Prepared by: Debbie Musil Kwantlen University College Chapter 14 Corporations: Dividends, Retained Earnings and Income Reporting Prepared by: Debbie Musil Kwantlen University College

Agenda Learning goals Vocabulary

Learning goals Prepare the entries for cash dividends, stock dividends, and stock splits, and compare their financial impact Prepare a corporate income statement Prepare a statement of retained earnings Evaluate earnings and dividends performance.

Vocabulary Basic earnings per share Interperiod tax allocation Cash dividend Intraperiod tax allocation Change in accounting principle Payment date Comprehensive income statement Payout ratio Price-earning ratio (P/E) Correction of a prior period error Record date Retained earnings restrictions Debt covenant Statement of retained earnings Declaration date Stock dividend Dividend Stock split Earnings per share (EPS) Weighted average number of shares Fully diluted earnings per share

Cash Dividends Cash dividend distribution of cash to shareholders To pay dividends, a corporation must: Have enough retained earnings and cash Declare a dividend payable Declaration date: Board of directors formally declares dividend Commits company to a legal obligation Declaration is recorded:

Cash Dividends 2 Record date: Payment date: Ownership of shares is determined Shareholders of record on this date will receive dividend No journal entry required Payment date: Dividend is paid to shareholders and recorded:

Stock Dividends Cash dividend Stock dividend Paid in cash Decreases assets and shareholder’s equity Paid in shares No change in assets or shareholders’ equity Decreases R/E and increases share capital Doesn’t change your % ownership

Stock Dividends 2 Stock dividend neither increases nor decreases the assets in the company, investors are not receiving anything they did not already own.

Stock Dividends 2 Reasons for issuing stock dividends: Satisfies shareholders' dividend expectations without spending cash Decrease the price of shares making them more affordable Emphasizes that a portion of shareholders’ equity has been permanently retained in the business Therefore unavailable for cash dividends

Entries for Stock Dividends Declaration date: Issue (payment) date:

Equity Section after Stock Dividend

Stock Splits Involves the issue of additional shares to shareholders Similar to a stock dividend Increases the marketability of shares by lowering market value per share Effect on share price is generally inversely proportional to size of split Two – for – one stock split will decrease the stock price by 50% Does not affect shareholders’ equity Therefore no entries are required

Instead of a 10% stock dividend there was a two for one stock split Stock Splits 2 Instead of a 10% stock dividend there was a two for one stock split

Comparison of Dividends and Stock Splits Cash dividends reduce assets and shareholders’ equity (retained earnings) Stock dividends increase share capital and decrease retained earnings Stock dividends have no effect (but do increase number of shares issued)

Check for understanding Sing CD Corporation has had five years of record earnings. Due to this success, the market price of its 500,000 common shares tripled from $15 to $45 per share. During this period, the Common Shares account remained the same at $2million. R/E increased from $1.5 million to $10 million. President Bill Zerter is considering either ( a 10% stock dividend or (2) a two-for-one stock split. He asked you to show the before and after effects of each option on the accounts Common Shares and Retained Earnings and on the number of shares. (719)

Practice questions Self study 1-3 Questions 1, 4 BE14-15 E14-12

Corporate Income Taxes Income statement for corporations are the same as proprietorship or a partnership Major difference is income taxes Since corporation is a separate legal entity Affects income statement (income tax expense) and balance sheet (income tax payable)

Corporate Income Taxes 2 After a company determines its total income tax payable at year-end, it compares this amount to the total income tax instalments paid during the year. The difference between the income tax paid and income tax payable results in either an additional amount payable or a refund.

Corporate Income Taxes 3 Assume Leads had originally estimated that its taxable income would be $140,000. It has a 30% income tax rate, so its income tax was anticipated to be $42,000 ($140,000*30%). Leads remitted monthly instalments in the amount of $3,500 ($42,000/12). At year end, Leads actually reports taxable income of $156,000. Its total income tax liability is $46,800, and not $42,000 as estimated. Assuming it has already recorded and remitted $42,000 of income tax, the required adjustment entry is for $4,800 Dec. 31 Income Tax Expense 4,800 Income Tax Payable 4,800

Corporate Income Taxes 2 Interperiod tax allocation: Dividing income tax between amounts payable now and payable later Intraperiod tax allocation: Associating income taxes in a period with their related items of income

Comprehensive Income Statement Additional statement required in certain circumstances (R/E statement, income, balance sheet and cash flow statement) An expansion of the subsection of the Equity section for other and Comprehensive Income Includes all increases and decreases in shareholders’ equity except from share and dividend transactions

Retained Earnings The cumulative total of income less losses and less declared dividends since incorporation Represents part of shareholder’s claim on total assets of a corporation Not a claim on any specific asset (including cash) It would not be smart for a company to pay dividend = R/E. But there are restrictions to limit that : Contractual restrictions such as debt covenants Voluntary restrictions imposed by the Board of Directors

Prior Period Adjustments A prior period adjustment results from: the correction of a material error in reporting net income in a prior year, or the changing of an accounting principle Accounting treatment: Use corrected amount or new principle in reporting results for the current year Disclose cumulative effect of correction/change as an adjustment to retained earnings, not on income statement Correct/restate financial statements for prior periods Disclose effect of change in financial statements

Correction of Prior Period Errors Correction is made directly to retained earnings Since effect of error is now located there (all revenues and expenses have been closed to retained earnings) Any corrections are net of any income tax effect Example: overstatement of cost of goods sold Understatement of inventory, net income (now retained earnings), and income tax payable

Correction of Prior Period Errors Graber Inc, discovers in 2008 that is overstated its cost of goods sold in 2007 by $10,000 as a results of errors in counting inventory. Because costs of goods sold was overstated income before income tax was understated by the same amount, $10,000. If we assume an income tax rate of 30%, income tax expense would also be understated, but by $3,000 ($10,000*30%). The overall affect on net income is to understate it by $7,000 ($10,000-$3,000). In other words, net income is understated by the difference after tax [$10,000 *(100%-30%)]. If net income is understated, then R/E would also be understated by the same amount $7,000

Correction of Prior Period Errors

Change in Accounting Principle Occurs when the principle used in current year is different that that used in prior year May be voluntary or prescribed (by the CICA) Usually applied retroactively (prior years restated) unless not practical to do so Comparative amounts are restated Retained earnings is adjusted, net of tax Similar to adjustment for correction of errors

Reporting of Prior Period Adjustments Reported in the statement of retained earnings Adjustment is added to (subtracted from) opening balance of retained earnings, net of income tax effect Financial statements of prior years are restated to reflect the change

Reporting of Prior Period Adjustments Beginning of 2008 Graber changes from straight-line method of amortization for equipment to the declining-balance method. The equipment was purchased on January 2, 2004. The cumulative effect of this change is to increase amortization expense and accumulated amortization by $24,000 for the year of 2004-2007 Amortization expense increase  reduces net income  reducing R/E

Reporting of Prior Period Adjustments Jan. 2 Income Tax Payable 7.200 Retained Earnings 16,800 Accumulated Amortization 24,000 To record retroactive effect of change in amortization method

Sample Statement of Retained Earnings

Statement of Retained Earnings Shows the changes in retained earnings during the year Transactions that affect retained earnings:

Sample Statement of Retained Earnings

Check for understanding? Vega Corporation reported retained earnings of $5,130,000 at December 31, 2007. In 2008, the company earns $2,000,000 of net income. It declares and pays a $250,000 cash dividend. Vega also records a pre-tax adjustment of $275,000 for an overstatement resulting from a mathematical error that affected 2007 ending inventory. The company also incurred a $25,500 change to retained earnings for the reacquisition of common shares. Its income tax rate is 30%. Prepare a statement of retained earnings for the year ended December 31. (727)

Practice Questions Self-study 4+7 Question 7+9+11+13 BE 14-610

Earnings Performance: Earnings per Share Indicates net income earned by each common share Reported on the income statement Formula to calculate: Weighted average number of common shares = shares issued during the year x the fraction of the year they are outstanding Example: April 1 = 3/12 months if calendar year used Net income less Preferred Dividends Weighted Average Number of Common Shares Earnings per Share ÷ =

Earnings Performance: Earnings per Share Assume that a company has 100,000 common shares on January1, and issued an additional 10,000 shares on October 1. The weighted average number of share for the year would be calculated as follows:

Earnings per Share: Complex Share Structures When a company has securities that can be converted into common shares Example: convertible preferred shares If converted, the additional common shares will result in a reduced (diluted) EPS figure Two EPS amounts are calculated: Basic EPS: as regular EPS formula from previous slide Fully diluted EPS: calculated as if all securities were converted into common shares

Earnings Performance: Price-Earnings Ratio Helps investors compare earnings of different companies Formula to calculate: A high PE ratio is an indicator that investors believe the company has good earnings potential P/E ratio of 34 means that the shares are trading 24 times it’s earnings. Market Price per Share Earnings per Share Price-Earnings Ratio ÷ =

Payout Ratio Indicates what percentage of earnings a company is distributing to its shareholders Can be calculated for both common and preferred shares: Payout ratios vary with the industry High payout ratios can indicate that a company is not reinvesting enough in its operations Cash Dividends Payout Ratio ÷ = Net income

Check for understanding Shoten Limited reported net income of $249,750 on its October 31, year-end income statement. The shareholders’ equity section of its balance sheet reported 3,000 $2-noncumulative preferred shares and 50,000 common shares. Of the common shares, 40,000 had been issued since the beginning of years, 15,000 were issued on March 1, and 5,000 were repurchased on August 1. The preferred dividend was declared and paid during the year. Calculate Shoten’s earnings per share. (731)

Practice Questions Self study questions 8-10 BE 14-1114 E 14-10+11