1. Earnings Per Share and Retained EarningsC 16
hapter
Earnings Per Share and Retained Earnings
An electronic presentation
by Douglas Cloud
Pepperdine University 1 1 1 1

2. Objectives
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.
Continued 2 2 2 4

3. Objectives 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.
Continued

4. Objectives
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).

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

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. Weighted Average Shares
A corporation had 12,000 shares of common stock outstanding at the beginning of the year. On March 2, it issued 2,700 shares; on July 3, it issued another 3,300 shares, and on December 1, it reacquired 480 shares as treasury stock.
The nearest whole month is used
Months Shares Shares Fraction of Year Equivalent
Are Outstanding Outstanding Outstanding Whole Units x =
January-February 12,000 x 2/12 = 2,000
March-June 14,700 x 4/12 = 4,900
July-November 18,000 x 5/12 = 7,500
December 17,520 x 1/12 = 1,460
15,860
Total weighted average common shares

8. Weighted Average Shares
A corporation begins operations in January 2004, and issues 5,000 shares of common stock that are outstanding all during On December 31, 2004, it issues a 2-for-1 stock split.
Months Shares Shares Fraction of Year Equivalent
Are Outstanding Outstanding Outstanding Whole Units x =
January-December 5,000 x 12/12 = 5,000
The two-for-one split is retroactive to January ,000
Total weighted average common shares ,000
Continued

9. Weighted Average Shares
On May 28, 2005, the corporation issues 5,000 shares of common stock; on August 3, it issues a 20% stock dividend; and on October 5, it issues 2,005 shares of stock.
2004 Data on 2004 Statement
Months Shares Shares Fraction of Year Equivalent
Are Outstanding Outstanding Outstanding Whole Units x =
January-December 5,000 x 12/12 = 5,000
5,000 x 200% x 120% = 12,000 equivalent whole units
Continued

10. Weighted Average Shares
2005 Data on 2001 Statement
Months Shares Shares Fraction of Year Equivalent
Are Outstanding Outstanding Outstanding Whole Units x =
January-May 10,000
June-July 15,000
August-September 18,000
Issued 5,000 shares
Issued 20% stock dividend

11. Weighted Average Shares
2005 Data on 2005 Statement
Months Shares Shares Fraction of Year Equivalent
Are Outstanding Outstanding Outstanding Whole Units x =
Increases 20%
January-May 10,000
June-July 15,000
August-September 18,000
12,000
Increases 20%
18,000
October-December 20,000

12. Weighted Average Shares
2005 Data on 2001 Statement
Assumed Shares Shares Fraction of Year Equivalent
Outstanding Outstanding Outstanding Whole Units x =
January-May 10,000
June-July 15,000
August-September 18,000
12,000
18,000
October-December 20,000
x 5/12 = ,000
x 2/12 = ,000
x 3/12 = ,000
16,000

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. 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. Diluted Earnings Per Share
To be included in the diluted earnings per share calculation, any potential common share must have a dilutive effect on earnings per share.

16. 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.

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

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

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

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

21. Treasury Stock Method
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.

22. Average Market Price Per Share
Treasury Stock Method
The per share unrecognized compensation cost (net of tax) related to the stock option.
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
1,000 x ($18 + $2)
$25
Proceeds
Average Market Price Per Share
$20,000
$25 =
= (800)
Assumed increment in common shares for
computing diluted earnings per share 200

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

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

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

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

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

28. Convertible Securities
Security Impact Order in Ranking
A $1.80 2
B $2.50 4
C $1.60 1
D $2.00 3
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).

29. If Convertible Security Is Dilutive
Add Increase to Numerator
Revised Numerator
Revised Denominator
Add Increase to Denominator
Revised
= Tentative Diluted EPS

30. Additional Disclosures
1. Identifies the amount of preferred dividends deducted to determine the income available to common stockholders.
2. Describes the potential common shares that were not included in the diluted earnings per share computation because they were antidilutive.
3. 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.

31. There are four significant dates for a cash dividend.
The date of declaration
The ex-dividend date
The date of record
The date of payment

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

33. Cash Dividend
On November 3, 2004, 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, 2004 to stockholders of record on November 24, 2004.
November 3, 2004
Retained Earnings 30,000
Dividends Payable: Preferred Stock 10,000
Dividends Payable: Common Stock 20,000

34. Cash Dividend
On November 3, 2004, 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, 2004 to stockholders of record on November 24, 2004.
November 24, 2004
Memorandum entry: The company will pay dividends on December 15, 2004, to preferred and common stockholders of record as of today, the date of record.

35. 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, 2004
Dividends Payable: Preferred Stock 10,000
Dividends Payable: Common Stock 20,000
Cash 30,000

36. 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.

37. Fully Participating Preferred Stock
Preferred Common
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 common 1, ,400
Dividend to each class of stock $7,600 $5,400

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

39. Property Dividend
Occasionally, a corporation will declare a property dividend that is payable in assets other than cash.

40. Property Dividend
The corporation typically uses marketable securities of other companies that it owns for the property dividend.

41. Property Dividend
Corporation C declares a property dividend on March 16, 2005, payable in Company D stock on June 1, The Company D stock was purchased early in 2004 for $24,000 and was reported at its fair market value of $29,000 on December 31, 2004 (along with an unrealized increase in value of $5,000). The market value on the declaration date is $31,000.
Continued

42. Property Dividend March 16, 2005 Allowance for Change in Value of
Investment in Available-for-Sale
Securities 2,000
Unrealized Increase in Value of
Available-for-Sale Securities 5,000
Gain on Disposal of Investments 7,000
Retained Earnings 31,000
Property Dividends Payable

43. Property Dividend June 1, 2005 Property Dividends Payable 31,000
Investment in Available-for-Sale
Securities 24,000
Allowance for Change in Value of
Securities 7,000

44. Stockholders often view stock dividends favorably even though--
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--

45. Stock Dividends Stock Dividend
What factors might enhance the perceived attractiveness of stock dividends?
Stock Dividend

46. Stock Dividends
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.

47. Stock Dividends
The corporation may state that it will pay the same fixed cash dividend per share.
The stockholders may see the market price decreasing to a lower trading range, making the stock more attractive to additional investors so that the market price may eventually rise.

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

49. Stockholders’ Equity Prior to Stock Dividend
Stock Dividends
Stockholders’ Equity Prior to Stock Dividend
Common stock, $10 par (20,000 shares
issued and outstanding $200,000
Additional paid-in capital 180,000
Retained earnings 320,000
Total stockholders’ equity $700,000

50. 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 Earnings 46,000
Common Stock To Be Distributed 20,000
Additional Paid-in Capital From
Stock Dividend 26,000
20,000 shares x 0.10 x $23
Par
Continued

51. 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 Issuance
Common Stock To Be Distributed 20,000
Common Stock, $10 par 20,000
Par

52. Small Stock Dividend Common stock, $10 par (22,000 shares
Stockholders’ Equity After Stock Dividend
Common stock, $10 par (22,000 shares
issued and outstanding $220,000
Additional paid-in capital 206,000
Retained earnings 274,000
Total stockholders’ equity $700,000
Note: Total remained the same

53. 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 Earnings 80,000
Common Stock To Be Distributed 80,000
20,000 shares x 0.40 x $10
Date of Issuance
Common Stock To Be Distributed 80,000
Common Stock, $10 par 80,000
Continued

54. Large Stock Dividends Common stock, $10 par (28,000 shares
Stockholders’ Equity After Stock Dividend
Common stock, $10 par (28,000 shares
issued and outstanding) $280,000
Additional paid-in capital 180,000
Retained earnings 240,000
Total stockholders’ equity $700,000
Note: Same total as small stock dividend

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

56. Statement of Retained Earnings
Retained earnings, as previously reported, Jan. 1, 2004
Plus (minus) Prior period adjustments (net of income tax effect)
Adjusted retained earnings, January 1, 2004
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, 2004
Statement of Retained Earnings

57. Accumulated Other Comprehensive Income
Other comprehensive income might include--
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.

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

59. 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.

60. Appendix: Quasi-Reorganization
Click the button next to me to skip the Appendix material.

61. 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.

62. Appendix: Quasi-Reorganization
The suggested readjustment procedures include the following steps:
1. The corporation reports to the stockholders about the restatements proposed and obtains the stockholders’ formal consent.
2. Any amounts written off are first charged against retained earnings and then against additional paid-in capital.
3. The corporation begins its “fresh start” with a zero retained earnings balance.
Continued

63. Appendix: Quasi-Reorganization
The suggested readjustment procedures include the following steps:
4. The corporation presents a balance sheet as of the date of readjustment in which the assets and liabilities are reported at their fair values.
After the quasi-reorganization, several additional accounting procedures are suggested:
Continued

64. Appendix: Quasi-Reorganization
5. 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.
6. Additional paid-in capital is not reduced for losses occurring after the readjustment.
7. 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.

65. C 16
hapter
The End