Retained Earnings, TreasuryStock, and the Income

Statement

Chapter 14

Retained Earningsand Dividends

Retained Earnings shows the amount of income allowed to accumulate from the beginning of the corporation’s life to the present.

Retained Earnings represents a claim on assets, but it is not cash.

Retained Earningsand Dividends

The balance in the Income Summary account is closed to Retained Earnings at period end.

Dividends are distributions to the stockholders.

To declare dividends there must be adequate retained earnings.

Objective 1

Account for stock dividends.

Stock Dividends

What are stock dividends? They are a proportional distribution of a

corporation’s own stock to shareholders. They do not change total stockholders’

equity. A stock dividend is a transfer of retained

earnings to contributed capital.

Small Stock Dividend Example

The dividend is valued at the product of the number of shares distributed times the market price at declaration date.

San Diego Company, with 300,000 shares of $2 par value common stock outstanding, declares a 15% stock dividend when the shares are trading at $20.

Small Stock Dividend Example

How much stock do the shareholders receive?

300,000 × 15% = 45,000 shares 45,000 at $20 per share = $900,000, and

45,000 at $2 per share = $90,000

What is the entry when the dividend is distributed?

Small Stock Dividend Example

Retained Earnings 900,000Common Stock

90,000Paid-in Capital inExcess of Par

810,00015% common stock dividend distributed

Large Stock Dividend

This significantly increases the number of shares outstanding and is likely to reduce the per share price.

A common practice is to transfer the par value of the dividend shares from Retained Earnings to Common Stock.

Large Stock Dividend Example

A 50% dividend is declared on a company’s $1 par value common.

There are 200,000 shares outstanding.

Retained Earnings 100,000Common Stock 100,000

50% common stock dividend distributed

Stock Split

This is an increase in the number of authorized, issued, and outstanding shares.

It is a reduction in the par value. The market value is usually affected

proportionately.

Stock Split

A 5-for-1 stock split means that the company would have five times as many shares outstanding after the split as it had before.

Each share’s par value would be divided by five.

Stock Split Example

Prior to a 5-for-1 split, San Diego Company had 500,000 shares of $10 par common stock authorized and 100,000 issued.

After the split, 2,500,000 are authorized. 500,000 are issued. What is the par value per share? $10 ÷ 5 = $2

Objective 2

Distinguish stock splits

from stock dividends.

Similarities Between StockSplits and Stock Dividends

Both increase the number of sharesof stock owned per stockholder.

Neither change the investor’scost of the stock they own.

Neither type of income createstaxable income for the investor.

Differences Between StockSplits and Stock Dividends

A stock dividend shifts an amount from retained earnings to paid-in capital.

The par value per share remains unchanged. A stock split affects no account balance. It changes the par value of the stock. It increases the number of shares of stock

authorized, issued, and outstanding.

Objective 3

Account for treasury stock.

Treasury Stock...

– are shares that a company has issued and later reacquired.

Purchasing treasury stock decreases assets and stockholders’ equity.

Treasury Stock Example

San Diego Company purchased 1,000 shares of its own $10 par value common stock at $20 per share (500,000 shares are authorized, 10,000 are issued.)

Treasury Stock 20,000Cash 20,000

Purchased 1,000 shares of treasury stock

Treasury Stock Example

Stockholders’ Equity(Before purchase of treasury stock)

Common stock, $10 par, 10,000 issued $100,000+ Paid-in capital in excess of par 800,000= Total paid-in capital $900,000+ Retained earnings 50,000= Total stockholders’ equity $950,000

Treasury Stock Example

(After purchase of treasury stock)

Common stock, $10 par, 10,000 issued,9,000 outstanding $100,000+ Paid-in capital in excess of par 800,000+ Retained earnings 50,000= Subtotal $950,000– Treasury stock, 1,000 shares 20,000= Total stockholders’ equity $930,000

Sale of Treasury Stock Example

No gain or loss is recognized on the sale of treasury shares.

Excess of sales price over cost is credited to Paid-in Capital-Treasury Stock transactions.

Assume that 100 shares of treasury stock are sold at $22.

Cash2,200

Treasury Stock2,000

Paid-In Capital from Treasury Stock

200Sold 100 shares of treasury stock

Sale of Treasury Stock Example

What if 100 shares of treasury stock are sold at $18?

Cash1,800

Paid-In Capital from Treasury Stock

200Treasury Stock

2,000Sold 100 shares of treasury stock

Sale of Treasury Stock Example

Sale of Treasury Stock Example

What if the resale price is less than cost? Debit Paid-in Capital from Treasury Stock

Transactions. Debit Retained Earnings if the Paid-in

Capital from Treasury Stock Transactions is too small.

Retirement of Stock...

– decreases the outstanding stock of the corporation.

Retired shares cannot be reissued. There is no gain or loss on retirement.

Objective 4

Report restrictions onretained earnings.

Restrictions onRetained Earnings

Restrictions are reported on the notes to the financial statements.

Appropriations are restrictions on retained earnings that are recorded by formal journal entries.

Retained earnings appropriations are rare. There are many acceptable variations in

format for presenting stockholders’ equity.

Variations in Reporting Stockholders’ Equity

1 The heading Paid-in Capital does not appear.

2 Preferred stock is often reported in a single amount.

3 Additional Paid-in Capital appears as a single amount.

4 Total stockholders’ equity is not specifically labeled.

Objective 5

Identify the elements of acomplex income

statement.

The Corporate Income Statement(Continuing Operations)

Allied CorporationIncome Statement

Year Ended December 31, 20x5

Net sales revenue $500,000Cost of goods sold 240,000Gross profit 260,000Operating expenses 181,000Operating income 79,000

The Corporate Income Statement(Continuing Operations)

Operating income 79,000Other gains (losses):

Loss on restructuring operations 10,000Gain on sale of machinery 21,000

Income from continuing operations before income tax 90,000Income tax expense 36,000Income from continuing operations 54,000

The Corporate Income Statement(Special Items)

Discontinued operations income of $35,000, less income tax of $14,000 21,000Income before extraordinary item and cumulative effect of change in depreciation method 75,000Extraordinary flood loss, $20,000, less income tax savings of $8,000 –12,000Cumulative effect of change in depreciation method, $10,000, less income tax of $4,000 6,000Net income $69,000

The Corporate Income Statement(Earnings per Share)

Earnings per share of common stock(20,000 shares outstanding):Income from continuing operations $2.70Income from discontinued operations 1.05Income before extraordinary item and cumulative effect of change in depreciation method 3.75Extraordinary loss –0.60Cumulative effect of change in depreciation method 0.30Net income $3.45

Analyzing the CorporateIncome Statement

Extraordinary items are both unusual and infrequent.

They are reported net of their tax effect. The environment must be considered when

determining whether an item is unusual. Accounting rules specify extraordinary

items.

Analyzing the CorporateIncome Statement

Extraordinary items include expropriations. Also, they include losses due to natural

disasters. hurricane flood fire

Analyzing the CorporateIncome Statement

Changes in accounting methods can result from either of two scenarios:

1 Adoption of a newly required accounting standard

2 Changing accounting methods

Earnings Per Share Example

On January 1, San Diego Company had 100,000 common shares outstanding.

On May 1, the company purchased 15,000 treasury shares.

On September 1, they issued 50,000 new shares.

Income for the year was $135,000. What are the earnings per share?

No. of Shares Fraction WeightedOutstanding of Year Average100,000 × 4/12 = 33,333 85,000 × 4/12 = 28,333135,000 × 4/12 = 45,000Total 106,666

EPS = $135,000 ÷ 106,666 = $1.27

Earnings Per Share Example

Earnings Per Shareand Preferred Stock

Preferred dividends must be subtracted from income subtotals (income from continuing operations, income before extraordinary items, and net income) in the computation on EPS.

They are not subtracted from income or loss from discontinued operations, or from extraordinary gains or losses.

Earnings Per Shareand Preferred Stock

Corporations with complex capital structures present two sets of EPS amounts.

1 EPS based on outstanding common shares (basic EPS)

2 EPS based on outstanding common shares plus the number of additional common shares that would arise from conversion of the preferred stock

ReportingComprehensive Income

FASB Statement 130 requires companies with certain gains and losses to report a comprehensive income figure.

Comprehensive income is the company’s change in total stockholders’ equity from all sources other than from the owners of the business.

FASB 130 New ComprehensiveIncome Components

Unrealized gains or losseson certain investments

Foreign-currencytranslation adjustment

ReportingComprehensive Income

Prior Period Adjustments...

– are corrections to the beginning balance of Retained Earnings for errors of an earlier period.

The correcting entry includes a debit or credit to Retained Earnings for the error amount.

It also includes a debit or credit to the asset or liability account that was misstated.

De Graff CorporationYear Ended December 31, 20x5

Retained earnings, Dec 31, 20x4 (original) $390,000Less: Prior-period adjustments – to correct error in the 20x4 income tax 10,000Retained earnings, Dec. 31, 20x4, adjusted $380,000Net income for 20x5 114,000 Total $494,000Deduct: Dividends declared in 20x5 41,000Retained earnings, December 31, 20x5 $453,000

Statement of Retained Earnings Example

Objective 6

Prepare a statement ofstockholders’ equity.

Statement ofStockholders’ Equity

Most companies report a statement of stockholders’ equity, which is more comprehensive than a statement of retained earnings.

Statement ofStockholders’ Equity...

– reports changes in all categories of equity during the period.

It reports stock transactions, dividends, and the effects of treasury stock transactions.

Statement of Stockholders’ Equity Example

AdditionalCommon Paid-in Retained Stock Capital Earnings

Balance, December 31, 20x4 $ 80,000 $160,000 $130,000Issuance of stock 20,000 65,000Net income 69,000Cash dividends (21,000)Stock dividends – 8% 8,000 26,000 (34,000)Purchase of treasury stockSale of treasury stock 13,000 Balance, December 31, 20x5 $108,000 $264,000 $144,000

Statement of Stockholders’ Equity Example

Treasury Stock Total

Balance, December 31, 20x4 $(25,000) $345,000Issuance of stock 85,000Net income 69,000Cash dividends (21,000)Stock dividends – 8% -0-Purchase of treasury stock (9,000) (9,000)Sale of treasury stock 4,000 17,000Balance, December 31, 20x5 $(30,000) $486,000

End of Chapter 14