Chapter 15 The Corporate Income Statement and the Statement of Stockholders Equity

1
Chapter 15The Corporate Income Statement and
the Statement of Stockholders Equity
2
LEARNING OBJECTIVES

• Identify the issues related to evaluating the
  quality of a companys earnings.
• Prepare a corporate income statement.
• Show the relationships among income taxes
  expense, deferred income taxes, and net of taxes.
• Describe the disclosure on the income statement
  of discontinued operations, extraordinary items,
  and accounting changes.

3
LEARNING OBJECTIVES (continued)

• Compute earnings per share.
• Prepare a statement of stockholders equity.
• Account for stock dividends and stock splits.
• Calculate book value per share.

4
Performance MeasurementQuality of Earnings
Issues

• OBJECTIVE 1
• Identify the issues related to evaluating the
  quality of a companys earnings.

5
Quality of Earnings Issues

• Current and expected earnings are an important
  factor to consider in evaluating a companys
  performance and analyzing its prospects.
• Because of the importance of net income (bottom
  line), there is significant interest in
  evaluating the quality of earnings.

6
Quality of Earnings Issues

• Quality of earnings refers to the substance of
  earnings and their sustainability into future
  accounting periods and may be affected by

• Accounting methods and estimates chosen by
  management.
• The nature of non-operating items in the income
  statement.

7
Choice of Accounting Methods and Estimates

• Choices of accounting methods and estimates
  affect a firms operating income.
• The choice of estimates affects both current and
  future operating income.

8
Choice of Accounting Methods and Estimates

• Due to the considerable latitude in the choice of
  estimates, management and other financial
  statement users must be aware of the impact of
  accounting estimates on reported operating
  income.
• The relative importance of each estimate depends
  on the industry in which the firm operates.

9
Effect of Accounting Methods and Estimates

• An accounting method or estimate that results in
  lower current earnings produces a better quality
  of operating income.

10
Effect of Accounting Methods and Estimates

• 1. Full disclosure.
• Requires that management explain the significant
  accounting policies used in preparing the
  financial statements in a note to the statements.
• 2. Consistency.
• Requires that the same accounting procedures be
  followed from year to year.

11
Nature of Non-operating Items

• The top of the income statement shows income from
  continuing operations.
• The lower part of the corporate income statement
  can contain such non-operating items as
  discontinued operations, extraordinary gains and
  losses, and effects of accounting changes.
• When analyzing financial statements, the analyst
  must be careful to look beyond a bottom line
  that may have been influenced by non-operating
  items that are not expected to recur.

12
The Corporate Income Statement

• OBJECTIVE 2
• Prepare a corporate income statement.

13
Corporate Income Statement Issues

• Either single-step or multi step formats can be
  used.
• The accounting profession has taken the position
  that income for a period should be all-inclusive
  comprehensive income.

14
Corporate Income Statement Issues

• Comprehensive income includes all revenues,
  expenses, gains, and losses over the period,
  except for prior period adjustments.
• Several items must be added to the income
  statement discontinued operations, extraordinary
  items, accounting changes, earnings per share.

15
Discussion
Q. Define the concept of comprehensive
income. A. Comprehensive income is the change in
a companys equity during a period from sources
other than owners and includes newt income,
change in unrealized investment gains or losses
and other items affecting equity.
16
Income Taxes Expense

• OBJECTIVE 3
• Show the relationships among income taxes
  expense, deferred income taxes, and net of taxes.

17
Income Taxes Expense

• Income taxes expense is the expense recognized in
  the accounting records on an accrual basis that
  applies to income from continuing operations.
• The amount payable is determined from taxable
  income, measured according to the rules and
  regulations of the income tax code.

18
Income Taxes Expense

• Management has an incentive to use methods that
  minimize the firms tax liability.
• There can be a material difference between
  accounting income and taxable income.
• This discrepancy can result from differences in
  the timing of the recognition of revenues and
  expenses between GAAP and income tax accounting.

19
Deferred Income Taxes

• The amount by which income taxes expense differs
  from income taxes payable is reconciled in an
  account called deferred income taxes.

20
Deferred Income Taxes

• Income tax allocation is a 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.

Dec. 31 Income Taxes Expense
144,500 Income Taxes Payable
92,000 Deferred Income Taxes 52,500
To record estimated current and
deferred income taxes
21
Net of Taxes

• Net of taxes means the effect of applicable
  taxes (usually income taxes) has been considered
  in determining the overall effect of an item on
  the financial statements.
• The phrase is used when a company has items that
  must be disclosed in a separate section.
• Each such item should be reported net of the
  applicable taxes.

22
Discussion
Q. Accounting income should be geared to the
concept of taxable income because the public
understands that concept. Comment on this
statement, and tell why income tax allocation is
necessary.
23
Discussion (continued)
A.
Accounting income and taxable income should
not be treated the same because they serve
different purposes. The purpose of accounting
income is to give some indication (however
imperfect) of the increase or decrease in the
businesss well-being the sole purpose of
taxable income is to provide a basis for the
collection of government revenues from the
taxpayer. Income tax allocation is necessary
because there are differences between accounting
and taxable income caused by the timing of
revenues and expenses.
24
Discontinued Operations,
Extraordinary Items, and
Accounting Changes

• OBJECTIVE 4
• Describe the disclosure on the income statement
  of discontinued operations, extraordinary items,
  and accounting changes.

25
Discontinued Operations

• Discontinued operations are segments of a
  business that are no longer part of its ongoing
  operations.
• GAAP require that gains or losses from
  discontinued operations be reported separately on
  the income statement.

26
Extraordinary Items

• APB 30 defines extraordinary items as events or
  transactions that are distinguished by their
  unusual nature and by the infrequency of their
  occurrence.
• Extraordinary material items should be reported
  separately from continuing operations on the
  income statement.

27
Extraordinary Items

• Extraordinary items include
• An uninsured loss from flood, earthquake, fire,
  or theft.
• Gain or loss from the passage of a new law.
• Taking of property by a foreign government.
• Gain or loss from an early retirement of debt.

28
Accounting Changes

• Although a violation of the consistency
  principle, a company is allowed to make
  accounting changes if current procedures are
  incorrect or inappropriate.
• A change from LIFO to FIFO inventory method can
  be made.

29
Accounting Changes

• The cumulative effect of an accounting change is
  the effect that the new accounting principle
  would have had on net income in prior periods if
  it had been applied instead of the old principle.
• Accounting changes are shown on the income
  statement immediately after extraordinary items.

30
Earnings Per Share

• OBJECTIVE 5
• Compute earnings per share.

31
Earnings per Share

• The APB concluded that earnings per share of
  common stock should be presented on the face of
  the income statement.
• It is usually shown just below net income.

32
Earnings per Share

• An EPS amount is always shown for
• Income from continuing operations.
• Income before extraordinary items and the
  cumulative effect of accounting changes.
• Net income.
• Gain or loss from discontinued operations or
  extraordinary items.

33
Earnings per Share

• It is necessary to determine if the number of
  common shares changed, and if the company paid
  preferred stock dividends during the year.
• When a company has only common stock and has the
  same number of shares outstanding throughout the
  year, the EPS calculation is simple.

34
Earnings per Share

• If the number of shares outstanding changes
  during the year, it is necessary to figure the
  weighted-average number of shares outstanding for
  the year.
• If a company has nonconvertible preferred stock
  outstanding, its dividend must be subtracted from
  net income before EPS for common stock is
  computed.

35
Complex Capital Structures

• Some companies have a complex capital structure
  that may include exercisable stock options or
  convertible stocks and bonds.
• These convertible securities have the potential
  of diluting the EPS of common stock.

36
Complex Capital Structures

• Potential dilution means that a stockholders
  proportionate share of ownership in a company
  could be reduced by conversion, which would
  increase the total shares outstanding.

37
Complex Capital Structures

• A company with a complex capital structure must
  report two earnings per share
• Basic earnings per share.
• Diluted earnings per share.
• Diluted EPS is calculated by adding all potential
  dilutive securities to the denominator of basic
  EPS calculation.

38
Discussion
Q. When does a company have a simple capital
structure? A complex capital structure? A. A
company has a simple capital structure when it
has only common stock or nonconvertible preferred
stock and no other securities that can be
converted into common stock. A complex capital
structure exists when there are additional
securities that can be converted to common stock.
39
The Statement of Stockholders Equity

• OBJECTIVE 6
• Prepare a statement of stockholders equity.

40
The Statement ofStockholders Equity

• The statement of stockholders equity summarizes
  the changes in the components of the
  stockholders equity section of the balance
  sheet.
• It is used because it reveals much more about the
  years stockholders equity transactions than the
  statement of retained earnings.

41
Retained Earnings

• Retained earnings are the part of stockholders
  equity that represents claims to assets arising
  from the earnings of the business.
• Retained earnings are not the assets themselves.
• The existence of retained earnings means that
  assets generated by profitable operations have
  been kept in the business.

42
Retained Earnings Balances

• A credit balance does not mean that cash or
  designated assets have been set aside.
• A debit balance in retained earnings represents a
  deficit.

43
Restrictions onRetained Earnings

• A corporation may be required to or may want to
  restrict all or part of its retained earnings.
• A restriction means that dividends can be
  declared only to the extent of unrestricted
  retained earnings.

44
Restrictions onRetained Earnings

• Reasons for restricting retained earnings
  include
• A contractual agreement.
• State law.
• Voluntary action by the board of directors.

45
Restrictions onRetained Earnings

• A restriction does not change the total retained
  earnings or stockholders equity of the company.
• It simply divides retained earnings into
  restricted and unrestricted.
• The most common way to disclose restricted
  retained earnings is by reference to a note to
  the financial statements.

46
Stock Dividends andStock Splits

• OBJECTIVE 7
• Account for stock dividends and stock splits.

47
Stock Dividends

• A stock dividend is a proportional distribution
  of shares of a corporations stock to its
  shareholders.
• It represents no change in the firms assets and
  liabilities because no assets are distributed as
  when a cash dividend is paid.

48
Reasons for Declaringa Stock Dividend

• A board of directors may declare a stock dividend
  for several reasons
• To give stockholders some evidence of the
  companys success without paying a cash dividend.
• To reduce the stocks market price by increasing
  the number of shares outstanding.
• To make a nontaxable distribution to
  stockholders.
• To increase the companys permanent capital.

49
Accounting for Stock Dividends

• The effect of a stock dividend is to transfer a
  dollar amount from retained earnings to the
  contributed capital section on the date of
  declaration.
• The amount transferred is the FMV (usually market
  price) of the additional shares to be issued.

50

• Entries to record the declaration and
  distribution of the stock dividend are
• Feb. 24 Stock Dividends Declared
  60,000
• Common Stock Distributable 15,000
• Paid-in Capital in Excess of Par
• Value, Common 45,000
• Declared a 10 stock dividend
• on common stock
• Mar. 15 Date of Record no entry required.

51

• (continued)
• Entries to record the declaration and
  distribution of the stock dividend are
• Mar. 31 Common Stock Distributable 15,000
• Common Stock 15,000
• Distributed stock
• dividend of 3,000 shares

• Stock Dividends Declared account is closed out to
  Retained Earnings at the end of the accounting
  period.
• The effect of the stock dividend is to
• Permanently transfer the market value of the
  stock, 60,000, from retained earnings to
  contributed capital.
• Increase the number of shares outstanding by
  3,000.
• Common Stock Distributable is not a liability
  account because there is no obligation to
  distribute assets.

52
Stockholders EquityBefore and After Stock
Dividends

• BEFORE AFTER
• Common Stock 150,000 165,000
• Paid-in Capital in Excess of
• Par Value, Common 30,000 75,000
• Total Contributed Capital 180,000
  240,000
• Retained Earnings 900,000
  840,000
• Total Stockholders Equity 1,080,000
  1,080,000
• Shares Outstanding 30,000 33,000
• Stockholders Equity per Share 36.00 32.73

53
Stockholders InvestmentBefore and After Stock
Dividends

• BEFORE AFTER
• Shares owned (individual) 1,000 1,100
• Shares outstanding 30,000 33,000
• Percentage of ownership 3 1/3 3 1/3
• Proportionate investment
• (1,080,000 x .03 1/3) 36,000 36,000
• Before and after the stock dividend, the
  stockholder owns 3 1/3 of the company.
• All stock dividends have an effect on the market
  price. Some are so large that they have a
  material effect.
• A large stock dividend (gt 20-25) should be
  accounted for by a transfer of the par or stated
  value of the stock on the date of
  declaration from Retained Earnings to
  Contributed Capital.

54
Stock Splits

• A stock split occurs when a corporation increases
  the number of issued shares of stock and reduces
  the par or stated value proportionally.
• This may be done when a company wants to lower
  the stocks market value per share of stock and
  increase its liquidity, since a high market price
  hinders marketability.
• A stock split does not increase the number of
  shares authorized.

55
Before Stock Split

• Contributed Capital
• Common Stock, 5 par value,
• 100,000 shares authorized,
• 30,000 shares issued and
• outstanding 150,000
• Paid-in Capital in Excess of
• Par Value, Common 30,000
• Total Contributed Capital 180,000
• Retained Earnings 900,000
• Total Stockholders Equity 1,080,000

56
After Stock Split

• Contributed Capital
• Common Stock, 2.50 par value,
• 100,000 shares authorized,
• 60,000 shares issued and
• outstanding 150,000
• Paid-in Capital in Excess of
• Par Value, Common 30,000
• Total Contributed Capital 180,000
• Retained Earnings 900,000
• Total Stockholders Equity 1,080,000

57
Stock Splits

• No journal entry is necessary, but a memorandum
  entry in the general journal, identifying the
  change in shares is issued and par value is made.
  
• After a stock split, equity per share is cut in
  half.
• However, the shareholders proportionate interest
  in the company remains the same.
• If the number of split shares exceeds the number
  of authorized shares, the board of directors must
  secure state and stockholders approval before
  additional shares can be issued.

58
Discussion

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

59
A.
Discussion (continued)

• A stock dividend is a distribution of shares
  to stockholders that involves a transfer from
  retained earnings to contributed capital. A stock
  split involves an increase in the number of
  shares outstanding and a proportional decrease in
  par or stated value, but it has no effect on the
  balances in the stockholders equity accounts.

60
Book Value

• OBJECTIVE 8
• Calculate book value per share.

61
Book Value

• The book value of a companys stock represents
  the total assets of the company less its
  liabilities.

62
Book Value per Share

• Book value per share represents the equity of the
  owner of one share of stock in the net assets of
  the corporation.
• Book value per share does not necessarily equal
  the amount the shareholder would receive if the
  company were sold or liquidated.

63
Book Value per Share

• Book value per share (common stock only) equals
• Total Stockholders Equity Shares
  Outstanding
• If a company has both preferred and common stock,
  the determination of book value per share is more
  complex.