1. 15-1 Copyright  Houghton Mifflin Company. All rights reserved. Chapter 15 The Corporate Performance Statement and the Statement of Shareholders’ Equity Belverd E. Needles, Jr. Marian Powers Sherry K. Mills Henry R. Anderson - - - - - - - - - - - Multimedia Slides by: Dr. Paul J. Robertson New Mexico State University Steve Leask Steve Leask New Mexico State University

2. 15-2 Copyright  Houghton Mifflin Company. All rights reserved. LEARNING OBJECTIVES 1.Identify the issues related to evaluating the quality of a company’s earnings. 2.Prepare a corporate income statement. 3.Show the relationships among income taxes expense, deferred income taxes, and net of taxes. 4.Describe the disclosure on the income statement of discontinued operations, extraordinary items, and accounting changes.

3. 15-3 Copyright  Houghton Mifflin Company. All rights reserved. 5.Compute earnings per share. 6.Prepare a statement of shareholders’ equity. 7.Account for stock dividends and stock splits. 8.Calculate book value per share. LEARNING OBJECTIVES

4. 15-4 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 1 Identify the issues related to evaluating the quality of a company’s earnings. Performance Measurement: Quality of Earnings Issues

5. 15-5 Copyright  Houghton Mifflin Company. All rights reserved. Quality of Earnings Issues »Current and expected earnings are an important factor to consider in evaluating a company’s performance and analyzing its prospects. »Because of the importance of net income (bottom line), there is significant interest in evaluating the quality of earnings.

6. 15-6 Copyright  Houghton Mifflin Company. All rights reserved. Quality of Earnings Issues »Quality of earnings refers to the substance of earnings and their sustainability into future accounting periods and may be affected by:  Accounting methods and estimates chosen by management.  The nature of nonoperating items in the income statement.

7. 15-7 Copyright  Houghton Mifflin Company. All rights reserved. Choice of Accounting Methods and Estimates »Choices of accounting methods and estimates affect a firm’s operating income. »The choice of estimates affects both current and future operating income.

8. 15-8 Copyright  Houghton Mifflin Company. All rights reserved. Choice of Accounting Methods and Estimates »Due to the considerable latitude in the choice of estimates, management and other financial statement users must be aware of the impact of accounting estimates on reported operating income. »The relative importance of each estimate depends on the industry in which the firm operates.

9. 15-9 Copyright  Houghton Mifflin Company. All rights reserved. Effect of Accounting Methods and Estimates »An accounting method or estimate that results in lower current earnings produces a better quality of operating income.

10. 15-10 Copyright  Houghton Mifflin Company. All rights reserved. Effect of Accounting Methods and Estimates »The existence of alternatives could cause problems in the interpretation of financial statements were it not for two conventions.

11. 15-11 Copyright  Houghton Mifflin Company. All rights reserved. Effect of Accounting Methods and Estimates 1. Full disclosure. Requires that management explain the significant accounting policies used in preparing the financial statements in a note to the statements. 2. Consistency. Requires that the same accounting procedures be followed from year to year.

12. 15-12 Copyright  Houghton Mifflin Company. All rights reserved. Nature of Nonoperating Items »The lower part of the corporate income statement can contain such nonoperating items as discontinued operations, extraordinary gains and losses, and effects of accounting changes. »When analyzing financial statements, the analyst must be careful to look beyond a “bottom line” that may have been influenced by nonoperating items that are not expected to recur.

13. 15-13 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.What is the basis of the statement, “Accounting income is a useless measurement because it is based on so many arbitrary decisions”? Is the statement true?

14. 15-14 Copyright  Houghton Mifflin Company. All rights reserved. A. This question addresses the issue of quality of earnings. Net income may differ depending on the accounting methods and estimates used. Thus, the same events may produce different income figures. Also, the timing of transactions and other actions may affect the reporting of discontinued operations, extraordinary gains and losses, and accounting changes in the income statement. This does not mean that reported net income is useless, however. Rather, it means that the user must not read reported figures blindly. This question addresses the issue of quality of earnings. Net income may differ depending on the accounting methods and estimates used. Thus, the same events may produce different income figures. Also, the timing of transactions and other actions may affect the reporting of discontinued operations, extraordinary gains and losses, and accounting changes in the income statement. This does not mean that reported net income is useless, however. Rather, it means that the user must not read reported figures blindly.

15. 15-15 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 2 Prepare a corporate income statement. The Corporate Performance Statement

16. 15-16 Copyright  Houghton Mifflin Company. All rights reserved. Corporate Income Statement Issues »Either single-step or multistep formats can be used. »The accounting profession has taken the position that income for a period should be all-inclusive comprehensive income.

17. 15-17 Copyright  Houghton Mifflin Company. All rights reserved. Corporate Income Statement Issues »Comprehensive income includes all revenues, expenses, gains, and losses over the period, except for prior period adjustments. »Several items must be added to the income statement: discontinued operations, extraordinary items, accounting changes, earnings per share.

18. 15-18 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.Define the concept of comprehensive income. A.The concept of income or loss for a period that includes all revenues, expenses, gains, and losses, except prior period adjustments.

19. 15-19 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 3 Show the relationships among income taxes expense, deferred income taxes, and net of taxes. Income Taxes Expense

20. 15-20 Copyright  Houghton Mifflin Company. All rights reserved. Income Taxes Expense »Income taxes expense is the expense recognized in the accounting records on an accrual basis that applies to income from continuing operations. »The amount payable is determined from taxable income, measured according to the rules and regulations of the income tax code.

21. 15-21 Copyright  Houghton Mifflin Company. All rights reserved. Income Taxes Expense »For convenience, many small companies maintain their accounting records on a tax basis. »The purpose of accounting is to determine net income in accordance with GAAP, not taxable income and tax liability.

22. 15-22 Copyright  Houghton Mifflin Company. All rights reserved. Income Taxes Expense »Management has an incentive to use methods that minimize the firm’s tax liability. »There can be a material difference between accounting income and taxable income. »This discrepancy can result from differences in the timing of the recognition of revenues and expenses between GAAP and income tax accounting.

23. 15-23 Copyright  Houghton Mifflin Company. All rights reserved. Deferred Income Taxes »The amount by which income taxes expense differs from income taxes payable is reconciled in an account called deferred income taxes.

24. 15-24 Copyright  Houghton Mifflin Company. All rights reserved. Deferred Income Taxes »Income tax allocation is 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. Dec. 31 Income Taxes Expense 144,500 Income Taxes Payable 92,000 Deferred Income Taxes 52,500 To record estimated current and deferred income taxes

25. 15-25 Copyright  Houghton Mifflin Company. All rights reserved. Net of Taxes »Net of taxes means the effect of applicable taxes (usually income taxes) has been considered in determining the overall effect of an item on the financial statements. »The phrase is used when a company has items that must be disclosed in a separate section. »Each such item should be reported net of the applicable taxes.

26. 15-26 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.“Accounting income should be geared to the concept of taxable income because the public understands that concept.” Comment on this statement, and tell why income tax allocation is necessary.

27. 15-27 Copyright  Houghton Mifflin Company. All rights reserved. A. Accounting income and taxable income should not be treated the same because they serve different purposes. The purpose of accounting income is to give some indication (however imperfect) of the increase or decrease in the business’s well-being; the sole purpose of taxable income is to provide a basis for the collection of government revenues from the taxpayer. Income tax allocation is necessary because there are differences between accounting and taxable income caused by the timing of revenues and expenses. Accounting income and taxable income should not be treated the same because they serve different purposes. The purpose of accounting income is to give some indication (however imperfect) of the increase or decrease in the business’s well-being; the sole purpose of taxable income is to provide a basis for the collection of government revenues from the taxpayer. Income tax allocation is necessary because there are differences between accounting and taxable income caused by the timing of revenues and expenses.

28. 15-28 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 4 Describe the disclosure on the income statement of discontinued operations, extraordinary items, and accounting changes. Discontinued Operations, Extraordinary Items, and Accounting Changes

29. 15-29 Copyright  Houghton Mifflin Company. All rights reserved. Discontinued Operations »Discontinued operations are segments of a business that are no longer part of its ongoing operations. »GAAP require that gains or losses from discontinued operations be reported separately on the income statement.

30. 15-30 Copyright  Houghton Mifflin Company. All rights reserved. Extraordinary Items »APB #30 defines extraordinary items as “events or transactions that are distinguished by their unusual nature and by the infrequency of their occurrence.” »Extraordinary material items should be reported separately from continuing operations on the income statement.

31. 15-31 Copyright  Houghton Mifflin Company. All rights reserved. Extraordinary Items »Extraordinary items include:  An uninsured loss from flood, earthquake, fire, or theft.  Gain or loss from the passage of a new law.  Taking of property by a foreign government.  Gain or loss from an early retirement of debt.

32. 15-32 Copyright  Houghton Mifflin Company. All rights reserved. Accounting Changes »Although a violation of the consistency principle, a company is allowed to make accounting changes if current procedures are incorrect or inappropriate. »A change from LIFO to FIFO inventory method can be made.

33. 15-33 Copyright  Houghton Mifflin Company. All rights reserved. Accounting Changes »The cumulative effect of an accounting change is the effect that the new accounting principle would have had on net income in prior periods if it had been applied instead of the old principle. »Accounting changes are shown on the income statement immediately after extraordinary items.

34. 15-34 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.Why should a gain or loss on discontinued operations be disclosed separately on the income statement?

35. 15-35 Copyright  Houghton Mifflin Company. All rights reserved. A. A gain or loss on discontinued operations should be disclosed separately on the income statement because the usefulness of the income statement and the evaluation of the ongoing activities of the business are enhanced if results from continuing operations are reported separately from those of discontinued operations. Such disclosure allows for comparisons with past continuing operations and projections to future operations. A gain or loss on discontinued operations should be disclosed separately on the income statement because the usefulness of the income statement and the evaluation of the ongoing activities of the business are enhanced if results from continuing operations are reported separately from those of discontinued operations. Such disclosure allows for comparisons with past continuing operations and projections to future operations.

36. 15-36 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 5 Compute earnings per share. Earnings per Share

37. 15-37 Copyright  Houghton Mifflin Company. All rights reserved. »The APB concluded that earnings per share of common stock should be presented on the face of the income statement. »It is usually shown just below net income. Earnings per Share

38. 15-38 Copyright  Houghton Mifflin Company. All rights reserved. »An EPS amount is always shown for:  Income from continuing operations.  Income before extraordinary items and the cumulative effect of accounting changes.  Net income.  Gain or loss from discontinued operations or extraordinary items. Earnings per Share

39. 15-39 Copyright  Houghton Mifflin Company. All rights reserved. »It is necessary to determine if the number of common shares changed, and if the company paid preferred stock dividends during the year. »When a company has only common stock and has the same number of shares outstanding throughout the year, the EPS calculation is simple. Basic EPS = Net Income Weighted-Average Common Shares Outstanding Earnings per Share

40. 15-40 Copyright  Houghton Mifflin Company. All rights reserved. »If the number of shares outstanding changes during the year, it is necessary to figure the weighted- average number of shares outstanding for the year. »If a company has nonconvertible preferred stock outstanding, its dividend must be subtracted from net income before EPS for common stock is computed. Earnings per Share

41. 15-41 Copyright  Houghton Mifflin Company. All rights reserved. »Some companies have a complex capital structure that may include exercisable stock options or convertible stocks and bonds. »These convertible securities have the potential of diluting the EPS of common stock. Complex Capital Structures

42. 15-42 Copyright  Houghton Mifflin Company. All rights reserved. »Potential dilution means that a shareholder’s proportionate share of ownership in a company could be reduced by conversion, which would increase the total shares outstanding. Complex Capital Structures

43. 15-43 Copyright  Houghton Mifflin Company. All rights reserved. »A company with a complex capital structure must report two earnings per share:  Basic earnings per share.  Diluted earnings per share. »Diluted EPS is calculated by adding all potentially dilutive securities to the denominator of the basic EPS calculation. Complex Capital Structures

44. 15-44 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.When does a company have a simple capital structure? A complex capital structure? A.A company has a simple capital structure when it has only common stock or nonconvertible preferred stock and no other securities that can be converted into common stock. A complex capital structure exists when there are additional securities that can be converted to common stock.

45. 15-45 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 6 Prepare a statement of shareholders’ equity. The Statement of Stockholders’ Equity

46. 15-46 Copyright  Houghton Mifflin Company. All rights reserved. »The statement of shareholders’ equity, also called the statement of changes in shareholders’ equity, summarizes the changes in the components of the shareholders’ equity section of the balance sheet. »It is used because it reveals much more about the year’s shareholders’ equity transactions than the statement of retained earnings. The Statement of Stockholders’ Equity

47. 15-47 Copyright  Houghton Mifflin Company. All rights reserved. Retained Earnings »Retained earnings are the part of shareholders’ equity that represents claims to assets arising from the earnings of the business. »Retained earnings equal a company’s profits since the date of its inception, less any losses, dividends to shareholders, or transfers to contributed capital.

48. 15-48 Copyright  Houghton Mifflin Company. All rights reserved. Retained Earnings »Retained earnings are not the assets themselves. »The existence of retained earnings means that assets generated by profitable operations have been kept in the business.

49. 15-49 Copyright  Houghton Mifflin Company. All rights reserved. Retained Earnings Balances »A credit balance does not mean that cash or designated assets have been set aside. »A debit balance in retained earnings represents a deficit.

50. 15-50 Copyright  Houghton Mifflin Company. All rights reserved. Restrictions on Retained Earnings »A corporation may be required to or may want to restrict all or part of its retained earnings. »A restriction means that dividends can be declared only to the extent of unrestricted retained earnings.

51. 15-51 Copyright  Houghton Mifflin Company. All rights reserved. Restrictions on Retained Earnings »Reasons for restricting retained earnings include:  A contractual agreement.  State law.  Voluntary action by the board of directors.

52. 15-52 Copyright  Houghton Mifflin Company. All rights reserved. »A restriction does not change the total retained earnings or shareholders’ equity of the company. »It simply divides retained earnings into restricted and unrestricted. »The most common way to disclose restricted retained earnings is by reference to a note to the financial statements. Restrictions on Retained Earnings

53. 15-53 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.What is the difference between the statement of shareholders’ equity and the shareholders’ equity section of the balance sheet?

54. 15-54 Copyright  Houghton Mifflin Company. All rights reserved. A. The statement of shareholders’ equity is a financial statement that summarizes changes that occurred during the accounting period in components of the shareholders’ equity section of the balance sheet. The shareholders’ equity section of the balance sheet lists the items in contributed capital and retained earnings on the balance sheet date. The statement of shareholders’ equity is a financial statement that summarizes changes that occurred during the accounting period in components of the shareholders’ equity section of the balance sheet. The shareholders’ equity section of the balance sheet lists the items in contributed capital and retained earnings on the balance sheet date.

55. 15-55 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 7 Account for stock dividends and stock splits. Stock Dividends and Stock Splits

56. 15-56 Copyright  Houghton Mifflin Company. All rights reserved. Stock Dividends »A stock dividend is a proportional distribution of shares of a corporation’s stock to its shareholders. »It represents no change in the firm’s assets and liabilities because no assets are distributed.

57. 15-57 Copyright  Houghton Mifflin Company. All rights reserved. Reasons for Declaring a Stock Dividend »A board of directors may declare a stock dividend for several reasons:  To give shareholders some evidence of the company’s success without paying a cash dividend.  To reduce the stock’s market price by increasing the number of shares outstanding.  To make a nontaxable distribution to shareholders.  To increase the company’s permanent capital.

58. 15-58 Copyright  Houghton Mifflin Company. All rights reserved. Accounting for Stock Dividends »The effect of a stock dividend is to transfer a dollar amount from retained earnings to the contributed capital section on the date of declaration. »The amount transferred is FMV (usually market price) of the additional shares to be issued.

59. 15-59 Copyright  Houghton Mifflin Company. All rights reserved. »Entries to record the declaration and distribution of the stock dividend are: Feb. 24 Stock Dividends Declared 60,000 Common Stock Distributable 15,000 Paid-in Capital in Excess of Par Value, Common 45,000 Declared a 10% stock dividend on common stock Declared a 10% stock dividend on common stock Accounting for Stock Dividends

60. 15-60 Copyright  Houghton Mifflin Company. All rights reserved. Mar. 15 Date of Record; no entry required. Mar. 31 Common Stock Distributable15,000 Common Stock15,000 Distribution of a stock dividend of 3,000 shares Accounting for Stock Dividends

61. 15-61 Copyright  Houghton Mifflin Company. All rights reserved. »The effect of the stock dividend is to:  Permanently transfer the market value of the stock, $60,000, from retained earnings to contributed capital.  Increase the number of shares outstanding by 3,000. »Common Stock Distributable is not a liability account because there is no obligation to distribute assets. Accounting for Stock Dividends

62. 15-62 Copyright  Houghton Mifflin Company. All rights reserved. Stock Splits »A stock split occurs when a corporation increases the number of issued shares of stock and reduces the par or stated value proportionally. »This may be done when a company wants to lower the stock’s market value per share of stock and increase its liquidity, since a high market price hinders marketability. »A stock split does not increase the number of shares authorized.

63. 15-63 Copyright  Houghton Mifflin Company. All rights reserved. Contributed Capital Common Stock, $5 par value, 100,000 shares authorized, 30,000 shares issued and outstanding $ 150,000 Common Stock, $5 par value, 100,000 shares authorized, 30,000 shares issued and outstanding $ 150,000 Paid-in Capital in Excess of Par Value, Common 30,000 Paid-in Capital in Excess of Par Value, Common 30,000 Total Contributed Capital $ 180,000 Total Contributed Capital $ 180,000 Retained Earnings 900,000 Total Stockholders’ Equity $1,080,000 Before Stock Split

64. 15-64 Copyright  Houghton Mifflin Company. All rights reserved. Contributed Capital Common Stock, $2.50 par value, 100,000 shares authorized, 60,000 shares issued and outstanding $ 150,000 Common Stock, $2.50 par value, 100,000 shares authorized, 60,000 shares issued and outstanding $ 150,000 Paid-in Capital in Excess of Par Value, Common 30,000 Paid-in Capital in Excess of Par Value, Common 30,000 Total Contributed Capital $ 180,000 Total Contributed Capital $ 180,000 Retained Earnings 900,000 Total Stockholders’ Equity $1,080,000 After Stock Split

65. 15-65 Copyright  Houghton Mifflin Company. All rights reserved. Stock Splits »After a stock split, equity per share is cut in half. »However, the shareholders’ proportionate interest in the company remains the same. »If the number of split shares exceeds the number of authorized shares, the board of directors must secure state and shareholders’ approval before additional shares can be issued.

66. 15-66 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.What is the difference between a stock dividend and a stock split?

67. 15-67 Copyright  Houghton Mifflin Company. All rights reserved. A. A stock dividend is a distribution of shares to shareholders that involves a transfer from retained earnings to contributed capital. A stock split involves an increase in the number of shares outstanding and a proportional decrease in par or stated value, but it has no effect on the balances in the shareholders’ equity accounts. A stock dividend is a distribution of shares to shareholders that involves a transfer from retained earnings to contributed capital. A stock split involves an increase in the number of shares outstanding and a proportional decrease in par or stated value, but it has no effect on the balances in the shareholders’ equity accounts.

68. 15-68 Copyright  Houghton Mifflin Company. All rights reserved. OBJECTIVE 8 Calculate book value per share. Book Value

69. 15-69 Copyright  Houghton Mifflin Company. All rights reserved. Book Value »The book value of a company’s stock represents the total assets of the company less its liabilities.

70. 15-70 Copyright  Houghton Mifflin Company. All rights reserved. Book Value per Share »Book value per share represents the equity of the owner of one share of stock in the net assets of the corporation. »Book value per share does not necessarily equal the amount the shareholder would receive if the company were sold or liquidated.

71. 15-71 Copyright  Houghton Mifflin Company. All rights reserved. Book Value per Share »Book value per share (common stock only) equals: Total Stockholders’ Equity Shares Outstanding »If a company has both preferred and common stock, the determination of book value per share is more complex.

72. 15-72 Copyright  Houghton Mifflin Company. All rights reserved. Discussion Q.What is the significance of book value per share of stock? A.Book value per share represents the equity of one share of stock in the net assets (assets minus liabilities) of a corporation. It can apply to both common and preferred stock.

73. 15-73 Copyright  Houghton Mifflin Company. All rights reserved. 1.Identify the issues related to evaluating the quality of a company’s earnings. 2.Prepare a corporate income statement. 3.Show the relationships among income taxes expense, deferred income taxes, and net of taxes. OK, LET’S REVIEW...

74. 15-74 Copyright  Houghton Mifflin Company. All rights reserved. 4.Describe the disclosure on the income statement of discontinued operations, extraordinary items, and accounting changes. 5.Compute earnings per share. 6.Prepare a statement of shareholders’ equity. CONTINUING OUR REVIEW...

75. 15-75 Copyright  Houghton Mifflin Company. All rights reserved. 7.Account for stock dividends and stock splits. 8.Calculate book value per share. AND FINALLY...