Income and Retained Earnings

Chapter 12: Income and Changes in Retained Earnings

• Sales and net income patterns are crucial for evaluating a firm's financial performance.
• Investors find increases in key metrics like sales and net income appealing.
• The market price of common stock and the amount of the cash dividend per share depend on the current and future earnings of the corporation

Reporting the Results of Operations

• The most essential element of corporate financial reporting is considered to be periodic income.

Developing Predictive Information

• Revenue measures the value of products/services sold, increasing a company's assets.
• Expenses cover production/distribution costs, decreasing the company's assets.
• An income statement presents revenue and expenses for a period, offering insights for investors/creditors to estimate 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 the income statement.

Reporting Irregular Items

• Showing unusual, nonrecurring items distinctly from typical activities enhances financial statement's usefulness.
• Two unusual, nonrecurring event categories that require special treatment in financial statements: discontinued operations and extraordinary items.

Continuing Operations

• The initial section of an income statement reflects ongoing business activities, specifically retail stores in Farmer Corporation.
• $300,000 is the income tax expense shown in this section that relates only to continuing operations.
• Income from continuing operations indicates ongoing operations' profitability which helps predict future earnings.

Discontinued Operations

• When management decides to sell or discontinue a segment. that segment's results are reported separately on the income statement.
• The disclosure of discontinued operations enables users to assess the performance of ongoing operations.
• The income statement includes two items in the discontinued operations: income/loss from operating the segment before disposal, and gain/loss on the segment's disposal.

Extraordinary Items

• Gains/losses that are unusual and unlikely to reoccur
• Example: Loss from a plant damaged by an earthquake in a region where earthquakes rarely occur.
• Extraordinary items appear after discontinued operations, following subtotal income before extraordinary items, are always shown net of related income tax effects.

Other Unusual Gains and Losses

• Some transactions are not typical of normal operations and do not meet the criteria for extraordinary items.
• Examples being losses from labor strikes and gains/losses from plant asset sales.
• Material gains/losses is listed as individual revenue or expense items rather than being combined with broad categories.

Restructuring Charges

• Restructuring operations has become a common aspect of the American economy
• Charges include expenses related to asset write-downs/sales, severance payments, and relocation.
• Presented as a single item determining operating income.

The Unusual and the Extraordinary

• Management used to lean towards classifying many losses as extraordinary, while classifying many gains as part of normal, recurring operations.
• Accounting profession intends for extraordinary items to be rare and defines extraordinary items very carefully.
• There isn't a definitive list of extraordinary items; classification is a matter of judgment.

Earnings Per Share (EPS)

• Investors buying/selling stock rely on this accounting statistic
• Computed to assess whether stock price is reasonable.
• Common stockholders' share of net income divided by the average number of common shares outstanding.
• Applies only to common stock.

Weighted-Average Number of Shares

• Determined by multiplying shares outstanding by the fraction of the year shares remained unchanged.

Preferred Dividends and Earnings per Share

• Preferred stockholders participate in net income only to the extent of preferred dividends when a company has preferred stock outstanding.
• Calculate earnings applicable to common stock by initially deducting current year preferred dividends from net income.

Presentation of Earnings Per Share

• Required to be stated in the income statements of all publicly owned corporations

Financial Analysis and Decision Making

• Relationship between earnings per share and stock price shown as price-earnings (p/e) ratio, a reflection of the company's future prospects.

Basic and Diluted Earnings per Share

• The first one is based on the actual outstanding shares, while the second incorporates the potential dilution from convertible securities.
• Investors should recognize the risk that future earnings per share may be reduced by conversions when the difference between basic and diluted is significant.

Other Transactions Affecting Retained Earnings

• Corporations with profits may be unable to pay due to early stage development and reinvestment in the company

Cash Dividends

• Three requirements for the payment of a cash dividend: adequate Retained Earnings, sufficient cash, and dividend action by the board of directors.

Dividend Dates

• Four significant dates are involved in the distribution of a dividend: Date of declaration, ex-dividend date, date of record, and date of payment.
• Only dates of declaration and payment require entries.

Liquidating Dividends

• Dividend exceeds the Retained Earnings account, returning paid-in capital to stockholders
• Occurs when the corporation is reducing operations or going out of existence or making a permanent reduction in company size

Stock Dividends

• Distribution of additional stock shares in proportion to holdings
• Each stockholder receives additional shares but their ownership percentage remains the same.

Reasons for Stock Dividends

• Allow management to distribute a perceived value to stockholders, while conserving cash for company needs.
• Also, tend to keep the share trading price in a lower range which is more attractive to investors

Distinction between Stock Splits and Stock Dividends

• Stock splits intend to lower the market price to a desired trading range, representing higher increases in outstanding shares.
• Accounting varies, and therefore dividends are not treated the same as stock splits.
• Stock dividends don't affect stock's market value or stockholders' proportional ownership.

Statement of Retained Earnings

• Indicates changes in stockholders' equity from profitable operations, increased by net income and is decreased by dividends declared.

Prior Period Adjustments

• Corrects a material error made in prior year's net income report, adjusted in the retained earnings statement.

Restrictions of Retained Earnings

• Contractual agreements preventing the company from declaring dividends below a certain level
• Disclosed in notes accompanying financial statements.

Comprehensive Income

• Some changes in financial position aren't included when determining net income.
• Presented net of income tax, elements such as Home Depot Inc follow third approach of comprehensive income.

Statement of Stockholder's Equity

• Expanded form of retained earnings statement showing yearly changes in all equity accounts.
• Contains beginning balances and stock transactions.

Stockholders' Equity Section of the Balance Sheet

• Statement includes variations like the title selections, items, and extensive details of classification.

Ethics, Fraud and Corporate Governance

• SEC brought enforcement actions against Just for Feet Inc's employees/vendors because they overstated Just for Feet's reported income using fictitious co-op revenue and "booth" income.
• Under the Sarbanes-Oxley Act, there are increased criminal penalties for lying to external auditors and the SEC are more likely to prosecute.