1 © Copyright Doug Hillman 1999 Additional Stockholders’ Equity Transactions and Income Disclosures

2 © Copyright Doug Hillman 1999 Retained Earnings l Cumulative net income of past years minus net losses and dividends declared during those years l Primary factors affecting retained earnings ›Net income or loss ›Restrictions of retained earnings ›Prior period adjustments ›Dividends

3 © Copyright Doug Hillman 1999 Restrictions on Retained Earnings l Tells the financial statement reader that company may not pay out this part of retained earnings as dividends l Required restrictions ›To comply with legal or contractual limits on dividend distribution l Voluntary ›To show reasons why management wishes to restrict dividends

4 © Copyright Doug Hillman 1999 Prior Period Adjustment l An error in preparing financial statements in one accounting period not discovered until a later period l Treat correction of error, if material, as adjustment of beginning retained earnings ›Adjusts affected balance sheet account ›Adjusts beginning retained earnings

5 © Copyright Doug Hillman 1999 Dividends l Distribution of cash, stock, or other corporate assets to stockholders l Declaration decreases retained earnings l When board of directors takes formal action, declaration, dividend immediately becomes liability

6 © Copyright Doug Hillman 1999 Cash Dividend l Date of declaration ›Increase Dividends - a nominal account closed to Retained Earnings ›Increase Dividends Payable l Date of record ›No entry ›Determines persons who will receive dividend ›Stock sold after is sold ex-dividend

7 © Copyright Doug Hillman 1999 Cash Dividend l Date of payment ›Decreases Cash ›Decreases Dividends Payable l Cumulative preferred in arrears ›First must pay arrearages ›Then pay current period preferred ›Then common is entitled to dividends

8 © Copyright Doug Hillman 1999 Stock Dividends l Issuance of additional shares of authorized stock l Reasons ›Need to conserve cash ›Give measure of company’s success ›Increase permanent capitalization ›Decrease market price

9 © Copyright Doug Hillman 1999 Small Stock Dividend l Involves less than 20-25% of previously outstanding shares l Transfer from retained earnings to paid- in capital an amount equal to market value of shares l Reasoning is that small stock dividends do not decrease market value significantly

10 © Copyright Doug Hillman 1999 Small Stock Dividend l Date of declaration ›Increase Stock Dividends, a nominal account closed to Retained Earnings, for market value ›Increase Stock Dividends to be Issued for par value ›Increase Paid-in Capital-Excess Over Par for difference

11 © Copyright Doug Hillman 1999 Small Stock Dividend l Stock Dividends to be Issued appears in paid-in capital l Date of payment ›Decrease Stock Dividends to be Issued ›Increase Stock

12 © Copyright Doug Hillman 1999 Large Stock Dividend l Involves more than 20-25% of previously outstanding shares l Transfer from retained earnings to paid- in capital an amount equal to par value of shares l Reasoning is that large stock dividend should decrease market value

13 © Copyright Doug Hillman 1999 Large Stock Dividend l Date of declaration ›Increase Stock Dividends, a nominal account closed to Retained Earnings, for par value ›Increase Stock Dividends to be Issued for par value l Stock Dividends to be Issued appears in paid-in capital

14 © Copyright Doug Hillman 1999 Large Stock Dividend l Date of payment ›Decrease Stock Dividends to be Issued ›Increase Stock

15 © Copyright Doug Hillman 1999 Effect of Stock Dividend l Small stock dividend ›Increase paid-in capital by market value of shares issued in dividend ›Decreases retained earnings by market value of shares issued in dividend

16 © Copyright Doug Hillman 1999 Effect of Stock Dividend l Large stock dividend ›Increases paid-in capital by par value of shares issued in dividend ›Decreases retained earnings by par value of shares issued in dividend l Capitalizes (makes permanent) some of retained earnings

17 © Copyright Doug Hillman 1999 Stock Split l Decreases the par or stated value per share and increases number of shares issued proportionally l Total paid-in capital remains the same l Total retained earnings remains the same l Market value of shares decreases proportionally

18 © Copyright Doug Hillman 1999 Treasury Stock l Shares of own stock reacquired by corporation l Acquisition reduces assets and stockholders’ equity l Shown as deduction from stockholders’ equity

19 © Copyright Doug Hillman 1999 Treasury Stock l Acquisition ›Increases contra owners’ equity account Treasury Stock by cost ›Decreases Cash

20 © Copyright Doug Hillman 1999 Treasury Stock l Reissuance above cost ›Increases cash by proceeds ›Decreases Treasury Stock by cost ›Increases Paid-in Capital from Treasury Stock Transactions by difference

21 © Copyright Doug Hillman 1999 Treasury Stock l Reissuance below cost ›Increases cash by proceeds ›Decreases Treasury Stock by cost ›Decreases Paid-in Capital from Treasury Stock Transactions by difference

22 © Copyright Doug Hillman 1999 Treasury Stock l Reissuance below cost ›If Paid-in Capital from Treasury Stock Transactions does not exist –decrease any paid-in capital from same class of stock –retained earnings

23 © Copyright Doug Hillman 1999 Book Value of Common Stock l Divide stockholders’ equity available to common stockholders by number of shares outstanding l When more than one class of stock is outstanding ›subtract liquidation claims of noncommon from total stockholders’ equity to determine equity available to common

24 © Copyright Doug Hillman 1999 Presentation of Stockholders’ Equity Paid-in capital Stock Common stock, $1 par, 10,000 sh authorized, 8,000 sh issued$ 8,000 Additional paid-in capital Paid-in capital-excess over par, common24,000 Total paid-in capital$32,000

25 © Copyright Doug Hillman 1999 Presentation of Stockholders’ Equity Retained earnings Restricted for plant expansion$10,000 Unrestricted50,000 Total retained earnings60,000 Total paid-in capital and R.E.$92,000 Deduct: Treasury stock1,000 Total stockholders’ equity$91,000

26 © Copyright Doug Hillman 1999 Quality of Income Information l Accounting methods and estimates used to prepare financial statements l Number and size of nonrecurring revenue and expense items on income statement

27 © Copyright Doug Hillman 1999 Intraperiod Tax Allocation l Assigning the tax consequences of nonrecurring items to the item l Assume a nonrecurring loss of $40,000 with a tax rate of 30% Loss$40,000 Tax savings due to loss12,000 Loss net of tax$28,000

28 © Copyright Doug Hillman 1999 Continuing Operations l Financial statement users want to know income from continuing operations l It is important number for predicting future earnings

29 © Copyright Doug Hillman 1999 Nonrecurring Income Statement Items l Discontinued operations l Extraordinary items l Cumulative effect of change in accounting principle

30 © Copyright Doug Hillman 1999 Discontinued Operations l A line of business or class of customer may qualify as discontinued segment l When management decides to dispose of a segment, results for segment must be reported separately

31 © Copyright Doug Hillman 1999 Discontinued Operations l Two elements reported for discontinued segment ›Operating income or loss for period ›Gain or loss on disposal of the segment l Each element reported net of tax

32 © Copyright Doug Hillman 1999 Extraordinary Items l Gains and losses that are both unusual and infrequent l Must consider the environment in which firm operates l Reported net of tax

33 © Copyright Doug Hillman 1999 Examples of Extraordinary Items l Uninsured losses from earthquakes and fires l Gains or losses from early retirement of debt l Gains and losses from passing a new law l Gains and losses from foreign governments taking business property

34 © Copyright Doug Hillman 1999 Changes in Accounting Principle l Consistency principle states should use same accounting principles from period to period l Change permitted when it improves reporting l Reported net of tax

35 © Copyright Doug Hillman 1999 Changes in Accounting Principle l Changes in principle often would have changed prior periods’ expenses l Total change in net income for prior periods is cumulative effect of a change in accounting principle

36 © Copyright Doug Hillman 1999 Reporting Earnings Per Share l Income from continuing operations l Discontinued operations l Extraordinary items l Cumulative effect of change in accounting principle l Net income

37 © Copyright Doug Hillman 1999 Earnings Per Share l Expresses net income on a per- common-share basis l Under FASB Statement No. 128 presentation depends on whether simple or complex capital structure l Simple capital structure - no debt or equity that could dilute EPS l Complex capital structure - dilutive securities

38 © Copyright Doug Hillman 1999 EPS - Weighted Average Common Shares l For total year, sum of ›Number of shares outstanding times fraction of year outstanding l Used as denominator in EPS calculations

39 © Copyright Doug Hillman 1999 EPS - Simple Capital Structure l Net income minus dividends on preferred stock l divided by l Weighted average number of common shares outstanding

40 © Copyright Doug Hillman 1999 Complex Capital Structure l Convertible debt or equity securities that have potential to dilute (decrease) EPS l Present two earnings per share figures l Basic earnings per share ›EPS based on weighted average common shares l Diluted earnings per share ›Assumes all dilutive securities converted

41 © Copyright Doug Hillman 1999 EPS Example l Net income $48,000 l Stock ›10% Convertible Preferred, $100 par, 1,000 shares issued and outstanding, convertible into 7,000 common ›Common, $1 par, –Issued and outstanding 1/1 to 4/1, 16,000 shares –Issued and outstanding 4/1 to 12/31, 20,000 shares

42 © Copyright Doug Hillman 1999 EPS Example l Weighted average common shares outstanding computation ›16,000 x 1/4 = 4,000 ›20,000 x 3/4 = 15,000 l Weighted average common shares outstanding ›19,000 shares

43 © Copyright Doug Hillman 1999 Basic EPS Computation l Preferred dividends ›1,000 x ($100 x 0.10) = $10,000 l Net income available to common ›$48,000 - $10,000 = $38,000 l Basic EPS ›$38,000 / 19,000 = $2.00 per share

44 © Copyright Doug Hillman 1999 Diluted Earnings Per Share l Assume convertible preferred converted into common at beginning of year l Weighted average common shares ›19, ,000 = 26,000 l Net income available to common ›$48,000 - $0 = $48,000 l Diluted EPS ›$48,000 / 26,000 = $1.85 per share

45 © Copyright Doug Hillman 1999 Analyzing Information l Major differences in capital structure between companies l Number of shares issued and outstanding l Treasury stock l Market value l Dividend yield l ROA l EPS and P/E ratio