1. Corporations: Effects on Retained Earnings and the Income Statement
Chapter 12
Chapter 12 explains the effects on corporate retained earnings and the income statement.

2. Account for stock dividends
Learning Objective 1
Account for stock dividends
The first learning objective is to account for stock dividends.

3. Stock Dividend
Proportional distribution of corporation’s own stock to shareholders
No cash provided to shareholders
Does not change total stockholders’ equity
Transfer of retained earnings to contributed capital
Common stock
Retained earnings
A stock dividend is a distribution of a corporation’s own stock to its shareholders. Unlike cash dividends, stock dividends do not give any assets to the shareholders. Stock dividends:
• affect only stockholders’ equity accounts (including Retained earnings and Common stock)
• have no effect on total stockholders’ equity
• have no effect on assets or liabilities
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4. Why do Companies Issue Stock Dividends?
Conserve cash
Continue dividends without using cash
Reduce market price
Increased supply of shares may cause price to fall
Reward investors
Shareholders feel they have received something of value
A company issues stock dividends for several reasons:
1. To continue dividends but conserve cash. A company may wish to continue dividends to keep stockholders happy but the company may need to keep its cash for operations. A stock dividend is a way to do so without using corporate cash.
2. To reduce the market price of its stock. A stock dividend may cause the company’s stock price to fall because of the increased supply of the stock.
3. To reward investors. Investors often feel like they’ve received something of value when they get a stock dividend.
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5. Entries for Stock Dividend
Small
Large
Distribution is less than 20 to 25% of issued shares
Debit Retained earnings for market value of shares to be distributed
Distribution is greater than or equal to 25% of issued shares
Debit Retained earnings for par or stated value of shares
Rare
As with a cash dividend, there are three dates for a stock dividend:
Declaration date
Record date and
Distribution (payment) date
The declaration of a stock dividend does not create a liability because the corporation is not obligated to pay assets. With a stock dividend, the corporation has declared its intention to distribute its stock. The entry to record a stock dividend depends on the size of that dividend. Generally accepted accounting principles distinguish between:
• A small stock dividend (less than 20% to 25% of issued stock).
• A large stock dividend (25% or more of issued stock).
Stock dividends between 20% and 25% are rare. Small stock dividends are accounted for at their market value. Here’s how the various accounts are affected:
• Retained earnings is debited for the market value of the dividend shares.
• Common stock is credited for the stock’s par value.
• Paid-in capital in excess of par-C/S is credited for the remainder.
Large stock dividends are rare, but when they are declared, they are accounted for at par value, instead of market value. Par value is used because the larger number of shares will reduce market value, making it an invalid measurement of the dividend value.
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6. Exercise 12-13 10% x 450 = 45 share dividend GENERAL JOURNAL Apr 30
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Apr 30
Retained earnings (45 x $17)
765
Common stock (45 x $1) 45
Paid-in capital in excess of par-C/S
720
Exercise provides an example of a small stock dividend. On April 30, 2010, the market price of Seabury’s common stock was $17 per share and the company distributed a 10% stock dividend. The company has 450 shares outstanding – 10% of which is 45 shares. Since this is a small stock dividend, Retained earnings is debited for the shares multiplied by the market value of $17. Common stock is credited at par value. Paid-in capital in excess of par-C/S is credited for the difference.
Requirements:
1. Journalize the distribution of the stock dividend.
2. Prepare the stockholders’ equity section of the balance sheet after the stock dividend.
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7. Exercise 12-13 (continued)
The stockholder’s equity section of the balance sheet after the small stock dividend is above. Notice the stock account increased by $45 and the shares issued increased by 45 as well. Paid-in capital in excess of par-C/S increased. Retained earnings, however, decreased. The total stockholders’ equity is the same.
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8. Account for stock splits
Learning Objective 2
Account for stock splits
The second learning objective is to account for stock splits.

9. Stock Splits Increases: Decreases:
the number of shares authorized, issued and outstanding
Decreases:
par value per share
market value
Balances in the accounts are unchanged
Record in a memorandum entry
A stock split is fundamentally different from a stock dividend. A stock split increases the number of authorized, issued, and outstanding shares of stock. A stock split also decreases par value per share, whereas stock dividends do not affect par value or the number of authorized shares.
For example, if a company splits its common stock 2 for 1, the number of outstanding shares is doubled and par value per share is cut in half. A stock split also decreases the market price of the stock. Because the stock split does not affect any account balances, no formal journal entry is needed. Instead, the split is recorded in a memorandum entry, a journal entry that “notes” a significant event, but which has no debit or credit amount.
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10. Stock Split Example
A company has 25,000 shares of $10 par common stock outstanding
A 2-for-1 stock split is declared
An example helps illustrate how stock splits work. A company has 25,000 shares of $10 par common stock outstanding. If a 2-for-1 stock split is declared, the shares will double and the par value will be cut in half.
Results in 50,000 shares of $5 par common stock outstanding
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11. Effects of Dividends and Stock Splits
Event
Common stock
Paid-in capital in excess of par
Retained earnings
Total stockholders’ equity
Cash dividend
No effect
Decrease
Stock dividend
Increase
Stock split
This table summarizes the effects of dividends, both cash and stock, and stock splits. Cash dividends decrease Retained earnings, and therefore total equity. Cash dividends do not affect the Paid-in capital accounts because cash, an asset, is distributed to the shareholders. On the other hand, stock dividends do increase both the Common stock and Paid-in capital in excess of par accounts because stock is distributed. Stock dividends also decrease Retained earnings. The decrease in Retained earnings is offset by the increase in the Paid-in capital accounts, so the net effect on total equity is zero. Stock splits change the par value and number of shares of stock, but no entry is made. Therefore, no accounts are affected.
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12. Account for treasury stock
Learning Objective 3
Account for treasury stock
The third learning objective is to account for treasury stock.

13. Treasury Stock Shares that a company has issued and later reacquired
Reasons corporations purchase their own stock:
To increase net assets by buying low and selling high
To support the company’s stock price
To avoid a takeover by an outside party
To reward valued employees with stock
A company’s own stock that it has previously issued and later reacquired is called treasury stock. In effect, the corporation holds the stock in its treasury. A corporation may purchase treasury stock for several reasons:
1. Management wants to increase net assets by buying low and selling high.
2. Management wants to support the company’s stock price.
3. Management wants to avoid a takeover by an outside party.
4. Management wants to reward valued employees with stock.
Treasury stock transactions are common among corporations.
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14. Accounting for Treasury Stock
Contra equity account
Debit balance
Recorded at cost (not par)
Reported beneath Retained earnings on the balance sheet
Reduction to total stockholders’ equity
Decreases outstanding shares
Not eligible for dividends
Here are the basics of accounting for treasury stock:
• The Treasury stock account has a debit balance, which is the opposite of the other equity accounts. Therefore, Treasury stock is contra equity.
• Treasury stock is recorded at cost, without reference to par value.
• The Treasury stock account is reported beneath Retained earnings on the balance sheet as a reduction to total stockholders’ equity.
Treasury stock decreases the company’s stock that is outstanding. Outstanding shares are important because only outstanding shares have voting rights and receive cash dividends. Treasury stock doesn’t carry a vote, and it gets no dividends.
Outstanding shares
Issued shares
Treasury shares
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15. Treasury Stock Journal Entries
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Treasury stock
Cash
To record purchase of treasury shares
To record the purchase, debit Treasury stock and credit Cash at cost.
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16. Treasury Stock Journal Entries
If treasury stock is sold above cost, the excess is credited to “Paid-in capital from treasury stock transactions”
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Cash
Treasury stock (at cost)
Paid-in capital from treasury
stock transactions
If treasury stock is sold for more than its cost, the difference is credited to a new account, Paid-in capital from treasury stock transactions. This excess is additional paid-in capital because it came from the company’s stockholders. It has no effect on net income. Paid-in capital from treasury stock transactions is reported with the other Paid-in capital accounts on the balance sheet, beneath Common stock and Paid-in capital in excess of par.
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17. Treasury Stock: Sale Below Cost
If treasury stock is sold below cost, the shortfall is debited to “Paid-in capital from treasury stock transactions”
IF there is a sufficient balance
The resale price of treasury stock may be less than its original cost. The shortfall is debited first to Paid-in capital from treasury stock transactions. If this account’s balance is too small, then debit Retained earnings for the remaining amount.
Otherwise, Retained earnings is debited for any remaining shortfall
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18. Treasury Stock Journal Entries: Sale Below Cost
Situation 1 – Paid-in capital from treasury stock has a sufficient balance to cover the shortfall
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Cash
Paid-in capital from treasury
stock transactions
Treasury stock (at cost)
There are three situations that could arise when selling treasury stock below cost. First, the “Paid-in capital from treasury stock transactions” account could have a large enough balance to cover the entire shortfall. In this situation, it is debited for the difference between the selling price and the cost of the treasury stock.
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19. Treasury Stock Journal Entries: Sale Below Cost
Situation 2 – Paid-in capital from treasury stock has a balance too small to cover shortfall
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Cash
Paid-in capital from treasury
stock transactions
Retained earnings
Treasury stock (at cost)
For amount that zeros out account
Another situation exists when the Paid-in capital from treasury stock transactions account has a balance, but it is too small to cover the shortfall. In this situation, it is debited for its balance. This will zero out the account. Retained earnings is debited for the remainder of the shortfall.
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20. Treasury Stock Journal Entries: Sale Below Cost
Situation 3 – Paid-in capital from treasury stock has a zero balance
GENERAL JOURNAL
DATE
DESCRIPTION
REF
DEBIT
CREDIT
Cash
Retained earnings
Treasury stock (at cost)
Sometimes, Paid-in capital from treasury stock transactions does not have a balance. In this situation, the entire shortfall is debited to Retained earnings.
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21. Report restrictions on retained earnings
Learning Objective 4
Report restrictions on retained earnings
The fourth learning objective is to report restrictions on retained earnings.

22. Restrictions and Appropriations of Retained Earnings
Requirement by lenders to maintain a minimum level of equity by limiting:
payment of dividends
purchases of treasury stock
Reported in the notes to the financial statements
Appropriations
Restrictions on retained earnings recorded by formal journal entries
Board of directors may designate purpose of appropriation
Dividends and treasury stock purchases require a cash payment. These outlays leave fewer resources to pay liabilities. A bank may agree to loan a company money only if it maintains a minimum level of equity by limiting both its payment of dividends and its purchases of treasury stock. To ensure that a corporation maintains a minimum level of equity, lenders may restrict the amount of treasury stock a corporation may purchase. The restriction often focuses on the balance of Retained earnings. Companies usually report their retained earnings restrictions in notes to the financial statements.
Appropriations are retained earnings restrictions recorded by formal journal entries. A corporation may appropriate—that is, segregate in a separate account—a portion of retained earnings for a specific use. For example, the board of directors may appropriate part of retained earnings for expansion.
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23. Complete a corporate income statement including earnings per share
Learning Objective 5
Complete a corporate income statement including earnings per share
The fifth learning objective is to complete a corporate income statement including earnings per share.

24. Any Corporation Income Statement
Sales revenue
Cost of goods sold
Gross profit
Operating expenses
Operating income
Other gains (losses)
Income from continuing operations before income tax
Income tax expense
Income from continuing operations
Discontinued operations, net of tax
Income before extraordinary items
Extraordinary loss, net of tax
Net Income
Here is a template for a corporate income statement. Items newly presented in this chapter are in red. Each of these will be described.
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25. Income from Continuing Operations
Measures profitability of the ongoing operations
Useful for making projections about future earnings
Any Corporation
Income Statement
Sales revenue
Cost of goods sold
Gross profit
Operating expenses
Operating income
Other gains (losses)
Income from continuing operations before income tax
Income tax expense
Income from continuing operations
The topmost section reports continuing operations. This part of the business should continue from period to period. Income from continuing operations therefore helps investors make predictions about future earnings. The other gains (losses) section includes items such as gains and losses on sales of plant assets. Income tax expense has its own line.
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26. Discontinued operations
Special Items
Reported after income from continuing operations
Discontinued operations
Extraordinary items
After continuing operations, an income statement may include two distinctly different types of gains and losses:
• Discontinued operations
• Extraordinary gains and losses
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27. Discontinued Operations
Segment of a business that has been sold
Identifiable division of company
Reported separately because they will not be around in the future
Shown net of tax
Gain - income tax expense = Gain, net of tax
Loss - income tax savings = Loss, net of tax
Most corporations engage in several lines of business. Each identifiable division of a company is called a segment of the business. A company may sell a segment of its business.
Financial analysts are always keeping tabs on companies they follow. They predict companies’ net income, and most analysts don’t include discontinued operations because the discontinued segments won’t be around in the future. The income statement reports information on the segments that have been sold under the heading Discontinued operations. Gains and losses on the sale of plant assets are not reported as discontinued operations. Instead, they are reported as “Other gains (losses)” up among continuing operations because companies dispose of old plant assets and equipment all the time.
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28. Extraordinary Items Both unusual and infrequent Examples:
Losses from natural disasters
Foreign government takeover (expropriation)
Reported net of income tax effect
Extraordinary gains and losses, also called extraordinary items, are both unusual and infrequent. Losses from natural disasters (floods, earthquakes, etc.) and the taking of company assets by a foreign government (expropriation) are extraordinary items. They are reported separate from normal operations because of their infrequent nature. Extraordinary items are reported along with their income tax effect.
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29. Earnings Per Share (EPS)
Most widely used business statistic
Measures amount of net income for each share of common stock outstanding
Issued shares – treasury shares = outstanding shares
Key measure of success in business
The final segment of a corporate income statement reports the company’s earnings per share, abbreviated as EPS. EPS is the most widely used of all business statistics. Earnings per share (EPS) reports the amount of net income for each share of the company’s outstanding common stock. EPS is a key measure of success in business. EPS is computed as shown on the next slide.
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30. Net income – preferred dividends
Earnings per share
Net income – preferred dividends
Average number of common shares outstanding
EPS figures are reported for:
Income from continuing operations
Income from discontinued operations
Income before extraordinary items
Extraordinary gains or losses
Net Income (loss)
The formula to compute earnings per share is net income minus preferred dividends divided by the average number of common shares outstanding. Corporations report a separate EPS figure for each element of income.
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31. Net income – preferred dividends
Exercise 12-21
Net income – preferred dividends
1,000 shares x $30 par x 2%
$110,000
$600
Exercise provides practice on computing earnings per share (EPS). The numerator of EPS is computed by subtracting preferred dividends from net income. Preferred dividends for this company total $600. This is found by multiplying the number of preferred shares by the par value and then by the dividend rate of 2%.
$109,400
Numerator of EPS
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32. Exercise 12-21 (continued)
Average number of common shares outstanding
52,000 shares issued
2,000 treasury shares
The denominator of EPS is the average number of common shares outstanding. This company has treasury shares, which must be subtracted from the shares issued to derive outstanding shares.
50,000 common shares outstanding
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33. Exercise 12-21 (continued)
Net income – preferred dividends
Average number of common shares outstanding
$109,400
The numerator is divided by the shares. The result is EPS of $2.19.
50,000
$2.19 EPS
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34. Statement of Retained Earnings
Reports how retained earnings changed over the accounting period
The statement of retained earnings reports how the company moved from its beginning balance of Retained earnings to its ending balance during the period.
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35. Prior Period Adjustments
Corrections to Retained earnings for errors of an earlier period
Correcting entry includes
Debit or credit to Retained earnings for error amount
Debit or credit to asset or liability account that was misstated
Reported on Statement of retained earnings
A company may make an accounting error. After the books are closed, Retained earnings holds the error, and its balance is wrong until corrected. Corrections to Retained earnings for errors of an earlier period are called prior-period adjustments. The prior-period adjustment either increases or decreases the beginning balance of Retained earnings and appears on that statement.
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36. Comprehensive Income
Change in total stockholders’ equity from all sources other than from its owners
Net income plus or minus
Unrealized gains/losses on certain investments
Foreign currency translation adjustments
All companies report net income or net loss on the income statement. However, there is another income figure. Comprehensive income is the company’s change in total stockholders’ equity from all sources other than its owners. Comprehensive income includes net income plus some specific gains and losses, as follows:
• Unrealized gains or losses on certain investments
• Foreign-currency translation adjustments
These items do not enter into the determination of net income, but instead are reported as other comprehensive income.
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37. End of Chapter 12
This concludes our coverage of Chapter 12.