12–1 Chapter 12 The Corporate Income Statement and the Statement of Stockholders’ Equity

12–2 Copyright © Cengage Learning. All rights reserved. Motorola, Inc. Click here for the Motorola financial reports archive.here Motorola had good earnings in 2005 and 2006 but had a decrease in revenue of 15% in 2007 Additionally Motorola experienced a large operating loss of $553 million in 2007 What important questions should investors ask about Motorola’s future? Can the improvements be made and can Motorola come back to prominence? © Royalty Free/ Corbis

12–3 Copyright © Cengage Learning. All rights reserved. LO1 Quality of Earnings The substance of a company’s earnings and their sustainability into future accounting periods What methods or estimates might affect the quality of earnings? Gains and losses on transactions Write-downs and restructurings Nonoperating items Investors should understand which items included in earnings are recurring and which are one-time items. Income from continuing operations (before nonoperating items) gives a clear signal about future results.

12–4 Copyright © Cengage Learning. All rights reserved. LIFO produces a higher cost of goods sold. An accelerated depreciation method yields a higher depreciation expense. Produces a lower operating income The Impact of Estimates and Methods Different accounting methods have different effects on net income

12–5 Copyright © Cengage Learning. All rights reserved. Ordinary Gains and Losses  appear in the other revenue and expense section of the income statement,  one-time events should not go here but often are © Royalty Free PhotoDisc Collection/ Getty Images

12–6 Copyright © Cengage Learning. All rights reserved. Write-Downs and Restructurings Imagine that a company decides to “write- down” the value of a large asset below its carrying value on the balance sheet Reduces current operating income and boosts future income by shifting future costs to the current accounting period How does this affect income? Often called “big baths” or taking all possible losses

12–7 Copyright © Cengage Learning. All rights reserved. Nonrecurring Items Reported on the income statement: Discontinued operations Extraordinary gains and losses The effects of changes in accounting principles are no longer reported on the income statement. © Royalty Free PhotoDisc Collection/ Getty Images

12–8 Copyright © Cengage Learning. All rights reserved. Discussion: Ethics on the Job Charles Brink, the new CEO of RDR Industries, instructs the CFO to take all possible losses in the current year. He says he wants to wipe the slate clean of costs associated with the previous management. Q.Do you think the CEO’s instructions are ethical? How will this action affect future years’ performance? While the CEO’s actions are legal, taking a ‘big bath’ on losses makes it possible for him to claim large improvements in future years. The decision may be more about his personal gain than the best interest of stockholders, and is not an ethical action.

12–9 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. If an analyst believes that a company has a poor quality of earnings, what does this mean? A. In general, the analyst believes that the substance of a company’s earnings is not sustainable into the future.

12–10 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. Does a company’s choice of inventory costing method have an impact on its quality of earnings? Why or why not? A. Yes. Certain methods will produce a higher cost of goods sold, thus yielding a lower operating income. If a company makes choices that continually manipulate its earnings, it will not be seen as able to sustain these earnings if they are created through accounting methods alone.

12–11 Copyright © Cengage Learning. All rights reserved. LO2 Taxable Versus GAAP Taxable IncomeAccounting Income Determined by deducting allowable expenses from income Federal tax laws dictate which expenses corporations may deduct Determined in accordance with GAAP Income taxes expense is recognized on an accrual basis The difference between accounting income and taxable income, especially in large businesses, can be material

12–12 Copyright © Cengage Learning. All rights reserved. Deferred Income Taxes Represents the amount by which income taxes expense differs from income taxes payable Income tax allocation A technique used to account for the difference between income taxes expense based on accounting income and the actual income taxes payable based on taxable income

12–13 Copyright © Cengage Learning. All rights reserved. Vistula Corporation has income taxes 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

12–14 Copyright © Cengage Learning. All rights reserved. Deferred Income Taxes Rules for recording, measuring, and classifying deferred income taxes Deferred income taxes are 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. What are temporary differences? Revenues and expenses or gains and losses that are included in taxable income before or after they are included in accounting income

12–15 Copyright © Cengage Learning. All rights reserved. Example of Temporary Difference Treatment of advance payment for goods Accounting income (Revenue is not recognized until goods are shipped) Taxable income (Revenue is recognized when cash is received) Result Taxes paid > Taxes expense Creates a deferred income taxes asset (prepaid taxes)

12–16 Copyright © Cengage Learning. All rights reserved. Net of Taxes taxes have been taken into account in reporting an item on the income statement Used for one time items keeps from distorting income taxes associated with ongoing operations © Royalty Free/ Corbis

12–17 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. Why are taxable income and accounting income usually different? A. They are calculated using different rules. Taxable income is calculated using tax rules and allowable expenses. Accounting income is calculated using GAAP. Thus, the two amounts are usually different.

12–18 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. What is the income tax allocation procedure? A. A procedure used to account for the difference between income taxes expense based on accounting income and the actual income taxes payable based on taxable income. The difference goes to the Deferred Income Taxes account.

12–19 Copyright © Cengage Learning. All rights reserved. LO3 Earnings Per Share (EPS) Used to evaluate a company’s performance and compare it with other companies Should be presented on the face of the income statement Usually disclosed just below net income Show earnings per share for income from continuing operations and other major components of net income © Royalty Free C Squared Studios/ Getty Images

12–20 Copyright © Cengage Learning. All rights reserved. Basic EPS Vistula Corporation had net income of $669,000 and 200,000 shares of common stock outstanding.

12–21 Copyright © Cengage Learning. All rights reserved. Calculating Weighted-Average 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. 1 to Dec. 31, 260,000 shares were outstanding. Vistula 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 outstanding = 12/12235,000 Dividends for nonconvertible preferred stock outstanding should be subtracted from net income before earnings per share for common stock are computed.

12–22 Copyright © Cengage Learning. All rights reserved. Has the potential to dilute EPS of common stock Diluted EPS Simple Capital Structure No preferred stocks, bonds, or stock options that can be converted into common stock Complex Capital Structure Issued securities or stock options that can be converted to common stock Diluted earnings per share are calculated by adding all potentially dilutive securities to the denominator of the basic earnings per share calculation.

12–23 Copyright © Cengage Learning. All rights reserved. Dilution of Ownership S. Green owns 10,000 shares of a company’s common stock, which equals 2 percent of the outstanding shares of 500,000. Suppose holders of convertible bonds convert the bonds into 100,000 shares of stock. Now, S. Green’s 10,000 shares would equal only 1.67 percent (10,000 ÷ 600,000) of the outstanding shares. Reporting requirements Companies with a complex capital structure must report basic and diluted earnings per share.

12–24 Copyright © Cengage Learning. All rights reserved. Stop & Apply Q. Kraffton Corporation had net income of $495,300 and 200,000 shares of common stock outstanding. Compute earnings per share. * * Rounded A.

12–25 Copyright © Cengage Learning. All rights reserved. Stop & Apply Q. Possible Corporation had net income of $759,500 and 500,000 shares of common stock outstanding. It also issued preferred stock that could be converted into 100,000 shares of common stock. Compute diluted earnings per share. A. * * Rounded

12–26 Copyright © Cengage Learning. All rights reserved. LO4 Comprehensive Income Transactions that affect stockholders’ equity, but are not stock transactions 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 © Royalty Free C Squared Studios/ Getty Images

12–27 Copyright © Cengage Learning. All rights reserved. Statement of Stockholders’ Equity Summarizes changes in the components of the stockholders’ equity section of the balance sheet

12–28 Represent stockholders’ claims to assets arising from the earnings of the business Copyright © Cengage Learning. All rights reserved. Retained Earnings Assets kept in the company to help it grow Retained Earnings may have a debit or credit balance A debit balance means that past dividends and losses have been greater than its previous profits © Royalty Free C Squared Studios/ Getty Images

12–29 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. If you were interested in the changes that occurred in each of the stockholders’ equity accounts, which financial statement would be most useful? A. Statement of Stockholders’ Equity

12–30 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. Where are foreign currency translations reported? A. As part of comprehensive income on the statement of stockholders’ equity or in a separate comprehensive income statement.

12–31 Copyright © Cengage Learning. All rights reserved. LO5 Stock Dividend Proportional distribution of shares of a corporation’s stock to its shareholders changes the content of stockholders’ equity Involves no distribution of assets Moves $ from RE to Contributed Capital © Royalty Free/ Corbis

12–32 Copyright © Cengage Learning. All rights reserved. Why Issue a Stock Dividend? May reduce the stock’s market price since the number of shares outstanding increases Gives stockholders some evidence of the company’s success without using cash unlike a cash dividend Increases the company’s permanent capital by transferring an amount from retained earnings to contributed capital Nontaxable distribution to stockholders

12–33 Copyright © Cengage Learning. All rights reserved. Stock Dividends Illustrated Rivera Corporation has the following stockholders’ equity structure before stock dividends are declared:

12–34 Copyright © Cengage Learning. All rights reserved. Rivera Corporation declares a 10 percent stock dividend on February 24, distributable on March 31 to stockholders of record on March 15. The market price of the stock on February 24 is $20 per share. Stock Dividends Illustrated (cont’d) Date of Declaration:

12–35 Copyright © Cengage Learning. All rights reserved. Rivera Corporation declares a 10 percent stock dividend on February 24, distributable on March 31 to stockholders of record on March 15. The market price of the stock on February 24 is $20 per share. Stock Dividends Illustrated (cont’d) Date of Distribution: No entry is required Recall that this date is used to determine the owners of stock who will receive dividends Date of Record:

12–36 Effects of Stock Dividends on Contributed Capital Total stockholders’ equity is the same before and after a stock dividend The assets of a corporation are not reduced as they would have been if a cash dividend had been declared and paid The proportionate ownership in the corporation of any individual is the same before and after a stock dividend * Rounded

12–37 Copyright © Cengage Learning. All rights reserved. Stock Split A corporation increases the number of shares of stock issued and outstanding and reduces the par or stated value proportionally Has the effect of lowering a stock’s market value per share and increasing the demand for the stock at this lower price Stock splits and stock dividends reduce earnings per share because they increase the number of shares issued and outstanding.

12–38 Copyright © Cengage Learning. All rights reserved. July 15: MUI Corporation’s 15,000 shares of $5 par value common stock issued and outstanding were split 2 for 1. Each stockholder’s proportionate interest in the company remains the same because each share of $5 par value stock was converted to 2 shares of $2.50 par value stock. Stock Split Illustrated A stock split does not increase the number of shares authorized, nor does it change the balances in the accounts in the stockholders’ equity section of the balance sheet. No journal entry required, memorandum entry is appropriate.

12–39 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. What is the difference between a stock split and a stock dividend? A. A stock dividend changes the makeup of stockholders’ equity in that it transfers capital from retained earnings to permanent capital accounts. A stock split does not change the makeup of stockholders’ equity.

12–40 Copyright © Cengage Learning. All rights reserved. LO6 Book Value per Share When a company has only common shares outstanding, calculate book value per share as follows: Shares outstanding Includes common stock distributable Does not include treasury stock When a company has both common and preferred stock, subtract the call value of the preferred stock plus any dividends in arrears from total stockholders’ equity. (Use par value if call value is not specified.)

12–41 Copyright © Cengage Learning. All rights reserved. Crisanti Corporation has total stockholders’ equity of $4,028,800 that includes: 6,000 shares of $100 par 8 percent convertible preferred stock outstanding; 83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares of 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 * * Rounded

12–42 Copyright © Cengage Learning. All rights reserved. Crisanti Corporation has total stockholders’ equity of $4,028,800 that includes: 6,000 shares of $100 par 8 percent cumulative preferred stock outstanding; 83,600 shares issued and 82,600 shares outstanding of $10 par value common stock; and 1,000 shares of 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) * * Rounded

12–43 Copyright © Cengage Learning. All rights reserved. Stop & Review Q. What is the meaning of book value per share of stock? A. It represents the equity of the owner of one share of stock in the net assets of a company.

12–44 Copyright © Cengage Learning. All rights reserved. Stop & Apply Q. Grapple Corporation has 2,000 shares of 6 percent $100 par value cumulative preferred stock and 50,000 shares issued and 48,400 outstanding of $10 par value common stock. Total stockholders’ equity is $1,945,000. One year of dividends are in arrears and the preferred stock is callable at $110. What is the book value per share for both classes of stock? A. * Rounded

12–45 Copyright © Cengage Learning. All rights reserved. Chapter Review Problem The stockholders’ equity of Latte Company on July 31, 20x7, was as follows: Contributed capital Common stock, no par value, $6 stated value, 500,000 shares authorized, 300,000 shares issued and outstanding $1,800,000 Additional paid-in capital 800,000 Total contributed capital$2,600,000 Retained earnings 670,000 Total stockholders’ equity $3,270,000 The board declares a 10 percent stock dividend on August 15, 20x7, distributable on September 9 to stockholders of record on September 1. The market price on Aug. 15 is $20 per share. Required: Record the stock dividend in the general journal on the date of declaration. Determine the book value per share after the dividend.

12–46 Copyright © Cengage Learning. All rights reserved. Chapter Review Problem (Solution) * * Rounded