Corporations Effects on Retained Earnings and the Income

Corporations: Effects on Retained Earnings and the Income Statement Chapter 13 1 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Learning Objectives Account for stock dividends Account for stock splits Account for treasury stock Report restrictions on retained earnings Complete a corporate income statement including earnings per share 2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1 Account for stock dividends 3 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Stock Dividend A distribution of a corporation’s own stock Affects only stockholders’ equity accounts No effect on total stockholders’ equity No effect on assets or liabilities Stockholders receive proportionate shares Example– 10% stock dividend; every stockholder receives 10% of shares distributed Total number of shares issued and outstanding increases Ownership percentages remain the same 4 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Why Do Companies Issue Stock Dividends? Conserve cash Continue dividends without using cash Reduce market price per share Share supply increases; market price decreases Less expensive; more attractive investment Reward investors Shareholders receive something of value 5 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Entries for Stock Dividend Same three dates for a stock dividend Declaration date; record date; distribution date Small stock dividend Distribution is less than 20 to 25% of issued shares Debit Retained earnings for market value of shares to be distributed Credit Common stock for the par value of the stock and Credit Paid-in capital for excess of par—common 6 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Entries for Stock Dividend (Continued) Large Distribution is greater than 20% to 25% of issued shares Debit Retained earnings for par or stated value of shares Credit Common stock for par or stated value of shares Rare 7 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Stockholders’ Equity Presentation Equity after 5% Common Stock Dividend Equity after 50% Common Stock Dividend 8 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

S 13 -2: COMPARING AND CONTRASTING CASH AND STOCK DIVIDENDS Compare and contrast the accounting for cash dividends and stock dividends. 1. In the space provided, insert either “Cash dividends, ” “Stock dividends, ” or “Both cash dividends and stock dividends” to complete each of the following statements: a. Both cash dividends and stock dividends ________decrease Retained earnings. Stock dividends b. ________ has(have) no effect on a liability. 9 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

(Continued) Stock dividends c. ________ increase Paid-in capital by the same amount that they decrease Retained earnings. Cash dividends d. ________ decrease both total assets and total stockholders’ equity, resulting in a decrease in the size of the company. 10 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Yummy, Inc. , had 310, 000 shares of $1 par common stock issued and outstanding as of December 1, 2012. The company is authorized to issue 1, 400, 000 common shares. On December 15, 2012, Yummy declared and distributed a 5% stock dividend when the market value for Yummy’s common stock was $3. Requirements: 1. Journalize the stock dividend. 2. How many shares of common stock are outstanding after the dividend? 11 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1. Journalize the stock dividend. Journal Entry ACCOUNTS DATE Dec 15 Retained earnings DEBIT CREDIT 46, 500 Common stock 15, 500 Paid in capital in excess of par-common 31, 000 2. How many shares of common stock are outstanding after the dividend? 310, 000 +15, 500 = 325, 500 12 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2 Account for stock splits 13 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Stock Splits A stock split: Cuts par value per share Increases the number of shares of stock issued and outstanding Leaves all account balances and total stockholders’ equity unchanged Balances in the accounts are unchanged Record in a memorandum entry–a journal entry without debits and credits 14 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Stock Split Example Before split After split 15 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Effects of Dividends and Stock Splits Stock dividends and stock splits have similarities and differences Event Cash dividend Stock split 16 Paid-in Total Common Retained capital in stockholders stock earnings excess of par ’ equity No effect Decrease Increase Decrease No effect No effect Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Decorator Plus Imports recently reported the following stockholders’ equity (adapted except par value per share): Suppose Decorator Plus split its common stock 2 for 1 in order to decrease the market price per share of its stock. The company’s stock was trading at $20 per share immediately before the split. 17 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1. Prepare the stockholders’ equity section of Decorator Plus Imports’ balance sheet after the stock split. Paid-in capital: Common stock, $0. 50 par, 480, 000 shares authorized, 228, 000 shares issued Paid-in capital in excess of par Total paid-in capital Retained earnings Total stockholders’ equity 18 $ 114, 000 140, 000 $ 254, 000 650, 000 $ 904, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2. Were the account balances changed or unchanged after the stock split? Paid-in capital: Common stock, $0. 50 par, 480, 000 shares authorized, 228, 000 shares issued Unchanged Paid-in capital in excess of par Unchanged Total paid-in capital Unchanged Retained earnings Unchanged Total stockholders’ equity 19 $ 114, 000 140, 000 $ 254, 000 650, 000 $ 904, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

3 Account for treasury stock 20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Treasury Stock Shares that a company has issued and later reacquired Reasons corporations purchase their own stock: To increase net assets by buying low and selling high To support the company’s stock price To avoid a takeover by an outside party To reward valued employees with stock A common practice among corporations 21 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Accounting for Treasury Stock Contra equity account Debit balance Recorded at cost (not par) Reported beneath Retained earnings on the balance sheet Reduction to total stockholders’ equity Decreases outstanding shares Not eligible for dividends Not eligible to vote Issued stock – Treasury stock = Outstanding stock 22 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Treasury Stock Journal Entries Purchase of treasury stock Company debits Treasury stock and credits Cash Sale of treasury stock at cost 23 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Treasury Stock Journal Entries Sale of treasury stock above cost Difference is credited to Paid-in capital from treasury stock transactions Sale of treasury stock below cost Difference is debited to Paid-in Capital from treasury stock transactions, if available Otherwise debit Retained earnings 24 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Treasury Stock Journal Entries Sale of treasury stock below cost Paid-in capital from treasury stock transactions is insufficient to cover shortfall Debit Retained earnings for the difference 25 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Treasury Stock and Stockholders' Equity Reported beneath Retained earnings as a reduction 26 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Discount Center Furniture, Inc. , completed the following treasury stock transactions: a. Purchased 1, 400 shares of the company’s $1 par common stock as treasury stock, paying cash of $5 per share. b. Sold 400 shares of the treasury stock for cash of $8 per share. Requirements 1. Journalize these transactions. Explanations are not required. 2. Show Discount Center will report treasury stock on its December 31, 2012 balance sheet after completing the two transactions. In reporting the treasury stock, report only on the Treasury stock account. 27 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

1. Journalize these transactions. Explanations are not required. DATE a. Treasury stock Cash DATE b. Cash Journal Entry ACCOUNTS CREDIT 7, 000 Journal Entry ACCOUNTS Treasury stock Paid-in capital from treasury stock transaction 28 DEBIT 7, 000 DEBIT 3, 200 CREDIT 2, 000 1, 200 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

2. Show Discount Center will report treasury stock on its December 31, 2012 balance sheet after completing the two transactions. In reporting the treasury stock, report only on the Treasury stock account. Stockholders’ equity Treasury stock 1, 000 shares at cost 29 5, 000 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

4 Report restrictions on retained earnings 30 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Restrictions on Retained Earnings Restrictions Requirement by lenders to maintain a minimum level of equity by limiting: Cash dividend payments Treasury stock purchases Reported in the notes to the financial statements Appropriations Restrictions on retained earnings recorded by formal journal entries Board of directors may designate purpose of appropriation Segregate in a separate account A portion of retained earnings for a specific use 31 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Stockholders’ Equity with Appropriations The heading Paid-in capital does not appear All additional paid-in capital accounts are combined 32 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

5 Complete a corporate income statement including earnings per share 33 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

The Corporate Income Statement More complex with unique items Public corporations must publish financial statements Sections Continuing Operations Special Items Earnings Per Share Details important to investors 34 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

The Corporate Income Statement Continuing Operations Should continue from period to period Useful for making projections about future earnings Unique items Gain on sales of machinery–other Not core to the business Income tax expense Subtracted to arrive at income from continuing operations 35 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Special Items Reported after income from continuing operations Two distinctly different gains and losses: Discontinued operations Extraordinary items 36 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Discontinued Operations Segment of a business that has been sold Each segment is an identifiable division of company Reported separately because the segment will not be around in the future Shown net of tax Gain - income tax expense = Gain, net of tax Loss - income tax savings = Loss, net of tax 37 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Extraordinary Items Extraordinary gains and losses Both unusual and infrequent Not expected to recur in the foreseeable future Examples: Losses from natural disasters Foreign government takeover (expropriation) Reported net of income tax effect Items not qualifying as extraordinary Gains and losses on the sale of plant assets Losses due to lawsuits Losses due to employee labor strikes Natural disasters that occur frequently in the area 38 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Earnings per Share (EPS) Most widely used business statistic Measures amount of net income for each share of common stock outstanding Issued stock – treasury stock = outstanding shares Key measure of success in business Separate EPS figure for each element of income Income from continuing operations Income from discontinued operations Income before extraordinary item Extraordinary gain or loss Net income 39 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Earnings per Share (EPS) Calculation Preferred dividends also affect EPS 40 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

EPS and Preferred Stock Preferred dividends must be subtracted from income to compute EPS Preferred dividends are paid first Common will get what is left * Assume the annual preferred dividend would be $10, 000 (10, 000 shares X $1. 00 dividend per share) 41 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Altar, Corp. , earned net income of $118, 000 for 2012. Altar’s books include the following figures: Preferred stock, 3%, $50 par, 1, 000 shares issued and outstanding. . . . . $ 50, 000 Common stock, $2 par, 53, 000 issued. . 106, 000 Paid-in capital in excess of par—common. . . 460, 000 Treasury stock, common, 1, 200 at cost. . 24, 000 1. Compute Altar’s EPS for the year. $(118, 000 – 1, 500)/51, 800 = $2. 25* 42 (2. 249034749) rounded Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Statement of Retained Earnings Reports how retained earnings changed over the accounting period Corporate dividends appear where drawings would appear in proprietorships or partnerships 43 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Combined Statement of Income and Retained Earnings Income Statement of retained earnings 44 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Prior-Period Adjustments Corrections for errors of an earlier period Due to the closing of accounts, the error is held in Retained earnings Correction called prior-period adjustment Correcting entry includes: Debit or credit to Retained earnings for error amount Debit or credit to asset or liability account that was misstated Reported on statement of retained earnings 45 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Reporting Comprehensive Income Change in total stockholders’ equity from all sources other than from its owners Net income plus or minus: Unrealized gains/losses on certain investments Foreign currency translation adjustments* Gains (losses) from post-retirement benefit plans* Deferred gains (losses) from derivatives* *The calculation of these items will be explained in future accounting courses. 46 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 13 Summary Stock dividends are either small (less than 20%– 25%) or large (greater than 20%– 25%). Small stock dividends are valued at the stock’s fair market value. Large stock dividends are valued at par. Stock dividends have no effect on total stockholders’ equity, but do increase paid-in capital and decrease Retained earnings. Stock splits reduce par value and market value per share. Stock splits increase the number of issued and outstanding shares. Stock splits have no effect on any general ledger accounts. 47 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 13 Summary Treasury stock occurs when a company repurchases previously issued shares. Treasury stock is a contra equity account; therefore, increases in Treasury stock decrease total stockholders’ equity. Treasury stock purchases are recorded at cost, not par. All gains/losses on treasury stock sales are reported in the stockholders’ equity accounts. Restrictions on retained earnings most often arise from loan restrictions. These restrictions usually require companies to maintain minimum levels of retained earnings, thereby restricting amounts available for cash dividends and treasury stock purchases. Restrictions must be disclosed in the footnotes to the financial statements. 48 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 13 Summary The corporate income statement extends its coverage to include items that aren’t continuing. Extraordinary items—those infrequent and unusual—are reported separately, net of their tax effect on the income statement. Earnings per outstanding common share reported for each major income statement item. The statement of retained earnings may include prior-period adjustments for corrective items. Comprehensive income includes the four items identified that aren’t normally reported on the income statement. 49 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

50 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. 51 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.