Slide
12-1
Chapter
12
McGraw-Hill/Irwin
INCOME AND CHANGES
IN RETAINED EARNINGS
© The McGraw-Hill Companies, Inc., 2002
Slide
12-2
Reporting the Results of Operations
Information about net income can be divided into
two major categories
Normal, recurring revenue and
expense transactions.
Income from
continuing
operations.
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1. The results
of
discontinued
operations
Unusual, nonrecurring events
that affect net income.
2. The impact
of
extraordinary
items.
3. The effects
of changes in
accounting
principles.
© The McGraw-Hill Companies, Inc., 2002
Slide
12-3
Ross Corporation
Income Statement
For the Year Ended December 31, 2003
Net Sales
Cost of goods sold
Gross margin
Operating expenses:
Selling expenses
General & Admin. exp.
Loss on settlement of lawsuit
Income taxes
Income from Continuing Operations
Discontinued Operations
Extraordinary Items
Cumulative effect of a change
in accounting principle
Net income
McGraw-Hill/Irwin
$
$
8,000,000
4,500,000
3,500,000
This tax expense
$ does
1,500,000
not include
920,000
effects
of unusual,
80,000
nonrecurring
items.
300,000
2,800,000
$
700,000
These unusual,
245,000
(70,000)
nonrecurring items
are each reported
140,000
net of taxes.
$ 1,015,000
© The McGraw-Hill Companies, Inc., 2002
Slide
12-4
Discontinued Operations
When management enters into a formal plan to sell or
discontinue a segment of the business, the related gains
and losses must be disclosed on the income statement.
Discontinued
Operations
Income/Loss from
operating the segment
prior to disposal.
Income/Loss on disposal
of the segment.
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Slide
12-5
Discontinued Operations
When management enters into a formal plan to sell or
discontinue a segment of the business, the related gains
and losses must be disclosed on the income statement.
A segment must be a separate line
of business activity or an operation
that services a distinct category of
customers.
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Slide
12-6
Discontinued Operations - Example
During 2003, Apex Co. sold an unprofitable
segment of the company. The segment had a
net loss from operations during the period of
$150,000 and its assets sold at a loss of
$100,000. Apex reported income from
continuing operations of $350,000. All items
are taxed at 30%.
How will this appear on the income
statement?
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Slide
12-7
Discontinued Operations - Example
Loss on segment operations
Less: Tax benefits ($150,000 × 30%)
Net loss
$ (150,000)
45,000
$ (105,000)
Loss on disposal of assets
Less: Tax benefits ($100,000 × 30%)
Net loss
$ (100,000)
30,000
$ (70,000)
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
12-8
Discontinued Operations - Example
Income Statement Presentation:
Income from continuing operations
Discontinued operations:
Loss on operations (net of
tax benefit of $45,000)
Loss on disposal of assets (net
of tax benefits of $30,000)
Earnings before extraordinary item
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$ 350,000
(105,000)
(70,000)
$ 175,000
© The McGraw-Hill Companies, Inc., 2002
Slide
12-9
Extraordinary Items
 Material in amount.
 Gains or losses that
are both unusual in
nature and not
expected to recur in
the foreseeable future.
 Reported net of
related taxes.
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Slide
12-10
Extraordinary Items - Example
During 2003, Apex Co. experienced a loss of
$75,000 due to an earthquake at one of its
manufacturing plants in Nashville. This was
considered an extraordinary item. The
company reported income before
extraordinary item of $175,000. All gains
and losses are subject to a 30% tax rate.
How would this item appear on the 2003
income statement?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
12-11
Extraordinary Items - Example
Extraordinary Loss $ (75,000)
Less: Tax Benefits
($75,000 × 30%)
22,500
Net Loss
$ (52,500)
Income Statement Presentation:
Earnings before extraordinary item $ 175,000
Extraordinary Loss:
Earthquake loss
(net of tax benefit of $22,500)
$?)
(52,500)
?
Earnings before cumulative effect of
a change in accounting principle
$ 122,500
?
McGraw-Hill/Irwin
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Slide
12-12
Accounting Changes
Type of Accounting
Change
Change in Accounting
Principle
Change in Accounting
Estimate
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Definition
Replaces one GAAP with
another
Revision of an estimate
because of new
information or new
experience
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Slide
12-13
Change in Accounting Principle
 Occurs when changing from
one GAAP method to another
GAAP method.
 Make a catch-up adjustment
known as the cumulative effect
of a change in accounting
principle.
 The cumulative effect is
reported net of taxes and after
extraordinary items.
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Slide
12-14
Change in Accounting Principle
Example
Also in 2003, Apex Co. decided to change from
the double-declining balance to the straight-line
method for depreciation. The effect of this
change is an increase in net income of $65,000.
Apex reported income before cumulative effect
of an accounting change of $122,500 during the
year. All items of income are subject to a 30%
tax rate.
How would this item appear on the income
statement?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
12-15
Change in Accounting Principle
Example
Computation:
Increase in income
$
Less: Tax expense ($65,000 × 30%)
Net increase in income
$
65,000
(19,500)
45,500
Income Statement Presentation:
Earnings before cumulative effect of
a change in accounting principle
$
Cumulative effect of change in
accounting principle:
Change in accounting method
(net of $19,500
tax expense)
$ ? tax expense)
Net Income
$
McGraw-Hill/Irwin
122,500
45,500
?
168,000
?
© The McGraw-Hill Companies, Inc., 2002
Slide
12-16
Change in Estimates
 Revision of a previous
accounting estimate.
 The new estimate should
be used in the current and
future periods.
 The prior accounting
results should not be
disturbed.
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© The McGraw-Hill Companies, Inc., 2002
Slide
12-17
Change in Estimates - Example
On January 1, 2000, we purchased
equipment costing $30,000, with a useful
life of 10 years and no salvage value.
During 2003, we determine that the
remaining useful is 5 years (8-year total
life). We use straight-line depreciation.
Compute the revised depreciation expense
for 2003.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
12-18
Change in Estimates - Example
Asset cost
Accumulated depreciation
12/31/02 - ($3,000 × 3 years)
Remaining to be depreciated
Remaining useful life
Revised annual depreciation
$
$
$
30,000
(9,000)
21,000
÷ 5 years
4,200
Record depreciation expense of $4,200 for
2003 and subsequent years.
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Slide
12-19
Let’s move
on to a few
final
topics.
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Slide
12-20
Price-earnings Ratio (P/E)
Often, the Price-Earnings Ratio is used to evaluate
the reasonableness of a company’s stock price.
Price-Earnings
Ratio
Current Stock
=
Price
÷
Earnings Per
Share
Let’s examine this
further.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
12-21
Earnings Per Share (EPS)
A measure of the company’s profitability and
earning power for the period.
Earnings
Per Share
Net
=
Income
÷
Weighted Average
Number of Shares
Outstanding
Based on the number of shares
issued and the length of time
that number remained
unchanged.
McGraw-Hill/Irwin
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Slide
12-22
Earnings Per Share (EPS) Partial Income Statement
Remember that Apex Co. income from
continuing operations of $350,000. The
after-tax loss from discontinued operations
was $175,000. The extraordinary loss was
$52,500 and the cumulative effect of
accounting changes was a gain of $45,500.
Assume that Apex has weighted average
shares outstanding of 156,250. Prepare a
partial income statement showing the EPS
for Income from Operations and for the
other special items.
McGraw-Hill/Irwin
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Slide
12-23
Earnings Per Share (EPS) Partial Income Statement
Income from continuing operations
Loss from discontinued operations
Income before extraordinary items and
cumulative effect of accounting change
Extraordinary loss
Cumulative effect of accounting change
Net Loss
Income
Statement
Amounts
EPS
$ 350,000 $
2.24
(175,000)
(1.12)
$ 175,000 $
(52,500)
45,500
$ 168,000 $
1.12
(0.34)
0.29
1.07 *
* Rounded.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002
Slide
12-24
Earnings Per Share (EPS)
If preferred stock is present, subtract preferred
dividends from net income prior to computing EPS.
Earnings
Per Share
=
Net Income - Preferred Dividends
Weighted Average Number of
Common Shares Outstanding
EPS is required to be reported
in the income statement.
McGraw-Hill/Irwin
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Slide
12-25
Accounting for Cash Dividends
Declared by board
of directors.
Not legally
required.
Creates liability
at declaration.
Requires sufficient
Retained Earnings
and Cash.
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Slide
12-26
Dividend Dates
Date of Declaration


Board of directors declares the dividend.
Record a liability.
Date
Description
Dividends
Dividends Payable
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Debit
Credit
$$$$
$$$$
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Slide
12-27
Dividend Dates
Ex-Dividend Date

The day which serves as the ownership cut-off
point for the receipt of the most recently
declared dividend.
Date
Description
Debit
Credit
NO ENTRY
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Slide
12-28
Dividend Dates
Date of Record

Stockholders holding shares on this date
will receive the dividend. (No entry)
X
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Slide
12-29
Dividend Dates
Date of Payment

Record the payment of the dividend to
stockholders.
Date
Description
Dividends Payable
Cash
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Debit
Credit
$$$$
$$$$
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Slide
12-30
Dividend Dates - Question
Date
On
Debit
June 1,Description
2003, a corporation’s
board Credit
of
15-Jul Dividends
Payable
20,000
directors
declared
a dividend for the
2,500 shares
Cash
of its $100
par value, 8% preferred stock. 20,000
The
dividend will be paid on July 15. Which of the
following will be included in the July 15 entry?
$100 × 8% = $8 dividend per share
$8 × 2,500Earnings
= $20,000 total
dividend
a. Debit Retained
$20,000.
b. Debit Dividends Payable $20,000.
c. Credit Dividends Payable $20,000.
d. Credit Preferred Stock $20,000.
McGraw-Hill/Irwin
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Slide
12-31
Accounting for Stock Dividends
Distribution of additional shares of stock to
stockholders.
No change in total
stockholders’ equity.
No change in par
values.
All stockholders
retain same
percentage
ownership.
McGraw-Hill/Irwin
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Slide
12-32
Summary of Effects of Stock
Dividends and Stock Splits
Small Stock
Dividend
Large Stock
Dividend
Stock Splits
Total
Stockholders'
Equity
Common Stock
Paid-in Capital
No Effect
No Effect
No Effect
Increases
Increases
Increases
No Effect
No Effect
No Effect
Retained Earnings
Decreases
Decreases
No Effect
Increases
Increases
Increases
No Effect
No Effect
Decreases
Number of Shares
Outstanding
Par Value per
Share
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Slide
12-33
Prior Period Adjustments
The correction of an error identified as
affecting net income in a prior period.
Adjust retained
earnings retroactively.
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The adjustment
should be disclosed
net of any taxes.
© The McGraw-Hill Companies, Inc., 2002
Slide
12-34
Comprehensive Income
Normally, there are 3 ways that financial
position can change.
Issuance of new
shares of stock.
Net Income or
Net Loss
Payment of
Dividends
GAAP excludes some unrealized items from
income, such as the change in market value of
available-for-sale debt and equity investments.
McGraw-Hill/Irwin
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Slide
12-35
Comprehensive Income
GAAP requires that unrealized items that are normally reported
on the balance sheet be added back to compute
“Comprehensive Income.”
The accumulated amount of
changes affecting
Comprehensive Income is
reported in equity.
As a second
Income statement.
McGraw-Hill/Irwin
There are 3 options for
reporting Comprehensive
Income.
Combined with
Net Income on the
Income
Statement.
As an element of
Stockholders’
Equity.
© The McGraw-Hill Companies, Inc., 2002
Slide
12-36
Hang in there!
We’re coming down
the home stretch!
Yeah, that’s
easy for you
to say!
End of
Chapter
12
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2002