The Corporate Income Statement and the Statement of Stockholders' Equity 14

Performance Measurement: Quality of Earnings Issues OBJECTIVE 1: Define quality of earnings, and identify the components of a corporate income statement.

Exhibit 1: Corporate Income Statement

Performance Measurement: Quality of Earnings Issues The most commonly used predictors of a company’s performance are expected changes in earnings per share and expected return on equity. –Net income is a key component of each of these measures.

Performance Measurement: Quality of Earnings Issues The most commonly used predictors of a company’s performance are expected changes in earnings per share and expected return on equity. (cont.) –Income from continuing operations is made up of revenues, costs and expenses, gains and losses from the sale of assets, write-downs of assets, restructurings, and income taxes expense on continuing operations.

Performance Measurement: Quality of Earnings Issues The effect of accounting estimates and methods –For earnings per share and return on equity to be valid, the quality of earnings must be good.

Performance Measurement: Quality of Earnings Issues The effect of accounting estimates and methods (cont.) –The quality of earnings is affected by the following: The accounting methods and estimates the company’s management chooses Gains and losses reported in the operating section The existence of write-downs or restructurings The nature of nonoperating items

Performance Measurement: Quality of Earnings Issues The effect of accounting estimates and methods (cont.) –The quality of earnings is affected by the choice of one acceptable estimate, method, or procedure over another. –Uncollectible accounts—methods and percentage estimate

Performance Measurement: Quality of Earnings Issues The effect of accounting estimates and methods (cont.) –Inventory—methods and applications –Depreciation of plant assets—methods, estimates of life, and estimates of residual value –Depletion of natural resources—estimate of life in tons, barrels, and so on

Performance Measurement: Quality of Earnings Issues The effect of accounting estimates and methods (cont.) –Amortization of intangibles—difficulty in estimating useful life –In general, choosing the most conservative figure produces the best quality of earnings.

Performance Measurement: Quality of Earnings Issues Gains and losses –It is best not to refer only to the bottom-line figure.

Performance Measurement: Quality of Earnings Issues Write-downs and restructuring –A write-down is recorded when the value of an asset drops below its carrying value. –A restructuring is the estimated cost of altering a company’s operations, often involving plant closures and layoffs.

Performance Measurement: Quality of Earnings Issues Write-downs and restructuring(cont.) –Both write-downs and restructurings reduce current operating income and are often an indication of bad decisions having been made by management.

Performance Measurement: Quality of Earnings Issues Non-operating items –Discontinued operations –Extraordinary gains and losses –Accounting changes

Performance Measurement: Quality of Earnings Issues Non-operating items (cont.) –Generally, gains and losses, asset write-downs, restructurings, and nonoperating items have no effect on cash flows; however, sustainable earnings generally do have a relationship to future cash flows. –Quality of earnings is especially relevant to considerations pertaining to return on assets and return on equity.

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Income Taxes OBJECTIVE 2: Show the relationships among income taxes expense, deferred income taxes, and net of taxes.

Table 1: Tax Rate Schedule for Corporations, 2008

Income Taxes Corporate taxable income and tax liability –Corporate taxable income is determined by subtracting allowable business deductions from includable gross income. –Tax rates currently range from a 15 percent to a 39 percent marginal rate.

Income Taxes Corporate taxable income and tax liability (cont.) –Computing income taxes for financial reporting purposes differs from computing income taxes due the government for the same accounting period because financial reporting income is governed by generally accepted accounting principles, whereas taxable income is governed by the Internal Revenue Code.

Income Taxes Because accounting income normally differs from taxable income, income tax allocation is usually necessary. –Under income tax allocation method, the difference between the current tax liability and income taxes expense is debited or credited to an account called Deferred Income Taxes.

Income Taxes Because accounting income normally differs from taxable income, income tax allocation is usually necessary. (cont.) –Adjustments to this account must be made in light of legislated changes in income tax laws and regulations. –The Deferred Income Taxes account can have a debit balance (asset) or a credit balance (liability).

Income Taxes

Certain income statement items must be reported net of taxes.

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Earnings per Share OBJECTIVE 3: Compute earnings per share.

Key Ratios Basic earnings per share Diluted earnings per share

Exhibit 2: Motorola's Earnings Per Share Presentation

Earnings per Share An earnings per share figure is a measure of performance that can be composed of several parts. –A simple capital structure requires only one earnings per share figure. –A complex capital structure requires both a basic earnings per share figure and a diluted earnings per share figure.

Earnings per Share Potentially dilutive securities and their application to earnings per share. –Stock options and convertible preferred stocks or bonds have the potential to dilute earnings per share. –A stockholder’s proportionate share of ownership could be reduced, so presentation of both basic earnings per share and diluted earnings per share is required.

Earnings per Share Potentially dilutive securities and their application to earnings per share. (cont.) –Diluted earnings per share are calculated by adding all potentially dilutive securities to the denominator of the basic earnings per share calculation.

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Comprehensive Income and the Statement of Stockholders’ Equity OBJECTIVE 4: Define comprehensive income, and describe the statement of stockholders’ equity.

Exhibit 3: eBay's Statement of Comprehensive Income

Exhibit 4: Statement of Stockholders’ Equity

Exhibit 5: Stockholders’ Equity Section of a Balance Sheet

Comprehensive Income and the Statement of Stockholders’ Equity Corporate income statements should present comprehensive income. A statement of stockholders’ equity is a labeled computation of the changes in stockholders’ equity accounts during the period.

Comprehensive Income and the Statement of Stockholders’ Equity It reveals everything that is in a statement of retained earnings and is also a summary of the period’s stock transactions. Ordinarily, Retained Earnings shows a credit balance. However, when a debit balance exists, the corporation is said to have a deficit.

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Stock Dividends and Stock Splits OBJECTIVE 5: Account for stock dividends and stock splits.

Stock Dividends and Stock Splits A stock dividend is the proportional distribution of additional stock to a corporation’s present shareholders. –It conserves cash. –It tends to lower the stock’s market price. –It allows for a nontaxable distribution.

Stock Dividends and Stock Splits A stock dividend is the proportional distribution of additional stock to a corporation’s present shareholders. –It increases the company’s permanent capital by transferring a portion of retained earnings to contributed capital. –Journalize the declaration and distribution of a small and a large stock dividend. Observe stockholders’ equity before and after the dividend.

Stock Dividends and Stock Splits

A stock split is a distribution of additional stock for the purpose of effecting a decline in market price. –Par or stated value decreases. –At most, a memorandum entry is needed.

Stock Dividends and Stock Splits

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Book Value OBJECTIVE 6: Calculate book value per share.

Book Value Book value per share when there is no preferred stock.

Book Value Book value per share when there is preferred stock. –The call value is deducted from stockholders’ equity in the numerator. –Dividends in arrears are also deducted.

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