Chapter 16 Earnings Per Share and Retained Earnings

Chapter 16 Earnings Per Share and Retained Earnings

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.

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.

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 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 The nearest December 1, it reacquiredwhole 480 shares as treasury stock. month is Months Shares Are Outstanding usedof Year Shares Fraction Equivalent = Whole Units Outstanding x Outstanding 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 Total weighted average common shares 15, 860

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 Are Outstanding Shares Fraction of Year Equivalent = Whole Units Outstanding x Outstanding January-December 5, 000 x 12/12 The two-for-one split is retroactive to January 1 Total weighted average common shares Continued = 5, 000 + 5, 000 10, 000

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. 2000 Data on 2001 Statement Months Shares Are Outstanding January-December Shares Fraction of Year Equivalent = Whole Units Outstanding x Outstanding 5, 000 x 12/12 = 5, 000 x 200% x 120% = 12, 000 equivalent whole units Continued

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

11 Weighted Average Shares 2001 Data on 2001 Statement Months Shares Are Outstanding Shares Fraction of Year Equivalent = Whole Units Outstanding x Outstanding January-May June-July August-September October-December 12, 000 10, 000 15, 000 18, 000 20, 000 Increases 20%

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

13 Diluted Earnings Per Share A corporation with a complex capital structure is required to report two amounts theearnings face of Yes… on basic its income per statement. 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 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 Flowchart of EPS Computations Capital Structures Any options, warrants, or convertible securities outstanding? No Yes Simple Capital Structure Complex Capital Structure Basic EPS Go to next slide Net Income - Preferred Dividends Weighted Average Common Shares

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

18 Convertible Securities Stock Options and Warrants 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? Yes No Stop

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

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.

21 Treasury Stock Method The share assume a corporation has To illustrate Step 3 per further, unrecognized compensatory stock options to purchase 1, 000 compensation cost common shares $18 per share outstanding the (net ofattax) related entire year, and that theoption. average market price for the to the stock common stock was $25 per share. Shares assumed issued from assumed exercise: 1, 000 Proceeds x ($18 + $2) $20, 000 = Average Market Price Per Share $25 Assumed increment in common shares for computing diluted earnings per share 1, 000 = (800) 200

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

23 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share Increase in Earnings Per Share Numerator $5, 400 Security A = $1. 80 Increase in Earnings 3, 000 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. Continued

24 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share Security B $4, 800 1, 920 = $2. 50 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

25 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share Security C $8, 000 5, 000 = $1. 60 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

26 Convertible Securities Numerical Value Impact on Diluted Earnings Per Share Security D $6, 300 3, 150 = $2. 00 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

27 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).

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

Additional Disclosures Identifies the amount of preferred dividends deducted to determine the income available to When a corporation reports its basic and common stockholders. diluted earnings per share on its income Describes the potential common shares that were statement, it also isdiluted required to make not included in the earnings per share additional disclosures thewere notes to its computation because in they antidilutive. financial statements. 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.

Cash Dividend 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

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

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 Earnings 30, 000 Dividends Payable: Preferred Stock Dividends Payable: Common Stock 10, 000 20, 000

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 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 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 Stock Dividends Payable: Common Stock Cash 10, 000 20, 000 30, 000

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. 35

36 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) Total to allocate $13, 000 Allocated - 9, 000 Remainder $ 4, 000 $20, 000/$50, 000 to preferred and $30, 000/$50, 000 to common 2, 400 $3, 000 1, 600

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) 2% dividend on par 400 Remainder to common ($13, 000 $10, 000) 3, 000 Dividend to each class of stock $6, 400 $3, 000 600 $6, 600 37

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. Continued

39 Property Dividend March 16, 2001 Allowance for Change in Value of Investment in Available-for-Sale Securities Unrealized Increase in Value of Available-for-Sale Securities Gain on Disposal of Investments Retained Earnings Property Dividends Payable 2, 000 5, 000 7, 000 31000

40 Property Dividend June 1, 2001 Property Dividends Payable 31, 000 Investment in Available-for-Sale Securities Allowance for Change in Value of Investment in Available-for-Sale Securities 24, 000 7, 000

Stock Dividends They receive no corporate assets. Stockholders often view stock dividends favorably even though-- 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.

Stock Dividends J The stockholders may What see thefactors stock might dividend as evidence of corporateenhance growth. the perceived stock as J The stockholders mayattractiveness see the stockofdividend evidence of sound financialdividends? policy. J 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. J The corporation may state that it will pay the same fixed cash dividend per share.

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

44 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

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 Earnings 46, 000 Common Stock To Be Distributed 20, 000 Additional Paid-in Capital From 20, 000 shares x 0. 10 x $23 Par Stock Dividend 26, 000 Continued

46 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 Common Stock, $10 par 20, 000 Par

47 Small Stock Dividend 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

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 Earnings 80, 000 Common Stock To Be Distributed 80, 000 Date of Issuance 20, 000 shares x 0. 40 x $10 Common Stock To Be Distributed 80, 000 Common Stock, $10 par 80, 000 Continued

49 Large Stock Dividends 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

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 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 Statement of Retained Earnings 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

Accumulated Other Comprehensive Income Other comprehensive income might include-- ý Unrealized increases (gains) or decreases (losses) in the market value of investments in available-for -sale securities. ý Translation adjustments from converting the financial statements of a company’s foreign operation into U. S. dollars. ý Certain gains and losses on “derivative” financial instruments. ý Certain pension liability adjustments.

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

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. 54

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.

Appendix: Quasi-Reorganization The suggested readjustment procedures include the following steps: 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.

57 Appendix: Quasi-Reorganization After the quasi-reorganization, several additional accounting procedures are suggested: If losses or readjustments are identified that are determined to have occurred before the readjustment date, they are recorded as a reduction of additional paidin 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.

58 Chapter 16