INTERMEDIATE ACCOUNTING Chapter 16 Retained Earnings and Earnings Per Share © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Requirements to Distribute Dividends Retained Earnings is an account used by a corporation to summarize the earned capital component of its shareholders’ equity, which primarily 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 a corporation’s accumulated prior net losses or dividends in excess of earnings. 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.

Cash Dividends (Slide 1 of 2) 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.

Cash Dividends (Slide 2 of 2) 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.

Property Dividends A property dividend is a dividend that is payable in assets other than cash (such as inventory or investments) and often referred to as a dividend in kind. A property dividend occurs when a corporation enters an exchange in which it gives up something of value but for which it receives no asset or service in return.

Script 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 script dividend and issue promissory notes (called “script”) 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.

Stock Dividends (Slide 1 of 3) 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.

Stock Dividends (Slide 2 of 3) 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.

Stock Dividends (Slide 3 of 3) A stock dividend is not the same as a stock split. Small stock dividends: Fair value is ordinarily the appropriate value to use when the stock dividend is less than 20% or 25% of the previously outstanding shares. Large stock dividends: Valued at par value of the additional shares issued The total par value is transferred from retained earnings GAAP suggests that the use of the term dividend be avoided or, when this is not possible, use terminology such as stock split effected in the form of a dividend.

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. 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.

How Do We Account for Prior Period Adjustments (Restatements)? 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.

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.

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

Earnings Per Share (Slide 1 of 2) 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.

Market Price per Share (of the Common Stock) Earnings Per Share (Slide 2 of 2) 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.

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 (sometimes called earnings per common share) is computed as follows: Basic Earnings per Share = Net Income ‒ Preferred Dividends Weighted Average Number of Common Shares Outstanding

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 follows: Actual Shares Outstanding Fraction of Year Outstanding Weighted Average Number of Common Shares Outstanding × =

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.

When Do Companies Report Diluted Earnings per Share? 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.

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.

Flowchart of EPS Computations

Share Options and Warrants (Slide 1 of 2) 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 calculate additional dilutive shares resulting from stock options and stock warrants. Under this method, the number of shares added to the earnings per share denominator is the difference between the assumed shares issued and the assumed shares reacquired.

Share Options and Warrants (slide 2 of 2) 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.

Change in Shares—Treasury Stock Method

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

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.

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.

Calculation of Tentative EPS

Special Issues Related to Diluted Earnings per Share If a corporation reports a loss from continuing operations, then it does not include potential common shares in calculating diluted earnings per share. A positive overall net income due to having gains from extraordinary items or discontinued operations does not change this requirement.

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.