McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Twelve: Income and Changes in Retained Earnings

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved This tax expense does not include effects of unusual, nonrecurring items. These unusual, nonrecurring items are each reported net of taxes.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved A segment must be a separate line of business activity or an operation that services a distinct category of customers. Discontinued Operations 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.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 a loss on the sale of its assets of $100,000. Matrix reported income from continuing operations of $1,750,000. 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 a loss on the sale of its assets of $100,000. Matrix reported income from continuing operations of $1,750,000. All items are taxed at 30%. How will this appear on the income statement? Discontinued Operations

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Discontinued Operations

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Income Statement Presentation: Discontinued Operations

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 $1,575,000. 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 $1,575,000. All gains and losses are subject to a 30% tax rate. How would this item appear on the 2005 income statement? Extraordinary Items

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Income Statement Presentation: Extraordinary Items - Example

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Let’s move on to a few final topics.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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)

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Remember that Matrix, Inc. has income from continuing operations of $1,750,000. The after- tax loss from discontinued operations was $175,000 and the extraordinary loss was $52,500. Assume that Matrix has 156,250 weighted average shares outstanding. Prepare a partial income statement showing the EPS for income from continuing operations and for the other special items. Remember that Matrix, Inc. has income from continuing operations of $1,750,000. The after- tax loss from discontinued operations was $175,000 and the extraordinary loss was $52,500. Assume that Matrix has 156,250 weighted average shares outstanding. Prepare a partial income statement showing the EPS for income from continuing operations and for the other special items. Earnings Per Share (EPS)

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved * Rounded. Earnings Per Share (EPS)

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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)

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Date of Record Stockholders holding shares on this date will receive the dividend. (No entry ) Date of Record Stockholders holding shares on this date will receive the dividend. (No entry ) Dividend Dates X April 2005

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Date of Payment Record the payment of the dividend to stockholders. Date of Payment Record the payment of the dividend to stockholders. Dividend Dates

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Summary of Effects of Stock Dividends and Stock Splits

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Statement of Retained Earnings with Prior Period Adjustment

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Restrictions of Retained Earnings If I loan your company $1,000,000, I will want you to restrict your retained earnings in order to limit dividend payments. Loan agreements can include restrictions on paying dividends below a certain amount of retained earnings.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved As a second Income Statement. Combined with Net Income on the Income Statement. As an element of Stockholders’ Equity. Comprehensive Income GAAP requires that unrealized items that are normally reported on the balance sheet be added back to compute “Comprehensive Income.” The accumulated amount of changes affecting Comprehensive Income is reported in equity. There are 3 options for reporting Comprehensive Income.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Statement of Stockholders’ Equity This is a more inclusive statement than the statement of retained earnings.

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved Stockholders’ Equity Section of the Balance Sheet

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved End of Chapter Twelve