Earnings Per Share and Retained Earnings

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Earnings Per Share and Retained Earnings
An electronic presentation by Douglas Cloud
Pepperdine University
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Objectives

• 1. Know the equation for computing basic earnings
  per share (EPS).
• 2. Understand how to compute the weighted average
  common shares for EPS.
• 3. Identify the potential common shares included
  in diluted EPS.
• 4. Apply the treasury stock method for including
  stock options and warrants in diluted EPS.

Continued
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Objectives
5. Calculate the impact of a convertible
security on EPS. 6. Compute diluted EPS.
7. Record the declaration and payment of cash
dividends. 8. Account for property dividends.
9. Explain the difference in accounting for small
and large dividends.
Continued
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Objectives
10. Understand how to report accumulated other
comprehensive income. 11. Prepare a statement of
changes in stockholders equity. 12. Account for
a quasi-reorganization (Appendix).
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Basic Earnings Per Share
Net Income Preferred Dividends Weighted Average
Number of Common Shares Outstanding
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Weighted Average Shares
Since a corporation earns its net income over the
entire year, the earnings are related to the
common shares outstanding during the year.
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Weighted Average Shares
A corporation had 12,000 shares of common stock
outstanding at the beginning of the year. On
March 2, it issued 2,700 shares on July 3, it
issued another 3,300 shares, and on December 1,
it reacquired 480 shares as treasury stock.
The nearest whole month is used
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Weighted Average Shares
A corporation begins operations in January 2004,
and issues 5,000 shares of common stock that are
outstanding all during 2004. On December 31,
2004, it issues a 2-for-1 stock split.
The two-for-one split is retroactive to January 1
5,000
Continued
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Weighted Average Shares
On May 28, 2005, the corporation issues 5,000
shares of common stock on August 3, it issues a
20 stock dividend and on October 5, it issues
2,005 shares of stock.
2004 Data on 2004 Statement
5,000 x 200 x 120 12,000 equivalent whole
units
Continued
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Weighted Average Shares
2005 Data on 2001 Statement
January-May 10,000 June-July 15,000 August-Sep
tember 18,000
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Weighted Average Shares
2005 Data on 2005 Statement
January-May 10,000 June-July 15,000 August-Sep
tember 18,000
12,000
18,000
October-December 20,000
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Weighted Average Shares
2005 Data on 2001 Statement
Assumed Shares Shares Fraction
of Year Equivalent Outstanding
Outstanding Outstanding Whole
Units

x
x 5/12 5,000 x 2/12
3,000 x 2/12 3,000 x 3/12
5,000 16,000
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Diluted Earnings Per Share
A corporation with a complex capital structure is
required to report two amounts on the face of its
income statement.
Yes basic earnings per share and diluted
earnings per share.
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Diluted Earnings Per Share
Diluted earnings per share shows the earnings per
share after including all potential common shares
that would reduce earnings per share.
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Diluted Earnings Per Share
To be included in the diluted earnings per share
calculation, any potential common share must have
a dilutive effect on earnings per share.
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Diluted Earnings Per Share
Step 1 Compute the basic earnings per share.
Step 2 Include dilutive stock options and
warrants and compute a tentative DEPS.
Step 3 Develop a ranking of the impact of each
convertible preferred stock and convertible bond
on DEPS.
Step 4 Include each dilutive convertible
security in DEPS in a sequential order based on
the ranking and compute a new tentative DEPS.
Step 5 Select as the diluted earnings per share
the lowest computed DEPS.
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Flowchart of EPS Computations
Capital Structures
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Complex Capital Structure
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Stock Options and Warrants
Convertible Securities Outstanding?
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Stock Options and Warrants
Assumed Shares Issued
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Treasury Stock Method

• Step 1. Determine the average market price of
  common shares during the period.
• Step 2. Compute the shares issued from the
  assumed exercise of all options and warrants.
• Step 3. Compute the proceeds received from the
  assumed exercise by multiplying the shares issued
  by the option price plus any unrecognized
  compensation cost (net of tax) per share.
• Step 4. Compute the assumed shares reacquired by
  dividing the proceeds by the average market
  price.
• Step 5. Compute the incremental common shares.

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Treasury Stock Method
The per share unrecognized compensation cost
(net of tax) related to the stock option.
To illustrate Step 3 further, assume a
corporation has compensatory stock options to
purchase 1,000 common shares at 18 per share
outstanding the entire year, and that the average
market price for the common stock was 25 per
share.
Shares assumed issued from assumed exercise 1,000
(800)
Assumed increment in common shares for
computing diluted earnings per share 200
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Convertible Securities
Convertible bonds and convertible preferred stock
are considered in DEPS after stock options and
warrants.
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Convertible Securities
Numerical Value Impact on Diluted Earnings Per
Share
9 convertible preferred stock dividends of
5,400 were declared during the year. The
preferred shares are convertible into 3,000
shares of common stock.
Continued
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Convertible Securities
Numerical Value Impact on Diluted Earnings Per
Share
10 convertible bonds. Interest expense (net of
income taxes) of 4,800 were recorded during the
year. The bonds are convertible into 1,920
shares of common stock.
Continued
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Convertible Securities
Numerical Value Impact on Diluted Earnings Per
Share
8 convertible preferred stock. Dividends of
8,000 were declared during the year. The
preferred shares are convertible into 5,000
shares of common stock.
Continued
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Convertible Securities
Numerical Value Impact on Diluted Earnings Per
Share
7 convertible bonds. Interest expense (net of
income taxes) of 6,300 was recorded during the
year. The bonds are convertible into 3,150
shares of common stock.
Continued
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Convertible Securities
Security Impact Order in Ranking
A 1.80 2 B 2.50 4 C 1.60 1 D 2.00 3
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If Convertible Security Is Dilutive
Add Increase to Numerator
Add Increase to Denominator
Revised Tentative Diluted EPS
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Additional Disclosures

• 1. Identifies the amount of preferred dividends
  deducted to determine the income available to
  common stockholders.
• 2. Describes the potential common shares that
  were not included in the diluted earnings per
  share computation because they were antidilutive.
• 3. Describe any material impact on the common
  shares outstanding of subsequent transactions
  after the close of the accounting period but
  before the issuance of the financial report.

When a corporation reports its basic and diluted
earnings per share on its income statement, it
also is required to make additional disclosures
in the notes to its financial statements.
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Cash Dividend

• The date of declaration
• The ex-dividend date
• The date of record
• The date of payment

There are four significant dates for a cash
dividend.
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Cash Dividend
Date Accounting Procedures
Date of Declaration
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Cash Dividend
On November 3, 2004, the board of directors of a
corporation declares preferred dividends totaling
10,000 and common dividends totaling 20,000.
These dividends are payable on December 15, 2004
to stockholders of record on November 24, 2004.
November 3, 2004
Retained Earnings 30,000 Dividends Payable
Preferred Stock 10,000 Dividends Payable
Common Stock 20,000
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Cash Dividend
On November 3, 2004, the board of directors of a
corporation declares preferred dividends totaling
10,000 and common dividends totaling 20,000.
These dividends are payable on December 15, 2004
to stockholders of record on November 24, 2004.
November 24, 2004
Memorandum entry The company will pay dividends
on December 15, 2004, to preferred and common
stockholders of record as of today, the date of
record.
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Cash Dividend
On November 3, 2001, the board of directors of a
corporation declares preferred dividends totaling
10,000 and common dividends totaling 20,000.
These dividends are payable on December 15, 2001
to stockholders of record on November 24, 2001.
December 15, 2004
Dividends Payable Preferred Stock 10,000 Dividen
ds Payable Common Stock 20,000 Cash 30,000
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Fully Participating Preferred Stock
A corporation has issued 10, participating,
cumulative preferred stock with a total par value
of 20,000 and common stock with a total par
value of 30,000. The preferred stock is two
years in arrears. The Corporation declares a
13,000 dividend.
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Fully Participating Preferred Stock
Preferred Common
Dividends in arrears 2 x (10 of
20,000) 4,000 Current dividend (10 x
20,000) 2,000 Common dividend (10 x
30,000) 3,000 Total to allocate 13,000 Alloc
ated ( 9,000 ) Remainder 4,000 20,000/50,0
00 to preferred and 30,000/50,000 to
common 1,600 2,400 Dividend to each class
of stock 7,600 5,400
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Partially Participating Preferred Stock (up to
12)
Preferred Common
Dividends in arrears 2 x (10 of
20,000) 4,000 Current dividend (10 x
20,000) 2,000 Common dividend (10 x
30,000) 3,000 2 dividend on par
400 600 Remainder to common (13,000
10,000) 3,000 Dividend to each class of
stock 6,400 6,600
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Property Dividend
Occasionally, a corporation will declare a
property dividend that is payable in assets other
than cash.
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Property Dividend
The corporation typically uses marketable
securities of other companies that it owns for
the property dividend.
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Property Dividend
Corporation C declares a property dividend on
March 16, 2005, payable in Company D stock on
June 1, 2005. The Company D stock was purchased
early in 2004 for 24,000 and was reported at its
fair market value of 29,000 on December 31, 2004
(along with an unrealized increase in value of
5,000). The market value on the declaration
date is 31,000.
Continued
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Property Dividend
March 16, 2005
Allowance for Change in Value of Investment in
Available-for-Sale Securities 2,000 Unrealized
Increase in Value of Available-for-Sale
Securities 5,000 Gain on Disposal of
Investments 7,000
Retained Earnings 31,000 Property Dividends
Payable 31000
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Property Dividend
June 1, 2005
Property Dividends Payable 31,000 Investment in
Available-for-Sale Securities 24,000 Allow
ance for Change in Value of Investment in
Available-for-Sale Securities 7,000
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Stock Dividends

• They receive no corporate assets.
• Their percentage ownership does not change.
• Theoretically the total market value of their
  investment will remain the same.
• Future cash dividends may be limited because
  retained earnings is decreased by the amount of
  the stock dividend.

Stockholders often view stock dividends favorably
even though--
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Stock Dividends
What factors might enhance the perceived
attractiveness of stock dividends?
Stock Dividend
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Stock Dividends

• The stockholders may see the stock dividend as
  evidence of corporate growth.
• The stockholders may see the stock dividend as
  evidence of sound financial policy.
• Other investors may see the stock dividend in a
  similar light, and increased trading in the stock
  may cause the market price not to decrease
  proportionally.

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Stock Dividends

• The corporation may state that it will pay the
  same fixed cash dividend per share.
• The stockholders may see the market price
  decreasing to a lower trading range, making the
  stock more attractive to additional investors so
  that the market price may eventually rise.

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Stock Dividends
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Stock Dividends
Stockholders Equity Prior to Stock Dividend
Common stock, 10 par (20,000 shares issued and
outstanding 200,000 Additional paid-in
capital 180,000 Retained earnings 320,000 Total
stockholders equity 700,000
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Small Stock Dividend
M Corporation declares and issues a 10 stock
dividend. On the date of declaration, the stock
sells for 23 per share.
Date of Declaration
Retained Earnings 46,000 Common Stock To Be
Distributed 20,000 Additional Paid-in Capital
From Stock Dividend 26,000
Par
Continued
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Small Stock Dividend
M Corporation declares and issues a 10 stock
dividend. On the date of declaration, the stock
sells for 23 per share.
Date of Issuance
Common Stock To Be Distributed 20,000 Common
Stock, 10 par 20,000
Par
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Small Stock Dividend
Stockholders Equity After Stock Dividend
Common stock, 10 par (22,000 shares issued and
outstanding 220,000 Additional paid-in
capital 206,000 Retained earnings 274,000 Total
stockholders equity 700,000
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Large Stock Dividends
M Corporation declares and issues a 40 stock
dividend. On the date of declaration, the stock
sells for 23 per share.
Date of Declaration
Retained Earnings 80,000 Common Stock To Be
Distributed 80,000
Date of Issuance
Common Stock To Be Distributed 80,000 Common
Stock, 10 par 80,000
Continued
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Large Stock Dividends
Stockholders Equity After Stock Dividend
Common stock, 10 par (28,000 shares issued and
outstanding) 280,000 Additional paid-in
capital 180,000 Retained earnings 240,000 Total
stockholders equity 700,000
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Statement of Retained Earnings
Although not a required separate financial
statement, some corporations include a statement
of retained earnings in their financial
statements.
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Retained earnings, as previously reported, Jan.
1, 2004 Plus (minus) Prior period adjustments
(net of income tax effect) Adjusted retained
earnings, January 1, 2004 Plus (minus) Net
income (loss) Minus Dividends (specifically
identified, including per share
amounts) Reductions due to retirement or
reacquisition of capital stock Reductions due
to conversion of bonds or preferred
stock Retained earnings, December 31, 2004
Statement of Retained Earnings
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Accumulated Other Comprehensive Income
Other comprehensive income might include--

• Unrealized increases (gains) or decreases
  (losses) in the market value of investments in
  available-for-sale securities.
• Translation adjustments from converting the
  financial statements of a companys foreign
  operation into U.S. dollars.
• Certain gains and losses on derivative
  financial instruments.
• Certain pension liability adjustments.

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Accumulated Other Comprehensive Income
A corporation may report its comprehensive income
(net of income taxes)--

• On the face of its income statement.
• In a separate statement of comprehensive income.
• In its statement of changes in stockholders
  equity.

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Statement of Changes in Stockholders Equity
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Appendix Quasi-Reorganization
Click the button next to me to skip the Appendix
material.
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Appendix Quasi-Reorganization
A corporation that incurs net losses over an
extended period of time may find itself in
serious financial difficulty. Rather than enter
into a formal bankruptcy or other legal
proceedings, the corporation engage in a
quasi-reorganization.
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Appendix Quasi-Reorganization
The suggested readjustment procedures include the
following steps

• 1. The corporation reports to the stockholders
  about the restatements proposed and obtains the
  stockholders formal consent.
• 2. Any amounts written off are first charged
  against retained earnings and then against
  additional paid-in capital.
• 3. The corporation begins its fresh start with
  a zero retained earnings balance.

Continued
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Appendix Quasi-Reorganization
The suggested readjustment procedures include the
following steps
4. The corporation presents a balance sheet as of
the date of readjustment in which the assets and
liabilities are reported at their fair values.
After the quasi-reorganization, several
additional accounting procedures are suggested
Continued
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Appendix Quasi-Reorganization
5. If losses or readjustments are identified that
are determined to have occurred before the
readjustment date, they are recorded as a
reduction of additional paid-in capital and not
current income or retained earnings. 6. Additional
paid-in capital is not reduced for losses
occurring after the readjustment. 7. Retained
earnings is dated as of the readjustment date,
and this dating is disclosed in a note to the
financial statements until such dating loses it
significance.
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