Earnings Per Share and Retained Earnings C 16 hapter Earnings Per Share and Retained Earnings An electronic presentation by Douglas Cloud Pepperdine University 1 1 1 1

Objectives 1. Know the equation for computing basic earnings per share (EPS). 2. Understand how to compute the weighted average common shares for EPS. 3. Identify the potential common shares included in diluted EPS. 4. Apply the treasury stock method for including stock options and warrants in diluted EPS. Continued 2 2 2 4

Objectives 5. Calculate the impact of a convertible security on EPS. 6. Compute diluted EPS. 7. Record the declaration and payment of cash dividends. 8. Account for property dividends. 9. Explain the difference in accounting for small and large dividends. Continued

Objectives 10. Understand how to report accumulated other comprehensive income. 11. Prepare a statement of changes in stockholders’ equity. 12. Account for a quasi-reorganization (Appendix).

Basic Earnings Per Share Net Income – Preferred Dividends Weighted Average Number of Common Shares Outstanding

Weighted Average Shares Since a corporation earns its net income over the entire year, the earnings are related to the common shares outstanding during the year.

Weighted Average Shares A corporation had 12,000 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 480 shares as treasury stock. The nearest whole month is used Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-February 12,000 x 2/12 = 2,000 March-June 14,700 x 4/12 = 4,900 July-November 18,000 x 5/12 = 7,500 December 17,520 x 1/12 = 1,460 15,860 Total weighted average common shares

Weighted Average Shares A corporation begins operations in January 2004, and issues 5,000 shares of common stock that are outstanding all during 2004. On December 31, 2004, it issues a 2-for-1 stock split. Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-December 5,000 x 12/12 = 5,000 The two-for-one split is retroactive to January 1 + 5,000 Total weighted average common shares 10,000 Continued

Weighted Average Shares On May 28, 2005, the corporation issues 5,000 shares of common stock; on August 3, it issues a 20% stock dividend; and on October 5, it issues 2,005 shares of stock. 2004 Data on 2004 Statement Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-December 5,000 x 12/12 = 5,000 5,000 x 200% x 120% = 12,000 equivalent whole units Continued

Weighted Average Shares 2005 Data on 2001 Statement Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-May 10,000 June-July 15,000 August-September 18,000 Issued 5,000 shares Issued 20% stock dividend

Weighted Average Shares 2005 Data on 2005 Statement Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = Increases 20% January-May 10,000 June-July 15,000 August-September 18,000 12,000 Increases 20% 18,000 October-December 20,000

Weighted Average Shares 2005 Data on 2001 Statement Assumed Shares Shares Fraction of Year Equivalent Outstanding Outstanding Outstanding Whole Units x = January-May 10,000 June-July 15,000 August-September 18,000 12,000 18,000 October-December 20,000 x 5/12 = 5,000 x 2/12 = 3,000 x 3/12 = 5,000 16,000

Diluted Earnings Per Share A corporation with a complex capital structure is required to report two amounts on the face of its income statement. Yes… basic earnings per share and diluted earnings per share.

Diluted Earnings Per Share Diluted earnings per share shows the earnings per share after including all potential common shares that would reduce earnings per share.

Diluted Earnings Per Share To be included in the diluted earnings per share calculation, any potential common share must have a dilutive effect on earnings per share.

Diluted Earnings Per Share Step 1: Compute the basic earnings per share. Step 2: Include dilutive stock 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. Step 4: Include each dilutive convertible security in DEPS in a sequential order based on the ranking and compute a new tentative DEPS. Step 5: Select as the diluted earnings per share the lowest computed DEPS.

Flowchart of EPS Computations Capital Structures Any options, warrants, or convertible securities outstanding? Simple Capital Structure No Complex Capital Structure Yes Basic EPS Go to next slide Net Income - Preferred Dividends Weighted Average Common Shares

Yes, go to next slide Complex Capital Structure Diluted EPS Basic Net Income - Preferred Dividends EPS Weighted Average Common Shares = Stock Options and Warrants Convertible Securities Continued next slide Average Market Price > Option Price ? No Yes, go to next slide

Stock Options and Warrants Convertible Securities Outstanding? No Average Market Price > Option Price ? No Develop Ranking of All Convertible Securities Yes No Yes Apply Treasury Stock Method Diluted EPS Computations * Options and Warrants Adjustments * Convertible Securities Adjustments Individually Dilutive? Yes Stop No

Stock Options and Warrants Change (Increment) in Shares + - Assumed Shares Issued Proceeds ($) Assumed Shares Reacquired (at average market price)

Treasury Stock Method Step 1. Determine the average market price of common shares during the period. Step 2. Compute the shares 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 option price [plus any unrecognized compensation cost (net of tax) per share]. Step 4. Compute the assumed shares reacquired by dividing the proceeds by the average market price. Step 5. Compute the incremental common shares.

Average Market Price Per Share Treasury Stock Method The per share unrecognized compensation cost (net of tax) related to the stock option. To illustrate Step 3 further, assume a corporation has compensatory stock options to purchase 1,000 common shares at $18 per share outstanding the entire year, and that the average market price for the common stock was $25 per share. Shares assumed issued from assumed exercise: 1,000 1,000 x ($18 + $2) $25 Proceeds Average Market Price Per Share $20,000 $25 = = (800) Assumed increment in common shares for computing diluted earnings per share 200

Convertible Securities Convertible bonds and convertible preferred stock are considered in DEPS after stock options and warrants.

Convertible Securities Numerical Value Impact on Diluted Earnings Per Share Increase in Earnings Per Share Numerator Increase in Earnings Per Share Denominator $5,400 3,000 = $1.80 Security A: 9% convertible preferred stock dividends of $5,400 were declared during the year. The preferred shares are convertible into 3,000 shares of common stock. Continued

Convertible Securities Numerical Value Impact on Diluted Earnings Per Share $4,800 1,920 = $2.50 Security B: 10% convertible bonds. Interest expense (net of income taxes) of $4,800 were recorded during the year. The bonds are convertible into 1,920 shares of common stock. Continued

Convertible Securities Numerical Value Impact on Diluted Earnings Per Share $8,000 5,000 = $1.60 Security C: 8% convertible preferred stock. Dividends of $8,000 were declared during the year. The preferred shares are convertible into 5,000 shares of common stock. Continued

Convertible Securities Numerical Value Impact on Diluted Earnings Per Share $6,300 3,150 = $2.00 Security D: 7% convertible bonds. Interest expense (net of income taxes) of $6,300 was recorded during the year. The bonds are convertible into 3,150 shares of common stock. Continued

Convertible Securities Security Impact Order in Ranking A $1.80 2 B $2.50 4 C $1.60 1 D $2.00 3 Security C has the lowest impact on DEPS and is the most dilutive. It is the first convertible security (after options and warrants) to be included in DEPS (if dilutive).

If Convertible Security Is Dilutive Add Increase to Numerator Revised Numerator Revised Denominator Add Increase to Denominator Revised = Tentative Diluted EPS

Additional Disclosures 1. Identifies the amount of preferred dividends deducted to determine the income available to common stockholders. 2. Describes the potential common shares that were not included in the diluted earnings per share computation because they were antidilutive. 3. Describe any material impact on the common shares outstanding of subsequent transactions after the close of the accounting period but before the issuance of the financial report. When a corporation reports its basic and diluted earnings per share on its income statement, it also is required to make additional disclosures in the notes to its financial statements.

There are four significant dates for a cash dividend. The date of declaration The ex-dividend date The date of record The date of payment

Cash Dividend Date Accounting Procedures Reduce Retained Earnings Increase Liabilities Date of Declaration Date of Record Memorandum Entry Date of Payment Reduce Assets Reduce Liabilities

Cash Dividend On November 3, 2004, the board of directors of a corporation declares preferred dividends totaling $10,000 and common dividends totaling $20,000. These dividends are payable on December 15, 2004 to stockholders of record on November 24, 2004. November 3, 2004 Retained Earnings 30,000 Dividends Payable: Preferred Stock 10,000 Dividends Payable: Common Stock 20,000

Cash Dividend On November 3, 2004, the board of directors of a corporation declares preferred dividends totaling $10,000 and common dividends totaling $20,000. These dividends are payable on December 15, 2004 to stockholders of record on November 24, 2004. November 24, 2004 Memorandum entry: The company will pay dividends on December 15, 2004, to preferred and common stockholders of record as of today, the date of record.

Cash Dividend On November 3, 2001, the board of directors of a corporation declares preferred dividends totaling $10,000 and common dividends totaling $20,000. These dividends are payable on December 15, 2001 to stockholders of record on November 24, 2001. December 15, 2004 Dividends Payable: Preferred Stock 10,000 Dividends Payable: Common Stock 20,000 Cash 30,000

Fully Participating Preferred Stock A 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. The preferred stock is two years in arrears. The Corporation declares a $13,000 dividend.

Fully Participating Preferred Stock Preferred Common Dividends in arrears: 2 x (10% of $20,000) $4,000 Current dividend (10% x $20,000) 2,000 Common dividend (10% x $30,000) $3,000 Total to allocate $13,000 Allocated ( 9,000 ) Remainder $ 4,000 $20,000/$50,000 to preferred and $30,000/$50,000 to common 1,600 2,400 Dividend to each class of stock $7,600 $5,400

Partially Participating Preferred Stock (up to 12%) Preferred Common Dividends in arrears: 2 x (10% of $20,000) $4,000 Current dividend (10% x $20,000) 2,000 Common dividend (10% x $30,000) $3,000 2% dividend on par 400 600 Remainder to common ($13,000 – $10,000) 3,000 Dividend to each class of stock $6,400 $6,600

Property Dividend Occasionally, a corporation will declare a property dividend that is payable in assets other than cash.

Property Dividend The corporation typically uses marketable securities of other companies that it owns for the property dividend.

Property Dividend Corporation C declares a property dividend on March 16, 2005, payable in Company D stock on June 1, 2005. The Company D stock was purchased early in 2004 for $24,000 and was reported at its fair market value of $29,000 on December 31, 2004 (along with an unrealized increase in value of $5,000). The market value on the declaration date is $31,000. Continued

Property Dividend March 16, 2005 Allowance for Change in Value of Investment in Available-for-Sale Securities 2,000 Unrealized Increase in Value of Available-for-Sale Securities 5,000 Gain on Disposal of Investments 7,000 Retained Earnings 31,000 Property Dividends Payable 31000

Property Dividend June 1, 2005 Property Dividends Payable 31,000 Investment in Available-for-Sale Securities 24,000 Allowance for Change in Value of Securities 7,000

Stockholders often view stock dividends favorably even though-- They receive no corporate assets. Their percentage ownership does not change. Theoretically the total market value of their investment will remain the same. Future cash dividends may be limited because retained earnings is decreased by the amount of the stock dividend. Stockholders often view stock dividends favorably even though--

Stock Dividends Stock Dividend What factors might enhance the perceived attractiveness of stock dividends? Stock Dividend

Stock Dividends The stockholders may see the stock dividend as evidence of corporate growth. The stockholders 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.

Stock Dividends The corporation may state that it will pay the same fixed cash dividend per share. The stockholders may see the market price decreasing to a lower trading range, making the stock more attractive to additional investors so that the market price may eventually rise.

Additional Paid-In Capital Stock Dividends Small (<20 or 25%) Large Par Value Fair Value Retained Earnings Capital Stock Additional Paid-In Capital

Stockholders’ Equity Prior to Stock Dividend Stock Dividends Stockholders’ Equity Prior to 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 stockholders’ equity $700,000

Small Stock Dividend M Corporation declares and issues a 10% stock dividend. On the date of declaration, the stock sells for $23 per share. Date of Declaration Retained Earnings 46,000 Common Stock To Be Distributed 20,000 Additional Paid-in Capital From Stock Dividend 26,000 20,000 shares x 0.10 x $23 Par Continued

Small Stock Dividend M Corporation declares and issues a 10% stock dividend. On the date of declaration, the stock sells for $23 per share. Date of Issuance Common Stock To Be Distributed 20,000 Common Stock, $10 par 20,000 Par

Small Stock Dividend Common stock, $10 par (22,000 shares Stockholders’ Equity After Stock Dividend Common stock, $10 par (22,000 shares issued and outstanding $220,000 Additional paid-in capital 206,000 Retained earnings 274,000 Total stockholders’ equity $700,000 Note: Total remained the same

Large Stock Dividends M Corporation declares and issues a 40% stock dividend. On the date of declaration, the stock sells for $23 per share. Date of Declaration Retained Earnings 80,000 Common Stock To Be Distributed 80,000 20,000 shares x 0.40 x $10 Date of Issuance Common Stock To Be Distributed 80,000 Common Stock, $10 par 80,000 Continued

Large Stock Dividends Common stock, $10 par (28,000 shares Stockholders’ Equity After Stock Dividend Common stock, $10 par (28,000 shares issued and outstanding) $280,000 Additional paid-in capital 180,000 Retained earnings 240,000 Total stockholders’ equity $700,000 Note: Same total as small stock dividend

Statement of Retained Earnings Although not a required separate financial statement, some corporations include a statement of retained earnings in their financial statements.

Statement of Retained Earnings Retained earnings, as previously reported, Jan. 1, 2004 Plus (minus) Prior period adjustments (net of income tax effect) Adjusted retained earnings, January 1, 2004 Plus (minus): Net income (loss) Minus: Dividends (specifically identified, including per share amounts) Reductions due to retirement or reacquisition of capital stock Reductions due to conversion of bonds or preferred stock Retained earnings, December 31, 2004 Statement of Retained Earnings

Accumulated Other Comprehensive Income Other comprehensive income might include-- Unrealized increases (gains) or decreases (losses) in the market value of investments in available-for-sale securities. Translation adjustments from converting the financial statements of a company’s foreign operation into U.S. dollars. Certain gains and losses on “derivative” financial instruments. Certain pension liability adjustments.

Accumulated Other Comprehensive Income A corporation may report its comprehensive income (net of income taxes)-- On the face of its income statement. In a separate statement of comprehensive income. In its statement of changes in stockholders’ equity.

Statement of Changes in Stockholders’ Equity APB Opinion No. 12 states: “…disclosures of changes in the separate accounts comprising stockholders’ equity (in addition to retained earnings) and of the changes in the number of shares of equity securities during at least the most recent annual fiscal period…is required to make the financial statements sufficiently informative.

Appendix: Quasi-Reorganization Click the button next to me to skip the Appendix material.

Appendix: Quasi-Reorganization A corporation that incurs net losses over an extended period of time may find itself in serious financial difficulty. Rather than enter into a formal bankruptcy or other legal proceedings, the corporation engage in a quasi-reorganization.

Appendix: Quasi-Reorganization The suggested readjustment procedures include the following steps: 1. The corporation reports to the stockholders about the restatements proposed and obtains the stockholders’ formal consent. 2. Any amounts written off are first charged against retained earnings and then against additional paid-in capital. 3. The corporation begins its “fresh start” with a zero retained earnings balance. Continued

Appendix: Quasi-Reorganization The suggested readjustment procedures include the following steps: 4. The corporation presents a balance sheet as of the date of readjustment in which the assets and liabilities are reported at their fair values. After the quasi-reorganization, several additional accounting procedures are suggested: Continued

Appendix: Quasi-Reorganization 5. If losses or readjustments are identified that are determined to have occurred before the readjustment date, they are recorded as a reduction of additional paid-in capital and not current income or retained earnings. 6. Additional paid-in capital is not reduced for losses occurring after the readjustment. 7. Retained earnings is dated as of the readjustment date, and this dating is disclosed in a note to the financial statements until such dating loses it significance.

C 16 hapter The End