Copyright © Cengage Learning. All rights reserved. Chapter 12 The Corporate Income Statement and the Statement of Stockholders’ Equity

Copyright © Cengage Learning. All rights reserved Quality of Earnings Refers to the substance of earnings and their sustainability into future accounting periods. Because of the importance of net income (bottom line), there is significant interest in evaluating the quality of earnings. Quality of earnings is affected by these items: –Accounting methods and estimates –Gains and losses on transactions –Write-downs and restructurings –Nonoperating items

Copyright © Cengage Learning. All rights reserved When a company has both continuing and discontinued operations, the operating income section is called income from continuing operations The Corporate Income Statement The corporate income statement includes: –Revenues –Expenses –Gains and losses –Income tax expense –Discontinued operations –Extraordinary gains and losses –Earnings per share

Copyright © Cengage Learning. All rights reserved Corporate Income Statement

Copyright © Cengage Learning. All rights reserved The Effect of Accounting Methods and Estimates A firm’s operating income is affected by estimates and accounting methods. Accounting estimates should be based on realistic assumptions, but there is considerable latitude in making the estimate. The importance of estimates depends on the industry in which the firm operates.

Copyright © Cengage Learning. All rights reserved Accounting Estimates Uncollectible accounts receivable Sales returns Useful life of an asset Residual value of an asset Total units of production Total recoverable units of natural resource Amortization period Warranty claims Environmental cleanup costs

Copyright © Cengage Learning. All rights reserved Accounting Methods 1.Percentage of net sales or aging to estimate uncollectible accounts receivable 2.LIFO, FIFO, or average cost to value inventory 3.Accelerated, production, or straight-line depreciation 4.Revenue recognition methods

Copyright © Cengage Learning. All rights reserved Effect of Accounting Methods and Estimates Some methods and estimates are more conservative than others. Conventions that help overcome this problem –Full disclosure Requires that management explain the significant accounting policies used in preparing the financial statements in a note to the financial statements –Consistency Requires that the same accounting procedures be followed from year to year

Copyright © Cengage Learning. All rights reserved Gains and Losses Result from the sale or disposal of operating assets or marketable securities Are one-time events but appear in the operating section of the income statement

Copyright © Cengage Learning. All rights reserved Write-downs and Restructurings Write-down –The recording of a decrease in the value of an asset below the carrying value on the balance sheet, and –The reduction of income in the current period by the amount of the decrease –Also called a write-off Restructuring –The estimated cost associated with a change in a company’s operations –Usually involving the closing of facilities and lay off of personnel

Copyright © Cengage Learning. All rights reserved Write-Downs and Restructurings (cont’d) Reduce current operating income –Boost future income by shifting future costs to the current period Are often an indication of bad management decisions –Paying too much for the assets of another company –Making operational changes that do not work out “Big bath” –Taking all possible losses in current year so that future years will be “clean” of these costs –Often occurs when a company is having a bad year or a change of management takes place, so that the company can show improved results in future years

Copyright © Cengage Learning. All rights reserved Can significantly affect net income Analysts consider nonoperating items when reviewing a company’s financial statements since these are nonrecurring items Nonoperating (Non-continuing) Items Discontinued operations Extraordinary gains and losses

Copyright © Cengage Learning. All rights reserved Stop & Review Q.What is quality of earnings? A.The substance of earnings and their sustainability into future accounting periods.

Copyright © Cengage Learning. All rights reserved Income Taxes Objective 2 –Show the relationships among income taxes expense, deferred income taxes, and net of taxes.

Copyright © Cengage Learning. All rights reserved Income Taxes Expense The expense recognized in the accounting records on an accrual basis that applies to income from continuing operations The taxes payable is determined from taxable income, measured according to the rules and regulations of the income tax code. Financial accounting determines net income in accordance with GAAP, not taxable income and tax liability.

Copyright © Cengage Learning. All rights reserved Income Taxes Expense (cont’d) There can be a material difference between accounting income and taxable income. Results from differences in the timing of the recognition of revenues and expenses between GAAP and income tax accounting

Copyright © Cengage Learning. All rights reserved Deferred Income Taxes –The account used to record the difference between income taxes expense and income taxes payable

Copyright © Cengage Learning. All rights reserved Vistula Corporation shows income tax expense of $289,000 on its income statement, but has actual income taxes payable of $184,000. Record the estimated income taxes expense applicable to income from continuing operations using the income tax allocation procedure: Deferred Income Taxes Illustrated

Copyright © Cengage Learning. All rights reserved Deferred Income Taxes Recognized for the estimated future tax effects resulting from temporary differences in the valuation of assets, liabilities, equity, revenues, expenses, gains, and losses for tax and financial reporting purposes Temporary differences –The recognition point for revenues, expenses, gains and losses is not the same for tax and financial reporting

Copyright © Cengage Learning. All rights reserved Example of a Temporary Difference Treatment of advance payment for goods –Financial income (Revenue is not recognized until goods are shipped) –Taxable income (Revenue is recognized when cash is received) Result –Taxes paid > Tax expense –Creates a deferred income tax asset (prepaid taxes)

Copyright © Cengage Learning. All rights reserved Classification of Deferred Income Taxes Depends on the classification of the related asset or liability that created the difference –Current –Noncurrent

Copyright © Cengage Learning. All rights reserved Earnings per Share Objective 3 –Compute earnings per share.

Copyright © Cengage Learning. All rights reserved Earnings per Share (EPS) Used to judge a company’s performance and to compare it with the performance of other companies Presented on the face of the income statement –Disclosed just below the net income An EPS amount is always shown for –Income from continuing operations –Income before extraordinary items –Net income –Gain or loss from discontinued operations or extraordinary items

Copyright © Cengage Learning. All rights reserved Basic Earnings per Share If the number of common shares changed, or the company paid preferred stock dividends during the year, the weighted average must be calculated. If a company has nonconvertible preferred stock, the dividend must be subtracted from net income before EPS for common stock is computed.

Copyright © Cengage Learning. All rights reserved Vistula Corporation had net income of $669,000 and 200,000 shares of common stock outstanding. Basic EPS

Copyright © Cengage Learning. All rights reserved Suppose that from Jan. 1 to March 31, Vistula had 200,000 shares outstanding; from April 1 to Sept. 30, it had 240,000 shares outstanding; and from Oct. 31 to Dec. 31, 260,000 shares were outstanding. Envest had net income of $669, ,000 shares × 3/12 year 50, ,000 shares × 6/12 year120, ,000 shares × 3/12 year 65,000 Weighted-average common shares outstanding235,000 Dividends for nonconvertible preferred stock outstanding should be subtracted from net income before earnings per share for common stock are computed. Calculating Weighted-Average

Copyright © Cengage Learning. All rights reserved Capital Structure Simple –No bonds, stocks, or stock options that can be converted into common stock –Use basic EPS calculation Complex –Includes exercisable stock options or convertible stocks and bonds Are potentially dilutive securities –Have the potential of diluting the EPS of common stock »A stockholder’s proportionate share of ownership in a company could be reduced by conversion, which would increase the total shares outstanding –Report two earnings per share figures Basic earnings per share Diluted earnings per share

Copyright © Cengage Learning. All rights reserved Diluted Earnings per Share Calculated by adding all potentially dilutive securities to the denominator of the basic EPS calculation Shows stockholders the maximum potential effect of dilution on their ownership position in the company Difference between basic and diluted EPS can be significant

Copyright © Cengage Learning. All rights reserved Comprehensive Income and the Statement of Stockholders’ Equity Objective 4 –Define comprehensive income, and describe the statement of stockholders’ equity.

Copyright © Cengage Learning. All rights reserved Includes items like: Net income Changes in unrealized investment gains and losses Foreign currency translation adjustments Comprehensive income can be shown as part of the statement of stockholders’ equity or in a separate statement Comprehensive Income Transactions that affect stockholders’ equity, but are not stock transactions

Copyright © Cengage Learning. All rights reserved Statement of Stockholders’ Equity Summarizes the changes in the components of the stockholders’ equity section of the balance sheet Also called the statement of changes in stockholders’ equity Reveals much more about the year’s stockholders’ equity transactions than the statement of retained earnings

Copyright © Cengage Learning. All rights reserved Statement of Stockholders’ Equity

Copyright © Cengage Learning. All rights reserved Book Value Objective 6 –Calculate book value per share.

Copyright © Cengage Learning. All rights reserved When a company has only common shares outstanding: Shares outstanding Includes common stock distributable Does not include treasury stock When a company has both common and preferred stock Subtract the call or par value of the preferred stock plus any dividends in arrears from total stockholders’ equity Represents the equity of the owner of one share of stock in the net assets of the corporation Book Value per Share

Copyright © Cengage Learning. All rights reserved Crisanti Corp. has total stockholders’ equity of $4,028,800 that includes: 6,000 shares outstanding of $100 par 8 percent convertible preferred stock; 83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares treasury stock. No dividends are in arrears and the preferred stock is callable at $105. What is the book value per share for both preferred and common stock? Book Value per Share Illustrated

Copyright © Cengage Learning. All rights reserved Crisanti Corp. has total stockholders’ equity of $4,028,800 that includes: 6,000 shares outstanding of $100 par 8 percent cumulative preferred stock; 83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares treasury stock. One year of dividends are in arrears and the preferred stock is callable at $105. What is the book value per share for both preferred and common stock? Book Value per Share Illustrated (Dividends in Arrears)