12–1 chapter 12 the corporate income statement and the statement of stockholders’ equity

12–1

Chapter 12

The Corporate Income Statement and the Statement

of Stockholders’ Equity

12–2Copyright © Cengage Learning. All rights reserved.

Motorola, Inc.

Click here for the Motorola financial reports archive.

Motorola had good earnings in 2005 and 2006 but had a decrease in revenue of 15% in 2007

Additionally Motorola experienced a large operating loss of $553 million in 2007

What important questions should investors ask about Motorola’s future? Can the improvements be made and can Motorola come back to prominence?

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LO1 Quality of Earnings

The substance of a company’s earnings and their sustainability into future accounting periods

What methods or estimates might affect the quality of earnings?

Gains and losses on transactionsWrite-downs and restructuringsNonoperating items

Investors should understand which items included in earnings are recurring and which are one-time items. Income from continuing operations (before nonoperating items) gives a clear signal about future results.


LIFO produces a higher cost of goods sold. An accelerated depreciation method

yields a higher depreciation expense.

Produces a lower operating income

The Impact of Estimates and Methods

Different accounting methods have different effects on net income

FIFO and Straight-Line

LIFO and Double-Declining-Balance

Net sales $462,500 $462,500

Goods available for sale $200,000 $200,000 Less ending inventory 30,000 25,000

Cost of goods sold $170,000 $175,000

Gross margin $292,500 $287,500

Less depreciation expense $20,000 $40,000 Less other expenses 85,000 85,000

Total operating expenses $105,000 $125,000

Income from continuing operations before income taxes $187,500 $162,500


Ordinary Gains and Losses

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

one-time events should not go here but often are

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Write-Downs and Restructurings

Imagine that a company decides to “write-down” the value of a large asset below its carrying value on the balance sheet

Reduces current operating income and boosts future income by shifting future

costs to the current accounting period

How does this affect income?

Often called “big baths” or taking all

possible losses


Nonrecurring Items

Reported on the income statement: Discontinued operations Extraordinary gains and losses

The effects of changes in accounting principles are no longer reported on the income statement.

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Discussion: Ethics on the Job

Charles Brink, the new CEO of RDR Industries, instructs the CFO to take all possible losses in the current year. He says he wants to wipe the slate clean of costs associated with the previous management.

Q. Do you think the CEO’s instructions are ethical? How will this action affect future years’ performance?

While the CEO’s actions are legal, taking a ‘big bath’ on losses makes it possible for him to claim large improvements in future years. The decision may be more about his personal gain than the best interest of stockholders, and is not an ethical action.


Stop & Review

Q. If an analyst believes that a company has a poor quality of earnings, what does this mean?

A. In general, the analyst believes that the substance of a company’s earnings is not sustainable into the future.


Stop & Review

Q. Does a company’s choice of inventory costing method have an impact on its quality of earnings? Why or why not?

A. Yes. Certain methods will produce a higher cost of goods sold, thus yielding a lower operating income. If a company makes choices that continually manipulate its earnings, it will not be seen as able to sustain these earnings if they are created through accounting methods alone.


LO2 Taxable Versus GAAP

Taxable Income Accounting Income Determined by

deducting allowable expenses from income

Federal tax laws dictate which expenses corporations may deduct

Determined in accordance with GAAP

Income taxes expense is recognized on an accrual basis

The difference between accounting income and

taxable income, especially in large businesses, can be

material


Deferred Income Taxes

Represents the amount by which income taxes expense differs from income taxes payable

Income tax allocationA technique used to account for the difference between income taxes expense based on accounting income and the actual income taxes payable based on taxable income


Vistula Corporation has income taxes expense of $289,000 on its income statement, but has actual income taxes payable of $184,000.

Dec. 31 Income Taxes Expense 289,0000 Income Taxes Payable 184,000 Deferred Income Taxes 105,000 To record estimated current and

deferred income taxes

Record the estimated income taxes expense applicable to income from continuing operations using the income tax allocation procedure:

Deferred Income Taxes Illustrated


Deferred Income Taxes

Rules for recording, measuring, and

classifying deferred income taxes

Rules for recording, measuring, and

classifying deferred income taxes

Deferred income taxes are recognized for the estimated future tax effects resulting from temporary differences in the valuation of assets, liabilities, equity, revenues, expenses, gains, and losses for tax and financial reporting purposes.

What are temporary differences?Revenues and expenses or gains and losses that

are included in taxable income before or after they are included in accounting income


Example of Temporary Difference

Treatment of advance payment for goods Accounting income

(Revenue is not recognized until goods are shipped)

Taxable income(Revenue is recognized when cash is received)

ResultTaxes paid > Taxes expenseCreates a deferred income taxes asset (prepaid

taxes)


Net of Taxes

taxes have been taken into account in reporting an item on the income statement

Used for one time items

keeps from distorting income taxes associated with ongoing operations



Stop & Review

Q. Why are taxable income and accounting income usually different?

A. They are calculated using different rules. Taxable income is calculated using tax rules and allowable expenses. Accounting income is calculated using GAAP. Thus, the two amounts are usually different.


Stop & Review

Q. What is the income tax allocation procedure?

A. A procedure used to account for the difference between income taxes expense based on accounting income and the actual income taxes payable based on taxable income. The difference goes to the Deferred Income Taxes account.


LO3 Earnings Per Share (EPS)

Used to evaluate a company’s performance and compare it with other companies

Should be presented on the face of the income statement

Usually disclosed just below net income

Show earnings per share for income from continuing operations and other major components of net income

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Basic EPS

gOutstandin SharesCommon Average-Weighted

IncomeNet EPS Basic

Vistula Corporation had net income of $669,000 and 200,000 shares of common stock outstanding.

shareper 35.3$shares 200,000

$669,000 EPS Basic


Calculating Weighted-Average

Suppose that from Jan. 1 to March 31, Vistula had 200,000 shares outstanding; from April 1 to Sept. 30, it had 240,000 shares outstanding; and from Oct. 1 to Dec. 31, 260,000 shares were outstanding. Vistula had net income of $669,000.

200,000 shares × 3/12 year 50,000

240,000 shares × 6/12 year 120,000

260,000 shares × 3/12 year 65,000

Weighted-average common shares outstanding = 12/12 235,000


$669,000 EPS Basic

Dividends for nonconvertible preferred stock outstanding should be subtracted from net income before earnings per

share for common stock are computed.


Has the potential to

dilute EPS of common stock

Diluted EPS

Simple Capital Structure

No preferred stocks, bonds, or stock options that can be converted into common stock

Complex Capital Structure

Issued securities or stock options that can be converted to common stock

Diluted earnings per share are calculated by adding all potentially dilutive securities to the denominator of the basic

earnings per share calculation.


Dilution of Ownership

S. Green owns 10,000 shares of a company’s common stock, which equals 2 percent of the outstanding shares of 500,000. Suppose holders of convertible bonds convert the bonds into 100,000 shares of stock.

Now, S. Green’s 10,000 shares would equal only 1.67 percent (10,000 ÷ 600,000) of the outstanding shares.

Reporting requirements

Reporting requirements

Companies with a complex capital structure must report basic and diluted earnings per share.


Stop & Apply

Q. Kraffton Corporation had net income of $495,300 and 200,000 shares of common stock outstanding. Compute earnings per share.


$495,300 EPS Basic *

* Rounded

A.


Stop & Apply

Q. Possible Corporation had net income of $759,500 and 500,000 shares of common stock outstanding. It also issued preferred stock that could be converted into 100,000 shares of common stock. Compute diluted earnings per share.

A. shareper 27.1$

shares 600,000

$759,500 EPS Diluted *

* Rounded


LO4 Comprehensive Income

Transactions that affect stockholders’ equity, but are not stock transactions

Includes items like: Net income Changes in unrealized investment gains and losses Foreign currency translation adjustments

Comprehensive income can be shown as part of

the statement of stockholders’ equity or in a separate statement



Statement of Stockholders’ Equity

Summarizes changes in the components of the stockholders’ equity section of the balance sheet

Preferred Stock$100 Par

Value 8% Convertible

Common Stock $10 Par Value

Additional Paid-in Capital

Retained Earnings Treasury Stock

Accumulated Other Compre- hensive Income Total

Balance, December 31, 2009

Net income 540,000 540,000Foreign currency translation adjustment ($20,000) (20,000)Issuance of 10,000 shares of common stock 100,000 400,000 500,000

Conversion of 2,000 shares of preferred stock to 6,000 shares of common stock (200,000) 60,000 140,000 —10 percent stock dividend on common stock, 7,600 shares 76,000 304,000 (380,000) —Purchase of 1,000 shares of treasury stock ($48,000) (48,000)

Cash dividends

Preferred stock (48,000) (48,000)

Common stock (95,200) (95,200)

Balance, December 31, 2010 $600,000 $836,000 $1,444,000 $1,216,800 ($48,000) ($20,000) $4,028,800

$800,000 $600,000 $600,000 $1,200,000 $3,200,000

12–28

• Represent stockholders’ claims to assets arising from the earnings of the business

Copyright © Cengage Learning. All rights reserved.

Retained Earnings

• Assets kept in the company to help it grow

• Retained Earnings may have a debit or credit balance

• A debit balance means that past dividends and losses have been greater than its previous profits



Stop & Review

Q. If you were interested in the changes that occurred in each of the stockholders’ equity accounts, which financial statement would be most useful?

A. Statement of Stockholders’ Equity


Stop & Review

Q. Where are foreign currency translations reported?

A. As part of comprehensive income on the statement of stockholders’ equity or in a separate comprehensive income statement.


LO5 Stock Dividend

Proportional distribution of shares of a corporation’s stock to its shareholders

changes the content of stockholders’ equity

Involves no distribution of assets

Moves $ from RE to Contributed Capital



Why Issue a Stock Dividend?

May reduce the stock’s market price since the number of shares outstanding increases

Gives stockholders some evidence of the company’s success without using cash unlike a cash dividend

Increases the company’s permanent capital by transferring an amount from retained earnings to contributed capital

Nontaxable distribution to stockholders


Stock Dividends Illustrated

Rivera Corporation has the following stockholders’ equity structure before stock dividends are declared:

Contributed Capital Common stock, $5 par value, 50,000 shares authorized, 15,000 shares issued and outstanding $ 75,000

Additional paid-in capital 15,000 Total contributed capital $ 90,000 Retained earnings 450,000 Total stockholders’ equity $540,000


Rivera Corporation declares a 10 percent stock dividend on February 24, distributable on March 31 to stockholders of record on March 15. The market price of the stock on February 24 is $20 per share.

Stock Dividends Illustrated (cont’d)

Feb. 24 Stock Dividend Declared 30,000 Common Stock Distributable 7,500 Additional Paid-in Capital 22,500 Declared a 10 percent stock dividend on

common stock, distributable March 31 to stockholders of record on March 15 15,000 shares x .10 = 1,500 shares 1,500 shares x $20/share = $30,000 1,500 shares x $5/share = $7,500

Date of Declaration:


Rivera Corporation declares a 10 percent stock dividend on February 24, distributable on March 31 to stockholders of record on March 15. The market price of the stock on February 24 is $20 per share.

Stock Dividends Illustrated (cont’d)

Mar. 31 Common Stock Distributable 7,500 Common Stock 7,500 Distributed a stock dividend of 1,500 shares

Date of Distribution:

• No entry is required • Recall that this date is used to determine the owners of stock who

will receive dividends

Date of Record:

12–36

Stockholders’ Equity

Before Dividend

After Dividend

Common stock $ 75,000 $ 82,500 Additional paid-in capital 15,000 37,500 Total contributed capital $ 90,000 $ 120,000 Retained earnings 450,000 420,000 Total stockholders’ equity $540,000 540,000 Shares outstanding 15,000 16,500 Stockholders’ equity per share $ 36.00 $ 32.73

One Stockholder’s Investment Shares owned

500

550

Shares outstanding 15,000 16,500 Percentage of ownership 3 1/3 % 3 1/3% Proportionate investment ($540,000 x .0333) $18,000* $18,000*

Effects of Stock Dividends on Contributed Capital

Total stockholders’ equity is the same before and after a stock dividendThe assets of a corporation are not reduced as they would have been if a

cash dividend had been declared and paid The proportionate ownership in the corporation of any individual is the

same before and after a stock dividend

* Rounded


Stock Split

• A corporation increases the number of shares of stock issued and outstanding and reduces the par or stated value proportionally

• Has the effect of lowering a stock’s market value per share and increasing the demand for the stock at this lower price

• Stock splits and stock dividends reduce earnings per share because they increase the number of shares issued and outstanding.


July 15: MUI Corporation’s 15,000 shares of $5 par value common stock issued and outstanding were split 2 for 1.

Common Stock Before Stock Split After Stock Split Shares issued and outstanding 15,000 30,000 Par value per share $5.00 $2.50 Amount of common stock equity $75,000 $75,000

Each stockholder’s proportionate interest in the company remains the same because each share of $5 par value stock was converted to 2 shares of $2.50 par value stock.

Stock Split Illustrated

A stock split does not increase the number of shares authorized, nor does it change the balances in the accounts in the stockholders’ equity section of the balance sheet.

No journal entry required, memorandum entry is appropriate.


Stop & Review

Q. What is the difference between a stock split and a stock dividend?

A. A stock dividend changes the makeup of stockholders’ equity in that it transfers capital from retained earnings to permanent capital accounts. A stock split does not change the makeup of stockholders’ equity.


LO6 Book Value per Share

When a company has only common shares outstanding, calculate book value per share as follows:

gOutstandin SharesCommon Total

Equity rs'Stockholde Total Shareper ValueBook

Shares outstanding• Includes common stock distributable• Does not include treasury stock

When a company has both common and preferred stock, subtract the call value of the preferred stock plus any dividends in arrears from total stockholders’ equity. (Use par value if call value is not specified.)


Crisanti Corporation has total stockholders’ equity of $4,028,800 that includes: 6,000 shares of $100 par 8 percent convertible preferred stock outstanding; 83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares of treasury stock. No dividends are in arrears and the preferred stock is callable at $105. What is the book value per share for both preferred and common stock?

Total stockholders’ equity $4,028,800 Less equity allocated to preferred shareholders (6,000 shares x $105)

630,000

Equity pertaining to common shareholders $3,398,800

shareper $105.00 shares 6,000 $630,000 :Stock Preferred

Book Value per Share Illustrated

shareper $41.15 shares 82,600 $3,398,800 :StockCommon *

* Rounded


Crisanti Corporation has total stockholders’ equity of $4,028,800 that includes: 6,000 shares of $100 par 8 percent cumulative preferred stock outstanding; 83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares of treasury stock.One year of dividends are in arrears and the preferred stock is callable at $105. What is the book value per share for both preferred and common stock?

shareper $113.00 shares 6,000 $678,000 :Stock Preferred

Book Value per Share Illustrated (Dividends in Arrears)

Total stockholders’ equity $4,028,800 Less: Call value of outstanding preferred shares $630,000 Dividends in arrears ($300,000 x .08) 48,000 Equity allocated to preferred shareholders 678,000 Equity pertaining to common shareholders $3,350,800

shareper $40.57 shares 82,600 $3,350,800 :StockCommon *

* Rounded


Stop & Review

Q. What is the meaning of book value per share of stock?

A. It represents the equity of the owner of one share of stock in the net assets of a company.


Stop & Apply

Q. Grapple Corporation has 2,000 shares of 6 percent $100 par value cumulative preferred stock and 50,000 shares issued and 48,400 outstanding of $10 par value common stock. Total stockholders’ equity is $1,945,000. One year of dividends are in arrears and the preferred stock is callable at $110. What is the book value per share for both classes of stock?

A. Total stockholders’ equity $1,945,000 Less: Call value of outstanding preferred shares $220,000 Dividends in arrears ($200,000 x .06) 12,000 Equity allocated to preferred shareholders 232,000 Equity pertaining to common shareholders $1,713,000

shareper $116.00 shares 2,000 $232,000 :Stock Preferred shareper *$35.39 shares 48,400 $1,713,000 :StockCommon

* Rounded


Chapter Review Problem

The stockholders’ equity of Latte Company on July 31, 20x7, was as follows:Contributed capitalCommon stock, no par value, $6 stated value, 500,000 shares authorized, 300,000 shares issued and outstanding $1,800,000Additional paid-in capital 800,000Total contributed capital $2,600,000Retained earnings 670,000Total stockholders’ equity $3,270,000 The board declares a 10 percent stock dividend on August 15, 20x7, distributable on September 9 to stockholders of record on September 1. The market price on Aug. 15 is $20 per share.

Required: Record the stock dividend in the general journal on the date of declaration. Determine the book value per share after the dividend.


Chapter Review Problem (Solution)

Aug. 15 Stock Dividend Declared 600,000 Common Stock Distributable 150,000 Additional Paid-in Capital 450,000 Declared a 10 percent stock dividend on

common stock, distributable on September 9 to stockholders of record on September 1 300,000 shares x .10 = 30,000 shares 30,000 shares x $20/share = $600,000 30,000 shares x $5/share = $150,000


$3,270,000 Shareper ValueBook *

* Rounded

12–1 chapter 12 the corporate income statement and the statement of stockholders’ equity

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