1. INTERMEDIATE ACCOUNTING
Chapter 16
Retained Earnings and Earnings Per Share
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2. Learning Objectives
Explain the accounting and reporting for different types of dividends.
Discuss the accounting for prior period adjustments and restrictions of retained earnings.
Explain the various components of shareholders’ equity and related disclosures.
Compute basic earnings per share (EPS) including the computation of weighted average common shares.
Compute diluted earnings per share including the identification of potential common shares.

3. What Comprises Retained Earnings?
Contributed capital typically arises when the corporation issues shares to shareholders; earned capital arises as the corporation generates earnings
Retained Earnings is an account used by a corporation to summarize the earned capital component of shareholders’ equity, which comprises the cumulative amount of net income over the life of the corporation minus the cumulative amount of dividends paid out to shareholders.
A deficit is a negative retained earnings balance resulting from accumulated prior net losses or dividends in excess of earnings.

4. Requirements to Distribute Dividends Learning Objective #1
To pay cash dividends, a corporation must meet legal requirements and have assets available for distribution.
Usually, a corporation must restrict the amount of retained earnings available for dividends by the cost of treasury shares held.
Contractual agreements (such as long-term bond covenants) may restrict a corporation from declaring dividends.

5. Cash Dividends
The most common type of dividend is the cash dividend.
Four dates are important for any type of dividend:
Declaration date
Ex-dividend date
Date of record
Date of payment
The declaration date is the date the board of directors formally declares that a dividend will be distributed to shareholders of record on a specific future date, typically four to six weeks.
The ex-dividend date occurs several days before the date of record to enable the corporation to update its shareholders’ ledger by the date of record.

6. Cash Dividends (Slide 2 of 4)
The ex-dividend date is important to investors because on the ex-dividend date the stock stops selling with dividends attached.
The date of record is the date which determines which shareholders will receive the dividend for the next payment date. These investors are listed in the shareholders’ ledger on the date of record.
The date of payment is the date the corporation distributes the dividend checks and makes a journal entry to eliminate the liability and reduce cash.

7. Cash Dividend Accounting Dates

8. Cash Dividends (Slide 3 of 4)
Example On November 2, 2016, Bengal Corporation’s board of directors declares preferred dividends totaling $25,000 and common dividends totaling $40,000. These dividends are payable on December 14, 2016, to shareholders of record on November 23,
November 2, 2016
Retained Earnings 65,000
Dividends Payable: Preferred Stock 25,000
Dividends Payable: Common Stock 40,000
November 23, 2016
Memorandum entry: The company will pay dividends on December 14, 2016, to preferred and common stockholders of record as of today, the date of record.
December 14, 2016
Dividends Payable: Preferred Stock 25,000
Dividends Payable: Common Stock 40,000
Cash 65,000

9. Cash Dividends (Slide 4 of 4)
If its accounting period ends before the dividend payment, the company reports Dividends Payable as a current liability.
Usually, the amounts of dividends payable to each class of stock can be easily determined.
Preferred stock may be either fully or partially participating.
In these cases, a corporation must compute the dividends payable to each class of stock.
If fully participating, preferred stock shares equally with the common stock in any extra dividends, distributed proportionally based on the respective total par value.

10. Cash Dividends (Slide 4 of 4)
Example Edgecombe Corporation has issued 10%, participating, cumulative preferred stock with a total par value of $20,000 and common stock with a total par value of $30,000. Edgecombe distributes cash dividends of $9,000, and there are no dividends in arrears.
Par value of preferred stock is 40% an par value of common stock is 60%.
If fully participating, dividends to preferred stock is:
10% preferred dividend ($20,000 x 10%) $2,000
Extra dividend (40% of unallocated dividend) ,600 Total dividends to preferred $3,600

11. Dividend Distribution

12. Property Dividends (Slide 1 of 2)
A property dividend is a dividend that is payable in assets other than cash (such as inventory or investments).
This nonreciprocal, nonmonetary transfer to owners occurs when a corporation enters into an exchange giving up something of value but receiving no asset or service in return.
Example Freestone Corporation’s board of directors declares a property dividend, payable in investment securities, which are bonds issued by Bandera Company.
The bonds are recorded as an investment by Freestone and classified as “available for sale.” The bonds are carried on Freestone’s book at a fair value of $40,000. The current fair value is $43,000.

13. Property Dividends (Slide 2 of 2)
Freestone makes the following journal entries to record the property dividend:
Declaration Date
Investment in Bandera Company Bonds
($43,000 ‒ $40,000) 3,000
Gain on Disposal of Investments 3,000
Retained Earnings 43,000
Property Dividend Payable 43,000
Date of Payment
Property Dividends Payable 43,000
Investment in Bandera Company Bonds 43,000
On the date of payment, Freestone does not adjust the gain or loss, even though the fair value may have changed since the declaration date.

14. Scrip Dividends
A corporation may have adequate retained earnings to meet the legal dividend requirements but insufficient cash to justify a current cash dividend.
In this case, it may declare a scrip dividend and issue promissory notes (called “scrip”) requiring the corporation to pay dividends at some future date.
The dividend liability will be classified as short-term or long-term depending on the maturity date of the script.
Script dividends are rare.

15. Stock Dividends (Slide 1 of 6)
A stock dividend is a proportional (pro rata) distribution of additional shares of a corporation’s own stock to its shareholders.
Types of stock dividends:
A stock dividend usually consists of the same class of shares. This type of distribution is called an ordinary stock dividend.
The distribution of a different class of stock (i.e., common on preferred) sometimes is called a special stock dividend.
A stock dividend differs from other dividends in that no corporate assets are distributed.

16. Stock Dividends (Slide 2 of 6)
The following factors may enhance the perceived attractiveness of a stock dividend:
The shareholders may see the stock dividend as evidence of corporate growth.
The shareholders may see the stock dividend as evidence of sound financial policy.
Other investors may see the stock dividend in a similar light, and increased trading in the stock may cause the market price not to decrease proportionally to the increased number of shares.
The corporation may state that it will pay the same fixed cash dividend per share.

17. Stock Dividends (Slide 3 of 6)
A stock dividend is similar to a stock split but not accounted for like a stock split; instead retained earnings is decreased and contributed capital is increased
Small stock dividends:
Valued at fair value when the stock dividend is less than 20% or 25% of the previously outstanding shares.
Large stock dividends:
Par value of the additional shares issued
GAAP suggests that the use of the term dividend be avoided or use terminology such as stock split effected in the form of a dividend.

18. Accounting for Stock Dividends

19. Stock Dividends (Slide 4 of 6)
Example Querry Corporation has the following shareholders’ equity prior to the stock dividend:
Common stock, $10 par (20,000 shares issued and outstanding) $200,000
Additional paid-in capital 180,000
Retained earnings 320,000
Total shareholders’ equity $700,000
Querry Corporation declares and issues a 10% stock dividend (a small stock dividend). On the declaration date, the stock is selling for $23 per share.
Declaration Date
Retained Earnings 46,000
Common Stock to be Distributed 20,000
Additional Paid-in Capital from Stock Dividend 26,000

20. Stock Dividends (Slide 5 of 6)
Date of Issuance
Common Stock to be Distributed 20,000
Common Stock, $10 par 20,000
Querry’s resulting shareholders’ equity follows:
Common stock, $10 par (22,000 shares issued and
outstanding) $220,000
Additional paid-in capital 206,000
Retained earnings 274,000
Total shareholders’ equity $700,000
Note that the total shareholders’ equity is the same as before the stock dividend
Assume, instead, that Querry declares a 40% stock dividend (a large stock dividend), when the stock is selling for $23 per share.

21. Stock Dividends (Slide 6 of 6)
Querry uses the par value of $80,000 for the 8,000 shares to record the dividend.
Declaration Date
Retained Earnings 80,000
Common Stock to be Distributed 80,000
Date of Issuance
Common Stock to be Distributed 80,000
Common Stock, $10 par 80,000
The resulting shareholders’ equity is as follows:
Common stock, $10 par (28,000 shares issued, outstanding) $280,000
Additional paid-in capital 180,000
Retained earnings 240,000
Total shareholders’ equity $700,000

22. Stock Splits and Liquidating Dividends
A stock split results in a corporation issuing additional shares.
A reverse stock split reduces the number of shares outstanding.
A stock split does not affect retained earnings.
Companies make a memorandum entry to reflect the impact of the split on shares authorized, issued, and outstanding.
Liquidating dividends represent a return of contributed capital than a distribution of retained earnings.
A corporation usually declares these dividends when it is ceasing or reducing operations.
A liquidating dividend also may arise when a corporation with natural resources pays a dividend based on earnings before depletion.

23. Prior Period Adjustments (Restatements)
Learning Objective #2
Prior period adjustments (restatements) are retrospective adjustments of retained earnings that can arise from changes in principles, change in accounting entity, and corrections of errors of prior periods.
Example In 2017, Rycker Corporation discovers that it did not accrue $10,000 of interest expense for 2016.
Assuming a related income tax effect of $3,000, Rycker makes the following correcting entries in 2017:
Retained Earnings 10,000
Interest Payable 10,000
Income Tax Refund Receivable 3,000
Retained Earnings 3,000

24. How Do We Account for Prior Period Adjustments (Restatements)
How Do We Account for Prior Period Adjustments (Restatements)? (Slide 2 of 2)
If Rycker’s January 1, 2017, retained earnings balance was $102,400, it reports the correction on its December 31,2017, statement as an adjustment to the beginning retained earnings balance.
Retained earnings, as previously reported January 1, 2017 $102,400
Less: Correction of overstatement in 2016 net income due
to interest expense understatement (net of $3,000
income taxes) (7,000)
Adjusted retained earnings, January 1, 2017 $ 95,400
Rycker discloses the effect of the error on the prior year’s net income and earnings per share in the period in which the correction is made.
If comparative statements are presented, Rycker makes corresponding adjustments to it net income, retained earnings, assets, or liability account balances for all the periods reported.

25. Restrictions (Appropriations) of Retained Earnings
A restriction (appropriation) is a policy where the board of directors makes a commitment that a portion of retained earnings is unavailable for dividends.
A board of directors may restrict retained earnings to meet legal requirements, such as meeting a state’s requirements concerning treasury stock.
The board may restrict retained earnings to meet contractual restrictions related to issuing long-term bonds.
Corporations disclose restrictions of retained earnings in a note with a clear description of the legal or contractual provisions and the amount of the restriction is required.

26. Reporting Changes in Shareholders’ Equity Learning Objective #3
A full set of financial statements should show investments by and distributions to owners during the period
This disclosure must include the changes in the different classes of common stock, additional paid-in capital, retained earnings, accumulated other comprehensive income, and treasury stock
The purpose is to report the changes in the corporation’s financial structure to help users assess changes in its financial flexibility, profitability, and risk
The statement of shareholders’ equity is usually reported in matrix form

27. Bardwell Corporation: Statement of Shareholders’ Equity (Slide 1 of 2)

28. Bardwell Corporation:
Statement of Shareholders’ Equity (Slide 2 of 2)

29. Accumulated Other Comprehensive Income
Comprehensive income includes both net income and “other comprehensive income.” Other comprehensive income (loss) might include the following items:
Unrealized increases (gains) or deceases (losses) in the fair value of investments in available-for-sale securities
Translation adjustments from converting the financial statements of a company’s foreign operations into U.S. dollars
Gains and losses on certain types of derivative financial instruments that are designated as cash flow hedges
Certain types of pension plan gains, losses, and prior service cost adjustments

30. Statement of Retained Earnings for 2016

31. Miscellaneous Changes and Noncontrolling Interest
If a corporation receives donated assets (e.g., a plant site from a governmental unit to induce it to locate in a particular community, the corporation records the asset at its fair value and the resulting credit in a Donated Capital account.
Noncontrolling interests represents a portion of a subsidiary that is not owned by a parent corporation.
The parent corporation consolidates all 100% of the assets and liabilities of its controlled subsidiaries, then the portion of net assets not owned by the parent is then reported as a separate portion of equity called the noncontrolling interest.

32. Real Report: Shareholders’ Equity
and Related Changes (Slide 1 of 4)

33. Real Report: Shareholders’ Equity
and Related Changes (Slide 2 of 4)

34. Real Report: Shareholders’ Equity and Related Changes (Slide 4 of 4)
Questions:
How many shares of treasury stock were acquired in 2013? At what average price were they acquired?
During 2010, Starbucks acquired 10.8 million shares of treasury stock at an average price of $26.71 per share ($288.5 million ÷ 10.8 million shares).
What was Starbucks’s other comprehensive income for 2013 and what was Starbucks’s ending 2013 balance in Accumulated Other Comprehensive income?
Starbucks reported another comprehensive loss of $44.3 million for fiscal year 2013; net of tax unrealized holding gain related to hedging instruments of $43.2 million, currency translation adjustment loss of $41.6 million, and an unrealized holding loss net of tax on available-for-sale securities of $0.4 million. The balance in accumulated other comprehensive income at September 29, 2013, is $67.0 million.

35. Real Report: Shareholders’ Equity and Related Changes (Slide 5 of 4)
What were the total dividends declared during 2013? How much did dividends change in 2013 from 2012?
Total dividends declared were $668.6 million. This was an increase of $124.9 million dollars from 2012 when $543.7 million dividends were declared.
How many shares of common stock were issued for stock option compensation in 2013? At what average price were the common shares issued?
During 2013, Starbucks issued 14.4 million shares of common stock for stock options at an average price per share of $25.47 [increase in shareholders’ equity due to stock option transactions of $366.8 million ($ $366.8 million ÷ 14.4 million shares)].

36. Earnings Per Share Learning Objective #4
The primary components of net income (loss) are:
Income (loss) from continuing operations, which includes operating revenues and operating expenses
Results from discontinued operations, which includes the income (loss) from the operations of a discontinued component as well as the gain (loss) from the disposal of the discontinued component
Extraordinary gains or losses, which are the results of unusual and infrequent events
Corporations are also required by GAAP to report earnings per share information on its income statement.
Earnings per share is calculated as net income minus preferred dividends divided by weighted average number of common shares outstanding.

37. Market Price per Share (of the Common Stock)
Price/Earnings Ratio
One ratio often used by investors to evaluate return and risk is the price/earning ratio, which investors often use in intercompany comparisons of share price relative to profitability. The price/earnings ratio is computed as follows:
Price
Earnings Ratio
Market Price per Share (of the Common Stock)
Earnings per Share =
When using earnings per share information for intercompany comparisons, a user must be sure that calculations are comparable.

38. How are Basic Earnings per Share (EPS) Computed?
There are two types of corporate capital structure:
A simple capital structure is a type of corporate capital structure that consists of common stock outstanding and possibly nonconvertible preferred stock.
A complex capital structure is a type of corporate structure that has both common stock outstanding and potentially dilutive securities, such as share options, convertible debt, or preferred shares.
A corporation with a simple capital structure is required to report basic earnings per share. Basic earnings per share (or earnings per common share) is computed as:
Basic Earnings per Share =
Net Income ‒ Preferred Dividends
Weighted Average Number of Common Shares Outstanding

39. Denominator Calculations
If a corporation has issued or reacquired common shares during the period, the denominator is the weighted average number of common shares during the period, calculated as:
Actual Shares Outstanding
Fraction of Year Outstanding
Weighted Average Number of Common Shares Outstanding × =
Example Alamance Corporation had 15,000 shares of common stock outstanding at the beginning of the year.
On March 2, it issued 2,700 shares; on July 3, it issued another 3,300 shares; and on December 1, it reacquired 600 shares of treasury stock.
The weighted average number of shares is 18,850 shares.

40. Weighted Average Shares
Note that for simplicity, the nearest whole month is used to determine the fraction of the year. In practice, corporations will base their weighted average calculations on the actual number of days outstanding.

41. Stock Dividends and Splits
The simplest way of giving retroactive recognition to stock dividends or stock splits is to assume (for EPS calculations) that the stock dividend or split occurred at the beginning of its earliest comparative period.
Example Vance Corporation begins operation in January and issues 5,000 shares of common stock that are outstanding during all of 2016.
On December 10, 2016, it issues a 2-for-1 split. At the end of 2016, the weighted average number of shares is 10,000.
During 2017, Vance enters into the following transactions:
On June 1, 2017, it issues 5,000 shares of common stock.
On August 9, 2017, it issues a 20% stock dividend.
On October 1, 2017, it issues 2,000 shares of common stock.

42. Comparative Weighted Average Shares
Note that the 2-for-1 stock split actually issued on December 10, 2016, and the 20% stock dividend issued on August 9, 2017, are both assumed to have been issued on January 1, 2016.

43. Computation and Reporting of Basic Earnings per Share (Slide 1 of 3)

44. Computation and Reporting of
Basic Earnings per Share (Slide 2 of 3)

45. Computation and Reporting of
Basic Earnings per Share (Slide 3 of 3)

46. Diluted Earnings per Share Learning Objective #5
Share options and warrants, convertible preferred stock, convertible bonds, participating securities, differing classes of common stock, and contingent share are referred to as potential common shares if they are securities that can be used by the holder to acquire common stock.
A corporation with a complex capital structure is required to report both basic and diluted earnings per share amounts on the face of its income statement.
Diluted earnings per share (DEPS) is the earnings per share after including all potential common shares that would reduce earnings per share.
Potential common shares are only included in the calculation of diluted EPS if they have a dilutive effect.

47. Computing Diluted Earnings per Share
The steps for computing DEPS are as follows:
Step 1. Compute the basic earnings per share for the company.
Step 2. Include all dilutive share options and warrants and compute a tentative DEPS.
Step 3. Develop a ranking of the impact of each convertible preferred stock and convertible bond on DEPS, from the most dilutive to the least dilutive.
Step 4. Beginning with the most dilutive security first, include each dilutive convertible security in DEPS in a sequential order based on the ranking in Step 3 and compute a new tentative DEPS.
Step 5. Report as the diluted EPS the lowest computed DEPS.

48. Flowchart of EPS Computations

49. Share Options and Warrants (Slide 1 of 3)
A corporation always considers share options and share warrants in its diluted earnings per share calculation if these items are dilutive.
Dilution occurs whenever the average market price is greater than the option (exercise) price.
The treasury stock method is used to determine the change in the number of shares.
This method assumes the company uses the proceeds received from the exercise of options or warrants (exercise price x number of shares issued) to acquire as many treasury shares as possible, and then only issues the minimum number of additional shares.

50. Change in Shares—Treasury Stock Method

51. Share Options and Warrants (Slide 2 of 3)
The steps for the treasury stock method are as follows:
Step 1. Determine the average market price of common shares during the period.
Step 2. Compute the shares that would be issued from the assumed exercise of all options and warrants.
Step 3. Compute the proceeds received from the assumed exercise by multiplying the shares issued by the exercise price [plus any unrecognized compensation cost (net of tax) per share].
Step 4. Compute the assumed shares that would be reacquired by dividing the proceeds (Step 3) by the average market price (Step 1).
Step 5. Compute the incremental common shares that would need to be issued.

52. Average Market Price per Share
Share Options and Warrants (Slide 3 of 3)
Example Plummer Corporation has compensatory share options for employees to purchase 1,000 common shares at an exercise price of $18 per share throughout the year, and the average market price for the common stock during the year was $25 per share.
The unrecognized compensation cost (net of tax) related to the share options is $2 per share.
Shares issued from assumed exercise 1,000
Shares assumed required:
(800)
Assumed increment in common shares for computing DEPS 200
Proceeds
Average Market Price per Share
1,000 × ($18 + $2)
$25
$20,000 =

53. Convertible Securities
The if-converted method is used to calculate additional dilutive shares resulting from convertible bonds and convertible preferred stock.
Each convertible stock or bond is assumed (for computing DEPS) to have been converted into common stock at the beginning of the earliest period reported.
The impact of each convertible security on the corporation’s DEPS is computed as follows:
Impact on DEPS =
Increase in EPS Numerator
Increase in EPS Denominator

54. Impact of Convertible Securities on DEPS
(Slide 1 of 2)

55. Impact of Convertible Securities on DEPS
(Slide 2 of 2)

56. Computation of Tentative and Final Diluted Earnings per Share (Slide 1 of 2)
A corporation computes its diluted earnings per share in the following sequence:
Step 1. Calculate basic earnings per share.
Step 2. Compute the incremental shares from the assumed exercise of share options and warrants.
Step 3. Include the dilutive convertible securities in diluted earnings per share in sequential order according to their dilutive effect on tentative earnings per share.

57. Computation of Tentative and Final
Diluted Earnings per Share (Slide 2 of 2)
Step 4. Repeat with each dilutive security in the ranking until the impact of the next convertible security is antidilutive (or until all dilutive securities are used). Any remaining securities in the ranking are antidilutive and are excluded from diluted earnings per share.
Step 5. Final diluted earnings per share is the last tentative figure. It contains all the dilutive convertible securities included in the tentative diluted earnings per share computations.

58. Calculation of Tentative EPS

59. Special Issues Related to Diluted Earnings per Share (Slide 1 of 5)
If a corporation reports a loss from continuing operations, then it does not include potential common shares in calculating diluted earnings per share even if there is a positive overall net income due to having gains from extraordinary items or discontinued operations does not change this requirement.
Example Davis Corporation reports a loss from continuing operations of $75,000 and income from discontinued operations (net of tax) of $97,000.
Davis has 50,000 weighted average common shares outstanding.
In addition, Davis has a convertible bond that is convertible into 12,000 common shares.

60. Basic Earnings per Share Diluted Earnings per Share
Special Issues Related to
Diluted Earnings per Share (Slide 2 of 5)
When calculating earnings per share, the potentially dilutive shares would be ignored because they are antidilutive to the loss from continuing operations.
Davis would report earnings per share as follows:
Loss from continuing operations $(75,000)
Income from discontinued operations (net of tax) 97,000
Net income 22,000
Basic Earnings per Share
Diluted Earnings per Share
Loss from continuing operations $(1.50) ($1.50)
Income from discontinued operations
(net of tax)
Net income $0.44 $0.44

61. Special Issues Related to Diluted Earnings per Share (Slide 3 of 5)
Example Ryan Corporation reports income from continuing operations of $30,000 and a loss from discontinued operations of $63,000 (net of tax).
Ryan has 40,000 weighted average common shares outstanding and has a convertible bond that is convertible into 15,000 common shares.
Ryan would report earnings per share as follows:
Income from continuing operations $30,000
Loss from discontinued operations (net of tax) (63,000)
Net loss $33,000

62. Basic Earnings per Share Diluted Earnings per Share
Special Issues Related to
Diluted Earnings per Share (Slide 4 of 5)
Basic Earnings per Share
Diluted Earnings per Share
Loss from continuing operations $ 0.75 $ 0.55
Income from discontinued operations
(net of tax) (1.58) (1.15)
Net income $(0.83) $(0.60)
The dilutive shares are used to calculate dilutive earnings per share because they dilute earnings per share from continuing operations.

63. Special Issues Related to Diluted Earnings per Share (Slide 5 of 5)
The display on the next two slides shows the computation of diluted earnings per share for Randolph Corporation, assuming the following:
Share options are outstanding.
Both convertible bonds and convertible preferred stock are outstanding.
The convertible bonds are dilutive but the convertible preferred stock is antidilutive.
The computation results in diluted earnings per share of $1.94.
Note that Randolph reports both basic and diluted earnings per share on its income statement.

64. Computation and Reporting of
Diluted Earnings per Share (Slide 1 of 2)

65. Computation and Reporting of
Diluted Earnings per Share (Slide 2 of 2)

66. Additional Considerations
Conversion Ratios
After issuing convertible securities or share options, a corporation may declare a stock dividend or stock split.
Typically, the “conversion ratio” for convertible securities and stock options is proportionally adjusted for the stock dividend or split.
Contingent Issuances
A corporation may be obligated to issue common shares in the future if certain conditions are met.
This stock is referred to as contingently issuable common stock.

67. Real Report: Earnings per Share Disclosure (Slide 1 of 4)

68. Real Report: Earnings per Share Disclosure (Slide 2 of 4)

69. Real Report: Earnings per Share Disclosure (Slide 3 of 4)
Questions:
Why was the average number of common shares used in the diluted earnings per share computation more than the weighted average number of common shares used in the basic earnings per share computation?
Starbucks issues stock options and RSUs to its employees. Because the average market price was greater than the exercise price, these securities are dilutive.

70. Real Report: Earnings per Share Disclosure (Slide 4 of 4)
Examine footnote 12. At September 29, 2013, how many stock options were exercisable, and how many were vested and expected to vest? How does this amount compare to the number of dilutive shares used by Starbucks to compute diluted earnings per share?
Note 12 discloses that at September 29, 2013, Starbucks had 22.0 million stock options outstanding. Of this amount, 13.3 million options were exercisable. Employees had 21.0 million shares that were vested and expected to vest. Using the information in footnote 14, the stock options and RSUs result in 13.0 million incremental common shares for computing diluted earnings per share.