Income and Changes in Retained Earnings - PDF

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 brand...

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 mer- chandise 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 avail- able 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, recur- ring 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 suf- ficient 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 oper- ations 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 Reporting the Results of Operations 529 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 7,300,000 Income from continuing operations $ 700,000 Discontinued operations: Operating loss on motels (net of $90,000 income tax benefit) $ (210,000) Gain on sale of motels (net of $195,000 income tax) 455,000 245,000 Income before extraordinary items $ 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) (175,000) (70,000) Net income $ 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. Exclud- ing 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 dis- continued 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 extraordi- nary 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 result- ing 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 restruc- turing 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 opera- tions 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 law- suit 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 restructur- ing 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 corpora- tion, which amounted to $4,000,000, includes the following items: Loss on a discontinued segment of the business (net of income tax benefit) $750,000 Extraordinary gain (net of income tax paid) 300,000 Adjust net income to develop a number that represents a good starting point for pre- dicting 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 out- standing 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, deter- mined 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 state- ments.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 Corpora- tion 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 signifi- cance. 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. Reporting the Results of Operations 533 Financial Analysis and Decision Making The relationship between earnings per share and stock price is 8 or less. A mature company with stable earnings usually sells expressed by the price-earnings (p/e) ratio. This ratio is sim- between 10 and 12 times earnings. Thus the p/e ratio reflects ply the current stock price divided by the earnings per share investors' expectations of the company's future prospects.3 for the year. (A p/e ratio is not computed if the company has Unfortunately, the term earnings per share often is used sustained a net loss for this period.) Price-earnings ratios are without qualification in referring to various types of per-share of such interest to investors that they are published daily in the data. When using per-share information, it is important to financial pages of major newspapers. Price-earnings ratios and know exactly which per-share statistic is being presented. For other measures useful for evaluating financial performance are example, the price-earnings ratios (market price divided by covered in Chapter 14. earnings per share) for common stocks listed on major stock Stock prices actually reflect investors' expectations of future exchanges are reported daily in The Wall Street Journal and earnings. The p/e ratio, however, is based on the earnings over other newspapers. Which earnings per share figures are used the past year. Thus, if investors expect earnings to increase sub- in computing these ratios? If a company reports an extraordi- stantially from current levels, the p/e ratio will be quite high— nary gain or loss, the price-earnings ratio is computed using perhaps 20,30, or even more. But if investors expect earnings to the per-share earnings before the extraordinary item. Other- decline from current levels, the p/e ratio will be quite low, say, wise, 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 coun- tries is challenging for many reasons. One important reason is that national differences in accounting principles are a source of cross-country differences. For exam- ple, 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 primar- ily 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 state- ment 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 recommen- dation 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 conversion of the preferred stock would have on basic earn- ings per share. Let us assume that a company has an outstanding issue of Basic earnings per share is computed in the same manner preferred stock that is convertible into shares of common as illustrated in our preceding example of Perry Corporation. stock at a rate of two shares Diluted earnings per share, on the other hand, is computed on of common stock for each the assumption that all the preferred stock has been converted share of preferred stock. The into common stock as of the beginning of the current year.4 conversion of this preferred (The mechanics of computing diluted earnings per share are stock would increase the covered in more advanced accounting courses.) number of common shares outstanding and might dilute The purpose of showing diluted earnings per share is to alert (reduce) earnings per share. Any common stockholder inter- common stockholders to what could have happened. When the ested in the trend of earnings per share needs to know what difference between basic and diluted earnings per share is sig- effect the conversion of the preferred stock would have on nificant, investors should recognize the risk that future earnings earnings per share of common stock. Keep in mind that the per share may be reduced by conversions of other securities into decision to convert the preferred shares into common shares additional shares of common stock. When a company reports is made by the stockholders, not the corporation. both basic and diluted earnings per share, the price-earnings To inform investors of the potential dilution that might ratio shown in news papers is based on the basic figure. occur, two figures are presented for each income number Convertible preferred stock is not the only potential diluter of from the income statement. The first figure, called basic earnings per share. Convertible debt instruments (e.g., convertible earnings per share, is based on the weighted-average num- bonds) are another type of financial instrument that may reduce ber of common shares actually outstanding during the year. earnings per share if the holders choose to redeem them. Simi- This figure excludes the potential dilution represented by larly, stock options may reduce earnings per share if the holders the convertible preferred stock. The second figure, called choose to exercise them and purchase additional shares of stock. diluted earnings per share, incorporates the impact that 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 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 invest- ment 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 534 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 prac- tical 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 ac- quire 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 125,000 Cash 125,000 To record payment of $1 per share dividend declared Dec. 15 to stockholders of record on Jan. 10. 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 stockhold- ers' 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 bal- ance 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. Stock- holders 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 stock- holder 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 corpora- tion 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 divi- dends (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. Other Transactions Affecting Retained Earnings 537 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 250,000 Stock Dividend to Be Distributed 50,000 Additional Paid-in Capital: Stock Dividends 200,000 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. The Stock Dividend to Be Distributed account is not a liability because there is no obliga- tion 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 stock- holders' 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 50,000 Common Stock 50,000 Distributed 10,000-share stock dividend declared June 1. 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 man- agement to distribute something of perceived value to stockholders while conserving cash which may be needed for other purposes like expanding facilities and introducing new prod- uct 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 differ- ence 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 divi- dends 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 out- standing 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 divi- dends 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 man- agement intent. STATEMENT OF RETAINED EARNINGS The term retained earnings refers to the portion of stockholders' equity derived from profita- ble operations. Retained earnings is increased by earning net income and is reduced by incur- ring 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 corpora- tion, 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. Other Transactions Affecting Retained Earnings 539 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 earn- ings 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 begin- ning 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 pre- vents 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 accom- panying 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 incorpo- rated 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 mar- ket 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 adjust- ment 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 compre- hensive 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 com- prehensive 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 over- all 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 Other Transactions Affecting Retained Earnings 541 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. Vari- ations 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 revenue of over $19 million was a substantial percentage of periodic reporting for many investors is the reporting of net Just for Feet's reported income of $43 million. income. Investors often are attracted to companies that report A marketing strategy employed by Just for Feet was the increasing income each year. As a result, overstating net concept of a "store within the store." A particular vendor would income is the most common objective for engaging in inap- install a "booth" in a Just for Feet store that sold its products. propriate financial reporting. For example, if a customer entered a Just for Feet store and The Securities and was interested in a Nike product, the customer could go to the Exchange Commission Nike booth where only Nike products were displayed. When (SEC) brought a series of this marketing strategy was introduced, the vendor absorbed enforcement actions against the cost of purchasing and installing the booth., Just for Feet Just for Feet, Inc., its for- was ostensibly buying the booths from vendors and receiv- mer employees, and employ- ing back from vendors reductions in the amounts owed for ees of former vendors related to the overstatement of Just for merchandise purchases (merchandise credits). The net effect Feet's reported income. Although Just for Feet overstated its of these transactions—which the SEC describes as "round- income through a number of different techniques, two promi- trip" transactions—was that merchandise purchases would be nent techniques used to overstate income related to fictitious reduced because of the credits issued by vendors, and fixed co-op revenue and fictitious "booth" income. assets, the booths, were increased by a like amount. This had Just for Feet was a national retailer of athletic and outdoor the effect of overstating current period income. footwear and apparel. Just for Feet filed for bankruptcy pro- In addition, Just for Feet was reducing advertising tection, and it began the process of liquidating its assets and expenses (this is how the booth income was recognized) and settling its liabilities. reducing accounts payable based on projected purchases of Just for Feet incurred large amounts of advertising booths during the year. Vendors did not bill Just for Feet expenses. A vendor (e.g., Adidas, Fila, Nike) would often for the booths it ostensibly purchased, so Just for Feet had reduce the amount that Just for Feet owed for merchandise no support for the $9 million in booth income recognized purchases if a particular advertisement featured the vendor's as a reduction of advertising expenses. Just for Feet's audi- products. These reductions in amounts owed were referred to tor confirmed with vendors the dollar amounts owed due to as "advertising co-op" or "vendor allowances." These vendor purchases of booths (a confirmation of accounts payable). allowances were unwritten and not guaranteed. Just for Feet In a number of instances, Just for Feet's management was sent vendors copies of advertisements placed, and the vendor able to persuade representatives of the vendor to return false determined whether to grant an advertising allowance. confirmations. In one fiscal year, Just for Feet recorded $19.4 million One important facet of the Just for Feet fraud is that the in co-op receivables (and recognized revenue as a result of SEC has brought enforcement actions against a number of recording the receivables) that was not earned. The fictitious 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 custom- ers to falsely confirm to the auditors that they owe amounts that are in fact not owed. Such behavior has always repre- sented 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 543 Concluding Remarks We discussed various aspects of stockholders' equity, focusing first on paid-in capital in Chap- ter 11 and then on earned capital in Chapter 12. These discussions complete our detailed cov- erage 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 compa- nies present three primary financial statements to their stockholders, creditors, and other inter- ested 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.  Demonstration Problem 545 date of record (p. 535) The date on which a person must be price-earnings (p/e) ratio (p. 533) Market price of a share of listed as a shareholder to be eligible to receive a dividend. Follows common stock divided by annual earnings per share. the date of declaration of a dividend by two or three weeks. prior period adjustment (p. 539) A correction of a material diluted earnings per share (p. 534) Earnings per share computed error in the earnings reported in the financial statements of a under the assumption that all convertible securities were converted prior year. Prior period adjustments are recorded directly in the into additional common shares at the beginning of the current year. Retained Earnings account and are not included in the income The purpose of this pro forma computation is to alert common statement of the current period. stockholders to the risk that future earnings per share might be restructuring charges (p. 530) Costs related to reorganizing reduced by the conversion of other securities into common stock. and downsizing the company to make the company more discontinued operations (p. 529) The net operating results efficient. These costs are presented in the income statement as a (revenue and expenses) of a segment of a company that has been single line item in determining operating income. or is being sold, as well as the gain or loss on disposal. segment of the business (p. 529) Those elements of a business earnings per share (p. 531) Net income applicable to the that represent a separate and distinct line of business activity or common stock divided by the weighted-average number of that service a distinct category of customers. common shares outstanding during the year. statement of retained earnings (p. 538) A financial statement ex-dividend date (p. 535) A date three days prior to the explaining the change during the year in the amount of retained date of record specified in a dividend declaration. A person earnings. May be expanded into a statement of stockholders' buying a stock prior to the ex-dividend date also acquires the equity. right to receive the dividend. The three-day interval permits the statement of stockholders' equity (p. 540) An expanded compilation of a list of stockholders as of the date of record. version of a statement of retained earnings. Summarizes the changes during the year in all stockholders' equity accounts. Not extraordinary items (p. 529) Transactions and events that are a required financial statement, but widely used as a substitute for unusual in nature and occur infrequently—for example, most the statement of retained earnings. large earthquake losses. Such items are shown separately in the income statement after the determination of income before stock dividend (p. 536) A distribution of additional shares to extraordinary items. 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 stock- holders 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 extraor­ dinary loss of $47,400 (net of related income tax benefits). Instructions a. Prepare journal entries (in general journal form) to record the transactions affecting stock­ holders' 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. с Prepare a statement of retained earnings for the year ending December 31, 2009. Solution to the Demonstration Problem a.  Self-Test Questions 547 С Self-Test Questions The answers to these questions appear on page 567. c. Hamilton's accountant discovers that the entire price 1. The primary purpose of showing special types of events paid several years ago to purchase company offices separately in the income statement is to: in Texas had been charged to a Land account; conse­ quently, no depreciation has ever been taken on these a. Increase earnings per share. buildings. b. Assist users of the income statement in evaluating the d. As a result of labor union contract changes, Hamilton profitability of normal, ongoing operations. paid increased compensation expense during the year. с Minimize the income taxes paid on the results of ongo­ 3. When a corporation has outstanding both common and pre­ ing operations. ferred stock: d. Prevent unusual losses from recurring. a. Basic and diluted earnings per share are reported only 2. Which of the following situations would not be presented in if the preferred stock is cumulative. a separate section of the current year's income statement of Hamilton Corporation? During the current year: b. Earnings per share is reported for each type of stock outstanding. a. Hamilton's Los Angeles headquarters are destroyed by a tornado. с Earnings per share is computed without regard to the b. Hamilton sells its entire juvenile furniture operations amount of the annual preferred dividends. and concentrates on its remaining children's clothing d. Earnings per share is computed without regard to the segment. amount of dividends declared on common stock. 548 Chapter 12 Income and Changes in Retained Earnings 4. 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 a. Includes prior period adjustments, cash dividends, and dividend is declared but does change when it is distributed. stock dividends. b. Between the time a stock dividend is declared and b. Indicates the amount of cash available for the payment when it is distributed, the company's commitment is of dividends. presented in the balance sheet as a current liability. c. Need not be prepared if a separate statement of с Stock dividends do not change the relative portion of stockholders' equity accompanies the financial the company owned by individual stockholders. statements. d. Stock dividends have no impact on the amount of the d. Shows revenue, expenses, and dividends for the company's assets. accounting period. 1. What is the purpose of arranging an income statement to 9. Explain how each of the following is computed: show subtotals for income from continuing operations and a. Price-earnings ratio. income before extraordinary items! b. Basic earnings per share. 2. Frank's Fun Company owns 30 pizza parlors and a minor c. Diluted earnings per share. league baseball team. During the current year, the company 10. Throughout the year, Baker Construction Company had sold three of its pizza parlors and closed another when the 3 million shares of common stock and 150,000 shares of lease on the building expired. Should any of these events convertible preferred stock outstanding. Each share of pre­ be classified as discontinued operations in the company's ferred is convertible into two shares of common. What num­ income statement? Explain. ber of shares should be used in the computation of (a) basic 3. Define extraordinary items. How are extraordinary items earnings per share and (b) diluted earnings per share? distinguished from items that are presented as separate line 11. A financial analyst notes that Collier Corporation's earnings items in an income statement, but are not extraordinary? per share have been rising steadily for the past five years. 4. In an effort to make the company more competitive, Fast- The analyst expects the company's net income to continue Guard, Inc., incurred significant expenses related to a reduc­ to increase at the same rate as in the past. In forecasting tion in the number of employees, consolidation of offices future basic earnings per share, what special risk should the and facilities, and disposition of assets that are no longer analyst consider if Collier's basic earnings are significantly productive. Explain how these costs should be presented in larger than its diluted earnings? the financial statements of the company, and describe how 12. Explain the significance of the following dates relating to an investor should view these costs in predicting future cash dividends: date of declaration, date of record, date of earnings of the company. payment, ex-dividend date. 5. A prior period adjustment relates to the income of past 13. What is the purpose of a stock dividend! accounting periods. Explain how such an item is shown in 14. Distinguish between a stock split and a stock dividend. Is the financial statements. there any reason for the difference in accounting treatment of these two events? 6. In evaluating the potential future profitability of a company, how would you consider irregular income items, such as 15. What are restructuring charges? How are they presented in extraordinary items, discontinued operations, and prior financial statements? period adjustments? 16. Identify three items that may appear in a statement of retained earnings as changes in the amount of retained earnings. 7. Earnings per share and book value per share are statis­ tics that relate to common stock. When both preferred and 17. If a company's total stockholders' equity is unchanged by common stock are outstanding, explain the computation the distribution of a stock dividend, how is it possible for involved in determining the following: a stockholder who received shares in the distribution of the dividend to benefit? a. Earnings allocable to the common stockholders. 18. What is a liquidating dividend, and how does it relate to a b. Aggregate book value allocable to the common regular (nonliquidating) dividend? stockholders. 19. In discussing stock dividends and stock splits in an invest­ 8. Assume a corporation has only common stock outstanding. ments class you are taking, one of the students says, "Stock Is the number of common shares used in the computation of splits and stock dividends are exactly the same—both are earnings per share always the same as the number of com­ distributions of a company's stock to existing owners without mon shares used in computing book value per share for this payment to the company." Do you agree? Why or why not? corporation? Is the number of common shares used in com­ 20. A statement of stockholders' equity sometimes is described puting these two statistics ever the same? Explain. 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 follow- ing 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, respec- tively, 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 com- pany 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 com- mon 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 div- idend 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 out- standing 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 Treasury stock Discontinued operations Stock dividend Extraordinary item Prior period adjustment Basic earnings per share Additional paid-in capital Diluted earnings per share Comprehensive income 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. Exercises 551 h. A pro forma figure indicating what earnings per share would have been if all securities con- vertible into common stock had been converted at the beginning of the current year. i. 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 continu- ing operations. Net sales $12,500,000 Costs and expenses (including applicable income tax) 8,600,000 Operating loss from tennis shops (net of income tax benefit) 192,000 Loss on sale of tennis shops (net of income tax benefit) 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 state- ment 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 outstand- ing 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: 2008 2007 2006 Earnings per share $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 dur­ ing 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. с 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, decla­ ration 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. с 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 earn­ ings 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 cor­ porate 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. Number of shares of stock outstanding as of year-end. b. Total dollar amount of cash dividends declared during the current year. c. Market value per share at balance sheet date. d. 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 cur­ rent year is greater than the number of shares of stock outstanding at the end of the prior year. f. Earnings per share of common stock. g. 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. с 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. Determine the number of shares of stock outstanding after the four transactions described above. b. Determine the amount of cash that the company paid in the four transactions described above. с 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 transac­ tions, 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 divi­ dends 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? с 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 $55,120,000 Costs and expenses (including income taxes on continuing operations).... 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 Air­ lines had 1,000,000 shares of capital stock outstanding throughout the year. Instructions a. Prepare a condensed income statement, including proper presentation of the discontin­ ued 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 $19,850,000 Costs and expenses (including applicable income tax) 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. с 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 compari­ son 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