12 INCOME AND CHANGES IN
RETAINED EARNINGS
Chapter Summary
Chapter 12 continues the coverage of stockholders’ equity but shifts the focus from paid-in capital to retained earnings. The student is already aware that net income drives the changes in retained earnings. However, in any given period net income may reflect unusual and nonrecurring events. We begin by explaining how to define such items and how to present them so that the income statement may still serve as the basis for reasonable estimates of future earnings. The three categories of events, which require special treatment, are (1) discontinued operations, (2) extraordinary items, and (3) changes in accounting principle. Each item is explained and illustrated with a Case in Point capsule based on the experience of an actual company.
Before turning to the impact of various dividend transactions, we briefly review basic and diluted earnings per share. The emphasis here is on interpretation of the EPS figures, since the detailed mechanics of calculating these measures is beyond the scope of the first course.
The second major section of the chapter explains a number of stockholder equity transactions that affect retained earnings. The most obvious example of such transactions is the declaration of a cash dividend. The requirements for distributing a cash dividend are outlined as are the significant dates involved in the distribution of the dividend. Stock dividends are discussed since they too result in a reduction in retained earnings. This portion of the chapter closes with a brief explanation of prior period adjustments to retained earnings.
Additional topics covered in Chapter 12 include an introduction to comprehensive income and a review of the statement of stockholders’ equity.
Learning Objectives
1. Describe how discontinued operations, extraordinary items, and accounting changes are presented in the income statement.
2. Compute earnings per share.
3. Distinguish between basic and diluted earnings per share.
4. Account for cash dividends and stock dividends, and explain the effects of these transactions on a company’s financial statements.
5. Describe and prepare a statement of retained earnings.
6. Define prior period adjustments, and explain how they are presented in financial statements.
7. Define comprehensive income, and explain how it differs from net income.
8. Describe and prepare a statement of stockholders’ equity.
Brief topical outline
A Reporting the results of operations
1 Developing predictive information – see Management Strategy (page 505)
2 Reporting irregular items: an illustration
3 Continuing operations
a Income from continuing operations
4 Discontinued operations
a Discontinued operations are not really unusual – see Case in Point (page 506)
5 Extraordinary items – see Case in Point (page 507)
a Other unusual gains and losses
b Distinguishing between the unusual and the extraordinary
c Restructuring charges – see Case in Point (page 508)
6 Changes in accounting principle
a The cumulative effect of an accounting change
b Changes in principle versus changes in estimate – see Your Turn (page 509)
7 Earnings per share (EPS)
a Computing earnings per share
b What happens if more shares are issued?
c Preferred dividends and earnings per share
d Presentation of earnings per share in the income statement
e Interpreting the different per-share amounts
B Financial analysis – see Case in Point (page 512)
1 Basic and diluted earnings per share – see Management Strategy (page 512)
C Other transactions affecting retained earnings
1 Cash dividends – see Your Turn (page 513)
2 Dividend dates
3 Liquidating dividends
4 Stock dividends
a Entries to record a stock dividend
b Reasons for stock dividends – see Case in Point (page 516)
c Distinctions between stock splits and stock dividends
5 Statement of retained earnings
6 Prior period adjustments
a Restrictions of retained earnings
7 Comprehensive income – see Cash Effects (page 520)
8 Statement of stockholders’ equity
9 Stockholders’ equity section of the balance sheet
D Concluding remarks – see A Second Look (page 522)
Topical coverage and suggested assignment
Homework Assignment(To Be Completed Prior to Class)
Class Meetings on Chapter / Topical Outline Coverage / Discussion Questions / Exercises / Problems / Cases / Internet
1 / A / 1, 2, 3, 5 / 1, 3, 4, 5 / 1, 3 / 3, 6 / 1
2 / B – D / 9, 10, 14, 16, 18 / 7, 8, 10, 11 / 4, 6, 7 / 4
Comments and observations
Teaching objectives for Chapter 12
In this chapter, we discuss a variety of events and transactions that affect retained earnings. In the classroom, our objectives are to:
1 Explain the purpose of reporting irregular events separately from normal and recurring business activities.
2 Carefully define discontinued operations, extraordinary items, and accounting changes. Review and discuss the financial statement presentation of each category of event.
3 Illustrate the computation of earnings per share, and briefly discuss the distinction between basic and diluted earnings.
4 Discuss the nature and purpose of cash dividends and stock dividends, emphasizing the effects upon total stockholders' equity and the probable effects upon stock price. Illustrate the journal entries for each of the events.
5 Explain the nature of prior period adjustments. Discuss probability of occurrence in publicly owned and closely held corporations.
6 Review and discuss the statement of retained earnings.
7 Explain the nature of comprehensive income.
8 Review the statement of stockholders' equity portrayed as an "expanded" statement of retained earnings.
New features in Chapter 12
The changes to this chapter reflect the new organization of the material on stockholders’ equity. We have moved the prior treatments of stock splits and treasury stock transactions to Chapter 11 so that we might concentrate on retained earnings. In most other respects, the coverage of topics in this chapter parallels that in our previous edition. A section discussing the concept of comprehensive income has been added. The Case in Point capsules have all been updated. The assignment material has been expanded to include an exercise on comprehensive income.
General comments
Many accounting faculty ask us why we cover discontinued operations in the introductory course. Our answer is that in this era of "corporate restructuring," discontinued operations are commonplace in the financial statements of publicly owned corporations. Discontinued operations are far more commonplace (and more material in dollar amount) than are extraordinary items. (Prior period adjustments, by comparison, are virtually nonexistent in the financial statements of large corporations.)
We make these points in the text but feel that we owe a separate explanation to instructors. While extraordinary items and prior period adjustments are "traditional" accounting topics, discontinued operations is a relative newcomer. We also know that some introductory accounting textbooks still do not address this emerging topic.
In discussing irregular events, we focus upon the appropriate financial statement presentation rather than upon the recording of transactions. Most of these transactions are recorded in the same manner as ordinary transactions. Allocations of revenue, expenses, and gains and losses to such special categories as "continuing operations," "discontinued operations," and "extraordinary items" are made on a working paper at the end of the period. The tax effects relating to these items also are determined and allocated on a working paper rather than through journal entries.
We consider these working paper procedures beyond the scope of the introductory course. Entries to record accounting changes and prior period adjustments also are beyond the scope of the introductory accounting course. Anyone with responsibility for recording such transactions needs more of an accounting background than an introductory course can provide. Any user of financial statements, however, needs to understand the nature of these unusual items in order to interpret properly the operating results of the current period.
Several of our problems are intended to illustrate the presentation of irregular events in financial statements, including Problems 1, 2, and 3. These problems are successively comprehensive and challenging. We also recommend class discussion of Case 1 involving several well-known corporations.
In discussing earnings-per-share, we consider a conceptual understanding important, but regard most of the mechanics of per-share computations as beyond the scope of the course. For instance, we discuss the concept of diluted earnings-per-share, but do not get into any computations. We do, however, review Exercise 5. This exercise helps clarify the idea that earnings-per-share is based only upon the income applicable to common stock.
The "stockholders' equity" portion of this chapter includes a variety of short topics. We find an in-class review of Exercise 9 is an efficient way to cover many of these topics. As an overview, we use Problem 5, which also acquaints students with the unofficial "statement" of stockholders' equity.
Supplemental Exercises
Business Week Exercise
The article “A Closer Look at All Those Write-offs”, Business Week, October 13, 2003, states that corporate earnings write-offs has helped create “the worst quality of earnings in more than a decade”. How do corporate write-offs affect analysis of a company’s financial statements, particularly the income statement?
Group Exercise
The text points out that restructuring charges have been very common during the 1990’s. Visit websites for several large corporations, find the 2002 annual reports and study the notes to the financial statements for information on restructuring charges incurred by the corporations.
Internet Exercise
Visit websites for several large corporations, find the 2002 annual reports and review the income statements. Report on discontinued operations and extraordinary items.
CHAPTER 12 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1 Midas Corporation declared a 2-for-1 common stock split, but this transaction was erroneously recorded as a 100% common stock dividend. As a result:
a The common stock account is overstated.
b The total dollar amount of stockholders’ equity is overstated.
c The corporate records do not show the correct number of shares of common stock outstanding.
d The par value per share is understated.
2 Garrett Mfg.’s financial statements for the current year include the following:
Income from continuing operations $729,000
Prior period adjustment (increase in prior-year net income,
net of taxes) 125,000
Cash dividends paid to preferred stockholders 146,000
Gain from discontinued operations (net of taxes) 443,000
Cumulative effect of accounting change (reduction in
net income, net of tax benefit) 307,000
Extraordinary loss (net of tax benefit) 118,000
On the basis of this information, net income for the current year is:
a $429,000. b $747,000. c $726,000. d $853,200.
3 The following two items are disclosed in the stockholders’ equity section of Kent Corporation’s December 31, 2006, balance sheet:
Treasury stock (500 shares, at cost) $30,000
Additional paid-in capital: treasury stock transactions 10,000
If the company had reacquired 3,000 shares of treasury stock in February of 2006, then some of the treasury stock must have been sold during 2006 for:
a $4 per share above its par value.
b $4 per share.
c $64 per share.
d $64 per share above its cost.
4 At the beginning of the current year, Sutton Corporation had 400,000 shares of $1 par common stock outstanding and had retained earnings of $8,000,000. During the year, the company earned $6,000,000, declared a 5% stock dividend when the price of stock was $25 per share, and paid a year-end cash dividend of $3 per share. (The cash dividend was paid after the stock dividend had been distributed.) Sutton Corporation’s retained earnings at the end of the year amount to:
a $14,000,000. b $12,240,000. c $12,720,000. d $12,740,000.
5 Gerstan Corp. had 25,000 shares of 8% preferred stock, $100 par, and 500,000 shares of $1 par common stock outstanding throughout the year. Net income for the year was $2,200,000, and Gerstan declared and distributed a cash dividend of $3 per share on its common stock. Earnings per share amounted to:
a $4.40. b $2.00. c $4.00. d $1.60.
CHAPTER 12 NAME #
10-MINUTE QUIZ B SECTION
The stockholders’ equity section of the balance sheet of United Publishing at December 31, 2006, appears as follows:
Stockholders’ equity:
5% preferred stock, $100 par,
50,000 shares authorized, ?? shares issued $1,600,000
Common stock, $2 par, 500,000 shares authorized,
120,000 shares issued, of which ?? are held in treasury 240,000
Additional paid-in capital:
From issuance of preferred stock 280,000
From issuance of common stock 800,000
From treasury stock transactions 12,000
From common stock dividends 200,000
Total paid-in capital $3,132,000
Retained earnings ($96,000 equal to cost of treasury
stock is not available for dividends) 780,000
$3,912,000
Less: Treasury stock (at cost: 12,000 common shares) ……………… (96,000)
Total stockholders’ equity $3,816,000
Answer the following questions based on the stockholders’ equity section given above. The company had no treasury stock purchases before 2006.
1 Refer to the above data. What was the average issue price per share of preferred stock?
a $88. b $100. c $117.50. d $108.
2 Refer to the above data. How many shares of common stock are outstanding?
a 120,000. b 108,000. c 500,000. d 96,000.
3 Refer to the above data. A small stock dividend of 5,000 shares was declared and distributed during 2006. What was the market price per share on the date of declaration?
a $42 per share. b $40 per share. c $2 per share. d $38 per share.
4 Refer to the above data. If United Publishing had reacquired 14,000 shares of treasury stock early in 2006, then some treasury stock must have been sold during 2006 for:
a $5 per share. b $8 per share. c $6 per share. d $14 per share.
5 Refer to the above data. Assume that all remaining treasury stock is reissued at a price of $13 per share in January of 2007. What amount should be credited to the account Additional Paid-in Capital: Treasury Stock Transactions in the journal entry to record this transaction?
a $96,000. b $60,000. c $156,000. d $66,000.
CHAPTER 12 NAME #
10-MINUTE QUIZ C SECTION
The stockholders’ equity section of the balance sheet of Butterfly Fashions, Inc., at December 31, 2006, appears as follows:
Stockholders’ equity:
7% preferred stock, $100 par, callable at $105,
50,000 shares authorized, 50,000 shares issued $5,000,000