1. 1 Earnings Per Share and Retained Earnings C hapter 16

2. 2 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. Objectives

3. 3 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. Objectives

4. 4 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). Objectives

5. 5 Basic Earnings Per Share Net Income - Preferred Dividends Weighted Average Number of Common Shares Outstanding

6. 6 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.

7. 7 Weighted Average Shares P Corporation had 12,000 shares of common stock outstanding at the beginning of the year. On March 2, it issued 2,700 shares; on June 3, it issued another 3,300 shares, and on December 1, it reacquired 480 shares as treasury stock. Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-February12,000x2/12=2,000 March-June14,700x4/12=4,900 July-November18,000x5/12=7,500 December17,520x1/12= 1,460 15,860 Total weighted average common shares The nearest whole month is used The nearest whole month is used

8. 8 Weighted Average Shares R Corporation begins operations in January 2000, and issues 5,000 shares of common stock that are outstanding all during 2000. On December 31, 2000, it issues a 2-for-1 stock split. Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-December5,000x12/12=5,000 Total weighted average common shares 10,000 The two-for-one split is retroactive to January 1 + 5,000 ContinuedContinued

9. 9 Weighted Average Shares On May 29, 2001, R Corporation issues 5,000 shares of common stock; on August 3, it issues a 20% stock dividend; and on October 5, it issues 2,000 shares of stock. Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-December5,000x12/12=5,000 2000 Data on 2001 Statement 5,000 x 200% x 120% = 12,000 equivalent whole units ContinuedContinued

10. 10 Weighted Average Shares 2001 Data on 2001 Statement Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-May10,000 June-July15,000 August-September18,000 Issued 5,000 shares Issued 20% stock dividend

11. 11 Weighted Average Shares 2001 Data on 2001 Statement Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-May10,000 June-July15,000 August-September18,000 Increases 20% 12,000 Increases 20% 18,000 October-December20,000

12. 12 Weighted Average Shares 2001 Data on 2001 Statement Months Shares Shares Fraction of Year Equivalent Are Outstanding Outstanding Outstanding Whole Units x = January-May12,000x5/12=5,000 June-July18,000x2/12=3,000 August-September18,000x2/12=3,000 October-December20,000x3/12= 5,000 16,000

13. 13 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.

14. 14 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.

15. 15 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.

16. 16 Net Income - Preferred Dividends Weighted Average Common Shares Flowchart of EPS Computations Capital Structures Simple Capital Structure No Any options, warrants, or convertible securities outstanding? Complex Capital Structure Yes Basic EPS Go to next slide

17. 17 Stock Options and Warrants Convertible Securities Diluted EPS Complex Capital Structure Basic Net Income - Preferred Dividends EPS Weighted Average Common Shares = Average Market Price > Option Price ? Yes, go to next slide No Continued next slide

18. 18 Stock Options and Warrants Convertible Securities Average Market Price > Option Price ? No Yes Apply Treasury Stock Method Develop Ranking of All Convertible Securities Diluted EPS Computations * Options and Warrants Adjustments * Convertible Securities Adjustments Individually Dilutive? Stop No Yes

19. 19 Stock Options and Warrants Assumed Shares Issued Proceeds ($) Assumed Shares Reacquired (at average market price) Change (Increment) in Shares + -

20. 20 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. 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. Treasury Stock Method

21. 21 Treasury Stock Method 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 Proceeds Average Market Price Per Share 1,000 x ($18 + $2) $25 = (800) $20,000 $25 = Assumed increment in common shares for computing diluted earnings per share200 The per share unrecognized compensation cost (net of tax) related to the stock option.

22. 22 Convertible Securities Convertible bonds and convertible preferred stock are considered in DEPS after stock options and warrants.

23. 23 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share Increase in Earnings Per Share Numerator Increase in Earnings Per Share Denominator 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. ContinuedContinued $5,400 3,000 = $1.80 Security A

24. 24 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share 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. $4,800 1,920 = $2.50 Security B ContinuedContinued

25. 25 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share 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. $8,000 5,000 = $1.60 Security C ContinuedContinued

26. 26 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share 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. ContinuedContinued $6,300 3,150 = $2.00 Security D

27. 27 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). Convertible Securities Security Impact Order in Ranking A$1.802 B$2.504 C$1.601 D$2.003

28. 28 Testing to Determine if a Convertible Security is Dilutive Revised = Tentative Diluted EPS Add Increase to Numerator Revised Numerator Add Increase to Denominator Revised Denominator

29. 29 Additional Disclosures  Identifies the amount of preferred dividends deducted to determine the income available to common stockholders.  Describes the potential common shares that were not included in the diluted earnings per share computation because they were antidilutive.  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.

30. 30 Cash Dividend  The date of declaration  The ex-dividend date  The date of record  The date of payment There are four significant dates for a cash dividend.

31. 31 Cash Dividend Date Accounting Procedures Date of Declaration Reduce Retained Earnings Increase Liabilities Memorandum Entry Reduce Assets Reduce Liabilities Date of Record Date of Payment

32. 32 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. November 3, 2001 Retained Earnings30,000 Dividends Payable: Preferred Stock10,000 Dividends Payable: Common Stock20,000

33. 33 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. November 24, 2001 Memorandum entry: The company will pay dividends on December 15, 2001, to preferred and common stockholders of record as of today, the date of record.

34. 34 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, 2001 Dividends Payable: Preferred Stock10,000 Dividends Payable: Common Stock20,000 Cash30,000

35. 35 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.

36. 36 Preferred Common Fully Participating Preferred Stock 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 common1,600 2,400 Dividend to each class of stock$7,600$5,400

37. 37 Preferred Common Partially Participating Preferred Stock (up to 12%) 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 400600 Remainder to common ($13,000 - $10,000) 3,000 Dividend to each class of stock$6,400$6,600

38. 38 Property Dividend Corporation C declares a property dividend on March 16, 2001, payable in Company D stock on June 1, 2001. The Company D stock was purchased early in 2000 for $24,000 and was reported at its fair market value of $29,000 on December 31, 2000 (along with an unrealized increase in value of $5,000). The market value on the declaration date is $31,000. ContinuedContinued

39. 39 March 16, 2001 Allowance for Change in Value of Investment in Available-for-Sale Securities2,000 Unrealized Increase in Value of Available-for-Sale Securities5,000 Gain on Disposal of Investments7,000 Property Dividend Retained Earnings31,000 Property Dividends Payable31000

40. 40 June 1, 2001 Property Dividends Payable31,000 Investment in Available-for-Sale Securities24,000 Allowance for Change in Value of Investment in Available-for-Sale Securities7,000 Property Dividend

41. 41 Stock Dividends  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--

42. 42 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. The corporation may state that it will pay the same fixed cash dividend per share. Stock Dividends What factors might enhance the perceived attractiveness of stock dividends?

43. 43 Retained Earnings Capital Stock Additional Paid-In Capital Stock Dividends Small (<20 or 25%) Large Par ValueFair Value Retained Earnings Capital Stock

44. 44 Stock Dividends Common stock, $10 par (20,000 shares issued and outstanding$200,000 Additional paid-in capital180,000 Retained earnings320,000 Total stockholders’ equity$700,000 Stockholders’ Equity Prior to Stock Dividend

45. 45 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 Earnings46,000 Common Stock To Be Distributed20,000 Additional Paid-in Capital From Stock Dividend26,000 20,000 shares x 0.10 x $23 Par ContinuedContinued

46. 46 Date of Issuance Common Stock To Be Distributed20,000 Common Stock, $10 par 20,000 Par Small Stock Dividend M Corporation declares and issues a 10% stock dividend. On the date of declaration, the stock sells for $23 per share.

47. 47 Small Stock Dividend Common stock, $10 par (22,000 shares issued and outstanding$220,000 Additional paid-in capital206,000 Retained earnings274,000 Total stockholders’ equity$700,000 Stockholders’ Equity After Stock Dividend Note: Total remained the same

48. 48 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 Earnings80,000 Common Stock To Be Distributed80,000 20,000 shares x 0.40 x $10 Date of Issuance Common Stock To Be Distributed80,000 Common Stock, $10 par80,000 ContinuedContinued

49. 49 Large Stock Dividends Common stock, $10 par (28,000 shares issued and outstanding)$280,000 Additional paid-in capital180,000 Retained earnings240,000 Total stockholders’ equity$700,000 Stockholders’ Equity After Stock Dividend Note: Same total as small stock dividend

50. 50 Statement of Retained Earnings Although not a required separate financial statement, some corporations include a statement of retained earnings in their financial statements.

51. 51 Retained earnings, as previously reported, Jan. 1, 2001 Plus (minus) Prior period adjustments (net of income tax effect) Adjusted retained earnings, January 1, 2001 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, 2001 Retained earnings, as previously reported, Jan. 1, 2001 Plus (minus) Prior period adjustments (net of income tax effect) Adjusted retained earnings, January 1, 2001 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, 2001 Statement of Retained Earnings

52. 52 Accumulated Other Comprehensive Income  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. Other comprehensive income might include--

53. 53 On the face of its income statement. In a separate statement of comprehensive income. In its statement of changes in stockholders’ equity. Accumulated Other Comprehensive Income A corporation may report its comprehensive income (net of income taxes)--

54. 54 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.

55. 55 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.

56. 56  The corporation reports to the stockholders about the restatements proposed and obtains the stockholders’ formal consent.  The corporation presents a balance sheet as of the date of readjustment in which the assets and liabilities are reported at their fair values.  Any amount written off are first charged against retained earnings and then against additional paid-in capital.  The corporation begins its “fresh start” with a zero retained earnings balance. Appendix: Quasi-Reorganization The suggested readjustment procedures include the following steps:

57. 57  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.  Additional paid-in capital is not reduced for losses occurring after the readjustment.  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. Appendix: Quasi-Reorganization After the quasi-reorganization, several additional accounting procedures are suggested:

58. 58 C hapter 16