© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-1 INCOME AND CHANGES IN RETAINED EARNINGS Chapter 12

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-2 Information about net income can be divided into two major categories Income from continuing operations. 1. Results of discontinued operations. 2. Impact of extraordinary items. 3. Effects of changes in accounting principles. Normal, recurring revenue and expense transactions. Unusual, nonrecurring events that affect net income. Reporting the Results of Operations

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-3 This tax expense does not include effects of unusual, nonrecurring items. These unusual, nonrecurring items are each reported net of taxes.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-4 Income/Loss from operating the segment prior to disposal. Income/Loss on disposal of the segment. 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. Discontinued Operations

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-5 A segment must be a separate line of business activity or an operation that services a distinct category of customers. 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. Discontinued Operations

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-6 During 2005, Matrix, Inc. sold an unprofitable segment of the company. The segment had a net loss from operations during the period of $150,000 and its assets sold at a loss of $100,000. Matrix reported income from continuing operations of $350,000. All items are taxed at 30%. How will this appear on the income statement? During 2005, Matrix, Inc. sold an unprofitable segment of the company. The segment had a net loss from operations during the period of $150,000 and its assets sold at a loss of $100,000. Matrix reported income from continuing operations of $350,000. All items are taxed at 30%. How will this appear on the income statement? Discontinued Operations

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-7 Discontinued Operations

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-8 Income Statement Presentation: Discontinued Operations

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 12-9 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. 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.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin During 2005, Matrix, Inc. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. This was considered an extraordinary item. The company reported income before extraordinary item of $175,000. All gains and losses are subject to a 30% tax rate. How would this item appear on the 2005 income statement? During 2005, Matrix, Inc. experienced a loss of $75,000 due to an earthquake at one of its manufacturing plants in Nashville. This was considered an extraordinary item. The company reported income before extraordinary item of $175,000. All gains and losses are subject to a 30% tax rate. How would this item appear on the 2005 income statement? Extraordinary Items

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Income Statement Presentation: Extraordinary Items - Example

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Accounting Changes

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Change in Accounting Principle Occurs when changing from one GAAP method to another GAAP method. Make a catch-up adjustment known as the cumulative effect of a change in accounting principle. The cumulative effect is reported net of taxes and after extraordinary items. Occurs when changing from one GAAP method to another GAAP method. Make a catch-up adjustment known as the cumulative effect of a change in accounting principle. The cumulative effect is reported net of taxes and after extraordinary items.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Also in 2005, Matrix, Inc. decided to change from the double-declining balance to the straight-line method for depreciation. The effect of this change is an increase in net income of $65,000. Apex reported income before cumulative effect of an accounting change of $122,500 during the year. All items of income are subject to a 30% tax rate. How would this item appear on the income statement? Also in 2005, Matrix, Inc. decided to change from the double-declining balance to the straight-line method for depreciation. The effect of this change is an increase in net income of $65,000. Apex reported income before cumulative effect of an accounting change of $122,500 during the year. All items of income are subject to a 30% tax rate. How would this item appear on the income statement? Change in Accounting Principle

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Income Statement Presentation: Computation: Change in Accounting Principle

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Change in Estimates Revision of a previous accounting estimate. The new estimate should be used in the current and future periods. The prior accounting results should not be disturbed. Revision of a previous accounting estimate. The new estimate should be used in the current and future periods. The prior accounting results should not be disturbed.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin On January 1, 2002, we purchased equipment costing $30,000, with a useful life of 10 years and no salvage value. During 2005, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation. Compute the revised depreciation expense for On January 1, 2002, we purchased equipment costing $30,000, with a useful life of 10 years and no salvage value. During 2005, we determine that the remaining useful is 5 years (8-year total life). We use straight-line depreciation. Compute the revised depreciation expense for Change in Estimates

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Record depreciation expense of $4,200 for 2005 and subsequent years. Change in Estimates

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Let’s move on to a few final topics.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Often, the Price-Earnings Ratio is used to evaluate the reasonableness of a company’s stock price. Price-earnings Ratio (P/E) Let’s examine this further.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin A measure of the company’s profitability and earning power for the period. Based on the number of shares issued and the length of time that number remained unchanged. Earnings Per Share (EPS)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Remember that Matrix, Inc. has income from continuing operations of $350,000. The after-tax loss from discontinued operations was $175,000. The extraordinary loss was $52,500 and the cumulative effect of accounting changes was a gain of $45,500. Assume that Matrix has weighted average shares outstanding of 156,250. Prepare a partial income statement showing the EPS for income from continuing operations and for the other special items. Earnings Per Share (EPS)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin * Rounded. Earnings Per Share (EPS)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin If preferred stock is present, subtract preferred dividends from net income prior to computing EPS. EPS is required to be reported in the income statement. Earnings Per Share (EPS)

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Declared by board of directors. Not legally required. Not legally required. Creates liability at declaration. Requires sufficient Retained Earnings and Cash. Accounting for Cash Dividends

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Date of Declaration Board of directors declares the dividend. Record a liability. Date of Declaration Board of directors declares the dividend. Record a liability. Dividend Dates On March 1, 2005, 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.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Ex-Dividend Date The day which serves as the ownership cut- off point for the receipt of the most recently declared dividend. Ex-Dividend Date The day which serves as the ownership cut- off point for the receipt of the most recently declared dividend. NO ENTRY Dividend Dates

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Date of Record l Stockholders holding shares on this date will receive the dividend. (No entry) Date of Record l Stockholders holding shares on this date will receive the dividend. (No entry) Dividend Dates X April 2005

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Date of Payment l Record the payment of the dividend to stockholders. Date of Payment l Record the payment of the dividend to stockholders. Dividend Dates

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin On June 1, 2005, 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. On June 1, 2005, 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. $100 × 8% = $8 dividend per share $8 × 2,500 = $20,000 total dividend $100 × 8% = $8 dividend per share $8 × 2,500 = $20,000 total dividend Dividend Dates

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin All stockholders retain same percentage ownership. No change in total stockholders’ equity. No change in par values. Distribution of additional shares of stock to stockholders. Accounting for Stock Dividends

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Summary of Effects of Stock Dividends and Stock Splits

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Adjust retained earnings retroactively. The adjustment should be disclosed net of any taxes. The correction of an error identified as affecting net income in a prior period. Prior Period Adjustments

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Statement of Retained Earnings with Prior Period Adjustment

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Normally, there are 3 ways that financial position can change. Issuance of new shares of stock. Net Income or Net Loss Payment of Dividends GAAP excludes some unrealized items from income, such as the change in market value of available-for-sale debt and equity investments. Comprehensive Income

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin GAAP requires that unrealized items that are normally reported on the balance sheet be added back to compute “Comprehensive Income.” As a second Income Statement. Combined with Net Income on the Income Statement. As an element of Stockholders’ Equity. The accumulated amount of changes affecting Comprehensive Income is reported in equity. There are 3 options for reporting Comprehensive Income. Comprehensive Income

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Stockholders’ Equity Section of the Balance Sheet

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin End of Chapter 12