1. Income and Changes in Retained Earnings
Chapter 12
Chapter 12: Income and Changes in Retained Earnings

2. Reporting the Results of Operations
Information about net income can be divided into two major categories
Normal, recurring revenue and expense transactions.
Unusual, nonrecurring events that affect net income.
When a company’s income-related activities include events not part of its normal continuing operations, it must disclose this information. Reporting this information separately provides users with more information about what to expect in the future. Unusual items are reported in the order of discontinued operations and extraordinary.
Let’s look at an income statement with continuing operations, discontinued operations, extraordinary items.
Income from continuing operations.
1. Results of discontinued operations.
2. Impact of extraordinary items.

3. These unusual, nonrecurring items are each reported net of taxes.
This tax expense does not include effects of unusual, nonrecurring items.
Part I
Income from continuing operations is the net effect of revenues earned and expenses incurred from recurring items in the normal course of business.
Part II
The income tax expense subtracted from revenues is only the tax expense for the recurring items. The unusual items, such as discontinued operations and extraordinary items, are reported net of taxes.
Let’s look in more detail at discontinued operations and extraordinary items.
These unusual, nonrecurring items are each reported net of taxes.

4. 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.
Income/Loss from operating the segment prior to disposal.
Income/Loss on disposal of the segment.
Discontinued Operations
When a company has a discontinued operation, it must report two items: the income or loss from operating a segment that has been discontinued, and the gain or loss on the sale of the segment. The income tax expense relating to discontinued operations are shown separately from the income tax expense relating to continuing operations.
Let’s look at what qualifies as a segment.

5. 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.
A segment must be a separate line of business activity or an operation that services a distinct category of customers.
A business segment is a separate line of a business activity or a separate and distinct category of customers. Let’s take a closer look.

6. Discontinued Operations
During 2009, 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 2009, Matrix Incorporated sold a segment of their company. The segment had a net loss from operations of $150,000 and a loss on the sale of assets of $100,000. Matrix reported income from continuing operations of $1,750,000, and all items are taxed at 30%.
How will Matrix report the discontinued operation on their financial statements?

7. Discontinued Operations
First, determine the net loss on operations and the net loss on the sale of assets for Matrix. Remember that discontinued operations are reported net of taxes, so reduce the original losses by the amount of the tax benefits Matrix will receive because of the losses.
Let’s see how Matrix will report this on their income statement.

8. Discontinued Operations
Income Statement Presentation:
Matrix reports a loss on operations of $105,000 and a loss on disposal of assets of $70,000. Both are reported net of their tax benefits.

9. Extraordinary Items Material in amount.
Gains or losses that are both unusual in nature and not expected to recur in the foreseeable future.
Reported net of related taxes.
Extraordinary items are gains and losses that are both unusual and infrequent in occurrence. Some examples include losses from natural disasters and expropriation of property by a foreign government. Extraordinary items are also reported net of taxes.
Let’s look at an example of an extraordinary item.

10. How would this item appear on the 2009 income statement?
Extraordinary Items
During 2009, Matrix, Inc. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Chicago. 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 2009 income statement?
In 2009, Matrix Incorporated had an extraordinary loss of $75,000. Matrix reported income before extraordinary items of $1,575,000, and all items are taxed at 30%.
How will Matrix report this on their income statement?

11. Extraordinary Items Income Statement Presentation:
First, Matrix has to determine the net loss associated with the extraordinary item. Extraordinary items are reported net of taxes, so they have to reduce the original loss by the amount of the tax benefit they’ll receive because of the loss. The net loss Matrix reports on their income statement is $52,500.

12. Earnings Per Share (EPS)
A measure of the company’s profitability and earning power for the period.
Earnings per share is equal to net income divided by the average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders. Earnings per share is one of the most widely quoted financial ratios calculated. It is a measure of the company’s ability to produce income for each common share outstanding. Investors track this ratio carefully.
Let’s calculate earnings per share for Matrix.
Based on the number of shares issued and the length of time that number remained unchanged.

13. Earnings Per Share (EPS)
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, Assume that Matrix has 156,250 weighted average shares outstanding.
Let’s prepare a partial income statement using all this information.
Review the information for Matrix Incorporated. It is based on the work done with discontinued operations and extraordinary items on the previous slides. Assume that Matrix has weighted average shares outstanding of 156,250.
Let’s look at how earnings per share is reported on the income statement.

14. Earnings Per Share (EPS)
Matrix reports earnings per share for several items: income from continuing operations, discontinued operations, income before extraordinary items, extraordinary loss, and net income.
$1,750,000 ÷ 156,250
* Rounded.

15. Earnings Per Share (EPS)
If preferred stock is present, subtract preferred dividends from net income prior to computing EPS.
Net Income -
Preferred Dividends
Weighted Average Number of
Common Shares Outstanding
Earnings
Per Share =
If a company has preferred stock, the earnings per share ratio is slightly modified as net income less preferred stock dividends divided by the average number of common shares outstanding.
EPS is required to be reported in the income statement.

16. Cash Dividends Declared by Board of Directors. Not legally required.
Stockholders receive a return on their investment in two ways: increases in the market value of the stock, and cash dividends. To pay a cash dividend, a corporation must have two things:
(1) Sufficient retained earnings to absorb the dividend without creating a deficit, and (2) enough cash to pay the dividend.
Dividends are not legally required but rather are declared at the discretion of the Board of Directors. When the dividends are declared, a liability is created. There are four important dates to remember when discussing dividends:
(1) The date of declaration.
(2) The date of record.
(3) The ex-dividend date.
(4) The date of payment.
Let’s look at an example.
Requires sufficient Retained Earnings and Cash.
Creates liability at declaration.

17. Dividend Dates Date of Declaration
Board of Directors declares the dividend.
Record a liability.
On March 1, 2009, 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.
Part I
On March 1st, Matrix declared a $1 per share dividend on its 500,000 common shares outstanding. The dividend is payable on May 1st to stockholders of record on April 1st. Let’s look at the entry for March 1st.
Part II
The entry on March 1st includes a debit to Retained Earnings and a credit to Common Dividends Payable of $500,000.

18. Dividend Dates NO ENTRY Ex-Dividend Date
The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend.
The ex-dividend date is an important date for purchasers and buyers of stock. This is the date which serves as the ownership cut-off point for the receipt of the most recent declared dividend. If you buy stock after this date but before the payment date, you will not receive the dividend.
NO ENTRY

19. Dividend Dates Date of Record
Stockholders holding shares on this date will receive the dividend. (No entry) X
April 2009
Who owns the stock must be known on the April 1st record date, but an accounting entry is not needed.

20. Dividend Dates Date of Payment
Record the payment of the dividend to stockholders.
Part I
Let’s look at the entry for May 1st to record the payment of the dividend.
Part II
On May 1st, the payment date, Matrix would debit Dividends Payable and credit Cash for the $500,000 dividend.

21. Dividend Dates $100 × 8% = $8 dividend per share
$8 × 2,500 = $20,000 total dividend
On June 1, 2009, 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.
Part I
Review the information provided about dividends. What will be included in the July 15th entry?
Part II
July 15th is the payment date. This entry includes a debit to Dividends Payable and a credit to Cash for $20,000.

22. Distribution of additional shares of stock to stockholders.
Stock Dividends
Distribution of additional shares of stock to stockholders.
No change in total stockholders’ equity.
No change in par values.
Sometimes corporations will distribute additional shares of stock as a dividend. Reasons for doing this include: keeping the market price affordable by increasing the number of shares outstanding, and providing evidence of management’s confidence in the company.
All stockholders retain same percentage ownership.

23. Entries to Record Stock Dividends
In accounting for a relatively small stock dividend (say, less than 20%), the market value of the new shares is transferred from Retained Earning account to the paid-in capital accounts. This process is sometimes called “capitalizing” retained earnings.
In accounting for a relatively small stock dividend (say, less than 20%), the market value of the new shares is transferred from Retained Earning account to the paid-in capital accounts. This process is sometimes called “capitalizing” retained earnings
On June 1, Aspen Corporation has outstanding 1,000,000 shares of $1 par value common stock with a market value of $25 per share. The company declares a 5% stock dividend on this date. The dividend is distributable on July 15 to stockholders of record on June 20. Let’s look at the journal entries.
On June 1, Aspen Corporation has outstanding 1,000,000 shares of $1 par value common stock with a market value of $25 per share. The company declares a 5% stock dividend on this date. The dividend is distributable on July 15 to stockholders of record on June 20. Let’s look at the journal entries.

24. Entries to Record Stock Dividends
Part I
We begin by determine the amount that will be assigned to the stock dividend. The company has 1,000,000 shares of common stock outstanding. We multiply the number of shares time the stock dividend percentage to get the new shares that are issuable. In our case 50,000 are issuable and we assign the market price of $25 per share to arrive at the value of the dividend of $1,250,000.
Part II
Because 50,000 new shares will be issuable, the total change in the common stock account will be $50,000.

25. Dividend Dates Date of Declaration
Board of Directors declares the dividend.
Do not record a liability.
500,000 shares × $1 par value
On June 1st, Aspen declared a 5% stock dividend on its 1,000,000 common shares outstanding. The entry on this date is to debit Retained Earnings for the total amount of $1,250,000, credit Stock Dividend to be Distributed for $50,000 (50,000 shares issuable times $1 par), and credit Additional Paid-in Capital – Stock Dividend for the difference of $1,200,000.
The Stock Dividend to be Distributed account is not a liability account because there is no obligation to distribute cash or any other asset. If a balance sheet is prepared between the date of declaration of the stock dividend and the date of distribution of the shares, this account, as well as the Additional Paid-in Capital – Stock Dividend account, should be presented in the stockholders’ equity section of the balance sheet. Notice that Retained Earnings account was reduced by the market value of the shares.

26. Dividend Dates NO ENTRY Ex-Dividend Date
The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend.
The ex-dividend date is the date which serves as the ownership cut-off point for the receipt of the most recent declared dividend. If you buy stock after this date but before the payment date, you will not receive the dividend.
NO ENTRY

27. Dividend Dates Date of Record
Stockholders holding shares on this date will receive the dividend. (No entry) X
June 2009
Who owns the stock must be known on the June 20th record date, but an accounting entry is not needed.

28. Dividend Dates Date of Payment
Record the payment of the dividend to stockholders.
On July 15th, the distribution of the 50,000 common shares is made to the stockholders. The entry is to debit Stock Dividend to be Distributed for $50,000, and credit Common Stock for the same amount. Recall, the Additional Paid-in Capital – Treasury Stock was recorded on the date of declaration in the amount of $1,200,000. If you were the owner of 100 shares of common stock prior to the distribution, you would receive 5 shares in the form of the dividend, and would now have 105 shares.

29. Reasons for Stock Dividends
Management often finds stock dividends appealing because they allow management to distribute something of perceived value to stockholders while conserving cash which may be needed for other purposes.
Stockholders like stock dividends because they receive more shares, often the stock price does not fall proportionately, and the dividend is not subject to income taxes (until the shares received are sold).
Part I
Management often finds stock dividends appealing because they allow management to distribute something of perceived value to stockholders while conserving cash which may be needed for other purposes.
Part II
Stockholders like stock dividends because they receive more shares, often the stock price does not fall proportionately, and the dividend is not subject to income taxes (until the shares received are sold).

30. Distinction between Stock Splits and Stock Dividends
The difference between a stock dividend and a stock split lies in the intent of management and the related issue of the size of the distribution. A stock dividend usually is intended to substitute for a cash dividend and is small enough that the market price of the stock is relatively unaffected.
Stock dividends do not result in a change in the par value of the stock. On the other hand, stock splits result in a pro rata reduction in the par value of the stock.
The difference between a stock dividend and a stock split lies in the intent of management and the related issue of the size of the distribution. A stock dividend usually is intended to substitute for a cash dividend and is small enough that the market price of the stock is relatively unaffected.
Stock dividends do not result in a change in the par value of the stock. On the other hand, stock splits result in a pro rata reduction in the par value of the stock.

31. Summary of Effects of Stock Dividends and Stock Splits
A stock dividend can be classified as small or large. A small stock dividend is a distribution of stock that is less than or equal to 25% of the outstanding shares. A large stock dividend is a distribution of stock that is greater than 25% of the outstanding shares.
Stock splits are the distribution of additional shares of stock to stockholders according to their percent ownership. When a stock split occurs, the corporation calls in the outstanding shares and issues new shares of stock. In the process of a stock split, the par value of the stock changes.
Take a moment to review the impact of a small stock dividend, a large stock dividend, and a stock split on the financial statements.

32. Prior Period Adjustments
The correction of an error identified as affecting net income in a prior period.
Adjust retained earnings retroactively.
The adjustment should be disclosed net of any taxes.
Prior period adjustments are the corrections of errors in a prior period’s financial statements. Prior period adjustments require an adjustment to Retained Earnings and are reported net of tax.

33. Statement of Retained Earnings with Prior Period Adjustment
Rockford Company found an error that overstated income in a prior period’s financial statements. Net of taxes, the error is reported as a $65,000 reduction on the Statement of Retained Earnings.

34. 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.
Retained earnings can have legal or contractual restrictions. Some loan agreements place restrictions on dividend amounts, based on the balance in retained earnings. Restrictions on retained earnings are generally disclosed in the notes to the financial statements.
Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings.

35. Normally, there are 3 ways that financial position can change.
Comprehensive Income
Normally, there are 3 ways that financial position can change.
GAAP excludes some unrealized items from income, such as the change in market value of available-for-sale debt and equity investments.
Issuance of new shares of stock.
Net Income or Net Loss
Payment of Dividends
There are three ways that a company’s financial position can change: issuing new stock, reporting net income or net loss, and paying dividends. Generally accepted accounting principles, or GAAP, excludes some unrealized gains and losses from income. An example of an unrealized gain or loss is the gain or loss that results from reporting available for sale securities at market value.
Comprehensive income is a way to determine the whole impact of items not included on the income statement. Let’s look at this in more detail on the next slide.

36. 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.
Comprehensive income starts with net income and adds or subtracts certain unrealized gains and losses that are not reported on the income statement. Comprehensive income can be reported as a second income statement, reported below net income on the income statement, or reported as an element of stockholders’ equity.
As a second Income Statement.
Combined with Net Income on the Income Statement.
As an element of Stockholders’ Equity.

37. Statement of Stockholders’ Equity
Many companies issue a Statement of Stockholders’ Equity rather than a simple Statement of Retained Earnings. The Statement of Stockholders’ Equity is more inclusive and discloses changes in all equity accounts, not just Retained Earnings.
This is a more inclusive statement than the statement of retained earnings.

38. Stockholders’ Equity Section of the Balance Sheet
Here is an example of the stockholders’ equity section of a balance sheet. Notice that it reports both common and preferred stock at par value, additional paid-in capital for common and preferred stock, and retained earnings.

39. End of Chapter 12
End of chapter 12.