Income and Changes in Retained Earnings

Chapter 12

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Reporting the Results of Operations

Information about net income can be divided into two major categories
Normal, recurring revenue and expense transactions. Unusual, nonrecurring events that affect net income.

Income from continuing operations.

1. Results of discontinued operations.

2. Impact of extraordinary items.

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Matrix, Inc. Income Statement For the Year Ended December 31, 2009
Net Sales Cost of goods sold Gross margin Operating expenses: Selling expenses General & admin. exp. Loss on settlement of lawsuit Income taxes Income from continuing operations Discontinued operations Extraordinary items Net income $ $ $ 9,000,000 4,000,000 5,000,000

1,750,000 (175,000) These unusual, (52,500) nonrecurring items $ 1,522,500

This tax expense 1,500,000 920,000 does not include 80,000 effects of unusual, 750,000 3,250,000 nonrecurring items.
$

are each reported net of taxes.

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Discontinued Operations
When management enters into a formal plan to sell or discontinue a segment of the business, the related gains and losses must be disclosed on the income statement. Income/Loss from operating the segment prior to disposal.

Discontinued Operations

Income/Loss on disposal of the segment.

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Discontinued Operations
When management enters into a formal plan to sell or discontinue a segment of the business, the related gains and losses must be disclosed on the income statement.

A segment must be a separate line of business activity or an operation that services a distinct category of customers.

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Discontinued Operations
During 2009, Matrix, Inc. sold an unprofitable segment of the company. The segment had a net loss from operations during the period of $150,000 and a loss on the sale of its assets of $100,000. Matrix reported income from continuing operations of $1,750,000. All items are taxed at 30%.

How will this appear on the income statement?

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Discontinued Operations
Loss on segment operations Less: Tax benefits ($150,000 30%) Net loss Loss on disposal of assets Less: Tax benefits ($100,000 30%) Net loss $ (150,000) 45,000 $ (105,000) $ (100,000) 30,000 $ (70,000)

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Discontinued Operations
Income Statement Presentation:
Income from continuing operations Discontinued operations: Loss on operations (net of tax benefit of $45,000) Loss on disposal of assets (net of tax benefits of $30,000) Earnings before extraordinary item $ 1,750,000

(105,000) (70,000) $ 1,575,000

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Extraordinary Items
Material in amount. Gains or losses that are
both unusual in nature and not expected to recur in the foreseeable future. Reported net of related taxes.

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Extraordinary Items
During 2009, Matrix, Inc. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Chicago. This was considered an extraordinary item. The company reported income before extraordinary item of $1,575,000. All gains and losses are subject to a 30% tax rate. How would this item appear on the 2009 income statement?
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Extraordinary Items
Extraordinary Loss $ (75,000) Less: Tax Benefits ($75,000 30%) 22,500 Net Loss $ (52,500)

Income Statement Presentation:

Earnings before extraordinary item Extraordinary Loss: Earthquake loss (net of tax benefit of $22,500) Net income $ 1,575,000

(52,500) $ 1,522,500
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Earnings Per Share (EPS)

A measure of the companys profitability and earning power for the period.

Earnings Per Share

Net Income

Weighted Average Number of Shares Outstanding

Based on the number of shares issued and the length of time that number remained unchanged.
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Earnings Per Share (EPS)

Remember that Matrix, Inc. has income from continuing operations of $1,750,000. The after-tax loss from discontinued operations was $175,000 and the extraordinary loss was $52,500. Assume that Matrix has 156,250 weighted average shares outstanding. Lets prepare a partial income statement using all this information.
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Earnings Per Share (EPS)

Income Statement Amounts $ 1,750,000 $ (175,000) $ 1,575,000 $ (52,500) $ 1,522,500 $ EPS 11.20 (1.12) 10.08 (0.34) 9.74 *

Income from continuing operations Loss from discontinued operations Income before extraordinary items and cumulative effect of accounting change Extraordinary loss Net Income

$1,750,000 156,250
* Rounded.
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Earnings Per Share (EPS)

If preferred stock is present, subtract preferred dividends from net income prior to computing EPS.
Earnings Per Share Net Income - Preferred Dividends Weighted Average Number of Common Shares Outstanding

EPS is required to be reported in the income statement.

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Cash Dividends
Declared by Board of Directors. Not legally required.

Creates liability at declaration.

Requires sufficient Retained Earnings and Cash.

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Dividend Dates
Date of Declaration

Board of Directors declares the dividend. Record a liability.

On March 1, 2009, the Board of Directors of Matrix, Inc. declares a $1.00 per share cash dividend on its 500,000 common shares outstanding. The dividend is payable to stockholders of record on April 1, and paid on May 1.
Date Description Debit Credit

Mar. 1 Retained Earnings Dividends Payable

500,000 500,000

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Dividend Dates
Ex-Dividend Date The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend.
Date Description Debit Credit

Apr. 1

NO ENTRY

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Dividend Dates
Date of Record

Stockholders holding shares on this date

will receive the dividend. (No entry)
April 2009

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Dividend Dates
Date of Payment

Record the payment of the dividend to

stockholders.

Date

Description

Debit

Credit

May 1 Dividends Payable Cash

500,000 500,000

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Dividend Dates
$100 8% = $8 dividend per share $8 2,500 = a corporations board On June 1, 2009, $20,000 total dividend of directors declared a dividend for the 2,500 shares of its $100 par value, 8% preferred stock. The dividend will be paid on July 15. Which of the following will be included in the July 15 entry? a. Debit Retained Earnings $20,000. b. Debit Dividends Payable $20,000. c. Credit Dividends Payable $20,000. d. Credit Preferred Stock $20,000.
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Stock Dividends
Distribution of additional shares of stock to stockholders.
No change in total stockholders equity. No change in par values.

All stockholders retain same percentage ownership.

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Entries to Record Stock Dividends

In accounting for a relatively small stock dividend (say, less than 20%), the market value of the new shares is transferred from Retained Earning account to the paid-in capital accounts. This process is sometimes called capitalizing retained earnings.
On June 1, Aspen Corporation has outstanding 1,000,000 shares of $1 par value common stock with a market value of $25 per share. The company declares a 5% stock dividend on this date. The dividend is distributable on July 15 to stockholders of record on June 20. Lets look at the journal entries. 12-23

Entries to Record Stock Dividends

Common shares outstainding Stock dividend percent Additional shares issuable Market value per share Amount assigned to dividend 1,000,000 5% 50,000 $ 25 $ 1,250,000

Additional shares issuable Par value per share Change in common stock account

50,000 1 50,000
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Dividend Dates
Date of Declaration

Board of Directors declares the dividend. Do not record a liability.

Date Description Debit Credit

Jun. 1 Retained Earnings Stock Dividend to be Distributed Additional Paid-in Capital: Stock Dividend

1,250,000 50,000 1,200,000

500,000 shares $1 par value

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Dividend Dates
Ex-Dividend Date The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend.
Date Description Debit Credit

Jun. 20

NO ENTRY

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Dividend Dates
Date of Record

Stockholders holding shares on this date

will receive the dividend. (No entry)
June 2009

X
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Dividend Dates
Date of Payment

Record the payment of the dividend to

stockholders.
Date Description Debit Credit

Jul. 15 Stock Dividend to be Distributed Common Stock

50,000 50,000

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Reasons for Stock Dividends

Management often finds stock dividends appealing because they allow management to distribute something of perceived value to stockholders while conserving cash which may be needed for other purposes.

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).
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Distinction between Stock Splits and Stock Dividends

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 do not result in a change in the par value of the stock. On the other hand, stock splits result in a pro rata reduction in the par value of the stock.
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Summary of Effects of Stock Dividends and Stock Splits

Small Stock Dividend Total Stockholders' Equity Common Stock Paid-in Capital Retained Earnings Number of Shares Outstanding Par Value per Share No Effect Increases Increases Decreases Increases No Effect Large Stock Dividend No Effect Increases No Effect Decreases Increases No Effect Stock Splits No Effect No Effect No Effect No Effect Increases Decreases
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Prior Period Adjustments

The correction of an error identified as affecting net income in a prior period.

Adjust retained earnings retroactively.

The adjustment should be disclosed net of any taxes.

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Statement of Retained Earnings with Prior Period Adjustment

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Restrictions of Retained Earnings

If I loan your company $1,000,000, I will want you to restrict your retained earnings in order to limit dividend payments.

Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings.
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Comprehensive Income
Normally, there are 3 ways that financial position can change.
Issuance of new shares of stock. Net Income or Net Loss Payment of Dividends

GAAP excludes some unrealized items from income, such as the change in market value of available-for-sale debt and equity investments.
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Comprehensive Income
GAAP requires that unrealized items that are normally reported on the balance sheet be added back to compute Comprehensive Income. The accumulated amount of changes affecting Comprehensive Income is reported in equity. There are 3 options for reporting Comprehensive Income.

As a second Income Statement.

Combined with Net Income on the Income Statement.

As an element of Stockholders Equity.

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Statement of Stockholders Equity

This is a more inclusive statement than the statement of retained earnings.

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Stockholders Equity Section of the Balance Sheet

Simmons Company Stockholders' Equity Captial Stock: Common Stock - $10 par value; 50,000 shares authorized; 30,000 shares issued and outstanding Preferred Stock - $100 par value; 1,000 shares authorized; 500 shares issued and outstanding Additional paid-in capital From issuance of common stock From issuance of preferred stock Total paid-in capital Retained earnings Total stockholders' equity

$ 300,000

50,000 375,000 10,000 735,000 116,500 $ 851,500

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End of Chapter 12

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