The Corporate Income Statement and the Statement of Stockholders Equity

CHAPTER 12 The Corporate Income Statement and the Statement of Stockholders’ Equity

REVIEWING THE CHAPTER Objective 1: Define quality of earnings, and identify the components of a corporate income statement. 1. The most commonly used predictors of a company’s performance are expected changes in earnings per share and expected return on equity. Net income is a key component of both measures. 2. Because net income is so important in measuring a company’s prospects, it is equally important to evaluate the quality of the net income figure, or the quality of earnings. The quality of earnings refers to the substance of earnings and their sustainability into future accounting periods. It is affected by the accounting methods and estimates that management chooses and by the gains and losses, write-downs and restructurings, and nature of the nonoperating items reported on the income statement. Management also has choices about the content and positioning of these income-statement categories. 3. Net income or loss for a period includes all revenues, expenses, gains, and losses. A corporate income statement may therefore contain many line items and subtotals. On the income statement of a corporation that has both continuing and discontinued operations, the operating income section is called income from continuing operations. This section, which includes revenues, costs and expenses, gains and losses on the sale of assets, write-downs of assets, and restructurings, is followed by a section on income taxes. Appearing below that are nonoperating items, such as discontinued operations, extraordinary gains and losses, and the write-off of goodwill that has been impaired. Earnings per share data appear at the bottom of the statement. 4. The different estimates and methods that management can choose for dealing with such matters as uncollectible accounts, inventory, and depreciation produce different net income figures. In general, an accounting method or estimate that produces a lower, or more conservative, figure produces a more reliable quality of earnings. Management’s choices about how nonoperating and nonrecurring items are reported on the income statement also affect the “bottom line.” Financial analysts should therefore look beyond the net income figure to the notes to the financial statements, where generally accepted accounting principles require full disclosure of the significant accounting methods used in preparing the statements and any changes in those methods. 5. Although gains or losses on the sale of assets appear in the operating section of the income statement, they usually represent one-time events. They are not sustainable, ongoing operations, and management often has some choice as to their timing. Analysts should therefore ignore them when considering operating income. 6. A write-down (also known as a write-off) is recorded when the value of an asset drops below its carrying value. (Write-downs are reflected on both the balance sheet and the income statement.) A

restructuring is the estimated cost of altering a company’s operations, often involving plant closures and layoffs. Write-downs and restructurings are frequently an indication of bad management decisions in the past. Both reduce current operating income; however, because they shift future costs to the current period, they make it more likely that future earnings will show improvement. They are therefore often taken when a company is having a bad year anyway or when there is a change in management. 7. Generally speaking, gains and losses, asset write-downs, restructurings, and nonoperating items have no effect on cash flows; the cash expenditures for these items were made in previous periods. However, sustainable earnings generally do have a relationship to future cash flows. Objective 2: Show the relationships among income taxes expense, deferred income taxes, and net of taxes. 8. A corporation’s taxable income is determined by subtracting allowable business deductions from includable gross income. Tax rates currently range from a 15 percent to a 39 percent marginal rate. 9. Income taxes expense is the expense recognized in the accounting records on an accrual basis that applies to income from continuing operations. It may or may not equal the amount of taxes actually paid and recorded as income taxes payable in the current period. The difference arises because generally accepted accounting principles govern how income taxes are computed for financial reporting purposes, whereas the Internal Revenue Code dictates methods of computing income taxes owed to the federal government. 10. When income computed for financial reporting purposes differs from taxable income, the income tax allocation method should be used. Under this method, the difference between the income taxes expense and income taxes payable is debited or credited to an account called Deferred Income Taxes. This account is evaluated yearly to determine whether changes in income tax laws and regulations have made adjustments necessary. 11. Deferred income taxes are the result of temporary differences in the treatment of certain items (such as depreciation) for tax and financial reporting purposes. They are classified as current or noncurrent, depending on the classification of the asset or liability that created the difference. 12. To avoid distorting net operating income on the income statement, certain items must be reported net of taxes—that is, after considering applicable tax effects. These items are discontinued operations and extraordinary gains and losses. Objective 3: Describe the disclosure on the income statement of discontinued operations and extraordinary items. 13. Segments are distinct parts of a company, such as a separate major line of business or class of customer. Any gain or loss on the discontinued operations of a segment must be disclosed on the income statement separately from continuing operations and net of taxes. 14. Extraordinary items are events that are both unusual in nature and infrequent. Gains and losses arise from such extraordinary events as natural disasters, theft, the passage of a new law, and a foreign government’s takeover of property. Extraordinary gains and losses that are material in amount should be disclosed separately on the income statement (net of taxes) after discontinued operations. Objective 4: Compute earnings per share. 15. Readers of financial statements use earnings per share of common stock to judge a company’s performance and to compare it with the performance of other companies. Appearing on the income statement just below net income, the earnings per share section always shows (a) income

from continuing operations, (b) income before extraordinary items and the cumulative effect of accounting changes, (c) the cumulative effect of accounting changes, and (d) net income. 16. A company that has issued no securities that are convertible to common stock has a simple capital structure. In this case, the income statement presents only basic earnings per share, which is calculated as follows: Net Income − Nonconvertible Preferred Dividends Weighted-Average Common Shares Outstanding

17. A company that has issued securities that can be converted to common stock has a complex capital structure. Potentially dilutive securities, such as stock options and convertible preferred stocks or bonds, are so called because they have the potential to decrease earnings per share. When a company has a complex capital structure, its income statement must present both basic and diluted earnings per share. Diluted earnings per share shows the maximum potential effect of dilution on the ownership position of common stockholders. Objective 5: Define comprehensive income, and describe the statement of stockholders’ equity. 18. Corporate financial statements should report comprehensive income—that is, the change in a company’s equity from sources other than stockholders during an accounting period. Comprehensive income includes net income, changes in unrealized investment gains and losses, and other items affecting equity. Although sometimes reported in a separate statement or in the income statement, comprehensive income is most often reported in the statement of stockholders’ equity. 19. The statement of stockholders’ equity (also called the statement of changes in stockholders’ equity) is often used in place of the statement of retained earnings. It is a labeled computation of the changes in stockholders’ equity accounts during an accounting period. It contains all the components of the statement of retained earnings, a summary of the period’s stock transactions, and accumulated other comprehensive income, such as adjustments for foreign currency translations. 20. Retained earnings are the profits a corporation has earned since its beginning, minus any losses, dividends declared, or transfers to contributed capital. Ordinarily, Retained Earnings has a credit balance. When a debit balance exists, the corporation is said to have a deficit. Retained earnings are not the same as cash or any other asset; they are simply an intangible representation of earnings “plowed back into the business.” Objective 6: Account for stock dividends and stock splits. 21. A stock dividend is a proportional distribution of shares among stockholders. A board of directors may declare a stock dividend to (a) give evidence of the company’s success without paying a cash dividend, (b) reduce the stock’s market price by increasing the number of shares outstanding, (c) make a nontaxable distribution to stockholders, or (d) increase the company’s permanent capital. A stock dividend results in the transfer of a part of retained earnings to contributed capital. For a small stock dividend (less than 20 to 25 percent of outstanding common stock), the market value of the shares distributed is transferred from retained earnings; for a large stock dividend (greater than 20 to 25 percent), the par or stated value is transferred. A stock dividend does not change total stockholders’ equity or any individual’s proportionate equity in the company. 22. A stock split is an increase in the number of shares of stock outstanding, with a corresponding decrease in the par or stated value of the stock. For example, a 3-for-1 split on 40,000 shares of $30 par value would result in the distribution of 80,000 additional shares (i.e., someone who

owned one share would now own three shares). The par value would be reduced to $10. A stock split does not change the number of shares authorized or the balances in stockholders’ equity. Its main purpose is to improve a stock’s marketability by pushing its market price down. In our example, if the stock was selling for $180 per share, a 3-for-1 split would probably cause its market price to fall to about $60 per share. Although a stock split does not have to be journalized, it is appropriate to document it with a memorandum entry in the general journal. Objective 7: Calculate book value per share. 23. The book value of a company’s stock represents the company’s total assets less its liabilities. It is simply the stockholders’ equity or, to put it another way, the company’s net assets. If a company has common stock only, the book value per share is computed by dividing total stockholders’ equity by the number of outstanding and distributable shares. If the company also has preferred stock, the call or par value of the preferred stock, plus any dividends in arrears, is deducted from stockholders’ equity in computing the book value per share of common stock.

Summary of Journal Entries Introduced in Chapter 12

A. (LO 2) Income Taxes Expense XX (amount per GAAP) Income Taxes Payable XX (currently payable) Deferred Income Taxes XX (eventually payable) To record estimated current and deferred income taxes

B. (LO 6) Stock Dividends XX (amount transferred) Common Stock Distributable XX (par value amount) Additional Paid-in Capital XX (excess of par) Declared a stock dividend on common stock

C. (LO 6) Common Stock Distributable XX (par value amount) Common Stock XX (par value amount) Distributed a stock dividend