 2009 was $810,000.
Instructions
Using the format illustrated in Exhibit 12-6, prepare the stockholders' equity section of the balance sheet at:
a.
December 31, 2008.
b. December 31, 2009.
Show any necessary computations in supporting schedules.
The following information is excerpted from the financial statements in a recent annual report of
Blue Jay Manufacturing Corporation. (Dollar figures and shares of stock are in thousands.)
Extraordinary loss on extinguishment of debt
Loss from continuing operations
Income from discontinued operations
Preferred stock dividend requirements
Weighted-average number of shares of common stock outstanding
$ (8,750)
(19,470)
12,000
(3,100)
10,000
Instructions
a.
Rearrange the items to present in good form the last portion of the income statement for Blue
Jay Manufacturing Corporation, beginning with "Loss from continuing operations."
b.
Calculate the amount of net loss per share for the period. (Do not calculate per-share amounts
for subtotals, such as income from continuing operations, loss before extraordinary items, and
so forth. You are required to compute only a single earnings per share amount.)
Critical Thinking Cases
The following events were reported in the financial statements of large, publicly owned
corporations:
a. Atlantic Richfield Company (ARCO) sold or abandoned the entire noncoal minerals segment of its operations. In the year of disposal, this segment had an operating loss. ARCO also
incurred a loss of $514 million on disposal of its noncoal minerals segment of the business.
b.
American Airlines increased the estimated useful life used in computing depreciation on
its aircraft. If the new estimated life had always been in use, the net income reported in prior
years would have been substantially higher.
Ò
Union Carbide Corp. sustained a large loss as a result of the explosion of a chemical plant.
d. Georgia-Pacific Corporation realized a $ 10 million gain as a result of condemnation proceedings in which a governmental agency purchased assets from the company in a "forced sale."
Instructions
Indicate whether each event should be classified as a discontinued operation, or an extraordinary
item, or included among the revenue and expenses of normal and recurring business operations.
Briefly explain your reasons for each answer.
Chapter 12 Income and Changes in Retained Earnings
Jackson Publishing, Inc. (JPI), publishes two newspapers and, until recently, owned a professional
baseball team. The baseball team had been losing money for several years and was sold at the end
of 2009 to a group of investors who plan to move it to a larger city. Also in 2009, JPI suffered an
extraordinary loss when its Raytown printing plant was damaged by a tornado. The damage has
since been repaired. A condensed income statement follows:
Instructions
On the basis of this information, answer the following questions. Show any necessary computations and explain your reasoning.
a.
What would JPI's net income have been for 2009 if it had not sold the baseball team?
b.
Assume that for 2010 you expect a 7 percent increase in the profitability of JPI's newspaper
business but had projected a $2,000,000 operating loss for the baseball team if JPI had continued to operate the team in 2010. What amount would you forecast as JPI's 2010 net income if
the company had continued to own and operate the baseball team!
Ò
Given your assumptions in part b, but given that JPI did sell the baseball team in 2009, what
would you forecast as the company's estimated net income for 2010?
d.
Assume that the expenses of operating the baseball team in 2009 amounted to $32,200,000,
net of any related income tax effects. What was the team's net revenue for the year?
For many years New York Studios has produced television shows and operated several FM radio
stations. Late in the current year, the radio stations were sold to Times Publishing, Inc. Also during the current year, New York Studios sustained an extraordinary loss when one of its camera
trucks caused an accident in an international grand prix auto race. Throughout the current year, the
company had 3 million shares of common stock and a large quantity of convertible preferred stock
outstanding. Earnings per share reported for the current year were as follows:
Basic
Diluted
Earnings from continuing operations
$8.20
$6.80
Earnings before extraordinary items
$6.90
$5.50
Net earnings
$3.60
$2.20
Instructions
a.
Briefly explain why New York Studios reports diluted earnings per share amounts as well as
basic earnings per share. What is the purpose of showing investors the diluted figures?
b.
What was the total dollar amount of the extraordinary loss sustained by New York Studios
during the current year?
Critical Thinking Cases
565
c.
Assume that the price-earnings ratio shown in the morning newspaper for New York Studios's
common stock indicates that the stock is selling at a price equal to 10 times the reported earnings per share. What is the approximate market price of the stock?
d.
Assume that you expect both the revenue and expenses involved in producing television shows
to increase by 10 percent during the coming year. What would you forecast as the company's
basic earnings per share for the coming year under each of the following independent assumptions? (Show your computations and explain your reasoning.)
1.
None of the convertible preferred stock is converted into common stock during the coming year.
2.
All of the convertible preferred stock is converted into common stock at the beginning of
the coming year.
The following information has been excerpted from the statement of stockholders' equity included
in a recent annual report of Thompson Supply Company. (Dollar figures are in millions.)
Instructions
Use the information about Thompson Supply to answer the following questions.
a.
How many shares of common stock are outstanding at the beginning of the year? At the end of
the year?
b.
What was the total common stock dividend declared during the presented year? Thompson's
annual report disclosed that the common stock dividend during that year was $1.23 per share.
Approximately how many shares of common stock were entitled to the $ 1.23 per share dividend during the year? Is this answer compatible with your answers in part a?
Ò
The statement presented indicates that common stock was both issued and repurchased during
the year, yet the number of common shares shown and the common stock amount (first and
second columns) did not change from the beginning to the end of the year. Explain.
d.
What was the average price per share Thompson paid to acquire the treasury shares held at the
beginning of the year?
e.
Was the aggregate issue price of the 601,300 treasury shares issued during the year for stock
option plans higher or lower than the cost Thompson paid to acquire those treasury shares?
(Hint: Analyze the impact on Additional Paid-in Capital.)
f.
What was the average purchase price per share paid by Thompson to acquire treasury shares
during the current year?
g.
In its annual report, Thompson disclosed that the (weighted) average number of common
shares outstanding during the year was 77,500,000. In part a above, you determined the number of common shares outstanding as of the end of the year. Which figure is used in computing
earnings per share? Which is used in computing book value per share?
566
Chapter 12 Income and Changes in Retained Earnings
Elliot-Cole is a publicly owned international corporation, with operations in over 90 countries. Net
income has been growing at approximately 15 percent per year, and the stock consistently trades
at about 20 times earnings.
To attract and retain key management leadership, the company has developed a compensation
plan in which managers receive earnings in the form of bonuses as well as opportunities to purchase shares of the company's stock at a reduced price. In general, the higher the company's net
income each year, the greater the benefit to management in terms of their personal compensation.
During the current year, political unrest and economic upheaval threatened Elliot-Cole's business operations in three foreign countries. At year-end, the company's auditors insisted that management write off the company's assets in these countries, stating that these assets were "severely
impaired." Said one corporate official, "We can't argue with that. Each of these countries is a real
trouble spot. We might be pulling out of these places at any time, and any assets probably would
just be left behind."
Management agreed that the carrying value of Elliot-Cole's assets in these three countries should
be reduced to "scrap value"—which was nothing. These write-downs amounted to approximately
18 percent of the company's income prior to recognition of these losses. (These write-offs are for
financial reporting purposes only; they have no effect on the company's income tax obligations.)
At the meeting with the auditors, one of Elliot-Cole's officers states, "There's no doubt we
should write these assets off. But of course, this is an extraordinary loss. A loss of this size can't be
considered a routine matter."
Instructions
a.
Explain the logic behind writing down the book values of assets that are still in operation.
b.
Evaluate the officer's statement concerning the classification of these losses. Do you agree
that they should be classified as an extraordinary item? Explain.
c.
Explain the effect that the classification of these losses—that is, as ordinary or extraordinary—will have in the current period on Elliot-Cole's:
1.
Net income.
2.
Income before extraordinary items.
3.
Income from continuing operations.
4.
Net cash flow from operating activities.
d.
Explain how the classification of these losses will affect the p/e ratio reported in newspapers
such as The Wall Street Journal.
e.
Does management appear to have any self-interest in the classification of these losses?
Explain.
f.
Explain how (if at all) these write-offs are likely to affect the earnings of future periods.
g.
What "ethical dilemma" confronts management in this case?
You are a staff accountant for Pearce, Pearce, and Smith, CPAs, and have worked for several years on
the audit of a major client of the firm, Flexcom, Inc. Flexcom sells its products in a highly competitive market and relies heavily on the careful management of inventory because of the unique nature of
the products sold and the importance of minimizing the company's investment in inventory. Flexcom
sells cellular phones, personal handheld computers, and other communications devices that are particularly sensitive to changes in consumer demands and changes in technology, which are both frequent and significant in terms of their impact on the attractiveness of Flexcom's products to buyers.
In the course of your work, you have noticed several trends related to inventory that interest you
and that have caused you to explore further the underlying details. Specifically, you have determined the following:
•
Despite sluggish sales volume, the company's net income has steadily increased for each of
the last three years.
•
Inventory has been increasing at a higher-than-normal rate.
•
The allowance to reduce inventory for obsolescence has dramatically declined during the
last three years, going from nearly 10 percent of inventory three years ago to approximately
2 percent at the end of the most recent year.
Critical Thinking Cases
567
You are aware that, within Flexcom, profitability is a major factor in the evaluation of management
and has been cited in at least two recent situations as the basis for replacing individuals in leadership
positions.
Instructions
Prepare a brief report to your supervisor explaining why you are bothered by these trends and offer
one or more explanations that may underlie what is actually going on within Flexcom.
David Henry, in a BusinessWeek article entitled "Ouch! Real Numbers," indicates that new accounting rules will deflate earnings hype and, perhaps, stocks. He describes tighter accounting rules that
will reveal a lower level of normal earnings.
Henry goes on to say that extraordinary items were once just that—extraordinary. In recent
years, however, they have become much too common, with large adjustments taken for certain
"special one-time items," such as layoffs, inventory write-downs, acquisitions (of other companies), and so on.
Instructions
Why do you think there has been an increase in the frequency of "special items" in the income
statements of major U.S. corporations? Is it important for different companies to treat these special
items in the same way? Why or why not?
Important information concerning a company's operating performance can be found in its income
statement and statement of financial position (balance sheet). Using the search mechanism of your
choice, locate the most recent annual report of Martin Marietta Materials, Inc. and respond to
the following.
Instructions
a.
For the most recent day indicated, what were the highest and lowest prices at which the company's common stock sold?
b.
Find the company's balance sheet and determine the following: the number of outstanding
shares of common stock and the average price at which those shares were originally sold.
Ò
What is the relationship between the current market price and the amount you have calculated
in part b as the average price at which the stock originally sold?
d.
Find the company's income statement and identify the trend in basic earnings per share,
including discontinued operations. Did discontinued operations have a significant impact on
EPS?
e.
For the most recent year, what is the average number of shares of common stock that was used
to compute basic earnings per share? Why is that number different from the number outstanding in the company's balance sheet?
Internet sites are time and date sensitive. It is the purpose of these exercises to have you explore
the Internet. You may need to use the Yahoo! search engine http://www.yahoo.com (or another
favorite search engine) to find a company's current Web address.
Answers to Self-Test Questions
1.
b
2.
c, d
3.
d
4.
a, b
5.
‡, Ò