© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Financial & Managerial Accounting The Basis for Business Decisions FOURTEENTH EDITION Williams Haka Bettner Carcello

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin INCOME AND CHANGES IN RETAINED EARNINGS Chapter 12

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO1 To describe how irregular income items, such as discontinued operations and extraordinary items, are presented in the income statement.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Information about net income can be divided into two major categories Income from continuing operations. 1. Results of discontinued operations. 2. Impact of extraordinary items. 3. Effects of changes in accounting principles. Normal, recurring revenue and expense transactions. Unusual, nonrecurring events that affect net income. Reporting the Results of Operations

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin This tax expense does not include effects of unusual, nonrecurring items. These unusual, nonrecurring items are each reported net of taxes.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Income/Loss from operating the segment prior to disposal. Income/Loss on disposal of the segment. 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. Discontinued Operations

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin A segment must be a separate line of business activity or an operation that services a distinct category of customers. 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin During 2007, 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? During 2007, 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? Discontinued Operations

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Discontinued Operations

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Income Statement Presentation: Discontinued Operations

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Extraordinary Items Material in amount. Material in amount. Gains or losses that are both unusual in nature and not expected to recur in the foreseeable future. Gains or losses that are both unusual in nature and not expected to recur in the foreseeable future. Reported net of related taxes. Reported net of related taxes. Material in amount. Material in amount. Gains or losses that are both unusual in nature and not expected to recur in the foreseeable future. Gains or losses that are both unusual in nature and not expected to recur in the foreseeable future. Reported net of related taxes. Reported net of related taxes.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin During 2007, Matrix, Inc. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. 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 2007 income statement? During 2007, Matrix, Inc. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. 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 2007 income statement? Extraordinary Items

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Income Statement Presentation: Extraordinary Items - Example

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Let’s move on to a few final topics.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO2 To compute earnings per share.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin A measure of the company’s profitability and earning power for the period. Based on the number of shares issued and the length of time that number remained unchanged. Earnings Per Share (EPS)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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. Prepare a partial income statement showing the EPS for income from continuing operations and for the other special items. Prepare a partial income statement showing the EPS for income from continuing operations and for the other special items. 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. Prepare a partial income statement showing the EPS for income from continuing operations and for the other special items. Prepare a partial income statement showing the EPS for income from continuing operations and for the other special items. Earnings Per Share (EPS)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin * Rounded. Earnings Per Share (EPS)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin If preferred stock is present, subtract preferred dividends from net income prior to computing EPS. EPS is required to be reported in the income statement. Earnings Per Share (EPS) Net Income -Preferred Dividends Weighted Average Number of Common Shares Outstanding Earnings Per Share =

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO3 To distinguish between basic and diluted earnings per share.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Basic and Diluted Earnings per Share If a company has convertible securities, like convertible preferred stock outstanding, the conversion of these securities to common stock may dilute (reduce) earnings per share. Diluted earnings per share reflect the impact of the assumed conversion of the securities on earnings.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Often, the Price-Earnings Ratio is used to evaluate the reasonableness of a company’s stock price. Price-earnings Ratio (P/E) Let’s examine this further.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO4 To account for cash dividends and stock dividends, and explain the effects of these transactions on a company’s financial statements.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Declared by Board of Directors. Not legally required. Not legally required. Creates liability at declaration. Requires sufficient Retained Earnings and Cash. Accounting for Cash Dividends

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Date of Declaration Board of Directors declares the dividend. Record a liability. Date of Declaration Board of Directors declares the dividend. Record a liability. Dividend Dates On March 1, 2007, 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Ex-Dividend Date The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend. Ex-Dividend Date The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend. NO ENTRY Dividend Dates

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Date of Record Stockholders holding shares on this date will receive the dividend. (No entry ) Date of Record Stockholders holding shares on this date will receive the dividend. (No entry ) Dividend Dates X April 2007

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Date of Payment Record the payment of the dividend to stockholders. Date of Payment Record the payment of the dividend to stockholders. Dividend Dates

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin On June 1, 2007, a corporation’s board 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. On June 1, 2007, a corporation’s board 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. $100 × 8% = $8 dividend per share $8 × 2,500 = $20,000 total dividend $100 × 8% = $8 dividend per share $8 × 2,500 = $20,000 total dividend Dividend Dates

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin All stockholders retain same percentage ownership. No change in total stockholders’ equity. No change in par values. Accounting for Stock Dividends Distribution of additional shares of stock to stockholders.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Summary of Effects of Stock Dividends and Stock Splits

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO5 To describe and prepare a statement of retained earnings.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Statement of Retained Earnings with Prior Period Adjustment

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO6 To define prior period adjustments, and explain how they are presented in financial statements.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Adjust retained earnings retroactively. The adjustment should be disclosed net of any taxes. The correction of an error identified as affecting net income in a prior period. Prior Period Adjustments

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO7 To define comprehensive income, and explain how it differs from net income.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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. Comprehensive Income Normally, there are 3 ways that financial position can change.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin As a second Income Statement. Combined with Net Income on the Income Statement. As an element of Stockholders’ Equity. 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO8 To describe and prepare a statement of stockholders’ equity and the stockholders’ equity section of the balance sheet.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Statement of Stockholders’ Equity This is a more inclusive statement than the statement of retained earnings.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Stockholders’ Equity Section of the Balance Sheet

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO9 To illustrate steps management might take to improve the appearance of the company’s net income.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Improving the Appearance of Income Companies may take certain steps that are intended to improve the appearance of its financial performance in the financial statements. The Securities and Exchange Commission brought a series of enforcement actions against certain companies for taking these steps.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin End of Chapter 12